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A cash-rich FTSE 250 stock I’d buy alongside the BAE share price

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I’ve always considered the defence business a safe and attractive long-term investment target, and I think valuations are looking attractive right now.

Good start

QinetiQ Group (LSE: QQ) shares are up 3% as I write after the defence technology firm released a Q1 update. With “a good start to the new financial year with strong operational performance,” the firm’s revenue under contract is up to 85%, from 74% in April.

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QinetiQ has expanded and strengthened a number of its contracts with the MoD, and reckons it’s on track to meet its prior expectations for the year to March 2020, as expounded with FY 2019 results released in May. Back then, the company said it expected to record mid-single-digit revenue growth in 2020, after having “delivered a third successive year of organic revenue growth and an organic increase to operating profit,” and the latest update reiterates that.

I can’t help suspecting that current forecasts are a little too bearish, as they suggest a 3% drop in EPS this year, followed by a modest 2% move upwards in 2020. And the stock’s P/E valuation of around the 14 mark looks attractive, especially when we consider that QinetiQ was sitting on net cash at its last year-end, and does not shoulder net debt as many companies on similar valuations do.

Dividends are part of the picture, and though they’d deliver a yield of only 2.5% on the latest forecasts, cover by earnings would come in around 2.7 times. And dividends have been steadily progressive — the 7p per share on the cards for the current year would take the annual payment up 30% over five years, and that’s rising at more than twice the UK inflation rate over that period.

If you do invest in QinetiQ, I think you’ll have to be prepared for some volatility. As well as the industry being cyclical, the multi-year nature of many defence contracts can make year-by-year earnings look like too short a timescale to provide an accurate picture.

Short-term weakness

BAE Systems (LSE: BA) shares might look like they’re on a cheaper valuation compared to QinetiQ’s, with a more modest forward P/E of 11.6 this year, dropping to 11 for 2020. But one difference is that BAE carries net debt, which stood at £904m at its last year-end.

Taking that into consideration, I think it’s harder to separate the valuations of the two companies, though BAE’s has fallen in recent years. Despite steady and slowly rising earnings, share price weakness has dropped the stock’s P/E from 14.7 in 2016 — and I thought that was an attractive valuation at the time. Over the same period, dividends have been growing steadily and are forecast to yield 4.4% this year (and 4.6% next), though cover is a bit less than QinetiQ’s at around two times.

Part of the weakness of the past couple of years has surely been down to uncertainty over BAE’s long-term association with Saudi Arabia, which has traditionally been one of the UK’s biggest defence customers.

But I see that as just part of the cyclical nature of the business, based on long-term global politics. The defence industry is an unfortunately necessary one, and one that I think will continue to be profitable for investors for many years.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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