Benefit from rising defence spending

A robust pre-close trading update from Redditch-based Solid State (SOLI:1,165p) has prompted yet another round of analyst earnings upgrades.

The value-added electronics group supplies commercial, industrial and defence markets with durable components, assemblies and manufactured units for use in specialist and harsh environments. Specifically, Solid State focuses on industrial and ruggedised computing, displays, battery power packs, communications including antennas and secure radio systems, and imaging technologies.

A key driver of Solid State’s growth has been defence and security contract work, buoyed by geopolitical tensions that have sparked a renewed focus on global defence spending despite government budget constraints. The division increased its contribution from 14 to 18 per cent of group revenue of £126.5mn in the 12 months to 31 March 2023, and analysts at joint house broker Cavendish expect a third higher revenue contribution of £30mn in the new financial year. This implies a 20 per cent share of their newly upgraded group revenue estimate of £155mn (up from £147mn), which factors in 22 per cent annual growth.

In particular, Solid State is a major beneficiary of the secular growth in defence spending as a UK-based systems provider, having direct exposure to Nato agencies and relationships with Tier 1 suppliers such as BAE Systems (BA.). For instance, the group has been awarded two major contracts worth £17.1mn by the Nato Support & Procurement Agency to supply communication equipment to a defence customer, the contribution from which underpins a large proportion of the forecast growth in the 2023-24 financial year. Furthermore, given the bespoke requirements on these contracts, work on defence programmes can extend for multi-year periods, thus creating a stream of repeat business for Solid State. There are sound prospects for further contract wins, too.

Exposure to rising UK and US defence spending

Earlier this year, the UK government committed £5bn additional funding to the defence budget over the next two years, taking the country above its Nato commitment of spending 2 per cent of gross domestic product (GDP). Bearing this in mind, the incremental spending has been earmarked for capital expenditure rather than operational expenses, so benefits equipment suppliers, including Solid State. Importantly, both the main political parties are committed to robust spending on the military. It means that Solid State’s prospects look assured irrespective of which party wins the next general election.

Furthermore, the group has boosted its exposure to the defence sector through the August 2022 acquisition of California-based battery pack manufacturing business Custom Power. Since the Russian invasion of Ukraine, the US government has increased its defence expenditure budget and the US Department of Defence has placed a particular emphasis on procurement spending. Analysts at Cavendish believe that the country’s procurement budget will increase by $10bn to more than $155bn in 2024 as global security remains a high priority for both the Democrat and Republican parties. The geopolitical crisis in the Middle East, coupled with the threat posed to Nato countries by Russia, can only drive up demand for defence-related work. Solid State is a major beneficiary.

Multiple secular growth drivers

The group is not a one-trick pony either as it is benefiting from secular growth across several megatrends that offer strong growth opportunities. These include the increasing prevalence of batteries across many end markets, drones, robotics and automation.

In the medical sector, demand is being driven by technology as complex medical instrumentation becomes entrenched to improve patient outcomes, efficiency, reliability and precision. For the 2022-28 forecast period, analysts at Statista Market Insights predict that the medical devices market worldwide will grow 36 per cent to $610bn.

Solid State offers exposure to the UK government’s massive investment in public transport systems, too. The Department of Transport has allocated an additional £40bn of investment into road and rail programmes over the next two years, a sum equivalent to 90 per cent of the total transport budget in the 2022 fiscal year. This is good news for Solid State as its technology is being incorporated in parts of the modernisation programmes. For instance, Solid State has been awarded the contract to help deliver a new One Person Operation CCTV system for Transport for London (TfL), as part of the £2.9bn Piccadilly Line Upgrade on the London Underground Network that will see the introduction of 94 new state-of-the-art Tube trains from 2025.

Solid order book supports earnings visibility

Such is the organic momentum across the group that having upgraded earnings guidance at the annual results over the summer, the directors have done so again. It prompted analysts at broking houses Cavendish and WH Ireland to raise their pre-tax profit and earnings per share (EPS) forecasts by around 5 per cent to £12.5mn and 85p, respectively, for the 12 months to 31 March 2024. Having delivered £88mn of revenue in the first half, and with around 60 per cent of the £99.7mn order book slated for the second half, their £155mn revenue estimates are well underpinned.

Moreover, WH Ireland has halved its year-end net debt estimate to £2mn and expects net cash of £1.2mn in the 2024-25 financial year. It means more of Solid State’s bumper free cash flow can be recycled back into a business that is forecast to deliver a current-year pre-tax return on equity of 20 per cent and mid-teens return on capital employed (ROCE).

The shares have drifted in line with the FTSE Aim All-Share index since I highlighted the investment case (Alpha Research: An overlooked share to benefit from rising defence spending’, 20 July 2023), a performance that is completely out of line with Solid State’s operational outperformance. Frankly, I wouldn’t bet against another earnings upgrade as the year progresses.

Rated on 9.6 times operating profit estimates of £14mn to enterprise valuation of £135mn, and on a modest price/earnings (PE) ratio of 13.6, the shares rate a buy.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com at £16.95 each plus P&P of £4.95, or £25 plus P&P of £5.75 for both books.