Shrinking military budgets made 2014 a tough year for most defence companies. At home, continued pressure to cut the UK's budget deficit has seen defence spending slashed by about 8 per cent over the past four years, while sequestration in the US - the world's largest military spender - remains a threat.
Some of the sector's big names, such as Cobham (COB), have emerged from the trenches firing, though. Shares in the defence contractor rocketed after a positive trading statement in November revealed decent order momentum and confirmed the effectiveness of its cost-cutting programme. A bumper A$640m (£346m) contract to provide airborne search and rescue capabilities to the Australian Maritime Safety Authority was welcome news, too, after a difficult first half plagued by shrinking margins and orders.
But given the vast cuts to military spending in developed nations, exploring opportunities elsewhere has become a major focal point in the sector. Cobham's wooing of Asia Pacific countries aside, the likes of BAE Systems (BA.) and Ultra Electronics (ULE) have also ramped up efforts to strengthen ties in high-paying Asian and Middle Eastern markets. This trend could pay off next year, too, should territorial disputes in the South China Sea force other nations to follow Japan's lead in beefing up military operations.
Likewise, cyber defence could provide some respite from a lack of traditional military spending. After a number of high-profile breaches in 2014, companies are expected to look to companies such as Ultra Electronics and BAE to help stave off further threats from hackers. But this isn't just an issue that's high on corporate agendas. President Obama is equally keen to splash the cash on cyber security after the Pentagon's main social media accounts were embarrassingly compromised at the beginning of the year.
As one of the first to identify a shift in government spending away from traditional defence kit, BAE could be a major beneficiary of the drive to make the internet safer. Europe's largest defence contractor experienced a rocky 2014, yet it still outperformed the FTSE 100 for the third year running. A chunky dividend yield has attracted investors, too, as has the group's strong reputation, takeover speculation and the fact that the shares trade at a notable discount to those of peers.
But despite also boasting a useful foothold in cyber security markets - and its expansion into new territories - Qinetiq (QQ.) isn't so well placed. Margin pressure and UK budget uncertainty presents plenty of challenges - the loss of former chief executive Leo Quinn, who took the helm at Balfour Beatty this month, raises uncertainties, too. Moreover, as one of the Ministry of Defence's biggest clients, Qinetiq will be paying close attention to how May's general election plays out. The rising threat of terrorism has fuelled speculation that the next government could plough more money into defence, but none of the political parties looks likely to rush to bolster spending.
Rolls-Royce (RR.) finds itself in a tight spot, too. After a decade of strong growth the group issued two profit warnings in 2014. The falling oil price, a drop in the value of iron ore and slowdowns in the Chinese and eurozone economies are all weighing heavily on the group's building, energy and mining segments. A bribery scandal adds to growing setbacks in the marine business, but we expect engine deliveries to eventually offset other headwinds.
More generally, however, a plummeting oil price is good news for those companies with aerospace exposure as fuel accounts for about a quarter of airline costs. Should oil stay cheap then ticket prices could fall, which may boost air traffic growth - good news for those that make or service aircraft. Meggitt (MGGT), for instance, should benefit from a lower oil price. Like many of its peers, the engineer has found the caps set out for defence spending in the US Budget Control Act hard to stomach, while its civil aerospace business hasn't fared much better. That may change now as a low oil price supports a recovery in after-market revenues.
Aerospace parts supplier and engineer Senior also looks well placed and its shares are up 17 per cent on our buy tip (263p, 26 June 2014). Success in aerospace has helped boost operating profits and - with the highly experienced David Squires now set to take the helm (he joins form rival Cobham) - the group should continue to counteract muted demand in defence markets.
| Company name | Share price (p) | Market value (£bn) | PE ratio | Dividend yield (%) | 1-year performance (%) | Last IC view |
|---|---|---|---|---|---|---|
| BAE Systems | 502 | 15.8 | 12.0 | 4.0 | 14.7 | Buy, 426p, 5 Aug 2014 |
| Cobham | 329 | 3.7 | 16.4 | 3.0 | 13.8 | |
| Meggitt | 522 | 4.2 | 15.6 | 2.5 | -3.3 | |
| Qinetiq | 187 | 1.2 | 12.1 | 2.7 | -18.7 | |
| Rolls-Royce | 892 | 16.7 | 15.0 | 0.0 | -26.7 | |
| Senior | 312 | 1.3 | 16.1 | 1.7 | 5.1 | |
| Ultra Electronics | 1,815 | 1.3 | 14.8 | 2.4 | -7.3 |
Favourites
BAE's cheap share rating stands out as a buying opportunity, particularly given its chunky dividend and exposure to a number of growth markets. Despite ongoing spending cuts in the US, it's well placed to capitalise on the US Department of Defense's pledge to provide more funding for F-35 fighter jets and cyber security initiatives.
Outsiders
After an end-of-year rally, we now feel that Cobham's premium valuation is unreflective of a flat budget environment. Despite a restructuring programme, margins have contracted in recent years and are likely to continue doing so as US defence budget cuts continue to bite.
