The publication of the government’s long-awaited defence investment plan could spur a revival in UK defence shares, which have lost momentum in recent weeks.
A report in The Times suggested that publication of the document, which sets out defence spending priorities for the next decade, is due in the coming days. The government is expected to pledge an additional £18bn in defence spending.
Even if the figure in the plan falls short of this, investment in equipment is expected to underpin high-single-digit revenue growth among UK-focused players such as Cohort (CHRT), Babcock International (BAB) and Qinetiq (QQ.), which generate between 40 per cent and 60 per cent of their revenues from the Ministry of Defence, according to Jefferies.
The broker expects UK defence shares as a group to deliver compound annual earnings per share growth in the low teens over the next three years, “with upside risk from capital allocation decisions”, according to analyst David Farrell.
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The defence plan was initially due to be published last autumn. Its delay has been “a source of frustration for the industry”, according to Peel Hunt. Yet its publication should be a potential catalyst for UK-based defence projects, the broker added.
In recent weeks, UK defence shares have been caught up in the malaise that has affected the sector across Europe.
Since the outbreak of the latest conflict in the Middle East, Rheinmetall’s (RHM:DE) shares have fallen by 26 per cent, while Saab (SE:SAAB.B) shares are down 20 per cent. In the UK, BAE Systems (BA.) is down 10 per cent.
The run-up in valuations in recent years is clearly a factor. Even after their recent declines, Europe’s top defence contractors’ price/earnings ratios remain at a 45 per cent premium to their 10-year average.
Joakim Agerback, manager of Finserve’s Global Security Fund, said that although the growth in defence spending in the coming years is likely to be greater in Europe than elsewhere, “to a large extent that is priced in”.
Show, don’t tell
Finserve cut its exposure to European defence from 57 per cent of the fund’s holdings at the start of last year to a third by the year-end. With multiples now looking stretched versus US peers, Europe’s defence players need to show evidence of growing orders, revenue and earnings, Agerback said.
Investor wariness was evident in the reaction to Rheinmetall’s first-quarter results this month. The German company’s shares rose despite slightly softer sales, but then sold off after management highlighted uncertainty over significant orders for armoured vehicles and future missile and ammunition sales.
Defence shares have also faced pressure from short sellers, particularly some smaller UK players.
Publicly disclosed short positions against mini-conglomerate Cohort amount to 1.8 per cent of shares outstanding, but the actual level of shorting activity is likely to be higher, given that almost 5 per cent of its shares are lent out, according to Modular Finance. Six months ago, less than 1 per cent of its shares were borrowed.
Similarly, short positions against Chemring (CHG) account for 2.5 per cent of its shares, but 5.6 per cent have been borrowed – an increase from 1.4 per cent six months ago. Its shares have fallen by 15 per cent in a month.
At the same time, US-based private equity firm Albion River Management has been increasing its holding – from 4 per cent six months ago to 9 per cent currently, which makes it Chemring’s second-biggest shareholder.
Albion River is a defence-focused private equity firm that owns a group of software, power, energetics and pyrotechnics companies, including Derby-based energetics manufacturer Wescom. It did not respond to a request for comment.
There is currently “very strong interest” in UK defence SMEs both from private equity and strategic buyers, said Soben Durai, defence technology lead at broker Cavendish. UK companies benefit both from having the necessary clearance to work across the ‘Five Eyes’ alliance with partners such as the US and Australia, as well as links with European Nato allies, he said.
Chemring looks particularly vulnerable given the short-term pressures it faces on earnings. Although it has improved returns on capital employed (ROCE) from 10 per cent to 15 per cent over the past five years, it faces “moderate, temporary dilution” in earnings given over £100mn in capex planned for this year, according to Peel Hunt. Once this unwinds, the broker expects that Chemring’s ROCE could eventually exceed 20 per cent.
It is also Jefferies’ top pick among UK defence companies. The broker expects earnings growth of 25 per cent in its 2027 and 2028 financial years.
Citi analyst Charles Armitage argued that order books at companies such as BAE Systems and Babcock look more robust.
Although there will still be demand for ammunition once Ukraine’s war with Russia ends, “as soon as the stockpile is filled, I think demand’s going to drop 95 per cent”, he said on a recent webinar.
Both BAE Systems and Babcock are involved in much longer-cycle programmes for the construction of new ships and nuclear submarines that stretch for decades, Armitage added.
“BAE has got visibility out to 2060 in nuclear subs,” he said.