Join our community of smart investors

Pay the price for QinetiQ

The aerospace and defence engineer has solid foundations and would be a safe bet in the event of a downturn
April 17, 2019

There are cheaper stocks than QinetiQ (QQ.). The aerospace and defence engineer, which generates the bulk of its business from its partnerships with the UK and US governments, currently trades at a mild premium to its recent history – its shares have marched upwards on a near-consistent basis since their nadir in early 2018. But full-year results are a month away, and with orders expected to be well ahead of last year and the underlying business appearing in robust shape, we believe QinetiQ’s story merits investment.

IC TIP: Buy at 293p
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points

Strong balance sheet

Clean accounting

Diversifying sales base

Strong capital returns and operating profit margins

Bear points

Share rating above its average

Exposure to UK defence budget

QinetiQ's balance sheet is central to our investment case. QinetiQ claims to have “one of the strongest balance sheets in UK defence”. It has no debt and £249m in net cash, providing the group with firepower to deploy on acquisitions, returns to shareholders and capital investment, both in its own business and in customers' projects. The group made two acquisitions in 2018, both in the field of military training, which underline a recent trend away from its traditional engineering activities. And it recently agreed a £1.3bn deal under its long-term partnership with the Ministry of Defence (MoD) to modernise 16 defence facilities. QinetiQ will fund the capital investment itself and recoup the costs over the life of the contract.

Charlotte Keyworth, aerospace and defence analyst at Barclays, says that “customer-funded capex is a good use of organic investment” for QinetiQ, given the strength of its balance sheet. Meanwhile, Qinetiq shed financial risks by transferring a third of its in-house pension scheme, which removed £120m of bookkeeping surplus from its accounts.  

The profit and loss account is also clean. QinetiQ has managed to keep adjustments to a minimum, with only £23m in adjusting items relative to is statutory pre-tax profit of £145m in 2017-18, most of which are spread across small gains on the sale of property, investments and intellectual property. QinetiQ also expenses the vast majority of its research and development spend, capitalising only £1.5m of its total £310m R&D outlay last year. This compares favourably with, say, Rolls-Royce (RR.), whose capitalised R&D costs soared from £99m to £342m between 2016 and 2017 after a change in accounting policy. So QinetiQ adopts a transparent accounting policy, which should encourage investors.

It also makes good use of its resources, and it is adapting. The group has been criticised by City analysts for being overly exposed to its work with the MoD, which will account for around 70 per cent of its sales in 2018-19. And if you want to know what a black hole looks like, you needn’t look to outer space – the House of Commons public accounts committee highlighted a £7bn gap in the MoD’s 10-year funding plan in February.

In response to this legitimate bear point, the engineer is diversifying its revenue streams, and recently secured a seven-year, $164m (£125m) robotics contract with the US Army. The proportion of group revenues from the UK fell to 73 per cent from 78 per cent between 2017 and 2018, although much of the reduction stemmed from lower UK government spending. Meanwhile, QinetiQ is negotiating the second tranche of its long-term partnership with the government, under which it is expected to commit around £160m-worth of capital spending over the next three years in return for a pipeline of MoD work.

Consistently high returns on capital and a rise in operating profit margins demonstrate QinetiQ’s ability to translate its partnerships and investment into financial success. The dividend is well covered by earnings per share (see table). While management has offered no guidance about an extraordinary shareholder payout, QinetiQ has the headroom.

Analysts at JP Morgan Cazenove forecast full-year 2019 pre-tax profits and earnings per share of £114m and 18p respectively, rising to £118m and 18.3p in 2020.

QINETIQ (QQ.)   
ORD PRICE:288pMARKET VALUE:£1.64n
TOUCH:287.5-288p12-MONTH HIGH:315pLOW: 216p
FORWARD DIVIDEND YIELD:2.5%FORWARD PE RATIO:16
NET ASSET VALUE:142pNET CASH:£249m
Year to 31 MarTurnover (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
201675610916.35.7
201778310516.06.0
201883312219.36.3
2019*87511418.06.7
2020*91311818.37.1
% change+4+4+2+6
Normal market size:7,500   
Matched bargain trading    
Beta:0.6   
*JPMorgan Cazenove forecasts