Join our community of smart investors

Cobham remains vulnerable

Despite remedial actions, the defence contractor isn't out of the woods and its shares look expensive
July 27, 2017

Last week’s cover feature (“Protect yourself from profit warnings”) has prompted us to re-evaluate our neutral stance on Cobham (COB). That article outlined the difficulties faced by the defence contractor since the 2014 deal to acquire Aeroflex, a US-based maker of microelectronic components and test and measurement equipment.

IC TIP: Sell at 136p
Tip style
Sell
Risk rating
High
Timescale
Medium Term
Bull points

• Improved defence spending outlook

• Possible takeover target

Bear points

• Pressure on profit margins

• Execution of US Air Force contract

• Legacy of Aeroflex acquisition

It set out the problems linked to debt levels following the acquisition and to contract delays and underperformance in some of the group’s business units. These problems culminated in February's profit warning – the latest in a series since November 2015 – and precipitated a two-for-five rights issue, which was completed during the second quarter. The capital raising was undertaken as part of management initiatives to cut debt and improve the execution of contracts.

The trouble is that the criticism of the Aeroflex deal, at least in terms of its strain on the group's finances, has obscured persistent trading weakness. True, Cobham's troubles might have been symptomatic of a wider malaise in the defence industry, yet rivals such as Chemring (CHG) and Meggitt (MGGT) struggled for a time but managed to turn things around.

We think it boils down to a case of overstretch; management pursued an overly aggressive expansion strategy and got found out. The group’s chief executive and chairman were changed during the second half of 2016, but the underlying problems persist even though the outlook for global military budgets is now far more favourable. We think they will continue to weigh on margins for the foreseeable future despite recent remedial actions.

 

The contractor has struggled with a development contract for new air-to-air refuelling tankers for the US Air Force, which, along with related issues at its wireless, integrated electronics and semiconductor solutions businesses, prompted £574m in write-downs at the time of February’s profit warning.

With 20:20 hindsight, industry watchers now question whether the price struck for the Aeroflex acquisition was justified given that its sales had been in decline. That’s a matter for conjecture, but a near halving in full-year free cash flow provides a pointer to underlying capital indiscipline. Cobham was forced to tap shareholders for the second time in a year, as it edged towards the upper threshold of its net debt covenant of 3.5 times cash profits (Ebitda). Presumably the year-end multiple (three times Ebitda) should contract as a result of the £512m rights issue, although in absolute terms it only fell by £179m during 2016 despite £491m in net proceeds generated from the previous rights issue as recently as June 2016.  

COBHAM (COB)   
ORD PRICE:136pMARKET VALUE:£3.25bn
TOUCH:136-137p12-MONTH HIGH:155pLOW: 89p
FORWARD DIVIDEND YIELD:1%FORWARD PE RATIO:24
NET ASSET VALUE:See textNET DEBT:£531m
Year toTurnoverPre-taxEarningsDividend
31 Dec(£bn)profit (£m)per share (p)per share (p)
2014 †1.8524.32.39.30
2015 †2.07-39.8-2.59.75
2016 †1.94-847.9-46.01.77
2017*2.011565.3nil
2018*2.061775.61.40
% change+3+13+6-
Normal market size:20,000   
Matched bargain trading    
Beta:0.5   

*JPMorgan Cazenove forecasts (not comparable with historic figures); †Reported per share figures adjusted for two-for-five rights issue