Impressive Babcock looks good value

A day after being chosen for a 10-year Ministry of Defence (MoD) contract to service armoured vehicles and tanks, Babcock has dished up better-than-expected half-year results. Crucially, the engineering outsourcer is successfully replenishing the order book, winning about £5 billion of new work since July, and emergency services acquisition Avincis is settling in well, too. The shares appear undervalued.

First-half revenue rose by nearly a quarter to £2.1 billion, or by 10% excluding Avincis and at constant exchange rates, driving a 32% increase in underlying pre-tax profit to £187 million. Consensus forecasts were for just £168 million.

And at £18.5 billion, 94% of anticipated revenue for the year to March 2015 is already in the order book, and 59% for the following year. The big increase in orders includes Magnox nuclear decommissioning worth up to £3 billion, about £2 billion from the Maritime Support Delivery Framework, and £2 billion from Avincis, which Babcock bought for £1.76 billion in May.

Given that £3 billion of preferred bidder contracts moved into the order book during the first half, the total bid pipeline has slipped to £13.5 billion from £16 billion in July. But remember, there's a so-called tracking pipeline of contracts not yet come to market worth over £16 billion.

True, the summer firefighting season helped Avincis generate operating margin of 19.9%, and profit there was much better than expected, but even without that help Babcock returns remained stable at 10.2%.

"Consensus EPS estimates are likely to remain unchanged, but better cash conversion and a clearer path to value creation for Avincis should catalyse a rerating," says broker Jefferies. It adds:

The group's 14.2x CY15E PE multiple now sits at an undeserved discount to Capita (14.6x), G4S (15.8x) and Serco (23.8x). Excluding the additional cash pension contribution, the FY16E FCF yield is 5.3%.

With the potentially troublesome Scottish referendum a distant memory, Babcock shares have recovered strongly and, according to the relative strength index (RSI), appear temporarily overbought. However, at 1,174p Babcock trades on forward price/earnings ratio of less than 15 for the year to March 2016, which, as Jefferies points out, is a steep discount to the sector, and undeserved for the double-digit growth on offer.