AAR Corp. (AIR) Earnings Call Transcript & Summary

Thanks a lot, and good afternoon to everyone. I’m grateful that all of you could join us today for a discussion of our results for the second quarter of fiscal 2021. Before we get into the results themselves, I want to express my thanks to every one of our employees for the resilience and bravery they’ve demonstrated across the past 3 quarters while we’ve been working our way through this pandemic. In particular, over 2/3 of our workforce consists of essential workers, and they’ve kept showing up at work daily, which lets us keep delivering for our customers. I couldn’t be prouder of the whole team. I also want to thank Congress one more time for what it did on the CARES Act, which has enabled companies such as ours to hold on to their skilled workforce. On the business side, as we said last quarter, on the whole our commercial volumes have stabilized, and our government business has kept performing strongly. Although the environment remains challenging and uncertain, the stabilization encourages us, as do the positive vaccine developments, which will protect our people and should in the end also produce more travel and a recovery in our commercial markets. With that, moving to the quarter: our sales fell 28% year-over-year, from $561 million to $404 million, and adjusted diluted earnings per share from continuing operations dropped 52%, from $0.64 per share to $0.31 per share. Sales to commercial customers declined 48%, while sales to government and defense customers rose 13%. In the quarter, government and defense customers accounted for 52% of total sales. Our Aviation Services segment was up 6% sequentially versus our first quarter; that came from higher volume in our MRO business, which is seasonally stronger in Q1 over — Q2 over Q1, along with the ongoing strength of our government business. Overall, our commercial parts volumes stayed relatively stable through the quarter and were still above the lows reached in April and May. That said, our margin improvement progress encourages me in particular. Across the last several quarters, we’ve shrunk our footprint throughout the enterprise, cut our indirect and overhead spending, exited or restructured a number of underperforming contracts, and divested a loss-making noncore business. You’re now beginning to see what these actions have produced in our adjusted operating margins, which improved meaningfully, from 2.5% to 4% sequentially, on stable revenue; where cash is concerned, we generated $28 million from operating activities from continuing operations and also cut our accounts receivable financing program by nearly $7 million, which further strengthens our already strong balance sheet position and brings our net leverage below 1x EBITDA; we also keep adding significant new business that positions us for growth ahead. Our CFM56 partnership with Fortress locks in a source of supply to satisfy growing demand for used serviceable material on the -5B and the -7B engine variants. As we move past the pandemic, we anticipate that demand for USM will rise in every segment, with especially robust interest in these engine platforms. In addition, the Navy's follow-on contract to support the C-40 aircraft acknowledges how we performed over the past 5 years and allows for a broader scope of work across the next 5 years; notably, this marked the first instance of the contract going to an incumbent, which reflects the superior quality of our service. What's more, our 10-year deal with Honeywell to serve as its only authorized service center for 737 MAX Electronic Bleed Air System components puts us in position to assist MAX operators around the globe once that aircraft returns to service; these new contracts, together with others we've announced in the last several months, including the Unison expansion and extension, amount to almost $1.7 billion in total contract value secured thus far in this fiscal year. This illustrates the distinctive worth of our Aviation Services offering, and these business wins will assist in speeding up our recovery as we come out of the downturn. Having said that, I'll hand things over to our CFO, Sean Gillen, who will go through the quarter's results in greater detail.

Thanks, John. For the quarter, our sales came in at $403.6 million, which was a decline of 28%, or $157.3 million, compared to the same period last year. That drop was caused by how the pandemic affected commercial passenger flying activity. Looking at it sequentially, Aviation Services sales rose 5.9%, or $21.4 million, whereas Expeditionary Services sales fell 50%, or $18.6 million. Two things explain that sequential decrease in Expeditionary Services. The first is that we finished exiting the composites business at the close of Q1, and that business brought in $7 million of revenue during Q1 and 0 during the current quarter. The second, which we've talked about before, is that mobility had an especially strong Q1 because of elevated pallet shipments. Inside Aviation Services, our government and defense business rose 19%, or $30 million, versus the prior year, which shows strong performance on contracts we already hold. During the quarter, and also in Q1, our program to deliver 2 C-40 aircraft to the U.S. Marine Corps brought in strong revenue thanks to elevated activity on that program. Gross profit margin for the quarter climbed to 17.2% from 15.3% in the same quarter last year, which was driven by the CARES Act payroll support. Sequentially, gross profit margin rose from 12.1% in our first quarter, which reflects the steps we've taken to lower our indirect costs and to get out of underperforming contracts and product lines. SG&A expenses came to $43.4 million for the quarter; on an adjusted basis, SG&A was $38 million, or 9.4% of sales, which is down $13 million versus the same quarter last year and reflects the reduction of our overhead cost structure. Roughly $3.2 million of that improvement came from temporary reductions in compensation and benefits, which we brought back starting on December 1. As an update on what we previously disclosed, we've been in settlement discussions with the Department of Justice about an investigation of airlift under the False Claims Act. During the quarter, we recorded $6 million of additional accrual and discontinued operations, bringing our total reserve for this matter to $8 million, based on our latest settlement offer. We generated $27.6 million of cash in our operating activities from continuing operations for the quarter. That figure is net of a $6.8 million use of cash as we keep reducing the size of our accounts receivable financing program. If you exclude the accounts receivable financing program, cash flow provided by operating activities from continuing operations was $34.4 million. Inventory went down $12.7 million during the quarter. Our net debt at quarter end stood at $112.1 million, which is down $37 million from $149.3 million at the close of Q1. Our balance sheet and liquidity remain strong, with net leverage of 0.95x adjusted EBITDA, unrestricted cash of $110 million and unused capacity under our revolver of approximately $390 million. Because of that, we're well positioned to fund what we expect will be unique opportunities to grow our business over the coming quarters. Thank you for your attention, and I'll now turn the call back over to John.

Alright, thank you, Sean. Taking everything into account, we feel good about what we achieved in the present climate, and we're also happy with how far we've come on making our operations more efficient. Like I said, there are a number of reasons we're optimistic as several vaccines make their way to the market along with the distribution plans behind them. Once those vaccines get out and case counts come down, we anticipate that travel restrictions will be removed and that passengers will return to the skies. In the meantime, we anticipate revenue will stay fairly steady, and our attention will stay on generating cash flow along with further gains in margin. We'll keep our focus on winning new business too, and I have every confidence that our solid balance sheet, together with airlines wanting our lower-cost value-added services more and more, will open up additional growth opportunities. With that, I'll hand things over to the operator for questions.

Good to see that margin get better. John, there are a few items I'd like to cover with you. First, though, what did the quarter look like as we went month to month? It seems like the trough is already behind you, or at least mostly. This came in somewhat higher than the prior quarter. So my assumption is that's finished, and revenues are moving upward. But what was the pattern like from quarter to quarter — and month to month?

Right. Honestly, it stayed pretty steady across the quarter. I'd say the trough has passed. Parts volumes and MRO volumes had both risen compared with the April and May period; then as we moved toward June and July, the volumes we observed throughout the business held fairly steady in the months that came after.

Alright. So, how much can we actually learn from the discussions you're currently having with customers regarding the MAX coming back into service, and the potential for a slight bump in the production rate for that plane? Airbus has mentioned possibly increasing the build rate for the A320. And — clearly, we're all expecting traffic to recover. Have they given you any indication about how they think the fleet will shift in reaction to all of this? And how, if at all, does that play into your MRO planning and your expectations for more USM hitting the market if new aircraft begin to displace the older ones?

Yeah. It truly — it varies by customer. Obviously, you've observed that certain bigger airlines with MAXs on order have proceeded to accept delivery of those planes. For customers who already have the MAX in their fleet, they've started flying them. So it looks like those customers are sticking with that plan. More broadly, though, as you're aware, you've witnessed — there have been quite a few MAX cancellations; and the related pattern is that we've seen customers who, at the same time, are going to bring in new aircraft. They've also told us they anticipate keeping some older planes around longer than they would have expected to throughout COVID. That said, all of them — and again, this includes customers who currently buy USM as well as those in places like China who don't buy USM — have shown interest in USM material across the board. And during the quarter, we began to see a greater number of aircraft becoming available to acquire and eventually to dismantle. So that sequence of events — where a plane gets grounded, then eventually retired, then ultimately sold perhaps to a company like ours that might tear it down — you've seen a bit more of that entering the market. As a result, we anticipate that supply will begin to rise.

So, the planes you're beginning to observe — would those be CEO and NG variants? Or are we discussing aging jets where doing major rework on them truly wouldn't be worthwhile, types that are essentially being sent out to graze?

Yeah. No, we have — and for reasons tied to competition, I'd rather not dive too deep into specifics, but I'd describe the opportunities we've encountered as spanning quite a broad spectrum.

All right, and then real fast, a few other items. If, a few years from now, we ultimately have a streamlined fleet made up of, say, A320ceos and neos, 220s, 350s, and on the Boeing side, MAX and NG, 777, 787, with all the rest removed, does that help or hurt third-party maintenance?

On the whole, I'd call it a plus. Firms such as ours are here to deliver a service that's needed. Most airlines have handed off the bulk of that maintenance work. And absent some pressing reason for them to bring that work back in-house, we think the amount of work will remain for third-party maintenance providers, and for us especially.

All right. Then my final question concerns margins. You said you foresee margins continuing to get better. As I recall, when your margins were greater previously, that stretch also involved elevated SG&A, plus you had certain contract labor, which we take to be costlier. So looking ahead, with neither of those 2 factors present, how should we regard what margins are capable of? Is there some incremental margin, in your view or Sean's, that we ought to apply as revenues climb from here?

Our expectation is that we will emerge from this crisis with operating margins above where they stood before COVID.

Okay.

And — yes. That comes from several different things, mostly the steps we have taken; however, what you said about contract labor is accurate. We have carried out quite a few measures to reset what happens within our hangars, and going forward we don't anticipate depending on contract labor to the same degree we did previously. That is definitely one piece of it; there are several other efficiency programs currently being put into place in the hangars, so that once that work volume returns we will operate far more efficiently. On top of that, the company had various less profitable or even unprofitable activities before COVID; across the last 3 quarters, we have worked extensively to remove that drag from our earnings. And as we bring back stronger results from our parts businesses, for instance, along with greater hangar efficiency, you will begin to see that reflected in improved margins.

John, could you spend a moment discussing the discussions you've had with certain airline clients regarding their views on capacity recovery, and in particular how those discussions might have shifted over the past few weeks following the vaccine news, and sort of how they're approaching summer of '21 schedules and capacity?

Sure. Once again, you're in a spot where what gets discussed differs from one customer to the next. But the broad threads are consistent: there's an emphasis on being prepared for summer 2021. And what set the quarter we just completed apart from our first quarter — during the summer, if you remember, we experienced yet another surge, nowhere near as large as the one happening right now, but a surge nonetheless. And back then, we observed a fair amount of shifting in maintenance scheduling and parts volume patterns coming from the customer base. That same shifting in behavior has not appeared as we've moved through this latest surge. Instead, customers seem to be zeroed in on, "Fine, we'll have some ups and downs across the coming months. But ultimately, the vaccine will get distributed. Leisure travel demand has been held back and is waiting to be released, and we want to be prepared for that in summer '21." So although the level of expectation regarding — for growth in summer '21 travel compared with summer 2020 differs from customer to customer, on the whole, customers anticipate a stronger summer in '21 than what they had in '20, and they intend to be ready for it.

All right, and could you take us through the three components of your commercial segment, perhaps? So, where does each stand in terms of getting back on track? And then from a structural standpoint, what has shifted for each of the three regarding how large they might become once this is behind us, and whether they will be structurally reduced for some period, if that comes across clearly?

Certainly. When it comes to total size, I'd refer back to something we said before. Until there's a significant uptick in flying activity, we anticipate operating in a fairly steady revenue situation. Yet even in that steady state, our attention stays squarely on further enhancing our margins. Looking at the three parts of the commercial segment: in parts, covering both new and used, as noted previously, activity has been fairly consistent; we've experienced what I'd describe as somewhat stronger peaks, so to speak, over the past few weeks, which is a positive sign. Even so, on the whole, we'd anticipate consistent activity within the commercial parts operation. Once we emerge from this downturn, as we've discussed, we certainly foresee greater need in the USM operation. Our collaboration with Fortress has us quite enthusiastic. That's just one among several efforts currently underway on the USM front. However, I'd anticipate that operation might end up structurally bigger than before COVID, depending on how demand plays out. In a similar vein, for the new parts distribution operation, we keep bringing on additional distributorship arrangements. There are quite a few possibilities we're currently assessing for fresh parts distributorships involving various OEMs. Just like the airlines, the OEMs have — they're reviewing how they handle the aftermarket. And in the same way, as they consider their cost structures, we're noticing some interest from OEMs that in the past might not have given thought to a distribution partner, but now they're exploring one. So we're assessing that — those possibilities. And we believe that operation might likewise grow bigger because of fresh business wins plus same-store sales, so to speak, growth on the agreements we held before COVID; regarding the MRO operation, I'd say we're quite pleased with the footprint we possess. We removed capacity, which was an extremely tough call, but we did so by shutting our Duluth facility and also streamlining our footprint within other facilities that remain part of the network. And we think that in the end, we'll achieve improved yield from that footprint compared to before COVID, given some of the adjustments we've implemented. Lastly, concerning the commercial programs operation, that's one where we've implemented numerous changes across the past several quarters. As we've mentioned, we've either exited or reworked underperforming contracts. Most of those efforts have already been completed. We're optimistic regarding the contracts still left in our portfolio. I think we covered this during the prior quarter, though that sector had experienced significant pricing strain before COVID. And you've witnessed several players in that space take action, either leaving the sector completely or, as we did, walking away from contracts that weren't performing well. We think it's possible that pricing in that sector could reset once COVID passes; and if that happens, and if we're confident we can achieve a return, then we'll take part in that sector.

That sounds excellent. So, John, would it be accurate to say that the leg with the highest margin for all of you is going to be larger, while the 2 legs with lower margins are likely to be smaller for a period?

Yes.

All right. Then I've got a couple of quick MRO follow-ups. Have airlines given any sign they could contract out more work than was possible before COVID, in terms of the concessions they've managed to secure? And regarding the capacity rationalization you've completed, does that fully resolve the margin problem you had in MRO before COVID? Or will some of those same difficulties still be there, I suppose, pre-COVID, once we get past this?