US Edition Babcock
£13.95+53p
Questor says HOLD
THE wider stock market may have experienced some January jitters but, despite the volatility, shares in support services group Babcock have sailed on regardless.
The FTSE 100-listed company provided a confident trading update yesterday, sending shares 4pc higher, ahead of what promises to be an interesting year for shareholders.
“Our business model, the scale of our operations, the depth and breadth of our experience and our track record of delivering operational and financial efficiencies provide an excellent platform,” Babcock said in its trading update.
The order book was down slightly from £12bn at the end of September to £11.5bn in yesterday’s update. However, the company has won, extended or been made the preferred bidder on some £700m worth of contracts during the period and this should be added to the order book shortly. The biggest contracts have come from UK infrastructure spending including work on overhead electricity lines for the rail network worth £300m over the next seven years.
Although Babcock’s confirmed order book has shrunk slightly, the opportunity for the company in the future is growing. Babcock said the potential pipeline of contracts has increased from £15.5bn at the November update to about £18.5bn today. Peter Rogers, chief executive, told Questor that in the coming months decisions are expected on the £2.5bn Magnox nuclear decommissioning contract and up to £800m for the London Fire Brigade contract.
There is also a huge opportunity to become joint owner of the Defence Support Group (DSG) which supplies spare parts and maintenance for all the British Army’s armoured vehicles.
Historically, the support services company has a 90pc success rate when re-bidding for existing contracts and a 45pc success rate when it bids on new projects such as the DSG deal.
With 10 months of the financial year ending in March now completed and trading going well, Babcock should deliver solid revenue growth of about 6.6pc for the year, giving double-digit earnings-per-share growth. The company is also a strong cash generator and that is what makes the next year so interesting for investors.
The company’s last major acquisition was for the £1.4bn purchase in 2010 of VT Group, formerly known as Vosper Thornycroft and since then debt levels have fallen sharply, from £729m at the time of the deal to a forecast £590m at the end of March, and £330m forecast by 2016. Given its low debt ratio, Babcock could easily afford another big acquisition.
The support services company generates about £200m in free cash flow every year according to analysts’ estimates. With low debt levels and healthy cash flow, Babcock is well placed for another deal.
Mr Rogers confirmed that the company is locked in talks to take a stake in the helicopter transport firm Avincis, which is likely to value the business at £1.5bn. Babcock is believed to be considering a 50pc stake in Avincis that would cost about £750m. Avincis reported revenue of €575m (£478m) and operating profits of €97m for the year ended December.
What this means for Babcock shareholders is that, on Questor’s estimates, the deal could add about £40m, or 10pc, to the operating profits and earnings per share of the group.
Babcock shares are looking a little expensive trading at 17 times forecast earnings, falling to 16 times next year, compared with the long-run average of 12 times earnings. They are also quite high based on a price of 5.8 times the book value, compared with the long-run average of about 2.8 times.
However, any deal in the year ahead could quickly see those forecasts upgraded by at least 10pc on Questor’s estimates. On the downside, there is also one big cloud on the horizon in the form of the general election next year. Elections tend to cause a hiatus in government outsourcing decisions, especially when thousands of jobs are in question.
As a long-term investment, Babcock has proven to be a quality operator, and the shares have risen 9pc since the most recent buy recommendation (£12.74, December 19) and still offer a 2.2pc dividend yield that is forecast to grow by 12pc during each of the next two years. But the price is getting a little too rich. Hold