DBRS Changes Trend on Babcock International Ratings to Positive

DBRS has today confirmed its Issuer Rating of BBB (low) and Senior Unsecured Debt rating of BBB (low) on Babcock International Group PLC (Babcock or the Company). At the same time, DBRS has revised the trend on the ratings to Positive from Stable to reflect Babcock’s improved scale, product range and market position, and the better-than-expected improvement in financial metrics through debt reduction since the acquisition of VT Group plc (VT) in July 2010. Babcock is the leading engineering support services company in the United Kingdom, with the majority of its business involving long-term contracts with government customers. The Company reported total revenue of about GBP 3.0 billion for the 12-month period (LTM) ended September 30, 2011.

Babcock’s business risk profile and rating is supported by its strong engineering capabilities and specialized expertise, upon which it has been able to build a wide range of products and long-established customer base, particularly in the U.K. defence sector. The recent acquisition and smooth integration of VT has enhanced Babcock’s capabilities in defence training, air defence and support services, and better positions the Company to take advantage of the growing trend toward outsourcing in the U.K. defence segment and equipment fleet management in the private sector.

Babcock has good revenue and earnings visibility because of its sizeable order book of GBP 12 billion, or about four times its annual revenue, a large proportion of which is supported by long-term contracts. Risk of project execution has been moderate through “Shared Incentives” contracts, which split over-performance gain over pre-determined targets while limiting downside and cost indexation in fixed-price contracts. These are largely related to service and training contracts with relatively low execution risk.

Constraining Babcock’s business risk profile is the high level of customer and geographic concentration; high skilled labour intensity; the relatively low, albeit improving, margin typical for the engineering services industry; and its significant intangible assets. Approximately 80% of total revenue is generated in the United Kingdom, and the Ministry of Defence contributes more than half of revenue and holds the majority of large contracts in the order book. As a service company with a strong engineering focus, Babcock depends on the availability and retention of highly skilled employees to ensure adequate service delivery. DBRS recognizes that Babcock has a strong track record managing these risks through regular hiring and training and that labour cost pressure is not a cause for concern given the current economic conditions and high unemployment in the United Kingdom. However, this remains a risk that could potentially result in increased operating costs and margin pressure. This is especially crucial for projects of high complexity or entailing health risks such as nuclear decommissioning or submarine servicing.

The VT acquisition added a significant amount of goodwill and intangible assets, which totalled GBP 2 billion, or about 85% of total assets or more than 2.0 times (x) total equity as at September 30, 2011. As the companies acquired by Babcock over the past decade have been similar service-oriented companies with low asset bases, most of these intangible assets are related to brand value and enhancement in market position and engineering capabilities. As such, any material writedown of such intangible values, although not anticipated at this time, could result in significant erosion in Babcock’s equity base. Although on its own such writedown would not affect Babcock’s cash flow, DBRS will review the causes in the event of a material writedown and assess whether it would be indicative of a material decline in the Company’s value and cash flow.

Additional debt of GBP 400 million to finance the VT acquisition resulted in a deterioration in Babcock’s financial risk profile and ratios. Nonetheless, with strong operating performance and synergy savings from the VT integration in the past year, relatively low capital expenditure and a moderate dividend payout, the Company was able to apply the free cash flow from the combined operation to partly reduce its debt level. As a result, Babcock’s cash flow coverage ratios, as indicated by adjusted cash flow-to-debt of 26% and adjusted debt-to-EBITDA of 2.7x for the LTM ended September 30, 2011, are now consistent with the current ratings.

The Positive trend, which indicates that the rating could potentially be raised in the next 12 to 18 months, reflects our view that the VT acquisition and the smooth integration to date have strengthened Babcock’s competitive position and critical mass, as well as our understanding that the Company would continue to pursue debt reduction in the near to medium term to further strengthen its financial risk profile. DBRS would consider upgrading the rating by one notch if the Company continues to reduce debt and maintains its adjusted debt-to-EBITDA consistently around or below 2.5x and its adjusted cash flow-to-debt around or above 25% by and beyond the first half of fiscal 2013, while substantially achieving target synergy savings of GBP 50 million and sustaining its strong operating record.

Notes:
All figures are in U.K. pounds sterling unless otherwise noted.

The applicable methodology is Rating Companies in the Engineering and Construction Industry, which can be found on our website under Methodologies.