Key European defense stocks continued their decline on Thursday.
Investors are reassessing the sector's rally driven by European military expansion following Germany's cancellation of the F126 frigate program.
Analysts note that government defense procurement is heavily influenced by politics, with spending priorities subject to change at any time.
Following Germany's decision to halt a flagship naval project, investor enthusiasm for betting on European rearmament has cooled, leading to further losses for defense stocks on Thursday.
The German government's policy reversal, cancelling the F126 frigate program valued at over €12 billion where Rheinmetall AG was the expected prime contractor, has exposed significant underlying risks within the European defense industry.
An analyst team led by David Perry at JPMorgan stated in a Wednesday report: "This news serves as a reminder that governments can change procurement decisions at any time."
Rheinmetall AG fell another 1.8% on Thursday after plunging 18% on Wednesday. German peers Hensoldt AG and Renk AG dropped 6.7% and 2.5%, respectively, on Thursday, extending losses from the previous session.
Most major European defense contractors saw their share prices decline, continuing the downtrend from the prior trading day, with only Rolls-Royce Holdings Plc posting a minor gain of less than 1%.
Why does the F126 frigate cancellation affect the entire defense sector?
The project's termination sends a clear signal to the market: despite the sector's strong rally in recent years driven by expanding defense budgets, government procurement is deeply influenced by political factors and carries high uncertainty, with national military strategic priorities subject to constant adjustment.
Perry noted a fundamental difference between the defense industry and others: the buyers are almost exclusively sovereign governments, whose fiscal spending priorities can shift at any time.
"We remain convinced that Germany will spend heavily on defense procurement over the next five years and beyond, and that a significant portion of that will go to Rheinmetall for land combat vehicles and ammunition."
However, the JPMorgan analysts also acknowledged the possibility that Germany could reallocate its defense budget to other areas such as drones, space, or advanced air defense systems, potentially resulting in lower procurement volumes for armored vehicles and ammunition than the market previously expected.
Perry's team added: "The F126 cancellation also serves as a warning to investors that several of Rheinmetall's growth assumptions tied to this order could be invalidated."
The German government announced on Wednesday that it would not proceed with procuring six large F126 frigates. Instead, it will purchase eight smaller MEKO A-200 frigates from Germany's ThyssenKrupp Marine Systems, citing significant delays, rising costs, and various risks associated with changing the prime contractor to Rheinmetall.
In a statement on Wednesday, the German government said the MEKO-class frigates are capable of fulfilling the German Navy's core anti-submarine warfare tasks while also helping Germany meet its NATO defense obligations.
A year ago, following years of pressure from the United States, NATO members agreed to a plan to increase defense spending from 2% to 5% of GDP by 2025.
Michael Field, Chief Market Strategist at Morningstar, stated in an interview that investors are growing increasingly concerned that the substantial defense budgets promised by European and G7 nations may not materialize as planned, which could limit the earnings growth potential for defense contractors.
Field believes that countries like Germany will still need to replenish weapons stocks depleted by aid to Ukraine over the next decade. "The market is missing the point that defense spending doesn't start and stop with a war," he said.
In a report released Wednesday, S&P Global Ratings indicated that political divisions and varying fiscal conditions across Europe will lead to significant divergence in defense budget growth rates among countries.
The report suggests that defense contractors will be direct beneficiaries of increased military spending, but the broader European economy is unlikely to see substantial benefits from higher defense outlays. The industry could see a new wave of growth if the EU implements a unified procurement policy prioritizing European-made defense products.
Glimmers of Hope for Rheinmetall
Several brokerages have lowered revenue forecasts and significantly cut price targets for Rheinmetall.
Analysts at Jefferies cut their price target for Rheinmetall by 31% to €1,300 and lowered their revenue forecast for the company for 2030. They noted that Wednesday's stock plunge wiped over €10 billion from the company's market value, a loss far exceeding the profits the lost frigate order would have generated.
The analysts stated: "The company needs to present credible growth targets to rebuild market confidence. The market had expected Rheinmetall to secure the large F126 order imminently. With that expectation gone, the path to rebuilding trust is long."
However, Jefferies maintained a "Buy" rating on the stock, arguing that various optimistic expectations have now been fully priced out, thereby reducing investment risk.
JPMorgan suggested that losing the F126 order might not be entirely negative for Rheinmetall, as shipbuilding is widely recognized as a complex and high-risk business.
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