Going on the defensive: the defence sector stays strong

Josh Terlich

Mason Stevens

Last week we touched briefly on a couple of Aussie defence stocks and how global defence industry spending generally does not wane even during economic slowdowns. This makes sense particularly recently where there is a notable increase in geopolitical tensions and a constant tug-of-war between some of the world's superpowers. Governments the world over continue to plough money into their defence capabilities, and this looks set to continue. Australian defence stocks have benefited hugely - highlighted by the price rises in Austal (ASX:ASB) and Codan (ASX:CDA). Comparatively speaking though, the Australian defence 'manufacturing' sector is small with behemoths such as Boeing, Lockheed Martin, Northrop Grumman, Raytheon and General Dynamics dominating the global landscape. In this note we take a further look into a few stocks to understand exactly what they do - Electro Optic Systems (ASX:EOS) and Lockheed Martin (NYSE:LMT).

Source: Google Finance

EOS is no start-up and following a stellar price rise now has a market cap of ~AU$770m. The company offers a 'two for one' deal with a hand in both the defence and aerospace sectors. EOS specialises in remote weapons systems (such as that pictured on top of the army vehicle below) but also telescopes, domed observatories, laser satellite tracking and missile defence systems on the aerospace side.

EOS's field weapon systems are aimed at reducing casualties with the capability of being fired remotely from within the armoured vehicle or from other unmanned platforms. The company has customers in Australia, Singapore, Germany, and importantly, with the US. It has a contract with Lockheed Martin (which is the largest defence contractor in the US) - to jointly develop space tracking sensors. The largest shareholder of EOS is Northrup Grumman - which is a giant in the defence/aerospace industry (with a market cap of ~US$58bn) - currently holding an 8.2% stake. The importance of these strategic partnerships can't be underestimated.

FY 2018 was a standout year, with revenues more than tripling, rising from AU$23m to AU$86m. Net profit went from a $9m loss to a $15m gain. According to the company, demand for the company's products and services has gone gangbusters with an estimated backlog of confirmed orders and contracts expected to swell to AU$630m by 31 December 2019. Pipeline of tenders and contracts under negotiation are developing rapidly. EOS expects to convert this pipeline to around AU$2bn of contract awards for current products over the next three years to December 2022.

Source: EOS

Whilst Boeing is a bigger overall company (market cap of ~US$200bn), Lockheed Martin is the biggest defence company on the planet (market cap of ~US$110bn) specialising in arms production. Calendar year 2018 saw the company rake in close to US$60bn in revenues. The centre piece of the company's arsenal is the F-35 Joint Strike Fighter. The flagship warplane famous the world over will form a key component for the US Air Force, Navy, and Marine Corps, as well as around a dozen other nations' defence capabilities for decades to come.The F-35 is projected to remain in service until at least 2070. Over the next 50 years or so the JSF program is expected to generate well over US$1 trillion in revenue for Lockheed globally, which are mind boggling numbers and gives the reader an idea of the pay-offs involved in the defence game.

Lockheed has plenty more in the bag than just the F-35. From combat ships to hypersonic missiles, helicopters and spacecraft, LMT remains the world's top weapons manufacturer. In 2018, LMT secured both of the US Pentagon's hypersonic weapons contracts, capitalising on the recent spending spree the US government has been embarking on (which is in addition to the delivery of the F-35 program - America's most expensive weapons system at US$400bn). The US and other nations have 3,100 F-35s on order through 2035, making Lockheed possibly one of the better defence stocks for steady, long-term revenue. Sales of the jet currently make up ~25% of LMT's revenues. According to experts, the company has the industry's top portfolio of products, and exposure to multiple areas where US Pentagon budgets should grow for years to come. It has a seat at the table for every discussion involving a Pentagon priority, and should win at least its fair share of new business for a very long time.

Although many of the aforementioned stocks have seen some incredible rallies in the last 12 months, there may be more to come but investors should delve carefully into pipelines and customer bases. LMT for example trades at a premium to its peers as it has large exposure to US spending and a pipeline extending for almost 5 decades.  

Source: Google Finance

3 stocks mentioned

Josh Terlich
Josh Terlich
Investment Governance and Research
Mason Stevens

Josh is an investment governance manager at Mason Stevens, with over 13 years’ experience in financial services. He has worked for the likes of Magellan, Blackrock, Wise Owl, Investment Partners and the ASX.

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