Shares in Babcock International have come under pressure of late as the company has been lumped in with the rest of the business outsourcers. They include Interserve, which put out a shocking profit warning last week, and Capita, which has had to restate its earnings sharply downwards because of a change in accounting rules. Indeed, there are few in the sector, other than Babcock, that have not given some sort of profit warning over the past couple of years.
Another factor is the potential influence on defence spending were Jeremy Corbyn to be elected prime minister, given that Babcock gets 60 per cent of its revenues from defence, though not all from the UK. Disregard the Corbyn factor and the above seems hardly fair. Indeed, government pronouncements on defence and shipbuilding mean that the search for greater efficiencies should play to Babcock’s strengths.
Then there is the matter of margins. Mitie, for example, wants to lift these to above 5 per cent as part of its turnaround plan. Below that level is not unusual for the sort of work that such companies do — basic security and looking after buildings. Babcock made operating margins of 11 per cent in the last financial year and says that largely insignificant changes in the mix of work will see these fall to 10.8 per cent this year.
Then there are those accounting changes, under IFRS15. These are meant to stop companies failing to disclose losses at the start of long-term contracts and smoothing them over the full period. Babcock tends not to do this and has made clear that IFRS15 will have little impact.
Yesterday’s trading statement, marking the approaching end of the first half of the year, makes it plain that visibility of future earnings, always a key measure, has improved, with 89 per cent of revenues in place for the year, up from 76 per cent when the company reported results in May.
Babcock’s £19 billion order book has an average contract length of seven to eight years, while some of those UK defence contracts, such as engineering and flight training, last until the 2030s.
There is other new work being carried out in South Korea, on submarines, in Norway, providing aircraft to allow transport to healthcare, in France, training air force pilots, and a strong pipeline of identified future contracts. Babcock shares got a relief got a relief bounce of 46½p to 846½p but sell on ten times’ this year’s earnings, which looks too low.
MY ADVICE Buy
WHY Babcock has been unfairly classed in with other outsourcers, but its business is much more resilient and contracts much longer term
Cambian Group
It is not easy to read much into the interim figures from Cambian Group, given the upheaval the care services company has suffered over the past couple of years.
There was a profit warning in October 2015; debt had ballooned and trading had been poor. The solution, at the end of last year, was the sale of the adult services side to allow Cambian to focus on children’s services and to try to move margins here upwards by seeking to work for more difficult cases with a high degree of need. The halfway figures, therefore, contain a number of one-offs, while performance has been made more difficult by the task of separating the two businesses. At a reported level, losses before tax eased from £12.7 million last time to £1.2 million. There was a hit for the disputed changes to so-called “sleep-in” charges, whereby operatives at homes have to be paid for the time they spend on site but asleep.
The positives are that the average daily fee was up by 6 per cent, suggesting some progress in moving to higher-margin business. Meanwhile, the £377 million sale of adult services left £122 million of cash in the bank at the end-of-June financial year-end before the payment of a £50 million special dividend.
The shares, off 12¼p at 200p, have recovered strongly since they bottomed out below 60p in summer last year. There is little point in looking at this year’s figures. Based on earnings for 2018, they sell on a multiple of about 30 and the dividend yield, after the special, is negligible.
MY ADVICE Avoid
WHY Too early to buy the shares, which look expensive
Diageo
Diageo has been transformed over the past three or four years, moving from flat revenues to a rise of 4.3 per cent on an organic basis in the last year to the end of June, and the company is confident enough to forecast something similar this year.
It is investing heavily in its American spirits and Scotch business, an underperformer with a weakness on the quality vodka side. This will hold down margins in the short term and any gains will be weighted towards the second half, but Diageo is predicting 175 basis points of improvement over the three years to the end of June 2019, given that it has moved up its goal of productivity savings by £200 million to £700 million.
The problem is that this improvement has been largely tracked by the shares. The stock is up by 15 per cent so far this year and the shares sell on 21 times’ earnings. A £1.5 billion share buyback programme does not suggest that Diageo has much else to do with its strong cashflow. The shares have been falling on the back of the rising pound and lost 69½p to £24.26½ after some predictable warnings about the negative impact of recent changes to laws in India and the Chinese new year. They still look fully valued.
MY ADVICE Avoid
WHY Rating seems up with events, given pace of growth
And finally...
Shares in Intermediate Capital have been strong this year, up by more than a quarter since Tempus tipped them in February. The market is taking its time appreciating its shift from investing its own funds to a more asset management-based model, while the increasing reliability of earnings means that dividends may be raised. A note from Numis Securities suggests that recent share price weakness has been overdone. Intermediate’s way of doing business is one that other asset managers are looking at.
