US Edition Babcock
£12.74-3p
Questor says BUY
BABCOCK delivered rock solid profit and dividend growth for investors in the half-year results announced last month, and a small deal to buy a cyber security firm announced this week shows that the outsourcing group now has the firepower to make a much larger acquisition next year.
The FTSE 100-listed group splashed out £28m for Context Imformation Security, which in itself is a sensible move into a rapidly growing market. The deal comes only weeks after Babcock was linked to a £1.5bn deal to buy Avincis, the leading supplier of search and rescue helicopters and air ambulances in the UK.
The reason this is all happening now is because Babcock has successfully integrated the deal it pulled off nearly four years ago to buy VT Group, formerly known as Vosper Thornycroft. Peter Rogers, chief executive, mentioned the “powerful” balance sheet in the half-year update and analysts expect net debt to reduce to about £330m within the next 15 months, from £729m after the VT deal.
With low debt levels and strong cash generation Babcock is well placed for another deal. Putting it in perspective, back in 2010, the company issued 128m new shares and increased leverage to buy VT Group and on Questor’s estimates if Babcock did the same today that would provide it with funds to buy a company worth up to £2.2bn.
The company is in such a strong position because it has defensive revenue streams. Babcock refits and maintains many of the Royal Navy ships and submarines and owns or runs shipyards at Faslane, Rosyth and Devonport. Its chairman is Mike Turner, a former boss of BAE Systems.
The defence work the company bids for requires security clearance and customer confidence and this provides high barriers to entry. Babcock also controls a pool of highly skilled engineers of which there is a national shortage. Both these factors allow Babcock to price strongly and achieve attractive profit margins on work
The group has predictable and steady revenues. At the end of September an order book of £12bn gave the company certainty over half of its revenue for the year ended March 2015. Of the contracts it is already working on, the company has a 90pc success rate on re-bidding. The company has a 45pc success rate on new contrcts, and a £15.5bn bid pipeline of prospective work.
The company is well placed to pick up work from a government keen to cut costs. In the six months ended September group revenue increased 9pc to £1.58bn, and pre-tax profits jumped by about a third to £106m.
The core marine and technology division is performing well. Providing engineers on the new Queen Elizabeth class aircraft carriers is on track and the £350m overhaul of nuclear submarine HMS Vengeance is progressing well. The marine division reported revenue up 16pc to £654m, the majority of which was organic growth, while profit increased from £62.4m to £69.6m at the half-year stage.
The other big opportunity for the outsourcing group is around the British nuclear industry. Babcock has signed an agreement with EDF Energy to assist on the country’s first nuclear plant in a generation at Hinkley Point in Somerset.
Babcock is exposed to more risk on some of its naval profits. The government has asked for any cost overruns on the Queen Elizabeth carrier projects to be shared 50:50 with Babcock, up from 10pc previously. However, Babcock said in the half-year results that the total risk is still capped at any potential profit on the project.
Government decisions to outsource defence projects are also taking longer than expected and this could mean earnings take longer to feed through from the order book.
Babcock shares are near record highs trading on 18 times forecast earnings, falling to 16 times next year. That is a premium to sector peers and well above historic averages for the forward P/E ratio of about 12 times. That said, the company should have an exciting 2014 and will benefit from issues at rival Serco, so we retain our recommendation. Buy.