Johanna
Englundh:
Welcome
to
Morningstar.
As
we
head
into
the
second
half
of
the
year,
it’s
time
to
check
in
on
the
defence
sector.
What
has
been
the
most
important
news
in
the
first
half
of
the
year
and
what
can
we
expect
of
the
rest
of
the
year?
With
me
to
talk
about
this
is
Morningstar’s
equity
analyst,
Loredana
Muharremi.
Loredana,
so
looking
at
the
defence
sector
in
the
first
half
of
2024,
what
would
you
say
was
the
most
important
news?
Loredana
Muharremi:
Well,
looking
at
the
first
half
of
2024,
I
believe
that
the
two
most
important
themes
remain
the
European
defence
undercapacity
and
the
need
to
rely
less
on
asset
provider
along
with
the
supply
chain
issues.
So,
looking
at
the
undercapacity
portion
here,
so
underinvestment
meant
that
European
countries
are
now
struggling
to
provide
adequate
support
to
Ukraine
while
maintaining
their
own
supply.
And
we
can
see
these
across
all
platforms,
but
it’s
become
especially
critical
for
munitions.
So,
as
we
all
know,
all
NATO
countries
have
agreed
to
increase
their
defence
spending
at
2%
of
their
GDP.
And
we
expect
this
target
to
be
hit
by
all
countries
in
2024,
which
will
result
in
an
increase
of
around
10%
in
defence
spending
compared
to
2023.
So,
what
we
are
seeing
on
the
defence
side
is
that
governments
are
reducing
their
decision
process.
So,
they
are
increasing
the
speed
in
which
they
make
decisions
and
also,
they
are
focusing
on
increasing
production
capacity
and
relying
more
on
the
European
defence
contractor.
Then
looking
at
the
second
issues
on
supply
chain,
supply
chain
issues
are
due
to
the
material
and
the
labor
shortages,
but
they
are
being
exacerbated
by
the
fact
that
often
defence
contractors
don’t
have
a
clear
overview
of
their
supply
chain
network.
And
this
is
because
supply
chain
in
defence
is
very
complicated.
Imagine
that,
for
example,
for
missiles,
there
might
be
more
than
100
providers
across
more
than
12
tiers.
And
what
makes
things
even
more
complicated
is
the
fact
that
for
some
critical
components,
we
are
relying
from
non-NATO
countries.
For
example,
propellant
has
been
and
still
is
a
huge
bottleneck
for
munition
production.
Munition
propellant
is
made
by
nitrocellulose,
which
is
made
by
cotton
fibers,
which
Europe
sources
from
China.
In
fact,
Rheinmetall
(RHM)
has
declared
a
few
months
ago
that
Europe
relies
on
China
for
more
than
70%
of
its
cotton
fibers.
So,
this
is
a
risky
position
to
be
in
case
of
geopolitical
changes.
And
what
we’re
seeing
on
the
supply
chain
now
is
that
European
defence
contractors
are
trying
to
manage
these
difficulties
by
keeping
a
higher
level
of
inventories
on
purpose.
JE:
And
during
these
last
few
weeks,
we’ve
seen
some
names
in
the
defence
sector
losing
ground
on
the
stock
market.
What
is
behind
this?
LM:
Yes,
Johanna,
I
think
that
what
we
are
seeing
in
the
last
few
weeks
is
some
nervousness
from
investors
due
to
the
high
valuation.
And
just
consider
that
before
the
war,
European
defence
stocks
were
trading
at
an
average
of
9
times
their
P/E.
While
now
they
are
trading
at
an
average
of
27
times
their
forward
P/E,
which
puts
them
in
line
with
their
US
peers.
But
while
we
might
see
this
valuation
as
high,
it
is
important
to
consider
that
the
dynamics
that
we
are
currently
seeing
are
not
short-term
dynamics
for
two
reasons.
First
of
all,
constant
increase
in
the
defence
spending
and
an
acceleration
of
it
is
fundamental
if
Europe
wants
to
continue
supporting
Ukraine
and
also
replenish
its
own
stock.
For
example,
it’s
estimated
that
it
will
require
Germany
with
current
production
level
at
least
10
years
to
get
the
munitions
stocks
at
the
pre-war
level.
And
all
this
acceleration
and
this
growth
we
expect
will
lead
in
an
additional
defence
spending,
a
cumulative
additional
defence
spending
of
700
billion
[euros]
between
2023
and
2029
compared
to
our
estimates
of
pre-war.
And
while
US
companies
will
be
able
to
capture
some
of
this
growth
as
well,
the
majority
of
the
growth
will
be
captured
by
European
countries
as
Europe
is
very
focused
in
strengthening
its
own
defence.
And
beyond
this,
we
have
also
to
consider
that
the
long-life
platforms
that
are
being
currently
delivered
are
going
to
generate
decades
of
aftermarket
revenues,
which
presents
high
margin
and
high
cash
flow.
So,
if
we
consider
the
structural
growth
that
the
sector
has
still
to
experience
along
with
further
improvement
in
profitability
due
to
more
platforms
going
towards
full
phase
production
and
aftermarket
revenues
kicking
in
then
I
believe
that
this
valuation
can
be
justifiable.
JE:
And
do
you
have
any
specific
stocks
that
you
find
extra
interesting
at
the
moment?
LM:
Yes,
Johanna,
our
top
pick
in
European
defence
remains
Rheinmetall.
The
storyline
here
is
quite
straightforward.
Rheinmetall,
as
the
major
provider
of
defence
for
Germany,
is
set
to
profit
from
Germany
becoming
the
third
largest
defence
spender
by
2025.
Also,
Germany
is
one
of
the
three
major
supporters
of
Ukraine
and
heavily
relies
on
Rheinmetall
for
land
vehicles,
munitions
and
defence
systems.
And
looking
at
the
ammunitions
division,
that’s
another
important
growth
and
the
driver
of
profitability
for
Rheinmetall.
So,
we
expect
ammunitions
sales
to
increase
due
to
the
war
in
Ukraine.
Ukraine
uses
around
6,000
to
10,000
shells
per
day.
And
the
European
goal
is
to
be
able
to
produce
around
two
million
shells
per
year.
But
in
2023,
without
Rheinmetall,
the
European
countries
were
able
to
produce
less
than
200,000
shells
while
US
produced
around
140,000
shells.
As
of
today,
thanks
to
the
acquisition
of
Expal
and
further
capacity
improvement,
Rheinmetall
is
the
largest
producer
of
munitions
and
was
able
to
move
from
100,000
in
2022
to
more
than
350,000
by
2023
and
is
set
to
reach
700,000
by
2025.
Outside
of
Europe,
we
also
believe
that
Rheinmetall
has
a
fair
chance
of
winning
a
very
important
US
contract.
In
fact,
the
company
has
been
now
selected
along
with
General
Dynamics
(GD)
to
replace
around
3,200
M2
Bradley
vehicles,
a
contract
that
is
potentially
worth
around
$40
billion.
And
while
we
expect
General
Dynamics
to
come
with
more
efficient
prototype,
we
believe
that
Rheinmetall
prototype
will
have
some
superiority
in
technology,
especially
regarding
protection
systems.
JE:
So,
Rheinmetall
might
be
worth
a
closer
look.
Thank
you
so
much,
Loredana,
for
shedding
some
light
on
the
defence
sector.
And
until
next
time,
I’m
Johanna
Englundh
for
Morningstar.
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