Can EU Defence Stocks Fly Higher?

Some European defence stocks have already seen significant gains due to the prospect of increased spending, but opportunities may still exist for traders.

Setting New Records Every Day

European defence stocks have surged since February due to rising tensions between the US and its NATO allies, which prompted Europe to pledge a massive $840 billion increase in defence spending over the next several years. Companies like Germany's Rheinmetall, Italy's Leonardo, and France's Thales have seen their share prices soar, with stocks doubling or rising by as much as 85%. However, not all defence plays are equal.

Some countries have already exceeded their NATO defence obligations and may not increase spending as significantly as others, like Germany, which needs to catch up. Companies supplying these countries are presumed to be the biggest winners and may have already participated in the boost. As a result, many defence companies have seen their price-to-earnings (PE) ratios surge, with Rheinmetall's PE exceeding 30. Investors are betting on the potential for future sales, but European nations have previously pledged to increase defence spending, yet they have failed to do so for budgetary reasons. A resolution to the Ukraine conflict or de-escalating tensions between the US and Europe could reduce the urgency for increased spending.

Reliable Spenders

Among European defence plays with relatively low PE ratios, Melrose Industries and BAE Systems stand out as potentially undervalued, drawing attention to the UK. Despite already spending 2.3% of its GDP on defence (exceeding the 2% NATO target), Britain plans to increase spending to 3% of its GDP by 2029. Britain's consistent military spending and cross-party agreement on this measure suggest that its defence firms can rely on increased revenue.

Of the two "cheap" British defence plays, Melrose derives only about a third of its revenue from military spending, and its latest earnings disappointed investors due to supply chain issues in its main commercial aviation business. In contrast, BAE Systems receives 98% of its revenue from military contracts. The company could play a crucial role in a potential European pivot away from the US, as it has experience producing advanced weaponry like infantry fighting vehicles (IFVs) and tanks and is currently working on a sixth-generation fighter, allowing Europe to compete in air power.

BAE to Record Highs

BAE has recently broken out to record highs of 1665 GBX following a corrective broadening pattern, with the next target set at the mid-round resistance level of 1750 and eventually the 2000 GBX. If the recent decline continues, the stock could decline to 1400 GBX, opening the door to 1270 and exposing BAE to a peak.

Source: SpreadEx / BAE Systems

Key Takeaways

While some European defence stocks have seen significant gains, some defence plays may still be of interest to some traders. The UK’s BAE Systems, in particular, is well-positioned to benefit from Britain's planned increase in defence spending, standing out as a potential beneficiary of Europe's pivot towards greater military self-reliance.