QinetiQ Group — Investing for growth

We give an outline of the H118 performance as follows:

Excluding the 11-year £109m NCSISS contract, order decline in the division of £30.1m was accounted for with one-third due to the aggregation of smaller aircraft engineering orders (under the Strategic Enterprise order from 2015) and two-thirds from lower MOD commitments. However, order cover at the start of H218 stood at 91%, down from 93% last year but up from 79% at the start of the year. Reported revenue at £311.6m (H117: £293.3m) was up 4% at constant currency. Underlying operating profit of £47.3m (H117: £43.0m) was flattered by £6.5m of one-off items, leaving the underlying number down £3.6m without the benefit of acquisitions and currency. This fall in operating profit was primarily due to the lower baseline profit for single-source contracts and was in line with company expectations. We will discuss this in more detail in our section on margin pressure below.

The H118 report is demonstrating the structural challenges that the EMEA Services division is currently facing. The UK MOD is becoming more commercial in how it does business. In many ways this is a positive step away from the historic more chaotic, slow-moving and unpredictable nature of UK MOD procurement. However, the new dawn has brought a reduction in customer advances on contracts and currently budgetary pressures are putting a spotlight on shorter-term contracts.

QinetiQ is actively embracing the UK defence environment to help the MOD achieve the cost savings that it needs. The Air Strategic Enterprise and the first part of the LTPA amendment demonstrate a win-win for both parties and training is another area where further efficiencies can be delivered. In addition, QinetiQ is seeking to bolster its presence in international markets. H118 has seen record order success in Australia, which QinetiQ actually considers a home market, facilitated in part by the RubiKon acquisition. The outlook for EMEA Services remains in line with FY guidance stated at the FY17 results. The division is expected to deliver modest revenue growth in FY18 with lower baseline profit due to single-source contract dynamics.

The order picture here was quite encouraging, with orders of £122.4m (H117: £92.5m) boosted by a €24.2m order from the European Space Agency (ESA) for a spacecraft docking mechanism. The QinetiQ Target Systems acquisition also added to the order backlog. FY18 order cover was 80% at the start of H217, down from the exceptionally high 98% last year but up from the start of the year at 55%. 

Reported H117 revenue of £80.9m (H117: £68.5m) was flat on an organic basis. Underlying operating profit of £10.2m (H117: £8.9m) was an increase of just £1.0m on an organic basis, taking prior year non-recurring items, currency and acquisitions into account.

While the shorter order cycle at Global Products can leave the division’s results looking inherently lumpy compared to the stability of the EMEA Services division, the business is progressing in many areas. QinetiQ North America (QNA) addresses a market that the company believes is growing and the US DOD accounts for 8% of group revenues today. The business recorded significant orders in H118, with the maritime system market in focus. In addition, QNA demonstrated its technology in the areas of unmanned systems. The company acknowledges that this is a very competitive area, but it remains confident of future order success here. 

Staying with the international theme, the company has established a joint venture with the UAE to manufacture aerial targets. This is very much building on the QTS acquisition. It also gives a foothold in the region and the chance to move further up the value chain into greater advice and Test & Evaluation (T&E) work. The Middle East is an attractive market for QinetiQ and it is working on a number of opportunities to provide pre-procurement advice, capability assurance and support for defence transformation.

OptaSense is QinetiQ's fibre sensing solutions business and it has seen an improvement in performance as confidence returns to the oil field market. The business has undergone a change to both align itself to the customer and improve its commercial proposition. The stabilisation of the oil price has allowed capital expenditure commitments to increase in specific areas and more parties are alert to OptaSense's portfolio. There is also a security angle to this business, with power facilities and rail lines. 

QinetiQ’s Space Products business develops satellites, payload instruments, subsystems and ground station systems. Returning to the ESA contract, this is a three-year deal whereby QinetiQ will qualify and produce a first flight model of its International Berthing and Docking Mechanism. While in itself the system is lighter and more versatile than the competition, it also operates with both larger and small spacecraft. In addition, work on this project establishes a new product line for the business going forward.

The outlook for Global Products remains in line with FY guidance stated at the FY17 results. The division is expected to continue to grow in FY18, supported by contracted orders, the pipeline of opportunities and acquisition contribution.

There were a number of factors that we believe influenced the market at the time of QinetiQ’s H118 report and we address some of them here. Overall, we believe that QinetiQ’s strategy is to build for the medium-term a platform to supply a broad range of technical capabilities to address the global defence, security and critical infrastructure market.

The UK defence market has been under considerable scrutiny over recent months, not least with ongoing budgetary pressure concerns and a National Security Capability Review underway. In addition, the change of Defence Secretary earlier this month has also been stated, by some market participants, to have brought additional uncertainty. It is worth highlighting commentary from Ultra Electronics’ trading statement this month:

“The UK market has been difficult and has become increasingly so in the second half. There are mounting pressures in the funding of UK defence programmes and this has resulted in the UK MOD pausing, cancelling or delaying numerous programmes. Within the last few weeks a number of our UK orders budgeted for 2017 have been affected.”

The sector has understandably been concerned, not least with senior management changes and the perceived risk of further order delay or cancellation. With c 65% exposure to the UK MOD, it is understandable that investors want to understand developments here.

We believe that QinetiQ is continuing to manage things within its control and adapting swiftly to the change in UK MOD procurement that we described earlier. Key to this is longer-term contracts and delivering savings to the UK MOD while reducing margin headwinds. In addition, building the international portfolio from 26% of the group today to closer to half in the medium term will help QinetiQ to reduce its dependence on the UK MOD while leveraging the growth that overseas markets represent. There is also a potential to drive operating margins, as we will discuss later, as international business typically delivers a higher margin.

Order backdrop

We understand the importance of order book development for QinetiQ, not least as an indicator of success for the campaign strategy for the new management team. This is not just a question of overall quantum but more a focus on mix with a growing proportion of longer-term contracts. At the FY17 results, we said:

“CEO Steve Wadey has stated that most of the campaigns will take three to five years to have a meaningful impact on revenue. Therefore, in the next two years we would hope to see a number of important contract wins, a growing order book and continued organic revenue growth.” (Edison update report, Momentum Building, published on 5 June 2017)

Taking these items in turn, we described the H118 order performance as stable. While there was some anticipated impact from shorter-term R&D related weakness in the UK, we were encouraged to see new contracts across different areas of the group and order success at the acquisitions. In EMEA Services, the non-repeat of the £109m, 11-year Naval Combat System Integration Support Services (NCSISS) contract exaggerated the y-o-y step down in orders. However, the lower level of MOD commitments for the reporting period was just c £20m. In Global Products, the order total was boosted by the €24.2m ESA order we described earlier, which in itself establishes a new product line for future sales into space supply missions.

Order cover is the benefit provided by revenue under contract giving visibility and insulation from the SSRO regime. In each division, H118 order cover was lower than the prior period. However, it did in both cases, as one would hope, move up as H1 progressed. For EMEA Services, order cover at the start of H218 stood at 91%, down from 93% last year but up from 79% at the start of the year. For Global Products, order cover was 80% at the start of H218, down from 98% last year (which was exceptional) but up from the start of the year at only 55%. While we understand that the market may need to adjust its expectations of order cover downwards, we remain comfortable with the level of cover at the end of H118.

Leveraging the international opportunity is one of three core parts of the group strategy and order growth here is being supported by investment in the sales function. QinetiQ has unique and very exportable skills in the Test & Evaluation sector that support International growth. This is outlined further in the conversation on addressable markets later on. For international to contribute to half of group sales in the medium term, from 26% today, future acquisitions will also play a part.

EMEA Services is facing margin headwinds because of the baseline profit rate, which is set by the UK Single Source Regulations Office (SSRO) and is applied to all MOD contracts that are uncompeted. For new and renewed single-source contracts signed in FY18 the baseline profit rate will fall by 149bp from 8.95% in FY16/17 to 7.46% in FY17/18. It is important to note, though, that the rate is the starting point but companies can earn higher returns through adjustments for risk, capital requirements and good execution of contracts.

Around 75% of EMEA Services revenue is derived from single-source contracts. However, an increasing proportion of QinetiQ’s revenue is contracted on a long-term basis, which provides some protection from falling rates. For example, the £1bn 11-year contract amendment to the LTPA was contracted at the FY17 rate. Going forward, there is an additional c £100m of non-tasking revenues to be negotiated under the LTPA and the company is aiming to achieve conclusion by April 2018. With these actions fully underway, by FY19 only c £100m of revenue per year will be subject to annual repricing, hence protecting QinetiQ from feeling the full impact of the SSRO’s declining single-source baseline margin.

The H118 rate of cash conversion (after capex) progression does look somewhat alarming at first glance, moving from 94% in H116 to 98% in H117 to just 8% in H118. The key factor in this decline is the previously announced significant step-up in capex for the LTPA and hence within company guidance. The 11-year amendment saw QinetiQ committed to an additional £60-70m of capital expenditure on the programme, bringing the total to £180m, of which £120m will be spent in the next three years. Investment in the LTPA is reimbursed through the life of the contract itself which in turn adds visibility to contract return levels.

For detail on the capex spend, c £95m is being invested in modern tracking equipment, instrumentation and range infrastructure at the MOD Aberporth and MOD Hebrides ranges. This will help reduce the overall operating costs of the ranges, ensuring they remain competitive with the latest capabilities. QinetiQ is targeting the repatriation of UK defence money that defence primes spend on the MOD’s behalf. The company estimates that approximately half the UK’s test and evaluation money is currently spent overseas because the UK is not deemed to have the correct facilities. The Hebrides has the potential to provide ‘best in class’ facilities, unrivalled in size and interoperability of range, which should attract defence primes to use it as one of their testing grounds. The investment should also make the UK ranges world class, thus attracting international customers. This is a win-win situation. The MOD gets a higher return out of its fixed asset and it provides a platform for growth for QinetiQ. The Formidable Shield 2017 ballistic missile defence live-fire exercise showed the capabilities of the Hebrides range in a good light for the eight nations involved.

£85m will be spent developing the future military test pilot programme. QinetiQ will replace the oldest aircraft in the current flying fleet with new systems-rich aircraft that can deliver the new syllabus while costing less to maintain, thus reducing the overall running costs of the RAF’s Air Warfare Centre at Boscombe Down. A new commercial test pilot qualification will also be introduced, opening up the school to a wider range of students.

From a working capital perspective, the H118 movement was in part related to timing that is expected to reverse in H2; as such the working capital outflow for FY18 is expected to be in the £15-25m guidance range.

Reported H118 figures included a number of non-recurring items that have caused some consternation. While this is clearly a factor of accounting, and the company has been very detailed here, it is also a consequence of the company’s strategy in action.

To explain more detail, a £5.3m credit related to the release of engine servicing obligations with the investment in new aircraft for test aircrew training within EMEA Services. As we understand it, this is part of the strategy to invest in new aircraft and sell the old fleet. As the old fleet aged, it was becoming more expensive to maintain, hence the original provision was taken. With the new fleet acquired and the old fleet disposed of, the servicing costs have become much lower and thus the provision has been released. The investment in the new fleet is aligned with management’s strategy to invest in core UK Test & Evaluation capabilities. This delivers enhanced services and, particularly in this case, lower operational costs. So the non-recurring item here is essentially the manifestation of this strategy taking effect.

It is worth reminding ourselves of QinetiQ’s capital allocation policy as it is clearly aligned with the future size and shape of the company.

As we detailed before, CEO Steve Wadey has set in place a campaign strategy that will take three to five years to have a meaningful impact on revenues. The company is in a period of investment to deliver against future growth and has taken steps to outline its addressable markets. Exhibit 2 outlines the addressable markets, with a strategy of growing market share and leveraging strengths into adjacent markets.

We touched on the international theme in the discussion above. However, it is clear that the addressable markets include building a widening geographic reach for the company. QinetiQ has already started to invest in its business so that it can meet future growth. However, strategic M&A is going to play its part. Where today QinetiQ considers the UK, US and Australia home markets, adding new home markets could prove lucrative. Overall, the international business could grow to be worth 50% of the group from 26% today.

Following the H118 report, we have adjusted our FY18 and FY19 estimates. We have moved down our FY18 revenue estimate, but slightly moved up profitability on better underlying divisional performance. We have reduced our somewhat more optimistic FY19 expectations.

We have introduced a cash-based capped DCF valuation, which is, in our view, a conservative basis for estimating cash flow values as it does not assume any growth in the terminal value. While we normalise working capital to zero and capex to equal depreciation, it still eliminates some element of the potential tail value. The DCF on a calculated WACC of 8.0% currently delivers a value of 241p.

Our new forecasts have QinetiQ currently trading on 12.9x FY19e P/E, at a significant discount to the average UK aerospace and defence multiple. However, the shorter-term, multiple-based valuation does not fully reflect the strategy change and the future growth opportunities and we see upside for the stock price. As the company grows market share and leverages international opportunities, the improved profitability should support a higher valuation multiple.