Stockwatch: A share too good to be true?

Is the UK’s largest engineering support services share Babcock a value proposition or a tad "too good to be true"? 

My last macro piece identified how support services are behind the biggest rise in UK profit warnings in four years; yet Babcock has announced interim results showing double-digit advances at the top and bottom lines, and management is confident about the future.

It sustains progress seen in results for the year to 31 March 2015 and the AGM statement, citing "a stable order book with excellent visibility...we continue to experience strong demand for the critical services we provide through existing contracts...the board continues to expect significant opportunities for growth from our move into new markets and geographies..."

Stock has de-rated sharply

Yet the chart has shown a significant de-rating from near 1,300p in early 2014, typifying stocks that overshot on the upside, amid monetary stimulus, then groped for fair value. This coincided with contract delays in support services generally, plus the oil price plunge. 

At about 1,080p, Babcock trades near a 13% discount to the sector and its 12-month forward price/earnings (PE) multiple of 13.8 times compares with 16.8 for FTSE 100 peer Capita and 39.3 for mid-cap player Serco, although Serco is a turnaround situation where the high PE anticipates recovery. 

Latest defence review refreshes growth prospects

While the oil price slide has been a factor behind Babcock shares falling from 1,145p mid-year, the government’s latest defence review should foster opportunities outweighing this.

Babcock operates various naval bases and military training/logistics for the Ministry of Defence (MoD) and, while defence revenues have recently slipped 3%, an additional £12 billion of equipment spending is targeted by this review. Amid government austerity, Babcock has reduced MoD exposure from 70% to 40% of group revenue, albeit with low single-digit growth anticipated for defence & security for the current year as a whole.

Nuclear decommissioning and design are being pursued internationally, and the £1.6 billion acquisition of Avancis some 18 months ago introduced "mission critical services" by helicopter and plane, including offshore crew changes for the oil & gas industry. 

The financial review within the interim results cites revenue from oil and gas services down 9%, while emergency services grew by 10% and represented two-thirds of revenue within the acquired Avincis business.

Such a profile ought to be reasonably counter-cyclical with the main such risk - serving the oil & gas industry - small in context. Babcock’s operational risk profile looks, therefore, to be improving versus other support service groups, which implies an earnings rating at least in line with underlying growth.    

Contract delays/cancellations have not manifested

The group order book has been replenished by about £2 billion of contract work during the first half-year, a like-for-like increase of £1.5 billion, with 92% of targeted revenue for the 2015/16 year secured and 60% for 2016/17. This implies fears of an oil industry-related contraction were overdone and have, anyway, been substituted. 

Currency translation is more an issue, now that a quarter of revenue is derived overseas, although 6% growth in underlying operating profit versus 8% growth at constant currencies was largely due to weakness in the South African rand; emerging market currencies fell in expectation of a US interest rate rise, and labour unrest in the mining sector.  Euro weakness has also applied and could persist with monetary easing.  

Varied broker views and criticism of accounting

City views contrast, with Liberum and Exane BNP Paribas continuing to target 1,000p and 900p respectively, while Peel Hunt and JP Morgan Cazenove target 1,175p and 1,427p. 

Peel Hunt has downgraded from 1,248p after trimming its current year profit forecast by 1.5% and 2016/17 by 3%, albeit all due to the rand and euro. More significant to watch is Liberum quibbling with Babcock over the timing of revenue recognition, depreciation charges and provision for bad debts.

This is disconcerting when the figures look unusually good for support services generally, and, although Babcock’s board is well-balanced with non-executive directors, this kind of thing can get institutionalised without criticism. 

Cash conversion continues strongly, however, at 112% of operating profit in the latest interims; and note the five-year trend in cash flow per share has generally been well ahead of earnings. If certain accounting treatments had been aggressive (within the rules) in context of weak cash generation then that would flash red lights; for the time being, be aware of amber.

Dividend and balance sheet: less good as props

A 2.5% yield thrice covered by earnings is not going to limit downside, and the balance sheet likely deters conservative investors already.

Due to Babcock’s history of acquisitions, capitalised goodwill and intangibles have swollen to 140.6% of net assets - hence the striking negative trend in net tangible assets (see table) and amortisation charges hitting income statements, e.g. clipping 19.2% off underlying operating profit in the latest interims. 

The current ratio (current assets divided by current liabilities) is also quite poor at 0.84, mainly due to £1,162.6 million trade payables versus £762.3 million trade receivables, this profile having persisted. Net debt is £1,315.7 million, representing gearing of about 57% with net finance charges taking 15.3% off operating profit. The balance sheet appears manageable barring a recession.

Hopefully, this clarifies why sentiment is mixed towards Babcock and brokers divide on fair value. The government’s defence review does, however, look a very positive development for the group, and is capable of tilting risk to the upside on, say, a three-year view. At the same time, other support services groups have to contend with (local) government spending cuts, also by the private sector if the economy weakens. At the very least it makes Babcock more pertinent to follow.

For more information see their website, where there is a useful presentation on the interim results, also with a webcast.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.