CAE Inc. (NYSE:CAE) Q3 2019 Earnings Conference Call February 8, 2019 1:00 PM ET
Andrew Arnovitz - VP, Strategy and IR
Marc Parent - President and CEO
Sonya Branco - VP, Finance and CFO
Conference Call Participants
Benoit Poirier - Desjardins Capital Markets
Cameron Doerksen - National Bank Financial
Kevin Chiang - CIBC
Tim James - TD Securities
Good day, ladies and gentlemen. Welcome to the CAE Third Quarter Conference Call. Please be advised that this call is being recorded.
I would now like to turn the meeting over to Andrew Arnovitz. Please go ahead, Mr. Arnovitz.
Good afternoon, everyone, and thank you for joining us today. Before we begin, I'd like to remind you that today's remarks, including management's outlook for the fiscal 2019 and answers to questions, contain forward-looking statements. These forward-looking statements represent our expectations as of today, February 8, 2019, and accordingly are subject to change.
Such statements are based on assumptions that may not materialize and are subject to risks and uncertainties. Actual results may differ materially and listeners are cautioned not to place undue reliance on these forward-looking statements. A description of the risk factors and assumptions that may affect future results is contained in CAE's annual MD&A available on our corporate Web site and in our filings with the Canadian Securities Administrator on SEDAR and the U.S. Securities and Exchange Commissions.
On the call with me this afternoon are Marc Parent, CAE's President and Chief Executive Officer; and Sonya Branco, our Chief Financial Officer. After remarks from Marc and Sonya, we will take questions from financial analysts and institutional investors. Following the conclusion of that Q&A period, we'll open the line to questions from members of the media.
Let me now turn the call over to Marc.
Thank you, Andrew, and good afternoon to everyone joining us on the call. I'll first discuss some highlights of the quarter and then Sonya will review the detailed financials. I'll come back at the end of the call to talk about our outlook.
We continue to have good momentum with our training strategy in the third quarter as demonstrated by order intake of CAD882 million, which gave us a record CAD9 billion backlog. We concluded the royalty monetization transaction with Bombardier that we announced in November and we had good cash performance with over CAD155 million in free cash flow generation.
Operating income was lower year-over-year, which is part reflects the impact of the five-week work disruption last summer. We were successful during the quarter to accelerate production, to mitigate this impact, and so as expected, a disproportionate share of our annual growth outlook will be achieved in the last quarter of the fiscal year. Overall, our performance in the quarter and year-to-date supports our full-year outlook.
Looking at Civil, customer activity for training solutions remain strong with CAD587 million of orders and the Civil backlog reaches a new high of CAD4.6 billion. Orders included the recently-announced exclusive 10-year pilot training contract with easyJet and a long-term exclusive training contract with Endeavor Air. We also find exclusive business aviation pilot training contracts with Icon Aviation and Windsor Jet. Overall training center realization remains strong at 75%.
In products, Civil sold 16 full flight simulators during the quarter to customers including Nippon Cargo Airlines, Aeroméxico, Lufthansa Aviation Training, and Shanghai Eastern Flight Training Company. Over having an unprecedented year with 50 full-flight simulator orders booked in the first nine months and another 14 in the last six weeks alone. Based on our pipeline, we now expect Civil to book approximately 70 full-flight simulator orders for the year, which substantially exceeds the previous record. On the order front, the Civil book-to-sales ratio for the quarter was 1.28 times and for the trailing 12 months period was 1.31 times.
In Defence, performance for the third quarter was mixed. We had strong revenue growth driven mainly by a higher level of services activity on contracts that are being integrated and ramped up, and there were additional timing-related factors that contributed to the lower Defence margin in the quarter.
Defence book orders were CAD268 million including the first increment of an eight-year contract with the U.S. Air Force awarded for a total of more than CAD250 million to provide comprehensive C-130H aircrew training services.
Also of note, we won contracts to provide simulator upgrades and maintenance support for Germany and Spain's Eurofighter training programs and with Boeing for upgrades on P8 Poseidon aircraft simulators.
We also booked a next increment of a five year contract with the United States Navy awarded for a total of more than CAD160 million to provide primary and advanced virtual instruction services for the Chief of Naval Air Training program.
In addition, under a U.S. foreign military sale program the U.S. Navy awarded a contract to continue providing maintenance and sustainment services for the Royal Australian Navy's MH-60R helicopter training systems. The Defence book-to-sales ratio was 0.81 times for the quarter and 1.03 times for the last 12 months.
And finally in Healthcare, we continue to adapt and ramp up our sales force to pursue the largest segments for the healthcare simulation market like nursing, and we'll continue to release new products to simulate demand.
Our latest release of CAE Luna, an innovative infant simulator designed to fulfill clinical training requirements for neonatal and infant care. As well, we release CAE Vimedix 2.0 for ultrasound simulation which features new educational content and compatibility with our latest augmented reality add-on modules.
With that, I'll now turn the call over to Sonya who will provide a detailed look at our financial performance, and I'll return at the end of the call to comment on our outlook. Sonya?
Thank you, Marc, and good afternoon, everyone. Consolidated revenue for the third quarter was CAD816.3 million and quarterly net income was CAD77.6 million or CAD0.29 per share. This compares to CAD0.38 in the third quarter last year excluding the gain of approximately CAD0.15 per share attributable to the U.S. tax reform and fair valuation of CAE's prior investment position in the Asian Aviation Centre of Excellence.
Income taxes this quarter were CAD14.2 million, represented an effective tax rate of 15%, compared to a negative effective tax rate of 9% for the third quarter last year. The negative tax rate last year was mainly related to the U.S. Tax Reform, while the tax rate this quarter reflects the positive impact of tax audits in Canada and a change in the mix of income from various jurisdictions. Free cash flow improved in the third quarter reaching CAD155 million compared to a CAD146 million last year. The increase in free cash flow year-over-year results mainly from greater efficiency on our non-cash working capital accounts. With improved collections in the quarter, improving inventory efficiency and increased deposits on contracts.
Our positive free cash flow generation in the quarter enabled us to fund the CAD155 million U.S. payment for the closing of the royalty monetization transaction with cash on hand and without additional borrower. Additional uses of cash in Q3 included funding of capital expenditures of CAD61.6 million mainly for growth and we distributed CAD25.5 million in cash dividend. We used another CAD49.1 million to repurchase stock at a weighted average price of CAD25.54 per share under the NCIB program, for which CAE's Board of Directors just approved its renewal.
Our financial position continued to be solid with net debt of CAD985.7 million at the end of the quarter for a net debt to total capital ratio of 29.4%. During the quarter, we entered into an agreement to issue CAD550 million U.S. of senior unsecured notes to fund our acquisition of Bombardier's Business Aircraft Training business and to refinance some of our existing debt and recent term loans.
We're very pleased with the market's receptivity to our offerings with the participation of 19 large institutional investors in the U.S. and Canada. The notes consists of several U.S. dollar denominated tranches with fixed rates ranging from 4.45% to 4.9% annually and maturities ranging from 10 to 15 years. Return on capital employed was 11.7% this quarter compared to 12.8% last quarter and 11.9% in the third quarter last year. Part of the decrease this quarter results from the monetization payment we just made. We remain on track to our 13% ROCE target by our fiscal year 2022.
Now looking at our segmented performance, in Civil, third quarter revenue was down 15% year-over-year to CAD458.4 million and operating income was down 24% to CAD87.2 million for a margin of 19% excluding the net AACE gain last year. Civil training performance remained strong in the quarter with double digits top and bottom line growth and healthy margins. The overall decrease in revenue and operating income for Civil this quarter compared to Q3 last year reflects the timing impact that we expected from the adoption of IFRS 15 as it relates to simulator product deliveries. And the five-week work interruption last summer last year peak simulator deliveries were in the third quarter. So, this made for an especially tough comp. This year peak simulator deliveries will be in the fourth quarter amounting to approximately 40% of your expected annual total of 56 Civil simulator deliveries.
In defense revenue was up 27% year-over-year in the third quarter to CAD330.2 million while operating income was down 17% to CAD25.2 million for an operating margin of 7.6%. Revenue growth was driven mainly by higher level of services activity including contracts under a recently acquired Alpha-Omega Change Engineering business and the U.S. Navy chief of naval air training contract. These services programs are in the early stages of profitability ramp up and are still being integrated. So their contribution to operating income was nominal in the quarter. We had other timing related factors in the quarter that contribute to the lower defense operating income and margin including higher R&D expenses related to new development programs and delays and some higher margin programs that would normally have the offset R&D.
These are included the Canadian Fixed-Wing Search and Rescue program and the UAE Naval Training Center the delays resulted in part from the work disruption we had last summer as well as delays in receiving customer and OEM inputs that we required for these programs to advance, either timing-related factors and we have already taken measures including re-baseline of milestones with the customers to mitigate these impacts in the coming quarters. And in healthcare, third quarter revenue was flat compared to Q3 last year at CAD27.7 million. Healthcare segment operating income was CAD0.6 million in the quarter down from CAD1.5 million in Q3 of last year because of a higher investment in SG&A expenses to support the ongoing sales expansion and recent product launches.
With that, I will ask Marc to discuss the way forward.
Thanks, Sonya. We'll continue to have good success with our training strategy which is supported by solid secular growth trends and we're succeeding to grow our share of within large and growing markets. Or highly positive about our prospects in Civil and as a global leader in aviation training, CAE is the beneficiary of the long-term demand drivers that we see. Air travel continues to grow above the historical average rate of about 4% and airlines have been increasing the number of city pairs to cater the passenger demand. The result has been and continues to be the ongoing expansion of the global in-service fleet of aircraft, which is operated by flight crew who by regulation must train on a simulator on a regular basis.
In addition and a highly relevant the CAE is that we forecast demand for approximately 300,000 new pilots over the next decade to support this growth and to replace the large number of pilots who will reach retirement age. We believe there's no better industry partner than CAE to source, recruit, train and support pilots and the crew members over the course of their careers. We offer the industry's most comprehensive cadet to captain training solutions and we do so on a global scale. I continue to be highly pleased with our progress to form enduring partnerships and training with our customers. In South America last week, we acquired Avianca's share of our training joint venture as part of an exclusive 15-year training outsourcing agreement and we continue to cultivate a strong pipeline of outsourcing prospects that are at various stages of progress.
Last quarter we announced that we'll acquire Bombardier's Business Aviation Training business and we're making good progress on this front with the transaction having now cleared regulatory hurdles under U.S. antitrust law and pending the receipt of the remaining regulatory approvals and third-party concerns we now expect to conclude the acquisition by the end of March, which is earlier than we previously indicated.
Civil training remains the biggest growth vector of our company and our success there continues to have met the recurring revenue and profit profile of CAE's business. Simulation products represent about a third of our Civil business and it's noteworthy that we generated greater recurring revenues that there too by providing ongoing support for regular updates and upgrades to the largest commercial aircraft simulator installed base in the world and would continue to add to CAE's global customers installed base.
As I mentioned earlier, we expect to sell more full flight simulators this year than ever before which is testament to the strength of our competitive position and the positive underlying market conditions.
In Defence, we're working our way through a record order backlog. The timing related issues that affected operating income in the quarter are temporary and are already being addressed with the appropriate measures. We expect this to be mitigated in the coming quarters.
We're continuing to pursue a large market with over CAD4.6 billion of Defence proposals in the hands of customers pending decisions. Like Civil Aviation Defence forces around the world are facing the challenge of training and retaining sufficient numbers of critical personnel specifically pilots. As a result, we're seeing a greater move towards the outsourcing of defence training systems to industry partners like CAE and we expect to continue winning our fair share by building on our successes as a train systems integrator.
And in addition, we invest in the development and acquisition of new capabilities that we can leverage to bolster our prospects in our addressable market over the long term. Our experience as the lead training systems integrator for the UAE Naval Training Centre will undoubtedly enhance the value seek and contribute to other Naval programs to include the new Royal Canadian Navy's Canadian service combatant program for which CAE is part of a team selected as the preferred bidder.
As well, the acquisition of AOCE gives us access to new platforms like the F-15, F-16 and F-22 fighter aircrafts into an expanded market of higher security programs. All these avenues present potentially sizable opportunities for CAE over the long term. And finally, in Healthcare, we're now partway through our market repositioning to pursue the biggest current opportunities like nursing. Although it's taking longer to get to a double-digit growth cadence, we remain confident. Our new products are being well received by customers and would continue to make progress ramping up our sales force particularly in North America where we have made some significant recent additions. We remain encouraged as there's a large market opportunity for CAE in healthcare and that the market is poised for longer-term growth.
The international meeting on simulation in healthcare or IMSH took place just last week in San Antonio, Texas, is the largest and most important event of its kind in the healthcare simulation industry. It saw the highest participation in its history with a record number of exhibitors and participants, including a large delegation of hospital representatives. This is a tangible sign of the increased focus in the U.S. on the quality of patient care and sees healthcare was front center at IMSH as the commercial and thought leader in this field. In summary, we have good momentum in all of our markets, and we are on track to deliver on our growth -- outlook for the year.
With that, thank you for attention, and we're now ready to answer your questions.
Operator, we're now pleased to take questions from analysts and institutional investors.
Thank you. [Operator Instructions] Thank you. Our first question comes from Benoit Poirier of Desjardins Capital Markets. Please go ahead.
Yes. Good afternoon, everyone. Could you talk a little bit about the defense your confidence to reach your guidance for the full-year, I mean when we look so far in terms of EBIT margin, you've been averaging 9%. So in order to do meet the guidance, it must imply that you should be closer to 15% in Q4, so if you could provide more details about what will makes this guidance achievable? Thank you.
Yes. Thanks, Benoit. It's Marc. Look, I think we understand the ramp up for Q4, we certainly couldn't be confident giving the outlook or reiterated outlook that we have. I mean the confidence that we have is really based on the fact that we understand well the factors that leads to performance in Q3 as a whole and here is the whole I mean, and that are ones that we described in the call specifically in Q3, the day, the ramp up of our service contracts the AOCE, the U.S. Navy CNATRA that generating a lot of revenue and you see that revenue growth, which is quite impressive, but they're not carrying a lot of profit at this time. This is just ramping up they got integration cost associated with them and they'll ramp up over time over the next few quarters.
At the same time, we have some impacts in the two programs that generate higher margins product intensive programs like the Canadian Fixed-Wing Search and Rescue programs building simulators for C295 aircraft for example and some contract the naval contracts specifically in UAE. Though we understand the factors that lead, you know where those programs are. You've already rebase line those programs, you've got agreements with the customers. I personally involved in some of those. So, we have pretty good confidence in the programs that we have to execute some backlog in the core as what we will be able to get in the quarter as top and bottom line contribution from those programs, so that we understand pretty well.
At the same time that we have programs that we've already been selected also. Orders that we don't necessarily have right now, but we've been selected by the customers and we fully expect and have in most cases agreements with a customers to get those done by the time that we reach the end of quarter. And because we got work in progress and some of those programs those will trigger revenue and profit as soon as we sign them. So that's really the basis of the confidence in the outlook that we've given to be reaching the outlook in a quarter and defense specifically and is for the year as a whole.
Okay, perfect. And I know it's early, but fiscal 2020 obviously you're still ramping up a few projects. Could you talk a little bit about what this imply in terms of your Defence margins and your backlog? Is it closer 11%, 12% or closer to the low end and is there are a lot of ramp up expected also in fiscal 2020 that could probably put some pressure?
Well, look, the backlog that we have is in the 11%, 12% range. So that hasn't changed. The mix will get -- it will depend a lot on the service versus products mix that we get, that will be affected by the orders we win. So it's a bit early to provide you with the outlook for the year, this year we typically do that next quarter and we'll do that again. I mean it's suffice it to say it's a growth business and continue to grow business we could expect there are CAD4.6 billion proposal that would be out there that contributed nicely to the growth. But it's too early for me to tell you. But as I said the backlog at the moment supports 11%, 12% range. So I think we'll be more focused in the whole of our business as you've seen there has been in the last couple of years certainly this year on focusing on absolute dollar growth. So asset light growth in dollars because that more accurately reflects the mix of our business products versus services and then from a geographical point as well. But in the end it will support the ROC growth, the return on capital growth expectations that we have that Sonya talked about her business, the -- a whole 13% by our fiscal 2022.
Okay. And just for LTR could you talk a little bit about what we should expect in Q4 and going forward? I understand that there has been a lot of investment but just wondering if you're going to reap some benefits in Q4 and toward fiscal 2020.
Yes, we certainly anticipate that as we said in our outlook I think I've confident in terms of one thing there is probably worth noting is the investments that we make in healthcare, interest rate – the cash flow we generate the business supports itself. I think I don't know you want to expand on that Sonya.
So healthcare is cash flow positive, essentially self-sustaining. So it's using its own cash flow to reinvest in both R&D and sales expansion and we see that with our delivery of three new lines of manikins with these Juno areas and now with Luna to really kind of focused on that mid fidelity market and nursing market which is the largest pool of value. So continue to see good growth prospects and this investment on the sales expansion and the new product launches will yield higher volume.
Okay, perfect. Thank you very much for the time. I'll get back to…
Just to add to that Benoit that, one thing that hasn't changes like the profitability of the profits -- of the products that we have in healthcare is quite healthy. So any increase in revenue would result nicely in accretion to the bottom line.
Okay. Thank you.
Thank you. Our next question comes from Cameron Doerksen of National Bank Financial. Please go ahead.
Thanks. Good afternoon. Just a couple of questions for me, I guess maybe firstly on the -- you mentioned that you'd I guess bought out your JV partner Avianca, the JV there. I'm just wondering I guess sort of the second one we've seen of these not in recent years. I'm just wondering there is any other opportunities or you expect to maybe ultimately buy-out a number of other JV partners that you have on the training side?
Well, I think it will be a combination of things. I can't really comment on what the JVs that we have. You're going mark that, those are really confidential nature if we had some. But I think, look, I think there's a trend out there, and I've talked about before that there's more of a trend towards outsourcing training, because if anything we've created a very strong alternative for airlines to do that. So the pipeline of deals that I see is much stronger than previous years. Going back couple of years, I would always say the legacy one or two of these a year or certainly we've done better than that this year, and I'll expect that to continue. Pipeline is good, and that could contribute to being deals like we buy out the remaining portion of the JV, but notwithstanding that doesn't have to be the case. We certainly have other airlines that either are starting up, or have present installations that they might want to partner with us. So I've -- it has kind of come in either one of those fashions. But I think we're going to continue to see a higher level of activity from that point of view.
And if I could just add, as Mark said, we continue to see an active pipeline of conversations on outsourcing. And whether, the way that they culminate can take different forms. So now we've seen a couple of JV buyouts, or with Avianca, AirAsia last year, creation of new JV with Singapore Airlines, but also these things also culminate in long term training agreements with organic CapEx or existing CapEx deployments like, like easyJet.
So ultimately, the momentum, I think is stronger on these outsourcings, but they take many forms, whether it's JVs, M&A, or organic deployments, we're looking for the outsourcing, and it's essentially driving increased outsourcings for training to CAE.
Okay. Great. And just second question, I guess the Bombardier business acquisition is going to close here in the quarter. I'm just trying to -- I know it's probably going be pretty seamless, but I just wonder if there's any integration costs that we should expect in the quarter or early part of 2020. I would assume that there are there probably pretty low?
We should see some, some integration restructuring and transaction costs. So, while we believe that the execution risk is low. There is some overlap on certain roles and cost to integrate the transaction. So, I would expect to see some integration costs in the quarter. We had indicated at the time that we saw a level of synergies about CAD6 million. The integration cost should be a little bit in line or a bit higher than that and we expect depending on the timing, it should align with a shortly after the closing.
Okay. That's great. Thanks very much.
Thank you. [Operator Instructions] Our next question comes from Kevin Chiang of CIBC. Please go ahead.
Hi. Thanks for taking my question here. Maybe just a follow-up on Benoit's question earlier around, around defense margins, I'm just, I'm just wondering -- as you become more of a – or as you focus more on this training system integration strategy, does that inherently create more let's say quarterly volatility in your margin profile given the ramp up and some of the upfront costs you have to incur as you build up these programs, is that -- is that a -- is this margin volatility may be a consequence of that or is this your fiscal 2019 that is -- is this year just maybe a little bit more unique than a typical year?
I think if you were to look back I've been in this business for quite a few years now and actually used to run defence before I become CEO and I think you look back you'll find pretty significant quarterly variation. And that's to me is you should be expected to know of the -- specifically of the defence business because we in one quarter we're going to execute like we're doing in this quarter for example some programs that will drive different levels of profitability depending on which execution you do on those contracts in the quarter.
Remember we use percentage of completion accounting which means that we're booking profit at same time as we're incurring cost so getting a level of activity you have on that specific program in the quarter, it would dictate a number and of course if you execute another program in the following quarter that's a different profitability profile. It'll give you the different answer, as the service contracts will give you because they're longer term they will provide me if anything a more stable base both in terms of revenue you expect during those quarters and through and profit except when you're ramping up like we're doing on the ones that we talked about including integration of AOCE and the U.S. Navy CNATRA program.
So look, I would -- I guess this alliance would tell you, I think it's very hard to judge the performance on a quarterly basis. And that's why our outlook is yearly. And I think we're going to continue that way. And I really think that's where you should look at it and when we provide order intake, again, I think the best judge of the growth of the business has to look at leading indicators like that's the pipeline and more specifically on the book to bill judge on a 12 month basis again to eliminate these quarterly variation.
That's super helpful here and just maybe just a point of clarification. You talked about repositioning within Healthcare or other market repositioning here. Does that change how you think about the total size of the available revenue to you when this business matures? And then, secondarily in the near-term here as you go through this pivot, does that at least in the near-term change maybe how we think about operating leverage? Are there additional costs that we should be thinking about that might be incurred even as revenue starts to ramp up here as you execute against this strategy?
Look, I think the first pretty answer I would say the answer is, no. Look, I still am confident in the fact that the growth profile has been in the absolute size that we get to over the longer, but not too long period, so that hasn't changed that that we're going after nursing it. Remember what we said last year when we embarked on repositioning our business as we stopped waiting for really regulation to really come in forth and really be the driving force behind this business and refocus our efforts, our product development and our focus on the market as they are today and the market as they're today is largely in aggregate nursing programs. There are 2,000 of those programs in the United States alone. So that's what we're focused. And if I look at the size of that market, it by itself can support our ambitions of the size of the business and you could have -- so that hasn't changed.
In terms of the cost, I think what you're seeing has increased now affecting the lever is mainly SG&A, mainly sales sport to go after repositioning. You have a large number of schools out there, institutions, hospitals. So we're increasing the sales support force, so we are going to continue to do that. But as I said a bit previously on my answer to renewal 00:33:34 is that the margin profile of the products that we sell in Healthcare I think we start getting some decent revenue growth. It'll disproportionally drops at the bottom line.
That's super helpful. Thank you very much.
Thank you. [Operator Instructions] At this time, we'd like to welcome press and media to join the queue.
Operator, thank you. We will open the lines now to members of the media and I thank members of the financial community for their question.
Thank you. We do have one final question from an analyst that comes from Tim James of TD Securities. Please go ahead.
Thank you. Just jump in here quickly. Question I think for Sonya, I'm just taking a look and I'm trying to understand the large I guess CAD380 million increase in the combined assets of PP&E and the intangible assets in the quarter relative to the second quarter. I know CAD200 million of that is from the bombardier royalty monetization and it looks to me like another kind of net CAD35 million increase from CapEx, but then there's another kind of CAD150 million I'm trying to wrap my head around in terms of where that increase in those assets came from. Could you help me understand that?
Absolutely. So you're right. The main driver was the increase coming from calling the monetization which was CAD202 million of capital. Of course we've added CapEx in the quarter, but the missing piece in the reconciliation is foreign exchange. So the rate is quite high at 1.36 USD to Canada at the end of the quarter and that drove essentially all of the U.S. operations et cetera including assets like goodwill and tangible fixed asset and a much higher rate. And so that's the 100 sum odd plus that that drove that increase.
Okay. And that's helpful. I didn't realize the FX was that significant. Thank you, Sonya.
Okay. Operator, if you would please open the lines to members of the media.
My pleasure. [Operator Instructions] And we show no questions from the press or media. I'll turn the call back over to you for any closing remarks.
Okay. Well, thank you. I want to thank all of the participants this afternoon for joining us on our call. I remind you that a transcript of the call can be found on the CAE's Web site. Thank you.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you and have a good day.