Babcock International shares have surged 70% since mid-January, but are more gains possible from this turnaround story?
Shares in FTSE 250 company Babcock International, the UK’s second-largest defence contractor, currently trade at around 343p, having jumped by over 70% since mid-January. However, this stock may still have further to run: in early 2020, Babcock shares stood at 630p, while the stock even traded at over 1000p if we go all the way back to 2016, at which time it was a member of the FTSE 100 Index.
Defence work has become increasingly important for Babcock over the years, for instance in building some of the Royal Navy’s key ships and providing continuous support, including its critical role in maintaining the UK’s nuclear submarines. But partly what precipitated the company’s fall in sharp price in 2017 and related departure from the FTSE 100 that same year were worries about an over-reliance on the defence sector.
Then last year, the stock was hit hard by coronavirus and its related impacts, with Babcock suffering from extremely difficult trading conditions in aviation as well as oil and gas end markets. Babcock swung into a loss for the year through to March 2020, suspended its dividend and warned that margins were likely to be impacted by lower demand and productivity levels.
Brutal shock for investors
The company’s troubles came as a brutal shock for many among Babcock’s long-term investor base, which had come to associate the company with strong, consistent cash generation and a decent dividend. Worries that Babcock would look to mount an equity fund raising and announce a dilutive rights issue weighed on the shares.
In 2021, however, it has been a different story, with the stock having proved to be highly rewarding for those who jumped in early this year and continued to hold. The shares are up 30% year-to-date and have climbed by more than 70% from a low of 199p reached in mid-January.
Babcock signalled it would be avoiding a rights issue, although it took a one-off write-down, with total impairments and charges of £2bn. This also means underlying operating profit will be reduced by about £25m a year. Along with this, Babcock has pledged to reduce costs, with significant job losses, and has also outlined plans to raise about £400m from disposals.
From Babcock’s point of view at least, it could turn out to be a case of pain now for more gain later: the company has said the restructuring measures could result in substantial annualised savings – it expects about £20m of benefit to come through in the 2022 financial year. The moves followed a strategic review probing contract profitability and balance sheet health led by recently installed CEO David Lockwood, who took over in September last year.
Babcock has traditionally operated in four segments: marine, nuclear, land and aviation, serving both the defence and civil sectors. In the wake of the review, the company has stated that it intends to focus on being an international aerospace, defence and security company, providing value-added services across the UK, France, Canada, Australia and South Africa.
In August, Babcock announced the sale of its wholly owned subsidiary Frazer-Nash Consultancy, an engineering and technology solutions provider, for £293m to US engineer KBR. Frazer-Nash, which Babcock acquired in 2007, employs about 900 people.
Earlier this month, Babcock also completed the sale of its oil and gas aviation business to mechanical engineer CHC Group for just £10m – the oil and gas aviation operation had revenue of £154m in the year to 31 March, 2021, but made a pre-tax loss of £2m.
“This disposal is part of our plan to streamline and focus the group on our key markets. Divesting at least £400m of businesses will enable us to reduce complexity and increase our focus as we return Babcock to strength. The oil and gas aviation business has found a new home and we wish them all the best for the future,” said Lockwood this month, commenting on the most recent disposal.
Babcock’s results for the 12 months to 31 March 2021 were a pretty dismal affair, although this period covers the very difficult trading conditions experienced in 2020. The operating loss rose to over £1.6bn versus around £76m for the comparable year-ago period. Revenue fell from over £4.4bn to just under £4.2bn, while contract backlog eased from £9.5bn to £8.7bn. Babcock went from an underlying operating profit of £378m in the year-ago period to an underlying operating loss of around £28m.
However, net debt fell from around £1.7bn to approximately £1.35bn and free cash flow rose from about £56m to £170m.
Improvement on the cards?
There’s plenty of further upside potential for the shares, according to analysts, although this is not without downside risk. The high 12-month share-price target from analysts covering the stock is 600p, implying a 73% upside from today’s price. At the lower end, analyst estimates say the stock could go back to 200p. Analysts now expect Babcock to start paying dividends again in 2023 – the consensus forecast for 2023 of around 8p per share would imply a dividend yield of about 2.4%.
It could well take more than a year for Babcock to get back to 600p, if it ever does: Babcock has dubbed 2022 as “a year of transition”. Given its status as the second-largest UK defence contractor, there is significant dependence on UK government spending policies. Babcock, however, remains a turnaround play that could benefit from management’s efforts to improve business performance as well as better trading conditions across key markets versus 2020.
“Looking forward, Babcock will be a simplified and more focused group with a renewed emphasis on the exceptional engineering skills of its people. We will be well placed to take advantage of the many opportunities we see in both UK and international markets, leading to improved cash generation and profitability in the medium term,” commented Lockwood earlier this summer as the company reported its full-year results.