Smart Investor Tip: make room for this stock in your arsenal

FTSE 250-listed Chemring (CHG.L) is a developer, tester and producer of defence equipment, with products falling into four main areas: counter-improvised explosive devices (IEDs), countermeasures, pyrotechnics and munitions.

It started life in 1905 with the incorporation of the British Foreign & Colonial Automatic Light Controlling Company, and its more recent history includes supplying equipment for use in the Falkland and Gulf wars.

Today, it has a market capitalisation of £516 million, having embarked on an acquisition spree over the past decade. It operates across the globe, with 50% of revenue being derived from the US and part of its future strategy being to maintain a global footprint that reflects the balance of global defence spending.

Chemring's financials

In terms of performance, Chemring has an impressive five-year record, delivering a net profit in all five years. Net profit has grown from £32 million in 2007 to £74 million in 2011, although the bottom line has been rather flat for the past few years following a big jump in 2009.

Return on equity is impressive at 15.5% last year, and averaged 21.1% over the previous five years.

As for dividends, Chemring currently yields 5.5%, which puts it among the upper echelons of core income stocks. Interestingly, dividends per share have increased in each of the past five years, growing at an annualised rate of 24.2% per annum.

As mentioned, Chemring has made a number of acquisitions in recent years. However, debt has been kept at sensible levels, with financial gearing being a perfectly acceptable 73% last year. Interest cover, meanwhile, is ample at 5.9, and free cash flow is fairly impressive, averaging £44 million over the past five years versus net profit of £56 million over the same period.

NIche products

Given the nature of its business, Chemring’s economic moat is quite substantial. It could be argued that spending cuts and a lack of cash floating around the world economy mean that public and private defence and security budgets are cut in real terms.

However, Chemring specialises in niche products, such as gunship flares and mine/IED checking vehicles, which are likely to be needed for some time to come while ‘big ticket’ items such as aircraft carriers are put on hold.

Barriers to entry are significant owing to the knowledge and testing capabilities required to compete in this arena.

Good value?

With a net asset value per share of £2.43 and a current share price of £2.67, Chemring’s price-to-book ratio is just 1.1. This means that each share carries just £0.24 of goodwill and, since return on equity is impressive, the price-to-earnings ratio is very low at just 6.77. In other words, Chemring is dirt cheap.

Of course, I appreciate that Chemring is a defence company and so may not be attractive to ethical investors. However, from an investment perspective, Chemring is performing well, is financially sound and has a substantial economic moat. Added to this is its extremely low valuation and high yield.

Chemring is an attractive investment proposition for long-term investors.