Last year, only a handful of sectors benefited from the Russian invasion of Ukraine. One was the energy sector. The other was the defence industry.
The six largest companies listed in Europe – the UK’s BAE Systems (BA.), Thales (HO) and Dassault Aviation (AM) in France, Leonardo (LDO) in Italy, Rheinmetall (RHM) in Germany and Saab (SAAB B) in Sweden – have seen their share price jump between 35% and 136%.
Those companies have significantly outperformed their aerospace counterparts in the stock market. They also recorded positive performance last year when global equity markets tanked on fear of higher inflation and slowing economies.
Today, with the war in Ukraine far from over, and many of its European and US allies getting more and more involved in the conflict, some investors might wonder if the prospects for the defence industry are still attractive from an investment point of view.
Before the war in Ukraine started, military spending was increasing around the world.
In 2021, it reached an all-time high of $2.1 trillion (£1.75 trillion), according to SIPRI, an independent institute based in Stockholm, Sweden.
At the time, while the US was slightly reducing its military spending to $801 billion, focusing its R&D on next-generation technologies, Russia and China were increasing their budget by 2.9% and 4.7% respectively.
The war in Ukraine has pushed European countries to sharply increase their military budgets.
Next to this devastating conflict on the European soil, other factors are pushing military budgets up. The trade and geopolitical tensions between US and China, with fear of a potential invasion of Taiwan, is one of them. The tensions with Iran and Syria and the spread of ISIS in Africa are another.
According to UBS, a bank, the growth of ex-US defence budgets is expected to be 7% a year between 2022 and 2030, compared with 3% between 2014 and 2021, “driven primarily by security concerns in the South China Sea and Eastern Europe.”
“If tensions escalate and spending tracks towards cold war era levels, then we see a 9.5% budget compounded annual growth of rate”, they add.
Additional spending will primarily go on the development of anti-air and anti-missile systems, fighter jets, sensor and intelligence systems as well as cyber capabilities.
This has created a tailwind for European defence companies, which saw their share prices take off in the expectation of higher revenue and earnings in the near term.
The turnover of the six largest European companies is expected to reach €90 billion by 2025, according to Factset consensus data, from €72.4 billion in 2021 (+7% a year).
Their cumulative net profit is forecast to jump to €7.2 billion from €5 billion over the same period of time, which would represend a compound annual growth rate of around 12%.
Aggressive Valuations
This optimism is now well reflected in their valuation ratios.
The sector, which was trading close to par with the European equity market at the end of 2018, now trades with a 17% premium, based on the average P/E for the next twelve-months.
This level is “broadly in line with valuations observed back in 2014-16, when the sector re-rated on the back of growing geopolitical tensions”, according to UBS.
This rerating is supported by higher defence budgets and growing export opportunities, which clearly emerged with the war in Ukraine and could continue, if new tensions were to emerge in other parts of the world.
An acceleration of earnings growth for defence companies, at a time of possible recession in Europe, would only support to the outperformance of the industry going forward, no matter how expensive it might be.
