Cohort — Defence prioritisation to strengthen demand

Cohort delivered against FY22 expectations that were revised down at H122 and momentum has appeared to improve as the year came to a close. The bulk of the business performed well, with MASS, SEA, MCL and ELAC all ahead. Cohort responded to the anticipated weakness at EID, due to lower domestic orders in Portugal, and issues at Chess as project execution, contract delays and other issues impaired profitability. In addition, inflationary headwinds increased as the year progressed. The rest of the business made good progress, and as pandemic constraints eased and geopolitical tensions rose, the operational environment for defence companies improved. Most significantly, order intake remained strong and a record order backlog now underpins 90% of FY23 market consensus sales. With operational requirements gathering pace due to the Russian aggression in Ukraine, Cohort should grow strongly in FY23 and management are targeting double-digit growth in the medium term.

The key features of the FY22 results are summarised below:

Defence and security revenues accounted for 92% (FY21: 94%) of the group total in FY22, reflecting the drop of EID and Chess revenues, which more than offset the full year contribution from ELAC against five months in FY21. Non-defence sales grew by £1.9m to £11.2m. The defence and security sales can be split further by customer and market segment as shown in Exhibits 2 and Exhibit 3, respectively. Overall, group revenues were split 60:40 between products and the provision of services.

Board change

Cohort has also announced that its co-founder and largest shareholder (22.1%), Stanley Carter, is not seeking re-election to the board as a non-executive director (NED) at the forthcoming AGM. He formed the group with chairman Nick Prest in 2006 and was its first CEO before becoming co-chairman in 2009. He stepped down to his current NED role in 2015. Cohort has entered into a shareholder agreement with Carter, and he is expected to remain a supportive shareholder.

Divisional summaries

MASS

MASS provides training, electronic warfare and cyber security services to predominantly government customers. It operates through four divisions: EWOS (Electronic Warfare Operational Support), Digital Services, Strategic Systems and Training Support.

While MASS’s sales fell 3% in FY22 to £38.4m (FY21: £39.5m) it improved adjusted operating profit to £9.1m (FY21: £8.7m) with a record margin of 23.7% achieved due to favourable revenue mix, cost savings in delivering some longer-term contracts and flat overheads. It continued to face pandemic constraints in the early part of the year, but these moderated as the year progressed. The Training Support operations and export-oriented EWOS business were particularly affected, with some activity slipping into the current year. Its UK MOD revenues increased modestly, but this was more than offset by a shortfall in export revenues. The division generated a strong operational cashflow of £9.9m as outstanding invoices were collected during the year. That is not expected to recur in FY23.

Despite improved order intake of £34.1m (FY21: £25.6m) the book to bill ratio was negative and the order backlog declined to £72.8m as the operations continued to deliver against long-term contracts. With £26.8m deliverable in FY23 providing a lower than usual level of sales cover of 61%, management expects MASS to show only modest growth in the current year.

Chess

Chess Dynamics is an innovative, well-respected surveillance, tracking and gunfire control specialist for military and commercial customers.

As previously indicated, during the year there was a sharp drop in revenues and profitability at Chess. Revenues fell 41% to £16.9m (FY21: £28.6m). Over half the fall was caused by a mutually terminated contract that led to a reversal of £6m of already booked revenues in FY22. The system involved has subsequently been sold which, together with a robust order backlog, provides complete cover for FY23 sales expectations. Weaker margins on some projects due to delays, customer deployment changes and technical challenges continued, along with legacy project issues that the now established new management team has been working hard to correct. As a result, the adjusted operating profit fell to just £0.3m (FY21: £3.0m).

Order intake was a healthy £15.2m (FY21: £57.7m) net of the cancelled order, primarily for European land forces, including some extensions to existing contracts. It also included £4m of spares and repairs. The backlog of £40.7m (FY21: £42.3m) contained £22.0m for delivery in FY23.

Cohort is confident of a return to growth in the coming year as problem project issues are resolved by the strengthened management team and expects a performance close to FY21 levels.

SEA

SEA delivers a broad range of systems, products and services into the defence and transport markets. It operates through three divisions: Complex Systems, Maritime Solutions and Transport Management. In Maritime it provides combat systems requirements to UK and export customers including communications and ship and fleet protection such as torpedo launching systems (TLS). It also supplies anti-submarine warfare systems, including towed array sonars, infrastructure and training. It carries out technology research on behalf of the UK MOD into future maritime and soldier systems. Transport delivers automated traffic enforcement systems in the UK and United States.

SEA’s continuing activities grew revenues by 12% in FY22 to £31.0m (FY21: £27.0m) as a result of weaker transport and research sales, and despite the subsea business contributing £1m in FY21 up to its divestment in August 2020. Submarine system revenues stepped down again in FY22 as Australia shifted to a nuclear-powered option and cancelled the existing contract for a diesel-powered boat. SEA is optimistic that it should win the external communication system (ECS) when the programme is relaunched. Adjusted operating profit grew 44% £3.4m (FY21: £2.4m).

Order intake was strong at £36.8m but a repeat of the exceptional levels seen in FY21 of over £63m was not expected. Cohort is positive about prospects for further export and Royal Navy support contracts in FY23. Orders secured in FY22 included ECS and other systems work for the UK submarine fleet, including initial orders for the new Dreadnought class. The submarine segment should now start to grow. Export orders included TLS for the Philippines Navy and an initial ECS for a Royal New Zealand Navy frigate. SEA also acquired the 50% of the JSK activity in Canada that it did not already own, positioning it to secure and support business with the Canadian Navy including TLS for the new frigate programme. Order intake was also robust for the Transport business, ROADflow, where revenues returned to pre-pandemic levels. The backlog of £75.1m (FY21: £69.3m) is now the largest in the group, with £27m due for delivery in FY23 underpinning some 80% of sales expectations.

Management expects SEA to grow further in the coming year and adjusted operating margins to approach 12%.

EID

EID is Cohort’s subsidiary in Portugal, 20% owned by the Portuguese government, with capabilities in the increasingly important areas of tactical and naval command, control and communications (C3). It supplies domestically to naval and military customers as well as to a wide range of export customers including 145 naval vessels worldwide.

As previously indicated well in advance, EID sales declined sharply in FY22 following the completion of a large intercom systems export contract in FY21 and in the face of very low domestic activity. Sales more than halved to £8.2m (FY21: £21.0m). Sales to the Portuguese Ministry of National Defence fell to £3.9m (FY21: £5.9m) and export sales on which EID relies dropped to £4.2m (FY21 £14.9m). Adjusted operating profit was £0.9m (FY21: £4.8m) largely due to operational gearing, a margin of 11.1% (FY21: 23.1%) well below the historic range.

Order intake improved to £11.4m (FY21: £4.2m) following the award of a long-delayed order by the Portuguese Army. The order backlog improved to £23.1m (FY20: £20.0m). It provides order cover for its expected sales with £11.3m of the order book deliverable in FY23. While there are some good prospects, including a significant naval order for the Portuguese Navy that EID expects to secure in FY23, it still awaits a pickup in the important export markets, which could be helped by the increased global focus on up-to-date and secure defence capabilities.

Management expects EID to improve its performance in FY23 but to be short of levels achieved historically and we continue to take a cautious view.

MCL

Marlborough Communications Limited (MCL) is a leading supplier of advanced electronic communications, information systems and signals intelligence technology to the defence and security sectors. Its primary customer is the UK MOD, which accounts for more than 90% of revenues.

In FY22 MCL continued to recover from the challenges faced in FY20, delivering further revenue growth of 21% to £21.7m (FY21: £18.0m). Adjusted operating profit rose slightly to £2.2m (FY21: £2.1m) with margins falling slightly to 10.4% (FY21: 11.5%) due to a higher level of systems deliveries in FY21.

The order book grew substantially to £22.5m (FY21: £12.4m) in FY22 following very strong order intake of £31.8m (FY21: £21.8m). Orders secured included over £15m for hearing protection systems as well as close to £7m of additional work on autonomous vehicles. Management continues to try to secure larger and longer-term support opportunities for the Royal Navy that would improve visibility for MCL. It has the shortest order cycle of Cohort’s businesses with typical lead times of three to six months. However, it also tends to be at the forefront of the pace of defence operations and as such has seen positive momentum in its order pipeline in the last few months.

With £20.4m of the backlog due for delivery in FY23 providing order cover of its sales expectations of 80%, management expects MCL to grow further in the coming year.

ELAC

ELAC serves global naval customers including navies, system integrators and shipyards. It supplies hydroacoustic sensors for underwater surveillance, object avoidance and ranging including submarine and surface ship sonar suites, submarine rescue sonars, digital underwater communications and echo-sounders for manned and unmanned platforms.

ELAC made a stronger first full year contribution in FY22 than management expected compared to just five months in FY21, following its acquisition for a net consideration of £1.3m in November 2021. FY22 revenues were £21.5m (FY21: £8.3m) and contributed £3.8m (FY21: £1.2m) to adjusted operating profit at a margin of 17.5%. The margin benefited from £1.1m of cost recovery from Wärtsilä relating to an order that has yet to be finalised, with the underlying margin being 12.4%. A further £0.5m should be received from the arrangement in FY23 before it ends and hopefully the contract for submarine sonar systems is secured. Order intake of £57.1m benefited from securing a £43m contract for two Italian submarines from Leonardo, which provides long-term underpinning of its sonar activity, with options for two more boats. ELAC also secured new, upgrade and spares orders for its market-leading underwater communication systems. It also more than doubled the order backlog to £56.8m (FY21: £21.2m), with current year sales cover of 90%.

FY23 is expected to be a year of consolidation in the early stages of the Italian contract and with the lower cost recovery from the Wärtsilä agreement. Management expects performance to be in line with FY22.

The year-end order book of £291.0m (FY21: £242.4m) was once again a new record level for the year end with much of the increase driven by ELAC, which secured an order worth more than £40m for the development and delivery of sonar for two new Italian submarines. ELAC’s strong order performance compensated for more normal levels of intake at Chess and SEA, which both achieved significant export order levels in FY21. MCL also secured its best level of orders since joining the group, which included more than £15m of hearing protection orders and £7m of extensions to its work on autonomous vehicles for the British Army. Its products are most closely corelated to the increase in operational activity resulting from the war in Ukraine, with momentum building towards the year end. As a result of these factors, FY22 order intake of £186.4m was up 3.4%, representing a book to bill ratio for the group of 1.35x (FY21: 1.26x).

Of the FY22 year-end backlog, £127.7m (FY21: £99.7m) is expected to be delivered in FY23, providing 78% cover for consensus sales expectation of c £164m, substantially better than the previous year level of 64% and a record level. The subsequent increase in cover levels to 90% (July 2021: 70%) suggests that risk to revenue estimates may be to the upside due to low levels of infill orders required and the more favourable current defence environment.

Cohort continues to invest in organic growth in line with its agile growth strategy. Discussions over a new facility in Kiel are expected to lead to a c.£15m investment programme over the next few years. In addition, spending on new product development continues to grow with research and development (R&D) investment in FY22 of £11.3m (FY21: £9.5m) including close to £3.0m (FY22: £3.6m) that was self-funded. The current divisional focus on projects is:

It also continues to target value-enhancing merger and acquisitions opportunities both in the UK and overseas.

Adjusted net cash of £11.0m (excluding leases liabilities) was again better than expected, largely due to delayed capital expenditure, deferral of the Chess minority buy-out and the favourable timing of receipts. These factors are expected to unwind in FY23. As a result, management expects net cash balances to be reduced in FY23, after the £1.4m buy-out of the Chess minority that is now expected in H123. Lease liabilities rose marginally to £10.1m (FY21: £7.6m).

Since the start of FY23, Cohort has renewed and extended its banking facility. The new facility is for three years to July 2025 with options to extend it to July 2027. The £35m revolving credit facility has been agreed on broadly similar terms to the previous facility (which was due to expire in November 2022), and there is an option (accordion) to draw a further £15m. The facility has been extended from two to three banks.

Cohort’s strong financial position and the cash generative nature of the operations allows management to maintain a robust capital allocation policy. Organic investment and self-funded R&D spending remain key, while supporting the progressive dividend policy. The robust balance sheet also provides resources to pursue strategic value-adding acquisitions.

Overall, our estimates for FY23 are broadly unchanged, although there are some divisional mix changes. EID is starting to recover ahead of our prior expectations, while ELAC faces a year of consolidation ahead of delivery on some major contracts. Operations are generally returning to normal as travel restrictions are diminishing and client engagement is improving, which is reopening export opportunities. The evolving defence environment should remain supportive as allocated spending increases and the Ukraine conflict generates additional requirements. However, as we noted in our previous note, some customer resources may be diverted by shifting short-term priorities, with some services work being necessarily deferred.

We also introduce our FY24 estimate. We expect continued growth of revenues to £178m, an adjusted profit before tax estimate of £19.6m, and our adjusted EPS estimate is 35.6p. We now forecast end April 2024 adjusted net cash of £13.0m. Management guidance is for growth to accelerate in FY24 based on current orders for long-term delivery and the pipeline of opportunities.

In the longer term, management is targeting double-digit growth.

Our capped DCF valuation now stands at a value of 684p compared to 678p per share previously. The increase reflects the combination of higher starting net funds, higher investment levels reducing near term cashflows and a calculated weighted average cost of capital (WACC) of 7.2%. The sensitivity of our capped DCF model to WACC and terminal growth rate is shown below.