AAR Corp. (AIR) Earnings Call Transcript & Summary

Good afternoon. Thank you very much for joining us. It's my distinct pleasure to have with us executives from AAR Corp.: John Holmes, CEO; and Sean Gillen, CFO. And certainly, the aviation sector has been reeling from the COVID crisis, which is now over, right?

It is over. We're here to tell you.

It is over. Here to declare it official.

It is here in Florida, that's for sure.

That's for sure.

Slightly different than Chicago.

What we thought we'd do is open up with a couple of slides that you've prepared, just to give everybody a level-set on the business, and then we'll go into some Q&A.

Perfect. Thanks, Steve. It's good to see you live and in person. And thanks for having us. So as you mentioned, just for those of you who aren't familiar with the AAR story, we've got a few slides to zip through here very, very quickly before we go into the conversation. So AAR, we've been around since 1955. Obviously, publicly traded. This is a post-COVID number of $1.7 billion in revenue; pre-COVID, we were north of $2 billion of revenue. Obviously, we've been around for over 65 years. And so we've seen a lot of different cycles in the aviation industry. Certainly, nothing quite like what we've been through over the last 2 years, but we have seen a lot, and I know we'll talk about that later. We operate all over the world, 60 different sites. Some are bigger than others, and we'll talk about that in a couple of slides. But we are very unique in the aviation industry and believe very strongly in a close-to-the-customer business model. As an aviation services company, we focus heavily on tailored solutions, and that obviously often brings us very close to the customer. We report in 2 segments as a company: Aviation Services, that I'll come back to in a minute; and then Expeditionary Services. Expeditionary is about 5%, 10% of the business, and it is really a legacy manufacturing business. It's the only manufacturing business that we have left inside of AAR for those of you that have been around the story for a while. And in Expeditionary Services, we manufacture entirely defense. These are shelters, pallets and containers that are used in the theater for -- that are deployed whenever there is a conflict, and they're deployed in the theater of battle. And we've been in that business for many decades. I would characterize the Expeditionary Services as a bit of a legacy business for AAR. And the focus of the company over the last several years and will continue to be as we move into the future on the Aviation Services business, and that represents our largest segment, at about 90% of the company. Inside Aviation Services, we do 3 things: parts supply, MRO and integrated solutions. In the parts supply business, there's 2 areas of focus there. One is on used material. We're the largest in the world in terms of supply in used material, USM, which is a term that's gotten a lot of attention recently. We tear down dozens of aircraft and engines each year, recertify those parts and then sell them into the open market. And these parts are sold -- they're the same part number, form, fit and function -- as a brand-new part, but because they're used they're often sold at 30%, 40%, 50%, 60% less than buying a new part from the OEM. And those are largely rotable parts, meaning parts that can be repaired and reused. We are also one of the largest in the world for new parts distribution. We have a number of different relationships with Tier 2, Tier 3 OEMs, where we buy factory-new material, we are a stocking distributor, and then resell that to support the aftermarket. And that's another area that's been a significant source of growth for the company. We're the #3 player in the world, but the largest independent. Our 2 big competitors, one is owned by Boeing and the other is owned by Airbus, and we're the largest independent, meaning not part of a larger OEM, for aftermarket distribution. And these are largely consumable and expendable parts that aren't at the same dollar level that you would see in the rotable material that makes up the majority of our USM business. Moving to MRO, we are the third largest in the world and the largest in the world for heavy maintenance. That's airframe heavy maintenance. We have a number of facilities here in North America as well as a joint venture over in India. We are performing heavy maintenance scheduled checks, largely C and D checks, for our airline customers. We also have a large -- we're one of the largest in the world for landing gear overhaul, and we have a facility actually right down, not too far from here, in Miami. We also do component repair. So the work that's done on the airframe side, those are large checks done in hangars. We also repair individual components of the aircraft in a couple of component repair facilities that we operate. We also repair wheels and brakes. And we're involved in engineering services. So as our airline customers look to redesign or reconfigure their cabins, we help them with that engineering design. And occasionally, we'll perform the touch labor involved in actually making the modifications themselves. And the third area is our Integrated Solution area. This is predominantly a government area. AAR, in total, runs about 50% commercial, 50% government across the company. The largest concentration in our government business is here in Integrated Solutions, where we are on long-term supply chain contracts with different agencies of the government, from the Department of State, the Air Force, the Navy. We operate across a number of different services under long-term contract. And that business, that government programs business, has been a real success story for AAR over the last few years because we have made the migration from being a small subcontractor to a larger prime contractor to the government. And we've announced a number of wins and several billion dollars' worth of work over the last few years. And the neat part about that business is the more you win, the more you can win, because you're building a portfolio of past performance that can be used to bid on other work. So we've had a lot of success in that area. The other area of Integrated Solutions is our commercial programs business, which is largely power-by-the-hour supporting airlines under long-term component support agreements, where we supply inventory and also manage a repair loop to ensure on a per-flight-hour basis that the parts are in the right place at the right time when an airline needs them. Again, that's a business that had grown significantly. We've pulled back from that business based on market conditions in recent years, but it's still an area of focus for the company. So I mentioned before that AAR is very unique. And we are. There's really no other company in aviation that's quite like us, that does all of the things that we do and integrates them under one roof the way we're able to do. And if you look at these 3 businesses, the parts supply, MRO/repair and engineering and integrated solutions, they work very well together. There are companies out there, competitors, that do pieces of what we do, but they don't integrate them the way that we do. And many of them are not independent. I mentioned Boeing and Airbus being players. There are other competitors, such as Lufthansa Technik or Delta, that's part of an airline. We're the largest independent for what we do. And bringing our parts supply and the data that we collect there to help us develop repair and engineering capability, putting those 2 things together to support our long-term supply contracts for the government as well as commercial airlines under the power-by-the-hour contracts, that's all a very unique arrangement and made more unique by the fact that we are independent, not being part of an OEM or part of an airline. If you look at the company's growth strategy, and it's really kind of starting today, and as Steve declared, COVID is over, so we can have this conversation or we are going to regret, I'm going to knock on wood on that. If you look at where we are now, COVID, and we'll talk about this, I know, has been a very difficult period for the industry, but in a lot of ways created a great amount of opportunity for our company. We took a lot of actions to streamline the portfolio and really focus on that core services offering over the last 18 months, and that's put us in a position to recover very, very strongly as the overall market recovers. Our balance sheet is exceptionally strong, which gives us the ability to continue to invest in our core businesses around parts, the USM business as well as new parts distribution. We see opportunities to expand selectively in our MRO hangars, where we know that we have customer demand as well as the supply of labor. So we see opportunities for organic as well as inorganic MRO expansion. And then we also want to, over time, bring more proprietary content into the offering of the company. We have an incredible front end in terms of selling parts and repairs to commercial customers as well as parts and repairs to the government customer, and we are looking for ways to put more higher-margin activity through that front end, and that comes through proprietary content on parts, through PMAs, for example, as well as proprietary DER repairs that we would develop and perform in-house. And finally, on the digital front, we have a number of digital initiatives underway inside the company. Some of them are internal, just to make ourselves more efficient, and others are external to drive digital revenue to AAR. And so if you look at these things as they add up over time, we feel pretty good about our path, not just to recovery but to grow significantly beyond the market. So as I mentioned, we're in a unique position. It's been a very intense but very productive couple of years during COVID, and we believe that we're exceptionally well positioned to emerge very strong. And there we go.

Great. Thank you, John.

So I will ask one COVID-related question, despite declaring it over. You did mention that you took actions as a company. I think you're understating that a little bit. Can you describe some of the actions that you took, and then how that's made you more competitive, going forward?

I appreciate that. And all kidding aside, I mean, it's easy to talk about COVID being over because case numbers are going in the right way and we're down in Florida. But still it's a dynamic environment, and we're cognizant of that. But it has been, as I mentioned, a very productive period for AAR. We took a look at the portfolio in every respect as we entered COVID and determined that we could accelerate changes that we wanted to make inside the company. But because of what the market was going through, it gave us the opportunity to do so in a very short amount of time. So there were contracts that were underperforming that we ultimately exited or restructured. We had businesses, like our composites manufacturing business, that had been underperforming for years, and we took the opportunity to exit that business. We had facilities that were underutilized that we either exited or consolidated with other facilities. We had overhead in all forms that we took a hard look at. And when you're going through a crisis where you have multiple product lines of the company that are down on a sustained basis, 80%, 90%, it forces you to look at every single thing you do. And us, like many other companies, really took a dispassionate view. It was difficult decisions, but took a dispassionate view at the activities we were involved in. And we have emerged a much cleaner, more focused aviation services company. At the same time, we were able to generate a great deal of cash during this. And we really hit the overdrive button on cash generation, and that has served us well. Because, you would know this, I don't know that there's, maybe other than HEICO, another publicly held aviation company that is actually emerging from this crisis with less net debt than before going in. And that has given us a great amount of flexibility now that the market is starting to recover, overall. So like I said, it's been an intense but very productive period.

Fantastic. And do you think -- the nature of your business, in many ways, is helping your customers manage their own supply chains. Do you think that that's helped you manage through this crisis itself in terms of being prepared for those fluctuations?

That's a great question. Yes. Yes, in a way. And I tell you, probably the biggest thing that -- it's still a focus of ours, but the biggest thing that kind of unknowingly prepared us was our focus on labor. In our hangars, in our maintenance business, we are selling labor hours. And we have thousands of mechanics that work for us and have been working for us throughout the pandemic, coming to work every day, and we're very proud of them. And if I go back 3 or 4 years ago, well before COVID, we started to feel the effects of a shortage of mechanics in this country, and that had a pretty significant impact on our results at the time. And in order to deal with that, we developed a number of different partnerships with schools. We developed some of our own schools. We developed different ways to train people. We looked at our pay. And we really changed the way we recruit, train and the way we kind of expect to retain people once they come into the company. And all of those things, again unknowingly, were preparing us for the environment that we're in now. We're managing, and our most important supply chain is our labor supply chain, managing that supply chain in a very effective way. And don't get me wrong, it's still very tight right now and we're feeling it. But if I think about us versus some of the competitors that we see, particularly in the heavy maintenance market, I think we're dealing with it about as best as you can, due to that work that we did upfront.

Great. Great. What are you seeing and hearing from some of your airline customers about the return to travel volume pickup, et cetera, both domestically and internationally?

I think domestically and in certain international markets, and I'll talk more specifically in a second, there is a great deal of optimism right now. I think that there is a very high expectation that we are going to have a very strong summer, even stronger than last summer; in some cases, maybe even stronger than 2019. And I think that we are starting to feel that optimism in our businesses. I was with actually a president of a very large airline last night, and they're exceptionally bullish on domestic travel. They're much more bullish than they were last year at this time around European travel, both international as well as European domestic travel. I think there's still a big question about the timeline for recovery in Asia. For AAR, our 2 most important markets are North America as well as Europe. So the fact that there's a lot of optimism from our customers around the recovery and the strength of travel we'll see this summer. And of course, all of this is under the heading of it's still -- I mean, we're -- everybody is kind of counting on we're not going to see another crazy variant, nothing terrible is going to happen in that regard. But the optimism around our core markets in North America and Europe gives us a great reason to be confident about the coming quarters ahead.

Great. I've got a couple of questions about fleet dynamics. But first, I want to draw Sean into the conversation. John, you, mentioned the strong balance sheet and coming out of the crisis with more cash, lower net debt than going in. As you think about capital allocation and priorities as CFO, maybe just spend a few minutes on your thoughts there.

Appreciate that. And as you mentioned, the balance sheet, really low net leverage, 0.4x, and plenty of flexibility to allocate capital across our priorities. And the way that we see them is, first, organic investment, putting money to work in the business to help drive the growth. And specifically, that's going to come in inventory supporting the parts business, both used serviceable material, procuring new supply to match it to the demand. And then on the distribution side, as we win new business lines, having the upfront inventory purchase that comes with that. John talked about some of the digital initiatives as well as some select expansion in MRO. So I think organically, that's where we put capital to work. Second allocation would be for inorganic opportunity. We do believe that M&A can and should play a role in accelerating our strategy, and we're in a strong -- position of strength to be able to do that if opportunities do come up that make sense for us. And lastly is capital return. We were on the sidelines on capital return. We just reinitiated our share repurchase authorization back in December, $150 million expected to be utilized over 2 years. And so that's kind of how we rank our capital allocation priorities.

And on the M&A front, we've been talking just generally about the inability in the current environment to actually transact in a commercial aerospace-exposed business. Do you see that visibility returning? And when do you expect the M&A market to return in earnest?

So I think we do see the gap narrowing. And as John talked about, the increasing confidence around the outlook will serve to narrow the valuation gap that has existed, as everyone has kind of come through the downturn. We've been in the recovery, but there's still a lot of uncertainty of the pace of the recovery. I think as we come through kind of this calendar year and have better clarity of what demand looks like, that should lead to more opportunity for parties to come together around transactions.

Great. And as the market is recovering and travel accelerates, you have seen more strength in the MRO business, as fleet readiness is a priority. As we move through the recovery, how do you see the balance of your business contributing, going forward?

MRO has been very strong for the last few quarters. It was actually one of the first on the commercial side, one of the first businesses to recover. Now recovered at a lower level because as part of the changes that we made, we took out capacity intentionally. And so now we've been operating at near capacity for the last couple of quarters. But it's a much more profitable business because we've streamlined the operation. The area of the business that has been lagging has been the parts business, which is our most profitable business. And if you look at the last quarter, across both new parts and used parts, we were still kind of 20% to 25% below where we were pre-COVID. If you look at the customer sentiment now, and I think going back to my comments around the confidence in the strength of travel in the summer in our 2 most important markets, North America and Europe, we would expect to see that start to recover to pre-COVID levels. And again, all of that work that we did through COVID was designed to improve the operating margins of the company, and we've seen 6 straight quarters of operating margin improvement. We expect that to continue. And that will continue to be driven as our highest-margin activity, the parts business, recovers. And again, as long as we hold on the trend that we're on right now and that optimism remains in the customer base, we expect to see that business come back.

How should investors think about the nature of the fleet and those robust narrow-body production rates? Obviously, the MAX coming back to production. But as we think about narrow-body utilization relative to wide-body, how does that drive your business? How should we think about that impacting AAR?

The majority or vast majority of our business is narrow-body. And so domestic travel, whether it's business or leisure, is a good thing. And it's certainly a good thing as it recovers over in Europe as well. So in terms of the overall cycle of the fleet, certainly COVID has disrupted that cycle and elongated the life of current assets, which is a good thing for us because we're on all those existing platforms. But as the MAX comes in, we expect to be a MAX participant as well. And AAR, as we mentioned at the beginning, we've been around since 1955. We've seen generational turnover in aircraft over and over again. Markets mature at a certain point, material becomes available, repairs are developed and aftermarket develops, and that's how we participate. One comment, just going back to your question about the overall recovery in the parts business, I would add that in the USM business we expect to recover beyond the levels we saw pre-COVID because we do believe that there has been and will continue to be increased user adoption of used material. It's harder for an airline to buy a used part than it is to buy a new part. You buy a new part, it comes in a box, you take it out, put it on. You know exactly where it's been. It's never been used before, et cetera. To be set up to receive parts, to inspect parts that have been flown before, have been repaired before, that requires a different set of procedures inside an airline. And once those things are set up and you're able to buy used parts, and a lot of airlines are looking at that lower-cost alternative because of COVID, that expands the potential market. Additionally, if you look at our new parts business, we've announced a number of pretty significant distribution wins over the last 18 months, both on the commercial side as well as the government side. And as those contracts mature, that will take us beyond where we were pre-COVID on the new parts distribution business because we've expanded the base of OEMs that we support. So we feel that we're set up well to not just recover in our highest-margin businesses, but ultimately grow beyond where we were pre-COVID.

Because those offerings are, in fact, improving the profitability of the airlines itself.

That's right.

And how have you seen the recent very strong rise in fuel prices, which is a big cost component for the airlines, impact their buying patterns? Are they getting more and more interested in used serviceable material?

I think that's a great -- yes. Honestly, it's tough to parse how much of it is oil going to $100, versus just kind of general trend towards that as a result of coming out of COVID. But the more cost pressure an airline sees, the more they're going to look for lower-cost alternatives, and that's what we are.

Great. Okay. I don't want to lose sight of the government side of the business. That is a strong market exposure. Can you dive a little bit further into the trends that are impacting or driving the government side of your business?

Sure. We've talked a little bit about this. So we have some near-term, I'd say, very near-term headwinds on the government side of the business. Part of that was driven by the withdrawal from Afghanistan. We were actually a very significant contractor over in Afghanistan. And so that was a loss of revenue that we could not have predicted. So that -- we'll be feeling the full effects of that in the quarter that's ending now as well as the next quarter. We are doing everything we can to make up and then grow beyond that loss. We announced a win, the USAFE F-16 contract that we were awarded. It's going through the protest process at the moment, but we expect to secure that contract. And that will cover about half of the lost volume out of Afghanistan. There is a very strong pipeline of similar programs, PBL, CLS programs, and I mentioned making that migration from a subcontractor to a prime contractor and the ability for us to bid on a much wider range of contracts. The pipeline for the company has never been stronger. These things take a long time to win, but once you're on them these are long-term contracts. So overall, we feel about the government programs business we're dealing with some near-term headwinds, largely as a result of Afghanistan and some other programs that came to natural completion, but overall, we feel that we're well positioned there. Two other things I would mention. Then there's the parts business with the government. We sell a lot of new distribution material to the DOA. It's about half of our distribution business. And we've built a really strong franchise for ourselves in the new parts distribution business to the government. We have also seen some near-term moderation in the demand out of the government, and the macro theme is this administration has been prioritizing spend towards newer technologies, as opposed to sustainment. Now the current situation that, hopefully, we don't find ourselves in, but if we do, that may change the parts spend to support the fleet that's already installed, but we'll have to see how things unfold there. The last comment I would make about the government side of the business is, very similar to an airline, if there is now a lot of cost pressure to maintain readiness on the thousands and thousands of aircraft across multiple platforms that are deployed already, that's going to cause you to look at alternative, lower-cost solutions, which again is what we provide. And a very simple example of that is applying the used model, the used parts model, that's been very popular and increasingly popular on the commercial side, applying that to the government side. And if you look closely at some articles that have come out and some of the recent testimony in terms of confirmation hearings, there is an increasing drumbeat in Congress right now over looking at these types who have asking the services to more broadly consider aftermarket solutions such as what we offer. So we think, again, it's going to go very, very slowly, but as organizations all over the world look for lower-cost alternatives for whatever reason, we're in a good spot.

And that could be additive to sales, but more importantly, additive to margin.

That's right.

That's excellent. That definitely preempted one of my questions. Cargo, let's talk about cargo market. It's benefiting -- it's seeing some of the same trends, but do you see the strength in the cargo market abating?

Maybe overall, but not for us. I mean, it's an important part of our business. It became a more important part of our business during COVID. The majority of our wide-body exposure is to the cargo market. But for the customers that we service and the contracts that we're on, we feel pretty good about their demand.

Great. I guess, in terms of markets, we haven't talked about the aero engine business and that market for you. That's a very important market that you serve in terms of technology and next-generation engines. Can you talk a little bit about how you're a beneficiary of...

Are you talking about, like, a GTF?

Yes.

So I would say you're kind of a near- to medium-term beneficiary on the engine side for a couple of reasons. One, because of the overall interest in USM increasing. And airlines, there's a lot of deferred maintenance out there on their engines. And as they ramp up for a bigger summer flying season and growth beyond what they saw pre-COVID, we expect very strong demand for engine material. Then you overlay supply chain issues with production on top of that right now. And so you've got, even though the installed base is increasing, the ability to service that installed base is still somewhat challenged. So that's another pressure that would lead customers towards used material. So we see that as a near-term to medium-term benefit to us. But over time, I would put those engines in a similar category to everything else. Those platforms will mature. Material will become available. The checks may be farther apart, but they're going to require more expensive material at the time of the check. And so we ultimately see ourselves participating in that market the same way we have for the last several decades. Having said that, though, the installed base of engines that we support today, I mean, it's tens of thousands of engines. So I mean this is a -- it's a -- it will be a long time before we see any meaningful shift there.

Okay. Great. Maybe I open it up for questions in the audience, either online or live.

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And maybe just to repeat the question just so it gets picked up. The question was, given the last 6 quarters of margin expansion but the expectation of that continuing, understanding what's driving that pricing/mix shift, et cetera.

So a few different things. One is the permanent costs that we took out of the company as a result of the changes that we made during COVID, and there was about roughly $50 million of overhead costs that we characterize as permanent cost takeout. Other areas, there were underperforming contracts that, candidly, and businesses, that were masking the strong performance of some of our underlying businesses; most notable, the parts business. So we've kind of gotten rid of that headwind. In our heavy maintenance business, for example, we had talked a lot about and really sized that business around the millions of labor hours that we would produce each year. So we've talked about it being a 5 million or 5.5 million labor hour business. We took out about 1 million hours of capacity during COVID. And the reason that we did that is because that kind of 20% to 25% was largely being driven by contract labor. And our ability to make money on contract labor, it was basically a breakeven proposition for us. So we exited a facility, exited certain customers, shrunk our footprint and size inside of some of our other facilities to structurally bring that business down to where we're only working on aircraft with our own labor, where we can actually make money. And so that's improved the margin profile of that business. So all of those things I just described are really reflected in the numbers through the last quarter. The further margin improvement we expect to get will be the continued recovery of the higher-margin business that will shift the mix towards those higher-margin activities. And again, we expect recovery to pre-COVID levels in those businesses and then beyond, given the wins that we've had over the last 18 months.

Great.

Appreciate the question.

Okay. With no further questions, I want to give you a sincere and hearty thanks for being here with us today, and appreciate the time. And certainly, an exciting story and one that will continue to benefit as the aero recovery unfolds.

We appreciate it. It's great to be on stage with you. All right. Thanks, Steve.