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Edited Transcript of HO.PA earnings conference call or presentation 4-Sep-19 6:30am GMT

Half Year 2019 Thales SA Earnings Call

Paris Sep 5, 2019 (Thomson StreetEvents) -- Edited Transcript of Thales SA earnings conference call or presentation Wednesday, September 4, 2019 at 6:30:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Bertrand Delcaire

Thales S.A. - Head of IR & VP

* Jean-Loïc Galle

Thales S.A. - EVP of Space

* Pascal Bouchiat

Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems

* Patrice Caine

Thales S.A. - Chairman & CEO

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Conference Call Participants

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* Andrew Edward Humphrey

Morgan Stanley, Research Division - VP

* Celine Fornaro

UBS Investment Bank, Research Division - Head of EMEA Industrials Research

* Charles J Armitage

Citigroup Inc, Research Division - Head of European Aerospace & Defense Equity Research and Director

* Olivier Brochet

Crédit Suisse AG, Research Division - Research Analyst

* Tristan Sanson

Exane BNP Paribas, Research Division - Head of Aerospace & Defence and Equities Research Analyst

* Zafar Khan

Societe Generale Cross Asset Research - Equity Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen, and thank you for standing by. Welcome to today's Thales' 2019 Half Year Results Conference Call. (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, VP, Head of Investor Relations. Please go ahead, sir.

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Bertrand Delcaire, Thales S.A. - Head of IR & VP [2]

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Yes. Hello, good morning. Welcome, and thank you for joining us for the presentation of Thales' H1 2019 results. I'm Bertrand Delcaire, the Head of Investor Relations at Thales. With me today, Patrice Caine, our Chairman and CEO; Pascal Bouchiat, CFO of Thales; and a special guest, Jean-Loïc Galle, who is our Executive Vice President of Space, and who will update us on the latest business development in the Space side.

As usual, the presentation will be in English and followed by a Q&A session. It is webcast live on our website at thalesgroup.com, where the slides, press release and consolidated financial statements are available for download. A replay of the call will be available as from tomorrow morning.

With that, I'd like to turn over the call to Patrice Caine.

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Patrice Caine, Thales S.A. - Chairman & CEO [3]

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Good morning, everyone. So let's start with Slide #2. So what are the highlights of our H1 2019 results, which are undoubtedly solid. Once again, they demonstrate the resilience of our business model in spite of more contrasted performances at segment level.

Our Defence & Security order intake was particularly strong, completely offsetting the tough comps we had last year with the booking of the OneSKY jumbo contract. Organic sales growth, minus 0.5%, reflects the impact of the slowdown of Space as well as phasing effects in Transport.

As Pascal will explain, EBIT margin increased again at constant scope and currency, offsetting, first, the weaker performances in Space; and second, in Transport.

Finally, of course, we have been consolidating Gemalto since the 1st of April, and the main message there is that its results are fully in line with our expectations. In a nutshell, I think that these numbers continue to demonstrate how our strategic focus on profitable and sustainable growth keeps delivering value.

Let's move now to Slide 3. So as you know, this slide shows our key H1 figures in a few charts. At almost EUR 7 billion, order intake was up 10%, primarily driven by the integration of Gemalto.

Sales. Sales benefited as well from the integration of Gemalto. They grew by almost 10%, reaching EUR 8.2 billion at the end of June.

EBIT. EBIT amounted to EUR 820 million, up by 8% compared to H1 2018. As Pascal will show in a minute, the small decline in reported EBIT margin, 0.2 points, is purely due to the consolidation of Gemalto, whose profitability is more seasonal than the rest of the group. Once again, a strong EBIT performance.

At EUR 574 million, adjusted net income was up by 7%. As you know, for the first half, free operating cash flow is clearly negative, minus EUR 332 million.

And finally, as you can see on the last chart on the bottom right, our net cash has now turned into a net debt after the acquisition of Gemalto and the application of the IFRS 16 standard related to leases. No surprise here either.

So after this rapid overview, I now hand over to Pascal, who will comment our financial results in greater detail.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [4]

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Thank you, Patrice, and good morning to everyone. So I'm now on Slide 4. So starting with our order intake dynamics and key commercial successes in H1 2019. As Patrice mentioned, we achieved a solid order intake in the period, almost EUR 7 billion, 10% above H1 2018 on a reported basis. Excluding Gemalto's consolidation, order intake was down 1%, and you see on the chart that the contract unit value mix is quite stable compared to H1 last year. This is a solid performance if you remember that last year, we have booked the OneSKY contract, which is worth EUR 855 million.

In H1 2019, we booked 7 large orders, which is 1 more than last year. The 4 orders booked in Q2 include a pair of satellites, Spainsat NG, which we will build in consortium, and 3 significant defense orders: so a ground segment for the French military satellite, the onboard electronic systems on the Belgian Scorpion vehicles and a long-term maintenance contract for the French Air Force. The base of smaller orders with a unit value below EUR 10 million was stable over the first half and up 24% after the integration of Gemalto.

Moving on to Slide 5 and looking at sales. Well, the reported growth, almost 10%, is primarily driven by the consolidation of Gemalto. The currency effect is slightly under 1% of sales for the period, a EUR 16 million positive impact, mostly due to the stronger USD over the periods. Excluding scope and currency, organic growth was slightly negative, minus 0.5%. This small decline was driven by 2 factors: First, as you already know, we have been facing a slower-than-expected recovery in the space market, and Jean-Loïc will comment on this in more details. Second, we have quite high comps, especially in emerging markets as illustrated at the chart and (inaudible), which I will show in a few minutes.

Moving on now to Slide 6, looking at the adjusted P&L from sales to EBIT. I've mentioned already, EBIT was up 8% year-on-year and 4% organically. Actually, this table mostly captures the impact of the consolidation of Gemalto, which comes with higher gross margin, higher indirect costs and a more seasonal EBIT margin than the rest of Thales. You see the significant increase in gross margin, which is almost 27% of sales, and the following increase in indirect costs.

That's why I thought it would be more useful to show on Slide 7, which isolates the driver of EBIT margin before the consolidation of Gemalto. The usual EBIT bridge chart can be found in appendix. Operational performance, excluding its consolidation impact, is very solid. Gross margin continued to increase materially by 0.5 points. Indirect costs were flat as a percentage of sales. The strict control of marketing and sales expenses and G&A offsets the increase in R&D. As expected, restructuring costs increased by EUR 22 million to EUR 37 million, excluding Gemalto, mostly because of the engineering competitiveness plan in Transport. Finally, Naval Group's contribution returned to a more normal level of seasonality. Naval Group's management confirmed in July that it expects a 5% increase in net result this year.

All in all, excluding Gemalto, EBIT margin was actually up by 20 basis points. As you can see on the right, the consolidation of Gemalto was slightly dilutive, which is not surprising considering seasonality and impact of integration costs.

Moving on now to Slide 8. I will go through the performance of each of our operating segments in the next few slides. Let me just highlight key points. Negative Transport EBIT is due to a combination of one-off items, and I will further develop them in a minute. In parallel, the Defence & Security segment delivered a very strong performance with the margin moving from 12% in H1 2018 to an excellent 14.5% in H1 2019.

Slide 9 now. Looking at our Aerospace segment in more details, starting with orders. At EUR 1.8 billion, the order intake was down compared to H1 2018. The main reason behind this drop is a combination of 2 effects: the high basis of comparison in IFE and in training and simulations and the slow recovery of the commercial satellite markets.

At EUR 2.6 billion, sales were down by 5.7% and 7% organically. The driver behind this evolution is commercial satellite sales, and Jean-Loïc will further elaborate on this in a few minutes. At this point, let me stress that we now expect Space sales to decline by around 10% this year, which is in the upper range of our previous guidance.

All the other business lines delivered organic growth compared to H1 2018. EBIT amounted to EUR 270 million or 10.3% of sales, down by 0.1 points organically versus H1 2018. Considering the significant drop in sales, this is a very good performance, which we achieved thanks to the solid dynamics in Avionics. Let me point out that you should expect a bigger EBIT decline in H1 -- in H2, since as previously announced, we will book restructuring expenses in our Space business.

Now moving on to Slide 10 with Transport. First, order intake was back to a more normal level, EUR 556 million, after a strong H1 2018, in which we booked 2 large main line signalling orders. Sales were down by 8.9% organically. This negative growth has nothing to do with market dynamics. It's purely due to phasing effects on major urban rail projects. Sales growth was a bit exceptional last year. For example, H1 sales were organically up 22%.

The profitability of this segment turned negative, but this is primarily due to 3 one-off factors on top of natural quarter-to-quarter volatility: so previously announced restructuring costs linked with the engineering transformation plan, the mechanical impact of the drop in sales and the providence we add to Thales because of execution delay on a large metro project. Since these effects are one-offs, they're only affecting full year 2019 EBIT margin, and they don't put into question our medium-term expectations.

So we are now on Slide 11 with Defence & Security. Here, a very solid performance across the board. Order intake was up 16% organically, which is EUR 3.8 billion. Considering that H1 2018 order intake included the OneSKY project for EUR 855 million, the organic growth demonstrates once again the turnaround in defence budget and the strength of our competitive position.

Sales reached almost EUR 3.9 billion, up 6.8% organically. Most business lines contributed to this favorable sales growth. I could mention systems for combat aircraft, surface ships, optronics, infrastructure system and networks, radiocommunication products and so on. EBIT margin was substantially reaching 14.5%. This strong performance demonstrates what I had in mind when I was saying in the Q1 call that all planets are fully aligned for this business in 2019.

Strong revenue growth, good progress in our competitiveness initiatives, very low restructuring costs, very solid project executions and also positive one-offs representing in total a few ten of million euros. Because of that, you should expect H2 2019 EBIT margin to be below H1.

The last segment on Slide 12 with DIS, Digital Identity & Security. Let me highlight that this first period of consolidation is completely in line with our expectations. No need to comment on order intake since it is structurally aligned with sales in most of DIS business lines.

Pro forma H1 sales were flat. On the positive side, EMV cards showed good dynamics, notably driven by the reissue cycle in the U.S. The negative side, as expected, the HSM business was affected by the reorganization, if that goes through. The carve-out of the Gemalto post-HSM business, we had to sell, followed by the merger of the Thales and Gemalto teams. H1 EBIT amounted to EUR 37 million, which is in line with our full year guidance.

Turning now to Slide 13, a few comments on items below the EBIT. The cost of net financial debts and the other financial results is up by EUR 17 million. This is mostly due to the impact of the new IFRS 16 standard, which represented EUR 13 million. The finance costs on pension was stable, and so was our effective tax rate at 26.6% Minority interest were slightly down compared to last year, leading to an adjusted net income of EUR 574 million, up 7% and then adjusted EPS of EUR 2.7, up by 6%.

Moving to the key items on the cash flow statements, now on Slide 14. Excluding the impact of IFRS 16, operating cash flow before working capital changes, interest and tax was stable. Recurring pension cash out and net financial interest was also quite comparable. The pickup in income tax paid and CapEx are mostly due to the consolidation of Gemalto. As you heard, the biggest swing factor is the change in working capital, which is more negative than last year. Adding all these effects, our free operating cash flow amounted to a negative EUR 332 million, slightly below than last year on a comparable basis.

Thinking about full year 2019, let me remind you that we have 2 main sources of working capital volatility: the phasing of down payments on large export contracts and cut-off effects on payable and receivables. On previous calls, I have repeatedly explained how this year we'll face a EUR 200 million headwind from these cut-off effects.

Looking at down payments, it's probably fair to assume that, that would represent another EUR 150 million headwind over the full year. And we don't foresee at this point booking large export orders with large down payments before the end of the year. This is purely a phasing issue with the pipeline of opportunities remaining robust.

In addition, as I previously mentioned, Gemalto's cash conversion in 2019 will be depressed by one-offs. And of course, I mean, these calculations are before the positive impact of IFRS 16, which should be EUR 118 million this year.

So my final slide, Slide 15, will be to have a look at the evolution of our cash position. The 2 big items take our net cash position from EUR 3.2 billion at the end of 2018 down to a net debt of EUR 4.4 billion at the end of June 2019: the acquisition of Gemalto and the application of the IFRS 16 standards.

On the chart, you see the details of each of the building blocks in addition to negative free operating cash flow. IFRS 16 position, which impacted the net cash by a negative EUR 1.5 billion. Acquisition and disposal represented in total EUR 5.2 billion, including the acquisition at Gemalto and the disposal of our general-purpose HSM business. Third element, the dividend payments, amounted to EUR 336 million, significantly up versus H1 2018. And plus point is the deficit payment on UK pensions, which was roughly stable at EUR 48 million.

I'll now turn the call over to Patrice to talk about strategy and outlook.

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Patrice Caine, Thales S.A. - Chairman & CEO [5]

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Thank you, Pascal. So let's move now to Slide 17. So you've seen this slide in the past a few times. It is our -- the 5 strategic priorities that I set in the CMD in June last year. All of the team remained focused on the implementation. And in a month's time, at the upcoming CMD, we will come back on this priority, especially as we imagine the bottom 3.

This morning, I thought it would be more useful to update you on the situation of our Space business, so I asked Jean-Loïc Galle, our EVP of Space, to join us and share his views on the space market and on our strategy.

Jean-Loïc, the floor is yours.

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Jean-Loïc Galle, Thales S.A. - EVP of Space [6]

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Good morning, everyone. Thank you, Patrice, for giving me the opportunity to update the financial community on our Space business.

Turning to Slide 19, which provides an overview of our positioning. As a reminder, the Space business is part of what is called the Space Alliance, which involve 2 joint ventures with Leonardo: Thales Alenia Space, specialized in space infrastructures; and Telespazio specialized in services. Thales Alenia Space is fully consolidated in Thales' financial statements, and Leonardo's share is accounted for as a noncontrolling interest. On the other hand, Telespazio is consolidated as an equity affiliate.

With EUR 2.45 billion of sales last year, we are one of the world's largest satellite manufacturer. For example, we are the second largest manufacturer of civil satellites with a very long list of references. As you can see on the chart on the right, one of our key assets is that we have a well-diversified portfolio of customers. 50% of our sales come from what we call institutional customers: the European Space Agency, the European Commission and European space agencies. 20% of our sales come from military customers, in particular, the French and Italian Ministries of Defense. And 30% of our sales come from commercial customers, mainly telecommunication operators such as SES, Eutelsat or Inmarsat.

Thanks to technological investments, we achieved a quite significant growth in the past few years, plus 5% CAGR between 2014 and 2018. At the same time, we delivered solid EBIT margin in the high single-digit trend. But as Pascal explained, we expect our sales to decline by around 10% this year. So in the interest of time, I will focus my presentation this morning on the key drivers behind this decline, mainly the dynamics in the commercial telecommunication segment.

Moving now to Slide 20, which helps understand what has been happening in the commercial market. The chart shows a KPI that is closely followed within the space industry, the number of geostationary telecom satellites ordered worldwide each year. Let me remind you that although constellations attract a lot of attention, very few are operational, and geostationary satellites remain the dominant way to provide telecommunications from space.

As we have mentioned several times in the past, since the middle of 2017, the industry noticed a slowdown in orders, with several customers adapting what has been described as a wait-and-see approach due to a combination of higher uncertainty on the nature of demand in the coming years and the choice of technology to address this demand. Last year, at the June 2018 CMD, I presented the forecast from NSR, which predicted at that time, like most industry experts, that the slow labor of orders could not continue forever, in particular because operators have to replace the satellites in orbit once they reach the end of their lives. And as you can see on the chart, NSR was forecasting 15 orders to be booked in 2018.

The second half of 2018 clearly shows that this number was too optimistic. As you can see on the chart, the actual number of orders in 2018 was even lower than in 2017. However, the first 8 months of 2019 show that a recovery is now happening. Year-to-date, 10 geosatellite orders have been publicly announced. Over full year 2019, a few months ago, NSR was forecasting 20 orders, which is probably too optimistic. At this point, it's probably more reasonable to assume 15 or so orders for this year. What is now pretty sure is that it will be clearly above last year.

To take a longer-term perspective, and I am now on Slide 21. It's important to look at the demand that our customers, the satellite operators, will face in the coming years. And that's what you can see on the chart on the right. First, it's important to note that the demand for space-based telecom solutions is expected to grow quite strongly over the long term, plus 5%, according to the forecast from Euroconsult. So that's a very positive trend for us. However, it's also important to understand that this growth will come mostly from new applications. As you can see, video broadcast, which used to be the largest application of telecom satellites, is forecasted to progressively decline, while growth is expected to come from 3 categories of applications: first, consumer broadband, which means Internet access on land, typically in areas that are not well served by territorial networks; second, mobility, which refers to Internet access on both ships and aircraft; third, enterprise networks, typically to connect remote operations such as oil and gas platforms to IT networks, driven by the explosion of data volumes and the number of objects to connect to enterprise IT networks. And as you can imagine, the technological requirements to address these market segments are quite different from traditional applications like video, for example. For all of these data-hungry applications, delivering the highest data rate at the lowest cost becomes an absolute priority. For mobility, the challenge is also to deliver seamless connectivity to moving objects wherever they are located around the globe.

And to help them manage uncertainty around demand, satellite operators are eager to retrieve flexibility of satellites, be in terms of mission type or geographical coverage, so that the satellite can be repositioned above a region or a mission where demand is higher.

So how are we positioning ourselves to help our customers address this challenging transformation of the commercial market? I am now on Slide 22. Looking at the past few years, we have significantly increased our R&D investments to other satellite products that match this trend in demand. Since 2013, we have invested more than EUR 300 million in self-funded telecom R&D. These investments have allowed us to achieve global leadership in VHTS satellite solution, the large geostationary satellites that are optimized to deliver very high data rates at cheaper cost. This was, for example, demonstrated last year with the win of Konnect VHTS, which we are building for Eutelsat and which embarks the most powerful on-board digital processor ever put in orbit. More recently, we have been awarded SATRIA, a VHTS satellite that we will build for the Indonesian operator, PSN.

Recently, based on our discussion with many operators, we have decided to complement the VHTS satellite with the new fully digital satellite product line that will deliver the total mission flexibility that satellite operators now require. The investment to develop this new satellite, this new solution will temporarily weigh on our profitability in 2020 and 2021. That will, of course, strengthen our positioning in order to capture future market growth. To give an order of magnitude, I expect those investments should translate into low- to mid-single-digit EBIT margin until 2021, then growing back to the high single-digit by 2023.

This investment will also benefit our positioning in LEO constellations, constellation of satellites operating on lower orbit. In that segment of the market, we have a global leadership position, having built 3 telecom constellation now in operation. To develop Iridium NEXT, our latest project, we have, for example, developed crucial capabilities such as the management of data links between satellites. Thanks to that expertise, we are very well placed to play a key role with the new constellation that will develop in the coming years.

Turning now to Slide 23 and the key takeaways. All our end markets benefit from solid long-term dynamics. In the commercial segment, we are progressively emerging from the cyclical downturn, but the long-term outlook is solid and -- as I showed a few minutes ago. In an otherwise more connected world, space system remain uniquely placed to address some telecommunication needs. The dynamics with the institutional and military markets have also their own cyclicality, and both will clearly see growth in the coming years.

In November this year, European Space Agency's next Ministerial Council is expected to approve the significant growth of its budget. On the military side, space has become a priority topic. For example, the French MOD recently decided to commit an additional EUR 700 million to this area.

As shown on the chart on the right, the delayed recovery of the commercial market is weighing on our sales. It will be the main driver behind the 10% decline in sales in 2019 and the one in lower proportion that we anticipate in 2020. This financial trajectory does not assume the possibility that we book a telecom constellation, which would naturally represent a jumbo order for us. As highlighted, we already have a leadership position in the telecom market, which will be further strengthened by ongoing R&D investment. And as already said, these investments will naturally weigh on profitability in 2020 and 2021. They will, of course, enable us to maintain our leadership position in the market and to capture future growth.

With that, let me turn the call back to Patrice.

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Patrice Caine, Thales S.A. - Chairman & CEO [7]

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Thank you, Jean-Loïc. So this brings us to Slide 25. This slide is a recap of our updated full year financial objectives. With respect to order intake, we'll confirm our target to be slightly above EUR 18 billion, first. Second, our sales guidance is as well unchanged. However, considering the dynamics in Space, we are now expecting to be at the lower end of the 3% to 4% range we guided on previously. Sales. H1 DIS segment sales are in line with our expectations, leading us to confirm the 0% to 2% organic sales growth target. And finally, and more importantly, EBIT guidance remain unchanged, EUR 1.980 billion to EUR 2 billion.

So moving on Slide 26 now. Let me conclude with 1 last slide. So to remind you, our upcoming Capital Markets Day, where we hope to see and exchange with many of you, it is scheduled on the 3rd of October and will be held in Downtown Paris. You must have all received your invitation by now. If you haven't responded, please do so in the next few days. This Capital Markets Day will focus on the medium-term strategy of our new DIS segment, how it significantly strengthen our competitive position and the update of our medium-term financial objectives, including Gemalto, of course.

This concludes our presentation. Many thanks for your attention. And together with Pascal and Jean-Loïc, I will now be pleased to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Olivier Brochet.

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Olivier Brochet, Crédit Suisse AG, Research Division - Research Analyst [2]

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I will have a couple of questions, if I may. The first one is on the series of one-offs that we see in the first half and in the second half. Could you maybe elaborate a bit more on the various ones? Should we expect more in Transport, for instance, in H2? And how much did we have in H1? What was the amount in H1 in Defence? And is there any in Space in H1, please? And second question, on Satria, when do we expect the actual finalization of the contract? Or is there any reason to expect a delay or any difficulty going on that one? And last for free cash flow in 2019, can you give us a sense of the cash conversion for clarity sake, please?

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [3]

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Okay. Olivier, so first, I mean on one-off (inaudible) H1. Of course, it is pretty much [season]. We have a negative one-off item in Transport which relates to some execution delays on a specific metro project. And the overall magnitude of this is what we mentioned, a few tens [of million euro]. You can consider that (inaudible) close to EUR 40-odd million. So as negative one. And the positive one-off in H1, this relates to our Defence & Security business. Our performance in this segment in H1 was, as you have seen, extremely strong and, as I mentioned, that we delivered on all our performance drivers for this business. It's also true that we took advantage of the few tens of million euros. You could consider that overall it is close to EUR 40 million as well and which essentially relates to our ability to release some provisions as we are finalizing very successfully the completions of some projects. So I mean this is quite simple. H2, I mean, on our various businesses, I mean, I don't anticipate anything specific. Of course, as you know, we will book restructuring in H2 and in particular in our Space business. And the amount at stake will be also quite significant. Overall, you could consider that it should represent probably between EUR 40 million to EUR 50 million of restructuring costs that we will be booking on our Space business in H2, this to address, I mean, the need to address the overall head counts in our Space business, following and what Jean-Loïc explained in term of lower -- or longer recoveries that's expected in this business. Second question, on Satria, I will leave Jean-Loïc to answer.

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Jean-Loïc Galle, Thales S.A. - EVP of Space [4]

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Yes. On Satria. So we have signed the contract with the customer on -- during the first semester. And the second semester is dedicated for the customer to finance this project with a pool of banks and with a strong support and the positive support of Bpi in France. And we are expecting no difficulty to finalize this contract, and we are planning end of this year in order to put this contract into force.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [5]

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Okay, your last questions, Olivier, was about cash conversions, but I don't remember exactly, I mean, your questions, if you can rephrase.

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Olivier Brochet, Crédit Suisse AG, Research Division - Research Analyst [6]

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No problem. And Pascal, the question is very simply what cash conversion target that you have for the year.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [7]

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For the 2019 year. I mean clearly, I mean, [is there further] a bit of explanations? And this is what I started explaining when I discussed the cash flow slide a few minutes ago. All that I'm going to say, I mean, we already shared in the past, in particular at our last year Capital Markets Day but also when we released our 2018 figures. So overall, I mean, we said that the conversions ratio from net income to operating cash flow to be around 90%, and this excluding, I mean, one-off exceptional items where we face by definition volatility. I mention 2 more specific points, one being, I mean, the sequence of down payments following, I mean, the way we book large orders, in particular large-sized export project. And the second element underlying volatility is more, I mean, cutoff aspects with regard both receivables and payables. On the second item, you probably have in mind that -- back in 2017, where we achieved a level of free cash flow that was much above our net adjusted income, you'll probably have in mind that, in 2017, level of free cash flow was around EUR 1.4 billion for a net adjusted income that was more in line with EUR 1 billion. And I mentioned, at that time, that we had some -- these cutoff effects. And because of that, we would say headwinds in 2018. We said that half of this cutoff would reverse in 2018, and the second half in 2019. So I do confirm these points, which means that in 2019 we'll get, I mean, the second phase of this reversal, in total of around EUR 200 million.

Now coming back to my first drivers, which is about, I mean, the sequence of down payments coming from large-sized export contracts. As I said a few minutes ago, we have headwinds in 2019 with reversal of some large down payments we benefited from in particular in 2015 and 2016. And what I mentioned is that this should represents a EUR 150 million in 2019. The last point that you also need to have in mind overall is, I mean, the effects of the Gemalto acquisitions, within '19 some one-off cash out, in particular, I mean, relating to costs that have not going through our P&L in 2019 but where we'll face a cash out. And a good example of that is [strengthening expected fees] that are due to our, I mean, overall advisers, in particular I mean investment banks, that will be cashed out in 2019, whereas I mean this has been a [prediction in the past]. So you see, I mean, various items. So in total and to make a long story short, but I guess, I mean, it was necessary to provide you with this type of explanations, let's consider that in total, in 2019, 70% (inaudible) conversions ratio from adjusted net income into free cash flow is probably a good guidance for it in 2019.

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Operator [8]

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The next question comes from the line of Celine Fornaro from UBS.

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Celine Fornaro, UBS Investment Bank, Research Division - Head of EMEA Industrials Research [9]

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My first question would be regarding the Transport underlying performance, if Pascal or Patrice, you could provide slightly more detail. I understand there's a lot of one-off, but how are we performing in terms of H1 and H2, if we were to take these charges out? Because given the numbers that you've suggested, it does look that the H1 pickup in margin on the underlying business remains fairly weak. And how confident are you in terms of your pickup in H2 again on the underlying business? And my second question would be related to Gemalto performance, if you could provide a little bit more color on the -- I will say, the 2 different parts of the business, the fast growing one in theory, and the one on the SIM cards for H1. I mean particularly in Q2. And also, how is the business performing in July and August given that we're nearly close to Q3 results?

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [10]

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Okay, Celine. And so I suggest I'll start -- that I'll start answering your question on Transport and maybe [leading] Patrice to complement if necessary. So on Transport it's true that, when you look at our H1 figures, there are 2 points that we need to raise and which weighed quite a lot on our EBIT margin. One is what I explained a few minutes ago about these specific large-sized metro projects where we are facing execution delays. And I mentioned, I mean, an amounts which represents around EUR 40 million. And second point, which is also a one-off but which, I guess, all of us have fully anticipated because we communicated largely in the beginning of 2019, which is, I mean, the restructuring costs associated to the competitiveness program relating to our engineering base in Germany. And we mentioned beginning of 2019 that we would -- we will book a restructuring charge in 2019 between EUR 20 million and EUR 30 million, and this is what we have done in H1. No -- I mean to give a global picture on how we see 2019 in our Transport business overall in term of profitability and, I will say, underlying profitability. We said that in 2019 we should be able to come back to a level of EBIT margin that was, I mean, the level of margin at this business back a few years ago. And we mentioned that it should be the underlying profitability of our Transport business in 2019 should be close to 6%, and we confirm [these points]. Now you will need to adjust this 6% and the 2 one-off items I've just mentioned. I mean both, I mean, the restructuring charge in Germany but also, I mean, what I've just explained with regard this execution delay on this very specific large-size metro project. Patrice...

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Patrice Caine, Thales S.A. - Chairman & CEO [11]

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(inaudible). So the element -- I suggest a small complement to what you were -- rightly explained, Pascal. It's the volume effect, as we have a phasing effect on some large contracts, typically for [Alenia] (inaudible) or either jumbo contract, but we are closer to the end than to the beginning. So clearly, it generates less volume, less sales than in the past, but this is certain, say, quite mechanical effect.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [12]

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Second question was about giving you a bit of color on the underlying Gemalto business. So in H1 -- and so without considering that, as you know, we've started consolidating the business from Q2, but when we look at overall H1 figure for our new DIS business and which is essentially, I mean, Gemalto, as you know -- so overall, in H1, a level of business which is rather stable all in all, as compared to H1 2018 but, of course, I mean, taking into account, I mean, up and down [quarter bias underlying] business. And with regard, I mean, the 3 business, I will say that, I mean, the sequence is developing as expected, with obviously the continuous but well-under-control drop in sales. And I intend to keep focusing on those markets where we can maintain a sound level of profitability, which is absolutely the -- I mean, the case. On the -- like we mentioned, in the EMV segments, we see today a level of demand which is rather good and which is driven by, I mean, additional sales in particular in Americas, both U.S. but also Latin America, with probably 2 underlying drivers here. First is the fact that U.S. are entering into a renewal cycle after the introduction of EMV cards back 4 years ago. And second driver is also the development of contactless cards in Americas, both in the U.S. but also in Latin America.

Maybe last item that I've mentioned in my presentations, the fact that, the remaining HSM business, that's re-contributed to this new statement is suffering a bit following, I mean, the divestiture of our general-purpose HSM business; and the fact that we had to reorganize this business which is today merging with the existing or the preexisting Gemalto business [system]. And there is, of course, as you can imagine, various changes in positions, which creates a bit of disruptions to get that but we do believe that it's just a temporary effect. As always, it is doing quite well, in particular in the IoT business (inaudible). It's doing overall as expected, with a very strong growth rate in this business. So in a nutshell, this is what we can share with you, and all of that pretty much in line with what we expect. I think I'll remind all of us that the Gemalto business is a seasonal business, which means that DIS reporting segments will show an increasing part of level of seasonality which seems to be a bit more important than what we'll see [and also what's performed in Thales businesses].

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Bertrand Delcaire, Thales S.A. - Head of IR & VP [13]

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Last point, on -- Pascal, on identity, (inaudible) implemented.

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Patrice Caine, Thales S.A. - Chairman & CEO [14]

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So it is going, I will say, well...

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [15]

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Yes.

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Patrice Caine, Thales S.A. - Chairman & CEO [16]

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The underlying market, I will say, active in many parts of the world. By the way, this type of business is quite close to the ex-Thales, I will say, businesses. So from, I would say, large contracts, [we are looking to decide on] this -- of this business. And so, so far, so good, quite promising.

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Operator [17]

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Your next question comes from the line of Tristan Sanson of Exane.

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Tristan Sanson, Exane BNP Paribas, Research Division - Head of Aerospace & Defence and Equities Research Analyst [18]

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Three question on my side as well. So the first 2 are actually follow-ups on the question of strategy just for clarification. First, on the cash flow guidance. If I remember correctly, you said at the beginning of the year that you were aiming at 90% cash conversion, minus the EUR 200 million of cutoff effect; and this year should not be impacted by any material movement from net advances from working -- net customer advances on large contracts. So [anything as] something like a bit more than 1 billion. Now 70% applied to contracts. You suggested the net income is about something like [950] or 80 million your -- lower than what you could imply from your initial guidance. What has changed throughout the year? Is it your estimate of the working capital movement on the large contracts? Or anything else that has moved on the cash rate question justifying the slight cut? The first question. The second one is on the Defence margin. So I understand you have about EUR 40 million of headwind coming from, let's say, exceptionally good margin release on a Defence contract coming into completion. Do you have a further contract coming to completion with similar situation in H2 this year supporting your profitability? And can you give a kind of comparison of what H2 '19 margin in Defence would look like compared to H2 '18? And the last one is coming back to your helpful focus on Space. You gave a fairly good view of the general market order trajectory on the geostationary telecom satellite. Can you comment on the evolution of your market share over the same period of time? And what you expect this market share to be in '19, '20 will be helpful.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [19]

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Okay. Tristan, first, I mean, on the cash flow, I mean you are absolutely right. A few months ago -- I mentioned that -- on the reversal of down payments, I said that we believe that those reversals on previously booked large-size export contract -- the reversal of down payments could be compensated by new large-size export orders that we could book in 2019. And that would compensate these reversals. As I explained in my presentations, today, we believe that we will not get the advantage of large export contract with large down payments that could materialize in 2019. I mean, in term of business, I mean, there is nothing specific concerning about what I've just said. It's not a sequence of booking or phasing effects in those large-size export contract, but it's true that today my guidance for all of you will be to consider that it is unlikely that we will be able to compensate the reversal of historical down payments that we benefited in particularly 2015, 2016, by, in 2019, in H2 2019, new order intakes with large down payments.

Your second question is about just on profitability of Defence & Security, yes. I mean, as I mentioned, something around EUR 40 million, I will say, is a positive one-off. And second, I mean the excellent execution of projects and projects coming to an end in term of executions. This is what's the main impact (inaudible) in H2 2019, which means that I anticipate the level of EBIT margin in H2 2019 for Defence & Security business to be below what it was in H1. Or to make a long story short, I mean, H1 EBIT margin in Defence & Security was 14.5%. Today, probably a good guidance for you but -- I think a guidance for you will be to consider that H2 Defence & Security EBIT margin will be probably more close to 13.5%. So overall, I mean, a level of 14%, 1-4, EBIT margin for Defence & Security for the full year 2019 is probably a good rule of thumb. This is an excellent level of profitability. I'm not telling you that Thales will be able to sustain this level of profitability going forward. I mean I remain in line with what we shared with you at our last Capital Market Day, but it's true that, as I said many times, for Defence & Security business in 2019, all planets are actually well aligned. I have to admit that I don't remember the first question...

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Unidentified Company Representative, [20]

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Market share.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [21]

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Market share in Space, yes.

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Jean-Loïc Galle, Thales S.A. - EVP of Space [22]

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So concerning Space, as I have explained, 2 items. Yes, in term of volume of the market, we are also showing of the slowdown of the market, but I also explained that there was a change in the demand of our customer for more powerful satellite and more flexible satellite. And in this field, as I explained, we invested a lot in technology in order to be very well positioned to answer to those demand. And we have been awarded some contracts in '18 and '19 for those kind of satellites. So yes, we are gaining market share, and we expect to continue to gain market share in the future because of what we anticipated on the technology for this market. When we are speaking of market share, we are also speaking of competitors. And usually we don't comment about competitors, but we have to mention obviously that the company named Maxar, who used to be the market leader, has clearly dropped in term of market share, and this trend obviously has a positive impact on us.

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Operator [23]

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We will take our next question from the line of Zafar Khan from Societe Generale.

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Zafar Khan, Societe Generale Cross Asset Research - Equity Analyst [24]

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Just looking for a little clarification, please, on these Space sales numbers which you've given on your slides. Am I correct in thinking that those are the numbers that you actually booked through your sales line? So that's just the manufacturing sales that you obviously consolidate. And just to follow on from that, If I'm stripping out the Space contribution from the division, can you just give me some idea of what's happening to the Aerospace margins underlying and what the expectations are in the medium term?

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [25]

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Okay. Zafar, first, I mean, just in terms of clarifications, Everything Jean-Loïc presented this morning relates to Thales Alenia Space business, which as you know is fully consolidated within Thales. And here it is about the revenue of the sales line. Of course, this doesn't reflect the service component which is part of Telespazio; and which is in the part, of course, of the revenue that you have seen on Page 20 to 23. Then, I mean, your next questions was about the overall and -- I mean the Avionics component of our Aerospace segment?

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Zafar Khan, Societe Generale Cross Asset Research - Equity Analyst [26]

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Yes, that's what I'm asking for, just if I exclude the Space contribution from the Aerospace division, just trying to understand what the underlying margin trends are there.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [27]

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Okay. So overall, I mean, our avionics business performed extremely well in H1 2019 at a level which is a bit above what we mentioned to you at our last Capital Market Day. If you are reminded what we said a year ago, we said that our objective on Avionics business was to sustain a solid double-digit EBIT margin, I mean, basically in H1. It was really, I mean, as we took account of this guidance. So overall, we did extremely well with a good level of -- I will say so, robust level of growth. Now I mean, once again, we are talking here about H1, so I need to be a bit, of course, careful about that. I mean we don't see anything concerning on our Avionics business, but it's true that the level of performance that we achieved in H1 was pretty good.

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Operator [28]

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We will take our next question from the line of Andrew Humphrey from Morgan Stanley.

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Andrew Edward Humphrey, Morgan Stanley, Research Division - VP [29]

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Just a couple, if I may. And one is back on Defence & Security. I think you've been very clear in an answer to an earlier question on what your expectations are there for margin trajectory, but clearly we have a picture where your 2019 full year margin will be above your medium-term expectations for that, so I wanted to try and get an impression for whether there's been any difference in the mix or the underlying business this year that is the reason for that kind of medium-term margin expectation being lower. Because I mean the things you highlight in the press release are more around execution and better cost performance rather than mix. So that might, I guess, give us more of a clue about how conservative you're being there in the midterm. And the second area I wanted to ask about was Space. And please forgive me if I'm misreading this, but it looks as though your expectation in terms of the number of launches this year is going to be up. And yet your revenue expectations for the Thales business are for the decline this year of about 10% that you've highlighted but also for a further decline in 2020, so my question really is how can we reconcile that with your commentary that actually you are at the margin gaining some share in this market.

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [30]

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Okay, Andrew. So on Defence & Security, yes. I mean I do confirm that the overall EBIT margin that we should be able to reach in '20 and 2019 is above what we've seen as a mid-term guidance, and it will be a combination of 2 things. I mean, first, as I pointed out (inaudible), [including as you] mentioned, overall, I mean, a level of executions, level of competitiveness initiatives which have been extremely good. And a bit difficult to consider that, I mean, we'll able to keep executing this such as a quality of executions. I mean it's right to consider that on a business of this size we might not be able to keep being able to deliver with this which is even probably more than best-in-class level of performance. Second points, you're absolutely right. It's true that we are today taking advantage of favorable mix overall. And I don't want to comment any further because it will be, quite frankly, sensitive information, but it's also true that we keep seeing, I mean, customers putting a lot of pressure on the defense industry in term of prices. So we are also part of overall a competitive landscape and we need to take this into account when we guide you in term of margin for the midterm.

On Space, maybe I will start, and Jean-Loïc will complement. So overall it's quite -- I mean it's quite simple. It's really a lagging effect between on, one side, I mean, the level of demand from a market standpoint; and how this translates in our order intake and then in our level of revenue. And it's true that the drop in this market, I mean, that we are seeing in the -- Jean-Loïc's presentation will -- thus has resulted in a level of order intake which was as small in 2017 -- in 2018 at Thales Alenia Space. And even though progressively we will recover, it will take a bit of time before you can see this materializing in our sales line in our P&L. Jean-Loïc, do you want to complement?

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Jean-Loïc Galle, Thales S.A. - EVP of Space [31]

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No, just to be -- note with that you have to be aware that the development and production period of our satellite is between 3 and 4 years. And the peak of revenue is 2 years after the booking, the date of booking of the satellite. So clearly our turnover in '19 and '20 reflect the bookings that we had in '17 and '18. And it best explains the gap that you see between the increase -- the forecasted increase in the market for '19 and what we forecast for our sale in '19 and '20.

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Operator [32]

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We will take our next question from the line of Charles Armitage from Citi.

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Charles J Armitage, Citigroup Inc, Research Division - Head of European Aerospace & Defense Equity Research and Director [33]

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I'm still just coming back to Defence & Security margins. So 14.5% margins are fantastic, maybe 100 basis points of that due to provision release, so that gives me 13.5%. Am I to think that your 12.5% mid-term or 2021 target is -- there's just going to be some volatility? And should I be thinking that as -- that 12.5% as an average, or am I to think of that as the low end? i.e, are we talking about 12.5%, if everything goes well, we'll get to 13.5%, as we did this half; or 12.5%, plus or minus 100 basis points?

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Pascal Bouchiat, Thales S.A. - CFO and Senior Executive VP of Finance & Information Systems [34]

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Okay. Charles, I mean, first, just we'd like to tell you that, I mean, the 12.5% that you mentioned is the upper part of the range that we presented last year as being our mid-term guidance. Because we said that, our Defence & Security business, we believe that in the midterms should be between 11.5% and 12.5%. So I'm happy that we have taken the upper part of this range, I mean, at this point. I mean I keep concerning you the fact that it should be between 11.5% and 12.5%. So once again, it -- this proves that, in 2019, we'll be above this level. And this is what we explained today, for the reason I mentioned. What I suggest is to have this type of conversations about the mid-term guidance on our Defence & Security business when you'll see us in October, at our next Capital Market Day. A key point and probably, I mean, what we would like to pass to you in that message: Please don't take a single year as the year of reference for the next 5 years in terms of EBIT margin. At this point, we need to be -- and this is my overall message. We need to be a bit more careful and, at this point, being pretty much in line with what we said a year ago at our last Capital Market Day.

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Patrice Caine, Thales S.A. - Chairman & CEO [35]

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Yes. And I think it's time to conclude. I think Bertrand is telling me that we need to work to meet some of you guys now in downtown Paris.

So thank you for attending this call. Just as a last message: This is H1 results are solid and put us on a good footing to deliver on our full year guidance, of course. And we all look forward to seeing you at our Capital Market Day next month, on the 3rd of October.

So have a good day. Buh-bye, and see you on the 3rd of October.

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Bertrand Delcaire, Thales S.A. - Head of IR & VP [36]

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Thank you.

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Patrice Caine, Thales S.A. - Chairman & CEO [37]

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Thank you very much. Buh-bye.

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Jean-Loïc Galle, Thales S.A. - EVP of Space [38]

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Thank you.

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Operator [39]

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Thank you. Ladies and gentlemen, if you didn't have a chance to ask your question on today's call, please do not hesitate to send your questions to Thales group investor relations at ir@thales.com (sic) [ir@thalesgroup.com], and we will get back to you as soon as possible. Thank you all for your participation. You may now disconnect.