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Defence in a post-Covid world

How will the fallout from the coronavirus pandemic impact the global defence industry?
August 5, 2020

Defence companies have been a relatively safe haven during the Covid-19 crisis. While few stocks were left unscathed by the ‘Corona-crunch’, companies in the defence sector with more limited commercial exposure have largely outperformed the FTSE 350. Protective equipment specialist Avon Rubber (AVON) has been particularly impressive – its shares are up around 60 per cent so far this year, compared to a 21 per cent decline for the wider index.

 

That’s not to say that the good times will continue. There are threats on the horizon, not least over what will happen to defence spending moving forward. Post-pandemic budget pressures and the upcoming US election could motivate cuts to spending. But before looking ahead, it’s worth catching up with some recent results to see how defence companies have weathered the impact of Covid-19 thus far.

 

Mapping out the terrain

BAE Systems (BA.) saw its underlying operating profit dip by 11 per cent at constant currencies in the six months to 30 June, to £895m. This came as the Covid-19 pandemic hit in the second quarter, impacting cost recoveries and sales volumes in its UK air and maritime businesses as well as commercial aerospace demand in its US-based ‘controls and avionics’ segment.

Despite the pandemic, BAE secured £9.3bn of new orders during the first half, taking its total order backlog to £46.1bn. With its involvement in long-term government programmes – including building the UK’s Type 26 frigate and 15 per cent of Lockheed Martin’s F-35 Joint Strike Fighter jet – it therefore has good visibility over its earnings.  

Net debt has surged from £743m at the December year-end to £2bn. This follows a £1bn bond issue to fund its pensions deficit and the £217m acquisition of Raytheon’s (US:RTX) Airborne Tactical Radios business in May. It is likely to have increased further after the $1.9bn (£1.5bn) purchase of Collins Aerospace’s military global positioning system (GPS) business in July. Nevertheless, the interim dividend has been held steady at 9.4p and BAE will also the pay the deferred 13.8p final dividend for 2019.

Barring any further Covid-19 complications, the group is expecting a more positive second half. It is guiding that full year revenue will increase by a “low-single digit percentage” as volume growth from the F-35, combat vehicles and electronic defence offset commercial weakness. Meanwhile underlying EPS is projected to be a “mid-single digit percentage” below the 45.8p seen last year. Analysis consensus compiled by FactSet places EPS at 43p in 2020 with underlying operating profit ticking down 4 per cent to £2.02bn.

Ultra Electronics (ULE) had similarly good news for income investors – it has increased its interim dividend to 15.4p and is also set to distribute its postponed 2019 final payout. This comes as the group increased underlying pre-tax profit by 3 per cent to £47.9m in the six months to 30 June, aided by higher sales of its Orion radio systems. Although statutory pre-tax profit dropped by more than a fifth to £29.8m due to a loss of forward foreign exchange contracts. Still, Ultra has continued to pull in orders – including a $101m order for sonobuoys via its joint venture Erapsco – bringing its order book to an all-time high of £1.2bn.

 

Are defence budgets due for a course correction?

Conventional wisdom would suggest that economic downturns go hand-in-hand with a decline in defence spending as governments look to counter lower revenue and rising deficits. Given the scale of government borrowing to keep economies afloat during the Covid-19 crisis – and the recession ahead – arguably cuts to defence budgets are inevitable. While members of the North Atlantic Treaty Organisation (NATO) are committed to spending 2 per cent of their gross domestic product (GDP) on defence, as their economies shrink, their defence budgets are likely to follow.

Even the mighty US reduced defence spending in the wake of the global financial crisis and its behaviour then could be a precursor for what is to come – spending by the Department of Defence (DoD) dropped from $691bn in 2010 to $580bn in 2015. While it has been ramping back up in recent years, even before Covid-19 struck, growth was set to slow. In February, the Trump administration proposed a $705.4bn budget for the DoD for 2021, which would be just 0.1 per cent higher than the $704.6bn package approved by Congress for 2020. The pattern of US defence spending is significant for UK companies because it is the world’s largest defence market – more than two-fifths of BAE’s sales come from across the Atlantic.

 

Thanks to emergency measures in response to Covid-19, the Congressional Budget Office (CBO) reckons the US is facing a $3.7 trillion federal deficit in 2020 – up from its pre-pandemic estimate of just over $1 trillion – and a $2.1 trillion deficit in 2021. That means attention could turn to where savings can be made.

“What has historically happened is when Congress and fiscal conservatives come out and get serious about reducing the debt and reducing spending, defence is almost always part of what they come up with for a solution,” says Todd Harrison, director of defence budget analysis at the Center for Strategic and International Studies (CSIS). “So, we could be looking at a deficit-driven defence drawdown coming in the next two or three years.”

Much will also depend on November’s election. While defence spending typically enjoys bipartisan support, should Joe Biden secure the White House and the Democrats also take the Senate – an unlikely but possible scenario – that could also place defence cuts on the agenda. More progressive Democrats are likely to push moderates to prioritise spending elsewhere, such as on healthcare.

That said, the appetite to raid the defence budget could be tempered in light of the threat environment – tensions between the US and China have continued to ratchet up, Russia is becoming increasingly emboldened and there are worrying flare-ups at the Indo-China border. As we look to be entering a ‘new Cold War’ between the US and China, there is historical precedent from the last one. Despite recessionary conditions between 1980 and 1982, President Jimmy Carter still boosted defence spending as frictions with the Soviet Union increased. In theory, policymakers in Washington could even decide it prudent to expand investment in the military, particularly as the US continues its pivot towards Asia and seeks to counter China’s rise.

 

Closer to home

The UK defence sector is facing an integrated review into security, defence, development and foreign policy, which will shape the agenda for many years to come. While the defence secretary, Ben Wallace, says the review is “not driven by financial pressures”, it is running parallel to the government’s wider comprehensive spending review – and that is likely to face up to the fact that the Covid-19 bailout of the economy must somehow be paid for.

The Conservative party pledged in its manifesto that it would increase the UK’s defence budget by at least 0.5 per cent above inflation each year. Despite the Covid-19 turmoil, Professor Malcom Chalmers, deputy director general of the Royal United Services Institute (RUSI), expects this promise will be honoured: “There’s no indication so far that they’re about to renege on that commitment. I think the most likely scenario is that the defence budget will get a small real terms increase.”

Much has been made of adviser Dominic Cummings’ involvement in the review process. The Whitehall reformist has previously accused the MoD of “corruption” and has criticised government procurement processes, citing “a mix of ignorance, incompetence and flawed incentives so big powerful companies continue to loot the taxpayer.” Mr Cummings seems to prefer the likes of drones and artificial intelligence over expensive manned equipment.

The MoD spent £38bn on defence last year, of which more than 40 per cent went towards equipment and associated support. A perennial issue is the affordability of its equipment plan – the National Audit Office (NAO) has called the 10-year plan running to 2028 “unaffordable”, with forecast costs exceeding its £181bn budget by £13bn in a worst-case scenario.

“Traditionally what governments have done to balance the books when defence budgets have gone haywire is to delay projects and ordering,” says defence analyst Howard Wheeldon. “I think that we will see things that were planned for 2022/23 will be 2025/26 instead.”

Conservative MP Mark Francois recently warned Sir Nick Carter, the chief of the defence staff, that he should “nip back to department and ask them to sort their bloody selves out. Because if not, Cummings is going to come down there and sort you out his own way, and you won’t like it.”

 

What changes are we likely to see?

“The classic response of salami-slicing defence while retaining all of the options, even at lower mass or readiness, is becoming unsustainable”, says Professor Peter Roberts, director of military sciences at RUSI. The UK’s review will have to strike a balance between what is needed, wanted and affordable.

Writing in The Telegraph, Mr Wallace says that as the nature of warfare changes, the MoD will be “reshaped to operate much more in the newest domains of space, cyber and sub-sea.” That would follow the reorientation of US defence spending – its 2021 budget proposal includes an extra $3.9bn for space.

BAE’s electronics systems business looks well-placed – it provides technology used in electronic warfare, surveillance and communications intelligence and its capabilities have been bolstered by the recent GPS acquisition. Defence engineer Chemring (CHG) should also benefit from an increased focus on cybersecurity through its Roke advisory services. Roke saw double-digit revenue and underlying operating profit growth in the six months to 30 April, and also secured its first electronic warfare order with the DoD for the 'Resolve’ tactical system.

However, if defence departments spend more on cutting-edge technologies, it will likely require sacrifices elsewhere, particularly to address overhanging budget pressures such as at the MoD. Mr Wheeldon believes legacy programmes are likely to be the subject of cuts and BAE could feel some pressure. “When programmes are cut very suddenly…you lose all the support and MRO [maintenance, repair and overhaul] work that you were doing,” says Mr Wheeldon. “For a company like BAE Systems there will be some squeaking at the corners in terms of legacy programmes coming out, but I don’t think we will see any big changes in the capital programmes.”

The Tempest programme will likely remain untouched. Launched in 2018, it aims to produce the UK’s next generation of stealth fighter jets. With the potential to be unmanned, it is set to enter service in 2035, and replace the Typhoon. Tempest is being developed by a consortium of companies including BAE, Rolls-Royce (RR.), QinetiQ (QQ.) and Melrose’s (MRO) GKN. In order to spread the costs and ensure a large enough market to make the project viable, the UK is encouraging other countries to sign up – Italy has already joined and Sweden is said to be edging closer.