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FTSE 350: New strategic priorities bolster aerospace sector

Ministers are under pressure to ring-fence the wider sector
April 28, 2022

The deteriorating global security situation has put defence stocks back in the spotlight, but calls are mounting to afford the sector protected status for the same reason. UK government ministers are under increased pressure to enact existing national security provisions.

In the year prior to the initial lockdown, UK arms manufacturers recorded their second-highest level of sales, despite a court order restricting sales to Saudi Arabia. Coming out of the pandemic, prospects are even more favourable.

Figures from the Stockholm International Peace Research Institute show that the UK is the seventh-largest global arms exporter, with a market share of just 2.9 per cent. Yet the UK industry is predominately tech-driven in nature, with advanced capabilities in aircraft, electronic warfare, advanced maritime vessels, and missiles. It is not difficult to appreciate why UK defence contractors and, by extension, their intellectual property, would hold attractions for foreign buyers.

At the time of writing, two of the FTSE 350 Aerospace & Defence constituents were waiting on regulatory approval to move ahead with takeover deals. It’s been reported that officials are moving closer to approving the £2.57bn acquisition of Ultra Electronics (ULE) by Cobham, ironic given that the latter UK company was snapped up by US private equity interests in 2020. Cobham has agreed to a set of improved commitments to gain political backing. US engineering and aerospace company Parker Hannifin has also been forced to go down that road in its £6.3bn bid for UK aviation contractor Meggitt (MGGT). The UK’s Competition and Markets Authority has submitted the findings of its investigation to Kwasi Kwarteng, the UK business secretary, but the war in Ukraine has undoubtedly increased pressure on government officials to take greater account of national security issues when making these types of decisions. Nevertheless, the European Commission has said that Parke Hannifin had satisfied its own competition requirements.

The war has also given western governments further reason to consider their strategic options in relation to China, notwithstanding the situation in Taiwan. It is these considerations that are already driving contractual volumes for defence group BAE Systems (BA.). It is well-placed to benefit from the creation of Aukus – the security pact between Australia, the US and the UK  announced in September 2021. Australia's Hunter Class Frigate programme is under way and BAE’s engineering teams will be providing software and hardware upgrades to the Australian Mk 127 Hawk aircraft trainer fleet following a A$1.5bn (£796m) commitment by the Australian government. Opportunities are likely to expand further in the Asia Pacific region as western governments are applying pressure to countries in the region to scale down military imports from Russia – the globe’s second-largest arms dealer.

Away from the military sphere, at least partially, the coming year could be critical for Rolls-Royce (RR.), with longstanding chief executive Warren East heading for the exit. The engine maker will be sweating over the extent to which civil aviation volumes will recover in the coming months. Prospects are inextricably bound up with the health of commercial air travel, particularly long-haul flights. A sizeable proportion of group revenue is tied to the aftersales market, ergo the number of hours its engines stay in the air.

The group has been haemorrhaging cash in recent years as setback followed setback. There wasn’t much the group could do about the impact of the pandemic on flight numbers, but it has successfully addressed durability issues on its flagship Trent 1000 engines. It is also taking steps to deleverage its balance sheet by shedding non-core assets, including the €1.7bn (£1.42bn) sale of its ITP Aero business in Spain to Bain Capital, the private equity outfit.

Longer-term, it’s conceivable that the group will eventually benefit from the roll-out of small modular reactors (SMRs) after government officials recently sketched out plans aimed at reducing the UK’s reliance on external energy supplies. The new strategy will see a significant acceleration of nuclear power, with targeted generation of up to 24GW by 2050, equivalent to around 25 per cent of our projected electricity demand. The government said that SMEs will form a key part of the nuclear project pipeline.

 

NAMEPrice (p)Market cap (£mn)12-month (%)Fwd PEYield (%)Last IC View
BAE Systems74123,36041.0153.5Buy, 632p, 24 Feb 2022
Chemring Group32892918.0171.8Buy, 287p, 14 Dec 2021
Meggitt7736,05168.0340.6Hold, 763p, 3 Mar 2022
QinetiQ Group3411,9740.0172.1Buy, 266p, 11 Nov 2021
Rolls-Royce978,083-3.0320.0Buy, 104p, 24 Feb 2022
Ultra Electronics3,2382,31462.0241.9Buy, 2,336p, 19 Jul 2021
Source: FactSet