Investment extra: Picking defence shares
The dust may have settled on the Defence Sector Review but companies and investors are still none-the-wiser as to what it means so be wary, says Investment Extra's Ian Lyall
QinetiQ: Which makes open-wind tunnels to test jets, could be affected by the cuts
The dust may have settled on the Defence Sector Review but frankly companies and investors are still none-the-wiser as to what it means for the industry.
It may take weeks, possibly months, before the main operators know exactly where the Whitehall axe will fall. The fine detail of the headline 8% cut to the Ministry of Defence's £40bn budget will be found in a preliminary report, or green paper to be published by the end of the year.
After a period of review and consultation that will take us well into 2011, the government's formal white paper will set out spending guidelines for the next five years.
Until then it is just a guessing game, as these comments from Leo Quinn, boss of defence contractor QinetiQ, confirm.
'Orders have been delayed or cancelled, not just for us but for the industry,' he told the Mail.
'We've got the green paper by the end of the year and in spring we get the industrial policy paper. Until then it is too early for anyone to guess what the effect (of the cuts) is.'
That said, the early shake-out suggests there will be some obvious winners and losers.
Goldman Sachs has done some research and believes companies with exposure to the recovering civil aviation market such as Rolls-Royce may do better than a pure-play defence stock such as BAE Systems.
That said, the case for Rolls may be open to question following the grounding of a fleet of A380s fitted with the company's Trent engine.
Goldman has also stuck Cobham, the electronics firm, on its buy list. It says the group has the capacity to grow revenues by around 5% a year even in this difficult market. Shares in both the companies are among the best performers in the sector over the industry cycle of four to five years.
By far the biggest under-achiever in stock market terms at least is the aforementioned QinetiQ, both in the year to date and over the five-year period.
'Defence budget spending cuts in the traditional western markets have divided the defence sector into winners who have diversified export to other global regions such as Rolls-Royce and losers who have not done so,' says Daniel Harris of H20 Markets, whose analysis broadly mirrors that of Goldman.
'QinetiQ is among the latter, and is set to be hit by western defence budget spending cuts.'
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However the company's problems are also partly the fault of mis-management of the previous directors.
Its ailments are being progressively worked on by company doctor Quinn, who joined a year ago. Under his guidance I think they could actually be the surprise package of the sector – a recovery play. Quinn already has a head start on the painful cost-cutting that many of his rivals are currently contemplating.
His efforts thus far – six months into a two-year programme – were there to see on Thursday when the company published its interim results.
Underlying pre-tax profits rose 14% to £51.6m, helped by bumper sales of Q-NET, a Kevlar net that repels rocket launched grenades which is being used in Afghanistan.
Net debt, meanwhile, is already below management's target of two times EBITDA, which will allow the firm to restore dividend payments in the next six months.
The collective bargaining agreement Quinn recently negotiated will allow him to shrink its workforce by 10% over the coming years.
QinetiQ shares are the cheapest in the sector, valued at seven times 2012 earnings.
The current price of the stock reflect the mistakes of the former management and the so-called execution risks associated with Quinn's strategy.
His tenure so far has been characterised by taking the tough decisions and getting them right.
If you buy QinetiQ shares you are effectively putting your faith in Quinn and his senior management team.
But based on the chief executive's track record, particularly at De La Rue where he took the banknote printer by the scruff of the neck and gave it good shake, you may be backing a winner.
OUR VERDICT: QinetiQ is undoubtedly an interesting recovery play.
But with the uncertainty of defence cuts set to be a sector-wide depressant, this is perhaps one for the watch list for now.
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