The Structural Shift in Defense Tech: Software-Driven Margins and Long-Term Earnings Power

The defense technology sector is undergoing a profound transformation, driven by the integration of artificial intelligence (AI) into core operations. This shift is not merely a technological upgrade but a structural redefinition of how value is created and captured in the aerospace and defense industries. As hardware-centric models give way to AI-enabled systems, operating margins are expanding, and long-term earnings power is being redefined. For investors, this transition presents a compelling case for why defense tech is poised to outperform traditional industrials in 2026.

The Hardware-to-Software Transition: A Margin Expansion Catalyst

According to a report by Deloitte, the defense sector is witnessing a "paradigm shift" as AI moves from experimental pilots to embedded infrastructure, akin to the adoption of HTTP in the early internet era. This transition is particularly evident in maintenance, repair, and overhaul (MRO) services, where predictive analytics and digital tools are reducing downtime and optimizing resource allocation. For example, the U.S. Air Force has demonstrated how AI can enhance decision-making in complex operational environments, while the Department of Defense is integrating agentic AI into command-and-control systems.

The financial implications of this shift are significant. Software-driven business models inherently offer higher scalability and lower marginal costs compared to hardware-centric approaches. Palantir Technologies, a leader in enterprise AI platforms, exemplifies this trend. In Q3 2025, the company reported a 63% year-over-year revenue increase, driven by its Artificial Intelligence Platform (AIP), and achieved an adjusted operating margin of approximately 51%. Its "Rule of 40" score of 114%-a metric combining growth and profitability- underscores its ability to balance rapid expansion with disciplined cost management.

Durable Growth: Backlogs and EBITDA Expansion

The durability of earnings in defense tech is further reinforced by robust multi-year backlogs and EBITDA margin expansion. Kratos Defense & Security Solutions, a key player in autonomous systems and counter-drone technologies, reported a Q3 2025 backlog of $1.41 billion, with 37% expected to convert into revenue in 2026. The company also anticipates 100 basis points of EBITDA margin expansion in 2026 and 2027 as it transitions to higher-margin production contracts.

Palantir's backlog is equally compelling. Its U.S. commercial Total Contract Value (TCV) surged by 342% year-on-year in Q3 2025 to $1.3 billion, reflecting strong demand for its AI infrastructure. The company's $10 billion, 10-year contract with the U.S. Army provides a decade-long revenue tailwind, while its NATO adoption of the Maven Smart System signals global scalability.

Valuation Dynamics: Tech-Like Multiples for Defense Tech

The structural shift in defense tech is also reshaping valuation metrics. As noted in the Global X 2026 defense tech valuation report, the sector entered 2026 with a 26x multiple on 2026 earnings, a significant premium to traditional industrials, which trade at lower valuations due to less innovation-driven growth. Defense tech companies delivered 29% year-over-year earnings per share growth in Q3 2025, outpacing the S&P 500's performance. This divergence reflects the sector's alignment with software-driven margins and its ability to capture pricing power in a capital-light model.

Why Defense Tech Outperforms Industrials in 2026

Traditional industrials face structural headwinds, including capital-intensive operations and slower innovation cycles. In contrast, defense tech firms are leveraging AI to create defensible moats. Palantir's "Ontology" framework, for instance, has become a competitive differentiator in enterprise software, while Kratos's additive manufacturing capabilities are reducing production costs.

Moreover, global military modernization agendas and long-term procurement cycles are fueling demand. The U.S. Department of Defense's focus on AI as a foundational capability-spanning logistics, procurement, and mission planning-ensures sustained investment in software-driven solutions. For investors, this creates a virtuous cycle: higher operating margins, durable backlogs, and tech-like valuations.

Conclusion

The structural shift in defense tech-from hardware to AI-enabled systems-is redefining the sector's earnings power. With expanding operating margins, multi-year backlogs, and valuation premiums, defense tech is positioned to outperform traditional industrials in 2026. Companies like Palantir and Kratos exemplify this transition, offering a blueprint for how software-driven innovation can unlock long-term value in a capital-efficient manner. As the sector continues to integrate AI into its core operations, the investment case for defense tech becomes increasingly compelling.