Direct From The Desk: A deep dive into shipbuilder Austal

In the third episode of 'Direct from the Desk', I'm joined by Senior Analyst Aiden Bradley to take a deep dive into shipbuilder Austal (ASB). 

The company is one of the world's leading aluminium shipbuilders. They have a current market cap of around $850 million and they've had a tough 12 months dealing with a few issues, which saw their share price crunch down to $2.22 (at the time of writing). They were double that at the end of 2019.

The podcast discusses:

• The business & how it generates earnings
• Its reliance on the US Navy
• Why the share price is depressed
• The outlook from here & current valuation
• Why we think this stock is a deep value opportunity

Austal (ASB) currently resides in the Market Matters Emerging Companies Portfolio. The portfolio has returned 29.07% per annum since inception*.

In episode 1 we looked at small-cap consumer finance business Wisr (ASX:WSR) and in episode 2 we discussed software business Altium (ASX: ALU).

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*Inception 31^st January 2020

Edited Transcript

Hello and welcome to Direct From The Desk produced by Market Matters, a podcast that takes a deeper dive into a stock or sector, a theme or an event that we think you should be across. I'm James Gerrish, Portfolio Manager at Shaw and Partners, and the author of online investments at marketmatters.com.au. We run real portfolios. We invest in them. We write about our views, experiences and our portfolio decisions. Today's podcast is the third in a six-part series doing a deeper dive into six stocks that we like. We either own them or we're looking to buy them. Before we crack on to today's episode, it will be remiss of me not to remind listeners that any advice provided today is of a general nature only.

One of the world's leading aluminium shipbuilders is the third company we're covering in this series, following on from consumer finance business Wisr in episode one, and software business Altium in episode two. Austal, ASX code ASB, builds aluminium vessels. They have a current market capitalization of around $850 million. They've had a tough 12 months dealing with a few issues, which has pushed their share price down to around $2.25 at the time of recording. They were double that at the end of 2019. To join me this week on the journey is Senior Analyst at Shaw and Partners, Aiden Bradley. Mate, thanks for joining me, and can we start by providing listeners with a quick overview of the Austal business for those who perhaps aren't familiar with it?

Aiden Bradley:

Yep, no problem. Well, Austal actually is an incredible success story, regardless of what the current share prices are telling you, and that it's actually built a globally competitive manufacturing business out of Western Australia, or Australia generally. If you think of what happened to our car industry, it puts in perspective how well they've done. It started as a relatively small business here in Henderson in the Marine park, building aluminium commercial ferries, and aluminium is a very niche part of the global shipbuilding industry. Most larger vessels, mid-size larger vessels are obviously steel-hulled. Aluminium became the go-to for a certain class of high-speed commercial ferries and trimarines, and Australia, with two key manufacturers, led the way in that market and Austal, over the last couple of decades, has become the largest aluminium shipbuilder in the world.

That commercial market is substantive, but relatively small, and over probably the last five years has been 15, 20% of their total business. That commercial success actually attracted the attention of the US Navy, and over the last 10-year period, Austal has become more of a defence contractor, building aluminium-hulled vessels for the US Navy. Two main vessels there are called that the EPF and the LCS vessels, and that's been an incredible success story, has generated in excess of a billion dollars in revenue and more-

James Gerrish:

Sorry to interrupt there. The mix of revenue, you said commercial is now 15 to 20% of revenue for the business and the rest is defence?

Aiden Bradley:

Yeah, and because of COVID, no one's really ordering commercial vessels which are generally used for tourist reasons or regional inter-country travel. If you think Japan, Korea, these have been large markets for these types of vessels in the past. The commercial market pretty much is on hiatus at the moment. Yes, the US Navy contracts are the mainstay of Austal now. That's just re-emphasising that point that this, what was a relatively small commercial shipbuilder out of Western Australia has become this multi-billion-dollar defence supplier to the largest military in the world. That required it to build its own yard in the US for national security reasons. That's been a great success, that yard that they have in Mobile, Alabama. Very modern shipyard. That’s again positioned it to be pretty much the only aluminium supplier of vessels to the US Navy over the last decade.

James Gerrish:

Given the reliance now on building for defence purposes over in the US, what's the backdrop for defence spending looking like now, and how should we be thinking about the backdrop of defence spending and what the contracts look like from here on out?

Aiden Bradley:

Yeah. It's a victim of its own success in that regard, in that it has become so successful at supplying these vessels to the US Navy that it's now obviously, the vast majority of its business exposed to one customer, and that customer's appetite for aluminium vessels at the moment dictates the outlook for Austal. Luckily for Austal and probably unluckily for the rest of the world, tensions have continued to increase between the superpowers and as a result of that US, China focus, navies really have come to the fore because any potential conflict is probably going to be sea-based if you think about tensions around Taiwan, et cetera. There's been a lot of focus, particularly in the last five years, internationally.

US, China are the major players, and also here in Australia, obviously. We've all seen the headlines in recent times on building naval capacity, and there have been huge budget increases across the board. At the moment, the US has about 320 or so naval vessels and there's debate at the moment in Congress and elsewhere to increase that to 500 to match what China has done. Austal, having built their track record over the last 10 years with the US Navy are, in our opinion, now in a very strong position to win some of that major contract work from the US going forward.

Aluminium has been their key differentiator in the last 10 years. That's where they have their specialty, but it is a niche when it comes to both commercial and particularly defence vessels, and most of that, nearly all of that growth going forward in the US Naval numbers will be in steel. It's just more robust. It's what the bigger vessels tend to use as their hull.

James Gerrish:

And this is an area that Austal are going into?

Aiden Bradley:

Yeah, they've been slowly going into that. They've been building steel hulls, the smaller steel-hulled vessels here in Henderson and in Asia for a number of years. They did lose out on a couple of Australian steel contracts, but the US has been their main customer and the US, in supporting Austal, are co-investing to put steel shipbuilding capacity at Mobile. The US government is funding 50% of that $100 million expenditure free, non-repayable, zero-interest loan. It shows, in our opinion, Austal's credibility with the US government, but also the fact that they are positioning themselves, and the US government are positioning Austal to be a substantial steel shipbuilding company in the future as well, where most of that growth in capacity's going to come from. That to us was a really strong indicator that Austal is a tier-one supplier to the US Navy, now and going forward in the future.

James Gerrish:

How does the political backdrop landscape impact decisions around the demand for vessels and how separate, if you like, are the defence forces to the political backdrop? What it seemed to me that the administration under Donald Trump and the clearly growing tensions between China may have been, as crude as it sounds, may have been supportive of Austal more so than a Joe Biden presidency.

Aiden Bradley:

100%. I think you've seen weakness in Austal since Biden took over as president. The belief was that Trump would wholeheartedly support those very aggressive growth numbers that the US Navy wants, building the fleet up again to 500 vessels, which is pre-Vietnam war type numbers. There was the concern that with Biden coming in, with the need for COVID-related expenditure in the economy, that the Navy and military expenditure generally would suffer. That hasn't been the case, and we've been at pains to point out that actually defence is one of the sectors that tend to attract capital during recessions. It's got a high employment factor for every dollar that the government spends on it, and it tends to be high paying blue-collar workers in areas where people want votes.

In Mobile, Alabama, for example, Austal are one of the largest manufacturing companies in the whole state, so they get a whole multilevel layer of support from various political sides, both sides of the House. We haven't seen anything from Biden yet to suggest that they're going to hold back on this expenditure and at the end of the day, you just turn on your news every day, you see the mounting tensions with China. Any conflict that does happen, as I mentioned, is going to be naval-based, and there have been cuts in perhaps other areas of the defence budget, but the navy still seems to be an area that's going to attract its more than a fair share. Yeah, there hasn't really been the negative impact of Biden yet versus the Trump administration, so all positive from a macro standpoint. As I said, great for Austal. Perhaps not so good for the rest of the world if we have to build all these vessels to defend ourselves.

James Gerrish:

All right. Just going, digging down into more about the earnings and how they work. Obviously, in its simplest form, they win work, they win contracts, they build ships and ultimately, get paid for them, but how does the mechanics of that work? Is there a long tender process? It's obvious, very capital intensive business that has long lead-times, et cetera. Can you give us an understanding of how contract wins work and how it flows down into the bottom line in a simple sense?

Aiden Bradley:

Yeah. I think this is the key to why the stock has been weak over the last 12 months, is that these contracts from the US Navy are wonderful when you win them. They're multi-ship contracts, so the LCS programme, approaching 30, 40 ships now in total between the two suppliers. Each of those ships cost anywhere from US$350 up to close to US$500 million. These are huge programmes and hence, have to go through a lot of hoops within both the military complex in the US and the political complex. They can take a long time to be awarded. Then, when they are, they last in some cases, decades. That's where we are at with Austal at the moment. The two big aluminium programmes, the EPF and the LCS programmes that have sustained the business for the last 10 years are now coming to their natural end.

They're just completing off the final ships in the LCS programme, and the market now has to wait for them to win and to chore some probable steelwork that the US is planning to award over the coming years, but those programmes get delayed. There's obviously intense competition for them from various yards, including some of the largest defence contractors in the world. Austal's a relatively small player in this market. That's where we're at, at the moment, coming off two very successful programmes and just waiting for the award of the new programmes, which hopefully will occur in the next year or two.

If you look at when their steel shipbuilding capacity, which as I mentioned, is supported by the US government, it's planned to be complete mid '22, which coincides with the award of a couple of pretty sizeable steel ship projects that Austal are building on. We don't see that as a coincidence. We think the timing of them putting that steel capacity coincides very nicely with the award of a couple of contracts which they have high expectations of winning, and those contracts will be in the multi-billion dollars again. Yeah, you're coming off a highly successful 10-year shipbuilding period, now just waiting for the award of hopefully, the next 10 years of steel shipbuilding capacity in Alabama.

James Gerrish:

When you model this business, how do you think about the new contract wins going forward, because I know you're not alone here? Obviously, if I look out at consensus numbers out for FY22, '23, sales are declining. You've got flat to slightly lower earnings over that period. Do you allocate a probability to new contract wins, or how do you think about that in your numbers?

Aiden Bradley:

There are two revenue streams on the defence side that we model. One is the actual awards of the shipbuilding itself, which is very visible. These are big awards, 200, $500 million contracts, and then you basically model out the recording of the revenue from those over time as the ship goes through its initial steel cutting or aluminium cutting in the path to delivery to the end customer. There's a high degree of visibility on the actual shipbuilding when you're dealing with someone like the US Navy. There's also the servicing of those ships once they're delivered to the US Navy, which has been a growing revenue contributor for Austal. As they construct more ships and deliver more ships, they hope to get the maintenance and the sustainment contract for those ships over the life of the vessel, which can be a lower-risk, recurring revenue stream.

Then, there are the new contracts, and that's when you get into, as you've mentioned, the probability weight. You have to look out at their likely chance of success, the competitive landscape for each of the vessels, and apply in your valuation of the stock like Austal, or any construction company, the probability of them winning some of these big contracts going forward. As I mentioned previously on the call, they did lose a couple of major contracts in Australia. The LPB has been the main one, which went to a competitor here in WA, and they also did not win the frigate contracts in the US which we didn't expect them to win, but again, it shows the risks around their ability to win this work going forward.

James Gerrish:

You mentioned the sustainment component of it, so the servicing and maintenance of vessels. In the last update, that was a weak spot, so we were expecting a reasonable amount of growth in that area. It didn't deliver to the numbers that you were anticipating. What is the outlook from here? Do you see a bounce back in that, or what's your view around the metrics of that division?

Aiden Bradley:

We were expecting, as the aluminium shipbuilding contracts tailed off and were completed, that the service team maintenance component would sustain, using the term for it, Austal overall until they won some of the steelwork in the next two, three-year period. That business actually disappointed us. As you mentioned, that last result, they didn't secure as much of that servicing work as we would have expected, something they can strongly pitch for and position themselves for over a number of years, and the reason for that was, they discussed it in a lot of detail on their recent earnings call. They need to get onto servicing panels in the US. One is called the SEC East panel and the other is the SEC West. It's geographically split. They service two parts of the Navy, the East Coast and the West Coast.

Getting on those panels gives you a recurring revenue component of those service deals, and we were expecting an announcement on the SEC's panel ahead of now. It was meant to be some time, I'm looking in that April period, and that has not occurred yet. Again, you're dealing with the US government and US Navy. Nothing ever runs according to a perfect timeline, but I think in terms of the very near term, getting on those two panels will probably be the key catalyst for the stock, will really boost that recurring, more fixed-margin, low-risk sustainment revenue stream ahead of then hopefully winning the first of their steel contracts later in '21, into '22. Those first contracts will probably be quite small, because they don't have a track record in steel, but will basically set a platform for some bigger wins going forward.

James Gerrish:

There's been a few announcements out in the last couple of months, just around investigations that have happened or have been focused towards Austal, from looking retrospectively around accountancy issues. Can you give us a better understanding around what transpired there? How concerned, as investors, should we be of that? Does it change the relationship that they have with obviously, their biggest customer is the US Navy?

Aiden Bradley:

Yeah, badly timed, given the uncertainty around their revenue outlook to have any regulatory overhang or headlines. Well, we obviously track and bolt investigations, so there's the US regulator investigation, which is predominantly looking at costs and cost disclosure on the LCS programme, five years plus now ago. There's a related investigation by the ASX, just looking at what disclosure they provided around those cost blow-outs at that time to the market here, and whether they obviously follow all of the local listed regulatory requirements. The company has been at pains to stress that neither of these investigations has had, or will have a major financial impact on the stock.

Those cost blowouts occurred at the start of the LCS programme, which highlights a risk always with a big construction project of any nature. When you don't have the experience of delivering it, there's always the potential to suffer delays and cost blow-outs at the start. The good thing about working with the US Navy is once you're a prime contractor with them, they like their prime contractors to be reasonably profitable, not excessively profitable, but reasonably profitable, so that's one of the reasons why margins in recent years have been so good that the US Navy giving back to Austal as one of their key suppliers, some of those losses that they suffered in the past.

But the key here, outside of not having a major current financial impact is, what does this all mean in terms of your relationship with the US Navy? That's what we've tracked these investigations most closely in regards to, because at the end of the day, if your reputation with the US Navy is tarnished because they don't believe you are fully disclosing costs in the past, or you can't deliver on budget, then you're not going to win future work going forward. The key indicator for us that convinced us that we should be positively inclined on this stock was the fact that the US government, US Navy are co-investing at this time in that steel building capacity at Mobile, Alabama.

If they had any qualms or doubts about Austal as a prime contractor to them, they wouldn't be co-funding the company in expanding at Mobile and putting in that steel building capacity to secure work going forward. Our view is that the investigations are obviously, they're historical in nature. They're probably not going to have a major financial impact as the company has indicated and it seems, given that the evidence from the US government and Navy putting their money where their mouth is, is that there's not been a reputational impact today. These are historical events and shouldn't have a major impact on the relationship with their key customer going forward.

James Gerrish:

Just to summarise what we've just covered because I think what is coming across here, it's obviously a company that's had a tough 12, 18 months. There's no doubt about that. They've obviously had a tough time from an operational perspective. Their share price is reflective of that. They've had a couple of hits from left field from a regulatory standpoint, but I guess what these podcasts are designed to do is highlight the investment case in a stock. We've had obviously, a couple in the episodes prior, but this case is all around what is priced in the markets because it's trading on an exceptionally cheap valuation and we think in this short term, headwinds that the company has been facing, there is a better story going forward for this company.

Obviously, the old trusty metric that most people hang their hat on is the price-to-earnings ratio, and so using that, it's trading 10 times FY21 earnings. That's dropping below 10 times into FY22, doing three and a half per cent. It's got a really well-capitalised balance sheet. How do you think about it from a valuation standpoint? Do you think the risks going forward are very much shown through the currently depressed share price?

Aiden Bradley:

Yeah. I've been covering Austal on and off for a number of years now, and my view on it is I don't think its achievements with the US government and US Navy are fully appreciated in that it has become a prime contractor to the US Navy. It's the only international player to have achieved that. It stands in tendering for these contracts, toe-to-toe with the likes of Lockheed Martin, et cetera, massive defence contractors. There's huge value in that relationship that I don't think is fully captured, and the fact that the US government is co-funding the steel capacity at Mobile, the fact that that plant is the largest employer in the state, just gives Austal this great foundation now, and a 10-year track record of delivering pretty much from 2011 to the US Navy.

Of course, people have concerns when they look out two or three years and they see these contracts that they currently have ending and revenue falling off a cliff, but there's an extremely high probability ... There's never a certainty, but there's an extremely high probability that the shipyard at Mobile will continue to run at very high capacity, particularly in this COVID environment. The government is not going to see 100s, if not 1,000s of high paid skilled workers in Alabama go unemployed, and at the same time, you've got this backdrop of a lot of support for seeing almost a 200 vessel increase in the US Navy going through Congress at the moment.

Obviously, the uncertainty explains that low multiple that it trades on, one of the lowest multiples of any mid-cap industrial in the market, but I think you just got to view it that there's an extremely high probability that Mobile will be kept by the US government, either with shipbuilding or as a service centre at a very high utilisation rate going forward and that's the way we view it from a valuation point of view. Yes, we don't have visibility exactly on what they're going to win in terms of the awards. There's a number of awards coming in the next five years, and they're going to bid on two or three of them, but that yard, almost certainly over the next five, 10, 15 years, will be maintained at a very high level of utilisation and that's what's going to support earnings going forward.

James Gerrish:

Just to give you a bigger, broader understanding around valuations. Obviously, it's cheap relative to a pretty expensive market while yielding a market ... It's also, its average P/E over the last 5 years is around 15 times, so it's trading at a deep discount to its historical averages, and building obviously into a lot of this uncertainty that we've just been speaking about in this podcast today. Around their earnings and M&A potential, is this an area that can diversify their earnings going forward? Obviously, their reliance on the US Navy is big. They've obviously got a commercial division and sustainment area that is also an area of earnings for them, but is there a potential for an M&A that could diversify their earnings streams?

Aiden Bradley:

Yeah, I think that's your get-out-of-jail card. I think with Austal, if basically, the market doesn't start re-rating it as some of these contract awards are won in the next two to three years, there's both outward and inward M&A potential. They, themselves have a very strong balance sheet, over 300 million in cash now. They are actively looking at expanding shipbuilding and servicing capacity around the world. We've seen them move into Asia. There have been headlines about them looking at Subic Bay, which is a very large shipbuilding complex in the Philippines.

Again, this is a company with now decades of experience in IP, over a decade of experience delivering to probably the hardest customer in the world to win contracts from, the US Navy. Obviously, that then lends itself to them being able to utilise that experience and IP in building ships and servicing ships for other entities, but their focus is obviously on the US Navy, which is the big prize and that's where the internal M&A, Austal itself as a target, could potentially come into play, because if the market here, and it is a bit of a unique beast in that it's shipbuilder on the ASX with pretty much one customer being the US Navy.

If investors down here can't get their heads around that, trading on a market cap, as you said at $850, $300 million-plus in cash, well, that's a very small bite-sized chunk for any number of major defence contractors around the world that would want to get into Austal's position of being a prime supplier of vessels to the biggest customer in the world. We don't want to put out their M&A, and Austal as a potential target as one of our foundations of our positive recommendation, but it's there in the background as an obvious potential if it keeps trading on such low multiples.

James Gerrish:

We own this stock in our Emerging Companies portfolio. We're down and I think most people or most investors that bought it, obviously in the last 18 months are certainly down on their position. We do see clear value for the patient invest to understand the risk going forward. Just wrap up by giving us your ... You've got a buy recommendation. You've got a price target substantially higher than where the price is trading at now. Give us your final summation of Austal.

Aiden Bradley:

Yeah. All of that 20-year track record and shipbuilding 10 years with the US Navy means nothing if you can't continue to win work going forward. What we are looking for in the next six to 12 months is those awards on the servicing side, which is your bread-and-butter recurring revenues. It's getting on those two panels, which would again, indicate that their relationship with the US Navy is intact and positive. That's the SEC East panel and the SEC West panel. Both of them are meant to be potentially announced this year. That would see a recovery in that recurring revenue, and not just obviously underpin cash flow going forward, but also indicate quite clearly that the US Navy still views Austal very favourably.

And then, it's about having the steel capacity ready for some of these major awards that we expect as we roll into '22 and '23. The company has indicated that they'll probably get a test order from the US Navy. That could be as early as yearend '21 as well. I think, if they announce that they've won a steel contract, even if it's just a small initial test, I think that will refocus investors on the potential here for these multi-billion-dollar vessel awards that are going to be announced over the next one to two year period. Then again, we view this as, this is a modern shipbuilding facility in the US, and there's not many of them.

Most of the shipbuilding capacity over there is very antiquated. It's in a highly politically charged state in terms of needing to keep employment high. I think it's highly likely that it will retain a very high level of utilisation going forward, and that's the way we view the stock. The next year, the timing is uncertain, but the value is there. They've got the assets that basically will attract the awards and we're pretty confident that when we look back in say, two years’ time that this was just a little hiccup between the aluminium contracts which were the history of Austal in the last 10 years, and the steel contracts that will keep it flying for the next decade.

James Gerrish:

Well, I reckon that's a great way to sum up today's podcast. All right, mate. Thank you very much for giving us your insight on ASB. Much appreciated. I'm sure our listeners got plenty out of that recording and we'll catch up again soon.

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