Stockwatch: There’s underlying value in this short-sold outsourcer

Does this £3.2 billion engineering services group have intrinsic strengths to overcome weak sentiment, or is yet another example among outsourcers and utilities, to avoid “recovery plays?” Shares in Babcock International (BAB) has halved to about 630p in the last four years, despite a respectable trend in revenue, earnings and cash flow (see table).

Buying the dips has only meant a series of bull traps, despite the narrative also appearing sound. Babcock’s updates cite “critical” services to the defence, oil & gas and nuclear decommissioning industries; and despite three-quarters of revenue being UK-related – i.e. geared to the defence budget – the remainder is internationally diversified.

Income buyers have hesitated as growth investors sold

I suggest this is a good example how an “Occam’s razor” approach – i.e. follow the interpretation with fewest assumptions – is pragmatic. Essentially, the share register has involved a major churn. The de-rating, especially since mid-2017, reflects “ex-growth” fears with UK defence spending under pressure, and also volatile oil prices meaning shorter order cycles in offshore services.

Babcock’s yield has not been sufficient to attract income investors, who also tend to be conservative i.e. want to see intrinsic value back-stopped. Yet even after the stock has halved and consensus anticipates 10% dividend growth in its current financial year, the prospective yield is about 4.7%, “in line”, or even marginally below, what can be found elsewhere among unloved outsourcers and utilities.

In the post-Carillion debacle, attention is also on contractors’ operating margins, and, while Babcock’s are relatively respectable at 7-8%, there’s not much leeway if issues do arise. Investors have also seen the story at Capita (CPI) blow up, on a margin of 11.6% reduced to 7.6%, and MITIE (MTO) has gone from 5% to minus 0.3%.

It doesn’t follow that Babcock’s margin is inherently at risk; independent experts argue contractors have got to show to government what kind of healthy margin they need. But, for now, investors see one outsourcing disaster after another, and hear the Labour Party rant against any money going to shareholders.

Carillion’s operating margins were barely over 4% and involved aggressive practice such as long-dated trade payables boosting reported profit. Babcock is not exactly twee on this score either: its last balance sheet showed a ratio of trade receivables to trade payables of

0.77%. And, quite like other “offenders” in this regard, there’s no explanation in financial statements disclosing a mass of less-relevant detail.

Thus, Babcock shares are being sold off to a support level where investors feel the yield is both realistic and competitive. It doesn’t help how a range of other “recovery” stocks are being dragged down. But unless Babcock meets with an even tougher UK defence spending regime, at some point its yield will be seen as over-compensating for the risks, hence the stock will rise.

Babcock International Group – financial summary           Consensus estimates year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019                 Turnover (£ million) 3029 3321 3997 4158 4547     IFRS3 pre-tax profit (£m) 182 219 313 330 362     Normalised pre-tax profit (£m) 193 244 304 320 362 471 493 Operating margin (%) 6.6 7.3 8.0 7.9 7.6     IFRS3 earnings/share (p) 38.3 38.7 52.6 56.8 61.7     Normalised earnings/share (p) 40.7 43.6 51.0 54.0 61.8 77.2 79.7 Earnings/share growth (%) -24.3 7.1 17.0 5.9 14.4 25.0 3.2 Price/earnings multiple (x)         10.2 8.2 7.9 Annual average historic P/E (x)   26.8 20.9 18.4 14.7 11.1   Cash flow/share (p) 55.1 42.5 66.3 82.1 82.8     Capex/share (p) 13.0 10.7 19.5 24.9 26.7     Dividends per share (p) 20.5 23.7 21.9 24.2 26.2 28.9 30.0 Yield (%)         4.2 4.6 4.8 Covered by earnings (x) 2.0 2.1 2.3 2.2 2.4 2.7 2.7 Net tangible assets per share (p) -233 -215 -215 -176 -108                     Source: Company REFS              

Negative net tangible assets and debt, also weighing

It’s a worse-case scenario view, but one which does affect perception when longer-term growth comes into question. Last September’s balance sheet had over £1.6 billion debt, nearly all longer-term, versus £209 million cash in context of £2.7 billion net assets – albeit £3.2 billion of which constituted goodwill/intangibles (it’s why the table shows negative net tangible assets).

While net interest costs were covered over 9 times by operating profit – even after amortisation of intangibles – conservative investors are likely to look at this and reason, if interest rates are now in a medium-term rising scenario, Babcock’s financial risk profile will rise too. Its balance sheet is by no means stretched like some, but say inflation beats expectations in 2018 and central bankers are forced into swifter rate rises. Again, on a key issue, there is no clarification such as in note 10 (on debt) in the last accounts, exactly how insulated Babcock’s interest bill might be, spelling out for example how interest is capped at X% for period Y.

This looks another score, undermining confidence. It’s not helped by the Bank of England’s neo-Keynesian narrative of “accommodating the stresses of Brexit” suddenly changing to “rate rises sooner and sharper than expected.” Finally, the penny drops within its monetary policy committee, how headline UK inflation is established a full percentage point above its 2% target.

Directors buy nearly £180,000 worth of shares

After last November’s interims there was cluster buying: the chairman added £63,891 worth at 672.5p, the chief executive £99,213 at 667p, the communications director £14,912 worth at 693p. Then, early in December, a non-executive bought £33,900 worth at 678p. Certainly, this affirms a “bottom-up” view, from within the business, that the stock is over-sold.

Obviously, it has continued down, I suggest given the context of outsourcing alarm for investors into 2018, then early February wariness over inflation/interest rates. Investors are looking also to “top-down” issues, and forward, although markets’ rebound this week amid higher US/UK inflation shows it not altogether dictatorial.

Meanwhile Jeff Randall, a retired high-profile business editor, nowadays a Babcock non-executive director, has merely reinvested his dividend from 4,480 shares (probably an established scheme) with a purchase of 39 shares at the 751p high for 2018. Maybe he does not have resources to hand like the other directors’ remuneration, and this holding is appropriate for him in a diversified portfolio. Yet this forthright scribe of editorials and share tips in decades past lacks liveliness to add.

Short sellers

Since last June, the extent of disclosed short positions has soared from nothing to a material 6.7% – it would appear to be post the interim results, which contained nothing especially adverse. Marshall Wace, the hedge fund with the highest short position of 2.16% (and which profited in the order of £20 million from Carillion’s demise) is a tad tricky to interpret because its “Asia” limited company raised its short exposure by 0.1% on 31 January, while Marshall Wace LLP trimmed by 0.12% on 9 February. It’s unclear whether this relates to the fund’s overall risk management or is a bearish position starting to unwind.

A strategic down-bet is somewhat affirmed by the 6 February trading update, citing slower than expected annual revenue growth, at 2% to 3%, amid selective pressures on defence procurement. But that has to be considered in valuation context, and my insisting on a backstop is answered by way of the combined order book/bid pipeline remaining around £31 billion.

Contrarian ‘buy’ case

Who knows if inflation/interest rates take off, government continues to compromise national defences to pay for health spending, and oil prices slide, further reducing offshore activity.

Short sellers do seem to be taking a negative view on at least one such score. But these worse-case scenarios may not evolve, “short the outsourcers” is now quite a crowded trade, and 6.7% of Babcock equity will need buying back. If you appreciate the risks, consider testing a contrarian ‘buy’ case gradually and according to updates. Accumulate.

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