JPMorgan has named 2 cheap defense stocks it expects to surge in 2021 — and one with a 50% downside

  • The UK recently announced its biggest defense investment since the end of the Cold War.
  • The new announcement, combined with the defense outlook in Europe and the US, leaves JPMorgan equity analysts with positive view on the sector.
  • JPMorgan's top defense stock picks are BAE Systems and Thales, while it sees a 50% downside for Rolls-Royce.
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The defense sector has been one of the worst hit by the coronavirus , not least because of huge cuts to government spending. At the end of October, the sector's average price-to-earnings ratio hit a 20-year relative low against the European market, according to JPMorgan.

But sentiment on the sector started to turn last month when UK Prime Minister Boris Johnson announced the country's biggest defense investment since the end of the Cold War.

Johnson has promised an extra £16.5 billion in addition to the annual budget, which is almost £41.5 billion, or $55.4 billion, for this financial year.

The announcement of the UK's increased spending, combined with the outlook for Europe and the US, has fed into JPMorgan analysts' positive view on the defense-and-aerospace sector.

As part of JPMorgan's Europe and Global equity outlook released Monday, the equity analyst David Perry provided insight into the sector exploring the current state, the outlook for 2021, and a few key stock picks.

The UK, the eurozone, and the US play a key role in the sector's outlook. This new report provides insight into how JPMorgan views all three markets.

The UK equity market has been upgraded to neutral, despite what analysts describe as the "worst-performing equity region" this year.

"We continue to believe that FTSE250 is a better opportunity than FTSE100, and prefer UK domestic plays vs exporters," the JPMorgan equity analyst Mislav Matejka said. "Overall though, while we expect the UK equity market to be higher next year, we do not think it will be outperforming eurozone, or global peers."

The US has also been rated neutral, while the eurozone has been rated overweight.

"Eurozone tends to do better when value outperforms, while the US is heavily tilted towards quality/ growth style," Matejka said. "We argued at the start of November that market participation would broaden into value, which should, in turn, support the better performance of eurozone versus the US."

Defense outlook

In addition to the UK's decision on defense spending, political developments in three countries in particular have made JPMorgan more optimistic on the sector:

1. France announced plans to increase defense spending in 2021 by 4.5%.

2. Germany has awarded numerous major defense contacts.

3. If Republicans maintain control of the US Senate in January's runoff elections, the resulting political gridlock would make major cuts to defense spending unlikely.

Civil aerospace outlook

On the civil aerospace side, JPMorgan's analysts are less optimistic.

The International Air Transport Association expects the global airline industry to incur materially bigger losses both in 2020 and 2021 than ever before, something that will affect the civil aerospace industry, which provides hardware and software to the airlines.

Many investors are willing to look past 2020 and 2021 and toward a 2023 and 2024 recovery. But JPMorgan points to three reasons for investor caution:

1. There is no guarantee things will be back to normal in the space of a few years.

2. "Airlines have incurred huge debts in 2020-21, and perhaps beyond, and this makes it much harder for them to pay for maintenance and new aircraft," Perry said.

3. Some civil aerospace companies burned billions of dollars in cash in 2020, which weakened their balance sheets.

Based on the positive outlook for the defense market and the more negative view on the civil aerospace sector, here are the analysts' top two picks to buy and one to avoid at all costs:

Stock Picks

1. BAE Systems

Ticker: BA

Rating: Overweight

Price target: £6.20

Potential upside (as of 11/30): 19%

Analyst commentary: "On November 12th BAE held a CMD is which it passionately argued that it expects several years of top line growth, some expansion of EBITA margins, and much improved cash conversion. The improved cash conversion is driven by lower pension deficit funding (largely over by 2022) and improved working capital practices."

Source: JPMorgan Cazenove

2. Thales

Ticker: EPA:HO

Rating: Overweight

Price target: €91.00

Potential upside (as of 11/30): 14%

Analyst commentary: "Even if we look out to 2023E, we see that Thales is trading a major discount to French A&D companies like Airbus and Safran. Thales has a good mix of businesses: c50% of sales from defense provide stability (and some growth) and the other 50% of sales offer exposure to an improving economy post . Management is confident that in the next three years it will deliver organic sales growth, improving EBITA margins and better cash conversion."

Source: JPMorgan Cazenove

3. Rolls-Royce

Ticker: RR

Rating: Underweight

Price target: £0.50

Potential downside (as of 11/30): -50%

Analyst commentary: "RR remains the weakest company in the European A&D sector. In Civil Aero it derives most of its sales from log haul international travel, the segment that will be the slowest to recover from -19. Despite raising £2bn in new equity in 2020, RR still has the weakest balance sheet in the sector. It plans to raise a further £2bn from disposals in the coming year or so, but there is no guarantee of success here. We believe there is still a meaningful risk of another equity raise in the next 12-18 months."

Source: JPMorgan Cazenove

 

 

 

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