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This stock’s share price has already risen 85pc – but there’s plenty more to come

Chemring flares from aircraft - SRA JULIANNE SHOWALTER
Chemring flares from aircraft - SRA JULIANNE SHOWALTER

The prospects for many companies have deteriorated markedly since the start of the year. Significant threats such as high inflation, rising interest rates and war in Ukraine have combined to cause a weaker operating outlook across a wide range of industries.

However, not all sectors face a more difficult future than six months ago. The defence industry, for example, is poised to be reinvigorated by a new post-Cold War era in which the idea of spending more on the armed forces to provide greater security is widely accepted.

In Questor’s view, this will create more promising circumstances for Chemring. The FTSE 250 company designs, develops and manufactures countermeasures such as flares that protect military hardware from guided missiles. It also develops sensor technologies that detect a range of threats, including cyber, explosive and chemical.

Even before Russia’s invasion of Ukraine, the company was already growing quickly. Its interim results, published earlier this month, reported an 18pc rise in underlying pre-tax profits amid buoyant operating conditions.

As America, which accounts for just over half of the company’s sales, plans to increase its defence budget by 4.1pc to record levels next year, demand for Chemring’s products is likely to rise.

Although the impact of higher defence spending on its sales and profits is subject to time lags, as announcements typically precede tangible orders, the company’s long-term prospects are nevertheless increasingly upbeat.

A solid performance in the first half of the year allowed it to further reduce net debt levels. They now stand at just £18.4m, including lease liabilities, which equates to a gearing ratio of less than 5pc. Declining leverage not only reduces the risks that face the company in an environment of rising interest rates, but provides scope for it to engage in mergers and acquisitions to further enhance its growth prospects.

Acquisitions look more likely following the successful integration of Cubica Group, the artificial intelligence and machine learning specialist bought last year. Chemring’s strong cash flow and long-term policy to pay just 40pc of net profit as a dividend further suggest that it plans to make acquisitions alongside ongoing investment in improving its operations.

Encouragingly, the company’s underlying operating margin increased by one percentage point to 15.2pc in the first half of the year. This is largely due to its long-term strategy to focus more on higher-margin business areas, which should add to its investment appeal in an era of high inflation. With a return on equity of 12pc last year, the company appears to have a sound competitive position.

Of course, the strengthening of the dollar has had a positive impact on the company’s financial performance. In Questor’s view, it should continue to have a positive impact on Chemring’s bottom line as an increasingly uncertain global economic outlook prompts a flight to the perceived safety provided by the greenback.

A weakening in the global economy could, of course, inhibit government spending growth in the coming years. Although in normal times this would imply weaker prospects for the defence industry, vastly changed priorities following Russia’s invasion of Ukraine mean that rising military spending may increasingly be viewed as sacrosanct by policymakers.

Since this column advised readers to buy Chemring in June 2019, its shares have surged by 85pc. They now trade at about 17 times forecast earnings, which suggests that their margin of safety has narrowed since our initial recommendation.

However, the company’s significantly improved long-term prospects mean it has further capital growth potential and continues to offer good value for money.

With a solid balance sheet, scope to make further acquisitions and the capacity to improve margins as part of its growth strategy, it remains a stock worth buying and holding for the long term.

Questor says: buy

Ticker: CHG

Share price at close: 314.5p

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