On 1 July, the Prime Minister announced a $270 billion defence spending plan to upgrade the Australian Defence Forces (ADF). He made specific references to long-range missile systems, highly sophisticated sensor technology, as well as a very large spending commitment on ships. Reinforcing the need for the ramp up, Mr Morrison said:
"We have moved into a new and less benign strategic area, one in which the institutions and patterns of cooperation that have benefitted our prosperity and security for decades are now under increasing, and I would suggest, almost-irreversible strain".
The Prime Minister's many references to the Indo-Pacific region also raises the possibility of additional defence spending from other countries in our region over the coming years.
Which ASX shares are likely to benefit from the defence spending spree?
Some of the companies below already have sizable contracts with the ADF. Others are likely to see increases in revenue from this newly announced spending program. Less clear is the impact on ASX shares of any additional regional spending resulting from increasing global tensions.
Shipbuilding
The announcement of the $270 billion investment in Australia's defence forces made mention of ship building activities already underway. On 1 May, Austal Limited (ASX: ASB) announced it had won a $324 million contract from the Royal Australian Navy to design and construct 6 Cape-class patrol vessels. This addition will grow the nation's fleet to 18. Furthermore, in June the company announced a US$43 million modification to a previously awarded Littoral Contract Ship (LCS) contract with the United States Department of Defence.
Highlighting the importance of Austal to the US defence forces, the company also announced in late June the provision of US$50 million in funding from the US government. This is to maintain, protect, and expand US domestic production of steel shipbuilding capabilities for capital projects over the next 24 months.
In February, Austal had a forward order book of $4.9 billion and has announced several contract wins during the lockdown period. In fact, the company upgraded its earnings guidance for FY20. It is on schedule to deliver earnings before interest and taxes of $125 million, up by $15 million or 13.6% on the prior corresponding period.
Advanced weaponry
Electro Optic Systems Holdings Limited (ASX: EOS) saw its share price rise by 23.31% on Monday. This was on top of a 10.8% increase the previous week.
The company has been hot property since the Prime Minister's speech. On Friday, Electro Optic Systems announced that it was in negotiations with the Commonwealth Government for 251 remote weapons stations (RWS) to be purchased over 12 months. Electro Optic is the global market leader in lightweight remote weapons systems.
The company sells a range of products for the defence sectors. These include a communications platform it recently acquired after purchasing the satellite communications business, Audacy Corporation. So while it is an early beneficiary of the $270 billion defence spending, I certainly don't think this will be the last contract the company will win under the plan.
While Electro Optic is necessarily opaque, we do know it has a range of active defence contracts with various navies in NATO as well as previous RWS sales in South East Asia. I expect Electro Optic will continue to benefit from additional sales within the South East Asian region in the near future.
Defence materials
There are a number of small-cap defence contractors with proven track records listed on the ASX. Many of these are likely to benefit from increased defence spending both locally and from within the region.
One such example, with a market cap of $71 million, is Quickstep Holdings Limited (ASX: QHL). The company is Australia's leading independent manufacturer of advanced carbon fibre composite components. These are used across the defence aviation sector.
Quickstep is an approved supplier for the international Joint Strike Fighter (JSF) program – the largest military aerospace program in the world. Quickstep supplies more than 30 individual components with content on every aircraft produced. It has has an international client base and saw total sales lift by 14% in H1 FY20.
Unlike Electro Optic and Austal, this company is not a primary supplier of machines, it provides materials to others. Nonetheless, it has a rolled gold client list, including; Lockheed Martin, BAE Systems, and Boeing Defense. As defence spending rises not only in Australia but also within the region, I expect Quickstep to be a beneficiary.
The Quickstep share price has jumped 25% since the Prime Minister's speech outlining the $270 billion defence plan.
Foolish takeaway
The companies listed above are active defence contractors with robust and largely local supply chains. Additionally, all three have mature manufacturing capabilities and are trusted suppliers to both the ADF and US defence forces. As the $270 billion defence spending starts to roll out, I'm confident these companies will benefit, both locally and internationally.
