Go defensive with Ultra Electronics

Ultra’s order book saw 11 per cent organic growth in 2019, taking it to over £1bn. This reflects improving defence budgets as well as contract wins on new and existing programmes. Its core markets are the ‘five eyes’ nations – the US, Canada, the UK, Australia and New Zealand. Increasingly pivoting towards the world’s largest defence market, over 60 per cent of the group’s revenue now comes from the US. This is up from 44 per cent in 2015. With its focus on niche technologies, such as anti-submarine warfare and cybersecurity, Ultra is well placed to tap into high-priority areas of defence spending. Last year it won a five-year sole source contract to supply the US army with radio systems, worth a maximum of $500m (£406m).

There are concerns that, as the world hurtles towards a recession, future defence spending could be squeezed as governments pour money into welfare spending. But while coronavirus is monopolising attention right now, decision makers are likely to be conscious that the same geopolitical tensions will exist once this crisis has passed.

Ultra’s shares have been on something of a rollercoaster, tumbling in 2017 following a profit warning and struggling to rebound across 2018. This was compounded by the collapse of its acquisition of defence contractor Sparton in 2018 after the US Department of Justice (DoJ) raised competition concerns over the ‘sonabuoy’ market. Sonabuoys are electronic sensors that detect enemy submarines and Ultra and Sparton are the two major suppliers to the US navy via their joint venture, Erapsco. The DoJ has signalled an intention to open an anti-trust investigation into Erapsco, with a view to opening the market to other players. Analysts at stockbroker Berenberg view the threat to Ultra’s incumbent position as low given that new entrants will take time to develop, test and scale their technology. Meanwhile, Erapsco has secured a $1bn deal to supply the US navy with sonabuoys for the next five years.

March 2019 heralded a turning point in fortunes when Ultra revealed it had returned to organic growth in 2018 for the first time in seven years. It had previously been plagued by weak UK defence spending and disruption to US procurement processes. The positive momentum carried into 2019, with 7 per cent organic revenue growth and Berenberg expects this to continue. The aerospace and infrastructure division – which accounts for a quarter of total turnover – saw 10 per cent organic sales growth on the back of higher orders for high-pressure pure-air generating units for the F-35 jet.

Ultra's bosses hope to sustain the upward trajectory with a "focus, fix, grow" strategy. This aims to streamline Ultra’s portfolio and boost research and development (R&D) investment, something that had been neglected in favour of short-term profit growth. Last year saw self-funded R&D jump over a tenth to £31m and the aim is to increase this from 3.8 per cent of revenue to up to 4.5 per cent. Together with £3m of transformation costs and legacy contract losses, the effect of higher R&D spending was to push the underlying operating profit margin down 0.4 percentage points to 14.3 per cent in 2019. Management is guiding for stable margins in 2020.  

Including  operating lease liabilities of £41.2m, net debt ticked down 2 per cent to £155m last year. Equivalent to 1.6 times cash profits (Ebitda), this is within the group’s target range of 1.5 to 2 times. Meanwhile, free cash flow increased by 7 per cent to £72.5m.