Is QinetiQ a good dividend growth stock?

QinetiQ is the UK’s leading defence evaluation and research company. It’s listed in the FTSE 250, has paid a dividend for many years and operates in an industry that is usually quite defensive.

At a high level, QinetiQ has a good track record of growth, consistency, profitability and no debt. That all sounds good, but is QinetiQ a good dividend growth stock?

Table of Contents

• QinetiQ is not a simple business
• QinetiQ’s results over the last decade have mostly been good
• QinetiQ’s first ten years were a mess
• The recent period of success looks promising
• The company’s future plans seem optimistic but realistic
• QinetiQ has potential

QinetiQ is not a simple business

When you’re reviewing a company it’s always a good idea to start with a quick overview of what it does to make money. You can get an idea of what QinetiQ does from its website, but it might take a while because QinetiQ is not a simple business.

First of all, it operates in a wide range of areas from defence to energy to telecoms and even outer space. And it offers a wide range of services and products, from developing and testing military systems to training staff as well as developing advanced materials and technologies.

Personally I prefer simple businesses for several reasons. They take less time to analyse and any dividend model I come up with is likely to be more accurate. More importantly, narrowly focused specialist businesses tend to outperform generalists.

I wouldn’t call QinetiQ a generalist, but at this stage it certainly doesn’t look like a super-focused specialist.

QinetiQ’s results over the last decade have mostly been good

Now that we have a vague idea of what QinetiQ does it’s time to look at the all-important numbers:

After extracting QinetiQ’s numbers from SharePad and inserting them into this investment spreadsheet, a few things become clear:

• QinetiQ’s dividend has grown by 9% on average over the last decade
• Revenues and capital employed (equity plus debt) have increased at a similar rate
• Earnings have been more volatile, although there is a slight upward trend
• Before 2015 everything but the dividend was going in the wrong direction

The period before 2015 will need further investigating, but first I want to look at the company’s profitability because that can tell you a lot about a company’s competitive strength:

QinetiQ’s return on capital averaged an impressive 15% over the last decade, but as the chart above shows it has been far from consistent. Return on sales have been slightly less volatile, averaging 10% which is a solid if unspectacular result.

Another feature worth looking at is debt. In QinetiQ’s case it has no borrowings and only £27 million of lease liabilities, which is nothing for a company that routinely earns more than £100 million each year.

Unfortunately it does have other liabilities. Specifically it has a very large defined benefit pension scheme, which is common among previously government owned organisations (QinetiQ was once part of the Ministry of Defence).

QinetiQ’s pension scheme is in surplus (its assets are greater than its liabilities), but the scheme’s liabilities are almost £1.7 billion, which is about 17-times the company’s average earnings.

That’s a problem because I don’t like to invest where pension liabilities are more than ten-times average earnings. With larger pensions there a risk that any future deficit could be very expensive to reduce.

So now we’ve looked at QinetiQ’s business, its dividend record, growth, profitability and debt. Those are some of the most important things to check first, so now would be a good time to stop and think about whether or not it’s worth going any further with this analysis.

• Sanity Check: Should QinetiQ be added to your Blacklist now, or is it worthy of further investigation?

At this point I would say that while QinetiQ’s numbers are far from perfect, they’re not terrible either. Profitability is reasonable, it’s grown fairly consistently since 2015 and it doesn’t have any borrowings. It has a massive pension, but I would still like to look a bit deeper, and the obvious thing to look at next is that somewhat worrying pre-2015 period.

QinetiQ’s first ten years were a mess

QinetiQ started life in 2001 when the Ministry of Defence (MOD) broke up DERA (the Defence Evaluation and Research Agency) and spun part of it off as a private company.

20 years later QinetiQ’s relationship with the MOD is still extremely important. In 2003 it signed a 25-year Long-Term Partnership Agreement (LTPA) with the MOD to provide test and evaluation services covering a wide variety of military and civil systems. This includes testing and evaluating aircraft systems, warheads, underwater weapons, night vision devices and much more.

Following its transformation into a private company, QinetiQ launched itself into the commercial world with an acquisition-driven growth strategy mostly focused on international expansion.

This strategy was pursued aggressively and during its first decade QinetiQ spent far more on acquisitions than it made in profit. Unfortunately that is usually a very bad idea.

This period of excessive debt-fuelled acquisitions turned QinetiQ into an unfocussed and poorly integrated business with far too much debt. When the Global Financial Crisis hit in 2009, QinetiQ had borrowings of almost £800 million compared to average earnings of just £54 million.

That’s gave it a debt to average earnings ratio of 16. For context, in almost all cases I think anything over 5-times is excessive.

The solution to these self-inflicted problems was obvious; bring in a new Chairman and a new CEO armed with a turnaround strategy.

The turnaround strategy began in 2010 and it ticked all the right boxes:

• Focus on QinetiQ’s core strengths and competitive advantages
• Simplify the business
• Develop a more commercially oriented customer-focused culture
• Reduce costs, improve profitability and sell off weak acquisitions to pay down debt
• Fully integrate the remaining acquisitions and build a unified company following best practice across the group

This is standard fair for companies that have grown too unfocused, bloated and overindebted thanks to excessive debt-fuelled acquisitions.

Initially this was a two-year turnaround plan, but by 2013 the previously acquired US services business was struggling in a post-financial crisis world. This resulted in a £256 million impairment in the value of that business and a strategic review to work out what to do with it.

In 2014 the US services business was sold and the proceeds were used to reduce QinetiQ’s pension deficit, pay down debt and buy back shares. This more or less marked the end of the turnaround period, leaving the company significantly more focused and effectively free of debt.

This period was also marked by the arrival of a new post-turnaround CEO, focused on taking the now much more competitive QinetiQ forward into a hopefully brighter future.

So now we understand why QinetiQ had a very large loss in 2013 (it was caused by the write-down of the US business) and why revenues fell off a cliff in 2014 (the US services business was sold). To some extent this is ancient history, but it’s important to know for context.

More recently QinetiQ has been consistently successful, so let’s look at this successful period and then make another go/no decision on whether to take the next step and build a dividend model.

The recent period of success looks promising

QinetiQ’s revenues, earnings and dividends per share have almost doubled since the company was turned around. Admittedly this is growth from a depressed starting point, but clearly the company has been doing something right.

Most of this growth has been driven by international expansion into the US and Australia, with a significant amount of that growth coming from acquisitions. Fortunately these acquisitions are not on the same scale as the 2003-2010 period, but this reversion back to acquisition-driven growth is certainly something to be aware of.

More generally, the improvements made to QinetiQ from 2010 to 2015 seem to have worked. It is now a more focused business with a strong balance sheet and what appears to be a much improved cultural and operational base.

In short, this period of success has been mostly driven by military organisations around the world that need to improve their capabilities and reduce costs. With its improved capabilities, QinetiQ has been successfully competing for contracts arising from both those trends.

The company’s future plans seem optimistic but realistic

In a recent presentation to investors, the CEO outlined QinetiQ’s plans to grow by at least 60% over the next five years, with international revenues planned to grow even faster to become more than 50% of the group’s total by 2026.

Some back of the envelope calculations suggest that this is just about doable without taking on excessive debt. QinetiQ’s 15% average return on capital and small dividend means the company could drive growth of around 10% per year by reinvesting most of its earnings.

You can think of this as being like a savings account with a 15% (variable) interest rate. You could grow the account by 10% per year (which is a bare minimum if you want it to grow by 60% in five years) if you reinvest most of the interest back into the account each year and only draw a small income (dividend).

Of course, this will only happen if QinetiQ can find enough customers and contracts to drive revenue and profit at double digit rates. But it has managed to do that over the last few years so these plans are not completely delusional.

So now we’ve covered the company’s past operational and financial results and looked very briefly at its current situation and future plans. It’s time for another sanity check:

• Sanity Check 2: Is it worth digging deeper to estimate QinetiQ’s future dividends and intrinsic value?

The short answer is no, I don’t think it is; or at least I don’t think it is yet. Here’s why:

QinetiQ has potential

QinetiQ has the potential to be a good dividend growth stock at the right price, but there are a few issues which mean it doesn’t make sense, at least to me, to analyse the company in more detail. The main issues are:

1. QinetiQ has only operated as a profit-seeking company for 20 years, which for a dividend growth stock isn’t very long.
2. It spent most of its first ten years on a debt fuelled acquisition spree, leaving the company poorly integrated and overindebted.
3. It then spent five years fixing most of the self-inflicted problems created during the first ten years.
4. In the last five years the company has performed well, but five years is far too short a period to draw any conclusions from.
5. There are other issues I’m not too keen on, such as its very large defined benefit pension scheme and its reliance on large contracts and one very large customer (the MOD).

In other words, QinetiQ has performed well but only during the last five years. As a long-term investors I only want to invest in companies that have been successful over decades, and that isn’t QinetiQ (yet).

However, I don’t think the company is a basket case or fundamentally a bad business. I would be happy to invest at the right price but only after QinetiQ proven itself capable of producing solid results over a more than a decade.

On that basis I’m going to add QinetiQ to my Blacklist. This is a list of companies that I don’t want to invest in today, but might do in the future. I don’t think much is going to change my viewpoint over the next five years, so I’ll make a note to review QinetiQ again in 2026 to see how things have progressed.