UK Edition
Questor: keep buying Babcock – its skills are in short supply and a 4.3pc yield pays you to wait
While it is going to take time to persuade the sceptics that shares in Babcock are not cheap for a reason, that reason being further profit disappointment as the Ministry of Defence in particular brings pressure to bear on sales and profits, a forward price-to-earnings ratio of 8.5 and a yield of 4.3pc both smack of good value for a business that has excellent revenue visibility and a stunning record of dividend growth, while it also benefits from high barriers to entry.
Thankfully this column indicated that patience would be required late last year when it came to taking a contrarian view on the support services giant following its relegation from the FTSE 100. So it has proved.
The shares were cruising along nicely north of 850p until a cautious trading statement in July knocked them hard and erased the bulk of our profit. However, an update last week offered no further nasty surprises.
There was no further downgrade to revenue forecasts, after the decision to withdraw from two small, low-margin businesses and delays in some MoD work prompted the summer’s share-price slide. Almost 90pc of sales are now in the bag for the year to March, with 57pc in place for the following year, so visibility remains good.
- Read Questor’s rules of investment before you follow our tips. See Questor's tips every day at twitter.com/DTquestor
Profit forecasts were left unchanged in July and have held firm after the latest update. Babcock has now finished realigning its business across the marine, land, aviation and nuclear sectors to focus on higher-return business.
Meanwhile the skills it offers in submarine and vessel maintenance, staff training for the Forces and nuclear construction and maintenance remain in short supply. This should help to buttress profit margins in future and support cash flow at a firm where the conversion of profits into cash is also strong, the balance sheet healthy and dividend growth the norm.
The yield means that investors can afford to wait and see if Archie Bethel, the chief executive, can restore profit-growth momentum, the most likely catalyst for share price gains over the medium term.
The summer stumble was frustrating but looks like an opportunity to top up on Babcock.
Questor says: keep buying
Ticker: BAB
Share price at close: 722p
Update: Parity
Such are the trials and tribulations of investing in smaller stocks. The turnaround story at Parity, first tipped at 9.25p last winter, had been going well, as management was beginning to extricate the £15m company from a failed acquisition strategy.
A shift in focus from recruitment to higher-margin consultancy was taking up profits and driving down debt, to both increase the attractions and decrease the risks. Alas, there has now been an upset.
Interim results last week were solid: sales rose by nearly 1pc, operating profit by 12pc and pre-tax profits by 25pc to reflect the improved margins and lower interest bills. But John Conoley, the chairman, drew attention to what he termed a “short-term client-side delay” on a large contract.
- Questor archive: telegraph.co.uk/questor
This can happen at small firms, which may rely more heavily on particular customers, producers or individual executives and thus find themselves more exposed if something goes wrong unexpectedly.
Conoley took pains to emphasise that the business remained on track but for this delay, adding that profits should still meet expectations as long as there was no further slippage and the usual seasonal pattern of better trading in the second half came through.
However, that is a long list of ifs, buts and maybes. The shares took fright, chewing up a good chunk of our profit on the stock. And with debt going back up, albeit for the understandable reason of investment in working capital to grow the business, and profit forecasts now exposed to the risk of downgrades rather than offering the prospect of upgrades, the investment case looks less robust, even if the valuation remains compelling.
It feels like time to lock in some profits while we still have some before revisiting the stock early next year.
Questor says: sell
Ticker: PTY
Share price at close: 11.25p
Russ Mould is investment director at AJ Bell, the stockbroker