Babcock International Group PLC (LON:BAB) shares dropped after Morgan Stanley downgraded the stock, citing limited visibility on growth and margins, working capital concerns and factors outside the company's control.
Morgan Stanley cut its rating to ‘equal-weight’ from ‘overweight’ and lowered its target price to 800p from 975p.
READ: Babcock International says current trading in line with its expectations, and full year outlook unchanged
In November, the engineering and outsourcing group maintained its full year outlook as it reported a 6.6% increase in revenue to £2.3bn and a 11.3% rise in pre-tax profit to £181.9mln in the first half.
“We expected some relief with FY18 guidance being maintained and the fastest pipeline growth since 2013 at 13% year-on-year to £12.2bn from £10.8bn,” Morgan Stanley said.
“This should ultimately be reflected in accelerating organic growth to 5.5-6% assuming a win rate of 40% on new business, 90% retention on rebids and 0% inflation in the base portfolio.”
Babcock cuts 2019 estimates, margins under pressure
However, Morgan Stanley noted that Babcock cut its 2019 growth expectations to the low end of its mid-single digit target range due to delays to some government contracts.
At the 2017 full year results, the company had guided towards a margin downside of 10- 20 basis points (bps) relating to an extra £9mln pension charge in the Marine business.
“However, a £7.5m provision was incremental, driving margins down 30bps; in the absence of this margins would have been in line with Morgan Stanley estimates,” Morgan Stanley said.
“Whilst we expect margin pressure to reverse the key issue remains visibility over the longer-term outlook.
“This is exacerbated by the underlying volatility of joint ventures vs. group profitability, which reduces our conviction over the sustainability for a stable margin outlook in the medium term.”
Working capital a key concern
The company’s working capital also remains a key concern, Morgan Stanley said, pointing to delays to its French military air training contract (FOMEDEC).
The delay resulted in working capital cash outflows of £71.3mln during the first half.
“Whilst this is a timing issue, which can occur with contracting businesses, deteriorating cash conversion impinges on sentiment,” Morgan Stanley said.
It added: “Management is comfortable with the current position, but the market is not as contract provisions across the sector have been linked to an accumulation of receivables. We continue to think the shares are unlikely to find support until growth in these balance sheet items starts to unwind.”
Morgan Stanley said the market has already discounted significant downside to estimates and the stock appears cheap but it does not see material catalysts to change this negative perception in the short-term. “We still prefer Babcock vs.other outsourcers, but given uncertainties it's difficult to argue for capital allocation.”
Shares fell 3.23% to 674.50p in morning trading.
The downgrade comes after Goldman Sachs removed Babcock from its Conviction List following the first half, citing uncertainty in contracts for the company.