QinetiQ's backers want bangs for their bucks

As they fight for a £10bn PFI contract, the newly floated tech-heads are finding it tough out there

As knee-high, remote-controlled, bomb-disposing robots go, the Talon is impressive. Workers shuffling through the foyer at the headquarters of QinetiQ, formerly the Government's Defence Evaluation and Research Agency, stop in their tracks at the sight of the little tank-like machine. Controlled by an engineer at a video console, the robot motors across the hall, picks up a suitcase "bomb" with its pneumatic arm, swivels and, like an obedient dog, brings the bomb back to its master.

"Obviously, you wouldn't want it brought back to you if it were a live ordnance," the engineer chuckles.

It may look like a glorified contestant on Robot Wars but the Talon has been a big seller. As the wars in Afghanistan and Iraq have escalated, so has demand for the robot. More than 500 are being used by troops in the field. The US military, excited by its usefulness in reconnaissance and explosives removal, recently approved a version to be mounted with a machine gun.

War is good for the defence industry, and the Talon, clearly a point of pride for QinetiQ, is just one of an astonishing array of inventions and intellectual property the company has at its disposal. Based in Farnborough, Hampshire, QinetiQ is an amalgamation of government research labs that pioneered a range of technologies including radar and liquid crystal displays over more than six decades. That research means that it is sitting on what its chief financial officer, Doug Webb, calls "an embarrassment of riches". With wars raging and security concerns on the rise, these should be QinetiQ's salad days.

Yet eight months on from its £1.29bn float, the first of a state-owned company under Labour and one of the most controversial in recent memory, all is not well. QinetiQ's shares are trading at nearly a fifth below the February offering price. Even before the flotation, questions had arisen about the ability of the company to chart a path from monopoly MoD research supplier to commercial entity battling it out in a competitive global defence market. These questions remain unanswered.

"Some shareholders are disappointed," says one industry source, speaking on condition of anonymity. "The feeling among some is that this is not your thrusting management team that will take it to the promised land."

When Numis Securities initiated coverage of the company last month, it set a price target of 200p - the price at which the company went public nearly nine months ago.

So what has changed since February, when, despite a whirlwind of controversy, investor demand for new QinetiQ shares far exceeded those on offer? In the run-up to the float, critics accused Labour of giving away the company far too cheaply to the Carlyle Group, the American buyout giant that paid just £42m for a 31 per cent stake in 2003. The City, however, liked the story and the float was a rip-roaring success. Demand for shares was high. Carlyle made more than eight times its money on the float. It still holds a 10 per cent stake.

In their pre-float roadshow, QinetiQ management laid out a detailed strategy to grow the company beyond its MoD monopoly, which has been gradually opened to competition. The plan placed heavy emphasis on expanding in the US, the world's largest defence market.

"One of the selling points was the growth of the US business," says Andrew Gollan, an analyst at Numis Securities. "The market needs to see some progress on that front. They need to do a deal."

The company aims to increase its turnover from US business from roughly 30 per cent today to 50 per cent. That will likely come via acquisition.

QinetiQ's Mr Webb says it could splash out up to £200m: "The board is comfortable with gearing of debt to [earnings before costs] of two times, and for the right sort of deal, we would be prepared to go up to three times. It would have to be a particularly attractive deal, though.

"What we don't want to do," he adds, "is hamstring ourselves and miss out on the next attractive deal."

QinetiQ has bought six companies in the US in the past two years, including Foster-Miller, the maker of the Talon, in 2004, but there have been no acquisitions since the float.

Competition for MoD research and technology supply contracts, meanwhile, is more open than ever before. Led by the Defence Procurement minister, Lord Drayson, the MoD's Defence Industrial Strategy, released last year, lays out a new framework for the Government's purchase of weapons. Its emphasis on keeping important technological know-how in the UK is seen as a boon for QinetiQ, but against this is set ever more competitive bidding.

QinetiQ is, meanwhile, increasing its efforts to sell technology to other industries. It handles IT security for several large companies, the names of which it cannot reveal. It has also had some early success with its Tarsier runway debris detection system, which it sells to airports.

As analysts await the next purchase in America, the other shoe set to drop is the Government's imminent decision on Defence Training Rationalisation, a £10bn project to outsource military skills training.

Divided into two separate packages, it is the largest Private Finance Initiative to date. QinetiQ is leading a consortium that is bidding on both parts. It has proposed reducing the 10 training sites now in use to one massive new centre at RAF St Athans in South Wales. If QinetiQ and its partners - Land Securities, Trillium, Raytheon Systems and Serco - win the bid, it would mean not only billions of pounds of work in the coming years, and thousands of British jobs, but also a big fillip to the stock price.

Mr Gollan estimates that winning either DTR bid would add £80m to £100m in annual turnover to QinetiQ's books.

But supporters of a bid by a rival consortium, made up of VT Group, BAE Systems and Carillion, have accused the MoD of a conflict of interest arising from its 19.3 per cent stake in QinetiQ. Any benefit conferred by winning the contract would mean an increase in the value of the Government's stake in the company, thus making an unbiased decision unlikely, they argue.

The Government is expected to announce a preferred bidder by the end of November, which is when QinetiQ releases its interim results. Market observers are confident the QinetiQ consortium will win at least one part of the DTR deal.

Even so, QinetiQ is a difficult story for the market to digest. Rivals such as Cobham and Ultra Electronics have seen their share prices benefit in recent months from merger speculation. Both the MoD and Carlyle are expected to reduce their stakes in QinetiQ after the expiry of the post-listing lockup period in August, but because of the MoD's stake, the company is not considered a takeover target.

"QinetiQ is really seen as a protected species," said another industry source, preferring to remain anonymous.

There are also few companies with which to compare a sprawling former government defence research agency. "It's not well understood by the market," says Jeremy Batstone of stockbrokers Charles Stanley. "The absence of clarity of the business is hindering share price progression. There is inherent value, but it's like buried treasure. It will take a while to get unearthed."

Mr Webb can only hope that QinetiQ's interim results will help the City uncover the value lurking in its labs. "There is no real comparative out there, and that gives us a great opportunity to take ourselves forward to develop on 60 years of [research] heritage," he says. "It's up to the market to value that."