European Defense Shares Fall After Germany Scraps Flagship Naval Program

European defense shares extended losses on Thursday, as investors continued to reassess betting on Europe's rearmament boom after Germany scrapped a flagship naval programme.

Berlin's U-turn on the F126 program, which could have been worth more than 12 billion euros for which Rheinmetall had been expected to become the lead contractor, is now exposing a key risk to Europe's defense trade.

"This news reminds us that [governments] can and do change their minds," JP Morgan analysts led by David Perry said Wednesday.

Shares of Rheinmetall fell 1.8% following a 18% drop on Wednesday. German peers Hensoldt and Renk dropped 6.7% and 2.5% respectively, also following losses in the previous session.

Most of Europe's leading defense companies were in the red on Thursday morning, extending Wednesday's losses. Only Rolls-Royce made gains, rising less than 1%.

Why the F126 decision matters for defense stocks

The F126 cancellation emphasized to markets that, while defense spending may have driven the sector's rally in recent years, government procurement remains political, unpredictable, and subject to shifting military priorities.

Perry noted the major difference between the defence sector and other sectors: the customers are essentially always sovereign governments, whose financial priorities change.

"We are absolutely convinced that Germany will spend a lot of money on defence procurement in the next 5+ years and that it will buy significant amount of land vehicles and ammunition from [Rheinmetall]."

But the JPMorgan analysts also didn't rule out governments may buy fewer vehicles and ammunition than currently expected because they decide to reallocate money to other areas, such as drones, space, or advanced air defense systems.

"The decision to cancel the F126 is a reminder that other assumptions RHM has made for its businesses may prove incorrect," Perry's team added.

Germany announced on Wednesday it would instead buy eight smaller Meko A-200 frigates from the German TKMS, instead of the six massive F126 frigates, citing significant project delays, cost increases, and the risks associated with changing the prime contractor to Rheinmetall.

The Meko frigates "would be capable of fulfilling the German Navy's core mission of anti-submarine warfare—and, by extension, meeting our NATO obligations," the country's government said in a statement on Wednesday.

A year ago, NATO allies agreed to increase defense spending from 2% to 5% of GDP by 2025 after years of pressure from Washington.

There has been growing concern among investors that the big budgets, promised by European and G7 countries to keep up with NATO targets, will not materialize, and that companies' growth will be constrained as a result, Morningstar Chief Market Strategist Michael Field told CNBC on Tuesday.

In a decade, countries like Germany will still likely be restocking weapons it has given to Ukraine, Field said, adding that "the market is missing" that defense spending doesn't depend on "one war ending or starting."

S&P Global Ratings, meanwhile, expects defense budgets to grow unevenly among European nations due to political and fiscal fragmentation.

Defense companies will be the immediate beneficiaries, but European economies are unlikely to benefit significantly from higher defense spending, it said in a note on Wednesday. Common procurement and issuance, alongside a preference for European solutions, could provide another boost for companies.

The silver lining for Rheinmetall

Several equity analysts trimmed revenue expectations and slashed price targets on Rheinmetall.

Jefferies analysts cut their price target by 31% to 1,300 euros as they reduced expectations on its 2030 revenue targets, noting that the market cap wiped out by Wednesday's drop – over 10 billion euros – far exceeded the profit value of the contract lost.

"Restoring confidence will come through more credible targets," they said. "Rheinmetall will face a difficult task to restore the credibility of its communications after this clear blow to its expectations of an imminent F126 order."

They did, however, maintain a Buy rating on shares, saying that assumptions have now been derisked.

JP Morgan said the silver lining for Rheinmetall is that, ultimately, losing the F126 frigate contract might be a good thing, as building warships is "notoriously difficult."