It’s been an uncertain decade for the defence industry. Disappointing economic performance across the developed world has prompted a period of cutbacks to military budgets. This has created a headwind for many defence-related businesses, which has caused disappointing financial performance and falling share prices in many cases.
Today, though, the prospects for the industry seem to be much brighter than they have been in the recent past. Therefore, defence-related companies such as Rolls-Royce (LON:RR) and BAE (LON:BA) could offer growth potential.
While a decade ago the focus of the US government was on steering the economy through what would prove to be the biggest economic crisis in a generation, today it is seeking to stimulate further growth. One of the areas in which it is aiming to do this is higher spending on the military. Under President Trump, the $700 billion National Defense Authorization Act has been passed. This is set to boost activity within the defence sector, and could lead to the headwind of recent years becoming a tailwind for sector incumbents.
It would be unsurprising for US spending on defence to increase even further. Political appetite for higher spending in the US seems to be high. The aforementioned defence act passed by 89 votes to 8 in the Senate. Since spending on the military has been shown to have a somewhat positive impact on economic performance, further growth in military spending could be ahead. With the US having the biggest military budget in the world (and it being larger than the next eight biggest spenders combined), the industry could enjoy a positive future.
This week, Rolls-Royce released results that showed it is making progress with its turnaround strategy. Under its current management team, it has been able to deliver on its strategy to become more efficient. For instance, its transformation programme achieved £200 million in savings between 2016 and 2017. Further developments in this area are anticipated, and this could aid the company’s free cash flow and profitability.
Additionally, Rolls-Royce made progress on large engine deliveries, with them rising by 35%. It has also made encouraging progress in its troubled Power Systems division, which is seeing improved performance under new leadership.
Similarly, BAE also appears to have the potential to generate improving financial performance. The company has not experienced the level of difficulties of many of its industry peers in recent years. Nevertheless, its EPS in 2017 was only 3.6% higher than in 2013. This highlights the difficult conditions it has faced. With the company forecast to generate 6% EPS growth next year and having a P/E of 13.3, it seems to offer recovery potential.
With geopolitical risks being high in the Middle East and in North Korea, the prospects for defence stocks seem to be upbeat. And with the US adopting a major policy shift towards lower taxation and higher spending on infrastructure and the military, further spending growth could be ahead. This could boost the performance of stocks across the defence sector; many of whom still trade on relatively low valuations. As a result, BAE and Rolls-Royce could enjoy successful turnarounds.
For more investment ideas, enter your email address below to never miss an issue of Master Investor Magazine.