US MAJORS DEMONSTRATE STRENGTH ALL ROUND – THE WORST IS OVER?
By Julian Nettlefold
The Investor’s Chronicle published a main defence budget feature in September.
It stated that Budget cuts in the US, by far the world’s biggest buyer of military hardware, and across Europe threatened to plunge the defence industry into chaos. Withdrawal from Iraq and Afghanistan only compounded the problem and a subsequent slump in profits would surely spell doom for share prices, too. Well, it didn’t. In fact, aerospace & defence has been one of the best performing sectors over the past two years, almost doubling since mid-2011. There are, however, further challenges, and while the boom in commercial aerospace has softened the blow, justifying current valuations is easier for some than others.
Will America ‘do the right thing’?
Perhaps most pressing is the bloody political battle in Washington. According to the Stockholm International Peace Research Institute (SIPRI), America spent $682bn (£425bn) on arms in 2012, four times more than second biggest spender, China. But that was down 6 per cent in real terms and further significant cuts under sequestration, which took effect in March, look inevitable. Even the Pentagon’s travel budget has suffered judging by the noticeable drop in American visitors at the recent defence industry tradeshow in Docklands (DSEI). A series of significant deadlines over the next few months are unlikely to knock sense into Congressmen, either.
Indeed, with the US fiscal year-end (30 September) just days away, there’s still no agreement on a new budget, which includes President Obama’s request for almost $527bn for defence. And, despite the violence in Syria, Egypt and Kenya, few hold out much hope of a ‘grand bargain’ to end indiscriminate cuts. Remember, no deal by 1 January strips another $52bn from the Pentagon’s coffers. Best guess now is some kind of stopgap measure until mid-December. That would make a crucial deal to raise the $16.7trn borrowing limit, which the government could hit as early as next month, more likely.
Winston Churchill once said: “Americans can always be counted on to do the right thing…after they have exhausted all other possibilities.” Let’s hope so. Without agreement, the defence department will again be hobbled by a continuing resolution, meaning project delays and inevitable hold-ups for UK firms. That tends to affect companies such as Ultra Electronics (ULE) and Cobham (COB) first, as both rely on turning round orders quickly. Many of Chemring’s businesses are similarly short-cycle in nature and visibility poor.
One mustn’t underplay the importance of America’s military financial muscle on the UK sector. BAE Systems (BA.), Ultra, Cobham and Qinetiq (QQ.) do between 40 per cent and 50 per cent of their business there. And, despite the cuts, all – unless Qinetiq decides to sell its US division – will continue to rely on the states for a slug of work. Analysts told us in March that speculation about sequestration was actually worse than the impact (‘Defence industry kept guessing’). They were right. But is that enough to justify the sector re-rating to over 13 times earnings estimates for 2014?
“In some cases it is,” says Sandy Morris, an analyst at Jefferies. “Over here we took a much dimmer view of sequester than in the US and BAE was punished in a febrile market. But the market forgot that about 70 per cent of BAE’s business is not US defence and the impact was exaggerated.”
BAE’s share price has surged 50 per cent since November and now trades on 10.5 times earnings, underpinned by a £1bn share buyback programme and significant Middle East business.
Chemring (CHG), however, is a different kettle of fish. “If budgets are cut or even go sideways, they may be forced to compete on price and it could get messy,” warns Mr Morris. Yet the manufacturer of flares and countermeasures trades on an earnings multiple of almost 13.