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It’s beginning to look like South Korean ship builder Hanwha Ocean [KRX:042660] may be able to overcome Australian regulatory hurdles and – probably – shareholder price expectations in its effort to acquire Austal [ASX:ASB]. But a big question mark remains over the US regulatory hurdles.

It’s two months since the Australian shipbuilder said it had received an AUD 2.825 p/s offer indicative offer from Hanwha Ocean [KRX:042660] and nearly a year since Austal confirmed on 6 June 2023 that it was in talks with suitors over a potential sale.

On 2 April Austal refused to grant due diligence for the AUD 1.02bn (USD 675m) equity offer from Hanwha Ocean due to its belief an agreed deal would be scuttled by Australian or US regulators or both.

However, the Australian regulation risk appears to be diminishing. As this news service reported on 2 May Richard Marles, Australia’s Defence Minister, has said Australia does not have any concerns about Hanwha acquiring Austal. He added that security arrangements can be made to manage sensitive technology and intellectual property issues.

The comments regarding IP appear designed to address concerns about Austal’s ownership that may be held by other shipbuilders vying for a 20 February Australian government tender to build eight frigates at Austal’s Henderson shipyard in West Australia. (It’s unclear if the interested parties actually hold such concerns).

Despite the protracted nature of its bid attempt, a source familiar with the matter and a Korean sector banker have told the Flash the South Korean bidder remains motivated to acquire Austal. In mid-May a spokesperson for the S. Korean shipbuilder said it expects the process to take time due to issues including pricing and regulatory concerns.

From a pricing perspective at least, the deal looks doable. In recent weeks Austal shareholders, including Tattarang, its largest investor with 19.61%, and Chester Asset Management with 5.15%, have called on the board to grant due diligence so Hanwha Ocean can improve its offer.

This suggests the indictive bid may not be that far away from a level shareholders would accept.

From every angle, it increasingly looks like the main risk to a deal comes from the US side.

As Austal’s 2 April announcement stated, the shipbuilder designs and builds defense vessels for the Australian and US navies and is constrained by ownership clauses associated with defense contracts.

Importantly, Austal generates almost 77% of annual revenue from the US. So, in addition to requiring approval from Australia’s Foreign Investment Review Board (FIRB), a change of control deal would be subject to approvals from the Committee on Foreign Investment in the US (CFIUS) and the US Defense Counterintelligence and Security Agency (DCSA). 

Whether CFIUS or the DCSA would even consider a review is unclear. A quick assessment of recent DCSA reviews by foreign buyers finds that they have mainly involved companies from nations historically close to the US such as the UK, Canada or France. But if it does then Hanwha can expect a review to be lengthy.

In 2022 law firm Holland & Knight, citing a DCSA’s Annual Foreign Ownership, Control, or Influence (FOCI) conference, said the DCSA took 266 days to clear a Tier 2 company (some FOCI mitigation required) and 263 days for a Tier 3 company (full FOCI mitigation). According to Mergermarket data, merger parties received a CFIUS decision a median of 160 calendar days after deal announcement.

From a US regulatory perspective, one development to watch would be South Korea’s attempt to join AUKUS Pillar 2 – the military and technology sharing agreement between the US, UK and Australia. In early May, South Korean Defense Minister Shin Won-sik said the country welcomes the invitation from the three countries to join the partnership.

Acceptable price?

But if the regulatory picture does clear up then what price is acceptable?

Hanwha’s AUD 2.825 p/s indicative offer represents a solid 29.6% premium over the undisturbed price of AUD 2.18 on 2 June 2023 and translates to 13.39x EV/TTM EBITDA or 0.72x EV/Revenue. It has net debt of AUD 79m and operates at a net leverage of 0.96x.

Based on this premium, the offer, which increasingly looks to have been an opening shot in a deal Hanwha knew would be protracted, appears reasonable. Nonetheless, shareholder arguments that it requires a bump appear justified based on a table of global defense companies’ trading multiples.

Peers in the global defense sector as identified by Austal in its 29 May FY2024 investor presentation include RTX Corp [NYSE:RTX], Lockheed Martin [NYSE:LMT], General Dynamics [NYSE:GD], Northrop Grumman [NYSE:NOC], L3Harris [NYSE:LHX] and Huntington Ingalls [NYSE:HII].  As of 3 June they are trading at a median of 14.2x EV/TTM EBITDA.

The Asia-based peers are trading even higher at a median of 23.3x EV/EBITDA. And precedent M&As in the global defense sector were completed at 12.86x EV/EBITDA, according to Mergermarket data.

It all suggests a bump is required.

According to a 1 May AFR report Hanwha is – rather incredibly – ready to revise the offer to an “estimated AUD 1.5bn”. Whether this figure has any basis in reality is unclear. If true, it would translate to roughly AUD 4.14p/s — valuing Austal at 19.17x EV/EBITDA. The article also says Hanwha is prepared to pay 15% more than an “offer on the table” from Cerberus Capital Management and that one Austal “backer” thinks offers pitched around AUD 1.5bn are “far too low”.

(The Flash is skeptical of the aforementioned information, which comes from political and defense journalists rather than M&A reporters, and is trying to verify it.)

Nonetheless, shareholder optimism around Austal’s financial prospects may stem from positive news flow around contracts in recent times. Historically, the Australasia unit, which has been unprofitable due to declining defense and commercial vessel construction activity, has performed poorly compared to Austal US. But the prospects for both units are looking up. Yesterday Austal’s shares climbed 3.77% on a new USD 516m US Navy contract modification announced on 31 May after market close. In November 2023 Austal signed a deal to become the government’s primary shipbuilder in West Australia. The news boosted the share price by 3.2% and secured a AUD 12.7bn order book ensuring it is poised to benefit from the AUKUS deal for the next two decades.

Can Hanwha Ocean significantly raise its offer?

Unprofitable for years, Hanwha Ocean was struggling with a heavy debt burden until it completed a KRW 1.5bn rights issue in November that normalized its debt ratio. It now has KRW 1.65trn (USD 1.19bn) in cash and net debt of KRW 1.86 trillion (USD 1.36 billion). It also turned a profit in 1Q24.

According to Fidessa brokerage consensus compiled by Factset, Hanwha could generate KRW 445 million EBITDA in 2024 with a potential uptick afterwards. This would be its first annual surplus since 2021 and the company’s basis to pursue an expansion of business portfolio into maritime and defence.

Alternative scenarios 

Last September, this news service reported that private equity players are primarily interested in Austal’s US division. Austal US generated AUD 58.3m in TTM EBIT, while the Australasia unit recorded an AUD 5m loss. Whether shareholders would support such a move looks increasingly questionable in light of the latter’s improved outlook.

On the other hand, two sources told this news service that US-based strategic player Huntington Ingalls Industries [NYSE:HII] could be a viable alternative bidder to Hanwha. The first source said that while a US PE firm could bid, they have been focusing more on high tech defense opportunities as opposed to “old school industrials like Austal”. The second source said HII acquiring Austal presents a good opportunity to increase naval production, considering Austal US’s strength.

Other potential suitors include US-based PE firms Arlington Capital Partners, Cerberus Capital Management and JF Lehman, media has reported.

It’s doubtful any are as committed as Hanwha Ocean though. So until the US regulatory picture clears, Austal’s future ownership remains uncertain.