What QinetiQ Group plc's deal with Meggitt plc means for shareholders

Updated: 
Qinetiq logo on a jet fighter

Shares in QinetiQ(LSE: QQ) jumped nearly 5% in early deals this morning after the company announced that it has agreed to buy the Meggitt (LSE: MGGT) defence division. 

As part of its plan to streamline the business, Meggitt has sold QinetiQ its Target Systems division for £57.5m in cash. The unit, which provides unmanned aerial, naval and land-based target systems to 40 different countries from bases in Britain and Canada, is expected to make £5.5m in operating profit this year. According to QinetiQ's management, the deal is projected to increase its earnings in the first year of ownership, and the returns will exceed the cost of capital spent acquiring it within the first three years.

At first glance, it looks as if this deal is good news for QinetiQ and the company's shareholders. The firm has been able to acquire bolt-on growth at an attractive price of less than 12 times operating profit and the payback period is only three years.  

On the other hand, it looks as if Meggitt has been forced to do this deal at a knock-down price. 

A tough year 

It has been a tough year for Meggitt. Annual profits plunged 60% last August, largely because of a £50.8m hit on its currency hedges, while revenue rose 11% to £883m. However, the biggest surprise in the company's half-year results was the revelation that its retirement obligations had jumped £100m to £373.6m between December 31 2015 and its half-year end. To help reduce the deficit, the FTSE 250-listed group has agreed to pay £10.2m from the sale proceeds of its targeting division into the company's pension plan. 

To add to its woes, US activist hedge fund Elliot has taken a 5.2% stake in the business triggering speculation it intends to force a break-up or sale of the beleaguered aerospace engineer. 

City analysts have pencilled-in earnings per share growth for the business of 8% for 2016 and 9% for 2017. Based on these figures, the company is trading at a 2018 P/E of 12.8. 

Bolt-on growth 

Unfortunately, it has also been a tough year for QinetiQ. At the beginning of May, the firm reported a 17% fall in annual pre-tax profit, to £90.2m after one-off charges. Management blamed the earnings slump on "challenging markets" as the Ministry of Defence and other customers demand "more for less." 

To offset declining profits, management has promised to use the group's £200m-plus cash pile for bolt-on acquisitions and today's deal is part of this strategy. 

The City is expecting QinetiQ to report a pre-tax profit of £105m for the year ending 31 March 2017, including contributions from the Meggitt deal, pre-tax profits are likely to come in at around £110m for the year (barring any unforeseen circumstances) up 22% year-on-year. 

Conclusion 

So overall, QinetiQ's deal with Meggitt is good news for shareholders. It looks as if management has paid an attractive price for the business with a short payoff period and the earnings boost will accelerate QinetiQ's growth. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Meggitt. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.