Stockwatch: A 'defensive' contrarian play

Is the worm turning for defence contractors? The Mid-250 shares in Cobham (COB) - diversified in aerospace and defence - have bounced after appointing a new chief executive, with analysts projecting strong profits recovery. But the purer contrarian play to exploit a five-year chart low and stream of bad news is Chemring Group (CHG) in the FTSE Small-cap index.

The chart (below top) for this global leader in defence countermeasures shows persistent falls albeit consolidation in 2016, with bad news lately abating and broker forecasts (see table) anticipating a rebound.

Both companies derive nearly half their revenue from the US, hence offer a useful means of US dollar exposure while sterling continues to face uncertainties. The US economy looks pretty robust and (other things being equal) the dollar should benefit from the Federal Reserve very gradually raising interest rates. Moreover, a Trump presidency would boost defence spending.

At 2%, Chemring's prospective dividend yield is no prop compared with Cobham's circa 4.5%, but if forecasts are fair then its earnings cover is much better at about four times compared with 1.5 for Cobham.

Both stocks' forward price/earnings (PE) ratios are in the teens, Chemring justifiably rated lower given tighter liquidity. Currency translation is boosting the value of both groups' revenues/order books and several Chemring insiders have been buying stock. Excuse the terrible pun, but in a "bombed out" situation like this it only needs bad news to abate for a stock recovery trend to begin.

At 143p, the price is testing the upper end of a recent range that has tended to cap at about 145p, hence potentially a modest break-out.

Latest numbers boosted by sterling weakness

A recent update for the three months to end-July cites an eye-catching 20.2% increase in revenue to £109.1 million against the same period last year, helped by a delayed £100 million Middle East ammunition contract.

Later on, the update cites a 12.6% rise in the order book to £665.9 million since end-April with sterling weakness against the US dollar accounting for £50.5 million of this.

So, the numbers are benefiting from currency and it's also tricky to decipher whether the underlying trend is genuinely improving or boosted by a lumpy delayed contract. The dilemma with awaiting more evidence is the market speculating that after a long period of Chemring shares falling, probability now favours upside.

Mind a £32.6 million increase in net debt to £147 million, £11.3 million of which relates to the value of US dollar denominated debt rising due to sterling weakness. The underlying increase isn't explained, but it's a short timeframe where operations can trigger an increase, to worry. Chemring has, however, been a story of indebtedness, with a four for nine rights issue at 94p last April raising £75.2 million net to redeem £48.5 million equivalent of dollar debt.

Chemring's debt therefore still looks sizeable against net tangible assets of £74.8 million, but, including goodwill/intangibles (mainly as a result of acquisitions) net assets were £360.2 million at end-April. Certainly interest costs have needed reducing after a £7.8 million interim finance expense compared with a £3.8 million operating profit on underlying continuing operations, hence a £3.1 million operating loss which soared to £11.1 million including non-underlying items.

Lumpy profile, yet confidence in expectations

June's interim results, therefore, put a lot of emphasis on the second half and how brokers are viewing profit, to target over £30 million for the financial year as a whole. Three months ago the board had to indicate annual pre-tax profit slightly below expectations, but the near £32 million consensus lately factors this in.

Investec Securities advised 'buy' (mind, as company brokers do) on 27 July with a £32.5 million pre-tax target for earnings per share of 9.9p, and Chemring's latest update is headed: "the board's expectations for FY 2016 full year trading remain unchanged."

Such expectations would have been shared with the analyst, at least by way of signing off the forecast, and the update points to "a weighting of operating cash generation to fourth-quarter." So it's speculative but with a fair chance of happening now this delayed contract is underway. Looking back at an early April update, "this multi-year contract is expected to provide a significant contribution to FY 2016".

Admittedly, this puts a lot of emphasis on a lumpy contract in a context where last June management described defence spending as broadly flat. They were more positive on US/European spending for 2017 however, and, while they cited the Middle Eastern outlook as "uncertain", the modest recovery in oil prices plus regional instability may add elements of support.

Australia, India, Japan and Singapore are increasing spend and, since June, tensions over North Korea and the South China Sea are boosting Japan's defence ministry's calls for more.

So it's possible the worm is turning on industry fundamentals, besides Chemring overcoming a flow of turgidly bad news.

Insiders buy £112,690 worth of equity

After the June interim results a non-executive director bought 60,000 shares at 115p and the chairman 20,000 shares at 118.7p, then on 11 August the chief executive's wife bought 15,000 shares at 133p.

Altogether that conveys belief in long-term value and Chemring's long-term chart downtrend having reached bottom. The purchases coincide also with management pursuing site rationalisation and cost-saving initiatives (so mind that alluring normalised profit forecasts will get clipped by more non-recurring charges) and £26.7 million net proceeds from the rights issue are being applied (after reducing debt) for investment e.g. "progressing key strategic long-term US programmes."

An early-stage buy case, therefore, derives from various positives: medium-term scope for improved defence spending; a rights issue having mitigated debt and enabled investment; a stream of bad news ebbing; a five-year chart low and the directors buying. Chemring has plenty to prove but that goes with contrarian investing.

For more information see the website.

Chemring Group - financial summary						Consensus estimates
year ended 31 Oct	2011	2012	2013	2014	2015	2016	2017
Turnover (£ million)	724	740	472	403	377
IFRS3 pre-tax profit (£m)	85.4	18.8	-66.5	-5.2	-9.1
Normalised pre-tax profit (£m)	98.8	53.1	15.8	12.5	-1.9	31.9	40.9
Operating margin (%)	15.2	9.3	6.8	9.8	2.4
IFRS3 earnings/share (p)	32.7	5.9	-25.2	-0.6	-2.4
Normalised earnings/share (p)	38.9	21.2	12.1	7.4	0.9	9.7	11.4
Earnings per share growth (%)	5.3	-45.5	-43.1	-38.6	-88.0	988	17.5
Price/earnings multiple (x)					159	14.7	12.5
Cash flow/share (p)	33.8	33.0	15.9	6.2	6.3
Capex/share (p)	26.7	18.6	8.9	10.2	7.8
Dividends per share (p)	10.8	14.1	6.7	5.4	3.6	2.3	3.0
Yield (%)					2.5	1.6	2.1
Covered by earnings (x)	3.7	1.5	1.8	1.4	0.2	4.3	3.8
Net tangible assets per share (p)	7.6	9.1	21.4	27.9	26.8
Source: Company REFS

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.