CAE Inc. (NYSE:CAE) Q3 2024 Earnings Call Transcript

CAE Inc. (NYSE:CAE) Q3 2024 Earnings Call Transcript February 14, 2024

CAE Inc. beats earnings expectations. Reported EPS is $0.24, expectations were $0.18. CAE Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: 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 Mr. Andrew Arnovitz. Mr. Arnovitz, you may now proceed.

Andrew Arnovitz: Good afternoon, everyone, and thank you for joining us. Before we begin, I’d like to remind you that today’s remarks, including management’s outlook and answers to questions, contain forward-looking statements. These forward-looking statements represent our expectations as of today, February 14, 2024, 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 risks factors and assumptions that may affect future results is contained in CAE’s annual MD&A available on our corporate website and in our filings with the Canadian securities administrators on SEDAR+ and the U.S. Securities and Exchange Commission on EDGAR.

With the expected divestiture of our CAE’s Healthcare business, which is subject to closing conditions including customary regulatory approvals, all comparative figures discussed here and our financial results have been reclassified to reflect discontinued operations. 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’ll open the call to questions from financial analysts. At the conclusion of that segment, we’ll open the lines to members of the media should time permit. Marc, over to you.

Marc Parent: Thank you, Andrew, and good afternoon to everyone joining us on the call. Our performance in the third quarter reflects the continued strong demand for our Civil market solutions end points to the ongoing progress to transform our Defense business. We generated strong free cash flow in the quarter, enabling us to further bolster our financial position in line with our leverage targets. We also made excellent progress to secure CAE’s future with nearly $1.3 billion in total order intake for an $11.7 billion backlog. In Civil, we had strong financial performance that reflected the quarterly mix that we anticipated with demand for commercial and business aviation training solutions continuing to be robust across all regions.

Operationally, we delivered 13 full flight simulators to customers during the quarter. And our average training center utilization was 76%, which is up from 73% last year. We booked $845 million of orders with customers worldwide for an impressive 1.36x book-to-sales ratio, which is even more remarkable on revenue that’s 20% higher than Q3 of last year. We also had strong order activity in our JVs this quarter, representing another approximate $135 million of training services orders, which are not included in the order intake figure, but are reflected in the record $6.1 billion total Civil backlog. We received orders for 20 full flight simulators in the quarter, bringing our tally for the first three quarters of fiscal year to 57. Notable wins including penetrating more share of the existing market with long-term training services contracts with marquee airlines, including Air France KLM Group, and we renewed a flight services contract with Azul of Brazil.

We continue to have very strong momentum in business aviation as well with over $300 million of order intake in the quarter driven primarily by training services agreements with U.S. based customers including Solairus Aviation and Clay Lacy Aviation. The continued high level of order activity this quarter across all Civil segments underscores our ability to win share in a large secular growth market with these highly differentiated training and flight services solutions. In Defense, our financial performance was consistent with our expectations at this point on our path toward being able to generate higher margins in the business. Defense performance was lower than the third quarter last year, as we continue to retire risk on a group of distinct legacy contracts, which Sonya will describe in more detail in her section.

We booked orders for $429 million for a 0.9x book-to-sales ratio, giving us a $5.6 billion Defense backlog, which is up from $5.1 billion in Q3 of last year. They include a maintenance contract with the United States Air Force for the F-16 training devices and the continuation of training services on the C-130H transport in KC-135 tanker platforms. Defense orders also included an option exercise for the U.S. Army for fixed wing flight training and support services at the CAE Dothan Training Center. With that, I’ll now turn the call over to Sonya, who’ll provide you additional details about our financial performance. Sonya?

Sonya Branco: Thank you, Marc, and good afternoon, everyone. Consolidated revenue of $1.09 billion was 13% higher compared to the third quarter last year, while adjusted segment operating income was $145.1 million, compared to $156.8 million in the third quarter last year. Our quarterly adjusted EPS was $0.24 compared to $0.27 in the third quarter last year. We incurred restructuring, integration and acquisition cost of $23.5 million during the quarter relating to the AirCentre acquisition. Expenses related to the AirCentre integration which is progressing as planned are expected to wind down by mid fiscal 2025. Net finance expense this quarter amounted to $52.4 million which is up from $47.1 million in the preceding quarter and up from $47.7 million in the third quarter last year.

This is mainly the result of higher finance expense on lease liability. Income tax expense this quarter was $8.2 million for an effective tax rate of 12%. The adjusted effective income tax rate was 15% which is the basis for the adjusted EPS. As Andrew indicated at the outset, Healthcare is now classified as a discontinued operation and our net loss from discontinued operations was $1.9 million this quarter compared to a net income from discontinued operations of $2.1 million in the third quarter of fiscal 2023. The decrease to the third quarter of fiscal ’23 was mainly attributable to the transaction cost of $2.2 million incurred in the third quarter of fiscal 2024 in relation to the expected sale of the Healthcare business. Net cash from operating activities this quarter was $220.8 million compared to $252.4 million in the third quarter of fiscal 2023.

Free cash flow was $190 million compared to $239.8 million in the third quarter of last year. The decrease was mainly due to a lower contribution from non-cash working capital and higher payments to equity accounted investees to invest in the Civil training network expansion in support of our long-term customer agreements. Free cash flow year-to-date was $227 million compared to $185 million year-to-date last year. The increase was mainly due to a lower investment in non-cash working capital and higher cash provided by operating activities partially offset by some maintenance CapEx and again, higher investments in the joint ventures to support growth. We continue to target a 100% conversion of adjusted net income to free cash flow for the year.

Capital expenditures totaled $85.6 million this quarter with approximately 75% invested in growth to specifically add capacity to our Civil global training network to deliver on the long-term training contracts in our backlog. Our net debt position at the end of the quarter was approximately $3.1 billion or net debt to adjusted EBITDA of 3.16x at the end of the quarter. We expect to close the sale of our Healthcare business before the end of the fiscal year, subject to closing conditions including customary regulatory approvals. We intend to apply significant portion of the net proceeds of the transaction to reduce debt. As we have said in the past, the Healthcare sale transaction is a milestone towards the reinstatement of cash returns to shareholders and the board is now actively evaluating options in terms of form, quantum and timing of such return.

We’re prioritizing a balanced approach to capital allocation including funding accretive growth, continuing to strengthen our financial position commensurate with our investment grade profile and returning capital to shareholders. Now turning to our segmented performance. In Civil, third quarter revenue was up 20% of $622.1 million compared to the third quarter last year and adjusted segment operating income was down 5% to $124.2 million versus the third quarter of last year for a margin of 20%. This is right in line with our expectations for the quarter and our full year outlook for Civil. As expected, there were a few differences in the quarter compared to last year, mainly from the mix of stimulation products revenue and flight services activity, which offset the higher training utilization and increased volume from recently deployed simulators in our network.

In Defense, revenue was up 4% to $472.4 million, while adjusted segment operating income was down 18% to $20.9 million giving us an adjustment segment operating income margin of 4.4%. Defense margin this quarter included the negative impact of the ongoing retirement of 8 distinct legacy contracts that have completion dates mainly within our next two fiscal years. What these contracts have in common and why we’re monitoring them separately is that they were all entered into prior to the COVID-19 pandemic and our firm fixed price and structure with little or no permission for cost escalation. These contracts are only a small fraction of the business, but have disproportionately impacted overall Defense profitability as they have been the most significantly impacted by execution difficulties and the broader economic headwinds we’ve discussed in past quarters, such as the compounding effects of inflationary pressures and disruptions to supply chain and labor.

To be more precise, the execution of these 8 legacy contracts had an approximate 2 percentage points negative impact on the Defense segment operating income margin in the third quarter. With that, I will ask Marc to discuss the way forward.

Marc Parent: Thanks, Sonya. Looking ahead at each one of our segments. In Civil, we expect to continue our above market growth momentum for training and flight services solutions, underpinned by strong secular passenger tractor growth, continued success penetrating shared attorney market and a high level of demand for pilots and pilot training across all segments of aviation. For the current fiscal year, we continue to expect Civil to deliver adjusted segment operating income growth in the mid to high-teens percentage range. For the year as a whole, we continue to expect the Civil adjusted segment operating income margin to be in the range of fiscal 2023, which naturally implies an especially strong margin for Civil in Q4. In addition to growing our share in training expanding our position in digital flight services, we expect to maintain our leading share of full flight simulator sales and to deliver approximately $50 million for the year.

We have considerable headroom for growth in the Civil aviation market and our continued positive momentum underscores the strong demand for CAE’s highly differentiated trading and flight services solutions and our ability to win share within this large and secular growth market. Turning to Defense, we’ll continue transforming our business by replenishing our backlog with more profitable work and by retiring the legacy contracts as Sonya highlighted. These two trend lines remain positive and we expect them to culminate in a substantially bigger and more profitable business. Since augmenting the scale and capabilities of the Defense business approximately two years ago, we’ve grown the Defense backlog by over 20%. This sets us up very well for sustainable growth and includes the strategic and generational wins on next-gen platforms that we’ve talked about in recent quarters.

Still to come and not yet in backlog are the Canadian FAcT and RPA’s programs that are currently in contract negotiations and are also generational in size. The progress that we’re making — that we’ve been making to replenish and grow the backlog with higher quality profitable programs is the best indication of what the future holds for CAE’s Defense business. Together with a $9.5 billion pipeline of bids and proposals outstanding, we continue to see positive signs of the transformation underway. As we look to the remainder of fiscal 2024, we expect Defense to keep winning high quality profitable programs. And in the fourth quarter, we expect to further accelerate the retirement of risks associated with the legacy contracts to the extent that we can.

Clearly, we want to get them behind us as soon as it’s reasonably possible, and we’re closely monitoring them as a separate group. We’re highly focused on execution and expect to substantially reduce the negative impact from these legacy contracts over the next 6 to 8 quarters as they’re gradually retired. The extent to which the ongoing risk retirement on these programs might impact the best margins in the coming quarters really depends on the actual timing of program closeouts and our ability to mitigate these risks. And our dedicated teams are working to revise rebaselize some contracts, seek equitable adjustments on others and to find program efficiencies overall. And for CAE overall, we continue to be highly encouraged by the demand backdrop that we’re seeing in all segments and the growth that we expect by harnessing our global market and technology leadership and the power of one CAE.

These factors combined with highly focused execution and a solid financial foundation, portend continued good growth momentum and an excellent future for CAE. And with that, I’ll thank you for your attention now, and are ready to answer your questions.

Andrew Arnovitz: Thanks, Marc. Operator, we’ll now open lines to members of the investment community.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Fadi Chamoun with BMO.

Fadi Chamoun: I’m trying to kind of see how to best think about the trajectory of Defense margins. Marc, you mentioned the focus on accelerating the retirement of risk associated with these legacy contracts, which I understand that this quarter, the impact was 200 basis point. And there’s also the idea that the backlog growth and top line growth and kind of implementing higher margin contracts should be margin accretive as we go forward. Does the margin start to improve from the current level that we’re at right now or are we stuck at these kind of lower level for some time? The other thing, what exactly you mean by accelerating the retirement? Are you able to exit these contracts earlier or is it a cost action that you’re taking to improve the performance of these specific contracts?

Marc Parent: Lots there, Fadi, but fair question for sure. Look, yes, I’m going to go right to the end of your last question, because I remember right off the bat. When we talk about accelerating retirement, what we’re really talking about here is that we’re likely going to incur potential costs on a faster, put it this way, a faster timeline as we work through the execution on these contracts or even take actions like, for example, close out some of these contracts ahead of time. And I’ll give examples of that, but let me just end it right now. Because whatever we do, we’re going to offset it by mitigating efforts that we try to limit the cost growth. But let me just basically, tell you some of the things that we might do. Look, we might decide to de scope a contract.

And I’m talk about these 8 legacy contracts that we’re talking about. We might decide to de scope a contract. What does that mean? That means we close out and we’re looking at this in at least one specific contract, potentially incur liquidated damage. If that makes sense for us to cut off a future tail of programmatic risk on that program. So better to take that pay now, it’ll take a lot more later, if you know what I mean. But of course, that depends on the negotiation specifically that we have underway under with that specific customer. Other things we might do is we might agree to alternative terms course schedule and then we’re looking at that on some of these programs as well. Or we might incur a follow-on contract, say, an addendum and an engineering change proposal on any one of these contracts and we’re looking at that and that’s the potential of some of these contracts that what we’ll do is give us more work, in which case, we can spread the cost around over a bigger quantum, lessening the impact of any individual product.

So we’re doing all of that. So if I look back to your maybe the margin question, and I’ll quickly go to Sonya on this one. Look, we saw that, we talked about 200 basis points this quarter and I’m going to go straight to Sonya on that one, not going too deep on that. But there’s going to be variability from quarter-to-quarter for the reasons I talked about. This is not going to be linear because we are taking active steps to try to retire these contracts as soon as we can, especially retire the risk, take the right actions. Now mind you, we’re never going to give up on our customers. That’s not what we do at CAE’s. We will deliver the products and services that we committed to our customers at CAE’s culture and don’t forget that’s the mission that we have in defense.

So we’re not going to do that. But I mean that’s the way I would look at this. And finally before I give it to Sonya, the one thing I would tell you there’s nothing new here relative to disclosure that we gave you last quarter in terms of the quantum. What we’re trying to do here is to give you a little bit more precision on the number of contracts that are dragging our performance, these legacy contracts, the duration, how long they last and the steps that we’re taking to actively mitigate them. Now maybe, I’ll stop there, but I’ll turn it over to you, Sonya, expand on the 200 basis at least for this quarter anyhow.

Sonya Branco: So what we’ve done this quarter is endeavored to resends the few contracts that have a disproportionate negative impact on the business. In doing so, as you can appreciate, this is a process. There’s a strict definition and we’re committing to continuing disclosure to report back on these legacy contracts and our progress on them. So you can see that in this quarter, there was an impact of 2%, 200 basis points this quarter. But by the way, there’s also an impact of an under absorption of cost needed to achieve scale and support of all of the business, like R&D and SG&A, that can be up to another 100 basis points, so which makes the impact slightly higher at around 300 basis points. Now that’s a snapshot for Q3.

Now, I can’t say that the next 6 to 8 quarters will look exactly like it as we’re constantly working to all the different levers to mitigate these risks and work with our customers as Marc has highlighted. So while there will be some variability quarter-to- quarter, this quarter’s impact is a rough baseline of the headwind that we face on average.

Fadi Chamoun: So, basically, you’re talking about a scenario where you can take these losses upfront and ultimately kind of exit I know that contract risk earlier, so that’s what’s going to be lumpy? The comment about the 100 basis point absorption, is this tied to backlog deployment and how quickly you deploy the backlog to get improvement in that cost absorption? Is that what you mean by that?

Sonya Branco: Yes. As you drive volume and profitability, you have a better volume to support all of these costs that are needed to scale and support a business of this size and growing. So now at this level, there’s an under absorption that you can assume has about 100 basis points added to the other 200 basis points.

Fadi Chamoun: So the timeline of 6 to 8 quarters, that’s kind of the most, I want to say the pessimistic kind of timeline. Hopefully, you can deal with some of these contracts earlier, take some of these losses maybe earlier and then move on from that?

Marc Parent: Yes. That’s definitely what we’re going to be seeking to do.

Operator: Our next question comes from Cameron Doerksen with National Bank Financial.

Cameron Doerksen: Maybe I’ll ask a question on the Civil business. The utilization rate in the quarter was really strong, 76%, which I don’t have it going all the way back, it seems like maybe that’s one of the best Q3s you’ve had. I’m just wondering if you can maybe discuss what you’re seeing as far as demand across the various training components. Are you seeing any changes there or is it continuing to be strong in the fourth quarter like we saw in Q3?

Marc Parent: Well, Cameron, what we’re seeing is very strong demand. I can tell you, I’d look out my window here at the parking lot in Montreal, I can tell you it’s full. I keep saying that, but perversely, that’s a pretty good indicator of what we see as utilization of training centers, and that’s across all the training centers, I see no softening of demand. And as we said before, as you can do the math, we fully expect a pretty darn good and we have very good visibility on that because, obviously, we’re pretty close to the end and we know what scenarios we have to deliver. And again, we have some very strong bookings in our train center. And these days, I can tell you nobody is looking to cancel bookings.

Cameron Doerksen: And maybe just a very brief just follow-up to Fadi’s questions on Defense. You mentioned you may be seeking some, I guess, equitable adjustments. I know there’s something you’ve discussed in the past. Have you had any success there? I mean, are you optimistic at all that you’ll some relief from your customers with some maybe some pricing adjustments within these legacy contracts?

Marc Parent: I’m optimistic, but I’m not optimistic on the timing, meaning, because I can’t I’ve been wrong every time. So I could tell you that bulk of it, we’ve gotten a bit. I would tell you about, give or take, about 10% of what we believe that we have very, very strong cases and documented evidentiary reports claims into customers. But again, this depends on so many things that I don’t control that I would tell you we have made some assumptions, I would say conservative assumptions with regard to as we looked at mitigations on some of these legacy contracts, that some of that is included but certainly not the full quantum.

Operator: Our next question comes from Kevin Chiang with CIBC.

Kevin Chiang: I know you don’t have multiyear guidance for targets or Defense. But if I just kind of, if I rewind, let’s say, back to fiscal Q2 and you provided an update on defense at that point in time. I think the market read it as you have around mid-single-digit EBIT margin for the remainder of this year, maybe get up to higher single-digits in fiscal 2025 and then you can normalize to a run rate closer to your target of low-double-digits sometime in fiscal 2026, the fact that you haven’t changed your three year EPS target, I’m just trying to level set. Is that still the trajectory you think you can do as you roll off some of these contracts? Or was it like the double-digit EBIT margin maybe cloudier here today given the new disclosure you provided?

Marc Parent: Sonya?

Sonya Branco: Yes. So clearly, there’s some dependency on the timing of the risk retirement on those legacy contracts and the pace of the new programs ramping up, and we’re working this as indicated. At the same time, our outlook for Civil remains robust. We need to close out on the healthcare transaction that we expect to do so by the end of the fiscal year and finalize that impact as well. So we’ll be providing more insight on all of these in Q4 as we usually do.

Kevin Chiang: Maybe strategically, you’re running about ’21, I guess, these past few quarters you’ve been running kind of low-to-mid $20 million operating income. I’m just wondering, do you think the business is big enough to absorb these type of hiccups? And what I mean by that, it doesn’t look at the absolute dollars the impact from these legacy contract issues is large, but it’s also coming off a smaller base. I’m just wondering, I mean, this risk seems to be something you always have to deal with when you deal with the government and fixed price contracts. Just how do you think about the ability to absorb even small developments that weren’t planned, that end up being a little bit more negative than you anticipated and not having any kind of sideswipe margins where they have the past year or so?