Defense Primes

The question

Are defense primes and their sub-tier aerospace suppliers priced for a one-off budget bump, or for a sustained multi-year step-change in procurement and O&M spending across the United States and its treaty allies?

Base rates

The reference class is prior re-armament episodes in peacetime democracies: the Reagan buildup of 1981-1986, the post-9/11 expansion of 2002-2008, and the NATO response to 2014. In each case, prime-contractor revenue grew roughly 6-10% annually for five-to-seven years, operating margins expanded 150-300 basis points, and backlog-to-revenue ratios drifted from ~1.3x to ~2.0x before plateauing. The equity base rate for a diversified basket of primes during these cycles has been roughly the 70th percentile of industrial subsectors for the first four years, then converges to index returns as the cycle matures.

For aerospace structures and propulsion sub-tiers, the base rate is less flattering in the first two years of a cycle -- they absorb supply-chain stress and working-capital drag -- and considerably better in years three through six, when rate increases finally monetize. The commercial aerospace cycle has historically run on a 7-9 year up-leg; the current one began mid-2020 and has been interrupted twice, leaving the cumulative delivery deficit versus trend at roughly 1,500 narrowbodies.

The imputed probability embedded in forward consensus is that NATO European defense budgets plateau near 2.5% of GDP by 2028. Several member states have already legislated trajectories that clear 3%. The consensus forward is a reasonable central case; it is not a reasonable upper bound.

Why the consensus view is wrong (or incomplete)

The sell-side models the budget as the binding constraint. In the current cycle, the binding constraint is industrial capacity -- skilled labor, forging capacity, solid rocket motor throughput, shipyard dry-docks. Primes are turning away orders. When the constraint shifts from demand to supply, the economics of the sub-tier improve faster than the economics of the integrator, because sub-tier pricing power rises with utilization while prime margins are capped by cost-plus and firm-fixed-price mechanics on legacy programs.

The second piece the consensus misses is munitions replenishment. The combined NATO drawdown of guided munitions since 2022 will take roughly a decade to replace at current contracted production rates. That is a known, scheduled, and funded stream of revenue that does not require any assumption about future conflict. The market still prices this segment as cyclical.

Third, the commercial aerospace recovery is structurally entangled with defense through shared suppliers (forgings, castings, engine components). A Boeing narrowbody rate increase from 38 to 57 per month pulls on the same machining capacity as an F-35 rate hold. We own the shared bottlenecks directly.

Position construction

The book has two 20% anchors and three sub-books.

Anchors. BA at 20% is a production-rate recovery call; the incremental unit economics as 737 MAX rate moves toward 57/month are the strongest single driver in the book, and the defense segment is a free option. HWM at 20% is the purest read on the shared commercial-defense bottleneck in engine rings, fasteners, and structural forgings -- a business whose incremental margins on volume are the highest in aerospace.

Integrated primes and mission systems (~32%). LHX at ~15.5% captures communications, electronic warfare, and space payloads at a multiple that still embeds legacy program-execution risk the company has largely worked through. TDY at ~7.7%, CW at ~6%, and HII at ~3.2% round out the integrator exposure across instrumentation, naval nuclear components, and shipbuilding. TXT at ~4.2% adds rotorcraft and the Beechcraft trainer franchise.

Propulsion, motion control, and electronics (~7.5%). WWD (~4.3%) and MOG-A (~1.9%) are the propulsion and actuation specialists where rate leverage is highest. MRCY (~1.3%) is the embedded-computing sub-tier where the multiple is still depressed from a prior execution stumble.

Allied and asymmetric (~15.8%). ESLT at ~6.5% is the cleanest allied-market exposure with direct benefit from European ground systems replenishment. RKLB at ~9.3% is the asymmetric position -- small launch and neutron development, with optionality on national-security payloads.

Asymmetric payoff

If NATO defense spending tracks legislated paths and Boeing hits 57/month on the MAX by late 2027, the weighted book returns roughly 18-28% annualized over three years. If budgets flat-line at current dollars and narrowbody rate slips by a year, the book returns roughly zero to -10%. If a second supplemental or a Pacific contingency package moves through in 2026 or 2027, the right tail is 35-50% with modest multiple expansion.

At 55% base, 25% bear, and 20% bull, expected value is roughly +14 to +20% annualized versus an SPY base rate near +8%. The payoff is asymmetric because backlog and multi-year contracts limit the bear-case revenue damage while supply-constrained pricing creates open-ended upside in the sub-tier.

Three things that would change our mind

1. A US continuing resolution extending past March that forces program starts and multi-year procurement authorities to slip, with language suggesting a broader budget-control framework is returning.
2. Boeing 737 MAX delivery cadence falling below 32/month for two consecutive quarters with management citing supplier rather than internal quality causes, signalling the sub-tier is cracking rather than tightening.
3. European member states legislating caps or delays to announced 3%-of-GDP paths, indicating the budget trajectory is political theatre rather than a committed procurement pipeline.

What we are explicitly NOT betting on

We are not betting on any single program win -- NGAD, Sentinel, Columbia-class, or a specific munitions award. We are not betting on a particular conflict. We are not betting on small pure-play unmanned or counter-UAS names whose revenue has not yet cleared the threshold where the sub-scale-industrial base-rate disadvantage reverses. The thesis requires only that allied spending stays on its announced path and that commercial aerospace rates continue to recover. Both are strictly weaker claims than picking winners, and the book is sized for them.