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Investing.com -- A significant increase in military spending by European nations is expected to drive revenue and profit growth for European defense contractors, according to Bernstein analysts.
Recent remarks from European leaders calling for a significant boost in military spending have driven a strong rally in European defense stocks.
“Much is now priced in current valuations, but the positive environment should last and translate into multiyear revenue and profit growth,” analysts led by Douglas S. Harned said in a Tuesday note.
NATO European countries are planning to boost their defense spending from the current 2% of GDP to potentially 3% or more. This increase could translate into an additional $220 billion for European defense, with nearly half of that amount potentially allocated to new equipment.
American companies have traditionally dominated European defense expenditures, but European defense stocks are now set to benefit the most from the increased local spending.
Despite historically having a smaller portion of defense budgets, European contractors rely heavily on local spending for their defense revenues.
Even as European budgets grow, defense exports to Europe from U.S. contractors make up only about 10% of their total revenues. Bernstein estimates that European contractors could see an incremental opportunity of approximately $40 billion in annual spending.
“In a 3% of GDP budget scenario, NATO expenditures would grow at an 8% CAGR until 2030, with equipment spending and European contractors poised to capture the majority of the opportunity,” the analysts said.
In this scenario, European defense equipment sales could grow at a CAGR of nearly 10% until 2030, surpassing the typical mid-to-high single-digit medium-term forecasts.
The defense sector in Europe has seen a 550% return since 2022, with defense backlogs increasing by over 70%, sales by 17%, and EV/EBITDA multiples nearly tripling.
Current valuations appear to imply defense spending nearing 3% of GDP, with an additional 0.5% increase already factored in since the beginning of the year.
According to the analysts, the sustainability of defense stock growth hinges on European leaders’ commitments being translated into actual funding and backlog expansion.
Gradual program implementation is expected to bolster revenue and profit growth for contractors, supporting their high valuations. However, the full potential of these developments has not yet been reflected in earnings estimates or company guidance.
Contractors will need to scale up and invest in more capacity to meet the demand.
Companies like Leonardo SpA (BIT:LDOF), Dassault Aviation SA (EPA:AM), Rheinmetall (ETR:RHMG), SAAB (ST:SAABb), Kongsberg Gruppen ASA (OL:KOG), and Thales (EPA:TCFP), which have a greater focus on Europe, are likely to benefit more than BAE Systems (LON:BAES), which has a broader international presence.