AAR Corp. (AIR) Earnings Call Transcript & Summary

Thanks. Good morning, everyone, and thanks for joining us on AAR's Fiscal '22 Fourth 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 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 those forward-looking statements. As a result, these statements do not guarantee future performance; those risks and uncertainties are covered in the company's earnings release and in the Risk Factors section of the company's Form 10-K covering the fiscal year that ended May 31, 2021, and the Form 10-Q covering the fiscal quarter that ended February 28, 2022. In offering these forward-looking statements, the company undertakes no obligation to provide updates reflecting future circumstances or anticipated or unanticipated events. Some non-GAAP financial information will be covered on today's call. 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.

Thanks, and good morning to all of you. I'm grateful that you're with us today as we go over what we achieved in the fourth quarter and throughout fiscal 2022. Prior to getting into the results, I'd like to spend a moment looking back at the fiscal year that just closed. We started that year feeling optimistic, believing that the growing appetite for domestic leisure travel that we observed early last summer would serve as a signal of what was coming for business and international travel. Not long after, the Delta and Omicron variants appeared, and those markets failed to recover anywhere near that pace. On top of that, the U.S. pullout from Afghanistan, along with the expected wind-down of several other government programs of ours, generated headwinds for our government business, which had provided a critical source of strength throughout the pandemic. And in the broader macro picture, labor remained scarce, inflation stayed elevated, and economic growth prospects were uncertain. Given that environment, I could not be more proud of what we achieved this year. It wasn't guaranteed that AAR would find a way to steer through the pandemic as we did. That reflects the efforts of our team in figuring out a path forward, and our customers for seeing the value we provide, and I'd like to express my thanks to both. Now to the full year results. Sales rose 10%, going from $1.65 billion to $1.8 billion, while adjusted diluted earnings per share from continuing operations climbed 82%, moving from $1.31 per share to $2.38 per share. We managed to more than compensate for a 13% drop in sales to government customers through a 34% gain in sales to commercial customers. What matters even more is that we kept driving efficiency gains and cost discipline, which produced substantial earnings growth. For the quarter, sales climbed 9%, from $438 million to $476 million, and adjusted diluted earnings per share from continuing operations rose 53%, from $0.47 per share to $0.72 per share. Sales to our commercial customers grew 28%, while sales to government and defense customers fell 13%. On a sequential basis, total sales grew 5%, and adjusted EPS grew 14%. Our adjusted operating margin for the quarter came in at 7%, compared with 5.2% a year ago and 6.7% in the third quarter. We keep seeing solid performance in our MRO operations, with our hangars staying close to full, and we keep gaining from the efficiency programs we put in place throughout the company during the pandemic. In our parts activities, we experienced additional recovery during the quarter, though demand is still uneven, and used serviceable material availability for supporting our trading operations is still tight for some platforms. Now to our government business. Although revenue declined, it's worth pointing out that even with that drop, we managed to grow margins in the quarter. If I pull back for a moment, I want to point out something about this quarter: our adjusted operating margin and EPS came in above where they stood before COVID, even though sales fell 15% versus the pre-pandemic peak. That was a target we set near the start of the pandemic, and I take pride in how our team has worked to meet that pledge. On cash flow, we had another solid quarter, producing $40.2 million from operating activities tied to continuing operations. Under our share repurchase program, we also bought back $22 million of stock during the quarter. Despite that buyback, we brought net debt leverage down to 0.3x EBITDA, and we remain in an exceptionally strong position to finance our growth. Now to new business. This quarter, we told the market about a marketing partnership with ProvenAir Technologies, a firm that built a digital tool applying proprietary algorithms to examine and dynamically create back-to-birth trace history for aircraft parts. We already use this capability internally, and through this partnership we can now offer this emerging digital solution to our customers too. We also announced our relationship with Aero Design Labs, a business that created an aerodynamic drag reduction system kit for the 737NG. For the 737 to 700, this kit could cut fuel burn by 1.5%, equal to more than 40 tons of CO2 reduction for each aircraft every month, and the gains should be even bigger for the 737 to 800 and 737 to 900. We will serve as the company's exclusive distribution provider and have put money into the business to support its growth. Last, earlier this week, we said we had become the first non-OEM to receive the Captains of Industry contract from the Defense Logistics Agency. That recognition creates a long-term strategic supply chain relationship with the U.S. Department of Defense and gives us access to unique chances to support the U.S. and its allies. With that, I'll hand the call to our CFO, Sean Gillen, to result — to walk us through the results in greater detail.

Appreciate that, John. Revenue for the quarter came in at $476.1 million, which represents an 8.8% increase, or $38.5 million, compared to the same period a year ago. Within our Aviation Services segment, sales rose 9%, fueled by the rebound in our commercial operations, while our Expeditionary Services segment saw a 4.5% gain. On the whole, commercial revenue climbed 28% versus the prior year period, whereas government sales fell 13%, a decline attributable to the wind down of our Afghanistan activity along with the natural completion of other government programs. Moving sequentially, commercial sales grew 11%, and government sales dropped 3%. Our gross profit margin for the quarter stood at 18.9%, compared with 16.4% in the same quarter last year, and on an adjusted basis, gross profit margin was 18.6% versus 16.5% a year earlier. In our commercial business, gross profit margin reached 17.7%, and in our government business it was 20.8%. That government margin benefited from sustained strong performance together with certain contract modifications that produced a higher recovery on indirect costs. SG&A expenses totaled $56.9 million for the quarter. That number reflects greater investments in our digital initiatives, plus $2.9 million tied to investigation and remediation matters and strategic project costs. Keep in mind that our fourth quarter has traditionally been our highest SG&A quarter due to seasonality, and we stay dedicated to lowering SG&A as a percentage of sales even as we keep investing in our growth. Net interest expense came to $0.6 million this quarter, down from $0.9 million a year ago, as a result of lower borrowings even with interest rates having risen. As John mentioned, cash flow from our operating activities from continuing operations was $40.2 million. Beyond that, we put $22.2 million toward share repurchase and decreased our accounts receivable financing program by $3 million. Our balance sheet continues to be exceptionally strong, with net debt of $46.5 million and net leverage of just 0.3x. In line with the previous 2 quarters, we anticipate carrying out our plan to deploy the entire $150 million share repurchase authorization over roughly 2 years from when it was announced. I appreciate your time, and I'll now hand the call back to John.

Okay. Thanks, Sean. As we look ahead, although demand is still extremely robust for commercial travel both domestically and in Europe, the overall rebound in global traffic remains more gradual, and we're keeping an eye on the macroeconomic climate and how it might affect the air travel market. From our perspective, demand for commercial parts ought to broadly follow the recovery in commercial flying. Within our commercial parts operations, the expansion of used parts sales will likewise be affected by supply availability, which is still constrained on particular platforms, whereas growth in new part sales ought to keep benefiting from the new distributorships we've recently secured along with those still in our pipeline. MRO demand is still strong, and we anticipate the hangers staying largely full for the rest of this fiscal year. In our government segment over the upcoming quarters, we anticipate growth coming back as recent program wins ramp up and as we turn opportunities from our robust pipeline into business. Regarding Q1 in particular, as you're aware, Q1 has historically been a sequentially weaker quarter compared with Q4, and we anticipate that pattern holding true this year; we also anticipate making near-term investments in our business as we get ready for additional commercial parts demand and possibly to finance inorganic growth. For the full year FY '23, since the path of the commercial aviation market recovery is still hard to forecast, made worse by rising macroeconomic uncertainty, we'll stick with our recent approach of not offering formal guidance. That said, judging by what's visible today, we anticipate sequential quarterly growth resuming starting in Q2, and we'll keep providing updates as the year progresses. Looking further out, we remain exceptionally well positioned. Our distinctive independent Aviation Services business model keeps resonating with commercial as well as government customers. Our end markets are expanding, and our balance sheet is strong enough to finance our ongoing expansion. I'm enthusiastic about all the opportunities in front of us, and the team and I stay committed to creating value for our shareholders. Before we open the floor to questions, I'd like to spend a few moments honoring our Chairman, David Storch. We announced yesterday that David has decided to retire from the Board effective in January. David joined AAR in 1978 and was its CEO from 1996 until 2018. Throughout that period, he more than quadrupled the company's sales while steering through many peaks and valleys in the aviation industry, including both 9/11 and the great financial crisis. Even more significantly, he built and exemplified the doing-it-right approach, which is the culture we still live by, and laid the groundwork for the company to become the pillar of strength and opportunity that it is today. I congratulate David on his retirement and thank him for his leadership, counsel and friendship. With that, I'll hand it over to the operator for questions.

John, I appreciate what you said about the fiscal year '23 outlook and, I suppose, the absence of visibility. But could you assist us at all, or give us any finer detail regarding the commercial business? According to you, MRO is mostly full. So that unit sounds like it may be flat to up somewhat, yet what is the expected growth specifically for the parts side in fiscal '23, if you could offer any further information about that?

Yes. On the MRO side, you have that correct. Based on what we observe at present, the hangers are mostly full, and we anticipate sustained robust demand across the year in heavy maintenance. Regarding the parts side, the distribution business, the commercial distribution business, keeps expanding, and that is mostly powered by the new wins we have announced over the last 18 months as they come online. Thus we anticipate growth in the new business, in the new parts business because of those wins. When it comes to the used parts business, the story is more inconsistent. We witnessed a fair amount of accelerated demand during Q3 as well as during most of Q4. That demand has eased somewhat now that we are in the first quarter of this year. Another element at play there is that we see very strong demand in certain platforms; but consequently, there is also considerable demand for material, and that material is in tight supply. And so with certain platforms where we see strong and consistent demand, locating the used material to service that demand is a little bit more challenging. So — to sum up, I feel very good about MRO, feel good about the continued recovery and growth in commercial parts distribution, but trading is a somewhat uneven story given the factors I just described.

All right, that's useful. And clearly, your leverage is quite low. Based on what you've said, it seems like you may be eyeing some investment possibilities — previously, you've mentioned how appealing PMA is. Are you still exploring that? And on the organic side, do you expect there are meaningful chances to put money into engines, airframes, or other feedstock, given the surplus marketplace you're seeing in the near term?

Yes. Excellent question. So when it comes to feedstock and the trading operation, our balance sheet capacity and our speed — our capacity to act fast and outpace rivals whenever packages or material show up — is among our biggest strengths right now. We're in the market constantly, every day, worldwide, hunting for the right material. And once we locate it, we can close extremely quickly. So that's certainly going to be a source of capital deployment for us across the year. Regarding PMA and other initiatives in particular, we do have organic PMA work in progress, and the progress encourages us. It's early and growing slowly, but we do have a solid team dedicated to organic PMA work; and as we've said before, we'll keep evaluating inorganic opportunities to strengthen that effort if assets come up and we can achieve valuation, et cetera, that matches expectations.

All right, that's excellent. And just let me squeeze in one last thing. When I look at the investments, you clearly had solid cash growth from '21 to '22. How should we frame this — you also have a significant amount of capital locked up in working capital. So beyond the earnings growth, how should we think about free cash in '23? Could working capital be a chance to free up some cash? Or are we looking at only modest expansion over '22?

Yes. The steady cash flow we've managed to produce makes us quite proud, and it pairs with the steady margin gains, and so on, that we've achieved across the business as a whole; we definitely anticipate being cash flow positive once more this year, and staying consistent when it comes to generating cash flow is our aim. That said, though, returning to what you asked earlier, should a chance arise to make an excellent buy of hot engine material or feedstock to supply other areas of the trading business, that cash will be put to work, and put to work fast. Once more, that's a benefit of the market; so although the overarching aim is to keep generating cash and keep getting more efficient with our working capital, we intend to stay flexible so we can respond to opportunities in the market.

Regarding what you mentioned about the parts segment's inconsistent performance, I believe you noted a pickup during Q3 and Q4, followed by a slowdown at this point. As certain of those markets recover now, can you spot any split between narrow-body and wide-body?

Yeah. I would say the inconsistency stems somewhat from — it comes more from the narrow-body side. When it comes to trading, our wide-body operation mostly serves the cargo market. That has remained steady all through the pandemic and extremely, extremely robust; and those are precisely the places where we're seeing scarcity in material supply.

Then, regarding the CFM56 tie-up with Fortress, what kind of performance are we seeing? You brought up hot section possibilities in that area. Looking ahead, do you expect those volumes to rise?

Indeed, excellent question; that collaboration is still going very strongly. For serving the narrow-body sector, it has provided us with terrific material, and on fulfilling the material commitments they pledged when the agreement started, Fortress is performing really well. At this stage, I'd say it has reached its full ramp. As Fortress grows its operation and adds to its engine lineup, we keep cooperating with them, so growth on that platform is conceivable. Still, right now it runs at maximum capacity, exactly matching what we anticipated.

Then, regarding what you put into your workforce during COVID: how much time do you figure remains before further spending is required? Or what amount of traffic would have to appear for you to call it capacity?