Defence Order Delays And Cash Strain Will Eventually Support Long Term Earnings Momentum

Catalysts

About Cohort

Cohort is a defence technology group made up of seven businesses that supply technology based products and services to the UK and allied militaries worldwide.

What are the underlying business or industry changes driving this perspective?

• Although global defence spending is rising and Cohort has an order book of over £600m that extends into the mid 2030s, long development and acceptance cycles on programs such as the Italian Navy submarine contract, with around £10m of provisions still held, mean any slippage in testing or sea trials could delay revenue recognition and keep net margins under pressure for longer.
• While demand for undersea surveillance and protection of subsea infrastructure is increasing through programs like Atlantic Bastion and products such as KraitSensor, KraitArray and ELAC’s Enlitor, the need for customers to finalise concepts of operation and integrate AI partners like Helsing could slow deployment. This may push out expected revenue and limit near term margin expansion.
• Although governments are raising defence budgets in Europe and Asia Pacific and NATO members have set higher long term spending ambitions, Cohort’s reliance on converting a large pipeline of prospects into firm multi year orders across navies in Portugal, Italy, Canada, New Zealand, Australia and Japan means any procurement delays or reprioritisation could cap growth in group revenue and keep earnings volatility elevated.
• While EM Solutions has widened exposure to satellite communications and contributed strongly to divisional margins at 16.8% and over 17% net margin guidance for the Communications and Intelligence division, the integration of new technologies and coordination with group companies like EID and MASS may require sustained investment and working capital that weighs on free cash flow and near term earnings.
• Although rising use of drones, counter drone systems and electronic warfare is feeding demand for Chess, MASS and MCL, operational challenges at Chess in shifting from an engineering focus to volume production, along with supply chain tightness in components such as permanent magnet motors, could constrain delivery schedules and limit the pace of improvement in divisional net margins.

Assumptions

How have these above catalysts been quantified?

• This narrative explores a more pessimistic perspective on Cohort compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Cohort's revenue will grow by 7.0% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 6.5% today to 9.7% in 3 years time.
• The bearish analysts expect earnings to reach £33.4 million (and earnings per share of £0.79) by about May 2029, up from £18.3 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as £38.7 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 23.8x on those 2029 earnings, down from 28.3x today. This future PE is greater than the current PE for the GB Aerospace & Defense industry at 23.7x.
• The bearish analysts expect the number of shares outstanding to grow by 0.28% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.68%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Order conversion risk across a long dated book of over £600m and a large pipeline of prospects. If customers defer or cancel programmes such as Italian Navy submarines, Atlantic Bastion or naval communications upgrades, revenue could be pushed out beyond current analyst timelines and increase earnings volatility.
• Execution risk on complex delivery and test milestones, including factory, harbour and sea acceptance trials on the Italian submarine contract where around £10m of provisions remain on the balance sheet. Any technical issues or schedule slips could delay revenue recognition and keep net margins below the 9.7% level bearish analysts are assuming.
• Working capital and cash conversion risk, with a first half operating cash outflow of £27.9m and net debt of £32.5m linked to large second half deliveries and roughly £600m of annual receipts and payments. Sustained pressure on cash generation could constrain reinvestment and weigh on future earnings.
• Operational and supply chain risk as businesses such as Chess move from engineering led to volume production and face tight supply in components like permanent magnet motors. Difficulty scaling output or securing parts could limit the ability to meet demand in areas like counter drone and air defence, capping revenue and margin progress.
• Acquisition and integration risk as Cohort pursues further deals in areas such as autonomy, artificial intelligence and satellite communications. Higher valuation expectations from vendors or misjudged targets that fail to deliver order growth similar to EM Solutions could dilute returns and put pressure on group earnings and return on capital.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Cohort is £13.5, which represents up to two standard deviations below the consensus price target of £16.17. This valuation is based on what can be assumed as the expectations of Cohort's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of £19.3, and the most bearish reporting a price target of just £13.5.
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be £343.3 million, earnings will come to £33.4 million, and it would be trading on a PE ratio of 23.8x, assuming you use a discount rate of 8.7%.
• Given the current share price of £11.3, the analyst price target of £13.5 is 16.3% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.