The European defence stocks benefitting from higher spending

The defence of Europe’s borders looks set to play a key role in elections on both sides of the Atlantic this year. With Republican Party nominee Donald Trump threatening to let Russia do “whatever the hell they want” to Nato members who fail to meet defence spending pledges, the EU’s senior leaders seem to have heeded that call. 

European Commission (EC) president Ursula von der Leyen said earlier this month that Europe needs “to turbocharge our defence industrial capacity in the next five years”.

“Europe must spend more, spend better, spend European,” she said, while also pledging to appoint a defence tsar if she is returned as commissioner in June. 

Changes are already taking place, following this month’s launch of the commission’s first European Defence Industrial Strategy, which has set some ambitious targets. It wants to make sure member states procure at least 50 per cent of defence budgets within the EU by 2030, rising to 60 per cent by 2035. It also wants 40 per cent of equipment to be procured “collaboratively” by the end of the decade.

This represents a step-change from the current situation, where following decades of underinvestment in defence capabilities by European governments, there are clear gaps both in capacity and capabilities.

According to the EC’s vice-president, Josep Borrell, between the start of Russia’s invasion of Ukraine in February 2022 and June last year, 78 per cent of defence acquisitions by EU member states were made from outside the European Union, with 63 per cent from the US. What’s more, between 2021 and 2022 only 18 per cent of equipment was procured collaboratively – well below the EU’s current benchmark of 35 per cent.

 

Better together?

The commission’s argument for closer working ties makes sense. National governments all doing their own thing leads to “duplications and foregone opportunities to mutualise and synchronise investment in commonly needed equipment or infrastructure”, it said, which makes private sector cooperation and integration less likely.

According to McKinsey, European defence bodies currently have 179 different weapons systems in service, compared with just 33 in the US.

“And then there’s two to three times as many suppliers in Europe [as in] the US,” said Jane Edmondson, head of thematic strategy at VettaFi, which created the index for the HanETF Future of Defence ETF (NATO).

Yet making a more integrated defence policy work in practice is a much tougher challenge.

Like foreign policy, defence “is a national competence, and member states will jealously guard their sovereignty in this field”, said Mujtaba Rahman, Europe managing director at political risk consultancy Eurasia Group.

On top of this, there’s the capability issue already mentioned, particularly when it comes to military fighter jets.

The German government’s decision to buy a fleet of Lockheed Martin’s (US:LMT) fifth-generation  F35 fighter jets in 2022 was due to the fact that neither the Eurofighter Typhoon nor any other fourth-generation fighter jets are certified by the US to carry nuclear weapons, and Europe currently doesn’t have a fifth-generation model of its own, according to Alexander Wahl, an analyst at investment bank Stifel.

Although Airbus (FR:AIR), Dassault Systèmes (FR:DSY), Spain’s Indra Sistemas (ES:IDR) and engine makers Safran (FR:SAF) and MTU Aero Engines (DE:MTX) have been developing a next-generation fighter aircraft known as the Future Combat Air System (FCAS) since 2017, Italy’s Leonardo (IT:LDO) is working on a competing Global Combat Air Programme alongside the UK’s BAE Systems (BA), Rolls-Royce (RR) and Japan’s Mitsubishi Heavy Industries (JP:7011).

Even within the FCAS programme and a similar Franco-German initiative to build tanks, known as the Main Ground Combat System, there has been “infighting over workshare and product specifications, provoking repeated delays”, according to Johanna Möhring, a European security and defence analyst for the French Institute of International Relations.

The promise of more money could help to smooth egos. An €8bn (£6.8bn) European Defence Fund had been set up even before Russia’s invasion of Ukraine and an initial €1.5bn has been allocated to the European Defence Industry Programme. A further €500mn has been committed to boost ammunition production (a programme known as ASAP, which may have been named by the Ukrainians). 

Although this is small beer compared with the €240bn spent by member states in 2022 and a big increase won’t be likely until the next EU budget cycle is approved in 2027, “the politics is moving in a direction where I wouldn’t be surprised if in the next EU budget there was a significant pot of money and then in the one after an even larger one”, said Luigi Scazzieri, a senior fellow at the Centre for European Reform, a think tank.

 

Friends and neighbours

Taking an EU-wide approach to defence procurement should help to alleviate some of these domestic squabbles, but could bring issues of its own. Firstly, there’s the possibility of sparking a trade war with the US, which has “used political leverage” over allies in favour of its domestic industry, said Anand Menon, director of the UK In a Changing Europe think tank.

The reason why so many central and eastern European air forces use Lockheed’s F35, for instance, is “because the US, while facilitating their entry into Nato, at the same time made sure they bought US kit”, he said. 

Then there’s the UK, which spends the most of any central and western European nation on its military, according to the Stockholm International Peace Research Institute.

“We’re a large chunk of the European defence market,” Menon said. “So, from an industrial point of view, if you want heft, it makes very little sense to leave Britain out.”

Europe’s defence industry is sizeable. According to the EC, it generates around €70bn of revenue and employs 500,000 people.  

But the UK also offers a much higher degree of military capability than most of its European peers. Excluding it on the basis that it is not an EU member is “privileging economic autarky over security”, Menon argued. Éric Béranger, the head of Europe’s biggest missile maker, MBDA, called for the UK’s inclusion in the EU’s defence plans in an interview in the Financial Times last week. 

Ten years ago, the UK was one of only three Nato members (alongside the US and Greece) that was already meeting its commitment to spend at least 2 per cent of its gross domestic product on defence, but secretary general Jens Stoltenberg said on Thursday that “two-thirds of our allies” will hit this target this year.  

The uplift in commitments by Europe’s governments should translate into a cumulative increase in defence spending of €700bn-€800bn between 2022 and 2028, by which time total European defence spending could reach €500bn a year, McKinsey estimates.

Yet these have generally so far been slow to translate into contracts, other than for short cycle orders for urgent restocking of munitions. The companies supplying much of this, like Germany’s Rheinmetall (DE:RHM) and BAE Systems, have been among the biggest gainers since the war in Ukraine broke out.

Last week, Rheinmetall reported that orders last year had increased by 44 per cent to a record €38.3bn. It also increased its medium-term revenue estimate from weapons and ammunition to €5bn-€6bn a year, from guidance of €4bn by 2026 that it gave at a capital markets day in November.

Demand for ammunition remains the most pressing, but “orders are eventually coming” for larger kit, with governments in Lithuania, Austria and the Netherlands all recently agreeing deals for air defence systems and logistics vehicles, Stifel analyst Wahl said.

Italy’s Leonardo also presented a new industrial plan to investors last week, at which it forecast a cumulative new order intake of €105bn over the next five years. It is a “global, diversified player” that will benefit from increased spending on both sides of the Atlantic, VettaFi’s Edmondson said.

On top of the industry’s big beasts, there are a host of other companies that may be second-hand beneficiaries of higher European defence spending. A screen produced by BofA analysts in January highlighted partners and suppliers of defence companies such as French IT consultancies Alten (FR:ATE) and Capgenmini (FR:CAP), German industrial giants Siemens (DE:SIE) and ThyssenKrupp (DE:TKA), Finnish telecoms equipment supplier Nokia (FI:NOKIA) and support services company Mitie (MTO).

For their management teams and investors, this summer’s European parliamentary elections may grab more of their attention than usual.