The FTSE 250 to me is a great place to try to identify tomorrow’s big stock stars today.
I think defence systems and technology firm QinetiQ (LSE: QQ) could well be one of these.
Better still is that it looks very undervalued both compared to its competitors and to analysts’ future cash flow projections
What does it do?
The firm is a world leader in the evaluation, integration and securing of military mission-critical platforms, systems, information and assets.
It was formed in 2001 when the UK’s Ministry of Defence (MoD) split its Defence Evaluation and Research Agency.
The smaller part was rebranded the Defence Science & Technology Laboratory and the larger part was renamed QinetiQ.
Stellar growth since 2022
From 24 February 2022 when Russia invaded Ukraine, QinetiQ’s share price has risen 83%.
This is unsurprising as its history made it extremely well-placed to benefit from MoD and other orders.
In 2003 it signed a 25-year partnering agreement with the Ministry worth up to £5.6bn over that period. 2019 saw a further £1.3bn long-term agreement with it. Later that year, QinetiQ was also named as the Ministry’s key supplier on its new £1.2bn Digital and IT Professional Services framework.
By the time of its full-year 2024 results released on 12 June, revenue had jumped 21% year on year — to £1.912bn. This was ahead of expectations, as was underlying operating profit rising 20%, to £215.2m.
What’s the growth outlook from here?
Given the still severe global security threat, big orders have continued rolling into QinetiQ.
August saw it awarded a €284m Aerial Training Services contract for Germany’s armed forces. In September, it received an open-ended contract for advanced technology to be installed on the US Navy’s next Ford-class aircraft carrier.
In late October, it entered the US market as a prime contractor for the first time to provide aerial target systems to the US Army.
The principal risk I see to the firm’s earnings growth is any major fault in one of its products. This could prove costly to remedy and could damage its reputation longer term.
However, as it stands, analysts forecast that QinetiQ’s earnings will increase 10.7% a year to end-2027.
How undervalued are the shares?
To ascertain value, I always begin by looking at key stock valuation measures that I have found most useful over the years.
On the price-to-earnings ratio, QinetiQ trades at just 18.7. The average of its competitors in the sector is 21.5, so it is cheap on that basis.
The same is true of its 2.8 price-to-book ratio against its peer group average of 4.1. And this is also the case on the price-to-sales (P/S) ratio. QinetiQ trades at a P/S of just 1.4 against a 1.7 competitor group average.
To work out what this means in share price terms, I ran a discounted cash flow (DCF) analysis. This shows QinetiQ shares are 49% undervalued at their current £4.55. Therefore, a fair price is £8.92, although they may go lower or higher than that due to market unpredictability.
So, while there are many great bargains in the FTSE 250, this may not be the best but certainly looks to be one of them.
Consequently, if I did not already own another stock in the defence sector (BAE Systems), I would buy this one right now.
