Arming for the Long Run

For the Layman

• European nations have, for decades, massively underinvested in defence industries.
• Looking ahead, however, this scenario is expected to flip with the EU massively increasing its investments in the industry, mainly owing to two reasons: 1. Increased tensions with Russia and 2. Functional breakdown of NATO
• Major Beneficiaries are expected to be Rheinmettal AG (RHM), Dassault Aviation (AM) and Thales (HO). For a diversified play into the entire European Defence space, the iShares Europe Defence UCITS ETF (DFEU) can be a suitable option. For a higher beta play, Leonardo (LDO) and SAAB (SAABB) can be suitable alternatives.

Euro-Defence is Here to Stay

Increased Tensions with Russia –About almost four years of war with Ukraine, it's difficult to see Russia rejoining the peaceful community anytime soon, and even if it did, there is always a risk of the deal heading south.

Reduction in US support –Along with the above, there is the added pressure of not being able to rely on the US as a counterweight. Though the US administration will change in time, likely improving rhetoric toward Europe, US capacities will remain constrained. Regardless of the party in power, the US budget can't afford to manage risks in both Europe and Asia.

This has thereby forced the EU to raise its defence expenditure by a notch, creating space for investors. Europe has, in fact, committed to increasing total defence spending to 5% of GDP by 2035, with 3.5% directed to core defence and 1.5% to defence-related expenditures.

In 2020, before Russia invaded Ukraine, the EU’s defence investment was €234 billion; however, owing to the invasion, it increased to €381 billion and is expected to rise by over 100%, reaching €800 billion by 2030.

Within the EU, France, Germany, Italy, Spain and Poland are expected to be the top spenders.

As can be seen, among the top five spenders in the EU, only Poland and Germany have both high intent (as evidenced by political will) and the ability (as evidenced by low debt-to-GDP ratios) to invest. This would directly help the defence companies in these local jurisdictions, as there will be a strong drive to boost local economies and offset increased government debt, thereby eliminating any fiscal damage via multiplier effects.

Currently, all the major Polish defence contractors are state-owned, leaving only German defence contractors as pure plays in the theme.

German Defence Budgets set Rheinmetall for a Surge

Germany’s defence expenditure is expected to rise 25% YoY to €108 billion in fiscal 2026 and to €153 billion by 2029, implying a CAGR of 9%.

It should be noted that procurement (weapons & ammunition, armoured vehicles and tanks) is expected to account for approximately 37% of the budget in the coming years. The EU has about 2 million active personnel (excluding Turkey’s 0.5 million). For comparison, the US has about 1.3 million active personnel.

Given this, Rheinmetall (RHM) is expected to capture over 50% of the procurement budget, making it the prime winner. RHM is a German Defence Contractor that generates about 30% of its revenue from Germany and 46% from the rest of Europe. To limit any fiscal damage through multiplier effects, local contractors are expected to gain, as mentioned earlier.

Other Beneficiaries

Other Beneficiaries are expected to be Dassault Aviation (AM) and Thales (HO).

AM is poised to drive growth through 2027 amid rising geopolitical tensions and a backlog of 239 Rafale fighter jets. More business jets could boost profits, though trade tensions and the new Falcon 6X's initially lower margins may trim gains. Supply-chain disruptions and production ramp-ups raise costs, but greater volume and a 26% share in Thales can oset them.

HO is key to Dassault’s Rafale platform, supplying electronics and radars to the fighter. Demand for air defence solutions across Europe supports a ramp-up of SAMP/T NG deliveries. More submarine orders would lift Naval Group's revenue and profit.

An alternative diversified option is iShares Europe Defence UCITS ETF (DFEU). DFEU is an ETF that seeks to provide investors with total return that reflects the performance of the STOXX Europe Targeted Defence Index.

Higher-Beta Alternatives

The above-listed companies, such as Rheinmetall, Dassault and Thales, are large-cap companies expected to benefit from the European defence theme. For higher-risk appetite investors seeking higher returns, high-beta mid-cap defence companies such as Leonardo (LDO) and SAAB (SAABB) can be suitable alternatives. Both of these companies are part of the iShares MSCI Europe Mid Cap UCITS ETF.

LDO’s profit growth is likely to remain driven by defence, with a large and growing backlog and ample margins that should persist amid elevated global threats. Defence and helicopter results are critical to Leonardo achieving consensus profit, though supply chains remain a risk.

While looking at SAABB, its Gripen E fighter jet could get a massive boost from a potential Ukraine order for 100-150 jets. Furthermore, SAABB’s opportunities include missile systems, unmanned aerial vehicles and aircraft.