Join our community of smart investors

The new arms race

Defence stocks gained further momentum following the US presidential election, but a destabilised geopolitical landscape and technological change are creating favourable long-term growth opportunities
March 10, 2017

The period since the end of the second world war has been dubbed ‘The Long Peace’ by historians, the years characterised by an absence of major wars between the great powers of the day. That’s not to say that countries haven’t sought to exert influence through regional conflicts; a point not lost on anyone unfortunate enough to be resident in, say, either Aleppo or Sana’a in recent times. Even when cocooned in the relative stability of a western capital such as London, it’s difficult to avoid the impression that it’s a very troubled world out there, or perhaps that’s symptomatic of our media age – everything seems that much closer to home.

Nonetheless, since the turn of the millennium, there have been at least 16 large-scale military conflicts and insurgencies across the globe. The human cost, as often said, is incalculable, but as an investment magazine it would be wholly remiss of us not to highlight the economic benefits that flow through from defence spending, particularly as the industry emerges from a lengthy spell of fiscal retrenchment.

You could make the case that, in the age of globalisation, geopolitical developments will increasingly influence state economics. But they should also inform how investors allocate capital. More specifically, the deterioration – or perceived deterioration – in matters of global security means that we’re entering a period when countries steadily increase military spending.

 

Steady sales/cash flows in almost any market

It isn’t difficult to appreciate why defence stocks have been marked up following the US election, but the performance of the sector isn’t wholly intertwined with the wider economy. Although you wouldn’t necessarily argue that defence stocks are countercyclical in the purest sense, it is true that the industry’s financial performance has exhibited limited correlation to the rest of the economy, particularly in the US. That’s largely because demand for its products doesn’t depend on the consumer, but there are other points to consider.

Even though aerospace and defence stocks are largely reliant on the public purse, government contracts aren’t always predicated simply on fiscal considerations; the need to guarantee state security is often the overriding factor. In addition, military contracts are often conducted with payment schedules staggered over the lifetime of the project, or single-source contracts, where the government awards a contract without competitive tender. Staggered or contingent payment schedules can flatten revenue streams and aid working capital management, although the potential downside is that contractors can find themselves lumbered with onerous legacy contracts that were priced incorrectly at the outset – no shortage of examples on that front. However, the combination of these factors means that companies in the sector can generate steady sales and cash flows in almost any market.

 

Multiples primed by growth expectations

Investors in the sector have been ultra-bullish at the prospect of having a Republican in the White House, and Donald Trump’s campaign statements regarding defence spending were nothing short of hyperbolic.

That’s certainly reflected in the outperformance of aerospace and defence stocks since the changing of the guard in November. The S&P’s Aerospace and Defence index has increased in value by around a fifth since election night and has easily outperformed the Dow Jones Industrial Average, while the iShares US Aerospace & Defence ETF (ITA), which holds a market-cap-weighted basket of stocks in the industry, has outstripped returns for the S&P 500 by 50 per cent. On this side of the tracks, the rally has been a little more muted, possibly as a consequence of Cobham's (COB) most recent profit warnings; nevertheless, the FTSE 350 aerospace and defence index is up 11 per cent since the first week of November.

Given the surge in valuations, many investors will be wondering if they’ve missed the boat – and it is true that many sector constituents are trading at or near their 12-month highs. But even though share values for the sector started to retrace significantly through 2016, enterprise/cash profit (EV/ebitda) and price-earnings (PE) multiples don’t appear to be overly stretched when forecast growth rates are factored in to the equation. You wouldn’t necessarily view current valuations across the sector as compelling; they merely reflect the fact that investors are paying higher multiples in expectation of accelerated growth. And despite their recent outperformance on the stock market, they still offer above-average dividend yields.

Although it is true that some larger industry players such as Northrop Grumman (NYSE: NOC) and Lockheed Martin (NYSE: LMT) now trade in advance of their long-term price/book value ratios (P/BV), that metric isn’t overly revealing when set against companies with high levels of intangible assets on their books. And most of the larger sector constituents carry substantial amounts of goodwill, patents and other intellectual property as non-current assets.

 

Price Max (1-yr)Min (1-yr)% change (1-yr)% change (3-yr)PEDYEV/ebithaP/BVMarket-cap (£)
BAE Systems643.5p650.5p468.9p28.857.1163.319.46.020.4
Meggitt458.3p482p364p10.4-7.414.53.199.71.53.56
Rolls-Royce 770.5p826.01p595.9p9.4-17.513.308.67.614.2
Cobham128p199.62p110.7p-37.1-48.8NA8.3210.14.72.19
Senior191.2p242p171.6p-10.2-33.013.33.4481.60.80
Ultra Electronics 1,982p2,030p1,595p11.26.515.32.3511.24.11.40
Northrop Grumman$242.93$251.8$186.6826.4100.719.91.4812.38.134.2
Lockheed Martin$267.76$269.36$215.3422.563.715.32.7212.751.277.7
Boeing$182.18$183.91$121.0752.342.123.93.1210.1137.6111.6
Raytheon 'B'$153.75$154.83$121.823.156.620.61.9112.14.545.0
General Dynamics$189.65$192.41$129.0839.771.519.91.7712.45.257.4

 

A genuine case of buying British

Unpalatable as the arms industry is to many, a prospective upsurge in defence budgets, both at home and abroad, promises to feed through to rising cash flows and revenues for the UK’s defence contractors. And like it or not, it’s an industry in which Britain clearly excels. Statistics from UK Trade and Investment, a government body that promotes British exports abroad, show that the UK has sold more arms than Russia, China, or France on average over the past 10 years. Behind the US, we’re the world’s second-largest defence exporter.

Figures from ADS Group, the national trade body for the UK’s aerospace, defence, security and space sectors, show that the combined industries generate around £65bn a year, 55 per cent of which is linked to exports, while aggregate operating profit minus the cost of capital comes in at £26bn – high margin, high profitability. The sectors directly support roughly 340,000 jobs in the UK, to say nothing of the multiplier effect through the supply chain and into the wider economy.

If anything, the importance of the UK’s armaments industry has been magnified by the political dimension following the UK’s decision to leave the European Union (EU). The emphasis is now very firmly on establishing bilateral trade partnerships. Arms sales, which the UK has expanded over the past decade despite the financial crisis and global recession, represent a strong geopolitical card for the UK, particularly as some of its erstwhile partners in the EU come under criticism for their seeming indifference to another cash-strapped, supranational body – the North Atlantic Treaty Organization (Nato).

 

An industry red in tooth and claw

The morally dubious nature of these exports attracts a considerable amount of criticism, as anyone familiar with the Al Yamamah Saudi arms deal of the mid-1980s will testify – or not, as the case may be, where matters of national security are concerned.

HM Government is currently defending itself against a judicial review brought by the Campaign Against the Arms Trade (CAAT). The group, which has campaigned against arms sales since 1974, is hoping the review will eventually lead to the suspension of UK arms sales to Saudi Arabia. CAAT may be familiar to readers who have opted for ethical investment funds, as it has sought to highlight public bodies (local councils, pension funds, charities etc) that hold shares in companies trading in arms and encourage them to disinvest.

There is a lot at stake for the UK and its defence contractors if sales to the region were curtailed due to political or judicial pressure. Figures show that Britain’s weapons trade with the Middle East is increasing, with the region taking over 60 per cent of British arms exports over the past two years. A cynic – or perhaps a pragmatist – might take the view that if the UK stopped selling arms to regimes with questionable human rights records, then another country – possibly one with an even more questionable human rights record – would simply step in to fill the void. We’re unaware of any like-minded bodies to the CAAT operating in Moscow or Beijing. Unlike their counterparts in authoritarian regimes, western military strategists can’t operate in a bubble, and the motivation behind said criticism has also occasionally been brought into question.

The Donald weighs in over Nato

Judging by some shrill media coverage in the aftermath of the US Presidential election, you might think that it’s already time to reach for your tin hat. In a recent article, admittedly somewhat at odds with the postwar consensus, Germany’s Spiegel magazine questioned whether the time had come for the country to acquire its own nuclear deterrent. This decidedly fanciful proposition was raised in response to an interview with Donald Trump published in German tabloid Bild in which the US Commander-in-Chief dismissed Nato as “obsolete”.

For “obsolete” read ‘cheap’. Donald Trump’s comments were prompted by the view that Uncle Sam has been effectively picking up the tab for most of its partners in the military alliance. Even on the campaign trail – in his trademark blunderbuss approach – the then Presidential candidate warned that allies unwilling to “reimburse” the US for its military protection might be forced to go it alone. In fairness, however, the President hasn’t confined his opprobrium to foreign governments; he has also threatened (via the ‘Twitosphere’) to cancel Boeing's (NASDAQ: BA) Air Force One contract and replace Lockheed Martin's (NASDAQ: LMT) F-35 Joint Strike Fighter with a cheaper plane, effectively shifting blame for the Pentagon’s profligacy on to the companies receiving military contracts.

Fenella McGerty, principal analyst at IHS Jane’s, told the IC that while calls from senior US defence personnel for European Nato members to increase spending have intensified since the election of Donald Trump, they are not a new feature of alliance relations. Ergo comments by the then US defence secretary Robert Gates in 2011 that Nato would be consigned to “military irrelevance” unless allies reversed plans to cut spending.

 

Eastern Europe and Ukraine

Indeed, the prolonged contraction in European defence spending actually came to an end in 2015, although eastern European spending had started to pick up a year earlier as concern over Russian actions in Ukraine prompted countries to bolster defence investment. As domestic security threats worsened, coupled with the arrival of more than a million refugees in Europe and terrorist outrages in France and Belgium, countries such as Germany have decided to boost their security budgets.

Although spending in western Europe increased in 2016 for the first time since 2009, the Jane’s analyst said that “the wheels were already in motion before the election, but we are likely to see a strengthening of planned increases to defence investment in Europe in response to this more intense international pressure”.

However, whether the mooted increases will prove sufficient to placate officials on Capitol Hill is open to question. “Jane’s expects that France and Germany will implement real increases to defence for at least the next five years, although only German spending will increase as a percentage of GDP reaching just over 1.2 per cent by 2023. For German spending to reach the 2 per cent of GDP [Nato baseline requirement] threshold within the next decade would require annual increases of 9 per cent on average. This could be difficult to implement at the same time as balancing government spending.”

Parallels with the Reagan era

Transparently, the President’s warning on Nato was an exercise in brinkmanship; a possible vestige of Mr Trump’s previous incarnation as a real estate huckster in midtown Manhattan. Although hardly nuanced, the comments did place the spotlight on the lukewarm support offered to the alliance by what many critics in the US believe should be its most voluble advocates, not least of which is Angela Merkel’s centre-right coalition in Berlin.

Donald Trump’s ‘call to arms’ for Nato may have elicited a predictably dismissive reaction from senior German politicians, together with various EU apparatchiks, but eastern European and Baltic member states obviously see Nato as a bulwark against the rising tide of nationalism in Russia. (Poland remains one of a handful of Nato members that has consistently complied with the organisation’s defence spending requirements.) Anyway, by now it should be obvious that the new man in the White House isn’t overly concerned with being ‘on-message’ and seems rather more intent on a policy of rapprochement with Moscow, albeit from a position of heightened military strength.

The President has asked Congress to approve a near-10 per cent increase in the overall defence budget, which he insists will be funded by increased tax revenue from an expanding economy. The proposed $54bn (£43.7m) increase would be the biggest rise in the Pentagon’s budget since the height of the military incursions in Iraq and Afghanistan.

President Trump is seeking to bypass constraints contained within the Budget Control Act of 2011, which capped spending for the Pentagon, the US Department of Energy (US nuclear) and other national security agencies at $549bn in 2018. Indeed, about two-thirds of the budget increase had already been proposed by the President’s predecessor, Barack Obama, which should aid, though perhaps not guarantee, Congressional approval.

There is a historical precedent here. After years of shrinking Pentagon budgets, the Reagan administration’s first budget called for a 25 per cent increase in defence spending relative to the previous proposal. Reagan’s four-year target of $224bn in military expenditure was never achieved. But even though defence budgets during the Reagan era came in below the initial plan, the industry still outperformed for much of the 1980s – that’s a point worth considering.

Fears of escalation in the East China Sea

The ruckus over the Nato budget is feeding into an increasingly febrile atmosphere in defence circles. And it’s not just Donald Trump doing the tub-thumping; South China Morning Post revealed that pressure had been building on Beijing to resume double-digit increases in defence spending in the coming year to meet the increasing challenges facing China’s military – but to no avail.

Last year’s budget for the People’s Liberation Army increased by 7.6 per cent to Yuan 954bn (£111bn), the first single-digit increase since 2010. This year the increase is expected to come in slightly below that rate, possibly in response to a lowering of China’s economic growth target for 2017 to around 6.5 per cent from last year’s 6.5-7 per cent range.

The proposed pullback in the budget hasn’t played well domestically. China’s influential state-run tabloid Global Times called for a rise of at least 10 per cent to deal with the uncertainty brought by political change in Washington. Given China’s determination to project greater political influence, both regionally and globally – and assuming the domestic loans market doesn’t derail the economy – it’s difficult to imagine that spending won’t eventually revert to its former growth rates, particularly in light of an ongoing maritime spat with Japan over eight tiny uninhabited islets in the East China Sea, north-east of Taiwan.

To Japan they’re the Senkaku Islands; to China they’re the Diaoyu Islands. Japan has claimed sovereignty of the islands since 1895, claiming they were never under the control of China’s then ruling Qing Dynasty. Furthermore, the islands were not included in territory ceded by Japan under the 1951 peace treaty that legally defined the territory of Japan after the second world war. Last year, China stepped up both military and commercial fishing activity around the disputed islands, infuriating Tokyo. Other countries in the region have looked on anxiously as the rhetoric over the dispute has escalated, but both sides remain steadfast in their claims.

 

Constitutional change in Japan?

History shows how important the China-Japan axis is to peace and stability in the region, but that relationship is looking more fraught because of the rise in Chinese nationalist sentiment, coupled with intensifying speculation that Japan might abandon – or, at least, significantly amend – its pacifist constitution, meaning the Japanese military might be able to engage in foreign combat for the first time in 70 years.

It’s certainly curious that Japan’s defence spending has risen for the fifth straight year since Abe commenced his second term as prime minister, to a hefty ¥5.13 trillion (£36.6bn). The fact that Japan is in the market for next-generation military hardware is rather at odds with its pacifist constitution, which bans the use of force as a means of settling international disputes. It also decrees that the Japanese people will forever renounce war – but that may not, ultimately, be good for business. 

 

 

Cyber security gains prominence in strategic thinking

It’s not just regional instability that’s driving defence spending; there are also domestic security issues to take on board, specifically increased fears over terrorism, together with the rate of technological change. You won’t find a better example of the last point mentioned than the scramble under way among western governments to react effectively to the increased threat of cyber attack. Last year the UK chancellor, Philip Hammond, outlined a £1.9bn spending pledge as part of a new National Cyber Security Strategy against the growing online threat, while The European Commission also recently committed to strengthening EU cyber security policies.

IHS Jane’s Intelligence Review takes the view that cyber space, once a peripheral issue, has become “an extension of ‘real world’ conflict theatres”, and therefore a central consideration in strategic defence planning. The rise of state-sponsored or politically motivated cyber attacks is primarily attributable to its suitability for covert political activity; a potential threat brought to the fore by US intelligence services during last year’s presidential race, with the hacking of the Democratic National Committee computer systems highlighting the vulnerability of US networks.

For investors, this promises to be one of the fastest-growing areas of the wider defence market; research company MarketsandMarkets forecasts that the global market in digital security will reach $101bn in value this year, and hit $170bn by 2020. There’s an added advantage in that it straddles both the private and public spheres. Consequently, corporations such as BAE Systems (BA.), already a leading supplier of cyber, intelligence and security services to government agencies, is increasingly looking to leverage those capabilities in the private sector.

 

UAVs - the shape of things to come

BAE Systems is also at the forefront of another technology that has already revolutionised the ‘strategic theatre of operations’, but is also being utilised across a range of civil applications, namely unmanned aerial vehicles (UAV), or drones. The deployment of UAVs has expanded rapidly in recent years for surveillance, reconnaissance, mapping, border patrol, search and rescue, agricultural imaging and traffic monitoring – to name but a few.

The development of the Taranis stealth drone by BAE is one of the most secretive military projects ever undertaken in the UK. Dubbed “the most advanced British aircraft ever built”, the Taranis has been shrouded in secrecy since its inception. The technologies utilised in the project will eventually feed into the Anglo-French Future Combat Air Systems (FCAS) agreement, which will involve a consortium made up of BAE, Dassault Systemes (EPA: DSY), Rolls-Royce (RR.), Safran SA (EPA: SAF), Leonardo Finmeccanica SpA (BIT: LDO), and Thales SA (EPA: HO). Other UK defence corporations such as Qinetiq (QQ.) and Cobham have been involved in the development phase. Analyst speculation has it the Taranis is capable of supersonic flight, is virtually invisible to radar, and can fly and select targets autonomously.

UAV technology has been around in rudimentary form since the Great War, but its evolution in the field has been bound up with advances in micro-processing; Moore’s Law has now reached the level at which UAVs that follow prototypes like the Taranis will be able to replicate many of the capabilities associated with modern combat aircraft. UAV deployment offers operational benefits in environments that are perilous to human life, but it’s also true that the aerial performance of combat aircraft is now constrained by the limitations placed upon it by the human body – ie, the pilot. The removal of the ‘soft machine’ promises to radically alter performance, while reducing costs substantially over time.

The UAV market has exhibited double-digit growth over recent years. Although Fenella McGerty believes “the draw-down of operations in Iraq and Afghanistan removes a major driver of the UAV market in the US”, the defence analyst confirmed that “Jane’s does expect the market to stabilise over the 10-year period due to increasing global tension and enduring conflicts”. Demand, it seems, is no longer dependent on the Pentagon, with “the rapid increase in non-US demand now driving growth in the total market. Jane’s expects the UAV market as a whole to expand at 8 per cent CAGR over the next five years so the market offers opportunities for both traditional and new suppliers”.

 

 

Brexit and the push for bilateralism

Whatever your view on the morality of armament sales, in many respects the industry stands to become something of a flag-bearer for the UK as it decouples from the EU and looks to broaden its trade ties globally. Surely it provides an exemplar for the types of industries that the government wants to encourage: high-tech, high-margin, high barriers to entry, high on the value chain.

Earlier this year, prime minister Theresa May clinched a $127m deal to co-develop a new fighter aircraft for the Turkish air force. BAE Systems will design the TF-X jet in partnership with Turkish Aerospace Industries. The initial commitment is small beer in financial terms, but the prime minister – who aims to turn the UK into Turkey’s ‘go-to’ arms supplier – expects the arrangement to generate contracts worth billions of dollars over a period of 20 years.

The deal could provide a template for co-developments outside the sphere of influence of the single market, but comments by Ms McGerty show that the industry isn’t oblivious to the potential risks posed by the UK’s decision to leave the trading bloc. Although she believes that “the UK is really well placed to benefit from technological shifts in the defence market” the reality is that “defence capabilities are met by both domestic primes such as BAE and Rolls-Royce but also by UK subsidiaries of European primes like Thales and Finmeccanica”. Therefore, the decision to leave the EU “could affect UK capabilities should companies decide to relocate certain operations to sites still within the EU”. Another potential implication, according to Jane’s, is that “we may see a reduction in European foreign direct investment, but the UK... may benefit from a more flexible procurement environment outside the EU. It’s really going to depend on the result of negotiations with the EU and the shape of the UK operating environment once separation is enacted”. Over to you, Mrs May.