ii view: Babcock locked on to full-year targets

This FTSE 250 defence contractor has comfortably outperformed the mid-cap index year-to-date, but is still down 8%. Buy, sell, or hold?

Trading update for the five months to 31 August 2022

ii round-up:

Engineering and defence company Babcock International (LSE:BAB) today reported in line trading for the first five months of the year, with the market backdrop remaining dynamic. 

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Continued geopolitical uncertainty has been leading to increased national defence requirements and potentially more opportunities, while macro factors such as inflation and supply chain stresses have increased delivery challenges.

Babcock shares fell marginally in UK trading, having fallen by around 4% year-to-date coming into this latest announcement. Shares for rival defence contractor BAE Systems (LSE:BA.) are up by more than 45% in 2022, while civil and military aircraft engine maker Rolls-Royce (LSE:RR.) has fallen by around 40%. The FTSE 250 index is down by nearly a quarter. 

Babcock delivers critical and complex engineering services across four areas: marine, land, aviation and nuclear. Along with servicing marine warships and nuclear submarines, it also supports land vehicle fleets such as those of the British Army.

The FTSE 250 company flagged ‘good’ order momentum during the period, with recently won contracts including a 10-year support contract for the Queen Elizabeth class aircraft carriers and the renewal of the Royal Air Force's Hawk fleet support contract at RAF Valley.

In July, Babcock reported an operating profit of £227 million compared to a prior year loss of £1.73 billion. Management continues to pursue a programme to reduce complexity, increase its business focus, and improve profitability and cash generation.

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In its financial year to the end of March, the company sold businesses worth £447 million, including the part sale of its aerial emergency services business. 

First-half results are likely to be announced in December. 

ii view:

Tracing its roots back to 1891, Babcock today employs over 25,000 people. Its major marine division generating close to a third of group sales provides value-add services across the UK, France, Canada, Australasia, and South Africa. Land and nuclear related account for a further quarter of sales each with the balance coming from aviation. The UK is its biggest market, generating just over three-fifths of overall revenues. 

For investors, the highly uncertain economic outlook and increasingly stretched finances of its biggest customer, the UK government, cannot be overlooked. Business costs for industry generally are rising, supply chain challenges persist, while the dividend payment is still halted following its suspension during the pandemic. 

More favourably, heightened geopolitical tensions following the invasion of Ukraine by Russia have helped underline the importance of defence spending. Action to reshape the company continues, cost savings are being pursued and a previously rejected merger proposal from Serco (LSE:SRP) should also not be forgotten.

On balance, and while stabilisation and an ongoing improvement programme are positives, caution is sensible as it remains to be seen just how any increase in government defence spend affects Babcock. 

Positives: 

• Reducing complexity and increasing focus
• Contract backlog previously rose 21% to £9.9 billion

Negatives:

• Business sales reducing diversity of operations 
• Dividend suspended

The average rating of stock market analysts:

Buy