Should You Buy Defense Stocks After the Iran Conflict Sent Them to All-Time Highs?

Buying defense stocks at a time of intense, seemingly intensifying, geopolitical conflict might appear to be a no-brainer, but it's not that simple. Backlogs and revenue are growing, and upside potential is considerable.

For a recent example, witness the recent announcement of framework agreements between the U.S. government and Lockheed Martin (NYSE: LMT), BAE Systems, and Honeywell to accelerate production of missile technology, including Precision Strike Missiles (PrSM) used to attack Iran. However, valuations and profitability still matter.

Soaring tension, soaring share prices

Defense stocks have outperformed the S&P 500 (SNPINDEX: ^GSPC) since Russia invaded Ukraine in 2022.

Data by YCharts.

This is largely due to soaring backlogs, driven by the need to replenish equipment used in Ukraine, NATO rearmament, and mammoth U.S. defense budgets.

Data by YCharts.

These backlogs have helped drive enterprise value (market cap plus net debt) higher relative to earnings before interest, taxes, depreciation, and amortization (EBITDA).

Data by YCharts.

Structural margin pressures?

However, a decade-long analysis of earnings before interest and taxes (EBIT) and EBIT margins shows that declining margins have challenged defense companies' ability to grow profits. Lockheed Martin's 46% increase in EBIT over the last decade (shown in the chart below) equates to less than 3.9% annual growth.

Data by YCharts.

The profit margin challenges are possibly structural and lasting, driven by increasing technological complexity and mounting negotiating pressure from the U.S. government, notably on fixed-price development contracts and, in particular, pressure to deliver in a timely fashion.

Boeing's (NYSE: BA) defense business stands out. Although the fixed-price contracts account for 15% of the segment's revenue, they led to multibillion-dollar losses and charges.

Data by YCharts.

The conflict with Iran has inevitably raised revenue expectations, but if margin pressures prove structural and lasting, are investors, in effect, betting on new conflicts to drive revenue expectations and defense budgets even higher? Are the current valuations justified for an industry that could struggle to grow earnings at more than an annual single-digit rate? Caution may be advised here.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Boeing, Honeywell International, and RTX. The Motley Fool recommends BAE Systems and Lockheed Martin. The Motley Fool has a disclosure policy.