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spk05: 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.
spk02: 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 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 risk factors and assumptions that may affect future results is contained in CA's annual MD&A. available on our corporate website and in our filings with the Canadian Securities Administrators on CDAR+, and the U.S. Securities 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 Perrin, SEAS President and Chief Executive Officer, and Sonia Branco, our Chief Financial Officer. After remarks from Marc and Sonia, 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.
spk03: Thank you, Andrew, and good afternoon, everyone joining us on the call. Our performance in the third quarter reflects the continued strong demand for our civil market solutions and 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 CA'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 a 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 1.36 times 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 US-based customers, including Solaris Aviation and Clay Lacey 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 which sees 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 continued to retire risk on a group of distinct legacy contracts, which Sonia will describe in more detail in her section. We booked orders for $429 million for a 0.9 times 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-138 transport and KC-135 tanker platforms. Defense orders also include an option exercise for the U.S. Army for fixed-wing flight training and support services at the C-8 Dothan Training Center. With that, I'll now turn the call over to Sonia, who'll provide you additional details about our financial performance. Sonia.
spk15: Thank you, Mark, 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 costs of $23.5 million during the quarter relating to the error center acquisition. Expenses related to the air center 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 liabilities. 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 costs 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 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. Pre-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 joint ventures to support growth. We continue to target 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 for our net debt to adjusted EBITDA 3.16 times 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 a 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 returns. 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% to $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 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 simulation 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%. The defense margin this quarter included the negative impact of the ongoing retirement of eight distinct legacy contracts They 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 are firm fixed price and structure with little or no provision 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 eight legacy contracts had an approximate two percentage points negative impact on the defense segment operating income margin in the third quarter. With that, I will ask Mark to discuss the way forward.
spk03: Thanks, Sonia. Looking ahead at each one of our segments, in civil, We expect to continue our above-market growth momentum for training and flight service solutions, underpinned by strong secular passenger traffic growth, continued success penetrating share and 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 and justice 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 and expanding our position in digital flight services, we expect to maintain our leading share of full-flight simulator sales and to deliver approximately 50 for the year. We have considerable headroom for growth in the civil aviation market, and our continued positive momentum underscores a strong demand for SEAS 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 that Sonia 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 RPAS programs that are currently in contract negotiations and are also generational in size. The progress 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 C'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 the Fed 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 is 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 six to eight quarters as they're gradually retired. The extent to which the ongoing risk retirement on these programs might impact defense margins in the coming quarters really depends on the actual timing of program closeouts and our ability to mitigate these risks. Our dedicated teams are working to rebase lines and 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 SEED. And with that, I'll thank you for your attention now, and I'm ready to answer your questions.
spk02: Thanks, Mark. Operator will now open the lines to members of the investment community.
spk05: Thank you. Ladies and gentlemen, if you would like to register a question. please press the 1-4 on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the 1 for about a three. One moment, please, for the first question. Our first question comes from Fadi Chamon with BMO. Please proceed.
spk07: Thank you, operator. Thanks, guys. So I'm trying to kind of see how to best think about the trajectory of defense margins. Mark, 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. Like, does the margin start to improve from the current level that we're at right now? Or are we stuck at this 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?
spk03: Okay, okay. Lots there, Fatty, but fair questions for sure. Look, yeah, I'm going to go right to the end of your last question because I remember that 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 you examples of that, but let me just end it right now. Because whatever we do, we get offsetted 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, you know, we might decide to de-scope a contract. And I'm talking about these eight legacy contracts that we're talking about. We might decide to de-scope a contract. What does that mean? That means we close it 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 than take a lot more later, if you know what I mean. But of course, that depends on the negotiations specifically that we have underway with that specific customer. Other things we might do is we might agree you know, to alternative terms or schedule, and then we'll look at that on some of these programs as well. Or we might incur a follow-on contract, say an addendum, an engineering change proposal on any one of these contracts, and we're looking at that, and that's a potential for 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 program. So we're doing all of that. So if I look back to your, maybe the margin question, and I'll quickly go to Sonia on this one. Look, we saw that, you know, we talked about 200 basis points per quarter, and I'm gonna go straight to Sonia on that one, not go too deep on that one. But what we're, there's gonna be variability from quarter to quarter for the reasons I talked about. This is not gonna be linear. Because we are taking active steps to try to retire these contracts as soon as we can, and 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 C. We will deliver the products and services that we committed to our customers at C's culture. And don't forget, that's the mission that we have in defense. We're not going to do that. I mean, that's the way I would look at this. And finally, before I give it to Sonia, the one thing I would tell you is there's nothing new here relative to disclosure that we gave you last quarter in terms of a 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 turn it over to you, Sonia, just expand on the 200 basis, at least for this quarter anyhow.
spk15: Absolutely. Thanks, Mark. Hi, Patty. So what we've done this quarter is endeavor to ring fence 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 approximate impact of 2%, 200 basis points this quarter. But by the way, there's also an impact of an under-absorption of costs 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, 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 six to eight quarters will look exactly like this, as we're constantly working to all the different levers to mitigate these risks and work with our customers, as Mark 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.
spk07: Okay. Okay. That's great. You're talking about a scenario where you can take these losses up front and ultimately kind of exit some of 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?
spk15: Yeah, 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.
spk07: Okay, so the timeline of six to eight 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. Yes, that's definitely what we're going to be seeking to do. Okay, thank you. I appreciate it.
spk05: Our next question comes from Cameron Dirksen with National Bank Financial. Please proceed.
spk01: Yeah, thanks. Good afternoon. 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, but 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?
spk03: You know, Cameron, what we're seeing is very strong demand. I can tell you, I 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, you know, what we see as utilization of training centers, and that's across all the training centers. I see no softening of demand, and, you know, as we said before, you know, as you can do the math, we fully expect a pretty darn good Q4. And, you know, we have very good visibility on that because, obviously, we're pretty close to the end. And, you know, we know what simulators we have to deliver. And, you know, again, we have, you know, very strong bookings in our train center. And these days, I can tell you, nobody's looking to cancel bookings.
spk01: Okay. No, that's good to hear. And just maybe just a very brief follow-up to Fadi's questions that's on the defense side. You mentioned you may be seeking some, I guess, equitable adjustments. I know this is something you've discussed in the past. Have you had any success there? I mean, are you optimistic at all that you'll get some relief from your customers with maybe some pricing adjustments within these legacy contracts?
spk03: I'm optimistic, but I'm not optimistic on the timing, meaning because I've been wrong every time. Okay, so I could tell you that the 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 that have documented evidentiary reports, claims into customers. But again, this depends on so many things that I don't control. I would tell you we have made some assumptions. I would say conservative assumptions with regards to we looked at mitigations on somebody's legacy contract, that some of that is included, but certainly not the full quanta.
spk01: Okay, that's helpful. Thanks very much.
spk05: Our next question comes from Kevin Chang with CIBC.
spk04: Please proceed. Thanks for taking my question. I know you don't have multi-year guidance or targets for defense, but if I just kind of 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 know, you hover around mid-single-digit EBIT margin for the remainder of this year, you know, maybe get up to higher single digits in fiscal 2025, and then you can normalize to a run rate, you know, closer to your target of low double digits sometime in fiscal 2026. The fact that you haven't changed your three-year EPS 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 is it like the double-digit EBIT margin may be cloudier here today given the new disclosure you've provided? Sonia?
spk15: Yep. 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.
spk04: Okay. I'll look forward to that. Maybe strategically, you know, you're running about 21, you know, these past years. you know, few quarters you've been running, you know, 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 seem like the absolute dollars impact on these legacy contract issues is large, but it's obviously coming off a smaller base. I'm just wondering, I mean, this risk seems to be something you'll always have to deal with when you're dealing with a government at fixed price contract. 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 side swipe margins the way they have the past year or so.
spk03: I think the way I look at it is when we talk about legacy contracts that we're dealing with here, they're not particularly large individually in terms of either revenue or backlog. But to your point, they can and they are and they have introduced disproportionately large costs in a given period as we work through them, especially if you do active efforts that we have to reach a customer settlement or agree to change in terms, things like that. But we have to remember as well that the business is not the size that we want it to be. So in the end of the day, when you have a hit in any of the quarters, it has material impact because of the small quantum that you have in the absolute number.
spk04: That's a fair point. Thank you very much, and best of luck as you close out the fiscal year here.
spk05: Our next question comes from James McGarrigle with RBC Capital Markets. Please proceed.
spk08: Hey, good afternoon, and thanks for having me on. So my question is with regard to how you're looking at deploying capital in the defense segment. It seems like returns on that business right now, they're below your targets. Do you think there's enough room to improve margins to bring returns in defense within your internal targets? Or any other thing to consider with regard to how you intend to deploy that capital that's tied up in the defense business?
spk15: Yeah, so we always look at a balanced capital allocation strategy, James. And the first priority is continue, as we obviously continue to do leverage and drive through a flexible balance sheet, is to invest in accretive growth. And our top priority is to serve the demand that we see on the civil market. And that organic capex is highly accretive and drives returns of 20% to 30% incremental pre-tax returns within three to four years. So wherever we have those opportunities, that is the first priorities in terms of capital allocation. Now, sometimes we do deploy some CapEx on the defense side. Ultimately, if we are to do so, we expect that to be on commercial terms and driving commercial-like margins.
spk03: Yeah, and maybe I'll just add to that, Sonia, on the And we've already talked about some of those, like, for example, the U.S. Army Hades contract that, you know, we'll be deploying a global 6,500 simulator in our existing facilities in the Dothan Training Center where we already deliver the fixed-wing training for the U.S. Army. And in that case, as Sonia said, you know, because it's a commercial solution which we deploy in business aircraft, we can – you enter into what's called a commercial contract with the U.S. Army, which, of course, in that case, would be capital that's well-deployed because it's going to be able to service with margins more like we get in the kind of civil environment. So you can imagine that's accredited to our terms. Another example I would give you to that is a contract that we've talked about for what was previously called the Flight School 21 contract, but we call it the FTSS contract, where we will be deploying capital to replace all the similar areas used by the U.S. Army at what we call Fort Rutgers, Fort Novosel. Now, again, we'll be very accretive capital deployment in defense because we will be able to enter into service contracts on the delivery training to U.S. Army on, again, commercial contracts, which are more favorable to us than traditional contracts in defense.
spk08: And then if we look at the book to bill on the defense side, you know, it came in below one. You did point to some unfunded backlog. So kind of within that backdrop, how should we be thinking about growth in this segment looking ahead? Is it fair to say, you know, you expect top line in defense to be higher in fiscal 2025 versus 24? So do you want to take it?
spk15: So, you know, to your point, the order intake at 0.9 is slightly below 1, but I would look at the overall total backlog because there is a dynamic of kind of the first-year funding and so on. So you could see the growth in the backlog. We're expecting some big Q4 awards, Q4, Q1 awards, you know, that Mark spoke about, some large Canadian contracts that we've been... selected, and we're expecting those to come in, and that'll drive some significant order intake and backlog growth.
spk03: Yeah, look, defense is a growth business. As I said in the remarks, we have 20% backlog growth in the last two years, and that doesn't include contracts that we've been selected on, like the future airport training in Canada and the RFAS training contract. We've been selected. Those two contracts are really generational in size. We're not under contract yet, so you've got to figure it out. Okay, we've got to get under contract, fully expect that to be in the first half of next year, and then we've got to start turning those to revenue, so there will be timing involved. But there's no doubt this is a real business.
spk08: Sorry, just one quick follow-up on the defense side before I turn it over. Are the low-margin contracts that are rolling off, the eight contracts you've identified, are those EBIT positive? I guess as those contracts roll off, you know, although they might be accretive to margin, is it even neutral, or are those losing money right now?
spk15: We don't necessarily give the details of the contracts individually. I think it's a mix, and so they will be, they're not particularly large on the revenue, but have that disproportionate impact on the cost. But I think the best measure to kind of look at it is a margin.
spk08: Okay, thank you very much.
spk05: Our next question comes from Conor Gupta with Scotiabank. Please proceed.
spk06: Thanks, Javier. Good afternoon, everyone. Just to follow up on defense, Mark, what has the dedicated team that you have deployed for these legacy contracts achieved so far, if you can give any concrete examples, and what is their mandate going forward?
spk03: A mandate is a successful execution of a contract to deliver what we committed to deliver to our customers. That's first and foremost. That's what C is about. And we have a critical mission defense, which, you know, it goes without saying what to do. That's first and foremost. And, of course, deliver it under the best financial terms that we can. And that's what their mandate is. So execute on the contracts and get us to the softest landing that we can. with regards to retirement of risk on those contracts. Work with our customers to try to establish win-wins, to re-scope those programs, de-scope those programs, move the schedule to provide us with scheduled aviation, get requests for equitable adjustments where we definitely are entitled to get them because of the extremely high inflationary environment that we've had to disproportionately you know, affected our costs. Those are all some of the things that our team is doing. And I would tell you, we didn't just put these teams on overnight. These teams have been working for some time, and they have had good progress in executing and reducing the burden that we're facing here in defense already. So we're already seeing the fruits of our labor here, which allows us to give the more precision that we gave you today.
spk06: That's great. Thanks. And if I can quickly follow up on civil, is there any change in discussion or language from customers, from airline customers, especially in light of the A320 engine issue that we saw recently as well as now the Boeing 737 problems?
spk03: The thing I would tell you is no, no, because airlines are scrambling to meet the demand that they see out there. Now, I mean, the impact is real. I mean, the impact of the engineering that you talked about is real. You can't have hundreds of airplanes grounded at any given time with not having some effect. So we're watching that. I would tell you it hasn't affected our business. The airlines that we operate with, which is a great majority of airlines in the world, but are scrambling to be able to get alternate lifts, whether it be keeping older airplanes down, you know, on station rather than new ones, leasing old ones, that kind of thing. So we're watching that. We're also watching the delivery delays specifically because the math is simple, right? I mean, we've talked about it many times before, but for every about 30 narrow-bodied deliveries, because it's a regulated market, it fills up one similar worth of demand. So Clearly, if this was to go on, you know, for a long, long time, then that would have effect. But for now, based on the discussions that we have with customers, there's still a lot of unmet demand in this market. And, you know, you can just see it with regards, again, to the order intake this quarter. I mean, we're talking a very strong book to bill on top of 20% growth in revenue. And what you see there is the testimony to our success in more outsourcing. I'm very, very happy to join another marquee customer like Air France KLM, which historically has not outsourced, outsourcing a portion of their training requirements to us. The growth they have is very large contracts in business aviation. So look, to me, we're basically seeing a softening demand. And going back to your question, the conversations that we have with airlines and business aviation customers are essentially like the one I just described.
spk06: Okay, that's great. Thanks for the time again.
spk05: Our next question comes from Benoit Poirier with Desjardins Capital Markets. Please proceed.
spk13: Yes, thanks very much and good afternoon. Just to come back on the defense margin, if we strip out the 200 billion impact from the legacy contract, it implies that the base is running at around 6.4%, which is obviously far from double-digit level. So could you maybe give us more color on actions to be taken to bring the base to double-digit? Is it related to delays in funding? Is it a matter of scale? revenue loss since the acquisition of L3 or higher bidding costs these days to support the high bidding environment?
spk15: Yes, Mehran. So, a couple of points there. So, first on your point of the 200 basis points, as I mentioned earlier on the call, there is the 200 basis points as a reflection of the impact of those legacy contracts, but there's also the impact of the underabsorption that we should consider. So these are the costs needed to achieve scale and support the business like R&D and SG&A. So that could be another up to 100 basis points. So I'd use that basis, the 300 in total. In addition, as we've mentioned in the past, the delay of the ramp-up of new expected orders and especially the transformational ones because they move the needle. So as these start to come in, and start to really reflect through the revenues. We spoke to it last quarter, it was 3%. It's really still minimal representation in the revenue, but 20% of backlog. So as these start to ramp up more materially, we expect that to step up and drive a meaningful impact.
spk13: Okay, and what is the strategy within defense business now to ensure that you don't run into contract issues like this in the future?
spk03: Well, I can tell you, Benoit, there's a lot of tuition value to what we've lived this in the last three years. So there's lots. But, you know, and they're well implemented. I think the first thing and foremost, which is obvious, and we have a lot of commonality with our peers in the defense industry across the board here, is we're certainly not getting into firm fixed price development contracts. Because in a lot of cases, you know, that's what got us into this situation in the first place. where you have development contracts that, again, fixed firm price, you incur delays because of, well, first of all, we went through COVID with everything that goes along with that with regards to, you know, part shortages with manpower shortages on top of everything escalating, you know, basically compound escalation with regards to the inflationary environment where we have no protection. So those are some of the things that obviously we're not doing. There's other things that we're doing, like, for example, making sure that we ban the service contracts, establishably tighter pricing bans on utilization so we don't get caught out that if the customer uses more or less of the demand that we somehow are disproportionately affected. So I will tell you there's a number of things, but that's what we're doing, and a very tight monitoring of execution at all levels.
spk13: Okay. And just looking at the civil margins, you reached 20% EBIT margin this quarter, which is a step down versus to the 25.4% achieved a year ago, despite having stronger revenue, greater utilization rate. Could you please let us know what drove that? and what makes you confident to achieve the implied 26% plus of its margin in Q4 in order to reach the mid-double-digit growth for the year?
spk03: Okay, I'll separate up the say. I didn't tell you 26. You said that. But, hey, okay, we said you can do the math. But, look, I think if you go back to what I said to you in the last conference call in the last quarter, I tried to point to that. So I would tell you the margins, as I said, are there where we expected them to be. And I'll give you some of the components here. Mix is very much at play here. And, you know, we've talked about mix before. And, yes, this mix looks kind of high. And, you know, on the basis of it, it is high. But I would point to last year in Q3, the mix was very favorable from a couple perspectives. It was from our products business, and it's also what from, you know, kind of the new segment that we have, but not a segment, but a new part of Civil, which is our software business, because last year we had a lot of what we call very favorable on-premise work. And I'll tell you what we mean by that. In our software business, we are actively, as a strategy, winning contracts. We're trying to move customers from on-premise work to software as a service. So Let me make you an analogy on that. If I was to say on-premise work, it would be like us in the core business to sell simulators. You sell a simulator, you get the revenue, you get the contract, you know, literally very fast. Now, contrast that with the training market. Going through software as a service is kind of like we're doing in training, where basically we're going to get paid over time. from a much better recurring standpoint, much more long-term, very attractive work, but obviously it's not going to give you a big SOI bump in one quarter. That's what we see. And when we look at the upcoming quarter in 2.4, we expect that kind of, that particular dynamic to be very favorable again. And that's really, you know, coupled with the number of simulators we deliver, and utilization in our training centers. That's why we're basically saying we expect a strong Q4, reflecting in the heightened guidance that we gave for civil last quarter.
spk13: Okay, and maybe last one for me. If we look at air center, it looks like that there's about $1 million of integration and acquisition costs taken so far. Obviously, the valuation multiple was very attractive, and you knew that it would be a two- or three-year journey. You just mentioned that IT infrastructure integration will be substantially complete by mid-fiscal year 25. I'm just wondering if you could give an update on the remaining costs to be taken and how much the AIR Center could be incremental in terms of margin and whether it's meeting any color about the return on capital employed specifically so far. Thanks.
spk15: Kevin, so we continue the integration of our customers on our systems to our network, and as I mentioned in the remarks, we expect to be done by mid-next year. So, you know, there's really good, great ramp-up of migrating our customers out of the previous network and to our network. And so, great progress done last quarter, and we expect a lot of great progress this quarter as well. So, while we won't necessarily kind of give an outlook on the cost, we expect that to be pretty much finished during the first half of next year.
spk13: Okay. Thank you very much for the time.
spk05: Our next question comes from Tim James with TD Cowan. Please proceed.
spk09: Thanks very much. Good afternoon. Most of my questions have been answered, but I just had one quick one for Sonia, just looking at some detail here. The depreciation expense in the civil business jumped surprisingly significant amount in the in the quarter relative to the second quarter? I'm looking at in particular just the sequential change. Is there any particular reason for that? Is this new or the report of the Q3 rate a good proxy going forward?
spk15: Well, I think the headline is growth, right? So, we deployed 20 plus simulators last year, 13 new year to date this year. And we've onboarded several training centers, whether it's Las Vegas, Savannah came online this quarter. We have another extension of our Phoenix training center that came online also this quarter. So you'll see that driving that depreciation expense and some of the interest that I spoke to on the lease liability. It's really deployment of new simulators and new training centers.
spk09: Okay, so it is just a natural step up then, you know, in relation to the assets in the business?
spk15: Yes.
spk09: Great. Thank you very much.
spk05: Our next question comes from Christine Lawague with Morgan Stanley. Please proceed.
spk14: Hey, good afternoon, everyone. Hi. Hi, Christine. Hey, Mark. You just reiterated the margins for the next quarter. It seems like for 4Q24 to get to your guidance, that implies about 16% revenue growth for the quarter year-over-year and margins a little bit north of 26%. With all the mixed headwinds that you highlighted this quarter, And it seems like some of that goes away next quarter. How do we think about the run rate for fiscal year 25? Is 26% the starting point? And how do we think about that for next year?
spk03: Well, I'm not going to question your math, but we've given you enough. But look, we're not guiding for 25 now. But clearly, I mean, you look at the order intake that we have, the book to bill that we have, and I think you're going to see strong growth.
spk14: Great. And, Mark, in terms of the software business, I mean, software as a service, especially with Sabre, historically, you know, would be a very accretive margin. I mean, when you look out a few years for the composition of software within Civil, how large could that be?
spk03: Well, boy, again, you're asking me for guidance that we're not ready to give at this time. But, obviously, we bought this business to grow it, and I've been very happy. with the order intake that we've had from customers. There's a lot of interest from Sea Airline customers. And I've been, you know, quite satisfied with the assumption that we had from day one that, you know, people would be very, airline specifically, would be very receptive for us bringing Sea's culture into this business. And we're seeing that. I see customers that have basically moved away from, you know, Legacy Sabre And once we bought it, and with the efforts that we've had, the customer outreach, the product development we've had, the investment that we've made, that they've come back to us. So, look, without giving you any precision on number, I see this growing, and I see a very strong interest in us delivering what we call our next-gen solution, which is software as a service, and that's going to be pretty good for recurring revenue going forward. Obviously, we've got to get through the the time it takes to move to on-premise, to a software as a service, and there's a lot of history of other companies that do that, but suffice to say that I'm very optimistic.
spk14: Great, thank you.
spk05: Our next question comes from Anthony Valentini with Goldman Sachs. Please proceed.
spk12: Hey guys, you got Anthony on for NOAA today. Thanks so much for taking my question.
spk03: Pleasure.
spk12: So I just wanted to ask on the defense business, you know, we're hearing from a lot of the U.S. defense primes that they're shifting their strategy in terms of how they are bidding on contracts, getting away from fixed price and going more towards cost plus. Is that something that you guys are also implementing into your strategy? Can you just talk about that a little bit?
spk03: Absolutely. Absolutely. I mean, look, The impact that we've had, you know, on fixed firm price contracts that are development-type contracts, you know, going through the period that we've had through COVID has been very, very detrimental and impactful, and we see them in our results. And we're going to see them, as we talked about, in these legacy contracts. Now, having said that, you know, we're going to work with our customers all the time. So although we might not do that, we're going to be imaginative and working with our customers to To give you an example, that in some cases, and we have entered into new contracts where the government specifically has said, okay, we agree with you that you don't necessarily have to take the cost, which have a lot of inflation relative to them, and consider them as pass-through contracts. So basically, the cost will be what the cost will be. So, yeah, I think we are basically... We're impacted by the same thing that a lot of our legacy peers are across the industry, and I think we're taking the same kind of actions.
spk12: Okay, that's helpful. As a follow-up there, Sonia, you had mentioned 200 basis points basically of like a drag from these challenge programs and then another 100 basis points of like the overhead absorption. So if I just kind of use those numbers and that implies something like a 7.5% margin, what's remaining that's going to drive this business to get to those double-digit percentages that you guys have historically talked about?
spk15: Well, as I mentioned, it's really the ramp-up of the new contracts that we've signed, and especially those transformational ones. They're large in size, accretive, and they will have a meaningful impact on the margin as they ramp up. They're really... nominal right now in terms of our revenues, and so as those ramp up, they'll have a more meaningful impact.
spk12: Okay. Thanks so much, guys. Appreciate the time.
spk05: Our next question comes from Jordan Leone with Bank of America. Please proceed.
spk00: Hey, good afternoon. Thanks for taking the question. So just a Hopefully a final one on defense margins. With a double-digit target, how confident are you in that timeline being 2025 where you start to see that accretion from new contracts? If we still continue to operate under a continuing resolution for this year, how much downside risk do you guys look at if we go through a sequestration?
spk03: Well, let me just start it off. Look, again, as I said, what we're talking about this quarter is no different than we've been talking about, you know, certainly in the previous quarter when we moved, you know, we've admittedly moved things out. What we're giving today is more precision, specific on these legacy contracts to give you an idea of what this represents, you know, by itself. And also to give you a feeling that, you know, we're quite confident in the core of this business. This is a strong business that we're working through these legacy contracts. So if I try to maybe give you a little bit more color specifically to the question, there continues to be two pieces here. The growth in the core business, which I see is very strong, and which is influenced by the ramp up in the transformative new business that we've talked about, the 20% growth in the backlog that we've had in the last couple of years. at the same time as the retirement of these legacy contracts, which drag against the overall margin. So we clearly see, as we said even before, that there's going to be an inflation where these two curves meet. And what we still predict is that's going to happen in the latter half of next year. There's no change there. But I think maybe we're giving a little bit more precision in this actual drag impact in this quarter. and introducing the fact that this isn't going to be linear. There's going to be variability because of the specific actions that we are taking to retire risk, but depending on the timing of the retirement at risk and our efforts to retire them as quick as possible is going to affect that. But the trend line driving the inflection is the one we've been talking is very much intact.
spk00: Great. Thank you.
spk05: You're welcome. Our next question comes from Fai Li with Odlem Brown. Please proceed.
spk11: Thank you. Thanks for taking my questions. Mark, your three-year EPS compound growth rate target hasn't changed from the mid-20% range. And I know you don't really want to talk about the 2025 guidance since you haven't provided, but that target implies pretty strong growth next fiscal year. And I just wanted to get a sense of, you know, how you see that target right now in terms of whether it's a stretch or you think you're pretty confident that you'll achieve it. Can you just maybe comment around that?
spk03: Well, look, I'm going to turn it over to Sonia. And she answered that question, I think, a little bit a while ago. But, look, the bottom line is just we're not ready to give that guise right now. We give it at the same time every year. That's going to be next quarter. But, and clearly there's going to be some dependency on the timing and the risk retirement defense. and the pace of the new programs are ramping up, that when we actually sign these generation contracts, such as the one fact that I talked about, at the same time, the output for civil remains very robust. You just saw the order intake that we signed this quarter on top of 1.3, over 1.3 on top of 20% growth in our revenue. So all of that has got to be factored in. Anything you want to add that's funny?
spk15: No, you covered it, and we'll provide more insights in Q4 like we usually do.
spk11: Okay. And just another question on the defense outlook. It basically sounds like relative to your expectations and your outlook going forward, nothing really changed from the previous quarter, yet you've provided additional guidance and markets reacting very negatively, or additional, sorry, information on the legacy contracts. Markets reacting very negatively around that. What's your thoughts around, you know, how the market's interpreting that additional information.
spk03: Well, I'm going to go stop predicting that one. All I can do is run our business. And, you know, I know I repeat everything I said, but I feel very confident about that we have a business in defense. I'll just go with the point. This is not a business that's broken. This is a business that's growing. with contracts that are going to be accretive to the margin expectations we have, we have a lot of backlog. In my experience in all my career, the one thing you want to have is backlog, because you have backlog. As long as your backlog is profitable, and it is profitable, it's profitable to the aims that we have. We're attacking very specific contracts here that are all very similar. Although the contracts themselves are different, they all point to the same kind of thing. Pre-COVID, fixed firm prices. And we're attacking with laser focus, with dedicated tire teams, while at the same time not keep our eye off the ball of the hundreds of other contracts that we execute in defense at any given time. Make sure we continue to execute those on plan, which we fully expect to do. So with all that, that basically forms my confidence in the defense business, albeit we are where we are.
spk11: Okay.
spk03: Thank you.
spk05: Thank you, operator.
spk02: Operator, thank you. Given that we're on the hour, I'd like now to open the line to members of the media. Should there be anyone with questions for Mark or Sonia?
spk05: As a reminder, to register a question, please press the 1-4 on your telephone. We have a question from Stéphane Roland from La Presse canadienne. Please proceed.
spk10: Yes, hello, Mr. Parent. Thank you for taking my questions, Mr. Olivier.
spk03: Yes, my pleasure.
spk10: Thank you. So maybe... I listened to the call. Maybe, because we're recording here for our radio clients, maybe explain to me a little bit in French What are the difficulties that you are currently experiencing with the defence sector?
spk03: OK, thank you for the question. Well, if we look within our defence sector, really, the challenges are that we have eight old contracts, distinct contracts, that were concluded really before the COVID-19 pandemic, and they have a contract structure that is literally learned à prix fixe. Ça veut dire qu'on n'a pas d'escalation, si tu veux, malgré que nos coûts augmentent, on n'aura pas plus pour le contrat. Donc, évidemment, ça implique des enjeux de profitabilité, même des pertes sur certains des contrats. Malgré que ça représente seulement une partie, même, je dirais, une petite partie de nos contrats totaux en défense, parce que À n'importe quel moment donné, on exécute littéralement des centaines de projets en défense. Ces huit programmes-là, ces huit contrats distincts-là ont un impact disproportionné sur notre rentabilité globale dans le secteur de la défense. Donc, évidemment, on accorde une très grande priorité à l'exécution, si on veut, le retrait de ces anciens contrats-là et la réduction des pressions sur les coûts are linked to these. So, these are really the issues that we see in the defense at the moment.
spk10: Okay. You just talked about accelerating the end of these controls. How are you going to deal with it? Does that mean that we will expect penalties a little earlier to free you later? Just explain to me a little bit what you intend to do on this side.
spk03: Oui, on déploie plus qu'une stratégie pour pouvoir, si on veut, réduire nos risques financiers le plus vite possible, éliminer ces risques financiers. Dans certains des cas, on pourrait envisager littéralement terminer le contrat plus tôt ou plus tard, parce que ça dépend des contrats, ils ont différents enjeux. Ce qui voudrait dire que dans certains cas, on pourrait, retourner à votre question, on pourrait avoir des enjeux, on pourrait avoir des pénalités. Mais si on aurait des pénalités, ce serait un choix qu'on ferait qui serait que payer la pénalité est moins que de continuer à exécuter sur le contrat et d'encourer des coûts ou des risques qui seraient supérieurs. Un bémol que je mettrais là-dessus, que jamais on arrêterait de livrer à nos clients, que ce soit des produits ou des services qu'on livre, parce qu'évidemment, on a une mission essentielle en dépense, puis à CE, évidemment, on n'abandonne jamais. Donc, ça, ce n'est pas un enjeu qu'on ferait.
spk10: OK. Peut-être une question un peu plus technique pour vous ou pour votre chef des finances. You talked about an impact on the margin of 200 base points. During the call, we were talking that it could go up to 300 base points, taking into account certain elements. Can you just explain the nuance a little bit?
spk15: Yes. So, the 200 base points is the impact of the eight contracts. The other 100 base points is if we incorporate l'impact de l'absorption des coûts un peu plus fixes, comme l'investissement arrêté, les coûts de vente, etc., et d'administration. Donc, ça inclut toujours un élément d'absorption.
spk10: Ce point de base-là, c'est par rapport aux vies de contrat ou c'est quelque chose pour l'ensemble du Groupe Défense? C'est ça que je n'ai pas tout à fait compris.
spk15: Yes, it would be the impact of the eight contracts on absorption. So, these eight contracts, if we take the direct costs on the margin, and then this allocation of absorption, it would be a total impact of 300 base points of these eight contracts.
spk10: Okay, perfect. Well, that's all the questions I had for you. Thank you very much for taking the time to answer them. It's always appreciated. Thank you. Merci.
spk15: Merci.
spk02: Operator, that's all the questions we have. I want to close the call here and thank all participants on today's call and remind you that a transcript will be available shortly on the website. Je tiens à remercier tous les participants à la téléconférence aujourd'hui. La transcription sera bientôt disponible sur le site web de CEL. Merci.
spk05: Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line. Thank you.
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