Babcock brings back dividend

The turnaround process for Babcock International (BAB) has been laborious.

Since former Cobham Group CEO David Lockwood and CFO David Mellors were appointed three years ago they’ve had to first clean up the company’s numbers, then find ways of plugging the gaping hole that emerged on its balance sheet once they had. Businesses have been restructured or sold off and renegotiations held with clients around loss-making contracts.

Yet the decision to pay an interim dividend – the first offered to beleaguered shareholders for four years – is the clearest sign yet that the defence contractor has emerged from it in a battle-hardened state.

It has, of course, been helped by favourable market conditions given the greater geopolitical strife, which is evidenced by some of the contracts won both during and after its half-year results.

Organic revenue grew by 18 per cent, helped by earlier-than-expected licence fees from a programme to develop frigates for Poland’s navy.

Lockwood said the company is benefiting from “a growing opportunity set, particularly outside the UK”, although deals signed domestically with the Ministry of Defence have been some of the most eye-catching – last week, it won a £750mn contract to upgrade the Devonport dockyard over four years in preparation for the next generation of nuclear submarines (into which it also has design input).

Just as importantly as winning new work, though, is delivering it profitably – especially given the company’s recent history. Its underlying operating margin rose from 5.7 to 7.1 per cent, much closer to its medium-term target of at least 8 per cent. It also converted more of this profit into cash – its underlying operating cash conversion ratio jumped to 82 per cent, from 63 per cent in the same period last year. This allowed the company to cut its measure of net debt by a further £72mn since its March year end to £493mn – or less than half of the £1.04bn it owed this time last year.

Babcock is heading in the right direction, with the improvement in cash flow particularly welcome. Yet investing in the company is still a risk – a net asset balance of £370mn for a company with almost £3bn of obligations (including a £150mn pensions deficit) is hardly what you’d call robust.

If it can maintain momentum, its current valuation of just over 11 times forecast earnings will start to look cheap. For now, though, it seems a fair reflection of its current state. Hold.

Last IC View: Hold, 351p, 20 Jul 2023