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QinetiQ benefits from belligerence

The FTSE 250 defence contractor is set to benefit from a step-up in global military spending
September 1, 2016

The great 19th century financier, Nathan Mayer Rothschild, could not be accused of equivocating on the subject of profiting from war. "Buy on the sound of cannons; sell on the sound of trumpets," the future 1st Baron Rothschild reputedly said in 1810 at the height of the Napoleonic Wars, a conflict that his family financed on both sides. Investors would do well to follow Nathan Mayer's exhortation. Following a prolonged fallow period, there are signs that global defence spending is about to ratchet up. That's good news for the defence industry in general, but particularly for a mid-tier contractor such as QinetiQ (QQ.) with high exposure to military budgets in the so-called EMEA zone (Europe, the Middle East and Australasia).

IC TIP: Buy at 230p
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points
  • NATO spending on the rise
  • Assured revenues
  • Niche, technology-driven products
  • Strong cash generation
Bear points
  • Post-Brexit uncertainties
  • MoD squeezing profit margins

Anxieties over security are on the rise in the face of repeated terrorist attacks in mainland Europe, perceived Russian aggression and - rightly or wrongly - the migrant crisis on Europe's borders. As a result, 2016 will mark the first year in nearly a decade in which defence spending by Europe's NATO allies has risen. The continent's three leading military powers - the UK, France and Germany - all plan to invest more in specialist hardware designed to neutralise threats, be they external, internal or in cyber-space. The security challenges of the 21st century, including the rise of asymmetrical warfare, are increasing demand for the type of niche, technology-driven products and test-and-evaluation expertise in which QinetiQ excels.

Immediately after the EU referendum result there were concerns over the UK's ability to meet its targeted military spend of at least 2 per cent of GDP, at least within George Osborne's budgetary strictures. But it now looks likely that Theresa May's administration will take a more relaxed view about the government's spending deficit, so her rise to power is viewed favourably by defence companies.

The new prime minister has kept faith with Michael Fallon as Secretary of State for Defence. He was a key contributor to the last UK government's Strategic Defence and Security Review, which demanded greater efficiencies from the defence procurement process. Happily, the MoD's focus on squeezing added value plays well for QinetiQ, which has a reputation for delivering more for less. This should help to shore-up its revenues in the event that MoD budgets come under further pressure, thereby offering downside protection that some industry rivals lack. It also helps that chief executive Steve Wadey has a long relationship with the MoD.

One note of caution: the MoD recently cut the profit margins allowed for single-source contracts in 2017 from 10.6 per cent to 8.95 per cent. Around half of QinetiQ's annual sales is covered by such contracts, where the government awards a contract without competitive tender. However, as the majority of 2017 contacts had already been signed, the impact is expected to be minimal.

Further afield, it is anticipated that defence spending in the Middle East and North Africa will start to grow again this year after falling away in response to the oil price slump, according to latest analysis from defence analyst IHS Jane's. The beleaguered region's defence spending is expected to rise to $180bn (£136bn) by 2020, up from the previous peak of $160bn in 2014.

QINETIQ (QQ.)
ORD PRICE:230pMARKET VALUE:£1.33bn
TOUCH:229-230p12-MONTHHIGH:276pLOW: 204p
DIVIDEND YIELD:2.8%PE RATIO:13
NET ASSET VALUE:55p†NET CASH:£275m

Year to 31 MarTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20140.7810113.84.60
20150.7610815.25.40
20160.7610916.35.70
2017*0.7711117.06.04
2018*0.7911117.36.40
% change+3+2+6

Normal market size: 10,000

Matched bargain trading

Beta: 0.6

*BoA Merrill Lynch estimates, underlying PTP and EPS

†Includes intangible assets of £81.4m, or 14p a share