A defensive trio: one safe, one cheap and one speculative.
The news that BAE Systems (LSE: BA) is likely to close its Portsmouth dockyard is a sad but unsurprising blow to the UK's defence industry. There's not much point in a 500-year-old naval dockyard when you've hardly got a navy, and there's precious little of that to defend these sceptred isles -- especially the oil-rich ones in the South Atlantic.
But at least the defence industry can protect your investments. Defence is, tautologically, a defensive sector. Well, maybe. What once was resilient in the face of recession, as governments maintained defence spending and undertook procurement on long life cycles, is now suffering from cuts in spending throughout the Western world.
There is one area in which defence stocks provide some counter-cyclical downside protection. The biggest threat to equities may be the eurozone or a hard landing in the Chinese economy, but military conflict in the Middle East is an ever-present threat. Anything that sent the oil price rocketing could prove devastating for Western economies, but would at least be a boost for the defence sector.
So how is the industry coping, and what investment opportunities are there? Here are three ideas: one safe, one cheap and one speculative.
BAE
BAE is the monster of the sector, with a market cap over £10bn. Its shares have has proved resilient in the face of defence cuts and falling revenues, helped by a generous dividend and £500m share buy-back programme. They have run up 25% over the past two months. That takes them out of bargain-buy territory; though, on a price-to-earnings (P/E) ratio of 8 and still yielding over 5%, they're not prohibitively expensive.
The company is seeking to diversify away from its dependence on NATO procurement, and is developing two non-defence business segments as well as pursuing international sales. Those are commercial aerospace electronics, and cyber security. It has spent £0.5bn over the last 12 months acquiring companies in the cyber security field, building a business in what must surely be a growth market.
Indeed, the US-based Electronics, Intelligence and Support division, which includes electronic warfare and other systems, was the biggest contributor to EBITDA at the half-year mark and delivered the bulk of operating cash flow. The traditional Land and Armaments division, manufacturing military hardware, saw revenues drop 40%. 80% of sales are in North America and Europe.
Modest gearing offsets a scary pension deficit, and the twice-covered dividend looks safe. But the company faces a strategic challenge in building its new businesses fast enough to compensate for declines in traditional markets.
Chemring
Less than a tenth of BAE's size, Chemring (LSE: CHG) disappointed the market with its full-year results yesterday, and dragged the whole sector down with it. At the close of the day, shares were down 14% at 386.5p, making it the day's biggest faller.
It seems the market was spooked by pessimistic comments from the chairman about the impact on defence budgets of the eurozone crisis and US spending cuts imposed by Congress. Nevertheless, the reaction seems a little harsh when underlying revenues were up 9% (25% including acquisitions) and earnings per share up 5%. More significantly, the order book was up 9% and the company has boosted non-NATO revenues from 20% to 29% of the total.
Chemring makes counter-IED devices and various kinds of munitions and pyrotechnics -- consumables that need operational replacement even if not used. A profit warning in November presented a buying opportunity, and yesterday's fall gives investors a second chance. It's trading on a P/E of 9 and yield of 3.3%, but the directors plan to increase the dividend payout.
Takeover target
A tenth smaller again, Avon Rubber (LSE: AVON) is a fascinating small cap with a long and chequered history. With roots in the tyre industry, it repositioned into various speciality products over the last two decades, and three quarters of revenues now come from manufacture of CBRN protective suits and respirators (with a quarter from products for the dairy industry).
What in the Cold War were NBC (nuclear, biological and chemical) suits have evolved into CBRN: with the R highlighting the increased threat of radiological contamination from terrorist activity. Every cloud has a silver lining in the defence industry.
The US accounts for 90% of Avon's revenues where it is a major supplier to the Defence Department. It has turned around operationally, with operating profit in the year to September 2011 up 20% on revenues down 8%, strengthened its balance sheet and brought a sizeable pension deficit under control.
On a P/E of 10 and yielding 1%, the shares aren't a steal. But with a strategic role in US civil defence supply, market-leading technology, a profitable business model and a tiny £100m market cap, it looks a prime takeover target to me.
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More from Tony Reading:
> Tony has shares in Chemring.
