Where to invest in the defence sector to get the best bang for your buck

23 May 2017

With the UK's decision to leave the EU and Theresa May's recent call for a General Election, it's fair to say that the UK political situation is going through a period of uncertainty. Of course there has also been a lot of change in the US.

There are many reasons to expect defence spending to increase. The political changes we are seeing, particularly with respect to immigration, will likely lead to governments investing to tighten border security.

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There are also threats from terrorism and numerous border tensions across the world and these threats are also likely to prompt governments into spending to bolster their defences and protect their citizens. So, given this current uncertainty, where should investors put their money to optimise returns in the defence sector? We consider some options below.

President Trump, who announced a “10%” increase in US defence spending, has also targeted overspend on defence programmes including F-35 and Air Force One. This suggests that it's not a free for all in the US which is by far the biggest defence market in the world. To be successful then, investors must focus on businesses exposed to the right programmes and technologies.

So which programmes or technologies are the ones to go for?

Over the last decade, we've seen a strategic move of defence primes away from the sharp end (bullets and bombs) and toward security, e.g. BAE Systems’ big acquisitions within cyber security (Detica) and force protection (Armor Holdings). This strategy has been in pursuit of real growth and has continued all the way down the supply chain.

The evolving worldview seems to be somewhat at odds with this established strategy though. The stance appears to suggest a rewinding of the clock to an era where the West faced a different set of threats. An era when nuclear supremacy, boots on the ground and a large navy was the answer, rather than sophisticated cyber security, light drones and carefully choreographed diplomacy.

Whatever happens, the lion’s share of any spending increase will likely be absorbed by “readiness”, i.e. maintaining, replacing and training on existing equipment. So businesses with positions in through-life maintenance or providing training services could be in a good place.

Won’t the overall increase in NATO defence spending be a good thing for business too?

What overall increase? Whilst NATO territories are talking about increasing defence spending to 2% of GDP, we’re more likely to see countries such as Germany at 1.2% of GDP in 2015 employing the same approach as the UK to evidence increased commitment. This included reclassifying soldier widows’ pensions and intelligence gathering costs to help reach the target.

To put it in perspective, Germany, the second largest economy in NATO after the US, would have needed to spend another $28bn on defence in 2016 to bridge the gap. For practical reasons this could not be done quickly and Angela Merkel has said she will not be accelerating the modest spending increase already planned.

There’s no doubt we will see some impressive, headline grabbing pieces of military kit ordered by NATO members, but it’s not likely that these alone will signal a material increase in spending.

What’s the bottom line?

Defence remains an attractive sector for investment: margins are strong, revenues are predictable and there isgrowth – the most likely channels and sources just need to be identified. There are many businesses out there that require investment and experience from the right investor to increase their scale and competitiveness.

As we’ve discussed above, businesses supporting “readiness” or providing broader training services are likely to fare well and there are other profitable niches as well. The priority then for a private equity (PE) house looking to invest in a defence business is to choose a company that possesses the know-how to be a market leader under the right ownership.

Edward Weston |  Deals
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Sam McGarey |  Deals
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