AAR Corp. (AIR) Earnings Call Transcript & Summary

Thank you, and good afternoon to all of you. I'm grateful that you could be with us today as we go over what we achieved in the third quarter of fiscal year 2024. But before we get into those numbers, I want to once more extend a warm welcome to the folks from Triumph Product Support who are now part of the AAR family. We closed the acquisition and the associated financing transactions shortly after our quarter came to an end, and this business — which now sits within our Repair & Engineering segment — substantially grows the component repair operation we had before, brings in differentiated repair capabilities for both current and next-generation platforms, and widens our footprint into the faster-growing Asian market. Integration has gotten off to a wonderful start, and I couldn't be more thrilled about the possibilities ahead with this business. Now, on to the results. We turned in yet another strong quarter. To be specific, sales rose 9% year-over-year, going from $521 million to $567 million, which marked a third quarter record. Sales to commercial customers climbed 18%, which more than made up for a 7% decline in sales to government customers. Over in Parts Supply, total sales grew 6% year-over-year, powered by strong results in our commercial distribution business. When it comes to USM, demand is still extraordinarily robust, and that produced yet another quarter of growth. Breaking that out a bit more, sales of individual USM parts rose considerably year-over-year, while large asset transactions — things like whole aircraft and whole engine sales — declined. That mirrors supply that has gotten even tighter in this market; take, for instance, opportunities such as the 757 acquisition we completed with American Airlines a year ago, which are now even harder to come by. That said, our sourcing team is the finest anywhere, and we keep the balance sheet flexibility needed to move fast whenever such opportunities present themselves. I brought up the strong commercial distribution performance, and I want to call that out in particular. Commercial distribution had a remarkable quarter, delivering 27% organic growth. Growth from existing product lines fueled this, along with the early ramp of wins we recently announced. Government distribution posted a weaker quarter against a very strong quarter one year ago. Even so, government bookings have been climbing, and we anticipate that growth will come back to that business going forward; in Repair & Engineering, sales rose 10% versus the prior year quarter, as we managed to push higher volumes through our hangars. The efficiency gains we keep achieving within our existing footprint make me proud; in Integrated Solutions, sales increased 15% versus the prior year quarter, thanks to more flight hours in our commercial power-by-the-hour programs and the contribution from TRAX. Lastly, in Expeditionary Services, sales fell 15% versus the prior year quarter, the result of fewer pallets shipped to the U.S. Air Force. As a reminder, we are the sole-source provider of these pallets, and we anticipate that the DoD's procurement volumes will come back to more normalized levels in our FY '25. Now let's turn to profitability. Our adjusted operating margin came in at 8.3%, which is higher than the 7.6% we posted in the same quarter a year ago, and the improvement came from margin expansion in Parts Supply and Repair & Engineering. That marks our 12th consecutive quarter of adjusted operating margin expansion on a year-over-year basis, and our margins now stand at roughly 50% above where they sat prior to COVID. We take particular pride in achieving this while operating in an inflationary backdrop, especially with labor costs on the rise. Adjusted diluted earnings per share from continuing operations rose 13%, moving from $0.75 per share to $0.85 per share, a third quarter record. On the cash side, we brought in $20 million of cash flow from operating activities from continuing operations. Thanks to our cash flow and EBITDA growth, net leverage finished the quarter at slightly below 1x adjusted EBITDA. As you're aware, we chose to fund the Product Support acquisition entirely through new debt. On a pro forma basis for that acquisition, net leverage at the close of Q3 stood at 3.6x adjusted EBITDA. Financing it completely with debt speaks to our confidence in ongoing cash flow generation and EBITDA growth, along with our capacity to delever as a result. Now to new business. In the quarter, we unveiled a new multiyear distribution agreement with Ontic covering the supply of certain military products to the U.S. government. We also rolled out a multiyear contract extension and expansion for flight hour component support services with ASL Airlines. In addition, we announced TRAX agreements to deliver eMRO services to Singapore Airlines, plus eMRO and eMobility services to Archer Aviation. The Singapore Airline award especially illustrates the strength of the AAR TRAX combination, since AAR played a key role in winning that award. And then, only yesterday morning, we announced an agreement to provide surplus CFM56 to 5B engine material to Cebu Pacific. That agreement builds on our long-term supply partnership with FTAI Aviation and adds greater predictability to our USM operations. With that, I'll hand things over to our CFO, Sean Gillen, who will walk through the results and the acquisition in greater detail.

Appreciate that, John. For the quarter, our sales came in at $567.3 million, which represents an 8.9% increase compared to the same period last year. Commercial sales rose 17.6% versus a year ago, and that was fueled by gains across all three of Parts Supply, Repair & Engineering, and Integrated Solutions. Commercial distribution was especially notable, since we're still pushing growth on product lines we already have while also bringing on newly won lines. On the government side, sales declined 7.4% from the prior year. That said, looking sequentially, government sales climbed 5%, reflecting early signs of a rebound in our government work across distribution, Integrated Solutions, and Expeditionary Services. Gross profit margin for the quarter reached 19.4%, compared with 18.1% in last year's same quarter, powered by solid results in Parts Supply and Integrated Solutions, which includes the high-margin TRAX offering. Our commercial business posted a gross profit margin of 19.8%, while the government business came in at 18.6%. SG&A for the quarter totaled $77 million. That figure contains $9.4 million tied to Triumph Product Support transaction expenses, $2.8 million for TRAX acquisition and amortization expenses, plus $2 million in investigation costs. Strip those out, and SG&A was $62.8 million, equal to 11.1% of sales. Net interest expense during the quarter was $11.3 million, and that number included $6.1 million of costs linked to the bridge financing commitment for the Product Support acquisition, which won't repeat in future periods. Cash flow from operating activities for continuing operations amounted to $20.4 million. That's after accounting for inventory investment in Parts Supply, particularly commercial distribution, which as we noted saw substantial sales growth during the quarter. At the close of Q3, our net leverage stood at 0.95x. As John mentioned, the Product Support acquisition was funded completely through new debt: $550 million of unsecured notes carrying a 6.75% interest rate, plus roughly $205 million drawn incrementally from our revolving credit facility, which we enlarged by $205 million alongside the acquisition. For Q4, we anticipate net interest expense of about $18.5 million, made up of $9.3 million related to the fixed rate notes and the remainder from the floating rate revolver along with amortization of financing expenses. Moving forward, consistent with how we reported for TRAX, our adjusted operating income and adjusted EPS will leave out noncash amortization expense tied to purchase accounting. Adjusted results will also exclude transaction expenses recognized in Q4, as well as integration costs we anticipate incurring across the next 12 to 18 months. As a reminder, we said we expect to achieve $10 million of run rate synergies from the Product Support acquisition and anticipate it being accretive in full year fiscal 2025. In Q4, though, we expect it will be slightly dilutive to earnings, because the incremental interest expense from the acquisition will modestly surpass incremental operating profit. As we noted before, we will step up the tax basis, producing roughly $9 million in annual cash tax savings for each of the next 15 years. Neither our GAAP tax rate nor adjusted EPS will be affected by this, and we anticipate an adjusted effective tax rate of roughly 27.5%. Before I hand the call back to John, I want to use this moment to express appreciation to our bank group for backing the financing of the acquisition. Their extra $205 million commitment to our revolver shows their belief in AAR and in what the acquisition can achieve, and it let us fund part of the acquisition with flexible prepayable debt that supports our delevering moving forward. Thanks for listening, and I will now give the call back to John.

Okay, thanks, Sean. Looking ahead in the market, ongoing hurdles with new aircraft deliveries, plus the GTF and other engine problems, mean that demand for current generation planes—along with the maintenance and parts they need—is going to stay robust. That's positive for AAR. Although this does mean USM supply is going to stay tight, we'll keep using our worldwide sourcing network to obtain material so we can satisfy that demand. It also means demand will stay elevated for our commercial distribution operations, where we anticipate meaningful growth continuing to come from existing lines and from newly awarded contracts; in Repair & Engineering, I'm pleased to share that this quarter we expect to start construction on expanding our airframe MRO facilities in Miami and Oklahoma City. When finished in our FY '26, these will bring roughly 15% more capacity to our network. Until then, we'll seek out ways to generate growth and greater throughput by using our current footprint, just as we did this quarter. In Integrated Solutions, we have a robust pipeline of government and commercial opportunities, and we anticipate awards being made this calendar year; we're also heartened by how much customer interest there is in the TRAX eMRO suite of offerings. As for Q4, we anticipate revenue growth in the mid- to high teens, which includes the contribution from the Product Support acquisition of about $65 million to $70 million in sales; and we anticipate adjusted operating margins of roughly 9% overall, reflecting the accretive contribution from the Product Support acquisition. More broadly, we are exceptionally well positioned to keep growing and expanding margins as we enter our FY '25 and beyond. The TRAX acquisition is performing well, and the rationale for the combination is proving out, as shown by the Singapore win announced recently; we're extremely excited about the differentiated high-margin capability that the Product Support acquisition delivers, and our team is already chasing many opportunities with our customers. All in all, our end markets are very strong, and we stay focused on carrying out our growth strategy. With that, I'll hand it over to the operator for questions.

There are several things I'd like to ask about. John, to start, I want to revisit a few of the points you made regarding the business. And specifically this idea of a slower OE ramp, which keeps more older aircraft flying for a longer period. In what way does that impact — really, what it's doing is fueling the Parts business. In what way is that impacting MRO, since I'm wondering whether it's pushing demand higher or pulling it lower, given that you simply can't pull airplanes out of an airline's schedule for a long enough stretch to do work on them.

Yes. It's a really — that's a terrific question. Regarding your initial point about Parts, without a doubt. The longer the current generation aircraft fleet keeps flying, and clearly, you're seeing extremely high utilization, the greater the parts requirements that will be generated. So that's positive for the Parts business. For the heavy maintenance business, over the medium term, it will be a beneficial thing. It will generate additional maintenance requirements. You've got aircraft that people thought would be retired that are now going to wind up going in for another maintenance event. That said, in the near term, it is creating a great deal of movement in the maintenance schedules at the airlines, as carriers such as United and Southwest, 2 of our big customers, seek to shift things around to adapt to the new delivery schedules that they're receiving from the OEM. So it's producing a bit of churn for us in the near term. But all things considered, it will be a positive for us.

All right. Then turning to Parts Supply, I was hoping to walk through the quarter in sequence. The 6.5% growth versus a year ago was strong, though perhaps we had anticipated slightly more, and your margins were healthy; but regarding that top line increase and how it stacks up against earlier quarters, how should we interpret that 6.5% as we examine the individual months, whether early in the quarter or late in the quarter? Does some pattern exist?

I wouldn't really highlight any meaningful pattern across those months. It was pretty consistent, I'd say. Still, let me break down that 6.5%, okay? There are essentially two main categories within it. One is new parts distribution, and the other is USM; and inside each of those two categories, I'd like to go one step deeper. Within new parts distribution, the commercial side, as we noted, enjoyed a fantastic quarter. We achieved 27% organic growth compared with a year earlier in new parts commercial distribution. And when you examine our peer group, that's roughly the strongest result you'll find anywhere. So we're quite pleased with how commercial distribution is performing. Government distribution came in lower than it did a year ago. A year ago, we enjoyed a very robust quarter; this time around, we likewise had a decent quarter. It simply came in below the prior quarter. We had observed bookings, and I think we've discussed this on earlier earnings calls, we have watched government bookings fall over the course of last year. So now we're experiencing the consequences of that. Conversely, we're currently observing government bookings rising over the past several months; so we anticipate that will fuel a return to growth in government distribution as well. So there are several shifting elements on the commercial — on the new parts distribution side. Then moving over to the USM, moving over to USM, as we noted, we essentially split that into two categories: large asset sales, meaning whole aircraft and whole engines, and then the everyday parts sales. The everyday parts sales sit at record levels. We recorded double-digit growth in everyday parts sales within USM; those packages are the parts that right now are simpler to source. So we're acquiring them, we're repairing them, and we're reselling them. The whole assets, the bigger dollar assets, those are more difficult to obtain. And so we recorded a year-over-year drop in large asset sales. And clearly, that team's priority is to keep utilizing the global sourcing network to secure the right assets to satisfy the demand. So in any case, I wanted to walk you through it. There are a few separate shifting elements beneath that 6.5%; and ideally, that provides you with a bit more color.

Right. Regarding what you just mentioned, what makes it simpler to obtain USM in smaller component and part lots rather than complete planes, and so on? My assumption is that when a whole plane is sitting somewhere, an airline would rather not part with it — they'd prefer to return it to flying. Is that the explanation?

Yes, that's precisely it. You'd want that plane flying. And as for a complete engine, engine shops currently have no capacity. Every slot is taken. So assuming you possess a spare engine, you'd want it mounted on a wing and in operation.

All right. Then one final item regarding engines. Considering the MAX and geared turbofan circumstances, as carriers prolong the service lives of aging planes and powerplants, we observe continued expansion involving Pratt and CFM across their upkeep networks for those powerplants, GTF and LEAP. Would you be at all interested in entering the engine MRO sector?

That inquiry arises fairly often. Right now, the largest clients within our trading operation are the engine MROs themselves — the MTUs, Delta TechOps, and so on; therefore, competing against our own customers isn't something we do. What we favor is serving as the provider that backs that expanding need throughout the engine MRO network.

All right, and then one brief question for Sean regarding margins. They have been performing nicely. Your Parts segment is robust, and inside Repair & Engineering, there's solid demand for airframe MRO. Plus, with the Triumph asset and the TRAX acquisitions, both of which add to margins, might you approach double-digit operating margins at some point in fiscal '25?

Yes. I believe that is definitely the priority. As John mentioned, during Q4, we expect to be near 9%; and when you consider the ongoing mix shift toward Part Supply along with the effect of the Triumph Product Support acquisition and TRAX too, everything there boosts margins and moves us toward that 10%.

John, perhaps I could just build on one of those earlier questions. Looking at the fourth-quarter guidance, sales growth in the mid- to high-teens range would appear to suggest organic growth in the mid-single digits, compared with the 9% you delivered during the quarter that just ended. Yet your outlook sounded quite positive regarding many of the factors behind it. So what accounts for the, I suppose, deceleration? Is it purely comparisons? Do you expect USM to fall sequentially, since government sounds like it's improving and parts distribution remains solid? There may be some volatility in MRO. Still, when I add everything up, it looks perhaps a bit stronger. So could you walk me through how that math works?

Yes. I'd say comparisons are part of it—clearly there was strong performance a year ago. So that's definitely contributing somewhat. As for your point about government, I'd describe it this way: on the whole, we're seeing government get better, yet a significant improvement isn't something we'd anticipate this quarter. So a similar pattern shows up in Q4, and however strong the commercial results are in trading, in commercial distribution, and in the hangars, continued weakness in the government market offsets that. Over the course of our FY '25, we anticipate a return to growth in government, which should pair nicely with the continued strength we expect in the commercial markets too.

Regarding the government aspect — if I check the President's budget request for FY '25, though admittedly many factors could shift, it appears to point toward a significant retirement cycle; and up to now, there haven't really been any signs of higher sustainment spending. Are you observing something other than that? Since it looks like there's optimism regarding government that things will begin improving once we reach FY '25. So I'm simply wondering what's driving that.

Right. What we're picking up matches that, but it hasn't turned into orders as of yet. When you examine the stated levels, the inventory levels, throughout the platforms we serve, almost uniformly, those are under the inventory levels required to satisfy sustainment expectations; so eventually, we definitely anticipate a replenishment in parts and pallets especially to reach those stated levels. That inflection point hasn't appeared for us so far. Like I said, within government distribution, we're experiencing stronger months along with stronger bookings, which might serve as an early signal that this inflection is beginning. Yet it still hasn't become what we'd describe as a meaningful trend.

So just to make sure I have this right — the gap mostly reflects softness in certain government segments, while MRO is more stable, which makes parts the real chance here?

On the government MRO side, things have stayed consistent. When it comes to the government distribution operation, absolutely, that's where the opening is, similar to what we see in parts; looking at government as a whole at AAR, there are ways for us to expand within the government programs operation, meaning the supply chain program. We currently have quite a few bids submitted that haven't been awarded yet; our expectation is that awards will be announced during this calendar year. They take time, though once they land, they're substantial. And beyond that, there's the Expeditionary operation, the mobility operation, where you'll notice gains as soon as the pallet awards begin flowing in. So within AAR's government business overall, we have several distinct categories.

Understood. All right, so one final question, this one's directed at Sean. You provided a bit of detail suggesting we might move nearer to 10% when considering the coming year. Could you split out how Parts Supply fits within that figure? It appears there could be a chance there — USM, I'd imagine, is roughly flat — yet perhaps as parts distribution grows more established, a chance emerges. And then, following on from that, could you share any detail regarding how we should view free cash? Does it begin to ease off after some of the parts distribution? Or does it begin to improve following some of that parts distribution expansion?

Yeah, and when you consider margin enhancement across the business, Parts Supply has played a major role in that. And when you look at the coming year, we believe that it will remain the fastest-expanding piece within the fastest-expanding segment, driven in particular by commercial distribution, plus ongoing expansion in USM, and Parts Supply operating margin sits near 13%, therefore additive to the company overall and it will assist in fueling that better margin projection for the coming year. Then regarding free cash flow, a solid quarter, $20 million of operating cash during this quarter. Looking back at the earlier portion of this fiscal year, somewhat more weighted toward inventory investment to help fuel part of that expansion. As we move into the next fiscal year, clearly, a significant emphasis on producing cash and delevering in addition to growing EBITDA, I believe you'll observe somewhat stronger free cash flow results on that, with the qualification that the USM market, as John mentioned, stays dynamic, and we remain well positioned to source new material to satisfy that demand which keeps growing.

John, you brought up the GTF problems during your prepared comments. What's your take on how lengthy this cycle appears for the supplemental GTF worker? Where do you see the peak at this moment?

That's a really common thing people are asking about across the industry right now. So I'm not sure I'd have any sharper perspective than anybody else. That said, what I'd note is that, broadly, when you combine that with the more sluggish pace of introducing aircraft overall, we believe this heightened demand will last for years.

Understood. Understood. And regarding the CFM CB connection, ought we to anticipate further comparable connections coming along? Has the tie with FTAI progressed to a stage where you now foresee a greater quantity of parts?