AAR Corp. (AIR) Earnings Call Transcript & Summary

Good afternoon, everybody, and thanks for joining AAR's fiscal year 2023 second quarter earnings call; with us today are John Holmes, President and Chief Executive Officer, and Sean Gillen, Chief Financial Officer. Prior to starting, please let me note that remarks on this call might contain forward-looking statements, as outlined in 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 forward-looking statements. As a result, these statements do not guarantee future performance. Those risks and uncertainties are addressed in the company's earnings release and the Risk Factor sections of the company's Form 10-K for the fiscal year ended May 31, 2022, and Form 10-Q for the fiscal quarter ended August 31, 2022. In offering the forward-looking statements, the company takes on 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 these non-GAAP measures to the most comparable GAAP measure appears in the company's earnings release. Now I'd like to hand the call over to AAR's President and CEO, John Holmes.

Alright, thanks, and good afternoon, everyone. I appreciate you all taking the time to join us today as we go over our results for the second quarter of fiscal year 2023. Revenue for the quarter rose 8%, climbing from $437 million in the same quarter a year ago to $470 million. Adjusted diluted earnings per share from continuing operations rose 30%, moving from $0.53 per share to $0.69 per share. Our commercial customer sales grew 21%, while sales to government and defense customers fell 12%. On a sequential basis, commercial customer sales were up 66%, and government customer sales rose 3%. I'm glad that we keep seeing improvement in the rebound of our commercial volumes, even though global flights remain roughly 20% below 2019 levels. Specifically, within our parts activities, we saw demand improve sequentially for both USM and new parts distribution. While that's encouraging, we're even more encouraged by the chance for additional improvement, since volume in these activities is still more than 20% below our FY 2020 levels; beyond that, we anticipate that the full ramp-up of our new distribution agreements and greater adoption of USM will bring growth opportunities past the market recovery. In MRO, we achieved sequential growth thanks to facility optimization and expansion in the non-hangar portions of our MRO operations. Our government sales still reflect the earlier wind down of certain programs, including Afghanistan, but I'm pleased that we got back to sequential growth this quarter. Turning to margin, we posted another strong quarter, with our operating margin coming in at 7.6% on an adjusted basis, up from 6.1% last year and 6.9% last quarter. That speaks to our dedication to cost discipline, a mix shift toward parts, which is our highest margin activity, and outperformance on certain programs; we do still face labor market tightness, though it seems to be stabilizing, and the programs we set up years ago to build a proprietary set of labor pipelines keep serving us well; we're talking with our customers about price increases for calendar year 2023 so we can address the higher labor costs we're facing. As we mentioned on last quarter's call, we had compelling opportunities during the quarter to invest in new long-term business and in attractive USM assets; those investments came to roughly $60 million in the quarter, which led to a use of cash in operating activities from continuing operations of $46 million; we also bought back $28 million of stock in the quarter under our share repurchase program. Even after those investments and the share repurchase, our net leverage stood at 0.9 x EBITDA, and we still have considerable balance sheet strength and flexibility. Among the investments in new long-term business we announced during the quarter was the expansion of our distribution relationship with Unison. This significant new agreement broadens our long-term distribution of select Unison igniter plugs, ignition leads, harnesses, and related spare parts to now cover all aftermarket customers worldwide. Additionally, in the quarter, we disclosed a fresh multiyear arrangement with flydubai for flight hour component support, broadening our assistance to cover the newly added, expanding 737 MAX fleet at flydubai. Last but not least, we entered into a new Airinmar contract with Cebu Pacific, a low-cost airline headquartered in the Philippines, to deliver a comprehensive range of services spanning aircraft, warranty management, and value engineering. Prior to handing things over to Sean, I want to address the inclusion within the DoD's FY 2023 National Defense Authorization Act of a clause specifying that the Navy and Air Force will put in place processes and procedures for procuring used serviceable material to sustain their commercial derivatives, aircraft, and engines. In the past, the U.S. government has mostly bought new aircraft and new aircraft parts; this piece of legislation formalizes the approach for the DoD to evaluate employing USM as a superior value option whenever it becomes available, and represents an initial move toward opening up a substantial, untapped market for our used parts offerings. Through the years, we have discovered excellent partners in Congress across numerous initiatives, and I want to express gratitude to them for their efforts on this vital chance to generate taxpayer value; with that, I'll pass it to our CFO, Sean Gillen, to go over the results in greater detail.

Thanks, John. During the quarter, our sales came in at $469.8 million, which was an increase of 7.6%, or $33.2 million, compared to the same period a year earlier. On the commercial side, we saw a 21% rise, but government sales fell 11.7% because some government programs wrapped up, including our contracts in Afghanistan. Looking sequentially, commercial sales grew 6.2%, and government sales grew 3.5%. Our gross profit margin for the quarter stood at 18.3%, compared with 18% in the prior year quarter, while adjusted gross profit margin reached 18.8%, versus 16.7% in the prior year quarter. In our commercial business, gross profit margin was 18.4%, and in our government business, it was 18%. The margin improvement this quarter reflects ongoing strong results in our parts supply and MRO activities, along with favorable cost performance on certain commercial and government contracts, which pushed contract profitability higher during the period. SG&A expenses for the quarter totaled $52.8 million. That number includes ongoing investments in our digital initiatives, plus $1.1 million tied to investigation and remediation matters. Net interest expense came to $2 million for the quarter, compared with $0.4 million last year, due to higher interest rates and borrowings. As John mentioned, cash used in operating activities from continuing operations was $45.9 million, driven by investment in new long-term business wins and buying inventory to support our USM activities. We repurchased roughly 700,000 shares, or $28.2 million, which is more than in prior quarters because we capitalized on favorable market dynamics during our open window; we have the balance sheet strength to keep investing in our business and to keep executing on our share repurchase program, on which we still have $57.6 million of authorization left. We finished the quarter with net debt of $149 million and net leverage of just 0.9 x. Last week, we pushed out the maturity of our revolving credit facility by another five years and raised the size from $600 million to $620 million, giving us substantial liquidity. We're grateful for the ongoing support of our bank group in completing that extension and upsizing. Thanks for your attention, and I'll now hand the call back to John.

Alright, thanks, Sean. As we look ahead, our biggest airline customers in North America remain assured regarding resilient demand and their growth plans. We're also heartened by fresh signals of improving demand in Europe, and preliminary evidence suggests that loosening lockdown measures in China—where flight activity remains 70% below where it stood in pre-COVID 2019—is already producing a rise in flight hours. On top of that, we're starting to observe indications that engine green time availability for some carriers could be running low, which will translate into more engine shop visits—a key driver of demand for our USM parts. This turning point is something we've expected for a while, and we're now witnessing the first signs of it materializing. Turning to our government business, we anticipate that long-term contract and short-term procurement awards will keep adding to results for the remainder of this fiscal year, generating ongoing growth. Broadly speaking, we anticipate that sequential sales growth in Q3 will match the Q2 increase, and we look for additional growth in Q4. We anticipate that Q3 margins will align with the levels recorded across the past few quarters. Over the medium and longer term, we think we're positioned exceptionally well for growth for a number of reasons. First, commercial market conditions look favorable, encompassing robust leisure and business travel demand, the reopening of international markets after travel restrictions were relaxed, and OEM production difficulties that are stretching the lifespan of the current fleet. Second, while our parts volumes are recovering, they remain significantly under pre-COVID levels, and we have every reason to expect that they will not merely fully rebound but also expand, driven by greater acceptance of USM and the maturation of several recently awarded new parts distribution contracts. Third, our U.S. government programs offering aligns with the best value commercial best practices that the U.S. government is increasingly pursuing, and the new NDAA language makes it easier for the government to act on more of our offerings. Moreover, we're complementing these growth initiatives with investments in digital efficiency, which—together with better operating leverage and a mix shift toward parts—should keep fueling margin expansion; with that, I'll hand things over to the operator for questions.

Hey, good afternoon.

Hey, Rob. How are you?

Thanks, that's good. Hey there, John. I'd like to kick things off with something at a more macro industry level, perhaps. There's been chatter that the slower-than-expected OE ramp coming out of Airbus and Boeing is going to produce a drawn-out aftermarket cycle across the coming 2 years. John, I'd love to hear what you think about that.

Yeah, we'd be on the same page there. In our view, that ranks among the central positive dynamics giving us belief in the expansion we're describing, insofar as the platforms that represent our bread and butter are set to remain in service longer than folks initially expected.

So, regarding USM — I wanted to get a bit more detail from you on what the USM market looks like right now, and then perhaps you can connect that to what you said about the NDAA and discuss how far you reach into military USM as opposed to commercial, an area where your track record is obviously solid.

Absolutely. As for the USM market overall, a few quarters back we discussed expecting a turning point when it came to that business recovering, and that tied to both supply and demand. Demand from customers has been slower to return than we expected back then, and several things have contributed to that. Lately, what our customers have told us and what we've observed is that plenty of green time remained on their engines; put differently, in many instances their aircraft sat parked because of pilot shortages, and they were shifting engines between planes to put off maintenance. For the key customers we serve, that green time is running out, and now those engines and that postponed maintenance are reaching their due date. Take the engine shops we support, for instance — we're noticing indications of rising demand as they review their 2023 input schedule. On the demand side of that engine turning point, our view is that we're just at the start. Combine that with the availability of surplus material — the market has been extremely tight; only lately have we begun to see certain asset types we support become obtainable, and that's partly why we deployed capital this quarter: to act fast and secure that material. Looking ahead into early next year, we're already seeing additional chances to deploy capital toward buying material to meet that expected growth in USM demand. That covers the commercial side. On the government side, we've had some wins here and there selling used material to the government — sometimes involving small parts, and sometimes involving an entire aircraft, as with the C-40s a couple of years back. Never has there been a structural shift in the law, which is exactly what this NDAA language reflects, forcing services such as the Air Force and the Navy to take USM into account; for commercial derivative aircraft such as the C-40s or the P-8s, which are 737s, or the C-32, a 757, we believe this might be the starting point for significant opportunities at AAR. How much and for how long is, I'd say, an open question. We're genuinely encouraged that this language now sits within the NDAA.

All right. Sean, should you be in a position to do so, could you break down that 21% rise in commercial aero during the quarter, you know, by the various sub-business lines?

Yes. I'd say, you know, that 21% was really spread across every commercial activity in that period, and we recorded especially strong results in our distribution business, which mirrors certain of the new business wins from the past several years. Likewise, in our commercial PBH, which is tied to flight hours and somewhat more international than a few of our other commercial activities, we observed better flight hour activity, and that propelled that top line. So strength everywhere in commercial, though I'd call out those two as fueling a portion of the outperformance.

All right. Given that you might keep putting money into distribution, what's the way we ought to be thinking about cash flow for the fiscal year's second half?

Yes, over the past eight or nine quarters, if you examine how our cash has performed, the cash we've produced is something we take real pride in, and clearly the balance sheet's low leverage ratio shows that. Our inventory positions have provided us with cash. Looking ahead, during this year's back half, we'd anticipate being in more of an investing mode, similar to how things went for us in the second quarter.

Okay. Thanks so much.

Thanks, Rob.

Yeah. Hey, good afternoon, John and Sean.

John Holmes, hi there. Ken Herbert speaking.

John, hey. To kick things off, I'd like to focus on how working capital got used during this quarter. Could you break down the portion that went toward backing distribution agreements, as opposed to the assets tied to the USM business? When it comes to USM, my hunch is that engines make up more of it than other systems do — so what are you observing on the pricing front? Is there a notable rise in the amount you must spend to bring those assets in? Given how constrained supply is, what's the right way for us to frame that?

When you look at where that capital went first, the split leaned a bit toward USM. Between the two categories—USM and the new parts distribution agreements—the weighting tilted somewhat heavier to USM, though honestly it was pretty even across both. Now, regarding those new parts distribution agreements, what you're really talking about is the initial provisioning inventory purchases that come bundled with these contracts at the point we bring them on. Naturally, as those contracts age, we gradually draw those positions down. On the question of pricing within USM, I'd rather not go into specifics, mainly because of competitive considerations. The market is still tight, and we're managing to capture the appropriate spreads between what we pay for material and what we sell it for. In essence, we're market in, market out when it comes to those USM purchases.

All right, that's useful. Looking ahead, you've clearly been lengthening certain arrangements, such as the one with Unison. It appears that fresh OEM clients are being brought on board. How does the picture look regarding further OEM partners when you consider, well, extra distribution deals? Given what you've said about how cash gets used in the back half of the fiscal year, it sounds like more opportunities exist.

Yeah. Distribution is an area where we're seeing plenty of chances. There's room to grow our agreements with partners such as Unison, and that expansion is something we're genuinely proud of. It's a major one for us, and that relationship goes back 10 years, and we keep discovering additional things we can do together. We've got several other long-term OEM relationships that fall into that same bucket, where there are chances to grow as they reconsider how they handle aftermarket in the wake of COVID. There are new areas too. We announced an expanded agreement with Leach. For us, that's a new market. It's electronic distribution; we're selling piece parts into production lines, so that represents a new market for us. Leach is the launch deal in that space, which we've extended, and we see additional opportunity there. Opportunities also exist in the BGA market. Obviously, there's a lot of interest in BA. Since COVID, that's been a really strong market overall, and we believe the way for us to take part in it is via distribution; that would be a new focus for us as well, but a number of OEMs we're speaking with are interested in leveraging our distribution network.

All right, that's quite useful. You've mentioned before that you'd ideally like to witness a step change in aviation margins once the parts business begins recovering — in particular, I suppose surplus material, since that's among the higher margin portions of the business. As we start to see acceleration in some of these agreements, and clearly with USM availability and rising demand, how should we think about margins in that segment during the second half?

Right. Overall on margins, we just posted a really solid quarter. For Q3, near term, I'd say margins should look like what we've turned in over the past several quarters. Once again, you've witnessed fairly steady results on that front. That covers the near term. Past that, to the point you raised, with mix moving more toward parts as that business recovers and expands, and with us beginning to capture certain efficiencies in MRO stemming especially from these digital initiatives we've put money into, we'd anticipate further expansion past roughly that 7% mark once those factors kick in across the medium and long term.

All right, that's useful. Just one last thing from me. Previously, I'm aware that you've had an initiative around lowering costs; before, I believe there was a goal of roughly bringing SG&A to 10% of sales or less. I realize that's not a topic you've brought up lately. Looking ahead, how are you viewing the chances to cut costs? Does that sit in the SG&A line? Or is it elsewhere in the company? Where ought we to expect you to find additional cost savings across the coming few quarters and as we head into fiscal year 2024?

Yes, absolutely — that's a really good question. First off, when it comes to hitting that 10% or lower for SG&A as a share of sales, that remains our objective. Our view is that the bigger driver on the path to that objective is going to be the top line bouncing back. During COVID, we pulled out a great deal of cost, as you're aware, and we made plenty of structural adjustments to the business, and at this point our priority is simply remaining disciplined about holding onto those adjustments while we expand. As the top line keeps bouncing back, we anticipate that share will decline. Another point worth mentioning is that we're putting money into investments, especially on the digital side, that we do run through expense, and they pass through those lines. Those investments are very much — we're right in the middle of them at the moment. They're projects. Each one has a start, a middle, and a finish, and once we bring those projects to completion, we would anticipate those costs declining and the efficiency produced by those projects beginning to take effect.

Perfect. Well, thank you very much, John.

Thanks a lot, Ken.

Hi there. Good evening, everyone. Strong results. Appreciate you taking the questions.