Stockwatch: a status change for this once troubled share

Defence contractor Babcock International Group (LSE:BAB) appears to be a select share that has shrugged off market volatility linked to trade tariffs, continuing to rally after a 23 April trading update in respect of its financial year to 31 March.

At 810p, it has regained 2017-18 levels, significantly helped by expectations for defence spending, helping explain a forward price/earnings (PE) multiple in the mid-teens and dividend yield just above 1%.

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Frustratingly, I feel a sense of déjà vu in that its narrative is not dissimilar to when I drew attention to it as a “buy” at 630p in December 2019. A strong majority Conservative government had been elected, which looked positive for defence spending. Moreover, there had been a pattern of substantive concerted director share buying. Margins were recovering to near 9% and the order book and pipeline was up 10% to £34 billion.

This share had performed well in the early noughties, quadrupling to over 500p before the 2008 crisis took them below 400p, which helped set up a rally to 1,250p by early 2014. There then followed a long if volatile derating to around 250p in early 2021 amid serial issues around contracts and accounting, which for long-term followers conspired to link “defence” with classic operational risks of contractors.

Covid probably contributed to further downside from 630p in late 2019 but a sideways consolidation at around 300p from mid-2023 appeared also to reflect scepticism that Babcock has truly sorted its woes.  

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Whether I mostly had bad fortune on timing or underestimated factors, Babcock shows how not to let jaundice creep in - “once bitten, twice shy”. The trigger for a rerating was the July 2023 annual results showing a 10% organic revenue advance, coming in a context of the Ukraine war raising awareness of the UK’s need to raise defence expenditure to help contain Russia.

The big picture had changed decisively and while I did pick up on BAE Systems (LSE:BA.) as a means to capitalise, the sense of Babcock being a problem company – despite respectable news – had stuck in me.

Source: TradingView. Past performance is not a guide to future performance.

Margins around 6% are much better than some contractors

A big issue why some investors avoid such groups is the low-end of margins, exposing them to risk of any big contract going seriously wrong and that losses arise.

When I last wrote on Babcock over six years ago, its combined order book and backlog was up 10% to £34 billion, although £1 billion involved a single contract and £2 billion needing confirming.

So when the company cited the contract backlog up 7% organically to £9.5 billion in mid-2023 despite disposals, I was not exactly convinced this was anything special. More significant perhaps for the rerating was guidance for a reinstated dividend in respect of the March 2024 year, but even this was immaterial in total return context at 5p per share. It did at least signal that disposals had completed and free cash flow was expected better henceforth.

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Despite two substantive contracts – training solutions for the French air, space and navy forces worth up to £684 million equivalent, plus a five-year extension to a military land equipment contract with the British Army worth around £1 billion – the overall contracted backlog has risen over 5% to £10.1 billion from last September to March alone. Obviously, it helps that they are lumpy and beginning rather than expiring.

Inherently low margins are chiefly why infrastructure-oriented groups such as Kier Group (LSE:KIE) trade on mid-single-digit PE’s and is priced also for a material yield above 5% (in respect also of a problematic past). But facilities manager MITIE Group (LSE:MTO) shows how weak sentiment towards a contractor can bake in a rerating: this share is recently up around 20% as confidence grows, and it can continue to grow its normalised operating margin to 5% by 2027.

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Perhaps sentiment has improved towards contractors generally as managers have been forced to address contract risk (for example by diversification), cut costs and pursue transparent clean accounts. Margins in defence are assisted by barriers to entry in an increasingly high-tech industry, although one cannot assume governments will not negotiate strongly.

The 23 April update cited Babcock’s underlying operating margin up from 7.0% to 7.5% year-on-year, but did not offer guidance as UK employment costs rise. I suspect such a margin area is as good as it gets.  

Babcock International Group - financial summary
Year ended 31 Mar

Source: historic company REFS and company accounts.

Debt reduction is chief dynamic at company level

The table shows the balance sheet derisking from £1.9 billion net debt in March 2020 to £426 million four years later. For the latest March 2025 year end it is guided at £373 million including leases, or £101 million without them.

Debt was probably a chief reason why disclosed short positions of over 0.5% of Babcock’s issued share capital reached 8% in 2019-20. I had thought this could potentially trigger a rebound if squeezed, but Covid intervened and shorts actually closed out in mid-2021. There have been none over 0.5% since, implying Babcock’s risk/reward is seen as fundamentally improved.

Aside from sorting its various issues, I find Babcock’s overall dynamics not exactly dissimilar to five years or so ago. It does, however, look as if defence spending is picking up and obviously this could last (well over) five years. Constant currency organic revenue growth was 11% to £4.8 billion in the latest year, reflecting “a continuation of the strong growth noted at the third quarter update in February, notably in nuclear and marine”. This together with the 0.5% margin improvement enabled a 17% increase in underlying operating profit to £363 million.

Underlying cash conversion of around 80% helped underlying free cash flow of £153 million, even after a £40 million pension deficit repair and 14% net debt reduction.

Median rating between BAE Systems and Qinetiq

At around 1,740p, BAE commands a 12-month forward PE above 22x, though its 2.2% prospective yield has lower projected earnings cover at just over 2x versus more like 6x for Babcock. Most likely, Babcock’s board does not want to get too aggressive with dividend recovery whereas BAE has a far more consistent record.

At near 400p, QinetiQ Group (LSE:QQ.) trades on a forward PE around 12x with only a modest 2.4% yield like the others, albeit covered three times by earnings.

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As to whether domestic versus international revenue is much of a factor in the rating, and despite its “international” name, Babcock derives a relatively modest one-third of its revenues from abroad, chiefly Australia, France, Canada and South Africa.

For BAE, it is quite the opposite, the UK relatively modest at 24% last year, with the US biggest at 44%, hence the company is potentially exposed to US tariffs. The Middle East constitutes 13% and rest of world 13%. This enables over £30 billion of annual revenue versus under £5 billion for Babcock, international reach obviously helping to scale revenue.

Qinetiq is even more diversified internationally with around 90% of its revenues deriving outside the UK.

I therefore recognise at least a strong “hold” stance on Babcock given defence industry prospects. Perhaps the group needs to bolster its international capability, although it would involve investment and possibly raise risk. Perhaps moving away from UK dependency would support a firm long-term “buy” case.

It seems hard to identify what might now detract from the shares, and I would not be surprised to see Babcock continue to creep up. For now, I conclude with a “hold” rating” to be reviewed at annual results due 25 June.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.