Ship builder Austal is a rare bright spot in the struggling manufacturing sector. Its shares have almost quadrupled since the 2012 low, amid continued strong sales growth and a healthy order book. Austal has scope for further gains in the next 12 months, albeit at a slower pace.

It is easy to give up on small-cap industrial companies after they soar. Austal has rallied from $1.20 to $1.84 in the past five months and has a one-year total return (assuming dividend reinvestment) of 77 cent. It’s not cheap, but it looks a better bet than many small caps.

To recap, Austal designs and makes defence and commercial ships. These include the Littoral Combat Ship (LCS) and other military high-speed vessels for transport and human relief for the United States Navy, and patrol boats for the Australian Navy. It also makes high-speed catamaran ferries and has delivered 250 vessels over the past 25 years.

Austal is recovering after a tough few years. Revenue and earnings fell sharply in 2010-2012 as the fallout from the Global Financial Crisis hurt sales orders and a high Australian dollar hurt exporters generally. Austal slumped from $2.60 in 2010 to 52 cents in late 2012.

Chart 1: Austal

Source: ASX

That was a huge turning point. Austal reported revenue of $680 million and after-tax net profit of $28.9 million in the first half of 2014-15, buoyed by strong sales orders and growing market recognition here and overseas for its products.  

Austal this month announced the US Navy was funding construction of two extra LCS, taking the tally to 10 built by the company as prime contractor. The US$691 million contract lifts Austal’s forward order book to $3.1 billion. And the US Navy has an option for construction of another Littoral ship in 2016.

The contract size surprised the market, judging by Austal’s share-price spike. In a research note, Macquarie Group said the award was ahead of its expectations. “The Navy budget only funded three LCS this year and we expected Austal to be awarded one ship with long lead times for a second vessel given its contract is running six months behind the Lockheed contract.”

Macquarie noted that Austal’s rival for this craft, Lockheed, was only awarded one vessel. It wrote: “Importantly, this is the first time the Navy has had to award an uneven number of ships and been forced to choose between the two builders.”

That is a critical point. Austal products are creating higher interest in the US and internationally. Winning contracts from the US Navy takes great skill and once secured, typically leads to significant recurring work in maintenance and vessel upgrades. Macquarie says this work could turn into a material “annuity-style” business for Austal over time.

A $3.1 billion-dollar order book, contracted work out to 2020 in its US shipyards, and rising, recurring income from maintenance contracts, are valuable assets for a $638 million company. However, Austal’s most valuable asset, and hardest to quantify, is its growing relationship with the US Navy and how that will help drive sales with other navies.

Even so, Austal has plenty of work ahead to lift performance. A flat single-digit return on equity (ROE) over the past four financial years is too low for a company of Austal’s quality, and a potential investment concern. Always look for companies with rising ROE as it leads to higher intrinsic value and a higher share price over time.

At $1.84, Austal trades on a forecast FY15 Price Earnings (PE) multiple of about 13 times, based on a small number of consensus forecasts. Macquarie has an outperform recommendation and $1.96 12-month share-price target, implying modest gains from here.

The median price target from four brokers that cover Austal is $1.80. One has a strong buy, two have a buy, and one has an underperform recommendation. The market thinks Austal has had its run for now.

Prospective investors should watch and wait for better value in Austal. After stellar gains, the stock is due for consolidation. It would be one of the more interesting small-cap industrial stocks to buy during a significant market pullback or correction this year.

Big contracts and billion-dollar order books make easy headlines. The reality is Austal competes in a highly competitive global ship-building market that is hostage to government budgets and defence spending, and the general economic cycle. Orders can be lumpy or deferred, and it only takes a few disappointments to sink earnings.

As such, Austal suits experienced investors with a 3-5 year perspective. If Austal continues to realise its global ambition, the share price will be a lot higher by then.

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Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 5, 2015.