Thales S.A. (HO) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to today's Thales acquires Cobham Aerospace Communications to strengthen its Avionics portfolio conference call with Yannick Assouad, Executive Vice President, Avionics; and Pascal Bouchiat, Senior Executive Vice President, Chief Financial Officer. [Operator Instructions] I must advise you that this conference is being recorded today. I would now like to hand the conference over to Mr. Bertrand Delcaire, Head of Investor Relations. Please go ahead, sir.

Hello. Good morning and welcome and thank you for joining us on such short notice. This morning we will discuss the announcement regarding Cobham Aerospace Communications, AeroComms in short and I suggest we stick to the shorter name. I am Bertrand Delcaire, the Head of Investor Relations at Thales. With me today, Yannick Assouad, Executive Vice President, Avionics; and Pascal Bouchiat, our CFO. The presentation will be in English and followed by a Q&A session as explained. It is webcast live on our website at thalesgroup.com and the slides and the press release are also available for download. A replay of the call will be available as from tomorrow morning. With that, I would like to turn over the call to Pascal Bouchiat.

Thank you, Bertrand. And good morning, everyone, and thank you for joining us on this call. So starting this presentation with Slide 2. I'm very delighted to announce that Thales has signed a memorandum of understanding with Cobham Limited owned by Advent International to acquire AeroComms for enterprise value of $1.1 billion. AeroComms is a leading supplier of advanced ultra-reliable safety cockpit communication systems and Yannick will explain in a minute what they exactly do. It will enable Thales Avionics to establish itself as a leader in the very attractive and fast-growing cockpit communications and connectivity markets. With this acquisition, Thales aims to pursue its strategy to strengthen its Avionics portfolio, reinforcing its global leading positions, adding recently developed cutting-edge products to its portfolio while consolidating its solid positions with major OEMs and gaining access to strong aftermarket/retrofit opportunities. AeroComms, which is expected to generate around $200 million in revenue this year, also has a very attractive financial profile; double-digit type of growth expected in the midterm and solid operating margin and hence significantly accretive to our aerospace segment profitability. From a value creation standpoint, this transaction is also compelling. The acquisition enterprise value of $1.1 billion represents 17x expected full year 2023 EBIT presynergy and 15x expected full year 2023 EBIT post run rate cost synergies. This multiple reflects AeroComms' superior growth profile and is consistent with comparable these multiples. The team have already identified run rate pretax net cost synergies of around $10 million and incremental revenue synergies of up to $40 million. This deal will be EPS accretive from year 1. So after this brief introduction, let me now turn over the call to Yannick, who will tell you more about AeroComms and the strategic rationale for the deal. Yannick?

Thank you, Pascal. Good morning, everyone, and thank you for being with us today with short notice as we said. I am now on Slide 3. As Pascal explained, AeroComms is focused on aircraft safety communication system. It has 3 main product families; L-Band Satcom systems dedicated to cockpit communication, digital audio and radio management solutions and passive antenna system; all enabling connectivity, communication and navigation of an airplane. It serves a broad set of customers both civil and military and benefit from both OEM production ramp-up and significant retrofit opportunities. It benefits from strong growth opportunity driven by 2 clear pillars: the market itself, as you know, we are in a period where we have ongoing OEM delivery ramp-up; but also from a wave of operating fleet retrofit opportunity; and product themselves, this growth is also fueled by the recent launch of state-of-the-art products. Aviator-S for L-Band Satcom, it is today the best-in-class product already adopted by major OEMs like Airbus and Dassault and brand new DRAIMS, which is a digital audio/radio communication system also adopted by Airbus. And thanks to this unique position, its 2023 sales are on track to be already above pre-COVID level. Overall, we expect it to sustainably grow at double digit thanks to these new products and above market growth meaning gaining market share. On top of superior growth, AeroComms is also generating robust profitability and will thus have an accretive impact on our Avionic business and group margins. Moving now to Slide 4. So Slide 4 provides more detail on each of AeroComms 3 main product lines. Let me just stress here the first column, Satcom. AeroComms address a major trend in safety critical cockpit communication, namely the replacement of low bandwidth HF solution by L-Band, Inmarsat, Satcom. Its product, Aviator-S is already very well adapted to this market, being very compact and low cost. Looking at the narrowbody fleet in service today, we expect the penetration rate of L-Band Satcom to increase from around 20% today to 50% to 60% in the coming 3 to 4 years driving a major retrofit opportunity. Moving now to Slide 5. The reason of the strategic move for us is really the trend on connected cockpit, which is really at the heart of the future of aviation. At our ESG Investor Day back in 2021, I had stressed how the principle of air traffic management are strictly based on pre-authorized routes that follow the location of [indiscernible] dating back to the middle of the 20th century. Optimizing flight trajectory and airspace operation is a major CO2 reduction opportunity for aviation and connected cockpits are essential technology to deliver on this vision. It's a clear enabler. Actually this requires 2 key technologies; a permanent secure high bandwidth connectivity, powerful cybersecurity across the full connectivity spectrum and digital audio and radio management inside the cockpit. This technology opens a use case opportunity beyond flight operation opportunity. For example they allow the introduction of digital solution to reduce crew stress and workload. In the longer term they support the introduction of increased automation in the cockpit for improved safety. Moving to Slide 6. And this is where the combination of our current Avionics business and AeroComms is really a perfect match to address this opportunity. AeroComms brings L-Band Satcom, digital audio/radio control and audio navigation antenna;, strongly complementing our portfolio in glass cockpit computers, navigation and cybersecurity. And you have on the slide what is the current status of an airplane today and where we will be moving in the near future and near is clearly not long term, way before the end of the decade, to really allow what I said in terms of optimizing route of any plane on the planet. Moving now to Slide 7. Slide 7 is another way to illustrate the strength of the combination. You have a cockpit in front of you and clearly you see what actually Thales provides in terms of glass cockpit navigation, computer and cybersecure line and you see on the top what Cobham AeroComms is providing today. And clearly, Thales and AeroComms will be in a position to provide a full range of cockpit solution for a fully connected avionics offering with the integration of AeroComms DRAIMS, their digital audio/radio management system with Thales FlytX cockpit display system, which is already a reality on some platform like the [indiscernible] program. Thales audio navigation solution will be effectively supported by AeroComms antenna portfolio. And last, but not least, AeroComms' Satcom Aviator-S with the connection with Inmarsat and Thales FlytLINK Satcom Iridium, which we are developing right now could lead to the best-in-class redundant Satcom solution. So strategic fit is really built on the unique state-of-the-art product portfolio of both companies. With that, I will now hand over to Pascal, who will comment on synergies and the financial impacts of the transaction.

Okay. Thank you, Yannick. So I'm now on Slide 8, cost and revenue synergies. So starting with cost synergies on the left. The team estimates that the combination will generate run rate pretax net cost synergies of around $10 million representing 5% of current sales and is driven by the usual levels. Consolidation of Thales Avionics Satcom and audio and radio control activities within AeroComms. R&D efforts and technology road map alignment, some level of vertical integration and purchasing optimizations as well as convergence in support and spares and repairs activities. We forecast that the vast majority of these run rate cost synergies will be achieved by the end of 2026. We have already identified meaningful revenue synergies. First estimates correspond to a run rate of around $40 million in incremental revenues. As usual, with revenue synergies, they will take a bit more time to materialize as they will notably depend on product development road maps. Still around half shall already capture in 2027. All these positive effects resulting from the combination will improve the cost profile and EBIT margin of Thales Avionics and the group overall. So moving now to Slide 9. I already mentioned the transaction terms. Let me stress here that because of its superior growth profile, the valuation multiples are slightly above Thales. Beyond being financially compelling and the strong strategic rationale detail by Yannick, this acquisition will offer significant shareholder value creation potential. As the transaction is paid in cash, it's expected to be EPS accretive from year 1. This transaction abides by all the M&A criteria that we have articulated with Patrice over the past few months strengthening one of our core businesses with an easy to integrate acquisition. This is really a plug-in approach that we mentioned previously. A deal that will clearly reinforce our technology portfolio with state-of-the-art products. A transaction that is accretive to our financial profile looking at both revenue growth and also profitability. And of course valuation that is consistent with its financial profile in line with our disciplined capital deployment strategy. So I will finish the presentation with highlights of the timetable and next steps. I'm now on Slide 10. So transaction signing is subject as usual to Works Council consultation processes at both Thales and the target science. Closing will be subject to customary merger control and regulatory approvals as well. Under these conditions, closing of the transaction is expected sometime during H1 2024. So this concludes our presentation. Many thanks for your attention. And together with Yannick, we now welcome your questions.

[Operator Instructions] And your first question comes from the line of George Zhao from Bernstein.

I guess first is on the margins. The financial valuation I think that implies close to 30% margins. Are there unique commercial contract types that has allowed this business to generate that level of margins and how sustainable is that going forward? And second one on the top line regarding this double-digit medium-term growth. How do you think of that in terms of the market growth versus your share gain versus new products? Because certainly we're in an environment where, as you said, we're seeing ramp-up in OE production, aftermarket growth already in the market. So how do you distinguish that versus I guess the growth premium you expect in this business?

Okay. George, maybe I will start with your first question and then leave the floor to Yannick to complement and maybe to discuss about any top line growth. And we mentioned getting market share and why we believe that this business will grow a bit quicker than the market. So I guess, George, that you run the math and I guess your assessment of profitability is clearly correct. What we need to have in mind is that AeroComms really have developed a state-of-the-art and unique type of products with quite a strong position at key audience. So it's really the unique situations in terms of products that allows also this type of margin, first point. Second point, what is also quite important to consider and this is presented, I guess it's on Page 3 of the presentation. You will notice that the aftermarket and retrofit proportions is quite significant representing almost 50% of AeroComms. And as we highlighted and as we all know, of course level of margin on aftermarket and retrofit is significantly above what it is on linefits. So this is really what is underpinning this quite favorable level of profitability, which we do believe is sustainable here again driven by new products that have been developed in the last few years both on high bandwidth Satcom, but also on the digital radio and audio. Maybe Yannick will comment a bit about the development of those 2 new products that are really quite unique in terms of their positioning as compared to the overall competition. Yannick, maybe on this point?

Yes. So to complement what Pascal said. First of all, the sales today of AeroComms is based on one, their legacy product that they produce for linefit and they maintain them. And recently they introduced those 2 new products that I described, the Satcom the L-Band Inmarsat Satcom and DRAIMS, and progressively those 2 products are going to replace the legacy product. So that's one. And they have better margin on those new products than they had on the former one. That's one explanation of the sustainability of this margin. The other one is that on Satcom and you see it again on Slide 3, you see that the Satcom is only today 30% of their sales. That share is going to increase vastly because today, as I said, certainly a small percentage of airplanes that are equipped with high bandwidth communication equipment and we see it coming on line fit. There is more and more airlines that ask for Satcom communication on their new airplane. And in addition when usually they ask for communication in their new airplane, they are going to want to retrofit their legacy fleet. So there is a huge potential of retrofit of fleet of airplanes with this Satcom product. So really you'll see the share of Satcom growing in the coming years and it so happened that they have also better margin on the Satcom itself and the audiocom. So that's really the reason why it is very dynamic in terms of growth potential and that's why we believe as well that their current very attractive EBIT profile can be sustained in the future.

Maybe to complement, George, if you allow. On top of this overall positioning with the right products, it's also the fact that clearly AeroComms is a well-managed business. They managed to drop their overall cost structure in particular throughout the COVID '19 crisis. They have put in place quite a significant optimization of their industrial footprint and it's clear that as they see -- and this has really started. Maybe we mentioned that the level of revenue in 2023 is expected to be above the pre-COVID level. So they are now taking advantage of this overall leverage effect with low cost and taking advantage of quite a strong top line revenue. So this also explains this level of margin. In terms of superior level of growth, I guess Yannick started to mention at this point with in particular the Satcom and also some developments also driven by this changing regulations that opens the door for increase of Satcom solutions on airplanes. So overall, yes, we do believe that this superior level of costs reflects the quality of the portfolio and this level of margin reflects both this unique positioning from a product standpoint, but also the aftermarket component and also the overall cost structure of AeroComms, which has been well streamlined in the recent past.

And your next question comes from the line of Tristan Sanson from BNP Paribas.

Congrats for the deal. A few on my side. Can you first talk about the track record of execution and supply chain management at AeroComms? Is there anything we should focus on in the first stages of integration on this point? Second one, can you tell us a bit more about the track record on top line generation especially what was the pattern of revenues generation throughout the crisis? How much did it drop? How fast did it recover? How cyclical was it? And when you're talking about double digit going forward, double digit can be anything from 11% to 99%. So are we talking about more like 10%, 12% or 15%, 20% or what's the type of that? And maybe third one would be are the technology synergies that you're seeing for the Thales Group beyond cockpit avionics?

Okay. I'll start with the supply chain question if I may. There is a difference between Avionics as it stands today and then the fact that they are much more vertically integrated. We are not as vertically integrated as they are and clearly we had less visibility on the inventories that our Tier 1 had an electronic components that they have themselves because they are procuring direct because they are building everything either in France or in South Africa including the printed circuit board they make themselves. So this is coming much earlier and they managed it very well to such a point that they had no major untimed delivery performance during the worst of the component crisis for us, which was let's say end of '21 to mid '22, which was really the period in which we had many decommitments from all the component manufacturers. But they had inventory prior to that period and therefore, they were able to navigate that period of 6 to 10 months, which was really bad for all the electronic manufacturers. They were able to navigate it much better than we did. And clearly today, the fact that they are very vertically integrated helps tremendously both the management of their supply chain which is not as deep as ours, but also their cost I must say as well. So clearly it's value-added. Do you want to answer the...?

Yes. About the sales portfolio, Tristan. So yes, of course AeroComms as all aerospace companies have been affected by the crisis, but this being a very temporary impact. When you look at their top line profile, 2020 was around 20% below pre-COVID level or below 2019. But in 2022 they have already fully recovered, which is good. So 2022 very close to the pre-COVID level in terms of top line showing how quick they managed to get this level of rebound. And we expect 2023 to be probably double digits above pre-COVID level. So you see a level of impact for the cost, which has been quite modest and quite a swift recovery in terms of top line and today a level of 2023 expected to be significantly above pre-COVID level. Now going forward and for the reason that Yannick mentioned, we are quite positive. So what does it mean in the next few years? I would consider that a low teens to mid-teens target is basically what we might have in mind for the next few years, which you see is pretty good and which is above market trend on this matter.

And another question on further product synergies. Clearly I described the main synergy and really the fact that our product lines are very complementary between what we do in Avionics and what they do in communication and connection of the cockpit, cybersecure communication of the cockpit. So we have synergies of sale associating the 2 programs. We have synergies of cost because, as you know, moving forward to have secured info going to a connected cockpit, you will have to have redundancy in the communication. So in the years to come, probably it will be a dual Satcom that will be needed both Iridium and Inmarsat to cover the entire earth. And clearly we see synergies since on our side, we have further progressed on the Iridium Satcom and we have further progressed and already producing Inmarsat Satcom, which is why they were ahead of everybody in the market and they pick as a consequence a good market share. But to come clearly, this communication channel would have to be redundant and this is where there is a lot of synergy because there we are starting an Iridium development so there's a lot of synergy there. Do I see further synergies? Clearly we didn't look at what it could give in the cabin. And will there be one day communication for the airplane globally, cabin plus cockpit? It's a big question mark, Tristan, because of the safety matter of the cockpit communication. But clearly a future that we need to watch of course.

Okay. That's fair. But you're not talking about like synergies with the rest of the group's portfolio like Thales Alenia Space or the defense business and after all those years they can commit?

Clearly the connectivity expertise is also very important as well for all our defense businesses. Clearly they are specialized in airborne system and therefore it's probably more towards our defense business on airplane rather than on-ground equipment that there is also synergy with the rest of Thales. And the synergy with Thales Alenia Space is already something that we are taking benefit already in Avionic and they will benefit from that clearly. Having a link with satellite business is useful when you talk about Satcom connectivity.

And your next question comes from the line of Ben Heelan from Bank of America.

I wanted to ask a couple. Firstly, who do you think of as the big competitors in this space? Is it Honeywell or are there other people that we need to be thinking about? Secondly, do you think or do you foresee any potential risks from a regulatory process just that you're going into that process quite confident that you're not going to need to make any remedies, et cetera? And I think Pascal, for my third question, you mentioned for the revenue synergies, I think you said around half by 2027. That seems to be quite a significant digestion period. So why are you not able to cross-sell aftermarket, upsell aftermarket, leverage the product from a revenue synergy perspective earlier than 2027?

Okay. Maybe I will let Yannick answer the first ones and I will answer the last one.

The main player in this arena is Collins so actually it's not Honeywell. It's Collins that have -- Collins, I don't know if you recall, but has acquired ARINC as you said in the U.S. like 10 or 12 years ago and they started the communication on ARINC standard -- the cockpit communication on ARINC standard that was very low band. But they are in this field since the acquisition of ARINC. When the era of satellite communication started, of course Collins looked at it and clearly decided to invest in the Satcom and they are developing an Iridium Satcom module right now as we speak. It so happened that AeroComms took a position earlier than Collins, but Collins is the main competitor in that type of communication today.

On regulatory issue, at this point we don't see anything specific in this matter, Ben, and of course we have to be a bit cautious. But nothing specific to report on this aspect.

And maybe to add, the reason why we are not seeing any big hurdle is that today our sales and we need little sale on Satcom equipment because we were in the process of developing our equipment, but we have no significant sales today in that arena. So clearly we don't see any major hurdle because we are not very present today on the Thales side.

Now on the revenue synergies, yes, my message was that it was more back loaded than front loaded. And so that when we discuss about synergies, of course we are very clear maybe on the short term on the cost synergies because it's a bit easier. And of course as any acquisitions and I guess that we have demonstrated our ability to get cost synergies on previous transactions, of course there is no issue in this matter. Hence I mentioned that by the end of 2026, we'll have executed virtually all our cost synergies. This on the assumption that closing will take place in H1 2024. Now revenue synergy, of course we are always a bit more cautious. Of course we'll not wait until 2027 by definition. Now what you also need to do is that we will of course develop cross-selling, upselling as quickly as possible and this will start quite quickly. It's more about when it comes to going to the market with combined offering where it takes of course a bit more time. So yes, we might be a bit cautious in terms of timetable for revenue synergies. But once again it's not just in our hands, it's also product development, it's also relationship with customers and the fact that I guess it makes sense for us to be a bit on the safe side on this matter, Ben.