Buy into the Babcock turnaround

However, having substantially reset earnings expectations this year (see chart above) prospects may finally be improving. Large orders have come in at the marine business and there is growing optimism about a resurgence in defence spending. We think investors should take heed of the recent momentum in the shares, which signals that a long-awaited recovery may finally have begun.

Babcock breaks its activities down into four segments: marine, land, aviation and nuclear. Marine accounts for the biggest share of Babcock sales and profits at 33 per cent and 37 per cent, respectively. Meanwhile two-thirds of the group’s turnover is derived from the UK.

While half-year results last month revealed a fall in sales owing to the conclusion of a number of contracts, including aircraft carrier work, the more significant news was the signing of a deal worth around £1.25bn to build five Type 31 frigates for the UK government. The deal took Babcock’s order book up to £18bn in November from £17bn at the group’s March year-end. The contribution to profits from this Type 31 contract will start to really be felt in 2022, with broker JPMorgan forecasting that it will contribute annual profits of about £10m, rising to £20m through to 2028. Perhaps more significant has been growth in the bid pipeline, which stood at £16bn following the Type 31 win, compared with £14bn at the end of March. Babcock has since won a £1bn contract to design weapons systems for Australian Navy submarines.

The UK’s latest review of its defence expenditure in September brought a 2.3 per cent above-inflation increase in the defence budget, excluding operations, for 2020-21. This takes the four-year real-terms increase in core defence spending to 9.6 per cent, which represents the biggest such increase since the early 1980s, according to the Royal United Services Institute. The specialist nature of Babcock’s services gives it a bidding advantage; for example its Devonport facility where it maintains warships and submarines cannot be replicated by rivals. 

While orders are encouraging, investors still need more encouragement on Babcock’s ability to generate cash. There may be upward pressure on working capital from contract delays in Italy and Spain, along with the group’s entry into two new markets for aviation, Norway and Canada, which will hopefully restore the division’s performance. However, the company still expects full-year free cash flow excluding pension contributions to come in at around £250m. It has also set a target of £1.4bn of free cash flow over the next five years, which should bring net debt down from 1.9 times cash profits (Ebitda) and into its target range of 1 to 1.5 times.