Europe’s Defense Stocks Cool. These 2 Are Still Taking Off.

European defense stocks are taking a breather after a run-up. (Hilary Swift/Bloomberg)

European defense stocks are taking a breather. The Select Stoxx Europe Aerospace & Defense exchange-traded fund has plateaued for the past two months, after surging by two-thirds from January to June.

No wonder. Germany’s Rheinmetall, the sector darling, now boasts a trailing price/earnings ratio around 95, compared with 57 for Nvidia. European arms makers in aggregate trade at a one-third premium to U.S. peers, says Loredana Muharremi, the analyst covering the space for Morningstar. “The majority of European spending increases has been anticipated in market forecasts,” she says.

Questions still linger over that anticipated Old World arms bonanza, says Sidharth Kaushal, a senior research fellow at the United Kingdom’s Royal United Services Institute. “The industry needs to believe that the interest is neither transitory nor likely to be spent outside Europe,” he notes.

Northern Europe, led by Germany and the Nordics, should march steadily toward the North Atlantic Treaty Organization’s new goal of spending 3.5% of gross domestic product on defense, predicts Camille Grand, a distinguished policy fellow at the European Council on Foreign Relations. The Mediterranean rim not so much. “Italy, Spain, and Portugal will probably try to evade their commitments,” he says.

Buying European could prove challenging in some of the sexier, and more expensive, weapons systems. U.S.-made F-35 fighter jets and Patriot air defense systems are best in their class globally.

Europe holds its own on the ground and at sea, though, with Germany signaling big spending on Euro-made Boxer and Patria armored vehicles, along with Leopard tanks. Rheinmetall, spurred by Ukrainian demand, now makes more 155-mm artillery shells than the U.S. “The U.S. share in the air domain is massive,” Grand says. “The land domain benefits German industry.”

Marquee U.S. systems aren’t necessarily all American, Muharremi adds. Six European companies are “tier one” contractors on the F-35, including electronics from BAE Systems and Italy’s Leonardo, and a vertical takeoff mechanism from Rolls-Royce Holdings. Rheinmetall lately signed a joint venture with U.S. champion Lockheed Martin to produce ATACMS and Hellfire missiles on the Continent.

Europe’s most intractable problem in defense is its most intractable problem elsewhere: national governments pursuing their own interests. Six European nations can manufacture arms, Muharremi says. Each one steers spending toward its national champions: Dassault and Thales in France, Saab in Sweden, and so on.

The result is a hodgepodge of 179 weapons systems supplying European militaries, compared with 33 in the U.S., where the top four contractors soak up more than half of Pentagon procurement, according to Morningstar research. “Joint procurement will be the key to expanding Europe’s defense base,” Muharremi says.

Some pan-European projects are flourishing. MBDA—a joint venture of French-based Airbus, BAE, and Leonardo—has a seven-year backlog for its missiles, including the Storm Shadow deployed to Ukraine, Muharremi says.

She still sees value in European defense names, eventually. “If you look out three years, they are still cheap compared with U.S. counterparts,” she argues.

Despite foot-dragging in some capitals, Grand sees European military spending climbing by as much as 200 billion euros ($233 billion) annually, or 45%, “in the coming years.”

Rheinmetall is Morningstar’s top pick, even at nosebleed valuations. “They are the top contractor to Germany, which is about to become the world’s No. 3 defense spender,” Muharremi reasons. She’s also keen on Leonardo as a top name in electronic warfare.

Just don’t expect another vertical takeoff for the sector.

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