Cohort — Defence remains an increasing priority

Cohort has consistently maintained its strategy focused on delivering growth from defence and security activities through a combination of organic and acquired growth. The strategy is agile, allowing devolved management and providing an entrepreneurial environment with disciplined financial and operational oversight and support from headquarters. The centre also encourages and coordinates strategic cooperation and development between the operations. While the pandemic constrained some operational and marketing activities due to travel and other restrictions, performance remained resilient. This was despite the well-flagged and persistent hiatus in orders for EID in Portugal over the last two years, and the more recent disruption to Chess in FY22. As both the UK and the global defence market environment have received a new impetus, Cohort’s operations appear well-positioned to benefit from increased defence spending. In addition, Chess is resuming a positive trajectory as end-markets for its specialities are stimulated by learning from the Ukraine conflict, and even EID should experience a resumption in both domestic and export orders in 2023 leading to an improved performance from FY24.

NATO member states spent $1.18tn on defence in 2021, with the total having grown progressively since 2015 from $0.90tn. This is despite only eight of the member states meeting the agreed 2014 commitments to spend over 2% of GDP, of which 20% should be on equipment. The median spend was c 1.6% of GDP. The response to Russia’s invasion of Ukraine has been for many states to recommit to achieve the GDP goal sooner, and in the case of Germany, for the first time. On top of the support to Ukraine, the result should be significantly higher available funding for suppliers.

Cohort has a strong track record of delivering organic and acquired growth, albeit constrained in the last couple of years by the COVID pandemic and the coincident hiatus in activity at EID in Portugal. The contract adjustment at Chess in FY22 also detracted from group development, but this reversed in H123. Cohort entered FY23 with a strong order book of £291m, representing almost two years of revenues and providing order cover for FY23 externally forecast sales of 78%, well above the historical normal range of 55–65%. Strong intake in H123 has increased cover to 95% in a record backlog of £304m. With high levels of H123 working capital unwinding in H223, Cohort should end the year with adjusted net cash balances and, having secured an extended £50m bank facility in July, looks positioned to pursue new strategic opportunities should they arise.

As well as creating immediate demand for defence equipment, the war in Ukraine has focused the attention of NATO members and other European countries on national security issues. Commitments to increase defence spending should provide a more supportive environment for suppliers, especially in Europe and the United States, although inflationary pressures could erode the budgetary capacity of governments. The result has been not only a boost to orders for defence suppliers but also a re-rating of the defence sector, building on the resilience displayed by companies during the height of the pandemic despite operational constraints. Cohort operates on an increasingly international basis although it still is heavily oriented towards the UK, which accounts for c 60% of revenues. The issues at EID in Portugal and more recently Chess have delayed the return to growth, but our capped DCF valuation suggests potential upside of c 50% and the FY24e P/E rating of 11.8x appears undemanding.

Cohort is a defence and security holding company. It has six independent autonomous subsidiaries based in the UK (MASS, SEA, MCL and Chess), Germany (ELAC SONAR) and Portugal (EID), all of which provide specialist capabilities for defence and security markets, both domestically and to export customers. Since floating on AIM in 2006, Cohort has been progressively pursuing its strategy of building an independent group through both organic growth and strategically targeted, value-creating strategic acquisitions. The most recent acquisitions of EID, Chess and ELAC SONAR have served to broaden the group offering as well as extend the geographical footprint to customers in Europe and global export markets. The acquisitions have further focused the group on its core markets in defence and security (92% of FY22 sales), with small positions servicing markets in transport (5%) and other commercial markets (3%, including education). In FY22, product sales accounted for 60% of group revenues and services for 40%, much of which is delivered against multi-year contracts and programmes. These exposures have helped to insulate the group from the impact of the pandemic, however lockdowns and travel restrictions did constrain contract execution and new business development activities, although these are now returning to more normal patterns.

The growth strategy remains underpinned by the business model that focuses on the progressive development of the core defence and security capabilities of the group.

The strategic goal of Cohort is to build on the agility, innovation and responsiveness of smaller, more entrepreneurial business models while providing the stability of a larger company with shared skillsets and knowhow, and broader and enhanced market access, all of which is combined with a stronger financial position. There are three key strategic objectives that form the basis for profitable growth while maintaining stakeholder confidence:

Organic growth – to be delivered through assured execution for customers, innovative and responsive engagement, identification of new opportunities and development of high-quality and high-performance leadership teams across the group.

Acquisitions – M&A remains a key element for Cohort as it seeks a proactive engagement with potential targets to demonstrate benefits from financial, structural and cultural aspects. It maintains a strong acquisition team and has been adept at structuring transactions to bridge value gaps.

Maintain confidence – with disciplined financial control, an evolving strategic approach, clear and consistent messaging to stakeholders, and a rapid, responsive attitude should issues arise.

Over the years group management has been fast to respond to operational challenges that have arisen, whether they are foreseen, such as the reduction in activity for submarines at EID, or more surprising, such as the pandemic or the contract issues at Chess. In general terms, management has been very proactive in appropriately managing overheads to reflect volumes.

The FY23 strategic priorities remain consistent with recent periods and the strategic objectives. For organic growth the main focus is on increasing the order book at all subsidiaries and improving order intake at EID. In addition, the group is seeking to capitalise on opportunities that may arise from the greater focus on defence by governments, especially in NATO, while proactively managing the challenges in the supply chain and labour markets. For M&A, the renewal of the group’s financing was completed in July 2022. The two-part facility totalling £50m (£35m RCF and £15m accordion) was agreed on similar terms to the previous £40m facilitating the active search for appropriate value-creating acquisitions, with the acquisition of the outstanding Chess minority clearly aligned with this intention. In terms of maintaining confidence, completing the improvement of operational controls at Chess is also a focus.

Another element of consistency at Cohort has been the senior management team. After selling Alvis to BAE Systems in 2004, Nick Prest co-founded Cohort with Stanley Carter, who had founded its original business SCS in 1992, and became its chairman on flotation in March 2006. The current CEO, Andy Thomis, worked with the founders on the flotation and was its finance director before moving on to become corporate development director and managing director of MASS from 2007 until his appointment as CEO in May 2009. Simon Walther joined Cohort as finance director in May 2006. Clearly the team enjoy a stable and successful working relationship, which few listed defence peers can claim.

Cohort remains a predominantly UK-oriented company. However, following the acquisition of EID in Portugal in 2016 with its own strong export activity, the export-oriented Chess Technologies in 2018 and ELAC SONAR in Germany in 2020, the proportion of sales generated in overseas markets has increased. In FY22, overseas sales represented more than 40% of the group total, more than double the level in FY16 despite the currently depressed activity levels at EID. Most of the revenue increase since FY18 (pre-pandemic) has been from Europe (despite the decline in Portugal) and the Asia-Pacific region, with more modest increases in the UK and the US.

Defence and security accounts for 92% of group sales with just 8% from commercial segments. Most of the commercial revenue is generated in the UK, although transport systems does export, notably to the US. The group provides technical expertise and services across its divisions in addition to product and system sales.

Many of Cohort’s contracts are fixed price in nature and these often include an element of technology development. The company holds risk and builds contingency into its projects, which if successfully delivered can be unwound, typically at the year end. With a largely fixed overhead base, this tends to skew H1/H2 performance, as can be seen in Exhibit 5. Although temporarily distorted by the impact of COVID in FY21 and by the Chess revenue deferral in FY22, the proportional split averages 40:60 in H1 against H2 in most years. We expect this historical second-half weighting will continue in FY23, although we expect a more normal weighting.

One of the strategic priorities continues to be to stabilise and build visibility. Order cover is typically in the range of 55–65% at the start of any given year. Cohort can also operate with an increasing level of shorter-term contracts, which can be supportive at the operating margin level but may not be visible in order book charts.

With £128m of backlog due for delivery in FY23 at the start of the year, order cover reached an exceptional 78% and following a further £20m of intake had risen to 90% by July 2022. By H123 the cover level stood at 95% with over £80m of the H123 backlog due for delivery in H223, giving us significant confidence that our FY23 estimate can be met.

Group order intake also remained positive in H123 with a book to bill ratio of 1.1x, notwithstanding the continued lack of activity at EID and a pause at MASS as customer resources were temporarily diverted to focus on events elsewhere. Exhibit 6 gives a picture of the visibility of the order book across the divisions. As can be seen, the backlog is now well extended with some longer-term orders improving visibility for MCL, historically the subsidiary with the shortest order cycle.

Geopolitical tension has escalated sharply during 2022 with Russia’s invasion of Ukraine focusing attention on defence capabilities and spending among NATO members and allies. Operational requirements to aid Ukraine have also boosted current demand for equipment and services with diversion of NATO resources likely to require replenishment. Concerns in Asia-Pacific have also increased, mainly relating to China and its ambitions.

NATO defence spending fell significantly as military budgets declined due to the spending constraints faced by governments following the financial crisis in 2008/9, reaching a low point in 2015. Following the adoption by member states of the Defence Investment Pledge in 2014 (>2% of GDP with >20% equipment procurement), there has been a sustained growth in spending among European members and Canada. The United States, which already far exceeds the required levels, has also continued to grow defence spending and remains the largest budget in the world by some margin.

The UK meets both NATO targets for defence spending adopted in the pledge but was only one of nine NATO member states to do so in 2022. Many more passed the 20% equipment threshold, but the median GDP spend was just over 1.6%. The war in Ukraine has led to a recommitment to attain pledge levels. Most countries have committed to spending more on defence more rapidly.

Cohort has longstanding relationships with the UK MOD across many different business areas. Many of the existing equipment and support contracts and programmes remain stable, long-term in nature and operationally important, for example in submarines and combat aircraft electronic warfare operational support (EWOS). The shorter cycle businesses, such as MCL and to some extent Chess, are able to rapidly fulfil more immediate operational requirements that, in general, are driven by the pace of defence operations.

Recently there has been discussion of the UK increasing the proportion of GDP spent on defence to 2.5% or even 3.0% by 2030. Such ambitions look increasingly unlikely given the state of the UK’s public finances. In his recent Autumn Statement, the new chancellor of the exchequer deferred commitment to existing and future defence spending decisions made after the 2021 Integrated Review of Security, Defence, Development and Foreign Policy until a further review expected in Q1 2023 is complete. Defence is the fifth largest departmental budget in the UK (c 5.9% of government spending) after health, work and pensions, business, energy and industrial strategy, and education. While retaining 2% of GDP as a minimum target, we assume that the environment in the UK remains a potential opportunity given military requirements. The enormous competition for the allocation of funding makes such an assumption uncertain, exacerbated by inflationary pressures and growth concerns, but we feel that following the Ukraine invasion, national security and defence is likely to remain a priority. While this is nothing new, the ability of Cohort to provide value-for- money, responsive and flexible solutions and service propositions appears to be continuing.

As released in the UK MOD Annual Report and Accounts for 2021/22, defence spending cash out-turn in the fiscal year to April 2022 was £45.9bn, up from £35.1bn in the year to April 2015. That continues the growth of recent years but remains below the peak levels of the previous year and well below the higher levels seen in the early 1980s and at the turn of the decade of around £50bn. Under existing plans it is expected to reach £48.6bn in cash terms in 2024/25, representing a real annual average increase of 3.4% from 2020/21, although the current review may affect that.

In 2021/22 capital expenditure on equipment was £14.2bn (31% of UK defence spending) with a further £7.5bn (16%) spent on equipment support and £5.1bn on infrastructure (11%). Service personnel costs accounted for £10.4bn or 22% of the total.

Cohort’s challenge is to maximise its opportunities in the evolving budgetary environment, which can change planned spending on programmes, for example submarines, while also responding to operational requirements that may now increase from recent low levels.

Germany is currently the third largest contributor to NATO, after the US and the UK. Following the invasion of Ukraine, the German government has reversed three decades of policy. It has also committed to at least 2% of GDP spending levels, partially through a €100bn (£85bn) special fund for military equipment modernisation that should lead to increased investment levels over the next three years. Germany has never met the goal and would probably overtake the UK in absolute spending terms if it does meet the target unless the UK increases defence spending to more than 2.5% of its GDP. In 2021 the German MOD received funding of €46.9bn. To meet the target, defence spending would have to rise to €75.5bn in 2022 compared to the draft budget appropriation of €50.3bn and €85.6bn by 2026, albeit Germany faces similar pressures to the UK in terms of public spending constraints and inflationary pressures.

In Portugal, neither of the NATO targets is currently being met; in 2021 it spent only €3.3bn or 1.6% of GDP. Portugal does not appear to have committed to the pledge, so equipment contracts remain more severely constrained than in other countries, however we believe there is a pipeline of domestic equipment orders to be placed. This could improve order intake for EID, which also continues to seek opportunities in its export markets.

Prospects in the Rest of the World are unlikely to diminish as the regional tensions in Asia-Pacific and elsewhere continue to exercise several governments. Globally defence expenditure remains on a rising trend and Cohort continues to develop export relationships from its UK, Portuguese and more recently added German operations.

Cohort has seen a return to growth in H123. The easing of pandemic constraints has been partial but accompanied by a boost to defence market prospects following Russia’s invasion of Ukraine. However, there has been some diversion of customer financial and human resources to focus on the effects of the conflict, which has delayed some programmes and mitigated increased operational demand for equipment and services. Chess has recovered strongly but EID remains in a depressed phase with Portuguese naval orders not expected to materialise until the first half of 2023. The key highlights of the H123 results are:

SEA, EID, ELAC and MCL all increased their backlogs from the start of the year, with particularly strong order intake at SEA (£37.5m) and MCL (£16.1m). While Chess saw its backlog decline, its intake was significantly ahead of H122, but with deferred revenues from FY22 being delivered during the period sales were exceptionally high. MASS continued to work through its existing backlog but management believes it is starting to rebuild its business development pipeline. Over £80m of the group’s H123 backlog should be delivered in H223, providing strong order cover of 95% for FY23 consensus forecast revenue expectations and providing confidence in our estimates. Management indicates the pipeline of opportunities remains strong for H223.

Earnings revisions

Overall the H123 performance and 95% order cover supports our estimates for FY23 and FY24. We do now expect modestly higher revenues with slightly lower margins due to changes in the divisional mix. The Chess minority purchase in November for £1.0m leads to a small enhancement in FY23 EPS, with a slightly greater benefit for the full year effect in FY24. The growth in PBT is partially mitigated by the increase in corporation tax effective from next year.

After paying for the Chess minority, the company remains in a strong financial position, with near neutrality for adjusted net funds (excluding leases) of £4.9m expected at the year end.

MASS provides the core capabilities in Cohort’s electronic warfare (EW) and ICT service offerings, with its predominant customers being government bodies. It includes Cohort’s developing cyber capability and data security services and operates through four divisions:

MASS is consistently the group’s most profitable business, with longstanding client relationships providing tailored and well-integrated solutions; operating margins have increased year-on-year from 2019 to 2022. It benefits from long-term service contracts including its Joint Command and Staff Training (JCAST) contract of over 20 years with the UK armed forces’ Strategic Command. This contract has been extended over a two-year period for a value of over £11m, commencing in the summer of 2022, and demonstrates MASS’s commendable customer-tailored capabilities.

As mentioned in our August update note, MASS’s sales fell 3% in FY22 to £38.5m (FY21: £39.5m). Its adjusted operating profit improved to £9.1m (FY21: £8.7m) with a record margin of 23.7% achieved due to favourable revenue mix, cost savings in delivering some longer-term contracts and flat overheads. Despite improved order intake of £34.1m (FY21: £25.6m), the book to bill ratio decreased marginally and the order backlog declined to £72.8m as the operations continued to deliver against long-term contracts.

The trends continued in H123 with lower sales and subdued order intake, but with a higher margin of 23.0% (H122: 19.5%), benefiting from an improved mix of work, although management expects it to fall slightly in H223. Of the £64.8m backlog, £14m is deliverable in FY23, underpinning revenue expectations for a stronger second half, with an overall profit performance in line with last year. It assumes some return to more delivery of training services, especially in the UK.

Chess Dynamics is an innovative, well-respected surveillance, tracking and gunfire control specialist for military and commercial customers. It was acquired by Cohort in 2018, having supplied a range of equipment and systems to defence leaders since 2005. It designs, manufactures and supplies a range of electro-optical and electro-mechanical systems to the defence and security markets including tracking, targeting and drone-protection systems.

As previously indicated, in FY22 there was a sharp drop in revenues of 41% to £16.9m (FY21: £28.6m). Over half the fall was caused by a mutually terminated contract that led to a reversal of £6m of already booked revenues in FY22. The system involved has subsequently been sold, which, together with a robust order backlog, provides complete cover for FY23 sales expectations. Order intake was a healthy £15.2m (FY21: £57.7m) net of the cancelled order, primarily for European land forces, including some extensions to existing contracts. It also included £4m of spares and repairs. The FY22 end backlog fell slightly to £40.7m (FY21: £42.3m)

Despite much stronger order intake in H123 of £14.3m (H122: £6.1m), the order backlog declined further to £35.9m (FY22: £42.6m) due to the exceptional revenue performance due to the project deliveries delayed from last year, although these carried lower margins. With £12m of revenue to be delivered in H223 from the backlog, management expects Chess to have a far stronger second half margin and deliver an overall improvement for FY23. Cohort completed the buyout of the outstanding 18.16% minority for £1.0m on 30 November 2022, which will modestly boost group EPS in FY23 and beyond.

SEA delivers a broad range of systems, products and services into the defence and transport markets. It operates through three divisions:

FY22 order intake was strong at £36.8m, but a repeat of the exceptional levels seen in FY21 of over £63m was not expected. Orders secured in FY22 included ECS (External Communications System) and other systems work for the UK submarine fleet, including initial orders for the new Dreadnought class. Export orders included TLS for the Philippines Navy and an initial ECS for a Royal New Zealand Navy frigate. SEA also acquired the 50% of the JSK activity in Canada that it did not already own, positioning it to secure and support business with the Canadian Navy, including TLS for the new frigate programme. Order intake was also robust for the Transport business, ROADflow, where revenues returned to pre-pandemic levels.

2022 has seen a new era of global conflict, which provides a significant opportunity for the division’s maritime defence business. With the ongoing invasion of Ukraine, Russia continues to pose a significant threat to the North Atlantic, with its large submarine fleet of c 64 vessels. Additionally, China now has the largest navy in the world, by both tonnage and the sheer number of vessels, with maritime capability on a par with the US Navy; the Chinese Navy consists of well-armed ships with modern sensors and weapon systems. Its invasive cyber and espionage capability, alongside its focus on missile capability, poses an ongoing threat to Taiwan. Combined, these factors have driven increases in defence spending particularly in the maritime domain in the UK and Far East Asia. This is advantageous for SEA, being a trusted brand that supplies to the Royal Navy and increasingly sells to Australia and Canada. Consequently, we expect a boost in order intake in upcoming years.

In Q123, Cohort announced that SEA had been awarded a new £34m contract by the UK MOD to upgrade systems and equipment of the anti-submarine warfare and countermeasures system on various platforms that the Royal Navy uses. In-service system support will be provided for a five-year period with the option to further extend for two years. The order significantly strengthened the division’s order backlog to £96.3m at H123, providing improved visibility of future revenues.

With positive H123 revenue development and £17m of the significantly increased backlog deliverable in H223, management expects a stronger H223 performance to deliver FY23 adjusted operating profit ahead of FY22.

EID is Cohort’s subsidiary in Portugal, with the Portuguese government owning 20%. Its capabilities lie in the increasingly important areas of tactical and naval command, control and communications (C3). It supplies domestically to naval and military customers as well as to a wide range of export customers including 145 naval vessels globally.

EID sales declined sharply in FY22 to £8.2m (FY21: £21.0m) following the completion of a large intercom systems export contract in FY21 combined with low domestic activity. Adjusted operating profit was £0.9m (FY21: £4.8m,) largely due to operational gearing, with the margin of 11.1% (FY21: 23.1%) well below the historical range. Order intake improved to £11.4m (FY21: £4.2m) following the award of a long-delayed order by the Portuguese Army. The year-end order backlog improved to £23.1m (FY21: £20.0m).

EID’s H123 performance was disappointing as the continued delays to orders led to lower revenues and a larger adjusted operating loss. Of all Cohort’s activities, EID was affected the most by continued supply chain and order delays, as well as price increases, which have led to the deferral of some deliveries into H223 and FY24. With £8m of H223 revenues deliverable from the £23.7m backlog, management expects some improvement in operating profit, but a break-even result now appears likely.

While there are some good prospects, EID now expects to secure an anticipated significant naval order for the Portuguese Navy in the first half of calendar 2023. It also still awaits a pickup in its important export markets, which could be helped by the increased global focus on up-to-date and secure defence capabilities and tensions in Asia-Pacific boosting maritime defence investment.

Marlborough Communications Limited (MCL) is a leading supplier of advanced electronic communications, information systems and signals intelligence technology to the defence and security sectors. Its primary customer is the UK MOD, which accounts for more than 90% of revenues. It supports a diversified portfolio of C4IS capabilities, including hearing protection systems, communication headsets and radio communication devices. Alongside this, its ISTAR portfolio includes signals intelligence and EW systems, as well as unmanned aerial vehicle (UAV)/counter-UAV technologies.

In FY22, MCL continued to recover from the challenges faced in FY20, delivering further revenue growth of 21% to £21.7m (FY21: £18.0m). Adjusted operating profit rose slightly to £2.2m (FY21: £2.1m) with margins falling slightly to 10.4% (FY21: 11.5%) due to a higher level of systems deliveries in FY21. The order book grew substantially to £22.5m (FY21: £12.4m) following a very strong order intake of £31.8m (FY21: £21.8m). Orders secured included over £15m for hearing protection systems as well as close to £7m of additional work on autonomous vehicles. Management continues to try to secure larger and longer-term delivery and support opportunities for the Royal Navy that would improve visibility for MCL. It has the shortest order cycle of Cohort’s businesses with typical lead times of three to six months. However, it also tends to be at the forefront of the pace of defence operations and as such has seen positive momentum in its order pipeline in the last few months. Strong H123 order intake further increased the period end order backlog to £24.8m (H122: £13.0m), significantly higher than historical levels.

With high UK MOD activity levels, including the supply of armoured fighting vehicle hearing protection, the continuing geopolitical tensions and a good pipeline of opportunities, visibility has increased. Management appears confident that it can repeat the strong performance in H223, providing a much-improved FY23 profit.

ELAC SONAR, the most recent acquisition for a net consideration of £1.3m in November 2021, serves global naval customers, including navies, system integrators and shipyards. It supplies hydroacoustic sensors for underwater surveillance, object avoidance and ranging, including submarine and surface ship sonar suits, submarine rescue sonars, digital underwater communications and echo-sounders for manned and unmanned platforms. EID is its sister company, with both cooperating on sonar naval projects.

ELAC made a stronger first full-year contribution in FY22 than management expected compared to just five months in FY21, following its acquisition. FY22 revenues were £21.5m (FY21: £8.3m) and contributed £3.8m (FY21: £1.2m) to adjusted operating profit at a margin of 17.5%. The margin benefited from £1.1m of cost recovery from Wӓrtsilӓ, relating to an order that had yet to be finalised, with the underlying margin being 12.4%. A final £0.4m was received from the arrangement in H123 before it concluded as the contract for submarine sonar systems was secured, benefiting FY22 order intake of £57.1m. The £43m contract for two Italian U212 NFS submarines from Leonardo provides long-term underpinning of its sonar activity, with options for two more boats; ELAC is supplying the sonar suite kaleidoscope 2.0 to the submarines. ELAC also secured new, upgrade and spares orders for its market-leading underwater communication systems. It also more than doubled the order backlog to £56.8m (FY21: £21.2m), which further increased to £58.6m at H123.

It delivered a weaker H123 performance due to slightly lower sales and the anticipated adverse business mix as it continued work on the early stages of its major Italian sonar contract, which carries lower margins than exports and legacy products and spares. The adjustment payments from Wärtsilä to cover costs incurred on a delayed order prospect ended during the period and contributed £0.4m of the £0.9m divisional operating profit. £13m of revenue to be delivered in H223 is in the opening order book. Management expects ELAC to deliver a stronger H223, although FY23 will see a reduced profit contribution. With navies requesting larger, more capable solar arrays, ELAC has stated it will move into a new facility in a few years to cope with these larger projects; and the division will likely start to focus on expanding globally as a result. The first £1.5m of the £15m capex investment for the project was committed in H123.

Cohort remains oriented towards the UK defence and security market, notwithstanding the substantial increase in overseas and export sales over the last decade, principally arising from the acquisitions of EID in Portugal and ELAC SONAR in Germany. While prospects for improved global defence spending have improved over the last 12 months as geopolitical uncertainties have increased, the UK budget still risks being constrained by domestic political and economic upheavals, as GDP grows more slowly and energy induced inflationary pressures partially consume increased funding levels. In the current environment Cohort’s agile, innovative and flexible offer appears appropriate, delivering value for money as a specialist and expert solutions provider. The pace of spending and demand for new solutions is also influenced by operational and regional tensions. Other sensitivities include:

We continue to use our capped DCF methodology as our main valuation tool for Cohort. The valuation utilises our forecast cash flows for a period of six years, then assumes zero growth in the terminal value. To reflect the lack of growth, we also normalise capex to depreciation and working capital movements to zero in the terminal cash flow. Given the high levels of inflation and increased UK interest rate environment, we have increased our assumed risk-free rate from 2% to 3%, which increases the cost of equity assumed to 9%. For Cohort our calculated WACC is now marginally above 8.0%. The DCF currently returns a value of 610p per share, which would have been 687p using the previous assumptions (683p previously).

For a company such as Cohort where we envisage a continued growth of cash flows due to the strategy of enhancing long-term organic growth in defence markets with selective, value-creating and complementary acquisitions, we feel that such a methodology is inherently conservative. We show a sensitivity analysis to terminal growth rate and WACC assumptions in Exhibit 29 below, with the value closest to our calculated levels highlighted.

When considered against its UK defence peer group, Cohort had been derated significantly over the last 12 months, with the share price falling by 16%, in part due to the issues that arose at Chess in H122. However, the core performance has been relatively resilient through the pandemic and the defence market outlook is significantly better than it has been for a long period. As can be seen from the table below, Cohort trades at a 28% discount or 23% if we adjust to exclude the outliers (Babcock, Rolls-Royce, and Senior). Most defence peers have responded well in 2022 to the improved defence environment, notably BAE Systems, which is up c 50% in response to the invasion of Ukraine. Given that Cohort has already returned to growth in H123, ahead of expectations, and has a record order book combined with a strong balance sheet to support strategically targeted M&A, the discount appears unwarranted to us and should narrow.