This FTSE 250 defence stock looks like a hidden growth gem to me

With countries hiking defence spending as the world grows more insecure, this FTSE 250 firm has seen surging orders and it looks undervalued to me.

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FTSE 250 defence firm QinetiQ (LSE: QQ) looks poised for further growth as the world becomes more dangerous.

There appears no end in sight for the Russia-Ukraine conflict. Tensions in the Middle East have risen after Iran directly attacked Israel for the first time. And the US believes China’s President Xi Jinping ordered his military to be ready to invade Taiwan by 2027.

They say hindsight is a wonderful thing, but as an investor, foresight is better. Since Russia invaded Ukraine on 24 February 2022, many first-tier FTSE 100 defence stocks have rocketed in value.

As the global security situation worsens, much as we do not want this, they should continue to do well. But it is the second-tier defence stocks in the FTSE 250 that may see the biggest growth from now.

Booming defence budgets

At February’s Munich Security Conference, NATO members vowed to increase their defence spending to at least 2% of gross domestic product (GDP).

This followed US presidential hopeful Donald Trump’s comments that his administration would not protect NATO members that failed to meet the target.

Germany’s IFO Institute has calculated that €1.8trn must be spent to compensate for 30 years of under-investment in European defence.

And 22 April saw the UK pledge an extra £75bn to be spent by 2023 to push its defence spending up to 2.5% of GDP.

A company formed out of the MoD

I cannot think of a FTSE 250 company better placed to receive such orders than QinetiQ.

Its very foundation in July 2001 came from the UK’s Ministry of Defence (MoD) splitting its Defence Evaluation and Research Agency. The smaller portion was rebranded as the Defence Science & Technology Laboratory, and the bigger portion became QinetiQ.

In 2003, it signed a 25-year agreement to provide the MoD with testing and evaluation technology for military and civilian use.

It also provides such services to other institutions and companies, including in the US through its Avantus operation.

A growing business

One risk in the stock is a failure in any of its key products, which would be very costly. Another is that the world suddenly becomes more peaceful, much as it would be great were this to happen.

However, its 16 January Q3 trading update showed its order backlog had increased from around £2.97bn in the same period the previous year to £3.13bn at that point.

It is on track to deliver 2024 revenue of £1.871bn (against 2023’s £1.58bn) and operating profit of £210m (versus £153m last year).

5 March saw it announce it had won a key supplier role for the MoD’s £1.2bn Digital and IT Professional Services framework.

QinetiQ now projects a near-doubling in its revenues to £3bn over the next four years. This follows seven straight years of growth.

At a price-to-earnings (P/E) valuation of just 18 against a peer group average of 35.3, it also looks very undervalued.

discounted cash flow analysis shows it to be around 47% lower than its fair value should be. So a fair price would be around £6.51, although this does not guarantee it will ever reach that level.

This undervaluation is one reason I would buy the stock if I did not already own BAE Systems’ shares. The other reason is what I see as its exceptional growth potential. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Simon Watkins has positions in BAE Systems. The Motley Fool UK has recommended BAE Systems and QinetiQ Group Plc. 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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