The first duty of government is to afford protection to its citizens – but if it can do that on the cheap, so much the better. Since taking over as defence secretary from Sir Michael Fallon in November, Gavin Williamson has been engaged in a very public spat with the Chancellor of the Exchequer over the proportion of the state tax take destined for the Ministry of Defence (MoD). No surprises on that score – it’s a perennial debate at the heart of government – but the eventual outcome could have some unnerving effects for investors in the UK aerospace and defence sector.
Unconventional threats and new priorities
The signs are far from encouraging, partly due to the emergence of new security challenges. Recent comments by Mark Sedwill, the UK’s national security adviser, suggest that threats from unconventional warfare, cyber-attack and disinformation campaigns could be prioritised over the planned modernisation of the UK’s conventional forces. The threat posed by these forms of warfare mean that the focus is switching to the intelligence agencies and the police. For policy makers, the threat posed by Vladimir Putin’s Russia – whether real or imagined – still provides the most compelling reason for bolstering the UK’s conventional forces, particularly as there is little appetite for further western intervention in the world’s security hot-spots. But given fiscal constraints, it’s obvious that something has to give.
The National Security Council is due to discuss the findings of a security review led by Mr Sedwill, but he has already warned that the UK’s £56bn annual budget for defence and security is unlikely to be increased following the review’s findings. The UK armed forces will have to wait for a financial settlement until the outcome of the review, known as the National Security Capability Review. However, the prospect of defence cuts, targeted at areas such as the UK’s amphibious landing ships and even Royal Marine numbers, have grown as details of a funding shortfall in the UK’s defence budget have emerged. Some of the military’s larger capital spending commitments were predicated on the ability of the MoD to deliver multi-billion-pound cost savings – but these have proved elusive. (The National Audit Office recently reported that cannibalisation of parts in the MoD – particularly in the Royal Navy – had increased by 49 per cent during the past five years). Add in the fall in sterling since the EU referendum and lower projections of economic growth and it is little wonder that spending plans are now in doubt.
The new defence secretary, a relative novice in ministerial terms, could not be accused of failing to fight his corner. Mindful of budgetary pressures, he has turned his attention to defence industrial policy, as a means of justifying budgets in the years ahead. The MoD and defence contractors obviously have open channels of communication, but the MoD now plans to change the way it engages with businesses as part of the procurement process. The aim is to give UK contractors a better sense of what military requirements are in train, thereby aiding their ability to develop new equipment with an eye on strategic and commercial imperatives.
Ultra sets industry alarm bells ringing
This new co-ordinated response is to be welcomed, not least because it should also help export efforts (on a rolling 10-year basis, the UK remains the second largest global defence exporter, with 9 per cent of the total market). But recent profit warnings from the likes of Ultra Electronics (ULE), where revenues were held in check due to delays to the Royal Navy’s Dreadnought ballistic submarine programme, have undermined confidence in the domestic defence industry, at least those parts of it overly exposed to the MoD budget.
The group warned of “mounting pressures in the funding of UK defence programmes”, which have “resulted in the MoD pausing, cancelling or delaying numerous programmes”. The underwater warfare and maritime segments account for around a third of group revenues, although Ultra is fulfilling obligations on procurement programmes for several other countries, including the US, Canada, and Australia – so the MoD’s budgetary constraints, though material, have been tempered through diversification. Ultra is effectively a second-tier contractor to the MoD unlike, say, the likes of BAE Systems (BA.), Rolls-Royce (RR.) or Babcock (BAB), but around 13-15 per cent of the top line is still linked to MoD spending, hence the sharp markdown that accompanied November’s profit warning.
Babcock counts the MoD as one of its major customers, a point borne out by recent contract wins, including a £360m deal to become marine systems support partner for the UK navy’s new aircraft carriers and Type 45 Destroyers. This formed part of a £2.1bn order intake at its September half-year – impressive enough, yet an accompanying 7 per cent decline in the share price indicates that the market shares management’s caution on domestic defence budgets, although it should be noted that valuations for Babcock have also suffered due to prevailing negative sentiment towards the outsourcing sector.
QinetiQ – hand in glove with the MoD, but loosening the grip
Perhaps the one contractor with the most to lose from a sustained fall-away in UK defence spending is QinetiQ (QQ.), which has been a key player in homegrown defence procurement since it was spun out of the Defence Evaluation and Research Agency in 2001. The MoD's right to veto any of the group’s transactions was relaxed five years ago, to make it easier for QinetiQ to raise funds and make acquisitions or disposals.
However, the group still derives the lion’s share of its sales from the UK military. This relationship, specifically a long-term partnering agreement with the MoD for testing, evaluation and training services, has aided top-line visibility. And management believes that the addressable market in these areas could expand due to the repatriation of evaluation work currently carried out abroad. Nonetheless, the percentage of revenue generated from outside the UK has increased significantly, so with Brexit on the horizon the push to attract more overseas customers takes on an added dimension.
That QinetiQ is targeting overseas markets isn’t surprising, given the success that UK arms exporters continue to have in global markets. It’s curious that politicians rarely trumpet the success of this sector of the economy – it’s almost as though it’s our dirty little secret – but there is obviously no shortage of contractors from other countries that would be willing to fill the breach if the likes of BAE Systems suddenly opted for ploughshares over swords.
BAE Systems – a broad-based, beta play
BAE Systems isn’t as exposed to the vagaries of MoD budgets as QinetiQ, at least not proportionally, but it has significant capital tied up in multi-billion-pound domestic contracts, including 10-year partnership arrangements to support the UK Typhoon and F-35 Lightning fleets, along with big-ticket contracts for the Royal Navy’s Queen Elizabeth Class aircraft carrier and Type 26 frigate programmes.
Nevertheless, such is the scale and global reach of its operations that many investors include the UK contractor as a beta play on the global defence market. Even though the group’s new chief executive, Charles Woodburn, announced 1,900 redundancies shortly after taking the reins, BAE, which is one of the five leading contractors to the US Department of Defense, is well placed to benefit from the $700bn defence bill passed by the US Senate in 2017.
And there’s a global dimension to take on board. According to the Jane’s Defence Budgets, worldwide defence spending will increase by 3.3 per cent in 2018, the fastest growth rate for a decade, reaching $1.67 trillion in 2018. So, even if domestic defence spending flatlines in real terms through this year, the impact of increases in overseas budgets (driven, in part, by a deteriorating security environment in the Asia-Pacific region), should help to mitigate any deferrals or cancelled projects on the part of the MoD.
