Defence transformed

But concerns about the lethal use of force by autonomous robots are now real. Earlier this month, six advanced robotics companies, the highest-profile being the Hyundai-owned Boston Dynamics, wrote an open letter to peers seeking pledges “not to build, authorise, support or enable the attachment of weaponry to robots with advanced mobile functions”.

Adding weapons to commercially available robots that can be operated remotely or autonomously will “harm public trust in the technology in ways that damage the tremendous benefits they will bring to society”, the companies said. 

That is not the only shift. Last year, the European Defence Agency held an exercise to identify the main challenges the continent’s armed forces are likely to face over the next 20 years. As well as the prospective “dominance” of unmanned and autonomous units on the battlefield, its 10 scenarios included wars being fought in space, and battles being won or lost by the side that has the best software.

As futuristic notions become a reality, governments and security personnel are raising the alarm about how other civilian technologies could be adapted by states for nefarious purposes. 

Jeremy Fleming, head of the Government Communications Headquarters (GCHQ), told the Royal United Services Institute (RUSI) earlier this month that the threats facing the UK “are changing rapidly”. He flagged risks including China's promotion of the BeiDou satellite system as a rival to the GPS network to direct ships, aircraft, submarines and missiles.

“Many believe that China is building a powerful anti-satellite capability, with a doctrine of denying other nations access to space in the event of a conflict. And there are obvious fears that this technology could be used to track individuals,” he warned.

World in motion

When it comes to defence, there are more immediate concerns. As well as the fracturing relationship between the US and China, the war in Ukraine means that “the world we live in now is far more uncertain, challenging and dangerous than the world in the 30 years since the end of the Cold War”, notes General Sir Richard Barrons, a former commander of the UK’s Joint Forces Command and now co-chairman of global defence consultancy Universal Defence & Security Solutions.

European nations arguably became complacent in the post-Cold War era, falling far behind their Nato commitments to allocate 2 per cent of government budgets to defence spending. A major reappraisal has taken place since Russia’s invasion of Ukraine: Germany, which had allocated 1.33 per cent of gross domestic product (GDP) for defence this year, introduced a €100bn (£87bn) fund to modernise its armed forces in June, more than a fifth of which was allocated to “command capability and digitalisation”. 

France, which budgeted $44.5bn, or 1.9 per cent of GDP, is in the process of adding a further €3bn to its budget. In the UK, Liz Truss’s new government is going even further. Defence secretary Ben Wallace told The Telegraph last month that it will double spending from around £50bn this year (around 2 per cent of GDP) to £100bn by 2030, equating to 3 per cent of national income.

In countries such as the UK, the defence industry nowadays plays a much bigger role in assisting the Ministry of Defence (MoD), in everything from aircraft maintenance to support services more generally. To take one example, the Royal Air Force had around 90,000 serving personnel in 1990. At the end of July, that figure was fewer than 38,000.

Combine this greater industry presence with the increased spending commitments, and the result has been a broad rerating of the defence sector this year, although the performance of individual equities (particularly in the UK) has been mixed. BAE Systems (BA.), which provides shells to the MoD, which has been sending supplies to Ukraine, is up 45 per cent. Babcock International (BAB), which is shedding divisions as it attempts to bring down debt, is down 9 per cent.

But policy changes will take time to feed through. As Phil Williams, managing director of UK trade body Team Defence, notes, funding and executing increased spending plans will not be simple. “You can’t just suddenly say, ‘I want more fighter aircraft’,” he says.

“Investors are looking at these businesses with a lot more interest but [they are] also cognisant of the fact that in the real world, you might want to spend 3 per cent of GDP on defence… but can you do that immediately, given all of the other pressures?” adds Robin Speakman, an analyst at Shore Capital. “The answer is no.”

Similarly, new contracts, as and when they are awarded, will not immediately produce a new wave of defence systems and applications.

Defence companies often dedicate a lot of resource, people and energy “on stuff that’s not going to be operational for another 15-20 years”, says Henry Carver, an analyst at Peel Hunt. The MoD currently has a number of warships on order that have been in the pipeline for around a decade, for example. “That’s how long it takes to procure those things. It’s a very complex, long-term investment landscape.”

Empty vessels

Looking ahead, however, a more widespread use of autonomous and unmanned aircraft, tanks or ships looks inevitable, because they’re “cheaper to buy, cheaper to operate and more effective than the current recipes”, according to Barrons. 

Unmanned naval vessels, for instance, wouldn’t need bathrooms, hospitals, bed spaces, kitchens or other facilities for human occupants.

However, these are only likely to be deployed alongside manned units, which will be “in smaller numbers and further out of harm’s way”, Barrons says.

The key to picking potential winners from this evolving market is not to look at what companies are doing right now, but “how responsive and adaptable they are”, says Carver.

He cites Chemring (CHG) as an example. The company grew rapidly by providing munitions during the two Gulf wars but then fell foul of an acquisition spree and had to rationalise its business.

“Now, it’s actually quite a diverse defence group with cyber capability, moving into hardware and having devices that can give you cyber capability on the battlefield – literally, finding the enemy nearby and being able to disable [them]."

Dan Wasserbly, head of Americas news at Janes, the defence news and intelligence service, says the sector “certainly seems to be trending in the direction of requiring less manpower”, but dismisses the idea of a future automated battlefield.

“A sad but fundamental part of warfare is controlling territory, as we see in Ukraine now,” he says. “And with technology today you can’t necessarily control territory with an unmanned aerial vehicle.”

However, the war in Ukraine has shown that relatively cheap drones with bombs strapped to them can disarm tanks that cost millions to build. Other staples of past wars, including aircraft carriers, also seem vulnerable.

In recent months, the US Navy has deployed its most expensive ship. The USS Gerald R Ford, the first of a class of four new carriers, was first ordered in 2008 and cost $13.3bn to build. 

“It’s arrived in the inventory of the US Navy just as countries like China have worked out how they can build ballistic and cruise missiles specifically to kill aircraft carriers at ranges that will reach 3,000 kilometres,” Barrons notes.

This matters not only to governments but to the taxpayers footing the bill. Prime defence contractors such as BAE Systems and Babcock have huge resources tied up in the shipyards serving aircraft carriers, destroyers and other big pieces of naval kit. The two companies, alongside France’s Thales (FR:HO), make up the Aircraft Carrier Alliance that will deliver and service the UK’s two new carriers at a reported cost of £6.2bn. Is the risk that these developments become outmoded a risk to future earnings?

Not necessarily. Technological advancement in defence is “a process, not an event”, says Barrons, who adds: “you can’t just throw everything away”.

Although he expects aircraft carriers’ era as “the primary weapon” in seaborne campaigns to be nearing its end, heavy investments are still being made into ways to prolong their viability.

Kevin Craven, chief executive of ADS Group, a body representing aerospace, defence and space companies, says that although the structure of carriers will remain the same, the elements that go into them – the weapons, propulsion and communications systems – “are likely to change a number of times through the lifecycle of the assets”.  

Similarly, militaries that previously fitted tanks and ships with radios and data exchange devices are tipped to shift gear, instead embedding a ‘digital backbone’ whereby communications connect via a secure cloud to a central system providing real-time information.

But procurement procedures do need to be shaken up to reduce the risk of obsolescence, according to Team Defence's Williams. “If you look at a lot of the military kit we want to buy now, a lot of it is software-driven… high-tech stuff that changes within six months,” he says.

If the buying procedure is too lengthy, “it’d be way out of date before you place the first order”.

Proving their worth

The autonomous tanks, ships and aircraft still need building, though, and the incumbents are best-placed to do so, according to analysts. As a result, the weight of cash set to funnel into the sector from rising government budgets has already fed through to valuations – whatever the delay between spending intention and contract signing.

Prior to Russia’s invasion of Ukraine, the defence sector traded at a 20 per cent discount to the wider market, according to BofA Securities. By the summer, this had changed to a 40 per cent premium. On a forward price/earnings (PE) valuation, Swedish fighter jet maker Saab (SE:SAAB.B) experienced the sharpest rerating of the European defence heavyweights – from a 20 per cent discount to a 55 per cent premium.

And some spending will translate into top and bottom-line growth almost immediately, which means analysts’ earnings per share (EPS) estimates have also been increasing. A look at 12-month EPS forecasts shows German tank maker Rheinmetall (DE:RHM) has experienced the biggest anticipated growth – 55 per cent higher than at the beginning of 2021. Forecasts for Norway’s Kongsberg (NO:KOG) had also increased by 20 per cent over the same period.

Higher government spending “has a very direct translation into activity for us”, says Andy Thomis, chief executive of Cohort (CHRT) – an Aim-traded group of defence businesses that offers surveillance, communications and specialist data technology services to businesses.

UK defence shares currently trade on an average forward PE ratio of 13.2 – a 49 per cent premium to the FTSE All Share Index.

Thomis expects domestic companies to benefit from greater spending on systems capability through investments in artificial intelligence (AI), machine learning, cyber security and autonomous networks. Chemring and Qinetiq (QQ), the defence technology specialist spun out of the Ministry of Defence’s now-defunct Defence Evaluation and Research Agency in 2001, are also likely beneficiaries.

Fighting machines

The use of AI in defence is highly controversial, but it too is on the increase. The technology is already being deployed for exercises such as target recognition, due to its ability to quickly scan and process thousands of images. The issue is how big a role the technology will play as capabilities continue to develop.

New forms of weaponry have to conform with three principles under international law: distinction (between combatants and civilians), proportionality (prohibiting excessive civilian harm when engaging military targets) and precaution (to avoid civilian harm).

There have been discussions at the UN on what this means for AI’s role in terms of actively firing on targets. But as of yet few conclusions have been drawn.

Vincent Boulanin, a senior researcher at the Stockholm International Peace Research Institute, says one strain of thought is that international law is all about the effects of actions, and if the effects of decisions taken by AI systems are lawful, there shouldn’t be an issue with its use. The other is that concepts such as distinction and proportionality require “some kind of human judgment or context-based assessment that cannot be made by machines”.

Yet insisting on maintaining “meaningful human control” is no longer an adequate response given both the rapid advances and the ubiquity of AI in defence, Christina Balis and Paul O’Neill of RUSI said in a recent paper.

Reaction times are a key sticking point. Speeding up the process between observing a threat and acting on it “will typically confer a lead to those who get there first”, the authors said.

“It only takes one side to start using AI to speed up their decision-making and response times for the other to be pressured to do so as well.”

Williams uses the example of hypersonic missiles – those that can travel five times faster than the speed of sound. 
An anti-hypersonic missile defence system not run by AI may not react quickly enough to be effective, “because a human would take too long to process the data”.

The battle for AI supremacy is already being played out between the US and China. Within the past month, the US has imposed controls that led to companies halting the sale of equipment to semiconductor manufacturers in China. 

US-based companies Land Research, Applied Materials (US:AMAT) and KLA Corporation (US:KLAC), all of which hold key stakes in different parts of the chip-making process, have already taken action to comply, according to the Financial Times.

Technological advancement has been seen as a key plank of US military strategy since the introduction of the Third Offset strategy by the Obama administration in 2014, Boulanin notes. 

Although the US cut overall military spending by 1.4 per cent last year to $801bn, and research spending by 1.2 per cent, overall R&D funding rose by 24 per cent between 2012 ans 2021. By contrast, arms procurement dropped by 6.4 per cent over the same period.

Cyber warfare and misinformation campaigns are other important factors in the technological battle between states, a development that has an obvious read-across for cyber security businesses. Williams says it is now almost impossible for a state to go to war unless it has secured itself against a cyber attack.

Barrons adds that cyber attacks and misinformation are now part of an established grey space, or 'tolerance warfare', where states engage more persistently in forms of combat that stop short of firing weapons.

There are limits to this kind of behaviour, however. “Some people had argued that things like cyber war would replace kinetic fighting, and it was always rubbish – as you’re seeing in Ukraine,” says Barrons.

Nonetheless, he outlines a scenario where a future war could be fought at distance, using precision missiles, cyber attacks and misinformation campaigns where “no boot ever goes on the ground before they’ve broken the will” of a rival nation. The algorithmic skills developed by social media giants to feed people content will also be deployed in conflicts, he predicted.

But whether it will be the technology giants providing those is open to question. The US Department of Defense (DoD) has been keen to engage with Silicon Valley and to buy in existing technologies as opposed to creating them from scratch, but has had mixed results.

Alphabet’s (US:GOOGL) Google backed away from Project Maven – a contract with the DoD to use AI to interpret video images that could have been used to improve drone strikes – after a backlash from its workers.

However, Amazon (US:AMZN) and Microsoft (US:MSFT) were so keen to win a $10bn Joint Enterprise Defense Infrastructure, or JEDI, cloud computing contract, that its award was cancelled following a legal spat between the pair. The work is being retendered under different terms.

Moreover, if the likes of Google are unwilling to provide AI capabilities to the military, others will. Palantir Technologies (US:PLTR) doesn’t disclose how much it makes from defence contracts specifically, but around 55 per cent of its revenue in the first six months of this year came from government customers.

UK beneficiaries of new-found spending commitments may also stem from unfamiliar places. “I think there’s a growing recognition that we need to reach outside the traditional defence suppliers,” Williams says.
“Although BAE Systems, Rolls-Royce (RR.) [and] Babcock are embracing new technology, there’s a recognition that there are other industries that are able to do stuff much better, faster, quicker.”

Thomis envisages more integration with small businesses and technology partners – either through acquisitions, partnerships or licensing deals. 

“Much of the industry and the way we do things has to evolve over the next few years – and is evolving already to meet this new demand. The question is, can it evolve fast enough? I’m confident that it can.”