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For now defence-orientated firms are holding up much better than aerospace specialists  
Thursday 16 Apr 2020 Author: Tom Sieber

On 19 March NATO secretary general Jens Stollenberg made a plea for allies to maintain defence spending despite the significant economic costs associated with the coronavirus crisis.

The simple fact he was even making this statement reflects a genuine fear that expenditure in this area will be cut as public finances become more strained.

This would have clear implications for the defence sector. Because of the significant crossover in the skills and expertise required, many companies operate across the spectrum of defence and commercial aerospace and index provider FTSE combines the two in its sector classification.

However, looking at the FTSE 350 firms which sit in this classification there is a clear delineation between those which are principally focused on aerospace and those which specialise in defence.

DIVERGING FORTUNES

The table offers a rough guide to companies’ defence exposure and shows their share price performance year-to-date.

While defence-orientated firms have seen their shares hold up reasonably well through the market turmoil, aerospace specialists have struggled.

This makes sense. The latter category of businesses serve the big plane manufacturers like Airbus and Boeing which are currently suspending production at assembly plants to protect workers. The customer base for new planes – global airlines – are facing an indeterminate period of virtually zero demand with their fleets grounded.

The long-term implications for how coronavirus will impact air travel demand is hard to gauge but even if the huge drop in passenger numbers proves to be short term, it will have a lasting impact.

Planes and individual parts will not need replacing as soon as expected given the reduction in flight hours and those airlines which do survive will have more limited capability to invest.

This has particular implications for Rolls-Royce (RR.) which derives a substantial chunk of its income from spares and repairs-type agreements linked to its installed base of Trent-series engines.

WILL DEFENCE BE DEFENSIVE?

Investment bank Berenberg believes defence should, in relative terms, prove a safe haven amid the coronavirus with, in its view, the impact limited in the immediate future to ‘operational disruption because of containment or disruption measures’.

It adds: ‘Over the longer term, the fundamentals of defence are unchanged: 1) spending globally, and more importantly in the US, remains at an elevated level compared to history; ‘2) an increasing number of militaries are undertaking major equipment modernisation plans; and 3) global strategic threats are undiminished.

‘Order books and win rates remain high with current business underpinned substantially by long-term contracted and committed programmes.’

While this argument has some merit, there are reasons investors shouldn’t be complacent about the prospects for defence firms.

Dominant name BAE Systems (BA.) certainly isn’t taking anything for granted judging by its most recent trading update (3 Apr).

While it didn’t see any coronavirus impact in the first quarter, it has seen ‘more significant disruptions’ going into the second quarter. Payment of the full year dividend has been deferred (not cancelled yet) with an update on the payout promised alongside first half results on 30 July.

It is also taking measures to conserve cash, though it is pressing ahead with the $2.2bn acquisitions of the Collins Aerospace military GPS business and Raytheon airborne radios division with financing for these deals already in place.

ACTIONS BY OTHERS

On 14 April, Ultra Electronics (ULE) deferred the payment of its full year dividend of 39.2p even if it had not yet seen a deterioration in trading, and countermeasures specialist Chemring (CHG) reported all of its businesses remained open and kept its own full year payout in place. On 25 March tech and equipment supplier Avon Rubber (AVON) announced the award of a body armour contract that could be worth up to $333m over its three and a half year term.

In a blog post for think tank the Atlantic Council, security experts Christopher Skaluba and Ian Brzezinski write: ‘There will be pressure to shift financial priorities to address the fiscal and health consequences of this pandemic, which could sound the death knell to the 2014 Wales defense investment pledge in which NATO nations recommitted to spending an equivalent of 2% of gross domestic product (GDP) on defense.’

Given many defence programmes tend to be multi-year affairs it may take time for the impact of the coronavirus to feed through.

As the chart on US defence spending shows, expenditure continued to grow in the immediate aftermath of the 2007/08 global financial crisis with the cuts only coming through in 2012 and 2013 – though this also reflected the dialling down of US commitments in Iraq and Afghanistan.

FINDING GROWTH ELSEWHERE COULD BE TRICKY

Another factor to consider is that spending in other markets, notably the Middle East, made up for cuts in Europe and the US in the wake of the financial crisis.

With the economic impact of coronavirus more widespread and with Middle Eastern countries in particular exposed to the collapse in oil prices, these markets seem less primed to provide an alternative source of growth this time round.

Prior to the full impact of coronavirus becoming apparent we argued BAE shares were worth buying on the basis of growing exposure to the world’s largest defence market in the US and to areas of priority like weapon systems and secure communications.

With the shares now at a cheaper price we remain positive on the long-term story. However, investors may have to accept some deterioration in the outlook.

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