Is FTSE 100 Stalwart Babcock a Good Value?

LONDON -- Capital appreciation is the goal of many investors, and one method of achieving it is to buy companies with steady earnings growth. If the shares are bought when cheap, two drivers could move its price up: growth in earnings and an upward P/E re-rating.

Highly successful fund manager Peter Lynch classified steady growers as "stalwarts," which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know whether reliable earnings growth can continue and whether the shares are cheap.

Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 index, where the compound annual earnings-growth rate has been just 0.7% over the last five years:

Consistent growth in profit that is backed by cash flow is a promising characteristic in today's markets, so for this series I'm examining firms with annual earnings growth between 4% and 20%.

One contender is Babcock International Group (BAB 1.56%), which provides outsourcing services to government and private-sector customers, including extensive work with the U.K.'s armed forces. This table summarizes the company's recent financial record:

So earnings have grown at an equivalent 16.5% compound annual growth rate, putting Babcock in the stalwart category.

Babcock is an engineering support services organization employing more than 25,000 people in sectors like defense, energy, telecommunications, transportation, and education. Around 36% of revenue comes from support services, 35% from marine and technology, 20% from defense and security, and 9% from international operations.

With the release of its half-year results on Nov. 6, Babcock revealed good progress with a set of desirable growth figures and a reduction in debt. The order book is up and now stands at 12.5 billion pounds, which, the company argues, provides "excellent visibility of future revenue streams." The directors said the firm entered the second half with about 90% of the 2013 financial year's anticipated revenue contracted and more than 50% of the 2014 financial year's projected orders booked. There has also been growth in the bid pipeline and new opportunities coming into the tracking pipeline, they said.

If the recent upbeat results are any indicator, further earnings growth seems likely.

Babcock's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and if the shares offer good value:

1. Growth: Revenue, earnings, and cash flow have all been growing steadily. Score: 4/5
2. Level of debt: Net gearing is around 67%, with borrowings just over three times earnings. Score: 3/5
3. Outlook and current trading: There's good recent trading and a positive outlook. Score: 5/5
4. Enterprise value to free cash flow: A trailing 28 and above historical growth rates. Score: 2/5
5. Price to earnings: Trailing at around 16 -- in line with historic earnings-growth rate. Score: 3/5

Overall, I score Babcock 17 out of 25, which encourages me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100. The shares seem fairly priced when compared to the FTSE's P/E ratio of around 11 and the firm's growth predictions.

Foolish summary
A record of steady growth and falling debt is attractive when taken with the positive outlook. The score dips on the valuation indicators, demonstrating that investors have noticed such attributes. There doesn't appear to be a valuation anomaly here.

Right now, forecast earnings growth is 6% for 2014, and the forward P/E ratio is 13.4 with the shares at 991 pence. Considering that and the other factors analyzed in this article, I think it looks like the shares price in the expectation of further earnings growth, so I'm keeping Babcock on watch for now.

Babcock International Group is one of several stalwarts on the London Stock Exchange that are steadily growing earnings, each with the potential to deliver significant capital appreciation when purchased at sensible prices.

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