The European defence sector has experienced a remarkable upswing, rising approximately 2.5 times since Russia's invasion of Ukraine three years ago. This surge can be largely attributed to escalating military conflicts and subsequent increases in defence budgets across the continent. However, amid this robust growth, a disparate group of smaller contractors, particularly in the UK, has found itself lagging behind. Three notable British suppliers—Qinetiq, Chemring, and Avon Technologies—are emblematic of this trend.

The challenges faced by these smaller contractors are multifaceted and extend beyond merely the difficulties presented by the London stock market. In fact, their current plight is largely rooted in issues related to earnings, their exposure to various geographic markets, and legacy constraints that have accumulated over time.

For instance, Qinetiq, which specializes in providing critical services such as testing and evaluation, recently announced a downgrade to its full-year guidance. This revision indicated a slowdown in revenue growth and a tightening of underlying margins, ultimately suggesting a substantial 15 percent decrease in earnings before interest and taxes (EBIT). This decline is partly attributed to the loss of short-term contracts, which often vanish with the transition of new governments, as was the case in both the United States and the United Kingdom.

Compounding these difficulties are legacy contracts that Qinetiq secured at lower margins, alongside significant restructuring costs that continue to erode profitability. A significant portion of Qinetiq’s vulnerability stems from its exposure to the US market, where the company relies heavily on government contracts. This reliance puts defence service contractors directly in the crosshairs of the Department of Government Efficiency, which has the potential to disrupt their business operations.

In a stark contrast, Qinetiq's American competitors, often referred to as “Beltway Bandits” due to their connections within Washington D.C., experienced a downturn almost immediately following the recent US elections. Notable companies like CACI, Leidos, Booz Allen Hamilton, and Science Applications International Corp saw their stock prices plummet by between 25 to 45 percent since November 11.

Qinetiq, which spun off from the UK Ministry of Defence back in 2001, generates around 20 percent of its revenues from its operations in the US. Chemring, another significant player, derives about one-third of its income from American contracts. On the other hand, Avon Technologies, renowned for manufacturing protective equipment such as gas masks and helmets, sees a staggering 70 percent of its revenue tied to US markets, particularly through sales to first responders and police forces.

In a bid to stabilize their share prices, both Qinetiq and Chemring have initiated stock buybacks. While these actions may provide a short-term boost to their market value, they also raise concerns. In a time of substantial demand, many industry experts argue that it would be far more prudent for these companies to reinvest in their operations rather than focusing on buybacks.

This situation prompts questions about the ambitious revenue targets set by these companies. Chemring, which specializes in supplying components for missile systems and explosives, is aiming for £1 billion in revenues by 2030, representing a significant increase from the previous year’s £510.4 million. This ambitious goal implies a compound annual growth rate of nearly 12 percent, which outpaces both last year’s performance and the company’s average growth over the past five years.

Despite the setbacks faced by these smaller contractors, their stocks are now relatively inexpensive compared to the industry's leaders. Adjustments in valuations have made the stars of the sector, such as Germany's Rheinmetall, appear overvalued at 45 times forward earnings—more than double the valuations of Qinetiq and Chemring. However, the historical disappointment of these smaller companies has set a low bar for expectations.

This scenario presents a unique opportunity for smaller contractors to catch up, provided they can deliver on their projected earnings. According to Visible Alpha's consensus forecasts, Chemring is expected to see EBITDA growth of 16.5 percent by 2026, while Avon is projected to achieve a 15 percent increase. In an industry characterized by long lead times and significant investment, the potential for patience to yield dividends remains a viable strategy.