AAR Corp. (AIR) Earnings Call Transcript & Summary

Good afternoon, everyone, and thanks for joining us for AAR's Fiscal 2022 Third 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, please note that remarks 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 make actual results differ materially from what those statements suggest. As a result, they are not a guarantee of future performance. You can find discussion of these risks and uncertainties in the company's earnings release and in the Risk Factors section of our Form 10-K for the fiscal year ended May 31, 2021, as well as our Form 10-Q for the fiscal quarter ended November 30, 2021. In making these forward-looking statements, the company undertakes no obligation to update them for future circumstances or for anticipated or unanticipated events. We will also discuss certain non-GAAP financial information today. A reconciliation of those non-GAAP measures to the most comparable GAAP measures appears in the company's earnings release. Now I'd like to hand the call over to AAR's President and CEO, John Holmes.

Okay, thanks, and good afternoon to all of you. I'm grateful you could be with us today as we go over what we achieved in the third quarter of fiscal year 2022. First off, I'd like to say that the people affected by what's happening in Ukraine are in our thoughts. Russia's invasion, which was unprovoked, leaves us feeling both sorrow and outrage, and we stand alongside everyone who is enduring hardship. We do almost no business in either of those nations, yet even so, we've halted every bit of our commercial dealings with the sanctioned countries and territories. Having said that, let me move to the quarter itself: our sales came in at $452 million, which is a 10% rise compared with a year earlier, when they were $410 million, while adjusted diluted earnings per share from continuing operations climbed 70%, going from $0.37 per share to $0.63 per share. Looking at it sequentially, total sales were up 3.6%; within our commercial business, MRO delivered yet another robust quarter. Our Parts activity got off to a sluggish start during the period, yet it picked up steam once the effects of the Omicron variant began to fade. As we've talked about before, Parts Supply carries our highest margin, and when it comes to recovery, it has trailed MRO. The momentum Parts showed in the quarter leaves us feeling confident about a complete recovery down the road and, eventually, additional growth coming from that activity; over on the government side, we managed to achieve sequential growth even with the headwinds created by the Afghanistan withdrawal. On the subject of earnings, I'm especially happy that we turned in yet another quarter of margin expansion, with our adjusted operating margin reaching 6.7%. On a sequential basis, that's an increase over the 6.1% we posted in the second quarter, and it kept surpassing pre-COVID levels even though our commercial sales are still off by over 25%. Now for cash; it was another outstanding quarter, with $16 million in cash generated from operating activities from continuing operations. We also bought back $20 million of stock, in line with the share repurchase program that we announced earlier in the quarter. Even following those share repurchases, our balance sheet stays solid, with net leverage at 0.4x, and we remain in an exceptionally strong position to finance our growth. On the new business front, we announced during the quarter a 10-year renewal of our component MRO contract for providing depot-level maintenance on NATO's E-3A AWACS aircraft. In addition, after the quarter closed, we announced a new exclusive distribution agreement with Collins Aerospace for supplying de-icers and supporting products to the global aftermarket. This win matters a great deal, since it's our first exclusive commercial distribution agreement with Collins, and it also marks a step into the business jet market, where we see adjacent opportunities for growth. This latest distribution win shows both the value proposition our offering delivers to component OEMs and our capacity to generate market share gains in this activity. With that, I'll hand things over to our CFO, Sean Gillen, who will walk through the quarter in greater detail.

Thanks, John. For the quarter, our sales came in at $452.2 million, which was an increase of 10.2%, or $41.9 million, compared to the same period a year ago. Within our Aviation Services segment, sales rose 12.4%, helped by a rebound in our commercial markets, while sales in our Expeditionary Services segment fell by $6.4 million because a pallet order was delayed, and we now anticipate receiving that order in Q4. Commercial sales grew 28% versus a year ago, whereas government sales declined 8%. The drop in government sales largely came from winding down what we do in Afghanistan along with the natural conclusion of other government programs. Afghanistan sales for the quarter totaled $8 million, and at present we expect that figure to fall to roughly $1 million in the fourth quarter. On a sequential basis, commercial sales were 2.8% higher, and government sales were up 4.6%. Our MRO operations stayed close to capacity. And while parts volumes kept rising through the quarter, parts growth overall was held back by the slower start that John mentioned. On the government side, the sequential increase in sales came from our success in securing extra work in our government program's operations, which was more than enough to make up for less activity in Afghanistan. Gross profit margin for the quarter stood at 17.8% against 21% in the prior year quarter, which had benefited from CARES Act payroll support. Adjusted gross profit margin came to 17.3%, an increase from 16.1% in the prior year quarter and from 16.7% in Q2. This improvement in margin is still being fueled by the efficiency gains and portfolio refinement steps we took while the pandemic was ongoing, along with better conditions in our commercial parts activities. Gross profit margin for our commercial business was 20.1%, and for our government business it was 14.5%; during the quarter, commercial's margin got a boost from intercompany procurement activity done on behalf of government customers. SG&A expenses for the quarter totaled $48.9 million, or 10.8% of sales. If you exclude adjustments of $1.7 million tied mainly to investigation and remediation costs, that figure would have been nearer to 10.4% of sales. Net interest expense for the quarter was $0.6 million, down from $1 million last year, because of lower borrowings. Average diluted share count for the quarter was 35.7 million; that reflects the repurchase of 0.5 million shares during the quarter. We expect to keep carrying out our previously committed plan to deploy the full $150 million authorization across approximately 2 years. As John noted, we generated cash flow from our operating activities from continuing operations of $16.2 million, and we also brought down our accounts receivable financing program by $2.2 million in the quarter. That strong cash flow mostly funded the $20 million share repurchase in the quarter, and our balance sheet is still exceptionally strong, with net debt of $63.9 million and net leverage of 0.4x. Thank you for your attention, and I will now turn the call back over to John.

Okay, thanks, Sean. When it comes to the environment, like I said before, we don’t have any significant sales in Russia or Ukraine, so right now we aren’t seeing any major business effects from that conflict. That said, we’re definitely paying attention to the rise in fuel prices tied to it and watching how it might affect the operating costs of our airline customers. Here at home, the labor market is still tight. Our attrition, especially in the hangars, has been running higher than it was prior to the pandemic. Still, we’re lucky because back in 2019 we took aggressive steps to deal with our labor supply when shortages first started showing up. So far, those steps have let us handle the current situation better than a lot of our competitors, and our customers keep backing the moves we need to make to get through this tight labor market. On the commercial demand side, our biggest North American and European commercial customers are still optimistic about demand recovering in the business and leisure travel market, and we saw that turn into accelerating parts volume during the quarter. This growing demand is encouraging. Because of that, we expect our parts activities to keep recovering over the next several quarters. In the near term, we’re looking for modest sequential sales growth in Q4, with a more meaningful inflection in our FY ’23. That said, we know we’re still in a dynamic environment, and new COVID developments could keep affecting this trajectory. On margins, this quarter is a good picture of the full effect of the margin improvement actions we took during the pandemic, and how much more we can expand will depend on the mix and pace of the recovery. Early in the pandemic, we took a series of actions to drive operating efficiency and balance sheet strength, aiming for higher margins even without a full sales recovery. I’m extremely proud that we’ve delivered on that plan. We’ve now expanded operating margins for 6 straight quarters, and we’re one of the very few companies in commercial aerospace with a stronger balance sheet than we had before the pandemic. Our performance has put us in position to invest in our business, both organically and inorganically, and to keep delivering value for our customers, shareholders and other stakeholders. With that, I’ll turn it over to the operator for questions.

John, to begin with. The 28% rise in Aviation during the quarter — could you speak to how MRO performed compared with the parts side of the business?

Certainly. Each of those matched what we observed in Q3. In parts, as we noted, the opening was slower, volumes were down a little at the start of the quarter, which we think stemmed from a pullback tied to Omicron — caused by the Omicron variant. As that variant’s impact faded over the remainder of the quarter, parts volumes picked up, and that has lasted through today; ultimately, they exceeded what we recorded in Q2. Still, net-net parts came in roughly flat versus the prior quarter. MRO stayed steady from Q2 into Q3. The hangars there continue to be mostly occupied, and we are quite pleased with how that segment performed. The sequential quarterly growth, however, originated elsewhere in the commercial business; our commercial programs unit showed a rebound. Customers in that segment flew additional hours, which produced more revenue because of how the PBH program works. Beyond that, we saw solid results in other parts of MRO, specifically from component repair and from our landing gear operation.

All right, that's useful. And if I may, regarding the aerospace segment. Could you go a bit further into what risk might exist for the business, along with the rebound, stemming from elevated crude or fuel costs affecting your airline clients? On one hand, I realize it would clearly encourage the use of newer equipment, which could generate additional USM feedstock. Yet on the other hand, there's plainly a threat to the balance sheet as well as the operating model. So could you walk us through what you anticipate in terms of how this might affect your business across the coming quarters?

Yeah. Absolutely; and I believe you pointed out, there are several competing dynamics at play. Of course, this is something we're keeping an eye on. And it's something AAR has encountered numerous times throughout the decades we've operated in this sector. What I'd say is this is quite a significant — it depends on how much of those fuel price hikes the airlines can eventually push through to the consumer. We speak with many of our customers, and they hold differing opinions about how much can be passed along. So that element is what ultimately shapes how they view their costs. But we are — when we consider our customers' operating expenses and to the degree they experience lasting increases, that will push them toward cheaper options, and we represent a cheaper option.

All right, that's useful. And just one last thing, if I may, perhaps directed at Sean. The balance sheet, one could make the case, is now considerably underutilized while we keep witnessing some improvement on the commercial side. What's your thinking on capital allocation and other opportunities? Or do you believe you ought to perhaps place a bit more onto the balance sheet as you consider speeding up growth in any areas?

Yeah. That's a fair question. And I'd say the priorities for allocating capital are unchanged; we are seeing a growing chance to invest organically, particularly in the Parts business; so inventory has been generating cash across the last several quarters. And I believe we're finding opportunity in new business wins within distribution, along with procurement activity and used serviceable material, to put money into that. I think inorganic opportunity keeps existing through acquisition; so that will be — we believe that might be a place for us to direct capital. And then regarding repurchase, we completed $20 million during the quarter, so we've had a solid beginning to the new repurchase, and we'll keep looking to deploy money there; but I'd say the balance sheet, as you mentioned, is arguably underlevered, yet we do believe we possess sufficient and complete opportunity to deploy money.

John, perhaps we could revisit what Ken was asking about regarding fuel. To put it plainly, could you say specifically whether any shifts in behavior are showing up among your customers at this stage — for instance, when it comes to paying for optional upgrades? Or maybe they intend to schedule maintenance checks or heavy visits on aging aircraft, since given how fuel prices stand today, they might figure it makes more sense to take those planes out of service? Have you noticed anything like that so far, or had any conversations along those lines?

That's a terrific question. Honestly, the answer is no. Everyone certainly has it on their mind, but the main topic we're hearing from our customers — and once more, I'm talking about North America and Europe — centers on getting ready for what our airline clients anticipate will be a really robust spring and summer. Beyond that, we're also picking up what feels like a pleasant bit of unexpected news about how quickly business travel has come back. As a result, the carriers are concentrating at the moment on ensuring they have sufficient equipment on hand and in shape to handle what they expect will be a pair of very solid quarters. That's the main takeaway.

All right, understood. That actually sets up my next point nicely, since I was hoping to ask — the fiscal fourth quarter tends to be your peak season. From what I gathered in your prepared remarks, you mentioned expecting Parts to keep bouncing back with modest growth in Q4. But how does that apply to the whole company? Should we anticipate that sharp quarter-over-quarter jump from Q3 to Q4? And beyond that, could you offer some general direction on how to frame next year, given how uneven things are with COVID — do we look for the usual seasonal decline in the fiscal first quarter, or, considering the current conditions, do you believe revenue gains continue to stack up sequentially?