European Defense Companies - Q3 24 and a Look Ahead

In part 1 Nordic companies well positioned in defense buildup of our analysis, we noted that European defense companies have good prospects for long-term growth. This part 2 deepens the analysis and focuses on all of Europe, with particular attention to companies and sectors that stood out in the Q3 reporting and appear interesting going forward.

Europe is in a critical security and trade policy phase, characterized by several challenges:

1. An ongoing full-scale war in Ukraine.
2. Totalitarian regimes in the east challenging the rules-based world order.
3. Demands from the USA for increased defense investments alongside threats of trade tariffs.
4. The risk of falling behind in high-tech defense and space.

Europe is characterized by low defense readiness, depleted stockpiles, and low production capacity, as well as a significant dependence on the USA as the main actor in NATO.

Support for Ukraine, the security situation in Europe, and the demand from the USA for increased defense investments mean that large investments cannot be avoided within Europe. Our assessment is that European defense companies have had, and still have, better conditions than their American counterparts to achieve greater percentage improvements in margins and profit growth. As a result, the strong price increase, combined with uncertainty about the right valuation level, has contributed to high volatility (sharp price movements) in the stocks. However, the trend does not appear to be slowing down.

The European Defence Agency (EDA) published on December 4, 2024, the annual Defence Data report for 2023, which specifies defense investments for all 27 EU members. In 2023, defense investments rose by 10% to a record €279 billion. The estimate for the EU's defense spending for 2024 is expected to reach €326 billion in 2024, an increase of almost 17%. There is a clear delay in both getting new orders out and for existing orders to enter the companies' income statements. It also temporarily raises valuation based on the market's knowledge of increased turnover at a good margin.

The war in Ukraine has fundamentally changed Europe's defense landscape. After nearly three years of conflict, the shortage of ammunition has become one of the biggest challenges. The intense use of artillery far exceeds what many European countries were prepared for. Ukraine fires about 2,000 shells per day, while Russia fires about 10,000, which may be underestimated given the large difference. To meet demand, several European countries and defense companies have increased their production capacity and invested in factories for shells, propellants, and explosives. At the same time, international cooperation is being strengthened to streamline production and reduce bottlenecks.

We clearly see this trend in the Q3 reports, where Rheinmetall stands out in the company's Weapon and Ammunition segment. Sales increased by 25.1% to 501 million euros. The operating profit rose by 54.2%, from 86 to 133 million euros, raising the segment's operating margin to 26.5%.

During the first nine months of 2024, the segment reached record sales of 1.554 billion euros, an increase of 64.3%, driven by increased deliveries of artillery shells and medium-caliber ammunition. The acquisition of Rheinmetall Expal Munitions contributed 352 million euros and further strengthened the company's position. The result reflects both increased demand and the company's strategic expansion.

Several other defense companies have recently taken significant steps to strengthen their ammunition production capacities. Here are some examples:

• Thales has been chosen as the main supplier for a new production line for 155 mm artillery ammunition in Australia. The facility is expected to produce up to 100,000 shells annually from 2028.

• Nammo has secured a four-year supply of TNT to ensure the production of 155 mm artillery shells. This is a response to the growing demand and the need for stable supply chains.

• BAE Systems received an order worth 20 million pounds from the UK's Ministry of Defence for small-caliber ammunition. This strengthens the UK's ammunition stockpile and supply security.

For a closer analysis of the major companies' changes in order books, revenues, and margins as well as margin growth, the following can be mentioned:

Thales: Strong growth during 9M 2024 with order intake of €15.6 billion (+23%) and sales of €14.1 billion (+6.2%). Defense & Security drove the development with €7.2 billion (+8.5%). Despite challenges in the DIS segment, Thales confirms its targets: sales growth of 5-6% and EBIT margin of 11.7-11.8%. Strong order book and partnership with Mistral AI support future growth.

Leonardo: Q3 and 9M 2024 showed new orders of €14.8 billion (+7.8%) and revenues of €12.1 billion (+12.4%). EBITA rose 15% to €766 million. The Defense and Helicopter divisions performed well, but Aerostructures reported an EBITA loss of €129 million. Net debt decreased to €3.1 billion (-19%). Focus on defense, cybersecurity, and space, with collaboration with Rheinmetall and a new Space Division.

Hensoldt: 9M 2024 results showed revenues of €1.4 billion (+21%) driven by the Sensor segment and TRML-4D radar. Adjusted EBITDA rose 24% to €187 million (margin 13.6%). Order intake increased 21% to €1.86 billion with an order book of €6.5 billion. The ESG acquisition increased net debt to 2.9x. The company benefits from increased defense spending and expects continued growth, especially in Optronics. Limited exposure to Ukraine and small risks related to US funding.

In addition to covering the immediate need in Ukraine, these technology areas can be considered central and driving in the European defense industry and its armed forces:

• Unmanned systems (UAV/UGV/USV): Continued strong demand for drones for reconnaissance, intelligence, and precision strikes, both at tactical and operational levels.
• Cybersecurity: Increased digitization of military platforms and systems leads to a great need for robust cyber solutions, including protection against disruption, hacking, and disinformation campaigns.
• Electronic warfare, advanced air and missile technology: Complex air defense (SAM systems), hypersonic missiles, and airborne sensor and radar equipment.
• Space-related defense solutions: Satellite-based surveillance, communication, and navigation systems are gaining increasing strategic importance, especially for military intelligence activities.
• Climate-adapted defense technologies where European defense companies have intensified their focus on, for example, lightweight composites for aircraft and vehicles.

This largely aligns with the stated strategic investment areas from European armed forces but also to meet current and future threats and technological shifts. We see increased hybrid warfare and that the rules-based world order is clearly in turmoil at sea. This also gives increased strategic focus on the naval sector, with the modernization of submarine fleets and the development of new frigate classes.

For long-term exposure in the defense sector, we believe that a combination of traditional companies with a strong position in traditional defense together with companies at the technological forefront in the segments mentioned above and preferably with civilian applications is a good mix.

Also read our analysis report: New European strategy in an era of changing European security order. There we highlight the geopolitical and trade policy challenges that the EU and Europe face and the importance of a strong and cohesive European strategy.