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14 Oct 16. Buy Babcock’s standout quality. Trading without the trauma of PR scandals and plethora of provisions endured by many in its outsourcing peers, we reckon Babcock (BAB) is the high-quality stock to own in this troubled sector. With much of its sales coming from contracts with the Ministry of Defence as well as nuclear decommissioning and emergency services support, Babcock boasts some good barriers to entry. Cash conversion is high and the group is steadily bringing its debt levels down. Meanwhile, the shares are trading at a low single-digit earnings multiple, which we reckon is unjustified. Especially as, unlike many of the other big name outsourcers, organic sales and profit growth are holding up – by July the group had already booked more than half its revenue for year ending March 2018.
Babcock has strong customer relationships and focuses on highly-specialised work. This has contributed to an over 90 per cent success rate when re-bidding for contracts and 40 per cent for new bids.
Marine and technology makes up its largest division, contributing over a third of group revenue and two-fifths of operating profit. Recent work includes providing maintenance and in-service support to the Royal Navy’s fleet of submarines and warships, and helping build the Queen Elizabeth-class airship carrier. This drove operating profit up 14 per cent to almost £200m last year.
The government’s 2015 five-year strategic defence and security review, which committed to increased defence spending, including more defence equipment and equipment support, should benefit Babcock’s defence and security division which accounts for 17 per cent of sales and 18 per cent of operating profit.
Meanwhile, the building of the first new nuclear capacity in 25 years at Hinkley in Somerset could also deliver future long-term earnings for the support services business – 31 per cent of group revenue and another 18 per cent of operating profit. Babcock already carries out civil nuclear decommissioning work at Magnox sites and Sellafield via its subsidiary Cavendish Nuclear. Earlier this year EDF announced Babcock’s joint venture with French engineering company Boccard as the preferred bidder to carry out work on the Balance of Nuclear Island mechanical package at Hinkley Point C. Cavendish Nuclear has also signed a deal with Hitachi to collaborate on nuclear decommissioning in Japan.
Acquisitions have been an important part of Babcock’s growth strategy, but organic growth is still going strong. Organic revenue grew 8 per cent at constant currency rates last year, while operating profit was up 6 per cent. Admittedly, this was down from a respective 12 per cent and 11 per cent in 2015. However, this is still superior to that achieved by other outsourcers. For example, Capita (CPI) increased its organic sales just 4 per cent during the 12 months to December 2015 and expects the figure to fall to just 1 per cent this year. Meanwhile, sales declined at Mitie (MTO) last year.
Weaker oil and gas prices meant the international division was the only part of Babcock to see a drop in performance last year, particularly from the South African equipment and truck businesses and power division. International revenue declined 3 per cent to £790m while operating profit, accounting for over a fifth of the total, fell 8 per cent.
Babcock benefits from a large pipeline of work and an order book that stood at £20bn at the end of May. Unlike outsourcers such as Mitie and Capita, as well as Serco (SRP) and G4S (GFS), Babcock had no exceptional charges last year. What’s more, its net debt is declining. Net debt was reduced to £1.2bn in May, down from £1.3bn the previous year. This is equivalent to two times cash profit