Cohort — Update 16 December 2015

Cohort continued to make strong progress in the six months to October 2015, boosted by full period contributions from the FY15 acquisitions of J+S and MCL. Revenues of £49.7m were up by 32% on the prior year. Group adjusted operating profit increased by 40% to £3.5m (£2.5m) with advances apparent at MASS and SEA, SCS flat on the prior year, and MCL just above break even.

Order intake during the period was £55.7m (£64.5m in H115), representing a positive book-to-bill ratio of c 1.1x. H115 included a very strong performance at SEA including the extension of the external communication systems (ECS) contract to the whole of the UK submarine fleet. The backlog increased by 4.5% to £140.0m from £134.0m at the year end.

There was an operational cash outflow of £4.9m as favourable working capital positions unwound as expected during the period. Gross cash of £11.4m compared to £19.7m at the start of the year, with an operational inflow anticipated during H216. The interim dividend increased 19% to 1.90p (1.60p) reflecting management's confidence.

MASS (29% of FY16e group sales/42% of FY16e group adjusted operating profit): MASS revenues fell by 2%. However, margins improved to 15.7% during the half year, compared with 12.3% in the comparable period, reflecting a better mix of increased sales of higher-margin electronic warfare (EW) operational support export contracts, and a decline in lower-margin education sales. Operating profit of £2.4m was up from £1.9m in H115. H2 margins should show further improvement over H1 aided by the higher export content. MASS’s H2 margin has historically exceeded 20% in each of the last three years, but may be slightly below this in H216 – a more normal level. Order intake was encouraging, and the divisional backlog of £52.4m at the period end compared to £53.4m at the start of the year, and £52.5m at H115. Of this, some £15.0m is for delivery in H2, which compares to just £11.7m a year ago.

MCL (11% sales/9% adj. op profit): MCL normally has a much stronger H2 due to the MOD's in-year spending patterns. The H1 sales increase of 25% was boosted by two extra months of consolidation, albeit these are the weaker months at the start of the year. H115 included sales from now completed contracts where margin contribution was strong as risk retired, and their absence led to the modest fall in profit to close to break even. Efforts to extend contract lengths and the order cycle are encouraging, with the £11.2m contract for hearing protection for the MOD the most notable success so far. The positive outlook is supported by a £13.9m order backlog with £7.2m deliverable in H216. This compares to £6.1m deliverable of the £7.2m backlog at H115.

SCS (16% sales/11% adj. op profit): At SCS the prior period still included sales from the now concluded support contract for operations in Afghanistan, where margin contribution was strong as risk retired with a full contingency release in H215. This has been replaced by increased but lower-margin airworthiness work as new platforms enter service. So, despite the 25% increase in sales to £9.1m (£7.2m) the operating contribution was virtually unchanged at £0.3m as the mix change led to a margin reduction of 100bp to 3.3% for the period. SCS had a period-end order book of £17.7m, which represents a substantial increase over the year-end level of £9.8m and £6.3m at the previous half year. With £7.2m of this deliverable in H216, full-year forecasts are very well supported.

SEA (41% sales/36% operating profit): SEA made good progress with J+S fully integrated at the half year for the first time. J+S accounted for substantially less than the £10.1m improvement in H1 divisional sales, which increased to £22.3m, implying strong growth for the ongoing activities. The 64% operating profit increase to £1.8m (£1.1m) reflected the weaker mix due to tough offshore energy markets and a slightly lower margin for continuing activities. The order backlog of £56.2m compared to £69.0m at the year end, and £80.7m at H115. The H2 deliverable content is £19.0m, compared to £21.1m 12 months previously.

The delay in completing the €19m acquisition of EID in Portugal has been extended, primarily due to the Portuguese election. Cohort now indicates that an initial purchase of 57% (excluding the Portuguese government’s stake) should be completed early in 2016 for €10.8m, in line with the original terms on a “locked box” basis so no value should be lost to shareholders. Cohort will consolidate 100% from the initial purchase date, with any cash value flowing to the minority adjusted from the final stake purchase price. Now the new government has been established, the balance should be completed by June 2016, possibly sooner.

H1 provides a solid underpinning of FY16 forecasts and appears attainable given likely enhanced ordering patterns due to the current high operational activity in defence markets. The order backlog is now increasingly spread across the four divisions as MCL and SCS extend average contract lives into FY17 when £45m of the current bookings are deliverable, aiding visibility. EID will now make an initial small positive contribution in the current year. According to the company, a positive H2 operational cash flow should leave year-end net cash balances at around £9m, assuming the initial stake purchase in EID. If completed fully, this will reduce by a further £5m.

We use a sum-of-the-parts for Cohort’s divisions, calendarised for 2016 against UK defence peers multiples. As the divisional mix has changed, defence valuations have continued to rise and the MCL minority potential cost has been reduced by £6.5m, our valuation has increased.

The resulting sum-of-the-parts value of 445p is some 13% higher than our previous figure of 395p.It implies some modest upside with existing forecasts. Further contract wins in H2 such as the expected ECS contract for submarines, together with follow-on opportunities in hearing protection, airworthiness and training support could provide some further upside.

We have made some modest adjustments to our full-year forecasts as a result of the change in mix in the divisions. We expect SEA to produce slightly lower H2 revenues than last year due to the timing of milestone payments, with SCS now expected to be slightly stronger than anticipated.

The consolidated contribution from EID is only going to be for a relatively short period in FY16. The consolidation will initially be for 100% but with a significant minority until the government stake purchase is transacted. We now expect only £3m of revenues and an adjusted operating profit contribution of £0.2m in the current year compared with our previous estimates.

At the year end the expected cost of the option to purchase the outstanding minority of MCL was £12.5m, but has now been reduced to just £6.0m. The option is exercisable by 31 December 2016. Cohort expects to assume full control by the end of FY17. The reduced minority expectation also increases our EPS modestly in FY17.