With increasing turmoil in the Middle East sending defence budgets across the region and developed world higher, are investors looking to profit better off purchasing turnaround play Chemring Group (LSE: CHG) or industry titan BAE Systems (LSE: BA)?
Chemring shares are currently selling off to the tune of 7% at the time of writing, after results showed pre-tax losses rose to £9.1m from £5.2m for the previous fiscal year. The company also revealed net debt rose to £154m due to an acquisition spree undertaken during the boom years of the American wars in Iraq and Afghanistan. Disclosure in October of a rights issue intended to pay down this debt ended up netting Chemring some £75m, of which £45m will go towards early debt repayments and the rest towards routine debt obligations.
Halving the current debt levels will enable Chemring to finally begin planning for future growth rather than concentrating on paying off debtors. However, headwinds remain for the company as the majority of revenues come from low margin items such as countermeasures and explosives that are mainly used during times of combat. With defence budgets in major markets such as the US reorienting from war footing to long-term, big ticket projects, Chemring risks years of declining revenue. Management is moving towards selling less cyclical, high-margin military and civilian sector intelligence products, but this process will take years to provide as much revenue as traditional products.
Furthermore, shares aren’t currently a bargain as they trade at 12.5 times next year’s forecast earnings. With limited growth potential and no interim dividend proposed for the next six months, I believe investors can find much better uses for their capital in this buyers’ market.
Defence titan BAE Systems derives some 75% of revenue from the United States, UK and Saudi Arabia. This narrow focus has paid off with defence budgets in all three countries set to rise over the medium term. BAE shares have popped to the tune of 10% since the UK announced increased defence budgets in November. While the company is best known for splashy, ‘big ticket’ items such as aircraft carriers, tanks and fighter jets, management is reorienting business towards more stable revenue streams in the cyber security and electronic systems sectors. These two divisions now account for nearly 25% of overall sales and are set to continue growing.
Although revenue has decreased for four consecutive years on the back of Western governments drawing down operations in Iraq and Afghanistan, the company has done a good job of maintaining earnings per share remarkably consistent. EPS have shrunk a modest 4% over the past five years even as revenue has dropped over 25%. City analysts are forecasting increased profits for 2016 and shares are trading at 12.5 times earnings. Although this is not particularly cheap, the 4.1% yielding dividend and better earnings potential than Chemring makes BAE a relatively safe choice for a dividend-paying defensive share. While share prices may not skyrocket any time soon, BAE may reward long-term investors looking for stability and solid dividends.