Alongside sales growth, QinetiQ expects margins to improve over the medium term. Its latest quarterly trading update, which was released on July 21, was in line with previous company guidance and reaffirmed its expectation for a one percentage point rise in operating margin.
Meanwhile, strong operating cash flow, which has meant that cash conversion has averaged 163pc over the past two years, further improves the company’s competitive position.
It provides scope for generous capital expenditure that is expected to be at the upper end of previous guidance in the current financial year. The firm’s asset-light business model means greater agility that further aids its capacity to invest in new tech to disrupt incumbents.
Of course, government plans to raise defense spending depend on their affordability. The world economy’s outlook has grossly deteriorated over recent months, as factors such as high inflation and rising interest rates have led to more subdued growth forecasts.
However, in Questor’s view, the geopolitical environment has changed to such an extent over recent months that growth in military spending could essentially become ringfenced.
QinetiQ’s recent share price surge means that it now yields just 1.9pc. Despite raising dividends at an annualized rate of 10pc over the past decade, a lowly yield means that its investment appeal is centered on the potential for capital growth rather than income.
Trading on 16 times forecast earnings, its shares are also now far more expensive than at the time of our first look at the stock in 2017. Then, the company traded on a low prospective rating of 13. However, its financial outlook has materially improved since then.
Now, rising defense budgets provide a clear earnings growth catalyst that justifies a higher valuation. With a solid balance sheet, international growth opportunities and prospective margin improvements, it remains a worthwhile purchase for long-term investors.
Questor says: buy
Share price at close: 380.8p
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