Stockwatch: this defence stock requires a taste test before committing

Investments in behemoth defence contractor could pay off for alert investors.

Does the recent downtrend in QinetiQ (LSE:QQ.) merit buying into? The mid cap shares in this £1.6 billion defence contractor plunged from over 380p to 250p when Covid-19 struck markets in March.

They rebounded near 340p then traded sideways to about 310p in early August, since when it drifted back as low as 255p last Tuesday. But despite stock markets’ falling mid-week, this level appeared to gain support and the price is currently around 260p. 

On a long-term view, this wavering about does not interrupt an uptrend from 98p in November 2010, and there looks a key support level around 200p in February 2018. 

Although a fundamentals-oriented investor might say that is chartist mumbo-jumbo, Qinetiq has made pretty poor progress overall since flotation at 200p in 2006. 

It is another acquisitive defence-related stock complex to grasp, possibly suffering somewhere from government cuts. The horror show of Babcock International (LSE:BAB) may have cast a long shadow. 

Despite plentiful ‘director shareholder’ announcements to sift through, they are mainly share awards as part of a pre-arranged scheme. The only one involving material cash was a non-executive director of six years buying 10,000 shares at 302p on 1 July. At least there has been no selling, and although directors can judge markets poorly, it is possible the recent trend has drifted down from a fair judgment of value. 

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At 260p the stock trades on around 13x earnings if consensus is fair. Earnings per share (EPS) consolidates around 19p to 20p in the next two financial years to end-March. It is also on 2.6x tangible net asset value and the current lack of dividends means no yield prop. While that is not unusual currently, Qinetiq’s ongoing investments mean less cash for committed pay-outs, despite a pretty strong record on free cash flow.  

Some history helps set the context 

Qinetiq is the UK’s sixth-largest defence contractor, originating from a government-owned agency. After a 2002 flotation became postponed, US private equity group Carlyle bought 34% for £42 million with the Ministry of Defence retaining majority control. 

This private equity link remains significant in terms of instilling an acquisitions strategy, especially in the US. It has been logical given the US is the world’s largest defence market but after all these years this strategy has not exactly been transformational. Anyone buying in at 220p immediately post-flotation has made a 16% return, or about 1% annualised.  

Also US revenues constitute 41% of ‘international’ revenues in the last financial year and barely 13% of group total. The UK dominates with 69%, hence Qinetiq remains significantly focused on UK defence spending. 

In principle that is supported by a Conservative government, albeit with Covid-19 now a disruptor. While geographic diversity helps mitigate risks to sterling, the stock cannot be seen as a hedge.    

Meagre returns for patient holders contrast with Carlyle making nearly 10x its money and Qinetic’s chairman £20 million, from the flotation. A cynic would say Qinetic exemplifies how private equity exacts rich gains for its operators and you need to be wary what it sells on. Each time this charge is levelled, private equity blames plc management. 

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Retail investors had to pay 220p or more because they were excluded from the flotation on grounds Qinetiq was too complex to understand. A business should be reasonably understandable. 

Investors then typically revert to group numbers rather than underlying specifics, and the last two years are uninspiring. The table shows profits and operating margins declining since the 2018 year, as if this is a typically tired acquirer. 

Attractions of free cash flow generation

Even so, the margin remains attractively in double digits, also returns on equity and capital employed (albeit slipping out of the teens’ percentage levels in the 2020 year). There is healthy conversion of operating profits to cash flow, as shown by the trend in operating cash flow being around or better than EPS. 

While profits have lately trended down, capital expenditure has ramped up, which may mean gains in the years ahead.

Specifically, the annual cash flow statement to March 2020 showed a 26% rise in net cash generated from operations to £156 million. However, investment jumped 53% to £185.5 million – a £29.5 million disparity in context where £38 million had been paid out as dividends in the last financial year. 

I believe this is the reason why dividends have been dropped, though Covid-19 has caused some business disruption.  

Strictly, the board said on 1 April it would postpone the decision on paying a final dividend until later in the year, due to “the unprecedented nature of Covid-19…and to protect the long term”. 

The virus had caused some disruption to customer trials and product shipments albeit in context of “a strong order book, underpinned by significant long-term contracts”. 

The end-March 2020 balance sheet had cash of £105.8 million albeit down from £190.8 million in 2019. There was no debt although I should note £28.8 million “other financial liabilities”. 

Also, the income statement had only a £1 million net finance expense against £133.2 million underlying operating profit. There is also a £275 million undrawn revolving credit facility, should need arise. 

Acquisitions mean goodwill/intangibles constitute 36% of net assets, however net tangible assets per share are still a reasonable 98.8p per share – i.e. there is backing.    

Qinetiq’s financials are therefore good in parts. While the long-term record as a plc does not inspire – doubting potential as a tuck-away – it can merit a ‘buy’ at a certain valuation range. Has this appeared? 

Hopes rest on higher order intake working through to profit 

The last annual results were presented as a fourth year of growth defined by revenue, up 18% or 10% organically – with orders up 25% to the largest annual intake in nine years. 

Yet growth diluted the further down the income statement you looked. A first quarter update covering three months to end-June upheld this theme of strong order intake, although actual revenue and profit had been impacted by Covid-19. Prompt cost-cutting, however, mitigated this and delivered strong cash performance. 

Also, in terms of organic fundamentals, last July a fresh agreement was struck with the US defence counter-intelligence and security agency to run all its operations. 

Consolidating Qinetiq’s US operations under a single entity was presented as fundamentally changing and improving how the group approaches this key defence market:

“enabling much greater levels of collaboration…to leverage investment across the group…building bigger propositions that add value to the US warfighter.” 

One is left guessing as to what real financial upshot there will be, mind.  

Management says its strategy of “innovation for customers’ benefit, whilst enhancing shareholder returns, is gaining momentum”. It is increasingly relevant to a heightened uncertainty and a raised increasingly complex threat environment. Strategic milestones delivered during the period to help “leverage our capabilities globally”. But what will actually materialise? 

Acquisitions – and disposals – continue, e.g. the Naimuri software and data analytics bought last July for £25 million, after three weeks earlier a data classification/secure e-mail solutions business had been sold for £30 million. 

The issue of complexity arises again, for an outside observer: both companies look fair enough relative to Qinetiq’s strategy. You wonder at the extent, deal-making is about juggling finances and to bolster growth.  Certainly, it is beyond outside analysts’ ability to forecast.

Investment credentials but upside is speculative 

Qinetiq does merit further attention and following, in its current price range. The difficulty is whether this additional order intake gets offset by ongoing Covid-19 disruption, by way of translation into actual revenues also profit; but it may be, Qinetiq has positioned itself to cope better, since March. 

I am wary. Enough of its narrative seems financial PR, and they have axed the dividend to allow flexibility for acquisitions in order to boost the numbers. 

If you seek tuck-away stocks that do not tax the mind, better avoid. Qinetiq also does not amount to a conviction stock. 

But if you are enterprising and alert, buy a small stake and watch what evolves. If updates affirm hopes from higher order intake, then add. If a more challenging macro environment compromises the story later this year, cut losses. The downside should not be great, meanwhile possibly the foundations weigh risk/reward to upside. ‘Buy’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.