Why Babcock shares surged an incredible 45% today

Its shares have endured a seven-year downtrend, but the submarine maker has just risen at a rate of knots.

A pledge by shipyard business Babcock International (LSE:BAB), that it can find calmer waters without having to tap shareholders, triggered a big turnaround in its FTSE 250 share price today.

Babcock's reliance on self-help measures rather than a dilutive rights issue was met with relief in the City, even though the early results of a wide-ranging review of the defence services business has thrown up the need for a potential asset write-downs worth £1.7 billion.

New boss David Lockwood, who joined Babcock from Cobham in September, also signalled the prospect of 1,000 redundancies as part of efforts to strip out layers of middle management.

More details will emerge in the company's annual results, but with the vast majority of his balance sheet review being one-off and non-cash, Lockwood expects the ongoing reduction in operating profits will be a smaller-than-expected £30 million each year.

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His new financial baseline and the removal of rights issue worries helped Babcock shares to surge more than 45% to 351p, which is the highest level since November's disclosure that the Ministry of Defence contractor was carrying out a strategic review.

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In a field dominated by stocks affected by Covid-19, Babcock was one of the 10 worst performing stocks in the FTSE 250 index in 2020 after falling by around 60%.

What we learned from Babcock's review

Today's review laid bare some of its strengths and weaknesses in a business spanning the four areas of marine, land, aviation and nuclear.

It said its operations in the UK defence sector were an attractive market, with the company hopeful of remaining a strategic partner across key future programmes such as the Government's 2030 vision for UK shipbuilding. Babcock's operations include the Devonport naval dockyard. 

In contrast, the 2014 acquisition of the Avincis search-and-rescue helicopters business was highlighted as an example of a deal that failed to deliver.

This will be particularly painful for longer term shareholders after they stumped up £1.1 billion to help pay private equity owners for a business that has subsequently produced low returns on high amounts of capital.

The sale of Babcock's oil and gas aviation business has already been agreed, with Babcock additionally looking for £400 million of disposals over the next year as it focuses on reducing a debt pile of £750 million.

This figure is already much lower than the City consensus of £920 million, helping to put further momentum into the shares on top of the company's vow to “return Babcock to strength without the need for an equity issue”.

The company's forecast for 2021 earnings of £307 million was also slightly better than expected, although there was a note of caution that 2022 will be a year of transition.

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Analysts at Liberum said the £1.7 billion of potential write-downs were larger than many had forecast but that management were right to clean up the balance sheet “once and for all”.

They believe the aviation division will be responsible for most of the accounting red pen, adding that there are favourable comparisons with a previous review at outsourcing business Serco where there was a significant cash drag from onerous contract provisions.