Why the arms industry is a lone UK success story

A recession might be looming for Britain, but we are still top dog in at least one industry – though whether you think it’s something to be proud of is a different matter. After a controversial deal with Saudi Arabia last year, Britain now heads the world arms export league, with a record £10bn in overseas orders compared with £5.5bn in 2006, according to the Defence and Security Organisation (DSO).

The UK fulfils a third of all worldwide export orders for military equipment, with the £4.4bn government-to-government sale of 72 Typhoon aircraft to the Saudis the icing on the cake. The contract, called Salam – Arabic for peace – could be worth up to £20bn over several years, including upkeep, spares and training.

It’s quite a shift in the status quo. US firms have been used to leading the field in the global arms market, with Britain, Russia and France vying to be runner-up. Last year’s achievement has lifted the UK to a clear second place over the past five years with $53bn of sales, compared with America’s $63bn, Russia ($33bn), France ($17bn) and Germany and Israel ($9bn each) trailing, says the DSO.

Ironically, the US, which spent more on arms in 2007 than in any other year since World War II, imported more weapons from the UK than from any other country. Is this just a flash in the pan? “Defence sales are notoriously lumpy,” says Roy Isbister, an analyst with Saferworld, “and 2008 orders could plummet. A clear indication of the UK’s arms exports can only be gained by looking at sales over several years.” And the latest figures indicate orders, not deliveries. In delivery terms, the Stockholm International Peace Research Institute (SIPRI) reckons Britain was the sixth-largest 2007 supplier.

But the depressing reality is that prospects look bright for the weapons industry. Global arms buying rose 6% last year to £1.3 trillion, and is up nearly 50% since 2000, says SIPR, with the US responsible for around half that total. And while most of America is feeling the pain of the housing slump, politics dictates that the arms industry won’t be squeezed.

“Ongoing security threats, rising costs and a lack of political will make any near-term cuts in the main US defence budget unlikely, regardless of who wins the election,” says Jane’s analyst Matthew Smith. “The candidates’ defence views differ little outside Iraq.” SIPRI expects the US to spend more than $700bn on the military this year and next. Pentagon spending projections show that the top brass expect the main budget to grow each year until at least 2013. Meanwhile, the soaring oil price is giving one of our biggest customers, the Saudis, ever more spending power.

Most importantly, with the UK racking up a 2008 first-quarter trade deficit of £11bn, despite the weak pound, the Government is keen to fly the flag for one of our few remaining manufacturing success stories. The last authoritative study, issued seven years ago by the Ministry of Defence and independent economists, found that in the late 1990s, defence exports, at an average £6bn a year, supported 97,500 jobs, half of which would be lost if exports halved.

The MoD, defence attachés abroad and the DSO all promote British weapons exports, while the likes of BAE Systems and VT Group have been singled out for praise by trade minister Lord Digby Jones: “The UK has a first-class defence industry, with some of the world’s most technologically sophisticated companies.” Below we look at how BAE is cashing in Stateside.

The best bet in the defence sector  

Despite flak flying around over a corruption probe at BAE Systems (LSE:BA), the world’s third-largest defence contractor – and Europe’s biggest – seems to have unlocked the secret to getting involved in major US and British military projects, including the F-35 Joint Strike Fighter, the Eurofighter, the Astute submarine and mine-resistant ambush-protected (MRAP) vehicles used in Afghanistan and Iraq. BAE now derives some 50% of its sales from the States, where it’s the sixth-largest supplier to the Pentagon.

JP Morgan has reiterated its ‘overweight’ rating on the stock after the share price slid amid concerns about the investigation of an arms deal between BAE and Saudi Arabia by the US Department of Justice, dismissing the sell-off as “indiscriminate”. The company has just appointed a new chief executive, Ian King, to repel further assaults on the company’s name; one of his first jobs is to “implement a report on how BAE should best act ethically”.

Underlying 2007 profit grew 22% to £1.48bn, including a 28% second-half advance. The group has forecast further good growth this year on the back of the end-2007 order book standing at £38.6bn, up 22%. On consensus profit forecasts, the stock trades on a current year pe ratio of 12, falling to 11 next year, which looks cheap given its solid growth prospects.