Stockwatch: time to buy the drop after Qinetiq’s plunge?

It has become easy to assume defence shares are a strong trade. Sector leader BAE Systems (LSE:BA.) has nearly trebled over three years amid serial upgrades. Revelations from European politicians of the need to substantially raise defence spending, boosted belief that such shares offer growth and defensive qualities in every respect.

Mid-cap QinetiQ Group (LSE:QQ.) dropped a bomb-shell on such assumptions yesterday, cautioning of contract delays both in the UK and US, lumping in a raft of exceptional charges and seeming to downgrade profit expectations to 31 March 2025 in the order of 15%. Its shares plunged over 20% to around 410p, and a recovery failed despite a wider market rally. After a further drop to 390p this morning, the shares appear currently supported around 400p.

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This group builds high-tech integrated solutions for defence platforms and systems. It originated as a 2001 demerger from the UK Defence Evaluation and Research Agency; the UK, US and Australian governments accounting for over 90% of revenue.

The chart may suggest this drop is nothing more than near-term mean reversion to a support level in an upward trend-line. Indeed, going back to 100p in late 2010, QinetiQ has always been on a relatively volatile uptrend.

Source: TradingView. Past performance is not a guide to future performance.

I initially drew attention as a “buy” at 260p in September 2020, with the shares trading on a price/earnings (PE) ratio of around 13x, reiterating this at 319p in November 2023 given it appeared better value than BAE Systems which I had favoured regularly.

Is this a buying opportunity versus BAE Systems?

At 1,660p, BAE trades on a forward PE near 22x with a dividend yield around 2.2% and market value at 4.3x net asset value. At around 400p, QinetiQ could be on a mid-teens near-term forward PE due to implied downgrades, with a 1.8% yield albeit possibly 3x earnings cover. Its price-to-book is over 3x, or 12x net tangible assets, but these are high-tech engineering groups where intangible values can be justified.

Perception is therefore going to focus on earning power – where assumptions as recent as January are now disrupted and questions are how deep and for how long this goes.

Source: historic Company REFS and company accounts

On 21 January, an update left full-year March 2025 and medium-term expectations unchanged. Forecast was for high single-digit revenue growth at a stable 12% operating margin. That is now downgraded to around 2% growth on a 10% margin.

Consensus had been for £2,040 million revenue and £177 million net profit, but new guidance implies £1,950 million revenue for this latest financial year and, with the second-half margin falling to 10%, it looks like a net profit downgrade of 13% or more.

The March 2026 revenue prospect also appears tweaked down from around 7% growth (recent consensus for £2,190 million) to 5% or below, though hopefully this may be firmer at annual results in May.  

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If the March 2025 earnings per share (EPS) prospect is around 27p, then the near-term PE is around 15x. While a material discount to BAE, it is not yet clear how the US government market may pan out under the Trump administration, and whether this is a proverbial first profit warning. QinetiQ seems a casualty of Elon Musk’s aggressive cuts to federal departments.

It does at least seem clear that management is trying to pack all necessary exceptional charges into the next set of results, hopefully to move on.

Near-term contracts presented as chief problem areas

Only two months ago, management cited “good visibility in the medium term” on the group’s services side, despite “short-term UK order intake slower than expected due to the fiscal environment.” The UK represents around 50% of group revenue, generally with long-term contracts performing well.

In global solutions, (around 25% of revenue, chiefly US) they said: “order intake remains robust with stable revenue despite contracting headwinds in the US.”  

They now cite “tough” near-term trading conditions persisting to affect both the UK and US “resulting in further delays to a number of contract awards.”

Indeed, UK intelligence (around 25% of revenue) is seeing further delays to short-term contracts, hence there has been some downsizing.

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In global solutions, “essential long-term programmes have delivered good on-contract growth”. But it is unclear what portion these constitute versus “further delays to short cycle contract awards, particularly in higher margin product sales.

It’s unclear what is meant by “geopolitical uncertainty” impacting a usual fourth quarter weighting to higher margin product sales from the US. If a catch-all that includes an America First approach to procuring, then it hardly bodes well.

That a £140 million impairment charge is said to be due to the market backdrop and US operational performance, leaves me wondering if this is yet another example of a historically acquisitive company with stoked issues – manifesting as problems once markets get tough.

A US restructuring under a new boss explains this charge, but there also seems to be up to £65 million additional (non-cash) charges and provisions relating to inventory and cost recovery. The March 2025 accounts will be somewhat dirty.

An essential grasp of all this would be to await evidence at full-year results on 22 May, at least of mitigation in near-term “tough” markets, and that US operations are sorted and guidance for 2026 seems reasonably secure rather than a range of outcomes.

I cannot see that QinetiQ should right now be in a closed period, but directors and senior management are yet to buy shares, and you would look for something substantive rather than a concerted effort at £5,000 or so each

Modest support could still follow in weeks ahead from a £150 million share buyback programme since last June being extended to £200 million to June 2027.

Return of private equity interest?

Around 20 years ago there was controversy about how Carlyle private equity made £290 million from financing the demerger and flotation of Qinetiq. Only a few weeks ago, I also recall speculation how Bain was interested in making an offer, but it seemed the UK government might thwart US ownership of a key defence supplier.

There does not seem anything intrinsically wrong with private ownership, and the business appeals like it did in 2001. QinetiQ’s financial profile is amply cash generative which explains net gearing only around 20%. If the challenges are indeed near term, then now is the time for a private equity approach.

Not surprisingly, management reminds how longer term, “the underlying strength of the group coupled with the relevance of our mission-critical capabilities to national security needs of our customers in the UK, US and Australia as well as NATO allies, positions us well for long-term future growth.”

In conclusion, I think more evidence is needed to assume QinetiQ’s problems are transitory, lest this is profit warning number one. If the directors buy, that will tilt me in favour of a starter position. For now: Hold.

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