Cohort — Agile and responsive

Interim results from Cohort indicate that the company strategy remains on track to deliver growth in FY18 against a still challenging market backdrop. The returns to shareholders have been further improved by the successful actions to address the performance of SCS, the buyout of the MCL minority in FY17 and the increase of the interest in EID to 80%, as expected. The agile and flexible nature of Cohort’s strategy leaves the company well-positioned to pursue suitable further complementary, selective opportunities to enhance organic performance as they arise.

H118 results were underpinned by better than expected performances at MASS and EID. MASS’s improved result included a contribution from the Training Support Business that was previously part of SCS, as well as strong development of the cyber activity, including the Metropolitan Police Service (MPS) Digital Forensic Programme secured at the end of FY17. While below management expectations, EID’s operating margins of 19% were above our FY18 estimate, although falling from the exceptional levels delivered in FY17 that resulted from very high margin marine support work. SEA experienced an improvement in first half margin performance as its mix moved towards deliveries of maritime systems with a reduction in research activity, largely for the MOD for land forces. However, this trend also led to lower revenues than anticipated. MCL’s revenue and profit contribution was also lower than anticipated due to deferred timing of some hearing protection systems deliveries as well as some slippage on milestones of a development programme.

Management expects a stronger second half with both MASS and EID continuing to make better than expected progress. MASS should see continuing positive development for cyber and the EWOS business in H218 and beyond, and EID should recover some revenue slippage from H118 as well as executing its 100% order cover. Although SEA and MCL have faced challenges in the first half, we expect improved contributions in H218. Better margin performance at SEA as the mix shifts towards marine systems is encouraging and research may recover from very low levels at some point in the future. At MCL, margins are as expected weaker than the exceptional levels seen last year, but the volume of activity should rise sharply in the second half in support of the various hearing protection programmes.

Although our FY18 revenue estimate has been reduced by £4.3m (3.9%), our profit forecasts remain unchanged at the pre-tax and profit levels. In addition, our FY19 numbers remain largely as before, except for a minor tweak to EPS (31.2p versus 31.3p previously) due to the higher contribution we now expect from EID with its 20% minority. The balance sheet remains supportive. The company is expected to end FY18 with close to £10m of net cash after spending c £6m on the MCL final payment (£2.5m) and the purchase of the additional 23% interest in EID (£3.53m).

In our SOP calculation we have enhanced our relative ratings of Cohort’s businesses against their UK defence peers, reflecting the more resilient growth and margin performance being achieved. The uplift in valuation premiums to peers has been partly offset by declines in several peers’ ratings that appear to be largely company-specific but have weighed on the overall sector against the backdrop of budgetary issues faced by the MOD. Our peer based SOP falls 4% to 460p, from 477p, as a result of these changes. The progress is reflected in the increase in our capped DCF for Cohort, which now returns a value of 506p (vs 481p), mainly due to improved working capital.

The salient features of the interim results are as follows:

MASS (H118 sales: £17.2m; 38% of group sales) produced the strongest result for the group, with good delivery in Electronic Warfare Operational Support (EWOS).This area will continue to support growth in the division. In addition, the business delivered growth in cyber markets with the Metropolitan Police Service (MPS) Digital Forensic Programme secured at the end of FY17 and potential future orders. The Training Support Business (previously part of SCS) is included in the H118 result. The division’s operating margin was affected by a higher bought-in element. £15.0m of the current order book is scheduled for delivery in H218.

SEA (H118 sales: £15.7m; 35% of group sales) delivered a lower top-line result but a higher operating margin due to increased maritime system export deliveries. There is a natural lull between the completed design work on the Astute Class and the increased activity on Dreadnought Class, and export sales of torpedo launch systems helped to counter this. SEA has been affected by the current lower demand from the UK customer, as has MCL. Research work weakened further with most land activity halted and future work in the area is being brought into the Simulation, Support and Product (SSP) activity. Meanwhile, the ROADflow product range is seeing growth. The division has taken action to mitigate oil & gas sector challenges and the business generates strong returns on depressed revenues. £16.6m of the current order book is scheduled for delivery in H218.

EID (H118 sales: £6.7m; 15% of group sales) performance reflected lower than expected sales (rescheduled to H218) and reduced operating margin from the abnormally high level seen in FY17. Cohort announced the acquisition of an additional 23% of EID last month, taking the total holding to 80% as expected, enhancing future EPS. Going forward, Portugal is seeing a relatively robust level of spending with upgrades to maritime and land communication systems, from which EID should benefit. The order book of £29.7m underpins 100% of H218 expected revenue performance and adds confidence that FY18 guidance will be met.

MCL (H118 sales: £5.1m; 12% of group sales) revenue and operating profits were lower than management expected. Although the division is seeing better order cover than it has seen historically, this division has been affected by a challenging customer backdrop and project delays. The hearing protection systems revenue was affected by a planned lower level of deliveries. As with SEA, the UK MOD tightening of spending is apparent and will likely have an impact on H218 revenues for the division. FY18 performance for the year is expected to be similar to last year.

Since floating on AIM in 2006, Cohort has been progressively pursuing its strategy of building an independent group in defence technical services, systems and products, through both organic growth and bolt-on acquisitions. A series of acquisitions has seen the company continue to develop, despite ongoing pressures on defence budgets. The group remains a predominantly defence and security company (86% of H1FY18 sales), but has small positions servicing markets in oil & gas (2%), transport (7%) and other commercial markets (5%, including education).

Cohort provides a holding company structure for four independent autonomous subsidiaries, all of which provide specialist capabilities for varying defence and security niches, as shown in Exhibit 4.

Cohort’s strategy is based around the three elements of agility, acquisition strategy and making the most of the market opportunities that present themselves. We will address each of these in turn.

Cohort's FY17 Annual Report states: “Within our markets we have sought to use our agility and innovation to identify niches where future prospects are attractive and where we have some sustainable competitive advantage.”

By the very nature of Cohort’s business structure, each subsidiary has operational autonomy. While Cohort today employs c 720 people globally, the group employs just 10 people at its headquarters in Theale, which really demonstrates how much autonomy each business has.

The devolved structure enables each business to remain close to its customers and be as responsive as required, hence the focus on agility. However, the group structure and balance sheet bring scale and confidence and allow the smaller companies to address opportunities and win contracts of a nature that their standalone size might preclude.

Management is prepared to step up to make significant adjustments to the portfolio. This was demonstrated in December 2016 with the restructuring of the former SCS division. As a defence consultancy business, combining technical expertise with armed forces experience and domain knowledge, it had been operating in a challenging business environment due to a general tightening of some consultancy fees by its main customer, the UK MOD. The negative mix effect was a product of the increase in the proportion of lower-margin work following the end of several profitable projects, particularly following the cessation of activity in Afghanistan.

To give the right platform and opportunity for the operational parts of SCS to continue to deliver their valued and profitable service to customers while reducing the overhead, SCS was divided and rehomed. The Air Systems and Capability divisions moved into SEA, while Training Support and Communications Systems divisions became part of MASS.

Many of Cohort’s contracts are fixed price in nature and these often include an element of technology development. The company holds risk and builds contingency into its projects, which if successfully delivered can be unwound, typically at the year end. With a fixed overhead base, this can tend to skew H1/H2 performance. This can be seen in Exhibit 4. We expect that this historical second half weighting will continue in FY18.

A key element to Cohort’s growth strategy over the years has been to support organic growth with targeted M&A. The company will consider a target as either a standalone business to join as a subsidiary, or as a bolt-on acquisition where it is closely aligned with an existing business. The chart below gives an outline of the current four divisions, in terms of when they were founded and when they joined the Cohort group.

It is important to recognise that each time Cohort has brought a new subsidiary company into the group, the target company brings with it longstanding customer relationships in addition to a quality product/service portfolio. Quality of the management is vital given the level of autonomy expected and the limited bandwidth of capacity at the HQ level.

Cohort is prepared to take part shares in businesses but with a controlling interest, as we saw at EID and MCL. It is additionally important to recognise that when management states that it intends to increase the shareholding that it does so. While timing may be contingent on external factors, Cohort management has achieved subsequent holding increases at EID and MCL within financial expectations.

Targeted M&A activity will focus on businesses that offer technology and end market opportunities. For standalone businesses, Cohort sees opportunity in defence and security markets around the globe for a target that would benefit from being part of a larger group. This strategy can build “home” markets within the defence sector, such as Portugal can be considered today.

It should be remembered that a disciplined and cautious approach runs through the group’s M&A strategy. In addition, the integration of companies, most recently EID, requires time and attention. Typically, cash generation within the group is strong and will support future acquisitions. Naturally, this metric can see year on year fluctuations. FY17 cash conversion was just 27% (FY16: 73%) reflecting a working capital unwind plus some slippage in contract payments. However, over the last four years, cash conversion has averaged 80%.

Cohort’s order book progression shows additional strength. Exhibit 6 gives a picture of the visibility of the order book across the divisions. Part of the strategy has been to stabilise and build out visibility. Cohort’s delivery schedule does stretch out to 2025; however, order cover is typically in the range of 55%-65% at the start of any given year. Cohort can also operate with an increasing level of shorter-term contracts, which can be supportive at the operating margin level but may not be visible in order book charts. The agility we described above supports this approach.

Cohort's FY17 Annual Report states: “The political and economic context within which Cohort operates has not changed appreciably since last year. On the one hand the international and domestic security environment calls for greater resources to be devoted to defence and counter terrorism in the UK and many other countries. On the other hand the pressures on public expenditure in the UK are strong and this applies in varying degrees in many other markets, including Portugal.”

The above paragraph from the company’s annual report highlights the fundamental dynamic within the global defence market. For the UK in particular, recent peer group market commentary has put the spotlight on short-term contract delays for the sector.

Cohort has longstanding relationships with the UK MOD across many different business areas. The existing programmes in submarines and combat aircraft EWOS remain stable, long-term in nature and operationally important. The planned fleet additions by the UK MOD are outlined in Exhibit7.

However, from a shorter-term contract perspective, the UK MOD is under continued budgetary pressures and the changing terms of trade have had an impact on the business environment. There are additional challenges with the single-source regulatory regime keeping pressure on margin and there has been a notable commentary on the concerns over current trading from across the sector. Even the change of defence secretary has caused alarm for some, while also being seen as a reason for further delays on contract decisions.

Within the divisions, MCL is expected to remain somewhat unpredictable in terms of business due to its shorter order book lead times. However, in hearing protection new and follow-on orders in June demonstrated the group’s technical cooperation and supplier status with the UK MOD and provide a more visible and sustained delivery programme. For SEA, it is likely that the Research business will remain under pressure in the short term and it is now part of the SSP business. For MASS, the business has been investing and has been building its order book, and while delivery timing remains difficult to predict, the division is expected to return to growth.

The H118 report has demonstrated some project delays due to budgetary tightening at the UK MOD. However, export business is developing well and the order book underpins FY18 prospects.

Innovation continues across the Cohort businesses to drive growth and to meet changing needs around the globe. The company expects to increase self-funded R&D by 25% in FY18. In addition, Cohort is very well positioned to address lateral markets including security. For MASS, the innovation focus is on EW and cyber, while at SEA the focus is on the Krait Defence System (which we will discuss later) and the developing further ROADflow derivatives.

Non-UK business currently represents c 32% of group revenues and export activity is expected to accelerate further with EID. Cohort identifies opportunities in the Middle East (regional competitiveness), South-East Asia (Chinese assertiveness) and Eastern Europe (pressure from Russia). With 25 NATO countries planning to increase defence spending in real terms, the number of countries moving towards the 2% of GDP guideline is increasing. Exhibit 8 reflects NATO’s belief that the non-US NATO members will continue to see a real increase in their defence spending. With the 2018 NATO summit set for Brussels in July, the message from the secretary general is: “In response to evolving threats, NATO has implemented the biggest reinforcement of our collective defence in a generation... We are also stepping up our efforts against cyber-attacks and hybrid threats.”

Turning now to the subject of traffic enforcement, Cohort is a clearly established market participant through its SEA subsidiary. The company is able to provide both the system and subsequent support work for a number of road traffic situations. One area that has seen increased interest in recent years is monitoring level crossings, where reckless driving and disregard for signals can have dramatic consequences. The only way to eliminate all risk in this area is to remove the level crossing itself, and UK National Rail has closed more than 1,000 in the last six years. However, SEA’s ROADflow Signal System has been selected by the UK Home Office to improve public safety and provide enforceable evidence to prosecute offenders. The system is relatively swift to install as it does not require either connectivity with rail signalling or installation of road based sensors.

From bus lane cameras to monitoring yellow box junctions, the direction of travel for SEA’s transport monitoring solutions is encouraging. The company is working well with Transport for London and FY17 was a record year for ROADflow sales at 108 units (over 400 in total installed at the year end). Global trends in road safety suggest that export opportunities are good, although timing is always tricky to predict.

MASS was founded in 1983 and was acquired by Cohort in August 2006 for £13m. Employing c 250 people, MASS operates from sites in Lincoln and St Neots. MASS provides the core capabilities in Cohort’s electronic warfare (EW) and ICT services offerings. It serves the defence, government, education and commercial markets, and includes Cohort’s developing cyber capability. MASS competes against significant cyber security providers including Ultra Electronics and BAE Systems Applied Intelligence.

MASS is the group’s most profitable business. However, FY17 was affected by slower electronic warfare operational support (EWOS) order intake and a delay to the Metropolitan Police Services (MPS) digital forensic services contract. Nevertheless, MASS did deliver order growth in FY17 and has good visibility through FY18. In addition, the EWOS business delivered strongly in H118 and the now-secured MPS contract could lead to opportunities to provide this cyber service to other police forces both in the UK and overseas. In addition, post the restructuring of SCS, this business now includes a capability in military collective training.

SEA was formed in 1988 and acquired by Cohort in October 2007 for £25m. SEA employs c 300 people in Beckington, Bristol, Barnstaple and Aberdeen. The division operates in four market-facing areas: Maritime, Research & Advice, Simulation, Subsea and Transport. Across its various activities, SEA competes against major companies such as Thales, QinetiQ, Selex and Babcock.

Maritime defence is a key focus of the division in the areas of communication systems, sonar and weapons launch. The company’s External Communications System (ECS) is in service with the UK Royal Navy’s operational and planned submarine fleet (including Dreadnought Class). In terms of trading, the business is in a natural lull as the work on Astute finishes and before the full transition work from Vanguard to Dreadnought begins. Core to the system is its open architecture, which facilitates low-cost upgrades and replacement of the radios it controls. SEA is working with its sister company EID to develop a combined technology maritime communications system that could be attractive to both UK and export customers.

The company’s work in the area of sensors is moving towards state-of-the-art low-profile towed line arrays that are more suitable for deploying with smaller vessels, including unmanned water vehicles. An example here is the Krait Array with directional sensing abilities, which has drawn interest from both sides of the Atlantic. The company launched the Krait Defence System earlier in 2017 to incorporate the array technology within a modular anti-submarine warfare suite offering four levels of capability. Meanwhile, SEA’s torpedo launcher systems can be configured to launch any lightweight torpedo and can operate with mixed payloads via an auto-recognise ability. It is the sole supplier to the UK Royal Navy in this area. This is also another area for exports, as in August the company announced a £5m torpedo launcher system contract from Hyundai Heavy Industries for the South-East Asian market.

Research & Advice works closely with the UK’s Defence Science and Technological Laboratory (DSTL). Work here covers multiple areas but the business has suffered from delays to budgetary issues at DSTL in FY17, which has had an impact on overall divisional performance. The company has made reductions here and is merging the operation into the simulation activities. The Simulation business provides development to support work for a UK MOD and international training audience. In addition, post the restructuring of SCS, this business now includes a capability in military air safety, ensuring that military aircraft are fit to fly in the UK and overseas.

For the relatively small Subsea business acquired with J+S in 2014, the offshore energy segment has continued to prove challenging. However, while demand levels remain weak, in FY17 the business did see a pick-up in margin as the workflow switched from replacement to repair.

The Transport business brings things much closer to home, providing a complete range of enforcement technologies for roads in London and New York. The ROADflow traffic monitoring and enforcement system has seen strong growth over recent years and remains good. We will discuss market opportunities here in greater detail later.

For FY18, the opportunities for SEA focus closely on growth in Maritime and Transport.

MCL was established in 1980 and Cohort acquired a controlling 50% plus one share stake for £8.8m in July 2014. On the 31 January 2017, Cohort acquired the remaining non-controlling interest in the business, for consideration and earn out in line with the original purchase agreement.

Based in Surrey, MCL employs c 27 people and has been supplying specialised and innovative communications and surveillance technologies to meet Command, Control, Communications, Computer Information Systems (C4IS) and Intelligence, Surveillance, Target Acquisition and Reconnaissance (ISTAR) missions for the UK armed forces since its foundation. It identifies requirements, designs solutions and/or seeks out available technologies to meet them, and supports advanced electronic and surveillance technologies in operation.

MCL supplies the special forces and intelligence agencies, but technologies are increasingly being adopted by the regular army. The customisation of commercial off the shelf technologies (COTS) differentiates MCL’s business model from other Cohort group businesses. MCL competes against a range of niche systems suppliers, which are often small private ventures.

MCL is the UK’s leading supplier of hearing protection for the armed forces and has tens of thousands of systems in operation today.

The acquisition of an initial 57% stake in EID was completed on 27 June 2016. A further 23% was acquired in November 2017 for an additional consideration of €3.97m from existing cash resources and debt facilities. The Portuguese government is expected to retain a minority stake of 20% hereafter. Andy Thomis and Simon Walther have seats on the board.

Based near Lisbon with a regional office in Indonesia, EID employs around 140 people. It has an experienced management team and a modern manufacturing facility at its main location. EID has been spending around 10% of sales on self-funded R&D to upgrade its technology, notably to IP-based communications systems. Over the last few years EID has been placing increasing emphasis on higher-margin export markets as budget constraints in Portugal have hit home. EID’s offerings have proved to be highly attractive in export markets compared to some of the more major suppliers like Harris, Rohde and Schwarz and Thales, combining a high level of functionality and technical sophistication with a low cost base and competitive pricing.

Domestic activity has been focused on longer-term support work providing a recurring stream of revenues, although contracts tend to be relatively short and renewed on a regular basis. However, in August, the business was awarded a contract by the Portuguese Navy for the supply of Integrated Communications systems to the Tejo Class Coastal Patrol Vessels, worth a total of €4.6m.The contract encompasses the supply of radio equipment, ICCS, integration engineering and logistic services. The contract also includes additional supplies for the second batch of the Viana do Castelo Oceanic Patrol Vessels, currently being built in Portugal.

In addition to adding Portugal as a home market, EID contributes the strong and growing export market relationships it has developed, both to other NATO Europe countries and further afield, for example Egypt and Indonesia. Over 120 warships now utilise EID’s communications equipment, which can be provided for both new build and upgrade projects. This global presence is expected to stimulate new export opportunities for Cohort’s existing businesses.

We continue to derive a fair value for Cohort from the simple average of a capped DCF and a peer-based group SOP. The current value is 483p (from 471p), equivalent to a P/E ratio of 15.5x our FY19e EPS, which represents a c 50% premium to the current share price and equates to a c 10% P/E premium to the UK defence sector. We feel that this is warranted by the continuing growth in EPS and dividend, as well as the maintenance of strong group margins and operational cash flows. Thus the recent share price fall seems unjustified as Cohort trades on a FY19e P/E multiple of just 10.2x against the UK defence sector on an estimated 13.7x, a substantial discount.

We have utilised a capped DCF methodology to value Cohort. The valuation utilises our forecast cash flows for a period of six years, then assumes zero growth in the terminal value. To reflect the lack of growth, we also normalise capex to depreciation and working capital movements to zero in the terminal cash flow. For Cohort we use a calculated WACC of 7.8% in our base assumption. Our working capital assumptions and lower provision consumption has improved our forecast cash flows. The DCF currently returns a value of 506p per share.

For a company such as Cohort where we envisage a continued growth of cash flows due to the strategy of enhancing long-term organic growth in defence markets with selective, value-creating and complimentary acquisitions, we feel that such a methodology is inherently conservative for a DCF. We show a sensitivity analysis to terminal growth rate and WACC assumptions in Exhibit 14 above, with the value closest to our calculated levels highlighted.

We also continue to analyse Cohort on a sum-of-the-parts basis, identifying the nearest peers for each division and calculated on a calendar 2018 basis. We feel that this is appropriate due to the nature of the group with standalone divisions. Given the variable fortunes of peers in the sector we have chosen to reassess our valuation premiums for the divisions against those used. The rationale for the upgrade in premiums is that Cohort is exhibiting greater resilience in profits, margins and cash flows than many of its peers, where ratings have adjusted to reflect generally company-specific issues. Currently the SOP value is 460p per share, below the previously calculated value of 479p despite the de-rating of the wider UK defence sector over recent months.

Our group-level estimates for Cohort remain broadly unchanged at the profit before tax and EPS level, although the higher contribution from EID does mean a higher minority charge in FY19, which reduces EPS marginally. Our FY18 revenue reduction is largely due to lower than expected sales at SEA and MCL offset by better than expected performances from MASS and EID. FY19 sales are unchanged, although divisional contributions have altered in both years.

A tax charge of around 17.5% is expected in FY18e and FY19e, with long-term changes to the R&D tax treatment likely to provide further favourable reductions to the rate in future years. The reduction of both the MCL and EID minority levels are enhancing to EPS, although the 80% ownership level in EID appears fixed for the longer term.

We expect the group to continue to generate strong free cash flows. Half-year net cash of £5.7m is expected to increase to just under £10m at the year end, despite the £3.5m outflow to fund the EID interest increase.

The payments for 80% of EID and the c 50% MCL minority are now complete and we expect a significant cash inflow in FY19 in the absence of any acquisition activity. Cohort also retains borrowing facilities totalling £25m that should support further M&A as new opportunities arise.