Have defense stocks hit their ceiling? Citi’s downgrade offers clues
European defense stocks have soared this year amid a regional push toward ramping up defense spending – but according to investment bank Citi, the bull run may soon run out of steam. The Stoxx Europe Aerospace and Defense index has gained almost 50% since the beginning of the year, with a handful of stocks, including Germany’s Renk , Rheinmetall and Hensoldt , more than doubling in value. The rally has been supported by action from European governments to hike their defense budgets, with the EU pledging to mobilize as much as 800 billion euros ($928 billion) for security spending, while the U.K. government also said earlier this year it would allocate much more funding to defense. In a note to clients on Monday, Citi’s European Aerospace and Defence analyst Charles Armitage downgraded Hensoldt, Renk and Sweden’s Saab to give them a “sell” rating. The stocks have gained around 174%, 260% and 110% this year, respectively. HAG-DE R3NK-FF,SDV0-FF YTD line Price of Hensoldt, Renk and Saab shares year-to-date. Armitage argued that the Hague summit is “likely to be as good as it gets” for the Western European aerospace and defense industry. His note was published before NATO’s 32 members confirmed they had confirmed they had committed to invest 5% of their gross domestic product in defense by 2035 – but Armitage, like wider markets, had anticipated the move. Under the agreement, 3.5% of NATO members’ GDP is set to be allocated to “pure” defense requirements, with the additional 1.5% going toward security and defense-related infrastructure. Regional defense shares moved higher still on Thursday, with the Stoxx Aerospace and Defense index jumping 1.5% higher the day after Nato’s annual summit in The Hague, Netherlands, concluded. Armitage said his team estimated Hensoldt, Renk and Saab were “pricing in more growth than seems likely with 3.5% of GDP, even assuming market share gains.” “We believe there is little chance of upside to these [NATO spending] targets, but some downside risk,” he said. “The stocks may rally on the news … but we believe the sentiment is likely to become less positive thereafter.” Looking ahead, Citi expects the debate on defense spending to shift toward “whether European countries will be able to achieve these targets,” which it sees as a downside risk to the stocks Armitage named in his Monday note. Citi isn’t the only major lender starting to question the upside of some of Europe’s top performing defense stocks. Last week, Bank of America also downgraded Renk and Saab, with analysts at the bank suggesting their view on the former were somewhat contrarian. “Investors we spoke to overall agreed that Renk is overvalued fundamentally,” they said in a research note. “However … investors likely think Renk could be a > €3bn org sales business by 2030, but there is no conviction Renk will guide for > €3bn org sales at the [November Capital Markets Day].” On Saab, BoA’s analysts said investors largely believe the valuation of Saab is too rich in the near term “for a business with limited revenue visibility mid to long term (vs peers)” and given its limited exposure to European budgets outside of Sweden versus its regional peers.
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