UK defence stocks soar on tough talk from Nato
28th June 2022 13:14
by Graeme Evans from interactive investor
Russia’s invasion of Ukraine has forced European governments to rethink their level of defence spending. This will inevitably mean more work for UK defence firms.
BAE Systems (LSE:BA.) shares were at a fresh record today as moves towards greater defence spending by the UK and Nato allies also benefited the ailing valuation of Rolls-Royce (LSE:RR.).
The latest leg up for BAE came as Nato’s secretary-general Jens Stoltenberg pledged to use this week’s Madrid summit to discuss the biggest overhaul of collective defence since the end of the Cold War. This could mean the number of troops at higher levels of readiness increasing to more than 300,000, from 40,000 currently.
Nato members spend up to 2% of GDP on their armed forces, but UK defence secretary Ben Wallace is today reported to want the UK’s defence budget to increase to 2.5% by 2028 and for the prime minister to press for other countries to follow suit.
BAE shares, which stood at 591p prior to Russia’s invasion of Ukraine, rose over 16p to 814p today as the war has fuelled interest in its military platforms, such as tanks, fighter jets, submarines and surface vessels.
About 35% of BAE’s revenues relate to short-cycle business and services, positioning it as an early beneficiary from a ramp-up in spending. Its geographic diversity is another advantage as more countries announce or make plans to counter the elevated threat.
Deutsche Bank today said it sees further upside potential for BAE’s shares to reach 860p, having forecast order intake of 19% in half-year results on 28 July.
Analyst Christophe Menard also expects 3% sales growth and earnings per share to lift 6%. He added: “An extra buy-back programme remains a possibility, especially as H2 business momentum and order intake should remain solid.”
In the FTSE 250, shares in the Royal Navy support firm Babcock International (LSE:BAB) today rose 27p, or 9%, to 322p, MoD research supplier QinetiQ Group (LSE:QQ.) by 6p to 364p and countermeasures business Chemring (LSE:CHG) by 3p to 325p.
Defence represents the second-largest division of Rolls-Royce, although it is less exposed to immediate geopolitical events because its products and services are delivered and maintained over decades of service.
However, shares still jumped by 4.9p to 86.7p at the top of the FTSE 100 index risers board today. They were below 80p on Friday and down 30% this year on expectations that the post-Covid recovery in international travel will be significantly delayed.
Bank of America recently cut its price target on Rolls-Royce to 77p, but counterparts at Morgan Stanley are much more optimistic after describing the company as “the clearest example of mispricing” in its aerospace coverage. They have a 118p price target.
The US bank said this month: “At current levels, we think the shares are only giving partial credit for a recovery, capitalising losses in the New Markets division into perpetuity, and giving no credit for the benign effects of flying hours agreements on leverage.”
Rolls employed about 11,100 people in its defence division in 2021, up from 10,500 in 2020, and representing a quarter of its workforce. Defence generated £1.4 billion in sales from original equipment, with a further £2 billion coming from aftermarket services.
While highlighting the long-term nature of the defence business, Rolls said in May that a strong order backlog gave it more confidence on revenue, profit and cash conversion “against the headwinds of inflation and supply chain risk”.
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