RNMBF - Rheinmetall Will Likely Have Tailwind For Years To Come

2023-03-24 08:37:43 ET

Summary

• Not many industries in Europe are booming like the defense industry. Rheinmetall is active in many areas and is currently flooded with orders.
• Given the geopolitical situation, there seems to be no end in sight.
• Even if peace is achieved in Ukraine, the German and European armies will still need to modernize and replenish their stocks.
• Rheinmetall trades with a 2023 P/E of less than 20 and a PEG ratio of less than 1.

Investment Thesis

Rheinmetall ( OTCPK:RNMBY , OTCPK:RNMBF ) is Germany's largest arms manufacturer and was recently included in the DAX, Germany's leading stock index. The company benefits from the geopolitical situation in Europe and that European arms and ammunition stocks are running low. Moreover, after decades of low spending, the German government increased its defense budget enormously because the German military was in an ailing condition. Since the beginning of the war in Ukraine, however, it has become clear that there is a need for action, and Rheinmetall is enjoying an immense tailwind.

Note: Most numbers in this article are Euro, as the company reports that way in its documents.

Company overview

Rheinmetall AG is a major defense company founded in 1889 in Düsseldorf, Germany, where it is still headquartered. The company has two main divisions: Rheinmetall Defence and Rheinmetall Automotive, each serving different market segments.

Rheinmetall Defence specializes in advanced military equipment, including battle tanks, artillery, ammunition, drones, and defense electronics. As a European player in the defense market, Rheinmetall competes with industry giants such as Lockheed Martin and Northrop Grumman.

Rheinmetall has pursued growth through strategic acquisitions, partnerships, and expansion into new markets. Until 2021, the company made several key acquisitions, including the purchase of drone manufacturer EMT Penzberg , the takeover of Canada-based defense electronics provider Oerlikon Contraves and, more recently, the Spanish EXPAL Systems, which is expected to be closed in summer 2023. Furthermore, Rheinmetall has formed alliances with other industry leaders to strengthen its market position, such as its joint venture with BAE Systems (BAESF) to create Rheinmetall BAE Systems Land (RBSL).

In September 2022, Rheinmetall announced a strategic partnership with Helsing, a leading European provider of software and artificial intelligence ((AI)) solutions for defense systems. The collaboration aims to develop the latest software-driven weapon systems, which are expected to significantly enhance the armed forces' capabilities. The alliance between Rheinmetall and Helsing combines the two companies' strengths with complementary expertise. Rheinmetall, renowned for its military equipment and technology, will benefit from Helsing's advanced software and AI capabilities.

One of the key lessons of the Russo-Ukrainian War is that digitization and AI-supported mission systems can give armies a meaningful edge on the battlefield. They are destined to play a key role in defensive operations.

Source: Rheinmetall

Industry Overview

In the context of the Ukraine war, we are currently seeing a complete depletion of European weapons stocks. And these are being destroyed in Ukraine much faster than Europe (and the US) can produce them. So even to get to the pre-war stockpiles, a lot would have to be built now. But Europe would also like to modernize its weapons and increase its production capabilities.

On February 27, 2022, German Chancellor Olaf Scholz announced a one-time investment of €100B dedicated to the German army. This funding will enable the realization of key projects in the short term. Additionally, Germany has pledged to meet NATO's spending target, which requires allocating 2 percent of the country's GDP to defense spending. This commitment signifies an increase in defense funding from approximately €47B (2021) to a range of €70B to €80B in the future.

Recent results & valuation

and this effect can already be seen in Rheinmetall's results. The order backlog is at a record level and currently stands at €26B. Sales in 2022 were €6.4B (€5.7B in 2021). This left an operating profit of €754M (€594M in 2021). The Group's operating margin increased to 11.8% (10.5% in 2021).

The company's current market capitalization is €11.4B, with debt of around €1.1B. However, the debt/EBIT ratio is relatively low at about 1.5, so debt is not a problem. Earnings per share in 2022 will be €10.8 (€6.72 in 2021). The current share price of €261 gives a P/E ratio of 24. The analysts' estimates are for earnings per share of €14 in 2023, implying a P/E of 18. The valuation is not exceptionally cheap, but given the rapid growth in earnings per share, the PEG ratio (price/earnings/growth) is below 1, which is considered undervalued.

The company indicates a revenue growth of about 20% for the next year from €6.4B to approximately €7.5B.

The company's primary constraint is its production capacity, given the huge order backlog and the high demand for weapons and ammunition that currently prevails and is likely to continue. There are enough orders, but the company cannot hire new employees and build production facilities as fast as needed. In 2021, the company had 21,000 employees; now, it has 25,000. In addition, there are 1,300 job offers on the company's website .

Long-term outlook

As with any business, the long-term prospects are difficult to assess. However, the replenishment and modernization of European armies cannot be achieved in one or two years. It is, therefore, reasonable to assume that high order backlogs will continue for years to come. The current order backlog alone will take years to fulfill, not counting additional future orders. Moreover, with the West unwilling to cede eastern Ukraine to Russia, this could become an ongoing conflict for years. In this case, manufactured weapons would continue to be supplied to Ukraine, thus slowing down the replenishment of European stocks. This will benefit Rheinmetall's production segment and the service sector.

The European countries see how this war is being waged in Ukraine and can therefore identify areas where they need to catch up or make technological progress. This opens up a whole range of additional sales opportunities for Rheinmetall.

Dividend

The dividend for 2021 was €3.3 and was risen to €4.3 in 2022, an increase of almost a third. This gives a yield of 1.6% on the current share price. Given the business outlook, I expect further increases in the coming years.

Risks

Despite its promising prospects, Rheinmetall is exposed to several risks that could disrupt its business or the defense industry as a whole. Political risks, such as changes in government policy or defense budgets, could adversely affect the company's financial performance. Currency risks resulting from exchange rate fluctuations could also impact Rheinmetall's profitability.

In addition, Rheinmetall's main products and services are subject to disruptions from technological innovations and competition. The defense industry is fiercely competitive, with established players constantly vying for lucrative contracts. Consequently, Rheinmetall must continue to innovate and adapt to market trends to maintain its position as a leading defense contractor.

Another risk is that the company produces weapons for Western countries, making it a desirable target for espionage, cyber-attacks, or other interference from a Russian or Chinese perspective. As long as the production facilities are in Western countries, they should be safe. However, there are talks about building a tank factory in Ukraine, which sounds like a very bad idea to me because Russia will most likely destroy it on the opening day.

Share dilution and insider selling

I always pay attention to share dilution and whether there is insider selling. In 2022 and 2023, there were several insider purchases by Executive Board members with a volume of several million Euros.

Conclusion

Unfortunately, not many industries in Europe are booming like the defense industry. Rheinmetall is active in many areas and is currently flooded with orders. Given the geopolitical situation, there seems to be no end in sight. Even if peace is achieved in Ukraine, the German and European armies must still modernize and replenish their stocks. The complete break between the West and the new axis, especially Russia and China in the East, indicates that a new arms race is imminent. Not a promising outlook for mankind, but as an investor, you can still profit from it and do more sensible things with your hopefully acquired wealth in the future. Rheinmetall trades with a 2023 P/E of less than 20 and a PEG ratio of less than one, making it a very attractive buy.

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