European Defence: Backlog growth supports a multi-year earnings cycle

• European defence equities have corrected over 11%, but backlog growth, margin expansion and rising capex indicate the structural cycle remains intact.
• FY2025 data shows a robust growth in revenue and earnings for major European companies, signalling early operating leverage and improving profitability.
• Backlog provides multi-year visibility, averaging ~3.5 years of revenue, with Rheinmetall at ~6.4 years and Saab at ~3.5 years coverage.
• Q1 2026 results confirm that defence demand is real and orders are coming, with execution risk remaining company-specific rather than structural.
• The sector trades at ~19x 2028 forward P/E versus a ~26x fair value estimate, implying ~32% potential upside over the investment horizon.

European defence stocks have corrected by more than 11% from their January 2026 peak, measured to 5 May 2026. The evidence so far suggests the pullback reflects profit-taking after a strong rally rather than a deterioration in the underlying thesis. Backlog continues to build, margins are improving across several core names, and companies are increasing capital expenditure. Taken together, this points to a sector positioning for a multi-year demand cycle.

Why the backdrop is becoming more supportive

The geopolitical context is reinforcing the investment case. The issue is no longer only about NATO targets or broad geopolitical anxiety. Europe is increasingly responding to the risk that US security support may become more conditional, transactional, and politically reversible.

Recent developments have sharpened that concern. Reuters reported that an internal Pentagon email considered possible steps against NATO allies that did not support US operations in the Iran war, including suspending Spain from NATO and reviewing US support for Britain’s Falkland Islands position. The US has also announced a withdrawal of 5,000 troops from Germany, while President Trump has indicated he is open to reducing US troop presence in Spain and Italy.

The shift is already visible in spending behaviour. The Stockholm International Peace Research Institute (SIPRI) estimates that Europe accounted for the largest share of the increase in global military expenditure in 2025, with regional spending rising 14% to USD 864 billion. Within NATO, European members spent USD 559 billion in aggregate, and most had already reached or exceeded the 2.0% of GDP threshold. Germany and Spain stand out as important examples: Germany lifted military expenditure by 24% year-on-year to USD 114 billion, crossing 2.0% of GDP for the first time since reunification, while Spain increased spending by 50% to USD 40.2 billion, also moving above the 2.0% threshold for the first time in decades.

Chart 1: SIPRI estimates that Europe accounted for the largest share of the increase in global military expenditure in 2025

The implication is clear: Europe is no longer simply discussing higher defence spending. It is already reallocating capital toward defence, and recent pressure on the US security guarantee makes that shift more urgent.

From policy ambition to implementation

At the EU level, the EUR 800 billion rearmament plan sets the overall direction. Within that, the EUR 150 billion SAFE (Security Action for Europe) loan programme provides a more tangible funding channel, with EU-backed financing supporting member-state procurement directly rather than relying only on individual national balance sheets.

SAFE is also moving beyond headline funding. The loan envelope has been allocated across participating member states, and national investment plans are starting to move through the approval process. Poland, the largest SAFE beneficiary, has already moved into loan-agreement preparation. This suggests the programme is beginning to enter the procurement pipeline, even if it has not yet fully translated into company-level orders.

At the national level, defence spending is also rising. Countries are moving toward or above NATO targets, with some already exceeding them. Germany is a useful example of how this transition works. Rheinmetall management has noted that 2025 and 2026 are still benefiting from Germany’s post-Ukraine-war special defence fund. The next phase should increasingly be supported by additional funding streams, including the rise in Germany’s regular defence budget from 2027 onward.

This timing matters. Current company backlogs are not yet a full reflection of the latest European rearmament measures. Today’s backlog still largely reflects earlier procurement cycles, existing defence orders and previously approved national funding. SAFE-funded orders and newer budget increases are only beginning to enter the order pipeline.

For investors, this distinction is important. The thesis is not that all new funding is already in backlog. The thesis is that the existing backlog base is already strong, while the next funding wave creates further order-conversion potential.

Evidence from company fundamentals

In FY2025, the top five holdings in the WisdomTree Europe Defence UCITS ETF (LSE: WDEF) — BAE Systems, Thales, Rheinmetall, Leonardo and Saab — delivered average sales growth of 10.3% and EPS growth of 21.1%.

Importantly, margins expanded across all five companies in FY2025 — the clearest signal that revenue growth is outpacing cost growth. This points to early operating leverage — the dynamic where fixed costs are spread over a larger revenue base, causing profit margins to expand as volumes rise. It signals that the cycle is not just generating higher demand; it is generating better-quality earnings.

Backlog: the clearest sign of a multi-year cycle

Backlog provides the strongest evidence that this is not a one-year story. Across the five companies, backlog covers about 3.5 years of current annual revenue on average. In practical terms, a meaningful portion of medium-term earnings is already secured before any new orders are signed.

Rheinmetall’s backlog alone covers around 6.4 years of revenue. Saab stands at roughly 3.5 years, while BAE Systems, Thales, and Leonardo each have around 2–3 years of visibility. This level of coverage helps anchor the investment case. It shows that higher defence budgets are already translating into multi-year revenue streams, supporting more predictable earnings than is typical for cyclical sectors.

Table 1: Backlog provides the strongest evidence that this is not a one-year story

Company Backlogs	Currency	2025 Backlog, local currency, million	2025 Revenue, local currency, million	Coverage (Years)
BAE Systems	GBP	83,600	30,662	2.73
Thales	EUR	53,323	22,136	2.41
Rheinmetall	EUR	63,761	9,935	6.42
Leonardo	EUR	46,624	19,503	2.39
Saab	SEK	274,532	79,146	3.47

Source: Bloomberg Finance L.P., iFAST Estimates

Data as of 31 March 2026

Margin expansion: improving quality of growth

Margin trends also support the view that the defence cycle is improving earnings quality, not just revenue scale. Across the five major European defence names, profitability moved higher in 2025, with all five companies showing year-on-year margin improvement.

The implication is that higher defence demand is beginning to show up not only in sales and backlog, but also in profitability. As volumes rise, fixed costs are spread over a larger revenue base, allowing margins to expand without a proportional increase in spending. Management commentary across companies points to the same driver: higher volumes leading to stronger operating leverage.

Chart 2: Margin trends also support the view that the defence cycle is improving earnings quality, not just revenue scale

A second factor is mix. BAE Systems is seeing a higher share of revenue from electronics and weapons, which carry stronger margins than naval and land platforms. Leonardo is moving in a similar direction by increasing the contribution from aftermarket services, which are structurally higher margin than new-build contracts.

Thales adds a slightly different dimension. Its margin improvement was supported not only by volume growth, but also by cost discipline in weaker segments. Even where revenues declined, margins improved, reflecting deliberate operational restructuring rather than pure scale effects.

Taken together, these trends show a sector where revenue is growing faster than costs, and where the mix is shifting toward higher-value activities. The result is improving earnings quality, not just higher scale.

Capex trends point in the same direction. Saab increased capital expenditure by 52% in 2025, while Thales rose 21%, Rheinmetall 19% and Leonardo 14%. The investment is targeted — production capacity, supplier resilience, automation, and specialised labour — confirming that companies are positioning for sustained demand rather than reacting to short-term order flow.

Q1 2026 results: progress is real, but execution risk is company-specific

Early Q1 2026 results reinforce this trend, although the picture is not uniform.

·       Thales delivered 9.7% organic revenue growth and strong defence orders

·       Saab reported solid sales growth, EBIT growth of 32%, and a resilient order book

·       Safran pointed to a supportive demand backdrop, although around half of its revenue is tied to commercial aerospace, making it a mixed rather than pure defence indicator

·       Airbus reported weaker group-level results, driven by delays in commercial aircraft deliveries rather than defence demand

Among the core defence names, the direction is positive. Thales delivered 9.7% organic revenue growth and maintained strong defence demand. Saab reported solid sales growth alongside EBIT growth of 32% and a resilient order book. The takeaway is clear: defence demand is real, orders are coming, and the structural cycle is converting into company results.

The picture is not perfectly uniform. Saab’s Q1 2026 order intake came in below the prior year despite strong revenue growth, largely because Q1 2025 benefited from unusually large orders. The quarter illustrates how defence order flow can be uneven and timing-sensitive even within a supportive structural cycle. This reinforces the importance of diversification, as quarterly results can vary materially across companies despite similar long-term demand tailwinds.

This is precisely why broad, diversified exposure remains the more practical approach for most investors. A diversified ETF absorbs that idiosyncratic risk without sacrificing exposure to the structural cycle.

Key risks

The thesis is not without risk, and investors should weigh the following before positioning.

Execution risk. Expanding production capacity across multiple geographies simultaneously introduces operational complexity. Delays in facility ramp-ups, supply chain bottlenecks, or programme cost overruns could weigh on near-term margins and delivery timelines.

Budget delay risk. Defence procurement is subject to political and administrative processes. Approved budgets do not always convert into contracts on schedule. Germany's late 2025 federal budget — delayed by coalition negotiations that held up passage of the supplementary defence spending package — demonstrated how timing slippage can defer order intake and create quarterly lumpiness.

Geopolitical de-escalation risk. A ceasefire, diplomatic resolution, or shift in the security environment could reduce the urgency of defence spending commitments. While structural NATO targets have been raised to 3.5% of GDP by 2035, political will may weaken if the threat perception subsides.

From re-rating to execution

The sector is transitioning from a policy-driven re-rating phase to a fundamentals-driven phase. Earlier in the cycle, markets price in the idea. Later, they demand proof. We are now in the second phase, and company results are beginning to provide that proof.

The European defence thesis remains intact. Geopolitical urgency is increasing. Funding is moving into implementation. Company fundamentals are already showing tangible signs of conversion — in revenue growth, earnings expansion, backlog visibility, and capital investment. The recent pullback has reset expectations to a more disciplined level. It has not changed the direction of the cycle.

Based on our estimates, the sector trades at approximately 19.7x 2028 forward P/E against our fair value estimate of 26x. Our target price for the ETF is EUR 41.7, implying potential upside of approximately 32% over our investment horizon. Investors looking to gain exposure may consider the WisdomTree Europe Defence UCITS ETF - EUR Acc (LSE: WDEF).

Table 2: Projections for the WisdomTree Europe Defence ETF

	2025	2026E	2027E	2028E
EPS	10.83	14.56	17.68	21.04
EPS Growth	-	34.44%	21.43%	19.00%
PE Ratio	38.26	28.46	23.44	19.69
Upside Potential (Fair PE of 26x)	-	-	-	32.03%
Target Price  (EUR)	-	-	-	41.70
Source: Bloomberg Finance L.P., iFAST Estimates
Data as of 5 May 2026

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

This research report was prepared with the assistance of artificial intelligence (AI) tools.  iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.