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MarketsIntermediate· 7 min read

The defence spending supercycle

The one thing to remember

A defence prime is a bond-like business with equity risk: reliable, politically driven, and structurally capped on the upside.

The question

Value a company whose only customer is a government.

Figure

How the defence spending supercycle works, in one picture

1The demand is real and it is not cyclical in the usual way2But a single customer is a moat and a cage3Read the cash, not the profit4Separate the primes from the disruptors

The same argument as the text, as a chain. Each step is what makes the next one possible.

Figure

The divergence that precedes most disasters

Y1Y2Y3Y4Y5Reported profitOperating cash

Reported profit climbing while the cash it supposedly generated goes nowhere. Either customers are not paying, or the sales were never really made.

  1. 1

    The demand is real and it is not cyclical in the usual way

    Rearmament programmes run for a decade or more, and the order books are long and visible. That is unusually good forward visibility, and it is why these businesses trade like a hybrid of an industrial and a bond.

  2. 2

    But a single customer is a moat and a cage

    Being the only firm that can build a particular platform is a genuine moat. It also means your customer knows your costs, sets your margin, and can change the rules. Government contracts are frequently margin-capped in a way commercial businesses are not.

    There is a ceiling on how good this ever gets. That is fine. Just do not pay a growth multiple for it.

  3. 3

    Read the cash, not the profit

    Programme accounting lets long contracts be recognised over years, which makes reported profit an estimate. Defence primes also carry large pension obligations. Free cash flow is the honest number here, and it can diverge from earnings for years.

  4. 4

    Separate the primes from the disruptors

    The established contractors and the new drone, software and space entrants are completely different investments. One is a slow, safe, capped compounder. The other is a venture bet on displacing a customer relationship that has existed for fifty years.

Try it
Reinvest the dividend, or take the cash?Interactive
Reinvested Taken as cash
Reinvested
£100,627
Spent
£54,868
Difference
83%
Same company, same dividend. The only difference is whether the cash buys more shares. Over decades that choice is most of the outcome.
You have got it when

You can say whether you are buying the capped compounder or the venture bet.

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The bottom line

A defence prime is a bond-like business with equity risk: reliable, politically driven, and structurally capped on the upside.

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