Tempus has a favorable outlook on Babcock. This positive assessment is not only due to the stock’s impressive performance, which has seen nearly a twofold increase since it was last recommended nearly a year ago, rising 150% since our buy suggestion in September 2023.

The recent strategic defense review unveiled on Monday, along with the ongoing geopolitical tensions exacerbated by the Russian invasion of Ukraine in early 2022, positions a defense contractor like Babcock advantageously in today’s military landscape.

When it comes to servicing, refitting, and refurbishing an expanding fleet of submarines and warships, Babcock has substantial resources through its vast dockyard in Devonport.

For those looking to develop cost-efficient warships for the Royal Navy and international markets, Babcock operates a shipyard at Rosyth in Scotland.

Moreover, for essential support in engineering, maintaining military equipment, and training British Army personnel, Babcock has established a dedicated division that recently secured a five-year exclusive agreement with the Ministry of Defence.

Although 70% of Babcock’s operations cater to military needs, its Cavendish Nuclear division plays a significant role in the nuclear life cycle — from new builds and next-generation developments to fuel procurement and decommissioning of the aging fleet. This sector is not going away anytime soon.

Later this month, the company is expected to announce a 17% increase in operating profits, totaling £363 million, along with an 11% rise in revenue, reaching £4.83 billion for the financial year ending in February. Operating margins have improved from 7% to 7.5%.

Babcock currently has a work backlog valued at £10.1 billion, which has increased by £600 million since the autumn.

The company has maintained positive cash flow of £153 million, even after considering a £40 million pension deficit repair payment, leading to a net debt reduction of 14% down to £373 million.

Historically, Babcock faced significant challenges. During the latter half of the last decade, it was considered one of the market’s most undesirable stocks. Following the consolidation efforts of former CEO Peter Rogers, the company struggled with complexity and performance transparency, making it difficult for investors to gauge the severity of its situation.

The stock plummeted from a peak of nearly £13 in 2014 to around £5 by the time the previous leadership was replaced and David Lockwood, known for turning around struggling companies, took charge.

However, Lockwood’s tenure did not immediately halt the downward trend in share prices. The onset of the Covid-19 pandemic and a substantial accounting reset unveiled the true extent of the company’s issues, causing the stock to dip to 210p in spring 2021.

Lockwood faced a challenging corporate culture characterized by dysfunction, where the celebrated federated business model had led to reinforced divisional silos. A company rich in engineering heritage was not appropriately fostering or investing in internal expertise or talent retention.

Babcock is the UK’s second-largest defense contractor by workforce and revenue, next to BAE Systems. Although it does manufacture some original equipment, Babcock primarily offers support services, which had previously confused investors about its value proposition: Was it a prestigious defense firm or merely a service provider? However, those uncertainties appear to have subsided, with the stock now reaching a nine-year peak.

Forecasts indicate that Babcock’s annual revenues may rise by another third by the end of the decade, and operating margins are projected to exceed 9%.

Following an 8% surge on Monday, the stock now trades above £10 per share, raising the question of how much of this growth is already factored into the current price.

The shares are currently valued at more than 20 times the expected earnings for this year and 18 times the projected earnings two years from now—considered high for a support services firm.

Furthermore, there is minimal potential for a takeover premium, as Babcock is deeply integrated with the Ministry of Defence. The dividends offered are so small that the yield remains below 1%.

Tempus is content to hold onto Babcock shares, but it recognizes that market corrections are possible, suggesting that investors might consider taking some profits.

Advice: Hold

Reason: A key player in the defense sector, yet the stock price appears to be at a peak.