CAE Inc.: Minor Turbulence On A Long Flight
- CV-19 has decimated the air travel business, with many airlines fighting to stave off bankruptcy.
- CAE Inc. (CAE) is a global leader in aviation training, with ~60% of revenues from civil aerospace training, and ~37% from highly stable defense aviation training.
- Short-term industry headwinds have resulted in a substantial decline in CAE shares and a significant reduction in valuation to levels from around two years ago.
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Cowritten by Geoff Phipps
Aviation is the branch of engineering that is least forgiving of mistakes. ― Freeman Dyson
Along with most parts of the aerospace supply chain, shares of CAE have declined significantly as a result of CV-19 impacts. Shares are down nearly 55% from late-February levels. While CAE does have exposure to commercial air travel, the nature of their business carries some unique attributes that may allow for attractive entry points in coming months.
Below is a one-year share price performance of CAE’s NYSE listed shares:
The near-term outlook for the commercial aviation industry carries substantial uncertainty as a result of CV-19. The new challenges faced by airlines has been highly publicized, with numerous carriers seeking bailouts and debt relief across the globe.
For investors that are interested in taking a longer-term view of the aviation industry, there are places to look other than airlines and aircraft manufacturers, some of whom may not emerge unscathed from short and mid-term decreases in global aviation activity.
CAE Inc. (NYSE:CAE) presents an opportunity for investors to gain exposure to the aerospace industry without taking on the degree of restructuring and bankruptcy risk faced by airlines or aircraft manufacturers. Founded in 1947, CAE boasts the world’s largest aviation training network. The Company trains more than 220,000 civil and defense crew members annually, including over 135,000 pilots. This is a highly regulated business, and with most pilot training entirely outsourced, possessing status as a preferred training partner is a highly attractive attribute.
CAE’s Defense and Security division is a major partner to North American and European militaries, claiming over 50 defense agencies as partners. This division primarily provides training to operators through the use of simulator technology platforms. This business provides a stable, recurring business, and represents a critical component of the mission readiness doctrine for increasingly modernized defense forces.
While the civil aerospace simulation and training segment is CAE’s largest division by revenue, The Company generates about 37% of sales from its Defense and Security division.
Because of the nature of the CAE’s business, customers operate on a contract basis which is compiled into a backlog, similar to an infrastructure company. This provides CAE with a more stable business model compared to airlines. Below is a chart of the Company’s consolidated backlog:
Source: Company reports
The Civil Simulation and Training division typically generates margins in the 20% range, while margins are lower in Defense and Security, around 11%. This aligns with the relative business risk profile, as civil aerospace training is a more cyclical business that defense.
The Impact of CV-19 on CAE
Noting that CAE operates on a March 31 year-end (FY20), the Company just reported 4Q and full-year results. At a consolidated level, CAE reported earnings of C$0.46 per share, higher than the sell-side consensus of C$0.38. EBIT margins were reported at 19.8%, also higher than the consensus estimates. The backlog was nearly flat quarter-over-quarter at about C$9.5b.
The Company did expect a significant decline in financial performance through the first half of 2020, particularly in the civil aviation business. A large number of CAE’s customers in this division are experiencing significant challenges. At the end of March, 19 of 55 pilot training centers were closed, but only 13 were shut by the beginning of March. Pilot training requirements need to be completed for pilots to maintain their licenses and be able to return to full duty status once the aviation effects of CV-19 dissipate.
Declines in new aircraft deliveries over the next year will generate headwinds, though will likely recover substantially over the back half of 2020. Given that civil aviation training is a capital heavy business, it’s likely to expect EBIT margins to decline substantially, before stabilizing and slowly recovering.
The Defense segment was not entirely immune to the pandemic. This was primarily attributed to delays in backlog execution and customer order activity. Sell-side analysts had projected defense revenue in 4Q of C$407 mm, and the Company reported C$342 mm.
Company comments suggest that majority of this contraction occurred during March, as defense agencies were focused on maintaining some normalcy in workflow and personnel allocation.
Given the long-term requirement for military training services, it’s likely that this business line will be very stable over the balance of 2020. CAE commented that it has about C$3.6b of active proposals submitted and pending customer decisions, as compared to C$3.8b in 3Q. This indicates that the defense backlog should remain healthy over coming quarters.
CAE has traded on a forward EV/EBITDA multiple of between 5.8x (through the GFC) to nearly 13x (mid-2019).
FCF yields have remained fairly stable in the 0-5% range over the past 15 years. Even through the GFC, the Company only experienced a short period of negative FCF.
While CAE is not trading near trough valuation levels experienced through 2008-2009, the Company has increased its revenue footprint by over 100% since this period and has demonstrated remarkable stability in gross margins, EBITDA margins, and FCF yields. This is a testament to the mission-critical nature of the business model.
It the 4Q earnings update, The Company did note that they expected negative FCF in 1H before turning positive in 2H.
Corporate Balance Sheet
CAE finished FY20 with net debt to EBITDA of 2.8x, much lower than covenants at just above 4.0x (not formally disclosed but indicated by management). This is likely to trend higher in the next couple of quarters on a trailing basis, as civil aviation will require some time for training centers to re-open.
The Company finished FY20 with net-debt to capital at 47.8%. In March 2019, CAE closed on the acquisition of Bombardier’s aircraft training (BAT) business. Subsequently, management had stated a goal of returning the net-debt to capital ratio to the low end of a 35-45% range within 2-3 years. CV-19 related challenges likely extends the endpoint of this target by 1-2 years, but management remains committed to deleveraging.
Importantly, the Company has just C$260 of debt maturing to the end of 2021 and confirmed a new C$500mm unsecured revolving facility in 4Q.
Considering the nature of the business, the lack of near-term debt maturities, significant room on covenants, and a strong history of FCF generation, the credit profile of CAE is not an area for concern.
CAE provides a unique set of exposures to the aviation industry. Training and certifications are ongoing activities in this highly regulated industry. While demand for new pilots and new aircraft deliveries will continue to show weakness, CAE benefits from the stability of ongoing certifications, a substantial backlog, and a very stable defense training business.
There is significant risk associated with playing a rebound in aviation through highly-levered airlines and aircraft manufacturers. As a contract service provider to these industries, CAE offers a high level of stability, a track record of FCF generation, and a reasonable balance sheet.
While valuation metrics have not hit 2008-2009 trough levels, the coming months may provide the opportunity to own a high-quality business at a meaningful discount to historical valuation levels. Monitoring the re-opening of the global aviation industry will provide valuable insight into determining an entry point on CAE shares.
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