Babcock shores up its own defences

David Lockwood has now been in the chief executive’s role at Babcock International (BAB) for nearly four years, yet he joked as he began the company's results presentation that “this has actually been the first fun year”.

The company's turnaround has undoubtedly been a slog. The first two years’ results were full of accounting restatements and contract reassessments that blew a big hole in its balance sheet. Then there’s been the task of reducing the defence contractor’s debt mountain, largely through the sale of non-core assets. And just when investors thought things were looking up, the company reported in April that this year’s results would incorporate a loss of £100mn on an unprofitable contract with the Ministry of Defence (MoD).

This contract to build five Type 31 frigates was awarded in 2019 and will run to 2028 – so far, Babcock has built 40 per cent of the first ship. The £100mn charge was recognised to cover potential losses over the lifespan of the contract, although Babcock remains in a dispute process with the ministry about renegotiating it. Lockwood was keen to point out that the dispute hasn’t affected its relationship with the MoD, citing recent other recent wins, including a £400mn, six-year contract to manage the Skynet military satellite communications system. 

He also argued that the frigate deal was the last major contract awarded to Babcock before he and chief financial officer David Mellors were appointed to the company, and that they had strengthened risk management procedures in a bid to prevent similar losses.

Excluding the loss on the frigates contract, underlying operating profit grew by 17 per cent. There was also better news in terms of both cash generation and net debt – cash from operations rose by £307mn to £349mn. This, and some disposals, helped it to cut net debt by around £400mn to £565mn. Babcock is now a “higher quality, lower risk and more predictable business”, Lockwood said.

Demonstrating this, the company set medium-term guidance of achieving an operating margin of at least 8 per cent (up from 6.6 per cent, excluding the Type 31 loss and other one-offs). It also plans to reintroduce a dividend in its 2024 financial year.

Investors were clearly sold, with the shares climbing by 11 per cent. They are priced at nine times broker Shore Capital’s forecast earnings, and with defence budgets growing there's an argument to be made that they represent good value. The company is still working through legacy issues, though, and we think there are better opportunities elsewhere in the sector. Hold.

Last IC View: Hold, 308p, 22 Nov 2022