EUR 850.00 For Business Accounts Only

Morningstar | We Lower Babcock’s FVE as U.K. Ministry of Defence Cuts Back on Submarine Programme Costs. See Updated Analyst Note from 19 Jul 2018

We are decreasing our fair value estimate for narrow-moat Babcock to GBX 870 from GBX 960 per share for the London-listed shares, mainly to adjust for lower-than-expected infrastructure spend by the U.K.’s Ministry of Defence, affecting 2018 and 2019 revenue for the firm’s largest divisions, marine and land, which combined generate close to 80% of group revenue. Contrary to management expectations, we do not believe that U.K. defence cuts on submarine expenditures (close to GBP 100 million, representing 6% of marine division sales) are temporary by nature, as the cost-savings programmes are focused on noncritical defence segments. Additionally, the land division's South African assets face headwinds after years of strongly benefiting from improved commodity pricing and strong demand from its main power customer Eskom. We estimate that power station outage delays in South Africa, owing to management changes, will reduce the land division's revenue growth rate by 100 basis points. We maintain our narrow moat rating.

Despite the downward revision to our fair value estimate, we still believe the shares are attractively valued. Our differentiation versus consensus is largely based upon lower perceived effects of additional revisions to the U.K. Ministry of Defence's military equipment plans. Although we are unhappy with the outcomes of the latest review of the newly created Submarine Delivery Agency, we believe additional cost-saving programmes, if the economic impact from Brexit worsens, will be directed towards non-mission-critical services, and thus will have limited impact on Babcock's support service revenue. The firm enjoys high switching costs, as long-term support services for strategically important assets increase customer loyalty. In highly regulated areas where safety is top-priority, like mission-critical defence and emergency services, changing supplier can lead to significant operational and cost risk (such as the cost of failure) for customers.

Additionally, with Babcock’s international contract wins in 2018 (with an Italian aerial firefighting contract and Swedish air ambulance services in the third quarter, and French military air training and Norwegian Air Ambulance contract wins achieved at the beginning of the year), the firm is diversifying operations in order to be less dependent on the U.K. Babcock’s new structure, with more clarity and focus on four key sectors--marine, aviation, land, and nuclear--should enhance its ability to capture (international) opportunities.