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Babcock's rudderless ship

The defence engineering group has been a long-term disappointment for investors, and right now a turnaround looks even further away
October 1, 2020

Babcock (BAB) provides critical engineering services across the marine, nuclear, land and aviation markets. Within these sectors, its primary focus is on defence activities, which accounted for more than half its revenue in the year to 31 March. The group’s biggest customer is the UK Ministry of Defence (MoD), and as its number two supplier behind BAE Systems (BA), Babcock does everything from military training to shipbuilding. But despite its defence proclivities, the group has struggled to shake the perception that it is a traditional outsourcer like Serco (SRP) as opposed to a defence contractor like QinetiQ (QQ.). This hasn’t been helped by a long track record of underperformance – its shares have gone from almost 1,300p in 2014 to just 235p now.

IC TIP: Sell at 235p
Tip style
Sell
Risk rating
Medium
Timescale
Medium Term
Bull points

Strong order book

Focus on non-discretionary activities

Potential takeover target

Bear points

Aviation weakness

Possible defence cuts to come

Analyst downgrades

Pension obligations

Likely value trap

Readers of the magazine's Ideas Farm data pages may have noticed Babcock as a consistent presence in our weekly list of London’s most shorted stocks. Short interest currently stands at close to 6 per cent of its issued share capital. While this is down from the 9 per cent peak last year, short interest is rising once again. This comes in the wake of a dire set of full-year results unveiled in June in which Babcock sank to a £165m statutory operating loss, from a £197m profit a year earlier. It was weighed down by over £500m of exceptional charges, largely relating to its aviation business. Here, Babcock is paying the price for past mistakes, in particular its £1.8bn purchase of helicopter operator Avincis in 2014, which put it in the business of transportation back and forth from oil rigs. Crude oil was priced at around $108 (£84) per barrel when the deal was completed, and within a few months the price fell dramatically and has yet to recover anywhere near previous highs. An increasingly competitive pricing environment has only compounded these woes.

The aviation segment – which accounts for around a fifth of overall underlying operating profit – has seen its margin deteriorate from 15.5 per cent in 2016 to 12.1 per cent in 2020. With the ongoing Covid-19 crisis set to squeeze margins across the whole business, this could make it harder for Babcock to meet its medium-term target of sustaining an 11 per cent group margin. The overall underlying operating profit margin came in at 10.8 per cent last year, down from 11.4 per cent in 2019.

 

 

Sliding further

The Avincis acquisition has not been Babcock’s only hurdle. In the past, the group has found itself under siege from a mysterious research firm called Boatman Capital. It first released a report on the company in October 2018, alleging that it “systematically misled investors by burying bad news about its performance”. That was followed by a sequel in May 2019 that criticised Babcock’s corporate structure, labelling it as “opaque” and “needlessly complex”. Babcock decried the “malicious attack” at the time, and while the veracity of Boatman’s claims are questionable, its reports nonetheless helped erode investor confidence.

There is now new leadership at Babcock’s helm. Long-standing chief executive Archie Bethel was replaced by David Lockwood – former head of Cobham – in September, which followed the appointment of Ruth Cairnie as chair last year. While both Mr Lockwood and Ms Cairnie have demonstrated confidence in their company by purchasing shares, this has done little to change investor or analyst sentiment.

Analyst downgrades have become an almost regular occurrence, with the latest set of revisions coming in the wake of Babcock's August trading update. The group revealed that its underlying operating profit in the three months to 30 June was down 40 per cent year on year, with around half of the reduction due to lower productivity in the wake of Covid-19. The pandemic has hit its short cycle work in particular – such as its airport and rail activities – which accounts for around a fifth of total revenue. But Babcock’s long-term contracts have not been left unscathed, either. With profits being recognised when certain milestones are reached, slower progress has fed through to lower margins.

 

 

On the defensive

There are things to like about Babcock – for example, around 80 per cent of its revenue is derived from long-term, non-discretionary contracts. The group is currently sitting on a £17.3bn order book, which has been buoyed by the contract to design and build five Type 31 frigates for the UK navy. With each ship costing on average £250m to produce, profits are set to ramp up from 2022 – analysts at JPMorgan estimate that annual underlying operating profit from the Type 31 programme will be £10m in 2022 before eventually rising to £20m. The group has also identified a £17bn pipeline of opportunities, of which almost 50 per cent are outside of the UK.

But it may not be all plaining sailing in defence. Military budgets could come under pressure in a post-Covid world as governments face up to the scale of borrowing undertaken to weather this crisis. An additional complication is the UK’s integrated review into security, defence, development and foreign policy, which will shape the agenda for years to come. Babcock could find itself in the crosshairs of Dominic Cummings and his war on Whitehall waste. Mr Cummings has been particularly scathing about MoD procurement in the past – not entirely unwarranted given the blackhole in its 10-year equipment plan, which the National Audit Office (NAO) estimates could be up to £13bn. Even if Babcock wasn’t subject to outright cuts, it has previously experienced slower growth when defence projects are delayed.

The UK’s review is likely to see a shift away from conventional warfare – something that Babcock has traditionally specialised in – towards newer capabilities such as space and cyber. It’s therefore not ideal that the group chose to sell its cybersecurity business, Context, for £107m in March. Babcock is looking to expand its technological capabilities and has its eye on the MoD’s ‘maritime electronic warfare systems integrated capability’ (MEWSIC) contract that will provide the next generation electronic warfare programme for surface ships.

 

Pesky pensions

Following the Avincis acquisition, Babcock saw its net debt more than double in 2015, to £1.3bn, although it has been slowly decreasing ever since. Excluding lease liabilities, net debt ticked down by 4 per cent in the year to 31 March to £922m. Equivalent to 1.7 times cash profits (Ebitda), this is above the group’s 1-1.5 times target range. Net debt has since fallen further thanks to the £85m sale of its stake in military training services business Holdfast, but Babcock is guiding that leverage will increase to 2 times cash profits by the end of the current financial year. It’s worth noting that those lease liabilities tot up to a not insignificant £673m and Babcock also used around £100m of ‘invoice factoring’ last year – this is where trade receivables are sold to banks who go on to recoup the money owed from suppliers so that Babcock can receive cash more quickly.

The group does have a decent track record of generating free cash flow, but while it had been aiming for £250m of underlying free cash flow last year, the actual total came in at £192m. This came amid a £27m working capital outflow as Covid-19 delayed customer payments and also interrupted asset sales leading to higher-than-expected capital expenditure. Babcock is aiming to produce £1.4bn of free cash flow over the next five years, but analysts at Numis believe it will fall short of this target at £713m. This is largely based on lower expected profits and higher pension contributions. Having made a £70m payment to its pension schemes in 2020, this is expected to rise to £75m in 2021. Babcock will also pump an additional £90m into its Rosyth dockyard scheme over two years, although the starting point has yet to be determined. With uneven deficits across its three main pension schemes – the total actuarial deficit is £500m – Babcock has warned that its pension funding will be more volatile in the coming years.

 

A value play or a value trap?

Looking at a range of valuation metrics (see table), Babcock has been getting cheaper over the past few years and in its weakened state, it has already become a takeover target – it rebuffed two unsolicited advances from Serco for an all-share merger in 2018 and 2019. Serco could conceivably come back for another crack – chief executive Rupert Soames recently told the Financial Times that “the market is facing an era of consolidation and we are in a position to be a part of it”. Babcock could also show up on the radar of private equity, particularly in the wake of Cobham’s sale to Advent International – although the government’s ‘golden share’ in the Rosyth and Devonport dockyards would complicate a foreign buyout.

 

Beware of a value trap
Babcock has been historically cheap and its valuation will likely drop even further
 201620172018201920202021 (e)2022 (e)
Price-to-earnings12.811.08.15.95.55.34.3
Price-to-book value2.01.71.20.90.80.40.4
Enterprise value-to-sales1.31.10.90.70.70.60.6
Enterprise value-to-operating profit (Ebit)13.112.37.96.26.98.07.0
Return on equity (%)15.915.115.014.713.88.19.5
Note: Year to 31 Mar
Source: FactSet

With the shares being so depressed, investors may be tempted to see this as a buying opportunity. But according to analysts’ predictions, return on equity (a key meaure of quality and profitability) is set to fall further, which doesn’t bode well for its recovery prospects.

 

 

BABCOCK (BAB)    
ORD PRICE:235pMARKET VALUE:£1.2bn  
TOUCH:235-236p12-MONTH HIGH:660pLOW:224p
FORWARD DIVIDEND YIELD:8.5%FORWARD PE RATIO:5  
NET ASSET VALUE:505p*NET DEBT:65%**  
Year to 31 MarTurnover (£bn)Pre-tax profit (£m)***Earnings per share (p)***Dividend per share (p) 
20184.6651383.029.5 
20194.4851884.030.0 
20204.4542869.17.2 
2021***4.1127844.217.7 
2022***4.2232251.020.4 
% change+3+16+16+11 
Beta:1.2
*Includes intangible assets of £2.6bn, or 505p a share
**Includes lease liabilities of £673m
***Liberum forecasts, adjusted PTP and EPS figures