BAE Systems and UK Defence Stocks: What the Rearmament Trade Prices In

BAE Systems is Britain's biggest defence company. Last year it booked a record £30.7bn of sales, about $40bn at $1.32 to the pound (the rate BAE uses in its guidance), and £3.3bn of underlying EBIT, according to its full-year results. EBIT is earnings before interest and tax, a measure of operating profit; "underlying" strips out one-offs.

Make a guess

BAE is a British company. What share of its sales last year came from customers in the United States?

Tap your guess

0–15%Your guess15–30%Your guess30–45%Your guess45–60%Your guess

01234567890123456789%US share of sales

Spot on.Close, a little low.Close, a little high.Way off, too low.Way off, too high. It was 43%.

About 43% of BAE's sales, £13.2bn, came from US customers, against 27% from the UK. BAE is as much an American defence contractor as a British one.

US share of sales43%

UK share of sales27%

That surprises most people. US customers bought £13.2bn, the UK £8.3bn, Saudi Arabia £2.8bn the rest of Europe £3.6bn and everyone else £2.7bn. In practice, BAE owns one of the larger US defence businesses, making combat vehicles, artillery, electronic warfare kit and satellites, inside a London-listed shell. Investors buying it as a pure "European rearmament" play are mostly buying American budgets.

More of BAE's sales come from America than from Britain

Sales last year£30.7bn

• 43.0%£13.2bnUnited States
• 27.0%£8.3bnUnited Kingdom
• 11.7%£3.6bnRest of Europe
• 9.1%£2.8bnSaudi Arabia
• 8.8%£2.7bnRest of world

BAE reports five sectors. Air (Typhoon jets, F-35 parts and the Saudi support contracts) is the biggest at £9.3bn of sales. Electronic Systems, mostly US, is the most profitable, at a 15% margin. Maritime builds submarines and frigates and earns the thinnest margin, under 7%, because its new programmes are at an early stage and BAE is spending to expand capacity at its Barrow shipyard.

Electronics earns the best margins; submarines and ships the thinnest

Electronic Systems15.4% on £7.5bn

Air11.9% on £9.3bn

Platforms & Services11.4% on £5.0bn

Cyber & Intelligence9.3% on £2.4bn

Maritime6.7% on £6.8bn

Underlying EBIT margin and sales by sector last year. Source: BAE Systems full-year results.

How big is BAE's order backlog, and what is in it?

The backlog hit a record £84.0bn at the half-year, per BAE's half-year results. First-half sales rose 9% to £15.8bn, underlying EBIT rose 11% and underlying earnings per share (EPS) rose 13% to 38.9p. Management raised every line of its full-year guidance: sales growth to 8–10%, EBIT growth to 10–12% and EPS growth to 11–13%.

The cash number was the eye-catcher. Free cash flow, the cash left after running the business and investing in it, was £1.8bn in the half, against an outflow of £368m a year earlier. Most of that swing came from customer advances, cash governments pay up front on big contracts. It is real money, but it is borrowed from future years: BAE will do the work later without the matching cash inflow.

The orders behind the backlog run into the next decade

1. Last yrTürkiye orders 20 TyphoonsWorth about £4.6bn to BAE
2. Last yrNorway picks the Type 26A £10bn government-to-government deal
3. This yrDreadnought contract£5.9bn for nuclear-deterrent submarines
4. This yrFirst export GCAP contractsOver £5bn to the Edgewing joint venture
5. End of decadeFirst Türkiye Typhoon deliveredKeeps the Warton line busy

Three programmes matter most for the long run. Typhoon, the Eurofighter jet BAE builds with Airbus and Leonardo, had looked close to the end of production; Türkiye's order for 20 aircraft, worth about £4.6bn to BAE, plus German and Italian top-ups, now keep the line going. GCAP (the Global Combat Air Programme, the successor to the project once branded Tempest) is a sixth-generation fighter BAE is designing with Leonardo of Italy and Japan's JAIEC through a joint venture called Edgewing. And submarines: BAE builds the UK's Dreadnought nuclear-missile boats and will build the British share of SSN-AUKUS, the attack submarine shared with Australia and the US.

How much will the UK actually spend on defence?

Less than the headlines suggest, at least for now. The government's pledge at the NATO summit was 5% of GDP on "national security" within about a decade, split into 3.5% for core defence and 1.5% for resilience such as energy security and border protection. The second bucket is loose enough to include spending that rarely reaches a defence contractor.

The actual money is in the Defence Investment Plan. Its funding explainer sets the Ministry of Defence budget at £68.3bn this financial year, rising to £79.1bn three years later, a total of £297.7bn. NATO-qualifying spending is 2.6% of GDP this year and 2.7% in each of the next three. The headline £15bn "uplift" over four years includes £4.7bn that the Treasury has not yet found.

The MoD budget rises about £11bn in four years, then the plan stops

204060£80bn0

£68.3bn

£73.8bn

£76.5bn

£79.1bn

This fin. yrNext yrIn 2 yrsIn 3 yrs

The defence secretary, John Healey, resigned before the plan was published, saying the settlement "falls well short" and that the extra money was "backloaded". Calibre Defence's analysis notes that the plan ring-fences £63.6bn for the nuclear enterprise (Dreadnought, SSN-AUKUS and warheads), gives GCAP £8.6bn and munitions £11.1bn, but cancels the planned Type 83 destroyer and Type 32 frigate.

Then the politics turned over. Keir Starmer resigned and Andy Burnham became prime minister this summer, committed to NATO's 3.5% goal. Healey is now chancellor. In his first party-conference speech in the job, reported by Defense News, he cast defence as the engine of a "new age of industrialization", citing three new floating submarine docks on the Clyde, and the new defence secretary, Wes Streeting, promised to back "British by buying British wherever our industry can deliver." But Healey has not said whether the government will reach 3% by the end of the decade, the target he resigned over, and his first Budget must still close the £4.7bn gap.

For investors, the mix matters as much as the total. Surface ships and the Army are, in effect, paying for submarines and the new fighter. That is good news for BAE's Barrow yard, Rolls-Royce's reactor business in Derby and Babcock's submarine support work, and less good for anyone who hoped for a broad, fast increase.

Did UK defence stocks rise as much as Rheinmetall, Saab and Leonardo?

No. Measured from the day before the invasion, the UK names roughly doubled or tripled while the continental leaders multiplied many times over. Saab is now 11.2 times its pre-invasion price, Leonardo 7.2 times and Rheinmetall 9.6 times. BAE is at 3.0, Babcock 2.9, Chemring 1.9 and QinetiQ 1.8, with France's Thales at 2.6. The FTSE 100, London's index of its largest listed companies, is at 1.4, a 39% rise.

Continental names multiplied; UK pure plays roughly tripled at best

Saab11.2x

Rheinmetall9.6x

Leonardo7.2x

BAE Systems3.0x

Babcock2.9x

Thales2.6x

Chemring1.9x

QinetiQ1.8x

FTSE 1001.4x

Latest share price as a multiple of the close on the day before the invasion, in local currency, excluding dividends. Source: Yahoo Finance; Yield Theory calculations.

Part of the gap is starting point. Rheinmetall and Leonardo were cheap, unloved and directly tied to European land and air budgets that went from stagnant to surging. BAE was already a steady compounder with half its business in the US, where budgets grew but did not explode. Rolls-Royce is the outlier, up 11.9 times, but that is mostly a civil aerospace turnaround; we cover it in our Rolls-Royce issue.

Babcock and Rheinmetall soared then slumped; BAE held its ground

0100200300400500Pre-warYr 1Yr 2Yr 3Yr 4NowBAE 304, Babcock 291304BAE Systems291Babcock178QinetiQ139FTSE 100Pre-war100100100100Yr 11429214099Yr 2185129121103Yr 3191164163109Yr 4285406173132Now304291178139

This year the trade has cooled. JP Morgan's analysts, reported by Yahoo Finance, say European defence stocks have trailed their local markets by about 6% on average. Investors have marked down companies seen as exposed to technology displacement, naming Rheinmetall among them, and favoured long order books and hard-to-replace products. Rheinmetall is 53% below its peak, Babcock 41% and BAE 22%. Citi, via Proactive Investors, stress-tested a world where Europe stops at 3% of GDP rather than 3.5%; it kept BAE and Babcock on "buy", BAE only provided the US keeps its own spending plans.

Has ESG stopped keeping investors out of defence stocks?

Mostly, yes. Before the invasion, many funds labelled sustainable or ESG (environmental, social and governance) excluded weapons makers entirely. That has unwound. The UK's Financial Conduct Authority (FCA), the City regulator, stated plainly that "our sustainability rules do not prevent investment in or finance for defence companies", and that it is up to lenders and investors whether to provide capital.

Money followed. ClarityAI data reported by IPE show defence weighting in European "Article 8" funds (the EU's light-green sustainability category) rose from 0.9% to 1.42% over a year, up nearly 60%, and IPE reports that JP Morgan Asset Management removed defence exclusions on more than 100 funds. The catch for today's buyers: this is a one-time re-rating. Once the excluded money has come back in, it does not come back in again.

Babcock, QinetiQ, Chemring and Rolls-Royce: which have upside?

Babcock: the cheapest route to UK submarines

Babcock maintains the Royal Navy's submarines and runs the Devonport and Rosyth dockyards. Defence and nuclear make up about 80% of revenue. Its full-year results showed revenue up 8% organically to £5.2bn, with Nuclear, its biggest sector, up 14% at a 9.5% margin. Yet underlying EPS fell from 50.3p to 39.6p.

Find the cause

Babcock grew revenue 8% and nuclear revenue 14%, yet underlying EPS fell from 50.3p to 39.6p. Which line explains it?

Babcock, last financial year

Revenue grew 8% organically to £5.2bn A £140m charge on the Type 31 frigate contract The dividend rose 15% to 7.5p A second £200m buyback was announced

Tap the phrase you think is the tell.

Spotted it.Not that phrase. Excluding the Type 31 charge, underlying EPS rose 20% to 60.5p and the margin improved to 8.2%, beating Babcock's 8% target.

• “Revenue grew 8% organically to £5.2bn” Growth helps earnings. It isn't the cause.
• “A £140m charge on the Type 31 frigate contract” Rework on the first ships at Rosyth forced a £140m charge, booked in full this year.
• “The dividend rose 15% to 7.5p” Dividends come out of profit; they don't reduce EPS.
• “A second £200m buyback was announced” Buybacks shrink the share count, which lifts EPS.

Explain every phraseHide the other explanations

The Type 31 frigate charge is a genuine execution warning, and the shares have fallen 41% from their peak. But at about 891p, Babcock trades on 14.7 times pre-charge earnings, net debt excluding leases is just £22.7m, underlying free cash flow rose 71% to £262m, and it is buying back another £200m of shares. Its nuclear work sits in the ring-fenced part of the defence budget. It targets a margin of at least 9% over the medium term. This is the UK name where the price already assumes things go wrong.

QinetiQ: cheap, slow, with an option attached

QinetiQ runs the UK's military testing ranges and does research and engineering. Its full-year results were a mixed bag: organic revenue growth of just 1.3%, but a record £3.6bn of orders (including a £1.5bn extension of its range-running contract), margin up to 11.3% and EPS up 21% to 31.5p. It guides to 3–5% revenue growth this year and is reviewing "all options" for its troubled US business. At 453p the shares trade on 14.4 times earnings, with a £200m buyback extension. Not a growth stock, but cheap, and a US sale would simplify it.

Chemring: scarcity, priced in

Chemring makes countermeasures (flares that decoy missiles) and energetics, the explosives and propellants that every missile and shell needs, and Europe is short of them. Its interim results show a record £1.4bn order book, but underlying operating profit fell 8% as it spent £44m in six months on new factories, pushing net debt up to 1.47 times EBITDA. Bain Capital's approach at 390p a share was rebuffed; the stock now trades at 500p, 28% above that. The thesis is sound; the price already reflects much of it.

Rolls-Royce: a defence business hiding inside an engine maker

Rolls-Royce's defence arm makes military jet engines and the nuclear reactors for every Royal Navy submarine. Its half-year results show defence revenue up 17% organically to £2.5bn with a 21.0% margin and a £17.5bn backlog. But defence is only about 22% of group revenue, and management warns the margin will not hold at that level. Buy Rolls for civil aftermarket earnings, not for rearmament.

The mid-caps trade on lower multiples than BAE

24.3xBAE SystemsPrice to last year's underlying EPS

14.7xBabcockPrice to EPS before the Type 31 charge

14.4xQinetiQPrice to last year's underlying EPS

Is BAE Systems stock expensive now?

Compared with its own history, yes. On the day before the invasion, BAE traded at 601p against 47.8p of underlying EPS for the year just ended, per its results that year: a price-to-earnings ratio of 12.6 times. Today it is 24.3 times last year's 75.2p, or about 21.7 times this year's EPS if BAE hits the middle of its 11–13% guidance.

Put differently, the market value of roughly £55bn ($72bn) buys a free cash flow yield of about 3.7%, using the more than £2.0bn BAE guides to this year, and a dividend yield of 2.0%. Earnings have risen 57% from 47.8p to 75.2p since the invasion; the share price has risen 204%. Most of BAE's rally was a re-rating, not earnings.

That does not make it a sale. A business with £84bn of booked work, rising margins, a net debt of 0.9 times EBITDA at the last year-end and buybacks can justify a premium. The question is how much growth you need to earn a decent return from here, the logic of a reverse DCF.

BAE needs fast growth and a high multiple to beat the market

Pick BAE's yearly EPS growth over five years and the price-to-earnings ratio investors pay at the end

EPS growth a year

4%7%10%12%

Exit P/E

13x17x21x

Yearly share price return−6.1%−0.9%+3.3%−3.4%+1.9%+6.3%−0.7%+4.8%+9.3%+1.1%+6.7%+11.3%

−6.1%+11.3%

If BAE grows EPS 10% a year and keeps today's multiple, shareholders earn about 9% a year in price plus 2% in dividends: fine, not spectacular. If growth slows to 7% and the multiple drifts to 17 times, the price return falls to about 2% a year. The stock is priced for its guidance to keep coming true.

What could go wrong?

Four risks stand out. First, budgets: Healey's first Budget must find £4.7bn, energy costs and tight public finances limit his room, and a weaker economy could delay the path to 3%. Second, the US: 43% of BAE's sales depend on Washington's priorities, and a weaker dollar cuts reported profit (BAE says each 5-cent move shifts EBIT by about £70m). Third, execution: fixed-price shipbuilding contracts, like Babcock's Type 31, can swing from profit to loss. Fourth, peace: a durable Ukraine ceasefire would not cancel signed contracts, but it would take some heat out of multiples.

Check the claimThree common claims about UK defence stocks, tested

ClaimBritain's higher defence spending is fully funded.Tap to checkMythOnly 2.7% of GDP is funded, and £4.7bn of the £15bn uplift still has to be found. The 3% and 3.5% pledges have no money attached yet.Flip backClaimBAE Systems is mainly a bet on the UK budget.Tap to checkMythAbout 43% of sales come from the US, against 27% from the UK.Flip backClaimUK defence stocks missed the rearmament rally.Tap to checkPartly trueThey lagged Saab and Rheinmetall, but BAE still tripled while the FTSE 100 rose 39%. Rolls-Royce rose more, mostly on civil engines.Flip back

Our read

The European rearmament story is real, but for UK stocks the easy part is over. The ESG re-rating has happened, the order books are full and BAE's multiple has roughly doubled. From here, returns have to come from earnings, and the UK's own spending plan is flatter than the speeches.

BAE Systems is the quality holding: a record backlog, upgraded guidance and a US business that diversifies it away from the Treasury. At about 22 times this year's earnings it is fairly valued, not cheap. We would expect returns roughly in line with its earnings growth plus the dividend, and we would be more interested nearer the high teens.

The better risk-reward sits lower down. Babcock has been punished for one bad contract while its nuclear business, the most protected part of the budget, grows double digits; at under 15 times pre-charge earnings with almost no debt before leases and a buyback, it is our preferred UK name. QinetiQ is cheap at about 14 times, with a US exit as a possible catalyst. Chemring's energetics story is strong but largely priced, and Rolls-Royce is a civil aerospace stock first.

Where we see upside, and where it is priced in

Upside leftDe-rated, cash-backed

• Babcock: 14.7x pre-charge EPS
• QinetiQ: 14.4x, US review

Fairly pricedQuality, but no discount

• BAE: ~22x this year's EPS
• Chemring: 28% above Bain's rebuffed approach

Not a defence playOwned for other reasons

• Rolls-Royce: defence ~22% of revenue

The signals to watch: whether Healey's first Budget funds the £4.7bn gap and sets a date for 3%, whether BAE's cash flow holds up once the customer advances unwind, and whether Babcock's Type 31 charge is the last.

Go deeper

• Reverse DCF: work out what growth BAE's 22-times multiple already assumes, as we did in the scenario above.
• Segment reporting: how to pull apart BAE's five sectors or Rolls-Royce's defence arm from the group numbers.
• Risk and scenarios: build bull and bear cases around budget promises that may or may not be funded.

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