AAR Corp

NYSE:AIR

Earnings Call Transcript 2020-Q1

[Operator]

Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2020 First Quarter Earnings Call. We are joined today by John Holmes, President and Chief Executive Officer; and Sean Gillen, Chief Financial Officer.

Before we begin, I would like to remind you that the comments made during the call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as noted in our news release and the Risk Factors section of the Company's Form 10-K for the fiscal year ended May 31, 2019. In providing the forward-looking statement, the Company assumes no obligation to provide updates to reflect future circumstances, or anticipated or unanticipated events.

At this time, I would like to turn the call over to AAR's President and CEO, John Holmes.

[John Holmes, President and Chief Executive Officer]

Great, thank you very much, and good afternoon everybody. I really appreciate you all being here to joining us today to discuss our Q1 FY20 results. Our positive momentum continued with another quarter of double-digit sales growth. In the first quarter of FY20, sales grew 16% from $466.3 million to $541.5 million. Our adjusted diluted earnings per share from continuing operations increased from $0.54 per share to $0.57 per share.

We continue to see exceptional performance from our parts supply and government programs activities. And MRO, as you know, we took several actions last year to address labor shortages such as enhancing our recruiting efforts, partnering with various schools, and repositioning elements of our workforce across our network. We are pleased with the positive impact of these actions, which resulted in our third quarter of improvement in MRO. We are also pleased with the support that we received from our customers to better level out the maintenance schedule throughout the year. This allowed us to keep more of the workforce in place during the slower summer season.

During the quarter, we were awarded a $118 million contract from the Naval Air Systems Command in support of the US Marine Corps for the procurement, modification, and delivery of two C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO, and engineering teams to deliver a creative solution to the US Marine Corps.

The ability to deliver an overhaul versus factory new solution not only differentiates AAR from our competitors in the defense space but also demonstrates our ability to once again apply commercial best practices to deliver a more cost-effective solution to the U.S. government. We began work under this contract this past quarter, and we expect to deliver the aircraft in our fiscal 2021.

Subsequent to the quarter end, we announced a new parts distribution award from Leach Corporation, which is a wholly owned subsidiary of TransDigm. As part of this agreement, AAR OEM Solutions will be the Company's main distributor for electromechanical and solid-state switch gears to OEMs for new production, as well as to the -- both the commercial and military aftermarket. This is an important win for the Company and reaffirms the strength of our value proposition in parts supply and distribution.

We also announced a new agreement with Mitsubishi Heavy Industries Aero Engines to supply PW4000 engine parts in support of their engine overhaul business. This is our largest commercial contract in Japan to-date, and we're particularly proud about this win, because it allows us to support the demand for engine parts in this growing market.

We continue to execute on our growth strategy, and we're pleased with the progress as we continue to secure and execute on new business wins, and we're very excited about the strong start to FY20.

With that, I'll turn it over to our CFO, Sean Gillen.

[Sean Gillen, Chief Financial Officer]

Thanks, John. Our sales in the quarter of $541.5 million were up 16% or $75.2 million year-over-year. This included $73.4 million or 17% increase in Aviation Services revenues, driven by execution on new contract awards and strong demand in our part supply activities. The C-40 award contributed approximately $19 million of sales in the quarter.

Gross profit increased 14.6% or $10 million to $81.6 million. Gross margin was 15.1% versus 15.3% in the prior year period, primarily due to Expeditionary Services. Gross Margin within Aviation Services, however, improved from 15.3% to 15.6%. I would note that the C-40 award, while relatively in line with operating income margins and accretive to ROIC, is a bit dilutive to gross margin.

SG&A expenses were 10.7% of sales versus 10.3% in the prior period, which reflects increased investigation and compliance-related costs mentioned in the previous quarter as well as some additional sales and quality resources. Excluding the investigation and severance costs, which totaled $3.6 million, SG&A would have been 10.1% of sales in the quarter.

Regarding the investigation, we have received request for information from the government agencies involved, which we are fully cooperating with. Beyond that, we cannot provide further detail at this time.

Our income tax expense during the quarter was favorably impacted by tax benefits of $1.4 million, related to the vesting of restricted shares and stock option exercises. This compares to a similar tax benefits of $2.5 million related to stock compensation in prior year's quarter.

Net interest expense was $2.1 million compared to $1.6 million last year. During the quarter, our cash flow used from operating activities from continuing operations was $30 million, which improved $20 million from the prior year, excluding the impact of the accounts receivable financing program, which was flat in this quarter.

The cash used in this quarter was primarily driven by investments in inventory to support our part supply activities as well as some normal seasonality in MRO. We feel good about the strength of the balance sheet. Net debt ended the quarter at $163.4 million with net leverage below one-turn. In addition, I am pleased to share that we entered into an extension of our revolving credit facility, which will add an additional three years to the term and $100 million of borrowing capacity.

Our lowest pricing will also decrease from LIBOR plus 100 basis points to LIBOR plus 87.5 basis points with no other significant changes. Details of the extension will be filed this week. Finally, we are still on target to close the sale of our GOCO business before the end of calendar 2019. The exit of this business is consistent with the realignment of our strategy to GOCO.

Thank you for your attention, and I will now turn the call back over to John.

[John Holmes, President and Chief Executive Officer]

Great. Thank you, Sean. We're very pleased with our Q1 results. And as you saw on the earnings release, we are reaffirming our FY20 guidance for sales to be between $2.1 billion and $2.2 billion, and adjusted earnings per share from continuing operations to be in the range of $2.45 a share to $2.65 a share. We continue to expect SG&A expenses to be approximately 10.5% of sales and anticipate an effective tax rate of 24% in FY20. We will continue to reassess our guidance and modify it, if necessary, as the year progresses.

We are really excited about the strong start to the year. Our parts supply activities continue to deliver exceptional performance. We are executing on our government programs wins, and we're very pleased with the recovery that we see in the MRO business. We have a full pipeline of new business opportunities, and we look forward to a very successful FY20.

Thank you for your time and interest in AAR. At this point, we'll turn it back over to the operator for questions.

[Operator]

Thank you. [Operator Instructions] Our first question comes from the line of Robert Spingarn with Credit Suisse. Your line is open.

[Robert Spingarn, Credit Suisse]

I wanted to start, and maybe I missed it. And I appreciate that nice turbo run through of the quarter, nice and compact. I just want to ask about the Expeditionary margins and what's happening there. The C-40 is not there, right? That's in aviation services?

[John Holmes, President and Chief Executive Officer]

Yes, that's correct. The C-40 is in aviation services. And Expeditionary, we saw margin compression year-over-year, primarily due to product mix and what was shipped in the quarter. But we also saw an increase in raw material costs for our manufacturing business up in mobility, and that had an adverse impact on the margins in that business.

[Robert Spingarn, Credit Suisse]

So, when we think about the year, I don't know maybe this is for Sean. How -- what do those margins do within your -- what's contemplated in your guide for the next three quarters?

[Sean Gillen, Chief Financial Officer]

Yes. I think we haven't gone into the specifics on that, but I think for the balance of the year, we would expect some recovery in the margins, and then in the back end of the year to have kind of a strong year and get back to where it was close to the last year.

[Robert Spingarn, Credit Suisse]

And then just on the outsized growth, if I could call it that in Aviation Services, obviously, quite good in the mid higher teens there, could we maybe talk about that or deconstruct that a little bit into parts supply, which sounds like it's a real growth area for you versus the traditional businesses. Is that the right way to think about this, and these more aggressive contract acquisition, and perhaps talk about how that drives the growth, going forward, in aviation?

[John Holmes, President and Chief Executive Officer]

So, the growth came from a lot of areas in the company. And again, we were really excited about the strong start to the year. Parts supply, as we've talked about in the last several quarters, has really performed exceptionally well, and that's both parts supply in the aftermarket business, the trading business, as well as parts supply in the new parts business, the distribution business.

And we've announced a number of contracts, including two that we just referenced with Mitsubishi, as well as with Leach in those businesses, new and aftermarket parts. And we've announced a number of contracts over the last several quarters. And so those contracts, they take a little while to ramp up, but once they do they really contribute, so that's been -- that's been driving a lot of growth.

Also in the quarter, we had a very nice improvement in our MRO business. Last year, if you recall, our summer was particularly slow, which led to a number of issues that we then felt throughout the year as we look to go back into the labor markets to get technicians back on board. We had a very nice recovery in this summer, and that was a real nice contributor to the growth, and that also sets us up well for the balance of the year because if we think about where we were a year ago at this point in time, we're in the market recruiting for lots of technicians, because we're coming off of the soft summer. Given the fact that we've had a stronger summer, our demands for technicians at this point are much less than they were a year ago. So, we're set up well there.

And then as Sean mentioned, the C-40 win, we’re in early days of that contract, and it's not -- we don't have a full picture yet on how that revenue will pace quarter-to-quarter throughout the next two years. But as Sean said, we recognized about $18 million in the quarter, this quarter, and that obviously contributed to the revenue growth as well.

[Robert Spingarn, Credit Suisse]

So, if all-in, that's about a $70 million plus increase, $18 million of it is C-40. The other 50-odd million, if I wanted to think about parts supply versus kind of the core business, because the part supply is growing, if I understand correctly, from a very small base. So, everything you add Leach and so forth, is meaningful?

[John Holmes, President and Chief Executive Officer]

No, I wouldn't -- we don't want to get into specific growth of the specific operating units, but parts supply is not growing off of a small base. It's a meaningful base and it's been meaningful growth on a meaningful base for several quarters now.

[Robert Spingarn, Credit Suisse]

So, anything we can say about that other 50-odd million, whether it's MRO, parts supply. How do we think about that?

[John Holmes, President and Chief Executive Officer]

No, again, I don't think we want to get into details on that, on that element of it, but I would reiterate that we saw a very nice recovery in MRO, and we continue to see parts supply in both new and aftermarket do extremely well.

[Robert Spingarn, Credit Suisse]

Last thing is in the past or last quarter, we didn't talk so much about cash flow guidance because of the investment in new opportunities like parts supply, does that continue to be the case, you're not done at this point of the year?

[John Holmes, President and Chief Executive Officer]

It does and we'll note that we did see, as Sean mentioned, we did see a nice improvement in cash flow. We were still consumers of cash this quarter. We consumed about $30 million in cash. But if you take out the impact of the accounts receivable securitization, that's a $20 million improvement over last year. Seasonally, we do see cash consumption in the first quarter largely as a result of MRO. But we are very focused on cash generation, and we expect to see improved cash generation as we move throughout the year similar to what we did last year. But again, relative to guidance, we want to give ourselves the space.

The demand for parts in the aftermarket is extremely strong right now, and one of our most significant differentiators is our ability to move quickly and close on large buys of material. And so, we want to give ourselves the flexibility to do that. And then your point on distribution is right on. When you win these distribution contracts, typically there is an upfront buy material and that cash goes out, and as I said before, it does take a little while for those programs to ramp up. But once they do, they become nice contributors to margin as well as turn cash flow positive.

[Operator]

Thank you. Our next question comes from the line of Joseph DeNardi with Stifel. Your line is open.

[Joseph DeNardi, Stifel]

John to the extent that the labor market and MRO is driven by supply growth; I mean, this year domestic airline supply has probably grown 3%; next year, it's probably going to grow closer to 7% with the MAX coming back. So why shouldn't there be kind of additional strain, again, put on the labor market next year as the growth rate accelerates? Or do you think you've kind of properly de-risked that portion of the business for the foreseeable future?

[John Holmes, President and Chief Executive Officer]

I think, we've done a nice job in de-risking and I think your points are right on. The macro environment has not improved for what we do. But we've been, as we talked about throughout last year, very aggressive in terms of the kinds of things that we're doing to get out ahead of labor market. And a lot of that is developing proprietary relationships with tech schools, et cetera, so that we can develop our own pipeline of talent and that is working.

There's an additional ramp up there, because that allows you to get fresh talent in the door, and we're seeing some success there, which contributed to the results this quarter and will contribute throughout the year. But with that fresh talent, there is a bit of a learning curve when you get them in. And that learning curve translates to increased productivity in the hangar. So we've got a good team in place.

We're definitely in the market now, because we will have more demand in the second quarter versus the first quarter as we do every year. So we're in the market right now recruiting for talent. But once we get through this quarter, we'll have largely the team in place that will need for the year to handle the workload that we have.

As it relates to growth next year, we do have floor space. So we have, in a few of our facilities, we do have floor space available. And to the extent that we have demand for customers, and I should mention that we're extremely proud of our customer base in MRO. We've got a blue chip customer base. They're extremely supportive of us. They recognize the value of the service that we provide. They worked very closely with us throughout the summer to keep us fuller in the hangers and they did last year, so that we wouldn't have the labor challenges in the rest of the years as we saw last year. And a lot of them that did that are actually Max operators. So even though they were under significant pressure to have the fleet -- their fleet working harder, they were still able to support us by keeping us fuller during the summer when they needed the aircraft.

So thinking about next year, to the extent that we see demand for the customer base that we have and we can layer in additional lines of maintenance, we're certainly going to continue to extend these recruiting techniques that we've been working to meet additional demand in the hangers that we have available floor space.

[Joseph DeNardi, Stifel]

And then just in terms of kind of the pipeline of good sized opportunities, I mean, just given what you booked recently. Are there similar bigger type opportunities out there that you're targeting in the nearest term?

[John Holmes, President and Chief Executive Officer]

So I would say that the pipeline and we gave a little -- we gave some numbers on that back in July at the Investor Day. I would say that that pipeline is as strong as it was when we talked about it back in Investor Day. And there are definitely meaningful opportunities out there, particularly on the government side that could have positive impacts in the way that C-40 will. But the challenge for the government business is it's difficult to predict when those are going to occur. So to say that we've got opportunities in the near-term, yes, there are plenty that could hit anytime now. There are bids that have been out there for a while, but it's difficult to predict when those will happen.

[Joseph DeNardi, Stifel]

And then, Sean, just on the M&A pipeline, if you could just kind of maybe talk about that, qualitatively what it looks like if it's changed at all over the past quarter or two, and whether the opportunities are more on the commercial or defense side of the business? Thank you.

[Sean Gillen, Chief Financial Officer]

Yes. I'd say the pipeline continues to be pretty active but consistent with what it's been, at least the last couple quarters. There's some assets in market. There's some assets that we think are interesting that could be coming to market. And I'd say the split is pretty balanced between commercial and government. I think we see the opportunity to add to both parts of our business. And as we've talked about at the Investor Day, we're really looking to add IP to the business, whether it'd be in kind of the part supply distribution business, or enhancing some capabilities on the government side. So I'd say it's active and pretty well balanced across the portfolio.

[Operator]

Our next question comes from the line of Ken Herbert with Canaccord.

[Ken Herbert, Canaccord]

John, I just wanted to first again follow-up on the MRO business. Did you hit the inflection you talked about, and was that business profitable for the fiscal first quarter?

[John Holmes, President and Chief Executive Officer]

Yes and yes. And as it relates to inflection, it was a big improvement in the first quarter versus last quarter. And that improvement is not only important as it relates to the results for the quarter itself but as I mentioned earlier, it sets us up well for the rest of the year. Being able to maintain that team throughout the summer and being in the market now. And we're still in the market for mechanics as we enter the busy season here, but we're in the market for a lot fewer than we were last year. So we're in an important time right now as we go out there and recruit. We're very encouraged by the results that we're seeing and even as we start the second quarter. And yes, I think we're off to a very good start.

[Ken Herbert, Canaccord]

And as I look, there's a lot of growing or lot of speculation that with the MAX returning to service at some point in the next period of time here and with what's happened with narrow bodies and new deliveries, there's going to be a real step up in retirements maybe in calendar '20 and into '21. And I know that generates puts and takes in your business when I think about certainly the parts trading and maybe some lower demand for some of the new material perhaps on the distribution side. But can you just talk about how we should think about that if there is a step up from retirements and the impact on the various pieces of Aviation Services, whether it'd be sort of a net positive or where the risks might be?

[John Holmes, President and Chief Executive Officer]

Yes, I think that's a great question and we're certainly thinking about that dynamic. I think overall, we would characterize it as a net positive because today there is, particularly on the aftermarket part supply around engines, there is considerably more demand and more demand forecasted for the next several years for current generation 737 shop business. And to the extent that we're able to get more material, and we will be able to get more material as we see more retirements in that fleet, we've got demand for it.

And we're the largest in the world for that market. We've got, as we keep saying, tremendous balance sheet capacity, which we're excited about, and want to maintain. And our goal would be to be in a position where we can move quickly as material becomes available, and we've got outlets for that material. So that's the biggest driver of all of this. Our heavy maintenance contracts are for that fleet, they're longer term and they carry us several years out, so we feel good about the planned maintenance business there. But generally speaking, I would say that we view that as a net positive.

[Ken Herbert, Canaccord]

And then if I could just finally and maybe I don't expect you to get too specific on this. But as I think about your comments around parts supply and the very strong demand for material today, both new material through distribution and of course maybe alternative material through the parts trading side. It seems like it's clearly a favorable environment from a pricing standpoint. And I'm just wondering if you can disaggregate a little bit some of the trends you're seeing on pricing within parts supply versus volume? And maybe even just, if you're seeing any changes sequentially or you're getting better pricing sequentially without maybe giving more specifics as to how the growth breaks out. But any color around the price versus volume and trends you're seeing would be very helpful.

[John Holmes, President and Chief Executive Officer]

I wouldn't want to get -- and you got it. I wouldn't want to get too specific, just for competitive reasons. But given the tightness of availability of material in the market, you definitely have had some pricing favorability out there, and you've also seen that in terms of the price that you pay for assets. And that, again, is where we believe we excel is our ability to find material, make the buy right, which often comes down to speed of being able to close transactions and then command the best price and availability that you can in the market.

So in terms of trends, that's, we've seen that over the last several quarters, this quarter in particular, I don't know that we saw necessarily any sort of meaningful change from where we were in Q3 and Q4. And I don't know that we necessarily see a change in the near-term there as well.

[Ken Herbert, Canaccord]

And just one final clarification within trading as I think about your agreement say with Delta and other large customers. What percentage of your trading business do you sell into sort of your long-term contracts versus sort of spot market, or book and ship, if I think about it that way?

[John Holmes, President and Chief Executive Officer]

I don't know that we want to get into that specific. But what I can tell you is that it's been a focus of ours to increase the amount of business under contract in the in the trading business. And so that's a much greater percentage of that business than it was a few years ago. But I wouldn't want to get into specifics there.

[Operator]

Thank you. Our next question comes from the line of Michael Ciarmoli with SunTrust. Your line is open.

[George Herbert, SunTrust]

Good afternoon, John and Sean, great quarter. This is George on for Mike. You talked a lot about the three major things ongoing, kind of the three mega trends, the 737, what's going on with the DoD. And we seem to have a lot of airline pressure. I guess, I wanted to start my questions with what was announced last week. It looks like we're going to have entire retirement of squadrons out of the Air Force, a $25 billion cut into the budget. Do you have any opinion on what kind of impact that has on AAR, positives, negatives at all?

[John Holmes, President and Chief Executive Officer]

We don't have a strong view on that at the moment. For the contracts that we are on and for the contracts that we planned are bidding, none of that would have an impact anything that we're looking at. What we can say is that we think that AAR Solutions for the government and the C-40 is really an outstanding example of this. If the government is looking to save money, going after solutions like what we just offer with the C-40 is a wonderful opportunity for them.

And as we mentioned, that's a situation where the government came out. They wanted to buy two aircrafts. They were planning to buy new aircraft. AAR was able to present a solution that allowed them to buy used aircraft and actually get those delivered sooner than they would have if they'd bought new aircraft for considerably less.

And you can bet that we're going to take that example and market it all over the place to the U.S. government as an opportunity for them to save money, and not just in whole aircraft purchases. And we believe that there's more out there like this, but also as it relates to just new serviceable material as a source of savings in all areas of procurement. So that's a big part of our strategy.

[George Herbert, SunTrust]

And were there any PBL opportunities with the sale of the aircraft in terms of the maintenance also? Or was that not offered as you pursued the C-40 opportunity?

[John Holmes, President and Chief Executive Officer]

That's a great question. It was not offered in this particular case. But I will point out that we do have another C-40 contract with the Navy, where we perform the maintenance and certain supply chain services as well. So while it wasn't part of this transaction, it's something that we've done successfully elsewhere.

[George Herbert, SunTrust]

Yes, it sounds very exciting. It almost seems like the cost reduction focuses are a tailwind for AAR. Would you characterize it that way?

[John Holmes, President and Chief Executive Officer]

Yes, I would. I would.

[George Herbert, SunTrust]

Would you say that that also applies with the pressure that we're seeing with the airlines right now? We've had, I think, a slew of airline bankruptcies, and -- in the last 30 days. Is that also an emerging tailwind for AAR?

[John Holmes, President and Chief Executive Officer]

We certainly are keeping our eye on that and the credit worthiness of our customers. And obviously, there's been some news just in the last few days in a couple of airlines. So that's definitely something we're focused on. I am in touch with our customers almost every day and often at very senior levels. And while, they're seeing -- and as I think about North America, in particular, while they definitely seeing pressure in certain areas, their businesses are still historically extremely strong. And the day-to-day demand, both for parts and for maintenance out of the customers, is also very strong.

Coming back to your point, I do think, yes, as our customers look for more cost effective solutions versus buying from OEMs or other suppliers, the aftermarket solutions that AAR offers represent a great opportunity to get quality products and services at better cost.

[George Herbert, SunTrust]

Just going to, Leach, on the electronic power side. Is this your first distribution agreement in this kind of product set, or do you service others products like this with other companies?

[John Holmes, President and Chief Executive Officer]

Again, great question. There's a few firsts with this deal. Most notably, this is actually the first where we are distributing parts that will be used in new OEM manufacturing. So we've kind of moved one step up in the supply chain here, where we're distributing parts that will actually be -- where the customer base is not end users like the airlines or the government, the customer base is, actually in this case, the majority of the customer base is going to be OEMs that use the parts in their own manufacturing process. So that opens doors for us and we're excited about that. We've already started ramping up nicely on that contract, and it should bring with it other opportunities as well.

[George Herbert, SunTrust]

So would you expect that then to expand with other TransDigm subsidiaries, or would that -- is that in the in the cards do you think?

[John Holmes, President and Chief Executive Officer]

Well, I certainly would hope so. TransDigm, as you know with their operating model, they are fairly decentralized. So the subsidiaries make their own decisions. But certainly, we're focused on being successful with the contract we just signed with Leach. And we would do the best we can to leverage that success with other companies like Leach and certainly other companies within the TransDigm group.

[George Herbert, SunTrust]

Just wrapping up, adjusted EBITDA margin -- adjusted EBITDA guidance still in the 165 to 170 range?

[Sean Gillen, Chief Financial Officer]

No. So we didn't give adjusted EBITDA guidance for this year. Guidance for the year is sales, EPS, and we gave some color on SG&A effects.

[George Herbert, SunTrust]

I think that is it. And I'll look forward to hearing about your next military acquisition.

[John Holmes, President and Chief Executive Officer]

Okay, all right. Thank you.

[Operator]

We have a follow-up question from Robert Spingarn. Your line is open.

[Robert Spingarn, Credit Suisse]

I just wanted to ask about the SG&A guide, the 10.5% and whether or not that contemplates any more of these non-GAAP costs. In other words, what you saw in the first quarter?

[Sean Gillen, Chief Financial Officer]

So the 10.5% would exclude any of those compliance and investigation costs.

[Operator]

Thank you. I am showing no further questions in the queue.

[John Holmes, President and Chief Executive Officer]

Okay. Well, with that, we really want to thank everybody for the participation in the call and your time and interest in AAR. Thank you.

[Operator]

Ladies and gentlemen, that concludes the conference. Thank you for participating. You may now disconnect. Everyone, have a wonderful day.