In recent years, Babcock (BAB) has looked as though it was the best of a bad bunch, albeit damned by its association with UK public sector outsourcing and the travails of peers such as Carillion and Interserve. Many, including ourselves, viewed the group as unfairly tarnished by the comparison, noting that Babcock carries out a range of high-value services in specialised areas. However, we have come to feel increasingly perturbed by long-term signs of dwindling cash generation.
The shares are cheap against history
Barriers to entry
Declining cash conversion
The shares are heavily shorted
Stream of analyst downgrades
High debt
Babcock’s operations focus on specialised areas with barriers to entry such as marine engineering, fleet management and nuclear decommissioning. These areas compare favourably with the low-margin, cleaning and support services offered by many other UK-listed outsourcers. To underline this, at the end of last year, the group changed its classification on the FTSE from ‘business support services’ to ‘aerospace & defence’.
However, in recent years the group’s ability to wring free cash flow from its activities has been diminishing. Five-year cumulative free cash flow (FCF) (looking at five-year totals help smooth out the lumpy nature of annual cash flows) has pretty much gone nowhere since 2013 while cumulative profit after tax (PAT) has doubled, leading to plummeting cumulative FCF conversion (see graph).
Weak long-term cash conversion is a particular concern given the size of the group’s liabilities. Debt spiked back in 2015 following a series of acquisitions. Net debt has been nudging down since and is expected to have been lowered to 1.4 times cash profit for Babcock's financial year that just finished at the end of March. However, at the same time the company has become more reliant on leases. If these debt-like obligations are factored in using the standard method of valuing lease liabilities at seven times the annual rent bill, net debt plus lease obligations have actually risen over the period from £2.05bn to £2.31bn at the end of 2018. In addition, the group's pension deficit at the end of March 2018 was reported at £245m.
| BABCOCK (BAB) | ||||
| ORD PRICE: | 510p | MARKET VALUE: | £2.58bn | |
| TOUCH: | 509.6-510p | 12-MONTH HIGH: | 868p | LOW: 472p |
| DIVIDEND YIELD: | 6.3% | PE RATIO: | 6 | |
| NET ASSET VALUE: | 565p | NET DEBT: | 39% | |
| Year to 31 Mar | Turnover (£bn) | Pre-tax profit (£m)** | Earnings per share (p)** | Dividend per share (p) |
| 2016 | 4.84 | 460 | 74.0 | 25.8 |
| 2017 | 5.22 | 495 | 80.0 | 28.2 |
| 2018 | 5.36 | 513 | 82.9 | 29.5 |
| 2019** | 5.32 | 525 | 84.8 | 30.7 |
| 2020** | 5.16 | 521 | 83.9 | 31.9 |
| % change | -3 | -1 | -1 | +4 |
| Normal market size: | 2,000 | |||
| Beta: | 1.12 | |||
*Includes intangible assets of £3.1bn, or 613p a share **Peel Hunt forecasts, adjusted PTP and EPS figures | ||||
