Stockwatch: Favourable odds of double-digit upside in 2020

A strong Tory majority and prospect of UK/US trade deal imply more upside for this recovering mid-cap.

Is it finally safe to buy shares in Babcock (LSE:BAB)? This £3.2 billion defence contractor has seen a five-year bear market from around 1,250p, recently appearing to bottom at 417p in May – the last time Boatman Capital Research launched a critique of the business. 

After an apparent chart “double bottom” of 428p, the stock has been in a rising trend with a flourish from 565p to 641p around the general election to a current price of around 630p.

It was latterly accompanied by the noise of a shorting attack which made a few valid points, though was rebutted by the company and implicitly the recent market given the stock’s recovery. 

In long-term context, therefore, it may mark misplaced negativity on a downside trend, just as bullish reports over-egg prospects near a stock peak. 

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

Political factors may be the most vital dynamic

Most significant is the surprise general election result of a large majority Conservative government that speaks of an end to austerity. Time will tell where defence spending lies in context of election pledges on the NHS and police; however, a decisive outcome does at least eliminate risks to private sector outsourcing.

Babcock’s last annual report shows UK revenues easing 6.5% to £2.9 billion, representing 66% of total revenue, as a sense of hiatus in government contract awards contributed to bearish sentiment. It is now at least possible that defence spending grows.

Consensus is for a slight fall in earnings per share (EPS) to 71.5p in respect of Babcock’s year to 31 March 2020, then for 72.2p in 2020/21.  This appears plenty high enough given interim like-or-like EPS jumped from 11.5p to 25.6p, although net profit dynamics are stronger, with half-year net profit at £131 million.

The full-year number is expected to advance from £200 million to near £350 million. A 29% reduction in interim administrative expenses is chiefly boosting profit but means a lower cost base going forward. 

European revenues represent 14.5% of group total, hence Brexit trade negotiations will also be a key macro influence. With the US at just 4%, Babcock is also a potential beneficiary of the kind of major new UK/US trade deal President Trump entertains (or teases).

The new Johnson government appears to be signalling for greater public spending and is manifestly determined to achieve progress on trade both with Europe and the US. All this is speculative, but I suggest it is the key driver.

A consistent pattern of director buying 

Mind, I’ve twice been positive on Babcock after the directors bought meaningfully: four of them added £180,000 worth of shares at 667p to 693p in November 2017.

Then, in February 2018, I thought the stock was worth testing as a “buy” – similarly at 630p – and there was initial confirmation with a near 40% rise to 860p, albeit which then fell into a range around 700p after the July AGM guided down 2019 revenue prospects from mid to single-digit growth due to a “temporary” slowdown in defence and marine work.

Three non-executive directors then bought over £140,000 worth of shares at 737p.
They’ve kept buying - £162,590 at around 475p after last June’s prelims, the chief executive adding 20,000 shares, and, in July, a non-executive director bought 5,000 at 443p.

What’s more, in September the stock’s financial risk was supported by renewal of a five-year revolving credit facility, plus confirmation of a BBB credit rating. Babcock was also then selected as preferred bidder for the UK’s circa £1.25 billion new naval frigate programme.

A mixed albeit “in line” narrative has aided sentiment

A September trading update and November interims asserted Babcock’s marine and land (a range of services) divisions performing well. Activity levels increased in nuclear, although there was weakness on the aviation side (26% of interim group operating profit). Adjusting for “step downs” (lumpy contracts coming to an end, such as for aircraft carriers) underlying interim revenue would have grown 3.6% instead of being flat.

Significantly, the combined order book and pipeline was proclaimed up 10% to £34 billion since last March. I’d also treat this warily given a £1 billion increase in the order book to £18 billion relates to one key contract and a £2 billion rise in the pipeline to £16 billion needs proving beyond “significant new opportunities added in the UK and abroad.”

It’s still a notable straw in the wind for Babcock’s revenue dynamics at a time when the UK political context has just improved, and a US trade deal could offer further upside.

While the table of annual results shows a disappointing drop in the operating margin from over 9% near 6%, lower interim admin costs have helped it recover to 7.7% or 8.6% including joint venture contributions.

Admittedly, other variables look flat to mixed and free cash flow was just £6.8 million, albeit in-line with expected phasing and guided over £250 million for the full year, thus demonstrating an ability to reduce net debt besides sustaining dividends. 

Short selling ramped up from November 2017

For years, short-selling had been negligible, then shot up to around 5% of the company’s stock in early 2018. It has been roughly in a 6% to 8.7% range since. Just recently, four hedge funds have been increasing their shorts and four others closing, within an overall 7.5% short position.

Babcock remains somewhat vulnerable to short-sellers given it is a large complex group prone to lumpy contracts, and still carries hefty debt. Research firm Boatman’s invectives kicked off in October 2018, alleging Babcock had “systematically misled investors by burying bad news about its performance”.

In a second swipe in May 2019, it claimed profit from Babcock’s biggest contract had been over-estimated by as much as £75 million – nearly 20% of annual profits – although Babcock management refutes the allegations.

Significantly, for sentiment, a 20% fall in the stock then generated support that formed a basis for the shares to rise from about 430p last July. Most likely, the market takes encouragement that Babcock’s narrative on operations and orders is stabilising in a context where even, at 630p currently, the forward price/earnings (PE) multiple is 8.7x and the prospective yield 4.8%, covered around 2.4x by projected earnings and very roughly 1x by historic free cashflow.

Yet there are parallels with my previous piece on NMC Health (LSE:NMC) by way of substantial debts and intangible assets, hence no genuine asset-backing. Babcock’s interims showed end-September net debt varying according to the IFRS 16 accounting standard for leases: £1.1 billion pre-IFRS 16 and £1.7 billion post.  

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A decade and more ago, such extent of debt was deemed too onerous, but the QE years encouraged boards to radically raise their sense of “optimal debt structure”. Moreover, the Bank of England continues to hint it will keep interest rates low during the Brexit years.

Strictly, neither stock is investment grade, but I regard Babcock as less risky than NMC, which may have indulged off balance sheet debt and whose financial growth profile looks a bit too good to be true for a similar-sized £3.6 billion company.

Both stocks have substantial short positions that will need closing out by those involved to lock in profits, and I think both the macro and company level drivers for Babcock have tilted positively, even though my expectations are tempered.

Yet progress in operations may improve a weak balance sheet

The potential benefit from short-sellers only partially closing is shown by NMC rebounding 28% to 1,750p from 1,370p when I suggested it was one for alert traders (though generally investors should continue to avoid it). So, over time, I envisage this potentially positive technical factor to combine with better progress and prospects at Babcock.

The balance sheet will take time to improve, but the market appears already to be warming to better cash flow steadily reducing debt. Much depends on political decisions for a bullish rationale, but I think the odds are increasingly favourable that 700p-plus is a fair target for 2020. Buy.

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