Berenberg turns stock picking spotlight on defence sector

Highlighting the importance of stock selection in the defence sector, Berenberg shone a spotlight on increasing margin pressures in coming years and downgraded Qinetiq to 'sell', upgraded Ultra Electronics to 'buy' and reiterated a 'sell' on Cobham.

Berenberg, which also kept its rating on BAE Systems at 'buy', has crunched the numbers on the UK's Strategic Defence and Security Review (SDSR) 2015, which has given the country a stable, fully funded defence budget.

As a result, the German bank expressed concerns about the Ministry of Defence's procurement reforms and the government’s shift to a “technically compliant, lowest-price-wins” approach, as it feels this will in exert increasing margin pressure on contractors.

As timing of new equipment buys is "opaque", with deliveries not expected for several years, Berenberg has not adjusted company estimates specifically in response to the review.

Contracts caught by the new regime are estimated to see at least 200 basis points lower margins by 2018, driven by a rolling three-year baseline profit average and a tightening allowable costs regime.

Within the sector, analysts anticipate the changes will have the greatest impact on QinetiQ, with its huge exposure to the UK and renewals and re-pricing activities on several long-term contracts will peak in 2018, exposing circa 55% group revenue to the new regime.

On stock selection, Berenberg favoured companies with niche positions on growth programmes and greater export potential through technical superiority.

Ultra Electronics was upgraded and given a 2,100 price target reflecting a return to organic growth in 2016, a faster-than-expected pace of deleverage and good Sonobouy sales to the UK from the prioritisation of anti-submarine warfare.

Cobham is unloved because of negative earnings momentum in 2016 from the surveillance and Metelics divestments a stretched balance sheet and continuing weakness in key end-markets such as marine.

BAE, which is 22% exposed to the UK, is "well positioned for growth" from long-term, high-value bespoke contracts with MoD, with the recent review offering upside in the long-term and marginal impact from single-source regulations.