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Should You Buy Chemring Group plc After Its 40% Collapse?

Shares in defence company Chemring (LSE: CHG) have slumped by as much as 40% today after the company released a profit warning. It now anticipates that underlying profit for the year to 31 October 2015 could be reduced by £16m to £33m as a result of the potential for a delay to revenues from the 40mm ammunition contract announced on 14 September 2015.

This is despite significant progress having been made with the contract, with Chemring awaiting the receipt of the necessary permits and export approvals associated with the contract. As such, there is a realistic prospect that Chemring will be unable to recognise the revenue associated with the contract in the current financial year.

As a result of the above, discussions will be held between Chemring and its debt providers to negotiate amendments to the operation covenants and the waiver of any event of default that may result from the contract delay. Furthermore, Chemring is also proposing a rights issue of £90m in Q1 2016 which has been fully underwritten.

Clearly, today’s news is hugely disappointing and the short-term outlook for Chemring appears to be extremely challenging. In the short run, the company’s shares could come under additional pressure if there is further delay with the contract, while the outcome of discussions with the company’s lenders is a known unknown.

Despite this, Chemring has a relatively appealing order book, with 75% of expected financial year 2016 revenue already having been secured. And, while the contract delay is clearly disappointing and has caused investor sentiment to decline, it remains a delay rather than termination at the present time.

The problem for Chemring, though, is its relatively high levels of debt. As the company states in today’s update, managing its debt has required significant time and resources which could have been better spent elsewhere. Therefore, the company’s decision to raise £90m via a rights issue and pay down its debt appears to be a sensible one for its long term future – especially as monetary policy is likely to tighten in the coming years.

Looking ahead, the outlook for the global defence market is relatively bright. Chemring views the situation for US defence spending as being more positive than it has been for some time and, while ‘slow recovery’ may best describe demand for the countermeasures and sensors markets in which Chemring specialises, it remains well-placed to benefit from any upturn in defence spending across the globe over the medium term.

Certainly, Chemring has long-term growth potential and its order book for 2016 appears to be strong. However, more information is required on the status of the delayed contract to merit investment, while Chemring’s capital structure clearly needs attention, which is being undertaken via a rights issue. Therefore, it appears to be a stock to watch, rather than buy at the present time.

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Peter Stephens 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.