AAR: By Many Metrics, a Gift At This Price

Even though I have already allocated a full position, and then some, to AAR Corp. (NYSE: AIR), the recent sell-off in the market, and with AAR in particular, is WAY overdone.

Sometimes you get a gift, and you would be crazy to not take it.

Various valuation metrics as well as my discounted cash flow analysis (DCF) put AAR about 50-100% below fair market value without even accounting for a recovery in the marketplace!

Add this to recent insider buying, and the stock trading below tangible book value, and at a severe discount to its peers, and you get a classic low risk, high reward proposition that is hard to pass up.

It might take weeks, or it might take months, but I believe AAR at these levels represents a true bargain on a valuable business with a proven management team and execution strategy.

What follows are my reasons for picking up another 1/4 position Friday.

New to the AAR story?

AAR Corp. provides products and services to the aviation, aerospace, and defense industries worldwide.

It operates in four segments: Aviation Supply Chain; Maintenance, Repair, and Overhaul (MRO); Structures and Systems; and Aircraft Sales and Leasing.

Through its Aviation Supply Chain and MRO segments, AAR provides everything from aircraft parts, maintenance and logistics support, to the actual maintenance and repair of aircraft at its 4 MRO facilities at various locations throughout the U.S.

In addition, through its Structures and Systems segment, AAR provides vital products and services to the U.S. military including specialized construction of mobile shelters and pallets, as well as support and products for various military aircraft and aircraft support, storage and maintenance functions.

Finally, through its Sales and Leasing segment, AAR buys, sells and leases used aircraft for itself, on behalf of others, and through joint ventures.

Time To Go Shopping!

Here are my reasons why it’s prudent to add to your AAR position or start one immediately:

• AAR’s most recent earnings announcement and conference call exceeded expectations, and was as solid as can be, even in this current market. I went over their latest quarterly report in detail.
• As the current economy gets worse, more and more domestic airlines are outsourcing their MRO activities to cut costs and combat the rising price of fuel and the consumer slowdown.
• AAR is a diversified business, with a large chunk of their sales (40%) to the U.S. and other governments. Through this diversification, AAR can weather any economic storm better than other Aerospace and Defense companies.
• Insiders have begun to purchase shares of the company’s stock in moderate to large quantities over the last couple of months. This includes 5 different directors, and the CEO, David Storch, each purchasing anywhere from 4,000 - 24,000 shares at prices ranging from $10.20 - $17.16, with the most recent purchases being in the $10.20 - $12.60 range.
• Valuation metrics (more below) point to AAR trading below its peers, even though it has superior business fundamentals, and is a well diversified company with no direct competition for all 4 segments.
• AAR is trading below its fair book, and tangible book value by a wide margin, especially when compared to its peers (more below).

Now let’s take a look at some of those valuation metrics.

AAR Is Cheap Any Way You Slice It

• Discounted Cash Flow (DCF): Using my model (assuming Beta of 2.5, and a 9% market return and a 3.3% risk free return), I get a fair or intrinsic value for AAR of anywhere from $27.54-$30.60 per share using extremely conservative assumptions (such as 5% growth this year and next): Upside potential of 137% - 165%.
• Other Valuation Metrics: A picture is worth a thousand words, so let’s take a look at the numbers I compiled:

In this valuation matrix, I included 3 other companies that compete slightly with AAR in their Aviation Supply Chain, and MRO divisions.

There is no direct competition in their Structures and Systems segment, and for their Sales and Leasing segment, because it is such a small slice of their revenue, I did not feel it was justified to include some of the pure play leasing companies.

That left me with the following companies:

• Goodrich Corp. (NYSE: GR): Goodrich Corporation supplies components, systems, and services to the commercial and general aviation airplane markets, as well as to the defense and space markets worldwide
• Spirit Aerosystems, Inc. (NYSE: SPR): Spirit AeroSystems Holdings, Inc. engages in the design and manufacture of aero-structures worldwide. It offers structural components, such as fuselage, propulsion, and wing systems for commercial, military, and business jet aircraft. In addition, Spirit offers aftermarket services, such as spares, maintenance, repair, and overhaul (MRO), as well as engages in the sale of natural gas.
• Triumph Group, Inc. (NYSE: TGI): Triumph Group, Inc., engages in the design, engineering, manufacture, repair, overhaul, and distribution of aircraft components. It primarily offers aircraft and engine accessories, structural components and assemblies, non-structural composite components, auxiliary power units, avionics, and aircraft instruments. The company also provides maintenance, repair, and overhaul (MRO) services and serves original equipment manufacturers of commercial, regional, business, and military aircraft components, as well as commercial airlines, third-party repair and overhaul providers, and air cargo carriers.

There’s one number in particular that I want you to pay particular attention to: The tangible book value.

AAR is currently trading BELOW its net tangible book value! This means that the market is pricing shares of AAR Corp. BELOW the assets on its books.

Sure, that might be justifiable for a profitless and floundering banking stock, or a company that was headed towards financial ruin, but not a solid company with a proven track record like AAR.

Furthermore, if you look at the cash to debt ratio of AAR vs. its peers in my table, you can see that AAR’s ratio is about the same as, or better than its competitors, so any thought of AAR not being able to meet its debt obligations is far fetched and better reserved for some of the other players in the Aerospace and Defense industry.

Now let’s look at some of the other valuation metrics.

Let’s take a look at some of the other metrics:

• Price to Sales Ratio (P/S): By this metric AAR is trading at a discount to its peers and the overall industry. Upside potential of 44% - 150%.
• Enterprise Value to EBITDA (EV/EBITDA): Using this metric AAR is trading in-line or at a slight premium to it’s peers.
• Price to Earnings Ratio (P/E): Looking at AAR’s P/E ratios, both forward looking, and for the trailing 12 months, we can see that again AAR is trading at a discount to its peers. Upside potential for TTM P/E: 12% - 58%. Upside Potential for FORWARD P/E: 7.5% - 16%
• Price to Earnings to Growth Ratio (PEG): AAR is trading in-line to slightly below its peers.
• Price to Book Ratio (P/B): Looking at this ratio we see that AAR is trading at a significant discount to its peers, while being well capitalized as I previously mentioned. Upside potential of 13% - 95%.
• Price to Tangible Book Value Ratio (P/TBV): Finally we get to the most important metric for our purposes. Upside potential of 46% - 385%+
• Other Metrics: This includes past revenue growth, future expected revenue growth, as well as past and future profit growth expectations. Please note that AAR’s fiscal year ended in May 2008, so forward projections are being used for 2009 time periods for AAR vs. 2008 (which only has about 3 more months) for the other companies, which skews the results when looking at forward earnings and sales growth.

If we normalize for these factors, we see that analysts are also expecting these other companies to have similar sales deteriorations and slowdowns within their businesses.

Finally, looking at the gross margin comparison, because there is no apples-to-apples comparison to AAR, this metric is also not as useful to us at this time because of the disparate nature of the businesses in which AAR operates vs. its peers.

The Bottom Line

I’ve taken a blood bath on shares of AAR over the last year, and I was waiting for an opportune time to add to my position provided AAR showed strength within its operations, as well as management’s faith and belief in their own company.

AAR’s continued execution, even in the face of what can only be described as a brutal market, has given me the confidence to add to my position based on what I have presented to you here.

We have a strong and fully invested management team that is putting their money where their mouth is, valuation metrics that clearly favor our risk/reward proposition, and a ridiculous stock price that has AAR trading for less than the tangible assets on its balance sheet!

Talk about downside protection.

Needless to say, AAR more than qualifies for my Double Thesis.

Like I said, I don’t know when the market will turn, or how long it will take, but I do know that AAR will bounce back with it, and indeed, ahead of it, and outperform the market’s turnaround from here on out.

I would not at all be surprised to see AAR gain 50-100% in value in a relatively short timeframe, say less than 6 months, when things turn around and sentiment changes.

Just as things have been emotional on the way down, so to will they be emotional on the way up as people trip over themselves not to miss the next big move up and “catch” the bottom.

My job and passion is to get in ahead of these moves, and be patient through rigorous analysis and research.

I believe that AAR presents us with that opportunity right now.

Comments

[PeakOiler:]

Negatives: pennies a share in cash flow, no dividend. Investors left standing will be looking for yield in the months and years ahead because of the whupping they're taking now.

2008 Oct 26 09:18 PM

[Chris Ferna...:]

PeakOiler,

Sure, but what if I told you that management is focusing now on increasing those cash flow figures and conserving cash, as opposed to further increasing their acquisitions, to pay down their debt and increase their cash flow?

There is always more to the story than meets the eye.

I didn't get to go into details on all of that, but add that to the list of positives as well. Look at the cash flow, and free cash flow for the last 3 quarters and you'll see the trend developing.

Chris

2008 Oct 27 12:00 AM

[Military Doc:]

I agree with your thesis and bought into the company around $13, but given the current climate, talks of recession, decreasing flights hence maintenance decreases and the likelyhood of Obama being elected and cutting gov. contract spending makes for a better bargain in the coming days. I think it's realistic to say if you're patient $10.00-10.50 will be a great buy today.

2008 Oct 27 09:09 AM