Yahoo Finance The dangers of China and Russia make this defence company a must-have
Russia’s invasion of Ukraine is a game changer for the defence industry. It has thrust the world into a new era where elevated geopolitical risks are likely to prompt higher military spending among Nato members.
When coupled with China’s growing military assertiveness, the operating environment for defence-focused firms, such as FTSE 250 member QinetiQ, is likely to significantly improve over the coming years.
This has already led to an about-turn in investor sentiment towards the company.
After essentially flat-lining for nearly five years, its shares have surged by 50pc since Russia’s invasion began. In doing so, they have generated a 28pc capital gain since this column advised readers to buy them in March 2019. Over the same period, the FTSE 250 index has delivered a measly 5.5pc gain.
The defence contractor generates 73pc of its revenue from Britain. However, it has a growing presence in America and Australia, which together contribute almost a fifth of total sales, and this provides a significant long-term opportunity.
Indeed, the 2023 US budget request of $773bn (£638bn) represents a 4pc rise on the previous year, while Australia’s defence budget is expected to rise by more than 7pc a year in real terms over the next three years.
Crucially, the market segments in which QinetiQ operates are forecast to grow at a faster pace than overall defence budgets.
As a result, the company expects to more than double its revenue in both countries over the next five years. It also has exposure to other nations, including Canada, Germany and Belgium, which could further catalyse its long-term growth prospects while reducing its reliance on Britain.
International growth plans form a central part of the company’s overall strategy to increase total sales by 75pc over the next five years. Acquisitions are likely to play a key role in accomplishing that goal, with a solid balance sheet providing scope to borrow where necessary. Currently, the firm has net cash of £225m but it stated in its latest annual report that it would consider switching to a net debt position in order to improve its competitive advantage.
Alongside sales growth, QinetiQ expects margins to improve over the medium term. Its latest quarterly trading update, which was released on July 21, was in line with previous company guidance and reaffirmed its expectation for a one percentage point rise in operating margin.
Meanwhile, strong operating cash flow, which has meant that cash conversion has averaged 163pc over the past two years, further improves the company’s competitive position.
It provides scope for generous capital expenditure that is expected to be at the upper end of previous guidance in the current financial year. The firm’s asset-light business model means greater agility that further aids its capacity to invest in new tech to disrupt incumbents.
Of course, government plans to raise defence spending depend on their affordability. The world economy’s outlook has grossly deteriorated over recent months, as factors such as high inflation and rising interest rates have led to more subdued growth forecasts.
However, in Questor’s view, the geopolitical environment has changed to such an extent over recent months that growth in military spending could essentially become ringfenced.
QinetiQ’s recent share price surge means that it now yields just 1.9pc. Despite raising dividends at an annualised rate of 10pc over the past decade, a lowly yield means that its investment appeal is centred on the potential for capital growth rather than income.
Trading on 16 times forecast earnings, its shares are also now far more expensive than at the time of our first look at the stock in 2017. Then, the company traded on a lowly prospective rating of 13. However, its financial outlook has materially improved since then.
Now, rising defence budgets provide a clear earnings growth catalyst that justifies a higher valuation. With a solid balance sheet, international growth opportunities and prospective margin improvements, it remains a worthwhile purchase for long-term investors.
Questor says: buy
Ticker: QQ
Share price at close: 380.8p
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