Investors Track Aerospace and Defense Stocks Amid Growing Contract Backlogs

Lockheed Martin reported a record $156 billion backlog during its Q3 2023 earnings call. This figure, a 6% increase from last year, is driven by international demand for fighter jets and missile defense systems, particularly from NATO-member nations.

Raytheon Technologies, known as RTX, reported a backlog of $190 billion as of September 30, 2023, with $118 billion from defense contracts. CEO Gregory Hayes identified the Patriot missile system and classified contracts as key contributors. The commercial aerospace segment also improved, with Boeing announcing its highest order volume since 2018, totaling 640 net commercial aircraft orders in the first nine months of the year.

Global defense spending is projected to reach $2.4 trillion in 2024, according to the Stockholm International Peace Research Institute (SIPRI). This increase reflects rising tensions from Eastern Europe to the Indo-Pacific, presenting both challenges and opportunities for investors. The iShares U.S. Aerospace & Defense ETF (ITA) has returned 18% year-to-date, outperforming the S&P 500’s 11% gain. However, translating defense spending into profits depends on firms' ability to navigate constrained global supply chains.

Morgan Stanley’s aerospace and defense analyst Kristine Liwag noted ongoing supply chain challenges for contractors like Northrop Grumman. “Labor shortages have eased relative to 2022, but sourcing raw materials, especially titanium and specialty alloys, limits production scalability,” she explained in her October 2023 sector report. Despite these hurdles, Northrop Grumman reported $9.8 billion in Q3 revenues, a 9% year-over-year increase, with the B-21 Raider stealth bomber driving future growth.

The commercial aerospace recovery adds complexity to the sector. Airlines are modernizing fleets as passenger volumes return to pre-pandemic levels, benefiting original equipment manufacturers (OEMs) like Airbus and Boeing. Airbus delivered 381 aircraft in the first three quarters of 2023, an 11% increase year-on-year, and has a backlog exceeding 7,000 aircraft, projecting production increases into the next decade.

Cyclicality poses risks. The International Air Transport Association (IATA) expects global airline profitability at $9.8 billion in 2023, a fraction of pre-pandemic highs. Economic pressures in key markets could hinder commercial recovery, especially if rising interest rates affect travel demand. Companies focused on aftermarket services may perform better; for instance, Rolls-Royce Holdings reported £1.8 billion ($2.2 billion) in aftermarket revenue for the first half of 2023, 28% above the previous year.

Defense contractors are generally more insulated from economic downturns but must adapt to shifting political priorities. U.S. government appropriations are critical, especially as debates over federal spending caps arise. The Department of Defense's FY2024 budget request totals $842 billion, a 3.2% increase from FY2023. Funding is uneven; while nuclear modernization programs see consistent increases, some legacy systems face cuts.

International markets provide diversification. Japan’s defense budget rose 25% in 2023, the largest post-war increase, as it procures Lockheed Martin F-35 fighters and upgrades missile defenses. Germany’s €100 billion ($106 billion) military fund is translating into contracts for domestic firms like Rheinmetall and U.S. suppliers. However, export strategies carry risks. Geopolitical restrictions on sensitive technologies, such as engine components for Turkey’s TF-X fighter program, illustrate these complexities.

Investors should evaluate valuation shifts. Price-to-earnings multiples for defense firms average 18.5x forward earnings, slightly above their 10-year median. Strong cash flow visibility from long-term government contracts supports these levels, but delays in delivery timelines could trigger rapid corrections. Commercial-facing companies trade at steeper discounts due to lingering pandemic-related debt.

The sustainability of aerospace and defense strategies warrants attention. Environmental, social, and governance (ESG) frameworks increasingly impact institutional capital allocation, especially in commercial aviation. Net-zero emissions targets compel OEMs to invest in sustainable aviation fuels (SAFs) and electric propulsion systems, which can be costly. Defense firms face fewer direct ESG pressures but are subject to ethical investment exclusions. MSCI’s aerospace and defense ESG index excludes weapons manufacturers, limiting passive fund inflows.

Order books are a clear indicator of demand. As RTX’s Hayes stated, “demand is not the issue—execution is.” The ability of aerospace and defense companies to convert current backlogs into future earnings is crucial for investors considering this sector.