Is this FTSE 250 gem the next big thing in defence sector shares?

This FTSE 250 defence firm was founded by the MoD, has seen its order book and profits swell, and is still very undervalued.

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FTSE 250 firm QinetiQ (LSE: QQ) is a key player in testing and evaluation technology for military and civilian use.

It was formed in July 2001 when the UK’s Ministry of Defence (MoD) split 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 its technology. It also provides its services to other institutions and companies, including in the US through its Avantus business.

Soaring revenues and profits

None of us want to live in an increasingly dangerous world, but it looks like that is what we have. The Russia-Ukraine conflict rumbles on, as does the Israel-Hamas War, and China continues to threaten Taiwanese sovereignty.

In response to the growing threats, the UK recently committed to defence spending of at least 2.5% of its GDP each year by 2030. Just before this, NATO members pledged to increase theirs to 2%+ of their GDP as well.

Against this backdrop, QinetiQ’s 2024 results released on 12 June saw revenue jumping 21% year on year to £1.912bn from £1.58bn. This was ahead of expectations, as was underlying operating profit rising 20% to £215.2m from £178.9m.

Its order book increased to £1.74bn from £1.72bn, and underlying earnings per share rose 11% — to 29.4p from 26.5p.

Strong growth outlook

One risk in the firm is a failure in any of its key products, which can prove costly. Another is that the world suddenly becomes less dangerous, much as we would like to see that.

However, the firm expects high-single-digit organic revenue growth in 2025. It also forecasts around £2.4bn organic revenue at around a 12% margin by 2027.

Consensus analysts’ estimates are that its earnings will grow by 10.7% a year to the end of 2027. Return on equity is forecast to be 17.6% by that time.

All this provides a solid basis for QinetiQ’s promised £100m share buyback this year, in my view. These tend to be supportive of share price gains.

Additionally beneficial for shareholders was the 7% increase in the full-year dividend.

Is there value left in the share price?

QinetiQ’s shares currently trade at a price-to-earnings ratio (P/E) of just 18 against a peer group average of 38.

discounted cash flow analysis shows it to be around 36% undervalued at its current price of £4.50. So, a fair price would be around £7.03.

There is no guarantee it will reach that level, of course. But it does underline to me that it still looks very good value, despite share price rise over the past year.

Will I buy it?

I already have shares in BAE Systems that I bought a long time ago at a much lower price. Buying another company in the same sector would disrupt the risk-reward balance of my portfolio, which I will not do.

However, if I did not have this position I would absolutely buy QinetiQ shares today. In my view, it has excellent growth prospects, which should power share price gains.

These should also drive dividend payments higher over time, I think.

In short, I think this firm could well be the next big thing in defence sector shares.

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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