Rolls-Royce 19% Drop, 84bn Order Book|What Does the Defence Rally Already Know?

The Session: Defence Sells Off While the War Continues

Rolls-Royce came within half a percentage point of a technical crash, and the war that was supposed to make it untouchable is still very much ongoing. That is the sentence the UK market handed investors today, and most of them are still trying to parse it.

The broader FTSE 100 session reflected genuine unease. Petrol prices hit their highest level since the Iran conflict began in late February, according to RAC data, adding to inflation fears that have already shifted mortgage pricing and gilt yields before the Bank of England has moved once. Experian and Relx fell as the City repriced the long-term earnings risk from artificial intelligence — not a war story, but a parallel repricing that confirmed the session's tone: re-examine what you paid for. British Land broke from the pack with a statement that the return-to-office debate is effectively settled, a claim that usually signals rents are firming in central London even as broader sentiment darkens. And Marks and Spencer added 5 per cent after full-year results that looked dismal on the surface — revenue down 25 per cent, adjusted pre-tax profit down 24 per cent — but came in less bad than feared following last year's cyberattack, which the company had already factored into guidance.

Against that backdrop, BAE Systems fell 15.7 per cent from its one-month high, Babcock dropped 21.4 per cent, and Rolls-Royce retreated 19.4 per cent from its March peak. All three have been the FTSE 100's defining winners over the past five years — Rolls-Royce up more than 1,000 per cent, BAE Systems up 265 per cent, Babcock up 236 per cent. The order books have not shrunk. BAE's backlog stands at roughly £84 billion. Babcock's is around £10 billion, with full-year revenue rising 10 per cent and underlying operating profit up 19 per cent in its latest update. Rolls-Royce's defence arm carries a £7.3 billion book. The West is rearming, the spending is committed, and the earnings visibility runs for years. None of that has changed. What has changed is that investors are no longer pricing certainty — they are pricing what the execution of those contracts will actually cost.

The Revenue Model Nobody Priced for War

The defence stocks sold off not because the order books are in doubt, but because one of the three is not really a defence company in the way the market spent two years treating it.

Rolls-Royce draws the majority of its revenue from engine maintenance contracts tied to flying hours — not from weapons systems or government procurement cycles. When jet fuel costs rise and airspaces close because of the Iran conflict, fewer commercial aircraft fly, fewer engine hours accumulate, and the maintenance revenue that has been compounding at extraordinary rates suddenly faces a structural headwind that has nothing to do with the defence budget and everything to do with civilian aviation economics. A 40 per cent rise in underlying operating profits in the most recent full-year results confirms the business is genuinely exceptional. But the multiple investors assigned to those profits assumed that the aviation division would continue scaling unimpeded. The conflict has interrupted that assumption in a way that higher defence spending cannot repair — because Rolls-Royce's defence division accounts for only 25 per cent of group revenues.

That is the mechanism the Rolls-Royce P/E ratio of nearly 65, reached just months ago, was not incorporating. BAE Systems and Babcock are more straightforwardly exposed to government contract spending, and their own sell-offs reflect a separate problem: at price-to-earnings ratios of around 30, both were priced for continued acceleration, and even a strong order book does not prevent multiple compression when risk appetite tightens across the category. Babcock's latest results included a £140 million charge on its Type 31 frigate programme — a cost overrun that is exactly the kind of delivery risk that investors at stretched valuations have very little tolerance for. The order book promises revenue. It does not promise margin.

What the sell-off has not resolved is whether the aviation drag on Rolls-Royce is cyclical or durable. If the Iran conflict shortens — if airspace reopens and jet fuel costs retreat — the maintenance revenue model recovers faster than a weapons contract backlog would. The company's parallel exposure to small modular reactors and AI data centre backup power adds a growth vector that is entirely unconnected to either war or aviation. That is the counter-case, and it is real. But it requires the geopolitical timeline to cooperate, and that is not a variable Rolls-Royce controls.

What the Next Three Months Will Settle

The question that the sell-off opens but does not answer is whether the aviation revenue compression at Rolls-Royce is being treated by the market as a permanent rerating or a temporary discount — because the resolution of that question implies very different entry points for the other two.

History offers a partial guide. After the initial Ukraine shock in February 2022, BAE Systems and Rolls-Royce both surged on the defence rearmament narrative, then spent the following eighteen months digesting those gains as investors waited for the order book growth to convert into cash. The current drawdown has a different shape — it is steeper and faster — because this time valuations were already extended before the shock arrived. In 2022, BAE was trading below 20 times earnings when the rally began. At 30 times earlier this year, there was no cushion.

The verification benchmark here is Rolls-Royce's flying-hour data for the second quarter, which will feed into the interim results due later in 2026. If commercial engine hours hold within 5 per cent of the prior-year run rate, the aviation drag is containable and the defence premium can be rebuilt on the BAE and Babcock order books independently. If flying hours fall further — say 10 per cent or more — the market will be forced to separate the two revenue streams explicitly and value Rolls-Royce as a blended business rather than a pure-play re-arming winner. That distinction matters because the 1,026 per cent five-year return was built on a single narrative, and single narratives reprice sharply when the underlying mix becomes visible.

The leaning, conditional on a contained conflict duration, is that the BAE Systems and Babcock drawdowns are closer to finished than Rolls-Royce's. Both have cleaner exposure to committed government spending, and Babcock's 19 per cent operating profit growth suggests the execution problems are isolated rather than systemic. Rolls-Royce carries the open variable — how long civilian aviation stays suppressed. If the Iran conflict extends beyond the summer, the maintenance revenue assumption that built the £65 billion market capitalisation at its peak will have to be rebuilt from a lower base, and the question is whether investors are willing to wait for the SMR and data centre growth to accelerate while that happens.