UK Defence Stocks Retreat While Rolls-Royce Pulls Further Ahead

UK defence stocks have split into two distinct camps, with BAE Systems (BA) and Babcock International (BAB) giving back a substantial portion of their gains, while Rolls-Royce (RR) continues to attract buyers on a different growth story. The divergence matters for investors trying to read whether this is a sector-wide reset or something more structural.

How far UK defence stocks have fallen

BAE Systems has dropped 14% over the past three months and is now down 4% over the past year. Babcock has fallen harder, off 20% in three months and 16% over twelve months. At their peaks, both were trading on price-to-earnings ratios of up to 28, and it is fair to say that quite a lot of optimism was priced in.

Rolls-Royce has moved in the opposite direction: up 22% over three months and 50% over the past year. Its P/E remains a gravity-defying 48, down from a peak of 65, and reflects a market that is valuing the company on its power and nuclear ambitions as much as its defence revenue.

The sell-off in BAE and Babcock has two credible explanations. Rising hopes of a peace process in Ukraine and Iran have cooled the most aggressive sentiment around weapons procurement. There is also a longer-run question about the shape of modern warfare: cheaper systems such as drones may gradually take market share from high-cost platforms including frigates, tanks and fast jets. Neither point is new, but markets sometimes need time to absorb them.

BAE Systems: solid fundamentals beneath the noise

The operational picture at BAE remains robust. For the full year 2025, the company reported operating profit of £2,925m, up from £2,685m the prior year, and basic earnings per share of 68.8p, up from 64.9p. Total revenue reached £28.34bn, an increase of 7.69% from £26.31bn, while net income improved from £1.96bn to £2.06bn.

Analysts project BAE’s 2026 EPS at £0.83, according to Hargreaves Lansdown data, implying continued earnings growth. The order book remains long-dated, which gives earnings visibility well beyond the current political noise. The principal risk is unchanged: BAE is a government contractor, and Western governments are caught between rearming and managing strained public finances. That tension will not resolve quickly.

Babcock published its preliminary results for the year ended 31 March 2026 on 22 June 2026. Both companies currently sit on P/Es of around 24, cheaper than their recent peaks but not obviously cheap in absolute terms. The long-term investment case rests on sustained defence budget growth across NATO, which appears durable for now.

Why Rolls-Royce SMR contracts change the calculus

The case for Rolls-Royce is now as much about nuclear energy as it is about aerospace or defence. The company’s SMR unit has signed a two-stage contract with Great British Energy – Nuclear (GBE-N) for three small modular reactors to be sited at Wylfa on Anglesey, covering site-specific design, preparations for the build, and procurement of long lead-time equipment.

That contract followed the selection of Rolls-Royce SMR by Videberg Kraft to deliver three SMRs on Sweden’s west coast, making it Sweden’s first new nuclear capacity in over 40 years. Chief executive Tufan Erginbilgic described the selection as reinforcing ‘the status of Rolls-Royce SMR as the only company with multiple contractual commitments to deliver SMR units in Europe.’

Beyond the UK and Sweden, Czech state utility ČEZ Group has made an equity investment in Rolls-Royce SMR as part of a partnership targeting up to 3,000 MW of electricity generation in the Czech Republic, using units rated at 470 MW each. These are contractual commitments, not letters of intent, and they represent a credible pipeline rather than aspirational targets.

Rolls-Royce derives around half its earnings from Civil Aerospace and around a quarter each from Defence and Power Systems. The Power Systems division is benefiting from data-centre demand growth. That diversification has buffered it against the same defence sentiment headwinds hitting BAE and Babcock.

The setup for the next quarter

At a P/E of 48, Rolls-Royce leaves little room for execution disappointment. The SMR pipeline is genuine, but the distance between contractual commitments and commercial revenue remains long, and cost overruns in nuclear construction are almost a historical constant. Drip-feeding capital in, rather than committing a lump sum at current levels, is the more defensible approach.

For BAE Systems and Babcock, the recent dip has reopened a conversation that felt closed six months ago. Neither is cheap; both are operationally sound. The next test is whether NATO members convert political commitment to rearming into actual procurement orders that flow through to these companies’ backlogs. Any confirmation of that conversion, expected in the back half of 2026, would give the thesis firmer footing.