Is Babcock International The Ultimate Retirement Share?

Published in Company Comment on 16 October 2012

Will shares in Babcock International help you build a FTSE-beating retirement fund?

The last five years have been tough for those in retirement. Portfolio valuations have been hammered and annuity rates have plunged. There's no sign of things improving anytime soon, either, as the eurozone and the UK economy look set to muddle through at best for some years to come.

A great way of protecting yourself from the downturn, however, is by building your retirement fund with shares of large, well-run companies that should grow their earnings steadily over the coming decades. Over time, such investments ought to result in rising dividends and inflation-beating capital growth.

In this series, I'm tracking down the UK large-caps that have the potential to beat the FTSE 100 (UKX) over the long term and support a lower-risk income-generating retirement fund (you can see the companies I've covered so far on this page).

Today, I'm going to take a look at Babcock International Group (LSE: BAB), which specialises in providing outsourced support services to the armed forces and other organisations.

Below the radar

Babcock only joined the FTSE 100 in June, when it was promoted from the FTSE 250 (MCX). A look at the returns generated for Babcock shareholders over the last ten years shows why -- Babcock has clearly been a strong performer:

Total Return2007200820092010201110 yr trailing avg.
Babcock International42.7%-13.6%28.9%-1.2%32.3%26.4%
FTSE 1007.4%-28.3%27.3%12.6%-2.2%7.3%

Source: Morningstar

(Total return includes both changes to the share price and reinvested dividends. These two ingredients combined are what make it possible for equity portfolios to regularly outperform cash and bonds over the long term.)

Babcock has massively outperformed the FTSE 100 over the last ten years and illustrates why the FTSE 250 is often a good place to look for lower-risk growth shares that pay reliable dividends.

What's the score?

To help me pinpoint suitable investments, I like to score companies on key financial metrics that highlight the characteristics I look for in a retirement share. Let's see how Babcock International shapes up:

Year founded1891
Market cap£3.5bn
Net debt£661m
Dividend Yield2.3%
5 year average financials
Operating margin6.5%
Interest cover5.9x
EPS growth22.8%
Dividend growth24.9%
Dividend cover2.6x

Source: Morningstar, Digital Look, Babcock International Group

Here's how I've scored Babcock on each of these criteria:

LongevityLong engineering pedigree but less experience as a service company.4/5
Performance vs. FTSEOutstanding, albeit from a smaller start than its FTSE 100 peers.4/5
Financial strengthFairly heavily geared but good cash generation and stable margins.4/5
EPS growthVery respectable.4/5
Dividend growthImpressive growth while keeping high levels of dividend cover. Yield not great.4/5
Total: 20/25

Babcock International's links with the defence industry date back to the early 20th century and the company remained an engineering company until 2000, when it changed its focus to providing support services. Today it is the Royal Navy's main outsourcing partner and also undertakes work for the other armed forces and civilian organisations. Babcock's switch to services seems to have been a good decision, because the last ten years have seen substantial growth, culminating with the promotion of Babcock from the FTSE 250 to the FTSE 100, where it continues to perform well.

Beating the competition?

Indeed, Babcock has been so successful that it now trades at a slight premium to most of its peers in the support services sector. Babcock's price-earnings ratio of 15.7 and market value of £3.5bn make it larger and more expensive than its fellow defence specialist, Serco Group (LSE: SRP), which currently has a P/E of 14.6 and a market value of just £2.8bn. Babcock even profited from the failure of its peer G4S (LSE: GFS) to deliver security staff for the Olympic games, providing transportation for the thousands of troops who were drafted in to replace non-existent G4S security staff.

Babcock's near-term prospects seem solid, with a healthy bid pipeline and rising profits. Major changes to defence policy could hamper its progress, but it seems unlikely that the UK government will ever reverse its strong commitment to outsourcing. Although Babcock's shares may be available more cheaply in the future, I think it represents reasonable value at present and with a score of 20/25, is a decent candidate for a retirement portfolio.

Expert selections

Doing your own research is important, but another good way of identifying great dividend-paying shares is to study the choices of successful professional investors.

One of the most successful income investors currently working in the City is fund manager Neil Woodford, who manages more money for private investors than any other City manager. Neil Woodford's dividend stock picks outperformed the wider index by a staggering 305% in the 15 years to 31 December 2011.

The good news is that you can learn about Neil Woodford's top holdings and how he generates such fantastic profits in this free Motley Fool report. Many of Mr Woodford's choices look like excellent retirement shares to me and the report explains how he chose some of his biggest holdings.

This report is completely free and I strongly recommend you download "8 Shares Held By Britain's Super Investor" today, as it is available for a limited time only.

Warren Buffett buys British! The legendary investor has recently topped up on his favourite UK blue chip. Discover what he bought -- and the price he paid -- within our latest free report!

Further investment opportunities:

> Roland does not own shares in any of the companies mentioned in this article.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

nnnnineteen 18 Oct 2012 , 2:47pm

Ah yes, another small brown envelope passes from NW to TMF!

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