QinetiQ's defensive qualities

Much of its MoD work is tied to a 25-year long-term partnership agreement (LTPA) that runs to 2028 and generates around £320m of annual revenue. Under the LTPA, QinetiQ manages 16 core UK military sites, testing and maintaining new equipment and demonstrating how to use it. It fronts the capital expenditure to develop these facilities and is reimbursed by the MoD over the contract’s lifespan, securing a return above its cost of capital. This investment attracts more work from the MoD, but also entices international customers – government and commercial – to use these facilities and hire QinetiQ to develop similar capabilities.

Diversifying beyond the UK, international markets account for 31 per cent of total revenue – up from 21 per cent in 2016 – and QinetiQ aims for this to reach 50 per cent. The US currently provides 12 per cent of overall sales, with last year’s $105m acquisition of Manufacturing Techniques Inc. (MTEQ) more than doubling the size of its operations in the world’s largest defence market. 

The year to 31 March marked four consecutive years of organic revenue growth, with the 10 per cent increase beating consensus expectations (as compiled by FactSet) of 6.5 per cent. This was thanks to new work secured under the ‘engineering delivery partnership’ (EDP) with the MoD. But EDP work is lower margin, so while the underlying operating profit rose 7 per cent to £133m, the margin contracted by 1.3 percentage points to 12.4 per cent.

Amid stricter regulation of ‘single source’ MoD contracts, the margin has been trending downwards from the 14.9 per cent achieved in 2017. The baseline profit rate set by the MoD – which forms the basis of returns for defence contracts – dropped from a three-year rolling average of 10.6 per cent in 2016 to 7.63 per cent last year. However, it has improved to 8.22 per cent this year, which should help margin pressure abate. Management aims to sustain the underlying operating margin between 12 and 13 per cent. Analyst consensus predicts the margin will drop to 11.6 per cent this year before gradually recovering towards the lower end of the target range.

QinetiQ has not been immune to Covid-19 disruption, postponing its final dividend. In the larger ‘Europe Middle East and Australasia’ services division, reduced flying hours in Germany triggered a £4.3m goodwill impairment. Over in the shorter-cycle global products segment, demand for target systems has slowed and weak oil and gas markets saw fibre optic monitoring business OptaSense swing to a net loss. Global defence spending could be squeezed post-pandemic, but QinetiQ believes budget constraints could shift defence procurement to the “mission-led” projects it specialises in. Enduring geopolitical threats and rising tensions between the US and China (and more recently Russia, too) support the long-term outlook.

QinetiQ has a track record of reporting net cash on its balance sheet, supported by negative working capital – it receives customer payments quicker than it pays suppliers. It was sitting on £85m of net cash at the end of March, although this had almost halved from a year earlier due to the MTEQ acquisition and £14m purchase of training and simulation provider Newman & Spur Consultancy. Capital expenditure increased by over a third during the year, to £108m, and with ongoing investment in the LTPA, annual capital expenditure is guided to be £70m to £100m between 2021 and 2023.

The balance sheet should be strengthened by the upcoming £30m sale of data classification and secure messaging business Boldon James. Broker Numis estimates this will help push net cash to £164m this year. Pre-disposal, QinetiQ had £360m of total liquidity, including an undrawn £275m revolving credit facility, and it believes it can weather the Covid-19 crisis without raising additional capital.