QinetiQ (LSE: QQ) shares fell as much as 9.8% to 247.4p in the first hour of trading today after the defence and security technology group issued a Q1 update ahead of its AGM.
It said some customer contract award decisions in one of its divisions had been deferred or delayed. This seems to have spooked the market, despite management reiterating previous guidance on the group’s revenue outlook for its financial year ending March 2018.
After this morning’s price drop, the shares are on sale at more than 20% below their 52-week high of 319.7p.
Management confidence
In addition to the near-term unpredictability of order intake, QinetiQ faces some pressure on operating margins due to a lower baseline profit rate for single source contracts. This is reflected in analysts’ forecasts of a 5% fall in earnings this year.
However, the dividend is expected to rise by 5% (covered a healthy 2.7 times by earnings), giving a prospective yield of 2.5% and a clear signal of management’s confidence in the longer-term outlook for the group. This confidence is underpinned by continuing progress on delivering its strategy of improving customer focus and competitiveness.
Opportune time to buy
On the face of it, QinetiQ’s current-year prospective price-to-earnings (P/E) ratio of 14.5 looks pricey for a business with no near-term growth. But in addition to the longer-term potential, the strength of the company’s balance sheet persuades me that there’s greater value here than on first sight.
At its last year-end, QinetiQ had net cash of £222m (37.3p a share), representing 16% of its £1.4bn market capitalisation. This not only drops the P/E of 14.5 to a cash-adjusted 12.3, but also gives the company firepower to make earnings-enhancing acquisitions.
With the market focusing on immediate earnings prospects and the shares more than 20% off their 52-week high, I believe now is an opportune time to buy a slice of this FTSE 250 business.
A blue-chip buy
I also rate QinetiQ’s larger defence-sector peer BAE Systems (LSE: BA) as an attractive buy, with the stock at a 10% discount to its 52-week high. The £20bn FTSE 100 behemoth said in May that it had started the year with good momentum building on a strong operational performance in 2016. It also said there is an improving outlook for defence budgets in a number of its markets for 2017 and beyond.
Management reiterated guidance of a 5% to 10% increase on 2016’s 40.3p earnings per share, assuming an average $1.25 to the pound exchange rate in 2017. The City consensus forecast of 43.8p (+8.7%) puts the company on a P/E of 14 at a current share price of 613p, falling to 13 in 2018. Meanwhile, dividend forecasts give a yield of 3.6%, rising to 3.7%.
BAE doesn’t boast the net cash position of QinetiQ but its debt is relatively low for a FTSE 100 company. Net gearing (net debt divided by shareholder’s funds) is 45%, while well above 50% is not uncommon in the blue-chip index.
