Babcock update justifies unprecedented share price rally

It is an unfortunate sign of the times that the defence sector is booming, although that particular tide is lifting all boats. Indeed, given the general economic difficulties which many companies are currently facing, Babcock International Group (LSE:BAB)’s comment that the “macro environment remains supportive” is one which is rarely heard from boardrooms at present.

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And Babcock has remained busy even in the brief five-month period to 31 August which this update covers. The group has received several contracts of note, including a £65 million Type 31 frigate programme, a £114 million submarine disposal defueling and a A$250 million, eight-year follow-on contract with the Australian Border Force. Babcock has also launched its first fully-powered AI product Nomad which will provide real-time intelligence to front-line military and security services, while also entering into a number of partnerships with the likes of BAE Systems (LSE:BA.).

There is a slight blot on the landscape with lower revenues in its Land division, which accounts for 23% of sales due to lower Rail business, but any slack has more than been picked up elsewhere. Strong growth continues to be seen in the Nuclear business (37.5% of sales) and Aviation (7%), while Marine (32.5%) is also enjoying ongoing growth.

As such, Babcock is maintaining its previous guidance, which includes mid-single digit revenue growth and underlying operating margin of at least 9% in the medium term. The additional contracts which have been signed in this period add some further visibility to earnings, which is an important development – and add to the previously reported £10.4 billion contract backlog - which can support what is becoming an increasingly stretching valuation given the more recent strength of the share price.

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The group previously reported full-year revenues of £4.83 billion, which it expects to increase to £5.1 billion this year, with underlying operating profit estimated to rise to £401 million from £363.9 million. In addition, the upgrade to the underlying operating margin was prompted by a previous improvement to 7.5% from 5.4%, leading to an expected 8% this year and 9% thereafter.

This strengthening financial performance also resulted in an increase to shareholder returns. While the dividend increase to a projected yield of 0.5% was marginal, the announcement of a £200 million share buyback programme for the first time in the company’s history was a clear statement of intent and confidence in future prospects, and the programme is now 25% complete and expected to be fulfilled by the end of the year.

Indeed, the backdrop is set fair. Around 62% of group revenue is derived from UK defence, where the latest government pledge to spend 5% of GDP by 2035 leaves the door ajar for Babcock to make further progress. Of particular interest is the likely concentration of spend on the civil and defence nuclear budget. Nuclear accounts for 37% of group revenues and is Babcock’s largest unit, with its expertise in submarines also reaching over to its Marine business, which is the second largest revenue driver responsible for a third of sales.

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Expectations for prospects may be on a march, which has weighed on the opening reaction to the update, but for the most part the likes of Babcock have lived up to their billing.

The shares have risen by 156% over the last year, as compared to a gain of 11.9% for the wider FTSE100, and by 302% over the last three years. Despite this extraordinary rally, appetite for the group remains undiminished and the market consensus of the shares as a strong buy is unlikely to waver any time soon.