Chemring blasts through earnings expectations

As we have already seen with the likes of QinetiQ (QQ.) and Avon Rubber (AVON), the defence sector continues to be a bright spot amid the Covid carnage. Chemring’s (CHG) underlying operating profit rose by close to a quarter in the year to 31 October, to £55m, coming in 4 per cent ahead of consensus analyst expectations. The earnings beat saw the group’s shares jump by over a tenth, completing their rebound to above pre-pandemic levels.

Demand for the group’s defence equipment continues to grow. Chemring pulled in £436m of new orders during the year – 6 per cent higher than a year earlier – and it now has visibility over 78 per cent of expected revenue for 2021. This has been driven by the US market, with the larger ‘countermeasures and energetics’ division extending its contract with the US Department of Defense (DoD) to supply defensive flares for the F-35 Jet. Meanwhile, the 'sensors and information' business has received $200m (£150m) of additional orders for the ‘indefinite delivery, indefinite quantity’ (IQIQ) contract for the Husky mounted detection system (HMDS), which should underpin the programme’s revenue through to 2024.

With free cash flow more than doubling to £51m, Chemring’s net debt has declined by almost two-fifths to £48m, equivalent to just 0.65 times cash profits (Ebitda). This has supported a higher dividend payment.

Looking ahead, the main concern for the entire industry is the path of global defence spending post-pandemic. While there are concerns that the incoming Biden administration will spend less generously on defence, the shift towards more modern capabilities does play into Chemring’s wheelhouse. Its Roke engineering businesses has already secured its first electronic warfare order with the DoD for the tactical ‘Resolve’ system.

Chemring is less exposed to the UK Ministry of Defence (MoD), which accounts for less than 5 per cent of its revenue. But it should nonetheless benefit from the £16.5bn funding boost over the next four years. The focus of the UK’s plans should also bode well for defence technology group Cohort (CHRT) as its areas of expertise include cyber warfare, artificial intelligence and a focus on naval capability.

“I am optimistic about the future as far as the UK market is concerned,” says Cohort chief executive Andy Thomis. “Of course, we have domestic markets in Portugal and Germany and export markets around the world as well. But there is nothing going on which suggests that these are in contraction, particularly in Asia.”

Unlike Chemring, the group’s revenue dipped by a tenth year on year in the six months to 31 October, to £54m. This came as its largest business, tracking and targeting systems supplier Chess, delivered fewer counter-drone systems to export customers and advanced electronics provider MCL saw lower demand for equipment from the UK MoD.

Despite the drop in sales, adjusted operating profit climbed by 8 per cent versus a year earlier to £4.3m as electronic warfare specialist MASS benefited from more higher-margin service activity for the MoD. Engineering business SEA also returned to profitability, although restructuring charges, a loss on disposal of SEA’s subsea business and a write-down of intangible assets meant that Cohort swung from a £364,000 statutory operating profit to a £42,000 loss.

Its order book has expanded by almost a fifth since the April year-end to £219m, underpinning £71m of revenue for the second half. Providing long-term visibility, the group also has £51m of orders for beyond 2023. New order wins were led by Chess – which finished the first half with a record closing order book – laying the groundwork for a better second half.

Excluding lease liabilities, Cohort's net debt has risen by 30 per cent since the April year-end to £6.1m, although this is expected to fall back to around £5m notwithstanding the €11.3m (£10.3m) acquisition of naval sonar business ELAC that completed earlier this month. Mr Thomis says ELAC is “a very significant step forward for the next stage of our development”. While it will not impact the bottom line this year, it is expected to boost EPS by 2 to 3 per cent over the next two years.  

Both Cohort and Chemring benefit from the stability and visibility of long-term government contracts. Even if there are defence cuts to come, they are well positioned to capitalise on modernisation efforts and the shift away from conventional warfare. Buy on both counts.

Last IC View: Cohort: Buy, 571p, 23 Jul 2020; Chemring: Buy, 256p, 4 Jun 2020