Robots are coming to a battlefield near you.
In the film Live and Let Die, James Bond escapes from a pool of sharks by using a Rolex watch which contains a rotary saw. Q Branch designed and built this gadget and Bond's creator, Ian Fleming, is thought to have based Q Branch upon the research arm of Britain's Ministry of Defence which, amongst other things, had invented both radar and carbon-fibre technology.
The MOD sold its research arm back in 2001 to a private consortium which included the American private equity firm, Carlyle Group. Today the company lives on as QinetiQ (LSE:QQ) and its business consists of designing and manufacturing military and security equipment, as well as providing support services and training, for the American, Australian and British governments and the private sector.
The increasing pressure on government budgets means that defence spending is likely to shrink in the next few years. However, the changing nature of the defence and security industry should favour QinetiQ over the medium term due to the nature of its business.
A Bit of History
For many QinetiQ is best known for the controversial incentives given to its management when it was first sold. In 2007 the National Audit Office dished out some heavy criticism concerning the original sale price.
QinetiQ floated on the stock market in February 2006 at 200p and since then its shares have largely traded below this price. QinetiQ's shares have returned some 30% less than the FTSE 250 index this year as its shares have failed to participate in this year's market rally due to investors' concerns regarding future defence spending.
Investors should note that the British Government retains a "special share" which gives it the right to veto actions which may be "contrary to the defence or security interests of the United Kingdom." QinetiQ is not going to become a takeover target unless the UK does!
QinetiQ organises its operations within four areas: Autonomy & Robotics, Sensors & Spectrum, Training & Simulation and Cyber Security & Resilience. QinetiQ makes a lot of interesting products as the company's key facts sheet explains.
Show Me The Money
QinetiQ's diluted earnings per share for 2008/09 was 14.3p and its dividend was 4.75p. This puts QinetiQ's shares on a fairly modest price-earnings ratio of 9.9, yielding about 3.3% net. In its final year as a private company, diluted earnings per share were 11.7p, so QinetiQ has managed to increase its diluted earnings per share over the last four years by about 22%.
It's no surprise that QinetiQ, being a former public sector firm, operates several final salary pension schemes and it's even less of a surprise that the schemes are in deficit. The 2009 balance sheet shows a net deficit of about £76 million compared with scheme assets of approximately £647 million. For comparison QinetiQ's pre-tax profits for 2009 were £130 million, which indicates that the pension scheme deficit is manageable but investors should keep a wary eye upon it.
The New Face Of Warfare
The nature of warfare is changing significantly as the days when two armies directly confronted each other on the battlefield appear to be coming to an end. Conflicts are evolving into what military analysts call "fourth generation warfare" (4GW) where states are attacked by non-state groups which increasingly have access to military-grade weapons.
We see 4GW today in countries such as Afghanistan, Colombia, Mexico, Nigeria and Pakistan as guerrilla movements, multinational terrorist groups and drug cartels are challenging nation states. 4GW combatants are typically funded by "charitable donations", extortion and the sale of drugs whilst some are in part funded by other states.
4GW techniques include terrorism and creating civil unrest. Dealing with 4GW requires the adoption of different techniques and equipment compared to conventional warfare.
Coping With Change
A big concern for investors in defence businesses is the outlook for military spending by governments. It can't be denied that there's going to be a bit of a squeeze in the global defence budget for a few years.
But the security threats aren't going away and 4GW is here to stay as technological improvements put ever more destructive firepower into the hands of disaffected groups. I'd argue that over the medium term QinetiQ's businesses are well placed to cope with the changing nature of warfare because 4GW requires very different equipment and techniques from the traditional methods of waging war. QinetiQ doesn't make "big ticket" items such as heavy tanks and battleships which are of limited use against 4GW combatants where security and reconnaissance take priority.
Robots: The Future Of War
QinetiQ is the world's largest supplier of military robotics with its best-known products being the tracked robot TALON which is used for both bomb disposal and reconnaissance. Over 2,800 bomb-disposal TALONs have been supplied to the American forces in Iraq and Afghanistan and they have saved numerous lives.
A considerable amount of the fighting in Afghanistan and across the border with Pakistan is being conducted by unmanned remote-controlled drones which engage enemy targets without putting their human operators in danger. The increasing demands placed on Western militaries to avoid taking casualties means that it is only a matter of time before armed robots are used in ground combat.
Robots provide a relatively easy way to take the battle to the other side without placing your people in danger. Whilst we are a long way from seeing something like Arnold Schwarzenegger's Terminator on the battlefields and in our streets, in the near future Western armies and security forces will use armed robots which are able to select their own targets.
QinetiQ should have a big chunk of that business.
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