Chemring Group: an explosive investment opportunity in defence

The scale of additional military spending planned across Europe over the coming years is set to deliver a windfall for the continent’s defence industry. According to research compiled by Goldman Sachs, defence spending by EU member states is expected to rise by 1.8% of GDP in 2024 to 2.4% by 2027, an extra €80 billion a year. The UK has outlined a commitment to spend 2.5% of GDP by 2027, an extra £13.4 billion a year, taking total annual spending to £80 billion by 2027.

The bulk of this will end up in the hands of the sector’s biggest players, the national champions and defence giants, such as BAE Systems, Rheinmetall, Leonardo, Safran and Thales, but a good chunk will also trickle down to the smaller players. One such business that could benefit more than any other is Chemring Group (LSE: CHG).

Chemring could benefit from a captive defence market

On the face of it, Chemring doesn’t look to be one of Europe’s most important players in the defence sector. It has two main divisions, sensors and information, which accounts for around 40% of revenue, and countermeasures and energetics, which makes up 60%. The latter contains the firm’s advanced plastic explosive business, which is one of the most important in the whole European defence sector.

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Chemring only has one major competitor in advanced plastic explosives in Europe, France’s Eurenco Group, which is owned by the French state. It’s difficult to ship explosives around the world, so governments like to buy from local suppliers. With the European market dominated by just two players, that doesn’t give the rearming European nations much choice.

Sales are already benefiting from increased demand from European nations. With Ukraine firing around 10,000 shells a day, resupplying the country with explosives has become a priority for the country’s military backers. Chemring noted it had recorded “unparalleled demand for our specialist capabilities” in its full-year results for the year to the end of October, as it recorded a £932 million order backlog, up 24% year-on-year and roughly equivalent to more than three years of revenue.

In response to the increased demand (which is almost certain to continue), the company has outlined plans to invest £200 million to expand manufacturing capacities in Norway, the US and the UK. On top of this, the firm has been awarded a £90 million grant to support investment in its Norwegian site.

Unfortunately, while the countermeasures and energetics side of the business is doing well, the group’s sensors and information division struggled last year. A shift in order patterns translated into a 30% decline in order intake and a 37% decline in the division’s order book, even as revenue increased 14% to £213 million. But Roke, the leading business in sensors and information, is a key player in electronic warfare, and this is being noticed. Russia’s invasion of Ukraine and Hamas’s attack on Israel have both highlighted the increasing role of technology on the battlefield.

Last year Roke booked orders from customers in Sweden, Lithuania, Latvia, the United Arab Emirates and Japan – the latter its first in the East Asia region. So, while the division might have encountered some turbulence last year, it’s well positioned to grow in the new era of defence spending.

Chemring's shares look cheap

Considering its position in the market, it’s no surprise that Chemring has attracted takeover interest. Earlier this year it was rumoured that US private-equity giant Bain Capital was looking at offering 390p a share for the group, although no hard offer emerged.

In reality, it could be difficult for a private equity company that’s not based in Europe to take control, considering the national-security implications and the pivotal role the group plays in European defence. Still, the rumoured bid price does give a rough indication of what the business could be worth.

As the private-equity playbook often involves breaking up businesses and selling the component parts to the highest bidder, Panmure Liberum has crunched the numbers for each of Chemring’s four main business divisions to calculate the enterprise’s valuation on a sum-of-the-parts basis. Based on projected 2029 revenue (multi-year order backlogs make these figures relatively reliable), the broker put a value of £810 million on Roke as it’s set to have the second-largest revenue (£304 million) behind the Energetics business in 2029. Energetics could be worth as much as £680 million based on the projected 2029 revenue of £334 million, with companies such as BAE and Eurenco most likely to make an offer. The remainder of the enterprise could be worth around £250 million, according to the broker. Overall, on a sum-of-the-parts basis, Panmure Liberum has put the value of Chemring at 747p per share, more than double the current share price.

This underscores the value of the business, but it’s also worth touching on some of the issues that have held back growth at the company. The biggest of these is a legacy US government contract for the supply of countermeasures, signed in 2016 and extended into 2025. The contract has produced virtually no profit for the group. Last year, it also encountered production issues “due to adverse weather conditions”, and there were delays in its plans to expand automation. Both of these issues hit margins at a time when the company should have been celebrating the shifting winds in the defence sector.

If it can put these issues behind it and successfully ramp up production to meet growing demand, Chemring could be one of the best ways to play the European rearmament trade – assuming it’s not bought out before shareholders can reap the full benefits.

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