FTSE 350 Review: Ukraine drives the strategic imperative for aerospace & defence

PE appetite for defence companies meant last year saw the amalgamation of Cobham and Ultra Electronics, the former of which was itself taken private by Advent International at the start of 2020. Meggitt also departed from the official list, this time thanks to a £6.3bn government-sanctioned takeover by US aerospace rival Parker-Hannifin.

That leaves a handful of UK defence contractors within the FTSE 350, two of which – Rolls-Royce (RR.) and Babcock International (BAB) (categorised as an outsourcer in this review) – also support the civil defence and aerospace markets.

Ironically, the flurry of M&A deals came in the wake of updated rules to strengthen the government’s powers to scrutinise mergers and takeovers, with an emphasis on UK companies engaged in military and dual-use technology. Nonetheless, the deals were waived through. You’re left wondering whether the remaining constituents will come within the crosshairs of foreign buyers at some point.

Certainly, the percentage of shares held in the sector by UK fund managers has fallen markedly over the past decade in favour of US-based investors. The UK government has a veto on any foreign approaches for Rolls-Royce and BAE Systems (BA.), but critics have accused it of putting critical technology at risk due to a laisse faire attitude towards the country’s defence assets.

A year of outperformance for defence shares 

Despite the ongoing debate, the broader aerospace/defence sector outperformed all others, bar energy and mining, last year. If nothing else, the return highlights the non-cyclical nature of the sector – a boon during periods of market volatility – even though projected compound annual revenue growth is steady rather than spectacular.   

This is partly due to the long-dated nature of many defence contracts, especially in relation to large capital purchases. As has been demonstrated since Russia’s invasion of Ukraine, geopolitical imperatives will often trump fiscal considerations even when government finances are strained. Moscow’s belligerence has prompted many European nations to commit to meeting or exceeding the Nato annual spending target of 2 per cent of annual gross domestic product (GDP). A common procurement scheme has also been established to avoid competition and facilitate cost savings among European Union member states.

Modelling from McKinsey posits that European defence spending would have increased by 14 per cent to €337bn (£299bn) over 2021-26, assuming the invasion had never taken place. But in a separate scenario that factors in the invasion’s impact on defence funding, spending increases by 53 per cent to €453bn. It should be remembered, however, that purchasing power will dissipate if inflation continues to rise. McKinsey analysts also make the point that material support for Ukraine means that “weapons systems availability is critically low in several European countries” – that represents a commercial opportunity for the industry.

Beyond events in Ukraine, technological innovation and the rise of asymmetric warfare should support activity within the sector for the foreseeable future. Nowhere is this better illustrated than the step-up in demand for cyber warfare systems (technologies that have significant overlap with civilian applications). This also applies to rapidly evolving military applications linked to robotics, autonomous systems and artificial intelligence.

The UK defence industry got an unexpected boost when the government took the decision to prioritise defence spending as a means of stimulating the domestic economy in the wake of Covid-19. The pandemic also prompted UK defence contractors to examine potential vulnerabilities in key supply chains, so we are likely to see a realignment analogous to what’s taking place in the civil sector. The potential upshot is that smaller contractors and/or electronic component manufacturers are primed to feel the benefit.