AAR Corp. (AIR) Earnings Call Transcript & Summary

Okay, thanks so much, and good afternoon to all of you. I truly appreciate everyone taking the time to be with us today as we go over what we delivered in Q3 FY 2020. But before diving into the quarter's specifics, I want to say a few things about COVID-19. To start, our hearts go out to everyone who has been hit directly, and we want to express our gratitude to the healthcare professionals worldwide who are on the front lines combating this. As all of you are aware, the global aviation sector is facing a situation unlike anything we've seen before. AAR is stepping into this period of uncertainty from a position of strength. Our business mix is diverse, with roughly 35% of sales coming from government customers, plus meaningful commercial sales to cargo carriers. On top of that, we have a solid balance sheet, with net leverage under one-times, considerable liquidity, and strong ties with our customers. That being said, we do anticipate a significant hit to our commercial airline business because of the drop in commercial air traffic. To get ahead of the expected effects of COVID-19, we're implementing measures to keep costs in line with the falling demand. Those measures include a freeze on hiring, cutting or removing all non-essential spending, lowering executive pay, furloughs and, regrettably, workforce reductions. Even so, we're ready to take further steps if needed to address the changing business landscape. When it comes to possible government help, I've been speaking directly with members of both the House and the Senate, along with the Administration, about potential support, not only for the airlines but for the wider aviation industry as well. As you're aware, we've put in a lot of effort over the past several quarters to strengthen our recruiting, build training programs and team up with different schools to establish a pipeline for technicians. Because of our dedication and track record in developing and keeping a skilled workforce, we strongly back any government efforts designed to protect jobs. The safety and well-being of our employees, along with our customers and vendors, comes first. We're carefully tracking CDC guidance and have put remote working, social distancing and associated business continuity plans in place throughout all our offices and facilities. These actions, together with the broader business conditions, are generating a great deal of uncertainty and strain for our team. And I genuinely want to use this moment to express my thanks to the AAR employees for their hard work, commitment and adaptability as we navigate this challenging period. I'm extremely proud to be part of the finest team in aviation. Now, on to our results. We achieved a record third quarter, and I'm happy with how we performed overall. Sales rose 4% from $530 million to $553 million, and our adjusted diluted earnings per share from continuing operations went up from $0.62 per share to $0.67 per share. The quarter's solid outcome came from ongoing standout results in our government programs, parts supply, and MRO activities; during the period, we disclosed multiple fresh business wins, showing that AAR remains the preferred partner across the aviation services sector. To be specific, we shared that — we shared our intention to grow our airframe maintenance services alongside Air Canada so that its A330 fleet is covered. In addition, AeroControlex, a major producer of vital components for aviation, picked AAR as its sole worldwide distributor for the APU lube pump product line; we hold deep aftermarket knowledge in those specific products and are already witnessing outcomes from this sizable growth opportunity. Last, we landed a $90 million sole-source IDIQ contract with the Defense Logistics Agency covering specialized shipping and storage containers plus accessories. As the release noted, there are multiple restructuring steps we have already taken and will take so that AAR's performance and strength keep improving. As we discussed before, costs have risen in certain commercial programs contracts, and that was hurting our financial results. We acted decisively to leave one contract and restructure two others, letting us unlock capital, better cash flow, and higher margins. Those steps produced a one-time charge of $24.7 million that was mostly non-cash. We have also decided to pursue several more restructuring steps in our fiscal Q4, involving facility consolidation to cut costs further. Before I hand things to Sean, I am glad to report that after the quarter closed, we finished selling our last contract within the COCO Airlift business. As discussed previously, this wraps up the exit from that business as part of our strategic shift, and we are happy to have that piece of our plan done; with that, I will pass it to Sean, our CFO.

Thanks, John. Sales for the quarter came in at $553.1 million, which was 4.5% higher, or up $23.6 million compared with a year ago. Within that, Aviation Services revenues rose $33 million, or 6.6%, mostly from work we executed on government contracts, and those contracts make up roughly 35% of our revenue. Higher MRO volumes and robust demand in our parts supply operations also helped drive the gain. As John noted, in our commercial programs business we ended one contract and reworked two others during the quarter; those moves produced a one-time charge of $24.7 million that was predominantly non-cash, appearing in the P&L as a $9.8 million reduction in revenue plus forward loss reserves and other related charges in cost of sales of $14.9 million. Aviation Services gross profit fell $16.5 million, a decline caused by that one-time $24.7 million charge. If you set that charge aside, our profit would have risen by $8 million. Gross profit for government programs MRO and for parts supplies each went up versus a year ago. Gross profit within Expeditionary Services dropped $3.5 million. Although we had anticipated a recovery in this segment during the quarter, we are still seeing a delay in a large contract award along with certain operational challenges. In Q4 we are taking restructuring actions aimed at lowering fixed costs and overhead. Within Expeditionary Services, we will combine facilities, which will boost production efficiencies, remove excess capacity and bring down our overhead and fixed costs substantially. Together with our current backlog, we expect these restructuring actions to deliver better performance going forward. Also, as John covered, during the fourth quarter we began cost reduction measures in response to COVID-19, among them a hiring freeze, cutting or eliminating all non-essential spend, lowering executive compensation, furloughs, and reductions in force. All told, we anticipate the facilities consolidation and the COVID-19-related steps will generate one-time costs of roughly $15 million to $20 million pre-tax in the fourth quarter, with payback on these actions coming within one year. SG&A expenses for the quarter were 10.5% of sales, against 10.3% in the prior period, with the rise mostly attributable to investigation and compliance-related costs. If you exclude investigation and severance costs from both periods, SG&A would have been 9.9% of sales this quarter, versus 10.1% in the same quarter last year. Net interest expense came to $2.3 million, down from $2.4 million a year earlier, reflecting lower borrowings this year that were partly offset by higher rates. Cash flow provided by operating activities from continuing operations during the quarter was $9.7 million. We keep investing in inventory to support our parts supply activities. In addition, because we performed under a certain government program contract that paid in advance last year, we brought down our deferred revenue on that program considerably, which meant less cash flow in the prior year period. During the quarter, we returned $2.6 million to shareholders through a dividend of $0.075 per share. Our balance sheet remains strong, with net debt of $171.1 million and net leverage of 0.9 times. At the start of this year, we increased the size of our revolver, adding $100 million, bringing it to $600 million, and pushed out when it comes due until September 2024. The sole remaining maturity besides that one is a $23 million term loan that comes due in November 2021. At the close of the quarter, our total liquidity stood at $432 million, made up of $37 million in unrestricted cash plus $395 million of availability on the revolver. On top of that, we had $92 million of net capacity available through our accounts receivable facility. I appreciate everyone listening. And now I'll hand the call back to John.

Okay, thanks, Sean. Although we're happy with how Q3 went and with results for the year so far — both of which came in above the guidance we had already raised — because of what COVID-19 is doing to the commercial airline market, we think the wise move right now is to pull our fiscal year 2020 guidance. It's certain that COVID-19 is going to hit our commercial airline business hard. Even so, volume coming from government customers is solid and should keep climbing, and we have a sizable cargo operation that we could see growing under these conditions. When it comes to airlines, flying will come back and expand, planes will go back into service, and aftermarket parts and services will be needed. Along those lines, we think opportunities will open up for AAR, since capital limits, together with cheap fuel, will probably lead airlines to scrap orders for new planes and maybe keep existing planes in use longer. On top of that, demand for used materials will rise as airlines try to cut costs by using aftermarket parts. And as the biggest aftermarket parts supplier globally, we'll gain from more supply as planes get retired. Beyond that, we expect competition in the aftermarket — which had increased over recent years because of how long the upcycle lasted — to shrink as our rivals fight to stay alive or shift more and more toward their core activities. Let me stress again that AAR sits in a strong spot. We're diversified when it comes to end markets and geographies, and our balance sheet is exceptional. I came to AAR shortly before 9/11, and I've witnessed what this company is capable of when times get tough, and we head into this event in an even better place today. It makes me proud to be on such an incredible team, and I have no doubt we'll come out of this even stronger; with that, I'll hand things to the operator for questions. Thanks.

Good afternoon.

Hey, Rob.

John and Sean, clearly this is an extremely difficult period. Naturally, we're hoping for the best as you navigate all of this. To begin, I'd like to ask whether there's any way to give us a framework — perhaps based on what you've observed so far during March, or what you're hearing from your customers? And given those quite substantial capacity cuts that have already begun, do you have a sense of what the ASM decline looks like and how it connects to your business or the different businesses? Can we arrive at some sort of algorithm?

Well, I'm not certain an algorithm exists, but allow me to go through it one piece at a time across the company. As we said regarding the government side, during the past quarter — the third quarter — we experienced considerable growth on the government side. And right now, we see that carrying on, or we see the government business staying strong, and we anticipate further growth there. Cargo too — cargo through contracts we hold in our parts businesses, the supply engine providers or engine overall providers with parts for cargo customers, plus some activity in the MRO business — we expect the cargo business to remain solid and possibly grow, as I mentioned. When it comes to airline customers and MRO, we're in continuous communication with all of our major customers, and this is a highly dynamic environment that truly shifts daily. At present, we have a decent amount of work in the hangars; they're mostly full. But we expect a significant drop in that work as we move toward the summer. We're receiving varying information from different customers right now regarding the schedules they — they're assembling. The one encouraging aspect of all this is that, for many of our MRO customers, we are the primary maintenance provider, and they understand the value of maintaining solid lines of work with companies like us — and us in particular — and the message has been, we'll do everything we can to keep it full. That said, we are expecting a significant decline in maintenance activity across the facilities as we head into the summer. And then regarding the airline parts businesses, both new — or parts sales, both new and used — we would say that those — it's early to tell, and the business actually has been holding up, up until just the last few days. We did see some decline out of Asia in the third quarter, and that has continued. But the business has been holding up, though we have seen a decline just in the last few days. And we are anticipating that, that business tracks — the parts business tracks with — parts business and commercial PBH business tracks with ASMs.

All right. Could you remind us what portion of total revenue comes from cargo?

Sure. That figure isn’t one we generally disclose, and it moves around. Generally speaking, though, it falls somewhere in the 10% to 15% range for the commercial business.

Regarding the commercial side of things. Alright. Then another item I'd like to raise, when we consider each of these different strains — what words would you use for your cost structure? I'm not sure whether this one's directed at you or at Sean. Perhaps the best phrasing is this: your fixed costs compared with variable costs, considering how labor-heavy at least a portion of your operations is?

Right. Because of how our business works, you'd figure that the bulk of what we spend is variable, since when you look at the parts supply operations, our cost of sales is clearly the inventory we acquire that sits on our shelves or that we purchase in the market. Then the remaining pieces involve shipping and sales, correct? Thus, these are genuinely variable costs tied to activity levels. The place where you find somewhat larger fixed costs is the infrastructure needed to support, clearly, the hangars along with the MROs. Once more, much of the labor in that area leans more variable in nature when it comes to contracts and the personnel who handle the activity. After that, in commercial programs, a portion of the infrastructure supporting the supply chain carries a more fixed character. However — therefore, I'd say we operate with a cost structure that's highly variable throughout the entire company. Certain pockets exist where it's somewhat more variable in part supply, plus some fixed costs within the hangars and other places.

All right. Then the final item on my end is this — what's the right way to frame where working capital goes from this point? Clearly you're carrying parts inventory, and with activity having dropped off, do you reduce those holdings? Are you still actively buying parts? To the extent you can tell, how should we view working capital across the coming few quarters?

Yes.

could you give us a sense of things?

Yeah, I believe so, and as you point out, this is clearly a situation that keeps changing. At this moment we're definitely in a phase where we're using up the parts inventories we already have. As things calm down and chances come up, we'd consider possibly putting money in; however, at present, our attention is squarely on the cash needed to run the operation and on drawing from the inventory on hand to meet demand.

All right. Thanks to you both for that context.

Hello there, and good afternoon to John and Sean.

Hey, Ken.

John, first question on the commercial programs business. You mentioned one contract exited, two restructured — how should we think about what remains? With these steps taken, how do you see the risk now? Is it fairly well level set from here?

The actions we took on those contracts feel good to me; as we've said over the last couple of quarters, they'd been a headwind. Those came in response to restructurings within our customers. So I'm glad we could take those steps. As we noted, they'll deliver margin improvement and cash flow improvement; however, with COVID-19, power by the hour contracts, as the name suggests, rest on the airlines' flying hours, and we've seen declines across every fleet we support. Some of those contracts include minimum flight hour protections, though how those protections get enforced is truly uncharted territory. So we're talking with all our customers about what program support will look like going forward, as they weigh the impact on their own fleets from COVID-19.

All right, that's excellent. Thanks. And if I could just build on what was asked before, perhaps one useful way for us to frame this is: when you examine in particular the parts supply and MRO operations, clearly the airlines appear to be reducing discretionary outlays quite forcefully. From a timing perspective, I'm simply wondering — my assumption would be that you witness that effect, without a doubt, in parts trading and parts distribution quite quickly, maybe as you mentioned earlier, whereas over on the MRO side there's somewhat of a delay; yet afterward, emerging from all this, my guess is you'd observe it in trading and distribution quite rapidly. But could you perhaps explain how we ought to think about, for those two segments of the business — MRO and the parts side — the timing and the way this kind of moves through the company?

Yeah. Regarding parts, I believe your understanding is correct. Only within the past several days have we truly begun to witness a decline take shape; in fact, it was a decline in volume. Right up until the last couple of days, things were in fact holding up reasonably well. And we'd anticipate that, as airlines park their fleets and seek to cannibalize components from planes sitting on the ground, we'd anticipate a significant drop in those everyday parts activities, both where trade is concerned — more specifically, with respect to trading, the distribution operation, which is mostly consumables and expendables. So that isn't — those aren't components that would necessarily be subject to cannibalization. However, as airlines work through whatever inventory they have on hand, we'll witness a deceleration, and after that we might see some replenishment orders come in. Still, my expectation overall is that volume on the new parts side will fall too. Over on the maintenance side, once more, those are — assuming the aircraft returns, those amount to maintenance deferrals. And we'd be collaborating closely with our customers to ensure we're positioned to manage the maintenance events once they begin returning aircraft to service. And my expectation is that such activity will move ahead of any rebound in the parts business.

All right, that’s helpful. Last thing from me: could you share what you’re observing in China specifically, or perhaps across Asia more broadly? There’s been talk that certain segments of that economy—and at least domestic air travel in China—appear to be recovering. Are your customers over there reflecting that? And what does the outlook look like in particular?

Sure, that’s a good one. The short answer is that we have. Over the past 2 weeks, some movement has shown up, especially coming from China. As we moved into—roughly midway through Q3, we began noticing a significant drop in the number of orders coming from China specifically, while the rest of Asia was somewhat less affected. Yet during the past 2 weeks, we’ve observed a pickup in activity. In fact, 1 week ago, we booked a multimillion dollar landing gear purchase order from a Chinese carrier. That represents a major order under any circumstances, and especially given the current ones. So there are clearly indications that this market is coming back to life.

Excellent, thanks a lot, and best of luck.

Thank you, Ken.

Good evening, everyone. John, could you give us a bit more detail on how much of the business you anticipate will move in line with ASMs — the deviation parts? Is that roughly $1 billion a year in run rate?

We generally don't break out those components of the Aviation Services segment. But looking at Aviation Services, it's approximately a third, a third, a third: a third MRO, a third parts, and a third programs. Within programs, it's about evenly divided between government and commercial. So the commercial power by the hour programs, we would expect those to track with ASMs. Then within the parts business, apart from the government portion and the cargo portion — which I'd characterize as a bit more than half — the remaining half of the parts business, we would expect to track with ASM.

All right, and regarding your comment about tracking with ASMs — I mean, a few domestic carriers are mentioning drops of 70% to 80% over the coming 2 months. Would you say that's roughly the range you'd anticipate?

That's right.

All right, and moving to the commercial side, within the MRO, parts, and PBH, what portion of that commercial activity involves overseas carriers as opposed to domestic U.S. carriers?

Sure. International accounts for approximately 40% of our commercial business. So as far as ASMs go, I'd suggest weighting it geographically — let's say 40% international and 60% domestic.

And as you're aware….

All right.

...inside those hangars, there are 5 located in the U.S., which in my view serves the narrow-body market here at home, 2 in Canada, with a comparable situation there; plus a landing gear site in Miami; and then 2 component repair sites, one in New York and one in Amsterdam. So when it comes to MRO in particular, it leans heavily toward the U.S. domestic market along with Canada.

Understood. All right, and Sean, could you just discuss liquidity a bit? What amount do you believe you can tap, and at what point would you want to draw on some of it?

Sure. As I said during my prepared remarks, roughly $435 million is available to us, counting the revolver that we enlarged just last fall. Its maturity stretches out 4.5 years, landing in the fall of 2024, and at that point we increased it from $100 million up to $600 million altogether. That represents the liquidity the company can draw on. In addition, we established an AAR financing program 2 years back, and there is some capacity remaining beneath it. So regarding our current liquidity position, I'd say we feel good. Clearly we are doing contingency planning and talking with our banks to ensure it holds steady; still, we feel good about the steps taken across the last, let's say, 6 months and about where we stand right now.

All right. Then just one additional thing — sure, go ahead.

Yeah, I would put it this way. The steps we are clearly making, regarding both our fixed costs and our overhead, are entirely aimed at bettering the expense picture, along with the company's cash situation.

All right. Then, John or Sean, could you give us some context around the cost-cutting steps you've taken? How much of that stemmed from COVID-19 as opposed to the contracts that weren't performing? And what kind of revenue backdrop does that presume? Plus, if conditions worsen, when might you consider taking further measures?

Sure. The Q3 charge comes to $24.7 million, and that's clearly tied to the restructuring moves within the programs. The $15 million to $20 million range we gave for Q4 relates to the Q4 actions — covering the facility steps along with the people and overhead measures. That breaks down about evenly between facility-related steps and people-related steps; and I'd say it mirrors a demand picture that points to some of what you brought up regarding activity in the hangars and ASM. Should things decline, we're monitoring the situation carefully. It's still fairly early. As we said in the script, we'd be prepared to act further if necessary.