Description

CAE’s dominant near-monopoly status in third-party training / Full Flight Simulator (FFS) manufacturing makes it a high quality way to play the ongoing post-COVID air travel recovery / pent-up demand theme. It is a leading beneficiary of commercial air capacity recovery without worrying about other variables like loading factors, airfare, fuel, or labor cost. 

The business model incrementally benefits as airlines outsource more of their training work to third-party training facilities (market share gain angle) due to cost advantage (CAE believes it can save airlines 20% of cost). Today only 40% of training hours are outsourced to third-party independent training facilities but this number has been rising over the last 2 decades with the trend set to continue. The company’s disproportional exposure to Low-Cost Carriers (LCC) could accelerate its base earning power recovery given LCCs will likely take capacity market share post COVID and LCCs have higher tendency to outsource training. In addition, CAE is a large beneficiary of elevated global pilot retirement pace as “friction / pilot churn” is good for training demand. 

CAE also has a Defense business undergoing a margin improvement initiative under new leadership (ex-L3H veteran), that is currently integrating a double-digit-% EPS accretive military training acquisition. While this segment has been underperforming recently, its large international training exposure should allow it to benefit from improved military training demand post Russia-Ukraine conflict on a forward-going basis.

From a return perspective, I can see ~mid-30% upside over the next 12 months as various idiosyncratic levers boost training demand and lead to positive earning estimate revision before compounding at a more normalized low-teen rate after that; return can be further enhanced if air traffic recovery for CAE’s client base happens faster than expected and if multiple goes back to the historical high (bull case of up ~60% over the next 12 months).

Note: CAE is HQ’ed in Canada and reports in CAD. It has a CAD line that trades on the Toronto Stock Exchange but also a USD line that trades on NYSE. All “$” signs refer to CAD $ when talking about the business (revenues, profit, etc), except when talking about the stock price (I use the US line in the write-up)

Background / Company / Industry Description

What does CAE do? CAE sells flight simulator equipment and operates training network that services airlines, biz jet operators, and defense. The company has dominant position in flight simulation equipment and aerospace training market with a high market share. 

CAE enables pilot training by either 1) selling Full Flight Simulators (“FFS” / capital equipment) to airlines or 2) providing training services at its own training infrastructure, ultimately helping customers improve safety / accuracy in an industry that require high technical expertise with low tolerance for error 

The highly regulated end market gives CAE a tollbooth-like business, as pilots are required to train on a recurring basis (every 6 to 9 months), it is also more of an early cycle business within aerospace as training demand is more tied to “flying hours / capacity” rather than loading factor (you need two pilots regardless of how packed a flight is)

I would rate the market structure as attractive, where CAE has market share leadership across the board

• FFS equipment: CAE consistently commands 70%+ share in commercial aero FFS, 80% share in CY2019 (rest provided by L3H/OEMs/Thales)

• Commercial aero training services: owns ~75% of the non-airline (where training is done in-house) / non-OEM (Boeing and Airbus offer training services too) third-party independent training market

• Business jet training services: ~50% mkt share (duopoly with FlightSafety / BRK portfolio company)

Corporate history: the company started from a defense simulation root, and gradually expanded into dominant commercial aero simulator manufacturing before morphing into a services company in the last decade

• Founded in 1947, entered into defense simulator business with Royal Canadian Air Force in 1952 

• CAE grew to be a global exporter in 1980s as 85% of production was exported across the globe

• Became the leader in flight / system simulation by 1990s – across full-flight simulators (FFS) and visual / computer-based system

• Started to aggressively build the global training network to focus on providing services post 2000 

• Became global leader in civil aviation training by 2010s with 10k+ employees and 160 sites/ training locations in over 35 countries today

• Gained credibility with customer base due to expertise and innovation in simulators over many decades – then it used that to strategically enter into higher margin training biz

Pictures: here is a commercial jet FFS on the lift, and a helicopter FFS on the right. The picture at the bottom shows CAE’s Training Center at London Gatwick (with a dedicated wing for easyJet)

Segment description / revenue & profit mix: 

Civil Aviation Segment (~60% of revenue / ~80% of EBIT) / “Crown Jewel”

• ~1/3 EBIT from FFS equipment sales: these are $10-15mm per piece, around ~15-18% EBIT margin (lowest margin in this segment)

• ~1/3 EBIT from Commercial Training: est. low-20% EBIT margin pre-restructuring initiative

• 1/3 of this is “wet” training – an airline completely outsources to CAE and uses CAE instructor, courseware and training facilities

• 2/3 of this is “dry training” – an airline (usually bigger) uses its own instructor / courseware, and only rents CAE’s simulators 

• ~1/3 EBIT from Biz Jet Training: highest margin, est. high-20% pre-restructuring initiative

• Avg biz aviation operator has 3.5 aircrafts, with no resource to do in-house training so they completely outsource training

Defence & Security Segment (~37% of revenue / ~19% of EBIT) / “Cash Cow”

• Provides integrated live-virtual-constructive (LVC) training solutions across air, naval, land and public safety 

• Designs turnkey training facilities, training services, and simulation products / capabilities for customers 

Healthcare Segment: small / non-meaningful contributor to profitability

• LSD % of revenue and running at close to break-even (5% margin in outer-years is likely)

• Entered into this biz 10 years ago to improve clinical education and patient safety metrics by increasing penetration of simulation-based training solutions

A few KPIs in graphs

Pre COVID, CAE carried relatively stable utilization rate around ~70%-75% in its training center network, it doesn’t do spec build

This chart below shows the growing Full flight Simulators (FFS) deployed in CAE’s training network as a result of decade-long growth CapEx, acquisitions, and market share gains

CAE’s competitive advantages:

1. High barrier to entry: requires extensive training network (capital intensive) and strong market reputation (can’t be built overnight), too late for new competitor to gain scale

2. Credibility / proof of execution is hyper important in this industry given paramount focus on safety – hard for new players to get any love. Chicken & Egg problems, so once you have the lead you tend to maintain it

1. CAE’s moat has been fortified by seven decades of “industry firsts” 

3. Unbeatable scale from presence in 35+ countries and broad global training network of 60+ facilities

1. Unique capability and global scale to address total lifecycle needs of a professional pilot (cadet to captain)

2. Example: an airline can use 5 separate facilities of CAE in different continents and ensure consistency / quality

4. Vertically integrated & multiple ways to monetize: can pursue either capital equipment sale or services model / flexible partner to every airline customer

As a result, it has multiple favorable business qualities:

1. High degrees of recurring revenues:

1. Regulation requires extensive training to become a pilot and continuing education every 6-9 months to main license 

2. Over 60% of biz derived from provision of tech-enabled services & long-term agreements w/ airlines + defense customers

2. High renewal rate in training business (~90%) with large backlogs

1. Rarely sees cancellation in FFS orders given critical nature of training (no cancellation even during COVID) & simulators are fully funded before being built

3. Long term structural growth in global aerospace (RPK of 6%)

1. Consistent share gain potential to grow at above underlying mkt due to outsourcing

2. Very high FCF conversion of closer to 100% (before growth CapEx)

3. ROIC on growth capex is 20% to 30% incremental returns

Thesis Point #1: CAE has a strong business model, is a dominant & leading beneficiary of aero capacity recovery without worrying about other variables like loading factors, airfare, or labor cost

All roads to air capacity recovery goes through CAE. Training demand should lead air traffic recovery because airlines need to ramp up pilot training before traffic fully returns and OEMs ramp up aircraft deliveries. Airlines want to proactively have pilots operationally ready to fly in advance of re-establishing routes to maintain + defend their mkt shares. As a result, active fleet / capacity recovery usually comes back first, before recovery in air traffic measured by RPK (revenue passenger kilometers)

The important drivers are 1) active fleet of aircraft (how much is flying vs. parked) and 2) pilot churns. They both will continue to accelerate in my opinion

As a downside protection, airlines are incentivized to keep training some pilots even if they aren’t flying because time & cost required to re-obtain licensing once continuing education requirements expire can be extensive

CAE’s normalized Civil Aviation earning power will be higher post COVID as it has announced a capacity rationalization cost plan that will result in C$65-70 mm structural cost savings irrespective of volume. This restructuring plan is focused on optimizing asset + network facilities (involving relocation), and enhancing digital process (using virtual / remote training technologies), it started in calendar Q3 2020 and restructuring benefits have started flowing in throughout 2H CY 2021. As a result, the FY’20 (CY ’19) Civil Aviation margin of ~22% should improve to a ~25% in a normalized environment Pro-Forma to the cost savings alone

Timing of demand and capacity recovery: various commentaries and data around aerospace recovery / capacity recovery suggest CY 2024 is when we get back to Pre COVID baseline for commercial aviation. Looking at IATA’s official forecast, air passengers should return to 94% of Pre COVID level by 2023 and 103% of Pre COVID level by 2024. Slowest regions to recover have been APAC, Africa, Middle East and Caribbean, while North and Central America are way ahead of the pack. Europe’s progress was slow in a patchy 2021 derailed by Winter surge, Delta wave and Omicron wave (averaged at 40% of Pre COVID baseline) but that traffic is expected to double in 2022 and get to “normal” by 2023. This should be a large tailwind for CAE given its outsized FFS exposure in Europe. As a reminder, capacity recovery needs to “lead” demand recovery

Mgmt is quite confident about recovery trajectory and inflection in its training network utilization rate. CAE mgmt acknowledges forward bookings at airlines are very high esp on leisure travel – and CAE is working with them hand-to-hand so their pilot crew can be trained to handle the demand upswing

Here is the IATA air traffic demand forecast if you want to dig in further

https://www.iata.org/en/pressroom/2022-releases/2022-03-01-01/

Here is an exhibit courtesy of Jefferies that summarizes the IATA forecast by region 

Here is another exhibit courtesy of Jefferies that lays out its own capacity growth forecast by region, you can see it has ASK at ~101% of 2019 baseline by CY 2024

So that is commercial aviation traffic (that drives training demand), but what about the FFS sale business? Well, this business is tied to aircraft deliveries, which lags orders. You can see that gross orders (this table below courtesy of DB) from Airbus/Boeing have mostly returned to Pre COVID baseline, so deliveries should also normalize over the next 2 years. Airlines usually like to have their FFS delivered around the same time or even ahead of aircraft deliveries, so they can get started on pilot training and deploy those new aircrafts

What about business jet training (source of ~1/3 of Segment profit) demand? Well, fortunate for CAE, business jet market has been experiencing a boom over the last 12 months, and takeoff/landing stats across both North America and Europe both exceed Pre COVID levels. This piece of the business normalized very fast for CAE and it’s where CAE has been spending quite some growth CapEx as it invests behind the secular tailwind behind business jet traveling

Below exhibits illustrates the strong biz jet usage in US / Europe, and how low used biz jet inventory stands today vs. history

There has been some consternation in CAE shareholder base over the past 2 quarters as investors struggled with a lack of sharper recovery in training center utilization – after an uptick to 55% by calendar Q1 2021, it has been more or less choppy and only made limited progress to end calendar Q4 around 60%. I think some investors thought it should have covered back to mid-60s vs. mid-75% being the “normal” in 2018/2019 given the outsourcing tailwind and biz jet training strength. The reality is that CAE is way overexposed to Europe (where traffic recovery was weaker than expected in 2021) and way underexposed to North America (where recovery has been the strongest thus far). Please refer to the simulator geographic mix exhibit below. As a result, there is a lot of “pent up improvement” potential for CAE that is coming over the next 12 to 18 months

Thesis Point #1(a): there is extra benefits to CAE given LCC concentration in Civil Aviation Training, so this should really help accelerate CAE’s recovery

Fortunately for CAE, Lower-Cost Carriers tend to outsource training a lot more than legacy / major carriers due to their requirement for cost flexibility. Not only do LCCs outsource a lot more of their training needs to third-party training service providers (like CAE), they also give provide the highest margin business – “wet training”. Wet training is where CAE provides its own instructors and coursework, leading to highest revenue capture. I estimate ~45%+ of Commercial Aviation training revenues are from LCC

LCCs’ aggressive cost-cutting will give them an even larger cost advantage than pre-COVID and they are well positioned to more quickly respond to pent-up demand and take market share post normalization. LCCs’ ability to operate cash-positive routes with lower load factor than before is very important given lower level of demand post COVID. They also have higher degree of resilience and flexibility with regard to network planning and aircraft deployment. Credit Suisse airline team expects LCCs’ cost advantage will translate into market share gain – such that LCC capacity market share globally will rise to 30% by 2025 vs. 26% in ‘19 and 20% in ’14

You can see from this chart below that LCCs were the first to capture demand pick-up in the market post COVID trough in Europe

Thesis #1(b): CAE is playing offense and taking advantage of industry softness to further consolidate industry (multiple announced bolt on acquisitions since Fall 2020)

CAE is on the offense and announced multiple bolt-on deals since COVID disruption to improve its market share and competitiveness post COVID. The Saber AirCentre Airline Ops Software deal further expanded CAE’s addressable market beyond pilot training and established the company as a technology leader in digital-enabled flight and crew ops solutions

Flight Simulation Company (FSC) for EUR 70mm: Direct training competitor in Europe that CAE knows very well, in fact FSC bought most of its new simulators from CAE.

TRU Canada for US$ 40mm (divested by Textron): A single-facility simulator training and manufacturing company 2 blocks away from CAE’s Montreal HQ that mgmt knows very well. Builds simulators for many Textron aircrafts and helicopters. CAE acquired a good manufacturing operation and a good book of biz

Merlot for US$ 25mm: Merlot is a flight crew management and optimization software company, which helps CAE grow its network beyond pilot training (TAM expansion) and strengthens CAE’s digital flight operations portfolio

Saber AirCentre Airline Operations Software (just closed): Suite of flight and crew management and optimization solutions designed to enable airlines to operate their businesses with efficiency and precision. CAE acquired this asset for US$392.5mm and this business generated US$150mm revenues/$55mm EBITDA in CY 2019 – this deal is expected to be MSD % EPS accretive and even more FCF accretive within the first year post-closing

Thesis #2: airlines will increasingly outsource training services post COVID and this will benefit CAE

The likely-increasing outsourcing demand for commercial training post COVID positions CAE well for share gains. Today, 50% of training is done “in-house”, especially by legacy / full service airlines with large simulator & trainer infrastructure. Post COVID, many airlines likely to relinquish training duties to better control cost, turn fixed cost into variable in challenging times, and address growing efficiency / pilot capability gaps. Partnering with CAE gives airlines immediate access to world-wide fleet of simulators, courses, programs and instruction capabilities, and allows them flexibility in pursuing aircraft fleet options that suit their business

Mgmt indicated that a major airline could save 20% on training operations if outsourced to CAE due to its global presence and scale. CAE hasn’t converted any major America carriers to outsourced training model yet but that potential exists. Historically one challenge to outsource is competing interests with airline labor – but current environment could act as a catalyst. Industry disruption is often needed to catalyze changes in this industry given labor resistance to outsourcing. There have been many precedence of outsourcing out of downturn: for example, Japan Airlines outsourced training to CAE-JAL JV after it emerged from bankruptcy post GFC

It is difficult to call timing but CAE is in “advanced discussions with airlines about outsourcing & partnerships”

CAE Mgmt: “There are several discussions underway. That hasn't changed. The dynamic continues that airlines are more amenable to partnering with us. It's become more resilient and have flexibility in their training operations by turning a fixed cost into a variable cost. You can well imagine that airlines are pretty busy these days in terms of managing their operations. But I do believe that some of these deals will come to fruition, and it's just a natural for us. So -- but we'll keep you informed as they -- we don't control the time line, certainly, and we're patient”

Some of CAE’s smaller competitors may exit market / find it hard to scale given tighter financial resources & COVID disruption.

Below exhibit from GS illustrates market share today

CAE has multiple outsourcing models to entice airlines to switch: dry, wet, or JV models. JV model is a compromise for airlines that are reluctant to relinquish control given importance of safety and unionized trainer labor force. While CAE prefers to drive a straight-forward conversion from Dry Training (simulator rental) to Wet Training (simulator + instructor + coursework), CAE will align itself with the airline customers by forming JVs with the hope that eventually CAE will take full control of the training services (after airlines see the improved training efficacy and cost effectiveness). 

Among the thousands of CAE customers, it has long-term training center operations & training services agreements and JVs with ~40 major airlines / aircraft operators. The range of training solutions includes product and service offerings for pilot, cabin crew and aircraft maintenance technician training, training center operations, curriculum development, courseware solutions and consulting services.

Case studies for past JV deals – major outsourcings usually come after periods of industry struggle

Japan Airline JV announcement in 2014: Japan Airline filed for bankruptcy in 2010 and emerged from bankruptcy in March 2011

Detail of JV

• In 2013, JAL signed a deal with CAE where JAL outsourced all its Ab Initio pilot cadet training responsibility

• In 2014, JAL and CAE announced to form a 50/50 JV to provide flight crew training services across northeast Asia ex-China beginning in April 2015

• The JV would be made up of JAL’s existing training center in Tokyo and CAE’s training center in northeast Asia, with a total of 12 simulators

• JAL had a fleet of 220 aircrafts back then. The JV also included training services for third-party customers to use its simulator infrastructure

Singapore Airline JV announcement in 2017: Singapore Airline initiated an internal business review in 2017 after its first quarterly loss since 2012 due to intense competition from Emirates, Qatar Airways and Etihad – and CEO wanted “bold and potentially radical actions to tackle costs”

“…The review is aimed at identifying new revenue-generation opportunities and reshaping the business into one that continues to deliver high-quality products and services, though with a significantly improved cost base and higher levels of efficiency…”

Detail of JV

• Singapore Airline announced to establish 50/50 JV with CAE with initial focus on simulator training for Boeing aircraft types to support Singapore Airlines and other operators’ pilot training needs in the region 

• Singapore Airlines will transfer 4 of its BA aircraft simulators while additional FFS will be acquired progressively 

• “The joint venture will support the SIA Group’s fleet and network expansion plans, as well as our strategy to develop new revenue-generation opportunities through adjacent businesses”

Quotes from two recent CAE executives that support outsourcing ratio to meaningfully increase post COVID

Former CAE Civil Aviation Senior Executive:

“…I’ve seen within Europe as well a growing trend of even the large flight carriers looking to start outsourcing. It’s a very tough and big decision for an airline to take, pilots and training pilots is, because safety is a big issue for most airlines, they’re very slow to outsource it…

…but I’ve started to see a trend where some of them are. It’s a very big decision, and it’s a bold decision for any chief executive or senior team to decide to outsource their training, but we are seeing it now. I don’t have percentages, but the one thing I will be fairly comfortable with is the percentage that are outsourcing it and using third-party providers is going to increase…”

Ex CAE Defence & Security President: 

“…in an event where you have to take a lot of lay-offs, they’re now going to have to retool in order to get back up and online. If they own all the infrastructure that would now be sitting idle, that’s not good for them. They can hire and fire pilots more quickly than they can buy and sell airplanes or build training centres, so they’re looking for strategies to outsource training and maintenance to a greater degree. I’m saying this trend is going to accelerate due to the pandemic. 

I think they’re also looking for strategies to look for ways to put the aircraft-leasing burden on third parties and the OEMs, and have more flexible terms when it comes to cancelling orders…”

High-level outsourcing math suggest tailwind potential of 20c to 50c EPS uplift (over time) that could be supported by CAE’s existing commercial training network capacity

There is about 4mm hours annual simulation time needed for commercial pilot base today and it looks like CAE has ~30% mkt share at ~1.2mm hours (roughly confirmed by mgmt): the opportunity to get some hours from airlines themselves + earn high return on un-utilized capacity. This analysis below broadly illustrates the incremental EPS potential IF 5% to 25% of the internally-managed training gets outsourced over a number of years

Due to lack of more precise data, keep in mind this is more illustrative in nature and contains various subjective estimates pieced together via industry conversations

If demand for training is high, CAE can add simulators to its pre-existing training networks at 20-30% incremental ROIC

This is the commentary CAE made on Incremental ROIC pre COVID: “…And as we've seen now, all the new capital that we've deployed, it goes to work very quickly and within, call it, about 24 months, it generates 20-plus, 20% to 30% accretive incremental returns and cash flows…”

Here is my estimate of ROIC for a green field training center and how attractive incremental ROIC can be if CAE adds incremental simulators to the existing footprint: it does confirm the 20% to 30% incremental ROIC commentary. 

Again, please keep in mind this is more illustrative in nature and contains various subjective estimates

Thesis #3: elevated pilot churn going forward will drive a training boost via 1) increased “type training” demand and 2) new pilot training demand to replace retired pilots

Age-driven pilot retirement is accelerating, esp in US. FAA data suggests avg age of airline pilot is 51 years old vs. 46 years old back in 2000. Avg age of private aviation pilot is 48 vs 46 in 2000. More than half will be older than 65 retirement age in next 10 years so the industry needs to actively recruit to prevent pilot shortages. New pilot training is actually a higher revenue oppy for CAE vs. existing pilot’s continued training requirements

Globally, pilots over age of 50 represent 38% of total civil aviation industry pilot pool (commercial and biz jet). With the industry facing massive retirement numbers over the next 10 years, the percentage of pilots over the age of 50 continues to increase versus the pilot pool base. As experienced pilots retire, a chain reaction of new hires / pilot promotion is triggered, benefiting training in multiple ways

A few helpful exhibits from GS in case it’s helpful:

CAE’s Pilot Outlook analysis predicts 126k airline pilots to retire over the next 10 years (need to be replaced) and another 93k of “incremental” pilots needed to fly the growing fleet post COVID normalization. For airlines, 126k represents cumulative 38% retirement over 10 yrs, or 3.8% retirement per year

US has a particularly high churn problem (BA was estimating ~42% of commercial pilots to retire with 10 years back in 2018, implying a 4.2% annual retirement rate, higher than global)

A total of 264k new pilots will be needed (across airline and biz jet) to replace retirement, attrition and support incremental fleet growth

Biggest geographic area of demand is APAC – 91k out of 264k new pilot needed, followed by NAM at 65k and Europe 42k

This is from CAE’s “Pilot Outlook 2020” report

What does an elevated pilot retirement / pilot churn mean for CAE? More training

Pilots typically switch plane types every 5 to 10 years but COVID will fast-forward a lot of the type / role switching. “Pilot churn” defined as switching planes or switching seats (driven by retirement / promotion / route changes) is very helpful to training demand (i.e. even “First Officer to Captain” requires training because the pilot needs to get used to flying in opposite seat)

As airlines retire fleets of inefficient aircrafts and cuts higher-cost senior pilots / forcing them into early retirements, it creates a huge amount of pilot churn because most airlines in the world are seniority based. Lots of long-haul-type pilots will likely switch to short-haul post COVID to adapt to new capacity schedules so that will also introduce pilot churn

In aggregate, “friction” is great for CAE, CAE is indifferent between initial training, transitioning training, upgrade training and recurrent training – they all lead to simulator hours demand. “Type Rating” training costs between USD 15k to 25k spread over ~48 hours of simulator training – the range is wide because it depends on how drastic the aircraft type switch is. Since this “friction-driven” demand for training is more transient, airlines are more likely to outsource it as they don’t have the capacity prepared for elevated “conversion training”

Below is an illustrative analysis that illustrates EPS update if we get a wave of elevated “Type Training” as pilots get reshuffled to new roles and plane types – CAE could see 5c to 15c of EPS upside driven by this alone

Then there is also a new cadet training angle (to replace retired pilots). CAE is the “largest company in the world” in terms of training new pilots (new cadet) through “ab initio flight training network” – though revenue exposure is not disclosed – demand is stable for now. 

Airlines have largely maintained their original plans on new pilot talent development – as it takes 2-3 years to train a new pilot & and airlines don’t want to be short-sighted. CAE mgmt commentary suggests airlines thus far maintained their original plans on new cadet training and CAE won some share

CAE mgmt: “what I could tell you is none of the airlines that we trained and we trained a lot of cadets for airlines, none of them have reduced their level of activity” after COVID

CAE mgmt: “…People have maintained their original plans. In fact, we've won more business. We won, for example, with Boeing, we announced that last quarter, a contract to deliver pilots for them. So I haven't seen any impact. In fact, our flight hours are basically the same”

CAE has disclosed it has over 30 cadet training programs globally. Clients include Southwest, American Airlines, JetBlue, IndiGo, Jetstar, AirAsia, Kuwait Airways

Due to lack of quantitative disclosure, I did not quantify the upside from this angle – but optionality is there. New cadet training programs are quite expensive and likely high margin, press reports show that 18-to-20-month flight training course cost range is between $60k to $135k USD

Thesis #4: CAE also has an attractive defense business with a margin recovery plan under way

This is a small biz in a big end market with ample growth opportunity (50/50 between US and int’l). Rising global tension post Russia-Ukraine conflict and the shift to peer threat readiness will enable some growth inflection after a rough patch over the past 2 years

Defense forces globally continue to increasingly leverage virtual training and balance their training approach between live, virtual and constructive domains to achieve max. readiness and efficiency. US and allies are transitioning toward a peer threat national defense strategy that makes training a focus

Peer threat combat requires coordination across military dimensions (air, sea, land, cyber, space), which leads to expensive training exercises given the logistical preparation that must occur. This will drive more virtual training as government budgets are under pressure

CAE is a tier-1 training system integrator that competes with many of the larger defense OEMs, having delivered products/services to ~50 defense forces in over 40 countries. Training solutions typically include combination of training services, products and software tools. (i.e., contractor logistics support, maintenance services, systems engineering, staff augmentation, classroom instruction and simulator training at over 100 sites around the world)

CAE has a credible margin expansion plan was laid out before recent L3H acquisition – centered around improving mix of products vs. services to drive margin recovery. While segment revenue grew from ~$860mm in FY2015 to $1.3bn pre COVID, margin compressed every year as mix was unfavorable (adding a lot of lower-margin services revenues). CAE announced new President for this segment in August 2020 (from L3) to tackle a restructuring plan that is expected to add $50mm to EBIT starting in FY2022 + driving improving mix. CAE believes the backlog can support 11-12% EBIT. For example, 50% services revenue mix at 9% EBIT margin and 50% product mix at 13% EBIT margin would get it to 11% (mgmt assumption for the medium term)

Defence & Security Segment margin

Trend has been quite unfavorable for CAE’s legacy defense business (excl. the L3H acquisition contribution), where not only revenues have been sluggish, margin really fell off a cliff to the ~4% area for the past 2 quarters from the 7.5% to 8% average level over the previous 2 to 2.5 years. This annoyed the shareholders, but management’s explanation was that after many quarters of weak international order intakes as a result of COVID disruption, the remaining backlog had a lot of low-margin business mix in it and wasn’t able to converting into high-margin revenues in the short term.

The good news is that the backlog has been stabilizing with the last 2 quarters showing very strong Book-to-Bill ratios of above 1x. One would think orders would continue to strengthen post Russia-Ukraine conflict as countries emphasize on their military readiness globally

I assume the legacy Defence and Security Segment can reach ~9% margin by FY 2024, below their “low-teen %” aspirational goal (which is likely ultimately achievable but takes more track record of execution for me to believe in)

Thesis #4(a): CAE acquired L3H’s defense training business for CN $1.35bn in March 2021 (closed in July 2021) that will result in meaningful EPS accretion

It is a very complementary acquisition that came with meaningful cost synergy + potential revenue synergy. It is also immediately accretive to its own Defence & Security segment margin. Plan is CN $35mm to 45mm of cost synergies realized by year 2 from cost reduction from optimizing footprint, production / procurement cost efficiency, and G&A functional support cost rationalization. Revenue synergies could come from new biz opportunities due to broadened scope and capabilities (increased opportunities in the pipeline)

The deal is low-teen % EPS accretive, despite funding 80% of the acquisition with equity (which caused some overhang back in early 2021)

Some helpful exhibit from the acquisition deck

Return Expectation and Valuation

CAE generated CAD$1.34 of Adj. EPS in FY 2020 (ending March 2020), but I believe the “pro-forma” recovery-case earning power would be ~30% higher at ~$1.71 even without the incremental tailwinds from outsourced penetration, or pilot replacement acceleration. This is purely due to a few smaller bolt-on acquisitions in Civil Aviation segment, the training facility consolidation / expense rationalization initiative, organic margin improvement within the legacy Defence & Security business, and the accretive L3H military training acquisition upon synergy execution.

This would be before the benefits of 1) incremental outsourcing deals, 2) pilot-churn related training boost tailwind, and 3) Saber deal accretion. The range of outcome can be pretty wide depending on how successful CAE is in getting these outsourcing + pilot churn + new cadet training benefits, but I think it’s reasonable to piece together a scenario where CAE earns close to CAD $2 of Adj. EPS by FY 2024 (ending March 2024)

For valuation multiple, I’m using 22.5x P/E if base case plays out given absolute dominance in a secularly attractive industry with multiple fundamental tailwinds accelerating growth algo post COVID normalization

Pre COVID, this business averaged around 20x forward P/E and traded closer to 22-25x fwd P/E starting in 2018/2019 as appreciation for its growth profile increased. I believe the collection of assets is now stronger post COVID (assuming underlying demand normalizes) and competitive moat has been enhanced after the various thoughtful acquisitions, so it’s not unreasonable to use a 22.5x P/E (~10% premium vs. historical median) especially in a heightened geopolitical environment (that creates opportunities for the defense segment)

IF the idiosyncratic earning tailwinds (outsourcing, pilot churn, cadet training) do play out and allow CAE to beat Street estimate by the tune of 25% or more, multiple could even have upside optionality

Pre-COVID forward P/E multiple below:

From a downside standpoint, if I use 17.5x (bottom decile of historical multiples) on a set of “slower than expected recovery” assumptions, I get to ~16% of downside. So upside/downside is definitely asymmetrical here

Risks

1. Prolonged air traffic travel weakness / resurgence of COVID variants for more sustained period, pressuring utilization rate and recovery timeline.

2. Lack of execution in Defence & Security segment, CAE needs to both deliver organically (margin improvement initiative) and come through on the L3H deal’s earning accretion goal. Defense piece of business is always more of a black box

3. Initiatives airlines may take that offset tailwind to pilot training demand. For example, AAL mentioned accelerating its seat harmonization project where it could reach 2019 level of capacity with ~10% fewer aircraft (not sure how much of it is about flying each plane more hours vs. having denser seats)

Catalyst

Gradual beat & raise, improving defense orders/backlogs, no hard catalyst