Bag this cheap defence stock

published 25 May 2012

Sometimes even blockbuster news can fail to move shares. Chemring is the world's biggest maker of decoys, flares and other countermeasures, used to protect military aircraft from incoming enemy missiles. Its share price is pretty beaten down, yet I can't see why.

On 1 May Chemring revealed that it had bagged a contract worth up to $579m with the American army for its ground penetrating Husky radar (a device mounted on an armoured vehicle to protect troops against roadside bombs). On the same day, it also announced that it had signed a £21m deal with the Ministry of Defence, and was on track to meet its 2012 guidance. Indeed, with a £1bn order book (equivalent to 1.2 times sales), the company should weather the industry's current soft patch.

The biggest risk facing Chemring is its exposure to America, where it earned 43% of revenues in 2011. The Budget Control Act, which tasked Congress with identifying and agreeing $1trn of savings by December, came into effect in August. Failure to meet these criteria triggers a $500bn reduction in the defence budget over the next ten years. But I don't think this will happen as it could weaken America's capability to respond quickly in conflict situations.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Chemring (LSE: CHG), rated a BUY by Investec

The world remains dangerous and ageing equipment needs to be replaced. There are a number of export opportunities in places such as Brazil and India. Sales to non-Nato countries already make up 29% of group sales, and CEO David Price believes this could jump to 40% by 2015. Sales of munitions are steady with the UAE and Saudi Arabia being key customers.

The City is forecasting 2012 turnover and underlying earnings per share (EPS) of £815m and 54p respectively, rising to £847m and 58p in 2013. That puts the stock on a price-to-earnings (p/e) ratio of 6.2 with a 2.8% dividend yield. That's cheap for such a science-rich business. I'd rate Chemring on eight-times earnings before interest, tax and amortisation (EBITA). Adjusting for net debt of £317m and a £25m pension deficit delivers an intrinsic worth of 450p per share.

As for the bigger risks, such as budget cuts, these are more than reflected in the share price.

Interims are due out on 19 June and Investec has a price target of 550p.

Rating: BUY at 313p

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. See www.moneyweek.com/PGI , or phone 020-7633 3634 for more information.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.