European defence stocks back on investors' radar screen

* Big contractors seen as first to benefit from more spending

* Smaller firms' shares seen having potential for big gains

By Danilo Masoni and Atul Prakash

MILAN/LONDON, Dec (Shanghai: 600875.SS - news) 4 (Reuters) - The stepping up of air strikes in Syria following the attacks in Paris this month has alerted investors to the prospect of increased spending on defence, putting European firms in the sector back on their radar screens.

Defence-related stocks have outperformed the market since the Nov. 13 attacks but investors and analysts say there could be further gains to come, not only for prime contractors like BAE Systems (LSE: BA.L - news) and Finmeccanica (Other OTC: FINMF - news) but also smaller companies further down the supply chain.

IHS Jane's estimates that over 2015-2019 an extra $50 billion will be added to Western European defence spending as a result of budget changes already implemented this year by France, Germany and Britain.

In addition eastern European countries are looking to strengthen their defences following Russia's annexation of Crimea and the conflict in eastern Ukraine.

"We are turning the corner now," said Nick Cunningham, managing partner at institutional stockbroker Agency Partners. "It (Other OTC: ITGL - news) 's very early days. Budgets have just stopped falling but once the cycle reverses it carries on going up for 10 years."

The Stoxx Europe aerospace and defence index has risen more than 4 percent since the Paris attacks, while the main Stoxx Europe 600 market index ( .STOXX) has fallen back this week.

"Stay long on Finmeccanica, Thales (Paris: FR0000121329 - news) , Safran (Paris: FR0000073272 - news) and BAE Systems," said Gary Paulin, founding partner at equity brokerage Aviate Global.

Meanwhile on Friday Deutsche Bank lifted target prices for seven stocks - Thales, BAE Systems, Dassault Aviation (Paris: FR0000121725 - news) , Airbus, Meggitt (Other OTC: MEGGF - news) , Finmeccanica and MTU Aero Engines - saying the defence outlook was much improved and geopolitics had removed downside risk to European defence budgets.

In terms of share price performance Europe's big prime defence contractors have already advanced but are still seen by some analysts as having some way to go to catch up with U.S (Other OTC: UBGXF - news) . peers like Lockheed Martin (Swiss: LMT.SW - news) and Northrop Grumman because of an earlier improvement in the outlook for U.S. defence spending.

Moreover, according to Cunningham, peak spending in past cycles has lifted U.S. defence stocks to a premium rating in terms of price-earnings multiples of 115-120 percent of industrial sector PEs.

They are now trading at a differential of just 75-80 percent but have recovered from 50 percent in 2010-11, he said.

But the biggest gains could eventually be made by the shares of the smaller, lower-tier supplier firms who have suffered badly during the years of cutbacks, but investors and analysts say it will still take some time before increased defence budgets convert to increased spending.

"The really interesting argument here is that we should start looking at the mid-caps," said Cunningham, citing firms such as Rheinmetall (Xetra: 703000 - news) , Cobham (Other OTC: CBHMF - news) and Ultra Electronics.

According to Liberum analysts the 2015 PE for Rheinmetall (Amsterdam: RH6.AS - news) stands at 15.5, Cobham at 14.7 and Ultra Electronics (Other OTC: UEHPY - news) at 15.8. That compares with 20.2 and 19.3 for Lockheed and Northrop respectively.

Either way, the defence sector is back in focus for investors.

"Recent events have made people realise that defence spending has to continue," said David Battersby, investment manager at Redmayne-Bentley. (1 euro = $1.0886) (Editing by Greg Mahlich)