Fears the US will relinquish its commitment to NATO have put UK and European defense stocks on a dramatic upward trajectory, but Morningstar analysis suggests only a few names are still attractively valued.
German defense stock Rheinmetall RHM is now a five-star stock after its Morningstar fair value estimate was revised upwards. This makes it the most attractively-valued of the companies in our screen. Its new fair value estimate is the highest among 16 analysts’ price targets tracked by Morningstar.
UK company Rolls-Royce RR. and France’s Thales HO remain four-star stocks after returning 25.88% and 38.34% over the last month, respectively. This means they are still attractively valued.
The UK’s BAE Systems BA., Italy’s Leonardo LDO, Sweden’s SAAB SAAB B, are all trading in 3-Star territory, meaning they are seen to be fairly valued.
High levels of uncertainty punctuate the analytical picture amid a lack of clarity over order books and revenue. Fair value estimates are still subject to revision as analysts monitor each stock’s prospects.
“We’re facing considerable uncertainty right now,” says Morningstar equity analyst Loredana Muharremi.
“While everyone is attempting to gauge the impact on defense companies, the scale of the increase in defense spending remains unclear. We also don’t yet know precisely how it will be allocated or when it will translate into actual orders. As those details become clearer, we could see further upward revisions to estimates.”
Why Has Rheinmetall Stock Done So Well?
Germany’s Rheinmetall has been one of the stand-out performers in the European aerospace and defense sector.
A manufacturer of combat equipment and armored vehicles, Rheinmetall is headquartered in Düsseldorf.
Over the last 12 months, its stock price has risen 194.38% amid changing sentiment over defense in Europe. Following a declaration by incoming German chancellor Friedrich Merz that the country would seek “independence” from US contributions to NATO defense, its stock price has risen significantly once more.
Yesterday, Muharremi upgraded the Morningstar fair value estimate for Rheinmetall stock to €2,220 from €1,310, reflecting what she thinks will be a surge in European defense spending benefiting the company.
“We maintain our European defense spending projections, reaching 3.2% of GDP by 2030 ($876 billion) and 3.5% by 2032, before stabilizing around 3%,” she says.
“While equipment spending has averaged 28% of total budgets over the past four years, reaching 30% in 2024, we see this as insufficient to address decades of underinvestment.
“In the midterm, we expect Europe to prioritize inventory replenishment, with equipment spending rising to 50% of budgets in 2025-26 and 40% from 2027-30, before declining to 25% by 2034 as personnel and research and development investments grow. This aligns with Rheinmetall’s simulation discussed during the 2024 earnings call.
“This would create a cumulative $1.8 trillion opportunity in equipment spending by 2030, with Germany leading the increase.”
The change means that Rheinmetall is now the top stock pick in the European defense sector.
Why Has Rolls-Royce Stock Done So Well?
UK-based Rolls-Royce is famous for making jet engines, which it supplies to aviation manufacturers like Airbus AIR and Boeing BA.
In 2023, less than a third of its underlying revenue came from defense projects, totaling just over £4 billion. By the end of 2024, the company’s defense order book had reached a record £9.2 billion, amid the AUKUS submarine defense pact and a deal to supply F130 engines for the US Air Force’s ageing fleet of B-52 bombers.
This order book has contributed to a stock turnaround Muharremi says is “dramatic.”
“Under chief executive Tufan Erginbilic’s leadership, Rolls-Royce has repositioned itself as a financially strong, high-margin, and cash-rich aerospace and defense leader,” she says.
“The reinstatement of the dividend, buyback program, and accelerated transformation reinforce its commitment to long-term value creation.”
In 2019, Rolls-Royce stock was struggling. Shares were already on a downward tear when the pandemic unfolded in late December 2019 and early 2020, but the company then endured additional falls when governments restricted travel in March of that year.
It wasn’t until three years later that Rolls-Royce really started to make progress again. By the end of 2024, it was the UK’s third top-performing stock of the calendar year, delivering an 89.72% return to investors. Today, owners of the stock are still looking back on a superb 12 months. Since March 2024, Rolls-Royce stock is up 103.95%.
“Since the pandemic, Rolls-Royce has significantly improved profitability, margins, and free cash flow, achieving targets two years ahead of expectations thanks to an industry recovery and operational and strategic improvements including optimization of long-term service agreements, improved time-on-wing for its engines, renegotiated contracts, and restructuring its cost base.”
Earlier this month, the company met its mid-term targets two years early, leading Muharremi to raise Morningstar’s fair value estimate for Rolls-Royce stock to £9.60. Its stock currently trades at around £7.97, meaning it is undervalued and potentially an attractive investment. Increased defense spending in the UK and on the continent remains a tailwind for the company.
“We have increased defense revenue projections as we now expect European defense spending to reach 3.1% of gross domestic product by 2029, up from 2.4%, and 3.5% by 2032 (previously 2.8%),” Muharremi says.
Why Do Defense Stocks Rally?
Defense stocks are sensitive to geopolitical events and the threat of conflict. In recent history, they have risen when Russia invaded Ukraine in 2022, and when Hamas attacked Israel on Oct. 7, 2023.
Historically speaking, however, defense stock rallies are rare and difficult to predict.
“Defense companies don’t react to the macroeconomic cycle. They react to geopolitics,” says Morningstar industrials equity analyst Nicolas Owens.
“They’re relatively rare, and they’re not cyclical. It’s not like you can predict them every six years, and they don’t ‘flex’ with GDP.”
Investors should therefore be careful about trying to predict what will happen next.
“The reason the European contractors are moving up in unison is you essentially have a new buyer in town, which is European governments increasing their spending,” Owens says. “That’s rational.
“But it remains to be seen exactly who’s going to do what or what people actually want until the contracts are signed.”
As much was evident when Hamas invaded Israel, Owens adds.
“All the US defense contractors, and some European ones, traded up 9%-10% that morning,” Owens recalls.
“That, I think, displays the difference between sentiment and actual demand. Because, in my view, there was a disconnect in that case, between sentiment and the business fundamentals: the order book.
“On that Monday, governments probably replenished inventories for ammunition, artillery, and anti-missile systems and radar. Those orders are usually filled out of stockpiles that governments have already purchased, which they then refill a year or two later.
“Those expendables are a decent product line, but they’re not a big piece of the overall pie for these companies. To say that event made every defense contractor in the Western world worth 10% more just seemed a bit much.”
What matters most to investors are the fundamentals: orders, longer-term contracts, and research and development.
“Most of these companies make their money in peacetime,” he says.
“The whole point is to invent the next generation of weapons systems and to build it so whichever nation is doing the funding is prepared.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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