Interactive Investor

Stockwatch: this mid-cap share is worthy of attention

Analyst Edmond Jackson says that this firm with an attractive profile and a bold revenue target could help diversify your portfolio.

21st November 2023 12:30

Edmond Jackson from interactive investor

I have consistently covered BAE Systems (LSE:BA.) as a prime-quality defence stock and core holding, say, for a SIPP or ISA, given raised spending by governments in this era of uncertainty.  

Also worthy of attention is mid-cap QinetiQ Group (LSE:QQ.), a multinational, Farnborough-headquartered firm, which engages critical national infrastructure and also testing for air, land, sea and target systems. 

It was created in 2001 out of a defunct British government research agency, and listed in 2006 with an agenda to acquire defence and technology-related companies in the US, where it is a trusted government supplier, quite uniquely on some of the most sensitive US defence programmes. 

My recollection is troubles around 2009-10 that were not necessarily recession-related but impacted my perception of the group. In fairness and possibly helped by a 130p low in 2012, this helped set up a steady, if volatile, bull run to 380p by mid-2022.

I drew attention to it as a “buy” at 260p in September 2020 on around 13 times expected earnings, with healthy conversion of operating profits to cash. This aided a ramp up in capital expenditure, potentially benefiting results. At the time, I wrote: “The downside should not be great; meanwhile the foundations weigh risk/reward to upside.” 

An essentially attractive profile, if lacking appeal as a conviction play, continues to apply today. It means QinetiQ is not rated as highly as BAE (the affirmed favourite), but it may offer an opportunity if war in Ukraine and the Middle East does prompt higher spending on defence. 

Chart and fundamentals look broadly attractive 

QinetiQ fell to 308p last August, but the near-term volatility is entirely consistent with its decade-long uptrend, as if now at support level (for what technical analysis is worth). 

The forward price-to earnings (PE), normalised, is 11.7 times in respect of March 2024, easing to 10.6 times for 2025, assuming consensus forecasts. BAE, meanwhile, has reached nearly 16 times forward earnings, based on around 30% earnings growth in 2023, albeit easing below 10% in 2024. That is too much of a snapshot view to judge the overall value, but let us say BAE’s rating offers less room for setbacks.  

Prospective yields are likewise similar, with BAE slightly ahead at around 3%, although QinetiQ has better earnings cover at 3.5 times versus 2.1 expected for BAE. 

Both companies also have quite similar operating margins – slightly higher, also more consistently around 12% – although Qinetiq has a slightly higher return on capital at around 13%. 

QinetiQ Group - financial summary
Year end 31 Mar

 201520162017201820192020202120222023
Turnover (£ million)7647567838339111,0731,2781,3201,581
Net profit (£ million)10510612313811410612590.0154
Operating margin (%)14.49.816.817.413.511.69.39.612.6
Reported earnings/share (p)18.516.721.324.320.018.621.615.526.5
Normalised earnings/share (p)22.223.119.221.120.519.220.814.523.3
Operational cashflow/share (p)17.627.418.920.621.627.331.532.635.4
Capital expenditure/share (p)4.65.15.79.615.419.113.814.518.7
Free cashflow/share (p)13.022.313.211.06.28.217.718.116.7
Dividend per share (p)5.45.76.06.36.66.66.97.37.7
Covered by earnings (x)3.42.93.63.93.02.83.12.13.4
Cash (£m)199276224272191102191102191
Net debt (£m)-197-276-224-272-160-74.2-163-226212
Net assets (£m)2983255327447778858831,041968
Net assets per share (p)49.055.393.9131137156155182169

Source: historic company REFS and company accounts

Near-term niggle regarding the organic trend in orders 

Which company has the best revenue prospects?  

Historically, QinetiQ is superior by way of a 13.7% compound average growth rate in revenue, versus 4.3% for BAE. Some of that will relate to the former being expected to show near £1.9 billion revenue this financial year, versus the latter's of around £25 billion. Growth is arithmetically harder for bigger firms. 

I suspect a chief reason that QinetiQ dropped 10% to 315p following the 16 November interims, is a mere 2% organic rise in orders cited, versus 19% overall (helped by acquiring), relative to first-half revenue up 19% organically and 31% overall.  

Management blames a strong comparator, but it is not exactly consistent with the sense of defence being reliable. 

Consensus has been for a £100 million revenue rise to £2.0 billion in the March 2025 year, implying just over 5% growth.  

What probably counts more is the validity of QinetiQ’s objective for £2.4 billion organic revenue, achieved by the March 2027 year, and extended to around £3 billion by acquisitions.  

It says: “We have an active pipeline of such acquisition opportunities...we are prioritising bolt-ons in the US and Australia, our plan for net debt to EDITDA to remain under 1.5 times.” 

It is a bold target for revenue to nearly double from near £1.6 billion over four years; yet attractive if at all possible, now the operating margin is back in double digits (having eased below in the March 2021 and 22 years). Latest results show it rising to 11.3% on an underlying basis. 

Guidance was affirmed in the results for high single-digit organic revenue growth in its current financial year, with high-teens’ total revenue growth, and at a stable operating margin. 

But despite this week starting with positive news – a £136 million equivalent radar contract win in the US – it appears the market has been jolted into unease. Has management made a rod for its back, hence a risk of having to caution (against its guidance), say, towards March 2024? 

Foreign exchange and cash generation were also factors 

While interims show a 35% advance in underlying operating profit, it is down 26% to £93 million on a reported basis due to a £46 million foreign exchange derivative gain (in the first half of the 2023 year) becoming a near £21 million cost.  

This had been taken out in relation to the £470 million equivalent purchase of Avantus in the US; you could say it illustrates how acquisitions can be disruptive. 

Despite Avantus’ expertise in cyber, data analytics and software, it saw slower-than-expected first-half revenue, but contract awards have stepped up. 

Cash conversion was also lower at 50% due to near-term timing effects, but is guided “in line” for the full year. 

While such factors have temporarily weighed on headline numbers, it is reasonable to look through them, but does mean trusting to management’s guidance for the second-half-year. 

Despite US expansion, the UK constitutes 66% of group revenue, where defence spending seems unlikely to alter adversely despite the potentially disruptive effect of a general election next year. The US is at 22% and Australia the remaining 12%. It typifies mid-cap companies with domestic exposure  

By comparison, and as an FTSE 100 stock, BAE is a genuine global business, hence lower-risk, you could say, with the UK representing 27% of first-half revenue, the US 43% and Saudi Arabia 10%, ahead of Europe at 9%.  

Borrowings have jumped, to acquire Avantus 

There is no short-term debt, but longer term it has soared from £17 million to £386 million versus £104 million cash, for net gearing of 28% which generated a near £8 million interim net interest change.  

This took less than 7% off operating profit yet raises QinetiQ’s risk profile in a “higher for longer” interest-rate scenario (affirmed by the Bank of England governor yesterday). It still only measures up to BAE’s 30% net gearing. 

Buy for diversity within defence stocks  

I think such a case exists despite messy aspects to these interim results.  

QinetiQ’s strategic focus is supporting the UK, US and Australia, which are in a trilateral partnership known as AUKUS, a shared defence and security mission. US senators have requested the largest-ever budget for defence R&D, also test and evaluation at £116 billion equivalent, a 40% increase since 2020. The UK is investing £6.6 billion in R&D over four years, and the Australian government is raising defence spending by 7% to £42 billion equivalent. 

This is an attractive medium-term context despite small to mid-cap defence companies' ability to bowl googlies (not to get started on Babcock International Group (LSE:BAB)). QinetiQ’s 1% recovery this morning to 319p, after its recent drop, hints at finding support on the long-term trendline. Near-term revenue fears may be just that, given overall defence commitments. Buy.

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

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