Austal Offers More Questions Than Answers

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Can a revived order book and the transition of its business model turnaround near-term uncertainty and any reputational damage overhanging shipbuilder Austal?

-Austal shares look grossly undervalued, but brokers see plenty of uncertainty
-A declining order book in particular is seen as a major negative
-Austal has the potential to win new contracts, reversing negative momentum
-Reputational damage remains an added overhang

By Mark Story

Tough operating conditions saw shipbuilder Austal’s ((ASB)) half-year to December revenue ($840.3m), drop -19.1% on the previous corresponding period, including added headwinds from a higher USD/AUD exchange rate, a lower throughput in the US, and a reduction in Australasia commercial shipbuilding volume, following the delivery of three large ferries.

Covid-related travel restrictions also affected demand for commercial ferries in the past 12 months, and Austal’s sustainment services in the short to medium term.

However, the market took some solace from the recent successful delivery of Hull 419 by Austal’s Philippines business to Fjord Line of Norway. Despite the market’s enthusiasm for the Norway delivery, which gave the share price a badly needed kicker, the shares are still trading well down on the last 12 months.

Given the many question marks, Citi ponders whether there is deep value emerging in the shipbuilder’s lagging share price, which has largely been off radar for most investors.

The shares have gradually trended lower since peaking at $4.50 in September of 2019 and are trading around $2.40 in the second week on March 2021, despite value stocks making a fierce come-back since late 2020.

When backing out the support business, for which Citi assumes a multiple in line with global defence peers, the broker estimates investors are paying only around 4x earnings (EBIT) for Austal’s shipbuilding business, which is a whopping -56% discount to peers.

In Citi’s view, this sizeable discount reflects the market’s limited faith in Austal’s ability to replenish its shipbuilding pipeline, despite multiple opportunities in the US, Australia and the Philippines.

Given the company still has an order book of $2.9bn and multiple opportunities, Citi believes the discount appears high.

The robust nature of the company's balance sheet, with $166m of net cash at first half, should provide Austal with capacity for acquisitions or to return capital to shareholders. Citi suspects Austal may use its strong cash position to acquire a dry dock facility in San Diego, which the company currently lacks.

The broker also notes a key upside risk to its $3.30 target price is Austal winning a new US defence contract, and Asian defence opportunities.

Commentary provided by company management indicates anticipated baseline revenue for FY22 is currently $1.4bn (based on AUD/USD at 0.77), including contracted shipbuilding, the expeditionary fast transport (EPF 15) program which has been appropriated but not yet awarded, and support revenue at the first half run rate.

But given that Guardian Class Boat Patrol (GCBP) and Cape Class Boat Patrol (CCPB) alone constitute $1.3bn of the company’s top-line in FY22, Credit Suisse regards $1.4bn baseline guidance as conservative.

Due to recent weakness in share price, the broker has upgraded the stock to an Outperform from Neutral rating on valuation grounds.

But Credit Suisse notes that less favourable foreign exchange moves, and defence funding and program award decisions, particularly in the US, could pose a risk to its rating.

Despite the many headwinds, and ongoing question marks, Citi also rates the stock a Buy. The broker’s $3.30 price target suggests considerable upside (38%) if the tide turns for Austal.

Citi's Buy rating is carried by the belief Austal has multiple opportunities to replenish its US order book, while there is increased focus on smaller autonomous ships in the US, plus revenue should increase as more Littoral Combat Ships (LCS) and Expeditionary Fast Transport (EPFs) enter service.

Citi also notes naval shipbuilding opportunities are emerging in Asia.

Declining order book

While Austal indicated it has an aspirational long term support revenue target of $500m, Shaw and Partners believes shorter term order book issues remain concerning.

The broker wants to see greater evidence that the longer-term pipeline of construction work in the US business is being rebuilt from FY24 onwards.

A declining order book for shipbuilding and now also relative weakness in sustainment at least through 2021 are, from Shaw’s perspective, key reasons why the near-term outlook for Austal remains uncertain.

Echoing similar sentiment, Macquarie concedes while Austal’s many growth ambitions help underpin current valuation, new contract wins are required to build the pipeline beyond FY22.

While earnings (EBIT) improvement, driven by better shipbuilding margins in both the USA and Australasia, was encouraging, the broker wants to see new contract wins to boost current FY22 revenue above current circa $1.4bn baseline guidance.

Macquarie also wants to see greater confidence in the US operations sustainability beyond the LCS program, which is expected to wind down late FY23/24.

Battling reputational issues

Order book issues aside, Shaw suspects various investigations and findings by regulatory authorities here in Australia and the US, that put Austal’s reputation into question –which culminated in the resignation of the US CEO late February- also remain an overhang for the company.

However, what’s encouraging observes Shaw is management’s insistence that the reputational risk from these investigations is limited. Austal has outlined several potential awards/contracts that could improve the outlook for revenue over the coming years.

These include SEC East panel in the next month or so, SEC West later this year, the first steel order from the US Navy by end of 2021, and Several US Navy steel (and the autonomous EPF) programs are likely to be awarded in FY22-23, which coincide with the launch of Mobile’s steel capability in mid-2022.

What’s also encouraging, adds Citi, are the Australian Government’s 2020 Force Structure Plans for investment of $50bn in naval shipbuilding till 2030, which could be a significant opportunity for Australian defence manufacturers like Austal, especially given the government’s focus on local sourcing and maintaining a healthy shipbuilding base.

While acknowledging the near-term risks from a current lack of visibility on post 2022 work, Shaw views Austal as attractively valued versus peers.

Based on the discounted valuation, and on balance more likely positive than negative catalysts, Shaw continues to rate the company a Buy.

Operational risks

Ord Minnett equally remains cautious on the company’s outlook. Fuelling the broker’s caution are the operational risks as the business transitions its business model, including deploying capital, and market earnings expectations as the business moves from profitable mature programs -70% of group earnings (EBIT)- to new and as-yet-unawarded steel shipbuilding programs.

While Macquarie maintains its Outperform recommendation, it also shares Ord Minnett’s order book concerns, with the failure to win new contracts in FY21/22- to ensure continuity of US operations- as the key risks to its recommendation.

Ord Minnett notes that after losing out on the FFG(x) (guided-missile frigate) program to a competitor, Austal has had to pivot its business model in the US, expanding its shipyard and transitioning to a steel shipbuilding operation.

With the US government having assisted with the required capital expenditure, and with Austal investing US$100m (half funded by the US government) over the next two years, Ord Minnett believes the company is now in a position to win steel ship manufacturing contracts.

Ord Minnett assumes more EPFs will be awarded (small in contract size, albeit high-margin). But Austal management has also highlighted a number of different programs the company could win, including an offshore patrol cutter (OPC), light amphibious warship (LAW) and unmanned vessels, to refill the US construction pipeline.

Ord Minnett doesn’t disagree that Austal will likely win some work. But it’s concerned about Austal’s earnings profile as it transitions from mature, highly profitable aluminium programs to as-yet-unawarded new steel shipbuilding programs.

Adding to the broker’s concerns is the expected margin differential from new versus mature programs and design/build versus build-only roles.

Ord Minnett has retained its FY21 earnings (EBIT) guidance of $125m, and Hold recommendation on the company.

Broker ratings on the FNArena database show one Buy rating, two Outperform, and one Hold.

Consensus EPS growth forecasts for the coming two financial years are negative while annual dividends are currently projected around 9c for both FY21 and FY22 for an implied yield of circa 3.8%.

The consensus target is $2.85, suggesting 19.2% upside to the last share price, with Citi the high marker at $3.30.

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