European defense spending is rising, but equipment mix and local sourcing are the larger growth drivers

Overview

This industry report updates Bernstein's outlook for NATO Europe defense spending and translates country-level budgets, equipment allocation and domestic procurement into the addressable opportunity for European defense companies. It argues that the rearmament cycle remains highly visible, led by Germany, although Europe as a whole is unlikely to reach the new 3.5% of GDP target by 2035.

Core views

Bernstein expects European NATO defense budgets to reach 2.6% of GDP, or $730bn, in 2026, representing a 20% increase from 2025. The report places this increase in a long historical context: spending fell from roughly 10% of GDP during World War II to a 1.4% trough in 2015, and European NATO members did not meet the former 2% target until 2024. Fiscal capacity and geographic proximity to Russia are identified as the main drivers of differences in national spending. Lithuania, Estonia, Latvia, Poland and Greece already spend more than 3.5% of GDP, but collectively account for only 10% of European spending. The largest four markets—Germany, the UK, France and Italy—account for more than half of European military spending, making their budget paths especially important for the sector. Germany is Bernstein's most attractive market: it is expected to spend 2.7% of GDP, or $150bn, on defense in 2026, up 30% year on year and equal to 20% of European spending. Bernstein forecasts German equipment spending to grow at a 13% CAGR through 2035 and considers Rheinmetall the key beneficiary because of its broad domestic position. The UK, the second-largest market at 15% of European spending, is expected to spend $110bn, or 2.6% of GDP, in 2026; its opportunity is projected to grow at 5% CAGR through 2035, with BAE Systems best positioned, although the UK represents only 27% of BAE sales. France is projected at $80bn, or 2.2% of GDP and 11% of European spending, with a 7% CAGR opportunity; Bernstein argues that France's sovereign defense market will be captured by domestic suppliers. The report does not assume that the new 3.5% NATO target will be fully achieved. Bernstein models average European defense expenditure of 3.2% of GDP in 2035, implying total budget growth of only 4% CAGR through that year. However, it expects the corporate opportunity to grow substantially faster because a rising share of budgets should be directed to equipment rather than personnel and infrastructure. Equipment is forecast to account for 38% of spending in 2035, compared with 34% in 2026 and 29% in 2024. Bernstein also expects European players to capture most incremental demand, contrasting this with approximately 60% of spending represented by US imports in 2023. Combining these mix and sourcing changes, it forecasts a 12% CAGR in the addressable market through 2030 and 9% through 2035. The United States remains much larger than Europe: Bernstein forecasts $1tr of US defense spending in 2026, equal to 3.2% of GDP and more than all European countries combined. If a $1.25tr 2027 budget is voted, the report notes this would represent a 25% increase and 3.8% of GDP. For the European stock universe, Bernstein rates Leonardo, Rheinmetall, TKMS and Thales Outperform, while rating BAE Systems and Dassault Aviation Market-Perform. Its stated targets are £20.50 for BAE Systems, €330 for Dassault Aviation, €65 for Leonardo, €1,900 for Rheinmetall, €125 for TKMS and €290 for Thales.

Analysis framework

Bernstein begins with historical and forecast NATO budget data, compares spending intensity across countries, and identifies fiscal capacity and proximity to Russia as the key allocation drivers. It then converts total budgets into a company opportunity by modeling the equipment share of spending and the share likely captured by European suppliers. For covered companies, it links geographic exposure and product positioning to national markets and uses forward enterprise-value multiples, net-debt adjustments, discounted shareholder distributions and, for Dassault's Thales stake, a dividend-discount approach to derive 12-month targets.

Methodology notes

• Industry AnalysisSupply-demand framework

  Defense-budget and equipment-spending opportunity analysis

  The report projects national defense budgets and then estimates how much of those budgets will become equipment demand available to European defense suppliers.

• Industry AnalysisUpstream-Midstream-Downstream Transmission

  Budget allocation and local-procurement transmission

  Bernstein explains that growth in government budgets is amplified for manufacturers when equipment receives a greater share of spending and local European suppliers capture more incremental procurement.

• Valuation methodsEV/EBITDA valuation

  Forward enterprise-value multiple valuation

  For BAE Systems, Dassault Aviation, Rheinmetall and Thales, Bernstein applies forward EV/EBITDA multiples, adjusts for net debt, discounts to the valuation date and includes projected shareholder cash distributions.

• Valuation methodsDDM (Dividend Discount Model)

  Dividend discount valuation of Dassault's Thales stake

  Bernstein separately values Dassault's 25% Thales holding using a dividend-discount model with a 6% terminal growth assumption beyond the modeling horizon.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• BAE Systems PLC (BA/.LN)

  Best positioned for UK defense spending, although the UK accounts for only 27% of sales.

  Strengths

  Leading exposure to the UK's second-largest European defense market.

  Weaknesses

  Limited direct sales concentration in the UK relative to its group revenue base.

  Comparison

  Rated Market-Perform versus Outperform ratings for Leonardo, Rheinmetall, TKMS and Thales.

  Risks

  Lower US, UK or international funding, weaker European-defense sentiment if the Ukraine conflict subsides, and program-execution pressure on growth, margins or cash flow.

• Dassault Aviation SA (AM.FP)

  French sovereign-defense exposure, with the report expecting local suppliers to capture France's opportunity.

  Strengths

  Potential continued Rafale order intake, Falcon improvement and margin progression as Falcon 6X matures.

  Weaknesses

  Exposure to business-jet demand and Falcon supply-chain execution.

  Comparison

  Rated Market-Perform; Bernstein separately values its 25% Thales stake through a dividend-discount model.

  Risks

  FCAS uncertainty, softer business-jet demand, inability to ramp Falcon deliveries, and higher-than-expected self-funded R&D.

• Leonardo SpA (LDO.IM)

  Covered European defense supplier rated Outperform.

  Strengths

  Bernstein values the company on an EV/EBIT basis and sets a €65 target.

  Weaknesses

  Achievement of financial targets through 2028 is required.

  Comparison

  Rated Outperform, unlike BAE Systems and Dassault Aviation, which are rated Market-Perform.

  Risks

  Program-execution difficulties, lower US, European or international defense funding, failure to meet 2028 targets, and costly acquisition-led transformations.

• Rheinmetall AG (RHM.GY)

  Bernstein identifies Rheinmetall as the key beneficiary of German defense spending because it is Germany's one-stop shop.

  Strengths

  Strong domestic positioning in the report's most attractive market; Germany equipment spending is projected to grow 13% CAGR through 2035.

  Weaknesses

  Portfolio transition toward longer-cycle products creates execution demands.

  Comparison

  Rated Outperform with a €1,900 target.

  Risks

  A potential Ukraine cease-fire, additional ammunition and ground-vehicle capacity as demand shifts toward long-cycle products, and execution risk during the portfolio transition.

• TKMS (TKMS.GY)

  Covered European defense supplier rated Outperform.

  Strengths

  Bernstein applies an EV/EBIT valuation and sets a €125 target.

  Weaknesses

  The turnaround depends on operational execution and contract outcomes.

  Comparison

  Rated Outperform with Leonardo, Rheinmetall and Thales.

  Risks

  Further legacy-contract charges, failure to win F127 and F126 contracts, and poor operational execution slowing the turnaround.

• Thales SA (HO.FP)

  Covered European defense supplier rated Outperform and a constituent of Dassault's separately valued 25% stake.

  Strengths

  Bernstein applies a 13x EV/EBITDA multiple and sets a €290 target.

  Weaknesses

  Commercial satellite and cyber businesses face recovery challenges.

  Comparison

  Rated Outperform; Dassault's stake in Thales is valued separately in Bernstein's Dassault analysis.

  Risks

  French defense-budget uncertainty, slower commercial telecom-satellite recovery and prolonged cyber weakness.

Key data

• European NATO defense spending$730bn / 2.6% of GDP in 2026Forecast to increase 20% versus 2025.
• European average defense spending3.2% of GDP in 2035Bernstein's forecast remains below the 3.5% target and implies 4% budget CAGR through 2035.
• European defense addressable market growth12% CAGR through 2030; 9% CAGR through 2035Driven by rising equipment allocation and greater local supplier capture.
• Equipment share of defense budgets38% in 2035Compared with 34% in 2026 and 29% in 2024.
• Germany defense spending$150bn / 2.7% of GDP in 2026Up 30% year on year; Germany represents 20% of European spending.
• US defense spending$1tr / 3.2% of GDP in 2026A $1.25tr 2027 budget assumption would equal 3.8% of GDP and a 25% increase.

Impact & implications

Bernstein's central implication is that aggregate European defense-budget growth understates the opportunity for European equipment suppliers. Germany offers the strongest geographic exposure, while the sector's growth depends on sustained budget expansion, a continuing shift toward equipment, and domestic suppliers retaining a greater share of procurement.

Risks

• Political or fiscal pressure could reduce US, UK, European or international defense funding.
• A subsiding Ukraine conflict or potential cease-fire could weaken sentiment toward European defense stocks.
• Program-execution problems could constrain growth, margins and cash flow.
• Additional ammunition and ground-vehicle capacity could arrive as demand shifts toward longer-cycle products.
• Company-specific risks include FCAS uncertainty, weak business-jet demand, Falcon supply constraints, legacy-contract charges, missed naval contracts, French budget uncertainty and prolonged cyber weakness.

What to watch

• Whether European NATO members progress toward the 3.5% of GDP defense-spending target.
• German budget growth and the pace of equipment spending, which Bernstein identifies as the strongest European opportunity.
• The increase in equipment's share of defense budgets and the extent to which European suppliers replace US imports.
• UK defense-budget developments, Rafale order intake, Falcon operational improvement and Falcon 6X margin progression.
• Rheinmetall's transition toward a longer-cycle portfolio, TKMS contract awards and turnaround execution, and Thales's satellite and cyber recovery.