Why the defence business makes for a defensive play

WAR is not something that anyone likes to think about or get involved in. Most of us, I am sure, would much prefer peace. I know I would. Consequently, investing in the trappings of war can make some people a little uncomfortable. Nobody wants to profit from the misery of others.

There is another way of looking at it, though. Every country has the right and a duty to protect its sovereign borders and its people. That is where defence spending comes in.

It has as much to do with protection as it has about aggression. Without proper defences, hostile countries could ride roughshod over those that are less able to defend themselves.

That probably accounts for the rise and rise of defence spending. According to the European Commission, global military spending has more than doubled since the end of the Cold War. In 2017, it stood at a whopping US$1.7 trillion.

Admittedly, military spending includes expenditures on salaries and infrastructure. That said, the world's military arsenals are still expected to double in size by 2030 compared to 2016.

So, the defence sector is governed by rules that go beyond economics. Regardless of economic conditions, many countries consider defence spending to be sacred.

Almost any government expenditure can be cut except for when it comes to defence. That could mean that companies involved in providing arms are almost defensive in nature. In other words, they could be considered almost recession-proof.

Investors are spoilt for choice when it comes to the defence industry. They include the US$85 billion defence contractor Lockheed Martin, which makes the F-35 Lightning II stealth fighter that Singapore has just ordered, and Singapore's very own Singapore Technologies Engineering, which is valued at around a 10th of that.

What is remarkable is that many of these companies are resilient in the face of economic slowdown. Or perhaps it is because of economic slowdown that they have been resilient.

Collectively, their revenues have been largely unaffected by economic conditions. In 2006, before the Great Financial Crisis, total revenues at 18 major defence contractors was US$11.7 billion. In 2017, it stood at US$11.7 billion.

That belies the growth that some defence contractors have been able to achieve.

Eleven of the 18 companies have grown their revenues since 2006. Britain's Cobham, which designs missile-guidance systems, has grown its revenues at a compound annual rate of 1.2 per cent a year, while America's Esterline Technologies, which manufactures aircraft counter-measures, has grown 3.1 per cent a year.

Impressively, defence contractors can generate sizeable returns on equity. Many have generated bottom-line profits in the double-digits on every $100 of shareholder investment. The median is around 17 per cent. Some of the best performers include ST Engineering, Lockheed Martin and BAE Systems, which, apart from developing the Eurofighter Typhoon, is also involved in cyber security.

The high returns on equity are due to three main factors. Firstly, they are extremely efficient in their use of assets.

On average, they can generate as much as $8 of revenue on every $10 of assets employed in the business. Some of the most efficient contractors include Ultra Electronics, which generates $10 of sales on every $10 of asset employed and Northrop Grumman with an asset turnover of 0.93.

Ultra Electronics manufactures acoustic torpedo counter-measures, while Northrop Grumman is an expert in autonomous aircraft.

Defence contractors can also make a reasonable profit on the supply of defence equipment. But the profit margins are not excessive. France's Dassault Aviation, which manufactures the Rafale single-seater fighter, generates around $9.50 of profit on every $100 of sales. General Dynamics, which makes the Abrams main battle tanks, has a net profit margin of 8 per cent.

In the main, defence contractors are highly leveraged, which also helps to boost their returns on equity.

These businesses carry around $70 of liabilities for every $100 of asset. But given that many have reliable sources of revenues, it is unlikely that they could default on their obligations.

On average, defence contractors pay out around 30 per cent of profits as dividends, which means that they retain about 70 per cent for internal use. That coupled with their high returns on equity of around 17 per cent would suggest that they are able to raise their payouts at around 11 per cent a year.

Many of them have. Singapore Technologies Engineering has grown its payout at a compound annual rate of 8 per cent over the last 10 years; Dassault Aviation has grown its distribution at 13 per cent, while Lockheed Martin has grown its dividend at 16 per cent a year over the last decade.

No one likes the thought of wars. But in a world that is growing increasingly divisive, and with some political leaders growing increasingly more belligerent, defence contractors should always have a place in helping to maintain world order.

* David Kuo does not own shares in any of the companies mentioned