AAR Corp. (AIR) Earnings Call Transcript & Summary

Okay, thanks a lot, and good afternoon to all of you. I'm glad you could be with us today as we go over what we achieved in the third quarter of fiscal 2021. To kick things off, I want to acknowledge our team members once more. Because of their steadfast dedication, professionalism, and adaptability, we've been able to keep serving our customers without any breaks throughout this last year. Their loyalty and the sacrifices they've made mean a great deal to me, and I thank each of them for everything they've done and keep doing for AAR. Now, on to the quarter. Compared with the same period a year ago, our sales fell 26%, going from $553 million down to $410 million, while adjusted diluted earnings per share from continuing operations dropped 45%, from $0.67 per share to $0.37 per share. Sales to our commercial customers were down 42%, whereas sales to government and defense customers rose 4%. During the quarter, government and defense customer sales accounted for 49% of our total sales. As we noted on the previous earnings call, we anticipated revenue would be fairly steady, and that's exactly what happened this quarter, with sales rising 2% on a sequential basis; within MRO, hangar activity did pick up sequentially thanks to stronger demand tied to expected leisure travel. In our commercial parts operations, revenue held fairly steady, though it was encouraging that orders came from a wider set of customers this quarter compared with what we experienced in Q2. Our government businesses, which have delivered excellent results over this past year, kept up that momentum, posting yet another quarter of growth versus the prior year. On the profitability side, adjusted diluted earnings per share from continuing operations climbed 19% sequentially, which shows the margin improvement we continue to make; on an adjusted basis, leaving out the CARES Act benefit, our gross margin rose sequentially from 13.9% to 16.1%, and our operating margin went from 4% to 5%; over the last two quarters, we've now more than doubled our adjusted operating margin while revenue stayed stable. We're also pleased to have fully brought back salaries and 401(k) benefits at the start of the third quarter, something we'd made a priority as we work to draw in and keep top talent. Despite restoring compensation, we still managed to achieve a full point of adjusted operating margin improvement. That gain speaks to the operating leverage we've built through cost cuts, efficiency improvements, and portfolio reshaping over the past year. Now to cash. Once again, we were cash flow positive this quarter, even as we invested in new business wins. We brought in $18 million from operating activities from continuing operations and stay in a strong balance sheet position with 1.1 times net debt to adjusted EBITDA. On the subject of new business, we also kept winning and carrying out new contracts during the quarter. We broadened our distribution relationship with GE subsidiary Unison under a five-year program from the U.S. For the Air Force, we're going to supply and fix an overhaul of S-16 accessories, and we've lengthened our backing of the Navy's H-60 Seahawk platform by another 7 years. On top of that, work has started on the Honeywell 737 MAX EBAS contract we announced earlier. With that, I'll hand things over to our CFO, Sean Gillen, so he can walk through the results for this quarter in more detail.

Appreciate that, John. Turning to the quarter, revenue totaled $410.3 million, which represents a drop of 25.8%, equal to $142.8 million, versus the prior-year period. The main driver was a slowdown in commercial passenger flight operations tied to COVID-19. Looking sequentially, sales were up 1.7%, as commercial revenue increased 7% on MRO volumes, while government and defense revenue slipped 3.3%, a result of the anticipated activity reduction together with our effort to hand over two C-40 aircraft to the U.S. Marine Corps. Gross profit margin reached 21% for the quarter, compared with 11.8% in last year's comparable quarter, largely attributable to payroll support under the CARES Act. When you strip out the CARES Act assistance along with certain other adjustments, our gross profit margin came in at 16.1%. That matches the 16% we posted in the same period last year, even though sales fell sharply. On a sequential basis, adjusted gross profit made a big jump, climbing from 13.9% up to 16.1%, and that shows the impact of what we've done to bring down indirect costs and boost efficiency. Now looking at expeditionary services in particular, gross profit margin increased to 17%, compared with just 0.4% a year earlier, and that gain came from selling off the composites business as well as stronger results in the mobility operation. SG&A expenses for the quarter added up to $44.9 million. When you exclude certain items, selling, general and administrative expenses totaled $42.8 million, which works out to 10.4% of sales. That's $9 million less than what we recorded in the same quarter a year ago, and it shows the impact of trimming our overhead structure. Turning to how we handled the CARES Act payroll support, we recognized the entire deferred credit during Q3, so going forward there will be no income tied to that CARES Act support. There's an $8.8 million promissory note connected to the CARES Act that we anticipate paying off in the fourth quarter. Beyond that, some of our foreign subsidiaries remain eligible for stimulus programs run by foreign governments. Just like we've seen in previous quarters, when it comes to our GAAP income, government subsidies—CARES Act funds included—mostly appear as a decrease in cost of sales. That said, those benefits aren't factored into our adjusted results. During this quarter, we also had other adjustments: $4 million tied to loss provision and exit costs on commercial programs contracts, with $1.5 million of that bringing sales down. On top of that, a legal settlement produced a $4.3 million gain, which we've kept out of our adjusted results. And in this same quarter, we came to a tentative agreement with the Department of Justice to resolve the airlift investigation under the False Claims Act, settling it for roughly $11.5 million. Because of that, we recorded a $4.2 million charge during the quarter and moved it to discontinued operations. Just to remind everyone, we finished exiting our airlift business back in the fourth quarter of last year. During this quarter, our continuing operations brought in $17.6 million of cash from operating activities; we brought inventories down by $21 million compared with our second quarter, since working capital management remains a priority for us. Net debt stood at $108.4 million when the quarter closed, which is lower than the $112.1 million we had at the end of Q2 and also below the $171.1 million recorded at the end of Q3 last year. On top of that, our program for financing accounts receivable is down $37.2 million across the past year, moving from $85.6 million at the close of the same quarter a year earlier to $48.4 million. Leverage and liquidity overall stay solid, with net debt at 1.1 times adjusted EBITDA, $99.2 million in unrestricted cash, and more than $400 million of unused capacity available under our revolver. I appreciate your time, and now I'll hand the call back to John.

Okay, thank you, Sean. On the whole, we're heartened by the extensive media coverage of rising demand lately for domestic leisure travel, and our optimism regarding a wider commercial market rebound remains intact. For Q4, we anticipate a modest gain over the prior quarter, with further gains to follow as vaccines get rolled out and as the travel bans currently affecting several of our bigger international customers get removed. Once that happens and our revenue comes back, our commitment stands to use our present cost base to keep pushing margin improvement forward. Beyond that, our balance sheet leaves us extremely well positioned to finance growth. We plan to put money into our USM and distribution operations, and to keep funding our technology and digital programs. Those steps, combined with ongoing strength in our government business plus the first indications of a rebound in our commercial market, leave us more and more confident that we'll come out of the pandemic as a company that's even stronger and more profitable; with that, I'd like to hand things to the operator for questions.

Great results this period. And John, I'd like to discuss a few of the patterns here, perhaps just on a quarter-over-quarter basis. I realize you'd rather not separate out the segments in too much detail, but suppose we consider how things went from Q2 into Q3 for the commercial business parts compared with MRO. I believe you mentioned — was the total commercial increase across those two quarters 2%?

The sequential figure is 7%.

My apologies, that's 7%. In what way should we view this across those 2 distinct segments? Which one is performing better?

Yeah, absolutely; therefore, an increase was observed. Within MRO, we noticed a rise in maintenance work as we moved from Q2 into Q3; meanwhile, the parts segment stayed fairly steady, usually maintenance work tends to run ahead of demand for parts since fixing planes creates a need for parts; thus, that doesn't particularly catch us off guard, yet most of the expansion originated from the MRO division. On the components side, however, as I noted, we feel optimistic because a wider set of customers came back into the market for parts, in both new parts transactions and USM part transactions. Looking back at the previous 2 quarters, a significant amount of business was being pushed by the freighter and cargo sector and we believed, honestly, that we had not witnessed in some time from the passenger sector return during the quarter. Everything together still resulted in fairly steady results, yet it was heartening to witness a number of those clients return.

Yeah, regarding USM, what more is there to say about part-out activity given what you've observed and the trends?

Right, so that tends to differ depending on which kind of asset we're talking about. Take the freighter segment — the engines and airframes that serve it — demand has been really robust, and right now supply is fairly tight thanks to all the conversion work happening. Turning to the wider narrow-body space, the A320s of the current generation and the current generation 737NG, we're noticing growing interest from customers who previously weren't interested in USM, plus, as I noted, customers we hadn't heard from in some time are re-engaging. So we anticipate higher USM demand in that area, though it plays out differently from the freight and cargo market. In the broader narrow-body market, we're seeing more supply come onto the scene.

Yeah, I wanted to ask about the passenger-side supply situation — is it available, or are airlines and owners choosing to tear down some of those NGs, perhaps COs, and I'd guess older planes too? Are they just parked out there in the desert?

Right, so I'd say that overall, the progression from grounding to retirement to part-out has been somewhat slower to play out than we'd anticipated a couple of quarters back, yet we still expect material availability to rise over time. Naturally, we want to keep an eye on those macro trends, but what we're really centered on is our own contracts, which provide proprietary access to material so we can serve the demand we ourselves foresee — and the Fortress deal we announced last quarter illustrates exactly that.

All right, and one final item regarding this, if you consider the aircraft fleet your commercial operation provides catering for, can you estimate what share of those planes operate on domestic routes within the United States as opposed to those serving international routes?

That's something we would need to check.

Moving on to margins, Sean—could you break down where some of that gain is coming from? It sounds like it's tied to overhead, and you've cut a considerable amount there. Of that decrease, what portion will hold up once the recovery comes?

Yeah, we'd expect that nearly all of the overhead reduction will hold up as the recovery comes, and we're essentially committed to that lower overhead cost base. We're getting some efficiency gains in our operations, but there's also the lower indirect, which appears in gross profit. And then the SG&A decrease, you can see that in the quarter too; so a portion of that will return as volumes come back, but we do believe nearly all of it will stick.

At some point, once we're deep into this recovery and volumes return, you ought to be capable of reaching margins above what you managed previously, right?

To begin, I'd like to put you on the spot just a bit. Will your fourth quarter revenues be higher — I mean, clearly you're up against the anniversary of that big decline in fiscal '20's fourth quarter. So what's the right way to view the sequential move into Q4, and is this where we finally see revenues grow year-over-year for the first time?

Like we said, from Q3 to Q4 we're looking for a slight sequential gain, and we aren't quite prepared to declare year-over-year improvement, though it's quite near.

All right, that's useful. And to build on what we said about MRO — it sounds like your backlog is picking up. How should we think about where things stand at your hangars right now, whether we're talking utilization or the lines already reserved through Q4? In other words, how do we consider any spare capacity you might be carrying, and which way is that moving?

Sure. Broadly speaking, the demand levels we're currently seeing for hangar space give us reason for optimism. As we noted previously, we do have certain international activity that is trailing what we're observing in the U.S., and as you're aware, we run a couple of reasonably significant operations up in Canada, and Canada has been shut down much like what you're seeing over in Europe. So those operations still have ground to cover before returning to pre-COVID level, but within the U.S., a recovery is clearly moving ahead at a faster pace. As John said, we're highly focused on how efficiently we operate. What we've achieved across the last several quarters is an MRO operation that is far more efficient, more productive, and higher quality than the one we had before COVID. So we're approaching the process of bringing work back across the network with a lot of care and discipline, so that we hold onto the gains achieved in the past few quarters. One more point on MRO — the work being performed right now is a mix: part of it is preparation for what we anticipate will be a busy summer travel season, the leisure travel season, but you've also got some deferred maintenance that's beginning to flow through. And when we look at Q4 moving into Q1, chances are you wouldn't observe the usual seasonal drop in the hangars that has historically occurred, because airlines, at least in the U.S., will most likely use that window to catch up on deferred maintenance.

All right, that's useful. John, given the demand, have you seen any easing when it comes to labor rates, and how should we view the pressure in that area along with the balance between supply and demand?

Up to this point, it has stayed fairly steady across the whole pandemic.

Sean, one quick item for you. You said adjusted gross margins came in at 16.1%. Could you break that down between commercial and defense — meaning commercial sits somewhat under that figure while defense sits somewhat over it? Is that how we should look at it?

Correct. Commercial runs slightly lower. Defense runs slightly higher. Some of those specifics will show up in the Q, which we'll be filing before long.

Then, John, you touched on this briefly, but could you discuss your commercial exposure split between domestic and international? Like you said, it appears U.S. carriers are restoring capacity toward pre-COVID numbers somewhat more quickly than international — so at this stage, where do you stand on U.S. commercial versus pre-COVID, and where do you stand on international commercial versus pre-COVID?

Certainly. Our business mix traditionally has run at roughly 65% domestic and 35% international. On the domestic side, we've still got considerable ground to cover before returning to pre-COVID levels, and that applies to both MRO and especially the parts business. The International segment, as you noted, is trailing much further behind because of the restrictions currently in effect. China — China domestic has nearly recovered to pre-COVID levels, yet the Rest of Asia is extremely weak, and Europe likewise remains extremely weak compared with pre-COVID levels.

Moving on to the Fortress deal, it's obvious you folks see that as quite significant. My guess is a number of investors find it hard to pin down that opportunity precisely. Could you give us your best estimate — say, had that agreement been signed before COVID, what would it have done for the business, how much might it have helped? Thanks.