Cohort — Record year delivered despite pandemic

Cohort delivered another year of growth in FY20 despite some impact of COVID-19 in the final quarter, which in sales terms is normally the strongest quarter for the businesses. COVID-19-related factors including lockdowns delayed some customer acceptance and deferred new order processes. Management estimated these caused a slip of £3m of revenues and £1m of adjusted operating profit into FY21. Despite the pandemic, Cohort delivered record sales, adjusted operating profit and adjusted EPS in FY20, the key highlights of which are summarised in Exhibit 1.

The key features of the FY20 results are:

Defence and security revenue accounted for 90% (FY19 88%) of the group total in FY20. The increase is more than accounted for by the £14.5m incremental sales from the full-year contribution of Chess, compared to just five months in FY19. Defence and security sales can be split further by customer and market segment, as shown in Exhibits 2 and 3. Overall group revenues were split 57:43 between products and provision of services.

Sales rose by 5% in FY20 to record levels of £41.1m (FY19 £39.0m) and adjusted operating profit increased 9% to £8.9m (FY19 £8.2m), a margin of 21.7% (FY19 21.0%). The export-oriented electronic warfare operational support business was broadly flat year on year, with divisional sales growth driven by two long-term support contracts for the UK MOD. One was renewed last year and the further two-year extension of the Joint Forces Command support contract (JCAST) worth £11m was announced in July 2020. MASS has provided the service for 15 years and the extension includes three further one-year extension options. The order backlog did fall from record levels as the company started to work through the record FY19 order backlog. However, order cover for the current year now stands at almost 90%. We expect MASS to make further progress in FY21.

SEA’s revenues fell by 17% to £31.7m (FY19 £38.3m) as a result of expected naval export order deferrals which slipped into FY21. There was however a disproportionate drop through to adjusted operating profit which was 36% lower at £3.3m (FY19 £5.3m). While SEA’s opening order book of £33.6m is significantly better than at the start of FY20, and provides just under 50% sales cover for FY21, the structure of the orders is shorter term than the historic norm. To optimise costs to anticipated activity levels management has implemented a further restructuring programme that should complete by the end of July 2020 at a cost of £0.7m with annual savings of £1.3m.

There are some encouraging signals for the medium to long term, with submarine systems revenues expected to start to recover in FY21 driven by the UK Dreadnought programme, as well as a growing workload on the Australian submarine programme. The drop in SEA’s revenues can almost entirely be attributed to the decline in sales for the submarine segment from a peak in 2016. In addition, the level of research activity is picking up (FY20 sales £5.2m) and this is expected to continue with a growing proportion of naval research work.

Chess was acquired in December 2018. Its first full-year contribution in FY20 was ahead of plan, with like-for-like sales growth after a strong initial five-month contribution in FY19. Revenues of £25.2m compared to £22.9m in the 12 months to April 2019. The performance was driven by higher sales of naval systems to UK and overseas export customers. Adjusted operating profit was £3.9m, a margin of 15.6%. While the order backlog of £13.4m represents a significant reduction on the FY19 level, it has been boosted since the year end by a substantial order intake of over £27m, providing over 80% cover for FY21 consensus sales expectations. Management expects the division’s performance in the current year to be similar to FY20.

Following a disappointing FY19, EID saw a strong recovery, with sales improving 56% to £18.0m (FY19 £11.5m). Revenues for the Portuguese Ministry of National Defence more than doubled and accounted for over 50% of sales. The growth was achieved despite EID accounting for around 50% of the overall COVID-19 impact with some £1.5m of revenues deferred into FY21.The operational leverage led to an adjusted operating profit of £3.1m (FY19 £1.3m) a margin of 17.8% (FY19 11.8%), returning to management’s long-term expectation. The order book rose 46% to £36.5m providing over 90% order cover for FY21 sales. Management expects some key domestic Portuguese orders in the current year as well as further export orders.

Following a strong year in FY19 MCL experienced a more challenging year as deliveries of hearing protection systems and for UK submarine programmes did not repeat. There were also some delays to anticipated orders and changes to customer plans that resulted in a 31% decline in sales to £15.1m. Adjusted operating profit fell to £1.7m although the margin improved slightly to 11.0% (FY19 10.5%). Management continues to make efforts to lengthen the order book which at £8.6m provides limited visibility. It is currently pursuing larger and longer-term support opportunities for the Royal Navy. Order cover is similar to FY20 at just under 40% and management indicates a better anticipated level of near-term opportunities.

The year-end order book of £183.3m was 4% lower than the previous year’s record level. Order intake remained relatively robust considering the £70m of contract renewals booked in FY19. MASS notably booked a long-term £50m UK MOD support contract renewal in H219 which it is now trading, as reflected by its lower backlog. The book to bill ratio for the group was 0.95x.

Of the group backlog, £84.5m is expected to be delivered in FY21, providing 62% cover for the consensus sales expectation of c £136m, well above the prior year level of 55%.

In addition, the order intake in Q121 has been strong, with over £50m of orders booked since the start of the financial year including:

As a result, the order cover currently stands at 75% for the group. Management expects FY21 revenues to be split 40:60 between H121 and H221.

As well as the orders already booked, there is an encouraging pipeline of additional prospects that includes:

In line with its agile growth strategy management continues to invest in organic growth and target value-enhancing acquisition opportunities both in the UK and overseas. In FY21 £2.9m was spent on self-funded R&D. The divisional focus on projects is

MCL is looking at long-term business expansion by new applications of existing skills for the Royal Navy.

One impact of the pandemic has been the delay to regulatory processes. It has resulted in the longer than anticipated approval process of the German government for the proposed €11.25m acquisition of ELAC Nautik (ELAC) from Wärtsilä, first announced on 12 December 2019. Completion is now expected to be before the end of September.

ELAC develops and supplies sonar systems technology for naval surface ships and submarines and is complementary to Cohort’s other naval capabilities, notably at SEA. It also extends the group’s customer base and global reach, as well as establishing a presence in the German defence market. The company brings with it significant cash balances that will offset a major proportion of the cash cost, so the impact on net debt will be more modest than the purchase price suggests. However, in common with other defence contractors, ELAC has contract bonds and guarantees that do impinge on the availability of cash from a liquidity perspective, reducing available headroom.

As a reminder (see our note of December 2019) the deal should be financially compelling, directly enhancing EPS and allowing for some drawdown on the credit facility creating value quickly following completion. For the year ended 31 December 2018, ELAC generated revenues of €20.7m and EBIT of €1.4m, with growth expected for both in the year to 31 December 2019. The order book at 31 October 2019 stood at €26.4m, of which €20m is due for delivery in 2020, with a tail to 2025. We expect updated numbers to be provided on completion.

FY20 results were the first to implement IFRS 16, with £7.5m of leases and £6.0m of right of use assets added to the balance sheet. The change in accounting treatment reduced profit before tax by a mere £50k, although cash flow is unaffected.

Net debt of £4.7m was better than expected partially due to accelerated invoice settlement terms by the UK MOD aimed at supporting its suppliers’ cash performance as COVID-19 took hold. The robust balance sheet leaves some £35m of available liquidity, with £20m of gross cash and around £15m of the £40m four-year revolving credit facility (RCF) remaining undrawn. The RCF was increased by £10m in May 2020 and expires in November 2022, with an option to extend to November 2023.

In aggregate the changes to our earnings estimates are relatively small and are shown in the table below. We also introduce our FY22 estimates.

We calculate our fair value based on a simple average of a sum-of-the-parts calculation and a capped DCF. Currently this stand at 606p, before any benefit from the proposed ELAC acquisition.

Our sum-of-the-parts valuation based on the calendar year 2021 performance produces a value of 608p per share. It uses relative valuations to UK defence peers for each division.

Our capped DCF valuation methodology currently returns a value of 604p. The calculated WACC is marginally above 7.5% reflecting a cost of equity of 8% and modest debt levels. We assume no growth in the terminal cashflow value and normalise capex to depreciation with no working capital movements to reflect the static growth assumed. The sensitivity to various WACC and terminal growth rates is shown in the table below.