Is Chemring Group plc an unmissable buy after 45% profit growth?

Roland Head looks at the upside potential for Chemring Group plc (LON:CHG) and considers a possible alternative.

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Sales rose by 26.5% to £477.1m at defence firm Chemring Group (LSE: CHG) last year, while underlying earnings rose by 45% to 10.3p per share.

Today’s figures are likely to be a relief for shareholders, who stumped up £80m in a rights issue last year. The good news is that this cash influx seems to have been successful. Net debt fell by 43% to £87.6m last year, while underlying pre-tax profits rose by 71.7% to £34m.

Does Chemring now offer a buying opportunity for investors, or is the firm’s recovery already priced into the shares?

More to come?

It’s worth putting Chemring’s turnaround in context. The group’s share price is still 60% lower than it was five years ago. This year’s underlying pre-tax profit of £34m is 73% lower than the figure of £125.6m reported in 2011.

Although Chemring’s profits may not return to historical levels for the foreseeable future, I believe that profits are likely to continue recovering for some time yet.

Alongside that recovery, cash generation also improved last year. Cash flows from operating activities rose by 115% to £76.4m, while underlying free cash flow was £44.4m, broadly in line with underlying operating profit of £48.5m. These figures suggest to me that Chemring will be able to continue managing debt and gradually rebuilding its dividend.

Analysts expect its dividend payout to rise to 3p this year, giving a prospective yield of 1.8%. Alongside this, underlying earnings are expected to rise by 15% to 11.2p, putting the stock on a forecast P/E of 15.

Although currency effects gave a boost to Chemring’s recovery last year, I believe the shares look reasonable value at current levels, and are likely to deliver further gains.

A bigger and better choice?

If you want to avoid the uncertainty of a turnaround situation, then one alternative to Chemring is sector heavyweight BAE Systems (LSE: BA).

The firm’s shares have risen by 20% over the last 12 months, partly because the weaker pound has provided a significant boost to the value of BAE’s US dollar revenues. Management guidance is for underlying earnings growth of 5%-10% this year, which gives a figure of about 40p per share. Analysts expect the group’s dividend to rise to 21.3p.

At the current share price of 600p, these forecasts give BAE a 2016 forecast P/E of 15 and a prospective yield of 3.5%. A similar level of earnings growth is expected for 2017.

Is BAE a buy?

BAE made good progress on a number of fronts last year, signing a £2.1bn Typhoon support contract and beginning work on a major submarine project for the Royal Navy. But it’s worth noting that the group’s order backlog fell slightly during the first half of last year, while net debt rose to more than £2bn.

As a shareholder myself, I’ve no plans to sell. But I paid much less for my shares, which gives me a higher dividend yield. At current levels, the stock looks fully priced to me. I plan to wait for a better buying opportunity before adding to my holding.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares of BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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