Amid the complex outlook created by COVID-19, the cohort of listed ASX small-caps in the defence and aerospace sector have drawn increased attention.

To get an expert view on the sector, Stockhead spoke this week with Heath Andrews, senior equities analyst at corporate advisory firm PAC Partners.

Andrews has over 12 years’ experience in equities research with a focus area spanning across finance, tech, mining and construction, and also defence.

“It is a sector that I look at, partly because there’s not that many names in the Australian market,” Andrews said.

“But if you’re successful, it often means you’re in a strong position. So, although it’s a long road, usually if you’ve made it you’ve really got something worthwhile.”

The industry’s reputation as a recession-proof sector has also brought it back into focus in the wake of such an economic contraction.

“I think it’s pretty straightforward why defence has held up,” Andrews says.

“If you look at the US, they’ve been heavily impacted by COVID-19. But the government has rated its defence industry as critical, and it’s continued to operate through the shutdown.

“My view is spending on defence will probably increase rather than fall in the near term. US-China relations seem to be deteriorating, and they’re the two main players so I think defence spending will ramp up, and Australia is obviously more leveraged to the US in that regard.”

For those reasons, defence and aerospace stocks are often less correlated with the broader market cycle.

However, numbers compiled by Stockhead’s data team for a cohort of 13 defence-adjacent companies shows not every stock has been immune to the recent selloff.

Here’s a summary of the recent share price performance over a one-month, three-month and six-month timeframe:

Code Name Price ($) 1M Return 3M Return 6M Return Market Cap
AJX ALEXIUM INTERNATIONAL 0.047 4.3% -20.0% -51.8% $30.5M
BIS BISALLOY STEEL GROUP LTD 0.99 28.6% -3.9% -9.6% $45.0M
BCT BLUECHIIP LTD 0.062 -8.6% -46.7% -58.7% $38.0M
BRN BRAINCHIP HOLDINGS LTD 0.051 16.3% -3.8% 4.2% $72.8M
CDA CODAN LTD 6.87 18.7% -12.6% 10.8% $1.2B
DRO DRONESHIELD LTD 0.11 10.0% -45.0% -71.1% $27.8M
EOS ELECTRO OPTIC SYSTEMS 4.99 -11.1% -46.2% -27.1% $773.6M
ELS ELSIGHT LTD 0.385 48.2% 15.3% 0.0% $43.8M
MOB MOBILICOM LTD/AUSTRALIA 0.05 -12.3% -44.4% -54.5% $12.9M
OEC ORBITAL CORP LTD 0.915 70.4% 54.6% 170.6% $71.4M
QHL QUICKSTEP HOLDINGS LTD 0.067 -12.8% -51.4% -51.4% $48.5M
TTT TITOMIC LTD 0.735 -14.3% -18.2% -43.8% $109.3M
UUV UUV AQUABOTIX LTD 0.001 0.0% -50.0% -75.0% $758K
XTE XTEK LTD 0.64 22.1% 26.4% -15.9% $33.8M

Analyst view

The standout so far this year is Perth-based Orbital UAV (ASX:OEC), which manufacturers specialised two stroke engines for unmanned aerial vehicles (UAVs).

Orbital shares have rallied to new highs since the March selloff and are up by around 200 per cent for the year.

Speaking with Stockhead a couple of months ago, Orbital CEO Todd Alder said those gains were a by-product of a shift in strategy years earlier, when the company streamlined its operational focus.

That longer timeframe isn’t uncommon for companies tied to military and defence, and it often warrants a more patient approach from investors.

Here’s how Andrews assesses value in the space:

“You’re looking for companies with a tech advantage that’s quite difficult to replicate, and you also want to see evidence of some long-term contracts in place.

“The lead time to win contracts this sector is usually very long, but that generally means contracts are pretty sticky.

“It requires a proven track record of delivering quality products, with the right R&D around it.

“I’m also focused on costs. Defence is usually a high-cost business, but a lot of those costs are fixed. And if it’s matched by high revenue growth, that typically allows you to increase your margin on EBITDA. So they’re the key things I look for.”

And following its strong run in 2020, Orbital UAV is Andrews’ pick of the bunch among active defence-sector small caps.

“I think over the journey they’ve had a pretty hard road, but their sales are ramping up the fastest and the contracts are in place,” he said.

“They still have to deliver. But they’ve got a tech advantage in their field — two-stroke engines for UAV’s — because they’ve been doing it for 30 years and they have R&D behind them, so the factors are there.”

Andrews also likes the look of Quickstep (ASX:QHL), which manufactures carbon fibre components for the aerospace industry, predominantly from its central facility in Bankstown, NSW.

“It’s a similar story, the company’s had a hard journey, it’s now profitable. They reiterated guidance in their Q3 trading update, and the company expects revenue to grow by 9 per cent,” he said.

“Investors looking for value might want to take look at QHL. They’ve been sold off during the crisis, but the company is profitable and growing and I think there’s value there, so I quite like that one.”

Company perspective

Along with the analyst view, Stockhead also spoke with representatives from three ASX-listed companies — Quickstep, Orbital and DroneShield (ASX:DRO) — to get their perspective on market conditions in the wake of COVID-19.

Quickstep CEO Mark Burgess

Quickstep’s stock price hasn’t escaped the broader market selloff since March, but it reaffirmed guidance in April when the majority of ASX companies were withdrawing guidance altogether.

Burgess told Stockhead that while the company has negotiated some teething issues across its global supply chain, it “hasn’t seen any demand disruption at all”.

“We haven’t missed a single customer ship date over last three months, and we know some of our peers across Asia, the US and Europe have struggled in that regard,” he said.

Looking ahead, Burgess said the company was keeping an eye on any unexpected opportunities that evolve out of the crisis, now the initial threat had been negotiated.

“I think being known as a reliable credible supplier during a time of crisis can only stand you in good stead for when you want to re-compete or win new business,” he said.

“Particularly in North America, we’ll be watching with interest over the next six to 12 months for potential opportunities. Firstly in terms of filling supply gaps, and also because business competitors are in a challenged position while we’ve come through relatively unscathed.”

In view of that, Burgess attributed Quickstep’s lagging share price to “broader risk-off sentiment, rather than anything specific to the business”.

“Hopefully we can rebound quite quickly because people can see the numbers, and see confirmation that we’ve come out of this alright,” he said.

Droneshield CEO Oleg Vornik

For the anti-drone equipment manufacturer, COVID-19 has been a catalyst for taking a step back and reallocating resources towards a focus on artificial intelligence and machine learning.

“The thing about machine learning, it’s a bit of a buzz word but not a lot of people truly understand what it means,” Vornik said.

“It’s effectively a way to process large amounts of data to generate better and more accurate results than a standard yes/no algorithm.”

“Our customers are dealing with an evolving threat – there’s always new tech which makes it a bit of a cat and mouse game.”

“So machine learning and AI enables you to keep pace with the other side, and for the system to learn on the go, which our customers really appreciate.”

More broadly, Vornik said the business was positioned to benefit from the broader tailwinds behind the sector.

“We think there’s a lot of resilience in the business model. We are living in a time of increased government spending, and Droneshield is well positioned to be the beneficiary of that,” he said.

“The problem we’re trying to solve — drones being used in a nefarious manner — isn’t going away anytime soon.”

“Clients are going to continue to have budgets allocated for this matter, and if anything is going to change for us it’s really about doubling down on our core focus areas.”

Orbital UAV Vice President (US operations) Keith Hirschman

Speaking with Stockhead earlier this week from Oregon, USA, Hirschman highlighted that while the company benefited from the stability of the defence sector, it was also focused on building out its advantage on the product side.

“I think any sector that links to govt spending, especially the US government is going to be inherently a bit more stable,” he said.

“And if anything, defence becomes more prominent in times of crisis. Whether it’s a health crisis or market crisis, there’s always going to be a need for a security.”

“Then nested within that broader sector is our specialty area, which is the market for unmanned aircraft (UA) market.”

Hirschman said that having finally cracked the US market, Orbital now had an opportunity to capitalise from the ongoing shift towards UA solutions for military operations.

“The market is turning, and we’re at the forefront of that. There was a tolerance in the past for gasoline engines, but military forces worldwide understand that specialty fuels (like AVGAS) are an unnecessary logistics burden.”

“They want heavy fuel, and we’re a step ahead in the market because we have a design that fits a unique military need for heavy fuel engines.”

“Orbital’s direct injection technology allows for a clean burn. So we’ve got the versatility to say ‘give us whatever fuel you’ve got, we’ll figure out how to calibrate our engines to it’.”

“As the military expands its use of tactical UA, the state of the art for multi-fuel capability is there. They can demand that anyone in the competition bring that level of versatility, and it’s already built into our design.”

“So I don’t think we’ve seen the top of the demand for unmanned systems. There’s still plenty of market opportunities as that industry progresses.”