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“The greatest victory is that which requires no battle.” ― Sun Tzu, The Art of War
“One of the world’s largest private equity investors has made an approach to buy Chemring, the FTSE 250 defence group” ― Mark Kleinman, Sky News.
Bain Capital’s reported move is interestingly timed for several reasons. First, Chemring has an AGM trading update on Wednesday. Second, the stock had been strong of late on the realisation that Trump should be treated as a threat to Europe rather than its ally. Third, it follows a bad run for the shares as we wait for the result of the UK Strategic Defence Review.
Though Chemring is more domestic and specialised than the average defence contractor — 45 per cent of revenue is from the UK, with 17 per cent from Europe and 34 per cent from the US — a takeover might be seen as no more controversial than Advent’s purchase of Cobham in 2019 or Parker-Hannifin’s deal for Meggitt in 2022. The speculation alone should put a floor under the stock.
And at a surface level, Chemring’s defence-tech might appeal to Bain. Three of its partners published an editorial in December outlining why “private capital is poised to play a critical role in the modernisation of the US defence industry”.
The US Department of Defense has been seeking to encourage longer-term corporate R&D spend by offering fixed-price contracts and war-as-a-service type deals. Venture capital firms have already been attracted by the promise of more stable cash flow from long-term R&D, and private equity investors will soon learn to appreciate high barriers to entry and the opportunity to sweat manufacturing costs, Bain (the consultancy bit) says:
Large defense-focused companies typically have concentrated customer bases, considerable exposure to single programs, and sources of growth that differ from those in commercial markets. These factors make it more challenging for general partners and limited partners to commit capital.
In contrast, the value of venture capital deals in the defense sector has increased 18-fold in the past 10 years, significantly ahead of deal value in other industries. That growth results from multiple factors, including the DOD’s efforts to engage and fund early-stage companies and the increasing convergence of commercial and defense technologies. In the coming decade, government funding can play an important role in supporting early-stage businesses developing new products with long commercialization timelines.
That sounds a bit like Roke, Chemring’s Hampshire-based R&D lab that develops systems used for locating aircraft, tanks, mines and tennis balls.
But while Roke is part of a Sensors & Information division that accounts for about 40 per cent of Chemring’s group revenue, it has been the kind of terminal underperformer that any PE firm would be more likely to asset-strip than seek to turn around. Roke customers, having sought longer deals during the pandemic, have shifted back to reviewing their needs annually, so order intake last year plunged 28 per cent.
Chemring’s other business is to sell flares and military-grade plastic explosives. The Countermeasures and Energetics division accounts for about 60 per cent of group revenue, but has historically suffered from all the problems Bain notes. For example, Chemring has been unable to rid itself of a US countermeasures contract signed in 2016 on which it earns zero margin.
That just leaves explosives, where business is booming. A recent Shore Capital note explains:
There are four core reasons why demand for Energetics is so high. The first is that stockpiles in Europe have been depleted following the Ukraine war. Ukraine is fitting 5,000-10,000 artillery shells a day, [and] European production cannot meet the demand. Therefore, stockpiles are dwindling and will need to be replenished. Secondly, the stockpile level required has risen due to the increased threat posed by Russia. Russia can produce c. 3mn artillery shells annually, which is greater than the Western block combined. Given this threat, the previous stockpile levels are not sufficient and therefore will be raised. Thirdly, there is a joint effort to establish a defence and industrial base across Europe, and so governments are willing to subsidise production. Lastly, capacity is constrained following years of under-investment in explosive chemical compounds across the Western allies as European nations relied upon the peace dividend since the end of the Cold War.
Because it’s not a good idea to ship sophisticated plastic explosives across borders, domestic supply chains matter. That gives Chemring strategic importance. The company’s only competitor in Europe is The Eurenco Group, which is owned by the French state. And it appears the EU would rather expand independent production than support national interests.
The EU has awarded Chemring more than €66mn in grants to increase explosives production, versus just €29mn for Eurenco. Much of the investment is to add production in Norway, whose government said in October it was co-funding with a feasibility study for a new factory.
EU support makes “an extremely attractive partner for the EU and Nato member states that would like to develop sovereign capabilities for high explosive energetics”, says Shore.
Elsewhere, Chemring’s factory upgrade in Scotland should be finished soon, though health and safety certification will push back the start of production for at least a year. There’s also a new wing on a Chicago factory that supplies rocket fuel to Nasa, SpaceX and Blue Origin:
So far, Chemring shareholders have been sharing the burden. Management has wagered approximately £200mn, mostly debt-funded, that explosives demand will keep outstripping supply, no matter what happens in Ukraine.
Group net debt is forecast to double to £100mn by 2026, the same year net cash flow might return to break-even after three years of steep losses. That meant last year unexpectedly cancelling the final slice of a £50mn share buyback. Any payback has to wait until 2027:
Bain’s reported interest in Chemring is therefore a very timely reminder of what’s at stake.
Given how thin Roke’s order book was at the 2024 year-end, the news at Wednesday’s trading update is unlikely to be good:
So should Europe’s only independent supplier of military-grade advanced explosives be allowed to fall into the same PE portfolio as Bob’s Discount Furniture, Virgin Voyages and Bugaboo? Or should stakeholders be asked once again to suck it up and think of 2027? We’ll find out soon enough.
