UK defence equities would take a noticeable hit to their valuations if the government does not deliver on the NATO pledge to allocate 3.5% of gross domestic product to defence spending, Citi Research said, following the resignation of Defence Secretary John Healey in protest at what he described as inadequate funding.
In his resignation letter Healey highlighted that the government has put forward a plan to lift defence outlays to 2.68% of GDP by 2029, well short of the 3.5% target the UK committed to at the NATO summit in July 2025. Separately, the government had signalled in its 2025 autumn statement an aim to reach 3% of GDP by 2034.
Citi said it retains a base-case assumption that the UK will achieve 3.5% of GDP by 2035 for the purpose of its target prices, but it also modelled alternative outcomes to quantify downside risk if spending instead peaks at 3.0% or 2.68% of GDP. The analysis focused on three listed defence-related firms with significant UK exposure: Babcock International, BAE Systems and QinetiQ.
Babcock International carries the largest reliance on UK defence work among the trio, with 62% of its business linked to UK defence contracts. Under Citi’s 3.5% of GDP base-case, the bank’s target price for Babcock is 1,554 pence, implying 51% upside from the then-current share price of 1,031 pence. If UK defence spending settled at 3.0% of GDP, Citi’s fair value for Babcock falls to 1,416 pence, reducing the implied upside to 37%. Under the 2.68% scenario the fair value declines further to 1,328 pence, leaving a 29% upside.
BAE Systems has a smaller domestic exposure, with about 20% of its business tied to UK defence. Citi’s target price for BAE Systems is 2,438 pence under the 3.5% scenario, compared with a current share price of 1,963 pence, representing 25% upside. If spending instead reaches 3.0% of GDP, Citi’s fair value estimate falls to 2,368 pence, or 21% upside. At the 2.68% outcome, fair value is modelled at 2,324 pence, or 19% upside.
QinetiQ, which Citi identifies as having roughly 60% of its revenue tied to UK defence, shows the most constrained upside under the bank’s scenarios. Citi’s base-case target price of 569 pence implies 18% upside from the current 483 pence share price. Under a 3.0% spending outcome, fair value drops to 520 pence, an 8% upside, while the 2.68% scenario yields 489 pence, or a 1% upside.
Citi explained that its methodology adjusts each company’s fair value in proportion to its UK defence exposure and assumes limited operational leverage either way - in practice this means margins are held constant across the different spending scenarios. The firm modelled the direct impact of lower government defence budgets on the portion of revenues tied to UK defence work rather than assuming broader margin compression or expansion.
On the outlook for achieving a 3.5% defence budget, Citi analyst Charles Armitage said: "We continue to believe this will happen, even though it is not clear where the funding will come from," while stressing the analysis was intended to quantify the impact if ultimate spending came in lower.
Implications for markets
- Defence contractors with high UK exposure face the largest valuation sensitivity to UK budget outcomes.
- Sectors tied to government procurement and domestic defence supply chains could be affected by lower spending trajectories.
- Investors looking at UK defence names may need to weigh government funding risk alongside company-specific fundamentals.
This analysis quantifies the valuation sensitivity under the three discrete spending pathways modelled by Citi, and does not attempt to forecast how or when the government would reallocate funding to meet NATO commitments.