AAR Corp. (AIR) Earnings Call Transcript & Summary

All right. Yes. So everybody, thank you all. We're going to kick off AAR Corp. We've got Sean Gillen, Chief Financial Officer; and Dylan Wolin, Vice President of Strategy here. So let me hand it over.

All right. Thank you, Ron. Thanks for hosting us here. Appreciate that. So we have a handful of slides that I'll run through somewhat quickly to just kind of level set on who AAR is, what we do, and then we'll jump into some Q&A fireside chat with Ron. So go into the slides here, who is AAR? So we're an aviation services company focused solely on the aftermarket, and we sell to both the commercial as well as the government end markets. As you can see on the slide here, market cap is about $2.5 billion, pro forma sales of about $2.5 billion as well. When we say pro forma on this page, we mean pro forma for the TPS acquisition we announced before the holidays, and closed on March 1, which I'll go into some more detail as well. About 5,700 employees across the globe. Selected customers, you can see there are really kind of blue chip across the commercial space as well as government end markets. And then the business is listed on the right hand of the page, I will discuss in more detail on here, Page 4. So on this page, you can see the activities that we do, how we've organized our business into 4 segments, 3 primary segments and one what I'll call kind of a noncore manufacturing business, which is a bit of a legacy business. In terms of the 3 core areas, Parts Supply is our largest segment. It's also our most profitable in terms of the margin profile. Parts Supply consists of 2 primary activities. There's used serviceable material or USM as well as new parts distribution. USM is actually what the company was founded on when you go way back to refurbish parts that come off the aircraft or off the engine. They can go through a repair cycle and [ be ] sold back into the market. We're a leading independent player in that space and really a big part of what we do in parts supply. In new parts distribution, we distribute new parts on behalf of OEs into the global aftermarket. And so our global reach is a differentiator as well as our ability to sell to both commercial and government end markets. A lot of our competitors do one or the other, we do both. Parts Supply has been a nice growth business for us. Strong characteristics or strong demand drivers on USM and then in new parts, not only have we grown with the market, but we've outgrown the market by taking market share from competitors, and that's really winning new product lines from OEs that we distribute on their behalf. So that's the Parts Supply activities. Next segment, Repair & Engineering. And so in this segment, prior to the TPS acquisition, the largest activity here was our overhaul work that we do in our heavy maintenance work we do in our hangar network. We have 6 hangers, 2 in Canada, 4 in the U.S. And this is where we do work for large commercial airlines, think United, Southwest Air Canada. And every -- there's intervals, maintenance intervals that those aircraft require heavy maintenance events. So they come into our hangar, they're with us for 2, 3, 4 weeks. We do the overhaul work on the aircraft and send it back to the customer. It's a narrow-body focus work that we do here domestically. And like I said, on behalf of some of the larger domestic carriers as well. I'll touch on it, but we are expanding the hangar network based on demand from customers has exceeded the footprint. So we're expanding in both Miami and Oklahoma City, more on that in a few minutes. The other activity we have there is component repair. The TPS acquisition brings significant scale and capability into this segment on component repair. Next segment, Integrated Solutions, 3 main areas here. These are supply chain programs that we do on behalf of commercial airlines or the government. And so they outsource this work to us. They're able to fix their costs. We manage the supply chain on their behalf and get paid a fee associated with those activities. This is also where our TRAX acquisition, from a little over a year ago now is in the Integrated Solutions. TRAX is an ERP software that is targeted towards airlines as well as MROs. And then the last segment, just 3% of total revenue is Expeditionary Services. It's a business that manufactures pallets to the DoD. So as I mentioned, a bit of a legacy business, I think over time, will make sense elsewhere because it's not in the aviation services core that we're focused on. So a little more detail on the Triumph Product Support acquisition. You can see on Page 5 here. So like I mentioned just before the holidays, we announced the acquisition, we subsequently closed the acquisition on March 1. I'm very excited about this deal for a few reasons. One, it really scales our capabilities in component repair. Before this acquisition, we're kind of a #1 player in Parts Supply, both USM and distribution, #1 independent in the heavy maintenance activities. In component repair, we didn't have the same scale. So this brings significant scale as well as differentiated capabilities that we did not have previously, specifically some capabilities on DER as well as capabilities on structural component repair and things like that, that we just didn't have before. It also brings a footprint in Asia Pacific, specifically in Thailand. They stood up a facility, I think, at this point, almost 15-plus years ago, mature facility performing well. And now for the first time, we have bricks and mortar for repair activity. We've had sales offices and warehouses in Asia Pacific. This is the first time that we have repair capability in region wholly owned. And that's a real differentiator that we're excited about as well. The overall business is accretive to the margins -- AAR's margins. It's about 18% to 20% operating profit business. AAR today is about 8%. So pretty meaningfully expanding our margins. All of this will go in the Repair & Engineering segment, that I just touched on. And we also have the ability now that we have this capability in-house to drive volume from existing AAR activities into these facilities. So specifically on our USM activities trading as well as Integrated Solutions where we are managing the repair, but we're using third-party repair stations today, a portion of those volumes can now be done in-house at the formerly Triumph now AAR Component Repair Services Facilities. So pretty excited about what that means for our business. And then when we did -- when we announced the deal, we did also announce $10 million in run rate cost synergies. I think we've characterized those as really high conviction in those synergies, kind of identified as part of the deal thesis and really around cost and footprint optimization is really what underpins that $10 million. And then on a combined basis, strong free cash flow because of the margin profile of this business, as well as, as not as working capital intensive as some of our current activities. I think the combined free cash flow has improved from prior. Next couple of slides, I'll touch on briefly, just here you see that we do have a global reach. We're about 75% North America, the balance rest of the world, growing presence in Asia Pacific, also with the Triumph acquisition that I just mentioned. We're proud of the customer base that we have, not only across commercial airlines, but as well as regional airlines cargo airlines and then OEMs that we frequently partner with for distribution. And then we'll also work with on some of our supply chain management contracts. Similarly, on the government side, the U.S. government is our single biggest customer, but that's spread across a lot of different activities in parts of the U.S. government, different parts of the DoD, the State department and then outside of the U.S., do work with the Japanese and U.K. MOD and a handful of other governments across the world. So the TRAX's acquisition, I mentioned that when I was going over these segments and what we do. We announced this acquisition a little over a year ago, March of 2023. Very excited about the capability that it brings to AAR. As it says here, it's a software business, and it's targeted on airlines and maintenance facilities as well. Business has been around for over 20 years. It was previously privately held. The founders are still with us. We brought them on board, knew them for a number of years. We were able to get this deal done about a year ago and the early going or one year in, excited about the combination and our ability to sell TRAX to a broader set of customers and bring some of the capability that AAR had married up with what TRAX does, and it's been a good combination so far. And I think over time, having a seat with this ERP software, I think, will enable us to be in a position to do some things in the aftermarket that we couldn't do before. Specifically around some digital initiatives to improve the efficiency for our customers as well as marrying-up some of our part supply capabilities and their digital capabilities. So over time, really excited about the opportunity that TRAX brings. So what are the AAR growth drivers? I think everyone here and listening knows well that we're in an Industry that has a lot of tailwinds to it. Aviation Industry overall, but specifically the aftermarket, a lot of good demand drivers just in terms of demand for travel globally and a supply chain constrained OE side leads to additional opportunity for aftermarket providers like us. So not only are we operating in a growing market, I think we're uniquely positioned to take share and grow in excess of that. And it's for the reasons you see on this page here, Page 9: One, increasing USM adoption. There's airlines that don't buy USM in a meaningful way today that increasingly are looking for ways for cost savings. USM is a cost savings. And I think that will increase the adoption of USM as well as away from the commercial side, the government utilizing USM, which we're really leading those discussions with the U.S. government on how they can utilize commercial best practices across their purchasing activity. In distribution, we'll continue to increase our market share. We've had a really nice run in this business for about a decade now and continue to see a lot of opportunity for our offering to differentiate against not only peers but also OEs who manage their aftermarket today saying, rather than doing it themselves, they should use a third party, and AAR is at the top of that list, alphabetically as well as in terms of capability. So -- and then the other thing, as I mentioned, additional airframe maintenance capacity. We're expanding the hanger network, specifically in Miami and Oklahoma City. So those are places that we have hangers today. We're expanding those existing hangers to meet our customers' need. Customers came to us and said, we have -- we need more lines available to us, and we said, we'd be willing to expand for them. But we need them to commit to that, and they've done so. So very excited about that, breaking ground -- have broke ground or breaking ground basically as we speak. And those will take about 1.5 years or so to come online. We do continue to see government growing demand for our services. I mentioned TRAX on the previous page in terms of what that can do for our offering over time as well. And then some technology-driven MRO efficiency, bringing increased efficiency into the hangar network for us as well as bringing it to customers via TRAX elsewhere. And then we have developed our own proprietary PMA parts activities, greenfielding this ourselves, identifying parts that we think are good candidates for PMA, working with some of our customers around that as well. And the TPS, the Triumph acquisition came with some PMA capability as well. I'd say there -- they are where we wanted to be in a year or 2. So we're getting there that much quicker with the Triumph acquisition. Historical financial performance on Page 10. I won't go through all the detail here. I'll just say you can see the impact of COVID [ on ] that FY '21 time period, we're at May fiscal year-end. And then I think the thing we are most proud about is how we've been able to significantly expand our margins on essentially flat revenue. So if you look at FY '23 and the LTM Feb period and what that operating margin is 7.5% to 7.9% on an LTM basis, and that compares to a pre-COVID high of about 5.6%. And a lot of the activities that we did to improve our margins are shown here on Page 11. This is a quarterly look that you can see coming out of COVID continue to improve our margin profile essentially at an all-time high in the last quarter and on a pro forma basis for the TPS acquisition, which has higher margins. I won't go through everything on the right side of the page, but a lot of actions went into place to make that possible. I think we took cost out of the business. We exited some underperforming businesses and contracts, and then also have been benefited from Parts Supply growing in excess of other parts of the business. That's a higher margin -- that's the highest margin segment for us. We brought on TRAX. We're bringing on TPS. So a lot of the activities that we've done or the actions we've taken have all been around improving the margin profile of the company, which I think this page is a good proof point of what that means, not only in margin, but then you can see on the bottom portion of the page, how that flows down to adjusted EPS. So lastly, before jumping into Q&A, I just wanted to touch on our capital allocation framework. We think of that in 3 main buckets: one is maintaining a flexible balance sheet; two, investing organically in the business; then three, pursuing opportunistic acquisitions. On the back of the Triumph acquisition on a pro forma basis levered at 3.6x. So clearly, debt pay down. Well, integration and execution as well as debt pay down are kind of the key priority now on the back of the acquisition. We did fund the acquisition with a portion of prepayable debt. So we have the ability to delever as we generate free cash flow in addition to growing EBITDA. And we did as part of the deal, upsized our revolver, which provides the liquidity and flexibility that we want and need to run the business. After that, we do continue to see really attractive ways to organically invest in the business. I think specifically for us, that's inventory in Parts Supply. When we grow USM, when we win new distribution lines, it comes with an upfront inventory outlay that we then manage over for distribution over the life of that contract. And in USM, we find the demand in the market when we procure the material. So we'll continue to invest in that business to support growth there, which we see in the next few years. I mentioned the airframe maintenance expansion. Importantly, all or substantially all of that capital will be either refunded or repaid over time from state and local governments. So they're kind of putting up the money to help fund the expansion. We're, of course, signing a long-term lease with both of the -- in Miami and Oklahoma City or I should say, extending our leases but a very good invested capital or ROIC framework given that a lot of the invested capital is coming from the state and local governments. And then on acquisitions, clearly, where we are today, like I said, focused on integration and execution and debt pay down. But over time, we do think that opportunistic acquisitions will continue to be part of the story, both in terms of us increasing our scale, bringing new capabilities in and improving the margins of the company. So that's how we look at capital allocation. So with that, I think we'll jump into the Q&A portion of the presentation.

Maybe I'll kick it off. USM today, I mean, how is it going? I mean, I would imagine demand must be like through the roof.

Yes. USM activity is very strong. Demand like you said, is through the roof, very strong. A lot of users of USM are looking for it because of the cost savings and because they are using engines and airframes longer than they would have expected, which is driving more maintenance than they would have thought. So the demand side is very strong. The supply side is constrained because we rely on retirements of aircraft and engines as feedstock to support that demand. And it's been very well covered in the industry that the retirements have continued to be lower than expectations. And I think with the newest year-to-date coming out of the OE and the supply chain, that will likely continue to be the case. I think it will increase. But we are operating in a more supply-constrained environment in the USM world.

So kind of back on the supply piece, in an environment where you need, I guess, older aircraft to get the USM out of -- and the number of older aircraft that are actually coming out, is declining. I mean, what do you do?

Yes. I think this is where we're advantaged overall for a couple of reasons: one, we have some truly proprietary arrangements like our arrangement with Fortress on the CFM56, where they have a large and growing pool of CFM56 engines. We came together over 2 years ago now because they knew that there was USM opportunity on those that they weren't monetizing. And that's our bread and butter. So we kind of -- we did a lot of work together before then. We formally came together a little over 2 years ago. So we have an exclusive supply arrangement on the largest installed base for engines, and we're driving a lot of maintenance activity. So I think that's an area where we have a line of sight on supply that competitors don't. And then I think that's a proprietary contractual relationship. Other than that, I think our market position and our reputation in terms of how long we've been around and our speed to transact as a differentiator, which helps us on the margin source material, where some -- maybe some of our competitors at times are a bit more constrained. All that being said, it is still a supply-constrained environment, and we're operating in that. So continue to try to see where there's opportunity.

Got you. And then -- I'll grab you, one second. You mentioned on the chart, PMA, so where are you in that? And how is that going?

Yes. So as I mentioned, we kind of put up a greenfield initiative about a year ago to stand up our own capability, to identify candidates for PMA and then do the design and engineering and shepherd through an FAA approval process. We do have a part or 2, that's in the process to be approved. The time line for them to generate revenue and be meaningful for the financial results is still a little bit longer. But like I said, Triumph brings some capability that we didn't have parts that are already through the process and in the market. And I think it just accelerates our penetration in PMA. For us, obviously, we navigate our OE relationships and where there's PMA. So the playing field is a bit smaller for us than maybe other players. But we do think that there's room for more than 1, 2, 3 parties of PMA providers. And so that's one of the reasons we've gotten into that business.

And can you say -- or if you can't, you can't, where those initial parts are? Like what are they?

Yes, more interiors -- interior components, I'll leave at that. Interior components of the aircraft.

So you mentioned the supply constraints. And have you been able to get any pricing advantages from it in excess of your inflation and everything? Or you are using this opportunity to actually gain market share?

Yes, good question. On the parts supply side, the supply constraints have led to a dynamic pricing environment. USM is priced at a discount. Generally, USM is priced at a discount to the OE list price and OE list prices have gone up. So USM prices have gone up as well. It's not always 1 for 1 because it depends on the condition of the asset and how much repair work needs to go into it. But the cost to procure the material has gone up as well. So we've maintained a margin spread but it's not like that pricing increase fully falls to the bottom line for us because the cost of procure has gone up. I think where we have seen price in excess of our contractual amounts is more on the Repair & Engineering side. So in the Heavy Maintenance business, we sell labor essentially, it's a labor-intensive business, the contracts are structured based on labor hours. And obviously, the cost of labor has gone up meaningfully over the past couple of years, not just for us, but for everyone, but the entire aviation space as well. And so we've been able to go to our airline customers and say, "Hey, the contract says this, our labor wages -- our labor inflation is higher than that so we need to get something in excess". And again, that's not price in excess of cost, but I think it's just maintaining the margins. And I think the airlines recognize we're a critical part of the supply chain, and keeping that labor force intact is very important for them as part of their overall maintenance strategy. So we have been able to get that price in an inflationary environment, in a couple of different parts of the business.

And one more on distribution. Would you mind discussing how you think about distribution as critical for your own sales like pushing your USM, PMAs or [ Own Solutions ], but also how you compare to actually get like other OEMs sell-through your distribution channels when there is a lot of consolidation in that industry right now?

Yes. And I view -- I mean, so in part supply, USM is one distinct component, distribution is another. We utilize the same sales force. And then PMA is obviously very nascent and kind of separate from that. But in distribution, I think our value proposition just continues to resonate with the OEs, okay? So if they're thinking about how do I service the aftermarket? Should I do it myself? I think increasingly OEs are drawing the conclusion, they're better off using a distributor rather than calling on airlines across the world and MROs across the world to sell their parts. And then once they make that decision, they have to decide what distribution partner they want to use. And the 2 biggest players in the industry are more of a catalog-type model. We as well as ones that look like us are more of an exclusive model at 96 or something percent of our distribution lines are exclusive in nature. And that means that we only sell that OEs part, we don't sell competitors' parts. And what we can show them is that we help them increase their market share, push their price increase in the aftermarket and all that, we serve as an extension of their sales force essentially. And I think that value prop is resonated and then how do we win business versus other ones that look like us. I think our global scale and reach, our sales force technical selling capabilities as well as the fact that we sell both commercial and government are all differentiators when we think about some of the other players who are like us, the independent aftermarket distributors.

Can you speak to with the Triumph acquisition? How is that going? How integrated is it now? Has there been any -- have you been able to retain everybody and so on and so forth?

So it's going well. And I'd say on retention, yes, we've been able to retain everyone. A lot of the team was pretty excited about AAR being the new owner of the business, given that we're solely focused on the aviation aftermarket, like they are. And I think in the early going, the customer feedback has been very positive as well. I think we didn't appreciate how some customers weren't sure -- kind of -- was this asset going to stay with Triumph, if it didn't, where would it go? And then when it turned out that it was AAR, who is a company, they know, trust, they already use for a variety of activities. The feedback has been very positive from that standpoint. Integration is going pretty well so far. I think the good thing is we knew this business pretty well. We were in this business, not totally in the way of the capability we got, we had our own component repair facility so we knew how to run these businesses. So in the early going, so far, so good.

That's great. That's great. Then you mentioned -- kind of back to labor. How has it been actually retaining your workforce, attracting talent because the one thing we've heard kind of across this conference, but obviously, we've been hearing it for quarters and quarters now is that, technically skilled labor is hard to find, hard to retain, so on and so forth?

Yes. And I mean we're at the forefront of that. I mean you see labor availability continues to be tight. I do think that some of the things we put in place, and this actually goes back pre-COVID for us because I'd say our industry was maybe an early warning sign or hit earlier than most around labor tightness. We partnered with community colleges, local trade schools and other industry organizations to increase the supply of labor into the market. And in many ways, we're the first job for a lot of people who enter the aviation technician world. And retaining them is -- can be difficult. They come with us. They are with us for 2, 3, 4, 5 years. They get trained up and they're a pretty attractive person to go -- be hired by an airline or someone like that. But we do retain the one -- a lot. And then like I said, it's critical that we've been able to get some of that price increase to be able to pay the wages we need to keep attrition manageable. As it stands today, I'd say it's stable. It hasn't gotten better, but I think it certainly hasn't gotten worse. And so we've been holding the labor force together and maintaining really good quality and service at the same time.

Got you. And then that software product you guys sell to airlines. How is that going? And where are we relative to the plan when you first got into that business?