The Babcock (LSE:BAB) share price has been on a downward trajectory since 2014 due to management and accounting issues. But it seems investors may have just caught a break because the share price exploded by nearly 35% this morning.
So what’s changed? Why is the stock price suddenly rising? And should I be adding this business to my portfolio?
The explosive Babcock share price
The Babcock share price wasn’t off to a particularly good start in 2021 before today. After new management stepped up to the plate, a trading update was released. It announced that an internal review was underway that would likely result in a negative re-evaluation of the firm’s assets.
This is evidently not a positive thing to hear. However, as new management takes a more transparent approach to running the business, it seems that Babcock’s days of aggressive accounting may be over. At least, that’s what I see. This morning, the company released another update that appears to be the primary catalyst behind Babcock’s exploding share price.
Balance sheet impairments are estimated to be around £1.7bn. And operating profit will be £30m less each year as well. Comparing this revised figure to pre-pandemic underlying income, that’s approximately 10% of profits disappearing. Needless to say, this is not good news, so why did the share price go up?
Beyond removing a lot of uncertainty, the new management team is restructuring the business. Managerial layers are being eliminated to save £40m per year. Certain assets are being divested to raise a minimum of £400m before the end of 2021. And the firm’s net debt (excluding its lease liabilities) has fallen to £750m down from £1.2bn in December.
It is too soon to tell whether the new management team is pursuing the right strategy. But investor confidence is high. And that’s something Babcock hasn’t had in a long time.
Taking a step back
Restructuring a business is not a cheap or straight forward process. There are many costs associated with it that are likely to cause some short-term volatility in the Babcock share price. But even if the contract impairments are ignored, the business’s underlying profit still fell by 36% this year. In fairness, this is during a time of a global pandemic, so I think it’s likely to only be a temporary performance drop. However, it’s something I’ll be keeping an eye on in the future.
A closer look at the balance sheet write-offs reveals that the vast majority of it originates from intangible assets, specifically goodwill. As a reminder, goodwill represents the premium paid when acquiring another business. And so, removing around £1bn of value from the books is a clear indicator to me that the firm vastly overpaid for historic acquisitions. While these were made under previous management, I would be quite concerned if a new acquisition were announced in the near future.
The bottom line
To me, Babcock looks like it could be at the start of a long-awaited turnaround. Once the restructuring is complete, and if the new strategy proves to be viable, then I believe the Babcock share price will continue to climb over the long term. But personally, I want to wait and see how things unfold during 2021. And so, the company is staying on my watch list for now.
