Investors in Babcock International PLC (LSE:BAB) have been warned to expect the unexpected tomorrow, as stockbroker Liberum has withdrawn its ‘buy’ recommendation on the eve of the defence engineer’s results.
Babcock shares had strengthened by around 1.1% earlier in Wednesday’s deals supported, broadly, by positivity in the market as UK inflation data came in better-than-feared.
All is not so rosy, however, according to stockbroker Liberum which has axed a ‘buy’ recommendation and previous 460p price target, to put its view on the share ‘under review’.
What’s going on?
What’s going on?
“On the surface, there has been remarkably little going on at Babcock since the interim results, a note distributed today by Liberum.
“We expect that when Babcock reports its FY results on Thursday, the reality will be very different, and there will be lots of talking points.”
The analyst added: “While we note the problems management inherited and the progress they have made on transformation, we see most of the issues as negative.”
‘Slow’ results a worry
The broker first points to the fact that Babcock’s release of financials tomorrow has been a longer than usual amount of time coming, which may potentially be due to auditor Deloitte.
“Delayed results are increasingly common, particularly for contractors, and also occurred at Babcock in FY 2020.
“One way to avoid a delay, is to report late. However, it is unusual for a main-list company to take this long to report, although they were also slow last year, which is more understandable given the significant re-statements.”
Frigate folly
The analyst also notes there’ll likely be challenges accounting around the ‘Type 31’ frigates contract, which is being delivered amidst a dispute with the customer, the Ministry of Defence, due to cost overruns.
In April, it was reported that Babcock and the MoD could not agree on who was responsible for the extra costs.
The Type 31 contracts were drawn up for five ships in 2019, pre-pandemic, with the production cost estimated to average around £250 million per ship, according to UK Defence Journal, but, following “unforeseen macroeconomic changes” costs have ballooned.
Babcock at the turn of the year delivered the first Type 31, HMS Venturer, before kicking off the construction of its second, HMS Active, in January.
The defence engineer reported previously that it had so far booked some £600 million of revenue related to the Type 31 programme but, unless contract terms are amended, the endeavour would be loss-making.
After failing to reach an agreement with the MoD, the issue was moved into an arbitration process.
If left unresolved, the Type 31 programme’s cost overruns would have to be incorporated into accounts for 2023, It was reported in April.
Babcock at that time said that write-offs related to the frigates were estimated between £50 and £100 million.
A more bearish view
“A negative outcome might be exceptional. But it is cash and will presumably affect the future profit take, which is not yet reflected in [market] consensus,” he said.
“Given Covid and supply chain challenges, and the ambitious pricing of £250 million per ship to begin with, the outcome could be multiples worse.”
The analyst noted that the UK government had already, in May, indicated that it would not show Babcock flexibility.
The longer-term implications of the dispute, according to the Liberum analyst, include a loss of Babcock’s credibility – he points to voices such as Admiral Lord Alan West and the Taxpayers Alliance which, he says, warned as early as 2019 that the frigates could not be built for £250 million apiece - and, looking forward, the company’s relationship with the MoD would “no doubt be damaged”.
Perhaps more acutely for investors, a negative outcome to the dispute could see Babcock’s balance sheet “stretched again”.
The note, also additionally questioned how much additional government would actually end up in Babcock's coffers in the near term, amid suggestions the UK might increase defence budgets, while it separately questioned the monetisable value left in Babcock’s non-core portfolio and highlighted negative forex impacts on the business.