Since 24 February 2022, the day Russia invaded Ukraine, the MSCI World index has contracted by 23.9 per cent, hardly surprising given the confluence of events. Yet over the same period, three of the five largest defence contractors have registered double-digit share price growth, with shares in BAE Systems (BA.) up by 50 per cent. Only Boeing (US:BA) has bucked the trend, although the aerospace giant’s woes are primarily linked to its civil aviation business.
The conflict in Ukraine is obviously a disaster from a humanitarian perspective, but the cold reality is that it will inform defence procurement decisions for the next decade, perhaps even longer. And with a seemingly dwindling number of viable investment options on offer, investors may be taking a closer look at sectors with counter-cyclical characteristics.
In these pages, Robin Hardy recently looked at the case for exposure to defence stocks, but if we assume that the rationale for gaining exposure to the industry has gained impetus, there must be specific areas of defence procurement that will be prioritised within national defence budgets. And those budgets are only moving in one direction due to the conflict in Ukraine.
In the three months following Russia’s invasion, European nations announced an aggregate increase of nearly €200bn (£176bn) to their defence budgets, but given their historical reluctance to boost defence spending, there must be doubts whether they will make good on their rhetoric. Perhaps the dread of renewed conventional warfare elsewhere in Europe will have a galvanizing effect.
Two interrelated areas of defence research and development (R&D) that stand to benefit from Russia’s aggression are unmanned aerial vehicles (UAV) and advanced missile systems. One of the most effective – and well-publicised – technologies being supplied to Ukraine is the High Mobility Artillery Rocket Systems, or HIMARS, produced by Lockheed Martin (US:LMT), while the Norwegian Advanced Surface-to-Air Missile System (NASAMS) developed by Kongsberg Defence & Aerospace and Raytheon Missiles & Defense has also featured prominently in Ukraine’s defensive efforts. Even a relatively low-cost option, Tukey’s Bayraktar TB2 UAV, has had a major impact on proceedings, no doubt forcing a strategic rethink in relation to battlefield technologies.
We have previously outlined why BAE Systems is a frontrunner in the development of next generation UAVs, but another company that is particularly well placed to profit from the lessons of Ukraine is Raytheon Technologies (US:RTX), a high-tech defence contractor we first highlighted in 2016. It is comprised of four specialised businesses: Collins Aerospace, Raytheon Intelligence & Space, Pratt & Whitney, and Raytheon Missiles and Defense. The last member of that quartet contributed 23 per cent of the group net income of $67.3bn (£60.8bn) in 2021, but a third of operating profits, with both measures significantly in advance of 2020 performance.
And things are looking up. Last week, the group beat out rivals Lockheed Martin and Boeing to secure a $985mn, 54-month contract from the Pentagon to develop prototypes for a hypersonic attack cruise missile alongside Northrop Grumman (US:NOC). It provides Raytheon and Northrop Grumman with a march on their rivals in advance of a slew of high-value contract awards expected in the years ahead. It also comes less than a month after the former contractor was awarded a $972mn contract to supply the US and other militaries with Advanced Medium Range Air-to-Air Missiles.
Through to the end of last year, Raytheon delivered a cumulative five-year return of 23.3 per cent. Although this compares unfavourably with the 27.7 per cent return on the S&P 500 index, its relative performance was negatively impacted by Pratt & Whitney’s exposure to the civil aviation sector. Sales and profitability for the division were well adrift of 2019 levels at the end of last year, although it recently delivered its one-thousandth F-135 military engine. Military contracts have provided an important buffer since commercial aviation was effectively grounded due to the pandemic, but passenger demand is growing again, albeit more gingerly than anticipated.
Minus $2.12bn in capital expenditure, the group generated free cash flow of $5.01bn in 2021 and is looking to double that figure by 2025. A tall order, perhaps, but cash profits are predicted to increase by 30 per cent. Investors certainly haven't been ignoring the aerospace/defence sector in the lead-up to war in Ukraine, and judging by the group's PEG and P/BV ratios (both at 1.7), its growth prospects are fully priced in. However, it trades below the sector average on that basis at a 24 per cent discount to its consensus target price, and, along with BAE Systems, is well placed to drive growth from the unfolding strategic narrative.
