CAE INC. $8.65 (Toronto symbol CAE; Conservative Growth Portfolio, Manufacturing & Industry sector; SI Rating: Above average) is a leading maker of full-size, computerized flight simulators. Airlines use these devices to train pilots to fly certain aircraft, and to prepare flight crews to handle emergencies. CAE also makes simulators for military aircraft, including fighter jets and helicopters.

In 2001, the company began operating pilot-training facilities, which nicely complements its simulator business. CAE is now the world’s second-largest provider of pilot training services, with 22 facilities on four continents. Demand for these services should grow, since it’s cheaper for airlines to send pilots to CAE’s schools than to train them in-house. CAE gets about half of its revenue from civilian airlines, and half from military organizations. That helps cut its exposure to the highly cyclical air travel industry.

Revenue from continuing operations fell from $1.01 billion in 2002 (fiscal years end March 31) to $938.4 million in 2004, mostly due to the drop in air travel after 9/11. Revenue grew to $986.2 million in 2005, and to $1.11 billion in 2006.

Profits from continuing operations fell from $0.61 a share (total $133.0 million) in 2002 to $0.20 a share ($47.4 million) in 2004. In 2005, CAE began a major restructuring. It sold businesses, closed plants and wrote off goodwill on failed acquisitions of years past. Consequently, it reported a loss for 2005 of $1.23 a share ($304.7 million). But disregarding special items, 2005 earnings were little changed at $0.19 a share.

Now these moves are starting to pay off. In 2006, CAE earned $0.28 a share ($70.9 million). If you disregard unusual costs, earnings improved to $0.35 a share ($87.7 million).

Research is key to CAE’s success

However, CAE is more profitable that it appears, because of the accounting treatment of its hefty research spending. In fiscal 2006, it spent $95.8 million (8.7% of revenue) on research, up 9.0% from $87.9 million (8.9% of revenue) in 2005. It has to treat these outlays as expenses, but they are more like investments that help CAE dominate its market.

Part of CAE’s restructuring plan is its new Project Phoenix research initiative. The company intends to invest $630 million in the next six years to improve its simulator technology. It also aims to apply this technology to new markets, such as video games and medical imaging.

Governments have agreed to contribute $220.5 million to Project Phoenix. CAE will repay these funds with royalties from new products and services that this project helps create.

The outlook for CAE’s core businesses is also improving. Air-travel volume has returned to its pre-9/11 levels, and continues to expand. CAE sold 21 full-flight simulators to civilian airlines in fiscal 2006, up 23.5% from 17 a year earlier. It will probably sell 26 simulators in the current fiscal year.

Of those 21 orders, 15 went to customers in Asia and the Middle East. This region supplied 16% of CAE’s revenue in fiscal 2006, up from 7% in 2005. Canada accounted for 9% of its 2006 revenue, the United States 35%, while Europe supplied 40%.

Worldwide presence cuts risk

Geographic diversification cuts CAE’s risk. However, the strong Canadian dollar means that CAE’s overseas profits now translate into fewer Canadian dollars. CAE hedges its foreign currency contracts to shield it from changing exchange rates.

Sales to China and India should expand rapidly in the next few years, as rising prosperity makes air travel more affordable. China alone will probably need 35,000 new pilots in the next 20 years to meet the expected demand.

Cost-conscious airlines in North America are also starting to replace aging aircraft with new, more fuel-efficient models. Meanwhile, baby-boomer pilots are approaching mandatory retirement age, and airlines will have to replace them in the next few years.

Both these trends should spur demand for CAE’s flight simulators and pilot training. Of course, growing demand could prompt new competitors to enter the pilot-training market. But CAE’s strong reputation will help it hang on to most of its clients.

Balance sheet is getting stronger

The success of CAE’s restructuring is starting to show up in its balance sheet. CAE cut its long-term debt by 15% in fiscal 2006. It now equals just 0.4 times shareholders’ equity. Intangibles represent just 7% of CAE’s total assets and it holds $81.1 million ($0.32 a share) in cash.

CAE’s stock fell to just $3 after 9/11, but got as high as $9.82 in March 2006. The stock also trades in New York (symbol CGT) as well as Toronto. If it prospers as we expect, buying by U.S. investors could one day spur a substantial rise in its shares.

The stock now trades at 19.7 times the $0.44 a share it should earn in fiscal 2007. The $0.04 dividend yields 0.5%.

CAE is a buy