AAR Corp. (AIR) Earnings Call Transcript & Summary

Good afternoon, everyone, and thank you for joining us on AAR's Fiscal 2022 Second Quarter Earnings Call. With us today are John Holmes, our President and Chief Executive Officer, and Sean Gillen, our Chief Financial Officer. Before we get started, I want to remind everyone that remarks made on this call may contain forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements carry risks and uncertainties that might lead actual results to differ materially from those statements. As a result, they are not a guarantee of future performance; these risks and uncertainties are addressed in the company's earnings release and in the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2021, and Form 10-Q for the fiscal quarter ended August 31, 2021. In offering these forward-looking statements, the company undertakes no obligation to provide updates reflecting future circumstances or anticipated or unanticipated events. We will also discuss certain non-GAAP financial information today. A reconciliation of these non-GAAP measures to the most comparable GAAP measures appears in the company's earnings release. At this point, I'd like to hand the call over to AAR's President and CEO, John Holmes.

All right, thanks so much, 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 second quarter of fiscal year 2022. Before I get into those results, though, I want to say something about the broader situation. As everyone is aware, the Omicron variant is now spreading, and that has led governments to impose restrictions that are affecting commercial passenger traffic. The market for commercial passenger traffic as a whole is bouncing back, but first the Delta variant and now Omicron make it clear that reaching a complete recovery won't happen along a straight path. Even with conditions shifting like this, we've kept our attention on executing on our own priorities, and we take pride in the several consecutive quarters of margin improvement and robust cash flows that we've posted. Now, on to the quarter we just reported. Our sales rose 8% compared with the same period a year earlier, going from $404 million to $437 million, while adjusted diluted earnings per share from continuing operations climbed 71%, moving from $0.31 per share to $0.53 per share. Demand for the MRO services we provide has stayed solid. Even while our MRO customers cope with shifts to their bookings and schedules, they've kept their focus on making sure the maintenance supply chain keeps running without disruption. Our customers have also been helpful during recent talks on pricing as we work together to deal with how tight the labor market has become. Parts supply, the activity where our margins are highest, saw steady volumes across the quarter, though they were lower than what we experienced early in Q1, before the Delta variant arrived. Broadly speaking, the supply chain supporting AAR's own operations is working well, but we have encountered longer turnaround times from certain repair subcontractors, along with freight delays, and those did push some sales out of Q2 and into Q3. On the earnings side, we turned in yet another quarter of margin improvement, with our adjusted operating margin coming to 6.1% for the quarter. Measured sequentially, that's an increase over 5.5% in the first quarter, and it came even as sales declined. What matters even more is that our margin topped pre-COVID levels even while our top line remains considerably lower. To show what that means, our adjusted margin for this quarter went from 5.6% to 6.1% versus 2 years ago, before the pandemic, even with our adjusted revenue falling $127 million across that same span; this year, the margin result for this quarter keeps confirming that the steps we've taken over the past 2 years to make our operations more efficient, put greater emphasis on more profitable offerings and get out of underperforming activities are working. We anticipate further margin improvement once demand for our commercial parts has completely recovered. Now for cash. We posted another solid quarter, producing $16 million from operating activities from continuing operations. We also kept lowering how much we draw on our accounts receivable financing program. Setting aside the effect of the AR program, cash flow from operating activities from continuing operations came to $26 million. Across the last 6 quarters, we've produced a cumulative $142 million of cash flow from operating activities from continuing operations. Now, on new business. In the quarter, we said we would extend our arrangement with flydubai for 5 years, supplying power-by-the-hour component support covering a fleet of 33 737NGs. In addition, we announced a sustainability effort from Fortress Transportation and Infrastructure, through which a percentage of all USM sales out of our CFM56 partnership will go toward buying carbon offset credits for our customers; this effort shows both how committed we are to helping customers shrink their carbon footprint and the reality that USM serves as a low-cost green substitute for buying new parts. Then, after the quarter closed, we announced a contract with the U.S. Air Force worth $365 million over 10 years, covering depot-level maintenance and repairs mainly for F-16 aircraft stationed in Europe. Our F-16 support goes back decades, yet this program lifts that support to another level. This contract's complexity and length represent a significant jump beyond our earlier F-16 support and will establish past performance that lets us chase other programs of a similar nature. Before I hand things to Sean, I also want to address the share repurchase program we announced earlier this afternoon. As we've noted previously, our capital allocation priorities are: first, organic investment in our business; second, adding synergistic capabilities through acquisitions; and third, returning capital to our shareholders. Thanks to our steady cash flow generation and our balance sheet's strength, we can pursue all 3, and this share repurchase program forms part of our plan to drive long-term shareholder value. With that, I'd like to pass it to our CFO, Sean Gillen, who will discuss the quarter in more detail.

Thank you, John. Revenue for the quarter came in at $436.6 million, representing an increase of 8.2%, or $33 million, compared to the same period a year ago. Within our Aviation Services segment, sales rose 8.9%, fueled by a rebound in our commercial markets, while our Expeditionary Services segment saw a $1.3 million decrease in sales. Commercial sales grew 33%, whereas government sales fell 15%. The drop in government sales was mainly attributable to the activity level in the year ago quarter on our program involving modification and sale of 2 C-40 aircraft to the U.S. Marine Corp. On a sequential basis, commercial sales were down 3.6%, largely because of the Delta variant's effect on our parts supply activities, and government sales decreased 4.7%, due to the wind-down of certain programs and reduced activity in Afghanistan. Gross profit margin for the quarter stood at 18% compared to 17.2% in the prior year quarter, and adjusted gross profit margin came in at 16.7% versus 13.9% in the prior year quarter. This considerable margin improvement resulted from the efficiency enhancement and portfolio refinement actions we've implemented, and it also captures the benefit from closing out certain contracts within our commercial and government businesses. Gross profit margin for our commercial businesses was 17.3%, and for our government businesses it was 18.9%. The adjustments this quarter affected both the commercial and government end markets but leaned more heavily toward commercial. SG&A expenses totaled $47.1 million for the quarter, or 10.8% of sales. If you exclude adjustments of $1.1 million tied to severance and investigation and remediation costs, that figure would have been nearer to 10.6% of sales, consistent with Q1 despite the sales decline. SG&A remains roughly $10 million under the pre-COVID level from Q2 of FY '20. Looking ahead, we don't anticipate SG&A growing proportionally with revenue. Consequently, as the commercial demand environment improves and we keep winning additional government business, we expect to bring SG&A down to 10% of sales or below. Net interest expense for the quarter was $0.4 million, versus $1.3 million last year, due to lower borrowings. Average diluted share count for the quarter was 35.6 million compared to 35 million in the prior year quarter. As John mentioned, we produced cash flow from our operating activities from continuing operations of $15.9 million and also lowered our accounts receivable financing program by $10 million during the quarter. In the quarter, we paid off our Canadian term loan of $24.7 million by drawing on our revolving credit facility, which further streamlines our debt capital structure. Our balance sheet remains exceptionally strong, with net debt of $61.8 million and net leverage of 0.4x. As for the share repurchase program, as noted in our release earlier this afternoon, it's a $150 million authorization allowing management to acquire shares at its discretion during open trading windows, and we plan to fully deploy the authorized amount over approximately the next 2 years. Appreciate everyone listening, and at this point I'll hand things back to John.

Okay, thanks, Sean. Now looking at what's next for this quarter. Right now, the Omicron variant hasn't had any effect on the maintenance schedules our customers follow. Because of that, we anticipate that MRO work will stay where it is today, and that's basically running at maximum. When it comes to parts supply, the piece of our business that reaches furthest around the world, added global travel bans are the more probable source of disruption, and those might push back even further the point at which we're fully back. Even so, we think every additional variant will pack less of a punch going forward. And while predicting exactly when is tough, we believe parts demand will come back in time as operators begin rebuilding their stock. Beyond that, we're looking to expand the business past simply riding the recovery, because interest in USM keeps building and because we keep locking in fresh long-term deals to distribute exclusively. Over on the government side, the F-16 program shows that the commercial methods we use best are landing well with that customer, plus our pipeline is completely full, so we think we can keep growing the portfolio of government programs. Even with all the unknowns, we're optimistic about our backlog and parts supply, how full our hangars are, and what's in the government pipeline. So we're expecting Q3 to bring sequential growth, with sales getting close to what we recorded in Q1. This marks our eighth quarter operating in a COVID environment. We're quite happy with what we've managed to deliver across that stretch, especially the gains in margin and how we've been able to shore up the balance sheet by generating cash consistently. The $150 million share repurchase program we launched speaks to both our progress and our confidence, and you should expect us to keep executing in the quarters and years ahead. With that, I'll hand things to the operator so we can take questions.

To kick things off, regarding that 33% increase in the commercial business, based on what you've said, it seems like parts supply might have declined quarter over quarter, or perhaps it wasn't a major factor behind that expansion. Could you break down that quarterly growth between MRO and, say, the parts distribution and parts trading segments?

Sure. Honestly, it was pretty evenly distributed. As we noted, toward the close of Q4 and as Q1 got underway, there was a genuine surge in parts activity overall. Then once Delta became a factor, we observed a slight decline. Still, it held fairly steady across this quarter, which rose modestly versus the previous quarter in both distribution and trading. MRO stayed about the same, but — so really, the bulk of the growth is driven by the parts operations.

All right. And clearly, we continue to encounter these fresh variants, and it appears things are trending later when it comes to the recovery. But how are you thinking right now about when a more significant inflection might arrive, whether in distribution or, more precisely I suppose, in parts trading? And which indicators are you monitoring that will provide you confidence or improved visibility regarding when that inflection should happen?

Well, I believe you've covered a big — that's an excellent question. I think you've covered, to a substantial degree, the destocking taking place globally. And demand for parts on narrow-body aircraft, especially in North America, has bounced back. What we're still waiting on is a rebound in international markets. And once again, parts is the most international portion of our business; so as soon as we gain clarity that borders are consistently open and travel restrictions are being removed, that is the point when we'd anticipate seeing steadier, more reliable demand within the parts business. And regrettably, predicting the timing of that is clearly extremely hard. But tied to that, since you've observed destocking is mostly finished and you've witnessed a preference in the USM — toward USM material, we think that as soon as demand becomes steadier while markets completely reopen, there will be a considerable rush on this material because shelves are bare and airlines will feel greater confidence about consistent flying; so forecasting when that will happen is tough, yet we do anticipate that when it does, it will be a fairly significant uptick.

One last thing on this topic. When you look at the cycle—not merely the coming few quarters, but the coming couple of years—how much are you modeling or assuming that demand for USM might exceed demand for aftermarket parts more broadly?

Getting into specifics on that isn't something I'd want to do. However, we've observed—from a market perspective, I'd say in international markets like Asia, plus legacy carriers right here in North America—a substantial rise in interest in USM; and so, once more, predicting the path and pace of that growth is hard, but we know it's there.

John, perhaps regarding the Omicron variant — I suppose, looking backward, Delta and, more precisely, the reaction to it appeared somewhat subdued compared to what we're witnessing at present, with travel bans and all the other developments. How should we — you mentioned we'd observe some sequential expansion returning to — consistent with the fiscal first quarter. How are you folks merely approaching that, given what you encountered with Delta and what could lie ahead going forward with Omicron?

Yes. Excellent question. Those remarks concerning sequential growth rest mostly on — as I noted, we did experience certain sales shifting out of Q2 and now they'll take place in Q3. So we're simply examining our backlog throughout the entire company, which provides us confidence that sequential growth will appear. Without a doubt, you put it well — the reaction to Omicron was certainly faster and wider than what occurred with Delta. Yet we generally concur with what other airlines have stated openly, namely that the effect of these — of every fresh variant will be briefer as society, as industry, and as governments manage to respond faster and then ideally ease restrictions faster too. Delta served as the initial illustration of that. Clearly, we're observing something — we're observing the following generation here with Omicron. Still, we're hopeful that every one of these cycles, so to speak, these waves, will last a shorter time than the one before. However, that remark specifically concerning quarter-over-quarter growth is connected to what we currently see in the present backlog.

Understood. And how much revenue ended up moving out of this quarter?