Cutbacks Spur Defensive Diversification

Published in Investing on 15 August 2012

Defence shares show resilience.

Britain's defence companies aren't exactly beating their swords into ploughshares, but diversification into civilian markets is just one response to cutbacks in defence spending that typifies current trends.

That augers well for the long-term future of companies in the sector, dominated by FTSE 100 (UKX) giant BAE Systems (LSE: BA). With their technological strengths and diversifying geographic markets, defence companies are starting to resemble their successful engineering sector peers.

Strategy

There are three strands of strategy evident in the industry:

  • Greater emphasis on civilian markets, especially aerospace;
  • Diversification into non NATO markets;
  • Cost-cutting drives.

Those three measures have provided a good degree of protection from defence cuts. And they position companies well to benefit from buoyant demand for airliners (driven by growth in emerging market economies), cyclical recovery in economic growth (whenever that may be) and eventual upturn in defence spending, which is as inevitable as human conflict.

It may be contrarian to consider buying into the sector when CEOs generally gave downbeat assessments of the outlook during the recent round of half-year results. But the resilience of the industry in the face of a triple whammy of cuts sets it in good stead for the future.

Russian roulette

It's not just that austerity measures have forced governments to rein back spending. The gradual withdrawal from Afghanistan is ending a period of heightened military spending that started with the war in Iraq.

On top of that, a political impasse in Washington over how to implement spending cuts has left the US playing a kind of budgetary Russian roulette. 'Sequestration' essentially means that if budget cuts aren't agreed by next January then all programmes will get an automatic 10% cut. With elections in November, it's starting to look like it could happen. That has helped to stall defence procurement.

But no Russian sales

It's only Western countries that are suffering from debt-induced austerity measures. The fast-growing economies of the East and South are increasing military spending.

Like their civilian counterparts, defence companies are following the money with increased sales to India, Brazil, the good guys in the Middle East and those parts of South East Asia for which governments will provide export certificates. That rules out China, of course, and Russia. For defence companies, BRICs is spelt 'BI'.

Home advantage

With a £10bn market cap, BAE Systems accounts for over half the total capitalisation of the UK's defence companies -- not counting Rolls Royce (LSE: RR), which has always been more biased towards commercial aerospace.

BAE's size and importance gives it a home advantage in UK defence spending. Government policy recognises the concept of national champions in defence, and the company is the lead contractor on major projects.

Nevertheless, its exposure to US spending is significant. Apart from international sales, its diversification efforts are aimed at the aerospace sector and cyber security, where it has carved out an interesting niche.

Third leg

Meggit (LSE: MGGT) is the only other FTSE 100 defence company. It is best known for its aircraft braking systems, which make up 30% of revenues. Alongside its significant commercial aerospace exposure, it is developing a third leg in energy markets. It recently won a $100m order from Brazil's Petrobras (NYSE: PBR.US) with its technologically advanced design of a heat exchanger.

Cobham's (LSE: COB) market cap of £2.4bn puts it just outside the FTSE 100. The recent acquisition of Danish satellite communications company Thrane and Thrane has helped shift the business mix, which is heavily exposed to military sales.

Its core business is air-to-air refuelling, a market in which it boasts a 75% global share. That's a strategic gem, and something that makes Cobham a perennial candidate for takeover speculation. It announced at the half year that it would focus more on commercial aviation, which currently accounts for nearly a third of revenues.

All three companies are worth a close look, as are some of the smaller companies in the sector.

It often pays to look at trends across sectors, rather than just analysing individual companies. For other industries with potential, read 'Top Sectors of 2012', a free Motley Fool report that examines three attractive industries. You can download it to your inbox by clicking here.

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> Tony owns shares in Cobham but no other shares mentioned in this article.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

ScottishPound 16 Aug 2012 , 10:16am

QinetiQ (LSE:QQ.) is also worth a look as a company that is reducing its costs and diversifying.

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