Babcock International Group PLC (BAB) Earnings Call Transcript & Summary

Hello, and welcome to the Babcock International Business update. My name is Rosy, and I'll be your coordinator for today's event. Please note, this call is being recorded. [Operator Instructions] I will now hand you over to David Lockwood, CEO, to begin today's conference. Thank you.

Thank you, and good morning, everyone, and thank you for taking time to join today's call. I'm going to give you a brief overview of this morning's announcement, and then David will give you an outline of the numbers before we go to Q&A. So I guess, back in January, we announced that we were looking at many areas of the business, starting with our strategic priorities, a new operating model to deliver those priorities and a contract profitability and balance sheet review to set the right financial baseline. Today, we're giving an early update on these areas, plus the first look at our full year results. These are being shared to give early transparency in all these key areas. What's the headline at its core. Babcock is a good business, and we have a route to restore the group to strength without the need for an equity reissue. This route includes self-help measures through the simplification of the business, taking out layers of complexity and generating proceeds through the rationalization of our portfolio in line with the strategy. And I think it's important to say that this is a rationalization in line with the strategy. We're not selling just to raise funds. Looking forward, we'll focus on being an international aerospace, defense and security company. We have a leading naval business, and we offer value-add services in many areas from land and air defense, to civil nuclear and through support in emergency services. We will focus on 5 countries, the U.K., France, Canada, Australia and South Africa. We see many opportunities across these markets in the medium term, and our new operating model and people strategy will help us maximize this potential while creating a better place to work for our employees. With that, I'll pass over to David, who will take you through the headline financials.

Thanks, David. So the one point to stress upfront which it says in the announcement, these are our early view of the numbers. We've literally just shut the year-end books, and we're going for year-end process and audit now. And obviously, there are a lot of adjustments here. We'll give you more details in -- when we do our preliminary results. We've also said that given the constraints of going through the year-end process and audit under COVID-19 restrictions and the volume of work we're flagging that there could be a delay in our preliminary results, and we will update you on a date as soon as we can. So to just run you through the headline numbers. Underlying revenue was GBP 4.7 billion, including our share of joint ventures, down 2% on last year, excluding FX and disposals. Underlying operating profit was GBP 307 million. This also includes our share of joint ventures but it's before the impact of the contract profitability and balance sheet review numbers, which we'll come on to. Closing net debt was GBP 750 million, and that benefited from 3 things that we've called out. The VAT deferral of GBP 56 million. That's a timing difference. Some corporation tax repayments of GBP 67 million. That's a one-off that we received in the second half of the year. And some foreign exchange translation benefit of about GBP 20 million. So that's where we closed the net debt position. We've also said, as we've done the last couple of times, we've given you the average net debt on a monthly basis, which is around GBP 1.2 billion so we're still a period end -- we still have period end cash management within the business, and that will unwind over time as we make it a more linear and predictable business. Then the net debt to EBITDA, our gearing ratio is 2.5x on a covenant basis at the year-end. So now if I just go on to the headlines of the contract profitability and balance sheet review, that we've set out the numbers in the release today. The total of the impairments and charges altogether is about GBP 1.7 billion. Most of this is one-off and noncash and includes about GBP 1 billion of goodwill and acquired intangible impairment. The ongoing impact of profitability is around GBP 30 million for future periods. That number is about GBP 20 million in FY '21, about GBP 30 million going forward. And we'll run you through, obviously, all the details when we do our preliminary results, but we put the 5 key balance sheet captions in the statement today with the approximate numbers for each and the items that have caused it. And finally, although we're not giving an outlook today because this is just an early view, we are stressing that with all the changes that we've outlined, FY '22 will be a transition year for obvious reasons. And therefore, we're cautious about the progress that we can make on the reported numbers in FY '22. So with that, I'll now hand back to David for Q&A.

Thank you, David. And with that, we'll go to the operator.

[Operator Instructions] And our first question comes from the line of Kean Marden from Jefferies.

I have a few, if I could, maybe focus on sort of free cash flow and balance sheet just initially.

Can we do one at a time though, because it's easier that way.

Yes, quite short anyway. So don't worry, I'm not going to ramble for ages. So just on the March 21 balance sheet. So you called out some tailwinds to the net-debt number, but they don't fully explain the gap between consensus and the GBP 750 million that you've reported. So I'm just wondering if you've made any progress on the working capital line or anything else that you'd like to call out there? And as an adjunct to that, just initially on that balance sheet question. Why is the gap between period end and average net debt expanded a bit during the year. So it looks like it's sort of GBP 400 million to GBP 450 million. You were guiding to GBP 350 million. That's the first topic of discussion, please.

Okay. I'll pick that one up. So the gap between average and closing, if you take the 3 things that we've called out in the statement, so VAT timing, the corporation tax, which is a permanent one-off cash inflow that we received and the FX translation, then the gap between closing and average is about the same as it was at the half year, slightly less and slightly less than it has been before. So as I said, there is still a period end focus to the way the business has driven cash, which we will change over time. But those 3 things will get you to about the same level of GAAP as you've seen before, it's actually slightly less.

Okay. And there's no -- okay. That's fine. And then secondly, I think initially, during meetings with analysts last September, you expressed the view that you could return the business to GBP 250 million of free cash flow generation. Do you still stand by those comments now?

So I wasn't here in September. I only joined at the end of November.

It's not -- the question is not just to you, sorry, apologies, I should have been clear.

Okay. So my recollection of what Franco said, was that the company had made GBP 250 million of free cash flow in a 12-month period, but that definition of free cash flow included disposal of businesses and the VAT deferral, which accounted for the vast majority of it. I'm looking at Simon McGough if that's what I recall you said, is that correct?

And exceptional. And exceptional cash.

So before exceptional cash, it was made up of those 3 components. So I don't think Franco said that there was return to GBP 250 million because we had a different definition of free cash. But we can talk about free cash more generally, David?

Well, I think the way once we do our preliminary results, and we're able to give you more detail. The way I would think about it going forward is we've said in the statement we're going to simplify the results by taking out the joint ventures from profit and equity accounting as per the standards. So what we will be looking at going forward is an operating profit number, which is due to our own subsidiaries in the business we run. We would expect to be able to deliver for a cash conversion number from that operating profit and that's what we would hold ourselves and the businesses to account for is the level of cash conversion. Below that, of course, you've got interest tax and the pension deficit payment and we can talk about those in more detail at the preliminary results, but it should be simpler to see what a good cash conversion would be on the operating profit when we've stripped out the joint ventures. And then, as I say, it's interest, tax and pension deficit below that, that gets you to a free cash.

Yes, I agree...

But you will have to wait till next time.

The next question comes from the line of Anvesh Agrawal from Morgan Stanley.

I just got a couple of questions. Maybe if you can -- first, you're obviously expecting a GBP 20 million, GBP 30 million negative effect, which is ongoing. Can you just let us know how long you expect this sort of impact to continue? And what are like your initial long-term margin assumptions for the business are? And then maybe just more sort of clarity on the planned disposable where you expect them? And how do you sort of expect to -- expect it to pan it out over the next 12 to -- 12 months or so?

Okay. Well, I'll do disposals, while David thinks about the best way to answer margin. So we've said a minimum of GBP 400 million in 12 months. Clearly, this is strategically driven, not need based. So when we lay out the strategy in the prelims, we'll be able to talk about this more thoroughly. So we have got identified businesses that we think would be more appropriately owned by somebody else. And we have got identified processes for those, which enable it to happen within 12 months. So as I say, by the time we get to the prelims, I hope we'll be able to be more -- but we will be more specific because in laying out the strategy in more detail here. It will become clear.

So on the points about margins, I mean, obviously, we're not giving guidance today. We're just doing the early view of the numbers. But when we simplified the accounting so that we don't put in operating profit, what you'll see is the actual trading margin that we're at with the businesses. And we've obviously given you a steer as to what the impacts of things like the operating model would be. And -- so I would start with where are we today. And within the numbers and obviously, because we've used the same format as before we've included the joint ventures. But you can work out from the half year statement that joint venture revenues that are included in that GBP 4.7 million would be of the order of GBP 300 million. And the joint venture profit that's included within the GBP 307 million would be of the order of -- at GBP 60 million. So the way we will report going forward, we would strip those out, and that gives you a picture of where we are currently operating. Obviously, we're not giving forward guidance at this point, but at least you've got a start point there.

Yes. And -- but then at least given your statement around the impact from that start point, at least, we expect the margins to go down at least for FY '22 before sort of any underlying improvement we can forecast, that's at least a fair way to sort of model the business right now?

So the number we've given you is for future periods because the contract and balance sheet view is about GBP 30 million, whereas in '21, it's about GBP 20 million.

So the next question comes from the line of Suhasini Varanasi from Goldman Sachs.

A couple of questions from me, please. I'll just go through them one by one. In the first page of your press release, you mentioned that you will be revising your forecast for profitability for future periods as you continue to assess the business. I just want to check if this is just caution or if we should expect further reductions on profitability in the future years as you revisit these contracts?

So we -- so we're revisiting our internal budgets and forecasts now, and we'll be able to report out more in -- when we do our preliminary results. The impact we expect from the contract profitability and balance sheet review for future periods will be about the GBP 30 million. Of course, that might change when we finalize the numbers, but we're not expecting it to change materially. It's the underlying forecast that we'll be looking at over the next 2 months, if that helps.

Got it. And the second one is on the disposal proceeds, please. Can you maybe give us some color on the scale of revenues and profits in total that's up for sale? And whether you are already in discussions with potential buyers at this point in time?

So I think we'll -- the aim is to cover that fully at the prelims. I think any half answer to this actually makes the problem harder, not easier. So we'll answer that at the prelims.

The next question comes from the line of Joe Brent from Liberum.

A couple for me as well, if that's okay. If we -- I know you're reluctant to give guidance. But if we look at the old basis of accounting and rebase FY '21 to around GBP 300 million. Is there any reason that number wouldn't grow given that FY '21 already had quite a big COVID effect and you'd hope that COVID effect gets less in FY '22?

Well, I'll do the COVID effect first. The single most important COVID effect for us is social distance working and probably efficient part of home working because this part of home working is greater to the inefficient parts of home working. If I take our largest site at Devonport, we still have nearly 50% of people permanently homeworking, and we still have social distance working on the frigate and in the submarines. So I think this idea that we're working -- that we're through it is not valid. And we really need that. That's the restriction we need to change that we can move to effective, what we're calling agile working, which is the best of the old and the best of the new. So we've got a target -- when we talk about operating model, that includes how we work. So we need to be able to move to that. And then for people who actually do the physical work, we need to work in a non-socially distance way to get back to where we were. And I don't see that fully happening in H1 at all. So that's very difficult to predict the benefit year-on-year. Do you want to answer the second part?

Well, and also, of course, COVID apart, it's a year of huge change. And we've said that in the statement, it's a year of transition. So we're changing the operating model of the whole group. And that is quite a big thing to do. We're also -- we've already said we started 3 disposal proceeds. And there are many other changes going on. So -- but that's -- that is the big transformation going on internally. And while all that is happening at the same time, I think we would be cautious as to what you can actually deliver in that year of change. It obviously sets the company up very well for future periods. But in that year of change, I think we should take a cautious view.

A lot others, but I'm going to ask one because you're busy. But on leverage for FY '22, if we assume you don't -- assuming you do make the GBP 400 million of disposals, what sort of leverage do you think that might leave you with at the year-end? A band would be good. And I think you said you can get to your target leverage into maybe 36 months, something like that. What's -- what is an acceptable leverage for you of the business going forward?

I will do the second one because the first one sounds like math's, so it's David's. Leverage is a function of where you get to a new business model and your risk appetite. As we look at how the opportunities develop and we look at the certainty we can drive into the business, when historically, we said 1.0 to 1.5x. And I don't think that's an unreasonable start place. I mean, would you go beyond 1.5 if you can de-risk the business. I think that's part of the Board's ongoing strategic assessment in the next 12 months.

And if you're looking at the shorter term, I mean, you will remember that the company has agreed to put extra pension deficit repair payments into the Rosyth scheme about, well, GBP 50 million extra this April and GBP 50 million extra next April. So that's obviously a short-term headwind and then there's the reversal of the timing differences around this period end's net debt position. So we called out the VAT in detail here, but you've also seen the difference between average and closing net debt. And that will reverse over time, not necessarily all in 1 year, but we will reverse that out so that we have a more linear business. So in the short term, there are some headwinds, but we do think a combination of the operating improvements and potential divestments get us to where we need to be in that time frame.

The next question comes from the line of Sash Tusa from Agency Partners.

I've got 3 questions. I'll ask them brief. First of all, just in terms of where the write-offs are, the fact that you have deemphasized Italy and Spain suggests that a very substantial proportion of the write-offs in impairments relate to Avincis. I just wondered if you could confirm that. And if there's any other major single focus for the write-offs in terms of previous acquisition?

so that -- we'll have to give you more at the preliminary results. So we're not going below group level today. This, as I say, this is just an early view of where we are at a total level. So we'll do the detail next time.

Okay. And then the other question that I will ask at the group level. I can understand that you feel that the reporting treatment of joint ventures is rather contaminated the view of operating profitability and the gap between that and cash flow. But on a broad level, does this mean that you are anti-joint ventures in this business because they do that? And hence, does that mean that you would just chew projects that require some sort of joint venture structure simply because you would rather be smaller and cleaner rather than larger and more joint?

No. So if I think about -- in our pipeline, there are several bids ongoing where we operate in some form of joint venture arrangements. Some of them are effectively special purpose vehicles to combine talents of organizations. Some are legal entities. What we're saying is that we should -- once we enter into a structure, we should account for it in accordance with the rules that apply to that structure and not say it was something it isn't. So they can still be a very good way of delivering our capability to market. In the right circumstance, we just want to account for them more simply.

Yes. And I'd emphasize that. I mean, you use work contamination. I certainly didn't. I think this is just perhaps patience so that we can see what the results, the margins and the cash that our owned businesses deliver. And we can see what our share of the results and share of the dividends are that our joint ventures deliver. So it's just a simplification.

[Operator Instructions] So our next question comes from the line of Thierry Anid from Citigroup.

I'm just trying to think about what should we think about ratings going forward? Currently mid-BBB on outlook negative. How do you intend to manage the business? Obviously, it's going to be dependent on your view on the capital structure, but like would you be comfortable with 1 or 2 notch lower than your current rating? That's my first question. And then you were talking about a discussion with banks in order to secure the protection. Can you give you a bit of color on that? Is it like extending your liquidity through RCF and like easing the covenants as well?

Okay. So I'll answer both of those generally rather than specifically. Obviously, we do look at our credit rating as something of great importance. We obviously don't control it. But we are determined to get ourselves back to a strong balance sheet, obviously, under our own steam, and that should play well into the medium- and long-term in terms of rating. In terms of banks, we've said that we are commencing discussions with them to protect the downside risks. There are certain things, obviously, that are not entirely within our control from a timing and quantity point of view like disposals. Obviously, our plans and the route we have -- we should be fine, as we say. But we do need to make sure that we've got all angles covered. And so we will be talking to them to make sure that these things go according to plan for the things we don't control that we've got those plans covered too.

Okay. And just a follow-up. In terms of off rating, do you have like sort of margin hedging that would increase if the rating were to be lower or this shouldn't be an issue?

Look, there'll obviously be several impacts, none of which I'll go into specifically now. So we factored in what we think might be certain risks. There's nothing material that I'd pull out for you now.

The next question comes from the line of Allen Wells from Exane BNP Paribas.

Just a couple from me. I'll take them one at a time, if you prefer. You alluded to this earlier, but can I just ask just for some clarification on those cash commitments over the next 12 to 18 months. Obviously, you talked about GBP 140 million of combined kind of tax deferral impact. You've alluded, I think, to the pension payments, which I think you said was GBP 50 million this year, GBP 60 million next year. Where are things like the Avincis line? Is there any additional kind of CapEx catch up requirements for things like ship building in there? Just to get a bit of an understanding of what the kind of slightly unusual cash headwinds might be and in terms of an update there for '22 and '23.

Yes, sure. So while you picked out the big ones already. So just the 2 specifics that you mentioned that we hadn't answered earlier, there is no update on the Italian situation. And as and when there is one, we'll let you know. So no update there. And on CapEx, yes, we do expect a few tens of millions to finish off the spend in Rosyth. So that will be largely during the first half of this year.

Okay. And then second question, just on the leverage. Obviously, you provided the net debt numbers ex leases. Could you just let us know to what extent you can, the year-end lease balance? And maybe just how much of that is of Avincis or the older Avincis business, part of which is obviously in the process of being sold and the rest of it, you kind of alluded to be under review?

So I'll give you the net debt including leases, which is about GBP 1.4 billion. At this stage, I won't split that down into where it comes from the different businesses, although you've got last year's annual report. And so GBP 1.4 billion, including leases.

Okay. And the very final question. Just to try and ask Sash's question slightly differently. When you talk about the GBP 30 million lower profitability moving forward, how much of this is potentially none -- it's what I call core business, none of it, I'm just thinking about, if that business is sold does some of that reduced profitability just dropped away with the sale? Or is this more around core impacts in that reduction?

Yes. So okay. So look, we haven't split out the impacts, either the one-offs or the recurring by sector or business at this point and nor we expect to because it is just an early year. So we haven't split that out. But the impact does cover a number of the businesses. We're not commenting on what is going to be disposed of at this point. So to the extent that anything would impact that GBP 30 million going forward, if we decided to divest, we would obviously update you if it was material.

The next question comes from the line of James Beard from Numis Securities.

I've got one question around net debt. You obviously like the difference between average net debt in period and net debt in here. What is your sort of ideal view of what that difference should be once you made the portfolio changes that you're planning to make? And how do you get there?

So okay. So simplistically, I don't think there should be a big difference, but it will take a little bit of time to get there. I think it's as much a cultural point as an operational point. So we will be focusing on cash flow as a priority measure 52 weeks a year. And the period end, therefore, in a sense, gets deemphasized. Now you don't do that overnight. So it takes some time to get there and contracts that have been set up or bids that have been set up in a particular way, need to run their course. So over the period of time that we've talked about here, 24 to 36 months, we would expect that to normalize. There's always a little bit of a spike around a period end in any business, but it shouldn't be that great.

Our final question for today is a follow-up from Kean Marden from Jefferies.

It's absolutely, I think, mainly from a few investors who've been IDing me. So -- and it's just on that balance sheet point again. So would it be right in thinking that the 1.0 to 1.5x reasonable net debt-to-EBITDA range that you referenced earlier. Along the way there, that would assume that the average net debt to period end reduces quite substantially. The invoice discounting, so the sort of circa GBP 100 million, utilization of that completely disappears and the GBP 450 million actuarial pension deficit, what assumptions have you made regarding dealing with that in that 1.0 to 1.5x ratio, please?

Okay. So firstly, we haven't actually updated a target capital structure. So David referenced what the group had previously said. I'm not, Marden, in any sense, saying that, that isn't reasonable. I'm just saying we haven't given the target than today. However, we definitely want a strong balance sheet and 2.5x is not as strong as we would like. So we obviously will be on that journey. And over that period of time, as I've already said, I would expect the gap between average and closing to narrow. I think over that period of time, you can see from the announcement today, we have slowed significantly and will stop the use of supply chain financing. Over a period of time, we will obviously stop the use of factoring, too. In terms of pensions, we don't actually have all the year-end numbers yet on pensions. So I can't necessarily help you on that. Obviously, pensions is a longer-term point rather than the shorter term working capital points that we've just listed out. We'll obviously meet all our pension obligations as they fall due, but they are slightly longer-term than the other points you raised.

We have come to the end of our Q&A session. So I will now hand back to David Lockwood for any closing remarks.

Okay. Well, thank you, everyone. I hope you found the statement, and this presentation helpful. And we look forward to coming back to you with the prelims and the answer to the questions that you'll have then. So thank you very much.

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