The defence and nuclear contractor looks cheap with the company poised to win more work
Thursday 28 Nov 2019 Author: Ian Conway

Defence contractor Babcock (BAB) could be on the verge of a real recovery having come through a cycle of earnings downgrades.

The company’s combined order book and pipeline has reached its highest ever level and the group is also moving into new markets like Canada and Norway. We believe you should buy the shares.

Despite a rally on the latest set of results, the price-to-earnings ratio of 10 times current-year earnings and the dividend yield of 5% still make Babcock a compelling long-term investment at current levels.

Babcock provides ‘mission-critical’ products and services to the UK armed forces, emergency services and civil nuclear industry as well as managing defence assets overseas.

While this isn’t a high-growth business on an underlying basis, contract wins from new clients and extensions from existing clients mean that the business grows its revenue steadily every year.

A RECORD PIPELINE

At the half-year stage in September the firm’s order book stood at £18bn, up from £17bn six months earlier, while the bid pipeline stood at a record £16bn against £14bn previously. Given that annual sales are in the region of £4.8bn this gives an idea of the ‘visibility’ of future income.

Defence makes up 74% of revenues with Marine and Aviation accounting for just over 40% and Land accounting for just over 30%. The biggest client is the Ministry of Defence (MoD) with 70% of sales to the UK in the first half.

Of the £18bn order book, over 80% is UK but of the record bid pipeline less than 50% is UK with international demand growing rapidly. Australia is investing in new submarines and frigates, while Canada is spending on submarine support and new naval platforms.

The remainder of Babcock’s sales and orders are in nuclear, including both maintenance of operational sites and the de-commissioning of closed sites such as Dounreay. Growth is slow but Babcock is a trusted partner and the industry is expected to generate £85bn of revenues over the next ten years across defence and civil projects.

Babcock’s balance sheet is solid with net debt to EBITDA (earnings before interest, taxes, depreciation and amortisation) of 1.4 times and consensus forecasts see it generating sufficient cash to get that ratio below one within three years.

Investors do need to consider the risk that, as an outsourcer, and with large exposure to the UK market, it might be vulnerable to the election outcome if the SNP or the Greens form part of a coalition.

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