Underappreciated Babcock ready for a rerating

Babcock sits alongside support services peers such as Serco (SRP), Capita (CPI), Mitie (MIO) and Carillion (CLLN). The past few years have demonstrated that a multitude of sins can be hidden by the accounting feats needed to construct an earnings statement based on outsourcing giants' byzantine long-term contracts. Babcock stands alone among this group in not having suffered a high-profile fall from grace, but the share price suggests the market fears it may be just a matter of time. We feel it may pay to take the contrarian view. While the company is highly reliant on estimates in constructing its accounts, it has key attributes that separate it from its peers, and it is interesting to note that shorting of the shares remains relatively muted at 3.6 per cent, according to FCA data -  that's marginally more than Capita and marginally less than Serco, but well below Carillion and Mitie.

The main difference with Babcock is the nature of the work it does for the govern­ment. The group operates in four sectors: marine, land, aviation and nuclear. In all of these sectors it offers specialised training and engineering with high barriers to entry, sparing it from the competition on price and thin margins as has been seen with other government contractors. This is re­flected in consistent growth in pre-tax prof­ its and EPS since 2011, and revenue since 2010. The group's operating margin also look good despite a slight first-half decline to 10.5 per cent from 10.8 per cent, due to contract mix. This is expected to recover in the second half of the financial year. The first half order book was another gripe, which played on fears that Brexit  is slowing government decisions. This declined 7.5 per cent to £18.5bn. However, the combined order book and bid pipe­line increased to £31bn from £30bn. The group's win rate is over 40 per cent for new bids and 90 per cent for rebids.

Perhaps investors' biggest worry from the first half, given the nature of the sector's woes, came from weak cash flows which took a knock from a £115m negative working capital movement. However,£44m relates to an initial in­ vestment  to begin work on a contract with Fomedec, which provides training and related services to the French Air Force. While working capital related to the contract will continue to rise in the second  half, it is expected  to reverse out the following year as lease agreements are signed with the French government. The other £71m of the movement related chief­ly to a one-off use of prepayments by the marine business and a one-off investment in Babcock's South African operation.

It is natural to fear such issues could mean cracks are beginning to show, but there are also reasons to take heart in Babcock's reported numbers. A change in accounting standards under IFRS15 effectively means that from next year sup­port services groups will have to recognise revenue and profit later in the life of a contract. Capita saw its shares fall sharply this year when it adopted  the standard early,  noting  that  under  the  new  regime its 2016 revenues and operating profits would be 5 per cent and 30 per cent lower, respectively. However, management at Babcock released a statement early in December, saying that following an audi­ tor's review of their contracts "the new standard is not expected to introduce any material change to the group's revenue recognition policy".

What's more, while cash flows may have disappointed in the first half, efforts to reduce debt have the potential to shore up confidence in 2018. Net debt edged down from 2 to 1.9 times cash profits in the first half of the year and is expected to finish March at 1.7 times before dropping to a targeted 1.3 times in the 2019 financial year. The shares still boast an attractive dividend yield with cover in the middle of the 2.5 to 3 times earnings range and management was confident enough to push through a 5.4 per cent increase at the half-year results.

Management also piled into the shares themselves after the interims, with four directors spending £212,000 at prices between 667p and 693p.