The company is Cohort (CHRT: 215p), a business that was brought to the Alternative Investment Market (Aim) in March 2006 by co-chairmen and co-founders Nick Brest and Stanley Carter, stalwarts of the defence industries and owners of 31 per cent of the issued share capital between them. In the 18 months following the listing, the company used its new paper to make selective acquisitions, a strategy that has paid dividends quite literally. In the four-year period to end April 2014, Cohort's underlying operating profit has doubled to £8.2m and, with the benefit of decent cash flow generation, this has enabled the board to more than double the dividend to 4.2p a share.
In the latest fiscal year, and following a restructuring of its defence consultancy business SCS, Cohort reported double-digit growth in profits on relatively flat sales, reflecting a doubling of operating profits to £1m at SCS and higher margins earned from advanced surveillance systems and software business SEA. The latter business accounted for £3.8m of group operating profit (before accounting for central overheads of £1.6m) and 40 per cent of Cohort's total revenue of £71.6m. The major income generator, electronic warfare and information systems business MASS, turned in flat operating profit of £5m on revenues of £27m, albeit up against a record performance in the previous year. And last week's announcement of a £3m contract with a new Middle Eastern customer for the provision of electronic warfare operational support services was very encouraging news. The net result was a 7 per cent increase in adjusted EPS to 19.1p meaning that Cohort shares are rated on a modest 11 times historic earnings and offer a 2 per cent dividend yield.
However, I always thought that a major re-rating would only happen when the company put to good use its cash pile. At the end of April, net funds of £16.3m accounted for over a quarter of shareholder funds of £62m and earned a meagre £125,000 of finance income in the prior 12 months. Clearly, there was scope to make earnings-enhancing bolt-on acquisitions by investing this capital elsewhere to generate a more productive income stream. Importantly, this is exactly what the board has been doing.
In fact, following the disposal of an underperforming unit to a joint venture between Thales and Finmeccanica, that cash pile had swelled to £21m by early July. It has also given Cohort the firepower to make two very smart-looking acquisitions.
Earnings-enhancing acquisitions
Three months ago, Cohort invested £8m in return for a 50 per cent stake (plus one share) in Marlborough Communications, a supplier of advanced electronic communications and surveillance technology. The consideration includes a £2m earn-out based on Marlborough's profits for the 2014 financial year. It's a good fit with Cohort's other businesses as it provides the company with the capability to offer fully integrated electronic warfare, communications and intelligence solutions to the UK Ministry of Defence and other customers.
Based in Surrey, and as a standalone entity, Marlborough has over 30 years' expertise in this area. It's very profitable, too: expect an operating profit of around £1.9m in the 12 months to end September 2014, so Cohort is paying little over eight times operating profit for its half-share of those profits. In other words, the company has immediately bought in around £900,000 of extra operating profit by deploying half its year-end cash pile of £16m.
In addition, Cohort has agreed to buy out the balance of Marlborough's shares in two years' time, but this obligation will lapse if the price at the time exceeds £12.5m. The exit price will be determined by Marlborough's order book and profit performance over the next two financial years. Either way, it looks a win-win situation to me.
The second deal, and one announced just five days ago, is equally attractive. For a total consideration of £12m, Cohort is acquiring J+S, a leading UK supplier of systems and in-service support for the defence and offshore energy markets. Its defence products include sonar systems, torpedo launchers and a range of other naval equipment. Established in 1956, J+S employs 137 staff and generates around 88 per cent of sales in the UK.
It's also a highly profitable operation: in the 12 months to end September 2014, J+S is expected to deliver operating profit of £1.5m on revenue of £14m. Moreover, buoyed by an order book in excess of £33m, prospects for the coming year look well underpinned, too. The acquisition will be integrated into Cohort's advanced surveillance systems and software business SEA, and greatly enhances its product range through J+S's submarine communication capabilities.
The bottom line is that without even dipping into the company's £7.5m overdraft facility with Royal Bank of Scotland, Cohort has bought in annual operating profit of around £2.45m in exchange for forfeiting £125,000 of finance income that its cash pile earned last year. From my lens at least, that looks smart business. It also looks smart in the eyes of analysts.
Analyst estimates
Analysts Chris Dyett and Rami Myerson at broking house Investec Securities note that with very little risk to earnings, the latest acquisition of J+S will enhance Cohort's EPS by 5 per cent in the current financial year to end April 2015, and by an eye-catching 15 per cent in fiscal 2016. Frankly it could be more because J+S has been growing strongly in recent years and the analysts "believe we have been conservative in our forecasts". You can see why because after factoring in a partial full-year profit contribution from both Marlborough and J+S in the current financial year to April 2015, Investec is pencilling in revenues a third higher to £95.5m and a £1.5m increase in operating profit to £9.7m. The respective figures for fiscal 2016 are revenues of £102.7m and operating profit of £11.4m.
In other words, the current-year profit growth embedded in Investec's forecasts is almost all accounted for by the two acquisitions. This significantly de-risks earnings and skews the risk towards an earnings beat if Cohort can leverage more business off the acquisitions and if the strong growth in J+S's order book is maintained. This is clearly not reflected in Cohort's current valuation.
In fact, with Cohort’s equity being valued at just £86m, or only 1.4 times net asset value, and the balance sheet completely ungeared, the company's enterprise value (market capitalisation less net cash) to operating profit multiple is only 8.7 times for the year to April 2015, falling to little over 7 times the year after. And that's without factoring in the possibility of Cohort's board making even more earnings-enhancing acquisitions.
It's worth flagging up, too, that the profits from acquisitions will help Cohort's board fund its very progressive dividend policy - the payout has grown by an average of 20 per cent a year since 2010 - and one that Investec expects will see the dividend lifted to 4.9p a share in the current financial year, rising to 5.6p a share the year after. On this basis, the prospective yields are 2.2 per cent and 2.6 per cent, respectively.
Looming share price breakout
As I alluded to at the start of this article, the technical set-up is very promising indeed. Having floated the company at 123p a share in March 2006, Cohort's shares hit an all-time high of 220p in August 2008 before suffering in the subsequent bear market. However, the share price had recovered all the lost ground by November last year. The price pattern since then has been a sideways move with a brief retest of the November 2011 intraday high of 225p in early July.
However, with the company set for some explosive profit growth in the next couple of years, and the valuation attractive, I now feel that the stage is set for a triple-top breakout on the point-and-figure chart (five point) above the 225p resistance level and one that will take Cohort shares into blue-sky territory. The technical set-up certainly indicates that a breakout could be on the cards.
For instance, the 14-day relative strength indicator (RSI) has a reading around 60 so is not yet too overbought, offering the platform for a potentially strong rally to emerge. Furthermore, the moving-average convergence divergence (MACD) trend-following momentum indicator has issued a buy signal and is in positive territory. For good measure, Cohort's share price is also above both the 50-day and 200-day moving averages (around the 200p level), so is not overly extended above these key trend lines. Importantly, there is no overhead resistance from them either.
So with the fundamental case for investing strong and the technical set-up favouring a breakout into blue-sky territory, I feel this is an opportune time to buy Cohort shares. True, they are priced on a wider then normal bid-offer spread of 205p to 215p, but it's worth noting that it's possible to deal within that spread. Moreover, the 40 per cent upside potential to my 300p target price is substantial enough to warrant buying them. My timeframe for achieving this target is six months, a period that covers the release of the interim results in January.
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
