Babcock International has agreed to buy a maintenance business from the Ministry of Defence, its biggest customer, for £140m.
The company is buying the Defence Support Group, which maintains and repairs a range of military vehicles and light weapons. The company’s contract with the MoD is expected to be worth around £2bn over 10 years - around 4.4% of 2015 estimated revenues according to analysts at Peel Hunt - and there is an option to extend it for another five years.
Babcock’s shares have dipped 7p to £10.54 on the news, and analysts at Liberum issued a sell note on the business:
As expected, Babcock have finalised the acquisition of DSG, and have detailed some of the terms. Babcock is paying £140m versus our guess of £150m. The contract is worth £200m per annum for 10 years, exactly in line with our expectations. There is no comment on the profitability.
However, Babcock has said in the past that DSG would replace the profits of NGEC [defence property contracts], thought to be £10m per annum. They have not told us whether that is pre or post an estimated £7m of expected interest. Management have also not said whether the contract follows the usual J curve, with greater profits further out.
We question whether the contract would be subject to Yellow book roles which come into force in April 2015, which are intended to cap profitability of contracts where a supplier has exclusivity. This contract will clearly add £2bn to the order book and we already estimate 2% accretion for 2016, which may not be in consensus. However, it is very unusual to see an outsourcer effectively buying a profit stream, and we question whether the contract is value accretive.
