Investment Column: Qinetiq is worth a punt in defence sector

Do you really want to be investing in companies whose major customer has promised to cut orders "ruthlessly and without sentiment"?

The Defence Secretary, Liam Fox, has said that the Ministry of Defence budget will be slashed by up to 20 per cent, and the defence industry is in suspended animation awaiting the looming Strategic Defence and Security Review. Meanwhile, the market is awash with rumours about where the axe will fall when the details are revealed in October.

Don't be put off. There are still opportunities for hardy investors with a long-term view.

The behemoth BAE Systems has seen its share price sliding fairly consistently for several months, as has the pyrotechnics and munitions specialist Chemring, and the equipment and services group Cobham (notwithstanding a brief rally in July).

"The spending review in October is casting a massive cloud over the defence sector," Keith Bowman, an equity analyst at Hargreaves Lansdown, said. "We have been seeing some nervousness in share prices in recent months as investors try to anticipate the cuts to come."

The qualities for investors to look out for are diversity, geographic reach, and involvement in the growing market for intelligence and security technology. The biggest single investment decision is about BAE Systems. In its favour, the defence giant has land, air, sea and security divisions and draws the majority of its revenues from the US. It also has a strong balance sheet and seven "home markets" – including Australia, Saudi Arabia, and India – that will provide some insulation from the cuts in the UK.

But the US defence sector is also facing a period of retrenchment: Robert Gates, the US Defence Secretary, last week announced $100bn-worth of cuts over the next five years. And in the UK there are concerns that some of its major programmes are at risk, with a disproportionate impact on its income. Tina Cook, an analyst at Charles Stanley, said: "BAE provides major platforms and programmes that can be cut or scaled back."

In contrast, a platform-agnostic, second-tier company like Cobham is more shielded. Not only that, but the group is strong in the kind of homeland security technologies – such as communications and surveillance – that are likely to hold up well regardless of pressure on overall defence budgets. Some analysts estimate Cobham's stock to be trading as much as 20 per cent below historical averages, leaving it considerable room for improvement. And although several US contracts have seen delays recently, confidence remains high, with growing speculation about further acquisitions. "Countries like the US and the UK might be scaling back on engagements in Iraq and Afghanistan, but homeland security is still a priority and that needs more sophisticated technology," Ms Cook said.

For similar reasons, Ultra Electronics has much to recommend it. The shares have been rising since the winter, and some analysts estimate a price-earnings ratio of upwards of 13 times, against an average of around 10 times for the sector as a whole. It's worth it. The company's intelligence and surveillance speciality, including cryptographic systems, communications systems and electronic warfare equipment, puts it right at the sweet spot for future growth potential.

Rolls-Royce is always a favourite in the defence sector. The company has performed well over the course of the recession and incipient recovery. In part, the group benefited from moving fast to cut costs as the global economy nosedived. But it is also a reflection of the strength in diversification. While its aerospace and defence businesses may feel the pinch from spending cuts, the marine, commercial, energy and civil nuclear businesses stand ready to take up the slack. That said, with shares bumping around at pre-recession levels of more than £5.50 for much of this year, Rolls-Royce looks like a hold rather than a buy.

Perhaps the most intriguing opportunity in the sector is Qinetiq. The embattled group spun out of the MoD technology arm in 2003 issued two profits warnings last year, revealed a 34 per cent slump in annual profits in May, and has announced more than 700 redundancies in recent weeks. But Qinetiq's problems are largely the after-effects of a trigger-happy acquisition strategy that saw it take over 20 companies in just eight years. And the chief executive, Leo Quinn – who took over in November – has big plans, including bringing down the group's debt-to-earnings ratio, establishing a more commercial culture and hitting a 10 per cent cost-cutting target.

Our top tips for investors are Cobham and Ultra Electronics, but for those with an appetite for risk, Qinetiq looks to have most upside.

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