BULL POINTS:
■ Prospects for VT deal
■ More government outsourcing
■ Low rating compared with peers
■ Possible FTSE 100 candidate
BEAR POINTS:
■ Execution risk
■ Increased financial gearing
The lonely hearts column for support services companies reads thus: fairly large, successful pragmatist seeks petite, but successful partner to make one and one equal three. Wants the two of us to grow together, enhance earnings and, possibly, make it to the FTSE100 index.
| IC Tip Rating: | |
|---|---|
| Tip style: | Speculative |
| Risk rating: | Medium |
| Timescale: | Long term |
Happily for investors, Babcock International found its ideal match in VT Group. With the acquisition set to complete on 8 July, the matrimony could fulfill the above and more. For example, analysts at brokers Brewin Dolphin and Panmure Gordon reckon that, assuming cost synergies of £58m a year, the acquisition will enhance earnings by 13 per cent in 2013. Assuming a market PE valuation of 13 times, these forecasts equate to a share price of 951p. Panmure Gordon also predicts a 14 per cent return on investment for Babcock, against a cost of capital for the deal of just 8 per cent.
The cost benefits are expected to come predominantly in the defence and training divisions, while the earnings enhancements are calculated without taking into account any selling opportunities that may arise from putting Babcock and VT together. Favourably, 65 per cent of revenues will come from defence, which, so far at any rate, is coming through the government's spending plans comparatively unscathed. Good news at the time of the detailed spending review on 20 October could be a catalyst for the share price.
The enlarged group has expertise in areas such as military air support and training. In May, Babcock announced it had signed an agreement with the Ministry of Defence, helping to boost its order book 48 per cent and further supporting the notion that outsourcing opportunities will present themselves. The combined group's order book will be more than £12bn, with an average contract length of about six years, providing assured revenues. Also important to note is that Babcock had no contracts cancelled last year, in a period of high uncertainty about spending.
True, there are some caveats to the VT deal. First, it will increase financial gearing - the ratio of net debt to cash profits will increase from about 1.6 to 2.9 times. But this is similar to when Babcock completed its last big deal for DML in 2007. Moreover, both Babcock and VT have been good at converting accounting profits into cash, and Babcock's bosses have promised to pay down the new debt by 2014.
| ORD PRICE: | 584p | MARKET VALUE: | £1.34bn | |
| TOUCH: | 583-584p | 12-MONTH HIGH: | 661p | LOW: 449p |
| DIVIDEND YIELD: | 3.6% | PE RATIO: | 9 | |
| NET ASSET VALUE: | 35p | NET DEBT: | 352% | |
| Year to 31 Mar | Turnover (£m) | Pre-tax profit (£m) | Earnings per share (p) | Dividend per share (p) |
|---|---|---|---|---|
| 2007 | 0.99 | 57.0 | 21.5 | 8.1 |
| 2008 | 1.56 | 85.0 | 30.0 | 11.5 |
| 2009 | 1.90 | 107 | 37.4 | 14.4 |
| 2010 | 1.90 | 129 | 46.3 | 17.6 |
| 2011* | 3.36 | 292 | 62.6 | 21.0 |
| % change | +77 | – | – | +19 |
NMS: 9,000 Matched bargain trading BETA: 0.6 *Brewin Dolphin estimates (Profits & earnings not comparable with historic figures and including VT's contribution) | ||||
Second, there is the execution risk inherent in any deal. Whereas VT has some US operations, Babcock's markets outside the UK have typically been in Commonwealth countries and in the Middle East. Babcock will also have to integrate VT's esoteric waste management business or sell it, as well as try to retain VT's best managers.
But momentum buying could boost the share price as Babcock's shares will be on the cusp of the FTSE 100 index after the deal is completed.
