DBRS Upgrades Babcock International Group PLC to BBB with a Stable Trend

DBRS has today upgraded the Issuer Rating and Senior Unsecured Debt rating of Babcock International Group PLC (Babcock or the Company) to BBB from BBB (low). The trend is revised to Stable. When the trend on Babcock’s previous BBB (low) rating was changed to Positive in January 2012, DBRS expressed the view that (1) the VT Group plc (VT) acquisition and its smooth integration strengthened Babcock’s competitive position and critical mass and (2) DBRS could consider upgrading the rating by one notch if the Company continued to strengthen its financial risk profile to maintain its adjusted debt-to-EBITDA consistently around or below 2.5 times (x) and its adjusted cash flow-to-debt around or above 25% by and beyond the first half of fiscal 2013. The rating upgrade reflects that Babcock has met and intends to maintain these financial targets, with adjusted debt-to-EBITDA of 2.3x and adjusted cash flow-to-debt of 26% reported for the 12-month period (LTM) ended September 30, 2012.

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 VT acquisition has enhanced Babcock’s capabilities in defence training, air defence and support services, and better positioned 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. DBRS understands that business integration of VT’s operations has been completed according to plan.

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 LTM ended September 30, 2012. The Company has good revenue and earnings visibility because of its sizeable order book of GBP 12.5 billion, or about 4.0x its annual revenue, a large proportion of which is supported by long-term contracts. Risk of project execution has been moderate through shared-incentive contracts, which split over-performance gain over pre-determined targets while limiting downside and cost indexation in fixed-price contracts. They are largely related to service and training contracts with relatively low execution risk and their effective execution has been instrumental in steadily improving EBITDA margin over the past five years.

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. Although the disposal of VT Services has reduced Babcock’s exposure to the U.S. defence market challenged by the country’s fiscal constraint, it also increases the Company’s geographic concentration. Approximately 86% of total revenue is generated in the United Kingdom, and the Ministry of Defence (MoD) contributes more than half of revenue and holds the majority of large contracts in the order book. DBRS understands that the Company has plans to expand its overseas presence with opportunities identified in the areas of mobile asset management, nuclear decommissioning, training, marine and military infrastructure management.

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, while 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 1.86 billion, about 63% of total assets, or more than 2.0x total equity, as at September 30, 2012. 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, enhancement in market position and engineering capabilities. As such, any material writedown of such intangible values, although not anticipated at this time, could potentially erode Babcock’s equity base. Although on its own such a writedown would not affect Babcock’s cash flow, DBRS would 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.

Babcock’s financial metrics have continued their improvements since March 2011 as the Company has applied part of the cash flows generated by the combined operations and proceeds from disposal of VT Services to reduce its total debt by about GBP 120 million between then and September 30, 2012. 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 2.3x for the LTM ended September 30, 2012, are now consistent with its BBB Issuer Rating. DBRS expects the Company to maintain its financial metrics at similar or moderately better levels in the foreseeable future, in view of continued operating cash flow, as well as modest capex and working capital requirements. Liquidity is strong, supported by the Company’s substantial cash balance, an undrawn credit facility and modest near-term debt maturity until September 2016.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Rating Companies in the Services Industry (May 2011), which can be found on our website under Methodologies. DBRS corrects that the applicable methodology in a previous press release published January 27, 2012, was erroneously indicated as Rating Companies in the Engineering and Construction Industry.