AAR: Getting Pummeled More than It Should?

| About: AAR Corporation (AIR)

AAR LogoJust in case you haven’t noticed, shares of AAR Corp. (NYSE: AIR), which provides products and services to the aviation, aerospace, and defense industries worldwide, have taken a dive in the last couple of weeks, more so than would have been expected as a result of a declining market.

After shares in the company’s stock recovered earlier this year to around $20 per share, they are now again hovering around the $12 mark after getting beaten down hard.

So what gives? Why all of a sudden, when nothing entirely earth shattering is taking place, is AAR getting pummeled way more than it should be?

I have a few theories that I’ll be sharing in this post, as well as previewing AAR’s Q3/09 earnings which will be reported Tuesday March 17th after the market closes, with their conference call to be held the next morning before the market opens.

In this post I’ll go over the important aspects that we need to be aware of before AAR announces earnings and then break them down into the following parameters:

  • What went right in the quarter: What were some of the positive developments that occurred within the company in the last 3 months.
  • What went wrong in the quarter: What were some of the negative developments that occurred within the company in the last 3 months.
  • What I want to see: All things considered, what I realistically want to see from the company as it relates to their business.
  • What we need to see: At the minimum, what we need to see for our investing thesis to still hold and an investment in this company to be prudent.
  • What we’ll probably see: After weighing what’s been going on for the last 3 months, what we can realistically expect when they do announce their earnings.
  • Bottom Line: What it all means, and what you should do.

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.

Want More?

  • Read: My first post about the FAA shutting down AAR’s landing gear facilities here.
  • OR: my second post detailing how AAR was cleared to reopen those facilities here.
  • OR: My latest company analysis and quarterly earnings breakdown here.
  • OR: Read why I recently added to my AAR position by clicking here.

What Went Right In the Quarter

Lower oil prices, Reopening of Miami facilities

I wouldn’t consider the fact that the FAA allowed AAR to reopen their Miami landing gear facilities “good news” per se, but it’s better than the alternative for sure.

While AAR’s landing gear facilities that had the problems and were temporarily shut down only accounted for 6% of total revenue for the company, it was important to note that when it comes to airplane safety these things need to be monitored closely.

If there was other good news in the quarter, it was that the price of oil continued to decline or stay steady, thus allowing airlines to be more profitable, and perhaps allowing them the capital to service their planes for unscheduled maintenance, or not put off scheduled maintenance by grounding certain older aircraft.

This is pure speculation on my part, as I don’t have any evidence to support this, but a lower price of oil could be a boon for the airline industry and thus AAR as well.

Other than that, there was no especially good news from within the company such as new contract wins, government orders or the like, just macro trends that might bode well for AAR, balanced out by other macro trends that might be the reason the stock has lagged the market lately, which I’ll go into below.

What Went Wrong in the Quarter

U.S. withdrawal from Iraq could be seen as a major negative

I’ll start off by stating the obvious that AAR’s continued wrangling with the FAA over maintenance of certain landing gear parts has not been a positive development, and instead of going away as I thought it had, it reared its ugly head again this quarter as AAR was forced to shut down these facilities for a short time.

I won’t go into detail about this, but once again, anything negative or the perception of anything negative when it comes to safety and the airline industry is never a good thing.

Hopefully this is behind us now once and for all, and AAR can go about its business serving the entire airline industry for Maintenance, Repair and Overhaul (MRO) services.

What I really wanted to go into as it might relate directly to AAR’s recently crumbling stock price is the change in administration, and the new President’s mandate and actions, to start withdrawing troops from Iraq.

The market could be perceiving these withdrawals as a negative on AAR’s earnings because of the fact that if there are less troops to service and less military demand, AAR’s Structures and Systems unit will suffer as government spending slows on war efforts, troop protection, movement and safekeeping.

If there are less troops in combat and in the field, there is obviously less need for AAR’s pallets, troop structures and transport systems products.

In addition, if there are fewer aircraft that are being utilized for protection and engagement, there is also less of a demand for parts, service and MRO on those aircraft.

So, it goes without saying that demand for this segment of AAR’s services could be seen taking a hit in the months and years to come from slower defense spending and military usage.

I think that this worry is a little unfounded for a few reasons:

  • The U.S. will continue to have a presence in Iraq and Afghanistan for years to come, albeit at a reduced rate in Iraq, and thus will still require the necessary troop deployment structures and MRO and parts capabilities that AAR can deliver.
  • The U.S. is redirecting efforts to Afghanistan, which will require all of the above mentioned equipment and maintenance.
  • Typically when war efforts are ramped down, planes and vehicles that were heavily utilized in these conflicts need a lot of repair work for many months or years after the conflicts. Maintenance is performed AFTER the initiatives, usually not during, in order to have a ready fleet for the next conflict.
  • AAR’s revenue as a percentage of total from government spending is about 35-40%, and is a steady source of income for many projects irrespective of certain conflicts that are occurring.

At any rate, the market could be taking a sell now, ask questions later response to these initiatives and this could be one of the reasons, along with continued weakness in the airline industry, why shares of AAR’s stock have plunged lately.

What I Want to See

Results in line

AAR is notorious for meeting or beating analyst’s estimates, and I expect no difference this time around.

In fact, AAR’s last earnings announcement left much to be desired as the company moved around some short term stuff to make their numbers, a trick that they won’t be able to duplicate this time around.

I wasn’t happy about the perception that AAR was just trying to “reach” their numbers, but the truth came out on the operating cash flow line to the tune of $18.6 million, and the company also delivered free cash flow to the tune of $10.66 million.

This quarter, analyst’s expect AAR to come in at $.46 per share, down from $.50 per share expectations not too long ago.

Revenue is expected to clock in at $366.2 million vs. $376.6 million a year ago, a decline of about 3%.

I want to see numbers come close to these marks, but I’m not interested in AAR’s ability to make their numbers and manipulate the bottom line.

The truth will come out in their cash flow and free cash flow figures, as well as margins, which have held up considerably well even under the increased pressure from a declining market.

What We Need To See

Something in line

We probably need to see something in line to keep our investment thesis in AAR feasible at this point.

Any additional decline in operating conditions, a decline in margins or something else unexpected to the downside would put my investment thesis in jeopardy and call into question whether AAR is a good investment for our money right now.

I want to see continued solid albeit lowered guidance in terms of the macro business picture, and a clear explanation about both the Miami landing gear fiasco, as well as what the U.S. withdrawal will mean for AAR going forward.

What We’ll Probably See

I don’t know

If I knew, I would be buying up options for the price move either way.

My guess is that based on the market’s beat down of AAR’s stock in the last few weeks, expectations are extremely low right now, so there is already some negative outlook and a slight miss already baked into the share price.

I think that anything better than a slight miss and reduced outlook will cause shares to spike and rally as investors exhale and take a renewed look at AAR’s potential once things turn around and consumer travel picks up.

Bottom Line

Let’s see what happens

It’s clear that things have been slowing down at AAR for quite some time now.

The question for us is are we closer to the inflection point of improving results, or merely a plateau for continued poor business trends and declining demand?

Or worse yet, could it be that we haven’t seen the worst of what this market has to offer, and that airlines and consumer spending are going to further retreat and take AAR down with them?

Coupled with the U.S. withdrawal from Iraq and the perception that AAR’s results will suffer as a result, it could be that AAR’s stock is destined to be mired in the muck for a while, and it’s best to move on to other investments that have a higher chance of rebounding much quicker.

That remains to be seen.

I’ll wait until I’ve digested the earnings and conference call before I make a decision one way or another, but as of right now, with shares trading around $12 per share, or right around where I added to my stake a while back, I feel that the risk/reward is still in our favor, and with any favorable news, trends or the turnaround that we know is coming, AAR’s shares could rise quickly as they have done many times before.

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Tagged: , Aerospace/Defense Products & Services, Earnings
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