Cubic Corporation's (CUB) CEO Bill Boyle on Q2 2014 Results - Earnings Call Transcript

May.12.14 | About: Cubic Corporation (CUB)

Cubic Corporation (NYSE:CUB)

Q2 2014 Earnings Conference Call

May 12, 2014 4:30 p.m. ET

Executives

William W. Boyle - Chief Executive Officer and Director

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

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

Paul G. Ketchum – Vice President of Accounting

Bradley H. Feldmann – President & Chief Operating Officer

Stephen O. Shewmaker – President of Cubic Transportation Systems and Executive Vice President of Cubic Corporation

Matthew Cole – Executive Vice President and Deputy for Strategy, Business Development & Diversification

Diane Dyer - Director of Investor Relations

Analysts

Julian Mitchell – Crédit Suisse

Patrick McCarthy – FBR Capital Markets

James Ricchiuti - Needham & Company

Josephine Millward – The Benchmark Company

Operator

Welcome to Cubic Corporation's Second Quarter Fiscal Year 2014 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. Thank you. You may begin.

Diane Dyer

Thank you, Operator. Good afternoon. Welcome to Cubic’s Second quarter Fiscal Year 2014 Earnings Conference Call. We have two speakers today, William Boyle, Cubic’s CEO; and John Thomas, Cubic's CFO who will review the fiscal 2014 second quarter and first half financial results and operational highlights that we announced this afternoon. 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. 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 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 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 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 conference call contains time-sensitive information that is accurate only as of the date of this broadcast, May 12, 2014. 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 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 amended 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 Boyle

Thanks, Jim. Good afternoon, everyone. Thank you for joining us today. I have just a few points to make before turning the call over to John Thomas. First, in today’s restatement of our financial results, simply put, Cubic’s net worth increased by $12.2 million to the end of fiscal 2013. Our Vice President of Accounting, Paul Ketchum is here to answer any questions you may have regarding the restatement during the Q&A period.

As we had mentioned on our last earnings call, we expect to start this year slow and the first half results turned out to be lower than we anticipated. Sales for the first half of 2014 were $661.6 million, being about $25 million lower than street expectations and EPS of $0.91 being about $0.25 lower than street expectations. Jay will cover this in much more detail but the main reason for the sales shortfall was in Mission Support Services which overall was impacted by lower U.S government spending. The main reason for the earnings shortfall was in transportation systems due primarily to additional startup service costs on our contract in Chicago.

Defense systems improved substantially in the first half. So even with Mission Support Services being down, our total defense income, including CDS and MSS nearly doubled from last year with combined operating income of $17.1 million versus $9.3 million last year.

In spite of the first year being below our expectation, after a further review of our business units, we feel that transportation will regain its momentum and the second half will be much better, particularly in the fourth quarter. Therefore we are holding to our guidance previously given for the year.

Finally, as you probably know by now, I’ll be stepping down as CEO in July and Bradley Feldmann will take that role. Brad, currently our president and Chief operating officer is with us today and will be available to participate in the Q&A session.

With that I'd like to turn to Jay Thomas, our CFO, for a more in depth discussion of the first half.

John Thomas

Thanks, Bill. I’ll start by discussing our consolidated highlights for the first half of fiscal year 2014. After that I’ll review our segment level results and give some color as to what’s happening in each of our businesses.

On a consolidated basis, net sales for the six months ended March 31, were $651.6 million this year compared to $683.4 million in the comparable period last (inaudible) million for the comparable period last year. Overall, our organic sales decreased primarily because of reduced activity in our Mission Support Services segment and a decrease in design build activity and transportation systems.

Adjusted EBITDA was $49.2 million for the first half of 2014 compared $69.5 million last year. As Bill mentioned, the most significant contributor to the decline were costs incurred on our Chicago contract and our transportation segment. I’ll discuss this in more detail when we cover the segment results.

Operating income was $34 million in the first half compared to $57.9 million last year, a decrease of 41%. Again the major reasons for the decline in operating income this year is attributable to the Chicago contract and due to $5.9 million of operating losses related to six acquisitions that we made during the last two years. As we have discussed on previous calls, acquisitions tend to be dilutive during the first two years due to transaction integration and compensation related arrangements of the acquired companies.

Net income attributable to Cubic was $24.5 million or $0.91 on a fully diluted basis for the first half compared to $43.9 million or a $0.64 last year, a 44% decrease. Consolidated total backlog was virtually unchanged at $2.67 billion as of March 31, compared to $2.65 billion as of September 30.

Now I’ll transition to segment operating results. Cubic Transportation Systems or CTS sales increased by 5% to $276.1 million in the first half versus $263.6 million last year. Acquisitions contributed $22 million sales in the first half and $1.5 million for the comparable period last year.

We experienced reduced sales on the Sydney and Vancouver design build projects this year compared to last year. These projects are at an advanced stage of completion. In contrast, there was an increase in sales from the Chicago Ventra contract as this system went into the revenue service in late fiscal 2013. For the Chicago contract, I’d like to give a quick refresh around our accounting treatment for this project since it is somewhat out of the norm compared to our typical design of build project. We capitalized the cost before G&A expenses related to building the system. These cost aggregated $79 million as of March 31. Once we started receiving revenues under the contract, we commenced amortizing the capitalized cost. We will continue to amortize this cost over the life of the contract, which will run for 10 years. A portion of the payment we will receive under the terms of the contract recoups our capitalized investment on this long term asset.

CTS operating income was $19.9 million for the first half versus $50.4 million last year. The decrease in operating income was attributable to three primary factors, cost in excess of revenues in the amount of $26.1 million on the Chicago project, an increase in cost to complete the Vancouver project and cost in excess of service revenues for our Sydney project. The two acquisitions that we made in this segment and revenues from the Chicago project are expected to contribute $80 million to $90 million sales this fiscal year compared to last year. Profitability in this segment has been very lumpy this year but it’s expected to improve in the second half as the Sydney and Chicago project continue to transition and revenues increase over cost over the next few quarters. As an update from our last earnings call in December, the completion of the Vancouver project has slipped from this fiscal year into next fiscal year and is the reason why we provide additional cost.

Operational use by patrons on the three major design build operating projects is increasing. In Chicago, there are over 1.7 million active venture accounts and the customer has announced the retirement of the legacy system effective July 1. In Sydney, the Opal Card has been rolled out on ferries and the train system with more than 188, 000 active users. In Vancouver, British Colombia, there are approximately 83,000 Compass Cards in circulation. CTS continues to receive awards for the excellence of its systems. In January, CTS worked with the Southern railway in UK -1, the best smartcard ticketing service at the MasterCard Transport Ticketing Awards. In March, Cubic’s Opal card project in Sydney received the Australian Smart Infrastructure Award which recognized excellence in design, delivery an used by patrons. And in April, CTS received the BritWeek award for innovation in the use of Opal payment cards on London buses.

Now turning to Mission Support Services or MSS, MSS sales decreased to $199.9 million in the first half compared to $235.6 million last year or a 15% decrease. Sales from the NEK acquisition contributed $19.6 million this year and $9.6 million for the comparable period last year. MSS experienced a 20% decrease in organic sales. The decrease in sales was attributable to the government shutdown last fall, reductions in the spending by the U.S government and a contract loss resulting from low price technically acceptable competitive award. Someone offsetting this decline was a competitive win that increased our simulation training services business. MSS operating income decreased to $4.6 million in the first half compared to $7.8 million last year. The decrease was attributable to lower sales, margin pressures resulting from low price technically acceptable pricing environment and a focused investment to increase our footprint in the special operation forces market.

During the first half of this year, we have seen a significant increase in bid activity. The increased bid activity includes re-competes, new domestic and international contract opportunities. The increased use of multiple awards contract vehicles by the DOD along with potential international opportunities, has increased the immediate bid opportunities available for MSS. We believe conditions in the professional services market will remain challenging through fiscal 2015, but we are encouraged by the recent level of activity in terms of our bid pipeline.

Now turning to Cubic Defense Systems or CDS; CDS sales were $185.6 million in the first half compared to $183.9 million last year. Training System sales increased overall compared to last year. The increase in sales was driven by higher activity on the Littoral Combat Ship contract and ground combat training related contracts, which was somewhat offset by lower sales of air combat training systems.

Secure Communication sales decreased this year compared to last year due to lower sales for global asset tracking and personal locator systems products, which was somewhat offset by higher data-link sales.

Acquisitions added $5.1 million to sales during the first half of this year. Operating profitability significantly improved this year to $12.8 million for the first half compared to $1.5 million last year. Profitability this year improved in training systems and in the secure communications product areas. Last year we took a charge for restructuring during the second quarter totaling $6.1 million. In March of this year, we completed the acquisition of Intific which is now part of CDS. Intific performs advanced research and game-based solutions in modeling and simulation, training for both defense and transportation users, cyber warfare and neuroscience. Intific’s research is funded by DARPA, the Volpe National Transportation Systems Centre and the Air Force Research Laboratory. Management has identified market opportunities from this acquisition that will enhance CDS’s ability to pursue new markets, leveraging the funded advanced research Intific is involved with. Through the current year, we expected Intific will contribute sales in the range of $7 million to $8 million. For the first half of the year Intific had an operating loss of $3.4 million. The operating loss reflects a onetime cost of $200,000 for transaction expenses and $3.1 million of option compensation related payments paid upon the close of the acquisition.

CDS backlog was up significantly at March 31, to $656.5 million versus $493.5 million at September 30. The increase in backlog reflected continued demand from both domestic and international customers for training systems solutions.

Now turning to the balance sheet, cash flow and capital allocation, Cubic’s balance sheet remains very strong with net working capital of $444 million as of March 31 and a long term debt to capital ratio of 12%. Operating cash flows was negative during the first six months by $27.4 million compared to a negative $56 million last year.

CDS and MSS were providers of cash and the CTS segment used cash this year. As we said on our last call, we expect CTS will be a provider of cash late in this fiscal year as major design build project milestones are completed. We’ve invested approximately $81.5 million in acquisitions for the first half of the year. Over the last two years, we’ve invested approximately $160 million across six acquisitions. Collectively, we paid less than 10 times EBITDA for these acquisitions before tax consideration and we expect that they will begin to be accretive by fiscal year 2015.

We continue to look for attractive acquisitions that fit our strategic plan. We also invested $10.9 million during the first half of the year into CapEx. Traditionally we’ve invested about 1% of sales into CapEx on an annual basis. Over the next few years, we plan to upgrade our IT infrastructure and update facilities which will increase capital spending levels. We will provide an update on this when we release our yearend results later this year.

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

William Boyle

Thanks, Jay. To summarize very briefly, MSS continues to compete in a very difficult environment with top margin conditions, although we are encouraged by the current strong level of bidding proposal activity. Compared to last year, Defense Systems is doing very well both in new bookings as well as profitability. So overall our total defense business is doing better this year. Our transportation business had a rough first half and while there are a lot of balls in the air, we expect them to do much better in the second half.

Now why don’t we proceed directly to the Q&A session? Although I should mention first that in addition to Brad Feldmann and Paul Ketchum, we also have Steve Shewmaker, President of CTS and Matt Cole, our Executive Vice President, here to participate on the Q&A session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from Julian Mitchell of Crédit Suisse. Please proceed with your question.

Julian Mitchell – Crédit Suisse

I just wanted to follow up on the notion of a recovery in earnings in transportation in the second half. I guess you did about $20 million of EBIT in the first half and a year ago in the first half you did about $50 million. So I guess how should we think about the second half of this year vis-à-vis those two numbers when you are talking about a recovery? And also I guess for Brad and for Steve, when you are looking sort of further out in transportation systems, are there any changes in process or the way of evaluating the project to try and reduce the risks of these negative shocks like we had in the first half or is it just part of the cost of doing business in this market? Thank you.

John Thomas

Julian, Jay Thomas. So we will see or I should say we are expecting that we are going to have a strong second half just because you have two projects that started services and the revenues ramp up. So that’s really where in the first half as we said in Chicago we had $26 million of cost. So we’ll see a definite improvement in Chicago and Sydney for the second half.

William Boyle

Anything to add?

Stephen Shewmaker

Yeah. This is Steve Shewmaker. How are you? In terms of -- this was not unexpected. We have -- rolling out three major projects in three different parts of the world, you expect a little trauma. So it wasn’t unexpected. However, your point is taken. We are putting together a plan to ensure that going forward we have three major projects at the same time that we have enough in place processes in place to manage all that.

John Thomas

We would expect improvement in the future.

Julian Mitchell – Crédit Suisse

Okay, thanks. And then just secondly within MSS, what can be done in terms of I guess extra restructuring or some kind of accelerated, cost out in that business. You undertook a -- what appears to have been a very successful restructuring effort in defense last year. I wonder in Mission Support what kind of -- I realize that this is probably a different business model, but what restructuring efforts can you do to try and get the earnings well above the breakeven run rate?

Bradley Feldmann

We already have -- this is Brad Feldmann. We already have reduced the number of operating divisions from eight to five and we reduced overheads quite a bit. I would expect that earnings in the future will increase slightly as we continue to win contracts. In the low priced technically acceptable environment it’s quite challenging, but I think we’ve seen some recent success. As Bill and Jay mentioned, we are bidding a lot and I would expect it to continue to improve.

Operator

Our next question is coming from Patrick McCarthy of FBR. Please proceed with your question.

Patrick McCarthy – FBR Capital Markets

My first question is on the CDS business. And I was wondering if you would exclude the international piece, is the domestic piece declining in line with the rest of the industry or it’s actually growing because of the LCS, [NBT] and the ground combat one that you mentioned this afternoon?

William Boyle

There is a slight increase domestically, but most of our growth is coming internationally. We’ve been very fortunate to win a bunch of contracts internationally. Most notably we won a contract in the ground combat domain in Turkey. And we would expect that to continue. We put a lot of emphasis on growing internally as you know the last few years.

John Thomas

I was going to mention that the challenge I think is funding. So if you look at funding for US Army, that’s a bit of a challenge in the end market.

Patrick McCarthy – FBR Capital Markets

Fair enough. Over on look at the mission systems, I guess you talked today about the increase in bid activity and just factoring the sort of cycle times that you see at that business, is it a situation where you could see a turn by the end of this year or are you still thinking that it’s more next fiscal year?

William Boyle

I think a lot of these contracts will be awarded later in the fiscal year, and therefore the revenue will be next year. But I would expect you to see an uptick in backlog by the end of the fiscal year. And we’ve had some recent success there and I would expect that business to grow going forward.

Patrick McCarthy – FBR Capital Markets

Okay, great. Has anything been awarded in the MSS business line that hadn’t been low cost technically acceptable?

Bradley Feldmann

Yeah. I mean not all their contracts are going OPTA so obviously a certain percentage.

Operator

Thank you. (Operator Instructions) Our next question is coming from Jim Ricchiuti of Needham & Company. Please proceed with your question.

James Ricchiuti - Needham & Company

I think you talked a little bit about the outlook for the year and I wonder if you you’d go through that again. Are you updating your guidance? I think going back you were looking for fiscal 2014 revenues of about $1.4 billion to $1.45 billion? And you also at the time I think gave it some sense as to what you could see in terms of EPS. Can you update that for us, if you would?

John Thomas

I think our guidance on sales was $1.425 million to $1.450 million. We are still holding with that and our EPS was $2.60 to $2.75 and we are still holding with that as well.

James Ricchiuti - Needham & Company

So Jay, that really does assume a pretty good snapback in the second half and you’ve talked about it what you could see in transportation. How should we think of the outlook for the other two business units?

John Thomas

You’ve seen Defense had a strong first half and we did restructure the business last year. So they’re performing relatively -- I think relatively strong in the second half. MSS, I don’t expect any big improvements in terms of their profitability. If we get any kind of lift in sales as Brad mentioned, it might show up in the fourth quarter. But we’re not counting on a lot of lift from their earnings. And you also can see in Defense Systems we have increased backlog there and that generally is a backlog business. So we should see some improvement there.

James Ricchiuti - Needham & Company

Got it. And just looking at a couple of the expense items, R&D, should we assume R&D over the balance of the year continuing to be at the levels in the first half?

John Thomas

It should stick at those levels. Historically we’ve been spending about 1.5% of sales, but the Intific acquisition could be a game change for Cubic because essentially what they do is funded research and a lot of it is on the same areas that we were spending our own money. So if we’re successful with Intific and we actually make fee our R&D as the percentage of sales come down essentially we’ll be recouping a portion of that is funded work that we’re doing for the government.

James Ricchiuti - Needham & Company

Okay. Jay, with that, it would be more of a fiscal 2015 development?

John Thomas

Yeah. We’d probably see the impact of that in 2015.

James Ricchiuti - Needham & Company

Okay. And one final question, just within the SG&A line, any unusual professional expense, anything that we should take into account as we think about expenses in the second half of the year?

John Thomas

Last year we had a fair amount because of the prior restatement. This year actually I don’t think the levels are as high as last year. So it’s nothing that we’d really called out in the Qs. So I don’t think there’s anything dramatic in those, other than the transaction related costs that we talked about on the call.

Operator

Our next question is coming from Josephine Millward of The Benchmark Company. Please proceed with your question.

Josephine Millward – The Benchmark Company

Hi Jay. Can you give us an update on the integration of Serco’s transportation business, the one you acquired and talk about the transportation pipeline, what does it look like? And when can we see this business return to double digit growth and double digit margins?

John Thomas

So let me -- I’ll address the margin side of that. We don’t really give specific guidance on margins, but I would say that the traditional margins PTS has been in the 12% to 13.5% on an EBITDA basis. So they should hold to those numbers through the year. As far as the integration of Serco, I’ll let Steve address that.

Stephen Shewmaker

Sure. Thank you. We actually call it ITMS business now and it’s -- the integration is going right to plan. We’re looking at a couple of very large opportunities in the UK and Australia for that business. I think we’re starting to realize some synergies with having that business in our industry and it fits right in with our Nextcity strategy. So it’s going very well actually.

Josephine Millward – The Benchmark Company

So Steve, the opportunities you are talking about, are they more smart city, Nextcity type of opportunities or traditional automated fare ticketing one services?

Stephen Shewmaker

The one, for example the UK will benefit the synergy of having that new contract we hope to get the UK will dovetail nicely with our existing business in the UK and allow us to deploy our workforce more efficiently.

Josephine Millward – The Benchmark Company

So do you see your pipeline improving or is it pretty steady? Because I know the sales cycle is quite long for a transportation project?

Stephen Shewmaker

You’re probably right there, but we’re looking at a very, very robust pipeline in the next seven, eight years.

William Boyle

But one of the interesting things about the ITMS acquisition was they didn’t have a lot of significant international exposure. And so part of the integration then was to get them up and running in markets outside the UK such as Australia and over in the Middle East and then eventually at some point in time into North America.

Operator

(Operator Instructions) At this time I’d like to turn the floor back over to Mr. Boyle for any additional or closing comments.

William Boyle

Okay. I guess that concludes the call then. I’d like to thank all of you for joining us today. If anybody has any further questions, please don’t hesitate to call or contact Diane Dyer, our Director of Investor Relations. So that concludes our call and we thank you for your interest in Cubic. Thank you all

Operator

Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.

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