Questor share tip: Hold Babcock on Avincis deal

The £1.6bn deal to buy the helicopter group brings risks for the FTSE 100-listed engineering services group, says Questor

Babcock shares have come back from record highs of £14.70 in recent weeks and now trade on 17.6 times forecast earnings.
Babcock shares have come back from record highs of £14.70 in recent weeks and now trade on 17.6 times forecast earnings. Credit: Photo: Royal Navy

Babcock
£12.75-91p
Questor says HOLD

BABCOCK has been a stock market favourite for the past three years, during which time its shares have more than doubled in value and the dividend increased by about 50pc. The company could make announcements on two major contracts, the £800m London Fire Brigade training and £2.5bn Magnox nuclear decommissioning within days.

However, yesterday’s £1.6bn deal to buy helicopter firm Avincis presents investors with the problem of whether to remain invested and back growth or bank the gains as debt levels and risk increase.

Avincis provides and maintains helicopters for air ambulance, police and fire services as well as shuttle flights to and from North Sea oil rigs. The company will give Peter Rogers, chief executive of Babcock, the opportunity to expand the group’s operations overseas but Questor is always wary that big deals can destroy as much value as they create.

The helicopter group reported revenue of £487m for the year ended December 2013, up from £480m a year earlier. The revenue was split roughly three ways between the UK, Continental Europe and Spain.

The helicopter company has grown rapidly under private equity owner KKR. The investment firm is understood to have doubled its return on its initial investment. During the three-year period from 2009, Avincis increased revenue by more than 90pc and operating profit almost doubled, mainly because of the 2011 acquisition of Bond Aviation. The rapid expansion of the helicopter group was funded with debt, £705m of which Babcock will take on to its balance sheet as part of the deal.

In terms of the new combined group, this will cause net debt levels at Babcock to increase to about £1.2bn, or 2.5 times Ebitda.

That revenue and earnings outlook could receive a major boost if the company is successful on bids for the London Fire Brigade training contract and the Magnox nuclear decommissioning, with announcements due on the progress of both bids by Monday of next week.

"I'd be surpised if we didn't win one of them," Mr Rogers added. Babcock has a 90pc success rate on re-bidding and a 45pc success rate on new contracts.

The FTSE 100-listed engineering services and defence support group has a 27,000-strong workforce and currently generates the majority of its revenue in the UK. Babcock refits and maintains many of the Royal Navy’s ships and submarines. It owns or runs shipyards at Faslane, Rosyth and Devonport and maintains military bases across the country. Its chairman is Mike Turner, a former boss of BAE Systems.

The core business at Babcock is helping the Royal Navy keep its fleet ship shape. Providing engineers for projects such as the UK’s largest new warship, the Queen Elizabeth class aircraft carrier, and the overhaul of nuclear submarine HMS Vengeance accounted for about half of the group’s revenue. The remainder is split 25pc from support contracts to the British army and the Royal Air Force carrying out training and the remaining 25pc providing engineers for sectors such as the UK nuclear industry.

There are several risks around a transaction of this size. Babcock is an engineering and support services specialist not a helicopter hire company. Expanding into a new area of business brings risks and also reduces the opportunity for cost cutting through joining similar departments. There is also the financial and reputational overhang from any adverse ruling on liability from a recent helicopter crash in Scotland involving Bond Aviation.

Questor thinks the success of these deals often comes down to the price, and Avincis is not cheap. The reason for the high price is the rapid growth – the order book has increased by 45pc to £1.9bn during the past 12 months, with £275m of contract wins coming in the last seven months of 2013 alone. These are fixed term contracts and the company boasts a 95pc retention rate.

One mitigating factor is that Babcock’s management team under Mr Rogers has a good track record with acquisitions. The £1.4bn deal to buy VT Group (formerly Vosper Thornycroft) in 2010 raised similar concerns and took debt levels as a ratio of earnings even higher. In the end, the deal was a great success.

The latest transaction will be partly funded by a proposed five-for-13 rights issue, raising £1.1bn. The 139.3m shares issued at 790p drives a theoretical ex-rights price of £12.06.

Babcock shares have come back from record highs of £14.70 in recent weeks and now trade on 17.6 times forecast earnings.

Questor downgraded the shares to a hold (£13.95, February 14) as the price was looking a little rich and they have fallen 9pc since then. The implied discount of the rights at about 35pc means investors holding the shares should take up their rights by the deadline on April 14.

Babcock is a quality operator but the rating is still looking a little rich. This deal looks to be at a high price and brings added risk, so for now the advice remains. Hold.