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.