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Babcock offers overlooked value

The support services sector has faced challenges in recent years, which has led investors to neglect the prospects of the engineering specialist
October 12, 2017

While engineering and support services specialist Babcock (BAB) continues to deliver solid earnings growth, its shares have struggled as investors have taken fright as the wider support services cohort has thrown up profit warning after profit warning. In the past year alone we have seen shares in peers Carillion (CLLN), Capita (CPI) and Interserve (IRV) drop unceremoniously following severe warnings about their underlying health. Look back to the end of last year and Mitie (MTO) warned on profits - in a trading statement which is now being probed by the Financial Conduct Authority and the Financial Reporting Council. All in all, investors smelling something rotten in the sector haven’t had to look far to find justification for their views.

IC TIP: Buy at 823p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points

Valuation at a historical low

Solid dividend yield

Falling debt

Strong forward order book

Bear points

Concerns over sub-sector

Poor share performance this year

Perhaps, then, this is why Babcock's shares haven't been feeling the market's love and currently trade on a forward price/earnings (PE) ratio that, according to Bloomberg data, is in the lowest per cent of its five-year valuation range and the bottom 5 per cent of the 10-year range. True, sentiment wasn't helped when earlier this year the company said it would be exiting its Magnox nuclear decommissioning contract after five years, rather than the 14 originally agreed. The volume of work required transpired to be significantly higher than had been originally tendered for, and the lost work is expected to re-enter the pipeline in the near term.

Indeed, Babcock looks an altogether more reliable proposition than its rickety peer group. For one thing, the order book remains healthy at £19bn, with 89 per cent of revenues for 2017-18 in place and 57 per cent of 2018-19. The win rate remains strong, with success in over 40 per cent of bids for new work and over 90 per cent for renewals. The order book is predominantly made up of new work, with rebids accounting for just 30 per cent of the total. Management is targeting single-digit organic growth in constant currency and stable margins.

The specialised nature of Babcock’s work provides a moat that makes it less vulnerable to disruption when compared with rivals operating in less technical spheres. Looking at the order book as of March this year, around half was comprised of contracts with a total value exceeding £100m, reflecting their complexity and scale.

However, many of the problems encountered by Babcock peers have been hidden away on impenetrable balance sheets. The reliability of reporting by support services companies, along with sectors such as aerospace, defence and construction, should be improved next year by the mandatory implementation of IFRS 15, an accounting standard that governs the way revenues are recognised from contracts with customers. The transition will not be easy for some companies, with early adopter Capita already reporting a revenue drop. Energy services company Utilitywise (UTW) has found itself with negative retained earnings and is likely to miss revenue expectations. By contrast, Babcock’s management said last month that IFRS 15 “is not expected to have a significant impact on earnings”. They will update again ahead of adopting the standard.

Historically, the ratio of a company's revenues to its accruals (income and costs reported in the profit-and-loss account but not yet paid in cash) has been a strong indicator of the potential for restatement of profits, with higher levels indicating a higher risk. Further reassurance of the quality of Babcock's profits can therefore be taken from the chart below from broker Panmure Gordon, which shows the median level of accruals for support services companies between 2006 and 2015. Babcock has the lowest of the group, and is the only one not to have issued a warning in recent years.

A solid balance sheet and good cash conversion (operating cash conversion was 115 per cent last year) add to the impression that Babcock is an exception in a sector blighted by warnings.  

BABCOCK (BAB)   
ORD PRICE:823pMARKET VALUE:£4.2bn
TOUCH:822-823p12M HIGH / LOW:1,038p795p
FORWARD DIVIDEND YIELD:3.8%FORWARD PE RATIO:9
NET ASSET VALUE:532p*NET DEBT:44%
Year to 31 MarTurnover (£bn)**Pre-tax profit (£m)**Earnings per share (p)**Dividend per share (p)
20154.5041868.123.6
20164.8445674.025.8
20175.2249580.028.2
2018**5.4552584.429.6
2019**5.8156089.631.0
% change+7+7+6+5
NMS:2,000   
Matched Bargain Trading    
BETA:0.65   

*Includes intangible assets of £3.22bn, or 636p a share

**Peel Hunt forecasts, turnover includes share of joint venture and associates, adjusted PTP and EPS figures