Babcock is 'too cheap to ignore', Kingfisher isn't

Two-thirds of FTSE 100 constituents have posted year-to-date rises, but it's two of 2017's biggest blue-chip laggards that lead the FTSE All-Share Wednesday.

By close of play yesterday, Kingfisher and Babcock were down 23% and 19% respectively over the past eight months. However, the pair took tentative steps forward mid-week as investors lifted them off multi-year lows.

Kingfisher, which owns the B&Q and Screwfix DIY chains, surged as much as 8% to a 15-week high at 320p after its first-half trading update beat expectations. Its five-year transformation plan is also on track.

Underlying pre-tax profit, which excludes restructuring costs of £46 million, rose 0.9% to £440 million, a 3% beat versus City forecasts, while adjusted pre-tax profit fell 5.7% to £394 million for a 12% beat. Adjusted earnings per share (EPS) dipped 4.4% to 13p, while the interim dividend is up slightly to 3.33p.

UK profits of £215 million were also well above consensus of £201 million, and sales in France were better-than-feared. Other international markets disappointed.

Currently two years into its ONE Kingfisher plan, which aims to deliver £500 million of sustainable annual profit improvement, chief executive Veronique Laury says the firm is "on track to deliver our full-year strategic milestones".

"Changes are now visible in our stores with new product ranges being well received by customers. We are also changing our ways of working alongside the continued rollout of our unified IT platform."

Kingfisher is "cautious on the second-half backdrop in the UK and France" but "comfortable" with full-year expectations. Still, analysts aren't convinced. UBS has a 'sell' rating and 265p price target, while Cantor Fitzgerald recommends clients 'hold' with a 340p target.

While a forward price/earnings (PE) ratio of around 13 might not appear expensive, it doesn't scream value either, given pressure on consumers and transformation execution risk.

A £4.2 billion market cap makes Babcock the FTSE 100's second-smallest company. After an inexorable rise to £13 in early 2014, the outsourcer has struggled, dipping below £8 last week.

Back on the front foot, it was up almost 5% Wednesday to 840p after claiming it will meet full-year expectations - and analysts are positive. "A comparison with support services peers suggests ongoing undervaluation by around 24%," writes Panmure Gordon's Michael Donnelly.

Revenue visibility continues to improve, we're told, with 89% of sales now in place for 2017/18 and 57% for 2018/19. "The order book and bid pipeline of opportunities have remained stable."

It's started work on a number of new contracts won this financial year, including projects in the UK, South Korea, Oman and France. Revenue in its Marine division will be slightly lower than the previous year, but that'll be offset by growth elsewhere.

Investors had been worried new accounting rules might have a similar impact to that which caused Capita to revise down 2016 profits by almost a third recently. However, Babcock says IFRS 15 will have no significant impact on earnings.

Liberum's Joe Brent believes Babcock is undervalued. At a forward 2018 price/earnings (PE) ratio of 9.1 times, it's trading at a 43% discount to the sector average, he tells us. A target price of £11 implies upside of around a third.

True, post-Brexit uncertainty and the possibility of a Jeremy Corbyn victory in any new general election pose challenges - Labour is in favour of renationalising privatised assets. However, Babcock "should deliver mid-single digit revenue growth in 2018, which makes the business too cheap to ignore".

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.