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Babcock signs £2.6bn MoD contract

Babcock has secured another lucrative MOD contract, but doubts remain over its acquisition of helicopter group Avincis
October 6, 2014

What’s new:

- New £2.6bn MoD contract adds to growing order book

- Share price has fallen a quarter since Avincis acquisition

- Chief executive due to retire

IC TIP: Buy at 1053p

Babcock International (BAB) continues to profit from its close ties to the Ministry of Defence, judging by the signing of a £2.6bn contract to continue running the Clyde and Devonport naval bases in Plymouth until 2020. The contract, which also saw BAE Systems (BA.) secure £600m to maintain British warships, submarines and naval bases for the next five years, is the second biggest to be placed by the government since it took power in 2010, fuelling hopes that the UK government's defence cuts may be coming to an end.

The signing of this contract, which was first mentioned in Babcock's annual results, follows the August announcement of a £180m deal to supply and support training to the armed forces. But questions still remain over Babcock’s March acquisition of helicopter group Avincis. The company's stock is down by more than fifth since the unveiling of the £920m deal, which was funded by a £1.1bn rights issue at a hefty 42 per cent discount to the previous market price.

Avincis came with net debt of £705m, but also a £1.9bn order book that should generate plenty of cash. The share price may also have taken a hit due to the approaching retirement of popular chief executive Peter Rogers, reckons Nick Spoliar at brokerage WH Ireland.

Investec says…

Buy. Babcock has a strong business model with predictable earnings, a solid order book, defendable profit margins – helped by high barriers to entry and a technically skilled workforce – and a growing overseas footprint. But Babcock’s share price has steadily steamed south since the announcement of the Avincis acquisition in March. The rights issue has been a factor, but the business uncertainties around the Scottish Referendum, which was another excuse, have gone away for now. The recent weakness creates an appealing entry point in our view, with an attractive valuation against peers. We expect the group to report solid interims in mid November, and still forecast EPS of 68p for the year ending March 2015, rising to 77.1p in 2015-16.

Liberum says…

Sell. Babcock has announced the signing of the Maritime Support Delivery Framework, which replaces the Warship Support Modernisation Initiative. The contract was anticipated, so we see no impact on revenues. However, we understand from industry sources that there was some pricing pressure on the re-negotiation. The contract is valued at £2.6bn, of which £0.6bn is already in the order book. This will contribute to exceptional order book growth – from £11.5bn in March to an estimated £18.6bn in September. But £2bn of that is optical (MSDF), and £1.9bn is acquired (Avincis). We remain cautious in light of a slowing core business and unsustainable growth at Avincis.