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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 '19 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 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 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 take questions from financial analysts and institutional investors. Following the conclusion of that Q&A period, we will open the lines 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 for 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 continued to have good momentum with our training strategy in the third quarter, as demonstrated by order intake of $882 million, which gave us a record $9 billion backlog. We concluded the royalty monetization transaction with Bombardier that we announced in November. And we had good cash performance with over $155 million in free cash flow generation. Operating income was lower year-over-year, which in part reflects the impact of the 5-week court disruption last summer. We were successful during the quarter to accelerate production, to mitigate this impact and still 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 remained strong with $587 million of orders, and the Civil backlog reached a new high of $4.6 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 signed exclusive business aviation pilot training contracts with Icon Aviation and Windsor Jet. Overall, training center utilization remained 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. We're having an unprecedented year with 50 full-flight simulator orders booked in the first 9 months and another 14 in the last 6 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 1.28x and for the trailing 12-month period was 1.31x.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 booked orders were $268 million, including the first increment of an 8-year contract with the U.S. Air Force, worth a total of more than $250 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 program and with Boeing for upgrades on P -- Poseidon aircraft simulators. We also booked the next increment of a 5-year contract with the United States Navy worth a total of more than $160 million to provide primary and advanced virtual instruction services for the Chief of Naval Air Training program. In addition, under the U.S. foreign military sale program, the U.S. Navy awarded us a contract for maintenance and sustainment services for the Royal Australian Navy's MH-60R helicopter training systems. The Defence book-to-sales ratio was 0.81x for the quarter and 1.03x for the last 12 months.And finally, in Healthcare, we continue to adapt and ramp up our sales force to pursue the largest segments of the healthcare simulation market, like nursing, and we continue to release new products to stimulate demand.Our latest release is CAE Luna, an innovative infant simulator, designed to fulfill clinical training requirements for neonatal and infant care. As well, we released 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, Mark, and good afternoon, everyone. Consolidated revenue for the third quarter was $816.3 million, and quarterly net income was $77.6 million or $0.29 per share. This compares to $0.38 in the third quarter last year, excluding the gain of approximately $0.15 per share attributable to the U.S. tax reform and fair valuation of CAE's prior investment position in the Asian Aviation Center of Excellence.Income taxes this quarter were $14.2 million, represented an effective tax rate of 15% compared to a negative effect of 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 the change in the mix of income from various jurisdictions.Free cash flow improved in the third quarter, reaching $155 million compared to $146 million last year. The increase in free cash flow year-over-year results mainly from greater efficiency on our noncash working capital account, 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 USD 155 million payment for the closing of the royalty monetization transaction, with cash on hand and without additional borrowing.Additional uses of cash in Q3 included funding of capital expenditures for $61.6 million, mainly for growth, and we distributed $25.5 million in cash dividends.We used another $49.1 million to repurchase stock at a weighted average price of $25.54 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 $985.7 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 USD 550 million 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 receptivity to our offering, with the participation of 19 large institutional investors in the U.S. and Canada. The notes consist 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 $458.4 million, and operating income was down 24% to $87.2 million for a margin of 19%, excluding the net AACE gain last year. Civil training performance remained strong in the quarter, with double-digit top- and bottom-line growth and healthy margins. The overall decrease in revenue in operating income for Civil this quarter compared to Q3 last year reflects the timing impact we expected from the adoption of IFRS 15 as it relates to simulator product deliveries and a 5-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 our expected annual total of 56 Civil simulator deliveries.In Defence, revenue was up 27% year-over-year in the third quarter to $330.2 million, while operating income was down 17% to $25.2 million for an operating margin of 7.6%. Revenue growth was driven mainly by higher level of services activity, including contracts under our 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 contributed to the lower Defence operating income and margin, including higher R&D expenses related to new development programs and delays in some higher margin programs that would normally help offset the R&D effort. These 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 require for these programs to advance. These are timing-related factors, and we've already taken measures, including rebaseline 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 $27.7 million. Healthcare segment operating income was $0.6 million in the quarter, down from $1.5 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 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 within large and growing markets. We're highly positive about our prospects in Civil. And as a global leader at aviation training, CAE is a 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 numbers of city payers to cater to 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 crews, who, by regulation, must train on a simulator on a regular basis.In addition, and highly relevant to CAE is that we forecast demand for approximately 300,000 new pilots over the next decade to support this growth and to replace the larger 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 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 (sic) [ Aircraft ] 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 consents, we now expect to conclude the acquisition by the end of March, which is earlier than we previously indicated.Civil training remains the biggest global vector of our company. And our success there continues to augment the recurring revenue and profit profile of CAE's business. Simulation products represent about 1/3 of our Civil business. And it's noteworthy that we generated recurring revenues there too, by providing ongoing support for regular updates and upgrades to the largest commercial aircraft simulator installed base in the world. And we continue to add the CAE's global customer 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 $4.6 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 the best training systems to industry partners, like CAE, and we expect to continue winning our fair share by building on our successes as a training 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 Center would undoubtably enhance the value CAE can contribute to other enabled programs to include the new Royal Canadian Navy's Canadian Surface Combatant program, for which CAE is part of the 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 aircraft 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 part way 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 have been well received by customers. And we continue to make progress ramping up our sales force, particularly in North America where we have made some significant recent additions. We remain encouraged that 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. It's 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 CAE Healthcare was front setter at IMSH as the commercial and thought leader in this field.In summary, we've good momentum in all of our markets, and we're on track to deliver on CAE's growth outlook for the year.With that, I'd like to thank you for your attention. And we're now ready to answer your questions.
[Operator Instructions] Our first question comes from Benoit Poirier of Desjardins Capital Markets.
Could you talk a little bit about Defence, 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 meet the guidance, it must imply that you should be closer to 15% in Q4. So if you could provide more details about what makes this guidance achievable?
Yes, thanks, Benoit. This is Marc. Look, I think, we understand the ramp up for Q4, or else we were -- certainly couldn't be confident giving the outlook or reiterating the outlook that we have. I mean, the confidence that we have is really based on the fact that we understand well the factors that lead to the performance in Q3 as a whole -- the year as a whole, I mean, and the ones that we described on the call, specifically, in Q3, the ramp up of our service contracts, AOCE, the U.S. Navy CNATRA that generating a lot of revenue, and you see that in the revenue growth, which is quite impressive. But they're not carrying a lot of profit at this time because it is just ramping up, they've got integrated costs 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 2 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 contracts -- the naval contracts, specifically the UAE. So we understand the factors that lead where those programs are. We've already re-baselined those programs. We've got agreements with the customers. I've personally been involved in some of those. So we've pretty good confidence in the programs that we have to execute from backlog in the quarter as what we would 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, we have programs that we've already been selected for. So 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 the customers to get those done by the time that we reach the end of the quarter. And because we got work in progress in 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 the quarter and Defence, specifically, and then for the year as a whole.
Okay. Perfect. And I know it's early but fiscal '20, obviously, you're still ramping up a few projects. Could you talk a little bit about to what is implied in terms of your Defence margins and your backlog? Is it closer 11%, 12% or closer to the low end? And is there a lot of ramp up expected also in fiscal '20 that could probably put some pressure?
Well, look, the backlog that we have is in 11%, 12% range. So that hasn't changed. The mix will get -- 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 outlook for the year -- this year. We typically do that next quarter, and we'll do that again. I mean, suffice to say, it's a growth business, and continue to grow business. We fully expect that $4.6 billion proposal that we have out there just 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. I think we'll be more focused in the whole of our business. As you've seen, it's been, the last couple of years, certainly, this year, on focusing on absolute dollar growth, so SOI growth in dollars, because that more accurately reflects the mix of our business products versus services and from a geographical point as well. But -- and in the end, it will support the ROCE growth, the return on capital growth expectations that we have that Sonya talked about for business as a whole 13% by our fiscal '22.
Okay. And just for Healthcare, 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 are going to reap some benefits in Q4 and toward fiscal '20?
Well -- yes, we certain anticipate that, as we said in our outlook. I think and I'm confident. And then in terms of -- the one thing that is probably worth noting is the investment that we make in Healthcare, interest rate -- the cash flow we generate, the business supports itself. I think I don't believe you want to expand on that, Sonya?
Yes. So Healthcare is cash flow positive and 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 3 new lines of manikin with Juno, Ares and now with Luna to really kind of focus 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.
Just -- I'll just add to that, Benoit, that one thing that hasn't changed is 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.
Our next question comes from Cameron Doerksen of National Bank Financial.
Just a couple of questions from me. I guess, maybe firstly on the -- you mentioned that you'd, I guess -- your JV partner, Avianca, the JV there. I'm just wondering, and I guess, sort of the second one we've seen in these in that -- in recent years. I'm just wondering if there's 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'll be a combination of things. I can't really comment about the JVs that we have even -- we mark that those would be confidential in 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. Until back couple of years, I would always say that, like, see 1 or 2 of these a year, certainly we turned better on that this year. And I expect that to continue. The pipeline is good. And that could contribute to being deals like we buy out the remaining proportion of the JV, but not withstanding, 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 Marc said, we continue to see an active pipeline of conversation on outsourcings. 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 JVs with Singapore Airlines, but also these things also culminate in long-term training agreements with organic CapEx or existing CapEx deployment 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 wondering if that -- I know it's probably going to 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 they're probably pretty low.
We should see some integration, restructuring and transaction costs. So while we believe that the execution risk is low, there is some overlap on certain rules and costs to integrate the transaction. So I would expect to see some integration costs in the quarter. We had indicated at that time that we saw a level of synergies about USD 6 million. The integration costs should be a little bit in line or a bit higher than that, and we expect depending on the timing, it should align with shortly after the closing.
[Operator Instructions] Our next question comes from Kevin Chiang of CIBC.
Maybe just a follow-up on Benoit's question earlier around Defence margins. I'm just wondering, as you become more of -- or as you focus more on this training system integration strategy, does that inherently create more, let's say, quarterly volatility or margin profile given the ramp up and some of the upfront costs you have to incur as you build up these programs? Is that a -- or is this margin volatility maybe a consequence of that? Or is this year, fiscal 2019, that is -- is this year just maybe a little bit more unique than a typical year?
I think if you look back, I've been in this business for quite a few years now and actually used to run Defence before I became CEO. I think you will barely find pretty significant quarterly variation. And that to me is, it shouldn't be expected of the -- specifically of the Defence business because we -- in 1 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 what execution you do on those contracts in the quarter. Remember, we use percentage of completion accounting, which means that we're booking profit at the same time as we're incurring costs. So depending on the level of activity you have on that specific program in the quarter, it will dictate the number. And of course, if you execute another program in the following quarter as a different profitability profile, it'll lead to different answer. And the service contracts will give you -- because they are longer-term, they will provide to me, if anything, a more stable base, both in terms of revenue you expect during those quarters 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 guess, this alliance will tell you. I think it's very hard to judge performance on a quarterly basis. And that's why our outlook is yearly. And I think we'll continue that way. And I really think that's the way you should look at it. And when we provide order intake, again, I think, the best judge of the growth for the business is to look at leading indicators, like the pipeline and more specifically on the book-to-bill, judge on a 12-month basis, again, to eliminate these quarterly variations.
That's super helpful here. And just -- maybe just a point of clarification. You talked about repositioning within Healthcare or that of a 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 obviously 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're executing against this strategy?
Look, I think, first of all, the 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 can get to over the longer, but not too long period. So that hasn't changed that we're going after nursing. Remember, what we said last year, we embarked on repositioning our businesses. We stopped waiting for really regulation to really come in force and really be the driving force behind this business and refocus our efforts, our product development and our focus on the market that's there today. And the market that's there today is largely it aggregates nursing programs. There are 2,000 of those programs in United States alone. So that's where 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 -- so that hasn't changed. In terms of the cost, I think, what you're seeing is increased now, affecting the leverage is mainly SG&A, mainly sales force to go after repositioning. You have a large number of schools out there, institutions, hospitals. So we're increasing the sales force. So we're going to continue to do that. But as I said a bit previously on my answer to Benoit Poirier is that the margin profile of the products that we sell in Healthcare, I think, we started getting some decent revenue growth, it'll disproportionately drop to the bottom line.
[Operator Instructions]
Operator, we'll open the lines now to the members of media, and I thank members of the financial committee for their questions.
We do have one final question from an analyst that comes from Tim James of TD Securities.
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, it was about $380 million increase in the combined assets of PP&E and the intangible assets in the quarter relative to the second quarter. I know $200 million of that is from the Bombardier loyalty monetization and it looks to me like another kind of net $35 million increase from CapEx. But then there's another kind of $150 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 what's causing the monetization, which was $202 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 closed quite high at CAD 1.36 to USD at the end of the quarter. And that drove essentially all of the U.S. operations, et cetera, and closing assets, like goodwill, intangible, fixed assets, at a much higher rate. And so that's the $100-some-odd-plus million that drove the increase.
Okay. Then that's helpful. I didn't realize the FX was that significant.
Okay. Operator, if you would please open the line to members of the media.
[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, and remind you that a transcript to the call could be found on CAE's website. 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.