Cohort plc (CHRT.L) Earnings Call Transcript & Summary

Good morning. I'm Andy Thomis, Chief Executive at Cohort plc. I'm very pleased to be able to announce Cohort's results for 2021-'22. The presentation today will follow our usual format. I will introduce the highlights. My colleague, Simon Walther, Cohort's Finance Director, will take you through the results in more detail. Then I will bring proceedings to a close with some comments about the outlook for Cohort and the defense market more broadly. Here are the highlights. Our profit performance was in line with the revised guidance that we gave in December. That is some way behind where we were last year, and we'll explain the reasons for that in detail as we go through the results. A more positive indicator for the future is that our order intake was very strong, and we finished the year with a record order book. That gave us a very high level of order cover for the current year, and it's improved even further since now standing at 90% of expected full year revenue. I'm also happy to report that cash flow was very strong and well ahead of profit. We finished the year in net funds of GBP 11 million, somewhere ahead of where we expected to be. That and our positive outlook have given us the confidence to continue growing the dividend, which once again will be 10% ahead of last year. So what are the moving parts behind those headline numbers? Simon will give you the detail, but in broad terms, this is the picture. It won't be a surprise to those who followed us for a while, but MASS was once again the largest contributor to group profit. Revenue fell slightly, but a more favorable mix resulted in a larger profit contribution. At MCL, we saw an increase in customer activity in several important areas. That resulted in a strong performance for the year and an unusually strong year-end order book. It was the first full year contribution from ELAC SONAR and it exceeded our expectations. ELAC won a hugely prestigious contract to supply the SONAR system for the Italian Navy's new submarines, the largest in its history. We also saw a welcome return to growth at SEA under the stewardship of its new Managing Director, Richard Flitton. But 2 of our businesses contracted, and overall, that had an impact on the group's performance. We expected a less positive result of EID, and we highlighted that last year. At Chess, we experienced some growing pains and that resulted in a significantly worse outcome than we had expected. Before we get into the detail, a quick word about the future. Cohort ended the year with a record order book, and that has since grown and that is the strongest single indicator of our future prospects. The market dynamics have moved in our favor with big increases in defense spending announced across Europe since the Russian invasion of Ukraine. That follows on from the U.K.'s GBP 4 billion a year increase announced last year. Cohort's high-tech focus is an excellent match for these growth opportunities. The value of good military communications and intelligence gathering could not have been demonstrated more clearly than by events in Ukraine. We still see some headwinds, especially in relation to lead times and prices for critical components. Nevertheless, these developments give us real confidence about the future trajectory of revenue and profit. With that, let me hand you over to Simon, who will talk through the results in greater detail.

Thank you, Andy. As already highlighted, revenue is down nearly 4%, and I'm going to explain the detail behind this in the following slides. The improvement in gross profit despite lower revenue is due to improved mix at MASS, higher export sales at SEA and more naval work at EID. We also saw higher spares and repair work across the group, which is typically higher margin. One of Chess's poor-performing projects was closed out in early 2021-'22. The overhead increase is mostly a full year of ELAC, but also investment in overhead, particularly senior management at Chess and at head office to address more commercial demands from the subsidiaries, but also to deal with the ever-increasing level of compliance faced by a listed group, even on AIM. We also saw a return to more overseas travel and return to face-to-face meetings and importantly, trade exhibitions. Turning to the subsidiaries. These are, as in the past, [ in our priced ] order, so we begin with the weaker businesses. Chess had a very disappointing year and was worse than we expected. It was the Chess performance that required us to adjust downward our overall group expectations for the year last December. The fall in revenue at Chess was due to delayed orders and delivery problems, partly our own, but also customer-driven delays and some component delays. On the lower revenue, the net margin was much weaker, in part due to the overhead burden, but also continuing margin leakage on a few legacy projects. We expect to close those out this year. The investment in overhead at Chess was focused on its management team, and this has begun to turn the business around. The new year has started better, and we expect a stronger trading performance this year with nearly 100% of its revenue expectation now in order. But also a much better cash performance, reversing much of the cash leakage over the last 2 years. As we expected at the start of the financial year, EID was much weaker due to a large delivery in 2021 of vehicle intercoms to an export customer, not repeated in the current year. An important order for the Portuguese Navy was further delayed and is now expected to be secured in early 2023. EID is around 75% of its revenue expectation for '22-'23 on order. But we do not expect EID to return to historical performance levels of high teens net margin until '23-'24 when the naval part of the business should have higher activity. ELAC contributed a 4 years trading performance as compared with 5 months last year. On a simple pro forma basis, this year was stronger than last year with improved mix, spares, repairs and legacy hydrographic equipment sales, and improved recovery of direct labor costs due to the large Italian contract commencing in the first quarter of '21-'22. ELAC's order coverage for revenue expectations for the coming year are over 90% as it was last year. The mechanism we negotiated with ELAC's previous owner, Wärtsilä, to compensate us for the delay to an overseas order will continue until November '22. It will have paid us just over EUR 2.4 million in total with EUR 0.6 million expected to be recognized in '22-'23, half of what we recognized in '21-'22. The export order remains in our pipeline of opportunities. As in most years, MASS was the largest contributor to group profit. Despite slightly lower revenue, trading profit was up due to improved mix and flat overheads. The drop in revenue was a cessation of the Metropolitan Police service contract and slippage of EWOS training provision and some Joint Forces Command activity into '22-'23, partly a lingering impact of COVID as well as focused distraction, particularly at JFC by the Ukraine conflict. MASS continues to play a key role in its core market, reinforced by the extension of its JFC support work out to July 24, and we continue to play a critical role in support in the U.K.'s electronic warfare and cybersecurity capabilities. MASS's order book extends out to 2027 and now has around 70% of its coming year's expected revenue on order. A good year at MCL with higher revenue and profit. As usual at MCL, the profit was quickly converted to cash. MCL saw more activity in unmanned air and ground vehicle systems, offsetting the completion of deliveries to the U.K. submarine program, the latter now moving into a support phase. MCL's strong relationships with customers and suppliers has seen its activity with the U.K. MOD over the last 6 months, markedly increased and MCL enters the 2022-'23 financial year with a very high level of order cover at 80%. We expect MCL to continue to grow this year, although like all our businesses, supply chain delays remain a challenge. SEA had a better year, although slightly short of our expectations. The significant order wins of last year drove more export and Royal Navy work, and we also saw transport start to recover after the COVID lockdowns. SEA secured GBP 100 million of orders over the last 2 years, and it gives it a strong base of '22-'23, 80% covered and its order book stretches out to 2030. SEA has a strong pipeline in its naval system business, and we expect further long-term orders in the coming year. These bridges provide a useful summary of the main moving parts for revenue and adjusted operating profit or trading profit between last year and this. All of these have been explained in the previous slides. The net funds bridge shows a much stronger net cash inflow than was expected this time last year. I was guiding towards a breakeven position as at the 30th of April '22. We beat that comfortably with some CapEx, delay ELAC, the Chess minority acquisition slipping into '22-'23 and also better working capital performance. Some of the latter is expected to unwind in the coming year. As we announced last week, 19th of July, we renewed our group banking facility, adding Commerzbank to NatWest and Lloyds. The new facility is for GBP 50 million compared with GBP 40 million and extends our facility to July '25 with options to extend to July 2027. Looking forward into the coming year, we expect to acquire the Chess minority in the first half of this year for a cost of no more than GBP 1.4 million. For the analysts amongst you, I have indicated our amortization of other intangible assets for the next 3 years. The tax rate this year, 13.5% will rise to 18% in the coming year due to the mix of profit sources. And with U.K. rates still expected to rise to 25% in April '23, our rates will go up to 24% thereafter. As already indicated, some of the timing advantage in our closing net funds at 30 of April '22 is expected to unwind in '22-'23. And we expect to end the year around GBP 4 million of net funds, but that is never easy to predict. Thank you. And I'll now hand back to Andy.

I hope that's painted a clear picture for you of the results. I'm going to round off the presentation with some words about the future, then I'll try to sum up. Let's start with the wider market picture. The U.K.'s integrated review last year identified 2 major threats to the global order. Russia was seen as the more acute in the short term, but China was assessed to be the greatest state-based threat to the U.K.'s economic security. Of course, alongside those growing sources of instability, we have the well-known ones in Iran, North Korea and elsewhere. The U.K.'s assessment of Russia sadly turned out to be [ pursuit ] as became apparent in February this year. There is every reason to agree with the conclusion on China, too. President Xi is continuing to make threats to Taiwan and may have been emboldened by Russia's breaking of the taboo on invading a peaceful neighbor. China's investment in its vast fleet of surface ships, including 3 aircraft carriers and what is now the second largest submarine fleet in the world shows he means business. The Chinese buildup and the Russian invasion of Ukraine have had a galvanizing impact on defense expenditure around the world, not least in the group's domestic markets. The 2021 U.K. defense review announced a GBP 4 billion a year increase in spending. The U.K. support to Ukraine has resulted in a notable increase in equipment acquisition activity levels. In Germany, the government announced a long-term increase in defense spending and an immediate EUR 100 billion boost to deal with equipment shortcomings and shortages. Germany is not yet a major market for the group, but ELAC SONAR provides underwater communications and echosounders for the Navy, and we expect the need for provision and support of these to increase. We also see a new emphasis on naval spending in Portugal. A fleet of 6 offshore patrol vessels are set to build there as well as a new multipurpose naval ship. EID aims to provide its new generation of communication system for these as well as new radios and intercoms for the Portuguese army. We continue to see good prospects in export markets with the Ukraine conflict and the growing assertiveness of China, driving expenditure in NATO, Southeast Asia and beyond. In the NATO countries, we're seeing increased interest in land-based surveillance. In wider markets, our strong maritime systems offering has generated a lot of interest. For example, Australia has commenced to a large increase in defense spending, including the acquisition of a fleet of nuclear submarines, working with the U.K. and the U.S. in the new Aukus alliance. Japan is reviewing its defense plans with a view to doubling the level of spending. It's also looking to build new alliances. For instance, through participation in the Anglo Swedish Italian Tempest combat aircraft program, and that's a huge change of direction. All of that adds up to a market opportunity that is growing for a business like Cohort. In particular, we're seeing an increased focus on secure communications, command and control and surveillance systems. The importance of these could not have been more clearly demonstrated than in the Ukraine conflict where we've seen Russian troops forced to use the Ukrainian mobile phone network, allowing easy intercept and for them, disastrous tactical outcomes. Another area of focus is antisubmarine warfare, detection and localization of hostile submarines and the technology to defeat their missions. That stems from the realization of the growing threat posed by both Russia and China in this domain. A third technology focus is artificial intelligence and autonomous systems for land, sea and air use. These will be vital in reducing the demand for highly trained defense manpower and enabling faster and more effective responses to aggression. Finally, we see increasing demand for cybersecurity and cyber defense services and software. These are now equally important as battlefield tools as for strategic impact. These are all areas where Cohort is supplying products and technology. Overall, I believe we're well positioned to meet current and evolving customer requirements. This slide shows the runoff of our order book. The left-hand column breaks out the order book between the group businesses. All 6 of them have orders on hand of more than GBP 20 million, including MCL, which is unusually high. 3 of them have over GBP 50 million. After a very successful year of order intake, SEA has now overtaken MASS as the company with the largest order book, now above GBP 75 million. The total of nearly GBP 300 million is a record high for the group. The slide shows that order book now extending well beyond the next 2 years. In fact, SEA's order book now goes after 2030 and we expect that to extend even further if we're successful in winning some of the opportunities we can see currently. This slide provides more detail on that order book breakdown. The second and fourth columns of the table are important for comparison. They show the deliveries on order for the current year in comparison to the situation this time last year. MASS has more or less maintained its position. All of the others have grown sharply, especially ELAC, MCL and SEA. SEA sees a particularly good set of prospects and expects to improve its position further this year. Overall, at the beginning of the year, we had 78% of the consensus external revenue covered by firm orders, much better than the 64% last year. By the middle of this month, that had grown to 90% compared to 70% at the same time last year, with more than GBP 20 million of new orders went already this year. Overall, since the pandemic began in 2020, we've won over GBP 365 million of new orders. That is much better than we feared might be the case when the first lockdowns were announced in March 2020. I should emphasize that this order book picture does not mean that future revenue is set in stone. There can be delays to planned deliveries because of supply chain disruption or for other reasons and occasionally, customers change or cancel orders. But this is the closest we have to a crystal ball, and it provides a strong indication of future growth. One reason that our order book has grown is that we've invested in product and technologies that meet the evolving needs of our customers. We continue to track those needs, and we continue to invest. This slide gives some examples. SEA is working on several fronts, all closely aligned to current defense needs. FILS, the Future Individual Lethality System was a U.K. defense research program that SEA has developed into a specialist sensor and communication system that can be integrated with inventory weapons. SEA is also developing specialized communications architecture to allow data transmission to and from autonomous vehicles. It continues to develop the capability of its road flow range of traffic enforcement systems. EID is developing its product line to match or exceed its rivals capabilities at highly competitive prices. Its new soldier system for the Portuguese Army is a good example, as is the latest version of its maritime communication system, including some new high security features. Chess has an ambitious development program, focusing on integrating novel sensors, deep learning technology for target identification, and a new small high-definition sensor for autonomous platforms. ELAC is pushing more boundaries with the development of its trademark Sphere SONAR technology, developing smart sensors to create more sensitive and flexible acoustic sensor suites than ever before. Ultimately, these will make use of artificial intelligence technology, a potentially hugely disrupted technology and submarine detection in cluttered environments like the South China Sea. And MASS continues to develop its electronic warfare training systems and software products to meet the challenges faced by real-life users as tactics and technology evolve in this vital area. That brings me to the end of what I wanted to say today. And this slide provides a summary of the key points I'd like you to take away. The group's order book is at a record level, and we see a good pipeline of further opportunities. As of now, some 90% of our expected revenue for the year is covered by firm orders. That's a higher percentage than ever before at this point. One reason for this strong position is that our technologies and products are aligned with evolving customer needs. That's a benefit of our devolved business model and small innovative operating businesses. Despite this strong position, there are headwinds. We've seen increases in lead times and prices for some critical components arising from COVID disruption, logistics delays and pent-up demand from other sectors. Nevertheless, we expect to grow in the current year, and we expect that growth to accelerate in 2023-'24 and beyond. Our long-term aim is to target double-digit growth in revenue and profit. We'll achieve that through a combination of investment in new technology and adding new businesses to the group. So overall, we continue to see the future this way. Thank you for your attention. We'd be happy to answer any questions.

There are 2 questions from the online chat. The first one is from Mike Jeremy at Equity Development. Your notes on MASS mentioned support for STEM students, how are you finding recruitment or success in attracting talent being located in Cambridge region? Second, do you include lease obligations in net debt?

Thank you. This is Andy Thomis. Well, it's not just MASS and not just Cambridge. I mean, we -- as a growing business and it's a business which adds value primarily through its people, but not a capital extensive business. We are looking to grow our STEM workforce, and we're pursuing that on a number of fronts. Of course, we need to recruit experienced people. And I think we have a good offering to do that, as a business, which offer some exciting work opportunities. But we're also engaging at the educational level that includes MASS base not only at Cambridge, but also in [ Livingston ]. And our other businesses in the U.K. and overseas as well. And we've had some success at this. We've grown our workforce by about 5% over the last year, and we're looking to continue to do so. It is a tough market, especially for certain specialized skills. And that's sort of double when you take into account that these sometimes it be security clear as well. But I think we are making some headway. Our HR initiatives have been an important part of what we've been doing over the last year, and we see that as being a really important priority for us going forward. So I hope that answers the question. But let me invite Simon to comment on the other part of the question.

Yes. I'm Simon. Thanks, Mike, for the question. The answer is very easy. It does not. Our bank covenant never included as part of net debt at the moment, IFRS 16 updated are removed in those calculations.

The next question comes from Robin Speakman at Shore Capital Markets. Color on capital allocation, please. Working capital expectations for the current year, CapEx and R&D requirements, plans, opportunities. Also, color on inflation and managing these costs.

Again, Simon here. I'll take the first part of that question, and let ask Andy to comment on the inflation, who is the expert. The working capital of the business, obviously, is quite erratic. Some of our businesses like MASS and MCL generally relatively low working capital. And a very cash flow to some of the others, which are in longer-term programs like SEA, ELAC and Chess and to set extend EID, and a little bit more working capital margin in that. And the figures can go up and down. I mean this year has been positive flow on working capital to be driven by SEA and ELAC. Chess had a weak year. I think for the coming year, I expect ELAC and SEA to be weaker in terms of cash generation hardly from -- unwinding cash advances. But we would also expect Chess to improve more be cash generative for the coming years. In terms of CapEx, generally, the CapEx for the group runs at sort of around the GBP 2 million mark per annum. That's mainly in IT and some production machinery. But for the next few years, we have got a capital commitment -- regional capital commitment to come on ELAC's new facility in Germany that we mentioned. Numbers are still being finalized on that, but we'd expect that over the next 3 years probably to be around -- the order of around GBP 13 million to GBP 15 million spread over those 3 years, and that's certainly our assumption for the next few years. In terms of R&D, of our R&D spend this year will be GBP 11 million, just under GBP 3 million is private venture R&D. So GBP 8 million is funded by the customer. A great deal of our R&D spend is customer fund because it's quite bespoke for what they need. It all qualifies for R&D expenditure, both in the U.K. and Portugal. There is no subsidy in Germany. But as you can see, the spend on R&D is quite high for the group across both funded and unfunded R&D. I'll ask Andy on the inflation point comment to questions.

Yes. Thank you, Simon. So yes, inflation is a concern. We can manage it in a number of ways. So typically, we will aim to agree with customers where there are long-term contracts that prices are adjusted on annual basis according to appropriate indices. And in short-term contracts -- well assumption about the likely level of inflation. Inflation is particularly concentrated in certain areas. Semiconductors are an important set of products for us. And inflation in that area has been high. I think it's fair to say that generally speaking, the value of semiconductor content in terms of value of our products is not -- doesn't make up a high proportion of those and so it doesn't have an overall very large impact on cost. I think perhaps a more concern is the increase in lead times that we're seeing. We can manage that to a certain extent by building up stocks of important semiconductor item, but we can't manage that entirely, and we may see an impact from that. I noted this morning that on the today program, there was some from me society of motor manufacturers and traders, mentioned exactly the same [indiscernible] production. So that is something of a headwind. On the positive side, though, we have this very strong order book position and a strong record of order intake and good market backdrop. So that sort of underpins our overall position and confidence in the future. I hope that answers the question.

The next question is from Matthew Tom at [indiscernible]. I'd expect the answer to be yes, but assume you can increase price where cost of goods sold is increasing.

The straight answer to that is sometimes, of course, there's also competitive pressure in some areas of our activity. But as I explained a moment ago, for longer-term contracts, we frequently managed to build in price indices. And everyone's costs are going up, and that does tend to mean that our prices go with.

Andy Edmond from Equity Development asks, congratulations on the order book, and you rightly stressed the importance of extended longevity. Is it your sense that the recent trend to longer term ordering will continue?

The answer to that is, we believe that it will do, certainly this year, we see some good opportunities for really pretty long-term contracts with the stretch the longevity of the order book further. In part, one reason for this longevity has been that we've been winning more contracts in the Maritime side of the business. And naval ship and naval submarine build programs are naturally very long, and that tends to extent -- we'll get to more order book and the visibility of revenue going out quite a few years. Simon, would you want to comment any further on that?

I think you might -- some areas, particularly Naval. You said they are long term. We are seeing customers probably through a combination of trying to -- I think, ensure retention capability industry is looking to invest for longer turn outs. We have seen this year just gone SEA secured a 10-year support contract, and we will be surprised if those contracts of that tier ratio -- I mean over the next few years, there are a number in our pipeline. So very much so that they're going towards that rental support.

Peter Ashworth at Shore Capital. Is there a seasonality to activity? Do you expect the acceleration in orders to continue?

Yes, [indiscernible] Simon?