Renewed defence spending boosts BAE and Rolls-Royce stocks

Governments around the world are making commitments to increase their defence spending, which is good news for companies like BAE Systems and Rolls-Royce. But while BAE has been soaring, Rolls-Royce is also having to deal with concerns in the civil aviation market.

On 9 May, it was reported that the UK government had handed contracts worth over £2bn to BAE Systems [BA.L] and Rolls-Royce [RR.L] in order to forge ahead with the building of next-generation nuclear submarines.

Four new HMS Dreadnought submarines, powered by Rolls-Royce’s nuclear reactors and built at BAE’s shipyard in Cumbria are set to plunge into service with the Royal Navy from the 2030s.

These are the first contracts that are part of a planned near-£10bn investment from the UK government.

A growing emphasis on defence

It is also a strong signal that the UK is increasing its focus on national defence in the wake of the Russian invasion of Ukraine and threats of nuclear attack. Other nations are also following suit, with the US and Germany pledging to increase defence spending not only to help Ukraine in the current crisis, but also to strengthen national security in the event of further conflict. The latter’s commitment to increasing spending in this area is particularly notable, given Germany’s wariness of military power following the Second World War.

Even investors who have previous felt discomfort around the sector are taking a second look at defence stocks.

In March, analysts at Citi argued that they could even be considered a socially responsible investment. They said defence stocks could now be considered a legitimate ESG sector, given that weapons can help protect free democracies and their populations from the actions of aggressive dictators.

While not everyone agrees with this line of thinking, a recent survey from Finder found that 68% people in the UK would not feel guilty if an investment of theirs performed well but included companies in the weapons manufacturing sector.

Could defence spending news boost ailing Rolls-Royce?

The Rolls-Royce share price climbed 2.5% after the Dreadnought announcement on 9 May to 80.5p at the close on 11 May. This was a welcome rise, given that the company’s share price has dropped 31.6% since the Russian invasion of Ukraine on 24 February.

The Rolls-Royce share price has struggled due to concerns surrounding the potential impact of the war, rising fuel prices and cost of living pressures on Rolls-Royce’s civil aerospace division. It makes up 41% of group revenue, compared with the defence division’s 29%.

BAE’s share price is going strong

The BAE Systems share price, however has climbed 26.3% since the invasion to 744.8p at the close on 11 May. The company manufactures defence equipment, including the Stormer armoured vehicles being sent to Ukraine and the Eurofighter Typhoon fighter jet used by NATO members. In its recent first quarter update, the group said it expects more orders to flow in because of the current geopolitical climate.

“We see other nations increasing or likely to increase their defence budgets to address the threat environment and for NATO countries to move to, and even beyond, their 2% of GDP commitments,” it said.

BAE added that it also saw a positive US defence spending outlook and a growing commitment in the UK to cyberdefence, warships, aircraft and submarines, including the Dreadnought class.

It said first-quarter trading has been in line with expectations and that 2022 guidance was unchanged, up 2–4% to £21.3bn.

Deutsche Bank has a ‘buy’ rating on the stock and an 860p price target given its focus on tanks, fighter jets, submarines and electronic systems. According to MarketScreener, analysts have a consensus ‘outperform’ rating on the stock and a 791.59p price target.

Other defence stocks likely to fare well from increased spending in the sector are Lockheed Martin [LMT], which is doubling the annual production of anti-tank Javelin missiles, used by the Ukrainian army. Its share price has risen 24.7% year-to-date as of 11 May. Another stock doing well is Sweden’s Saab [SAAB-B.ST], which has seen its share price surge 81.7% over the same period on the back of rocketing demand for its NLAW anti-tank missiles.

A less rosy outlook for Rolls-Royce

But what of Rolls-Royce? According to MarketScreener, there is more caution with a consensus ‘hold’ rating and 117p target price. Its exposure to civil aviation and engine manufacturing, repair and maintenance remain an issue in a post-pandemic and high inflationary environment.

“Governments are increasing their long-term budget allocations towards defence activities, underpinning the long-term growth outlook we hold for Defence” - statement made by Rolls-Royce

However, in a trading update on 12 May, Rolls-Royce hailed a strong performance in its defence business in the first four months of the year. It said that its “strong order backlog gives us confidence on revenue, profit and cash conversion against the headwinds of inflation and supply chain risk”.

It added: “Governments are increasing their long-term budget allocations towards defence activities, underpinning the long-term growth outlook we hold for Defence.”