Get defensive

Thousands of feet below, US Army Humvee vehicles roar across Iraqi sands on manoeuvres. The US military has been here for a long time now, and these cars have carried soldiers from the world’s most feared military force throughout. They are visually impressive, but they are unloved. In the past, the Humvee was prone to flipping when travelling around corners, and soldiers have been paralysed and killed in accidents. The HMMWV Rollover Mitigation program became a priority for the US Congress, and in 2016 UK automotive engineer Ricardo (RCDO) was brought in to fit an antilock braking and electronic stability control system to the vehicles. The initiative was successful, and the Humvee’s fatal design flaw was eliminated.

Over a thousand kilometres away, the Royal Navy’s HMS Duncan sails in support of a French carrier strike group in the fight against ISIS. The Type 45 destroyer is laden with British technology, ranging from Rolls-Royce gas turbines and a BAE naval gun to Ultra Electronics (ULE) weapons and radar systems. She is ferrying French Rafale fighter jets through the Mediterranean and providing aerospace battle support in missions against ISIS. Rafale is manufactured by Dassault (FRA:DSY) and is regarded as the French rival to the Eurofighter Typhoon. But HMS Duncan’s Lieutenant Luke Thompson says that “our two navies working so closely together in the Mediterranean shows how much our people and our kit complement each other”.

These are three landscapes for combat, with three militaries, working interdependently in one conflict – all sustained by the might of the British aerospace and defence industry. 

There are, of course, more than three ways to fight a war. Britain’s nuclear capability, which hums beneath the sea, is trumpeted as our ultimate deterrent. Cyber warfare is central to our national security strategy. Drones and other forms of autonomous warfare straddle the three main formats. UK defence companies are at the forefront of the future of war, and this offers extensive opportunities for retail investors. 

 

A safe sector

This industry is a critical cog in the UK economy. In 2018, the UK won defence orders worth £14bn – its best year ever, which was up on the previous year’s total of £9bn. Our share of the global defence export market was estimated at 19 per cent in 2018, which was the second-highest in the world. We are ahead of Russia and France, although markedly behind the US, which is a key market for UK defence players. The opposition from some quarters to Cobham’s (COB) planned takeover by US private equity firm Advent International exemplifies the pride that many in this country take in its defence industry, which, as other industries move overseas or simply evaporate, demonstrates Britain’s edge and ability in modern-day manufacturing. Compare the growth prospects of the defence industry with the fate of UK steel and fossil fuels, for example.

It is a vital source of jobs in the UK, too. A September 2017 report by the Department for Business, Enterprise and Industrial Strategy (BEIS) describes the industry as “a strong contributor to the manufacturing base”, directly employing more than 140,000 people and providing places for 4,300 apprentices. The September 2019 announcement of Babcock (BAB) as the preferred bidder for the UK’s Type 31 frigate programme was heralded by unions, including Unite, whose assistant general secretary for manufacturing, Steve Turner, described the decision as “one piece in the jigsaw needed to secure the future of UK shipbuilding and the thousands of jobs that it sustains in communities across the country”. 

Babcock will manufacture five ships at a cost of £250m per vessel, with construction set to commence in 2021 in the Rosyth dockyard in Fife, Scotland, and conclude in 2027. Unite now wants to ensure that these British ships will be built with British steel. With national security comes investor security – the defence industry is a national treasure, one backed by extensive government funding and a higher, more symbolic sentiment. As well as their growth prospects, there is a unique level of assurance for investors in defence stocks compared with, say, previous backers of the UK car industry.

But the make-up of armed forces around the world has shifted. A monopolistic industry with governments representing single buyers, defence companies’ offerings represent and reflect the demands bestowed upon them by the world’s largest militaries. The Cold War era, which saw hordes of tanks, planes and warships massed on borders in large numbers is gone, and forces are now smaller in number. Yet the sophistication of their technologies has increased, and with this unit costs have gone up. After years of austerity across Europe, so have defence budgets. China is a relatively new military power, and Russia is resurgent – this brings restrictions from established partners on which nations companies can do business with. Then there is the cost of doing business. There is a huge onus on aerospace and defence companies to invest in the research and development of cutting-edge technologies, such as autonomous planes, submarines and weaponry.

 

The sky's the limit

The world’s first military aircraft was not born in the UK. It was manufactured by the Wright brothers and sold to the US Army Signal Corps in July 1909. The Wright Military Flyer could fly at more than 40mph, powered by twin propellers turned by a four-cylinder engine. It cost $30,000 per plane.

Aerospace engineers on both sides of the Atlantic have achieved a remarkable rate of progress in under a century. A Eurofighter Typhoon pilot can tear across the skies at a top speed of around 1,550mph. UK aerospace and defence companies, such as Meggitt (MGGT), Senior (SNR) and Rolls-Royce, supply a wealth of components and engines to American and European planes that have increased in sophistication and ingenuity. Costs have risen accordingly.

Indeed, US defence orders are vital to many UK companies. Some groups, such as Meggitt, consider it to be their main defence market. Last year, the US spent $633.57bn on its military, according to research company Statista, up nearly 5 per cent on its 2017 budget. US defence spending accounts for 15 per cent of total federal expenditure, according to the Peter G Peterson Foundation. This is a lucrative market for UK companies, and a welcome shield from Brexit uncertainty for investors.

European governments have, meanwhile, identified the need to refresh their militaries following a period of lower budgets, and spending has risen. The UK’s latest review of its defence expenditure in September brought a 2.3 per cent increase in the core UK Ministry of Defence (MoD) budget, excluding operations, for 2020-21. According to the Royal United Services Institute (RUSI), bringing the four-year real-terms increase in core defence spending to 9.6 per cent is the biggest such increase since the early 1980s.

In 2015, the UK’s strategic defence and security review confirmed the government’s intention to buy 138 F-35 Lightning jets. The aircraft, developed by Lockheed Martin (US:LMT), forms a core part of the Royal Air Force's (RAF) fleet and is supplied by a host of UK-listed businesses. Meggitt recently signed a three-year, $65m contract with Lockheed Martin to supply rudder pedal assemblies on the F-35, while in its 2019 half-year results, Senior observed that longer-term growth in its defence offering “will be supported by further increases in the F-35 programme”. 

One of the MoD’s key responsibilities lies in identifying the needs of the UK’s three services, which submit their own requirements to the ministry. But far from competing with each other for government funding each year, they effectively take turns for funds, according to Keith Hartley, emeritus professor of economics at the University of York.

“Each of the services enters the queue, and they know full well that they’re not going to oppose the other services’ requirements, because they see themselves as next in the queue,” he says, suggesting “an element of collusion between the services, rather than competition”. There is an interdependence between the services’ needs and the allocation of resources, though. 

The F-35 is the obvious candidate for the proceeds from the increase in expenditure, Professor Hartley says, because of the MoD’s recent procurement of aircraft carriers. In September, the £3bn HMS Prince of Wales aircraft carrier exited the Rosyth dockyard for the first time, and the first F-35s took off from the vessel in October. “Having bought the damn things, we’re going to have to put even more expensive equipment on them to operate them and make them worthwhile,” he adds, “because without aircraft they’re useless!” 

A longer-term opportunity for UK companies lies in the successor to the Eurofighter Typhoon. The likes of Meggitt, Senior and Ultra Electronics all supply equipment and technology to the jet, and will undoubtedly look to support the Tempest fighter, a project led by BAE Systems, Leonardo, Rolls-Royce and missile manufacturer MBDA, along with the RAF and the MoD, which has so far committed a £2bn investment. 

Tempest will take to the skies in 2035, with the option of flying manned or unmanned. It will incorporate the absolute forefront of aerospace technology, including a virtual cockpit, which will be shown in a pilot’s helmet display. And although it is intended to replace the Typhoon, these two technological marvels may end up dominating the skies alongside each other.

 

 

Engineering growth

There is therefore a myriad of components across a military jet – brakes, radio and decoy systems that can fool a heat-seeking missile, for example – that support earnings growth across the aerospace and defence sector. These contracts can be agreed for relatively long time periods and roll on, and on, providing stable income sources for companies. But there is one part of a plane that is particularly lucrative for aerospace and defence players.

There lies a wealth of opportunity beneath the bonnet of a military jet. Rolls-Royce engines sit in the bellies of some of the world’s leading fighter planes, and the company is developing a new power plant for the much-awaited replacement for the US B-52 bomber. Rolls-Royce, which is the second-largest producer of jet engines in the world, says that it adds $8.6bn to the US economy, with over $2bn invested here and 6,000 employees. More than simply selling the engines, Rolls-Royce earns income from engine maintenance, and is investing here too. It is partnered with robotics partners, including Harvard University and the University of Nottingham, to explore embedding robots within engines to improve monitoring, along with robots that could inspect and fix engine problems.

Meggitt, meanwhile, agreed a $750m, 10-year contract in January 2019 with US engine titan Pratt & Whitney for the supply of parts for its F135 and F119 engines, which power the F-22 Raptor and F-35 aircraft. Meggitt generates 35 per cent of its income from defence, three-quarters of which is earned in the US.

The civil and defence aerospace markets typically run in counter-cycles to each other, according to Meggitt chief executive Tony Wood. Good times for the civil market can often coincide with a lull in defence, and vice versa. But Mr Wood has observed strong momentum in both areas, albeit slower growth in the civil market. “For companies like us, where we’re trying to have duality of applications of our technology across both markets, that’s been quite advantageous,” he says.

While it was historically the case that the battlefield proved the testing ground for civil aerospace technologies, Meggitt’s chief executive says this flipped through the late 1990s and into the new millennium. The vast majority of modern military innovation is now carried across from the civil market. Meggitt tends to fund the invention stage of a product or technology, while its customers will finance the development stage of its product.

Defence remains a very attractive market, Mr Wood adds. “It has a higher return on capital,” he says, because the customer is typically providing some funding. This also reduces the level of risk attached to a project. “A sovereign owner for a programme has generally been a more reliable owner than a commercial owner,” he observes.

 

Boots on the ground

We have established that defence stocks can offer UK equity investors their own body armour to protect against the headwinds of manufacturing decline, both at home and overseas. Protecting those who protect us on the ground has also become a significant earnings driver for London-listed companies – and not just the obvious defence juggernauts. 

Ricardo is predominantly an automotive engineer and consultancy. But as car sales continue to struggle across the world, the company recognises strength in diversity and has broadened its operations. Defence has grown rapidly as a proportion of Ricardo’s operations and now makes up about 10 per cent of the business – it expects to hold this share over the near term. But defence can offer Ricardo a source of growth while its primary end market is weak. 

As well as remedying the woes of the US Humvee, Ricardo has been busy fitting military cars, tanks and ships with technologies aimed at extending their lifespans, improving fuel efficiency and upgrading software. Its anti-brake system orders have exceeded $12m over its full year, with between 25,000 and 50,000 US army vehicles suitable for the upgrade, and the system has a potential worldwide market of 100,000 vehicles in more than 50 countries.

“There’s a lot more forward-looking activity that we do in the US,” says chief executive officer Dave Shemmans, which includes hybrid vehicles and a focus on fuel consumption, enabling servicemen to carry less fuel to the front line of combat. Not exclusive to Ricardo, however, are the limitations on business imposed by certain governments, and the US and UK both have countries deemed out-of-bounds for Ricardo. The US has a longer list of proscribed countries. “If they’re off-limits for the US we tend not to go and work with them because the US is such a big part of our business,” he adds. A surge in defence spending in China and Russia will not necessarily result in new markets for the likes of Ricardo, then.

A rise in the use of chemical weapons in the Middle East has also necessitated upgrades to troop protection, which has created opportunities for UK companies. In November, Chemring (CHG) announced that it had secured the order of a further 75 units under the US Department of Defense's (DoD) Aerosol & Vapour Chemical Agent Detector (AVCAD) programme after an initial contract award for indefinite quantities and deliveries last year, as the US seeks to bolster its defences against chemical warfare. Smiths Group’s (SMIN) detection business is also a supplier to this project. The overall programme is valued at $838m.

Avon Rubber (AVON) is heavily involved in protecting soldiers from chemical weapons. The company’s core business is making respiratory equipment for military, fire and law enforcement personnel, while it also manufactures milking equipment for dairy farmers. Its relationship with the DoD is the cornerstone of Avon Rubber’s respiratory work, representing 40 per cent of its addressable market. “Avon has been very successful in the US,” observes independent defence and aerospace analyst Howard Wheeldon.

Avon chief financial officer Nick Keveth commented that the company is looking to make inroads beyond its key market. “In Europe, austerity means there’s quite a lot of old equipment out there in this area, and that increasing trend of usage is now exposing a number of countries’ militaries with a need to upgrade and modernise their equipment.”

Chemical weapons are no longer exclusive to the battlefield and have found their way into the streets and airports, Mr Keveth observes, and this type of warfare has been on the rise in Syria and Iraq. Combatants now want to use respiratory protection for longer periods of time and have these systems integrated with electronics equipment. They’re relatively affordable, too, with Avon Rubber’s general service respirator masks costing between $100 and $500. 

Avon is also carving out a niche in a more specialised market for respiratory equipment. Significant investment is being made in underwater equipment, and the company has developed deepwater military rebreathers that can be used for up to eight hours, at a maximum depth of around 100m. There are probably only around 4,000 to 5,000 specialist divers in the world conducting these types of operations, Nick Keveth says, and accordingly Avon’s deepwater product costs around $75,000. At the top end of our fag-packet calculations, that is an addressable market of $375m.

 

Preparing for China

Britain can trace its naval origins back to the time of Henry VIII, and the Royal Navy is recognised as the country’s ‘Senior Service’. Our maritime capability remains essential to our national security, and today there is a veritable ocean of naval opportunities for UK defence companies around the world. Along with its recent Type-31 announcement, a resurgent Babcock agreed a £864m joint venture last year to provide ship management services to the Australian navy, and is also very active in Canada and South Korea. In Korea, Babcock is investing heavily in support of the nation’s submarine programme.

Cohort (CHRT) chief executive Andy Thomis highlights nascent submarine demand in the east. China has high ambitions across its military services, but has placed particular emphasis on its navy, he adds, while the overall geopolitical picture is deteriorating.

“We’re seeing, particularly in Asia, the proliferation of submarines, as China and India both grow their fleet, looking for regional dominance,” Mr Thomis says. This has prompted a response in demand for submarines from the likes of Thailand, Indonesia, Malaysia and Vietnam, he adds, along with an increasing need for anti-submarine warfare systems. SEA, a Cohort subsidiary, provides an array of submarine weapons, decoy and communication systems.

The old powers, too, have a critical need for cutting-edge naval technologies. Ultra Electronics’ corporate marketing director Chris Binsley spots an opportunity to capitalise on the US’s growing instinct for competition against Russia and China, as it balances its counter-terrorism objectives with a return to conflict with great powers. Ultra’s main offerings are in the maritime and ‘C3’ (command, communication and control) domains – its core market is the ‘Five Eyes’ network of the US, the UK, Canada, Australia and New Zealand. The network requires compatible communications systems, and Ultra products can be found on board surface ships and submarines, including technologies such as sonar systems for boats such as the Royal Navy’s Type 23 and Type 26 frigates and Australia’s SEA 5000 vessel.

Mr Binsley, too, sees a realignment of funding origin for defence technology. Companies are looking to align themselves with governments’ defence priorities in order to identify where their technologies can be overlaid on big mission systems, and partnerships are evolving between the public and private sectors. “Whereas governments would often fund a lot of these big programmes before and you’d often find a lot of defence technology flowing into the commercial field later on,” he says, “it’s actually becoming a bit more 50/50”.

 

The future of war

A return to Cold War battle lines may have prompted a build-up in more conventional weapons systems, albeit ones that can talk to each other via the internet and pilot themselves autonomously. Drones are an exciting development, with Cohort’s counter-drone specialist subsidiary Chess remaining at Gatwick Airport in defence against drones, as well as protecting military forces from the threats posed by these new beasts. But one threat to our national security encompasses the three traditional fields for combat, along with the entirety of our national infrastructure.

“Cyber is the most important threat that the UK is under,” analyst Howard Wheeldon says, adding that this is true for all nations. “We went late into the game, but we didn’t put enough money into it.” More funding has enticed businesses such as BAE Systems into supporting the government’s objectives on cyber security. Once again, it is clear that governments will not act alone in inventing, innovating and indeed funding the defence systems we need to protect ourselves. It is even clearer that investors stand to gain from exposure to stocks that thrive on the geopolitical uncertainty that has threatened nearly every other industrial activity.