Top 10 AUKUS related ASX opportunities
The AUKUS agreement is a done deal. I disagree with the structure but not the concept of national security or defence readiness. Here we go through the Australian market with an emphasis on dual use.
The past five years have seen a huge shift in political priorities towards national security, defence readiness, and strategic supply chain management.
This is evidenced in Australia by our national government having imposed foreign control and ownership restrictions on mineral assets, physical infrastructure, and development of new sovereign capability in defence.
I am not going to enter upon a debate here on what our national security policy should look like, or how our defence force should be structured.
Of course, I have views on these questions, but that is not the best use of my ability in the service of readers who are keen to locate investment opportunities.
In addition to three decades in the investment management industry, I spent fifteen years of my early career in physical sciences research. This involved me in a host of areas from laser physics through aerospace to quantum technology.
It is with this hat on that I will address the opportunity from AUKUS.
Of course, the vast majority of the revenue and profits from Australian expenditures in defence go to US, UK and European prime contractors. We sign the papers, and they build the platforms. This arrangement will now go on steroids.
Australia has some nuclear engineering expertise through the Nuclear Science and Technology Organisation (ANSTO), which runs the Lucas Heights reactor, and the universities, such as UNSW Nuclear Engineering.
However, the bulk of revenues associated with the planned nuclear submarine fleet will pass to US submarine builders General Dynamics XNYS: GD, Huntington Ingalls XNYS: HII, plus UK BAE Systems Plc XLON: BAE, and Rolls Royce XLON: RR.
I might cover those later in a global note.
There is talk of significant work by the Australian Submarine Corporation (ASC), but I think that is political window-dressing. Nobody would ever invest on that basis.
Nuclear submarines are complex to design and construct from start to finish.
Even apparently simple questions, like the availability of welders, are problematic.
My focus here will be pragmatic.
Which ASX listed firms interest me in the context of AUKUS?
Let’s get down to it…
(This post is free because Australia needs to understand why dual use is best)
Where to look for opportunities?
There are a number of so-called “pillars” in the AUKUS agreement between Australia, the USA and the United Kingdom for defence cooperation. In my view, Australia is clearly the junior partner, but there are technology cooperation agreements.
Due to the emphasis on interoperability, and Australia being the junior partner, there is only a small likelihood, in my view, of any indigenously developed system finding a large market in the USA or the United Kingdom. Defence does not work that way.
Defence procurement is always heavily politicised around the dimension of local jobs.
The USA is a much bigger economy than Australia.
If we are to sell goods, products or services into that market it must be niche.
Needless to say, this is already the structure of our domestic defence industry.
There are niche players on the ASX, and we can readily list them out.
Before I do, let me mention that military base expenditures are a large part of the AUKUS treaty agreement. With this in mind, we include critical infrastructure.
The other point of interest is commodities such as strategic metals.
The talk in the press always focuses on rare earths for their strategic significance to the defence industry. I am going to mostly ignore that sector, because the scale of military demand is miniscule compared to commercial demand.
This may surprise some readers, but it is not whimsy on my part.
I have documented that the annual percentage of Lynas XASX: LYC revenue that is attributable to all sources of US demand is about 1.5% of their annual revenue.
In rare earths, the USA is the largest exporter of rare earth concentrate to China.
The USA is a direct competitor in global rare earths, not our growth market.
This might be shocking to those who only read the Australian Financial Review.
If so, then find a more reliable source of news and analysis :-)
This is defence we are talking about.
There are facts, think tank talking points, and government press releases.
Thematic exposures for dual use technology
Here is my take on the key categories to examine:
dual use systems and platforms
critical materials that may be dual use
critical technology that may be dual use
critical infrastructure that may be dual use
We can readily triangulate between these categories and a list of ASX stocks.
Notice that I place heavy emphasis on dual use.
The current political rhetoric demonizes places like China for pursuing a dual use strategy in military procurement. In my view, this is foolish nonsense.
Here is an example with CAS 12045-64-6 standard Zirconium Di-Boride.
This is a refractory material with very high melting point that is useful in many industrial applications requiring a heat and wear resistant coating.
Here is one noteworthy application of such Ultra-High Temperature Ceramics (UHTC).
That is a Chinese hypersonic missile.
I once had a very entertaining match of verbal tennis over the military significance of Ultra-High Temperature Ceramics with an Australian government department head. They thought I meant “cookware”.
China has no problem sourcing the necessary nanomaterials for UHTC coatings because they have a highly developed civilian manufacturing industry.
Perhaps there is some Chinese cookware brand that uses Zirconium Diboride?
You can defray the costs of technology development over commercial applications in order to develop new materials. The supplier of the Zirconium Diboride nano-powder in the promotional video above makes its money in commercial materials to improve cement for construction. I don’t know if they do any military work at all.
However, China has a deep bench of specialty materials companies with the resources to develop such high-specification compounds for any targeted use.
That could be civilian or military.
Nature sets the laws of physics, and she does not care what you want the UHTC for.
You could design a hypersonic missile to attack US Aircraft Carriers, but the decision to use them, or not, may depend on who attacks whom first, where and when.
That is the calculus of military deterrence. It cuts both ways.
Of course, the ideal situation is to never use any military asset, but then all of the effort and expenditure on Research & Development simply goes to waste.
This is why dual use for military technology is best.
When I was a practicing defence research scientist, at then then DSTO, now DST, the official policy goal was to target Commercial Off-the-Shelf (COTS) technology. This means stuff designed for a commercial purpose but adapted to military use.
The use of spin-off technology greatly accelerates military development cycles to get important tools in the hands of defence personnel more quickly and cheaply.
The reason the USA stopped doing that was to protect the defence lobby.
Nobody at Lockheed Martin would like to have Space-X eat their lunch.
It is the same with drones.
DJI drones must be banned because they compete with US defence primes.
Ukraine uses DJI drones for combat, as does Russia, even though DJI banned that.
DJI banned the use of its drones in the war. The USA wants to ban DJI drones.
Lockheed Martin would prefer a nice fat contract to develop its own drones.
However, DJI is out in front by a country mile because consumers buy them. Those people put what is undeniably effective military technology to good civilian use.
This is not an aberration.
Dual use for military technology is how the world actually is and should be.
This is why I focus heavily on dual use technology for investment purposes.
In case you are unconvinced, do this small homework problem:
Name one major manufacturer of civilian airliners that does no military work.
This is a trick question, good luck on that mission!
Dual use systems and platforms
The shipbuilder Austal XASX: ASB has been active for many years across civilian and defence applications of fast aluminium hull monohulls and catamarans. They have shipbuilding operations in both Australia and the USA, with defence contracts.
The politics is sometimes messy, because many in the AUKUS defence lobby do not like the fact that the company does civilian work. I am not bothered by that.
Firms that do a mix of civilian and military work are able to sustain their shipyards, and their R&D effort, to remain at the cutting edge of naval architecture and technology.
The stock has emerged from a three plus year bear market and looks interesting
The Canberra outfit Electro-Optic Systems XASX: EOS, demonstrates why it is a good idea to have a broad civilian base to any defence equipment enterprise.
The sharp end of EOS is roof-mounted remote weapons systems for the protection of military vehicles. That is a combination of optics and electomechanical systems.
EOS is also emerging from a long bear market.
However, they also do innovative space and optical communications work.
The origins of this firm, and the reason they grew up in Canberra, is because they helped develop novel telescope technologies at Mt Stromlo Observatory.
Invariably, there is a lot of ignorant nonsense propagated about university labs and how irrelevant they are to the real world. The origin story of EOS proves otherwise.
Effective military technology, in active weapons systems, usually involves a sensor of some kind, that is used to acquire and track targets, and a weapon of some kind.
Lasers can be weapons, if you want them to be. However, they can also be used to zap errant satellites, that may be on a collision course with a valuable commercial satellite. EOS works on space debris tracking and management with advanced optics.
These systems adjust their mirror shape by tiny amounts in real time to compensate for the distortion of atmospheric turbulence to produce a focused beam in space.
Oddly enough, it was not the far-sighted military top brass that thought of that. It was academic physicists figuring out better ways to image distant galaxies.
The bottom line:
If you can see a Quasar at the edge of the universe you may just see a drone.
This is elementary, to those in engineering physics, but baffling to any politician.
Put them all in a submarine but leave the hatch open.
Dual use critical metals in focus
Some time ago, I prepared a critical minerals list for battery materials.
You can read the original research report here.
There is a bunch of metals there. For defence applications, I am going to make an editorial decision and focus on three: Titanium, Tungsten and Antimony.
Titanium is essential to airframes, missiles, armor, and submarine hulls
Tungsten is widely used in cutting tools, armor and artillery kinetic penetrators
Antimony is mainly used in fire retardants but also to harden ammunition
We will mention Nickel and Cobalt also, for superalloys used in aerospace, but there is no real shortage of that, whatever the US think tanks might say. A little will do.
There are no Rare Earths explicitly, but we pick up that via titanium feedstock.
Titanium, Zircon and Rare Earths
Iluka Resources XASX: ILU is the largest Australian producer of mineral sands. These are a source of both Zircon and Titanium products alongside rare earths.
Note that, like many companies that were the target of Australian government “help” this stock is in a very deep bear market. I cannot help what the Australian Political Class does to damage our national industries, but this one will recover.
Note that the stock failed to break through cost basis on the last rally and so is now in a deep bear market. Australian politicians seem intent on damaging other areas of our economy, so I am confident it will recover. Just be patient on the entry.
Avoid Woolworths until after the next election :-)
Iperinox XASX: IPX is developing titanium metallization, and the Titan mineral sands project in the USA. Unlike in Australia, the US Government is less likely to willfully destroy their strategic industry with dumb defeatist policies.
The stock looks overbought right now, but it is worth following.
Australian Strategic Materials XASX: ASM has their flagship Dubbo Toongi Zirconia project, which has significant Rare Earth, Zirconium and Hafnium potential. Their Korean subsidiary also controls valuable metallization technology.
This sort of bear market is brutal so look for some very deep value to eventuate.
It can be difficult to explain to government just why their offer of help can scare the wits out of professional investors. The story of ASM is an object lesson in that.
The essential problem with this company, and many like it, is that our government policy is to discourage sales to China, which has left this key project in limbo.
Western demand for rare earths is too meagre to fund these projects.
This could all change with any adjustment to policy, so keep it on your watchlist. However, I would not hold my breath on any positive development.
Iluka Resources does not have this issue since the government helped them to fully fund their rare earths refinery, and most of their mineral sands go to China anyway.
Iluka has a free pass to sell to China, so you want to be invested in that one.
You could talk about Lynas XASX: LYC but that story is known. They will build a small refinery for heavy rare earths in the USA, for the U.S. Department of Defence.
This is a great company, but the AUKUS exposure story is minimal.
The US DoD only needs a very small rare earth refinery.
Consider this stock the prime rare earth exposure when the China market improves.
It is true that there is an active charade in talking about the USA incessantly, but this has very little to do with the business. It keeps folks in Washington D.C. happy.
Tungsten
EQ Resources XASX: EQR is the largest Australian producer of tungsten concentrate, with operating mines at Mt Carbine in Queensland, and Saloro Spain.
The interim CEO Kevin MacNeil has deep knowledge of the tungsten industry and an impressive command of some of the quirks and gotchas in tungsten flow sheets.
Their uplift in recoveries at the Soloro operation was a mark of this expertise.
This is one of my firms to watch, with the US in desperate need of reliable and secure supplies of tungsten. I rate that need much higher than rare earths.
There is also Group 6 Metals XASX: G6M with their King Island Scheelite mine.
The Scheelite deposit is high-grade but minerals separation to produce a concentrate seems to have some teething issues. Monitor this as the bear market is deep.
Antimony
During World War II the USA had its supplies of antimony cut off. This metal is not used in huge volumes but is essential for hardening some forms of ammunition.
The best prospect for future antimony production is the mineral stibnite which shows up in the Victorian gold fields in association with gold mineralization. Our favorite exploration and development play is Southern Cross Gold XASX: SXG.
The challenge in the antimony supply chain is finding a Western friendly refinery.
This project is not yet producing so there is time to solve that issue.
Nickel and Cobalt
The Australian nickel industry is a mess because we encouraged China to go invest in other countries to source their minerals. They went to Indonesia instead. Fast forward a few years, and the Indonesian industry is now 11.5 times the scale of the Australian industry at 1,800,000 Mt per annum, versus 160,000 Mt for Australia.
The Indonesian laterite industry expanded when Chinese engineers slashed the capital cost of new plant through innovation and scale advantages.
US nickel demand is a measly 190,000 Mt per annum, and it is not growing. Using the US Geological Survey data, the apparent demand, from all sources was 217,000 Mt in 2019 and 190,000 Mt in 2023. The USA is about 5.5% of global demand.
Nonetheless, Nickel and Cobalt, and to a lesser extent Molybdenum, Niobium, Rhenium and Vanadium, are important in high-performance steel alloys.
These are not huge defence markets, but security of supply is important.
IGO Ltd XASX: IGO is one of the few Australian nickel-cobalt plays left standing. Of course, there is part Chinese ownership of their Greenbushes lithium mine, but the nickel and cobalt operations are unrelated to these, as if it actually mattered.
There is a deep bear market in virtually every company with a critical mineral that was the object of Australian Critical Minerals policy.
Telling the biggest customer in the world to go away was a bad move.
They did just that by funding new mine expansions in Indonesia.
However, IGO Ltd has sufficiently good assets that I think they will actually survive the attentions of the Australian Government and go on to bigger and better things.
There is no need to be aggressive in buying this stock. Dollar cost average and watch for a positive catalyst. It will turn, but the market is likely soggy for some time.
Ballistic steel for armour
Armour plate, of the kind used in military ships and vehicles is generally made from a specialty steel that is hardened to stop bullets. There is also ceramic and/or reactive armour used for breast plates, and tanks, but ballistic steel remains the mainstay.
Our top pick is Bisalloy XASX: BIS, which has been a supplier to the Australian Defence Force (ADF) for decades. Bisalloy has passed the test for US Military Specifications.
There are other such firms around the world, such as XSTO: SSAB.B in Sweden, but the supply of ballistic steel is quite constrained in the West, as it is a specialty product.
It can be hard for investors to understand why nerd-grade hardened steel might be a strategic national asset. However, Bisalloy passed their Mil-Spec Test so they are it.
Dual use critical technology in focus
Droneshield XASX: DRO is an electronic warfare play on defeating drone incursions into civilian or military airspace. This is a perfect example of dual use in practice.
Whereas the company started out with proposition that they would protect civilian airports from errant consumer drones using a knock-down radiofrequency jammer, they have now progressed to a general focus on electronic warfare.
Electronic warfare is a critical defence capability.
The company is not cheap, at 40x revenue, but this will almost certainly be a winner in the new AUKUS world. It is difficult to cohere the necessary skills to this job, as it is not only about software, and software defined radio, but radiofrequency physics.
There is enormous scope with Generative Artificial Intelligence for active spoofing and decoying to confuse enemy systems, or to jam these with appropriate signals.
Adaptive AI will be a keystone of future signals intelligence and electronic warfare.
Note that the level of $1.26 is cost basis, above market close around $1.15 as I write this stack. This looks like a fair entry but be prepared to wait to see how the stock trades when approaching cost basis from below. It could take a while to base.
Dual use critical infrastructure in focus
There is just one Australian infrastructure company that stands out for me for defence support and sustainment. This is logistics company Aurizon Holdings XASX: AZJ.
This stock was recently slammed after a small miss on earnings and the widespread market prejudice that the One Rail acquisition was a dud.
One can forgive infrastructure analysts for poring over the minutiae of discount rates, regulatory capital rulings, and the vagaries of grain and coal volumes. It is hard to be a CEO like Andrew Harding when you have 30+ experts telling you how to suck eggs and which of your plans will never ever amount to a hill of beans.
I have been a portfolio manager for close on three decades.
When the Market Galahs are active strong selling, I put on my thinking cap.
If you know even a teeny bit about defence, and warfare in general, and the location of major Australian Defence Force (ADF) bases, in particular, then it is not very hard to see that the One Rail assets are highly strategic.
If you want to ship an M1-A2 Abrams Tank from Adelaide to Darwin you are sure as heck not going to call Toll Holdings or Startrack. You will put it on a rail car on the Darwin-Tarcoola railway, just like the Russians do when shipping T-80 tanks.
The Americans do the same.
Infrastructure analysts do not think this way.
Don’t get them to execute ADF logistical planning in the event of wartime.
It is fine for investors to parse the minutiae of the next quarterly update on earnings and rail car loadings. However, sometimes they just entirely miss the point.
Conclusion
I have surveyed a dozen or so ideas, with ten opportunities in focus. Many of these are in deep value territory so there is no urgency to act on them.
However, I hope you enjoyed the ride and that my point on dual use technology finds fertile soil. I have spent much of my time in physical sciences research, and would offer two key takeaways and learnings from that experience:
Don’t assume that esoteric topics have no strategic or commercial value.
Don’t let an ignorant political class divert your attention from investment.
Politicians are the very last folks on Earth to exhibit understanding.
Politicians do not ever lead. They invariably follow.
Follow your nose, to find good investment opportunity, and there is a decent chance that some politician gave you a very cheap entry. Be patient and buy slowly.
The politicians will eventually follow, but only after the first 100% gain.
Happy investing and share your thoughts in the comments.
Incidentally, picked up some PWH on the dip today. Their expansion into the defence/space sectors seems to be going very well.
Thanks for the great report Kingsley. Has provided some welcome new perspectives on some of my watchlist stocks. I don’t read the AFR, but would be grateful for any recommendations of ‘reliable source(s) of news and analysis’.