Whichever government wins the UK election in May, defence budgets could be cut, according to analysts at UBS.
In a report on the sector it picks Qinetiq - the former Ministry of Defence research department - as the company most exposed to UK defence, with others having diversified elsewhere, notably the US. The bank says:
We are increasingly concerned about the outlook for UK defence budgets, especially under a potential Conservative government, but we see little political will to increase defence spending on either side of the political spectrum. Possible scenarios could see ~20% nominal declines from 2015 to 2019 under a Conservative government and ~10% nominal under Labour. The size of these cuts looks shocking and we believe that the cuts could end up being smaller, but we are concerned that there could be knee- jerk reaction against the sector as a whole.
Most of the UK defence companies have limited exposure to the UK defence market, having diversified to the US over the last 15 years or so. QinetiQ is the most exposed with about 75% of sales to the UK defence/security market. If in line with the budget, we estimate that a 10% cut to the UK defence budget (Labour) would reduce QinetiQ’s fair value by about 8% and 20% cut (Tories) would reduce it by about 17%.
On the other hand, US defence budget growth probably will hit sequester wall.
President Obama submitted a $534bn base defence budget, which is about 8% up versus the 2015 budget, versus UBS estimate for low single digit growth and sequestration to be removed. However, sequestration is still in place in law and the proposed budget will breach the current limit of ~$500bn. Given the Republican majority they will be forced to decide whether they are defence hawks or fiscal deficit hawks. We believe that they will end up being fiscal deficit hawks, the sequester will remain in place, although it will probably be stretched up in a one year deal, and the budget increases will end up more in the 2-4% range to $506-516bn.
If the US budget does increase as submitted, we estimate that the main beneficiaries will be BAE Systems, Cobham and Ultra Electronics with 3-4% potential profit uplift in 2017 (there is a 6-24 month delay between budget and outlay) and about 3% increase to fair value
