Defense Modernization And Pilot Shortages Will Drive Long-Term Upside Potential

Catalysts

About CAE

CAE is a global leader in civil aviation and defense training and simulation, providing mission critical solutions to airlines, OEMs and governments worldwide.

What are the underlying business or industry changes driving this perspective?

• Accelerating global defense modernization programs, including Canada's multidecade spending push and allied mission readiness initiatives, are expanding high-margin training and simulation awards, supporting sustained revenue growth and structurally higher earnings.
• Structural pilot shortages and record commercial and business aircraft backlogs are expected to drive a multi year upcycle in simulation demand and training utilization, boosting civil revenue and expanding net margins as CAE leverages its global network.
• Cross pollination of dual use technologies such as the CAE Prodigy Image Generator and large scale integrated mission environments unlocks reusable R&D and shared platforms across Civil and Defense, improving capital efficiency and long term returns on earnings.
• Portfolio streamlining, stricter return thresholds on capital and R&D, and a focus on higher value, longer duration contracts are set to reduce low return deployments and elevate project mix, expanding ROIC and free cash flow conversion from existing assets.
• Network and manufacturing transformation, including a leaner organization, optimized training footprint and end to end product operations leadership, is expected to lower unit costs and SG&A. This would raise segment margins and support stronger EPS growth.

Assumptions

This narrative explores a more optimistic perspective on CAE compared to the consensus, based on a Fair Value that aligns with the bullish cohort of analysts. How have these above catalysts been quantified?

• The bullish analysts are assuming CAE's revenue will grow by 6.8% annually over the next 3 years.
• The bullish analysts assume that profit margins will increase from 9.0% today to 11.7% in 3 years time.
• The bullish analysts expect earnings to reach CA$685.8 million (and earnings per share of CA$2.09) by about December 2028, up from CA$435.6 million today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as CA$534.8 million.
• In order for the above numbers to justify the price target of the more bullish analyst cohort, the company would need to trade at a PE ratio of 29.9x on those 2028 earnings, down from 30.3x today. This future PE is greater than the current PE for the US Aerospace & Defense industry at 29.2x.
• The bullish analysts expect the number of shares outstanding to grow by 0.55% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.1%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The civil training network is underutilized, with training center utilization at 64% and management acknowledging a temporary lull in commercial training activity and simulator deliveries. If the recovery in pilot hiring and air traffic is slower or weaker than expected, excess capacity and lower pricing power could weigh on civil revenue growth and compress segment margins and group earnings.
• Capital employed in Civil has doubled over seven years to about $6 billion while revenue has risen only about 50%. If the transformation plan fails to materially improve return thresholds, optimize the real estate footprint and redeploy or retire under-earning simulators, structurally low returns on invested capital could persist and limit growth in net margins and earnings.
• Management is counting on defense as a once in a generational opportunity, but large sovereign programs can be delayed, reprioritized or repriced as governments adjust budgets and shift toward autonomous systems and new procurement models. This could slow backlog conversion and reduce the uplift from higher margin awards, pressuring long term revenue visibility and segment profitability.
• The company is embarking on a broad transformation involving leadership changes, portfolio reviews, tighter capital discipline and network optimization. If execution missteps lead to disruption, cost overruns or the loss of key talent and customer relationships, the anticipated efficiency gains may not materialize, resulting in higher SG&A, weaker free cash flow and lower earnings than implied by the bullish scenario.
• Despite stronger free cash flow this quarter, CAE still carries net debt of approximately $3.2 billion and expects a run rate tax rate of about 25%. If interest rates remain elevated, deleveraging is slower than planned or tax reforms are more onerous than anticipated, higher finance and tax costs could offset operating improvements and restrain growth in net margins and earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bullish price target for CAE is CA$51.0, which represents up to two standard deviations above the consensus price target of CA$43.92. This valuation is based on what can be assumed as the expectations of CAE's future earnings growth, profit margins and other risk factors from analysts on the bullish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of CA$51.0, and the most bearish reporting a price target of just CA$30.0.
  
• In order for you to agree with the more bullish analyst cohort, you'd need to believe that by 2028, revenues will be CA$5.9 billion, earnings will come to CA$685.8 million, and it would be trading on a PE ratio of 29.9x, assuming you use a discount rate of 7.1%.
  
• Given the current share price of CA$41.06, the analyst price target of CA$51.0 is 19.5% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.