There were a number of factors that we believe influenced the market at the time of QinetiQ’s H118 report and we address some of them here. Overall, we believe that QinetiQ’s strategy is to build for the medium-term a platform to supply a broad range of technical capabilities to address the global defence, security and critical infrastructure market.
UK defence market backdrop
The UK defence market has been under considerable scrutiny over recent months, not least with ongoing budgetary pressure concerns and a National Security Capability Review underway. In addition, the change of Defence Secretary earlier this month has also been stated, by some market participants, to have brought additional uncertainty. It is worth highlighting commentary from Ultra Electronics’ trading statement this month:
“The UK market has been difficult and has become increasingly so in the second half. There are mounting pressures in the funding of UK defence programmes and this has resulted in the UK MOD pausing, cancelling or delaying numerous programmes. Within the last few weeks a number of our UK orders budgeted for 2017 have been affected.”
The sector has understandably been concerned, not least with senior management changes and the perceived risk of further order delay or cancellation. With c 65% exposure to the UK MOD, it is understandable that investors want to understand developments here.
We believe that QinetiQ is continuing to manage things within its control and adapting swiftly to the change in UK MOD procurement that we described earlier. Key to this is longer-term contracts and delivering savings to the UK MOD while reducing margin headwinds. In addition, building the international portfolio from 26% of the group today to closer to half in the medium term will help QinetiQ to reduce its dependence on the UK MOD while leveraging the growth that overseas markets represent. There is also a potential to drive operating margins, as we will discuss later, as international business typically delivers a higher margin.
Order backdrop
We understand the importance of order book development for QinetiQ, not least as an indicator of success for the campaign strategy for the new management team. This is not just a question of overall quantum but more a focus on mix with a growing proportion of longer-term contracts. At the FY17 results, we said:
“CEO Steve Wadey has stated that most of the campaigns will take three to five years to have a meaningful impact on revenue. Therefore, in the next two years we would hope to see a number of important contract wins, a growing order book and continued organic revenue growth.” (Edison update report, Momentum Building, published on 5 June 2017)
Taking these items in turn, we described the H118 order performance as stable. While there was some anticipated impact from shorter-term R&D related weakness in the UK, we were encouraged to see new contracts across different areas of the group and order success at the acquisitions. In EMEA Services, the non-repeat of the £109m, 11-year Naval Combat System Integration Support Services (NCSISS) contract exaggerated the y-o-y step down in orders. However, the lower level of MOD commitments for the reporting period was just c £20m. In Global Products, the order total was boosted by the €24.2m ESA order we described earlier, which in itself establishes a new product line for future sales into space supply missions.
Order cover is the benefit provided by revenue under contract giving visibility and insulation from the SSRO regime. In each division, H118 order cover was lower than the prior period. However, it did in both cases, as one would hope, move up as H1 progressed. For EMEA Services, order cover at the start of H218 stood at 91%, down from 93% last year but up from 79% at the start of the year. For Global Products, order cover was 80% at the start of H218, down from 98% last year (which was exceptional) but up from the start of the year at only 55%. While we understand that the market may need to adjust its expectations of order cover downwards, we remain comfortable with the level of cover at the end of H118.
Leveraging the international opportunity is one of three core parts of the group strategy and order growth here is being supported by investment in the sales function. QinetiQ has unique and very exportable skills in the Test & Evaluation sector that support International growth. This is outlined further in the conversation on addressable markets later on. For international to contribute to half of group sales in the medium term, from 26% today, future acquisitions will also play a part.
EMEA Services is facing margin headwinds because of the baseline profit rate, which is set by the UK Single Source Regulations Office (SSRO) and is applied to all MOD contracts that are uncompeted. For new and renewed single-source contracts signed in FY18 the baseline profit rate will fall by 149bp from 8.95% in FY16/17 to 7.46% in FY17/18. It is important to note, though, that the rate is the starting point but companies can earn higher returns through adjustments for risk, capital requirements and good execution of contracts.
Around 75% of EMEA Services revenue is derived from single-source contracts. However, an increasing proportion of QinetiQ’s revenue is contracted on a long-term basis, which provides some protection from falling rates. For example, the £1bn 11-year contract amendment to the LTPA was contracted at the FY17 rate. Going forward, there is an additional c £100m of non-tasking revenues to be negotiated under the LTPA and the company is aiming to achieve conclusion by April 2018. With these actions fully underway, by FY19 only c £100m of revenue per year will be subject to annual repricing, hence protecting QinetiQ from feeling the full impact of the SSRO’s declining single-source baseline margin.
The H118 rate of cash conversion (after capex) progression does look somewhat alarming at first glance, moving from 94% in H116 to 98% in H117 to just 8% in H118. The key factor in this decline is the previously announced significant step-up in capex for the LTPA and hence within company guidance. The 11-year amendment saw QinetiQ committed to an additional £60-70m of capital expenditure on the programme, bringing the total to £180m, of which £120m will be spent in the next three years. Investment in the LTPA is reimbursed through the life of the contract itself which in turn adds visibility to contract return levels.
For detail on the capex spend, c £95m is being invested in modern tracking equipment, instrumentation and range infrastructure at the MOD Aberporth and MOD Hebrides ranges. This will help reduce the overall operating costs of the ranges, ensuring they remain competitive with the latest capabilities. QinetiQ is targeting the repatriation of UK defence money that defence primes spend on the MOD’s behalf. The company estimates that approximately half the UK’s test and evaluation money is currently spent overseas because the UK is not deemed to have the correct facilities. The Hebrides has the potential to provide ‘best in class’ facilities, unrivalled in size and interoperability of range, which should attract defence primes to use it as one of their testing grounds. The investment should also make the UK ranges world class, thus attracting international customers. This is a win-win situation. The MOD gets a higher return out of its fixed asset and it provides a platform for growth for QinetiQ. The Formidable Shield 2017 ballistic missile defence live-fire exercise showed the capabilities of the Hebrides range in a good light for the eight nations involved.
£85m will be spent developing the future military test pilot programme. QinetiQ will replace the oldest aircraft in the current flying fleet with new systems-rich aircraft that can deliver the new syllabus while costing less to maintain, thus reducing the overall running costs of the RAF’s Air Warfare Centre at Boscombe Down. A new commercial test pilot qualification will also be introduced, opening up the school to a wider range of students.
From a working capital perspective, the H118 movement was in part related to timing that is expected to reverse in H2; as such the working capital outflow for FY18 is expected to be in the £15-25m guidance range.
Accounting non-recurring items
Reported H118 figures included a number of non-recurring items that have caused some consternation. While this is clearly a factor of accounting, and the company has been very detailed here, it is also a consequence of the company’s strategy in action.
To explain more detail, a £5.3m credit related to the release of engine servicing obligations with the investment in new aircraft for test aircrew training within EMEA Services. As we understand it, this is part of the strategy to invest in new aircraft and sell the old fleet. As the old fleet aged, it was becoming more expensive to maintain, hence the original provision was taken. With the new fleet acquired and the old fleet disposed of, the servicing costs have become much lower and thus the provision has been released. The investment in the new fleet is aligned with management’s strategy to invest in core UK Test & Evaluation capabilities. This delivers enhanced services and, particularly in this case, lower operational costs. So the non-recurring item here is essentially the manifestation of this strategy taking effect.
