Babcock & Wilcox Co (NYSE:BWC) Babcock & Wilcox will separate into two publicly traded companies in “mid-summer” 2015. Here's how we've analyzed Babcock & Wilcox Co's two businesses (excerpted from our most recent letter):
About 85% of Babcock and Wilcox’s profits come from two business units: nuclear operations and power generation. The power generation group’s revenue is cyclical. The nuclear operations group’s revenue grows steadily each year. The power generation group is about half after-market revenue and half new build. This business depends on capital spending by U.S. coal power plants. Meanwhile, the revenue in the nuclear operations business depends on a long range plan put forward by the U.S. Navy. Analysts have little visibility into the capital spending plans of U.S. utilities.
A deep recession like the one in 2008 and 2009 can cause utilities to delay their capital spending. On the other hand, the U.S. Navy does not slow down or speed up its plans depending on the business cycle. Some spending can be delayed in situations like budget disputes between the two parties in Congress and the President. Right now, Babcock and Wilcox has contracts for Virginia class submarines from now (2015) till 2018. They are also in the midst of producing Ford-class carrier CVN-79 (a nuclear powered aircraft carrier) which is planned for delivery in 2018. Work on CVN-79 started in 2013. So, Babcock has contracts in place and is working on ships that will not be delivered till 2018. That business is already contracted. But the Navy plans well beyond the period it contracts for.
For example, the Navy’s plan includes not just the 2 Virginia class submarines per year it has contracted for through 2018 but also the same number (2 subs) per year in 2019. Beyond that, the Navy is planning for 2 Virginia class subs every 3 years (1.5 subs per year) after 2020. The Ohio replacement class has also been planned even though Babcock is not yet under contract to provide heavy nuclear components for it. Babcock has supplied all previous classes of U.S. Navy subs. This includes the Ohio class subs the new class is set to replace. The first Ohio replacement class subs are planned for delivery in 2021, 2024, and then one per year for every year from 2026 to 2035. The Navy also plans to build one Ford class carrier every 5 to 6 years. Work on the second ship in the Ford class series started in 2013. The Navy plans to build 10 Ford class carriers. If each carrier is built 5 years apart and the same suppliers are used for each ship in the class’s series – Babcock will be kept busy making the heavy nuclear components for Ford class carriers into the 2050s. Work has already begun on the second ship in the Ford class series (the plan is to deliver this second ship in 2018) which means that Babcock will be supplying heavy nuclear components to aircraft carriers in serial production for at least the next 40 years under the Navy’s plan.
The profit on a ship in serial production is more predictable than the profit on the lead ship in a class, because the lead ship includes the design costs of the class. The first ship in a series is effectively a prototype. When building mega projects like the nuclear powered capital ships the U.S. Navy orders, the first ship in the class is both a prototype and a part of the series. The cost for the lead ship – when the design cost is included – is therefore much, much higher than the cost of subsequent ships in the series. For this reason, companies that make the ship may miscalculate the costs involve and earn an inadequate profit or even lose money.
Huntington Ingalls experienced this problem while working on the LHD-8 (USS Makin Island – Wasp Class Amphibious Assault Ship) and the LHA-6 (USS America – America Class Amphibious Assault Ship). The America’s design was based on the Makin Island. But significant changes were made. Huntington Ingalls’s margin dipped when it mispriced contracts. The company’s CEO explained Huntington’s problem is 2011 by saying: “…one of the things we saw in LHD-8 was we had priced it as if it was a repeat ship, but there was a substantial amount of new design on that ship. So we took a look at LHA-6 and asked ourselves, did we do the same thing on LHA-6? And, in fact, we had. LHA-6 had even more design change than LHD-8. And yet it was a fixed-price incentive contract that assumed a learning curve off of LHD-8.”
The classes of ships that Babcock supplies are usually in serial production for many years. Right now, the Virginia class sub and the Ford class carrier is in serial production. The Ohio replacement class is new (the first Ohio replacement will be delivered in 2021).
Babcock has double the margin (20% vs. 10%) of General Dynamics and Huntington Ingalls, despite the fact that Babcock is supplying the same projects that General Dynamics and Huntington are building. There are several speculative reasons for why Babcock might get higher margins on the heavy nuclear components it supplies to submarines than the overall margins on those subs. One is simply that the nuclear components could be a smaller part of the overall cost of the sub and not the first area one would look for cost savings. The other is that Babcock is in a monopoly position while General Dynamics and Huntington Ingalls are in a duopoly position.
Negotiations between a sole supplier and sole buyer do not center on price. The CEO of Huntington Ingalls – which builds the Ford class carriers and Virginia class attack subs that Babcock contributes heavy nuclear equipment to – explained how a sole supplier negotiates with the U.S. Navy: “…when you’re the sole source supplier to a sole source buyer you may remember from business school it’s a monopoly/monopsony kind of negotiations…How do you do that? How do you go do that negotiation…And what you end up doing in the negotiation is not talk so much about price. You end up spending a lot more time talking about scope and risk….we know what the budget is. We know what’s in the checkbook. How are we going to go get the most value for what’s in the checkbook?”
In the power generation business, Babcock’s margin is similar to Alstom’s margin in the same business. Babcock (and Alstom’s) margin depends on its ability not to bid so aggressively that it earns poor margins. Babcock’s CEO explained the problem in a 2013 earnings call: “In the power generation work, we’re one of the market leaders, and we capture a large percentage of that marketplace. The question is – for (power generation), is how competitive is it, and what margins can we command, and how low can we drive our internal cost structure?”
Both of Babcock’s most important businesses have low capital needs and therefore very high returns on capital. In the nuclear operations business, Babcock has a 20% pre-tax margin while General Dynamics and Huntington Ingalls have a 10% or lower margin. Babcock’s corporate wide sales divided by net tangible assets is about 7 times. So, a 20% EBIT margin translates into something like a 140% pre-tax return on capital. The exact return on capital of nuclear operations depends on how much of the company’s assets it ties up. However, the unit’s return on capital is clearly extraordinarily high. The power generation business has an 8% to 10% EBIT margin which is similar to Alstom’s Thermal Power EBIT margin. If this unit also turns its net tangible assets at about 7 times, the pre-tax return on capital would be in the 56% to 70% range. Again, the exact return on capital of this business unit depends on how much of the company’s assets are devoted to this unit. But it is once again clear that the return on capital is more than adequate. Even just a 30% pre-tax return on capital would lead to about a 20% return on equity without the use of leverage. And many companies in the kinds of markets Babcock competes in actually do employ some debt. It is reasonable to believe that the return on equity of each business unit would be higher than 20% a year in most years. When Babcock separates into two different companies, each of those companies will have above average returns on equity. The nuclear operations unit – the one that serves the U.S. Navy – will have incredibly predictable results. Investors may award that business a much higher multiple. The power generation business is also a good business. It is equal in quality to Alstom’s Thermal Power business. However, the results in that business will be lumpier. Investors may give that business the lower valuation in a spin-off. There is some sense in that. However, capital spending by coal power plants may actually be lower now and since the Great Recession than it would be in normal times. For that reason, the earning power of the power generation business may be higher than its results since 2008 suggest. Clearly, the nuclear operations business is the predictable business. The power generation business is the contrarian stock. But both businesses will be high return on equity stocks.
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