Shares of defence-focused technology firm Ultra Electronics Holdings (LSE: ULE) rose by more 16% when markets opened this morning after it reported “significant exposure to the strengthening US defence budget.”
Management reported strong order intake during the fourth quarter and said that 62% of 2018 revenue has already been secured, compared to 56% at the same point last year. The year-end order book stood at £900m, but executive chairman Douglas Caster said that the true figure could be higher, as it excluded sales from ongoing open-ended contracts in the aerospace and US defence sectors.
Mr Caster confirmed that cash generation has remained strong and reiterated the board’s plan to pay a final dividend of 35p per share for 2017.
All in all, it was a good update — but why have the shares rocketed? To understand this you need to rewind two months to November 13, when Ultra issued a profit warning. Lower UK defence spending had resulted in the MoD “pausing, cancelling or delaying numerous programmes”. The firm’s shares fell by about 20% in one day.
A brighter outlook
What’s interesting about today’s statement is that guidance for the current year is unchanged. Total revenue is expected to fall by 2% to £770m, while underlying operating profit is expected to drop 8.5% to £120m. What’s changed is the outlook, which now appears more positive.
So are the shares a buy? I’m tempted to say yes. Ultra Electronics is still trading around 15%-20% below the levels seen before November’s sell-off. That leaves the stock on a forecast P/E of 12.5, with a prospective yield of about 3.4%.
Given the group’s strong cash generation and more stable outlook, I think this is cheap enough to provide an attractive entry point for investors, even if growth does remains slow.
Another defence opportunity
Ultra Electronics isn’t the only buying opportunity I see in the defence sector. Another stock that’s on my watch list is engineering services group Babcock International Group (LSE: BAB).
The firm’s shares have been hit by the wide-ranging sell-off seen across the outsourcing sector. Fears of UK defence spending cuts have also hit the stock. But so far Babcock appears to have avoided the kind of problems faced by outsourcing rivals. Nor has it been hit by spending cuts.
Indeed, in November’s interim results, chief executive Archie Bethel commented on “the increasing number and value of our opportunities both in the UK and internationally.”
The group’s H1 results certainly appeared positive. Underlying revenue rose by 5.9% to £2,638.9m, while underlying pre-tax profit climbed 4.9% to £239.5m. Although the order book fell from £20bn to £18.5bn, the company reported an increased bid pipeline of £12.2bn, up from £10.8bn one year earlier.
In my view, Babcock has several advantages over other outsourcing firms. I’d expect its specialist focus on skilled defence and engineering work to make it harder to replace than — for example — a security or facilities management contractor.
The group’s specialist skills also appear to allow for stronger pricing. Its 9% operating margin is significantly higher than those of peers such as G4S or Serco.
Given these strengths, I think the stock’s 2017 forecast P/E of 8.6 and expected yield of 4.1% are probably cheap enough to deserve a ‘buy’ rating.
