FTSE 350: Defence takes a direct reputational hit

Happily, Brexit is another investment theme that is not expected to trouble BAE and its peers, given the limited aerospace and defence trading that takes place between the UK and the European Union.

The prospect of a Ministry of Defence (MoD) funding shortfall is more pressing. The department’s spending forecasts for its activities from 2018 to 2028 envisage a funding gap of £7bn that could rise to £15bn. In response, the National Audit Office recognised that the department is “improving its understanding of affordability risks”, but added that “we are not yet fully confident in the robustness of some of its underlying assumptions, particularly around efficiencies”. Black holes in the MoD budget aren’t a new phenomenon, and for now there’s no immediate indication that any contractors are under threat of losing agreements. Nevertheless, the long term for the likes of QinetiQ (QQ) and Ultra Electronics (ULE), both of which hold considerable exposure to UK defence expenditure, carries uncertainty.

What is certain is that Ultra suffered a nightmare 2018. It was forced to reckon with the cancellation of a major defence acquisition due to anti-trust concerns, along with an investigation by the Serious Fraud Office (SFO) over suspected corrupt business activities in Algeria by Ultra, its subsidiaries, employees and associated persons. News that the company had lowered its estimates for cash conversion rounded off a hat-trick of black marks for Ultra, which is currently the third most-shorted stock on the market. A new chief executive has gone some way towards placating observers, but we’re yet to be convinced of the investment case, having previously been fans.

Ultra isn’t the only company in the sector that has had a visit from the SFO. Back in January 2017, the watchdog entered into a deferred prosecution agreement with Rolls-Royce over misconduct that took place across a number of overseas markets. The company agreed an overall sum of £671m, the largest fine paid by a UK company for bribery. At the start of 2019, the SFO confirmed that its investigation has narrowed. Rolls-Royce’s malfunctioning Trent 1,000 engines took the shine off a year that otherwise saw investor confidence rise in response to chief executive Warren East’s turnaround programme.

Cobham (COB), a supplier of air-to-air refuelling systems, antenna and radar parts, will also make for an interesting watch. We’re still waiting to see what happens with the company’s ongoing dispute with Boeing – Cobham described its client’s damage claims as “unquantified”, as Boeing continues to withhold payments over a damaged tanker system. The company also sustained a £40m hit to profits over the cost of delays linked to its Wing Aerial Refuelling Pods. Cobham has much to do in improving its operations and restoring confidence from consumers and investors.