Earnings Call Transcript - CAE Q2 2024

Operator, Operator

Good day, ladies and gentlemen. Welcome to the CAE Second 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. You may now proceed, Mr. Arnovitz.

Andrew Arnovitz, Executive Vice President

Good afternoon, everyone, and thank you for joining us. 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, November 14, 2023, and accordingly, are subject to change. Such statements are based on assumptions that may not materialize and are subject to risks and uncertainties. Actual results may differ materially, and listeners are cautioned not to place undue reliance on these forward-looking statements. A description of the risks, factors, and assumptions that may affect future results is contained in CAE's annual MD&A available on our corporate website and in our filings with the Canadian securities administrators on SEDAR Plus and the U.S. Securities and Exchange Commission on EDGAR. 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. And at the end of that segment, we'll open the line to members of the media, should there be any questions. Let me now turn the call over to Marc.

Marc Parent, CEO

Thank you, Andrew, and good afternoon to everyone joining us on the call. We delivered a good performance overall in the second quarter with double-digit top and bottom line growth, driven mainly by continued strong momentum in Civil and higher contributions from Defense compared to the second quarter last year. We made excellent progress to secure CAE's future with nearly $1.2 billion in total adjusted order intake for a record $11.8 billion of adjusted backlog. We further bolstered our financial position on the path to meeting our short-term leverage target. In Civil, we had another quarter of excellent performance with demand for our training and flight operations solutions continuing to be robust across all regions, and notably in Asia, which has lagged in the global recovery in air travel. We booked $618 million of orders with customers worldwide for a 1.08 times book-to-sales ratio. We received orders for 15 full-flight simulators, including a multiyear purchase of eight new Boeing B737 MAX simulators for Ryanair and two Airbus A320 simulators for United Airlines. In commercial aviation training, we signed a multiyear training agreement with Delta Airlines, and in business aviation, we signed a multiyear agreement with Windrose Air Jetcharter. In flight operations, we signed long-term next-generation solutions agreements with Wizz Air and Air India. We delivered 11 full-flight simulators to customers during the quarter, and our average training center utilization was 71%, which is up nicely from 66% last year. The year-over-year increase points to the strength of the underlying commercial and business aviation training demand across all regions. Anyone who's traveled by air this summer will know just how busy the airlines have been trying to meet passenger demand. The sequential decrease in training center utilization that we experienced during this summer is a direct reflection of seasonality we typically see, as pilots are actively flying during that period. In Defense, performance was a bit lower than the first quarter but still higher than the second quarter last year. We booked orders for $527 million for a 1.1 times book-to-sales ratio, giving us a record $5.9 billion of adjusted Defense backlog. They include strategic opportunities, like the formalization of our contract with Bell Textron as part of Team Valor to provide simulation and training solutions for the all-important V280 tiltrotor, the platform for the Next Generation U.S. Army Future Long-Range Assault Aircraft program. Other notable wins include the previously announced simulation-based training contract with the U.S. Army's key next-generation airborne ISR system, which is called the High Accuracy Detection Exportation System, or HADES, based on Bombardier Global 6000 and 6500 business jets. Defense also received an order to provide the U.S. Army with support services for the Advanced Helicopter Flight Training Support Services contract for aircrew and non-aircrew personnel. Additionally, Defense was awarded contracts for modification and maintenance of F-16 training devices for the United States Air Force as well as for the upgrade of various training devices. With that, I'll now turn the call over to Sonya, who will provide additional details about our financial performance. Sonya?

Sonya Branco, CFO

Thank you, Marc, and good afternoon, everyone. Consolidated revenue of $1.09 billion was 10% higher compared to the second quarter last year, and adjusted segment operating income was $138.5 million compared to $124.7 million in the second quarter last year. Our quarterly adjusted EPS was $0.27 compared to $0.19 in the second quarter last year. We incurred restructuring integration and acquisition costs of $37.9 million during the quarter relating to the AirCentre and L3H MT acquisition. Net cash from operating activities this quarter was $180.2 million compared to $138 million in the second quarter of fiscal 2023. Free cash flow was $147.5 million compared to $108.4 million in the second quarter last year. The increase was mainly due to a higher contribution from non-cash working capital. We usually see a higher investment in non-cash working capital accounts in the first half of the fiscal year. This year, I'm pleased that we've already begun to see a reversal in that in the second quarter, and we expect that positive trend to continue into the back half of the fiscal year. We continue to target 100% conversion of adjusted net income to free cash flow for the year. Capital expenditures totaled $61.9 million this quarter, with approximately 60% invested in growth to specifically add capacity to our civil global training network to deliver on the long-term training contracts in our backlog. Income tax recovery this quarter was $8.5 million for an effective tax rate of negative 16%. The adjusted effective income tax rate was nil, which includes the recognition of previously unrecognized deferred tax assets, which had an approximate $0.05 positive EPS impact this quarter. Net finance expense this quarter ended at $48 million, which is down from $54.1 million in the preceding quarter and up from $41.3 million in the second quarter last year. Our net debt position at the end of the quarter was approximately $3.2 billion for net debt to adjusted EBITDA of 3.16 times at the end of the quarter. Following the end of the quarter, we announced a definitive agreement to sell Healthcare for an enterprise value of $311 million, a decision which better positions CAE to efficiently allocate capital and resources to secure growth opportunities in our large core simulation and training markets. We intend to apply a significant portion of the net proceeds to reduce debt. The transaction is expected to close before the end of the current fiscal year, subject to closing conditions, including customary regulatory approvals. With leverage having decreased to a ratio of approximately 3 times, we will consider reinstating capital returns to shareholders following the closing of the Healthcare sales transaction. We are 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, second quarter revenue was up 13% to $572.6 million compared to the second quarter last year. Adjusted segment operating income was up 9% to $114.3 million versus second quarter last year for a margin of 20%, both solid improvements over last year. And as Marc referenced, CAE's second quarter is normally seasonally softer with respect to training center utilization, which typically has some impact on business mix. In Defense, second quarter performance was better than the same period last year, with revenue up 8% to $477.4 million and adjusted segment operating income up 16% to $21.3 million, giving us an adjusted segment operating income margin of 4.5%. The year-over-year growth came mainly from a higher level of activity on programs, partially offset by higher SG&A expenses from higher bid and proposal costs associated with the pursuit of a larger pipeline of defense program opportunities. Defense performance was lower than the preceding quarter as we managed through the ongoing retirement of legacy programs from backlog. We also had lower revenue than we expected from newer and more profitable programs due to recent funding and award delays. With that, I'll ask Marc to discuss the way forward.

Marc Parent, CEO

Thanks, Sonya. Our outlook for CAE continues to be positive for the fiscal year and beyond. Our strong momentum is translating to robust order flow and a record backlog, which portends an excellent future for CAE. In our core civil and defense markets, our customers increasingly require innovative training and operational support solutions to perform at their best in mission-critical environments. And as we look ahead, we remain highly encouraged by the favorable secular trends that we see and in the growth that we anticipate by leveraging our global market position. As well, our technological expertise and the strength of our one CAE culture portends optimism. In Civil, we expect to continue growing at above-market rates, driven by the recovery in air travel, increased penetration of the existing addressable market for training and flight services solutions, and a sustained high level of demand for pilots and pilot training across all segments of aviation. For the current fiscal year, we now expect Civil to deliver growth in the mid- to high-teens percentage range of adjusted segment operating income. Given the profile of our planned simulator deliveries and the normal seasonality of training demand, performance will be mostly weighted to the fourth quarter. The higher expected annual growth is based on our strong performance year-to-date and the visibility that we have in a highly regulated aviation training market. In addition to continuing to grow our share of the aviation training market 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 full-flight simulators for the year. Approximately half of those deliveries are slated for the fourth quarter. Turning to Defense. We expect to continue making good progress transforming our business by replenishing our backlog with more profitable programs and retiring low-margin legacy contracts, which we expect to culminate in a substantially bigger and more profitable business. We strengthened our future position in recent quarters with strategic and generational wins, including next-gen platforms, giving us a record $5.9 billion adjusted backlog. Together with a record $9.5 billion pipeline of bids and proposals outstanding, we continue to see positive signs of the transformation underway. As we look at the remainder of fiscal 2024, the positive inflection we expect this year in Defense has been delayed because of the impact associated with the retirement of our lower-margin legacy contracts, specifically those awarded prior to COVID and current new program delays. While the inflationary impacts on these contracts are known and finite in nature, they continue to be the most significant factor contributing to the current low margin performance of the business and do not reflect its underlying potential. The essential trendlines of replenishing our backlog with larger and more profitable programs while simultaneously retiring legacy contracts remain positive. However, the prevailing U.S. government budget appropriation uncertainty is slowing the ramp-up of the new and higher-margin defense programs that we've been awarded. This is also impacting the conversion of our bid pipeline to orders that we expected to generate higher margin revenue for this fiscal year. As a result, we now expect second-half Defense adjusted segment operating income margins to remain in the current single-digit percentage range. We expect to see Defense segment performance improvements materialize next fiscal year, but this will ultimately depend on the duration and magnitude of delays to new programs in the current environment. We're firmly focused on retiring legacy contracts as soon as possible and mitigating the margin pressures associated with them. We remain pleased with the accretive margin profile on our newly awarded contracts, which should be the best indication of where the future performance of Defense is headed. We maintain our conviction that the ongoing retirement of legacy programs and a new order backlog growth will result in a low-double-digit percentage margin business at a steady state. Lastly, on Healthcare. I want to thank Jeff Evans and the entire Healthcare team for their dedication and excellent performance. We're proud of this significant contribution to patient safety that CAE Healthcare has made, and I believe that Madison Industries is the right home to take the business to the next level. Like CAE, Madison's mission is rooted in making the world safer, and I believe it will be ideally positioned to support the future growth of the business, which will continue to focus on evolving simulation to drive patient safety and quality outcomes. For CAE overall, we continue to be highly encouraged by the secular tailwinds at all segments and the growth we expect by harnessing our global market and technology leadership and the power of One CAE. With that, I thank you for your attention, and we're now ready to answer your questions. Operator, we'll now take questions from financial analysts.

Operator, Operator

Our first question comes from Fadi Chamoun with BMO. Please proceed.

Fadi Chamoun, Analyst

Yes. My first question is whether the mid-20% EPS growth guidance you've reaffirmed takes into account the anticipated divestment of Healthcare. Additionally, I am trying to understand the concerns regarding the Defense margin inflection point while you maintain the guidance for fiscal 2025. Are you still anticipating that Defense margins will improve in 2025, and what level do you believe is still achievable for double-digit margins in the latter half of 2025? I'm trying to reconcile the maintenance of this guidance with the divestment of Healthcare and the weaker performance in Defense.

Marc Parent, CEO

Thank you for the question, Fadi. Our three-year guidance remains our goal. We continue to experience strong growth and profit gains across our portfolio. It is clear that, as you mentioned, there are additional risks in Defense related to factors we've discussed, such as new program ramp-ups and the timing within the current budgetary context in the United States. However, we are focused on completing work on legacy contracts as quickly as possible. While I cannot provide guidance today for fiscal 2025, I will share more details as we approach that fiscal year if there is more information to offer. As I mentioned, the guidance is unchanged. Regarding Healthcare, its impact on our guidance is not insignificant, but it is relatively minor in relation to the results from the sale.

Fadi Chamoun, Analyst

Okay. And maybe one follow-up. I think we understand the budgetary issues and the ramp-up of new business. The backlog has been growing, and you've reported several quarters of increasing backlog, with a positive outlook for Defense. However, if we set aside the budget issues and potential delays, how can we gauge the margin impact today from these legacy contracts that will eventually come off the P&L? Will this happen next year or the year after? Is it a 300-basis point or 200-basis point impact? I'm trying to understand the core profitability run rate of Defense, regardless of the delays in the ramp-up of new business.

Marc Parent, CEO

Let me address your question by highlighting some key factors. First, when we refer to these lower-margin programs, we’re discussing a very small number of contracts, which represent only a fraction of our overall backlog. It's crucial to note that none of these contracts were awarded recently; all were granted prior to COVID. Therefore, although these programs are limited in number, we are seeing significant inflation impacts starting at 2% escalation, while currently experiencing inflation of 10% to 15%, which compounds and affects our operations. Staffing shortages also contribute to these issues, as these programs are particularly vulnerable to these challenges and are affecting the company's profitability. Furthermore, regarding the inflationary environment, for some of these programs, we have strong cases to seek reimbursement for the actual cost increases we've incurred. However, in the current climate, there is very little appetite for such negotiations, leading us to be competitive only for a minor share of what we believe we should be receiving. Additionally, we haven't observed the usual end-of-year budget adjustments that typically occur in defense spending, which adds to the difficulties faced by these programs. On the brighter side, when looking at new initiatives, particularly our transformational programs like FTSS, FAT, and HADES, a key point to note is their profitability potential. In Q2, these transformational programs accounted for only 3% of our revenue this quarter, yet they represent 20% of our backlog. These programs are associated with very attractive margins, which instill confidence in our ability to achieve our profitability targets, which are in the low-double-digit range. These are the factors currently influencing our situation.

Operator, Operator

Our next question comes from Tim James with TD Cowen. Please proceed.

Tim James, Analyst

Just have one question here. And I'm just wondering if you could give us an update on the progress with AirCentre, how it's performing versus expectations? And sort of year-over-year comparisons? I know there were some integration costs in the quarter. Maybe just some details on what those costs were around and what that provides for the business going forward?

Marc Parent, CEO

Thank you for the question, Tim. I’m quite pleased with our business and the progress we're making, especially regarding our success in the market. For instance, following the Paris Air Show, we received very strong orders, particularly from airlines in India, including a significant contract with Air India for our AirCentre suite of products. Since Air India is consolidating several airlines under its group, this is very promising for our business. I also recently visited Budapest and learned that Wizz Air has selected us for our AirCentre suite, among other positive developments. Overall, I’m very happy with our business performance and the impact we're having on our customers' perception of CAE. It's important to note that recognizing revenue will take time due to the Software as a Service nature of our offering. We purchased AirCentre at seven times EBITDA, and considering our spending, we are investing as planned to develop the business. We are on track with our goals, and it's positively contributing to this quarter.

Tim James, Analyst

Okay. That's really helpful. I want to just actually ask one more question, if I could. The working capital in the quarter was great, really impressive. Just wondering maybe if you can talk a little bit about whether there were surprises in there? What drove that? Is that kind of more indicative of what second quarters might look like going forward? Just any details on that strong performance?

Sonya Branco, CFO

Thanks for the question. Yes. No, like I said in the remarks, I'm very pleased to see strong reversal in working capital in the quarter. This is not a surprise. This is the outcome of continued focus on optimizing capital and our metrics. We saw good improvements all across the board, whether it's on our day sales outstanding, contract assets, and deposits on contracts. These all contributed to the positive reversal of working capital. We expect that momentum to continue in the second half.

Operator, Operator

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

Cameron Doerksen, Analyst

Just a couple of questions on the restructuring activity. We see that ongoing in Q2. Can you just maybe update us on where we are in that restructuring program? How much of that at this point is reflected in your cost base?

Sonya Branco, CFO

I wouldn't necessarily refer to it as a restructuring program any longer. The restructuring program was concluded last year. What we are focusing on now is the continued integration of the two acquisitions. For flight services, as Marc mentioned, we acquired that at 7 times EBITDA, anticipating investments to streamline and modernize the structure. We are currently making investments in our updated IT infrastructure and migrating customers, which we expect to wrap up by the middle of next year. Regarding L3H MT, this represents the second phase of our integration. The impetus for this was a major ERP implementation aimed at unifying both our legacy and new businesses. This has led to a planned second phase of further integration and synergies, which we expect to see by the end of this phase.

Cameron Doerksen, Analyst

Okay. So, we should expect, I guess, the outcome of these sort of integration activity to have maybe a more meaningful impact on margins as we look ahead to 2025, is that fair?

Sonya Branco, CFO

Sure. Yes.

Cameron Doerksen, Analyst

Okay. And maybe just secondly, wondering if you could talk about what you're seeing as far as opportunities to deploy additional capital into the training network? What are you seeing on outsourcing opportunities, JV opportunities?

Marc Parent, CEO

There are numerous opportunities available, Cameron. You can see the progress we've made. From the beginning, we came into this with considerable resources. Looking back to the COVID period, we maintained our asset size and positioned it effectively. As a result, we eliminated around $70 million in structural costs from our operations. We're currently seeing the benefits of those decisions. Since then, we've been capitalizing on the market opportunities. You've witnessed our expansion in business aviation training centers; we established one in Singapore and are soon launching another in Savannah. Las Vegas has already proven to be very successful. We've partnered with SIMCom for Orlando, and we announced a center in Vienna for next year. As for outsourcing, I'm pleased with the progress we've made, as I've mentioned before. We previously discussed Qantas, and I recently met with the CEO and his team at Aegean in Athens, Greece's largest carrier, finalizing a deal with them. There are additional agreements I can't disclose at the moment, but it's clear we're actively meeting with customers and identifying further growth opportunities to efficiently allocate capital, especially within the civil network, which is beneficial for margins.

Operator, Operator

Our next question comes from Kevin Chiang with CIBC. Please proceed.

Kevin Chiang, Analyst

Looking at Defense from a high level, although this analysis may be quite basic, if I consider your run rate and the adjusted segmented operating income alongside the capital invested in Defense, it seems your returns are around 3% to 4%. If margins were to be doubled or slightly more than that, you might see high-single-digit returns on that capital. However, this still appears relatively low to me, especially in light of the margin trends you've outlined for the medium term. How are you planning to increase that return? Is it about growing revenue while maintaining static capital? Do you think margins need to rise to the mid-teens over time to achieve better returns? I'm trying to understand the long-term trajectory of returns on capital in this area.

Marc Parent, CEO

Well, as I said, over a long period, we feel very comfortable about the service and achieving the target we've given of low-double-digit margins. Look, it's clear that we're not where we want to be today. We'd rather not be here, but it's finite, it's temporary. It's not reflective of the long-term potential business. And again, the same factors are at play here. I mean, really, the two overall factors that are at play. Number one is on risk retirement. Risk retirement on what we call these drag programs, and we're making progress. In some cases, we're actually moving to accelerated. I can tell you that in this past quarter, there were a few programs that we've shifted to 7-day work weeks to basically accelerate the schedule and get this behind us. Obviously, when we do that, we incur the cost, but I think it's worth it to make sure that we exercise contractual opportunity obligations to meet the schedule on those contracts. In the case of new programs, as I talked about during my remarks, we remain very bullish about the profitability of those new programs we're winning for all kinds of reasons. Such as something that I've talked about on previous calls, like being able to leverage and exercise what we call commercial rates on government contracts. That's going to be a mix of programs. But in aggregate, the profitability of all those new programs that we're winning is very accretive to the margin obligations we set. That's really what's happening here. And as I said, where we are today on those transformational programs. Again, in the second half, they make only 3% of our revenue. Next year, that's probably going to be about 15%. Obviously, accelerating as we go through the year. As you get into the end of the year, you're going to have more of the revenue being driven through the business from those transformational programs. At the same time, we'll be substantially down the curve of retiring the risk on the drag program. So that's what's at play here. And of course, what's affecting those two trend lines are some of the factors I talked about, like basically contracts moving to the right in terms of us being able to execute on a contract or in a lot of cases, no fault of our own, if I should say. In some cases, we've been selected for training contracts but we've been delayed as much as six months because the customer is not getting the airplanes on time because the OEMs have been affected by supply chain challenges that are not able to meet the production rates. All of those factors are at play here. But again, from a long-term standpoint, we feel very comfortable about the business.

Kevin Chiang, Analyst

I appreciate the insight, Marc. Regarding Civil, we've been observing the ongoing pilot shortage and the efforts airlines are making to address that backlog. One notable trend is the acceleration of pilots transitioning from first officers to captains. I'm curious if this creates more training opportunities for you and whether it influences your perspective on wet versus dry hours. If individual pilots are advancing in their careers more quickly than what was typical before the pandemic, does that affect the balance of your commercial revenue between wet and dry, or even the number of training events you usually conduct in a year with an airline or a specific pilot?

Marc Parent, CEO

I believe this situation has multiple implications. To address your inquiry about the factors prompting pilots to switch aircraft or advance from first officer to captain, it's important to note that such changes necessitate retraining, a requirement regulated globally. Our core business is training, and we are the largest training provider in the world, making this a significant catalyst for us. Therefore, this presents a favorable opportunity for our business. Moreover, the growth in pilot training is accompanied by a strong emphasis on safety. This plays directly to CAE's strengths, as we lead the world in pilot training. For instance, our agreements with companies like Boeing, which we announced at the Paris Air Show, highlight our partnership and our role in delivering their competency-based training program, starting in India. This collaboration leverages our technology, extensive training footprint, training hours, and data-driven insights to assist OEMs like Boeing and airlines globally. This ensures they can efficiently onboard new pilots and reposition pilots at a younger age, all while upholding the safety standards in aviation that we value. That's our primary focus.

Operator, Operator

Our next question comes from Kristine Liwag with Morgan Stanley. Please proceed.

Kristine Liwag, Analyst

Marc, so maybe going back to the Healthcare business. The past few quarters, we finally see it being profitable. Can you just give us a little background on why now for the sale? And then also as a follow-on, I mean, the Healthcare business was supposed to be in an industry in which you have low market share, that you had the opportunity for growth. Now that you won't have Healthcare anymore, are you thinking about another potential leg to the business as a strategic area for growth?

Marc Parent, CEO

Let me begin with Healthcare. Together with the Board, we are consistently reviewing our portfolio to ensure we are maximizing value for all stakeholders. In the case of Healthcare, we are currently in a position where we believe the upcoming investments needed for this business will be best provided by new capital sources. This approach will enable us to focus our investments and create synergies in our core operations. We believe this is the optimal time for such a transition. I am confident that Madison Industries is the ideal owner for this business. I have spoken with their CEO several times, and our shared values and cultural similarities make this transaction an excellent match for all stakeholders. This is my perspective on the matter. Regarding another aspect, we have already made strides in software, which is transforming Healthcare through technology.

Operator, Operator

Our next question comes from James McGarragle with RBC Capital Markets.

James McGarragle, Analyst

So, I just wanted to ask another question on the Defense margins with regards to that low-margin business rolling off. I'm just trying to better understand how these contracts get retired. Is it as simple as on a specific date, these contracts come off the books? And then the day after that, the margin profile improves by a certain percentage basis? Or is there a little bit more nuance than that? I'm just trying to get a better understanding on how these contracts get retired and then what visibility, I guess, you guys have in the margin improvement on the back of these contracts coming off the books.

Marc Parent, CEO

It's really a question of finishing the contracts. There are a number of contracts that we're executing that are to deliver products and services to specific customers without getting into the specific nature of each one. Each one has a contractual end date, and there are assumptions on our part with regards to the cost it's going to take us to be able to complete those programs and deliver what we promised to the customers on time. We literally manage that on a weekly basis to make sure that we can achieve what we said we're going to do, complete on time and at the cost that we assume. That's really what we're talking about. With regards to the assumptions we've made for us to be able to do that portends the outlook of a deal.

James McGarragle, Analyst

Okay. And are you able to provide some color on those dates when they will be coming off the books?

Marc Parent, CEO

I believe that overall, the trend lines remain as we've indicated. Looking at all our programs, it's reasonable to expect that we will be largely completed with them by the end of next year. Of course, they will conclude at different times, but we anticipate being substantially finished by the end of the next fiscal year.

James McGarragle, Analyst

Okay. And then just turning to the Civil side of the business, and I'm not asking for a fiscal 2025 guide, but more so thinking about how much room there is to recover to pre-pandemic levels of activity? And just looking at the most recent IATA data, still has passenger kilometers down 10% in Asia, down 4% in Europe. International travel is still down 7% versus pre-pandemic. So, on a high-level basis, is the right way to think about growth in fiscal 2025 whatever we assume that the base business can do in Civil in a normal environment? Plus then, a continued recovery to pre-pandemic levels in Asia, Europe, and international travel?

Marc Parent, CEO

I think it's certain that we're going to write it above pre-pandemic levels, no doubt about that. Again, as I was saying a while ago, when you think about the cost savings we've taken out of the business just by itself, even at pre-pandemic levels, would mean a higher margin, which you're already seeing in the results. A couple on that. Business aviation is very, very strong. And that's a very good part of our business from a profit standpoint. You saw the outsourcings that we're making. There's more coming down that path. I'm quite comfortable with it, as well as a very strong demand environment that we're seeing across the whole business. So, we don't have a target today for margins, except they're going to go higher.

Operator, Operator

Our next question comes from Benoit Poirier with Desjardins Capital Markets.

Benoit Poirier, Analyst

Just to come back on the transformational program that you were awarded, Marc, you mentioned that there was only a 3% contribution in the quarter, and this will go up to about 15% next year. Could you maybe provide some color about the profitability early days for those transformational programs? Just wondering about the accretion early days, whether they still contribute at a good profitability level or it takes two years or three years before ramping up at a good profitability level.

Marc Parent, CEO

It depends on the program, Benoit. Since it's a service contract, it usually takes longer because you're delivering service over time, unlike products that convert to revenue faster. In both scenarios, they will contribute to our double-digit goal from the very beginning, so you won't have to wait long for them to positively impact the numbers we see.

Benoit Poirier, Analyst

Okay. And just based on the comments made earlier about the pace for the legacy programs to ramp down, you mentioned mostly completed at the end of fiscal year '25. Consensus is currently expecting Defense margin to high-single-digit next year, almost pretty close to double-digit. Is that fair to say that it might be difficult to achieve, based on the comments made earlier?

Marc Parent, CEO

Well, as I mentioned, we're not providing guidance on fiscal '25 today. So, I will keep it consistent with what we've communicated throughout this presentation, with no new guidance from what I've previously stated.

Benoit Poirier, Analyst

Okay. And last one for me. Capital deployment, Sonya, you made great color about reinstating returns to shareholders. In the opening remarks, you mentioned the focus on growth, debt repayment, investment-grade, and then return to shareholders. Are there any optimal ratio you would like to operate going forward?

Sonya Branco, CFO

I think, as we mentioned previously, reaching three times was not the target but rather a milestone. We continue to pursue balanced capital deployment by investing in accretive capital, particularly in the Civil network, including training centers and simulators to meet demand, which have shown to be highly beneficial within 24 to 36 months, as we have observed before. We will keep working on reducing our leverage to maintain a comfortable investment-grade status. Ultimately, it’s about balancing these efforts and having ongoing discussions with the Board regarding potential returns to shareholders.

Operator, Operator

Our next question comes from Ronald Epstein with Bank of America.

Unidentified Analyst, Analyst

Good afternoon, everyone. This is Mariana Perez Mora up for Ronald today. My first question is about utilization rates. You have been growing a lot and penetrating in the civil training market and with all these training centers, and utilization rate is up to 71%. But you keep opening new sites. What is the sweet utilization rate kind of like spot when you think about both profitability but also being able to capture these opportunities? And when do you think you could achieve those type of like peak utilization, sweet spot rates?

Marc Parent, CEO

It's difficult to answer your question precisely because we can theoretically reach 100% utilization at our training centers, and we actually do achieve that at several locations today. However, maintaining this level across the entire fleet is not feasible due to necessary maintenance and other factors. I would note that 100% does not mean every hour of the year. For our commercial operations, we average about 6,000 hours annually, while our business aviation training centers operate around 4,500 hours per year, which better reflects our scheduling capabilities. Our overall utilization is increasing. We experienced some seasonality in Q2 due to heightened airline activity, especially in Europe during the summer, where our utilization was significantly lower than usual—this is expected. We're returning to seasonal rates, which have slightly impacted Q3. However, moving forward, we anticipate a strong recovery in utilization. Our goal is to maximize utilization in response to demand. Additionally, as we open new training centers and install more simulators, there will be a ramp-up period affecting utilization since these facilities may not be fully operational right away. This will influence the overall utilization figures we report.

Unidentified Analyst, Analyst

And is it fair to think about 80% kind of level, whenever you get to this normalized ramp up?

Marc Parent, CEO

We can achieve 80% utilization, as we have done so in the past. We don’t have a specific target for stopping; instead, we will focus on maximizing utilization. There isn't a one-size-fits-all approach since every training center is different, whether for business or commercial aircraft. Our priority is to address the unmet demand and increase our capacity to meet it. We are putting significant efforts and resources, both financial and human, into our digital transformation to enhance efficiency and improve returns. This will help us maximize the scheduling of simulators and training centers, thereby increasing the amount of training we conduct and enhancing returns on those assets. That is our focus moving forward.

Unidentified Analyst, Analyst

Okay. And then I'll dig a little bit deeper on capital deployment and shareholder-friendly capital deployment. Getting to net leverage targets, how are you thinking about this? Are you thinking about a regular dividend again or more opportunistic kind of like special dividends or share buybacks?

Sonya Branco, CFO

So, we haven't come out with that view yet. We're having ongoing discussions, and I won't necessarily get ahead of our Board today, but I can assure you that we're focused on first of all, closing the transaction, the sale transaction, continuing to generate cash. As a result, we'll continue that discussion and come back with Quantum and vehicle in the future.

Operator, Operator

Our next question comes from Konark Gupta with Scotiabank.

Konark Gupta, Analyst

Thanks, I'll just stick to one question. A lot of U.S. airlines are talking about their domestic demand as plateauing or coming down, but they are reallocating some capacity to wide-body aircraft for international travel. I'm curious if you are seeing any significant changes in reassignment training with pilots, especially with respect to your North American customers?

Marc Parent, CEO

No. All of those factors are just adding to what I talked about, Konark, in terms of the churn. Churn pilots moving either narrow bodies to widebodies or co-pilot to pilot or on 1 plane to another from a regional. Anything like that triggers demand for training. I can tell you there's a lot of unmet demand out there, both in commercial aviation and business aviation. As I said before, we're ramping up to satisfy it. That gives me optimism for the future and the reality of what I see that leads me to raise the outlook we have for Civil in the back half of the year.

Operator, Operator

Mr. Arnovitz, there are no further questions at this time.

Andrew Arnovitz, Executive Vice President

Thank you, operator. I want to thank all participants on the call today and remind you that a transcript of the call can be found later on CAE's website. Thank you, and good afternoon.

Operator, Operator

That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you.