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Cubic (NYSE:CUB)

Q4 2013 Earnings Call

December 05, 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

Matt Cole - Managing Director of Australia Operations and Vice President of Financial Operations

Analysts

Julian Mitchell - Crédit Suisse AG, Research Division

James Ricchiuti - Needham & Company, LLC, Research Division

Operator

Welcome to Cubic Corporation's 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. Welcome to our Fiscal 2013 Earnings Conference Call. We have 2 speakers today who will review our businesses and the fiscal year results we announced this afternoon: William Boyle, our Chief Executive Officer; and John Thomas, Cubic's Chief Financial Officer. After our prepared remarks, our executive team will be happy to take your questions.

By now, you should have a copy of our earnings press release, which crossed the wire about 0.5 hour ago. If you need a copy of the press release, you can go to www.cubic.com under the Investor Relations tab to find an electronic copy. We encourage everyone to read today's press release and refer to our most recent reports on Form 10-Q and Form 10-K. For anyone who has not yet seen a copy of these documents, they're available on Cubic Corporation's website and on the SEC's website.

Now I'll turn the call over to Jim Edwards, Cubic's Senior Vice President and General Counsel, 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, Cubic management will be making forward-looking statements, including, but not limited to, statements about future events or Cubic's future financial and operating performance. 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 call contains time-sensitive information that is accurate only as of the date of this broadcast, December 5, 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.

This conference call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Cubic believes this information is useful to investors because it provides a basis for measuring the company's available capital resources, the actual and forecasted operating performance of the company's business and the company's cash flow. 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-K report for the fiscal year ended September 30, 2013. Any discussion of non-GAAP measures is not intended to detract from the importance of 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, everyone. Thank you for joining us today. As you may have seen in the press release issued earlier today, to put it mildly, a lot of things didn't go well for us in the fourth quarter. While we're very disappointed by reporting these results today, we do expect a quick turnaround and should deliver much better results next year, although the first quarter may be somewhat mediocre. For those of you who haven't seen our release, EPS dropped to $0.74 for fiscal 2013, caused by a loss of $1.43 per share in the fourth quarter, primarily driven by a goodwill impairment charge in Mission Support Services of 50 -- and that's $50.9 million or $1.61 per share net of taxes. There were other issues in the fourth quarter in all 3 of our business segments and Jay Thomas will expand on all this in a few minutes.

As you know, in -- Cubic has not been in the practice of giving formal guidance, and I don't know what we might do in the future. However, due to our fourth quarter results, we feel now we owe it to you to give you some guidance and as clear a picture as we can of what we expect for the next year. And we'll attempt to do that throughout our discussion.

Through the third quarter of this year, we thought it would be an okay year for Mission Support Services, but that changed in the fourth quarter, which is normally their best quarter, due to a substantial drop in activity for readiness training at major U.S. training sites. As you know, the defense service marketplace is being impacted by delays in new business awards caused by the U.S. DoD budget uncertainty and sequestration. We believe this trend will persist into our fiscal years '14 and '15, as operations and maintenance and readiness spending appear to be bearing the brunt of the mandatory sequester rules now in effect.

Until there are some political compromise to change the mandatory cuts in U.S. DoD spending, we believe our Mission Support business will not markedly improve in the near term. Their environment will clearly continue to be difficult, so it's hard to see them doing better next year, and they may even see a further decline.

In spite of these DoD delays and cutbacks, Defense Systems, CDS, had success in garnering new business during the year and increased their backlog to $495.5 million from $430.6 million at the beginning of the year. This success is continuing since year end, with a couple of important wins announced just last week in the U.S. and with international customers for training-related work.

While Mission Support Services is struggling, we expect Defense Systems to do better next year after their cost-cutting initiatives during this current fiscal year and the strong inflow of new contract awards, and they would more than offset any possible decline in service profitability.

The other bad news in the fourth quarter came from our Transportation business, where we lost $1.2 million in the fourth quarter versus operating income of $15.9 million a year ago. This brought their operating income to $62.4 million this year versus $76.3 million last year. As most of you are aware, CTS is near the end of the development phase in 3 major projects: Chicago; Vancouver; and Sydney, Australia. While 3 of these design and build projects had issues in the fourth quarter, all of which CTS appears well on the way to resolving. However, a significant unexpected project-related cost, especially in Sydney, resulted in the $1.2 million loss for the fourth quarter.

While the first quarter of fiscal year '14 will be modest due to startup cost in Chicago, we feel the next year as a whole will be a very strong one for CTS, with sales and profits increasing due to recent acquisitions and the commencement of revenues on the Chicago project in the second quarter. Jay Thomas will cover this in much more depth shortly.

In summary, while we know new fiscal year '13 would be transitional for the company, we didn't expect to end the year so poorly, but it happened and we're moving on. Although we expect to start the year slow, we expect fiscal '14 to be a relatively good year, with substantial improvement in Defense Systems and Transportation. Next year, we expect sales to grow from $1.361 billion to a range of $1.42 billion to $1.45 billion, primarily nonorganic growth, and earnings per share to grow from $0.74 per share to somewhere between $2.60 and $2.75 per share.

I'd now like to turn to Jay Thomas, our Executive Vice President and CFO, for a deeper discussion of our year. Jay?

John D. Thomas

Thanks, Bill. I'll discuss our consolidated highlights for fiscal -- for the fiscal year and then provide some additional comments around our segment level results in the fourth quarter.

On a consolidated basis, total sales for the year were $1.361 billion versus $1.381 billion last year, or a 1% decrease. The 4 acquisitions we made during the year added $43.1 million in sales, while organic sales decreased by 5%. Adjusted EBITDA was $112.6 million or 8.3% of sales this year versus $150.9 million or 10.9% of sales last year. A number of factors contributed to the decrease in adjusted EBITDA during the year.

The largest component was an 8% decrease in gross profit margins on product sales, somewhat offset by a 4% increase in gross profit margin on service sales. Overall, our gross profit margins were down 2% for the year. In addition, during the year, we incurred $8.1 million in restructuring charges, primarily in our Defense Systems segment. We also had higher net SG&A expenses aggregating $3.6 million. These higher expenses were for stock-based compensation, higher professional fees related to our restatement last year, and cost related to a secondary offering, partially offset by an insurance recovery.

Operating income was $36.4 million for the year compared to $128 million last year. Operating income declined in all 3 segments for the year. The largest contributors to this decline in operating income were a goodwill impairment charge of $50.9 million taken in the fourth quarter within our Mission Support Services segment, which I'll address in a few minutes, and the previously discussed lower gross profit margins and higher net SG&A expenses. Net income attributable to Cubic was $19.8 million or $0.74 per share for the year, down from $91.9 million or $3.44 per share last year.

Net income was adversely impacted this year due to the higher interest expense and a higher effective tax rate of 42% compared to 29% last year. Our effective tax rate increased this year due to an unfavorable impact associated with the goodwill impairment because a large portion of our goodwill is not deductible for income tax purposes. In addition, we recorded a valuation reserve for a deferred tax asset related to our Australian operations. These charges were taken in the fourth quarter, which significantly impacted our effective income tax rate for the year.

Consolidated total backlog was $2.67 billion as of our fiscal year end compared to $2.83 billion last year. Total backlog was negatively impacted by $38 million due to currency movements primarily in our Transportation segment. Now I'd like to discuss our segment operating results.

Cubic Transportation Systems or CTS increased sales 1% to $516.9 million. During the year, we had higher sales from transit system contracts in Minneapolis, New York and Washington, a $7.8 million sales contribution from the NextBus acquisition, which was acquired in January, and a $2 million contract claim that was settled. These increases were partially offset by declines in design build activities in Sydney, Vancouver and the U.K. train operating companies. Sales comparisons were also negatively impacted for the year by 6-point -- $6 million in exchange rate differences. CTS operating income was down 18% to $62.4 million for the year, from $76.3 million last year.

The major cause for the decline occurred during the fourth quarter when management concluded we would likely incur higher completion cost than previously estimated on the Sydney and Vancouver design build projects, aggregating $17.2 million. The primary contributor to the increased cost estimate was a reassessment of the costs associated with a number of bus variants that we are equipping to accept the new Opal card on the Sydney project. The increased cost on the Vancouver project related to higher software development costs. We anticipate completing the design build phase of these projects in late fiscal '14.

We also increased transportation-related R&D to $9.9 million this year compared to $8.3 million last year. The increase in R&D spending is part of our Nextcity strategy and has been focused in the areas of open payment systems, multi-modal and tolling enterprise systems, Opal phone technology and data analytics. We plan to increase our R&D expenditure in fiscal '14 from '13 levels to maintain our market leadership positions and enable us to broaden our addressable market.

During the year, we made substantial progress completing and launching the Chicago transit open payment system or Ventra card. The card was launched to the public in August. As discussed on the last conference call, we did incur higher cost than sales generated related to the startup phase of this new system in the fourth quarter. We will continue to incur higher cost than revenues in the near term, which will impact CTS' first and second quarter results. We have had some issues gained at system launch, but we've made progress to remedy these. We are seeing a steady increase in ridership using the new card. As of last week, 66% of the total rides on the CT are using the new Ventras card. The system will eventually be expanded to the pay system.

Going forward, we estimate the Chicago open payment contract will contribute annualized sales approximating $45 million, commencing in our second quarter FY '14.

Last week, we announced the acquisition of a transport solutions business from Serco plc for an aggregate consideration of $70 million. The transport solutions business is an important piece of our Nextcity strategy to integrate solutions for the transport operators and travelers. We expect the transport solutions business will contribute approximately $52 million to $54 million in sales in the FY '14 and be neutral to earnings per share, although this will depend in part on the result of our purchase price allocation which we have not done yet.

In aggregate, as Bill mentioned, we expect FY '14, an increase in sales for CTS with the addition of the transport solution acquisition, a full year contribution from the NextBus acquisition and sales associated with the ramp-up of the Chicago open payment contract. With the exception of the first quarter, we expect CTS operating profits next year as a whole will improve compared to this year due to the increase in sales.

CTS is currently bidding fare collection jobs in North America, Europe and the Middle East. We are also pursuing toll-related work. In future calls, we will update you on pipeline pursuits focused around our Nextcity strategy.

Now turning to our Mission Support Services segment or MSS. MSS sales decreased 5% to $468 million this year. During the year, we acquired NEK services, which contributed $31.6 million in sales. Organically, the decline in sales for MSS was 11% for the year. MSS sales declined 28% in the fourth quarter compared to the prior year, excluding the NEK acquisition. MSS activity with our primary U.S. customer base had dramatically slowed late in the fiscal year, resulting from sequestration, mandated cuts and the uncertainty associated with the continuing resolution.

MSS had an operating loss of $36.1 million this year compared to an operating profit of $21.9 million last year. The loss was related to a $50.9 million goodwill impairment charge taken in the fourth quarter. As a result of the dramatic decline in MSS sales for the fourth quarter along with the decreased operating profits resulting from the effects of the low priced technically acceptable environment, we concluded that the value of our MSS business had been impaired and we took a charge against goodwill.

Our outlook for MSS is for continuing pressure on sales and operating profits due to lower activity by the DoD and continuing sequestration. MSS management has taken steps to mitigate these negative conditions by adjusting its cost structure to the current environment. In spite of the operating loss for MSS this year, the segment generated $39 million of cash flow from operations for the year versus $16 million in the prior year. MSS working in collaboration with Cubic Defense Systems was instrumental in our win of the LCS training-related contracts. Strategically leveraging MSS' cost-effective rate model with CDS will be an important discriminator for the corporation in the current environment.

Total backlog for MSS decreased 15% year-over-year. While some of this decrease is attributable to less demand by the DoD, we have also seen our customers using shorter duration task-order contract vehicles.

Now turning to our Cubic Defense Systems segment or CDS. CDS sales were virtually unchanged this year at $375.1 million. Included in sales were $3.7 million of sales from 2 small acquisitions completed during the year. During the year, CDS was awarded a new multi-year $298.5 million ID/IQ contract for the Navy's Littoral Combat Ship program. For the year, CDS had $4.4 million in sales associated with the LCS contract.

International customers continue to somewhat insulate CDS from lower spending by the DoD and constituted 39% of CDS' sales for the year. Operating income for CDS was $14.2 million this year compared to $34.6 million last year. Last year's operating income was higher by $12.5 million due to the favorable change in estimate on a training contract. Negatively impacting operating income this year were higher losses in the Secure Communications business.

For the year, Secure Communications had a loss of $8.1 million versus a loss of $4.4 million last year. The increased loss this year was attributable to cost growth on an ISR data-link program and a $2.8 million inventory write-down for the Global Track product line. CDS management has scaled back the Global Track product line, and we are currently evaluating strategic alternatives after several years of losses.

This year, the Global Track product line contributed sales of $5.8 million and had an operating loss of $5.4 million, including the inventory write-down.

As discussed earlier, also negatively impacting operating profits for the year was the $7.8 million restructuring charges associated with realigning the global CDS workforce. Earlier this week, we announced that CDS has been awarded additional work for the Navy LCS program, where they awarded the Mission Bay trainer contract. The Mission Bay trainer or MBT contract has a potential value of $112 million over the next 5 to 7 years. CDS has now been the sole awardee on over $400 million of potential work for the LCS program for immersive game-based and virtual training.

CDS has received approximately $45 million in funding to-date on the LCS and MBT contract awards. Separate from the LCS work, CDS was awarded follow-on training-related work totaling over $125 million during the year, with certain customers in the Asia Pacific region. Yesterday, we announced CDS booked an additional $70 million of follow-on work from the Asia Pacific for a training-related work. CDS gained market share across the training domain domestically, with the LCS and MBT wins, and solidified its strong international base of business.

We believe CDS will rebound in FY '14 with higher sales and improved operating profits due to the restructuring we did this year and the strong flow of contract awards.

Now turning to the balance sheet, cash flow and capital allocation. Our financial condition remained strong with net working capital of $479 million. We had cash, marketable securities and restricted cash as of year end totaling $277 million. Approximately $247 million of our cash and restricted cash was held by our foreign subsidiaries.

Earlier in the year, we took advantage of low interest rates and borrowed $100 million of unsecured senior debt in an attractive fixed interest rate of 3.35%. For the year, operating activities used $13.2 million of cash compared to $54.7 million used last year.

For the last 2 years, we have experienced operating cash outflows due to working capital requirements on design build contracts and capitalized costs for the Chicago open payment system. With these major projects nearing completion, we expect that operating cash flows will turn significantly positive toward the end of FY '14. We expect cash flow from operations will exceed EBITDA in FY '14.

This year, we used $71.5 million in cash on 4 acquisitions. Subsequent to year end, we used $70 million for -- of our foreign cash for the acquisition of Serco's transport solutions business. Our acquisition strategy is focused on growing our Transportation segment, and finding attractive consolidation opportunities in the defense market.

And with that, I'll turn it back over to Bill for closing thoughts.

William W. Boyle

Thanks, Jay. Since the goodwill impairment and Transportation Systems issues had such an impact in the fourth quarter, we thought it advisable to have our Senior Vice President and Corporate Controller, Mark Harrison; and our Executive Vice President of Transportation Systems, Matt Cole, with us to help us respond to any questions you might have. So with that, why don't we now open it up for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Julian Mitchell with Crédit Suisse.

Julian Mitchell - Crédit Suisse AG, Research Division

So I guess the first question is really on the Transportation Systems segment. The degree to which, I guess, some of the cost overruns you feel comfortable that you've got your arms around, and how confident you are that you'll see operating income growth in Transport for the full year '14?

John D. Thomas

Well, I think we've provided for the cost, and we're actually making some progress in monitoring what is going on as we -- it primarily relates to installing bus equipment, and so we're doing weekly assessments of how we're doing relative to our estimates. We feel pretty confident in the overall profitability as the business will improve for the whole year, primarily driven by the fact that we're going to have increased sales.

Julian Mitchell - Crédit Suisse AG, Research Division

Got it. And then in terms of Mission Support Services, what's the degree of, I guess, cost reduction or taking out some fixed cost that you can do there, given your comments on the top line outlook, looking out a couple of years, sounded pretty weak. Defense Systems, it seems like you've done a pretty good job on getting the cost base rightsized. What are you doing within Mission Support?

John D. Thomas

Well, we restructured the business twice during the year, most recently at the very end of the year. So it's just that the -- you're in an environment now where you oftentimes will find that on some competitive tenders, people will bid below your cost. So it's a little hard to predict right now, but we think we've taken out sufficient cost to be competitive in that environment.

Julian Mitchell - Crédit Suisse AG, Research Division

Got it. And then lastly, just on the acquisition outlook. You've been pretty aggressive in terms of stepping up M&A. Should we expect that to continue or you think the handful of deals that you've done is, for the time being, at least enough and the focus should be on integrating those?

John D. Thomas

Yes, I think in the near term, we'll be focused on integrating the acquisitions we've made. And I'd say that's a near-term in also completing these projects.

Operator

Our next question comes from the line of Jim Ricchiuti with Needham & Company.

James Ricchiuti - Needham & Company, LLC, Research Division

I wonder if relative to the guidance you're giving for revenues for this year, you can give us a sense of what the organic growth rate might be in the Transportation business?

John D. Thomas

I think the -- right now, our outlook, Jim, is the organic growth would really relate to us starting to generate revenues on the Chicago project for the year. The rest of the outlook in Transportation relates to the acquisitions that we've made.

James Ricchiuti - Needham & Company, LLC, Research Division

Jay, is there any way -- I'm wondering if you could give us some sense as -- even a range of revenues that you might be anticipating from the Chicago contract?

John D. Thomas

Yes, as I said on the call, we said on an annualized basis, we should start to generate around $45 million. So for the next year, that probably translates into something on the order of $25 million to $30 million.

James Ricchiuti - Needham & Company, LLC, Research Division

Okay. And can you talk at all about the tender, the level of tender activity in North America in terms of some of the larger projects and, obviously, there's been a lot of speculation about New York, how -- what's the pipeline look like?

John D. Thomas

I'm going to let Matt address that.

William W. Boyle

We'll let Matt address that.

Matt Cole

Yes, so the Transportation pipelines bordered on North America, we're currently bidding on fare collection contracts in the Middle East, in Continental Europe and some in North America. As Jay mentioned on the call, we're also looking to diversify some of the changes we've made in our technology recently, allow us to broaden our aperture and look at tolling opportunities as well, and we're looking at a number of those in North America. Overall, the Transportation pipeline over the next 5 years is -- sorry, 3 years, is $5.7 billion.

James Ricchiuti - Needham & Company, LLC, Research Division

$5.7 billion, and that's globally. And where does the bulk of that come from? Is it spread fairly evenly, domestic, internationally? Can you talk just in terms of how that might break out?

John D. Thomas

A fair piece of that would be existing business. So for instance, we have a recompete coming up in the U.K., so a fair piece of that pipeline would be the U.K. and then there would be opportunities like in Washington that we've discussed before.

Matt Cole

And as I said then, we've got some other business in Europe that we're pursuing, as well as some in the Middle East, and then a large balance of it in North America.

Operator

[Operator Instructions] Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

William W. Boyle

Well, we'd like to thank you, all, for joining us today. If anybody has any further questions, please call or contact Diane Dyer, our Director of Investor Relations. So -- and obviously, Jay and I and everybody's available, if you have any questions. So this concludes our call today, and we thank you for your interest in Cubic. Thank you very much.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

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