Alex Brummer

Investment special: Flying through storms

Our aerospace sector shows incredible potential for recovery

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The financial crisis has unleashed a great debate about rebalancing Britain’s economy. The conventional wisdom is that our prosperity during the Nice decade (non-inflationary continuous expansion, that is) was over-dependent on finance and that we need to refocus our attention on high-quality manufacturing.

Under New Labour, and the Tories before them, manufacturing was allowed to wither, declining from 18 per cent of GDP in 1996 to just 12 per cent now. The better news, however, is that what’s left behind is much better than what was lost. In certain sectors, including high-end engineering and aerospace, Britain has managed to retain a strong competitive edge. And unlike in previous decades, this has been achieved for the most part without large subventions from the public purse.

That does not mean all is well in engineering and manufacturing. The recent row over the order for Thameslink trains, which went to Siemens rather than the British-based Canadian firm Bombardier, exposed weaknesses in our public contract bidding process, which ignores social consequences such as the impact on existing jobs.

The Thameslink episode also demonstrated the hollowing out in the UK of medium-sized engineering sub-contractors which provide components to bigger manufacturers. In Germany 55 per cent of railway equipment suppliers are home-based. In Britain, thousands of smaller firms have been lost leaving the rail industry with just 25 per cent of its supply chain intact.

Given this engineering shrinkage it is remarkable that our aerospace industry remains largely as substantial as it is, despite  some major losses. Much of the R&D, design and technology which once went into Westland helicopters has moved to Italy (what is now AgustaWestland is owned by the Italian conglomerate Finmeccanica) leaving a modest assembly operation behind. Smiths Aerospace, an important maker of components and avionics, was allowed to slip into the ownership of the US giant General Electric in 2007 without a voice being raised in protest.

Nevertheless, we still have two world leaders in BAE Systems and Rolls-Royce, together with a number of other robust quoted companies in the sector including GKN, Meggitt, Cobham, Senior and Ultra Electronics. Of this group BAE and Rolls-Royce are the only remaining companies in Britain to have a special status: the government retains the equivalent of a ‘golden share’ in both, which means they enjoy a degree of protection, unlike most of what remains of the nation’s industrial crown jewels, from overseas ownership. Even in our open economic model, with its stress on free capital markets, it is impossible to imagine either group being sold to foreign rivals without a full Competition Commission inquiry and the ‘national security’ exception to competition law being asserted.

BAE and Rolls-Royce face very different forces in the months and years ahead. The strong dependence of BAE on military orders makes it vulnerable both to short-term defence cuts in the UK and to an expected longer-term downturn in Pentagon spending as American operations in Iraq and Afghanistan are scaled down. Last month the company revealed that it would be making 3,000 workers redundant at plants in Lancashire and East Yorkshire, many of them working on the manufacture of the Typhoon, or ‘Eurofighter’. New orders for this manned fighter have moderated and there is some concern that it may be the last of a generation of British-built combat aircraft, as modern fighting forces deploy more unmanned drones.

Despite these factors, the heavy fall in the company’s shares during the market correction of the last quarter almost certainly ignores BAE’s order pipeline, its strength in the US market place, the long-term value of its Al Yamamah contract with Saudi Arabia, and a dividend yield which stands at close to 8 per cent.

A strong reminder of the excellent prospects for Rolls-Royce, the world’s preferred engine maker for larger jets, came in late September when after two years of delays the Boeing Dreamliner, powered by Rolls-Royce Trent 1000 engines, finally made its maiden flight for Japan’s All Nippon Airways.

The civil aviation market is clearly exposed to economic risks. During the last downturn global output fell by 0.5 per cent. Even though earnings dropped by just 1 per cent, share prices across the aerospace and defence sector plummeted by 39 per cent, and civil aviation stocks saw the biggest declines. This time around civil aviation looks better protected than defence because order books are strong and production is picking up momentum.

Rolls-Royce also has diversified sources of income. A large chunk of earnings now comes from service contracts, it has a bigger foot in the maritime market with its acquisition of German engine maker Tognum, and has grown its interests in power systems for the energy industry. Nevertheless, Rolls and Meggitt (which makes braking and other systems) could be vulnerable if airlines decide to slow their order schedules.

GKN is supported by its wing construction activity on behalf of Airbus but is very exposed to a global setback for the car market, to which it is a major component supplier. Cobham, an expert in avionics and surveillance systems, is very dependent on its role as a supplier to the US military, which accounts for 40 per cent of sales.

Britain’s aerospace sector clearly faces big challenges. But what is encouraging for investors is that UK-quoted firms dominate their own supply chain, with companies like Ultra Electronics, which specialises in designing and producing sub-systems for both civilian and defence use.

Evidence from the last recession suggests that the sector has durable technology and that the markdown of shares in the sector was greatly overdone. British engineering and aerospace firms have demonstrated an ability to manage their way through the economic cycle, control costs and emerge relatively intact. They defy the generally poor public image of British manufacturing and their capacity for design and R&D — so important for the much wished-for re-balancing of the economy — remains unimpaired. Companies in this sector provide a useful long-term investment opportunity.

Alex Brummer is City Editor of the Daily Mail.