TheChek News Flow

It has been at least a decade since a pure-play UK-listed defence sector operator with a market value of GBP 500m or more has become a target, according to Dealreporter data.

Even a long-mooted tie-up between Cobham [LON:COB] and Meggitt [LON:MGGT] still looks some way off, this news service reported yesterday (23 May).

But there is one potential combination which could break that barren run - a possible tie-up between Ultra Electronics [LON:ULE] and Chemring [LON:CHG].

A merger between these two is a possibility, a banker tells the Flash. Both have been struggling in recent years, along with much of the sector, and need to find a way to improve performance. Finding synergies in a combination of the two businesses might be one way to reboot their ailing fortunes.

Ultra, in March, saw its own attempts to increase scale scuppered by the US Department of Justice (DoJ). The DoJ asked for additional information on an agreed USD 234m transaction with underwater warfare specialist Sparton. Eight months after its announcement in July 2017, Ultra and Sparton agreed to terminate the deal.

On the rebound, Ultra could seek out a deal with Chemring. Valued at GBP 590m, Chemring is larger than Sparton but still probably digestible. Combined, the two companies would have GBP 155m of net debt and GBP 202m of trailing-12-month EBITDA. In a takeover scenario, Ultra could fund in the region of GBP 250m as cash consideration in a transaction and maintain pro-forma leverage at 2x EBITDA. It is possible that this could be stretched if there is a compelling case for synergies, though it looks like a large part of any consideration would need to be funded by Ultra in equity.

Among mid-tier UK defence players, Meggitt [LON:MGGT] has the highest net debt to EBITDA ratio at 1.9x.

Chemring has faced takeover speculation on numerous occasions in the past. An unnamed bidder was reportedly interested around the time of a 2016 rights issue. Earlier, in 2012, Chemring held formal talks with private equity group Carlyle, though discussions ended without an agreement.

As well as a decent number of potential buyers, there’s also potential on Chemring’s shareholder register. Occasional activist investor Sterling Strategic Value owns 6.7% of the business.

Barriers to a deal between Chemring and Ultra include UK political sensitivities around the country’s industrial and defence industries. Melrose’s [LON:MRO] acquisition earlier this year of conglomerate GKN bore out that sentiment – politicians openly campaigned against the deal even though both parties were headquartered in the UK.

Then there are US regulators to satisfy. Ultra’s rejected attempt on Sparton means it, too, is likely to tread carefully. Both Ultra and Chemring generate around half their sales in North America.

Another possible obstacle to a transaction is Chemring’s high sector-relative price-to-earnings ratio, which would weigh on potential earnings accretion for Ultra if, as is likely, equity needs to be issued as consideration. Chemring trades at 16.5x versus mid-tier UK defence peers, including Ultra, Cobham [LON:COB], Meggitt and Qinetiq [LON:QQ.] that trade at an average 15.1x. Ultra trades towards the low end of the group at 13.6x.

Chemring, however, trades at a sizeable discount to the sector on an EV/sales basis, at 1.2x versus the sector average of 1.8x. On EV/EBITDA multiples, it also trades below peers, at 8.3x versus 9.8x. These prevailing sector multiples imply Ultra could pay a premium of 20% to 50% on Chemring’s GBP 2.13 share price, at yesterday’s close.

It has been a long wait, but perhaps Ultra and Chemring can bring the industry’s deal drought to an end.