Lionheart Holdings (CUB) Q2 2015 Earnings Report, Transcript and Summary

Greetings ladies and gentlemen, and welcome to Cubic Corporation’s Second Quarter Fiscal Year 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. At this time, I would now like to turn the conference over to Diane Dyer, Director of Investor Relations. Please go ahead.

Thank you operator. Good afternoon everyone and welcome to Cubic's fiscal year 2015 second quarter results conference call and webcast. We encourage everyone to refer to the Company's press release issued earlier today as well as the Company's reports filed with the SEC. For anyone who has not yet seen a copy of these documents, you can access them on the Investor Relations tab of Cubic's website at www.cubic.com or on the SEC's website. On today's call are Bradley Feldmann, Cubic's President and CEO, and John Thomas, Chief Financial Officer. Mark Harrison, Cubic's Senior Vice President and Corporate Controller will join the call for the Q&A session. Now, I’d like to turn the call over to Jim Edwards, Cubic's Senior Vice President and General Counsel for the Safe Harbor disclosure.

Thank you Diane, please note that certain information discussed on the call today is covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act. I caution listeners that during this call, Cubic management will be making forward-looking statements about future events or Cubic’s future financial and operating performance. Actual results could differ materially from those stated or implied by these forward-looking statements due to risks and uncertainties associated with the Company's business. These forward-looking statements should be considered in conjunction with and are qualified by the cautionary statements contained in Cubic's earnings press release and SEC filings, including its annual report on Form 10-K and quarterly reports on Form 10-Q. This call contains time-sensitive information that is accurate only as of the date of this broadcast, May 18, 2015. Cubic undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this conference call. This conference call will also include a discussion of non-GAAP financial measures as that term is defined in Regulation G. Cubic believes this information is useful to investors, because it provides a basis for measuring the company’s available capital resources, the actual and forecasted operating performance of the company’s business and the company’s cash flows. A reconciliation between the GAAP financial measures that correspond to these non-GAAP financial measures is contained in our earnings press release and our SEC Form 10-K report for the fiscal year ended September 30, 2014. Any discussion of non-GAAP measures is not intended to detract from the importance of comparable GAAP measures. With that said, let me turn the call over to Bradley Feldmann, our President and Chief Executive Officer.

Thank you, Jim. Good afternoon, everyone. Thanks for joining us on the call today. It’s good to be able to brief you again on our progress here at Cubic. As previously reported in our Form 12b-25 filed on May 12, our Q1 FY15 filing was delayed due to an audit committee investigation. The investigation resulted from an issue detected by our internal controls. The investigation which was conducted with the assistance of Latham & Watkins and Deloitte focused on the review of controls and procedures in connection how we account for cost-to-cost percentage completion projects. Based on this investigation, the audit committee concluded that certain cost estimates were inappropriately reduced in our Cubic Global Defense Systems business. This resulted in immaterial adjustments towards sales and operating income. We regret the delay that this has caused in releasing our financial statements. We take this delay in accurate financial reporting very seriously. Jay will address the impact on our financials in greater detail in his remarks. Based on this investigation and recommendations from the audit committee, we have made a number of organizational changes and have taken steps to improve our financial reporting process. These steps include realigning highly qualified personnel and streamlining reporting lines for our greater corporate controller oversight over segment level reporting. We are confident that these new and revised control procedures will prevent this situation from arising in the future. With that, I will now summarize some key data points about our results year-to-date. During the first half of 2015, we recorded sales of $657.3 million, down less than 1% compared to last year despite currency headwinds. And EBITDA for the first half was $50.4 million, up 2% over last year. We generated positive operating cash flow of $61.1 million year-to-date compared to negative operating cash flow of $29.3 million in the year-ago period. Despite these positive trends, we are reporting a net loss of $5.9 million this half or negative $0.22 per share due to the impact of a non-cash deferred tax valuation charge of $29.3 million or $1.09 per share and other unusual charges which impacted EPS by $0.23. Jay will discuss these results in more detail as we have had a number of factors that impacted our operating earnings. Before introducing Jay let me spend some time discussing our operating businesses. Cubic Transportation Systems EPS continues to roll out the NextCity strategy with much success. This strategy has allowed us to increase our pipeline by $8 billion over the next five years and our addressable transportation market from $4 billion to $12 billion. NextCity represents the integration of payments and information solutions for all forms of transportation in large urban regions. It extends our leadership position in fare collection, real-time passenger information, traffic management and enforcement into other markets such as tolling and analytics as well as integration solutions for parking and shared driving modes. Over the last five years, CTS has maintained a revenue CAGR in excess of 10%. We believe the robustness of the addressable market provides solid opportunity to maintain CTS’ long-term growth rate. CTS also continues to make great strides transitioning the electronic fare collection system in Sydney INTERPOL service. I recently met with a senior minister in the New South Wales government who is very happy with the system and its potential upgraded features offered by our NextCity solution. Our team in London continues to do stellar work with the successful introduction of the contactless bankcard winning five innovation awards with our customer this year. In Chicago, we are very excited to be adding smartphone compatibility to the vendor system, making it the first of its kind regional transport payment system. The smartphone application combines journey planning, real-time information, ticketing as well as payments. Our new to market smartphone application will begin roll out this summer. This is a key part of NextCity strategy and we expect more demand for smartphone capability across our customer base. During the first half of the year, CTS produced some big wins as well. We signed a contract with Irish Rail for our fully integrated ticketing management and distribution system, including the integration of dynamic ticketing pricing and seat reservations. This is our first contract in Ireland and another expansion for our NextCity strategy. With this win, we are encouraged to build a bigger presence in the Irish market. We also signed a strategic contract with transport for Greater Manchester to deliver the UK’s first real-time multimodal journey planner. This project will put Cubic at the forefront of urban traffic management, journey planning and real-time situational awareness and extends our traffic management and real-time capabilities great way. Now turning to our defense business. In February, we announced a major restructuring to combine the systems and services units. We believe the new combined defense company, Cubic Global Defense (CGD) under the leadership of Bill Toti, will allow us to better serve customers worldwide for both systems and services, accelerate additional revenue opportunities and provide a more agile organization that is necessary at today’s cost competitive environment. I recently returned from an extensive trip to the Middle East. Upcoming worldwide events like Expo 2020 Dubai and the World Cup in Qatar in 2022 are already driving security spending as well as the need for transportation infrastructure, providing joint development opportunities for CGD and CTS. We believe Saudi Arabia, Egypt, UAE and Qatar hold good promise for future growth for Cubic across the breadth of our offerings. Over the last six months, our core live training systems business has booked a number of orders in the Middle East and we expect this activity to continue due to the continued instability in the region, which drives demand for our systems and capabilities. We’re also active with the number of good opportunities for major transportation and traffic management projects within the region. On the C4ISR front, we are very enthusiastic about the recent acquisition of DTECH LABs, a provider of specialized tactical networking equipment for customers like U.S. Special Operations Command. This is a key part of our strategy to build a $200 million C4ISR business with mid-teen EBITDA margins in the near term. We expect that DTECH performance will improve in the second half of this year and we are working to expand its customer base both in the U.S. and internationally. In CGD Services, we have won several important contracts, a recompete with the U.S. Army in Korea for an important training program and work with the U.S. Marine Corps and U.S. Army's Training and Doctrine Command. Our national security business is improving under new leadership and we are targeting broader opportunities across the customer spectrum. Overall, we expect small incremental growth in Defense Services this year. We are diligently working to make progress on our One Cubic strategy. Our goal is to improve operating income by 200 basis points to 250 basis points by reducing overhead and streamlining certain manufacturing and purchasing activities across the Company, we will achieve this goal by 2018. To successfully execute our One Cubic strategy, we will be investing capital in a new ERP system. Our new ERP system will deploy SAP, Dassian and Workday worldwide to provide a scalable platform as we grow. I will now turn the call over to Jay to discuss our financial performance.

Thanks Brad. We are now current in our financial reporting with the SEC as we have filed both our first and second quarter fiscal year 2015 reports today. As Brad mentioned, in February, the audit committee at the request of corporate management initiated an investigation to review controls and procedures in connection with programs that are accounted for under the percentage of completion method of accounting. Based on this investigation, the audit committee together with corporate management concluded that the estimated cost on percentage of completion projects were inappropriately reduced at September 30, 2014 in our Defense Systems business. This had the effect of overstating sales and operating profits by approximately $750,000. This overstatement of sales and profits is considered immaterial to our September 30, 2014 results. Separate from the audit committee investigation, we also found immaterial errors that overstated our operating profits at September 30, 2014 by $1.6 million. We’ve corrected these immaterial errors and the audit committee findings in the quarter ended December 31, 2014. The correction of these errors in the first quarter of 2015 reduced our Q1 sales by $1.3 million and our operating profits by $2.1 million. We are now revising our fiscal year 2015 EPS guidance to be in a range of $1.10 to $1.30 per share. This revised guidance takes into consideration the projected effect of a GAAP deferred tax valuation allowance for the fiscal year totaling a negative $1.25 per share. The impacts of the unfavorable exchange rate comparisons on our EPS for the full year and the cost impact of the audit committee investigation aggregating a negative $0.25 per share. Our fiscal year 2015 sales guidance of $1.425 billion to $1.465 billion remains unchanged. Given that we are halfway through our fiscal year, I will focus most of my comments on our performance year-to-date compared to our first half performance last year. Consolidated sales year-to-date were $657.3 million, down less than 1% from last year. Sales from recent acquisitions year-to-date were $40.8 million compared to $18.1 million last year. The strong U.S. dollar negatively impacted our sales by $18 million or 3%. Adjusted EBITDA year-to-date was up 2% to $50.4 million from $49.2 million last year. Operating income decreased 11% to $30.4 million from $34 million last year. Operating income was impacted by a restructuring charge that we took in the second quarter this year totaling $5.4 million and costs related to the audit committee investigation totaling $2.5 million and $6.2 million of operating losses on recent acquisitions and higher corporate cost. A portion of the higher corporate cost includes a one-time stock-based compensation expensation for our former CEO totaling $1.7 million and planning cost related to a new ERP system we are implementing over the next year totaling $1.3 million. Average exchange rates this year compared to last year decreased operating income year-to-date by $3.1 million. The company's largest exposure is to the British pound. In fiscal year '14, the average exchange rate for the British pound to the US dollar was 1.64 compared to 1.55 this year. For the six months ended March 31, we had a net loss of $5.9 million or a negative $0.22 per share. The net loss resulted from a non-cash discrete tax charge of $29.3 million for a valuation allowance against our net US deferred tax asset or $1.09 impact to earnings per share in addition to the lower operating profits. The valuation allowance results from our recent history of US operating losses and expected US operating loss in fiscal year '15. After taking this into consideration, our effective tax rate for 2015 will be 63%. As Brad noted, we had $0.23 per share of unusual charges in the first half. These included the restructuring cost, cost of the audit investigation and the one-time stock-based compensation expense for our former CEO. Now turning to our Transportation Systems Segment or CTS, CTS sales increased 1% to $278.2 million for the six months ended March 31 compared to last year. In the first quarter, sales were negatively impacted by $6.5 million on the Vancouver contract due to cost growth and $14.8 million year-to-date for changes in exchange rates compared to last year. Revenues were higher this year on the Chicago contract compared to last year. ETS operating income increased 96% this year to $39.1 million, compared to $19.9 million last year for the six months ended March 31. The increase was attributable to increased gross margins year-over-year on the Chicago contract and a commercial settlement totaling $3.6 million. Offsetting these items was an additional loss on the Vancouver contract totaling $7.4 million for cost growth and unfavorable exchange rate comparisons totaling $2.4 million. The cost growth on the Vancouver contract includes schedule and scope changes. We are in commercial discussions with the client to recover these costs that have not yet reached an agreement. Now turning to Cubic Global Defense Services or CGD Services, Defense Services sales year-to-date were $186.5 million, down 7% from last year's $199.9 million. Sales were down primarily due to market pricing conditions and due to less training activity by the US DoD. Operating income was $1.1 million year-to-date compared to $4.2 million last year. Operating margins remained under pressure due to the impacts of LPTA pricing pressures, higher than normal compensation cost due to recruitment of new management personnel and $200,000 related to the reorganization announced in February. As we have said on prior calls, we believe the slowdown in our Defense Services business that we had experienced since 2012 should reverse this fiscal year. Now turning to Cubic Global Defense Systems or CGD Systems, Defense Systems year-to-date sales were $192.6 million, an increase of 4% over last year. Sales were lower from data links, ground training and engagement skills trainers were higher from air combat, training systems and acquired businesses including Intific and DTECH. Sales this year were impacted by unfavorable exchange rate comparisons totaling $3.2 million and due to cost growth on the LCS program outside the contract scope that reduced sales and profits by $5.1 million. Defense Systems' operating income was a negative $400,000 year-to-date compared to $12.8 million. Impacting operating profits this year were $4.2 million in costs for the restructuring announced in February, LCS program cost growth totaling $5.1 million and operating losses on recent acquisitions totaling $5 million and adverse foreign exchange comparisons totaling $700,000. We are expecting a significant improvement in the second half of the year in the Defense Systems through an improved performance across all parts of the business, including recent acquisitions. In addition, we expect that cost savings generated in the second half of the year will offset the restructuring charge. The Company’s total backlog was $3.1 million at March 31. Currency exchange rates have reduced our backlog in US dollars by over $120 million since September 30, 2014. Finally, turning to the balance sheet, cash flow and capital allocation. As of March 31, we had $176.1 million of $208.1 million in cash held by our foreign subsidiaries. We also had $69.2 million of restricted cash and $4.5 million of marketable securities held by foreign subsidiaries. We have not included income taxes on repatriating foreign earnings to the U.S. as we consider these earnings permanently reinvested. Year-to-date cash balances were negatively impacted by changes in exchange rates totaling $19.7 million. We generated $61.1 million in operating cash flows through March 31. All three operating segments had positive operating cash flows. In the first quarter, we invested $89.5 million to acquire DTECH LABS. Part of this purchase was funded by our U.S. revolving credit facility. At March 31, we had $55 million outstanding under this facility at a variable rate of 1.64%. Going forward, we will be investing $55 million to $60 million in a new ERP system and planned IT system improvement over the next two-and-a-half years. Over $20 million of this investment will impact our operating income during the implementation stage as this cost will not be capitalized. These costs will be incurred primarily in fiscal years 2016 and 2017. We expect that the new ERP system will generate net annual savings of more than $30 million per year, starting in fiscal year 2018. This investment will be funded primarily from US liquidity sources. Our acquisition strategy remains focused on opportunities that align with our NextCity strategy and building a mid-teen margin C4ISR business, both in the US and internationally. We are disciplined in this regard and only look at opportunities that have significant strategic and financial merit. And with that, I’ll turn it back over to Brad for his closing thoughts.

We’ve covered a lot today. We believe our underlying businesses are strong and we’re taking important actions to improve the Company’s performance going forward. I’m excited to begin this next stage of Cubic’s growth. With that operator, let’s proceed directly for the Q-and-A session.

Thank you. [Operator Instructions] Our first question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed with your question.

Thanks. Good afternoon. I have few questions. Haven’t had a chance to go through all the material yet, but just on a couple of things. Maybe if you could talk a little bit about the investment in ERP system of $20 million in ’16 and ’17. How should we think about that? Is that going to be spread fairly evenly over the two years and or do you see it more upfront?

So, Jim, it’s Jay Thomas. What we’ll do when we give our guidance for ’16 we’ll give a probably a little clearer statement, but most of that -- a lot of that will happen in ’16. We’ll give more color at year-end.

Okay. Just with your product gross margins being as strong as they were in the quarter, I think you attributed to just a better mix of your combat training systems. How should we think about the mix of the defense business going forward, was this an unusually strong quarter?

Well, I don’t know if it was really strong, because of the cost growth that we had on the LCS program, but I think the one thing that you will note is going to drive the gross margin profile of the systems business is DTECH because the margins in that business are materially higher than what is in our normal lineup of products. And in the quarter, we had clear of an incremental piece of amortization, because when we bought the company there was backlog that we acquired, so we had to amortize off a greater piece of the purchase price because of that profit and backlog.

And just on the topic of DTECH, and I’ll jump back in the queue, can you give us a sense of the pipeline of business for DTECH as we think about that over the next couple of quarters?

This is Brad Feldmann, how are you? The backlog is tens of millions of dollars and the market size is hundreds of millions of dollars and was a great expansion of our datalink business such that we are adding networking capability. And customers like SOCOM really liked the product and in fact we heard a quote recently that it would save our customers over 50% of their lifecycle cost by the equipment being more reliable and easier to use. So we are very happy with this DTECH acquisition and it’s a clear part of our C4ISR growth strategy.

Okay, thank you.

Thanks, Jim.

Thank you. Our next question comes from the line of Julian Mitchell with Credit Suisse. Please proceed with your question.

Hi, thank you. I just – there is a lot of moving parts in the numbers here, I was wondering if you could frame the target for increasing operating margin by sort of 200 basis points to 250 basis by 2018, how do we think about that phasing this year on a [clean] [ph] basis, what is your [operating] [ph] margins are doing this year and how much of that increase is sort of a hockey stick at the back end of the period?

I think we will start to see those savings really in late ‘17. It’s a good question because when you’re in that phase in period like we are going to be, we are going to have some overlapping systems. So we – part of the restructure was that we did take out some cost this year and we’ll be doing that in phases, but I would say the bulk of what we are going to get in savings will start to show up in the second half of ’17 and then in ’18.

And we believe overall that the new ERP system will make us much more efficient going forward in the future.

Got it. And then if I think about your revenue guidance of fiscal ’15, you’ve kept the range unchanged even with a bigger FX headwind, so just wondered organically, which pieces of the business are performing better than you had anticipated six, seven months ago.

The FX headwind really impacts the transportation business because of that 60% to 70% of their revenues are outside the US, so they are the ones who take the biggest slump. The services business, as you saw for the first half of the year was down about 7% comparable numbers, and then the defense systems business was actually up a little bit. So I think going forward defense systems business is probably going to have some organic growth this year. Where we sit with the defense services business, it’s really a function of every time a big decision comes down, there is a protest. And so delays when we can start on the contracts. So we have got a number of contracts where we are supposed to start work, but there is still protest going on. And transportation really is – they will see – they’re going to probably have a relatively flat year because of the FX impacts.

Got it. And then lastly, the sort of headline EPS is diluted by a lot of one-offs. So maybe if you could talk about any expectations you can give us on sort of free cash flow or operating cash flow for this year?

At this time, that's not something we're probably comfortable of giving complete guidance on it at this point.

Okay understood. Thank you.

Thank you. Our next question comes from the line of Josephine Millward with Benchmark Company. Please begin with your question.

Hello good afternoon, yes, hi good afternoon.

Hello Josephine.

Hello Brad, hi Jay. Nice transportation wins. Can you help us quantify the Irish Rail and the Manchester projects? And do you expect to start recognizing revenues on this project this year?

So I think in total, the two jobs are in aggregate, they’re about $50 million to $60 million U.S. and the answer is yes, both jobs are on percentage completion cost to cost. So as we're incurring cost, then they would be recognized revenue.

Great. Brad, can you expand on your transportation pipeline, because it seems like this is where you have a lot of activities, what are some big projects you're bidding on or waiting to hear award decisions in the coming quarters?

Well, of course, we've been in New York City for a long time and an RFP is due to come out here in the near term. We're also -- there is a great project in Melbourne, Australia as well as opportunities in the Middle East. As you can tell, we’ve moved the business somewhat from an automated fare collection system business to our NextCity vision and as we commented this opens up lots of opportunities for us. We are particularly excited about smartphones and how they can be used across the enterprise. Our ITMS business as well has some opportunities around the globe. So, we see more and more opportunities to bid going forward.

Okay, shifting gears to training systems. What is the annual revenue -- what's the revenue run rate on DTECH and how much are you -- what's based into the guidance?

That's not something that we would get that specific on Josephine.

Can you talk about what type of growth rate you expect from this business?

I'm sorry, what kind of --?

What type of growth expectations you have?

Yes, I would say, probably on an annualized basis, yes, the business has historically, I think that's disclosed in our financials, but historically it has run rates in the mid $40 million revenues and until it's really about what programs they would penetrate into. So there are a number of C2 type programs that they are out pursuing and that is an area where the DoD is actively spending money.

Okay. That’s helpful, thank you.

Thank you. [Operator Instructions] It appears there are no further questions at this time. I'd like to turn it back to Bradley Feldmann for closing comments.

Thank you all for joining us this afternoon. As always, we appreciate your continued support and interest in our Company. We are available if you have any further questions. Thanks very much.