Defend returns with Chemring

True, the description of Chemring as defensive may seem somewhat at odds with a tumultuous five years marked by profit warnings, a major rights issue, a Serious Fraud Office investigation and the temporary closure of a manufacturing facility following an accident. However, the shares’ strong momentum in the 12 months up to the recent market sell-off points to a marked improvement in prospects.

Chemring is pursuing a strategy of ‘less is more’. It has sold and closed a number of low-margin commodity businesses. Management is focusing on areas where it believes Chemring has a competitive advantage based on its intellectual property or where it is the sole supplier. Last year, operations were reorganised into two divisions. The sensors and information division accounted for 39 per cent of ongoing sales and 49 per cent of profit. It focuses on detecting explosive, biochemical and cyber threats. The lower-margin countermeasures and energetics division is focused on missile protection and rocket components.

While reported 2019 revenue was almost two-fifths lower than 2017 due to divestments, underlying operating profit was only down one-fifth, which reflected significant margin gains. Margin improvement is forecast to continue (see chart).

Improved working capital management has also helped reduce finance costs, which dropped from £6.1m to £4.6m last year. Meanwhile, Chemring has substantially reduced exposure to the Middle East, which has been the source of problems in the past.

The company has said it has yet to see any material impact from coronavirus, although it could cause supply-chain disruption. But, this aside, there are a number of reasons to feel positive about the outlook. Work from some major programmes (HMDS explosive detection and F-35 missile defence) is taking off, while prospects for the company’s Roke cybersecurity business look strong. Research firm Statista forecasts the global cybersecurity market to grow from $184bn (£141bn) to $248bn by 2023.

Chemring is also investing £50m in a Tennessee countermeasures facility, which underlines an anticipated pick-up in demand following a protracted lull since the withdrawal of troops from Iraq and Afghanistan. Meanwhile, the US Defense Authorization Act is expected to see budgets increase from $545bn this year to $747bn in 2024. The US accounts for 55 per cent of Chemring’s sales.

With 88 per cent of orders for 2020 secure, a focus on higher-margin work, and positive developments in end markets, we think investors would be well served to look beyond the possibility of coronavirus disruption. Priced at 16 times forecast earnings, the valuation does not look challenging to us. Buy.