The Super Cycle in European Defence Spending

1. Investment Research Services REPORT The Super Cycle in European Defence Spending Russia’s preparation pre-war: Russian military expenditure rising over the last three years

2. Overview In 2021, Russia’s military expenditures climbed by 2.9% to $65.9bn as it boosted the number of troops stationed close to the Ukrainian border. Russia spent 4.1% of its GDP on its military in 2021, an increase for three years consecutively. The ‘national defence’ budget line, which includes funds for operating costs and the procurement of arms and accounts for roughly three-quarters of all Russian military spending, was amended higher during 2021. A total of $48.4bn was ultimately spent, i.e., 14% higher than what was anticipated by the end of 2020. Russian military spending increased after a fall brought on by Western sanctions following Russia’s annexation of Crimea in 2014 and a sharp drop in energy prices in 2015. Figure 1: Russia’s total military expenditure and as a percentage of GDP showing a similar pattern pre-2014 and 2022 invasion 100 6.00% 90 5.00% 80 70 4.00% 60 $ bn 50 3.00% 40 2.00% 30 20 1.00% 10 0.00% 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2021 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2022 1993 1994 1995 1996 1997 1998 1999 Total Military Expenditure % of GDP Source: SIPRI Regardless of its errors in judgement, political blunders and glaring lack of soft power, Russia will only be able to win in Ukraine if it has a military advantage. Extended military force projection capabilities will once more turn into a valuable commodity in world politics and a key component of the new international order. 2

3. The Super Cycle in European Defence Spending A wake-up call to tighten national security post- Russia-Ukraine war The Russia-Ukraine war has given a stern warning to all European countries and other countries globally to strengthen their military capabilities to secure national borders. The war has also highlighted the importance of national security in an all-time low defence spending environment. Figure 2: Military expenditure as a percentage of GDP constantly falling across the world and the European Union (EU) 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1980 1982 1984 1986 1988 2000 2002 2004 2006 2008 1962 1964 1966 1968 2020 2022 1970 1972 1974 1976 1978 2010 2012 2014 2016 2018 1990 1992 1994 1996 1998 European Union United States World Source: World Bank, Military expenditures data from SIPRI are derived from the NATO definition The defence spending attitudes, which will likely lead to the next super cycle in budgetary defence spending. Following Russian plans to invade Ukraine in February 2022, most European defence representatives have declared a focus on increasing their military budget expenditure to maintain, modernise and add cutting- edge military equipment and vehicles. The spending on defence for European countries consistently for the last 40 years. conflict has significantly impacted European Global military spending surpassed the $2-tn mark for the first time in 2021. However, the upward trend continued, and by 2022, it reached at a total of $2,240bn, indicating a significant increase in just one year. Global expenditure in 2022 increased by 3.7% compared to 2021. There is an upward momentum in the total military spending post-Russian annexation of Crimea in 2014. The momentum remained despite the COVID-19 outbreak's disastrous repercussions on the world economy. has been falling Figure 3: Total military expenditure crossing the $2tn mark in 2021 8.0% 2500.0 6.0% 2000.0 4.0% 1500.0 ($ bn) ($ bn) 2.0% 0.0% 1000.0 -2.0% 500.0 -4.0% 0.0 -6.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2020 2021 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 1993 1994 1995 1996 1997 1998 1999 Europe Rest of the World Total Growth (YoY) Source: World Bank, Military expenditures data from SIPRI are derived from the NATO definition 3

4. The Super Cycle in European Defence Spending Change in political will: Prominent European leaders to increase defence spending The Russian invasion of Ukraine has had a profound impact on European security. It has also led to a significant change in political will amongst European leaders to increase their defence spending. In the years leading up to the war, several European countries were reluctant to increase their defence budgets, arguing that they could rely on the United States for their security. However, the war in Ukraine has shown that Europe cannot rely on the United States alone and that it needs to be able to defend itself. Here are some of the statements made by prominent European leaders about spending post-Russian war against Ukraine: increasing their defence Current Spending as a percentage of GDP (2021) Country Time Statement Target/Increase Chancellor spending on defence to increase more than 2% of the GDP. Olaf Scholz announced that Germany Mar-22 1.49% 2% of the GDP According to Prime Minister Mario Draghi, Italy will increase its defence expenditure from the current 1.4% of GDP to reach the goal by 2028 rather than the 2024 deadline that North Atlantic Treaty Organization (NATO) countries promised to achieve represent an increase of 40% from 2021 to 2024. Italy Mar-22 1.58% 2% of the GDP in 2014. This would Deputy country will raise its defence expenditure from 2.1% to 3% of GDP. Prime Minister Jaroslaw said the Poland Mar-22 2.22% 2–3% of the GDP President country’s defence spending must rise from the current 2% of GDP to 2.5%. Klaus Iohannis stated that the Romania Mar-22 1.86% 2.5% of the GDP Odd Roger Enoksen, the minister of defence for Norway, said that contribute an extra NOK3bn ($341mn) in 2022 to strengthen its armed forces along its 120- mile land border and 1,087.49-mile ocean border with Russia. the country will Norway Mar-22 1.75% 2.0% of the GDP Prime announced that Sweden will also boost its defence spending from 1.3% of GDP to 2% as soon as it is logistically improvements can then be used to enhance the country’s defence capabilities. Minister Magdalena Andersson Sweden Mar-22 1.3% 2% of the GDP feasible. These Denmark’s Prime Minister said that the country will increase its defence spending and try to become independent of Russian natural gas amidst Russia’s invasion country will boost its defence spending to reach 2% of GDP by 2033. Denmark Mar-22 1.33% 2% of the GDP of Ukraine. The These statements reflect the growing consensus amongst the European leaders that they need to increase their defence spending to deter Russia and defend themselves. 4

5. The Super Cycle in European Defence Spending NATO’s requirement on defence spending In 2006, NATO countries pledged to spend at least 2.0% of their GDP on defence to maintain the alliance’s preparedness and provide a coordinated response in the event of an attack on one of its members. Following Russia’s annexation of Crimea in 2014, the member nations agreed to a commitment to adhere to the 2% of GDP expenditure requirements by 2024. Till 2021, most European businesses failed to satisfy NATO’s threshold of a minimum of 2% in percentage of GDP. Up from just three allies in 2014, eight NATO allies in 2021 reached the recommendation of spending 2% of their GDP on defence. budget spending as a Figure 4: Military expenditure as a percentage of GDP constantly falling across the world and the EU 4.0% 2.5% 2.0% 3.0% 1.5% 2.0% 1.0% 1.0% 0.5% 0.0% 0.0% Czech… North… United… Slovak… Denmark Lithuania Estonia Belgium France Germany Norway Albania Croatia Hungary Italy Latvia Montenegro Poland Portugal Bulgaria Canada Luxembourg Netherlands Greece United States Romania Slovenia Spain Türkiye Share of real GDP 2014 (%) Share of real GDP 2022 (%) Nato Guidelines Source: SIPRI The NATO countries falling short of their requirement of spending 2% of GDP would require approximately $60– 65bn of additional funding from the countries. This is likely to increase the potential market opportunities for defence sector players. The funding requirement is calculated based on 2021 budget spending as a percentage of GDP and the additional funding required to match it to the 2% threshold. The United States, with a NATO market share of 69% in 2021, continued to be by far the biggest spender. European countries spent $41bn in 2021, with a growth of 3.0% over 2020, and commanded a world share of 20%. The United Kingdom’s military expenditure totalled $68.4bn in 2021, up by 3.0% from 2020. The United Kingdom’s military burden was 2.2% of GDP in 2021, above the NATO target of 2%. Figure 5: United States significantly dominates the defence spending among the NATO countries United Kingdom 6% United States Canada France Germany Italy United Kingdom Other Italy 3% Europe and Canada 31% Others 10% United States 69% Germany 5% France 5% Canada 2% Source: NATO There is a complete shift in political willingness to increase the defence sector’s budget spending. As per the statement and intent shown by European countries to boost their defence spending, an incremental budget spending of $60–70bn is expected. This is likely to positively impact the European defence companies’ order books. 5

6. The Super Cycle in European Defence Spending Figure 6: Additional defence spending to meet NATO’s 2.0% GDP requirement (in $bn) Source: SGA Research The percentage of equipment expenditure to total defence expenditure has improved significantly in the last few years and is expected to continue its uptrend. The major spending in the short term will go towards restocking what is being sent to Ukraine and upgrading the existing equipment. In 2021, 21 Allies met the NATO- agreed 20% guideline, compared to only 7 in 2014. Additionally, around 20 allies spent more in real terms on major equipment than they did in 2020. The incremental spending is likely to add to the market size of the defence sector. Figure 7: Percentage of equipment expenditure to total defence expenditure for NATO countries 60.0% 40.0% 20.0% 0.0% Monteneg… Netherlan… Luxembou… North… Czech… Slovak… United… United… Albania Norway Bulgaria Canada Slovenia Spain France Germany Hungary Latvia Türkiye Estonia Italy Lithuania Poland Portugal Belgium Denmark Romania Croatia Greece 2014 2022 Nato Guidelines Source: NATO Figure 8: Defence spending on equipment as a percentage of total defence spending is increasing for European countries 40% 30% 29% 29% 27% 30% 26% 26% 25% 25% 25% 22% 20% 19% 20% 16% 15% 14% 12% 11% 7% 10% 0% 2014 2015 2016 2017 NATO/EX-USA 2018 2019 2020 2021 2022 NATO/USA Source: NATO 6

7. The Super Cycle in European Defence Spending Demand driver for defence companies Maintenance and upgrades to drive short-term budget spending and companies Most European countries’ decreased since 1980. After Russia invaded Ukraine, the need for equipment upgrades has increased across Europe. Low equipment readiness has necessitated extensive upgrades, thereby defence budgets and driving the defence industry. Low levels of readiness for military hardware and vehicles necessitate urgent repair and improvement. Due to years of poor investment, Germany’s military equipment significant modification and upgrades. The average readiness rate was 77%, according to the Federal Government’s report on the material readiness of the Bundeswehr’s key weapon systems II/2021, published on 15 December 2021 (2020: 74%). The Ministry of Defence bases the calculation of this number on the inventory that is currently in hand. These include systems that can be utilised for deployment, commitments that are close to being operational, training and exercises. Legacy systems, which the ministry refers to as being in the saturation or degeneration phase, fall under the third group. is not operationally ready and needs revenue for defence defence budgets have leading to a rise in Figure 9: Germany’s material readiness for Bundeswehr’s main weapon systems as per category 100% 88% 90% 76% 80% 68% 70% 60% 50% 40% 30% 20% 10% 0% category 1 category 2 category 3 Source: Bundeswehr 7

8. The Super Cycle in European Defence Spending Re-stocking of weapons and vehicles sent to Ukraine Since the Russians invaded Ukraine in February 2022, several countries have sent arms to Ukraine. The United States, Turkey, the United Kingdom, Canada, Germany, Spain, France, Norway, Sweden, Finland and Denmark are some countries that have sent or pledged to send arms to Ukraine, and this is likely to continue until the war ends. Countries have sent munitions, missiles and equipment to Ukraine. Re-stocking orders in the short term are expected to benefit defence companies. It may take some years for the companies to fulfil the re- stocking demand because of supply constraints. A non-exhaustive list of countries contributing weapons and equipment to Ukraine: Country Description of Weapons Belgium 5,000 automatic rifles and 200 anti-tank weapons Canada 4,500 M72 rocket launchers, 7,500 hand grenades and 100 Carl-Gustaf M2 anti-tank weapons Croatia Infantry weapons and protective equipment Czech Republic Artillery shells, machine guns, submachine guns, assault rifles, pistols and ammunition Denmark 2,700 ‘shoulder-launched anti-tank missiles’ to the Ukrainian army, likely M72 anti-tank weapons Finland 2,500 assault rifles, 150,000 rounds of ammunition and 1,500 anti-tank weapons France Unspecified defence equipment Germany Kalashnikov rifles and portable rocket launchers Italy Air missiles, mortars and Panzerfaust anti-tank weapons Japan Bullet-proof vests, helmets and other equipment Lithuania Stinger surface-to-air missiles Netherlands 200 Stinger air defence systems, 40 Panzerfaust, 3 anti-tank weapons and 400 missiles Norway 2,000 M72 anti-tank weapons Artillery ammunition, antiaircraft missiles, light mortars, reconnaissance drones and other reconnaissance weapons Ammunition, bullet-proof vests and military equipment 1,370 anti-tank grenade launchers and 700,000 rifles, machine-gun rounds and light machine guns 5,000 anti-tank weapons, 135,000 field rations, 5,000 helmets and 5,000 pieces of body armour Poland Romania Spain Sweden United Kingdom Lethal and non-lethal aid, including light anti-armour defensive weapon systems Small arms, body armour and other msunitions, as well as an unspecified number of Javelin anti- tank weapons United States Focus futuristic technology-driven equipment Along with the demand for restocking and upgrading, there is a huge demand technology-driven weapons. The budget spending is likely to be not only focussed on land military vehicles but also on digital space and cyber-based systems. There is likely to be a greater proportionate of budget spending towards technologically advanced weapons as national security is certainly a bigger concern post- Russian invasion of Ukraine. Technology leaps in the areas of automation, robotics, AI, miniaturisation, cyber security and digitalization in security services are to drive the demand for these products. shifted towards long-term advanced Space, cyber and AI in defence to get a big boost in the coming years Transnational terrorism, interstate conflicts and the vulnerability of some governments across the world are just a few of the increasingly diverse and unforeseen threats to global peace and security. The current military conflict between Russia and Ukraine serves as a contemporary example of conventional worries, new challenges have emerged, such as hybrid warfare and cyberattacks. Autonomous capabilities powered by AI will aid in updating defence capabilities and speeding up decision-making. for advanced futuristic this. Along with more 8

9. The Super Cycle in European Defence Spending Supply chain constraints There investments in the question would be if the companies can deliver the order within the timeframe or will take years to fulfil these orders. There are supply chain constraints due to the Russia-Ukraine war as rising wages put pressure on costs. Companies will have to expand and increase are going to defence be numerous industry, but the orders and key their headcounts to meet these orders. From massive deliveries of steel and aluminium needed to build military ships and aircraft to landing gear brakes to items as small as semiconductors, shortages or delays have defence firms of all sizes. supply chain upended the plans of German defence policy enters a new era “We are living through a watershed era’ says all about the political seriousness and change in will towards national security and the need for an immediate increase in defence budget spending. ‘24 February 2022 continent’.”—Olaf Scholz, Chancellor of Germany, on 27 February 2022 whilst addressing a special parliament session. marks a watershed in the history of our Figure 10: Germany’s allocation of defence funds and total expenditure as a percentage of GDP 120% 2% 2% 100% 1% 80% 1% 1% 60% 1% 1% 40% 0% 20% 0% 0% 0% 2014 2015 2016 2017 2018 2019 2020 2021 2022 % on Equipment % on Personnel % on Others % of GDP Source: NATO Germany has committed to allocate 2% of its GDP to defence by 2024 and has established a separate off- budget fund of $100bn to fund Bundeswehr equipment. Germany’s defence budget increased in 2022, reaching almost $55.7bn. German defence spending will be much higher in 2022 because government’s commitment to increase the spending to 2.0% of GDP. This means that defence spending in Germany, which most recently amounted to around $55.7bn (2022), will soon increase to between $70bn and $80bn per year. of the German 9

10. The Super Cycle in European Defence Spending European defence companies are beneficiaries of the defence supercycle The Russia-Ukraine war highlighted the need for NATO countries to unite and support Ukraine and focus on their military capabilities. There is political pressure to increase defence spending, add advanced technology weapons and improve and upgrade the readiness of the existing equipment and vehicles. Not only the Russia-Ukraine war but also the tension with China- Taiwan, North Korea and Iran are driving the demand for military weapons and equipment. The stock price performance of Europe-based defence companies Stock 2022 (YoY) Return Rheinmetall 137% Saab 81% Thales 60% BAE Systems 56% Leonardo 32% Source: Yahoo Finance Beneficiary companies Rheinmetall AG A major arms supplier to Germany is the best player in the European Defence Super Cycle. In 2021, Rheinmetall reaffirmed its status as the German military forces’ top equipment partner. At the end of 2021, Rheinmetall attained a new record level with a combined order backlog with external third parties of €15.1bn for three divisions operating in the field of security and defence technology. Rheinmetall also successfully positioned itself with NATO members as a cutting-edge defence technology producer. The company is guided towards 18% sales growth in FY23 and is valued at around €7.4bn to €7.6bn. Major Supplier to Germany with bigger market share: Rheinmetall has identified opportunities from already Germany’s announce special fund of €100bn. It has worldwide capacity so it can respond to the increasing demand in the short term. Additionally, the company has accessed the additional headcounts and is preparing for the short- to medium- term increase in demand. €42bn qualified gross products potential for requirement for Figure 11: Rheinmetall has major exposure to Germany 31% 34% Germany Other parts of Europe Rest of the World 35% Source: Company filings 10

11. The Super Cycle in European Defence Spending Thales Thales company providing technology and services for various industries, including aerospace, defence, transportation and security. It offers a wide range of products and solutions such as avionics, communication systems and cybersecurity solutions. It is a global leader in advanced technologies, investing in digital and ‘deep tech’ innovations—connectivity, big data, AI, cybersecurity and quantum technologies. In 2022, Thales generated sales of €17.6 billion. Thales is likely to see a surge in the order book in the short- to medium-term due to re-stocking by many European countries. The company generates more than 60% of its revenue from the European region for its Aerospace Defence & Security segments and will benefit from the region’s spending. Rheinmetall increasing defence spending in Europe: Triggered by the military conflict between European countries are expected to increase their defence spending. The conflict means that certain Western and Eastern European countries are supporting Ukraine with deliveries of military equipment from their stocks. Additionally, the countries have also increased their willingness to improve equipment in terms of quality and quality, especially military capabilities for national and alliance defence. In the short and medium terms, this will result in a rising number of new, additional armament procurement projects offering significant Rheinmetall, making it one of the most important European armed forces suppliers. is expected to benefit due to the is a France-based €31.5bn equity market Russia and Ukraine, navigation systems, their armed forces’ business potential for expansionary budget Figure 12: Europe contributes a higher percentage of revenue 6% Noth America 10% Australia/NZ 23% Rest of the Word 61% Europe Source: Company filings Beneficiary companies As the countries continue to provide Ukraine with armaments, European defence businesses’ order books are expected to witness a significant increase because of restocking. Companies having exposure to shorter- cycle items like missiles, ammunition, ground artillery and land vehicles will stand to gain the most. Short-term demand will be driven by restocking and maintenance of equipment. Defence industries will also benefit in the medium- to long-term from the change in political will to enhance defence spending to strengthen national security. In the upcoming years, businesses with stronger exposure to the European market, like Rheinmetall or Thales, are projected to have significant increases in their positive order inflows. 11

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