When the foreign secretary, Liz Truss, said on Sunday that Britain needed to increase its defence spending and could not ignore the demand for conventional weapons, she turned the spotlight on a sector that has long been in the doldrums as defence budgets ran down.
Her remarks were underlined by a pledge from the German chancellor, Olaf Scholz, that his country would spend more than €100 billion on modernising its armed forces in the face of the Ukraine crisis — views echoed by other Nato countries.
While some investors have avoided shares in arms manufacturers on ethical grounds, current events make a powerful case for reconsidering the sector. It is only prudent for western Europe to prepare for the worst, in a strictly defensive posture.
Chloe Lemarie at the broker Jefferies said: “The move to 2 per cent of GDP spent on defence could trigger a 25 per cent growth in non-US Nato members’ budgets, which may translate into as much as a 40-50 per cent growth in procurement spend over the next five years.”
The emphasis, initially at least, will be on traditional rearmament. Tobias Ellwood, chairman of the Commons defence select committee, said: “Defending and holding ground requires ‘force presence’: mobile, hard power in the form of light and heavy armour and infantry, the very things that were cut in the last defence review. These cuts must now be urgently reversed.”
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Among large UK-quoted firms, the two most likely to gain are BAE Systems and Babcock International. In recent months this column has rated both only as a hold. The change in the tide is sufficiently sweeping to upgrade them to buys.
On the day Russia invaded last week, BAE announced 2021 revenue up £200 million to £19.5 billion, operating profit £459 million higher at £2.4 billion and basic earnings per share of 55.2p, up from 40.7p. The final dividend was 15.2p per share, making a 25.1p total for the year.
The company makes equipment from tanks to submarines, and electronic warfare systems to cyber-intelligence kit, employing 90,500 people in 40 countries. Onerous contracts, cost overruns and massive pension liabilities have held back the shares, though the pension problem is coming under control. The management has been trying to push into the higher-value electronic end of the business, but there may now be a reversion to more conventional production. The danger is that a rush of new business will lead to more unfavourable contracts and future cost hangovers unless a stricter discipline is imposed.
However, even after the surge in the price over the past week, the shares are still on a modest 13.4 times last year’s earnings, and yield 3.4 per cent. Both are ripe for improvement.
Babcock, the UK’s only nationally owned civil nuclear contractor, is a major aerospace and defence supplier of weapons, warships and submarine launch systems (it owns the Devonport and Rosyth dockyards). In December it announced half-year revenue 8.2 per cent higher at £2.22 billion and a turnaround from a £785.3 million loss to a £75.4 million profit.
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A constant criticism over the management’s strategy is that it has left the business at the mercy of geopolitics, but that should now turn in its favour. It was one of the chosen manufacturers to help make subs under last year’s Aukus security pact between the UK, Australia and the US. As with BAE, cash control is concerning. In the first half of the current year there was a £160 million net outflow, thanks to pensions and capital spending. A rush of new orders will help to solve such difficulties, but it must not be an excuse to loosen the reins.
Pre-Ukraine, for the year ending on March 31, Joe Brent at Liberum predicted earnings of 29.4p a share and a jump to 37p next year. That would put the shares at 333p on a 9 p/e ratio, modest enough to leave room for error. He expects a resumption of dividends then too, to offer a forward 3.7 per cent yield.
The other big UK defence contractor is Rolls-Royce, famous for its aero engines. But here the picture is more problematical.
It is significant that, while other defence stocks have been rising in virtually a straight line since the guns started firing, Rolls’s shares have shed 17 per cent. Some of that fall has internal origins, with the unexpected departure of the chief executive, Warren East scheduled for the end of this year. But the timing is bad, as the company is still in a turmoil that increased military orders will only partly alleviate.
Last week Rolls announced 2021 numbers showing a turnaround from £3.1 million statutory loss to a £124 million profit, translating to a tiny 1.48p earnings per share. The resulting p/e ratio of 67.5 is academic.
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For the past two years Rolls has been struggling with the pandemic’s impact on civil aviation, particularly as it charges airlines a fixed amount per flying hour. Grounded planes are therefore a dead weight. That headache should ease as travel returns to normal, and winning a contract to replace the engines in America’s B-52 bombers last year secured work for decades. But its Aeroflot contracts are in doubt, and it will have to fight Boeing and Lockheed for new military business.
Rolls’s shares may come good in a year or so, but there is still too much uncertainty. Avoid.
Quite a few smaller players should also gain from bigger government budgets. Chemring had ironically been trying to reposition itself from being a mainly military business into a wider technology firm specialising in cybersecurity and biological threat detection. There should be a swift about-turn on that strategy ahead of tomorrow’s annual meeting, but the company still faces a Serious Fraud Office money-laundering inquiry and the verdict on a fatal explosion at its Salisbury chemical plant.
At 312½p, up 52½p in a week, the shares are on 18 times last year’s earnings, and yield just 1.5 per cent. High enough for the moment.
Qinetiq, another share to have sped north since the invasion, says it operates “primarily in the defence and security markets”. It trains armies too, military equipment now being so sophisticated it needs specialists to explain how it works. Vicky McClure’s character in the TV series Trigger Point could have done with one of Qinetiq’s advanced bomb suits, complete with a heads-up display and sophisticated sensors.
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Qinetiq also has a €75 million contract from the European Space Agency to develop and assemble the ozone-monitoring Altius satellite.
However, in November the company reported supply issues on an unnamed “large, complex programme”, which will probably mean a writedown for the year ending this month. But at 292p, for a probable underlying p/e ratio of 12, the shares are fairly priced. Buy.
