European defence stocks 20-year discount is unwarranted – broker

Defence stocks, including BAE Systems PLC (LON:BA.) and Ultra Electronics Holdings PLC (LON:ULE), are trading at their biggest discount to the market in 20 years, according to JPMorgan Cazenove.

Stocks in the European defence sector have fallen by an average of 21% over the past three months, compared to a fall of just 5% for the wider European Stoxx 600.

Analysts at JPMorgan attribute this to two concerns: “fear that all governments will have less to spend on defence due to the impact of COVID-19 on their finances” and that “Joe Biden will win the US election and seek to cut US defence spending”.

“Both concerns may be valid but we believe investor concerns are probably overdone”, the analysts added, saying that the market has “more than discounted” this possibility in current European defence share prices.

Reflecting the risks to defence spending, the analysts have reduced their estimates for the sector’s sales, earnings per share and free cash flow and this has resulted in new lower share price targets, though this still results in considerable upside potential for BAE and Paris-listed Thales Group.

BAE’s price target is cut to 615p from 750p but this still would offer 55% potential upside from the last close price of 397p.

While COVID-19 has had a major impact on the national debt of the US and UK, respectively around 45% and 20% of BAE’s sales, the analysts said, “the defence spending of neither country looks excessive in historical terms”, at around 3% and 2% respectively of GDP.

“Regardless of who wins the US election, our new base case is that BAE has strong organic growth in 2021, followed by three years with almost no organic growth. However, in the defence sector EBITA margins are often regulated by govt customers and tend to be quite stable.”

BAE, for which the bank has an ‘overweight’ rating, is expected to achieve stable and solid margins, healthy cashlow and a stable dividend from 2022 to 2024.

An ‘overweight’ rating was also reiterated for Ultra, where a new target of 2,325p, cut from 2,620p, still offers 24% potential upside.

The stock has been the best performing European aerospace and defence name so far in 2020, down 11% and while “not as cheap” as BAE, the analysts said “we believe it deserves a premium rating” as it has the best EBITA margins, cash flow ratio and return on capital of the sector.

“We also believe ULE is a potential M&A target given its relatively small size and strong niche technologies.”