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There is a definite slowdown in AAR Corp’s. (NYSE: AIR) business as a result of the overall market forces and economic malaise, but all things being equal, the company still reported decent numbers after the market closed Wednesday night.

As I wrote about previously, I wanted to see AAR’s results come in somewhat in-line, which they did, but see significant improvement in their cash flow generation and paying down some of their debt load, which did occur.

So what does this mean for our investment? Is AAR still a good place to park our money even in the face of the continued economic storm?

In this post I’ll be breaking down AAR’s full earnings release, as well as their analyst conference call, and round out my post with what you should do with AAR’s stock.

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 (NYSE: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.

Hit Me With Some Numbers

Sales Higher as A Result of Acquisitions, Slightly Higher Organically

(Growth from previous year’s 2Q/analysts estimates where applicable):

  • Quarterly sales of $353.6 million (up 14% from prior year (3.5% organic)/vs. $369.2 million projected by analysts)
  • Quarterly income from continuing operations of $21.4 million (up 21% from prior year)
  • Quarterly earnings per share from continuing operations of $0.51 (up 21% from prior year/vs. $.49 projected by analysts)
  • Q2 Gross margin improves to 19.8% (up from 19.4% in the prior year)
  • Q2 Operating margin of 10.2% (up from 10.1% in the prior year)
  • Retired $56.6 million of their convertible notes for $33.3 million cash. As a result of these transactions, the number of shares used to calculate diluted earnings per share will be reduced by approximately 500,000 and result in $0.03 accretion to diluted earnings per share on an annual basis.
  • Backlog increased to approximately $600 million as of November 30th, up from $500 million at August 31, $465 million at May 31, and $310 million at August 31, 2007.
  • Operating cash flow: $18.6 million
  • Sales to Defense customers increased 32%; Defense business now represents 43% of total sales, up from 40% last quarter.

My Take: AAR definitely showed some of the impacts of the overall market decline and consumer spending slowdowns, thus affecting the airline industry.

This was one of the first times in quite some time that AAR failed to at least meet analyst’s estimates on the top line, while still maintaining their stellar record for meeting or beating on the bottom line, albeit with a little accounting shenanigans thrown in there, which we’ll discuss below.

Paying down their debt was also great news, and as a result, AAR retired more of their shares.

If you combine the 500,000 shares this quarter with the 400,000 or so from last quarter, that represents almost 1 million shares that have been retired and taken off the books which increases the value of the shares we own, and increases the earnings per share.

Other Business Highlights

Organic Growth Slows, Still Rising

As mentioned above, AAR’s organic growth slowed to 3.5% this quarter.

As a whole, their entire business saw modest growth of about 14%.

In this market, where slowing and more often than not, declining sales are the norm, to be able to even have an organic sales uptick despite the airlines cutting back tremendously, and the U.S. dollar strengthening, which hurts AAR’s overseas operations, was a great positive.

We knew that AAR was going to feel the crunch of the slowdown, but what we didn’t know was to what extent.

Right now it looks like there still may be some effects from the overall slowdown yet to come as there is a general lag between the airlines cutting expenses and it showing up in AAR’s business.

Here’s a breakdown of AAR’s 4 business segments and notes on each:

  • asc.jpgAviation Supply Chain (41.3% of sales) — Sales grew 1% to $146.1 million for the second quarter and gross profit increased 3% to $36.0 million, resulting in a gross profit margin of 24.6% compared to 24.2% last year.

AAR’s defense logistics business achieved double-digit sales growth during the second quarter while segment sales were unfavorably impacted by a planned reduction in sales to a major regional airline customer and foreign currency translation.

Sales growth was also impacted by weakness at the company’s component repair business in Europe.

My Take: I believe this regional airline customer was the previously mentioned Mesa Air Group (NASDAQ: MESA).

You can see the affect that the airline slowdown is having on AAR in this segment as sales barely inched forward at a rate of 1%, although AAR did squeeze out a bit more profit this time around.

It will be interesting to see if this is the “bottom” of AAR’s slowing sales to airline customers, or if there is further reduction in sales to these customers.

  • Maintenance, Repair and Overhaul (MRO) (24.7% of sales) — Sales grew 27% to $87.4 million for the second quarter and gross profit increased 36% to $13.5 million, resulting in a gross profit margin of 15.4% compared to 14.4% last year.

govtmroaom.jpg

The sales growth reflects the impact of the acquisition of Avborne Heavy Maintenance (now known as AAR Aircraft Services-Miami) and record results at the company’s landing gear business which benefited from investments in assets and productivity improvement initiatives implemented in prior quarter. The acquisition of Avborne Heavy Maintenance Inc. last fiscal year enhances AAR’s ability to service more wide body planes, which typically belong to international carriers.

My Take: Sales in this segment were largely the result of AAR’s previous acquisitions.

It seems that the outsourcing of MRO activities while still continuing, has slowed down and kept pace with the overall slowdown and cautiousness of the airline industry.

In fact, many airlines are holding back on maintenance as long as possible, and retiring airplanes that are due for major servicing rather than pay for their repair.

It has become cheaper to scrap the airplane and sell the parts, or lease it out to another carrier, than to keep it and pay the higher fuel costs (which have since moderated but are likely to go higher), and maintain an aging airplane.

  • Structures and Systems (32.4% of sales) — Sales grew 44% to $114.7 million for the second quarter and gross profit increased 75% to $18.9 million, resulting in a gross profit margin of 16.4% compared to 13.5% in the prior year.

Sales were positively impacted by increased market penetration at Mobility Systems and the acquisition of SUMMA Technology.

The gross profit margin improvement was driven by the favorable mix of products sold and improved performance at the company’s cargo systems business.

During the second quarter, AAR announced a $115 million contract to manufacture shelters as a subcontractor for BAE Systems for its family of medium tactical vehicles for the U.S. Army, a $40 million contract to manufacture containerized roll in/roll out platforms for the U.S. Army and a $300 million pallet repair contract.

The $300 million repair contract is not in the company’s backlog because the orders are for delivery during a 5 year time frame.

Cargo Box

Sales growth in this segment reflects AAR’s leading position in specialized mobility products for defense and humanitarian customers, and steady demand for cargo systems and composite structures.

My Take: This is the segment that continues to shine for AAR, and they have been doing their best over the last several years to grow this segment of their business and shield themselves from exactly the situation that is taking place now.

You can easily see that the U.S. government places a high level of trust in AAR, because they are one of the only, if not the only, provider for the special types of pallets and cargo systems that the military depends on.

AAR essentially has this part of the market cornered and it offers their overall business a great buffer to the ups and downs of the airline market.

  • Sales and Leasing Segment (1.5% of Sales) — During the second quarter, AAR performed a comprehensive review of its aircraft portfolio to assess the impact of the economic slowdown and credit crisis on market conditions.

Airplane on tarmac

Based upon that review, and taking into consideration the desire to improve liquidity and generate cash, the company made the decision to sell one of its four wholly-owned aircraft which had been acquired before September 11, 2001, and offer two of the remaining three aircraft for sale.

There is no outstanding debt associated with the two aircraft now offered for sale.

As a result of this decision, AAR recorded a $21 million pre-tax impairment charge to reduce the carrying value of the three aircraft to their net realizable value based on current market conditions.

In addition, the company sold two aircraft from its joint venture portfolio resulting in an increase in earnings from joint ventures.

At November 30, 2008, the company’s aircraft position includes 27 aircraft held in joint ventures and seven aircraft held in the company’s wholly-owned portfolio. AAR has not acquired any aircraft for lease since November 2007.

AAR achieved a 15.5% return on their investment on their portfolio of aircraft in fiscal 2008, and expect to do the same going forward.

Also within this segment, under an advisory services contract, AAR announced a deal with United Airlines (NASDAQ: UAUA) to help United sell or lease their entire fleet of 737’s which amounts to about 100 aircraft.

This deal has since been shelved. Management talked about how they presented United with various deals but they rejected them, and therefore they are no longer in a legal agreement to sell or lease any of their fleet, but they are still working with them.

My Take: The good news is that because AAR went on a buying spree years ago, they have a nice backlog of aircraft in their portfolio to sell and make some cash off of in times like this when the company is trying to create added liquidity.

The bad news is that because of times like these, the carrying value of those aircraft, and their real value on the open market is much lower than in years past, and has resulted in an impairment charge as the company had to lower the actual value of the planes on their balance sheet to account for the lower expected resale value of those aircraft.

I suppose you take the good with the bad.

On the conference call, AAR’s management stated that they won’t need to revalue any more aircraft because these were older pre 9-11 aircraft that had obviously lost value and needed to be revalued to present levels.

The rest of the fleet according to management, is already fairly to UNDERvalued, therefore, AAR will not need to do this sort of write down for the foreseeable future.

Looking ahead, if AAR keeps selling all their aircraft from this segment without replenishing their fleet (we still have some time before that happens), this might cause trouble in their business model going forward as they do look at selling 4-8 aircraft per year once they reach a certain maturity on their balance sheet, and they can flip them in the open market for a considerable profit, after already generating profit from leasing them to other companies for 5 years or so.

Conference Call Highlights

A Note of Caution, Slowing Growth Trends

  • More Color on Deal Flow: The CEO was asked by an analyst about overall business and the deal flow that AAR was seeing.

The CEO stated that the pace was “OK”.

Considering the fact that AAR had that many aircraft coming out of the system via the cutbacks and declines in the airline industry, he felt that they still see healthy demand even in the face of the headwinds and slowdown.

The CEO kept stating that they are focused on cash generation, and they expect to keep seeing “decent” results and growth.

In addition, the CEO was asked about continued growth or expansion opportunities in their Aviation Supply Chain segment, and he stated that there are still numerous growth vehicles available to the company, but that it all depends on their ROI, and how much of their balance sheet and capital they are willing to put towards securing those deals and customers.

My Take: The tone on this call was slightly more dour than on previous calls. It’s clear that AAR is seeing some type of slowdown and they have finally been hit, as has been pretty much every other business out there, by our official recession.

That being said, management did state that inventory turns were 2.4 during the last industry slowdown post-9-11, while they are 3.1 now.

Obviously AAR is running a lean operation now, and not carrying unnecessary goods on their books and staying as nimble as possible.

  • Mesa Airlines Discussion: Mesa Airlines, one of AAR’s customers, stated in May 2008, that if they could not resolve one of their contract disputes with one of their customers, they may have to file for bankruptcy protection.

During fiscal 2008, sales to Mesa Airlines were approximately $73 million, of which $56 million was in the Aviation Supply Chain segment, and $17 million was in the MRO segment.

As of this conference call, AAR’s management stated that if Mesa’s fleet stays constant, AAR will see a steady flow of order volume and business from them, otherwise they won’t.

My Take: As we know, Mesa is a small player in the regional airline market, and as a total percentage of AAR’s revenue.

However, because AAR’s margins are already so tight to begin with, and operationally they are trying to improve all of their business segments, even a small player like Mesa could have a disproportionate affect on the company’s margins, and if forced to write down any of the assets associated with their support of Mesa, it would indeed cause problems during the year.

I’ll be keeping an eye on this situation as it unfolds, but lower fuel prices are certainly one ingredient that will keep anything drastic from happening to Mesa in particular, and the overall airline industry as a whole.

  • Aircraft Resale Value: The CEO stated that the write-downs this quarter are not indicative of future write downs on their other planes in their portfolio. The write-downs for the 4 aircraft was about half the value ($40 million to $21 million) because they were pre-9-11, and therefore haven’t been evaluated lately in terms of their carrying value.

He stated that the rest of the fleet was valued fairly and didn’t need to be written down like the 4 that they did revalue this quarter.

In fact, management believes that they actually have “embedded gains” in the fleet, rather than further losses.

They intend to sell their remaining fleet of planes and use that cash towards other endeavors in their business, such as buying back their bonds, or supporting their other business segments.

Currently, 2 of AAR’s aircraft are parked with one for sale, and one set to be stripped for part sales, with both aircraft being owned through joint ventures.

Out of the 34 aircraft in the fold, 32 are currently are on lease, 1 AAR expects to sell in the very near future, and the other remaining airplane they expect to tear down and use for parts in their MRO/Supply Chain segments.

My Take: Management indicated on the conference call that they stopped purchasing aircraft about 1 year ago because the saw some of the weakness coming, and that they don’t expect to be purchasing other aircraft anytime soon as a result of slowing demand.

They will instead focus on selling and/or leasing the aircraft that they already have in stock, and will look to maximize their ROI for these particular aircraft.

As I stated above, this is both good and bad news.

As time goes on, AAR won’t have these aircraft to sell (currently valued at about $80 million) to aid them in cash flow generation, etc.

This isn’t a large part of AAR’s business anyway, so the impact should be minimal, but nonetheless, having a few spare aircraft to lease or sell in times of need, like now, is indeed a luxury.

  • Commenting on MRO Usage: AAR has been talking to new and existing customers about some added availability in the 3rd/4th quarter schedule for MRO bays that are open and not being used, and they are fairly confident that they will be able to fill those holes that are being seen now as airlines reduce their fleets further.
  • Future Growth Rate: AAR’s growth rate is going to be challenged by the environment and the way they are managing their business. 15% growth rate long term is what they strive for, but they don’t foresee that happening in the next few quarters as a result of what’s going on the business and overall market.

In other words, AAR is focusing right now on cash generation, and conservation, therefore, they are not spending as much for expansion and new business initiatives and therefore, their growth rate is going to suffer, but in a positive way as they will be more profitable with the business that they are generating, as evidenced by this quarter’s higher margins, and increased cash flow and liquidity.

Bottom Line

Good, Not Great Results, Slightly Lower Outlook

I was waiting for the earnings release that would indicate when we were mostly through with the downturn, and this wasn’t it.

In fact, this is the first time that AAR’s business seemed to be affected in line with the industries in which they operate, and it certainly didn’t help results, top or bottom line, that the U.S. dollar strengthened as well.

That being said, the mere fact that any business related to the airline industry, despite AAR’s diverse product and company offerings, is still able to pull off flat to slightly positive sales numbers is a testament to management and their lean operation.

This gives me increased confidence that AAR will be able to ride out the storm and when things do turn up, which they will, AAR will be one of the first companies to capitalize on this increased demand and the return of the U.S. consumer.

The one thing I didn’t like this quarter was AAR writing down the book value of their aircraft fleet and then making up the difference by calling in some of their convertible notes to make it look almost as if nothing happened, which brought their EPS in-line and gave them some free cash flow to talk about.

I’ll be looking closely at this in future quarters to make sure this isn’t done on a regular basis, but this is the first time since I’ve started covering AAR that they have ever taken from one pot to fill another, so their track record still remains solid.

For now, the stock remains right about at book value, and slightly above tangible book value, and I have slightly lowered my forecast and outlook for shares of AAR so that our risk/reward premium at these levels is not as high as it once was.

I still think AAR is a buy here, but more of a moderate buy instead of a strong buy.

Anything under $14 strengthens the risk/reward scenario, and anything under $12 per share is a screaming buy that must be acted upon immediately.

For now, with a price around $16.00, I see the upside potential in the low $20’s range, or about another 50% gain from here within 6-12 months.

Still not bad at all for a long term investor looking to play the recovery in the U.S. economy and specifically, the airline industry playing that turnaround by backing the best company in the field.

Bottom Line: If you already own shares of AAR hold your shares. If you don’t, nibble 1/4 - 1/2 position right here, and buy on any additional weakness, specifically anything under $14, and especially anything under $12, if the stock ever dips that low again.

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.

Want More?

  • Read: My latest company analysis and quarterly earnings breakdown here.
  • OR: Read why I recently added to my AAR position by clicking here.
Source: AAR Corp. Reports Decent Results, Slower Outlook