Small Caps | Mar 03 2014
-Margin expansion ahead
-Significant de-gearing expected
-Most risk potential from US budget
By Eva Brocklehurst
Ship builder Austal ((ASB)) has pleased brokers with margin expansion evident in the US operations. The first half profit of $14.3m beat both Macquarie's and JP Morgan's forecasts. The brokers expect further de-risking of the business in the second half given the company should receive proceeds from the sale of surplus land and a stock vessel.
The major risk to the company's outlook remains with the large contracts for the US Navy, and the potential for the US government to pull the plug on expenditure in order to rein in its budget deficit. Still, the brokers are happy with what the company already has under its belt and the margin improvement provides increased confidence in the outlook.
Macquarie believes the risk/reward is tipping investors' way. What could knock the share price around a little is the US congressional debates and related press articles. This is because of the cloud that hangs in the form of potential cuts to the US budget. Whether Austal has its programs cut will depend on the relative expense, construction speed and the need to fill capability gaps against overall budget demands. This is one area out of Austal's control. In the other areas, Macquarie estimates net debt will fall to $56.6m by June and, should the stock vessel be sold, this would mean the balance sheet becomes almost free of net debt by the year's end.
Macquarie observes US earnings are still key to the future of the company and growth will be driven by the ramping up of work on both of the Navy contracts and improving contract performance on Joint High Speed Vessels (JHSVs). Macquarie also expects the Australian yard to benefit from the revenue from the Australian Customs patrol boat contract. Prolonged weakness in the European fast ferry market has made Austal focus its Australian yard on defence. Austal is currently bidding on a number of programs which can be built at its Perth yard.
One item of positive interest for Macquarie is that in the contest for contracts for the US Navy's Littoral Combat Ships (LCS), Austal's vessel is now cheaper than the competing Lockheed item. This is important to a budget-constrained world and Macquarie expects the operating and maintenance costs of the Austal version will prove considerably cheaper over time. The contract structure is a fixed price incentive deal and the US Navy has a long-term target to acquire around 50 LCS. Austal was recently awarded a US$682m contract to build two LCS, the seventh and eighth that have been ordered from the US Navy and the fifth and sixth under a 10-ship block buy contract awarded in 2011. Macquarie estimates the total contract will add US$700m to annual revenue by FY15. In terms of the JHSVs, a troop and equipment carrying ferry, this is expected to deliver annual revenue of $280m per annum.
JP Morgan observes the company's revenue is on track for $1bn in FY14. The relatively geared balance sheet meant cash flow was a strong focus for the past few months but the broker expects cash flow will improve in the second half. The land sale, completed in January, is expected to provide proceeds of $17m. The company has also entered a "option to purchase" contract with a European ferry operator for the stock boat that has been sitting on the books for some time. JP Morgan estimates the carrying value to be $60m and management expects the sale to complete in the second half. The broker has an Overweight rating and $1.11 price target.
The pipeline of work is considered significant with the US Navy contracted out to 2017 and for possible extensions to 2019. This is the key driver of margin and the operation is now close to running at full capacity on the JHSV and LCS programs. JP Morgan is increasingly confident that management can reach the target of an 8% margin in FY16. Such a result will increase shareholder value and enhance the return profile, in the broker's opinion.
The company's Philippines operations also provided increased revenue in the half, driven by the completion of contracts including the delivery of the 80m high speed Aremti ferry.
In sum, Austal has a $2.4bn order book, with Macquarie noting it includes six funded LCS for the US Navy out of a 10 vessel contract and 2 JHSVs funded and delivered out of a 10 vessel contract, One Australian Customs Cape Class Patrol Boat has been delivered out of an eight-vessel contract and there are three 27-metre and one 21 metre wind farm support catamarans. Macquarie retains an Outperform rating and $1.17 target.
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