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The FTSE 250’s QinetiQ (LSE: QQ) is a world leader in evaluating, integrating and securing military mission-critical platforms, systems, information, and assets.
Following a 17 March trading update, the stock has fallen 26% in value.
However, given two new contracts signed recently and strong earnings growth prospects, this leaves it looking a bargain to me.
How does the business look?
Its March trading update highlighted that short-term delays are expected in some contracts, due to US and UK spending reviews.
Consequently, the firm now expects 2025 organic sales growth of around 2% compared to the previous high-single-digit forecast. It also expects to take a £140m goodwill impairment charge and £35m-40m in other charges.
A risk remains that such contract delays could continue for longer. Another is that any failure in its key products could be costly to fix and could damage its reputation.
However, on 6 May it announced two major new deals.
The first is a £160m contract from the UK’s Defence Science and Technology Laboratory to lead the Weapons Sector Research Framework for another two years.
The second is from the US Army for an undisclosed amount to provide survivability solutions for its long-range assault aircraft.
As it stands, analysts forecast that its earnings will increase 30% every year to the end of 2027. And it is this growth that ultimately drives a firm’s share price and dividends higher over time.
Can it benefit from rising defence spending?
The US’s 2 May withdrawal from peace negotiations between Russia and Ukraine puts that conflict back to square one, in my view. I also believe that even if Russia finally agrees to some settlement it will continue to test NATO’s eastern flank.
Meanwhile, US President Donald Trump says he expects NATO members to spend at least 5% of their gross domestic product (GDP) on defence. Last year they averaged 2%.
As a result of these factors, the European Commission announced in March the creation of a new €800bn (£670bn) defence fund. Germany subsequently exempted defence spending from its federal debt rules, freeing up unlimited euros of additional funding.
The UK government has also brought forward plans to increase defence spending to 2.5% of GDP by 2027. It also stated it wants to reach 3% during the next parliament.
I think that with its ongoing work with NATO countries, QinetiQ looks well placed to benefit from these spending increases.
How undervalued are the shares now?
QinetiQ’s price-to-earnings ratio of 15.8 is bottom of its peer group, which averages 25.4, so it is very undervalued here. These firms comprise Babcock International at 22, Rolls-Royce at 26, Chemring at 26.2, and BAE Systems at 27.3.
I ran a discounted cash flow analysis to find out what these numbers mean in share price terms. This shows QintetiQ shares are 54% undervalued at their present price of £4.15.
Therefore, their fair value is £9.02, although market vagaries could move them lower or higher.
Will I buy the stock?
I already own shares in BAE Systems and Rolls-Royce so any more defence sector stocks would unbalance my portfolio.
However, based on its strong earnings growth prospects that should drive the share price much higher over time in my view, I think it is well worth other investors’ consideration.
