Babcock: an overlooked defence investment

Defence is one of the hottest investment themes of 2024. Shares in BAE Systems (LSE: BAE) and its European peers have surged higher as investors have flocked to the European rearmament trade, repricing companies for increased spending on defence. The MSCI World Aerospace and Defence index has jumped 22.7% year-to-date and 45.3% over the past year (to the end of September) compared with a return of 18.9% and 32.4% for the wider MSCI World index. While most of the companies in the defence sector now look fully priced, some opportunities remain. One such opportunity is the defence contractor Babcock International (LSE: BAB).

Babcock profits from nuclear

Around 70% of Babcock’s revenue is tied to the UK defence and civil market; 30% comes from overseas customers. A good percentage of that international base comes from Australia and South Africa, putting the European segment of the firm’s business at less than 10%. As such, the company has missed out on much of the European rearmament trade, but it does have a big exposure to the UK’s nuclear strategic deterrent. Around a third of the firm’s revenue is tied to its nuclear business, with half its bottom line coming from there.

The new Labour government is undertaking a strategic defence review, which has frozen defence spending until its conclusions are published, probably in 2025. But the government has said it’s committed to the nuclear deterrent and that’s where Babcock stands to profit.

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Defence is generally a great industry from an investor’s perspective. Defence contractors have one main customer – the government of their respective countries – and such customers are quite reliable. What’s more, spending tends to come in cycles, and long-term cycles at that.

The UK’s nuclear deterrent is at the extreme end of what these long-term cycles look like. The UK maintains a fleet of submarines, which are managed with the US in the Atlantic fleet pool of Trident missiles. The current class of submarine leading the deterrent policy is the Vanguard class, which replaced the Resolution-class subs armed with Polaris missiles between 1993 and 1999. There were plans to replace Vanguard by 2024 (in 2006), but this date has slipped and slipped. The latest date is at some point in the next decade. Delays have, unsurprisingly, pushed up costs. First pegged at £11bn- £14bn in 2007, the cost of the new Dreadnought class now stands at £45bn (including a £10bn contingency fund). As the Vanguard class has been kept in service far beyond its intended lifespan, the costs of maintenance have crept higher.

These multi-decade projects give contractors a high level of visibility over revenue and profit and allow them to plan accordingly. Babcock isn’t building the Dreadnought submarines (that role is allocated to BAE), but it will have a leading role in supporting the submarines when in service. It already supports the Navy’s existing Trident-armed submarine fleet, and analysts believe this support work is already generating £400m to £500m in revenue.

At the company’s 2024 full-year results meeting, management highlighted that the UK will be operating four different types of nuclear power submarines over the next decade. That includes the Vanguard class as it’s replaced and nuclear-powered attack submarines – currently, the Astute class. These will be replaced towards the end of the 2030s with the Aukus class of vessel. The Aukus programme (Australia-UK-US) is a tripartite initiative initially aimed at developing and producing a new nuclear-powered attack submarine. This chain of developments locks in work for Babcock well into the next decade and beyond.

Babcock is cheap at the price

Babcock’s other businesses – in marine, land, and aviation – are just as important to the group, accounting for around two-thirds of revenue. Still, the nuclear side has revenue visibility. It has been doing this for decades and has the facilities in place and the right clearances. The government is unlikely to take the work away and give it to another supplier. And it’s here where the growth is expected to materialise over the next five years. Analysts at Panmure Liberum expect the company’s nuclear revenues to rise by around 5% a year through the end of the decade, based on existing contracts and planned nuclear-deterrent expenditure. Babcock’s marine division (port facilities and infrastructure) is also expected to see revenue grow from £1.4bn to £1.7bn. Overall revenue is expected to hit £4.9bn by 2028, up from the £4.4bn reported for fiscal 2024.

Revenue isn’t the whole story here. Babcock has recently had to spend heavily on major infrastructure projects to prepare for upcoming nuclear contracts. These have eaten into its earnings, but unexpected costs are always a risk and the company now seems to be past the peak. As spending decreases and economies of scale flow through, Panmure’s analysts have the company’s earnings before interest and tax (EBIT) margin rising from 5.4% in fiscal 2024 to around 8%. So, while revenue is only expected to grow 12% between 2024 and 2028, underlying profits could rise as much as 80% from £158m to £283m. Earnings per share are projected to rise to 53p by 2028.

Considering all of the above, Babcock looks cheap compared with its future growth potential and its competitors. On 2025 estimates, at 474p, Babcock is trading at a price/earnings (p/e) ratio of around 10.7, compared with the European sector average in the mid-teens.

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