Defense Stocks: Why Are Traders Nervous About Their Record High? -Euronews

The defense sector has become one of the most successful over the past two years, boosted by the war between Ukraine and Russia. In particular, European defense and aerospace stocks have outperformed their U.S. counterparts, with shares of Germany’s largest arms maker, Rheinmetall, soaring around 540% since February 2022.

Other defense stocks, such as Britain’s largest aerospace maker, BAE Systems, and French defense group Safran, rose 114% and 176% over the same period.

However, the record run took a pause following a warning from investment bank Goldman Sachs over valuations, sparking concerns about a shake-up in the defense sector. But why are traders worried about their record?

Fears of overvaluation

According to Goldman Sachs, European defense stocks trade at a 45% premium to broader equity markets, suggesting potential overvaluation within the sector.

The Euro Stoxx Aerospace & Defense Index (SXPARO) has jumped around 194% since February 2022, while the Stoxx Europe 600 Index (SXXP) has increased by a more modest 24%.

The top 10 SXPARO components, including Airbus, Safran, BAE Systems, Rolls Royce GE, Rheinmetall, Thales, MTU Aero Engines, Melrose Industries, Leonardo and Saab B, have all outperformed the broader market over the past two years. This outperformance coincided with increased investor interest in defense and aerospace stocks in a context of increasing public budgets in this sector.

The price-to-earnings (P/E) ratios of some of these stocks, such as Rheinmetall and Safran, are around 45, significantly higher than the ratio of 15 for the SXXP and 22 for the European industrial sector. Therefore, traders have good reason to be cautious at such high multiples, and Goldman Sachs’ warning may have triggered profit-taking in the sector, leading to a sharp correction in European defense stocks.

However, the selloff raises another question: Has the bullish trend in these stocks ended here or is this just a temporary setback before a new bullish wave? The answer could depend on the growth prospects of individual companies, compared to their current stock valuations. Below is a look at the past performance and outlook of the two most valuable defense stocks in this group.

Rheinmetall expects its turnover to exceed 10 billion euros in 2024

Rheinmetall shares benefited the most from increased military spending in Europe, with its market value jumping to 22.69 billion euros from 4 billion euros two years ago. Its overall annual sales rose 12% to €7.2 billion, with its second division, arms and ammunition sales, jumping 29% to €1.8 billion in 2023, representing approximately 24% of its overall turnover.

Other major divisions, such as automotive systems and electronic solutions, grew 14% and 13% year-over-year. The company expects its sales to reach a record of more than 10 billion euros this year, a growth of 39%. This implies a growth rate more than three times higher than in 2023.

In addition, the company’s operating margin increased steadily to 12.8% in 2023, following 12% in 2022 and 10.5% in 2021. In its annual income statement, Rheinmetall expects this figure to reach between 14 % and 15% in 2024. Therefore, a multiple of 45 does not necessarily indicate significant overvaluation when considering its growth prospects.

Safran forecasts 18% growth in sales in 2024

In 2023, the overall turnover of French aerospace and defense group Safran increased by 22% compared to last year to reach 23.2 billion euros, with operating profit up by 31% to 3.1 billion euros. However, growth has slowed from the 25% annual increase recorded in 2022.

Sales were mainly driven by its civilian engines, particularly delivery of the LEAP, up 38% from 2022, while its military engines fell 18% in delivery in 2023. The company expects its figure business will reach 27.4 billion euros, an annual growth of 18%. % in 2024, suggesting a further slowdown in its sales in 2023. Therefore, Safran’s growth trajectory may not fully justify its current price-to-earnings ratio of 43.

European Union aims for higher defense budgets

However, current geopolitical tensions could continue to support the growth of the European defense sector. Average European defense spending stood at 1.6% of GDP last year, below NATO’s 2% target, which requires an increase in 2024.

In 2023, military spending increased by 4.5% compared to 2022 to reach a record 280 billion euros, and its amount will reach 350 euros in 2024, according to the President of the European Commission, Ursula von der Leyen.

Since Russian aggression against Ukraine in February 2022, 78% of defense acquisitions made by EU member states have come from outside the region, of which 63% have come from the United States.

At the start of March, the first-ever European defense industrial strategy set targets to purchase at least 40% of defense equipment collaboratively, at least half of the defense acquisition budget within the EU by 2030 and to reach 60% by 2035. It encourages member countries to “invest more, better, together and European”.