Avon Rubber Plc, Chemring Group Plc, QinetiQ Plc and BAE Systems Plc: Is Now The Time To Buy Defence Companies?

Given the austerity policies of many governments during recent years and the tendency for cuts to fall first on defence budgets, one of the last places that investors will have probably thought to look for returns in the current environment is the defence industry.

With this and the sector’s recent share price weakness in mind, I’m going to look at some of the UK’s most loved — and unloved — defence companies.

Out of favour

Chemring (LSE: CHG) has seen earnings falling consistently since 2011, with the group swinging to a full year loss in both 2013 and 2014, prompting a sharp reduction in value for the shares throughout the same period.

However, consensus estimates now suggest that management could report their first profit for three years in December, with earnings per share anticipated at 14.2p.

If 2015’s results do mark the beginning of a turnaround for the group after five solid years of losses for the shares, Chemring could soon become one of UK aerospace and defence’s most attractive plays.

A strong performer

QinetiQ (LSE: QQ), the defence technology solutions business, has almost completely circumvented defence spending cuts, through its exclusive focus upon the commercialisation of intellectual property in small niche areas.

As with many defence businesses, the shares are probably more sought after for their stable characteristics than they are for any growth potential.

The key risk to further performance from the group is the government’s ‘more for less’ rules surrounding single source contracts, which could force QinetiQ into accepting lower margins in future periods.

For now, the group trades at 14.7x forward estimates for EPS in 2015 which, while not too demanding, still suggests a pretty full valuation in light of the lacklustre growth outlook over the near term.   

Limited gains

Avon Rubber (LSE: AVON) has built an impressive record for growth over the last 6-7 years, which has supported continuous gains in the share price since late in 2008

However, the group now trades on 20.8x the forward estimate for earnings in 2015, which is hardly cheap, even if earnings are growing at 10% per annum. This raises the question, how much longer can the shares continue to push higher for?

I can’t help but suspect that further gains may prove limited over the medium term, particularly if the full year financial results happen to surprise on the downside. There is probably better value elsewhere in the sector.

A steady-goer

BAE Systems (LSE: BA) is another company that has fared well throughout the downturn in defence spending.

In 2015, sales grew by 11% in the first half on favourable exchange rates and improved demand for Typhoon fighter equipment and services across Europe and the Middle East.  

The group’s forward order book also looks stable, if not healthy, with a number of new contract wins announced for the US business, in addition to a number of new orders from Egypt and Qatar.

This is while the F-35 program also continues to advance through various testing phases, which is reassuring, given that sales of this aircraft will comprise a considerable portion of BAE’s income in future years.

In the short term, consensus estimates suggest that earnings per share will rise considerably from 23.4p in 2014 to 36.79p in the current year, while the dividend is also expected to rise modestly from 20.5p to 21.0p per share.

These projections imply forward price/earnings (P/E) multiple of 12.37, which compares well against the average of 15.6x for US pure play defence companies, the nearest comparable group. The group is also likely to offer a yield of 4.6%, at current prices, which is covered 1.7x over by projected EPS.

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James Skinner has no position in any shares mentioned. 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.