Summary
- Increased geopolitical tensions in 2022 have created a renewed willingness by nations to invest in defence capabilities and energy security.
- After several preliminary calls, we were able to meet with Rheinmetall management in person in late 2022 and came away impressed.
- We believe the shares are trading at a more than 20% discount to fair value.
The following segment was excerpted from this fund letter .
Rheinmetall AG ( RNMBF )
Increased geopolitical tensions in 2022 have created a renewed willingness by nations to invest in defence capabilities and energy security. Whilst not traditionally an area of focus for VGI, team members have been conscious of this theme and on the lookout for any investment opportunities that may arise as a result. The return of travel in a post-COVID world enabled several members of the team to get back on the road and do one thing we love as part of the investing process – meet in-person with management teams and extensively tour company facilities.
After several preliminary calls, we were able to meet with Rheinmetall management in person in late 2022 and came away impressed with the management team and their shareholder alignment, with incentive compensation linked to Return on Capital Employed (ROCE) and operating cashflow, unique in the European market.
Rheinmetall is an international systems provider for defence products, with regional leadership positions in weapons and ammunition, vehicle systems and electronic solutions. There are a number of elements to the moat of the business: a) the currently approved production facilities in a highly sensitive areas (air defence systems, weapons and vehicle systems) where barriers to entry are high, b) technological capabilities and c) relationships with key customers.
The conflict in Ukraine has provided the catalyst for a significant renewal of defence capabilities across the European region, with NATO signatories having committed to significantly increase their spending after a long period of material under-investment; Rheinmetall will grow with these commitments. The current war is seeing supplies rapidly diminish through direct/indirect transfers and it is estimated that 10 years could be required to replenish German stocks to NATO commitment levels in Rheinmetall’s ‘home’ market.
In light of this, the German government has increased its defence spending commitment to 2% of GDP and established a 100bn euro special fund. New members have joined NATO and other countries have also committed larger percentages of budget spending to defence (Spain and Italy: 1.4% to 2%; UK: 2.2% to 3%). These commitments provide a strong multi-year tailwind to the Rheinmetall business.
Over the last several years, Rheinmetall has been undergoing a portfolio transformation process as it seeks to become a pure play defence technology business. Traditionally, the business has had a large exposure to Auto Original Equipment Manufacturer (OEM) customers (and Internal Combustion Engine ((ICE)) vehicles in particular) with ~50% of the revenue and operating profits in the business coming from the auto division in 2018.
Whilst the company has made investments to capture component revenue from EVs, their exposure to the ICE supply chain has been a drag on the trading multiple and sentiment. Recent portfolio management activities have created a ‘cleaner’ business with higher expected ROIC. Disposal of the pistons unit removes automotive revenue exposure and we project that, following a shrewd recent acquisition in the ammunition space (Expal), by FY25 ~70% of sales and over 80% of profits will come from the defence division.
Rheinmetall Sales and EBIT
Source: Company filings, VGI Partners analysis.
From a valuation perspective, we believe that there are a number of areas supporting valuation. Rheinmetall has a strong history of dividend payments, with dividends increasing at an 18% CAGR from FY17-22. At the FY22 Investor Day, Rheinmetall committed to increasing the dividend payout ratio from 35% to 40% – at expected FY25 dividend of 7.5 per share and assuming the business trades in line with historical dividend yields, we believe the shares are trading at a more than 20% discount to fair value. Historically Rheinmetall has traded in a range of 5x-7x EV/EBITDA – with a chance to re-rate to 6x-8x EV/EBITDA on a significantly higher earnings base.
European defence names generally trade at a significant discount to their US peers, but with such strong budgetary commitments, we see optionality here for a re-rate. The US defence landscape re-rated post a budgetary change from 2011-2020. The French defence budget markedly increased post the annexation of Crimea by Russia in 2014, providing a tailwind to Thales.
Potential risks here stem from the lumpiness of defence sector contracts – indeed we have already seen during our ownership period a delay in several contract awards, but we view these as short-term setbacks vs the longer arc of renewed defence spending in Europe. Further risks are in the relationship with key customers, such as the German government, highlighted by a recent issue with PUMA tanks malfunctioning in live fire exercises. Any export controls would also be a cause of concern given the business has 35% ex Europe revenue exposure and cause us to review the investment thesis.
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VGI Partners - Rheinmetall AG: Commitments Provide A Strong Multi-Year Tailwind