QinetiQ upgrades guidance amid robust defence orders

Defence companies that are unencumbered by exposure to civil aerospace have proved relatively resilient to the Covid-19 crisis, benefiting from the stability of long-term government contracts and the critical nature of their work. Results from defence contractor QinetiQ (QQ.) amply demonstrate the point. Its revenue for the six months to 30 September jumped by almost a quarter year on year to £603m. This was partly down to organic growth, but also reflects the acquisitions of advanced sensor maker Manufacturing Techniques (MTEQ) and training simulation specialist Newman & Spurr Consultancy (NSC) last year.

That’s not to say the group was completely unscathed by the pandemic. Over in the smaller global products division, QinetiQ Target Systems was hit by cancelled product trials and deployments due to travel restrictions, while fibre-optic sensing business OptaSense was weighed down by a weaker oil and gas market. This squeezed the global products underlying operating profit margin by 5.3 percentage points to 6.2 per cent. Still, this was unable to offset momentum in the ‘Europe Middle East and Australasia’ (EMEA) services division and QinetiQ’s overall underlying operating profit climbed by 16 per cent to £69m.

The Ministry of Defence (MoD) is QinetiQ’s biggest customer and the group secured a further £129m-worth of orders under their ‘engineering delivery partnership’ (EDP). That contributed to £563m of new orders in total during the first half, an almost two-fifths increase versus a year earlier.

While it is currently more UK-focused, QinetiQ is continuing to expand internationally – it generated £213m of revenue from outside the UK in the first half, up from £76m four years ago. The group says it is on track to grow its international revenue from 35 per cent of the total now to more than 50 per cent over the next five years.

On the back of a strong first half, QinetiQ has increased its full-year guidance, and now expects “low-double-digit” revenue growth versus “high-single-digit” growth previously. House broker Numis is pencilling in £139m of underlying operating profit for the full year – up from £133m in 2020 – rising to £145m in 2022.

QinetiQ is not the only defence company that has upgraded its outlook. BAE Systems (BA.) now believes its underlying EPS for the year to 31 December will be slightly higher than previously guided. This is thanks to “a good operational performance” against its order backlog and a lower effective tax rate offsetting foreign-exchange headwinds. At the time of its half-year results in July, BAE was anticipating a “mid-single-digit percentage” decrease from the 45.8p it saw in 2019.

Threats on the horizon

Investor sentiment regarding defence stocks has been weighed down in recent months by concerns over future defence spending. There are fears that governments will row back on defence budgets amid spiralling national deficits and the need to prioritise other areas of the economy post-pandemic. But long-term geopolitical threats haven’t simply disappeared during this health crisis so there is reason to believe defence spending will remain robust. Indeed, German MPs recently approved a €5.4bn (£4.8bn) order for 38 new Eurofighter Typhoon fighter jets, which are made by a consortium of companies including BAE. Meanwhile, as it faces an increasingly emboldened China, Australia is ramping up its 10-year investment in new and upgraded defence capabilities from AUD$195bn (£108bn) to AUD$270bn. That bodes well for both BAE – which is Australia’s leading defence contractor – as well as QinetiQ’s push for international expansion.

Over in the world’s largest defence market, there are worries that Joe Biden’s presidential victory will result in lower US defence spending than we have seen during the Donald Trump era. There is some level of certainty ahead as the 2021 national defence budget of $740.5bn was already approved earlier this year. BAE relies on the US for more than two-fifths of its sales, but is confident about its outlook across the pond. The group says its portfolio is “well aligned” with US military priorities and growth areas and doesn’t expect this to change under a new administration. Its order backlog in the US has continued to grow, aided by its acquisitions of the Collins Aerospace Military GPS and Airborne Tactical Radios businesses from Raytheon (US:RTX) earlier this year.

Closer to home, there is the shadow of the UK’s integrated review of its security, defence, development and foreign policy. We are likely to see a shift away from investment in traditional fighting capabilities towards space and cyber. That would leave BAE exposed with its focus on expensive platforms such as combat vehicles, although it also has sizeable businesses relating to electronic and cyber warfare. Meanwhile, QinetiQ is already a key strategic partner to the MoD’s digital and information technology unit and its testing, training and evaluation services should remain important as the MoD adopts new technologies.

Defensive plays

BAE says demand for its capabilities remains high and it is now expecting a higher level of new orders this year than its pre-pandemic forecasts. A dividend yield of 4.9 per cent is notable in this challenging income landscape, and even in the face of more modest defence budgets, analysts at JPMorgan believe that the dividend is secure. That makes the shares worth holding onto.

QinetiQ, meanwhile, is sitting on £113m of net cash – which is a third higher than its March year-end position – and it has kept the half-year dividend steady after reinstating the final dividend back in September. It therefore has balance sheet power for further M&A to assist its international growth story. The group also has visibility over 93 per cent of its revenue for the rest of the year and a healthy £3.1bn order backlog. Buy.

Last IC View: Buy, 278p, 20 Sep 2020