The past few years have been tricky for defence contractors as spending in key Western markets plummeted due to constrained budgets and the slow trailing off of major involvement in Afghanistan and Iraq. But positive results released today by Ultra Electronics (LSE: ULE) show that the future is beginning to look quite bright for some defence firms.
For Ultra, the key is an uptick in spending by big customers as well as a diversified line of businesses that are well placed to benefit from major growth areas such as remote surveillance and data security. In 2016 the increasing popularity of these segments together with the effects of acquisitions boosted the firm’s revenue by 8.2% year-on-year.
And this doesn’t look like a one-off event either as the company’s order book rose 6% during the period to stand at £799m. I reckon this will continue in the long run as the group’s second largest division, its communication and cyber security business, looks set to be a major winner in the years to come. As cyber warfare becomes an increasingly big worry for corporations and governments alike, firms such as Ultra that provide communication encryption, critical computer system protection and cryptography equipment are set to benefit for many years to come.
The company’s management team is also a major asset. Rather than diversifying into non-core business areas or making huge acquisitions, management has kept it focused on core competencies, steadily improved margins and maintained a healthy balance sheet with net debt down to 1.76 times EBITDA at year-end. As defence spending in Western countries once again rises, I reckon Ultra is an attractive option at 14.3 times forward earnings while offering a 2.35% dividend covered 2.8 times by earnings.
A lesson in what not to do
For an example of why management teams are so important we have to look no further than fellow defence contractor Chemring (LSE: CHG). During the boom years (for weapons manufacturers, at least) of the twin wars in Iraq and Afghanistan, the sky seemed the limit for contractors. Chemring’s former management team went on a debt-fuelled acquisition spree befitting the animal spirits of the time.
However once the bottom fell out on this market the company was left with a slew of struggling businesses, mounting losses and a boatload of debt. Thankfully it has learned from these mistakes and after a dramatic restructuring and £80m rights issue is finally beginning to turn the corner.
Full-year results released late in January showed revenue jumping 16.7% year-on-year on a constant currency basis, underlying profits rising 25% and net debt halving to £65.2m. It was also good to see underlying operating margins rising from 9.1% to 9.7% as management reorganised certain businesses, cut costs and emphasised cash flow.
The turnaround is still a work in progress but the company is certainly headed in the right direction. That said it remains highly valued at 17 times forward earnings and before I’d begin a position I’d wait to ensure Chemring can post at least two or three periods of positive momentum after such a long history of underperforming.
Investing in an appealing turnaround story is a high-risk, high-reward situation that wouldn’t be out of place in the Motley Fool’s latest free report, The Worst Mistakes Investors Make. This report is a great refresher for all investors on the common errors we all make that stop our portfolios from performing as well as they can.
To discover if you’re making any of these mistakes, simply follow this link for your free copy of the report.
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.