British stocks lead the way in defence aerospace boom

IT was a bad few days for civil aerospace firms at the Paris Air Show last week. After the first four days, total orders and commitments for civil aircraft totalled $14.1bn. To put that in context, at Farnborough in 2008, total orders and commitments for Airbus and Boeing alone came to more than $64bn.<br /><br />The civil aviation industry has been hit by high oil prices and consumers choosing to fly less. For those interested in high-tech and engineering stocks, the defence aerospace industry is looking increasingly attractive. North Korea&rsquo;s detonation of a nuclear bomb and instability in the Middle East following the disputed Iranian election result are sure to mean that governments will increase their defence spending. Middle Eastern countries have been expanding their militaries as regional jitters increase, and a number of Gulf countries put in large orders for defence aircraft in Paris. Ongoing operations in Iraq and Afghanistan also mean orders from the governments involved.<br /><br /><strong>POLITICAL TENSIONS</strong><br />The sector has underperformed the market by 21 per cent over the last three months, but as Omer Bhatti, head sales trader at WorldSpreads, says: &ldquo;If anything, political tensions have been building which would support the purpose of buying defence stocks.&rdquo;<br /><br />Jason Adams, an analyst at investment bank Nomura, says that the recession could lead to cuts in defence spending in the US and European countries but is bullish on the sector&rsquo;s international opportunities. &ldquo;Earnings risk is biased towards the upside over the next four years from the post-Iraq equipment recapitalisation effort, the increasing military campaign in Afghanistan and a large amount of export opportunities,&rdquo; he adds.<br /><br />While there is a risk that by taking positions in defence aviation stocks you could miss out on another cyclical rally, Nomura believes that the sector offer investors an attractive risk-reward profile at current depressed valuation levels.<br /><br />But which defence firms should be in your top flight of stocks? Adams&rsquo; preferred defence company is London-listed BAE Systems because he believes that the resilience of BAE&rsquo;s earnings has not been fully appreciated &ndash; BAE generates 38 per cent of revenues from through-life support services, which are essential to keep equipment operationally ready. Unlike some comparable firms, it also generates much of its revenue outside of the US and Europe.<br /><br /><strong>PROCUREMENT PROGRAMME</strong><br />For example, Saudi Arabia offers huge opportunities to the defence aviation market and BAE Systems will gain from its spending. BAE is expected to more than double its revenue from Saudi Arabia between now and 2011 as it delivers Project Salam, a series of deals that includes delivering 72 Eurofighter Typhoons, building a Typhoon assembly line in the country and various other contracts. There are also possibilities for a Eurofighter follow-on contract and a role in the Saudi Arabian army&rsquo;s modernisation efforts.<br /><br />Engine maker Rolls Royce and defence communications firm Cobham &ndash; both London-listed &ndash; also have good long-term prospects and strong business models.<br /><br />Rolls Royce has expanded its defence business &ndash; civil aviation will be 48 per cent of revenue in 2009, down from 53 per cent in 2006 &ndash; and Nomura sees long-term value in the company, which it believes has the best business model in the commercial aerospace sector.<br /><br />Cobham is well positioned in the high-growth defence electronics market and is currently in a bid competition to manufacture the next generation of vehicle intercom equipment for the US Army, which the group estimates would be worth $1.5bn. The decision is expected this summer.<br /><br />Political instability will always be with us, and those positioned to benefit will flourish in these troubled times.