Babcock International Group — Steadfast defence

Research: Industrials

Babcock International Group — Steadfast defence

Babcock’s capital markets day reaffirmed its transformation over the past two years, facilitated by a series of disposals and a focus on core defence expertise (69% of H124 revenue). It is well positioned to capitalise on growing global defence budgets stemming from geopolitical tensions, and to continue developing its overseas partnerships. With a strengthened balance sheet (H124 gearing of 1.1x), cash flow visibility, a healthy order backlog of £9.6bn (more than 90% of FY24 revenue covered) and improved relations with the UK Ministry of Defence (MOD), which is favouring more British SME suppliers, there appears to be plenty of upside potential.

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Industrials

Babcock International

Steadfast defence

Aerospace and defence

QuickView

8 February 2024

Price

£4.24

Market cap

£2.14bn

Share price graph

Share details

Code

BAB

Listing

LSE

Shares in issue

505.6m

Business description

Babcock is a critical supplier of defence equipment and services to the UK and its international allies. It contributes more than £3.3bn a year to the UK’s GDP, working closely with the Ministry of Defence. It operates through four segments: Marine encompasses naval ships and infrastructure, Nuclear involves submarines and engineering services, Land manages vehicle fleet and military training, and Aviation provides engineering services and pilot training for defence and civil customers.

Bull

Geopolitical conflicts likely to continue to drive an expansion in military budgets for NATO countries.

Poised to expand internationally (with modular Arrowhead 140 frigate design).

Strong market position as the second-largest supplier to the UK Ministry of Defence and a leader in UK maritime defence.

Bear

Continued supply chain disruptions.

Potential for incremental costs that are not foreseeable at contract inception (eg Type 31 frigates).

ESG criteria risk undermining defence sector.

Analysts

Natalya Davies

+44 (0)20 3077 5700

Andrew Keen

+44 (0)20 3077 5700

Babcock’s capital markets day reaffirmed its transformation over the past two years, facilitated by a series of disposals and a focus on core defence expertise (69% of H124 revenue). It is well positioned to capitalise on growing global defence budgets stemming from geopolitical tensions, and to continue developing its overseas partnerships. With a strengthened balance sheet (H124 gearing of 1.1x), cash flow visibility, a healthy order backlog of £9.6bn (more than 90% of FY24 revenue covered) and improved relations with the UK Ministry of Defence (MOD), which is favouring more British SME suppliers, there appears to be plenty of upside potential.

Successfully nursing its battle wounds

Babcock has taken a few bullets in the past decade, notably a significant pension deficit and unforeseeable costs (c £100m) related to a Type 31 frigate contract with the MOD. Nevertheless, strategic actions including management changes, a reduction of the pension deficit by c £400m and divesting six non-core assets in the past two years have refocused it on its core defence expertise (69% H124 revenue) and margin enhancement, targeting 8% in the medium term. A healthy order backlog of £9.6bn provides cash flow visibility, achieving positive FCF in FY23 (H124: £67m). With a £1.1bn debt reduction from H121 to H124, the strengthened balance sheet supports the reinstated dividend. Babcock continues to progress with new contracts, including a four-year £750m infrastructure contract with the MOD’s Submarine Delivery Agency, pivotal in supporting the UK’s submarine fleet.

Defence prospects remain encouraging

Since the start of 2022, geopolitical tensions have increased sharply, driving numerous NATO member countries and allies to increase core defence spending. According to Statista, in 2023 NATO members spent c $1.26tn on defence, which has grown progressively since 2015 from $0.9tn. This is despite only 11 of the 30 member states meeting the agreed 2014 commitments to spend more than 2% of GDP, of which 20% should be on equipment (median spend: c 1.8% of GDP, UK: 2.1%). Rising defence expenditure, particularly in the UK (forecast 2.5% of GDP by 2030), represents a significant boost to growth prospects.

Valuation: Wide discount to defence peers

Over the past year, Babcock’s shares have performed in tandem with UK defence peers, increasing c 56%, fuelled by increasing geopolitical risk and an expected doubling of profits in FY24. The company trades at a 2025e P/E of 10.1x, representing a 36% discount to peers despite the robustness of the order book, cash flow visibility and strengthening long-term UK and international partnerships.

Consensus estimates

Year
end

Revenue
(£m)

PBT
(£m)

EPS
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/22

4,101.8

202.8

30.7

0.0

13.8

N/A

12/23

4,438.6

128.9

17.7

0.0

24.0

N/A

12/24e

4,231.0

257.2

37.6

6.3

11.3

1.5

12/25e

4,347.5

286.4

41.8

8.3

10.1

2.0

Source: Refinitiv

EDISON QUICKVIEWS ARE NORMALLY ONE-OFF PUBLICATIONS WITH NO COMMITMENT TO WRITING ANY FOLLOW UP. QUICKVIEW NOTES USE CONSENSUS EARNINGS ESTIMATES.

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General disclaimer and copyright

This report has been prepared and issued by Edison. Edison Investment Research standard fees are £60,000 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations. Where Edison has used consensus estimates within this publication, we do not guarantee their accuracy or completeness.

Exclusion of liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2024 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

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