Investment Idea - Qinetiq Group (QQ.)

Qinetiq Group

Ticker: QQ.

Sector: Aerospace & Defence

Listing: LSE

Introduction

Qinetiq Group produces equipment for defence organisations, security agencies and intelligence services. Each product is designed to provides solutions to their clients' problems. It is also capable to produce a wide variety of equipment ranging from asset tracking to unmanned aerial vehicles. It has established presence in the UK, US, Europe and Australia.

Analysis

The firm has made a pre-tax loss of £66.1 million and loss after tax of £63.3 million for the 2010 financial year ending 31/03/2010. This is because the US and UK governments delayed orders for new equipment due to their huge budget deficits resulting from the financial crisis. Once divestment, disposal, impairment, reorganisation and amortisation costs from acquisitions are added to the loss after tax, the profit after tax is £72.8 million. However, the P/E is calculated using EPS of -9.3p (using loss of £63.3 million) is -13.25. P/E after the latter items added is 11.1. However, the EPS has gone up over the past four years before that latest results.

The cases are the same for dividend per share and dividend yield respectively.

Overall turnover has increased by 4.5% compared to the previous year with Mission Solutions and Systems Engineering contributing to the increase. The turnover from these businesses increased by 22.5% and 11.8% respectively with Technology Solutions QNA suffering a decrease of 25.7%. Funded orders have gone up overall by 3% which is contributed by Mission Solutions. This business had funded orders increase by 15.3% while the latter two decreased by 6.2% and 2.6% respectively. Net debt went down by 15% due to strong cash flow from its businesses and the weakening pound (since most of the debt is in US dollars).

There has been a change of management with the new chairman and CEO with effect on 1/3/2010 and 16/11/2009 respectively. Two new non-executive independent directors joined the board on 10/4/2010 with one stepped down on 4/8/2009.

A review, which is taken from (1), of the whole firm had taken place by the new CEO which has led to the following conclusions:

• QinetiQ's rapid acquisition-based growth and its efforts to find applications for its intellectual property in new industrial markets have not created value for investors to date. The decision to enter the US market was sound, but returns as yet have been lower than expected and the Group's balance sheet has become over-stretched. Internally, the organisation has become fragmented and overly complex and its processes weak. Insufficient strategic focus and transparency have led to a high level of cost and loss-making activity. These issues, combined with external market conditions - which are likely to remain difficult while the UK and US Governments develop policies to address their spending and deficit challenges - have caused the Group's performance over recent years to fall below its potential
• QinetiQ predominantly comprises service businesses, positioned to advise and support customers to achieve efficiency and effectiveness in their national markets. These businesses are based on - and continue to refresh - the deep domain and technical expertise of QinetiQ's people in the aerospace, defence and security sectors, and are capable of providing relatively stable and predictable income streams
• The Group also possesses a smaller proportion of product businesses with differentiated technology offerings which have been developed in-house. These activities are capable of global application, but necessarily have a less predictable pattern of revenue generation and have been managed with insufficient commercialisation or sharing of intellectual property between the UK and US businesses.

In order to strengthen its foundations and build a future path to sustainable and profitable growth, QinetiQ must now:

• Set a clear direction which reduces the span of focus and matches both customer needs and core QinetiQ strength
• Simplify and align structure with this direction, removing unnecessary layers
• Increase transparency and control through all levels
• Upgrade leadership to ensure a commercial, value-oriented mindset
• Create a strong performance culture of both accountability and empowerment in its people
• Establish a lower level of cost base to enable future competitiveness
• Ensure a more unified approach Group-wide to exploit key opportunities
• Drive for cash generation to strengthen the Group's balance sheet

The firms goals, taken from (1), are:

• Moving to a new structure comprising 3 divisions: US Services, UK Services and Global Products, to ensure efficient leverage of expertise, technology, customer relationships and business development skills
• Introducing standardised management reporting and regular reviews of key business drivers such as talent, innovation, cost reduction and portfolio focus
• Assessing the top leaders Group-wide, setting targets for performance and behaviours which reflect Group objectives for profit and cash, and providing appropriate incentives
• Installing a Group-wide performance management system and increasing communication and engagement with employees to maximise their contribution, underpinned by a tracked and measured productivity programme
• Rigorously examining business processes, key supplier contracts and, in the UK, legacy employee terms and conditions, to remove structural cost from the business to ensure competitiveness and enable investment in key opportunities
• Introducing a unified QinetiQ approach which leverages existing assets to capitalise on global opportunities [this refers to imposing a unified corporate culture across the firm]
• Eliminating loss-making activities and driving cash generation, including tight measurement of working capital, to reduce the gearing ratio to a target of below 2x+
• Suspending payment of dividends on QinetiQ's Ordinary Shares for 12 months, with the intention of paying a final dividend with respect to the financial year ending 31 March 2011.

This indicates that the new members of the management have a clear direction they want the company to take. This in turn will lead to the firm producing good returns and value for it's shareholders in the long term.

Financial ratios as at the close of 7/6/2010 (2):

The financial ratios of all companies in the same sector as at the close of 7/6/2010 (2):

Using the contrarian strategy, the stock satisfies most of the criteria. In this case I will use P/BV as the core ratio. This is because:

1. The P/BV and P/CF are below sector average and within the two lowest quintiles. The only exception is P/E since the firm has made a loss.
2. Unfortunately, the dividend yield is below sector average since the firm has decided to suspend dividend payment for one year. However, it intends to pay a final dividend at the end of the current financial year.
3. Dividend cover of 7.03 is greater than the desirable limit therefore the firm can sustain and increase above average yields once dividend payments resume.
4. The current ratio 1.36 is above the minimum amount although it is not desirable.
5. With P/S of 0.5, it is below sector average and very cheap compared to it's peers. With a prospective PEG of 0.8 it is good enough for a firm with market capitalisation greater than £300m even though it is above desirable limit of 0.66.
6. Obviously the EPS growth is below that of FTSE100, which is about 5.1%.
7. Future earnings growth forecasts do lean on the very conservative side and are unlikely to go down. Note that the images below are taken from Digital Look for comparison purposes.

Conclusion

This stock is a good buying the long term provided that the new members of the management perform better than expected

Note

I will not be responsible for any losses incurred by investors through investing in this stock. Investing in the stock market may result in not getting their initial amount back.

Full disclosure: Long QQ.

Source:

1. London Stock Exchange - Qinetiq Group plc Preliminary Results for year ended 31 March 2010 retrieved on 11/6/2010.
2. Digital Look retrieved 7/6/2010.