(News Bulletin 247) – The sector has experienced a spectacular surge in the stock market since the outbreak of this conflict, although its results have not really had a significant impact. The rekindling of geopolitical tensions has revived investor interest.

Defense groups have experienced many lean years on the stock market, undermined by falling military budgets in several countries and the lack of investor interest in companies directly or indirectly linked to weapons. This last point is linked to the rise of ESG themes (environment, social and governance, extra-financial criteria) which have weighed on the stock market appeal of this industry.

The outbreak of war in Ukraine, exactly two years ago, suddenly changed the situation, bringing these companies back into the market radar. For example, the prices of Thales and Dassault Aviation, the two stocks in the Paris sector (military activities represent a relatively small part of the revenues of Safran and Airbus) have increased by 60% and 59% respectively.

since the start of the conflict.

French groups are not really the best representatives of the surge in defense on the stock market. The German Rheinmetall saw its shares quadruple, which in turn allowed it to join the DAX 40, the benchmark index of the Frankfurt Stock Exchange. The British group BAE Systems “simply” more than doubled its share price.

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A “massive” increase in stock market multiples

“The outbreak of the war in Ukraine resulted in a fairly massive re-rating (an appreciation of stock market multiples, Editor’s note) of defense stocks. In the first weeks of the conflict, their rolling twelve-month PERs, c “that is to say the earnings multiples at which their shares trade, increased on average by 25% to 30%, before flattening out and then erasing their gains a little”, explains Yan Derocles, analyst at Oddo BHF .

“But after a pause, the re-rating movement has resumed since November-December, and the average PER of defense groups are now 44% higher than before the outbreak of the conflict in Ukraine,” adds the analyst.

Why have defense groups recently continued their stock market rally? “This more recent increase is obviously explained by the flaring up of the conflict between Israel and Hamas. This event happened at a time when investors were beginning to question the sustainability of increases in military budgets,” replies Yan Derocles. “The American presidential campaign, and the rise of Donald Trump in the polls also played a role. Donald Trump promised to “disconnect” American support for Ukraine, which, if this assertion were followed in fact, could force European countries to increase their aid to the country. And would therefore support the activity of European defense groups”, adds the analyst.

Geopolitical tensions therefore acted as a stock market catalyst for defense groups. Investors have started to anticipate – rightly – increases in state budgets. In the days following the outbreak of the conflict, Germany announced an exceptional envelope of 100 billion euros via a special fund to increase its military investments.

ESG fears allayed

Germany is far from being an isolated case. “Many countries had massively underinvested in defense for at least a decade. The outbreak of war in Ukraine was a rude awakening, reminding us that conflict could very well occur on Europe’s doorstep, that it can be long and potentially extend to several areas. Germany, Poland, the Baltic countries and even Finland have accelerated their military spending. This has not really been the case for the United Kingdom or France who were already investing a lot in defense. Even if in France, the military programming law provides for a step of the staircase, that is to say an increase in the budget, of 3.4 billion euros per year on average until ‘to 2030”, develops Yan Derocles.

However, the conflict has not resulted in dizzying impacts on the accounts of the companies in question.

“Overall, the progress on the stock market of defense groups is indeed due to an improvement in multiples, that is to say a better perception of the market share. Because otherwise, the conflict in Ukraine and its consequences have not “still had at this stage a huge impact on the financial results of companies in the sector, with the exception of companies operating on short cycles, which supply spare parts or ammunition, such as Rheinmetall”, notes Yan Derocles.

This conflict has, on the other hand, erased or at least mitigated the ESG fears that surrounded the sector. “Today we see that European defense groups are trading at multiples close to those of American companies in the same sector. This means that the heavy discount that Europe was suffering due to ESG investors’ aversion to sector has now subsided”, explains Yan Derocles of Oddo BHF.

“Since February 2022, many funds have reviewed their policy of excluding defense groups and have thus returned to the sector. Funds in most countries now look at whether a group supplies conventional or unconventional weapons but do not exclude more systematically companies with military activity. There are still a few exceptions like Belgium and Germany. But in the latter country discussions are currently taking place to change the rules because many German asset managers have underperformed the market, unable to buy the Rheinmetall share (which jumped 62% over one year, Editor’s note)”, develops the analyst.

Note, however, that Thales and Dassault Aviation slightly underperformed the CAC 40 last year, the first increasing by 12.3% and the second by 13.2% compared to an increase of 16.5% for the index. “Thales is not strongly exposed to immediate increases in the budgets of countries which have accelerated their spending. Its main customers in Defense remain governments which were already investing significantly in the military (France, United Kingdom, Australia). As for Dassault Aviation, the action suffers from the fragility of the supplier chain which disrupts the ramp-up of business jets (the group’s second largest activity with fighter planes, Editor’s note)”, explains Yan Derocles.

Still potential

There remains the question of stock market potential for the months to come. In a December note, Bank of America was relatively optimistic. The establishment noted that “defense orders continue to surprise” and “that growth will likely follow.”

Bank of America anticipated “another year of strong earnings growth with holding multiples.” The bank expected 10% growth in sector revenues on a comparable basis until 2025, an average operating margin improving by 125 basis points (1.25%) over the same horizon, and growth in earnings per share. by 23%.

Without waiting for a “significant” improvement in stock market multiples, Bank of America saw some room for increases this year on certain stocks (the Italian Leonardo, the British BAE Systems and Babcock) due in particular to “geopolitical tensions and the ‘acceleration of budgets’.

“The acceleration of military budgets was mainly observed in the order books of defense groups. This year and in 2025, this should begin to be reflected in the income statements and cash flow,” judges for his part. Yan Derocles.

“Especially as States are starting to let go. Historically, defense is a sector with low operational leverage, because governments scrupulously audit programs. But States are starting to modify the terms and conditions of contracts and also to increase pre -financing, so as to give oxygen to an industry which they greatly need”, he explains

“If the financial results of the groups improve as their order books predict, and if the States continue to support the sector, we can think that defense still has potential on the stock market,” concludes the analyst.