Defence and aerospace stocks Babcock International Group (BAB) and Meggitt (MGGT), are both trading at below their fair value estimate according to Morningstar equity analysts.
The latest results from both companies show profits growth – but their share prices have fallen over the past six months thanks to uncertainty raised by the Brexit vote. Defence spending decisions are widely expected to be delayed within the two-year negotiating period between UK and European Union.
However, Archie Bethel, chief executive at Babcock, is reported to have said he expects to benefit from US President Donald Trump’s demand that NATO members spend more on defence, helping the company to avoid the turmoil hitting peers who could potentially win fewer contracts after Brexit.
Morningstar equity analyst Jeffrey Vonk said as both companies operate businesses on complex civil and military platforms, conforming to stringent and sometimes challenging specifications, a delay, disruption or cancellation of any of these programmes will undermine the firm’s financial performance.
“In the defence business, both firm face significant uncertainty from government decisions,” said Vonk.
Shares of Babcock are down 3% this year while Meggitt has fallen 2.5%.
Babcock: Beneficiary of Rising UK Defence Budgets
Babcock in February said its outlook for full financial year remains unchanged. The company is the second-largest supplier to the UK’s Ministry of Defence. In November the company revealed a 7% rise in first-half operating profit to £269.7 million.
The company said since the end of its first half-year to September 30, it has continued to make progress with its existing contracts and its new order intake remains strong.
“Our UK markets remain positive, with the Group well positioned for the significant future outsourcing opportunities expected from both our defence and civil customers, and we see growing international demand for our specialist and complex engineering support services.
“Despite slightly slower organic growth, the Board expects the full-year results to be in line with its expectations. We therefore remain confident of making good progress both this year and beyond,” Babcock’s Bethel said in the half year report.
Morningstar’s Vonk believes shares of Babcock do not fully reflect the firm’s profitability growth potential.
“Based on long-term agreements, the firm offers maintenance and retrofit of warships and nuclear-powered submarines to the Royal Navy and provides fleet management for the British Army. The company is one of the main beneficiaries of rising UK defence budgets and the government's commitment to outsourcing to the private sector, as highlighted in the 2015 Strategic Defence and Security Review. The company’s strategic partnership with the British Army is a valuable intangible asset,” said Vonk.
Vonk believes that outsourcing in the international defence market will also increase, opening the door for accelerated growth in Babcock’s equipment support services and training activities outside the UK.
Meggitt: Falling Pound Boosts Profits
In 2016, Meggitt reported underlying operating profit growth of 17% thanks to benefit from currency and composites acquisitions, the company said in its full year report.
Stephen Young, chief executive at Meggitt said the stronger second half year performance last year gave the company good momentum going into 2017.
“We are past the peak of engineering investment on the many new aircraft programmes that have recently entered, or are entering, into service. Our increased content on these new programmes will drive higher revenue in the coming years. We are now focusing our resources to accelerate progress on our key operational initiatives which we expect will deliver significant improvement in operating margin and cash conversion by 2021,” said Young.
Meggitt is a global engineering company specialising in high-performance components and subsystems for the aerospace, defence, and energy markets, with highly engineered equipment on over 67,000 aircraft and many ground vehicles and energy applications worldwide, said Vonk.
While Morningstar’s Vonk believed shares of Meggitt are undervalued, returns on invested capital of this stock will exceed the costs of capital over analysts’ five-year forecast period.
“We estimate that nearly 50% of Meggitt’s revenue comes from aftermarket maintenance and repair services, which we view as evidence of sticky relationships via customer reliance on original equipment manufacturers like Meggitt. Strong customer relationships and high levels of embedded intellectual property, spanning a broad range of products and capabilities, have enabled Meggitt to win good positions on platforms, largely on a sole-source basis,” said Vonk.
Vonk added that both Babcock and Meggitt have seen dividend improvement over time. Vonk believes Babcock will increase dividends supported by a rise in operating profit expected over the next five years.
