As recently as five years ago, Babcock International (LSE:BAB, Financial) was trading at 10 British Pound ($13) a share. By early this year, it was trading under the £2.50 mark. It definitely has been a disappointment to investors over this timeframe.
However, as of the writing of this article, it’s trading above £3 again. Has this stock bottomed out at long last?
David Herro (Trades, Portfolio) seems to think so. According to GuruFocus data, Herro’s Oakmark Intl Small Cap fund has been buying this stock in each of the past four quarters.
About Babcock
The company operates in the defence sector and has four divisions, Marine, Nuclear, Land and Aviation, with revenues ranging between £472 million to £627 million for each of these divisions in the first half of 2021.
The stock is certainly risky, as its Altman Z-Score is in the distress zone and its Piotroski F-Score is a weak 3 out of 9, , showing poor capital management and a dnager of bankruptcy.
Despite the unpredictable industry it operates in, the company has some competitive advantages. It is the United Kingdom’s only domestically owned civil nuclear contractor and a significant supplier to the aerospace and defence sectors, suppling the U.K. government and others with weapons, warships and submarine launch systems. It owns the strategically important Devonport and Rosyth dockyards.
Half year results reported earlier this month show the company making progress after years of poor performance. Revenue was up 8.2% to £2.2 billion. Statutory operating profit vastly improved from a £785 million loss to a £75 million profit. These numbers have also been restated using more conservative accounting policies. That caused lower numbers in many areas but sets the stage for a cleaner policy in financial disclosures going forward. One improved number from the changes was underlying operating profit in the nuclear division, but only for a few million pounds.
It seems the company is finally turning around, so perhaps Herro is indeed buying at an opportune time. CEO David Lockwood seems to be bringing in a period of consistent execution, but he was humble in the results webcast, saying: “It has gone a bit better than plan."
Babcock International has a long history, tracing back to the 1800s with Babcock & Wilcox Enterprises, Inc. (BW, Financial). In 1891, Babcock & Wilcox set up its international division as a separate company, basing it in the U.K. Since the First World War onwards, the company has been an important U.K. defence supplier and a main player in the military-industrial complex with a range of governments as customers.
Potential risks
Geopolitical risk is a big factor in the U.K. Don’t expect much business from China, and politics within Europe itself have always been tense. However, Babcock is set to benefit from the recent Aukus security pact between the U.K., Australia and the U.S. involving submarines.
On the earnings presentation, Lockwood highlighted Omicron, rising inflation and supply chain constraints as risks but stressed that the company is only in the first year of what will he calls a multi-year turnaround. He also said Babcock’s balance sheet is “in a safe place."
I’m going to wait for the company's full year results (which come out in July) to check the updated Altman Z-Score before I believe that, though. No one wants to admit it if their company is financially weak. At least it seems it’s unlikely Babcock will need a rights issue, although a £160 million cash outflow in the first half of the year got me digging until I found that this was mostly for capital expenditure and pension contributions. Like the accounting policy change, this could be setting the stage for cleaner results in the future.
Herro has probably noted that company insiders have been buying its stock as well. The buys haven't been massive, but Lockwood recently spent £119,000 on shares. At least the direction of travel is good.
Valuation
In terms of valuation, the GuruFocus Value chart rates the stock as modestly undervalued. The stock’s forward price-earnings ratio is just at 8.7.
The U.K. financial press has been speculating that private equity groups are considering a takeover of Babcock. A takeover bid is very possible, in my view, because regulators didn’t block peers Ultra Electronics and Meggitt being taken private. Lockwood also has form here. He was the chief executive who turned another defence contractor, Cobham, around before it was bought out by Advent International early last year.
So far, Babcock’s recovery looks credible to me. The stock is on my watchlist. I’ll keep an eye on GuruFocus’ Guru Trades data and review the company again once I can see its full-year results.
