Questor: Babcock remains a hold despite defence deal

Babcock
£10.48 -13p
Questor says HOLD

Babcock [LON:BAB] announced yesterday that it will pay £140m for Defence Support Group (DSG), a government agency that maintains the Army’s equipment.

With the acquisition comes a decade-long contract to overhaul and repair the British Army’s “land fleet” of vehicles, including tanks, Land Rovers and trucks.

The contract is due to start in April and should bring in about £2bn of revenues for Babcock over its lifetime. There is also an option for it to be extended for another five years. This deal is the latest example of the private sector taking on what was once a public sector job, as the Ministry of Defence looks to cut costs so it can focus its shrinking budget on the frontline.

Babcock is a big provider of such services to the military: it maintains the Navy’s ships and submarines and is part of the consortium building the next generation of aircraft carriers. It also supports about a quarter of the RAF’s aircraft and has a contract to maintain the Army’s “white fleet” of civilian vehicles, as well providing training for the Armed Forces.

The DSG announcement means Babcock has replaced the revenues lost when it missed out on the contract to maintain military sites to rival Carillion.

That’s not to say the company is struggling for work. Babcock bills itself as “working diligently behind the scenes”, and at its half-year results in November announced an £18.5bn order book, bolstered by wins including Magnox nuclear decommissioning and upgrades to the UK’s rail infrastructure.

This meant the company had 94pc of its budgeted revenues for 2014-15 and 59pc for the following year. The nature of its work for major clients, such as governments, means that Babcock has long-term visibility about future work.

However, the 2015 Strategic Defence and Security Review is coming, and as the Treasury scales back the Forces in this age of austerity, future work may decline.

Babcock is heavily exposed to this, with 52pc of group revenues coming from its marine & technology and defence & security units. However, there may also be opportunities. If the Government is looking to reduce spending, the first companies it turns to are outsourcers who will do the job cheaper.

There has been some concern over Babcock’s £1.6bn acquisition of helicopter business Avincis earlier this year, which required a £1.1bn rights issue and put pressure on free cash flow. However, Questor believes the deal was a good move for the company, helping to diversify its offering.

Analysts at Exane BNP Paribas disagree, saying the risk posed by Avincis is underestimated. They believe the lower oil price will mean less demand for helicopters to service offshore rigs, and estimate oil and gas is 25pc of Avincis’s revenue.

The City has a more positive view, with 10 of the 14 analysts monitored by Bloomberg rating Babcock as a “buy”, two saying “hold” and two “sell”.

Questor last looked at the company in May when the shares were at £11.78, and rated it a hold. With the dividend yielding 1.7pc last year and forecast to increase to 2.1pc this year, Babcock is no stand-out payer. The price-earnings ratio is also fairly punchy at 19.2 last year, falling to 15.5 for 2014/15. By comparison, Carillion yielded 5.3pc last year and the P/E ratio was 9.5.

Babcock is a solid company but the stellar run its shares have enjoyed over the past few years means they are fully valued.

Hold.