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Aerospace & Defence - This is a sector of two halves. With oil price and security fears sky-high, and consumer confidence at rock bottom, civil aviation is struggling while the defence industry is booming. This week’s report looks at how investors can navigate these cross currents

The aerospace & defence sector is a tale of two cities. Though 14 stocks are lumped together in this segment, there is a broad spectrum. Some are totally defence, such as Chemring and BAE Systems, while others are largely civilian aerospace such as Meggitt, Umeco and Aero Inventory.

The rest are a mixture of the two, epitomised by companies such as Cobham, with a near-50:50 split. Its recent full-year results showed earnings up 6% to 12.1p a share which should rise to 14.4p this year and 15.8p in 2009.

The crossover company

Cobham has a broad spread of activities. Avionics and surveillance sales jumped 18% last year, driven by civilian satellite communications equipment and government-related intelligence agencies. Defence electronic systems rose 8% on the back of warfare systems equipment for US F-22, F-18 and F-16 aircraft programmes plus some US armoured cars. Mission systems is largely air-to-air refuelling, and sales rose 14% while aviation services advanced just 3%.

Cobham’s shares have outperformed the FTSE All Share by 16% over the past year. Generally the closer the company is to the consumable end of passenger planes the worse its performance has been this year. The recent slowdown in aviation growth means sales of many aeroplane parts could stagnate or even fall over the next 18 months. Rolls-Royce shares have dived 27%, so far this year as have Aero Inventory.

Aero shares went into reverse three weeks ago when the inventory management company announced a possible bid approach from a private equity company. The shares then rallied by almost a quarter. Most of Rolls’s money comes from selling spare parts for its jet engines. Aero’s profits are also dependent on spare parts volume. Two-thirds of Meggitt’s sales and profits come from aerospace equipment, of which a big chunk is brakes, wheels and tyres for passenger planes.

Airline-linked shares bashed

Nick Cunningham, aerospace & defence analyst at Evolution Securities, expects the de-rating of Rolls and Meggitt to continue. Share price ratings fell from nine-times earnings before interest tax depreciation and amortisation (EBITDA) to five-times EBITDA at the bottom of the past aerospace cycle. He says the 50% rise in fuel prices is crippling airlines, which will have to raise prices by at least 20%, causing a sharp double-digit percentage fall in passenger numbers. He reckons the plane-building cycle will peak in 2010, with 1,100 planes built.

So not only after-market suppliers will be affected. The worst-case scenario is that hundreds orders received by Boeing and Airbus will be deferred (the euphemism used by the companies instead of cancellation) as no money changes hands until construction starts.

Boeing’s B787 Dreamliner is still expected to be the most successful new plane ever launched, with 900 ordered to date. Airbus has won 189 orders for its troubled A380 jumbo and 370 orders for its successful but marginally profitable A350. Some analysts expect a third of these orders to be cancelled if the oil price hangs around the $150 a barrel for any length of time. After all 25 US airlines, mostly small ones, have gone bust in the past year and several large ones are in Chapter 11.

Economic problems in the US and the UK have led to a sharp slowdown in trans-Atlantic traffic, with worse to come, as flights now cost an extra 10% due to new fuel surcharges. Western airlines are more likely to cancel orders than Asian ones.

Some say such is the need for new planes in the Far East that the aviation boom will not disappoint. ‘Airbus and Boeing say privately that they expect some cancellations and have taken this into account,’ says Clive Forestier-Walker of Numis Securities. He points out that long-term growth in aviation averages 5% a year and there is little reason to suppose this will change much over the next decade or two.

However, A380 orders are running two years behind schedule and suppliers have been squeezed to cut costs. The Dreamliner is more than a year late. No orders have yet been handed out to machine tool makers to build the machines that fabricate crucial parts.

Hampson Industries is a key player. Its purchase of Odyssey and GTS in the US makes it the world leader in manufacturing tools to construct composite parts such as fuselages. Over half of new-generation jets will be made from reinforced plastic that is lighter and cheaper than aluminium.

The Dreamliner is supposed to start production this year or early in 2009. It won’t because Hampson has not received confirmation to build the tooling machines, which is the first step in the process though it is simply a matter of time, says the company.

Defence stocks hold firm

There is also a bit of a boom in defence despite the credit crunch and economic slowdown. Global defence spending has rocketed 45% to £665 billion over the past decade, led by the US which accounts for just over half the total.

UK companies of any size are deeply committed to the US, usually with large subsidiaries there. Also, British industry became the world’s largest exporter last year selling £10 billion abroad.

Most governments are still increasing spending especially on homeland security despite budget pressures. Revenues jumped 12% last year to a record £38 billion with almost half of sales in the US.

The acquisition drive into the US is expected to continue, with a record $7.5 billion spent last year most of it by BAE, which paid $4.5 billion for Armor Holdings on top of the $2 billion spent on United Defense Industries in 2005.

Smaller companies have also gone shopping in the US encouraged by the 17% fall in the dollar. Hampson, Cobham and Chemring have bought this year, with more expected.

The aim is to become local suppliers to ensure more orders from the Department of Defense, which is lifting spending from $630 billion in 2007 to $690 billion this year.

But only 7% of US spending went to foreign companies though, this should continue to rise. US spending is unlikely to fall as both political parties and presidential candidates support the industry, military costs are increasing along with global security fears and the US can afford to maintain spending.

However, dollar depreciation is a double-edged sword as it reduces profits when converted into sterling. Most UK defence companies derive half or more of their earnings in America.

Growth opportunities are also rising in places such as Australia, India and the Middle East, though top defence sector publisher Jane’s Information Group has warned Saudi Arabia might buy much more from Russia as relations between the two have warmed.

‘We expect the good times to continue as these are cash-rich companies that can afford to invest in both organic growth and acquisitions,’ said Jane’s in a recent report. ‘Defence budgets are separate from consumer spending cycles and should remain largely immune.’

Cash-rich

The financial strength of aerospace & defence is impressive. Financial information provider Hemscott says the sector’s net gearing is just 2% compared with 89% for the whole stock market. This does vary hugely from cash-rich giants such as BAE and Rolls-Royce to highly-geared outfits such as Croma, Chemring, Hampson and Meggitt.

Global spending on anti-terrorist measures or homeland security is expected to rise nearly 10% a year. This is especially good news for companies such as Qinetiq and also several companies not usually considered defence plays such as Datong and Logica.

Datong supplies intelligence-gathering systems to governments, especially the US. Logica sells software to EU defence and security establishments.

But being in defence does not automatically result in share price outperformance. BAE and Ultra Electronics have underperformed the broader market by some 6% in the past three months – better than Rolls-Royce at 14% and Meggitt down 20%.

Top of the list is a handsome outperformance of 43% by Hampson, following better-than-expected full-year results and earnings upgrades, and Smiths Group in second place with an 18% relative rise in its share price in the past quarter.

Key indicators

The economics:

• US & UK government defence spending

• Global economic growth

• Attacks by Al Qaeda

• Sino-American relations

• Oil price

• Airline cost-cutting

Sector facts & figures

Number of companies: 14

Main market: 11

AIM: 3

Sector PE: 11.5

Prospective yield: 3.4%

TOP ANALYSTS

Clive Forestier-Walker – Numis Securities

Old hand

Five-star rated aerospace analyst Clive Forestier-Walker recently stepped down from head of research at Numis Securities citing his age. ‘I am old enough to have got my free bus pass but still enjoy covering the aerospace & defence sector.’

Forestier-Walker knows his subject matter having seen fighting first hand during his 22 years in the Coldstream Guards. His first City job was with Kitkat & Aitken 22 years ago and he has been at Numis for the past five years. He is optimistic long term about civil aerospace while admitting that soaring fuel prices will see US airlines lay off planes.

‘This cycle is very different as it is driven by new markets for the first time,’ explains the analyst. ‘Far Eastern airlines need the planes and the manufacturers have a six-year order book which is unprecedented. The last downturn was 9/11 but the market picked up quite quickly. Share prices are perhaps too low as this is a real growth market. History shows a 5% annual growth pattern.’

Citing US defence spending up 9% for 2009 Forestier-Walker remains bullish and adds that spending ‘won’t slow down by much’. He expects the more service-oriented companies like VT Group and Babcock to thrive on tight budgets as they are ahead of US companies on private finance initiatives and taking out costs. His ‘naps’, or favourite buys, are BAE Systems, Babcock and VT Group.

Nick Cunningham – Evolution Secs.

Best defence

Cunningham has been an analyst for 21 years and joined Evolution just last year after spending two years at Panmure Gordon. He obtained an MBA from Warwick in 1984 and then spent two years at HM Treasury before moving to Laing & Cruickshank as an engineering analyst. Subsequently Cunningham worked for Société Générale and BZW before moving to Salomon Brothers (latterly Citigroup) in 1997, where he spent eight years as head of the aerospace & defence team.

Cunningham is probably the most bearish analyst on the civilian aerospace sector: ‘This is a credit crunch-induced recession but it is the huge rise in fuel costs which is the really big issue. Airlines can’t cut costs enough and will have to raise prices much more.’

Many more planes are likely to be parked or mothballed for several years. The major US airlines are cutting capacity by an unprecedented 11% in the fourth quarter of this year.

Cunningham says there are too many aeroplanes and expects big cutbacks to both the existing fleet and new orders at Boeing and Airbus. He expects a 50% fall in production to maybe 600 planes built per year from a peak in 2010 and points out that the worst crisis in 1968-71 saw deliveries slump 70%. Lockheed and Rolls-Royce almost went bust.

‘Only a big fall in the oil price will save the airlines and it will have to happen this summer,’ predicts the analyst.

He recommends BAE Systems and Ultra Electronics.

Adrian Murray – Exane BNP Paribas

Fuelled up

Rising fuel prices create a gloomy outlook for airlines believes Adrian Murray at Exane BNP Paribas. The analyst, who joined Exane two years ago having started his City career in 1993, adds: ‘Bulls say there is a seven-year production backlog at Boeing and Airbus but these orders can be cancelled or deferred.’

The airlines most likely to defer are the start-ups that can’t get cash. Most airlines are operating on a for-cash basis due to spiralling fuel prices. This emergency procedure cannot last too long or many more will go bust.

The latest generation aircraft consume around 25% less fuel than planes built in the 1980s. But many airlines don’t have enough cash to finance new planes. The UK’s leading airlines, Ryanair and easyJet, are well placed with their fleet of modern planes and robust finances but they are no longer planning to buy more planes.

Murray, who prior to Exane spent three years at Cheuvreux Research which is part of the Credit Agricole-owned corporate and investment bank Calyon, is more optimistic about Rolls-Royce than Cunningham. ‘Rolls grew its after-market sales by 10% a year during the last downturn despite a 30% cut in new engine orders. This time around there are twice as many Rolls-Royce engines installed which should provide protection.’

The defence side offers investors considerable protection (like Forestier-Walker he favours defence over civil aerospace) but Murray is concerned about increasing US protectionism.

BEST BUYS

BAE Systems – Dodged a bullet

The American investigation into bribery allegations at BAE systems is more of a nuisance than a negative, says Nick Cunningham analyst at Evolution Securities: ‘If BAE is found guilty as a corporate it may have to pay a fine though it is difficult to imagine that being very large in the context of BAE’s £16 billion market capitalisation and £1 billion of net cash. If BAE directors are found guilty as individuals they could go to jail.’

The only really serious consequence is exclusion from US contracts or being barred from making more purchases. This has not happened with BAE buying Armor Holdings and winning more large armoured vehicle contracts. Indeed the chief financial officer of Boeing went to jail for attempting to bribe a Department of Defense official who also went to jail. But Boeing has not suffered loss of contracts.

Cunningham is a BAE bull, forecasting earnings per share zooming from 31p last year to 37p this year and nearly 42p in 2009 slashing the price/earnings ratio to 10.5. He expects earnings growth to be strong through to 2015 boosted by more acquisitions. BAE lifted its cash pile to £730 million net of debt at the end of last year and could finish this year with more than £2 billion as it is generating over £1.5 billion a year, says Cunningham. His target price is 605p against the current 440p. There is a useful dividend yield of 3.3% this year which will hit 3.6% in 2009.

The key appointment of chief operating officer Ian King as chief executive to replace Mike Turner is welcomed by Cunningham as a sound choice though he was surprised a US executive was not chosen in light of BAE’s growing Americanisation.

Qinetiq – Free as a bird

Qinetiq has now nearly transformed itself from a UK government-based military research entity to an ambitious commercial company with a robust growth strategy, as Numis analyst Clive Forestier-Walker says in his new note.

Major shareholder US private equity firm Carlisle has sold its remaining shares removing a major overhang and the government is also selling its 19% stake. Qinetiq is well placed to grow faster than many of its defence peers as it specialises in high-tech solutions to tricky military and security problems and the City is waking up to its attractions.

The massive reorganisation the company has undergone in the last two years has achieved far greater commercial focus and won new investors. Analysts have consistently upgraded their profit forecasts since Qinetiq unveiled better-than-expected first-half figures last September.

The shares have responded, rising from a low of 165p and there is every chance they will finish 2008 up a further 20% as the target of long-term double-digit annual earnings per share growth becomes increasingly credible.

The key US operation, with 40% of turnover, has gained critical mass with sales topping $1 billion and organic profits growth of 18%. The Talon robots line is going from strength to strength due to roaring demand for bomb disposal equipment in Iraq and Afghanistan. More than 800 were shipped in the first half bringing the total to over 2,000 in Iraq and Afghanistan.

VT Group – Moving targets

Hampshire-based VT Group was known as Vosper Thorneycroft until 2002, when a shift in strategy away from the firm’s shipbuilding roots and toward civil and defence support services was initiated. VT Group has just merged its Portsmouth shipbuilding operations with BAE Systems’ Glasgow-based yard retaining a 45% stake that it can sell to BAE for a minimum of £380 million.

Any cash released by a sale will probably be recycled into bolt-on acquisitions as the FTSE 250 company develops the facilities management, fleet support and logistics services provided by its four divisions.

A £6 billion order backlog provides an excellent base, with VT confident of winning more contracts after being named the preferred bidder to provide flying training for the navy, airforce and army. Additional contract wins, notably in waste management, nuclear decommissioning and Private Finance Initiative (PFI) programmes such as Building Schools for the Future (BSF) will enable it to switch from an aerospace and defence to a support services stock. This sector trades on a prospective price/earnings multiple of 20, compared with VT’s 15 providing plenty of upside with a 750p target price.

STEER CLEAR

Meggitt – Short and sweet

There is still plenty of money to be made going short on lacklustre Meggitt. A consistent underperformer for more than two years – the shares peaked at 382p in early 2006 – Evolution Securities analyst Nick Cunningham has a 155p price target compared with the current 210p but reckons the shares could crash as low as 73p in 2010.

The mega acquisition of K & F Industries for £900 million in the US a year ago doubled the size of Meggitt making it number one in aircraft landing gear, tyres and braking systems with its Dunlop offshoot.

Original equipment is typically given away or delivered at a loss. But Meggitt capitalises such losses. It has also spent plenty on restructuring its operations every year for almost the last decade. This means such costs should be in the profit and loss account and not charged as exceptional items below the line.

If Meggitt’s earnings are adjusted to take into account these two discrepancies it slashes EPS by around a fifth. Furthermore, Meggitt has also lifted gearing to an uncomfortable 77% or £800 million, plus a £150 million pension deficit. It also meant group earnings were dominated by civil aerospace at just the wrong time in the cycle. As the de-rating cuts the group’s enterprise value the debt and pension deficit stay the same, slashing equity value. This is the negative effect of such high gearing. With the trough multiple in a civil aerospace downturn typically less than five times EV/EBITDA this means the shares could collapse a further two thirds.

Aero Inventory – Prospects sour

Doubts are surfacing whether the private equity player will make an offer at the hoped-for price of £7 a share or indeed whether it will make an offer at all. So Aero shareholders should sell while they still have the opportunity as the price will probably slump to near 400p compared with the current 570p without bid hopes. The problem for Aero is that a big decline in flights by its customers Quantas, All Nippon Airways and ACTS also means a ratcheted negative gearing as so much money is tied up in stock much less of which will be consumed. Though the sharp fall in Aero’s share price from a peak of 723p eight months ago sparked the approach, few private equity players will want to take on a business where profits could drop by half over the next two to three years unless new contracts are won. Net debt is expected to rise rapidly from the current 37% gearing.

Umeco – Shifting focus

Umeco has sharply changed its make up by buying several companies making plane parts from composite materials. This lessens its dependence on supplying Rolls-Royce with spare parts. It has also sold some of its underperforming activities such as chemicals distribution and repair and overhaul.

However, the distribution arm will still account for a quarter of profits going forward. The aerospace parts side is well positioned to make the wings for the next Airbus generation of planes but this is a decade away. Shorter term if Airbus and Boeing suffer a big order downturn then Umeco will feel the pain just as much. So, while profits should rise handsomely in the current year and to a slower extent next year, the going could get very sticky in 2010. On a prospective price/earnings ratio of 12 this year and 11 next year don’t make the mistake of thinking the shares are cheap.

RISING STAR

Further success included in the Price

David Price has looked to the huge and growing US market to continue Chemring’s expansion

The growth of Chemring over the past decade owes as much to David Evans as to his successor as chief executive, David Price, appointed early in 2005.

Profits amounted to about £2 million in 1999. This year they will jump by around half to £75 million. The group is the star performer in the sector in the past decade, with its share price joining the ‘ten-bagger’ club, up from £2 to £24.

David Evans’s forte had been growing the US business, which accounted for almost 50% of sales and profits in the first half. He made way for the younger Price, who has already moved Chemring to the FTSE 250, is set to take the company to the premier division.

Clear path

Price was educated at University College, London and is a fellow of the Institute of Electrical Engineers (IEE) and the Institute of Marine Engineering, Science & Technology. He was elected to the Defence Manufacturers Association Council in 2006, and to the Defence Industries Council in 2008.

Spanning 25 years, his career in defence contracting began in research and technical roles with EMI and Thorn-EMI. For the past ten years, Price has taken on several managerial and strategic roles, first with Thomson CSF (as chief executive of Missile Electronics, then managing director of Thomson UK Holdings). More recently, as managing director of Naval Marine Business for Rolls-Royce, the 53 year-old was responsible for managing a global business with a turnover of more than £450 million a year and his goal is to make Chemring one of the largest global players in the hugely fragmented ordnance, ammunition and pyrotechnics industry.

Collectively known as energetics, this sector – which Chemring has adopted as a divisional name – is worth $13 billion a year and is growing at around 3% a year.

The rise and rise of Chemring has until recently been based on its intellectual property on counter-measures or anti-missile defence devices. These are usually an array of different types of flares that decoy the rocket away from the target or make it explode harmlessly. A bit of luck was needed. Chemring was expanding fast in the US in 2000 and its new factory was up and running by the time the Afghanistan and Iraq wars started. Demand from the US Department of Defense almost quadrupled within two years and is still rising, with revenues up 21% in the first half though profits rose just 7%.

Explosive Energetics

Price, a married father of two, is the main man behind the explosive growth of the Energetics division. It was just 10% of the group in 2004, has grown to account for 60% of sales this year, is expected to rise to 70% next year and 80% in 2010. First-half growth was 64% – much of it from acquisitions, though organic growth contributed around 20%. Price and his team have pulled off 11 acquisitions in the past three years spending more than £200 million, funded 60% debt and 40% equity, transforming Energetics into a big earner.

Last month Chemring replenished its balance sheet, raising £60 million to help fund the US purchases of Martin Electronics – a specialist manufacturer of ammunition, fuses, signalling and other pyrotechnically activated devices for use in the defence sector, and Scot, which makes cartridge-actuated and propellant-actuated devices. Both acquisitions will be earnings-enhancing. The beauty of the strategy is Chemring can snap up these mostly sub-$100 million companies on a much lower rating than its own. Also, Chemring can transform its acquisitions through its global sales organisation and management. It uses its greater borrowing resources to cut finance costs and expand the company much faster than it would otherwise have done. The net result is the first two companies Chemring bought in 2005 have doubled their profits, with the remainder expected to follow suit.

Chemring will also spend another £200 million by 2010 and £200 million again over the following two years if all goes to plan. Not everything, however, has always gone to plan.

The big US ammunition and ordnance factory at Simmel Difesa blew up last year. Its re-start has taken longer than expected but production of naval ammunition, where Chemring has global leadership, is back on track. The group order book has grown 45% to a record £425 million, making Clive Forestier-Walker at Numis Securities confident the group will grow turnover at least 20% a year over the next few years. The analyst forecasts earnings per share rising from 53p in 2007 to 76p this year, 98p to October 2009 and 112p in 2010, cutting the price/earnings multiple to 11.

30 second Chemring

• Founded 100 years ago

• Employs more than 2,500 people

• Has 19 locations in the US, Europe and Australia

• Valued at £770 million

• Spent more than £200 million on 11 acquisitions in three years

• Plans to spend £300 million over next three years

CHARTING THE SECTOR

Sobriety follows a four-year party

The UK government’s straightened circumstances reinforce a cooler economic climate

by Simon Griffin

Having been one of ‘the’ sectors to be invested in during the bull market of 2003 to 2007, when it comprehensively outperformed the wider market, growing by a factor of four, 2008 has brought a changed outlook. Having topped out at 3,697 in mid-October, the FTSE 350 Aerospace & Defence sector index has dropped by some 22% in value, a relative weakness of some 4% against the market in general.

Support broken

From a technical perspective, support close to 3,160, which capped the upside in the spring of 2006, then acted as support during 2007 and the spring of this year, has now been broken.

This leads to the belief that this index has produced a head-and-shoulders pattern, which targets a fall toward 2,600 (some 9.5% below current levels) and a zone where the index found support and resistance in 2005 and 2006.

Such a move would take the index down to test possible support from the Fibonacci 38.2% retracement of the four-year bull run at 2,650. The only solace for bulls, at present, is the proximity of the base line of the bear channel within which the index is now trading. Accordingly, in the short-term the index might produce a minor bounce, though it is not expected to rise above the ‘neckline’ at 3,157, coinciding as it does with the bear channel return line. While the sector might well be dominated by companies that enjoy government largesse irrespective of the wider economic outlook, for now it seems to be set to drift lower.

Hampson Industries (HAMP)

BUY - 163p

TARGET - 200p

STOP LOSS - 158p

Since the shares based at 120p in late March, they have outperformed the wider market by some 50% and at best, the FTSE 350 Aerospace & Defence sector index by more than 70%. This after a decline set in last autumn and saw the shares fall by some 42%.

The shares have traded from above their long-term bull channel to below it, achieving a degree of symmetry and, despite the gloomy stance of the wider market, latterly resuming their upward trend. Simple trend line analysis has been the best guide to these moves and as recent gains have gathered momentum it has become possible to draw in a new minor bull channel. Though the 200-day average initially resisted as congestion close to 160p came under attack, sharp rises in volume prompted further gains to test 183p and the return line of the minor bull channel. Now a correction to test support from the average and channel base line has been seen. Within the context of the longer run bull trend, this offers a low-risk opportunity to buy in as a tight protective stop can be placed just below the channel base line, perhaps at 158p, with the expectation that the bottom formation that developed over the first half of 2008 will produce further gains toward a test of the last October’s 207p high and a test of the longer-term bull channel return line.

Qinetiq (QQ.)

BUY - 192p

TARGET - 245p

STOP LOSS - 188p

The defence specialist’s shares remain below their original float price almost two-and-a-half years on: never good to see and the first traded price of 213p will be a big milestone to pass.

Yet they have proved a good hunting ground for trading opportunities and, since bottoming at 166p in September, have gained more than 26%, outperforming the FTSE 100 by almost 20% and the Aerospace & Defence sector by 25%, seeming to have produced a large upward-sloping right-angle triangle, bouncing off resistance near 205p, which has so far capped the upside.

Once broken above, this pattern would be expected to produce a move to 245p in due course on an aggressive projection. Such a move would be via 213p and the high of 219p, twice tested.

Currently the shares are testing support from the base of the triangle and the coincident 200-day average, a bull trade would now benefit from a close protective stop. Any move below 190p would put this scenario into touch and risk a drop initially to 183p, then possibly a retest of the low 160p zone.