Across Europe, defense spending is on the rise as nations adjust their priorities in light of the ongoing conflict in Ukraine, with plans to add around €500 billion over the next decade.

The push is to have at least 65% of new defense contracts awarded to local companies.

Officials point out that sticking to the current 2% of GDP on defense will not be enough; some leaders suggest a rise to 2.5% or more to ensure long-term security.

Global defense spending is also on the rise, having increased by 7.4% to reach $2.5 trillion in 2024.

The focus is on building a strong domestic defense industry, reducing dependencies, and ensuring that investments are made where they can best support national security goals.

BAE Systems (BA.:GBR) stands out as one of the world’s largest and most versatile defense manufacturers.

The company makes aircraft, ground combat vehicles, warships, submarines, and advanced electronic systems.

It also plays a significant role in cybersecurity, making it a key supplier not only for NATO but especially for the U.S. and other allied nations.

The company’s diversified product mix is one of its strongest business advantages. BAE is heavily involved in long-term defense programs that include the production of advanced fighter aircraft, missile systems, and modernized ground vehicles.

These offerings have allowed the company to secure significant contracts with both European and U.S. military forces.

As European nations increase their defense spending to boost self-reliance, BAE is naturally positioned to benefit from these investments.

Countries in close proximity to potential threats, like those bordering Russia, have shown a growing interest in upgrading their military hardware.

In addition to traditional manufacturing, BAE has been investing in areas that promise long-term growth.

Recent initiatives include involvement in programs like AUKUS, where the company is working on projects such as Australia’s new nuclear-powered submarine fleet.

This not only strengthens the company’s role in international defense cooperation but also ensures a steady pipeline of future work.

BAE’s collaboration on missile systems, especially through its partnership with MBDA, also shows its commitment to staying at the forefront of defense technology.

Investments in ground vehicles and maritime capabilities are set to boost the company’s production capacity and help meet growing demand from its backlog.

As production ramps up, the operating leverage inherent in these investments could lead to more efficient operations and better margins over time.

The company’s focus on modernizing and expanding its manufacturing processes means that it can quickly adapt to changes in defense spending and market demands.

The strategic move to acquire Ball Aerospace is another step that enhances BAE’s capabilities.

This acquisition has strengthened the company’s position in space-related missions, adding another layer to its already diverse portfolio.

As space becomes an increasingly important frontier in defense, having a dedicated team working on these technologies means BAE is well prepared for future challenges.

All these factors combined enabled the company to increase its Uniform return on assets ”ROA” from 9% in 2018 to 14%.

Despite having strong tailwinds behind it and analysts’ expectations of further ROA improvement, the market has concerns about overall global defense spending and tariffs.

We can also see this through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market predicts that the company’s Uniform ROA will decrease to around 12%.

Tariff concerns, which have been a topic of discussion in the market, are less likely to impact BAE significantly.

Since any tariffs would essentially mean the government is taxing its own defense spending, the risk of such measures affecting the company remains low.

This gives BAE a stable operating environment, which is important as it continues to secure large contracts and manage a robust order book.

With a growing backlog and strong strategic initiatives in multiple defense sectors, the company is well-placed to capitalize on the current geopolitical climate.

The shift towards increased defense spending, especially in Europe, and ongoing investments in modern defense technologies have created a positive outlook for the BAE’s future.

The company’s extensive involvement in long-term projects and its diverse range of defense products make it a natural choice for nations looking to upgrade and modernize their military capabilities.

Best regards,

Joel Litman & Rob Spivey
Chief Investment Officer &
Director of Research
at Valens Research

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