Babcock rebounds following defence splurge

The hive of activity at the Devonport dockyard near Plymouth is a real illustration of the hike in defence spending following Russia's invasion of Ukraine. Devonport, which has been in operation since early in the 18th century, is Europe's biggest naval dockyard. Yet the 'peace dividend' that accompanied the end of the Cold War meant successive governments cut investment in many of the UK's defence facilities, and now the nation is playing catch-up. 

Babcock (BAB), which co-owns a large part of the base, was handed a £750mn contract in November to make infrastructure upgrades over the next four years that will equip the site to carry out deep maintenance work for current and future generations of UK submarines. At 10 Dock, for instance, an old Edwardian dock is currently being reconfigured to handle both Astute and Dreadnought class submarines. 

This is the biggest investment in Devonport in 30 years and the work has to take place while the yard remains operational. Currently on site, HMS Victorious – a Vanguard class nuclear submarine originally commissioned in the 1990s – is undergoing a £500mn refurbishment that will extend its lifespan for another 15 years. Several Type 23 frigates are also being upgraded and HMS Conqueror, the nuclear submarine that sank the General Belgrano ship during the Falklands War, is being decommissioned.

This is the type of "complex programme delivery" at which Babcock specialises, chief executive David Lockwood told Investors' Chronicle on a tour of the dockyard last week. 

Various asset sales in recent years show the shift to services over sales under Lockwood, resulting in higher cash flow and halved net debt between 2021 and now. Babcock has also reduced its pension deficit by £400mn to around £300mn. Another headache looks to have been solved as of this month as well: Babcock confirmed it had resolved a dispute with the Ministry of Defence over its lossmaking Type 31 frigate contract.

The company signed a deal in 2019 to build five frigates at a cost of £250mn per ship, but then steel, labour and other costs soared. It booked a £100mn loss covering the lifespan of the contracts last year and entered into a process in a bid to renegotiate terms. 

Lockwood said the terms of its settlement were subject to a non-disclosure agreement, but made further disputes less likely and provided a “much more robust framework to finish the programme”.

However, the fact that there was no accompanying lift to earnings guidance meant Babcock's shares initially plunged by 9 per cent last Wednesday, although this loss was regained in subsequent trading sessions. 

Liberum analyst Joe Brent said in a note that “it seems reasonable to assume no profit” on the Type 31 contract. Lockwood told analysts there had been “a lot of noise” about Type 31, but it only represents 5 per cent of the group’s revenue.

Babcock had seen its own peace dividend in terms of recruitment. There are currently around 7,300 workers on the site, which is a decline from around 13,500 when the site was privatised in the mid-1980s but a big uplift from the 4,000 or so that were working there in the early 2010s. This means it has "lots of old people and lots of young people” among its employees, but not as many in the middle of their careers. 

“Making sure we retain the experience for long enough to transfer the skills… is really important to us,” Lockwood said. 

Skilling up

After its recent disposals, 80 per cent of total revenue is driven by service provision rather than products. To deliver this, "engineering know-how" is more important than intellectual property, he argued. 

"You can have all of the drawings in the world but when we put a 40-year-old Warrior (armoured) vehicle in front of the engineers, how they actually approach the refit is down to the knowledge and understanding of the platform," he said.

The company is currently recruiting around 600 trainees a year plus older 'production support operatives' who don't qualify for apprenticeships but whom it is teaching through 'on the job' training in a bid to fill its own gap.

"We are an engineering company and haven't always behaved like one, and that's one of the reasons [that] on occasion we've got into trouble," he said.

He was also keen to highlight an improvement in contract discipline in recent years. Although lossmaking contracts still made up 11 per cent of last year’s revenue, this should reduce as older work is delivered. 

“Next year is our biggest year for [lossmaking] revenue and then that fades through to 2028,” he said.

The group’s operating margin, which stood at 6.3 per cent last year, would be 0.9 per cent higher without these contracts, Lockwood said.

Other improvements, including systems upgrades and rationalisation of overheads, will contribute towards Babcock’s medium-term goal of lifting operating margin above 8 per cent, chief financial officer David Mellors told analysts.

Brighter prospects have translated into broker upgrades and a 50 per cent increase in Babcock’s share price over the past year. Peel Hunt’s analysts think the company’s 8 per cent margin target can be beaten and says that, despite recent share price gains, Babcock still trades at a discount to peers. “We believe it is not too late to get on board,” the company’s analysts said in a note.

Not everyone agrees, though, with Liberum’s Brent arguing that a price of 11 times forecast earnings “is no longer cheap” relative to the company’s history and its peer group definition.

<booxut>

Read more from Michael Fahy

<boxout>