Rheinmetall Stock: 30%+ Of The German Defense Budget (OTCMKTS:RNMBF)

Author’s Note: This is the shorter version of an article published on iREIT on Alpha on the 13th of March 2022.

Rheinmetall AG (OTCPK:RNMBY) is one of the largest defense companies in Germany. It has a history that goes back well over 130 years, a market cap of around €6.6B, and it’s one of the companies that has seen perhaps the most interest from the recent changes in German defense policy.

The near and mid-term future is likely to see significant changes to Rheinmetall. In this article, I’m going to answer the most important question of all.

Should you invest in Rheinmetall?

What is Rheinmetall?

From the name, you might assume that this company is some sort of metal business. This is not the case. Rheinmetall is an international arms manufacturer, and it’s one of those that remain in Germany after two world wars and the cold war.

The company is a European play on Aerospace, vehicles, weapons, and defense. It’s a defense conglomerate with five business segments:

• Weapons & Ammunition with large/mid-caliber weapons and their munitions, weapon stations, protection systems, powder, etc.
• Vehicle Systems, focusing on armored Bandwagons, ABC, Tower systems, Logistical Radar vehicles, Tactical vehicles, and a service sub-segment.
• Electronic Solutions, focusing on anti-air systems, guidance systems, sensors, Cyber Security, simulations, etc.
• Sensors & Actuators focusing on Solenoids, Materials, Pump Tech, Emission, and Thermo Systems and Actuators.
• Aftermarket, such as Bearings, Casings, and Pistons.

The company doesn’t just build defense-related products, or it wouldn’t have survived years of low defense spending. The Rheinmetall business model focuses on two distinct revenue streams, from the segments above. The first is the obvious defense industry. The second is automotive supply parts.

The defense part is mainly Weapons & Ammunition, Vehicle Systems, and Electronic Solutions.

The Automotive part is found in Sensors & Actuators, as well as the Aftermarket segment.

Here’s a more detailed revenue split of the company.

The company is a leading, Tier-1 automotive supplier with high-tech products across the ICE, EV and FC value chain, with components and subsystems for hydrogen technology as well.

This revenue split means that fundamentally speaking, Rheinmetall is in a very good position to really take advantage of the increased geopolitical instability we’re seeing here. With other segments seeing tailwinds due to ESG, EV, and green tech as well as hydrogen, the company is in a good spot to really see its revenues increase moving forward.

Rheinmetall is a success story in the context of a 10-year trend, due to successful portfolio moves, including divestments, reorganizations, leading to increased sales, margins, and results.

The company is also a surprisingly able and stable dividend payor, with not even COVID-19 making that much of a dent in the dividend record. The company has no credit rating worth mentioning, but also has zero debt. It has a net debt/EBITDA of -0.02X as of 2021E.

Rheinmetall was in a bad spot about 9-10 years ago, but thanks to the aforementioned restructuring were able to save its business, margins, and core areas. This is not to say that the company is worry-free. Margins in the Electronics solutions/Defense segments continue to be below par due to some issues out of Norway and Brazil, though it’s likely we’ll now see a turnaround here.

The reason for the margin and operational slippage in 2013-2014 was significantly cut defense spending in Europe.

That is now, obviously, completely reversed.

The automotive segment meanwhile, is chugging along very nicely, with solid divisional margins due to moving its production base to low-cost countries such as Mexico, China, and India, with strong growth for mechatronics and hardparts for both segments. The margin here is approaching double digits.

However, the company has been targeting a reduction in automotive to reduce the volatility. The company also targets a below-20% ICE exposure over time, with 70% 2025E sales to the defense sector, and 10-15% towards the EV sector.

So Rheinmetall’s target is to become primarily a defense play, with a minor focus on EV and automotive/ICE applications over time. Given recent events, it seems more likely that the company might be able to manage this. There are also clear market drivers for such a development, including tightening regulations, increased demand for defense budgets, connectivity and digitization of armed forces, modernization of existing assets and new solutions for old products – such as hybrid/hydrogen.

This is why the company targets sales of €8.5B in 2025E, with a 10% RoE target and a CF/Sales ratio of 3.5%. Defense spending has also been a safe, anti-COVID bet, with budgets growing and tenders continuing despite the pandemic. The company’s markets, including Australia, UK, Germany, Hungary and USA are all growing. Several of these are considered to be Rheinmetall’s “Home” markets.

The company expects the German defense budget to increase massively over the next few years, rising 45% since 2014. The company’s portion of that budget is nearly 35% in the nation, making Rheinmetall a crucial play on German defense, in the same way, that Thales (OTCPK:THLLY) is a proxy to the French defense budget.

More than 46% of the company’s revenues is a pure defense play with appealing margins that are allowed for a healthy sort of growth and is likely to continue providing excellent growth moving forward. The company is also an active M&A’er when needed, with the last M&A being Gemalto. Rheinmetall has a very strong R&D focus and is at the forefront of cyber security.

In addition, and as I mentioned before, the company has probably the strongest balance sheet on the entire German defense market, and this will only grow stronger as its margins and cash flow generation are improved even more as the defense supercycle intensifies.

The need to digitize virtually every existing land system in the German army alone is a contract worth over €10B – and this is only the beginning for Rheinmetall. This was, by the way, already in the pipeline prior to the war – it’s only become more important now.

New markets are also interesting for the company, and Rheinmetall is developing JVs with BAE Systems (OTCPK:BAESY) in order to create a “new” home market in the UK, and there are plenty of potential procurements which now of course are looking better and better due to the conflict.

Overall, I deem that Rheinmetall is exactly what it seems like. It’s a conservative German player in Aerospace/Defense that even prior to this war was in a very good position for the next few years. It was a “BUY”, albeit with a lower upside, even at that time, and I was looking at it favorably.

What this conflict did is of course dial that upside up to perhaps twice as high.

I’ve never been a fan of buying a business due to trends. If this company wasn’t attractive prior to the war, I wouldn’t put my chips down on it now either – but the war has only made this company’s upside even better, and that’s why I’m viewing it favorably here.

The European defense sector is a big place, with at least 7-9 various peers that deserve mention in their own right. I intend to cover these businesses effectively, and I’ve already covered Airbus (OTCPK:EADSY). Needless to say, I pushed more money into Airbus as well, and I’m currently reviewing all of the companies in this segment to see where the strongest prospects are.

Rheinmetall, being 30%+ of the German defense budget, is definitely one of the highest on that list.

Rheinmetall – The risks

Naturally, no company is without risk. Neither is this one. The company’s continued exposure to automotive isn’t necessarily a bad one. However, it does come with a 20% Diesel drag, which is likely to remain for as long as the company is in the sector. While restructuring has been successful, the margins in these segments are lower, and their demand cycle can be even more volatile than the company’s other operations.

Furthermore, the company has been trying to grow more on an international basis – a good thing, but also comes with increased competition, as well as FX risk.

While Rheinmetall is significant in Germany, it remains a small player compared to some of its peers – and most certainly to some of the larger US companies in this sector.

Perhaps most importantly are the legal risks to investing in defense in Germany, due to incredibly restrictive export policies. The German government is extremely stringent about these things.

German military equipment exports are governed by the Basic Law (Grundgesetz – GG), the War Weapons Control Act (Gesetz über die Kontrolle von Kriegswaffen – KWKG), and the Foreign Trade and Payments Act (Außenwirtschaftsgesetz – AWG) in conjunction with the German Foreign Trade and Payments Regulation (Außenwirtschaftsverordnung – AWV). The “Political Principles Adopted by the Government of the Federal Republic of Germany for the Export of War Weapons and Other Military Equipment” of 19 January 2000 and the Council Common Position of the EU defining common rules governing control of exports of military technology and equipment of 8 December 2008 provide the licensing authorities with guidelines.

With regard to defense equipment, the Federal Republic of Germany distinguishes between war weapons and other types of military equipment. Almost all export licenses for military equipment are granted for EU countries whereas the supply of military equipment to countries in which there is an arms embargo (by the UN, EU, or OSCE) is virtually impossible. For other countries, the German government will make a decision on a case-by-case basis, paying particular attention to the criteria set out in the EU Code of Conduct.

What this means, and how I would interpret this, is that any expansion outside of the EU is likely to be problematic, putting a theoretical cap on Rheinmetall that’s not found in all other defense companies.

Rheinmetall’s valuation

However, no risk can take away the potential upside we’re seeing here. The EU seems set on arming itself, so defense companies are something we must be looking at here. Due to a recent, massive valuation explosion in Rheinmetall which we also saw in most defense companies, the fundamentals-based valuation targets are all relatively tepid. What I mean by this is that the current upside for Rheinmetall is extremely tilted towards future growth estimates.

From a DCF perspective, I’m assuming that Germany follows through with its 2% of GDP, which would be a doubling of the previous ones, and it will then rise to above 2% of the GDP. It’s also the fact that the operating margin for this business is extremely favorable.

On the back of this, I’m assuming a growth rate in EBITDA of 6-8% and sales growth of 4-6% for the coming 3-5 years. I’m also assuming a 3% CapEx/sales growth, which is in line with the historicals. A WACC of 9.15% brings this DCF to an implied EV/share of between €220-€270. That’s an extremely wide range – but then the sensitivities and assumptions are extremely high.

Also, as I said, and really remember this, that valuation is based on the fact, almost entirely, of that defense spending growth.

In order perspectives, we see more of a “mellow” development. Public comps include Thales, Leonardo (OTCPK:FINMY), Valeo (OTCPK:VLEEY), BAE Systems, and others. The average valuation for these companies ranges between 5-18X P/E (a wide spread), with an average of around 11X. That makes Rheinmetall overvalued here, not just on P/E, but on EV/EBITDA and on book values. The average yield in the segment is around 3%, which again makes Rheinmetall somewhat overvalued with its current 2.1% yield due to the massive valuation spike we’ve been seeing.

When it comes to NAV/SOTP, I’m assigning a higher, 10-14X EV/EBIT multiple to the company’s defense segment, trending towards 14X given the recent focus here, and a substantially lower 7-9X EV/EBIT due to the automotive margin weakness (comparatively). The company has no other significant assets, coming to a total of around €8.7-€9.5B gross, and around €7.6-€8.4B net, with a share count net of the treasury of around 43.2M. This implies a NAV/share of around €175-€194/share, implying an undervaluation here.

How to weigh and premiumize Rheinmetall here is difficult. It’s a legacy player, a proxy to the German defense budget, but it’s also overvalued here according to anything except a SOTP or a high-growth DCF valuation.

S&P Global gives us some thoughts here. 11 analysts range between averages of €83 and €205 – a massive variance coming to an average of about €148, with 8 out of 11 currently considering Rheinmetall a “BUY”. While these are thoughts, a spread such as this really gives us very little help.

What I say is this.

Rheinmetall’s appeal largely depends on how deeply impacted you believe that the EU and the remainder of the world – but mostly Germany – will be for the next few years.

If you believe that Germany will stick to and maybe even increase its plans here, then this isn’t just a good company, it’s a great play overall. The more positive you’re on this, the higher you can weigh the DCF/Growth-related estimates, and allow for fundamental premiums for Rheinmetall.

I’d be careful letting this get out of hand though. For myself, I’m electing to weigh DCF less than 25%, but I am assigning the company a 10% premium to reflect the titanium-like position on the German defense market. When weighing the different perspectives like that, I end up around €155-€172 – significantly lower than the DCF, but still at a potential upside on the higher range.

Equity analysts Alpha Value hold a €210/share price target for the company – one which I believe far too heavily assumes the DCF growth scenario to materialize. At such valuations, not even substantial DGR would provide a good yield. I see how they get there – but I choose to take a more conservative route.

I’m always careful when it comes to this sort of momentum. The company – as most defense businesses – have seen a massive sort of valuation growth, which I view as long-term debatable. We’ve already seen some drop-off here.

And while I staked out my initial position (just a few shares) the day after Putin invaded Ukraine, I’m hesitant to go all-out on Rheinmetall just yet – after not doing so initially.

However, I choose to take the mid-point of my guidance, coming to around €164/share, as my PT for the business.

And on this basis, Rheinmetall is a “BUY”.

Thesis

Tempers are heated, and with hot tempers come a hot stock market. Similar to the “nutty” valuations for work-from-home companies we saw during COVID-19, we’re now seeing a massive flow into defense stocks due to geopolitical tensions.

I will be the first one to remind you that much of this premium can be unwound in a relatively short time if things change.

However, I will state to you, dear readers, that we’re seeing a fundamental change in the defense policies of the European Union.

So some of these premiums and high valuations are very much justified. And I do believe Rheinmetall is up there.

The company’s ADR is relatively thinly traded, correlated to its smaller market cap. RNMBY is a 0.2X ADR, and I wouldn’t really tell anyone to buy this, but rather focus on trying to get access to the natively-listed German share. I would argue that in the longer term, Rheinmetall has a potential RoR upside of between 8-12% annually, or a direct upside to its valuation of around 8% – though note that many analysts consider the upside to be far higher than this, and Alpha Value considers it to be over 30%.

If we do see a massive sort of sales spike, it’s not unlikely that Rheinmetall sales numbers could climb towards €9-€10B in the coming years, which in turn would support dividends of upward of €5-€6/share, if the current remuneration policy was to continue to be followed.

Overall, I like Rheinmetall here – but I’m also aware that there’s considerable emotion involved, where I typically like to invest in “disliked” companies when they’re extremely cheap.