QinetiQ Group — Momentum building

The FY17 results were the first opportunity for new CFO David Smith (ex Rolls-Royce) to present to the market. He and CEO Steve Wadey delivered a set of numbers that showed progress in the right direction and building underlying momentum.

EMEA Services revenue was flat on an organic basis at £613.5m with performance across all business units described as “broadly consistent”. Underlying operating profit reduced to £92.7m (FY16: £93.8m) resulting in a margin of 15.1%. As previously mentioned it was boosted by a £5.2m credit. The company attributes 80bps of margin decline (£4.6m of operating profit) to the lower baseline rate for single-source contracts

Management reiterated its guidance that EMEA Services is facing margin headwinds because the baseline profit rate for new and renewed single-source contracts signed in FY18 will fall by 149bp from the 8.95% in FY16/17 to 7.46% in FY17/18. This rate is set by the Single Source Regulations Office (SSRO) and is applied to all MOD contracts that are uncompeted. 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. 76% of EMEA Services revenue (FY16: 74%) 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 Long Term Partnering Agreement (LTPA) was contracted at the 2017 profit rate. This is discussed further in our update note published in March 2017.

EMEA Services delivered 78% of group revenue in FY17 (FY16: 82%) so it is by far and away QinetiQ’s most dominant division. However, it is the one facing structural challenges because the UK MOD, its primary customer, is changing the way it does business. The MOD is becoming more commercial so the procurement regime is becoming tougher for industry. Historically, UK defence procurement has been chaotic, slow moving and unpredictable. QinetiQ and others therefore see the changes as positive in the long term, even if it means they suffer some near-term margin headwinds.

QinetiQ’s EMEA Services is responding in two ways: innovating and internationalising. In the UK QinetiQ is aiming to become more reactive and responsive, which it believes will enable it to take on an even bigger role in supporting UK defence testing and evaluation. It is modernising facilities, for example aircrew training facilities, to enable growth opportunities, and it is bringing together the supply chain to offer a joined up solution. For example, it has entered into a teaming agreement with Thales and Textron to provide innovative, cost-effective and technologically advanced tri-service training using a Textron Scorpion jet equipped with Thales and QinetiQ sensors as part of the Air Support to the Defence Operational Training (ASDOT) programme.

Outside the UK, EMEA Services is constantly looking for growth opportunities. A new international business was established at the beginning of FY17, representing 6% of group revenue. Order intake in Australia grew, QinetiQ Canada achieved its first home win to provide advice to the Royal Canadian Coastguard and a new QinetiQ office is being established in Malaysia to support sales and marketing in South-East Asia.

EMEA Services orders, excluding the £1bn LTPA amendment, grew 5% to £520.9m (FY16: £495.4m). Management states that 79% of its forecast EMEA Services’ FY18 revenue was under contract at the beginning of the year, compared with 77% at the beginning of the prior year. Its book to bill ratio improved from 1.2x in FY16 to 1.3x in FY17.

Global Products has shorter order cycles than EMEA Services so can have a lumpier revenue profile. In FY17 revenue was up 8% due to higher product shipments for the new US aircraft carriers, robotics and growth in OptaSense.

In FY17, 8% of QinetiQ’s group revenue came from the US Department of Defense (DoD). However, Global Products is showing encouraging signs that it is gaining increasing traction in the US. For example, it is currently bidding on a number of US robotics and autonomy competitions, two of which are likely to be awarded this year. QinetiQ’s specialisation in unmanned systems plays well to the US DoD’s focus on autonomy. The recent FY18 US defence budget requested 10% more for R&D than the Obama administration (as shown in Exhibit 1), much of which is expected to be spent on developing autonomous systems.

The OptaSense business is also performing well and showing interesting potential in commercial markets. Growth last year was driven principally by continued strength in its pipeline sensing business and some recovery in the North American oil and gas market. It has recently signed an agreement with Siemens to pursue new opportunities in the rail sector.

Integration of the Target Systems business acquired from Meggitt in December 2016 is progressing well and is expected to start delivery good growth. CEO Steve Wadey speaks with conviction about how as a former customer, he knows that the end-to-end targeting solution that QinetiQ can now provide is in high demand.

This is the first time management has issued guidance for FY18, and it is maintaining expectations for “steady progress excluding the non-recurring benefits in FY17”. EMEA Services is expected to deliver modest revenue growth with a continued headwind to operating margins due to the lower baseline profit rate for single-source contracts. The Global Products division is expected to continue growing in FY18. Cash flow in FY18 will reflect increasing investment in the LTPA with £80-100m of capital expenditure.

Our forecasts for FY18 remain broadly unchanged. The only notable change in Exhibit 2 is our dividend forecast. We had previously forecast a 10% rate of growth, which was unnecessarily ahead of management’s guidance for a progressive dividend policy. We now forecast 6% growth in FY18. Exhibit 3 introduces our FY19 forecasts for the first time.

QinetiQ is a business in transformation. CEO Steve Wadey said that he believes defence companies have two options in the changing defence environment: either sit back and try to defend the status quo of the past, or adapt and be part of shaping the future. He is choosing to meet the “challenges and opportunities head on”. QinetiQ has always been seen as technologically innovative, but management identifies a crucial nuance in that not only is it applying its innovative expertise to the technology but also to creating original and experimental customer-focused solutions and delivery. In QinetiQ’s own words, “turning creativity and innovation into tangible value for our customers increasingly requires innovative thinking across the broader range of activities.”

Initial evidence of this new way of operating was given in the recent agreement with Rockwell Collins to collaborate on the next generation of Navigation Satellite System (GNSS) receivers. Rockwell Collins is the global leader in secure military GPS receivers and QinetiQ has critical satellite navigation technologies that enable the development of multi constellation solutions. It is very significant that Rockwell Collins, one of the defence industry giants in the US, has chosen to partner with QinetiQ.

For the past year QinetiQ has been operating a campaign strategy with the aim of maximising opportunities for products across customers. There are reported to be more than 30 growth campaigns, all of which are worth tens of millions of pounds, and some are reported to be worth hundreds of millions of pounds. We expect that it will be three to five years before this strategy delivers meaningful revenue growth; however, if it is successful there should be an increase in order intake, notable contract wins and continued organic growth.

QinetiQ started FY17 with net cash of £274.5m. Operating cash flow of £117.7m covered capex of £32.9m and acquisition outlays of £65.7m (on Meggitt Target Systems and Rubikon). Share buybacks of £48.1m and dividend payments of £33.4m led to end-March 2017 year net cash of £221.9m. Management has guided that capex will rise to between £80-100m in FY18 in order to invest in facilities for the LTPA (for further details see our March note – we are modelling £100m). It is also expects a partial unwinding of net working capital. Company cash contributions to the pension plan are £13m per year until 31 March 2018. We therefore forecast £198.6m of cash at end FY18, leaving QinetiQ with a strong balance sheet. Its stated capital allocation priorities are:

QinetiQ is trading on 17.1x FY19e EPS, placing it in line with it aerospace and defence peers, which are trading on an average of 17.3x. It is also trading in line on an FY19e EV/EBITDA of 9.2x compared to a sector average of 9.7x. QinetiQ has less US exposure than most defence stocks so has not benefited from the wave of optimism surrounding US defence; however, the growth in FY17 came from North America so this perception of the stock may be outdated.