CAE Inc

TSX:CAE

Earnings Call Analysis

CAE Foresees Strong Growth and Margin Uplift

CAE expects robust growth in its Civil segment, projecting mid to high teens percentage operating income growth, sustained by robust demand for pilots and training services. The Defense segment aims to amplify profitability by eliminating less profitable Legacy Contracts and enhancing the backlog with better-quality work. The backlog has already expanded by over 20% since refining the Defense unit's capabilities, signaling sustainable growth and laying the foundations for potential wins in significant upcoming Defense contracts. Company leadership is optimistic, with efforts to phase out the aforementioned Legacy Contracts expected to mitigate negative impacts within 6 to 8 quarters, contributing to the anticipation of continued prosperous growth for CAE.

Civil Segment: Growth and Expectations

The Civil segment appears well-positioned for future above-market growth, leveraging the strong demand for pilot training spurred by secular passenger traffic growth. For the current fiscal year, management anticipates mid- to high-teens percentage growth in adjusted segment operating income. Margins in the forthcoming quarters are expected to match those of fiscal 2023, with a particularly strong fourth quarter predicted, and around 50 full-flight simulators expected to be delivered this year. This reflects the company's ability to capitalize on high demand for its differentiated training and flight services solutions.

Defense Segment: Backlog and Forecast

The company's Defense segment has seen a backlog growth exceeding 20%, bolstering its transformation strategy through more profitable contracts and the retirement of less favorable Legacy Contracts. Plans include negotiating impactful Canadian defense contracts and working off a $9.5 billion pipeline of bids and proposals. The aim is substantial growth and profitability, with an active focus on reducing the negative impact of Legacy Contracts over the next 6 to 8 quarters.

Risks and Mitigation in Defense

Defense margins face potential headwinds from the current portfolio of Legacy Contracts. Management's strategies for mitigating these legacy risks include contemplating contract descope, revised terms, and early contract closures when beneficial, balancing the prospect of near-term costs against longer-term risks. This quarter saw a negative impact of roughly 2-3% (200-300 basis points) on Defense margins due to these challenges, which serves as an approximate baseline for future quarters despite expected variability.

Adjusting Contract Strategies

Amid an industry-wide shift in defense contracting, the company is moving away from fixed-price development contracts—such as those that have been detrimental during COVID—to more flexible contracting approaches that may allow pass-through of certain costs. This strategic shift is in line with actions across the industry to mitigate the impact of inflation and other variables on contract execution.

Positive Outlook Despite Market Reaction

Company executives expressed confidence in the underlying strength of the business and its growth trajectory, underscored by the Defense segment's 20% backlog growth. They conveyed that margin improvement is anticipated with the ramp-up of new and transformative contracts, which are accretive but currently nominal in revenue. Despite market overreaction to disclosures on Legacy Contracts, the company remains focused on addressing these contracts while ensuring the performance of the broader portfolio.

Earnings Call Transcript 2024-Q3

[Operator]

Good day, ladies and gentlemen. Welcome to the CAE Third Quarter Conference Call. Please be advised that this call is being recorded.

I would now like to turn the meeting over to Mr. Andrew Arnovitz. Mr. Arnovitz, you may now proceed.

[Andrew Arnovitz, executive]

Good afternoon, everyone, and thank you for joining us today. Before we begin, I'd like to remind you that today's remarks, including management's outlook and answers to questions contain forward-looking statements. These forward-looking statements represent our expectations as of today, February 14, 2024, and accordingly, are subject to change. Such statements are based on assumptions that may not materialize and are subject to risks and uncertainties. Actual results may differ materially, and listeners are cautioned not to place undue reliance on these forward-looking statements.

A description of the risk factors and assumptions that may affect future results is contained in CAE's annual MD&A available on our corporate website and in our filings with the Canadian Securities Administrators on SEDAR+ and the U.S. Securities and Exchange Commission on EDGAR.

With the expected divestiture of our CAE's Healthcare business, which is subject to closing conditions, including customary regulatory approvals, all comparative figures discussed here and our financial results have been reclassified to reflect discontinued operations.

On the call with me this afternoon are Marc Parent, CAE's President and Chief Executive Officer; and Sonya Branco, our Chief Financial Officer. After remarks from Marc and Sonya, we'll open the call to questions from financial analysts. At the conclusion of that segment, we'll open the lines to members of the media should time permit.

Marc, over to you.

[Marc Parent, executive]

Thanks, Andrew, and good afternoon to everyone joining us on the call.

Our performance in the third quarter reflects the continued strong demand for our Civil market solutions and points to the ongoing progress to transform our Defense business. We generated strong free cash flow in the quarter, enabling us to further bolster our financial position in line with our leverage targets. We also made excellent progress to secure CAE's future with nearly $1.3 billion in total order intake for an $11.7 billion backlog.

In Civil, we have strong financial performance that reflected the quarterly mix that we anticipated with demand for commercial and business aviation training solutions continuing to be robust across all regions. Operationally, we delivered 13 full-flight simulators to customers during the quarter. And our average training center utilization was 76%, which is up from 73% last year. We booked $845 million of orders with customers worldwide for an impressive 1.36x book-to-sales ratio, which is even more remarkable on revenue that's 20% higher than Q3 of last year.

We also had strong order activity in our JVs this quarter, representing another approximate $135 million of training services orders which are not included in the order intake figure but are reflected in the record $6.1 billion total Civil backlog. We received orders for 20 full-flight simulators in the quarter, bringing our tally for the first 3 quarters of fiscal year to 57. Notable wins, including penetrating more share of the existing market with long-term training services contracts, with marquee airlines including Air France KLM Group, and we renewed a flight services contract with Azul of Brazil. We continued to have very strong momentum in business aviation as well, with over $300 million of order intake in the quarter, driven primarily by training services agreements with U.S.-based customers, including Solaris Aviation and Clay Lacy Aviation. A continued high level of order activity this quarter across all Civil segments underscores our ability to win share in a large secular growth market which sees highly differentiated training and flight services solutions.

In Defense, our financial performance was consistent with our expectations at this point on our path toward being able to generate higher margins in the business. Defense performance was lower than the third quarter last year as we continue to retire risk on a group of distinct legacy contracts, which Sonya will describe in more detail in her section.

We booked orders for $429 million for a 0.9x book-to-sales ratio giving us a $5.6 billion defense backlog, which is up from $5.1 billion in Q3 of last year. They include a maintenance contract with the United States Air Force for the F-16 training devices and the continuation of training services on the C-130H transport and KC-135 tanker platforms. Defense orders also include an option exercise for the U.S. Army for fixed-wing flight training and support services at the CAE Dothan Training Center.

With that, I'll now turn the call over to Sonya, who will provide you additional details about our financial performance. Sonya?

[Sonya Branco, executive]

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

Net finance expense this quarter amounted to $52.4 million, which is up from $47.1 million in the preceding quarter and up from $47.7 million in the third quarter last year. This is mainly the result of higher finance expense on lease liabilities. Income tax expense this quarter was $8.2 million for an effective tax rate of 12%. The adjusted effective income tax rate was 15%, which is the basis for the adjusted EPS.

As Andrew indicated at the outset, Healthcare is now classified as a discontinued operation, and our net loss from discontinued operations was $1.9 million this quarter, compared to a net income from discontinued operations of $2.1 million in the third quarter of fiscal 2023. The decrease to the third quarter of fiscal '23 was mainly attributable to the transaction costs of $2.2 million incurred in the third quarter of fiscal 2024 in relation to the expected sale of the Healthcare business.

Net cash from operating activities this quarter was $220.8 million compared to $252.4 million in the third quarter of fiscal 2023. Free cash flow was $190 million compared to $239.8 million in the third quarter last year. The decrease was mainly due to a lower contribution from noncash working capital and higher payments to equity accounted investees to invest in the civil training network expansion in support of our long-term customer agreements.

Free cash flow year-to-date was $227 million compared to $185 million year-to-date last year. The increase was mainly due to a lower investment in noncash working capital and higher cash provided by operating activities, partially offset by some maintenance CapEx and again, higher investments in the joint ventures to support growth. We continue to target 100% conversion of adjusted net income to free cash flow for the year.

Capital expenditures totaled $85.6 million this quarter with approximately 75% invested in growth to specifically add capacity to our Civil global training network to deliver on the long-term training contracts in our backlog. Our net debt position at the end of the quarter was approximately $3.1 billion for net debt to adjusted EBITDA of 3.16x at the end of the quarter. We expect to close the sale of our Healthcare business before the end of the fiscal year, subject to closing conditions, including customary regulatory approvals. We intend to apply a significant portion of the net proceeds of the transaction to reduce debt.

As we have said in the past, the Healthcare sale transaction is a milestone towards the reinstatement of cash returns to shareholders. And the Board is now actively evaluating options in terms of form, quantum and timing of such returns. We're prioritizing a balanced approach to capital allocation including funding accretive growth, continuing to strengthen our financial position, commensurate with our investment-grade profile and returning capital to shareholders.

Now turning to our segmented performance. In Civil, third quarter revenue was up 20% to $622.1 million compared to the third quarter last year, and adjusted segment operating income was down 5% to $124.2 million versus the third quarter of last year for a margin of 20%. This is right in line with our expectations for the quarter and our full year outlook for Civil. As expected, there were a few differences in the quarter compared to last year, mainly from the mix of simulation products' revenue and flight services activity, which offsets the higher training utilization and increased volume from recently deployed simulators in our network.

In Defense, revenue was up 4% to $472.4 million, while adjusted segment operating income was down 18% to $20.9 million giving us an adjustment segment operating income margin of 4.4%. The expense margin this quarter included the negative impact of the ongoing retirement of 8 distinct Legacy Contracts that have completion dates mainly within our next 2 fiscal years.

What these contracts have in common and why we're monitoring them separately is that they were all entered into prior to the COVID-19 pandemic and our firm fixed price in structure with little or no provision for cost escalation. These contracts are only a small fraction of the business, but have disproportionately impacted overall Defense profitability as they have been the most significantly impacted by execution difficulties and the broader economic headwinds we've discussed in past quarters, such as the compounding effects of inflationary pressures and disruptions to supply chain and labor. To be more precise, the execution of these 8 Legacy Contracts had an approximate 2 percentage points negative impact on the Defense segment operating income margin in the third quarter.

With that, I will ask Marc to discuss the way forward.

[Marc Parent, executive]

Thanks, Sonya. Looking ahead at each one of our segments. In Civil, we expect to continue our above-market growth momentum for training and flight services solutions, underpinned by strong secular passenger traffic growth, continued success penetrating share in training market and a high level of demand for pilots and pilot training across all segments of aviation. For the current fiscal year, we continue to expect Civil to deliver adjusted segment operating income growth in the mid- to high-teens percentage range. For the year as a whole, we continue to expect the Civil adjusted segment operating income margin to be in the range of fiscal 2023, which naturally implies an especially strong margin for Civil in Q4.

In addition to growing our share in training and expanding our position in digital flight services, we expect to maintain our leading share of full-flight simulator sales and to deliver approximately 50 for the year. We have considerable headroom for growth in the civil aviation market and our continued positive momentum underscores the strong demand for these highly differentiated training and flight services solutions and our ability to win share within this large and secular growth market.

Turning to Defense. We'll continue transforming our business by replenishing our backlog with more profitable work and by retiring the Legacy Contracts that Sonya highlighted. These 2 trend lines remain positive, and we expect them to culminate in a substantially bigger and more profitable business. Since augmenting the scale and capabilities of the Defense business approximately 2 years ago, we've grown the Defense backlog by over 20%. This sets us up very well for sustainable growth and includes the strategic and generational wins on next-gen platforms that we've talked about in recent quarters.

Still to come, and not yet in backlog, are the Canadian [indiscernible] and RPAS programs that are currently in contract negotiations and are also generational in size. The progress that we're making -- that we've been making to replenish and grow the backlog with higher quality profitable program is the best indication of what the future holds for CAE's Defense business. Together with a $9.5 billion pipeline of bids and proposals outstanding, we continue to see positive signs of the transformation underway.

As we look to the remainder of fiscal 2024, we expect Defense to keep winning high-quality, profitable programs. And in the fourth quarter, we expect to further accelerate the retirement of risks associated with the Legacy Contracts to the extent that we can. Clearly, we want to get them behind us as soon as is reasonably possible, and we're closely monitoring them as a separate group. We're highly focused on execution and expect to substantially reduce the negative impact from these Legacy Contracts over the next 6 to 8 quarters as they're gradually retired.

The extent to which the ongoing risk retirement on these programs might impact Defense margins in the coming quarters really depends on the actual timing of program closeouts and our ability to mitigate these risks. Our dedicated teams are working to re-baseline some contracts, seek equitable adjustments on others and to find program deficiencies overall.

And for CAE overall, we continue to be highly encouraged by the demand backdrop that we're seeing in all segments and the growth that we expect by harnessing our global market and technology leadership and the power of one CAE. These factors, combined with highly focused execution and a solid financial foundation portend continued good growth momentum and an excellent future for CAE.

And with that, I'll thank you for your attention now. I'm now ready to answer your questions.

[Andrew Arnovitz, executive]

Thanks, Marc. Operator, we'll now open the lines to members of the investment community.

[Operator]

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

[Fadi Chamoun, analyst]

So I'm trying to kind of see how to best think about the trajectory of Defense margins. Marc, you mentioned the focus on accelerating the retirement of risks associated with these Legacy Contracts, which I understand that this quarter, the impact was 200 basis points. And there's also the idea that the backlog growth and top line growth and kind of implementing higher-margin contracts should be margin accretive as we go forward. Like -- does the margin start to improve from the current levels that we're at right now? Or are we stuck at this kind of lower level for some time?

The other thing, what exactly you mean by accelerating the retirement? Are you able to exit these contracts earlier? Or is it a cost action that you're taking to improve the performance of these specific contracts?

[Marc Parent, executive]

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

Look, we might decide to descope a contract. And I'm talking about these 8 Legacy Contracts that we're talking about. We might decide to descope a contract. What does that mean? That means we close out and -- and we're looking at this in at least one specific contract, potentially incur liquidated damage if that makes sense for us to cut off a future tail of programmatic risk on that program. So better to take that pain now than take a lot more later if you know what I mean. But of course, that depends on the negotiations specifically that we have underway with that specific customer.

Other things we might do is we might agree to alternative terms or schedule. And then we're looking at that on some of these programs as well. Or we might incur a follow-on contract, say an addendum, an engineering change proposal on any one of these contracts, and we're looking at that and that's the potential of some of these contracts that what we'll do is give us more work in which case we can spread the cost around over a bigger quantum, lessening the impact of any individual product. So we're doing all of that. So if I look back to your -- maybe the margin question, and I'll quickly go to Sonya on this one. Look, we saw that -- we talked about 200 basis points this quarter, and I'm going to straight to Sonya on that one. We're not going too deep on that one. But what we're -- there's going to be variability from quarter-to-quarter for the reasons that I talked about. This is not going to be linear because we are taking active steps to try to retire these contracts as soon as we can and especially retire the risk, take the right actions.

Mind you, we're never going to give up on our customers. That's not what we do at CAE. We will deliver the products and services that we've committed to our customers, that CAE's culture and don't forget that's the mission that we have in Defense. So we're not going to do that. But I mean that's the way I look -- I would look at the [indiscernible]. And finally, before I give it to Sonya, the one thing I would tell you is there's nothing new here relative to disclosure that we gave you last quarter in terms of the quantum. What we're trying to do here is to give you a little bit more precision on the number of contracts that are dragging our performance, these Legacy Contracts, the duration, how long they last and the steps that we're taking to actively mitigate them.

Now maybe I'll stop there. We'll turn it over to you Sonya to just expand on the 200 basis, at least for this quarter anyhow.

[Sonya Branco, executive]

Absolutely. Thanks, Marc. So what we've done this quarter is endeavor to ring-fence the few contracts that have a disproportionate negative impact on the business. And doing so, as you can appreciate, this is a process. There's a strict definition. And we're committing to continuing disclosure to report back on these Legacy Contracts and our progress on them. So you can see that, in this quarter, there was an approximate impact of 2%, 200 basis points this quarter. But by the way, there's also an impact of an under-absorption of costs needed to achieve scale and support of all of the business. Like R&D and SG&A that can be up to another 100 basis points, so -- which makes the impact slightly higher at around 300 basis points.

Now that's a snapshot for Q3. Now I can't say that the next 6 to 8 quarters will look exactly like this as we're constantly working to -- all the different levers to mitigate these risks and work with our customers as Marc has highlighted. So while there will be some variability quarter-to-quarter, this quarter's impact is a rough baseline of the headwind that we face on average.

[Fadi Chamoun, analyst]

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

[Sonya Branco, executive]

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

[Fadi Chamoun, analyst]

Okay. So the time line of 6 to 8 quarters, that's kind of the most -- I want to say the pessimistic kind of time line. Hopefully, you can deal with some of these contracts earlier, take some of these losses maybe earlier and then move on from that.

[Marc Parent, executive]

Yes. That's definitely what we will be seeking to do.

[Operator]

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

[Cameron Doerksen, analyst]

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

[Marc Parent, executive]

Cameron, what we're seeing is very strong demand. I can tell you, I can look out my window here at the parking lot in Montreal, I can tell you it's full. I keep saying that, but perversely, that's a pretty good indicator of what we see as utilization of our training centers. And that's across all the training centers. I see no softening of demand. And as we said before, as you can do the math, but we fully expect a pretty darn good Q4, and we have very good visibility on that because obviously, we're pretty close to the end, and we know what [indiscernible] we have to deliver. And again, we have some very strong bookings in our training center and these days, I can tell you, nobody is looking to cancel bookings.

[Cameron Doerksen, analyst]

Okay. No, that's good to hear. And just maybe just a very brief follow-up to Fadi's question on the Defense. You mentioned you may be seeking some, I guess, equitable adjustments. I know that's something you've discussed in the past. Have you had any success there? I mean, are you optimistic at all that you'll get some relief from your customers with some -- maybe some pricing adjustments within these Legacy Contracts?

[Marc Parent, executive]

I'm optimistic, but I'm not optimistic on the timing meeting because I can't -- I've been wrong every time. So I can tell you that bulk of it, we've gotten a bit. I would tell you about give or take about 10% of what we believe that we have very, very strong cases, have documented evidentiary reports claims into customers. But again, there's -- this depends on so many things and I don't control that. And I would tell you, we have made some assumptions, I would say, conservative assumptions, with regards to if we look at mitigations on some of these Legacy Contracts that some of that is included, but certainly not the full quantum.

[Operator]

Next question comes from Kevin Chiang with CIBC.

[Kevin Chiang, analyst]

I know you don't have multiyear guidance for -- or targets for Defense. But if I just kind of -- if I rewind, let's say, back to fiscal Q2, and you provided an update on Defense at that point in time. I think the market read it as you have around mid-single-digit EBIT margin for the remainder of this year, maybe get up to higher single digits in fiscal 2025, and then you can normalize to a run rate closer to your target of low double digits sometime in fiscal 2026.

The fact that you haven't changed your 3-year EPS target. I'm just trying to level set. Is that still the trajectory you think you can do as you roll off some of these contracts? Or this expected double-digit EBIT margin, maybe cloudier here today given the new disclosure you provided?

[Marc Parent, executive]

Sonya?

[Sonya Branco, executive]

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

[Kevin Chiang, analyst]

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

[Marc Parent, executive]

Well, I think the way I'd look at it is, A, when we talk about these Legacy Contracts that we're dealing with here, they're not particularly large individually, in terms of either revenue or backlog. But to your point, they can and they are and they have introduced disproportionately large costs in a given period, as we work -- as we work through them, especially if you do like active efforts and we have to reach a customer settlement or agree to change in terms, things like that. So -- but we have to remember as well that the business is not -- it's not the size that we want it to be. So at the end of the day, when you have a hit in any way in the quarters, it has material impact because of the small quantum that you have in the absolute number.

[Operator]

Next question comes from James McGarragle with RBC Capital Markets.

[James McGarragle, analyst]

So my question is with regard to how you're looking at deploying capital in the Defense segment. It seems like returns on that business right now, they're below your targets. Do you think there's enough room to improve margins, to bring returns in Defense within your internal targets? Or any other thing to consider with regard to how you intend to deploy that capital that's tied up in the Defense business?

[Sonya Branco, executive]

Yes. So we always look at a balanced capital allocation strategy, James. And the first priority is continue, as we obviously continue to deleverage and drive towards a flexible balance sheet, is to invest in accretive growth. And our top priority is to serve the demand that we see on the Civil market. And that organic CapEx is highly accretive and drives returns of 20% to 30% incremental pretax returns within 3 to 4 years. So wherever we have those opportunities, that is the first priorities in terms of capital allocation. Now sometimes we do deploy some CapEx on the Defense side. Ultimately, if we are to do so, we expect that to be on commercial terms and driving commercial-like margins.

[Marc Parent, executive]

Yes. And maybe just add to that, Sonya. I mean, we've already talked about some of those, like, for example, the U.S. Army HADES contract, that we'll be deploying a Global 6500 simulator in our existing facilities in the Dothan Training Center, where we already deliver the fixed-wing training for the U.S. Army. So -- and in that case, as Sonya said, we're -- because it's a commercial solution, which we deploy in business aircraft, we can enter into what's called a commercial contract with the U.S. Army, which, of course, in that case, would be capital that's well deployed because it's going to be a service with margins more like we get in the kind of Civil environment, so you can imagine that's accretive to our return.

Another example I would give you instead is a contract that we've talked about for -- what was previously called the Flight School XXI contract, but we call it is the FTSS contract, where we will be deploying capital to replace all the simulators used by the U.S. Army at what we call For Rucker or Fort Novosel. That again will be very accretive capital deployment in Defense because we will be able to enter into service contracts on the delivery of training to U.S. Army on, again, commercial contracts, which are more favorable to us than traditional contracts in Defense.

[James McGarragle, analyst]

And then if we look at the book-to-bill on the Defense side, it came in below 1, you did point to some unfunded backlog. So kind of within that backdrop, how should we be thinking about growth in this segment looking ahead? Is it fair to say you expect top line in Defense to be higher in fiscal 2025 versus '24?

[Marc Parent, executive]

Sonya will take it.

[Sonya Branco, executive]

So to your point, the order intake at 0.9 is slightly below 1, but I would look at the overall total backlog, because there is dynamics of kind of the first year funding and so on. So you could see the growth in the backlog, but we're expecting some big Q4 awards, Marc -- Q4, Q1 awards that Marc spoke about and some large Canadian contracts that we've been selected and then we're expecting those to come in, and that will drive some significant order intake and backlog growth.

[Marc Parent, executive]

Yes,look, Defense is a growth business. As I said in the remarks, we have 20% backlog growth in the last 2 years. And that doesn't include contracts that we've been selected on, like the future aircrew training in Canada and the RPAS training contracts we have been selected. Those 2 contracts are really generational in size. We're not under contract yet, so you've got to figure it, okay, we got to get under contract, fully expect that to be in the first half of next year and then we got to turn those -- start turning those to revenue. So there will be timing involved. But there's no doubt this is a growth business.

[James McGarragle, analyst]

And sorry, just one quick follow-up on the Defense side before I turn it over. Are the low margin contracts that are rolling off, the 8 contracts you've identified, are those EBIT positive? I guess, as those contracts roll off, although they might be accretive to margin, is it EBIT neutral? Or are those losing money right now?

[Sonya Branco, executive]

We don't necessarily give the details of the contracts individually. I think it's a mix. And so they will be -- they are not particularly large on the revenue, but have that disproportionate impact on the cost. But I think the best measure to kind of look at it is the margin.

[Operator]

Our next question comes from Konark Gupta with Scotiabank.

[Konark Gupta, analyst]

Maybe just to follow up on Defense, Marc. What has the dedicated team that you have deployed for these Legacy Contracts achieved so far? If you can give any concrete examples? And what is their mandate going forward?

[Marc Parent, executive]

Mandate is successful execution of the contract to deliver what we committed to deliver to our customers. That's first and foremost, all because that's what CAE is about. And we have a critical mission defense, which it goes without saying what to do. That's first and foremost. And of course, deliver it under the best financial terms that we can, and that's what our mandate is. So execute on the contracts and get us to the softest landing that we can with regards to retirement of risk on those contracts. Work with our customers to try to establish win-win, to rescope those programs, descope those programs, move the schedule to provide [indiscernible], get request for equitable adjustments where we definitely are entitled to get them because of the extremely high inflation environment that we've had that disproportionately affected our costs. Those are all some of the things that our team is doing.

And I would tell you, we didn't just put these teams on overnight. These teams have been working for some time and they have had good progress in executing and reducing the burden that we're facing here in Defense already. So we're already seeing the fruits of our labor here, which allows us to give the more precision that we gave you today.

[Konark Gupta, analyst]

Okay. That's great color. And if I can just quickly follow up on Civil -- is there any change in discussion or language from customers -- from airline customers, especially in light of the A320 engine issue that we saw recently as well as now the Boeing 737 problems?

[Marc Parent, executive]

The thing I would tell you is, no, no, because airlines are scrambling to meet the demand that they see out there. Now I mean the impact is real. I mean the impact of the engine issue you talked about is real. You can't have 100s of airplanes grounded at any given time with not having some effect. So we're watching that. I would tell you, it hasn't affected our business. The airlines that we operate with, which is a great majority of airlines in the world, but are scrambling to be able to get alternative lift, whether it would be keeping older airplanes on station rather than new ones, leasing, [indiscernible] that kind of thing. So we're watching that.

We're also watching the delivery delays, specifically because the math is simple, right? I mean we've talked about it many times before, but for every about 30 narrow-body deliveries, that -- because it's a regulated market, it fills up one simulator's worth of demand. So clearly, if this was to go on for a long, long time, then that would add effect. But for now, based on the discussion that we have with customers, there's still a lot of unmet demand in this market. And you can just see it with regards, again, to the order intake this quarter, I mean, we're talking about a very strong book-to-bill on top of 20% growth in revenue.

And what you see there is the testimony to our success in more outsourcings. I'm very, very happy to join another marquee customer like Air France KLM, which historically has not outsourced, outsourcing a portion of their training requirements to us. The growth we have is very large contracts in business aviation. So look, to me, we're seeing -- we're basically seeing no softening demand. And going back to your question, the conversations that we have with airlines and business aviation customers are essentially like the one I just described.

[Operator]

Next question comes from Benoit Poirier with Desjardins Capital Markets.

[Benoit Poirier, analyst]

Just to come back on the Defense margin, if you strip out the 200 basis points impact from the Legacy Contracts, it implies that the base is running at around 6.4%, which is obviously far from double-digit level. So could you maybe give us more color on actions to be taken to bring the base to double-digit? Is it related to delays in funding? Is it a matter of scale, revenue loss since the acquisition of L3 or higher bidding costs these days to support the high bidding environment?

[Sonya Branco, executive]

Yes, Benoit. So a couple of points there. So first on your point of the 200 basis points. So as I mentioned earlier on the call, there is the 200 basis points is a reflection of the impact of those Legacy Contracts, but there's also the impact of the underabsorption that we should consider. But these are the costs needed to achieve scale and support the business like R&D and SG&A. So that could be another up to 100 basis points. So if I use that basis, so 200, 300 in total.

In addition, as we've mentioned in the past, the delay of the ramp-up of new expected orders and especially the transformational ones, because they move the needle. So as these start to come in and start to really reflect to the revenues, and we spoke to it last quarter, it was 3%. It's really still minimal representation in the revenue, but 20% of backlog. So as these start to ramp up more materially, that -- we expect that to step up and drive a meaningful impact.

[Benoit Poirier, analyst]

Okay. And what is the strategy within Defense business now to ensure that you don't run into contract issues like this in the future?

[Marc Parent, executive]

Well, I can tell you, Benoit, there's a lot of tuition value to what we've lived this in the last 3 years. So there's a lot. But -- and they're well implemented. I think the first thing and foremost, which is obvious, and we have a lot of commonality with our peers in the Defense industry across the board here is we're certainly not getting into firm fixed price development contracts. Because in a lot of cases, that's what got us into this situation in the first place where you have development contracts, that again, fixed firm price, you incur delays because of, well, first, we went through COVID with everything that goes along with that with regards to part shortages, with manpower shortages on top of everything escalating, basically compound escalation with regard to the inflationary environment where we have no protection. So those are some of the things that obviously we're not doing.

There's other things that we're doing like, for example, making sure that we band the service contracts, establishing the tighter pricing bands on utilization, so we don't get caught out that if the customer uses more or less of the demand that we somehow are disproportionately affected. I would tell you there's a number of things, but that's what we're doing and a very tight monitoring of execution at all levels.

[Benoit Poirier, analyst]

Okay. And just looking at the Civil margins, you reached 20% EBIT margin this quarter, which is a step down versus to the 25.4% achieved a year ago despite having stronger revenue, greater utilization rate. Could you please let us know what drove that and what makes you confident to achieve the implied 26% plus EBIT margin in Q4 in order to reach the mid-double-digit growth for the year?

[Marc Parent, executive]

Okay. I'll step right up to say, I didn't tell you 26%. You said that. But hey, okay, we said you can do the math. But look, I think if you go back to what I think what I said to in the last conference call, in the last quarter, I tried to point to that. So I would tell you that margins, as I said, are there where we expected them to be, and I'll give you some of the components here, a very -- there's -- mix is very much at play here. And we talked about mix before. And yes, this mix looks kind of high. And you don't -- the base of it is high. But I would point to last year Q3, the mix was very favorable from a couple of perspective. It was from our products business, and it's also what from kind of the new segment that we have, but not a segment, but new part of Civil, which is our software business because last year, we had a lot of what we call very favorable on-premise work. And I'll tell you what we mean by that. In our software business, we are actively as a strategy, going to winning contracts, we're trying to move customers from on-premise work to Software-as-a-Service.

So let me make you give an analogy on that. If I was to say on-premise work, it would be like us, in the core business, to sell simulators. You sell simulators, you get the revenue, you get the contract literally very fast. Now contrast that with the training market, going through Software-as-a-Service is kind of like we're doing in training, where basically we're going to get paid over time. So from a much better recurring standpoint, much more longer term, very attractive work, but obviously it's not going to give you a big SOI bump in 1 quarter. That's what we see. And when we look at the upcoming quarter in Q4, we expect that kind of particular dynamic to be very favorable again. And that's really coupled with a number of simulators we deliver and utilization in our training centers, that's why we're basically saying we expect a strong Q4, reflecting in the heightened guidance that we gave for Civil last quarter.

[Benoit Poirier, analyst]

Okay. And maybe last one for me. If we look at AirCentre, it looks like that there is about $1 million of integration and acquisition cost taken so far. Obviously, the valuation multiple was very attractive and you knew that it would be a 2- or 3-year journey. You just mentioned that the IT infrastructure integration will be substantially complete by mid fiscal year '25. So I'm just wondering if you could give an update on the remaining costs to be taken and how much AirCentre could be incremental in terms of margin and whether it's meeting the -- any color about the return on capital employed specifically so far?

[Sonya Branco, executive]

Yes, Benoit, so we continue the integration of our customers on our systems to our network. And as I mentioned in the remarks, we expect it to be done by mid next year. So there's really good, great ramp-up of migrating our customers out of the previous network and to our network. And so great progress done last quarter, and we expect a lot of great progress this quarter as well. So while we won't necessarily kind of give an outlook on the cost, we expect that to be pretty much finished during -- in the next -- first half of next year.

[Operator]

Our next question comes from Tim James with TD Cowen.

[Tim James, analyst]

Most of my questions have been answered. But just maybe one quick one for Sonya. Just looking at some detail here. The depreciation expense in the Civil business jumped surprisingly significant amount in the quarter relative to the second quarter, I'm looking at, in particular, just the sequential change. Is there any particular reason for that? Is this new or the report of the Q3 rate a good proxy going forward?

[Sonya Branco, executive]

Well, I think the headline is growth, right? So we deployed 20 plus simulators last year, certainly near to date this year and we've onboarded several training centers, whether it's Las Vegas, Savannah came online this quarter. We have another extension of our Phoenix training center that came online also this quarter. So you'll see that driving that depreciation expense and some of the interest that I spoke to on the lease liability. It's really deployment of new simulators and new training centers.

[Tim James, analyst]

Okay. So it is just a natural step-up then in relation to the assets in the business?

[Sonya Branco, executive]

Yes.

[Operator]

Our next question comes from Kristine Liwag with Morgan Stanley.

[Kristine Liwag, analyst]

Marc, you just reiterated the margins for the next quarter. I mean, it seems like for 4Q '24 to get to your guidance, that implies about 16% revenue growth for the quarter year-over-year and margins a little bit north of 26%. So with all the mix headwinds that you highlighted this quarter, and it seems like some of that goes away next quarter. How do we think about the run rate for fiscal year '25? Is 26% the starting point? And how do we think about that for next year?

[Marc Parent, executive]

Well, I'm not going to question your math. But we've given you enough. But look, we're not guiding for 25% now. But clearly, I mean, if you look at the order intake that we have, the book-to-bill that we have, and I think you're going to continue to see strong growth.

[Kristine Liwag, analyst]

Great. And Marc, in terms of the software business, I mean Software-as-a-Service, especially Sabre historically would be a very accretive margin. I mean when you look out a few years for the composition of Software within Civil, how large could that be?

[Marc Parent, executive]

Oh boy, again, you're asking me for to discuss -- for a guidance that we're not ready to give at this time. But obviously, we built -- we bought this business to grow it. And I've been very happy with the order intake that we've had from customers. There's a lot of interest from the airline customers. They see -- they -- and I've been quite satisfied with assumption that we had from day 1 that people would be -- various airlines specifically would be very receptive for us bringing CAE's culture into this business. And we're seeing that. I say, customers that have basically moved away from Legacy Sabre -- and once we bought it and that with the efforts that we've had, the customer outreach, the product development we've had, the investment that we made in it that they've come back to us.

So look, without giving you a precise number, I see this growing. And I see that a very strong interest in us delivering what we call our next-gen solution, which is Software-as-a-Service. And that's going to be pretty good for recurring revenue going forward. Obviously, we've got to get through the time it takes to move to on-premise to a Software-as-a-Service. And there's a lot of history from other companies to do that, but suffice to say that I'm very optimistic.

[Operator]

Our next question comes from Anthony Valentini with Goldman Sachs.

[Anthony Valentini, analyst]

You got Anthony on for Noah. So I just wanted to ask on the Defense business. We're hearing from a lot of the U.S. defense primes that they're shifting their strategy in terms of how they are bidding on contracts, getting away from fixed price and going more towards cost plus. Is that something that you guys are also implementing into your strategy? Can you just talk about that a little bit?

[Marc Parent, executive]

Absolutely, absolutely. I mean, look, the impact that we've had of fixed firm price contracts that are development type contracts, going through the period that we've had through COVID has been very, very detrimental and impactful, and we see them in our results. And we're going to see them as we talked about in these Legacy Contracts.

Now having said that, we're going to work with our customers all the time. So although we might not do that, we're going to be imaginative in working with our customers to give you an example that in some cases that we have entered into new contracts where the government specifically has said, okay, we agree with you that we don't necessarily have to take the costs which have a lot of inflation relative to them and consider them as pass-through contracts. So basically, the cost will be what the cost will be. So yes, I think we are basically -- we're impacted by the same thing that a lot of our legacy peers are across the industry, and I think we're taking the same kind of actions.

[Anthony Valentini, analyst]

Okay. That's helpful. As a follow-up there, Sonya, you had mentioned in your 200 basis points basically like a drag from these challenged programs and then another 100 basis points of like the overhead absorption. So if I just kind of use those numbers, and that implies something like a 7.5% margin, what's remaining that's going to drive this business to get to those double-digit percentages that you guys have historically talked about?

[Sonya Branco, executive]

As I mentioned, it's really the ramp-up of the new contracts that we've signed and especially those transformational ones. They're large in size, accretive, and they will have a meaningful impact on the margin as they ramp up. They're really nominal right now in terms of our revenues. And so as those ramp up, they'll have a more meaningful impact.

[Operator]

Our next question comes from Jordan Lyonnais with Bank of America.

[Jordan Lyonnais, analyst]

So just hopefully, a final one on Defense margins. With the double-digit target, how confident are you in that time line being 2025 where you start to see that accretion from new contracts if we still continue to operate under a continuing resolution for this year? And how much downside risk do you guys look at if we go through a sequestration?

[Marc Parent, executive]

Let me just start it off. Look, again, as I said, what we're talking about this quarter is no different than we've been talking about, certainly in the previous quarter where we moved -- we've already [indiscernible] move things out. What we're giving today is more precision, specific on these Legacy Contracts to give you an idea of what this represents by itself, and also to give you a feeling that we're quite confident in the core of this business. This is a strong business that we're working through these Legacy Contracts. So if I try to maybe give you a little bit more color specific to the question, there continues to be 2 pieces here. The growth in the core business, which I feel is very strong, and which is influenced by the ramp-up in the transformative new business that we've talked about, the 20% growth in the backlog that we've had in the last couple of years. At the same time, as the retirement of these Legacy Contracts, which drag against the overall margin.

So we clearly see, as we said even before that there's going to be an inflation where these 2 curves meet. And what we still predict is that's going to happen in the latter half of next year. There's no change there. But I think -- I think maybe we're giving you a little bit more precision is actual drag impact in this quarter and introducing the fact that this isn't going to be linear. There's going to be variability because of the specific actions that we are taking to retire risk or depending on the timing of the retirement of risk. And our efforts to retire them as quick as possible is going to affect that. But the trend line driving inflection is -- the one we've been talking is very much intact.

[Operator]

Our next question comes from Fai Lee with Odlum Brown.

[Fai Lee, analyst]

Marc, your 3-year EPS compound gross rate target hasn't changed from the mid-20% range. And I know you don't ordinarily want to talk about the 2025 guidance since you haven't provided it, but that target implies pretty strong growth next fiscal year. And I'm just wondering to get a sense of how you see that target right now in terms of whether it's a stretch or do you think you're pretty confident that you'll achieve it. Can you just maybe comment around that?

[Marc Parent, executive]

Well, look, I can turn it over to Sonya because she answered that question, I think a little bit a while ago, but look, it's going to -- the bottom line is just -- we're not ready to give that guidance right now. We give it at the same time of the year, that's going to be next quarter. But -- and clearly, there's going to be some dependency on the timing of the risk retirement, Defense and the pace of new programs ramping up that when we actually signing these generational contracts such as the one fact that I talked about. At the same time, the outlook for Civil remains very robust. You just saw the order intake that we signed this quarter on top of 1.3 -- over 1.3 on top of 20% growth in our revenue. So all of that has to be factored. Anything you want to add on this, Sonya?

[Sonya Branco, executive]

No, you've covered it, and we'll provide more insight in Q4 like we usually do.

[Fai Lee, analyst]

Okay. And just another question on the Defense outlook, and it basically sounds like, relative to your expectations and your outlook going forward, nothing really changed from the previous quarter, yet you've provided additional guidance. The market is reacting very negatively -- or additional, sorry, information on the Legacy Contracts, market is reacting very negatively around that. What's your thoughts around how the market is interpreting that additional information?

[Marc Parent, executive]

Well, long ago stopped predicting that one. [indiscernible] run our business. And just -- I don't want to repeat everything I said, but I feel very confident about that we have a business in Defense. I'll just with that point. This is not a business that's broken. This is a business that's growing with contracts that are going to be accretive to the margin expectations we have. We have a lot of backlog. And my experience in all my career, the one thing you want to have is backlog because you have backlog -- as long as your backlog is profitable and it is profitable. It's proximal to the aims that we have. We're attacking very specific contracts here that are all very similar. Although the contracts themselves are different, they all point to the same kind of thing. Pre-COVID, fixed firm price. And we're attacking them with laser focus with dedicated [indiscernible] teams, while at the same time not keep getting -- keep our eye off the ball of the hundreds of other contracts that we execute in Defense at any given time, make sure we continue to execute those on plan, which we fully expect to do. So with all that, that basically forms my confidence in the Defense business, albeit we are where we are.

[Operator]

There are no more questions at this time.

[Andrew Arnovitz, executive]

Operator, thank you. Given that we're on the hour, I'd like now to open the lines to members of the media should there be anyone with questions or [indiscernible], Sonya.

[Operator]

[Operator Instructions] We have a question from [indiscernible] from [indiscernible]

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[Andrew Arnovitz, executive]

Operator, if that's all the questions we have. I want to close the call here and thank all participants on today's call and remind you that a transcript will be available shortly on CAE's website [Foreign Language]

[Operator]

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line. Thank you.