AAR Corp. (AIR) Earnings Call Transcript & Summary

Thank you very much. Hi, everyone, and good afternoon. I appreciate your joining us today as we review our Q4 and full fiscal year 2023 results; for the entire year, sales increased 9%, going from $1.8 billion to $2 billion. Adjusted diluted earnings per share from continuing operations increased 20%, from $2.38 per share to a record $2.86 per share, driven by both sales growth and our adjusted operating margin improving from 6.3% to 7.5%. This robust performance reflects our continued execution of the strategy to leverage our improved cost structure and capture growth in higher-margin activities; now looking at Q4, sales were up 16% year-over-year, from $476 million to $553 million. Commercial customer sales increased 31%, while, as expected, government customer sales decreased 7%, largely due to certain government programs concluding in the prior year quarter. Adjusted operating margin was 7.8%, versus 7% in the prior year quarter, and adjusted diluted earnings per share from continuing operations increased 15%, from $0.72 per share to a record $0.83 per share. We kept seeing growth in our commercial parts activities as global air travel continued to recover. Additionally, as we mentioned in previous quarters, engine green time availability continued to decline, which generated more engine shop visits and the associated demand for engine parts, which represent the majority of our USM offering. USM supply remains constrained, and our team continues working to identify ways to secure material so we can meet the strong demand. Furthermore, our recently awarded new parts distribution contracts continued to ramp up. During the quarter, we encountered some delays from OEMs due to supply chain issues, and we are collaborating with our partners to obtain the overdue material so we can ship against our backlog. MRO demand remains robust, and although our hangers have been mostly full for some time now, we were able to move some additional volume through our footprint during the quarter. Labor availability remains tight, although our attrition levels have stabilized, and our many partnerships with schools and other talent sources continue to serve us well; in Integrated Solutions, even though our government work decreased, we saw better performance in our commercial power-by-the-hour programs, aided by increased international flying and the improvements we've made to that operation over the past few years; on the cash front, we generated cash flow from operating activities from continuing operations of $45 million. At quarter end, our net leverage was 1.07x EBITDA, down from 1.35x at the close of Q3 on a pro forma basis for the Trax acquisition, which leaves us at $0.76. Because of that, our balance sheet remains strong, and we have substantial flexibility to fund our continued growth. On the new business front, we announced in March that we had agreed to purchase 9 Boeing 757 to 200 passenger aircrafts fitted with 18 Rolls-Royce RB211 engines from American Airlines. With this acquisition, we secure feedstock to supply used serviceable material for the RB211 engine platform that supports the 757 cargo market, and that market has stayed strong. It also shows the type of asset purchase our part supply group makes to satisfy USM demand. I'd also like to mention the announcement from yesterday regarding the expansion of our Miami airframe maintenance facility. Since we made that announcement, the Miami-Dade Board of County Commissioners has given the project final approval. Our agreement with the Miami-Dade Aviation Department and United Airlines will increase volume at that location by 33%. This project meets all the criteria we've set out before for growing MRO capacity, including expanding a facility that already exists with government financial support, favorable conditions in the local market, labor market conditions and a long-term commitment from a customer. We anticipate breaking ground in our fiscal Q2, and construction should take about 24 months. The Miami-Dade Aviation Department will reimburse AAR for the project's anticipated cost of $50 million, or $0.76 per share. I want to thank United Airlines, Miami-Dade County Mayor Daniella Levine Cava, Miami-Dade Board of County Commissioners Chairman Oliver Gilbert and the Miami-Dade Beacon Council for their partnership and for turning this important development into a reality. Finally, I want to point out that beginning with Q1 of fiscal '24, we will split the reporting of what is now our Aviation Services segment into 3 separate segments: Part Supply, Repair & Engineering and Integrated Solutions. This split better mirrors how we run the company and how we see the areas of growth. It will also provide improved disclosure and insight to the investment community and other stakeholders. With that, I'll hand it over to our CFO, Sean Gillen, to go through the results in more detail.

Thanks, John. For the quarter, revenue reached $553.3 million, up 16.2% from the same period last year. Commercial revenue within that grew 30.7%, driven by growth across our commercial operations, while government revenue declined 7.1%, mainly due to some government programs concluding in the prior fiscal year. We also saw a decrease in defense distribution revenue tied to shipment timing at certain OEMs. Gross profit margin for the quarter was 19.5%, versus 18.9% in last year's comparable quarter. Our commercial segment delivered a gross profit margin of 20%, and the government segment's gross profit margin was 18.5%. The strong commercial margin reflects improved performance in our commercial integrated solutions business that John mentioned, plus the contribution from Trax, which has a higher margin. SG&A expenses for the quarter were $70.8 million; excluding certain Trax costs and other items detailed in the earnings press release, that figure is $64.1 million, or 11.6% of sales. That percentage increased sequentially but decreased year-over-year. For Q1, we expect a sequential decline in SG&A similar to last year. Net interest expense for the quarter was $4.7 million, compared to $0.6 million a year earlier, driven up by higher interest rates and borrowings. Our effective tax rate for the quarter was 23.2%, below our expectations due to certain state tax matters and other items in the period. We expect our effective tax rate to be about 25% to 26% in Q1 of FY '24, and approximately 27% for the full FY '24 year. Cash flow from operating activities, from continuing operations, was $45.3 million. We ended the quarter with net debt of 203.6 million and net leverage of 1.07x EBITDA. Given the Trax acquisition and other attractive opportunities to invest in our business, we opted not to repurchase stock in Q4. We still have $58 million remaining under our stock repurchase program, and we'll evaluate how to use the remaining authorization as well as whether to expand the program during the rest of this fiscal year, depending on alternative capital deployment options. On that note, we're seeing attractive investment opportunities in the USM market and may choose to deploy capital in Q1, which we expect will result in a use of operating cash during the quarter. Turning to our resegmentation, we plan to file an 8-K today that outlines financial results for the new segments for FY '22 annually and for FY '23 quarterly. The new part supply segment will consist of our used serviceable material and distribution activities. The repair and engineering segment will consist of airframe MRO, component and landing gear MRO and engineering. And the Integrated Solutions segment will consist of our government programs and commercial power-by-the-hour component solutions and our software solutions including Trax and Airinmar. Regarding Expeditionary Services, that segment stays unchanged — it includes our mobility systems. Alongside those reporting changes, we're also altering the metric used to evaluate segment results, going from gross profit to operating income. We've frequently heard from investors and analysts that they'd like greater transparency, and we hope these changes will be well received. In 2022, that's 28. Appreciate everyone tuning in, and at this point I'll turn things back over to John.

All right, thanks, Sean. As we look ahead, we anticipate that the recovery in the commercial market will keep going. By most measures and across most markets, commercial air travel is still under where it was before the pandemic. And, as you've been hearing lately from a lot of the big airlines, their growth prospects are still strong. What all of this tells us is that we stay optimistic regarding demand for what we offer. To be specific, we think interest in USM will stay strong. Supply is tight, yes, but it has been getting better, and we think that improvement will carry on as airlines accept new planes and as retirements pick up. Importantly, we don't think extra USM supply will hurt our profitability. Rather, our view is that it will produce additional growth, since right now the availability of USM is what's holding growth back; on the distribution side, we expect to secure more new lines with more OEMs, and that will generate further growth. The ongoing market recovery plus improvements in the OEM supply chain will give us tailwinds as well. Within Airframe MRO, we expect our hangers to stay mostly full for the whole year, and we're thrilled to be adding capacity once the Miami expansion goes live. Beyond that, we do have capacity open to serve rising demand at our component and landing gear repair facilities. In addition, we're assessing expansion at some of our other airframe MRO sites where we have long-term customer interest and access to labor. Last, in our government business, our F-16 program in Europe hasn't fully ramped yet and will contribute more meaningfully in FY '24 and after. More broadly, we're confident that our value proposition in this market and our pipeline of opportunities will turn into further growth over time; as for specific guidance, our operating environment is still exciting and dynamic, so we intend to keep up our current practice of giving an outlook each quarter through our FY '24. With that said, we expect Q1 sales to come in — to come in at the low teens year-over-year, driven by our commercial businesses, with adjusted operating margins comparable to what we just posted in Q4. Going forward, we expect yet another year of margin expansion, though at a slower pace than the last 2 years. As you're aware, we're hosting an Investor Day this Thursday, in New York, and we can't wait to see you there to talk through our growth strategy, long-term financial targets and commitment to continuing to deliver shareholder value in greater detail. Before we open it up for questions, I want to pause and thank our team for an outstanding year, along with our customers and other partners for their support. We keep making our MRO operations more efficient, added several key distribution wins, expanded support of our USM customers, added an important new capability with the acquisition of Trax, and extended and upsized our credit facility in a challenging market. That has produced 9 consecutive quarters of adjusted operating margin improvement and record adjusted earnings while maintaining superb financial flexibility. Making it through the pandemic in a winning position wasn't something guaranteed. And I have to say it again — our team makes me incredibly proud. Now, I'll hand things off to the operator so we can take questions.

I'm filling in for Mich Ciamoli. To start, I'd like to ask about the expansion of the Miami facility. After the build-out wraps up there, how long will it take to bring operations up to full speed? And what number of additional employees would you have to bring on to handle that extra capacity?

Yes, that's a wonderful question, and thank you for joining the call. Because we are growing at a location that already exists and where we have run operations for a considerable period, we expect that once the build-out wraps up, the ramp up will in fact move quite rapidly. We expect to bring on roughly 250 additional individuals to support this expansion. And once more, one factor behind growing at this location is our belief that we can tap a very robust labor pool, which is definitely what exists in Miami; therefore we will be bringing in that talent long before we begin operations.

Okay, that's really useful. Now I have a follow-up question about what margins might look like next year. You posted solid growth compared with a year earlier this quarter, yet once you take out the Trax costs, SG&A margin came in roughly unchanged from the same period last year. So what specifically has to happen for SG&A spending to get better and begin moving toward that roughly 10% of sales goal you've talked about before? Does that goal still make sense? Or has anything — wage pressure, for instance, or some other factor — shifted the calculation somewhat?

Yes. Getting to 10% of sales is the goal, I'd say; and reaching it, in my view, simply requires us to keep gaining leverage on the top line, across commercial as well as government sales. Trax, as I noted, sits a bit higher within SG&A, yet for the company overall it isn't a huge swing factor, and despite the current inflationary conditions, we continue to believe 10% of sales is achievable as top-line leverage builds.

John, Sean, this is a great way to close out the year. John, I'd like to begin by picking up on a few of the things you said regarding the USM marketplace. It appears you're seeing additional feedstock, and it certainly sounds as though you have some very near-term opportunities in the first fiscal quarter. Could you give us a bit more detail about where those opportunities are showing up, and perhaps how we ought to think about investments in the first quarter or throughout fiscal '24, particularly in the USM space?

Yes. Excellent question, and thanks for joining the call. Yes. Broadly speaking, I'd say we are observing the USM supply loosen, and we've been in a position to deploy — we can deploy capital all through our FY '23, and as we begin FY '24, some unique opportunities have come our way. And once more, as you're aware, one of our major strengths in the market is that when these situations arise — and they remain few and far between — we can act fast. As for discussing particular asset types and so on, I'd rather not, because of competitive dynamics; however, engines are a significant focus for us. And we're speaking with every part of the market, whether that's lessors undergoing portfolio changes, airlines undergoing fleet changes, or even other brokers in the market that hold assets available that match contracts we need to support.

All right, that's quite useful. And from what you've said, it appears that as you put money in and clearly shift a portion of that feedstock over to USM, you aren't anticipating — or at least in fiscal '24, the guidance doesn't suggest any meaningful decline in the pricing you receive in the market for that material, is that right? I mean, it seems there's still a sufficient imbalance that you ought to be able to secure price on the USM at minimum across the fiscal year?

Correct. We certainly are confident about keeping our spreads intact for the entire year.

All right, excellent. And let me squeeze in one last item, if I may; regarding the heavy MRO segment, we keep hearing about limitations on capacity, and it sounds like several sizable in-house airline shops might be pulling back from heavy MRO work, at least partly. So your added capacity strikes me as very sensible — it sounds like there are further chances out there to potentially bring on more capacity. Within the heavy MRO segment, how far ahead are you booked — or what does the backlog look like? And, I suppose even more significantly, it feels like if a moment ever existed for you to secure improved labor rates, that moment is now. So could you share what you're observing on that front?

Sure. The pledge we secured from United that prompted the Miami expansion, along with any other customers we're discussing possible further expansions with, those are commitments spanning multiple years. We're adding permanent new capacity, so we want to be sure we stay aligned with that, so we are definitely seeing airlines, since they expect a capacity shortfall for a while, being ready to enter multiyear agreements with us. So that's a positive. When it comes to labor rates, I believe we've addressed this during the past couple of calls. But broadly, we've had highly constructive conversations with our airline customers regarding labor rates. And we handle it contract by contract with the customers to modify labor rates — what we charge them — to mirror the labor cost we've encountered in the market. And in an inflationary setting, we've managed to generate margin expansion in that business through material efficiencies, but also because of some of those conversations.

All right. So would it be reasonable to think that once we have the new segmentation and can see the repair business separated out more clearly, some of that should flow down to your bottom line — meaning there's room for margin improvement specifically in that business?

Yeah, we can go into more detail on Thursday when we're together. But in general, we'll be able to see the margins for that business. That said, I'd note that our push for margin expansion won't come from raising prices for the customer. That's basically only to keep pace with rising labor costs. The margin improvement we anticipate achieving over time comes from investments in the facility; so Miami, taking advantage of the fixed cost structure there to add 33% more volume, or putting technology to use across our hangers, such as paperless drilling inspections, that sort of thing, to make ourselves more efficient within the operation.

I'd like to add something onto what Ken asked. If we consider the repair work that's scheduled at MRO facilities, and we keep hearing about turnaround times getting longer — when you take a look at the market, at what point do you figure those turnaround times will hit their highest level?

When it comes to turnaround times inside our own hangers, we've had a fairly consistent operation over the past several quarters, so we believe we're actually running the hangers pretty efficiently. On the subject of component repair turnaround time, once again, we're pleased with the TAT we've achieved in our own shops. A large portion of repairs gets outsourced by us, and those turnaround times have gone up, we've noticed. Trying to forecast the moment that peaks and then declines is hard. Still, based on what we're picking up — and I'm certain you're picking up the same from repair providers, a lot of whom are OEMs — our sense is that the supply chain environment overall is getting better, so for turnaround times, this year ought to be an improvement over last year.