Is there still room to play offence with defence stocks?

With the ongoing war in Ukraine, continuing conflict in the Middle East, and a reshaping of the global framework underway since Donald Trump came to office, defence stocks have been hot property in the world of investing. While Australian investors don’t have that many options when investing locally, an exception is ship builder Austal (ASX: ASB).

Austal has been a long-term holding for IML’s small and mid cap funds, which have seen its share price triple since the start of 2024. However IML portfolio manager Lucas Goode thinks there could still be plenty of upside for Austal in years to come.

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Lightly edited transcript – Recorded on 6 June 2025

Jason Guthrie: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers, where we bring you insights from our global collective of experts to help you make better investment decisions. I’m Jason Guthrie, and today I’m joined by Lucas Goode, portfolio manager at IML. Now, Lucas is part of the small and midcap team. There, he’s always full of energy, and today we’re going to discuss IML’s stock of the month, Austal, ASX ticker ASB. Lucas, welcome back to the podcast. I’ve been looking forward to this one.

Lucas Goode: Thanks, good to be here, Jase.

Jason: Now, Austal may be not that well known by a number of our listeners today, though it probably should be given it’s one of the only prime Australian and US defence contractors listed here on the ASX. Now, it’s no secret we’ve seen a lot of interest in markets on defence companies over the last 12 or so months, given the war in Ukraine and, more broadly, the increased geopolitical uncertainty under Trump. Tell us about Austal. Lucas, is this the main reason why you’re owning the company, or is there more to it?

Lucas: OK. Yeah, thanks, Jase, it’s a good question. To give a bit of colour to listeners, Austal is a ship builder, started out as a commercial shipbuilder, but essentially all the earnings these days are on the defence side, so we’ll focus on that. It is a prime contractor, as Jason mentioned, for the US and Australian Defence Forces. It makes boats for the US Navy and Coast Guard, and also for the Australian Border Force and Navy.

Look, and to answer your question, Jase. We’ve actually owned Austal for several years, so we were buying it when it was trading at a deep discount to net tangible asset backing. It’s worth considering why it was so unloved by the market and it’s because the market just despises short-term uncertainty, and there was a lot of short-term earnings uncertainty with Austal at the time because their two existing main programmes in the United States were rolling off. So the market was worried, “Well, what happens if they don’t get any work? Are they going to have to shut the shipyard down?”

We took a step back and said: “What do we think the future looks like for Austal?” What we saw was that the shipyard in Mobile, AL was the newest, most modern, most cost-effective, and most efficient shipyard in the United States defence industrial base. It’s also located in a warm-water port, nearer to the Pacific than the legacy shipyards in the northeast.

So it was just inconceivable that they wouldn’t win work. In fact, before we bought in, the US Defence Department had actually gifted Austal US$50 million to expand their facilities to make steel-hulled vessels. At the time, they were not making any steel-hulled vessels; the existing two programmes were both aluminium. I would say that’s a pretty good indicator that they were going to be given some work, but until they were given it, the market wasn’t willing to reward what was actually a very high-quality company with deep competitive advantages. So that’s why we initially bought into Austal.

Jason: So, given that as a bit of a backdrop, Lucas, since you first purchased it, what’s changed over the more recent period to see this re-rating in the company over the last 12 months or so?

Lucas: A lot’s changed – they’ve gone from having almost no order book to a record order book that stands at $14 billion now, the vast majority of which is in the United States. They’ve now been awarded 11 separate programmes they’re working on, which is exactly what we foresaw when we were entering into the stock. It just made perfect sense that they would become a partner of choice for the US Navy. They are deeply integrated into the Navy. It’s something that was very clear to me when I went there recently to see the facilities in Mobile.

To give you a sense of how integrated Austal is within the Navy, even before these new programmes, they’ve built 12% of the US Navy’s surface fleet by volume of vessels. So they’re a key component of that defence industrial base. What’s really highlighted that since is not just the billions of dollars worth of orders they’ve been given by the US Navy and Coast Guard, but they were gifted US $450 million by General Dynamics, who are the lead contractor for the Virginia class nuclear submarines to build a purpose-built facility to make submarines.

What’s incredible is that when I went out to site, they let slip that even though that facility hasn’t been built yet, they’re already building modules with 20% less man hours than General Dynamics as the head contractor. This actually makes sense when you realise that General Dynamics is based up in Virginia, heavily unionised, and their shipyards are nearly 130 years old. So Austal is much more flexible and modern and is building stuff much quicker, and that’s even before they turn the earth on that new submarine module manufacturing facility.

Certainly, a lot’s happened to drive that share price higher, Jason, even aside from just the general tear in defence stocks globally, which I’m sure you’ll ask me about at some point as well on this pod.

Jason: I sure will. Now, look, I’m no expert, but I’m sure shipbuilding is pretty capital intensive, and I see that Austal have raised money recently—around $200 million earlier this year. How is the balance sheet and earnings looking for the company today?

Lucas: Yeah, so the balance sheet is in a very strong position. I mean, as you rightly point out, Jase, shipbuilding is capital intensive, certainly when you’re expanding at the rate that Austal is. However, they did stand at about a net cash position of $200 million as of December, They’re also due to receive another US$200 million from General Dynamics as part of that amount I mentioned earlier.

They’ve got a little over a billion dollars of CapEx (capital expenditure) over the next three years on the submarine module manufacturing facility and the new assembly sheds that they’re going to use for two of the new programmes they’ve won—the T-AGOS and Ocean Patrol Cutters. But they should be able to easily fund the rest of it with operating cash flow or potentially some modest amount of debt. So the balance sheet is in a very strong position.

Jason: Maybe taking a bit of a different direction here, just playing devil’s advocate, with some of our investors defence companies do tend to raise some eyebrows, some concerns potentially. How does IML think about this in their investment process? Broader ESG themes and that risk management perspective. Specifically looking at Austal, where do they sit in the mix and why are you comfortable with the name?

Lucas: Yeah, it’s a good question, Jason. I look at it this way: they make boats; they don’t make weapons. Now, obviously, those boats do carry weapons, but they’re not manufactured by Austal, and they only perform work for the Australian Navy and our biggest military ally. So it’s a risk that we’re extremely comfortable with.

There’s no doubt there would be some investors that might screen out the entire defence sector. That’s not the way we look at the world. Clearly, countries need protection, and Austal forms a crucial part of that.

Jason: I know from previous calls there’s obviously been a bit of a trend in your portfolios, Lucas, over recent years with takeovers and M&A activity that has been great for client capital returns. And we’ve also seen some interest in Austal with takeover interest – I think it was a South Korean group that recently tried to acquire the business. It was a failed takeover, but they have taken a substantial stake earlier in the year. Is this part of the thesis going forward, the M&A, supporting the broader share price?

Lucas: It felt at one point, when there wasn’t that earnings visibility in Austal, that the only thing that would ever get the share price higher were rumours of M&A. Private equity was supposedly looking, and of course, Hanwha, which is the Korean company you mentioned, now owns 20% of the company.

That’s a long-winded way of answering your question, but the reality is no, I don’t think a takeover is at all likely. I mean, #1, Hanwha’s bid was $2.85, and the share price is nearly $6 today. So I somehow don’t think that’s going to get it done. I know I wouldn’t be accepting it. But less flippantly, I just really can’t conceive of a scenario in which a non-Australian or US buyer, or potentially British given they’re the third member of AUKUS, would be allowed to buy Austal now that they’re doing work on nuclear submarines. I think it’s extremely unlikely.

By the same token, Hanwha effectively has a blocking stake on any other bidder coming in. Andrew Forrest also owns 20%. So M&A is not part of the thesis anymore. Now it’s all actually about just earnings growth, and the earnings growth looks extremely material over the next five years.

Jason: So, on that point, it’s had a great run. It’s doubled in the last six or so months, which is more than double the returns we’ve seen from broader global defence benchmarks. What does the valuation look like today, and how are you trading the position in the portfolios?

Lucas: In terms of the financial metrics, I mean, again, on a near-term basis, it’s quite noisy because they are starting a whole bunch of new programmes, and there’s a lot of CapEx going on. But if you look three to five years out, just based on the current order book and Austal’s targeted shipbuilding and support margins, this is a business that should be earning $250 to $300 million of EBIT (Earnings Before Interest and Tax) It’s got an enterprise value of about $2 billion at the current share price: that still puts it at a significant discount to global peers.

That’s even before we get to future expansion in the shipyard. It was pretty apparent when I went out to Alabama a couple of months ago that there’s a lot of vacant-looking land adjacent to Austal’s facilities that is actually owned by the government. We know the Navy is likely to bring in a second shipbuilder for their troubled future frigate programme. The existing head contractor still hasn’t built a boat yet after four years.

It’s not asking too much to imagine that Austal will expand further and therefore add more programmes of increasing scale and therefore continue to increase their earning capacity. So, I do think this is just the start of a 10-year story, and that’s without even touching on Australia, where Austal has effectively been appointed the sole shipbuilder for the Australian Navy under the Strategic Shipbuilding Agreement.

Jason: Well, fantastic. Thank you, Lucas. Always enjoy your insights. Clearly, you’re passionate about Austal, and it’s done well in the portfolio. So look, defence no doubt remains a hot sector. There’s lots of interest in the space, thank you to our listeners.

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