The Cheapest Defense Stock

LONDON -- Since the financial crisis hit, defense stocks have not lived up to their reputation as defensive stocks. Austerity-driven spending cuts throughout NATO have been compounded by the rundown of the war in Afghanistan. Even FTSE 100 member BAE Systems (ISE: BA.L) has lost ground, dropping 25% since the beginning of 2009, during which the FTSE has risen 20%.

Chemring Group (ISE: CHG.L) , a long-time favorite of private investors, initially bucked that trend, with its shares nearly doubling. But the last year has been one of relentless decline, and disappointing half-year results last week sent the shares to a new low. At 293 pence, it's now the cheapest defense stock on the market, trading on a forward price-to-earnings ratio of 5.7, compared with 8.3 for the sector. Investors are punishing bad news severely in this nervous market, but in this case I think the reaction has been overdone. With a burgeoning order book, there is every chance that Chemring can recover lost territory. If so, then now is a great time to buy.

Delays in signing orders, rather than cancellations, were the main cause of Chemring's poor first-half performance. Chemring makes equipment that detects and disarms improvised explosive devices, countermeasures such as flares and chaff, munitions, and pyrotechnics for the military market. A large contract for counter-IEDs to be fitted to the U.S.'s Husky bomb-detection vehicles was delayed beyond the period end by budgetary constraints. That starved the first half of revenue, profit, and cash flow. But the delayed contract was signed just days into the second half, and the company remains confident of meeting full-year expectations.

First-half numbers don't look pretty. The six months to April 30 saw underlying profit before tax down 21% to 39 million pounds (with reported PBT down 50%) on revenue up 4% to 333 million pounds. Cash flow dropped from 50 million pounds to 18 million pounds.

But the interim dividend was raised by a third, a clear signal from management of its confidence in hitting full-year targets and in line with its policy of maintaining three times dividend cover. Chemring's dividend increases over the past 12 years have been one of its attractions for investors.

The company has also announced the sale of its marine division, the only part of the business that sells to nonmilitary customers. That's bucking the trend of the sector somewhat: BAE has led the way by seeking to reduce its dependence on NATO procurement, investing in its commercial aerospace and cyber security businesses.

The 32 million pound proceeds will be used to reduce debt and the pension deficit and help implement a 50 million pound share buyback. Though that latter program may boost the share price, it's a little disappointing. Chemring is not without financial risk, and the funds might better be devoted entirely to strengthening the balance sheet. Net gearing is 68% (with interest covered three times in the half year), the pension shortfall is currently 27 million pounds, and net tangible assets are negligible.

Middle East
Chemring is working hard to reduce its NATO dependency. Non-NATO revenue rose by 31% in the first half-year and now comprises nearly a third of total sales. The Middle East contributed the biggest increase. The company has also signed a joint venture agreement in India which will manufacture locally, subject to receiving a government license. There are also plans for JVs in Saudi Arabia and Brazil.

Call me cynical, but unless the world's politicians are about to beat their swords into ploughshares, defense spending is not going to fall off a cliff. The U.S. plans slightly increased defense spending next year (with a new presidential term) and for spending to level off thereafter. But the Middle East is a tinder box, and all the risk is to the upside.

High tech
Chemring's business is skewed to high-tech protective systems and munitions that have to be regularly replenished, even if unused. The company is able to rapidly gear up production in time of emergency.

Its record order book of more than 1 million pounds covers 94% of second-half forecast revenues, which means it's relatively safe to rely on its forward P/E. The company has disappointed the market a few times over the past 18 months and is now paying the price. But most of those disappointments have been due to delays in signing orders, and it maintains a strong competitive position in a number of high-tech niches in a market that -- regrettably, but inevitably -- is fundamentally robust. Yielding 5.4%, it doesn't deserve its 30% discount to the sector's forward P/E. At this price, I'm a buyer.

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Tony has shares in Chemring but no other shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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