New Fiscalism Investment Outlook - Akshay Agashe

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The Structural Trap:

Investment Outlook – Rebirth of

Fiscalism, Defense & Infrastructure

Akshay Agashe

[email protected]

(203) 364 7844

7/4/2016 1

mailto:[email protected]

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Table of Contents

Structural Trap Slide

Definitions and Japan Lost Decade 3-7

Potential Traps: US and EU 8-13

Global Structural Trap Convergence 14-16

Historical Policy Response 17-23

New Fiscalism

Definition and Capacity 24-26

Defense Needs 27-34

Probable Outcome - Defense & Infrastructure 35-36

Investment Case

Defense Industry Traditional & Evolving View 37-38

Cubic Corporation (NYSE:CUB) 39-51

CUB Valuation 52-64

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Structural Trap: Definitions

• Condition defined by Angel Ubide and Robert Dugger where capital is unable to flow from

unproductive to productive uses due to external obstruction, principally politics.

• Unlike a liquidity trap, a structural trap cannot be resolved through singular monetary or fiscal

policy given both proximity to the zero bound (fear of inducing deflationary expectations) and

political limitations on policy adoption.

• Classic example is Japanese Lost Decade (1990s). Combination of low asset yields, corporate

loyalty culture/accrued liabilities, aging demographic, and banking system moral hazard led to

“run-rate” of low growth and fiscal tightening despite enormous monetary stimulus.

• Long term consequences are still felt over 20 years later: disinflation/deflation, lower fertility

rate/demographic tightening, shorter business cycles, inability to ease fiscal policy.

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Structural Trap: Japanese Lost Decade

• Following the 1985 Plaza Accord, GDP growth slowed as the JPY appreciated, forcing the BOJ to aggressively cut its policy rate. As a result M2 surged, feeding an asset price bubble which burst in 1989 as the BOJ attempted to again tighten policy.

• Japanese corporate culture “hourensou” promises high salaries, secure employment, retirement benefits/healthcare. Political incentive to monetize bad debt created “zombie” companies.

• SOE banks were overwhelmed by bad loans, but forced to continue lending in order to maintain low unemployment and make full commitment to employees of large zombie corporations. Zombies crowded out new investment and inefficiently absorbed tax revenue.

• Combination of aging population and senior-friendly politicians increased systemic moral hazard exacerbating misallocation of capital. Politicians promised to maintain status quo in order to win aging electorate, providing bankers reprieve for poor underwriting practices.

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Structural Trap: Japan Ancillary Effects • Corporations respond to lower profitability by reducing annual wage increases, automation, and

outsourcing.

• Aggressive monetary policy satisfied goal of decreasing household savings rates, but could not maintain proportionality via real wage growth.

• Net effect is declining savings rate without proportional shift in private consumption expenditure.

• Long term demographic effects compound problem. Low growth, fiscal tightening, and declining real wages slow down marriage and decrease child births (parasitic single), avenues for explosive growth decrease and economy assumes “run-rate” at low rate of unemployment.

• Business cycles become shorter (JP has averaged 2 consequent quarters of negative GDP growth every 3 years since 1990 vs. every 9 years for US).

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Structural Trap: Warning Signs

• Most evident signs of a structural trap are (1) declining fertility (2) declining bond yields (3) rising

current tax burden (% of GDP) (4) near zero bound benchmark interest rate.

• Given lower output and rising current government liabilities, the central bank is forced to ease

monetary policy until marginal return turns negative.

• Failure of BOJ monetary policy is reaching peak levels currently as even negative interest rates

cannot spur further investor risk rotation, and terms of trade easing from 2014 QQE ll has been

almost entirely wiped out. Despite expanding the monetary base by 20T Yen, the USDJPY is

nearly unchanged since the start of QQE ll.

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2015

Total BOJ Assets vs USDJPY

BOJ Balance Sheet: Total Assets (%YoY, LHS)

USDJPY (RHS)

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Structural Trap: Other Developed Markets

• Japan’s structural trap is already reaching point of societal capitulation, as demographic effects

are 20 years old. The question is whether similar conditions exist elsewhere in the world.

• Both the United States and EU show similar behavior to Japan: declining fertility, falling bond

yields, rising current tax burden (% of GDP), and near zero policy rates respectively.

• Framework is slightly different, but structural problems already well known:

• US: Rising structural unemployment via automation/outsourcing, growing income inequality.

Reduced government demand impulse via steady state expenditures.

• EU: monetary union without fiscal union led sovereign asset/liability mismatch. Monetary

policy limited because asymmetric competitive advantage via terms of trade easing.

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Potential Structural Trap: United States

• The US population is aging with a massive liability balloon coming due and the effect can be

seen via rising total value of social security, medicare, medicaid, and interest on debt as a

percent of current government expenditures (62% of total as of 10/2015).

• Government expenditure as a percent of GDP has remained constant despite declining real GDP

growth over the last 20 years and rising tax revenues as a percentage of GDP (previous slide).

• Implication is marginal return per USD spent continues to decline while gross expenditure rises.

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Source: Federal Reserve

US Federal Current Government Expenditure Composition

Total SS, MC, Interest( % Gov Expenditure, LHS)

Total Current Government Expenditure (RHS)

Total SS, MC, Interest (RHS)

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US Federal Government Reaction Function

Nominal GDP (%YoY, SA)

Real GDP (%YoY, SA)

Government Total Expenditure (% GDP)

50 per. Mov. Avg. (Government Total Expenditure (% GDP))

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Potential Structural Trap: United States

• US government expenditure paralysis is largely explained by surging fiscal liabilities coming due over the next 10 years without a proportional proximate source of revenues.

• The total US 75+ population is due to grow by 15 million, or 108% increase over a 10 year span.

• Assuming Medicare and Medicaid expenses at $11,250 and $1425 respectively annually, and average social security monthly payments between $850 and $1400 per month, we arrive at a 10 year expenditure requirement of an additional $322B to $422B annually. This would imply a 5.3% to 7% rise in total expenditures from 2016 or an additional 2% to 2.3% of 2015 GDP.

• In reality the total burden will be larger as this cost excludes rising life expectancy and caps program usage at age 90. Public pensions and interest on additional debt required are also excluded from this calculation.

• This process is consistent with the Japan structural trap story. Governments give away more when the going is good, and cant walk away from promises when conditions weaken and the US is no different.

108%

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Source: National Census, Kaiser Family Foundation

Peo

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Age

10 Year Demographic Shift

Population (RHS) %Change (LHS)

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Potential Structural Trap: EU

• The EU faces a more severe and accelerated version of the potential US structural trap,

combining effects of demographic tightening, entitlement spending, and widespread and

prolonged government monetization of declining labor conditions.

• While the US may be anticipating a surge in benefit spending over the next 10 years, the EU like

Japan is several years ahead (5 years) given the median age of its population, and the

fundamental lack of competitiveness across the economic periphery due to shared currency.

• Median age in EU: ~42 years old, United States: ~38 years old, Japan: ~47 years old

20%

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2006 2007 2008 2009 2010 2011 2012 2013

Source: Eurostat

Government Social Benefits (% of GDP)

European Union (15 countries) Germany (until 1990 former territory of the FRG)

France United Kingdom

Greece Spain

Italy Portugal

5%

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11%

13%

15%

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Eurostat, Federal Reserve. Note: Excludes public pension liabilities, allocated interest on debt

Government Social Benefits (% of GDP)

EU US

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Potential Structural Trap: EU • Fiscal independence with shared monetary policy has allowed less competitive states to slowly

monetize declining labor conditions via the issuance of government debt as output receded.

• Debt concealed underlying causes (converging global skill gap, declining cost advantage) and

allowed nations such as Germany to cement leader status as budget surplus was achieved.

• Since 2011 the ECB, in combination with economically stronger member states, has spent more

than 1.5T Euros to recapitalize crippled banks across the Euro periphery which held exposure to

doomed “cross-linked “ sovereign debt as individual periphery fiscal burdens became

unbearable.

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Potential Structural Trap: EU • Monetization of weak labor markets also includes Japan and US-like social spending programs

particularly within the weakest growth periphery and oldest median age nations.

• The oldest populations in Europe are two of the four largest economies, Germany and Italy,

creating a rapid need for future productive labor replacement.

• Programs are unable to guarantee quality work as household work intensity has been

declining on a per capita basis since the global financial crisis .

• The decline has been particularly severe among periphery states which were the principal

benefactors of bank bailouts and theoretical recipients of ECB monetary policy.

0%

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14%

16%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Eurostat

People Living in Households with Very Low Work Intensity

EU (27 countries) Greece

Spain Portugal

Cyprus Italy

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Potential Structural Trap: EU • Monetary policy is incapable of providing true demand impulse due to shared currency.

• While aggressive monetary easing, QE, and credit easing have helped support EU terms of

trade via EUR depreciation, export growth has remained asymmetric across the union.

• Leaders such as Germany disproportionately absorb currency effects for majority of trade which

is internal within the EU. As of 2014, 65% of German exports, 54% of Greek exports, 70% of

Portuguese exports were contained within EU reducing the effect of terms of trade (ToT) easing.

• Given that leaders have higher median household wealth, ToT easing effect on output is also

asymmetric as Germany gains less on a marginal basis than Greece but absorbs a significant

share of competitiveness.

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Global Structural Trap Convergence

• The full extent of the structural trap can be seen via impairment of the younger able bodied generation. As fiscal liabilities grow and GDP remains at an anemic run-rate, we see a Japan-like deflation of real wages especially in demographics where labor is expendable – young and unskilled/blue collar.

• While there is some cultural distortion in comparing separate regions, it is evident that countries with deeper budget deficits and high rates of government monetization have larger percent of young adults living with their parents – e.g. Italy (46.6%), Spain (37.3%), Portugal (44.5%), Greece (51.5%). While US rate (15%) is lower versus the EU, it has soared since 2005.

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• The structural trap is potentially a global phenomenon motivated by declining competitive advantage, demographic tightening, and related fiscal accrued liabilities.

• The oldest regions in the world are those with the highest annual GDP, and the cross correlated nature of global trade creates a perpetually lower growth environment as labor productivity continues to decline.

• If external demand withers (as it did following the commodity collapse in 2014), developed economies are left with a shortage of risk adjusted yielding assets.

• Note that both labor productivity and CPI have converged across key developed markets (US, EU, Japan) since the global financial crisis.

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Source: IMF

Developed Market CPI (monthly, YoY%)

France Germany United States United Kingdom

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• An enormous amount of government bonds currently trade at negative yields, indicating

a shortage of risk adjusted nominal returns.

• Historically bond volatility has been greater than equity market volatility, but this relationship has

been shifting over the last 8 years.

• This relationship is highly reflexive, that is, a surge in equity volatility leads to greater behavioral

shift towards risk adjustment, furthering shortage of returns.

• As developed government liabilities continue to surge as a function of the evolving structural

trap, it becomes progressively more difficult to tolerate volatility.

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Historical Reaction Function - Policy

• Given that Japan’s structural trap began nearly two decades earlier, the roadmap solution

has followed the Japanese government and the BOJ.

• Both the ECB and Federal Reserve applied BOJ precedent following the global financial crisis,

and began prolonged turns of asset monetization. There have been several effects:

• (1) Given lower bond yields, opportunity cost favors investing in riskier equities domestically

and even riskier equities in higher growth emerging markets.

• (2) Lower borrowing costs make riskier asset yields more stable, as borrowers are ensured

of capital availability and face lower debt service ratios.

• (3) Central bank monetization of assets should rapidly expand the monetary base and lead a

surge in broader money via the money multiplier effect.

• All 3 effects have been proven true up until a Japan-like inflection point in marginal value

of a unit of easing.

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Central Bank Assets

Federal Reserve: Total Assets (millions of USD)

Bank of Japan: Total Assets (100 millions JPY)

Central Bank Assets for Euro Area (11-19 countries, millions of EUR)

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Historical Reaction Function - Policy:

(1) Opportunity Cost Driven Yield Seeking • Yield seeking has occurred throughout the post-GFC period. Earnings yield over 10 year

treasuries has remained at high levels even after accounting for valuation effects. Emerging markets, which offer higher yields, saw a surge in capital inflows following the start of US QE 1.

• Inflection point:

• Yield seeking is a reflexive behavior based on perpetual growth rates and payouts. What we saw in 2015 was that a surge in cross asset vol – especially related to key economic industries – can immediately compromise real yield and lead to sharp capital outflows as was the case in EM and DM stock markets. Note the swift decline in EM equities with MSCI EM GDP-linked index.

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(2) Greater capital stability and availability • Capital intensive yielding assets such as REITs, MLPs, and high yield bonds have also

massively outperformed.

• This has largely been due to declines in cost of capital versus stable cashflow from operations,

allowing these entities to aggressively return capital to riskier tiers within the capital structure.

• Given lower rates, debt service ratios for these entities declined drastically allowing for pass-

through to higher risk operating partners. This was especially common in owner/operator REITs

and MLPs (note persistent and steep payout acceleration through period).

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(2) Greater capital stability and availability • Inflection Point:

• Credit oriented products can be overwhelmed simply by rising fear of credit risk, not mere physical rise in yields related to inflation. In the case of MLPs, the same decline in oil which damaged EM growth collapsed the yield passthrough structure as can be seen via the KMI dividend cut (previous slide).

• Note the decline in REIT Total Market Index along with rising HY OAS, despite rising payouts to equity holders in late 2015 through early 2016.

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Wilshire REIT Index vs. BAML HY OAS

Wilshire US REIT Total Market Index (YoY%, NSA, LHS)

BAML US HY OAS (%, NSA, RHS)

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(3) Broad Money Expansion • Broad money (M2) has expanded as expected along with monetary base (M0).

• Inflection Point:

• Money supply velocity has continued to decline suggesting that marginal output created per unit of broad money is seeing diminishing returns.

• Low interest rates reduce both bank NIMs and deposit rates due to yield seeking behavior. When charted, broad money (M2) expansion versus the monetary base (M0), it is unclear if exogenous money supply can create credit endogenously (bank loans vs depositors). This also suggests that broad money distribution is asymmetric across income class.

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Historical Reaction Function: Ancillary Behavioral Effects

• Structural traps also tend to incense serious behavioral changes within populations.

• (1) Political Extremism

• As countries battle one another for yield and resulting globalization leads to converging skill

levels across the world, many millions of people are left facing declining real wages and/or

structural unemployment.

• Brexit, Syriza, Podemos, Sanders, Trump, Le Pen are all extensions of outrage of lost

demographics.

• (2) Nationalism

• Declining asset yields lead to surge in self identity and nativism. Governments can incense

by attempting to localize goods/services and decrease imported inflation.

• (3) Militarism

• Yield seeking can turn aggressive as it has in the past centuries. Scarcity of resources

combined with growing nativism is fodder for conflict, and has precedent for many wars.

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Historical Reaction Function Summary

• (1) While the goals of aggressive monetary easing are achieved in name, the net effect is largely

mixed when economies are unable to achieve escape velocity growth rates.

• (2) Problems with primary yield seeking arise when either exogenous or endogenous factors

reduce the marginal value of a unit of monetary easing.

• (3) External yield seeking feeds capital systemically to lower and lower base economies and

industries, often leading to a palatable surge in credit risk.

• (4) Expansion of money supply stock does not mean proportional rates of return or symmetrical

provisions to all borrowers irrespective of income class.

• (5) Populations who are unable to understand causation trend towards more extreme ideologies

and less predictable behaviors which can lead extreme events.

• (6) Ultimately, policymakers have relied far too much on monetary policy to stimulate

structural trapped economies (following the failed Japan blueprint).

• Central banks have become cognizant of this reality:

• The ECB and Fed have resisted NIRP after seeing the near term outcome in Japan.

• Cross market correlation/ global risk has become a shadow mandate, mentioned in Federal

Reserve, ECB, and BOJ minutes despite bearing no direct relation to mandate.

• New rules from the US Treasury seek to limit capabilities of foreign Central Banks to transact

in domestic US financial assets and FX (given large bilateral trade) and thereby spreading

deflationary policy. Treasury Policy Change Guide.

• Alternatives must be considered to break the existing econopolitical structure, and

Japan is beginning to engage the new paradigm. It is my belief that the rest of the

world will follow, and that this will be the key investable theme of the next 3 years.

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https://www.treasury.gov/resource-center/international/exchange-rate-policies/Documents/2016-4-29 (FX Pol of Major Trade Partner)_final.pdf

https://www.treasury.gov/resource-center/international/exchange-rate-policies/Documents/2016-4-29 (FX Pol of Major Trade Partner)_final.pdf

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Forward Path – New Fiscalism

• Japan was the 1st true modern structural trap and has experienced the hardest condition

economically. As it capitulates to the reality of the structural trap and shies away from

monetary policy, so will the rest of the world.

• Abe has shifted his focus towards a social and fiscal policy program called Ichi-oku So-

Katsuyaka (All 100 Million Taking Active Parts) Initiative.

• Program aims to boost nominal GDP by 20% by focusing on demographic tightening by

increasing labor force participation and fertility rates.

• Since announcement, JPY strength forced Abe to backtrack on the VAT hike, delaying the

program 2 additional years. The government spending side is moving ahead, as Abe seeks a 5-

10T Yen supplemental budget after next month’s Upper House elections.

• BOJ likely to shift towards defense of JGB market to both appease fiscal hawks and maximize

efficient of fiscal easing, but otherwise pull back from maverick policies of last 3 years.

• Goal is to replicate 1950s US fiscal/monetary coordination and Abe advisor Etsuro Honda has

hinted at this detail.

• Abe has made no mention of monetary policy of the BOJ in his campaign platform for next

month’s election. A majority win for the LDP coalition will set stage for substantive shift to fiscal

policy with monetary policy playing role of safeguard against higher public debt burden.

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How Feasible is a Fiscal Revival? - Capacity

• Japan’s primary obstacle is the extremely late stage of fiscal intervention. Given recent JPY volatility, it is unclear if Japan still has the full benefit of seigniorage (profit made by the government by issuing currency). This is not the case in the US.

• Government debt to GDP may appear high, but a large amount is held by the Fed (note government debt net of Fed holdings sits at 71.2% of GDP). Coupons payments have been remitted to the Treasury throughout the period.

• The US is 10 years behind Japan in demographic tightening and also has the advantage of the world’s reserve currency (lower FX volatility), smaller debt balance (%GDP), and an unwinding central bank balance sheet ($200B due to mature in 1 year which is 5% of total holdings).

• As holdings mature, the US government can issue new longer term debt (at lower rates) put towards productive purposes.

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12/2

004

12/2

005

12/2

006

12/2

007

12/2

008

12/2

009

12/2

010

12/2

011

12/2

012

12/2

013

12/2

014

12/2

015

Mil

lio

ns


Federal Reserve Holdings Maturing in 1yr

% of Total Core Holdings Maturing <1yr (UST, Agency, MBS)

Core Fed Holdings (UST, Agency, MBS)

40%

50%

60%

70%

80%

90%

100%

01/2

003

08/2

003

03/2

004

10/2

004

05/2

005

12/2

005

07/2

006

02/2

007

09/2

007

04/2

008

11/2

008

06/2

009

01/2

010

08/2

010

03/2

011

10/2

011

05/2

012

12/2

012

07/2

013

02/2

014

09/2

014

04/2

015


Federal Reserve Holdings

US Government Debt (%GDP, net of Fed Holdings)

US Government Debt (%GDP)

25

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How Feasible is a Fiscal Revival? - Capacity

• On a nominal basis, US and Euro Area government sector debt is roughly 120% smaller than

Japan as a percent of GDP.

• In a vacuum (assuming no governmental obstacles, constant GDP, constant exchange

rates), this would imply that the US and Euro Area has roughly $22T and $13T in

additional capacity respectively.

• While it is arguable that Brexit increases the risk to further Euro Area leverage, the implication is

not the same for the USD where monetary tightening has already begun and the USD has

remained stronger.

0%

50%

100%

150%

200%

250%

03/2

005

06/2

005

09/2

005

12/2

005

03/2

006

06/2

006

09/2

006

12/2

006

03/2

007

06/2

007

09/2

007

12/2

007

03/2

008

06/2

008

09/2

008

12/2

008

03/2

009

06/2

009

09/2

009

12/2

009

03/2

010

06/2

010

09/2

010

12/2

010

03/2

011

06/2

011

09/2

011

12/2

011

03/2

012

06/2

012

09/2

012

12/2

012

03/2

013

06/2

013

09/2

013

12/2

013

03/2

014

06/2

014

09/2

014

12/2

014

03/2

015

06/2

015

Source: BIS

Total Credit to the Government Sector at Market Value (core debt, %GDP)

Euro area Japan United States

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How Feasible is Fiscalism? – Defense Needs • The need for infrastructure and military revitalization is glaring, and makes it easier for

the US Federal government to justify additional budget allocations.

• These needs are exaggerated by non-policy reactions to the global structural trap, especially the

pyramid of lower base lending.

• As yields decline internally, money flows outwards increasing competition for scarce yielding

assets (note the financial account flip in net liabilities for RU and CN).

• While the US and EU have responded to structural traps by cutting defense expenditures,

Russia and China have increase expenditures exponentially.

• In 2015, for the first time, total CN and RU defense expenditures exceeded those of the EU.

$-

$100

$200

$300

$400

$500

$600

$700

$800

$-

$50

$100

$150

$200

$250

$300

$350

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Bil

lio

ns

Bil

lio

ns

Source: Worldbank, *2015 extrapolated from YoY change in respective USD exchange rates

Military Spending By Region (Constant 2014 USD)

EUU (LHS) CHN/RUS (LHS) USA (RHS)

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How Feasible is Fiscalism? – Defense Needs • Both the US and EU defense expenditures sit near the respective “lines in the sand”.

• Current US defense secretary Ash Carter, an Obama appointed foreign policy dove, suggested

on numerous occasions that US defense expenditure can be no lower than 4% as a percent of

GDP. The US currently sits precariously above this level (4.11% as of Q1 2015).

• Despite a NATO suggestion of a 2% of GDP target for military expenditure, only 5 of the 28

countries achieved this target in 2015. 2 out of the 5 were eastern European countries (Poland,

Estonia) which cleared the threshold in 2015 directly in response to RU aggression.

• Germany, the largest economy in Europe sits at defense expenditures less than 1.5% of GDP.

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1947

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013


Gross Defense Expenditures (% of GDP)

United States European Union

Ash Carter Line-in-Sand

0%

1%

2%

3%

4%

5%

6%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Source: Worldbank

Military Expenditures (% of GDP)

EUU GBR FRA

DEU ITA USA (RHS)

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How Feasible is Fiscalism? – Defense Needs

• As yields decline domestically, capital flows outwards searching for new opportunities. Capital flows from slowing emerging markets do not necessarily find themselves in “friendly” hands.

• Between 2005 and 2015, China has quietly invested $482B in countries generally viewed as politically incompatible or explicit enemies of the US and EU.

• While this number may seem small in context of China’s gross financial account, it is massive in terms of local GDP. For example, Chinese investment in Zimbabwe over 10 years totaled roughly 13.5% of GDP over the same period. In December 2015, Zimbabwe officially adopted the RMB as legal tender.

• China is quietly building a sphere of geopolitical influence buttressing its declining asset yields and domestic M2 surge. Majority of total investment has been concentrated in resource and transportation sectors.

• Investment in capital starved proliferated states like Pakistan gives China the ability to both import and collateralize growth and control geopolitical narrative e.g. its “legitimate” claim to Indian territory.

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

Qata

r

Om

an

Sa

udi A

rabia

Tu

rkey

Ve

nezuela

Bra

zil

Iran

UA

E

Qata

r

Sri L

anka

Nig

eria

Ye

men

Pa

kis

tan

Ku

wait

Eg

ypt

Uzb

ekis

tan

Iraq

Lib

ya

Mo

rocco

Su

dan

Ukra

ine

Zim

babw

e

Ecuador

Pe

ru

Arg

entin

a

Cuba

Syria

Kyrg

yzsta

n

So

uth

Suda

n

Bo

livia

Rw

and

a

Uganda

Afg

hanis

tan

Nort

h K

ore

a

Source: AEI

China Gross Investment, Construction Loans, Distressed Purchases Abroad

Metals, Transport, Energy, Agriculture (% of Total, RHS) % GDP (10 yr total, LHS)

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How Feasible is Fiscalism? – Defense Needs

• Chinese incursion into and around disputed territories has surged over the last 5 years. The most well known examples are military exercises conducted in the South China Sea and along the Indian border in Arunachal Pradesh.

• Given historical animosity between India and Pakistan, China’s CPEC investment in Pakistan is seen as a geopolitical maneuver to solidify its claim on Indian territory.

• As a consequence, Chinese capital outflows have carried the ancillary effect of tracking a surge in nuclear proliferation within the region and North Korea.

Gross Nuclear Warhead Stock; EM ex RU

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How Feasible is Fiscalism? – Defense Needs • Other hotbed regions such as MENA and South America have also seen an uptick in

nationalism and ethnocentrism . In my 2016 Global Macro Outlook I argued that commodity

prices would pressure frontier economies with smaller FX reserve accounts, greater SOE driven

government revenues, and poor economic diversity such as Angola, Nigeria, Venezuela, French

Speaking Central Africa, and Ecuador prior to big names – KSA, Russia, large OPEC.

• As the limits of government monetization wane, countries such as Venezuela and Nigeria have

seen a significant uptick in social unrest and violence.

• KSA economic weakness and unwillingness to cooperate with the US has led a massive

hegemony shift with the US opening up relations with Iran and each country threatening to

expose the others’ political truths (9/11 funding etc.) to the general population.

• Unsurprisingly Israel/US relations have also weakened, and IS has further expanded nuclear

stock (prior slide).

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How Feasible is Fiscalism? – Defense Needs • According to the Heritage Foundation 2016 Index of US Military Strength, threats to the

US and its allies have both become more behaviorally volatile as well as gaining capacity

to do damage over a 1 year span between 2014 and 2015.

2014 2015

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How Feasible is Fiscalism? – Defense Needs • Unlike in the past, nuclear proliferation in rogue states combined with the snowball effect of

radicalism has left the west and its allies unable to combat threats in direct military fashion.

• For example, both Osama Bin Laden and Ahktar Mansour were killed via special operations in

Pakistan without knowledge of the local government.

• Just as the structurally trapped developed markets have seen the development of radical

ideologies, emerging and frontier markets facing a void of leadership have seen similar effects.

• Global terrorism incidents and intensity of violence have also risen exponentially,

mirroring nuclear stockpiles, EM yield seek, and CN/RU military expenditures.

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How Feasible is Fiscalism? – Defense Needs • Historically, the developed world has answered declining yields and unit labor cost arbitrage

conditions through the military industrial complex – destruction of productive capacity.

• In this case, however, recent maneuvers such as the Arab Spring have only fed the reflexive

loop of radicalism and consequently the fear of imported terrorism and conflict.

• Surging migration and related incidents have provided global governments the impulse to

both upgrade but also integrate defense and infrastructure technologies and services.

• For example brand new fighter jets will not prevent an urban terror attack, but better

intelligence / infrastructure data processing will.

Source: Goldman Sachs

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How Feasible is Fiscalism? – Probable Outcome Defense • Public opinion of government military consumption and investment expenditure in the US has

revitalized +15% since 2011.

• Actual expenditure is highly elastic to public opinion. Actual spending has diverged greatly from

model implied forward 3 year expenditures over Obama presidency to record wide.

• Relationship implies either surge in future military spending over 2017 – 2019, or further political

disenfranchisement of frustrated structurally trapped demographics.

• The last time Gallup Opinion suggested >37% support for additional spending (2000),

defense spending grew 37% over the next 3 years, or 11% annualized. In 1981 with public

opinion at 51% in support of additional spending, defense spending grew by 44% over the

next 3 years.

0%

10%

20%

30%

40%

50%

60%

1967

1970

1972

1974

1976

1978

1980

1983

1985

1987

1989

1991

1993

1996

1998

2000

2002

2004

2006

2009

2011

2013

2015

Gallup Opinion - Military and Defense Spending

Too Little About Right Too Much No opinion

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1967

1970

1972

1974

1976

1979

1981

1983

1985

1988

1990

1992

1994

1997

1999

2001

2003

2006

2008

2010

2012

2015

Gallup Public Opinion: 3yr Leading Indicator of Actual Military Consumption and Investment

Expenditure

Forward 3yr % Change in Government Defense Investment &Consumption Expenditure

Too Little Military Spending (Gallup Opinion)

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How Feasible is Fiscalism? – Probable Outcome

Infrastructure • Infrastructure investment needs are glaring and less partisan.

• 2016 ASCE report indicates that surface transportation is $1.1T underfunded through 2025, and

$4.3T underfunded through 2040. See full infrastructure report card here: ASCE Report Card

• Implies a loss of $1.2T of GDP over next 9 years, and a reduction of 1.1 million jobs by 2025

• Given growing defense needs, it is highly likely that infrastructure improvements will carry a

weight on surveillance.

• While sequestration in 2011 capped both military spending and other discretionary spending,

it is likely a military revitalization could incense other infrastructure spending.

• Both Hillary Clinton and Donald Trump share hawkish tone on military and a desire to rebuild

US infrastructure, suggesting that bipartisan policy may be possible.

• Given “new fiscalism” electoral pressure will prioritize defense and core

infrastructure investments

36

http://www.infrastructurereportcard.org/wp-content/uploads/2016/05/2016-FTA-Report-Close-the-Gap.pdf

http://www.infrastructurereportcard.org/wp-content/uploads/2016/05/2016-FTA-Report-Close-the-Gap.pdf

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Defense Industry – Traditional View

Traditional View

• Defense contractors composed of three primary categories: fixed assets, personnel, and service providers. Largest contractors offer diversified blend of categories.

• Monopsonistic industry driven by large government buyers (primarily US, UK and select allies). Contractors reply to local and federal RFPs, or foreign governments through DoD foreign military sales program (FMS).US Government defines military expenditures as part of discretionary section of the federal budget.

• Extra-budgetary expenditures may be approved by Congress which are not bound by DoD caps. *Note the deviation between gross expenditures and official DoD budget.

• Majority of contracts are approved in late US fiscal Q4 / Q1, creating backloaded seasonality.

• Valuation closely follows official budget forecasts/corporate guidance. Difficult to forecast innovation in a concentrated, bureaucratic, and seasonal/unpredictable revenue business.

0

100

200

300

400

500

600

700

800

900

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015


Federal Government National Defense Consumption Expenditures and Gross

Investment

Red = Republican Presidency

(GWB)

Blue = Democratic Presidency

(Clinton, Obama)

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Defense Industry – Evolving View

Evolving View

• Public opinion along with reality of shift in global hegemony and warfare will necessitate revitalization of “smart investment” in military and infrastructure.

• Revitalization will prioritize higher ROIC products and services better suited to deal with modern warfare.

• Contractors are preparing for this shift by moving towards specialized less capital intensive services and technologies. Best players in space focusing on integrating infrastructure and defense modernization concepts.

• Demand for traditional goods and services likely to continue to rise abroad in lower base countries to fight growing threat of foreign incursion, domestic/imported radicalism etc.

• Foreign Military Sales (FMS) now account for over 25% of US gross defense expenditures.

• Pressure on government budgets will force shift towards integrated products and services,

• Valuation should reflect adoption of new technologies and integration of product industries.

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Target Exposure – Cubic Corporation (NYSE:CUB) • Ideal target companies:

• (1) Exposure to new fiscalism driven global defense and infrastructure modernization.

• (2) Self aware management capable of capitalizing on opportunity.

• (3) Potential as an acquisition target.

• (4) Other idiosyncratic price drivers: sellside upgrades, countercyclical behaviors etc.

• Cubic Corporation benefits from all 4 drivers.

39

Market Cap (intraday)5: 1.08B

Enterprise Value (Jul 4, 2016)3: 1.35B Revenue (ttm): 1.45B

Trailing P/E (ttm, intraday): 32.27 Revenue Per Share (ttm): 53.99

Forward P/E (fye Sep 30, 2017)1: 16.87 Qtrly Revenue Growth (yoy): 8.00%

PEG Ratio (5 yr expected)1: 0.99 Gross Profit (ttm): 339.72M

Price/Sales (ttm): 0.75 EBITDA (ttm)6: 81.76M

Price/Book (mrq): 1.46 Net Income Avl to Common (ttm): 33.49M

Enterprise Value/Revenue (ttm)3: 0.93 Diluted EPS (ttm): 1.24

Enterprise Value/EBITDA (ttm)6: 16.52 Qtrly Earnings Growth (yoy): N/A

Financial Highlights Balance Sheet

Total Cash (mrq): 173.19M

Fiscal Year Ends: 30-Sep Total Cash Per Share (mrq): 6.42

Most Recent Quarter (mrq): 31-Mar-16 Total Debt (mrq): 441.37M

Total Debt/Equity (mrq): 59.53

Profit Margin (ttm): 2.30% Current Ratio (mrq): 1.49

Operating Margin (ttm): 3.18% Book Value Per Share (mrq): 27.48

Cash Flow Statement

Return on Assets (ttm): 2.09% Operating Cash Flow (ttm): -9.10M

Return on Equity (ttm): 4.51% Levered Free Cash Flow (ttm): -40.32M

Cubic Corporation (NYSE:CUB) Highlights

Fiscal Year

Profitability

Management Effectiveness

Income Statement

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About Cubic Corporation (CUB)

• Cubic Corporation (Cubic) is an international provider of systems and solutions that address the mass transit and global defense markets.

• The Company operates through three segments across the global transportation and defense markets, which include Cubic Transportation Systems (CTS), Cubic Global Defense Systems (CGD Systems) and Cubic Global Defense Services (CGD Services).

• (1) CTS segment is a systems integrator of payment and information technology and services for intelligent travel solutions.

• (2) CGD Services segment offers training, operations, intelligence, maintenance, technical and other support services to the United States Government and its agencies and allied nations.

• (3) CGD Systems segment is focused on two lines of business: training systems, which supplies to the Department of Defense (DoD) and approximately 40 allied nations, and secure communications (SC) products, which includes Intelligence, Surveillance and Reconnaissance (ISR) data links and modular networking.

• In 1H2015, CUB officially combined CGD Defense and Services under a single leader, William Totti. In order to highlight different capabilities, segments remain divided in this presentation.

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About Cubic Corporation (CUB): Business Segments

• (1) CTS: Cubic Transportation Systems

• Largest CUB business segment. CTS has accounted for the largest portion of CUB revenue

throughout its lifetime and 40% of sales over last 5 years

• Description: Systems integrator of payment and information technology and services for

intelligent travel solutions. Creates installed base of devices and back office systems for

transportation authorities worldwide focused on revenue management, real time passenger

information, traffic management, predictive analytics, tolling, and parking.

• Example solutions include numerous integrated mass transit technologies including: NYC

Metrocard, London Oystercard, Brisbane Go-Card (see case). Other technologies include traffic

coordination, tolls, and parking meters across US and foreign roadways.

• 38 million travelers use CTS products daily, 24 billion transactions conducted per year , 7 billion

passengers annually, Over 130,000 devices installed.

• CTS has historically generated over $500M in sales and $70M in Operating Income annually,

implying an operating margin of 14%.

CTS 2011 2012 2013 2014 2015 Q116 Q216

Revenue 433.1 522.2 529.5 599.7 566.8 125.8 148.7

Operating Expense 361.1 437.6 462.7 533.8 490.9 122.2 128.9

Operating Income 72 84.6 66.8 65.9 75.9 3.6 19.8

Operating Margin 16.62% 16.20% 12.62% 10.99% 13.39% 2.86% 13.32%

*$ millions

41

https://www.cubic.com/Transportation/Resources/Case-Studies/Australasia/Brisbane

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• (2) CGD: Cubic Global Defense Services

• CGD has accounted for roughly 30% of total sales over the last 5 years. CGD and Cubic Global

Defense Systems (CGS) account for roughly the same share of total revenue.

• Description: CGD provides tactical training and simulation, command, control, and

communications support to armed forces and other government agencies to assist in the field.

CGD provides physical services as opposed to back end technology systems (CGS).

• Example solutions include special operations tactical training programs to US and foreign

special operations forces, law enforcement and government agencies. Other solutions include

mission support physical training and tactical support, and national security counter terrorism

training services.

CGD 2011 2012 2013 2014 2015 Q116 Q216

Revenue 476.5 491.4 363 400.6 462.1 92.1 101


Operating Income 23.9 21.1 14.2 26.8 18.4 0.2 4.3

Operating Margin 5.02% 4.29% 3.91% 6.69% 3.98% 0.22% 4.26%

*$ millions

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• (3) CGS: Cubic Global Defense Systems

• CGS has accounted for roughly 30% of total sales over the last 5 years. CGS and Cubic Global

Defense Services (CGS) account for roughly the same share of total revenue.

• Description: Provide a range of live, virtual, and constructive gaming training technologies and

back end systems, running in conjunction with physical services (CGS) in order to support armed

forces and other government department agencies in the field.

• Example solutions include training systems to support air combat readiness, on the ground at

sea via game based training technologies. Other solutions include range design laser

engagement training simulations, live-fire range design, exercise planning and support software,

and detailed after action reviews. C4ISR communications products providing intelligence,

surveillance, reconnaissance, warfare command and control products, and secure mobile

networking solutions for military and first responders.

• Margins have been hampered in FY2016 stemming from acquisition accounting.

CGS 2011 2012 2013 2014 2015 Q116 Q216

Revenue 390.7 389.4 468.7 398.1 402.1 95.9 116.3


Operating Income 29.8 35.3 -36.1 7.8 6.6 -3.4 -21.2

Operating Margin 7.63% 9.07% -7.70% 1.96% 1.64% -3.55% -18.23%

*$ millions 43

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(1) Exposure to New Fiscalism Driven Modernization:

• CUB via its business segments is primed for renewed fiscalism within the evolving

structural trap global context.

• (1) CTS segments provides both a predictable source of revenues and an outlet to increase

surveillance and intelligence information in a highly vulnerable user base (mass transit) which is

already in dire need of revitalization (infrastructure). This combination is also highly desirable to

foreign markets which are even more exposed.

• (2) Integration of CGD and CGS allows CUB to source comprehensive projects requiring both

personnel training and backend systems improvement. CUB estimates focusing on integrated

projects increases CUB addressable market by $9B.

• (3) CUB is perfectly positioned to capitalize on a shift in military tactics towards homeland and

specialized operations focused on counter terrorism.

44

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• (1) CTS: Cubic Transportation Systems

• CTS segments provides both a predictable source of revenues and an outlet to increase

surveillance and intelligence information in a highly vulnerable user base (mass transit) which is

already in dire need of infrastructure revitalization. This combination is also highly desirable to

foreign markets which are even more exposed.

• Future Growth: “Next” platform incumbent infrastructure upgrades to address new technology,

urban congestion and related fears (terrorism), and to improve mobility and convenience of

users. Adjacent market expansion of integrated transit concept.

• Smart Cities (NextCity Initiative)

• Upgrade Existing Infrastructure: NYC Metrocard due for upgrade RFP with start date

in 2017, expect change orders in London. Follow contactless model in NYC.

• Expand digital fare and user data collection services: Ventra mobile App which

currently allows users to pay for rides on CTA (Chicago Transit Authority), Metra, Pace

from smartphone. Plans to expand technology across CTS platform. Improves

convenience and transit authority data flows.

• Increase Operating Margins: CTS traffic management system movement to Microsoft

Azure Cloud with goal of allowing customers to adjust traffic flow via mobile messaging

signs in a single integrated framework. Goal to reduce customer computing costs by

over 10%, and improve incumbency pitch.

• Adjacent Market Expansion: NextCity Toll: NH Department of Transportation, Greater

Manchester UK, Iarnrod Eireann Irish Rail. Fare collection and toll opportunities in

Middle East, Boston, Honolulu, Seattle, and Boston. 45

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• (2) CGD: Cubic Global Defense Services / (3) CGS: Cubic Global Defense Systems

• Integration of CGD and CGS allows CUB to source comprehensive projects requiring both

personnel training and backend systems improvement.

• Consolidation of two divisions under singular leadership, William Totti, in 1H2015 in order to

increase feedback between physical service and systems needs.

• Believe consolidation increases addressable market size by $9B, as it opens doorways for

new integrated solutions. CUB is already pursuing larger integrated project assignments

such as US Air Force KC-46 Maintenance Training and US Army Enterprise Training

Services.

• CUB is perfectly positioned to capitalize on a shift in military tactics towards homeland and

specialized operations focused on counter terror.

• Future Growth:

• Focus on integration of services and systems solutions and expansion into faster growing

markets abroad (FMS).

• Smart acquisition strategies meant on filling gaps in systems or services with recent focus on

surveillance and communications. Three recent transactions within C4ISR segment: GATR,

DTECH labs, Teralogics are estimated to be EPS accretive in FY2017. Goal to expand

segment to $200 million in sales by 2018.

• NextTraining initiative (part of the “Next” series)

• Further expand dominant market share gaming systems training in cyber security and

commercial aircraft segments into foreign markets.

• Expand MILEs laser based combat training simulations into foreign markets.

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(2) Transformation Under New Management

• CUB was founded in 1951 by Walter J. Zable who remained CEO until his death at 97 years old

in 2012. At the time of his death he was the oldest public company CEO in the world.

• Walter J. Zable owned 30% of outstanding stock at time of death which hampered liquidity and

institutional interest in the company. Zable also remained steadfast about retaining ownership,

preventing acquisition by a larger integrated defense contractor such as a NOC.

• Zable’s children have limited interest in running day to day operations, and have regularly sold

inherited equity, which combined with a 2.4M share secondary offering in 2013 has greatly

increased liquidity (volume has increase from 90,000 shares per day in 2012 to 170,000 shares

per day in 2016). As of December 2015, Walter Zable Jr’s stake has been reduced to 7.2%.

• Other insiders have bought CUB common stock, particularly in early 2016. While Walter Jr. sold

nearly 4% of O/S in December 2015, other insiders absorbed 20 bps (a total of 24 buyers vs 1

seller). 2014 CEO appointee Bradley Feldmann added 4 bps after previously lacking a stake.

• Starmine’s insider model can be seen below. Zable Jr’s large sales, weigh down on the output.

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(2) Transformation Under New Management

• In 2012 following the founder’s death, CUB generated significant buzz as an activist acquisition

target, or a special situation where the CTS division could be spun into a separate entity given

the regularity of its revenue versus defense segments.

• At the time the Zable family held steadfast to retaining some ownership, though total stake now

stands below 10%. As such it is plausible that a takeover is now a distinct possibility, especially

with Walter Zable Jr. already in his 70s.

• Current CEO Brad Feldmann has taken several initiatives to help stabilize CUB earnings (which

have historically been very seasonal) and create a longer term growth initiative.

• Instead of separating entities as desired by activists, he has worked to consolidate business

lines with the goal of increasing operating margins 200-250 bps by 2018 (OneCubic).

• Initiated ERP System (currently under completion) across entire CUB entity.

• 2020 Global Growth Strategy – NextCity, C4ISR expansion, NextTraining

• Acquire cutting edge technologies and integrate segments in order to target larger

contracts (as described in previous slides).

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(3) Potential Acquisition Target • While Walter J. Zable and family previously resisted the idea of selling or spinning out segments,

reduced ownership and operational involvement has weakened their position.

• Feldmann’s OneCubic and 2020 Global Growth initiatives should increase acquisition multiples

as revenue growth and margins become steadier. At Zable’s death it was estimated that CUB

would denote a lower than industry EBITDA multiple due to its irregular revenue flows and mix.

• Interest in Aerospace & Defense mergers & acquisitions activity has accelerated over the

last 2 years. While a number of transactions have been withdrawn or remain pending, the

initiation of talks is indicative of underlying sentiment shift. Note this chart also follows numerous

previously discussed trends such as terrorism, nuclear armament, M2 externalization, and

infrastructure need.

• This is also consistent with renewed private equity interest in the industry. Private Equity Interest

• CUB’s large tangible assets and incumbent systems make it an extremely desirable target.

0

50

100

150

200

250

300

$-

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

2009 2010 2011 2012 2013 2014 2015 2016

Mil

lio

ns

Source: Thomson Reuters Data Stream, *Incomplete includes both pending and withdrawn transactions, 2016 current through July

Global Aerospace & Defense M&A Activity

Completed Incomplete Deals (RHS)

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http://www.nationaldefensemagazine.org/blog/Lists/Posts/Post.aspx?ID=2237

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(4) Idiosyncratic Drivers – Valuation Activism/ Margin of Safety

• Sellside has historically deferred to simple conservative valuation methodologies,

avoiding multiples of other cutting edge industries and competitors.

• This opens room for hedge fund activism.

• Lack of sellside consensus on valuation methodology.

• Seasonality and monopsony lead to “average” multiple targets.

• Mixture of industries and complex products makes it difficult to understand growth.

• CUB trades much closer to BV of its assets than other larger “cutting edge” integrated

defense contractors.

• Looking at educational background of the board (many science Phd) and growth

initiatives, it is clear CUB treads a fine line between defense, infrastructure, and

technology – yet this combination is largely unacknowledged.

• For example, JPM applies a target of roughly 5 year quarterly average 8.4x pro forma 2017E

Adjusted EBITDA. There is little adjustment based on growth projection, purely historical average

multiple and forward guidance.

• In reality, the adjusted EBITDA multiple floated between 6.6x and 11.6x with a backwards

looking 5 year average of 9.5x. If CUB achieves JPM’s pro form adjusted EBITDA target,

a 9.5x multiple would imply value of $47.50.

• Needham simply provides a “Hold” rating without a price target.

2017E 2016E 2015 2014 2013 2012 2011 2010

Price 47.5 42.00 41.94 46.80 53.68 50.06 39.07 40.80

Adj EBITDA per share 5.00 3.85 5.20 4.80 4.33 5.89 5.22 4.51

Multiple 9.5 x 8.4 x 10.9 x 9.0 x 11.2 x 11.6 x 6.6 x 7.8 x

Upside 18.34% 4.63%

Implied Value CUB (Adj EBITDA multiple)

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(4) Idiosyncratic Drivers – Recession Hedge • Historically the defense sector has outperformed the broad equity market into business

cycle contractions and underperformed during expansions. There are several reasons, which were previously discussed in some form:

• As output declines, aggregate government spending tends to rise.

• Ancillary factors related to low output such as political unrest and geopolitical shift necessitate further defense expenditures.

• The military industrial complex has historically been a useful means for economic recovery. Destruction of productive capacity serves dual purpose of government and terms of trade stimulus.

• As we can see below, CUB has mostly outperformed the SPX into recessions historically, with a clear right hand skew. Also note outperformance has been rapid into the initial recession.

• In aggregate CUB provides value not only as a proxy for renewed fiscalism, but also on a portfolio level as a hedge against slowing global growth conditions.

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CUB Valuation Scenarios

• A probability weighted mixture of DCF and acquisition multiple driven scenarios provides

a target price of $52.71 or 31.31% upside over 7/1/16 closing price of $40.14.

• This is a conservative valuation method, but provides context to risk adjusted value.

• Holding period is lesser of 18 months and achieved price target.

• Given that many of CUB’s catalysts are fiscal, I suggest averaging into a position given the

chance of hyperbolic action into recession.

• Methodologies – DCF / Acquisition Adjusted EBITDA Multiple

• Cases:

• (1) Base Case – Temporary Brexit Headwinds – 50% probability

• Acquisition Multiple – 9.5x 2017E Adjusted EBITDA

• (2) Worst Case – Long Term Brexit Headwinds – 25% probability


• (3) Best Case – Small / Temporary Brexit Headwinds – 25% probability


52

Current Price $40.14

Acquisition Probability 15%

Probability DCF

Acquisition

Multiple

Worst 25.00% $38.99 $43.25

Base 50.00% $54.39 $55.99

Best 25.00% $61.69 $63.30

Price Target $52.71

Upside 31.31%

Valuation Summary: CUB

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Operating Assumptions – Industry Growth Rate

• Looking at CUB performance versus the Gallup Opinion 3yr Forward Defense Expenditure model, we see a strong historical relationship between public sentiment and CUB price change.

• CUB performance has been hindered by a historically dovish foreign policy presidency. Under 4 polling dates at which 36% or greater of the survey suggested “too little was spent on military spending”, CUB saw an average 3yr price change of 172% (or 39% annualized).

• Though we can handicap historical price results somewhat due to irregular events, it is still probable that industry growth rates will at least converge back to the model (~11% annualized growth over next 3 years). In reality growth rate should exceed model levels given sharp uptick in FMS as a share of total expenditures despite DoD declines.

-100.00%

-60.00%

-20.00%

20.00%

60.00%

100.00%

140.00%

180.00%

220.00%

260.00%

300.00%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1967

1971

1976

1980

1984

1988

1992

1996

2001

2005

2009

2013

CUB vs Public Sentiment Model (Gallup Opinion Poll)

Forward 3yr % Change in Government Defense Investment & Consumption Expenditure

Too Little Military Spending (Gallup Opinion)

3yr %Change CUB (RHS)

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Operating Assumptions – Brexit Headwinds

• Historically 20% of CUB revenues have come from the UK. As such Brexit has some quantifiable

impact on valuation.

• To handicap for FX depreciation, DCF models assume that growth rates are offset by the total

amount of GBP depreciation against the USD.

• Cases distinguish between both level of depreciation and duration of years under which effect

should be discounted.

• Under more bullish scenarios, it is anticipated that UK’s share of revenue will decline roughly 5%

as FMS takes a larger share.

• Brexit duration and magnitude will also play a role in CUB cost of capital, and as such each

scenario is further handicapped by higher and lower WACC.

• Brexit assumptions can be seen below:

Duration Magnitude UK % Sales WACC

Worst Perpetual 15.00% 20.00% 10.50%

Base 3 years 12.00% 17.00% 9.50%

Best 3 years 5.00% 15.00% 9.00%

Assumptions Brexit Headwinds

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Operating Assumptions– Revenue Growth / Operating Margins

• Brad Feldmann has remained consistent with his base case goals for CUB by FY2018:.

• 200-250 bp operating margin improvement over 2015. This implies a 2018E operating

margin between 9% and 9.5%.

• 13% to 15% EBITDA margin target.

• 10% annual revenue growth rate.

• DCF models test sensitivity of unlevered cashflow to scenarios, but have been adjusted lower

anticipating near term FX headwinds.

• Note amortization of purchased intangibles remains constant with management estimates in

each case.

• $13M of annual replacement capital expenditure is assumed in each case, maintaining an

annual depreciation expense of $4.3M.

• Average measures from 2018 to 2010 can be seen below.

EBITDA margin Annual Revenue Growth Operating Margin

Worst 8.75% 5.83% 7.79%

Base 10.79% 8.36% 9.89%

Best 11.20% 10.29% 10.36%

Operating Assumptions (2018-2020E)

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Base Case: DCF WACC 9.50% FX Translation 12.00%

0.095

Revenue Mix (2015) Revenue Mix DCF Implied Share Price

Cubic Transportation Systems 38.00% US 55.00% PT 54.39$

Cubic Global Defense Systems 28.00% UK 17.00% Upside 35.51%

Cubic Global Defense Services 34.00% Other 25.00%

Margin Improvement Assumptions Low High 2014A 2015A 2016E 2017E 2018E 2019E 2020E Terminal

EBITDA Margin Target 13% 15% Growth Rate Assumptions

Annual Growth Rate 10% CTS -5.49% 4.00% 10.00% 12.00% 12.00% 10.00% 6.00%

Operating Margin Target CGS 1.00% 4.00% 6.00% 7.00% 7.00% 7.00% 6.00%

CGD 15.35% 4.00% 8.00% 8.00% 8.00% 8.00% 6.00%

0 1 2 3 4

2014A 2015A 2016E 2017E 2018E 2019E 2020E Terminal

Sales

Cubic Transportation Systems 599.7 566.8 577.4 622.2 682.7 764.6 841.1 891.5

Cubic Global Defense Systems 398.1 402.1 409.7 425.4 445.9 477.1 510.5 541.1

Cubic Global Defense Services 400.6 462.1 470.8 498.1 526.9 569.1 614.6 651.5

Total Sales 1398.4 1431.0 1457.9 1545.7 1655.5 1810.8 1966.2 2084.1

Growth Rate 2.33% 1.88% 6.02% 7.10% 9.38% 8.58% 6.00%

Operating Expenses




Unallocated 8.01 25.513

Total Operating Expenses 1305.91 1355.613 1346.92 1410.11 1492.63 1631.42 1770.70 1897.78

Segment Operating Income




Total Operating Income 92.5 75.4 111.0 135.6 162.9 179.4 195.5 186.4

Operating Margins

Cubic Transportation Systems 11.0% 13.4% 12.0% 13.0% 14.0% 14.0% 14.0% 13.0%

Cubic Global Defense Systems 2.0% 1.6% 5.0% 7.0% 8.0% 8.0% 8.0% 7.0%

Cubic Global Defense Services 6.7% 4.0% 4.5% 5.0% 6.0% 6.0% 6.0% 5.0%

Total Operating Income 6.6% 5.3% 7.6% 8.8% 9.8% 9.9% 9.9% 8.9%

Expected Amortization (purchased intangibles)

Cubic Transportation Systems 7.358 6.306 5.251 2.986 0.958 3.043

Cubic Global Defense Systems 9.48 7.59 5.973 4.346 2.878 1.514

Cubic Global Defense Services 4.714 2.452 1.775 1.184 0.79 4.338

Total 22.6 27.6 21.6 16.3 13.0 8.5 4.6 8.9

Expected Depreciation & Amotization




Other and Corporate 0.8 1.3 4.0 4.0 4.0 4.0 4.0 4.0

Total 30.4 37.70 28.77 23.57 20.22 15.73 11.84 16.11

Segment EBITDA




Unallocated -7.21 -24.213 4.00 4 4 4 4 4

Total 122.9 113.1 139.7 159.1 183.1 195.1 207.3 202.5

EBITDA Margin 8.79% 7.90% 9.58% 10.30% 11.06% 10.77% 10.54% 9.71%

Tax Rate 45.00%

Capex 16.6 22.2 13 13 13 13 13 13

Working Capital 495.2 428.5

Pre-tax FCF 106.3 90.9 126.7 146.1 170.1 182.1 194.3 189.5

Taxes 19.831 48.997 57.03 65.76 76.54 81.94 87.44 85.26

Unlevered Free Cashflow 86.5 41.9 69.7 80.4 93.5 100.1 106.9 104.2

PV 69.70 73.40 78.02 76.28 74.34 1096.90

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Base Case: DCF Sensitivity Matrix

• Implied Value at 12% GBP depreciation, 9.5% WACC: $54.39

57

50 day MA 1.44 GBP Depreciation

WACC 1.368 1.296 1.224 1.152 1.08 1.008 0.936

54.39$ 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 71.99 70.26 68.55 66.88 65.23 63.61 62.02

7.50% 68.04 66.40 64.80 63.22 61.66 60.13 58.63

8.00% 64.57 63.02 61.49 60.00 58.53 57.08 55.66

8.50% 61.49 60.02 58.57 57.15 55.75 54.37 53.02

9.00% 58.74 57.33 55.96 54.60 53.27 51.96 50.67

9.50% 56.26 54.92 53.61 52.31 51.04 49.78 48.55

10.00% 54.03 52.74 51.48 50.24 49.02 47.82 46.64

10.50% 51.99 50.76 49.55 48.36 47.18 46.03 44.90

11.00% 50.14 48.95 47.78 46.64 45.51 44.40 43.31

11.50% 48.43 47.29 46.16 45.06 43.97 42.90 41.85

Base Case

35.51% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 79.35% 75.03% 70.78% 66.61% 62.50% 58.47% 54.50%

7.50% 69.51% 65.43% 61.43% 57.49% 53.62% 49.81% 46.07%

8.00% 60.85% 56.99% 53.20% 49.47% 45.81% 42.20% 38.66%

8.50% 53.18% 49.51% 45.91% 42.37% 38.88% 35.46% 32.10%

9.00% 46.33% 42.84% 39.40% 36.02% 32.70% 29.44% 26.23%

9.50% 40.17% 36.83% 33.55% 30.32% 27.15% 24.03% 20.96%

10.00% 34.60% 31.40% 28.25% 25.16% 22.12% 19.13% 16.19%

10.50% 29.53% 26.46% 23.44% 20.47% 17.55% 14.68% 11.85%

11.00% 24.90% 21.95% 19.04% 16.18% 13.37% 10.61% 7.89%

11.50% 20.66% 17.81% 15.00% 12.25% 9.54% 6.87% 4.26%

CUB (Temporary Brexit Headwinds, Base Case - DCF)

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Base Case: Acquisition Multiple Sensitivity Matrix

• Implied Value at 9.5x Adjusted 2017E EBITDA, 12% GBP depreciation, 9.5% WACC: $56.00

Acquisition Multiples (Base Case 9.5x 2017 Pro Forma EBITDA)

56.0 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x 42.12 41.50 40.89 40.29 39.69 39.10 38.51

7.50 x 45.12 44.47 43.81 43.17 42.52 41.89 41.26

8.00 x 48.13 47.43 46.73 46.04 45.36 44.68 44.01

8.50 x 51.14 50.40 49.66 48.92 48.19 47.47 46.76

9.00 x 54.15 53.36 52.58 51.80 51.03 50.27 49.51

9.50 x 57.16 56.32 55.50 54.68 53.86 53.06 52.26

10.00 x 60.17 59.29 58.42 57.55 56.70 55.85 55.01

10.50 x 63.17 62.25 61.34 60.43 59.53 58.64 57.76

11.00 x 66.18 65.22 64.26 63.31 62.37 61.44 60.51

39.49% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x 4.92% 3.39% 1.87% 0.37% -1.12% -2.60% -4.07%

7.50 x 12.42% 10.78% 9.15% 7.54% 5.94% 4.36% 2.79%

8.00 x 19.91% 18.16% 16.43% 14.71% 13.00% 11.31% 9.64%

8.50 x 27.41% 25.55% 23.70% 21.88% 20.07% 18.27% 16.49%

9.00 x 34.90% 32.93% 30.98% 29.05% 27.13% 25.23% 23.34%

9.50 x 42.40% 40.32% 38.26% 36.22% 34.19% 32.18% 30.20%

10.00 x 49.89% 47.70% 45.54% 43.39% 41.25% 39.14% 37.05%

10.50 x 57.39% 55.09% 52.81% 50.55% 48.32% 46.10% 43.90%

11.00 x 64.88% 62.47% 60.09% 57.72% 55.38% 53.06% 50.75% 58

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Worst Case: DCF WACC 10.50% FX Translation 15.00%

0.105

Growth Rate Assumptions Revenue Mix DCF Implied Share Price


Cubic Global Defense Systems 28.00% UK 20.00% Upside -2.87%



EBITDA Margin Target 13% 15%

Annual Growth Rate 10% -5.49% 2.00% 10.00% 12.00% 12.00% 10.00% 6.00%

Operating Margin Target 1.00% 2.00% 6.00% 7.00% 7.00% 7.00% 6.00%

15.35% 2.00% 8.00% 8.00% 8.00% 8.00% 6.00%

0 1 2 3 4


Sales




Total Sales 1398.4 1431.0 1415.8 1486.4 1576.4 1672.5 1761.6 1811.2

Growth Rate 2.33% -1.06% 4.98% 6.06% 6.10% 5.32% 2.82%

Operating Expenses











Operating Margins









Total 22.6 27.6 21.6 16.3 13.0 8.5 4.6 8.9






Total 30.4 37.70 28.77 23.57 20.22 15.73 11.84 16.11

Segment EBITDA




Unallocated -7.21 -24.213 4.00 4 4 4 4 4

Total 122.9 113.1 136.5 137.4 142.0 146.2 149.9 158.1

EBITDA Margin 8.79% 7.90% 9.64% 9.24% 9.01% 8.74% 8.51% 8.73%

Tax Rate 45.00%

Capex 16.6 22.2 13 13 13 13 13 13


Pre-tax FCF 106.3 90.9 123.5 124.4 129.0 133.2 136.9 145.1

Taxes 19.831 48.997 55.59 55.97 58.06 59.93 61.61 65.29


PV 67.94 61.91 58.12 54.28 50.51 759.94

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Worst Case: DCF Sensitivity Matrix



WACC 1.368 1.296 1.224 1.152 1.08 1.008 0.936

38.99$ 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 59.81 56.70 53.74 50.92 48.24 45.68 43.25

7.50% 56.53 53.61 50.82 48.17 45.65 43.25 40.96

8.00% 53.64 50.89 48.26 45.76 43.38 41.11 38.95

8.50% 51.08 48.48 45.99 43.62 41.36 39.22 37.17

9.00% 48.80 46.32 43.96 41.71 39.57 37.52 35.58

9.50% 46.75 44.39 42.14 39.99 37.95 36.00 34.15

10.00% 44.89 42.64 40.49 38.44 36.48 34.62 32.85

10.50% 43.21 41.05 38.99 37.03 35.15 33.37 31.68

11.00% 41.67 39.60 37.62 35.74 33.94 32.23 30.60

11.50% 40.26 38.26 36.36 34.55 32.82 31.18 29.61

Base Case

-2.87% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 49.00% 41.26% 33.88% 26.86% 20.17% 13.80% 7.75%

7.50% 40.82% 33.55% 26.62% 20.01% 13.73% 7.74% 2.05%

8.00% 33.63% 26.77% 20.23% 14.00% 8.07% 2.42% -2.96%

8.50% 27.26% 20.77% 14.57% 8.67% 3.05% -2.30% -7.40%

9.00% 21.58% 15.40% 9.52% 3.91% -1.43% -6.52% -11.36%

9.50% 16.47% 10.58% 4.98% -0.37% -5.46% -10.31% -14.93%

10.00% 11.84% 6.23% 0.87% -4.24% -9.11% -13.74% -18.15%

10.50% 7.64% 2.26% -2.87% -7.76% -12.42% -16.86% -21.09%

11.00% 3.81% -1.36% -6.28% -10.97% -15.45% -19.71% -23.77%

11.50% 0.29% -4.68% -9.41% -13.92% -18.23% -22.33% -26.23%

CUB (Brexit Worst Case - DCF)

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Worst Case: Acquisition Multiple Sensitivity Matrix

• Implied Value at 8.5x Adjusted 2017E EBITDA, 15% GBP depreciation, 10.5% WACC:

$43.20

61

Acquisition Multiples (Worst Case 8.5x 2017 Pro Forma EBITDA)

43.2 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x 36.85 36.23 35.62 35.01 34.41 33.82 33.23

7.50 x 39.48 38.82 38.16 37.51 36.87 36.23 35.61

8.00 x 42.11 41.40 40.70 40.01 39.33 38.65 37.98

8.50 x 44.74 43.99 43.25 42.51 41.79 41.07 40.35

9.00 x 47.37 46.58 45.79 45.01 44.24 43.48 42.73

9.50 x 50.00 49.17 48.34 47.51 46.70 45.90 45.10

10.00 x 52.64 51.75 50.88 50.02 49.16 48.31 47.48

10.50 x 55.27 54.34 53.42 52.52 51.62 50.73 49.85

11.00 x 57.90 56.93 55.97 55.02 54.08 53.14 52.22

7.74% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x -8.21% -9.75% -11.27% -12.78% -14.27% -15.75% -17.21%

7.50 x -1.65% -3.30% -4.93% -6.55% -8.15% -9.73% -11.29%

8.00 x 4.91% 3.15% 1.41% -0.32% -2.02% -3.71% -5.38%

8.50 x 11.46% 9.59% 7.74% 5.91% 4.10% 2.31% 0.53%

9.00 x 18.02% 16.04% 14.08% 12.14% 10.22% 8.33% 6.45%

9.50 x 24.57% 22.49% 20.42% 18.37% 16.35% 14.34% 12.36%

10.00 x 31.13% 28.93% 26.76% 24.60% 22.47% 20.36% 18.27%

10.50 x 37.69% 35.38% 33.09% 30.83% 28.59% 26.38% 24.19%

11.00 x 44.24% 41.83% 39.43% 37.06% 34.72% 32.40% 30.10%

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Best Case: DCF

62

WACC 9.00% FX Translation 5.00%

0.09

Revenue Mix (2015) Revenue Mix DCF Implied Share Price


Cubic Global Defense Systems 28.00% UK 15.00% Upside 53.68%



EBITDA Margin Target 13% 15% Growth Rate Assumptions

Annual Growth Rate 10% CTS -5.49% 4.00% 10.00% 14.00% 14.00% 12.00% 6.00%

Operating Margin Target CGS 1.00% 4.00% 7.00% 10.00% 10.00% 8.00% 6.00%

CGD 15.35% 4.00% 7.00% 8.00% 8.00% 8.00% 6.00%

0 1 2 3 4


Sales




Total Sales 1398.4 1431.0 1477.1 1586.0 1746.9 1939.6 2127.7 2255.4

Growth Rate 2.33% 3.22% 7.38% 10.14% 11.03% 9.70% 6.00%

Operating Expenses











Operating Margins









Total 22.6 27.6 21.6 16.3 13.0 8.5 4.6 8.9






Total 30.4 37.70 28.77 23.57 20.22 15.73 11.84 16.11

Segment EBITDA




Unallocated -7.21 -24.213 4.00 4 4 4 4 4

Total 122.9 113.1 141.2 162.8 199.7 216.8 234.0 219.2

EBITDA Margin 8.79% 7.90% 9.56% 10.26% 11.43% 11.18% 11.00% 9.72%

Tax Rate 45.00%

Capex 16.6 22.2 13 13 13 13 13 13


Pre-tax FCF 106.3 90.9 128.2 149.8 186.7 203.8 221.0 206.2

Taxes 19.831 48.997 57.69 67.40 84.01 91.73 99.44 92.81


PV 70.51 75.58 86.43 86.57 86.10 1260.41

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Best Case: DCF Sensitivity Matrix


63


WACC 1.368 1.296 1.224 1.152 1.08 1.008 0.936

61.69$ 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 75.63 74.02 72.43 70.86 69.32 67.80 66.31

7.50% 71.47 69.95 68.45 66.98 65.53 64.09 62.69

8.00% 67.82 66.38 64.96 63.57 62.19 60.83 59.50

8.50% 64.58 63.21 61.87 60.54 59.23 57.94 56.67

9.00% 61.69 60.39 59.10 57.84 56.59 55.36 54.15

9.50% 59.09 57.84 56.61 55.41 54.21 53.04 51.88

10.00% 56.74 55.54 54.37 53.21 52.07 50.94 49.83

10.50% 54.60 53.45 52.32 51.21 50.11 49.03 47.97

11.00% 52.64 51.54 50.45 49.38 48.33 47.29 46.26

11.50% 50.85 49.78 48.74 47.70 46.69 45.68 44.70

Base Case

53.68% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00% 88.41% 84.39% 80.44% 76.54% 72.70% 68.92% 65.20%

7.50% 78.06% 74.27% 70.54% 66.86% 63.24% 59.68% 56.17%

8.00% 68.96% 65.37% 61.84% 58.36% 54.93% 51.55% 48.23%

8.50% 60.89% 57.48% 54.13% 50.82% 47.56% 44.35% 41.19%

9.00% 53.68% 50.44% 47.24% 44.09% 40.98% 37.92% 34.91%

9.50% 47.21% 44.10% 41.04% 38.03% 35.06% 32.14% 29.26%

10.00% 41.35% 38.37% 35.44% 32.55% 29.71% 26.91% 24.15%

10.50% 36.02% 33.16% 30.35% 27.57% 24.84% 22.15% 19.50%

11.00% 31.15% 28.40% 25.69% 23.02% 20.39% 17.80% 15.25%

11.50% 26.68% 24.03% 21.42% 18.84% 16.31% 13.81% 11.35%

CUB (Temporary Brexit Headwinds, Best Case - DCF)

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Best Case: Acquisition Multiple Sensitivity Matrix

• Implied Value at 10.5x Adjusted 2017E EBITDA, 5% GBP depreciation, 9.0% WACC: $63.30

64

Acquisition Multiples (Best Case 10.5x 2017 Pro Forma EBITDA)

63.3 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x 42.20 41.66 41.12 40.58 40.05 39.53 39.00

7.50 x 45.22 44.63 44.06 43.48 42.91 42.35 41.79

8.00 x 48.23 47.61 46.99 46.38 45.78 45.17 44.58

8.50 x 51.25 50.59 49.93 49.28 48.64 48.00 47.36

9.00 x 54.26 53.56 52.87 52.18 51.50 50.82 50.15

9.50 x 57.28 56.54 55.81 55.08 54.36 53.64 52.93

10.00 x 60.29 59.51 58.74 57.98 57.22 56.47 55.72

10.50 x 63.30 62.49 61.68 60.88 60.08 59.29 58.51

11.00 x 66.32 65.46 64.62 63.78 62.94 62.11 61.29

57.71% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

7.00 x 5.14% 3.78% 2.44% 1.11% -0.21% -1.53% -2.83%

7.50 x 12.65% 11.20% 9.76% 8.33% 6.91% 5.51% 4.11%

8.00 x 20.16% 18.61% 17.08% 15.55% 14.04% 12.54% 11.05%

8.50 x 27.67% 26.02% 24.39% 22.77% 21.17% 19.57% 17.99%

9.00 x 35.18% 33.44% 31.71% 30.00% 28.30% 26.61% 24.93%

9.50 x 42.69% 40.85% 39.03% 37.22% 35.42% 33.64% 31.87%

10.00 x 50.20% 48.26% 46.34% 44.44% 42.55% 40.67% 38.81%

10.50 x 57.71% 55.68% 53.66% 51.66% 49.68% 47.71% 45.75%

11.00 x 65.22% 63.09% 60.98% 58.88% 56.81% 54.74% 52.70%

Date post:	13-Apr-2017
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