The company has a number of diverse business activities ranging from being a major supplier of naval equipment to the UK Royal Navy, a designer and manufacturer of petrol stations forecourt superstructures, and a manufacturer of high-quality open die hammer forgings for use within many industrial applications.
The primary reason I recommended buying the shares in the first place was down to the prospect of a recovery in earnings from MSI's defence activities and the upside from an earnings accretive acquisition last summer which boosted its petrol stations forecourt business. Progress was mixed with the defence business reporting a marked turnaround in the 12 months to the end of April 2016, reporting segmental operating profit of £1.75m on a 29 per cent rise in revenue to £21m. This contrasts with a loss of £247,000 on revenue of £17m the previous year. However, the forecourts business went into reverse despite the upside from the successful integration of the Petrol Sign BV acquisition into MSI's 'petrol station superstructures' business. Operating profit there declined by 45 per cent to £412,000 on revenue up 15 per cent to £15.5m, a reflection of project deferrals from major oil companies, dealers and supermarkets.
True, MSI's overall pre-tax profit rose by 9 per cent to £1.68m to deliver EPS up 17 per cent to 9.6p, but this was less than I expected last autumn when I initiated coverage. The main reason being challenging markets for the forgings business which manufactures a size-range of original equipment fork-arms for the forklift truck, construction, agricultural and quarrying equipment manufacturing industries together with aftermarket products. Several markets it serves were adversely impacted by deepening recessionary conditions and the division's three business operations in the UK, US and Brazil all had to contend with reduced weekly orders and revenue. The unit slumped to a loss of £343,000 on revenue down 20 per cent to just shy of £12m, quite a reverse from an operating profit of £1.25m in the prior year. There are no signs of an upturn either so the forgings business is likely to continue to prove a drag on performance in the current financial year. Chairman Michael Bell also notes the "fragility of the anticipated upturn remains a salient feature in our future planning and expectations" for the company's defence business.
There are positives, though, as the petrol stations forecourt structures business is seeing "a good number of the new station builds [that customers postponed last year] being resurrected for construction in the current year. With the summer construction period approaching full swing, there has been a significant upturn in order intake over recent weeks from our traditional markets in the UK, Eire and Eastern Europe." A forecourt superstructures operation has been opened in The Netherlands to strengthen the company's market position in mainland Western Europe and Mr Bell is "greatly encouraged by the positive response of the petrol station forecourt market to our business expansion programmes."
The shares are also heavily asset backed. Net asset value of 169p a share includes net funds worth 77p a share and plant and equipment worth 97p a share. The board maintained the payout at 8p a share, so the share price is supported by a solid 5 per cent dividend yield. Also, strip out net cash, and the shares are rated on 8.6 times last year's cash-adjusted earnings, hardly a punchy rating. However, it's one that highlights an uncertain market outlook for both the forgings and defence businesses.
In the circumstances, I am struggling to find a catalyst here to re-rate the shares anytime soon, and having banked both the half-year and final dividends worth in total 8p a share, I am inclined to crystalise a modest loss on the investment although medium-term income holders may wish to hold on as the payout is safe given the cash position and hefty directors shareholdings. Sell.
Cohort delivers
MSI is not the only company exposed to defence markets whose share price has been weak recently. Shares in Aim-traded UK defence company Cohort (CHRT:315p) are down by almost a fifth since I advised running profits at 390p in early April ('Cohort's contract boost', 4 Apr 2016), albeit they are still well ahead of the 214p level at which I initiated coverage ('Blue-sky buy', 6 Oct 2014), and I did recommend top slicing two-thirds of the holding when the price was 415p in mid-December to capitalise on a near-100 per cent total return ('On a roll', 15 Dec 2015). This meant that if you followed that advice the balance of your holding is in the price for free, and you also have cash in the bank.
The question is whether the shares have potential to re-rate from here? I think they do. That's because Cohort's defence prospects in the UK appear to be largely immune to any direct impact from Brexit, due to the long-term nature and operational importance of its major programme exposures, and export markets remain attractive. In fact, last month's earnings-accretive acquisition of a majority stake in EID, a Portugal-based supplier of advanced electronics, communications and control products for the global defence market, gives the company direct access in the EU as well as new export markets. Cohort acquired a 57 per cent stake in EID for £8.9m and intends to purchase a further 23 per cent from the Portuguese government for €4.4m (£3.7m) by the end of October. EID generated sales of €18.9m and operating profit of €2.9m in 2015 and continues to report low to mid-teens growth, so the investment will be immediately earnings accretive to Cohort especially as the company ended the full year to the end of April 2016 with net funds of £19.8m, a cash pile worth 49p a share.
I would also flag up that once you strip out a one-off exceptional tax credit worth 2.2p a share, EPS rose 22 per cent to 25p in the financial year, a performance underpinned by organic revenue and operating growth of 5 per cent and 13 per cent, respectively. In other words, the contracts Cohort has been winning have largely delivered this outcome rather than acquisitive growth. A closing order book of £116m underpins prospects for the year ahead when analyst Andy Chambers at Edison Investment Research believes Cohort's revenues will rise from £112m in the 12 months to the end of April 2016 to £132m to lift adjusted pre-tax profit by 20 per cent to £14.3m. On this basis, expect underlying EPS to rise to around 26.5p and underpin a further 17 per cent hike in the dividend to 7p a share following the 20 per cent increase the board have just declared.
On this basis, Cohort shares are rated on 10 times cash-adjusted forward earnings estimates and offer a prospective dividend yield of 2.2 per cent. That's a harsh rating for a company with a solid order book, exposure to a currency tailwind on overseas earnings, and one with a cash-rich balance sheet.
In the circumstances, I would recommend running your profits on the balance of your holdings as I can see the investment risk here to the upside. Analyst sum-of-the-parts valuations around 387p a share look a realistic target to me. Run profits.
