AAR Corp. (AIR) Earnings Call Transcript & Summary

Thanks. I appreciate it, and good afternoon to all of you. It means a lot that you're with us today as we go over our fourth quarter and full year 2020 results. Before diving into those numbers, I want to start by thanking the AAR team for its truly remarkable strength during these unprecedented times. In many cases, we have had to make difficult decisions so that our costs line up with a lower demand environment. I'm really proud of my teammates for their professionalism and resilience as we work through the impact of COVID-19. I also want to thank our customers for their unwavering support and for recognizing the unique value that AAR continues to bring. In addition, I'd like to comment on diversity and inclusion. These imperatives have been part of AAR's core values for decades. We have a long history, both internally and within our communities, of supporting and promoting underrepresented groups. However, the events in recent months have prompted us to broaden our efforts to try to understand systemic racism and discrimination and determine how we can continue to improve as a company and as a society. To that end, we are taking several additional steps that will enable us to rebuild our workforce with an even more diverse team as our industry recovers. Much as AAR has played an industry-leading role in addressing the shortage of skilled labor, so too can we play a role — a leadership role — in building a more diverse and inclusive aviation workforce at all levels in the industry. With that, I want to turn to our results. As you all know, the commercial aviation industry has been significantly impacted by the COVID-19 pandemic; in light of the challenging environment, I'm very pleased with our overall performance. Our sales for the year grew 1% from $2.05 billion to $2.07 billion. And our adjusted diluted earnings per share from continuing operations decreased 12% from $2.44 per share to $2.15 per share. Although our earnings for the year were down from 2019 levels, our results reflect 3 quarters of record sales and earnings performance and the fourth quarter in which we were able to effectively navigate a historic decline in the commercial aviation industry due to the unprecedented grounding of the world's fleet. Sales for the fourth quarter were down 26% from $563 million to $417 million. And adjusted diluted earnings per share from continuing operations were down 62% from $0.68 per share to $0.26 per share. We took numerous cost reduction actions early in the quarter to offset the impact, which we described in our May 21 8-K, including facility closures and consolidations, exiting unprofitable product lines and exiting or restructuring underperforming commercial programs contracts. That produced a pretax charge of $27.9 million for the quarter and moved our cost structure into far better alignment with the revenue base we have now. On top of that, our deal to divest the Composites manufacturing operation — which we announced a few weeks back — lost money in FY '20 and isn't core to what we offer in Aviation Services, so it's a step toward improving our profitability further. We had started the sale process earlier this calendar year, and we're glad to have reached a transaction that advances our multiyear strategy of focusing on our industry-leading Aviation Services and cutting complexity across our operations. Those actions, together with the ones we're still taking this quarter, have made permanent changes to our cost structure, and we expect them to lift margins as revenue comes back. Even in this environment, we keep going after new business and winning it, and I'd like to point to a few examples. During the quarter, we announced an agreement with BASF to distribute and maintain certain products that improve aircraft cabin air quality, plus a $125 million sole source contract with the U.S. Air Force to produce and repair 463L cargo pallets. We also announced a joint venture with Sumitomo to provide supply chain solutions to the Japanese defense market and to distribute parts from Japanese OEMs into the global aftermarket. In addition, after the quarter ended, we announced an extension and meaningful expansion of our agreement with Unison Industries, a subsidiary of GE Aviation. Under this agreement, we serve as its exclusive worldwide aftermarket distributor for aviation, military, civil and land vehicle products. The agreement also covers repair services and is valued at more than $1 billion over 11 years. This award shows the value of AAR's distribution model and connected businesses strategy, as well as our ability to use our relative strength to extend and grow our business during the pandemic. Before I hand it to Sean, I also want to touch on the expected agreement we announced yesterday with the U.S. Treasury under the Air Carrier Worker Support portion of the CARES Act. Under that agreement, we expect to receive $57.2 million to pay salaries, wages and benefits to the workforce currently employed in our U.S. airframe, landing gear, MRO operations. Of the $57.2 million, $48.5 million is a grant and $8.7 million is a low interest prepayable note. As you know, over the last 2 years, we have worked to successfully build a technical workforce for AAR, and we have launched initiatives to bring new talent into our industry. This grant helps ensure that those efforts will continue, and I really want to thank Congress, and in particular, the Illinois, Oklahoma, Indiana — and Indiana delegations as well as the administration for recognizing the essential services that our employees provide to the commercial aviation industry; with that, I'll turn it over to our CFO, Sean Gillen.

Thanks, John. Quarterly sales came in at $416.5 million, a decline of 26%, or $146.2 million, compared with the same period a year ago, and that figure includes a $7.5 million hit tied to exiting certain contracts. Government and defense customers accounted for 47% of consolidated sales, up from 35% in the prior-year quarter, since COVID-19 hit our commercial activities hard. To be specific, commercial sales fell 40% year-over-year. As John noted, during the quarter we took several steps to cut fixed costs and overhead, among them shuttering our Goldboro and Duluth facilities and exiting or restructuring underperforming contracts and product lines, mainly within our commercial programs business; those actions produced a predominantly noncash charge of $27.9 million, recorded in the P&L, along with a revenue reduction of $7.5 million, a $15.7 million rise in cost of sales, a $2.8 million increase in SG&A and a $1.9 million loss from joint ventures; we are continuing to take further actions in Q1 to lower costs and improve margins. These include the Composites divestiture as well as continued work on underperforming programs and additional footprint rationalization; we estimate that all of our actions will cut ISG&A by more than $50 million on an annualized basis. And we will stay disciplined about preserving these cost savings, which will enable margin expansion as demand recovers. Gross profit margin for the quarter was 8.7% versus 16.8% in the prior-year quarter. Excluding the charges, gross profit margin was 14.1% versus 17.0% in the prior-year period, which reflects $0.9 million of adjustments in the prior-year period related to facility repositioning costs. Aviation Services gross profit declined $53.2 million. Our government business across parts, repair and integrated solutions held relatively steady, and we were able to emphasize our cargo end markets. However, demand in our commercial airline businesses was lower as a result of the pandemic, including in both parts and maintenance services. Within our heavy maintenance business, although we started the quarter with full hangers, work slowed as the quarter progressed and stayed at reduced levels, which we expect to continue during our seasonally low Q1. In Expeditionary Services, gross profit fell $5.1 million. We expect performance in this segment to improve as Mobility executes on the Air Force pallet contract and we complete the divestiture of Composites. SG&A expenses were $47.3 million for the quarter. Adjusted SG&A was $46.5 million, down $10.8 million from the prior-year quarter. This reduction was primarily driven by the COVID-19 related overhead cost actions we took. During the quarter, we elected to draw the remaining available balance under our revolving credit facility as a precautionary measure, which resulted in net interest expense increasing $0.5 million to $2.6 million. We anticipate paying back that facility during this quarter, which would let us keep cash on hand at levels in line with our history going forward. During the quarter, operating activities from continuing operations consumed $18.6 million in cash, driven mainly by a reduction in accounts payable and partly offset by lower accounts receivable, contract assets and inventory. In the same quarter, we returned $2.6 million to shareholders through a dividend of $0.075 per share. Because we accepted payroll funding from the U.S. Treasury under the CARES Act, we cannot pay any further dividends until September 30, 2021. Our balance sheet is still solid, with net debt of $197.3 million and net leverage of 1.3 turns. Nothing comes due in the near term, and at quarter end our unrestricted cash stood at $404.7 million. Regarding the CARES Act funding, we anticipate receiving the money in our fiscal first quarter. When it arrives, we will book an increase to unrestricted cash along with matching liabilities for labor cost under the grant portion and for the unsecured note. That benefit will run through the P&L. More specifically, as salary, wages and benefit costs are incurred in our U.S. airframe and landing gear operations, we will offset that expense on the income statement until the funds run out, which we expect to take roughly 2 to 3 quarters. As with other government workforce subsidies, we will leave the income out of our adjusted earnings. Taking this funding does not reverse any of the cost actions we took in the fourth quarter. Thank you for listening, and I will now hand the call back to John.

Thanks, Sean. Even with the COVID-19 pandemic weighing on us, we're happy with how Q4 and the full year came out, and I feel proud of how courageous and committed our employees have been. Our government business is still solid and expanding, and putting greater focus on our cargo end markets is paying off. While conditions keep shifting a lot, our commercial airline businesses did better than we had anticipated, thanks to the cost steps we took early in the quarter and our strong customer ties. On top of that, our liquidity and balance sheet are still in good shape, which we see as an edge over competitors, letting us land new business. Our Unison win illustrates that well. Even so, we're staying sharply focused on producing cash so we can protect and strengthen our liquidity. We anticipate continuing to make structural changes to our portfolio, and those, together with steps already underway, will lift the company's margins as we recover. That said, how long this crisis lasts is still highly uncertain. Because of that, we aren't giving guidance for FY '21. We do expect Q1 sales, which by seasonality is usually our weakest quarter, to decline sequentially versus Q4, in line with earlier years. All in all, we're confident we can steer through today's conditions, and we think we have a chance to draw on our relative strength to come out of this crisis even stronger, more profitable and better set up for long-term growth. With that, I'll hand it to the operator for questions.

We understand this is a dynamic time, yes, and obviously very difficult, and one thing I think would be helpful for investors is seeing whether we can determine where the trough is. So given your 40% decline in commercial, how should we think about the months within the quarter? And then you mentioned this sort of seasonality on a sequential basis, but have you troughed? And could we discuss that separately for MRO versus parts?

Yes. Sure. Good question. So on the parts side, we felt the decline very early in the quarter. And I think the levels we're at now, which again are better than what we expected, have been holding for the last several weeks. And given the dynamic and the environment, it's difficult to call anything a trough. But we saw a decline, and they have been holding steady for the last several weeks. Now obviously, there's a lot of movement out there, particularly with the North American carriers in terms of the results of the recent surge and changes they may be making to their fleets; but so far, over the last several weeks, the parts businesses, both distribution and trading, have held in there. For MRO, throughout the quarter, we started the quarter with full hangers. And then throughout the quarter, we delivered aircraft. In many cases, those aircraft were not replaced by an additional aircraft; so we did see decline through the quarter. We are at a depressed level heading into the summer from where we would normally be. But seasonally, it's typically a low quarter for us. As it relates to MRO, we have a lot of dialogue with the customers right now about what the fall is going to look like; and I would say that's a very dynamic discussion. We're not yet clear on what the fall maintenance schedule will be. But we're confident that the customers are focused on keeping our facilities as full as possible, because they want to make sure that they're available to them as they see a recovery.

All right. I want to explore a bit how customers are viewing this situation. One lens we use is the number of aircraft sitting parked. So my understanding is that early in this crisis the parked fleet reached roughly 16,000 to 17,000 planes, and it has now fallen under 10,000, which is encouraging. Has that shown up as more business yet? Or do the aircraft returning to service simply not require maintenance?

We have not yet seen that conversion, though we do anticipate a growing backlog of maintenance needs accumulating in the system. And as airlines work to conserve their cash, we expect those maintenance events to materialize; however, we also consider this alongside possible retirements and new aircraft entering the fleet. And I believe those dynamics are still unfolding.

All right. Then the other item I wanted to raise with you was part outs and whether anything is going on in that area.

Yeah. So we haven't really seen a great deal of movement there, and of course we're watching that carefully. When you consider how our trading business has grown in particular over the last several years, the real limit on growth has been — and we did grow, but a further constraint has been having enough material available. So we're eager for chances to part out aircraft and deliver additional material into the market and grab a bigger share there. Something else we anticipate seeing as we work through this, and our sales force is putting in a lot of effort on it, is airlines that weren't traditional users taking serviceable material. With the cost pressure, we could see more customers who have typically bought from OEMs converting and seeking out alternative sources such as USM. So as additional material reaches the market and as we can convert more customers to benefit from the savings that come with purchasing USM, we expect to see growth in the recovery there.

And regarding that, about material arriving on the market, you mentioned that supply material is a significant factor. Is it simply that this hasn't happened yet, since the owners of those aircraft aren't certain what they want to do with them?

Yes, I'd say that's a reasonable assessment. And merely because aircraft are parked for retirement doesn't automatically mean they will head directly to part out. That requires time. And there's only so much capacity available in the market to part out aircraft. So many factors are involved in how that new material, or how that used material, reaches the market.

John, perhaps following up on what Rob asked, could you just help set the baseline for where we stand right now? For instance, how much was the commercial business down in June, or roughly where is it trending at present?

Yes. I'm not sure we really want to comment on specific months, but what we observed across the quarter was a 40% decline overall, and that definitely picked up pace from March to May. That said, the levels we're seeing in June — or saw in June — and are seeing in July are a bit better than those in April and May, though still depressed. So for now, we're staying put at where we currently are.

All right. All right. So perhaps you could give us a bit more clarity regarding what those conversations with certain airlines are actually like. My guess is that a number of them are clearly facing heavier financial strain at this point, and they'd be keener on moving risk and capital over to your balance sheet and making the most of that. Is that beginning to show up as an opportunity, or is it not there yet? And do you expect it will turn into one down the road?

I certainly think that could emerge from the airline side. In fact, we're already seeing it happen with the OEMs. Within the distribution business, there have been plenty of talks with OEMs across every level of the supply chain about, as you put it, capitalizing on our comparative strength in return for long-term distribution agreements. We are extremely attentive to where we stand on liquidity and on cash. So those deals get very careful consideration from us. Still, we regard it as a chance to make the distribution business even stronger, and that business has been a terrific success story over the past few years.

All right. And so, regarding the MRO business recovery, are you seeing any unusual asks from airlines about how that work gets financed? Given their liquidity compared with yours, are they requesting unusual terms from you?

Several months ago, early in the quarter, we had a number of those conversations about extended terms for our airline customers. And that was pretty much it. I wouldn't necessarily call that unusual. It was pretty much a universal request from all of our partners out there; and we, in turn, passed that down to our supply base as well. So we have given extended terms to our customers, and we've gotten extended terms from our supply base. And beyond that, we haven't seen any request that I would consider unusual.

I realize — perhaps I can't tell whether this is John or Sean. I realize you two won't be providing any particular revenue guidance for the year; however, I believe you mentioned removing $50 million of SG&A from the business, which probably implies $170 million. Would it be fair to say you're sizing the business for perhaps a $1.6 billion revenue run rate, just considering roughly how you've been operating at SG&A? Is that a reasonable bogey to consider?

I wouldn't view the SG&A target in terms of revenue sizing, necessarily. I would view the SG&A target in — really around enhancing our margins. As you can see, we're undertaking a lot of action during this period, and we're moving quickly to really reshape the structure of our cost base, as Sean mentioned, in many cases, permanently going forward; we've had a number of margin improvement targets for a long time, and we're really using this time to speed up our efforts in that regard. I don't know, Sean, whether you'd like to...

Right, and I'd like to clarify one thing, Mike — when I mentioned that figure, I was referring to an amount above $50 million, and that spans ISG&A, meaning indirect spend, along with SG&A. I just wanted to make that clear.

Understood. Understood. Then could you address — you touched on a few of those discussions with the airlines. But perhaps you could speak to part of the integrated program, the power-by-the-hour agreements? What I mean is, it looks like we'll be in a setting of lower flight hours for a good while. I believe United just indicated they anticipate 65% capacity during this third quarter. How does that affect those existing contracts you hold with your many airline customers?

Yes; so we too are braced for a prolonged stretch of weak flying. And that is how we're modeling the business and how we're sizing the business. Regarding commercial programs specifically, that's a business where you did witness a substantial drop immediately. Since by definition, you build according to flight hours, and many of those customers had grounded all — nearly all of their fleet over that stretch. As Sean noted, we did record some charges there, because those contracts, insofar as they are flexible enough to function in this environment, we keep them in place. Insofar as the contract won't align with the customers' operation and our needs going forward, we're seeking to restructure and remain with that customer. But in certain cases, we've elected to walk away from an agreement. And as we've discussed over the last couple of quarters, that business, even prior to COVID, had been under strain because of market dynamics and shifts in supply chain costs; and once again, we're using this chance to restructure that business so that when we emerge from it, it's far more profitable going forward.

All right, understood. That helps. Then I have one more question, and after that I'll get back in line. Inventories came in higher. When I consider the sheer absence of flying — say a carrier such as United has capacity dropping 65% — how do you think about working that inventory down when there are simply no flying hours to speak of, no pull on inventory anywhere in the wider supply chain, assuming distributors are fully stocked? I mean, does moving inventory turn somewhat problematic when there's so little consumption happening? How are you folks thinking about perhaps turning that inventory into cash in this depressed climate?

No, good question. Turning inventory into cash is a really difficult priority for us. You saw inventory rise, because before COVID, several agreements had been signed containing investment obligations. And in nearly every instance, we honored those commitments to our partners, especially in the distribution business; so that produced much of the inventory build. We feel good about the position we're in. We feel good about the parts we stock. The parts, especially in the commercial programs business, those are — inherently, for those parts, the faster-moving, more heavily consumed parts, simply because of how those contracts are structured. So in a normal environment that would be high demand, it's material. But as you note, we aren't in a normal environment. So we're redoubling efforts to market that material very effectively, getting creative about trading the material we hold against other services the customer base may need, and looking to move it as best we can. But there remains, as we keep saying, a great deal of uncertainty out there regarding how the overall fleet will unfold. And we may see certain asset classes where we'd have expected a shorter life actually getting extended, since new aircraft deliveries aren't going to happen. So we're watching that too. And I do want to mention the point I made in response to Rob Spingarn's question about another effort we have underway, which is converting customers to USM. This is a great moment to — when there's material available, particularly on our shelves within the market, to really tap the benefits of buying used material that is often available at 30%, 60%, 70% of lift to customers that actually do have demand. And just one more point on that. We are seeing — if we look across different markets, we have seen a meaningful uptick in Asia; we are starting just in the last few weeks to see more activity out of Europe. Certainly, you've seen major changes here in North America. But that's another avenue: go where the action is. At this moment, we are intensifying our push within the market that has progressed further along the recovery, as we aim to shift that material.

Understood. Is there any pressure on pricing for that material, John — whether on the parts trading you already do, or just from what I'd assume is a flood of parts out there, where you mentioned getting creative and trying different approaches to market that material? Is pricing eroding in the marketplace?

We have certainly observed pricing decline at the whole aircraft level, and we've seen some trades out there at meaningful discounts from where we saw pre-COVID. With certain higher dollar LRUs, we've seen a bit of that, but — and we expect to see that; but nothing — no kind of macro statistics I could give you at this point in terms of values at the part level.

Regarding the cargo business specifically, how durable is the strength we're seeing right now? Could you perhaps describe what the pipeline or lead times look like for cargo conversions?

Yeah. I mean, there's — clearly, a great deal is happening in that market; and you definitely have the established cargo carriers, and we mention how much we're focusing on it. We have sales resources that in the past had been handling dozens of commercial passenger accounts. Obviously, in many cases, their account base has gotten smaller or simply isn't as active as it once was. And we're shifting those resources over to concentrate on the cargo markets; and that's not just — that isn't only parts, it's heavy maintenance too. We actually had our first 747 cargo aircraft come into our Miami maintenance facility. It's the first time work has been done on a 747 in quite a long while at that facility. And we just finished one and sent it out, and we're hoping to do more with that same customer. So it's an area of focus and I believe an opportunity for us, once again, not only on the maintenance side, but on the parts side too.

And how are those discussions with the airlines going regarding their long-term MRO requirements? I mean, at one point before COVID, the market was really tight on labor — for you and for the airlines' in-house teams alike; but as the airlines restructure, are you having those longer-term talks about what the outsourcing model might offer them?

Yes. Yes. I'd describe it as a very dynamic environment, and it definitely matches what you're seeing out there in terms of their maintenance needs lining up with the flying they expect to do. So certainly, nobody is talking about bringing — at least among those we're speaking with, to my knowledge, nobody is talking about moving work in-house. Everyone remains committed to the outsource model. And there's genuine interest and focus among our customer base on ensuring that top-tier providers such as AAR are around to service the aircraft when demand recovers. That expectation, I'd say, given recent events here in the U.S., has shifted to the right compared with where people thought things would be a month or 6 weeks ago; but everyone expects a recovery. Different customers have differing expectations about the timeline for that recovery, and all of them recognize, though, that they will need an outsourced maintenance provider. And keeping our facilities full and running as well as they can to ensure we retain the workforce so it's ready when they begin to need maintenance at a greater scale is also a major focus for them.