Will defense sector's supercycle continue?

Visitors look around LIG NEX1's booth at Indo Defence Expo & Forum in Jakarta, Indonesia, June 13. Courtesy of LIG Nex1

Defense stocks in Korea, which surged sharply amid growing global geopolitical tensions, are now facing a valuation test as disappointing earnings reports on Friday triggered a steep decline in share prices, industry officials said Sunday.

According to the Korea Exchange, shares of LIG Nex1 plunged 14.93 percent to close at 513,000 won ($368.67). Institutional investors sold 107 billion won worth of shares, while foreign investors offloaded 51.8 billion won. In a single day, the stock erased an entire month’s gains.

The decline was sparked by its second-quarter earnings shock. After Thursday's market close, the company reported revenue of 77.6 billion won for the quarter — a 57.9 percent increase from a year earlier, but below the market consensus of 85.6 billion won.

Speculation that U.S. President Donald Trump and Russian President Vladimir Putin will soon hold a summit also added downward pressure, fueled by hopes for an end to the Russia-Ukraine war.

In response, Hanwha Aerospace, the leading defense stock, fell 5.47 percent. Other major domestic defense names also closed lower: Hanwha Systems was down 6.88 percent, Hyundai Rotem down 4.78 percent and Korea Aerospace Industries down 2.89 percent.

Friday’s plunge raised a fresh question to investors: Are domestic defense stocks overvalued? The numbers suggest they might be.

LIG Nex1's 12-month forward price-to-earnings ratio (PER) stands at 35.4, while Hanwha Aerospace and Hanwha Systems are at 23.4 and 41.3, respectively.

By comparison, the KOSPI market's 12-month forward PER is 22.2. Also considering that global defense giant Lockheed Martin has a 12-month forward PER of 19.6, these figures inevitably raise valuation concerns.

"The stock price has run too far ahead, leaving little room for further gains," said Lee Ji-ho, an analyst at Meritz Securities, in reference to LIG Nex1.

"Valuation pressures are likely to persist until there is either an upward revision of earnings estimates or confirmed progress in negotiations for new export contracts," added Jang Nam-hyun, an analyst at Korea Investment & Securities.

Nevertheless, many predict the industry's momentum will continue in the second half of the year. Geopolitical tensions in the Middle East are driving defense spending by countries such as the United Arab Emirates, while European nations are also increasing defense budgets.

Morgan Stanley also stated in a report late last month that the Korean defense industry is at the beginning of a structural supercycle, and projected that Korea will become one of the world’s top five defense powerhouses within the next five years.

Reflecting this outlook, target prices for leading defense stocks such as Hanwha Aerospace and Hyundai Rotem continue to be revised upward.

"With the order backlog surging, the mid- to long-term boom is expected to continue," an industry official said. "Many countries are showing interest in Korea’s defense sector, which could lead to additional contracts."