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Is Chemring plc A Buy After Dropping Like A Bomb Yesterday?

Share prices for defence manufacturer Chemring (LSE: CHG) dropped by a third yesterday after an unexpected announcement from management that a proposed £100m deal to supply ammunition to Middle Eastern countries has been postponed to next year. The delay of this contract meant that the company lowered profit expectations by £16m to £33m for 2015. 

Additionally, Chemring announced a £90m rights issuance to help pay down the company’s staggering debt load. With revenue last year of £356m, debt as of the end of October is estimated by management to be a whopping £155-165m. With interest payments of £15m in 2015, the debt load has meant that the company has been constrained in re-orienting plans for future growth.

While dilutive for current shareholders, the rights issue will be a significant benefit for the company going forward when lower debt obligations will allow the company to focus on badly needed restructuring plans. Management does have a strong record of focusing on drawing down debt levels, with net debt falling from £248m in 2013 to current levels, signalling a competent head office

Even after dealing with the debt issues, Chemring still faces very significant headwinds over the medium term. The U.S. Department of Defense is the company’s single largest customer and the United States market compromises just shy of 60% of revenues. While the proposed budget deal between Congress and the White House restores very moderate defence spending increases over the next two years, Chemring should certainly not expect the sky-high sales it once booked at the height of the Iraq and Afghan Wars. 

Growth areas for the company remain limited as its most profitable and highest margin sector, Sensors and Electronics, is forecast to continue shrinking as the US and UK governments no longer buy mass quantities of Improvised Explosive Device-detecting equipment, which were needed during the Iraq and Afghan conflicts.

While Chemring’s future remains tied to shrinking defence budgets in the developed world, other firms such as Cobham (LSE: COB) have been diversifying into other product lines to dampen the impact of defence spending slowdowns. Since 2011, Cobham has increased commercial sales from 27% to 39% of revenue by expanding into high-end component manufacturing for the telecoms sector.

While Cobham and Chemring have both been stung by eight successive years of shrinking US defence budgets, I foresee Cobham being a stronger play for long-term investors going forward due to its diversification into commercial sales, strong 3.65% dividend, and defence-related products that are less reliant on direct combat use than Chemring’s.

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Ian Pierce 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.