Shares in FTSE 250 defence outsourcing firm Babcock International Group (LSE: BAB) are down by nearly 20%, as I write. Babcock’s share price has now fallen by 65% over the last year.
The stock slumped after the company warned it might need to write down the value of some of its contracts and said that outlook for 2021 was uncertain.
I’ve come close to buying this stock on a number of occasions but have held off. I’m glad I did. But I’m wondering now whether this could be a chance to buy shares at a bargain price ahead of a recovery.
What’s happened?
In a trading update today, Babcock CEO David Lockwood warned that a detailed contract review has found “early indications” that future profits could be lower than expected. The company has decided not to provide any profit guidance for the current year, which ends on 31 March.
It’s unusual for a £1.3bn company to have no idea about profits during the final financial quarter. To be honest, I think it’s pretty worrying.
However, it’s probably fair to say that markets were already wary about the outlook here. Even before today, Babcock’s share price valued the stock at just 6.5 times 2021 forecast earnings.
After today’s news, I’ve decided to ignore these forecasts. If the company can’t issue guidance, then City analysts are unlikely to have much idea about profits either.
Why haven’t the shares fallen further?
In some ways, this is the news the market has been waiting for. Short sellers started targeting Babcock several years ago, suggesting profits might need to be written down. Most of Babcock’s peers in the government outsourcing sector have long since been forced into similar contract write-downs.
Babcock’s share price has already fallen by around 80% over five years. That may be why the stock hasn’t fallen further today.
I have to admit I was starting to doubt whether there was really a problem at Babcock. I thought perhaps the firm’s focus on defence and engineering enabled it to generate more reliable profits than other outsourcers.
Unfortunately, it seems that the short sellers were right after all.
Babcock share price: is this the bottom?
The big question now is what happens next? Will Babcock shares keep falling, or is this the bottom? One possibility is that we’ve now reached the point of maximum fear.
Stock markets hate uncertainty and until Babcock can clarify the extent of any problems, investors have no real way to value this business. When the company is able to provide an update on profits, we could see the shares start to recover.
That’s possible, but it’s not an outcome I’m prepared to bet on. For now, Babcock’s uncertain profits and substantial debt load make it uninvestable for me. I’m going to stay with my preferred play in the defence sector, FTSE 100 firm BAE Systems.