QinetiQ Group plc (QQ) Earnings Call Transcript & Summary

Hello, and welcome to the financial year 2022 H1 post-close trading update call. My name is Judy, and I'll be your coordinator for today's event. Please note that this call is being recorded. [Operator Instructions] I would now like to hand you over to today's team.

Good morning, everyone. I'm John Haworth, Head of Investor Relations at QinetiQ. Welcome to this morning's investor call, which is covering our FY '22 first half post-close trading update that we have released to the market this morning. I'm joined by Steve Wadey, CEO; and David Smith, CFO. Steve and David will provide a short overview of today's trading update, followed by an opportunity for you to ask questions. I'll now hand over to Steve.

Great. Thank you, John, and good morning, everybody, and thank you for joining today's call. So QinetiQ has delivered another strong half of underlying operating performance at group level. Our half year results are in line with market consensus subject to audit. Overall, performance across the group has been good, balanced by a notably strong performance in EMEA Services, offsetting short-term weaker performance in Global Products, particularly in the U.S. In the first half, we've continued to deliver strategic momentum. We've secured more than GBP 700 million of orders, an increase of 25% compared to the last half year. We've won some key programs for the future in each of our home countries: a $64 million order for the full rate production contract on the CRS-I robots in the United States, GBP 68 million order for the development of directed energy systems in the U.K. and AUD 27 million for Land Systems engineering support in Australia. For the full year, we are expecting to deliver approximately 5% organic revenue growth and underlying operating profit margin at the lower end of our 11% to 12% expected range prior to any potential onetime write-down I'll cover in a moment. This expectation includes short-term effects in the U.S. of the customer's priority shifting from counterinsurgency missions in Afghanistan to emerging near-peer threats in the Indo-Pacific. This also includes COVID-related delivery and supply chain challenges in our legacy QNA business, for example, on the initial production ramp-up of the CRS-I program. However, as David will cover, we've had excellent order intake, providing a solid foundation to deliver a stronger second half, enhanced by changes to leadership and organization focus, and our U.S. growth strategy remains the same. As I just referred to, we are experiencing technical and supply chain issues on a large complex program, which, if unmitigated, could result in the need for a one-off write-down to our short-term guidance. We are working closely with our customer and are making progress jointly with our supply chain towards recovery of the program and mitigating this risk to less than GBP 15 million. And we will report further on this at our interim results on the 11th of November. So whilst we're sharing today that we do have a timing challenge in the U.S. and a one-off risk on one of our large contracts, I can assure you that they are being proactively managed. And at the same time, we continue to make good progress implementing our growth strategy. I'll now hand over to David to say a few more words on our financial performance.

Thank you, Steve. As Steve has said, we had a strong first half with particularly impressive orders across the group, building backlog and future revenue cover. Our EMEA Services division has performed particularly strongly, with excellent growth in Australia and the U.K. Strong EMEA Services performance has offset shorter-term, weaker performance in the U.S., which reduced first half revenue profit and cash flow in Global Products. U.S. revenue reduced by 15% compared to the second half of fiscal '21 for the reasons Steve has summarized earlier. However, with excellent order intake in the U.S. in the first half at $184 million compared to $83 million last year, we have a solid foundation to deliver a stronger second half. Group operating cash flow has been good, and we retain a strong balance sheet with net cash of approximately GBP 140 million. Whilst we've experienced a timing challenge and a contract-specific risk in the first half, overall, we've delivered a strong set of financial results, and I'm confident in the future financial performance of the business. I'll now hand back to Steve.

Great. Thank you, David. So our strategy to build an integrated global defense and security company remains unchanged through both organic growth and strategy-led acquisitions. I can assure you that we are proactively managing both the timing challenge and the contract-specific risk that we've shared today and a continued strategic momentum towards our goal of more than 70% growth over the next 5 years. Our track record, our strong underlying performance and our focus gives me confidence that we are continuing to make steady progress towards our ambitious goal. And with that, I'll open the floor to take any questions.

[Operator Instructions] There are no questions in the queue at the moment. [Operator Instructions] The first question in the queue is coming from the line of Ross Martin from Border To Coast Pension Partners.

Just a question on the contract that you're having some problems with. What degree of visibility have you've got that the GBP 15 million could be the maximum level of the hit on that particular contract? And could you just give me an idea of what mitigation means, please?

So as we say in the statement, we're actually working very closely with both the customer and our main supplier on the contract. And clearly, there have been some technical challenges, and we're working very hard with our suppliers to overcome those and obviously discussing that progress with the customer as we go along. So I think over the next few weeks, we're confident we'll find solutions for this. But we are flagging now that we -- as a result of those, there may be some -- both some revenue and some cost implications of that which would require that write-down. We were pretty confident we can keep that lower than GBP 15 million. And obviously, we'll trying to reduce it to the minimum possible. But I wanted to flag that at this point in time, and we will all give an update at the November 11 trading report.

And I think, Ross, if I could just add a couple of words. I think David has covered the visibility and the rationale around the GBP 15 million. I think in terms of mitigation, really, there are 3 primary areas of mitigation. First and foremost, we have put additional effort and resource onto the program since the issues that David described have emerged. And that internal effort is secondly supplemented by an exceptionally close working relationship with the supply chain where we're seeing the specific issues. And the relevant suppliers themselves are putting additional focus and additional senior management support. And then thirdly, collectively ourselves and our suppliers are working intimately with our customer. So a combination of our internal supply chain and customer engagement really is the primary mitigation. And as we've said in the statement, at this point, we're making progress in overcoming the issues. But until we've actually got through them and -- at the other side, there is a risk. And as David said, given the level of exposure that has opened up here, we've needed to disclose that today. So hopefully, that gives you some assurance around the sort of the proactive management and mitigation strategy that we're adopting here.

Yes, that's great. Can I ask just one more, please. Just on Afghanistan and the part of the business affected there. Clearly, there was a sort of a relatively quick about turning your strategy there. Did you have much in previously for ongoing growth from that particular arena?

Well, I think -- I mean, a couple of points that I would pick up immediately. First of all, our strategy remains exactly the same. There's no change to our strategy in the U.S. In fact, we remain -- and for some of the changes that we may come on to, remain even more focused at the moment on delivering performance and seeking future growth. So the strategy hasn't changed. In terms of the shift from Afghanistan, I mean, the change has been ongoing now for a number of years, but it's absolutely true that in the last 6 months, there's been an acceleration of some of the impact of that with what we've seen with events over the summer. And we did have a number of projects that we're pursuing, which were contracted, where we've had stop work notices from the customer. And that sort of accelerated the impact. And as you've seen in the statement, we had -- we came into the half with a very low order intake because of COVID and these various transitions. The good news is that we had a very strong half in terms of order intake, $184 million of U.S. order intake in the first half. More than $100 million more than the second half of last year. And that gives us real confidence now that we have a much stronger half to come. Beyond that, and I've just come back from 2 weeks in the U.S., continuing to engage with customers and the internal teams on this, I would reinforce that our core sensors and autonomy capability and a number of the key contracts that we have and that we are shaping for the future are absolutely key to this shift towards the Indo-Pacific threat. So whilst this is an impact that we've had coming through the end of last year with low order intake and seeing the revenue impact this year, we are in a strong position with our capability set to meet these future needs. So yes, no change in strategy. Please do think about this as a short-term effect as these transitions are going through. But long-term strategy remains the same and focused now on delivering a much stronger second half than we had in the first half.

The next question in the queue is coming from the line of Rory Smith from Investec.

You've largely answered it on Afghanistan. So I was just wondering if we could -- apologies for laboring the point, but just drilling to what sort of -- if you'd be able to give some examples on what kind of work was sort of stopped at the last minute there. And clearly, that will have had an impact on efficiency. But I think the revenue performance looks strong as well. So if there's a sort of mix impact from EMEA Services, what's gone well in EMEA Services, that would be my sort of question.

I mean, Rory, I...

Go ahead, David.

Yes. I mean I think -- so within the U.S. funding, there were -- there was funding for sort of overseas contingency operations, which is primarily around force protection on the ground. And we were quite involved in that, and obviously, that's come to a pretty quick halt. There was also some training going on that we were involved in as well for things like pilots and stuff like that. So those are the sort of things, Rory, that have just come to a very quick halt. On the other side of the equation, as we said, actually, we had a really strong period for both in revenue and orders terms across most parts of the EMEA Services business, Australia had a very good first half and the U.K. business has also had very strong order intake. So we've actually been able to fully offset those U.S. headwinds. And without them, we actually had a really strong result in the first half. But it's unfortunate that we've had to deal with those issues and deal with them as quickly as we can. And as Steve said, we believe we will have a stronger second half in the U.S. Probably not back to where we were last year yet, but by the end of the year, we should be.

Very clear. If I could just -- sorry, if I could just add a follow-up to that. I noticed that an Australian order received. Would you be able to just add a bit of color to that, the more -- the backdrop in Australia more generally?

Yes. I mean our Australian business, Rory, as you know, has gone from strength to strength over the last 4 to 5 years with record performance every year. So we have a recurring record performance. But the team there is doing extremely well. About 3 years ago, we signed a contract called MSP, the major service provider contract with some partners, you had a one-off, you had several consortiums supporting the Australian defense force. And this is just another example where we've been able to take that relationship to the next level. A huge win for us at AUD 27 million. And this is all about engineering services, engineering support for the DoD in the way that they go about designing and procuring future land systems projects. So yes, it's completely in our wheelhouse. It's on our sort of focus. And of course, it really does demonstrate one of the big pieces of news of the last half is the announcement around the AUKUS relationship, the Australian, U.K., U.S. alliance that's being formed. And I think we're very pleased, and I'll be talking a lot more about this at our results on the 11th of November, the strength of relationship that is now forming between those 3 countries is directly aligned and supportive of our multi-domestic growth strategy, as you know, that is focused around those same 3 home countries. So yes, really, really good news, really good progress in Australia and directly on point with our long-term strategic ambition.

And the next question in the queue is coming from the line of Charlotte Keyworth from Barclays.

I just have a follow-up question actually. Just on the U.S. front. So we started the half with a lower backlog, and yet the order intake has been exceptionally strong. Was that a result of sort of timing around when these tenders are expected to be put to the market? Or do you see that -- looking at your sort of order pipeline for next year, is that a trend you'd expect to continue now into 2023?

Yes. I mean, I think as we said, Charlotte, and I'll sort of try to sort of bring more color to it, I think it absolutely is a timing issue. I really would think about what we've said as timing. So we had $83 million in the last half last year. And as you said, that meant that we entered this half with lower backlog coverage of the U.S. And if we step back and think about why we came into the half of that position, it's down to 3 effects. There were some really significant effects of COVID during that last half year. There was the transition to the new administration. And compounded with this, a shift in the customer's mission. And those 3 effects, without doubt, led us to the point of starting the year with the lower backlog. So it is a transitory change. And as we've demonstrated in this half, GBP 184 million in the first half. So lower orders means the revenue impact that we've had, but we've had strong orders and we've got a healthy pipeline for the second half. And as we rebuild that performance and deliver a stronger second half, I think we will just see ourselves return to the trajectory that we've been on in the past few years through our U.S. growth ambition. So I think you're right to think about it as a timing and a transitory period. And the -- I guess the additional point that we've had is also what we were just discussing with Rory around some of the stop work impact that we've had with the Afghanistan situation. So yes, I mean, transitory, and we're now into a much stronger second half position with GBP 184 million orders.

[Operator Instructions] The next question in the queue is coming from the line of [ Avi Houtshores ] from [ SAM ].

It's [ Avi ] here from [ SAM ]. Just a few questions from my side. I'll wrestle through them. The focus on the lower end of the 11% to 12% margin comment, is that all sort of H1? And is that all sort of under recovery in U.S. Global Products, and so therefore, there's no relevance to next year given the orders? Just checking where that margin impact is coming from. If you could give us some commentary on the non-U.S. side to Global Products that would be great. And then finally, if you could just discuss any cash impact from the different elements of today's news, that would be very helpful.

Yes, it's David, CFO. So the impact on margin is driven by the U.S., and clearly, significant in the first half. I think we'll still see some in the second half as well, but we'll be recovering back. The EMEA Services division has performed very well, and I think will continue to do so. So it really is from the U.S. in Global Products. And it doesn't change our view on fiscal '23 onwards. This, as I said, is an issue we think will be contained within this year. In terms of non-U.S. parts of Global Products, our Space business, our QinetiQ Target Systems business, both had decent first half. So it is really focused around the U.S. business. Cash, I mean, we had a reasonable cash position at the half year, GBP 140 million. I think it'd be a bit stronger at the end of the year. The U.S. clearly has had an impact on cash in the first half of the year, which has been somewhat offset elsewhere. The complex technology program, the write-down itself won't have a cash impact. We will have effectively already have seen a lot of that cash impact come through already. So that's not going to have an incremental impact on cash. So as I said, I think the outlook for year-end is still pretty positive in terms of where we'll end up on that cash at the end of the year.

And the next question in the queue is coming from Johnnie Smith from Tellworth.

I know people have asked a few questions about this [indiscernible] contract already, but I just wanted to understand a bit more about the nature of it. What exactly -- what sort of exact services were you providing? And I guess why is there a sort of a fixed cost or sort of a promised element to it?

Yes, Johnnie, again, thank you for the question. I'm afraid for various commercial reasons, we really can't go into the specifics. It is highly sensitive. But as we've said, it's due to some very complex technical and supply chain issues that we've been managing. And COVID has really not helped in terms of travel and engagement between our teams, between the supplier and between the customer. And it's been about managing these technical and supply chain issues. So we can't go into the specific nature of the technology, all the service that we're providing. But I can just reinforce the points that I was making earlier. We do have sort of a portfolio of large contracts that we manage. We've developed our project management and our risk management capability. And in this instance, as I said, the risk exposure is raised to a level where we've needed to disclose it today. But we are making every effort that we can in terms of engaging additional resources internally with the supplier and a very close dialogue with the customer. And clearly, everything we're doing is to overcome and mitigate that risk as quickly as we can. And I'm afraid, Johnnie, I can't really say a lot more than that in this instance. And we'll obviously say more when we get to the full results on the 11th of November.

And I guess -- I appreciate, I guess, the sensitivity of it. Are you able to say whether it's -- is it more a product sort of contract versus a services contract?

I'm sorry, Johnnie, I can't say any more than I said.

And the next question in the queue is coming from the line of Jack Barrat from Man's Group.

I appreciate you can't talk about the details of the contract specifically. Could you maybe just sort of reassure us that it's going to be bounded within this year or that you're confident by the end of this that it's a fiscal '22 issue not one that's going to drag on fiscal '23 and beyond?

Yes. I mean, Jack, yes, absolutely. I think that from our perspective right now, we absolutely see that we will be able to manage this situation to a definitive position within our full year period, whether that's in weeks or months, we'll see. We'll give an update of it on the 11th of November. But absolutely, we don't see this dragging on for a long period of time at this stage. Yes, I'm sorry, we can't go into more details, but you'll understand the sensitivity of it for reasons that you can -- you work out. But yes, we hope to be able to give you a more full update on the 11th, Jack.

Sorry, Jack, it's David. So the intent is the contract itself extends beyond this year. However, we'll make sure we take the necessary financial provision if needed this year.

Very clear. And just a follow-up because I guess I was very reassured to hear that it was sort of noncash. Because you've talked about a write-down today rather than sort of a downgrade. Or I guess, it will be a profit impact, but it's a noncash one. So just sort of, again, we're just trying to understand that, I guess, to [ Avi's ] question -- [ Avi's ] earlier question, sort of reassured that it's going to be a noncash impact or the cash impact has already been seen.

Well, that's what I'm saying, most of the cash impact has already been seen. It's really writing down. We used the word a bit broadly, but investment in the project to date.

Okay. Okay. And I guess if it is sort of written down and the project extends beyond this initial year, would there be any impact on group margins going forward, i.e., look, it's a contract that's provided for, that is not loss-making anymore, that's going to be at 0 margin. I mean I guess, yes, beyond...

Well, that's what I'm saying, Jack, that we'll take the necessary financial provision this year to treat it then as at least a breakeven project going forward.

Okay. Very clear. And that is within the GBP 15 million guidance?

Correct. Yes.

Very clear. And given you've reiterated medium-term targets, we can take that to mean that, that is within that going forward, that thought process was taken into account when we look towards the medium term as well?

That's correct. Yes.

Hence the one-off expression, Jack.

[Operator Instructions] We do have a follow-up question coming from the line of [ Avi Houtshores ] from [ SAM ].

It's [ Avi ] again. I'm sorry to labor a little point. Actually not [indiscernible] but the -- just on the prior question. If you have revenues coming through in '23, I'm assuming that will on 0 margin because it's really provided for. Will there not be a margin drag on the group just because you've got -- enforced breakeven margin on a positive revenue number? That's all.

You're right. I think what the question Jack asked me is does it change our margin outlook, and we've already effectively taken into account in that margin outlook.

There are no further questions in the queue. [Operator Instructions] We do have another follow-up question from the line of Rory Smith from Investec.

Could please just talk about the sort of current issues, [ temporary ] issues notwithstanding in the U.S., the sort of the more medium to longer-term evolution of that business? I mean I note that Mary Williams has stepped back. I guess that wasn't too unexpected. But actually, it looks like there's some strategic shift there as well with new business units being named. I was just wondering if you could add a bit of color to your thinking on how that helps...

Yes, of course. Yes, of course, Rory. Very pleased to. Yes, and as you said, maybe not unexpected, but Mary took a personal decision and chose to step back. She remains committed and she remains part of the company. I mean she's continuing as a strategic adviser to me and given her technology-based experience, I'll be drawing upon that, and also her insights into the industry as part of supporting our long-term growth ambitions and supporting thinking through acquisition-related strategy. So yes, that's sort of Mary's decision and she's chosen to take that position at the moment. And then with the Special Security Arrangement (sic) [ Agreement ] Board, David and I, we chose to consider that situation. And said, well, okay, how do we use this as an opportunity to create a platform to really enhance the focus on both our performance and build the capability that we need for our future acquisitive growth. And that's why we've gone through the reorganization that you've seen described in the note. So what we've done is we're in the process now of actively recruiting a new CEO, and we're in the marketplace looking for an individual that has the experience and the capacity to really lead that strategic step of growth. You know that our ambition, I think I reinforced it earlier, is to more than double the size of the business over the next 5 years through both organic and acquisitive growth. So we're looking for that individual. And working into that individual, we've now organized the business into 2 business units. We have what we call C5ISR Solutions. That is what was formerly known as the MTEQ business. And we've appointed a president directly to lead that P&L, working into the new CEO. And then secondly, we've renamed what was formerly the QNA business, Technology Solutions, and again, appointed a direct president to lead that. And those 2 leaders are there empowered and focused driving those relevant P&Ls, both on performance and organic growth. And then we've got the new CEO coming in to sort of lead the overall business and how we will develop the strategy. But as I said earlier, I think it's been a good time to put that alternative structure in, but it absolutely does give us the platform now to create the right capacity and capability to drive the next stage of growth for the business. And the key capabilities that we have in those 2 business units now are fundamental to the shift that the customer is seeing. The other thing that you will have noted in the announcement is that at Plc Board level, we've also strengthened the experience and the capability of our Board. We've recruited Larry Prior. Larry joins the Plc Board with huge experience, both in the U.S. but globally around the aerospace, defense and government services sector. So that brings a new dimension of experience to the Plc Board, and that will also support us looking at fulfilling our strategic ambitions not just globally, but also specifically within the U.S. So a whole host of changes really which are quite exciting, to be honest. And again, directly coupled into the point that I was making in response to Rory's question about Australia. Again, the company's strategy is built around 3 home countries, U.S., U.K., Australia. And we are very pleased to see the announcement of the AUKUS alliance that really does show that we're on exactly the right focus, on exactly the right trajectory to build from that future arrangement. So hopefully, [ Avi ], that just gives you a little bit more color about our future U.S. plans.

It was Rory, but that was really clear. Yes.

Rory, sorry.

And that was the final question in the queue. So I would now like to hand it over to the team to conclude today's call.

Okay. Great. Well, thank you, everybody, and I appreciate you joining. I mean, just to summarize the sort of key points. Number one, overall, we delivered a really strong set of half 1 results that I just want to draw out here. Excellent order intake of more than GBP 700 million, and that gives us a really great platform to deliver a strong second half. In that half 1 result, really exceptional performance and growth in our U.K. and Australian businesses. Secondly, yes, we have a timing issue in the U.S., and we have a contract-specific risk. Both of those are being actively managed by the team, and I can assure you they're transitory and they don't detract from our third point, which is our long-term strategy remains exactly the same. We're in a good position to deliver our second half and continue to focus on long-term sustainable growth, and we'll talk more about that on the 11th of November. So with that, thank you for joining. And of course, if you do have any other follow-up questions, please reach out and contact John Haworth accordingly. Okay. Thank you, everybody, and look forward to catching up on the 11th of November.

Thank you, everyone, for joining us on today's call. You may now disconnect your handsets. Hosts, you may please take [ disconnect ].