Broker tips: Essentra, Babcock, IMI

Jefferies downgraded its rating on Essentra to 'hold' as the cigarette filters and plastic packaging manufacturer's "self inflicted wounds" need time to repair.

The profit warning on 22 January outlined perfectly that new chief executive Paul Forman "has a sizeable job on his hands".

"The group needs to undergo significant change and while there is recovery potential, remedial work is needed, the recovery will take time to come through and will come from a lower-than-expected starting point."

Forman has outlined the areas of the group that need major work to repair and drive improvement.

"There is much work to do to get the group back to full health, and it will take time for the recovery to come through in earnest," Jefferies said.

"A fundamental change in culture is needed, but most the issues faced are self-inflicted, not structural in nature."

Analysts cut their full year PBT and EPS forecasts by 4%, but for the next two years take a more cautious view of the HPCP recovery and lower margin assumptions compared to other analysts and so raised their target price to 450p from 445p "to reflect recovery multiples".

Following BT's shock profit warning linked to a deteriorating outlook for UK public sector work, broker Shore Capital wondered "when will Babcock warn?"

Babcock's shares fell around 2% on Wednesday as investors read across the implications from BT and had also fallen in sympathy with Capita when it warned on profits last year.

With circa 70% of the group de-facto dependent upon the UK public sector, ShoreCap felt the market was expecting a similar warning from Babcock, even though the profile of services delivered and the infrastructure supported is "more than a little bit different" to BT and Capita.

"Babcock supports essential and critical infrastructure with professional engineering support services that attract less discretionary spend, but still support additional ancillary revenues. We see a very different, lesser revenue flow ‘risky’ profile," wrote analyst Robin Speakman.

"This is not to say that pressures on UK public spending are having no effect on Babcock, it cannot be totally immune, but it is difficult to delay spending on that decommissioning nuclear reactor, in servicing that submarine, or leaving a gap in national electricity grid infrastructure."

He said Babcock undoubtedly has other issues to address, namely convincing investors of the strength of its long term profitable growth potential.

But the weakness in the shares was a long term buying opportunity, the analyst said investors should not have too long to wait as the company updates on its third quarter on or about 28 February.

Looking at the new financial year, he pointed out that Babcock shares were trading at 10.6 times 2018 forecast earnings on a free cash flow yield of circa 8.0% with debt-to-EBITDA falling to circa 1.4 times.

Speakman is not alone, with Morgan Stanley recently expressing its preference for Babcock among the government outsourcers, with the continuing pressure on growth due to increased competition and fewer large outsourcing opportunities seen as more of a worry for Capita.

Credit Suisse has upgraded IMI to ‘outperform’ from ‘neutral’ and downgraded Rotork to ‘neutral’ from ‘outperform’, lifting the former’s price target to 1,220p from 1,020p and cutting the latter’s to 250p from 230p.

The upgrade of IMI is on the basis that around 60% of its end markets are depressed but have scope to recover. CS reckons that supported by cost cutting, the company’s margins can positively surprise.

CS noted than on an organic basis, IMI’s group revenues are 10% below 2014 levels with Oil & Gas and Nuclear markets significantly more depressed. The bank sees improving lead indicators for IMI’s business and expects organic growth to trough in 2017, particularly in the Critical business, which has driven earnings downgrades.

“We also think that IMI stands out as a short-cycle name where valuation attractions will increasingly come into focus when rolling forward to 2018. We increase our 2017-18 EBIT forecasts by 5%; we are 5% ahead of consensus.”

Credit Suisse said the downgrade of Rotork was mostly a valuation call as its view of the high quality of the company remains unchanged and it continues to expect growth to outperform its end markets and earnings per share to grow double-digit, supported by value-accretive bolt on deals.

“However, with the shares having re-rated versus UK capital goods by 25% since mid-September and with an ongoing sluggish outlook for mid/downstream O&G markets, we view the shares as fairly valued.”