ASX dogs of war to have in your crosshairs

Due to a perceived existential threat to Australia from China, the country’s spending on defence - now forecast to reach 3.5% of GDP by the end of the decade – has by default put greater focus on ASX-listed defence stocks most likely to benefit.

The federal government's 2020 Defence Strategic update noted a commitment to increase defence spending from $70bn to a whopping $270bn over the next 10 years.

As well as border protection, much of the major ramp-up in defence spending is also being spent on Australia participating in the ‘Five Eyes’ intelligence sharing network under a joint treaty with Canada, NZ, the UK and US.

There’s a growing cadre of ASX companies - ranging from satellite data and drone systems companies to military equipment suppliers and shipbuilders - with connections to the Australian defence sector.

Future growth

Everything being equal, there are around a dozen-plus listed companies – with a combined market cap of over $4.0bn - that could be direct beneficiaries of increased military spending.

The industry is down -29% over the past year (up 4.2% year-to-date), and the sector is trading at a median PE ratio of 13.1x, compare with the average PE ratio of 16.4x.

But investors should note, while the sector at large looks cheap, earnings are expected to grow by around 20% p.a.

While 70% of the Australian government’s defence spending is expected to go to foreign suppliers, there remains a sizeable pool for local suppliers to fight over.

While most companies in the defence space are minnows, with market caps under $100m, the top three: Smart sensor analytics company Brainchip Holdings $1.6bn (ASX: BRN), Codan (ASX: CDA) $1.2bn - which produces landmine detectors for defence and security force customers - and Australian shipbuilder Austal $723m (ASX: ASB) – comprise 80% of the sector’s total value.

While Brainchip and Codan have posted 1-year gains of 55% and 61% respectively, size and performance clearly aren’t mutually exclusive, with Austral down -18.37% over the past 12 months.

By comparison, the best performing defence stock over past 12-months is smallcap Bisalloy Steel Group (ASX: BIS), up 66.83%.

Three other defence small-caps to deliver 20%-plus growth for the 12-months were drone-stocks, Droneshield (ASX: DRO), satellite/space provider Kleos Space (ASX: KSS) which recently secured a $12m capital raise to fund the launch of future satellite clusters, and scale up Kleos’ data-as-a-service offering: and military equipment provider BlueChiip Ltd (ASX: BCT).

Consensus

Due to their size, consensus fails to cover the vast majority of stocks in this sector. However, based on Morningstar’s evaluation, every stock within the defence space is undervalued.

Current consensus includes:

• Austal: Moderate Buy

• Codan: Strong Buy

• Electro Optic Systems: Moderate Buy

• Kleos Space: Strong Buy (1 broker)

• Quickstep Holdings Ltd: Strong Buy (1 broker)

Broker coverage

Codan

Unlike a lot of its peers in this space, Codan is highly profitable, and in FY21 the company grew net profits by 41% to $90.2m.

Friday’s share price recovery ($7.20), after being dragged down by the tough love recently dished out to the tech sector, is welcome relief to the stock’s slide from the $19.41 high it was trading at mid-June last year.

Macquarie has an Outperform on the stock and shares the company’s confidence it can significantly grow future profitability. The broker's target price of $11.60 represents a 62.5% upside to the current price.

Austal

Based on the four brokers that cover Austal (as reported on by FN Arena), the stock is trading on 8.4% upside to the target price of $2.19.

Citi retains a Buy rating (target price of $2.35) and expects several shipbuilding projects to be awarded this year.

By comparison, Macquarie recently downgraded the ship builder to Neutral from Outperform (target $1.91) after the company was notified it will not be awarded the contract to construct offshore patrol vessels for the Philippines Navy.

Meantime, Credit Suisse has cut revenue estimates due to a softer US contribution, given labour shortages and global supply chain disruptions, but retains an Outperform rating (target trimmed slightly to $2.40 from $2.50).

Stay vigilant

Given the lack of broker analysis on defence stocks, it’s incumbent on you to watch out for any price sensitive announcements that could add a major kicker to the fortunes of any stocks within this sector.

For example, given the massive change in how the Australian military is adopting drone technology, stocks in this space are likely to receive their fair share of future government contracts.

If the Russian/Ukrainian war is any proxy, the deployment of small drones for battlefield surveillance is on the rise.

Australian government contacts aside, Quickstep Holdings (ASX: QHL) has etched out a niche in the global aerospace and defence sector by supplying the likes of Boeing with several composite parts for the F-15 and F-18 military aircrafts.

But despite delivering a solid first half, with underlying pre-tax profit up 82% to $2m, the stock is only up 5% over the past year.