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Cubic (NYSE:CUB)

Q3 2013 Earnings Call

August 01, 2013 4:30 pm ET

Executives

Diane Dyer - Director of Investor Relations

James R. Edwards - Senior Vice President, General Counsel and Corporate Secretary

William W. Boyle - Chief Executive Officer and Director

John D. Thomas - Chief Financial Officer and Executive Vice President

Analysts

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

George A. Price - BB&T Capital Markets, Research Division

Timothy Joseph Curro - Value Holdings, L.P.

Charles Clarke - Crédit Suisse AG, Research Division

Operator

Welcome to the Cubic Corporation's Third Quarter Fiscal 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. At this time, I would like to turn the conference over to Diane Dyer, Director of Investor Relations. Please go ahead.

Diane Dyer

Thank you, operator. Good afternoon, everyone, and thank you for joining us. Cubic Corporation is a leading international provider of cost-effective systems and solutions for mass transit and global defense markets. Today, after the market closed, we issued a press release reporting the company's financial results for the quarter ended June 30, 2013. A copy of the press release is available on the Investor Relations section of our website at www.cubic.com. We encourage everyone to read today's press release and refer to our most recent reports on Form 10-Q and Form 10-K. These documents are available from the SEC and from our website.

An archive of this call will be available later today on Cubic's website at the Investor Relations tab under Webcasts and Events.

On the call today are William Boyle, Chief Executive Officer; John D. Thomas, Executive Vice President and Chief Financial Officer; Paul Pecham [ph], Assistant Corporate Controller; and James Edwards, Senior Vice President and General Counsel.

Now I'll turn the call over to Jim Edwards for the Safe Harbor disclosure.

James R. Edwards

Thank you, Diane. Please note that certain information discussed on the call today is covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act. I caution listeners that, during this call, the Cubic management will be making forward-looking statements.

Actual results could differ materially from those stated or implied by these forward-looking statements due to risks and uncertainties associated with the company's business. These forward-looking statements should be considered in conjunction with and are qualified by the cautionary statements contained in Cubic's earnings press release and SEC filings, including its annual report on Form 10-K and quarterly reports on form 10-Q.

This conference call contains time-sensitive information that is accurate only as of the date of this broadcast, August 1, 2013. Cubic undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this conference call.

Also, please note that management will discuss certain non-GAAP financial measures. A reconciliation between the GAAP financial measures that correspond to these non-GAAP financial measures is contained in our earnings press release and our SEC Form 10-Q report for the quarter ended June 30, 2013. Any discussion of non-GAAP measures is not intended to detract from the importance of the comparable GAAP measures.

With that said, let me turn the call over to Bill Boyle, our Chief Executive Officer.

William W. Boyle

Thanks, Jim. Good afternoon, and thank you, all, for joining us today. Our third quarter results, which I assume you all have by now, were generally in line with Wall Street expectations, with earnings per share of $0.69, a bit higher than the consensus forecast of $0.65.

Although our sales of $340.4 million were a bit under the consensus of $349 million, which $3 million of that $9 million differential being due to currency rate movements. So the quarter was pretty much as you probably expected.

The 2 major changes in the third quarter were the improvements in our backlog and cash flow from operations. Like everyone else in the defense marketplace, we've been impacted by the sequestration and overall DoD environment. However, as we have said in the past, we expect to be impacted less than most others, primarily due to our transportation presence and our inroads into international defense markets.

Importantly, in the third quarter, defense systems backlog grew by $141 million and is now $91 million higher than at the end of last fiscal year. While defense systems sales in the third quarter were only $83 million, at the same time, they booked $234 million of new business into backlog, of which $159 million or 68% of that $234 million was international.

In addition, our other defense segment, Mission Support Services, increased their backlog by $64 million so far this year to $801 million. Thus, in a very difficult DoD marketplace, our 2 defense segments have actually grown their backlog by $155 million this year, and this does not even include approximately $270 million of the very important littoral combat ship award of almost $300 million earlier this year. Since although that is sole-source, it's an ID/IQ contract, which goes into our backlog only as task orders are received.

Transportation's backlog did decline this year by $121 million since year end. Some of this was expected due to the progress being made on major new contracts in Vancouver and Sydney. But about half of that decline, $59 million was simply due to currency exchange movements.

Their total backlog, of course, remains very strong at well over $1.5 billion, $1,543,000,000 to be precise.

With regard to cash flow from operations. After operating cash outflows of $56 million in the first 6 months of this fiscal year, we said that this would turn around in the second half and should be very strong next year. That turnaround, in fact, did happen in the third quarter with positive operating cash flows of $49 million, which made a big dent in the $56 million outflow earlier in the year.

With that, I'll now turn the call over to Jay Thomas, our CFO, who will review the specific segment results. Jay?

John D. Thomas

Thank you, Bill. I'll begin with a segment review for the third quarter, starting with Cubic Transportation Systems, or CTS. Sales increased 6% in the third quarter to $133.8 million from $125.8 million last year. The increase was primarily driven by higher sales on contracts in Minneapolis, New York and a suburban Chicago bus operator.

On the suburban bus contract, we are integrating the operator's bus fleet with the Chicago's new Open Standards Fare System, named Ventra. We are making significant progress on the Chicago Open Standards Payment System. Through June 30, approximately $61.8 million of -- in cost have been capitalized for this project.

We anticipate that Ventra will go live in mid-August and become fully operational in January 2014. Because of the work involved in preparing for the system launch, we will incur start-up costs over the next few months during the launch period.

During this period, we will incur approximately $2.5 million per month of expenses commencing in mid-August that will impact the operating income for CTS through the end of the calendar year, when we will start to -- receiving revenues on the contract.

CTS operating income decreased 5% in the third quarter to $18.2 million compared to $19.2 million last year. The decrease was due to less development work in the U.K. and an increase in the cost estimate to complete the smartcard ticketing system in Sydney, Australia. These decreases in operating income were partially offset during the quarter by higher operating income on contracts in the U.S., as well as a settlement on the European services contract.

Currently, we are working on pilots for rail and bus in Sydney, which are part of the city's new smartcard system named Opal. Upon completion of these pilots, this will lead to the final deployment phase of the project anticipated in late fiscal 2014, when we will transition to systems operation. On the Vancouver project, we had completed the pilot for the new smartcard system, and we'll move into full system operations by the fourth quarter of fiscal year 2014.

Year-to-date operating profit margins for CTS were 16.3% compared to 15.8% last year. We expect our operating profit margins will decline from the current levels due to the start-up costs we will incur on the Chicago project, as previously discussed, and higher spending for research and development related to next city in efforts to expand our addressable market.

We expect CTS will have lower operating margins for the fourth quarter and the first quarter of fiscal year 2014. We continue to see fiscal year 2013 as a transition year due to the major transit projects that are in the final stages of completion. Once these projects achieve system acceptance and move into the services space, we anticipate a more consistent operating performance from our Transportation segment.

Total backlog for CTS was $1.54 billion, down $120.5 million from $1.66 billion in the September 30. Approximately $59 million of the decrease was attributable to negative currency movements. I'll now review the highlights of Mission Support Services, or MSS.

MSS sales increased 1% in the third quarter to $123.8 million compared to $122.4 million last year. Lower sales from training contracts for the U.S. military were more than offset by sales from NEK, a special forces training company acquired in December. NEK added $11.4 million in sales for the third quarter and $21.1 million for the first 9 months.

Excluding sales from NEK, MSS comparable sales were down 8% for the quarter when compared to last year and were down by approximately 5% for the 9-month period. As Bill mentioned, it's a challenging environment for defense services.

In the third quarter, MSS operating income was $3.6 million, down from $5.9 million last year or 39%. For the 9-month period, operating income decreased 24% to $11.4 million from $15 million last year.

In both periods, the decreases in operating income were due to decreases in sales to the U.S. military and because of an operating loss from NEK in the amount of $700,000 during the third quarter and $1.2 million for the 9-month period, including the acquisition-related cost of $600,000.

MSS operating income is after a charge of amortization of intangibles related to acquisitions. The charge for the third quarter was approximately $3.3 million and the charge for the 9 months totaled approximately $9.4 million.

For the fiscal year, the total charge to operating income for the amortization of intangibles for MSS will be $12.5 million. MSS total backlog increased to $800.6 million as of June 30 from $737 million at September 30 or a 9% increase. The increase included $23.9 million of backlog from NEK.

In summary, MSS performance is reflective of the challenging DoD environment. We believe our expansion into the intelligence and special forces training markets position MSS into higher barrier to entry sectors of the professional services market, which should differentiate MSS performance over the long term.

MSS continues to pursue international and non-DoD related opportunities, which leverage its broad set of qualifications and would generate better performance if they're successful.

Next I'll provide an update on Cubic Defense Systems, or CDS. Sales for the third quarter decreased 29% to $82.8 million compared to $116.9 million in the same quarter last year, and decreased 5% for the 9-month period to $267.2 million from $280.9 million last year.

In comparison to last year, sales and operating income in the third quarter of 2013 were down due to a defense systems contract settlement that occurred in the third quarter of 2012. This settlement resulted in higher operating income and higher sales of $12.5 million for the third quarter of last year.

Sales were lower for the 3- and 9-month periods due to a decrease in ground combat training and small -- virtual small arms training systems. These decreases were partially offset by increased shipments of MILES and higher sales of air combat systems.

CDS operating income for the third quarter decreased 52% to $7 million, compared to $14.6 million in the same quarter of last year, and decreased 68% for the 9-month period to $8.5 million from $26.7 million last year. Operating profit margins in the third quarter were 8%, which is -- which was a significant improvement over the prior 2 quarters this fiscal year, reflecting benefits from the restructuring of CDS in the second quarter.

We anticipate that operating margin should continue to improve in this segment in the fourth quarter to more normalized levels in the range of 9% and 9.5%.

CDS total backlog at the end of the quarter was $521.8 million, an increase of 21% from the $430.9 million at September 30. We're anticipating CDS total backlog should increase over the balance of the fiscal year.

After the quarter-end, we announced that we completed 2 small acquisitions, Advanced Interactive Systems and PSMC. These businesses will be operated by our defense systems segment. The acquisitions will expand our capabilities in live fire virtual training and training services in the U.S. and international markets. I will now turn it over to Bill for closing thoughts.

William W. Boyle

Thanks, Jay. I don't have much to add to what already has been said other than to mention that early in the year, we talked about this being a transition year after last year's record year. All things considered, we think we're getting through this transition period okay.

And with that, I'd like to take whatever time we have left to hear any questions you might have. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Josephine Millward with Benchmark Company.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

Jay, in terms of the acquisition, can you talk about revenue contribution in the coming year?

John D. Thomas

On the 2 small acquisitions, it's probably going to be in the range of $10 million to $15 million, combined.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

What about profitability?

John D. Thomas

Typically, in the first year, we typically say that we would expect them to be a little bit on the dilutive side, but these are relatively small. So I don't think it's going to have much of a positive or negative impact in the first year.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

And do you expect NEK to become profitable in fiscal year '14?

John D. Thomas

Well, NEK -- if you add back the amortization, NEK is profitable. So, yes, we would expect that -- I think what we have said earlier in the year, we would expect NEK to be accretive next year in '14.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

And a follow-up. It looks like the U.S. government is going to be operating under a sequestered budget level in fiscal year '14. How do you plan for that in the coming years since the government fiscal year is coming very soon?

John D. Thomas

Well, technically, that all went into effect in March. And I think, across the board, you're seeing that there was a lot of indecision. So our service revenues are down 5% on a year-to-date basis. On an organic basis, they're down 8% in the quarter. Just looking at across the whole industry, it looks like the whole industry is performing about the same level. So we think that we'll probably see a bottom in the impact of sequestration some time in fiscal year '14 and '15. So we don't -- at this point, we're not giving any really specific guidance. But the market for services, specifically, is very soft.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

Right, I was referring more to the government in fiscal year '14 because it doesn't look like the Congress is going to be able to reverse sequestration for '14 and forward.

John D. Thomas

Yes, a lot of that is going to drive what our bookings are because remember, now, what's driving our revenues for us next year is what's in backlog. So it'll let -- what ends up resulting from the budget will probably kind of impact us in the second half of '14 and into fiscal year '15.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

Switching gears a bit. Can you talk about transportation upcoming opportunities? If you can give us an update on some major -- your bid and proposal pipeline for transportation?

John D. Thomas

So the largest activity would be in North America. There is a tender that's ongoing right now for Washington, D.C. We're not sure that they'll reach some sort of decision some time in this fiscal year. These things typically can take 6 to 9 months once a tender has gone in. Overseas, there are some opportunities in Western and Eastern Europe that we're looking at, and we still continue to look at some opportunities in the Middle East. And there will be a lot of follow-on work on existing contracts that we're working on. So there'll be follow-on work and a lot of other major projects that we're working on.

Operator

Our next question comes from George Price with BB&T Capital Markets.

George A. Price - BB&T Capital Markets, Research Division

First of all, just on the, in CTS, you mentioned a couple of moving parts within that and one was an adjustment to the project in Sydney. Can you quantify that adjustment? Is it at all material? Does it indicate any major slippages or overages or anything on that project?

John D. Thomas

So in the 10-Q, we actually specified that -- what the amount was. And from memory, it's a couple of million dollars. So we're really in the final stages of the development phase of the project right now. So it's -- I wouldn't consider that we've slipped the timetable. It was just a re-baseline of some cost to finish the development phase. So we're progressing on 2 pilots right now. 1 for the bus system and 1 for the rail system. And once we get complete on those pilots, then we're expecting to complete the development phase some time towards the end of our fiscal year '14.

George A. Price - BB&T Capital Markets, Research Division

Okay. All right. Very good. And then, I guess, did you -- is there also more detail in the Q? Apologies, I haven't gotten to that yet. But is there more detail in the Q on some of the other moving parts like European service contract claim?

John D. Thomas

Yes.

George A. Price - BB&T Capital Markets, Research Division

Okay. Great, great. And then, I don't think I've seen an update on what's going on with the diligence on the Serco Transportation business. Do you have any update there?

John D. Thomas

I think the only thing that we could say at this point in time is that we're continuing it with diligence. And that at the appropriate time that we've completed that, then there'll be some sort of announcement on that transaction. So it's still ongoing at this point in time.

George A. Price - BB&T Capital Markets, Research Division

Okay, okay. Great. And then, I guess, last question, maybe on the LCS training contracts. Has there been activity? Can you give us an update on those? Has there been activity there in terms of tasking and what that might look like?

John D. Thomas

Well, we've received, I think, a couple of task orders. So we did get some funding in the quarter. I think it was $30 million. So that project is well underway. We're in the process operationally of outfitting and building our -- well, we've been working on our facility that -- where we'll house all of this, which is down in Orlando. So we've got quite a bit of recruitment going on of people for the program. So it's up and running.

William W. Boyle

And we're expecting another award of $20 million to $30 million before the end of this year.

John D. Thomas

And there are some follow-on bid opportunities that we're pursuing. So there is a follow-on opportunity on LCS called the mission bay trainers. So that is something that we've submitted a proposal on.

George A. Price - BB&T Capital Markets, Research Division

Right. Okay. Great. And that was at the end of fiscal year or calendar year?

John D. Thomas

In terms of the funding?

William W. Boyle

Well, we hope at the end of the fiscal year, but it could go over to the calendar year. You're not -- can't be that precise about government awards.

Operator

[Operator Instructions] Our next question comes from to Tim Curro with Value Holdings.

Timothy Joseph Curro - Value Holdings, L.P.

A couple of questions. I noticed that you'd started compensating employees with stocks. Can we assume that you're going to initiate a repurchase program in order to, at least, offset the dilution associated with that?

John D. Thomas

Yes. The dilution for the -- this initial award is pretty small. It's -- I think, it will have an impact of maybe $0.01 a share. So it's not a huge dilution. Longer term, the company will -- does look at its dividend policy or repurchases as a general rule. So -- but at this point, we've made no decisions on that in the short term.

Timothy Joseph Curro - Value Holdings, L.P.

Okay. But is it reasonable to assume that since you have stock compensation expense of $1.6 million that, that would kind of be the run rate going forward?

John D. Thomas

Well, it depends on the amount of stock, if any, that is granted to employees in the future. We would expect that, that expense amount will go down in future quarters due to forfeiture rates and just the way that the stock is vesting.

Timothy Joseph Curro - Value Holdings, L.P.

Okay. And then, on another topic. Can, you provide an update on the Secure Communications segment? I noticed that you started rolling it into the defense systems segment. Is that because you're going to be deemphasizing it or, I don't know, getting out of it because of the losses that has been incurred?

John D. Thomas

Well, it's always been part of our defense segment. It's just that there were multiple areas there. There is a data links business. There is some very specialized communication products. And then we have a cyber product line. And then we have a product line that's involved in tracking logistics. So the latter 2, the cyber and the tracking and logistics product lines, are kind of nascent businesses. They're not doing well. And so, we are, at this point in time, probably going to take a hard look at this from a strategy standpoint. I'm pretty sure that the cyber business, it's just a matter of timing on that because they had to get through some product assurance issues. So on the other business, which is relatively small, that's something we'll be looking at when we do our strategic planning. So we'll be adjusting the operating side of that so that the Secure Communications business improves in the future.

Timothy Joseph Curro - Value Holdings, L.P.

Okay. It seems like an interesting sort of business is in there.

John D. Thomas

Yes. Unfortunately, the government funding for part of what the tracking business is doing, has really dried up. So that was something that we had hoped that would have pushed that business into profitability this year.

Operator

Our next question comes from Charles Clarke with Crédit Suisse.

Charles Clarke - Crédit Suisse AG, Research Division

Charlie here for Julian Mitchell. I just had a question on the CDS business, pretty impressive operating margin system in the quarter and obviously the guidance for the fourth quarter. Kind of 8% to 9% operating margin, is that a good run rate kind of moving forward for '14 and '15?

William W. Boyle

Yes, that is a fairly decent approximation of where we expect to be going forward. Yes.

Charles Clarke - Crédit Suisse AG, Research Division

All right. Great. And then, obviously, just part of that improvement, you said, was from restructuring. I just didn't know if you had any other restructuring plans maybe in Mission Support or kind of elsewhere around the business.

William W. Boyle

It's something we take a look at on a regular basis. There is nothing immediate in place. It depends on whether we keep growing in that market or reaction to any government activity or further slow down.

Operator

Our next question comes from George Price with BB&T Capital Markets.

George A. Price - BB&T Capital Markets, Research Division

I just had a follow-up, if I could. Just looking at the international side of the business -- and obviously, that's an area that you've had some success and want to expand further. I guess, could you talk about -- maybe a little more broadly, can you talk about where you think there are additional opportunities for Cubic where you need to invest. And what kind of investments you would need to pursue those?

John D. Thomas

Are you -- is this kind of broadly speaking for the company as a whole?

George A. Price - BB&T Capital Markets, Research Division

Yes.

John D. Thomas

Well, I think, the obvious thing for us is we've got this huge footprint in the defense business in a lot of countries. And so, we keep building systems, training systems. And then a lot of times that will turn into a services opportunity. So we're -- across the board and what we're doing in defense. We're looking to increase our footprint overseas. And I think, in Bill's comments, he mentioned that 68% of the bookings last quarter in defense were international awards. On the transportation side, geographically, we've done very well in obviously the United States, the U.K., Australia. We have some footprints in Northern Europe, and then we've got some -- we're looking at trying to open up some doors over in the Middle East. So part of our strategy of expanding into intelligent transportation, I think that's going to -- we're going to find probably initially a lot of activity in the European markets for that and North America. So we'll be -- if we're successful on some opportunities, we'll be using some of our capital, let's say, in offshore to help grow that business.

Operator

There are no further questions at this time. I would like to turn the floor back over to Bill Boyle.

William W. Boyle

Okay. If anyone has any further questions after this call, please contact Diane Dyer, our Director of Investor Relations. And that concludes our call today, and we think you, all, very much for participating and for your interest in the company. Thank you.

Operator

You may disconnect your lines at this time. Thank you for your participation.

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