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Are defence stocks tough enough?

Former City analyst Robin Hardy examines the case for exposure to defence stocks as government spending looks set to rise
July 6, 2022

Defence stocks – essentially any business that provides products or services to armed forces or branches of law enforcement – have been pushed to the fore since the start of the war in Ukraine, having long been seen by many investors as pariahs, alongside other ‘sin’ sectors such as fossil fuels, tobacco or gambling. This is despite them fundamentally ticking all the boxes for a highly investable business model: long-term contracts, strongly counter-cyclical (public spending cuts rarely extend to the military), an end market that seems never to go out of fashion – conflict – and sovereign clients (almost all contracts are with government agencies) who always pay, although contract negotiations can be cumbersome. So, what is driving the change? 

ESG volte face

In the world of environmental, social, and governance (ESG), pre-war, defence businesses were seen as doing substantial harm with their products and many were dealing with unpalatable regimes. Most funds with a focus on ESG would keep their distance and this led to poor total returns (usually despite high dividends) and low ratings. Almost in an instant, however, the Ukrainian war changes the dynamics. Many voices are calling for a revision of ESG standards to allow defence stocks to shed their pariah status and become a tolerated necessity that might even be seen as a social good. This is gaining traction and the sector is beginning to benefit from a double war dividend – faster growth and higher ratings. From an investment perspective, the sector has come in from the cold.

 

World goes back out into the cold

The Cold War officially ended on Boxing Day 1991. However, that was thrown sharply into reverse on 23 February with Russia’s invasion, with a rush to send weapons to shore up Ukraine, a rise in the global alert level leaving many European nations (and those further afield) looking under-prepared militarily and no end of finger pointing at nations within NATO for not fulfilling their defence spending commitments. The sector looks to be embarking on a winning streak with wide expectations that globally defence spending will increase and run at new, higher levels for the foreseeable future. 

While there is a lot of noise and sabre rattling, sudden and substantial increases in defence spending could be harder to push through. After two years of Covid many economies are still reeling, leaving limited latitude for many to borrow in order to invest. Diversion of public service funding into the military might also be unpopular at a time of wider consumer discomfort and there is limited scope for many nations to raise taxes. It is expected that defence spending globally will increase but the real swing factor in this space is what will happen to US spending. While a Democrat government is likely to be less inclined to materially grow military budgets, US defence budgets are close to 60-year lows at around 3.75 per cent of GDP, even though this is high by NATO and other western economy standards. If all NATO members fulfilled their commitment to spend 2 per cent of GDP, spending outside the US, China and Russia would rise by almost 8 per cent before any additional war-induced spending. 

 

Follow the money

In 2021, the nations of the world spent an estimated $2,100bn (or $2.1 trillion) on defence: that’s about £275 for every person or 2.5 per cent of global GDP (2.1 per cent ex USA). The US is head-and-shoulders ahead spending $801bn last year, more than the next 10 combined – unsurprisingly, the USA is the river in which the world’s defence contractors would prefer to fish but, as is the case with many countries, there is an understandable degree of protectionism and many governments prefer, where possible and practical, to shop local. Many nations, such as Saudi Arabia, are open market buyers and overall most defence businesses are able to cast their nets fairly wide. This means that larger stocks operating in this space can be viewed largely as dependable proxies on global (practically US) spending, but this is less so for smaller, niche businesses as we see with our three smaller UK picks later.  

Aggregated defence spending Nato, ex US

Source: NATO | Red column = spending if all NATO members actually spent 2 per cent of GDP

 

Checklists

Investment in this sector does not mean assured positive outcomes even if budgets globally are growing. What sort of checks should investors run when looking at defence stocks? The first is to consider the macro context for a company’s sectoral and geographic revenue bases, and to ask what else aside from defence contracts does it undertake? On top of this, government contracts can have timing asynchronous with corporate year-ends, and many profit warnings arise because of timing. Second, more specific to defence, are its contracts secure, does it deal with undesirable nations, does its product work and is its technology/IP still relevant? The Ukraine conflict, for example, has raised a lot of questions about a viable future for tanks and has shown the immense value of drones. Thirdly, do all the normal financial checks: is there growth and positive momentum, is there good cash conversion, are key financial ratios sound, are they getting paid, is there too much debt, is there evidence of onerous contracts and is the dividend (which is often large) affordable?

 

Smaller UK stocks

The number of UK-listed defence stocks is shrinking and most recently Meggitt has agreed to an offer by US controls business Parker-Hannifin and Ultra Electronics is to be bought by UK defence contractor Cobham, itself acquired by private equity house Advent. These sales have raised hackles in some quarters especially now that the global military landscape has shifted so far. The UK government did have rights of veto over selling off the family silver but waved the deals through anyway. 

The smaller end of the sector covers a diverse range of activities, largely towards the more passive or truly defensive end of the spectrum – ie, not guns or missiles, which is typically the preserve of the larger players. At this smaller end, profit and share price performances have been somewhat more volatile than the more turgid trends of the sector’s large caps. 

Avon Protection (AVON) – Avon makes protection clothing (gas masks/respirators, hazmat suits, helmets, boot/gloves and thermal imaging) servicing both the military and first responders. Avon is a great example of how a positive macro environment does not automatically make money for investors. Following a very well priced disposal (dairy machinery) and two key acquisitions in 2019 (3M’s body armour business and headgear specialist Team Wendy) along with a slew of attractive contracts, the share price more than tripled in just over a year – then the rot set in. A sector wide de-rating for industrials stocks, order slippage, some key product accreditation failures and cost recovery problems caused stage one of a share price collapse. The process to a fall below the kick-off point in 2019 was completed when, after a strategic review at the end of 2021, Avon withdrew from the body armour market barely two years after the 3M acquisition. 

Avon looks still to be a nest of problems with contracts delays, excess costs because of the armour closure and problems recovering supply chain inflation so much so that analysts are essentially unable to make reliable forecasts. Even by FY2024 there are still many questions over profit levels which makes Avon a riskier investment, but that is very much in the price. If 2024 targets are met, the shares are on 10 times PE ratio while more trusted industrial sector businesses such as Spirax or Halma trade above 25 times. Avon could be very cheap and could rise 50 to 75 per cent once the waters are less murky and the driver again becomes defence spending rather than internal firefighting. Forecasts are rock-bottom (broker Peel Hunt has halved profit estimates twice in just six months) so risk ought to be well priced with the shares close to 1,000p. 

Avon – marched them up to the top of the hill….

Source: FactSet

Cohort (CHRT) – Aim-traded Cohort has a heavy bias towards defence (c.95 per cent of revenues) with a diverse portfolio biased towards electronic warfare and communications systems working primarily in the UK, Germany and Portugal. This feels like a business in the right place for how warfare is evolving, with potentially less emphasis on tanks and ships and more on electronics and communications. Also Germany is seen as having the largest catch-up spending job to do within NATO. This looks to be reflected in the group’s order intake, which was up 18 per cent in the latest half year. 

But a potentially bright future is being dragged down by a weaker present with two divisions (EID hit by delays due to Portuguese elections and CHESS – the biggest drag – carrying order delays and cost excesses) offsetting decent progress elsewhere. Portugal looks to be rebounding and in the CHESS electro-optical business there has been a root-and-branch review that promises a turnaround. 

Forecasts have been trimmed and the share price has followed, but the stock has shown little progress since the outbreak of hostilities and the biggest institutional shareholder has been selling. As with Avon, the outlook is perhaps too unclear and again the rating (14 times 2024 EPS) reflects this but as problem areas fade, it does feel as if good total returns are possible here. But perhaps not in 2022; the shares are likely to remain highly volatile. 

Chemring (CHG) – is primarily a manufacturer of countermeasure systems (RF and infrared decoy systems to protect aircraft and ships from missile attack) along with sensors (detection of chemical, biological and IED weapons), and energetics (explosive expansion devices for the likes of airbags, aeroplane escape slides, military ejector seats and demolition charges). The war in Ukraine has increased business momentum in all of these areas and, overall, Chemring’s profile sits well with modern military profiles and for those seeking less aggressive products. There has also been a hefty investment programme just concluding (£150m spent – which is equal to more than 15 per cent of the market capitalisation) to improve operational efficiency on a broad front – this is expected to help convert modest revenue growth (3-4 per cent) into healthier profit growth but most likely not until after 2024, making it hard to reflect this in the valuation for now at least. 

Perhaps the most valuable part of the group is Roke, a business that provides technology, engineering and advisory services to governments on communications, cyber resilience, artificial intelligence/machine learning and big data. This is the revenue and margin driver for the group, overcoming the currently moderate growth from the elsewhere in the group, but this business is heavily skewed towards just one contract in the UK and defence procurement and renewal is infamously fickle. 

Chemring’s valuation is likely today viewed through the lens of the Cobham/Advent takeover of Ultra Electronics (at 15 times Ebitda) suggesting that there is value with the stock at less than 10 times Ebitda even after a strong performance that has delivered a 15 per cent total annual return (TSR) across the last five years. Takeout valuations may be less reliable with increased negativity around allowing UK defence stocks to be bought out, but Chemring still offers decent value and the TSR seen in the last five years could easily continue, especially when the payback from the large capital expenditure programme begins to flow. 

In our next article, we will look at the larger UK defence businesses, along with a scan of European players, before finally looking at the global leaders from the US feeding off that vast annual defence budget.