AAR Corp. (AIR) Earnings Call Transcript & Summary

Alright, thank you, and welcome everyone to this afternoon's call. I'm grateful you could all join as we walk through what we achieved in the fourth quarter along with the entirety of fiscal 2021. But before turning to those numbers, I want to take a brief pause to reflect on the year we've just closed out. Right as our fiscal year was about to begin, demand for commercial passenger flights fell to nearly zero, and throughout the entire twelve months that followed, those commercial traffic volumes never recovered — a situation that strained both our sector and our own business far beyond anything we could have envisioned previously. At AAR, we are guided by a deeply held set of values. Among the principles we hold is Every Day, Find a Way; throughout these past 16 months, that principle has proven more important than at any prior point, and the outcomes we achieved make me proud. My gratitude goes out to our team members for the dedication and stamina they showed, and to the customers who have stayed with us. I'm pleased to report that we're emerging from this difficult period as a company that is stronger and more sharply focused than before. Turning to the numbers: annual sales dropped 20%, falling from $2.07 billion down to $1.65 billion. Adjusted diluted earnings per share from continuing operations fell 39%, declining from $2.15 per share to $1.31 per share. What you're seeing in these numbers is how COVID-19 hit demand for commercial air travel, but you're also seeing how well our team cut costs and got more efficient to soften that blow. You might remember that COVID only partly affected our Q4 of last year, because our hangars finished up planes that were already inside when the pandemic started. So for the fourth quarter, I'm especially happy to share that sales rose 5%, from $417 million to $438 million, and even happier to share that adjusted diluted earnings per share from continuing operations climbed 81%, from $0.26 per share to $0.47 per share. Commercial customer revenue rose 3%, while government and defense sales were up 7%. On a sequential basis, total sales grew 7% and adjusted diluted EPS grew 27%. That EPS improvement came from our operating margin, which on an adjusted basis reached 5.2% for the quarter, compared with 3.2% a year earlier and 5.0% in the third quarter. Our MRO operations turned in a strong performance as airlines complete maintenance ahead of the expected rebound in summer leisure travel, and our government programs contracts also performed well. One thing worth noting: we have not seen much of a recovery in our commercial parts supply businesses, since operators keep drawing down their existing inventory. The supply of parts ranks among the businesses where we earn better margins, and what we saw during the quarter had not yet caught up with that unit's rebound. Now for cash: we posted another solid quarter, bringing in $23.5 million from operating activities tied to continuing operations. On top of that, we keep lowering how much we draw on our accounts receivable financing program. Excluding what that AR program contributed, operating cash flow from continuing operations reached $33.3 million. Looking at the year, our results demonstrate progress across 3 key areas. To begin, we moved quickly once the pandemic hit, trimming costs and making our portfolio more efficient. We accomplished this through consolidation of several facilities, permanent reductions in both fixed and variable expenses, exiting and restructuring a number of commercial program contracts that weren't performing well, and completing the sale of our Composites business, which had been losing money in recent quarters. Next, we continued to secure significant new business; notably, we established a partnership with Fortress to provide used serviceable material for the CFM56 to 5B and -7B engine types. We obtained a follow-on contract from the Navy that broadened and lengthened our support for its C-40 fleet; we grew our distribution relationship with GE subsidiary, Unison; we signed a 10-year agreement with Honeywell to serve as an exclusive repair provider for certain 737 MAX components. More recently, we reached a multiyear deal with United for heavy maintenance on 737s at our Rockford location. Last, we turned our attention to the balance sheet and how we manage working capital, and that allowed us to bring in more than $100 million in cash from operating activities tied to continuing operations, even with the spending we did to back new business growth. We showed we're capable of producing cash even when the market is weak. Because of that, our leverage is now comfortably below 1x, and we're in a very strong spot to finance our future growth. It's quite uncommon in the commercial aviation industry for a business to come out of the pandemic carrying less debt than it had going in. With that said, I'll hand things over to Sean Gillen, our CFO, so he can walk through the results in greater detail.

Thanks, John. For the quarter, our revenue came in at $437.6 million, which represents a 5% increase, or $21.1 million, compared to the same period a year ago. Within our Aviation Services segment, sales rose 6.5%, powered by ongoing robust results in government work along with the rebound in commercial activity. Over in Expeditionary Services, sales dipped a bit, which mirrors the sale of our Composites business. Our gross profit margin for the quarter stood at 16.4%, compared with 8.7% in the equivalent quarter last year, while adjusted gross profit margin came to 16.5% versus 13.6% a year earlier. Aviation Services gross profit rose by $32.9 million, and Expeditionary Services gross profit went up by $2.5 million. For our commercial operations, gross profit margin was 13.4%. That speaks to the comparative strength in MRO, where we've managed to push margin gains via the efficiency measures we've implemented. As the commercial market keeps bouncing back, we'd anticipate better commercial gross margins overall. Our government activities posted a gross profit margin of 19.7%, which stemmed from ongoing solid performance plus some specific events that took place in the quarter. The adjustments for the quarter include $2.1 million tied to shutting down our Goldsboro facility, which had backed our Mobility business inside Expeditionary Services; we've now finished consolidating those operations into Mobility's Cadillac, Michigan site, and the adjustment captures our latest estimate of proceeds from selling the building. Looking ahead, after Q4 ended, one of our commercial program contracts got cancelled. Because of that, we anticipate recording impairment charges somewhere between $5 million and $10 million during the first quarter of fiscal '22; this particular contract had been delivering weak results for us over recent quarters. With this cancellation, our restructuring efforts in commercial programs are essentially finished. As John mentioned, over the past year we've made moves to streamline some underperforming operations, such as selling our Composites business, shutting our Duluth heavy maintenance facility, and either exiting or restructuring certain contracts. Those actions, together with the cancelled contract I just talked about, added up to roughly $140 million in annualized pre-COVID sales that won't come back as commercial markets rebound. Still, the removal of these operations is now among the factors fueling our rising profitability. SG&A expenses for the quarter totaled $48.8 million. Adjusted for certain items, SG&A was $46.7 million, which is just $0.2 million higher than the prior year quarter even with the sales growth. Keep in mind, SG&A in the prior year quarter already included our cost-cutting steps; for fiscal year '22, we'd look for a slight rise in SG&A relative to FY '21 as we put money into certain initiatives like digital that will boost performance down the road; we remain committed to bringing SG&A as a percentage of sales down to 10% or below as our revenue recovers. As John pointed out, we brought in cash flow from operating activities from continuing operations of $23.5 million as we keep working down our inventory balance. On top of that, during the quarter we brought down the financing program for accounts receivable by $9.8 million, taking it from $48.4 million down to $38.6 million. Because of this, our balance sheet is still exceptionally strong, with net debt at $83.4 million compared to $197.3 million at the close of last year. And at year-end, our net leverage stood at just 0.7x. I appreciate your attention, and now I'll hand the call back to John.

Alright, thank you, Sean. As we look ahead, we feel good about the fact that the big jump we've recently seen in U.S. domestic leisure travel is something that will last, and that it points the way toward business and international flying coming back. Heavy maintenance has shown a solid rebound, and we anticipate that trend to keep going. On that point, we recognize the labor market is tight, but we think the programs we've put in place for hiring, training, and keeping skilled technicians will keep working in our favor, especially when combined with the money we keep putting into innovation to boost efficiency and set ourselves apart within our hangars. Also, even though the commercial parts supply side has been slower to bounce back, we've lately picked up a few small, early signals of improvement in that market too, in both our USM and new parts operations. Turning to the government side, which has performed very well for us, we do anticipate slower growth as purchasing under the prior administration settles into a normal pattern and certain programs reach their natural end, like the C-40 aircraft procurement effort for the Marine Corps. Still, the strong past performance we keep accumulating and the cost-cutting steps we've implemented leave us well placed to keep gaining market share, and our government pipeline stays robust. How quickly and along what path commercial air travel recovers is still unclear, and the arrival of the Delta variant makes that even more evident. Because of this, we aren't providing full year guidance. That said, for the near term, we look for Q1 results to come in around the same as Q4, or perhaps a bit stronger. As you're aware, Q1 is usually our weakest quarter while Q4 is usually our best, so under normal circumstances you'd expect a drop from Q4 into Q1. This year, though, expecting comparable performance shows that we believe our commercial markets will keep recovering. Looking at the medium and longer term, our position is extremely strong. We're in better shape now than we were before the pandemic began, and we're eager to take advantage of our efficiency improvements, a streamlined portfolio, and a solid balance sheet to keep delivering growth and margin expansion down the road. With that, I'll hand things to the operator for questions.

I was hoping we might go into more detail on a few points you just mentioned. To start, if we look back at Q4 and discuss MRO and parts as two separate items, what did the trend look like during that quarter and then as we moved into the first quarter?

Absolutely. Across the quarter, MRO held fairly steady, and that's still true as we enter the first quarter which, and I believe we said this on the previous earnings call, is somewhat out of the ordinary. Normally, MRO activity drops off as aircraft head back into the sky for summer flying. In this instance, what we're seeing is steadier performance in that area. On the parts side, those businesses kept getting a little better as Q4 went on, and there has been some modest improvement, especially in parts trading, right at the start of the quarter we're in now.

And John, within those figures, might anything be hard to spot—like cargo strength perhaps hiding a more serious passenger weakness?

No, not at all. Once again, cargo has stayed fairly steady across the whole pandemic period. Sure, we noticed some expansion in the early days when we shifted focus toward that segment; however, over the past few quarters, I'd characterize it as fairly steady. What you're picking up on, clearly, is that in the U.S. air travel is moving forward quickly, which means several of our bigger clients are using up stock they already had sitting on shelves rather than purchasing from vendors. We anticipate that will wrap up, and we look for increased movement in both used and new parts sales over the next few quarters as that stock gets depleted. Meanwhile, everywhere else—and our parts operation happens to be the most global piece of what we do—there are markets, with a single exception, China. I'll address that shortly. Those markets simply trail when it comes to total flight activity, and that clearly affects how quickly parts revenue recovers too. China, by contrast, as you're aware, has mostly gotten its domestic flying back, and it's been that way for a number of months. In fact, we set a record year in the China market.

You transitioned quite smoothly into my next question, which is about looking past the short term and considering the recovery across the various components of Aviation Services — mostly overhaul, plus parts. Regarding a return to pre-COVID levels, how would you describe it for MRO on one hand and parts on the other? What has to occur for Aviation Services to reach a figure in the mid-500s, $500 million? You follow what I'm asking.

Yes, absolutely. Correct. So within MRO, we've become far more disciplined regarding the work we accept after the pandemic compared with how we operated previously. We're truly aligning the amount of work we opt to take on, so to speak, with how much skilled labor is available. Before the pandemic, we depended very heavily on contract labor to generate additional labor hours, yet that came at a far less profitable level than what we can deliver now; therefore, given our present footprint and labor capacity, it's likely we'll be somewhat smaller in heavy maintenance while being a considerably more profitable operation than before the pandemic. That said, we keep examining our North American footprint and exploring ways to possibly better match that footprint to labor availability, based on where we find the greatest labor supply rather than where we stand today. So that's something we keep watching. Regarding the parts segment, in the U.S. end market, we believe it could actually surpass pre-COVID levels, judging by early signals; and we've discussed this during earlier quarters, based on what the customer base indicates — that acceptance of used material in the aftermarket would probably rise; so clearly, we must ensure we have material available to supply, yet we anticipate the possibility of even stronger growth from that business across the coming couple of years; and as for the new parts business, we stay extremely bullish about it. We've declared several new distribution agreements during the past couple of years. Additional ones are in the pipeline that we intend to announce. And with that business, as we bring on more parts, on both the government side and the commercial side, we certainly expect it to grow past pandemic levels. Lastly, regarding commercial programs, that's a business where we've invested substantial effort in restructuring. It sits in a far better position than before the pandemic. It's smaller than it was before the pandemic, but we still plan to remain a participant in that market, simply with more discipline about which contracts we pursue.

All right. So to wrap this up, can we measure how much of your MRO capacity you're actually using — how full are your hangars compared to what you could handle? That's the first part. Second part: we've been hearing stories that during COVID some capacity disappeared worldwide, and there might not be enough heavy maintenance capacity to go around. So those are my 2 questions — where your utilization stands now, and whether a shortage exists, and does that eventually give you a leg up on market share?

Sure, sure. If you look at capacity as our footprint, we've still got plenty of room left; but once more, what really matters for us is whether we can bring in skilled full-time workers; we do use some contract labor, though we'd rather not lean on it the way we did before COVID. So judging by labor capacity, we're essentially at full right now; and with that said, as I noted earlier, we're evaluating possible chances to reposition our footprint toward places where labor is available, and that would grow our capacity later on. Then on the question of an overall shortage, there's no doubt that maintenance activity is running at a heightened level at the moment. A great deal of deferred maintenance has piled up; and I believe that's true around the world, and you're definitely seeing it in North America, and I expect you'll see it in other regions too as aircraft return to service. So I share the view that a shortage exists. Much of that, I think, comes from return-to-service work, which clearly is a point in time. But our aim is simply to stay very disciplined, as I said at the outset, regarding the work we accept, since we want to keep those production efficiency gains we've delivered over the past couple of quarters.

Peter Osterland here, filling in for Mike. To start, I was hoping for some additional detail regarding the margin outlook for the near term. Do you still have any further operational efficiencies you intend to put in place that might deliver additional leverage? Conversely, as fiscal '22 gets underway, are there particular areas where cost inflation is creating pressure?

As we've said before, we've already made quite a few structural adjustments aimed at boosting the margin. Those are essentially complete. Sean brought up that latest contract that got cancelled, which will play a part in that. So a great deal of what shows up over the medium term will arrive as revenue rebounds in our more profitable parts activities. I'd say that's where the bulk of it will originate. Looking further out — medium to longer term, I should clarify — we'd anticipate further margin gains arising from some of our digital initiatives; we're putting money into that space. You'll begin to see that reflected in upcoming quarters through the investments we're making. But over the long haul, that ought to bring greater efficiency, especially within our hangar operations.

All right. Next, regarding your expeditionary segment — since it's a fairly small operation and its margins sit below what the company averages — might you be willing to explore strategic alternatives for it?

We don't normally talk about that kind of thing in public. Still, a number of years back we laid out that our approach is to be an aviation services company. So when we review the portfolio, anything that may not fit that approach over the long term is, of course, something we keep assessing.

John or Sean, could you tell us what commercial margins were this quarter — I suppose, adjusted commercial margins?

Sure; on an adjusted basis, we don't report margins separately, though you can sort of look at the adjustment and sort of assign part of it, yet it's fairly near the margin I provided regarding GAAP.

Alright, John — turning to the parts side of things, could you speak to whether any geographic differences are showing up? Are U.S. carriers managing inventory in a way that differs from others? And what's your sense of how much longer inventories can keep getting drawn down before those carriers need to return to the market?

Yes. Outside of China, without question, U.S. carriers are clearly much further along when it comes to drawing down that inventory. As I noted, only in the last few weeks have we begun to observe a meaningful uptick in activity across the parts businesses — both new and USM — and U.S. carriers are chiefly responsible for that. We'd expect a similar curve to play out globally as aircraft return to service. I said on a couple of prior calls that we conduct a substantial amount of business up in Canada. We have 2 excellent facilities there, and throughout this period Canada has mostly been closed down. Yesterday we were quite encouraged by the announcement that a time line exists for reopening the borders. Air Canada, for instance, then came out with its own announcement that more flights will be added to the network as a result. So we anticipate seeing that sort of thing as vaccines are rolled out worldwide. Those airlines will experience the same — I assume the same type of curve — where they'll use up whatever sits on the shelf and afterward turn to buying from us.

All right. All right. That sounds excellent. And then regarding Fortress, John, I believe you said that it's beginning to add to results. Could you describe whether that addition has reached its full run rate, or how much further there is to go before it's completely operational?

Yeah, that initiative is progressing very nicely. Fortress makes an excellent partner. Thus far, regarding the quantity of engines arriving at our facility, they are exactly on target. So I'd say the pace of engine induction is exactly as planned. As for the bookings, we're beginning to observe them now that engines are moving through processing, components are getting fixed, and they're being offered to buyers. So bookings are matching their forecasts precisely, yet you didn't witness particularly large shipments in this quarter or in Q4. You'll observe somewhat more during Q1, and we would anticipate that afterward in this fiscal year, when it comes to actual shipments during the quarter, we would be operating at full run rate.

All right, that sounds excellent. Then, to wrap up, Sean, regarding that $140 million figure you brought up — does it account for both the C-40 and the headwind from commercial programs? Is that what it refers to?

What that does is simply reflect, you could say, the operations we've either walked away from, such as shutting down Duluth or divesting the Composites business, plus agreements we've reworked or stepped away from. Before COVID, the sales those generated came to $140 million. So it isn't a projection of any sort for C-40 or similar things — it merely puts a number on the revenue from operations we've left behind across the past several quarters.

Understood. Alright. Since the commercial side is somewhat difficult to predict, might you describe your expectations for the defense business this year? Is there clearer visibility for you on the defense side?

Yeah. Clearly, with defense, we do have somewhat improved line of sight. However, regarding not providing guidance, I'd rather not get into particulars. As John said, a number of these contracts could be up for recompete and might ultimately remain or conclude. Consequently, there's uncertainty there, and I won't put a figure on the forward sales outlook for that.

John, looking ahead to fiscal '22, regarding your parts business, is there any reason demand might come in below aircraft utilization? My guess is that as utilization keeps climbing, USM could be an area where growth happens more quickly. To put a finer point on it, how do you see the pull on the parts side compared with utilization on the aircraft side as we move into fiscal '22?

Well, I think pent-up demand exists. That's undeniable. So once that inventory gets burned down, because utilization is elevated, we'd expect our recovery to, I'd say, somewhat exceed utilization early on as things catch up, so to speak, but after that it would move in line with rising utilization once we reach steady state for parts supply and consumption.

Do you figure that catch-up takes 1 quarter, or 2, or might it stretch out even more?

What I'd say is this — in the U.S., it's clearly going to arrive earlier than internationally, given the pickup in utilization you're witnessing there; pinning it down at this moment is tough. Let me return to my earlier point. To the extent that within only the past few weeks, we've observed somewhat higher highs, so to speak, in that parts activity. So we're encouraged. We're encouraged. Yet right now, I wouldn't want to try to forecast exactly when that elevation would show up.