AAR Corp.: Innovation for the Aviation/Aerospace Industry

As you sit back in your cozy airplane seat (ok, maybe not so cozy sometimes!), a brief thought enters your mind:

“I wonder who leases and maintains these planes and how much work is involved in keeping the airplane in good working order?”

“Everything from making sure that the hull is structurally sound and landing gear are operating properly, to the basic maintenance and parts that are needed to keep it running smoothly, safely and within FAA guidelines?”

Then, as the plane backs up from the tarmac, you look out your window and notice a cargo plane used by FedEx that is loading large storage containers into the plane that fit perfectly within its hull, and take up every inch of the plane’s interior to maximize space and safely deliver whatever needs to be delivered.

“That’s pretty cool.” You say to yourself.

As you are taxiing down the runway and preparing for takeoff, you look out your window again and notice some military personnel loading a large plane with supplies on heavy-duty pallets that you’ve never seen before, in addition to some large structures that can only be described as movable bedrooms or offices.

“Huh”, you say to yourself, “I didn’t know there was so much that went into supplies and troop housing and movement…interesting.”

Our flight is about to take off, and you think to yourself how cool it would be if you knew who made those clever looking pallets, storage containers, and structures that house our troops.

“Well, time to get some rest.” You say to yourself.

You recline your seat at 30,000 feet, and right before you drift soundly off to sleep, you also think to yourself: “Man, I wonder who the heck supplies all these parts and maintains all these airplanes in good working order?”

As you enter a dreamlike state, those thoughts leave your mind as quickly as they entered…

Wake Up!

I have good news for you. There IS a company that does ALL these things at the same time! Welcome to AAR Corp. (NYSE: AIR).

AAR Corp. is a diversified company that provides products and services to the aviation/aerospace/defense industry, which includes airlines such as Southwest, and the military and its contractors like Northrop Grumman.

AIR provides end-to-end services to these industries in 4 basic business segments. Within these 4 segments lies the brilliance of AAR’s dynamic investing opportunity as they all play off of one another, and feed into the company’s bottom line.

A Diversified Company in Multiple Expanding Fields

4 Business Segments:

The company operates within 4 business segments:

• Aviation Supply Chain (50% of sales): In this segment AAR does everything from parts trading and arbitrage (buying and selling parts), to supply chain management and stand-alone parts repair for the aerospace and defense industry.

Within this segment AAR takes care of everything a customer needs from finding and locating parts, to buying and selling those parts, refurbishing them, and finally, managing and storing them for customers until they need them.

• Maintenance, Repair and Overhaul (MRO) (20% of sales):AAR provides major maintenance inspections, line maintenance, aircraft modifications and upgrades to the world’s major regional and cargo airline fleets, and for the U.S military and government agencies.

Broken down further, these MRO checks and repairs are done every year (shorter maintenance 10 day checks), with heavy airframe maintenance every 4-5 years (30 day checks). The heavy checks are the granddaddy of MRO, which entail basically stripping down the airplane and building it back up. AAR sends the engines out for repair, but do all other maintenance on the airframe, and source the parts from the parts group of their business.

• Structures and Systems (25% of sales): This business segment is heavily weighted towards defense with over 88% of sales coming from the government and defense contractors, and only 12% to commercial entities.

This segment is comprised of 3 units:

Mobility Systems, in which AAR manufactures, designs and repairs pallets and a wide variety of containers and shelters in support of military and humanitarian tactical deployment activities.

Cargo Systems, in which AAR designs, manufactures and installs in-aircraft cargo loading systems.

Composite Structures, in which AAR designs and manufactures advanced composite materials for commercial, business and military aircraft as well as advanced composite structures for the transportation industry.

• Aircraft Sales and Leasing (about 5-10% of sales): This segment accounts for the smallest slice of their revenue pie and profit, but is a core part of their business, and often can lead to higher margins when they sell an older airplane from their fleet. Activities in the Aircraft Sales and Leasing segment include the sale or lease of used commercial jet aircraft.

Let’s Talk About the Company

Addressable Market

US military and defense spending will continue and could possibly increase in the foreseeable future.

In addition, the aerospace industry is growing like gangbusters with more and more people flying, and countries like China and India increasing demand for more planes and specifically, the types of services that AAR offers when those planes need to be repaired.

There are 18,000 airplanes in operation today, and that number is expected to double in the next 20 years!

In fact, growth is pegged at about 50% for transatlantic travel by 2013, with similar increases in the US and Europe alone, and almost double in Asia!

According to the Aerospace Industries Association (AIA), the US aerospace industry was highly successful in 2006, with total deliveries surpassing $184 billion, up more than 8% from last year’s $170 billion. While sales increased across the board for nearly all product and customer categories, most notable was a 21% surge in the civil aircraft sector.

The AIA projects that aerospace industry sales will grow another $11 billion to over $195 billion this year, as the Defense Department’s purchases and the space sector increase slightly while commercial aircraft, engines and parts deliveries jump another 15%.

AAR Corp. is poised to grow well above that industry growth rate for the foreseeable future.

Company Growth/Financials

AAR Corp. has been on a tear in the last few years as their business has expanded into new markets, while they have also grown their current market base with new clients, new business segments and expansion of current business segments.

The question for us now is, not what AIR has done in the past, but what they will do in the future.

Let’s take a look at the growth trends within each segment of AAR’s business over the last 3 years, and the total for the business:

2005-2007 Sales/Gross Margin Per Segment (In Millions):

As we can see from this table, AAR’s sales in each segment has seen steady growth, aside from the Sales and Leasing segment because the inherent nature of buying and selling aircraft creates a more “lumpy” earnings and margin story.

Let’s now take a look at each segment’s growth year-over-year as reported in the company’s latest earnings release on September 19th for their Q1/’08 period ended August 31st, 2007:

Q1: 2007-2008 Sales / Gross Margin Per Segment Comparison (In Millions):

Gross margin increased in 2 segments and decreased in 2 segments.

What alarms me more about this quarterly report, is that AAR seemed to “make their numbers” by selling 2 aircraft in Q1/07. I’m going to be watching this very carefully over the next few months and reporting period.

While sales did increase at a nice rate of 27%, as did margins, it was disturbing to see margins fall so much in the MRO segment year-over-year, and for 2 airplanes to be sold in their Sales and Leasing Segment to make up the difference in profit (they still missed analysts estimates by $.03 per share, the first time in years.)

I’ll be keeping an eye on these numbers for further signs of trouble.

Here’s a look at AAR’s Income Statement and growth percentages from 2005-2007, with 2008 estimates where applicable:

2005-2007 Sales/Income/EPS Figures:

(Note: All figures are in millions, except for EPS, and Diluted Shares.)

Once again, we don’t care necessarily where AAR Corp. has been in terms of numbers, but where they are going.

It’s obvious that sales are still growing nicely, and are expected to do so this year, acquisitions notwithstanding. On top of that, AAR is still growing net earnings.

But the laws of large numbers always catch up to companies, and that’s what’s happening to AAR.

As they make more money and earnings, it’s also harder to grow the top and bottom line by the same amount from year to year. The question for us then becomes, are the shares fairly valued for the potential growth from here on out, and obviously, they are, or else I wouldn’t have even gotten this far in my analysis.

What does need to be watched though, are the margins. Their latest quarter, as illustrated above, was less than stellar on the earnings front, and on the margin front.

Now, one good or bad quarter does not make or break a company, but I will be watching these trends going forward.

Also, any acquisitions that AIR makes, will determine whether these numbers increase or decrease, but if history is any guide, AAR is great at buying small companies that they can easily incorporate into their business, and are accretive to earnings without diluting shareholder value.

Margin Trends:

Looking at a company’s margins is critical to understanding their past performance and future prospects. Usually, businesses start out with smaller margins and they expand over time as the business becomes more efficient, and scales.

Let’s take a look at AAR’s margin trends and outlook for 2005-2008:

Lets take a look at the margin trends for the last 5 quarters:

AAR is doing a great job of expanding their margins, but lately, that trend has slowed and reversed.

Even so, they have still been able to drop more profit to the bottom line with less and less top line (or total sales) growth. This is exactly what you want to see from a company, the aforementioned margin problems notwithstanding.

The estimates in the first chart for ’08 are taken from analysts’ estimates as well as my own predictions about the business. I am being ultra-conservative in my assessment of this year’s margin trends because of the acquisitions that AAR is still trying to get a handle on (see my post about the most recent analyst conference call), and other one-time items that are going to erode their margins slightly this year.

However, that being said, I am sticking with AAR because I feel their margins will improve and expand going forward, and once that happens, if you aren’t already in the stock, it’s too late. The key is to spot trends and performance metrics before they occur on a large scale so that you can benefit by owning the stock.

Once AAR improves their operations at their flagging acquisitions, and cleans things up some more, and stays away from any more funny business selling aircraft to make quarterly numbers, I believe they will be on a strong upswing.

Valuation:

Below I will outline some brief valuation metrics. To get a complete break-down of my reasoning behind these, please refer to the complete research report on PeakStocks.com under the “Research Reports” section in a few days.

AAR Corp’s stock looks like a bargain at today’s prices (around $30 per share).

There is no one company that does exactly what AAR Corp. does. There are some companies that do MRO, some that do some parts, some that do some leasing, but none that do ALL the things that AAR does, and therefore, it deserves a premium for being a best-in-breed company for its diversity in all 4 segments that it competes in.

But for the purposes of putting some type of valuation on the company, I will offer up some comparables for valuation’s sake.

• Let’s start with the P/E ratio:

AAR’s trailing P/E ratio is 21.66, the industry average is 23.25, representing a discount of about 7%. This is for the aerospace/defense products and services industry.

I personally feel that AAR isn’t really in this industry at all, but more in their sister industry of “Air Services” of which Limco-Piedmont (Nasdaq: LIMC), an MRO provider competitor is a part of.

If you use this industry, the average trailing P/E ratio is 29.84, which then puts AAR at a discount of about 38%!

But this doesn’t tell the whole story. You see, the aerospace/defense industry is growing at about 13% year over year while the “air services” sector is growing at about 13% per year also, and AIR is growing in the high teens, about 18%, so by this measure, AAR is trading at about a 40% discount in terms of it’s valuation to growth multiple.

• Now Let’s Look at the Price to Sales (P/S) Ratio:

We can now take this one step further and look at the price to sales ratio, the ratio of a company’s total revenue, to their share price.

If we use the examples above again, we see that in the Aerospace and Defense Industry, the average TRAILING P/S multiple is 1.3, and for the Air Services industry it is 1.89.

Let’s take this down the middle, and be conservative, and make it about 1.5.

AAR’s P/S multiple is 1.08.

Again, if we were to take the average P/S of both industries, and then take the lower one for the aerospace and defense industry, we come up with AAR being undervalued by 40% using 1.5 P/S for the average, and undervalued by 20% using the much more conservative pure aerospace and defense industry’s multiple.

• Finally, let’s look at the Price/Earnings/Growth (PEG) Multiple:

The final valuation multiple that I would like to look at is the PEG ratio, or the P/E ratio divided by Projected growth.

Any multiple that is around 1 or less is considered a bargain for this metric based on the forward growth of a company.

AAR’s earnings are projected to grow at 18% for the next 5 years, and specifically, about 25% for the next 2 years (22% this year and 29% next year).

Based on these values, with a forward P/E ratio for 2008 (based on earnings per share of $1.73) is 17.9, and 13.8 for 2009 (based on earnings per share of $2.24).

This gives a forward PEG ratio of: 17.9/18 = .99 (2008) and 13.8/18 = .76 (2009).

Now, AAR just released fiscal 1Q/08 earnings a few weeks ago, and they missed analysts’ estimates for the first time in 12 quarters (3 years!) by $.02.

Every other quarter for the last trailing 3-year period, they have at least met, or beat estimates. I expect that trend to continue and look for margin improvements that will drop straight to the bottom line.

Not only is a PEG ratio of below 1 cheap, but AIR is growing earnings over the next 2 years at a much higher rate, at about 25%, which would make their PEG way below one, and if they beat earnings like they always do, it won’t be long before others realize that this stock is also dirt cheap as well.

Why I Invested In the Company

• AAR Corp. represents a fantastic risk/reward profile when you take into account its current share price, the continued growth of the company and the overall industry, and the improving fundamentals.

• Specifically, when I look at the valuation of AAR corp. compared to its peers, there is a significant discount with the shares trading around $30. By my calculations based on forward earnings, improving margins and cash flow, AAR is trading at about a 30-40% minimum discount to where it should be. We are getting a cheap stock here with little downside and a ton of upside potential.

• Margins are improving. Aside from a slight hiccup this year, margins have been steadily improving and are expected to do so over the next few years. This represents a sweet spot for us as we can buy a company that is starting to really scale their business and squeeze more and more profit out of it, which in turn, creates more value for us as shareholders.

• US military and defense spending will continue and could possibly increase in the foreseeable future. In addition, the aerospace industry is growing like gangbusters with more and more people flying, and countries like China and India increasing demand for more planes and specifically, the types of services that AAR offers when those planes need to be repaired. There are 18,000 airplanes today, and that number is expected to double in the next 20 years!

• AAR is a diversified company, operating in 4 primary segments as outlined above, with no segment representing more than 50% of total revenue, and each one showing double digits growth. AAR is a diversified company that does not depend on any one segment of their business to remain functional.

• At the same time, the beauty of their operations lies in the synergies that exist between all their business segments. If you are using them for MRO, you are probably also going to be using them for parts, and supply chain management.

Likewise, if you are getting parts from them, you are probably also using them to refurbish, store and maintain your parts.

Also, if you are leasing airplanes from AAR, you are probably using them for MRO AND Supply Chain management.

The only segment that doesn’t overlap is the Structures and Systems segment, but this is a good thing, as it ads another layer of protection and diversification to their business portfolio if the other segments underperform.

• There are no direct competitors that do exactly what AAR does. Although there are companies that compete with AAR within each segment, there is no apples-to-apples comparison because no one is as diversified as AAR is within the aerospace and defense industry.

• AAR is expected to grow earnings at about 25% for the next 2 years and about 18% over the next 5, with total revenue growing at a high teens rate, far outpacing the industry average. I think these numbers are conservative because AAR is using capital to make acquisitions and expand their business. In addition, acquisitions are made with cash, and NOT stock, so shareholder value is not diluted.

• Seasoned management. The CEO owns about 2% of the company (a large number at a company this size) and has been at the company for over 28 years and has been CEO for over 11 years. The rest of the management team is just as tenured and focused and in total own about 4.25% of the company.

Possible risks

• The war in Iraq and other military operations. Obviously, the very first thing you need to worry about with any company that relies on the government for 30% of their income, is that it will eventually dry up.

• Adverse affects in the aviation industry. After September 11th, 2001, the aviation industry took a big hit that took years to overcome. If something like that happens again, less people will travel, there will be more unused planes, and less need for repairs and parts for those planes. AAR’s sales will be immediately affected in a negative way.

• Hiring enough skilled workers. This is a bigger concern than you might think. Finding skilled, trained and qualified workers in this industry is easier said than done, and competition is fierce. In fact, AAR has had to turn down business as a result of not having enough workers on staff!

• Dependence on debt to finance the business. AAR has not had a free cash flow positive year since 2005. This is a disturbing trend and fact.

This last quarter however, Q1/08, they did become cash flow positive, but not free cash flow positive.

I’m ok with this for the most part because you have to spend money to grow a business, and with a big business like AAR Corp., it can take years to see the fruits of your labor, but this is definitely something to keep an eye on.

• Deteriorating Margins. If margins don’t improve, as I believe they will, and as management has said they will, it won’t be long before fundamentals deteriorate and the business suffers.

This can include needing to tap the equity markets for more cash and diluting shareholders further, making less and less cash to finance the business, and finally, a shrinking growth rate as the company will be forced to pay more attention to their cash position, and have less money for acquisitions and business expansion which can all become a vicious cycle that leads to the overall business trending downward for years.

• Other risk factors. Things like options scandals, margin deterioration, losing business, losing customers, increased costs, overall market volatility, etc. Pretty much anything that can go wrong within a business is a risk factor, but the ones listed previously are the main risks to the business, with these being secondary, and possibly primary, risk factors going forward that all businesses need to worry about.

The Bottom Line

AAR Corp. is a well diversified company that is trading at a significant discount to the market and its peers. In fact, because AAR has no direct peers, it should always deserve a premium valuation to the sector and industry in which it operates.

The fact that it doesn’t is good news for us as it presents an excellent buying opportunity for a stock that we can hold on to for years to come.

Further, AAR is one of the leaders in the Parts and Supply Chain segment for Aviation/Aerospace and Defense contractors.

No one does it better.

If you need someone to handle your airplane or other vehicle parts (AAR now is doing supply chain management for non-airplane parts as well), you come to AAR Corp. From start to finish, from finding the parts to refurbishing them, storing them and maintaining them, AAR has been doing this for over 50 years, and there are few companies that can even come close to the total package of services, logistical operations and expertise that AAR has.

In terms of their Maintenance, Repair and Overhaul (MRO) segment they are rapidly expanding this unit, and making acquisitions as well as contemplating more acquisitions to further bolster their place among the better MRO companies around.

More and more airlines are outsourcing this segment of their business as they don’t want to deal with the added logistical headache that it causes, and focus more on their core enterprise of getting people from point A to point B.

As this trend plays out, AAR will be there to further service these individual companies through added capacity, acquisition, or other strategic partnership/relationship that should see them grow and expand this area of their business.

In their Structures and Systems segment, demand continues to be strong on the military front, as well as civilian needs from different states, and governments from not only the U.S., but from around the world as well.

The only thing that will slow this segment down is a change in the war status.

Finally, more and more airplanes are being needed for the increasing travel around the world. The growth in China, India and other countries for more planes is voracious.

As a result of this need, AAR will be called upon going forward to supply more and more airplanes for lease within their niche of 10-15 year old planes, and then be able to tie in all their business segments into this: supply chain for the parts for the planes, MRO to fix the planes.

AAR is a diversified company that does not depend on any one segment of their business to remain functional.

At the same time, the beauty of their operations lies in the synergies that exist between all their business segments.

If you are using them for MRO, you are probably also going to be using them for parts, and supply chain management.

Likewise, if you are getting parts from them, you are probably also using them to refurbish, store and maintain your parts.

Also, if you are leasing airplanes from AAR, you are probably using them for MRO AND Supply Chain management.

The only segment that doesn’t overlap is the Structures and Systems segment, but this is a good thing, as it ads another layer of protection and diversification to their business portfolio if the other segments underperform.

If there was a negative with their business, it’s their debt. They are carrying over 300 million in debt, and they haven’t had a free cash flow year since 2005 because of all their growth and expansion. I’m ok with this, as long as we see some return within the next year or so.

Put it all together, and you get a well-oiled machine that has been doing this stuff for over 50 years, and slowly expanding their business through smart acquisitions and expansions, while letting underperforming segments go.

Steady management, as well as consistent returns on capital and financials, has allowed AIR to average 100% returns in their stock for the last 5 years.

While we don’t pay for past performance, I believe that as long as AAR keeps doing what they are doing: improving margins, growing sales, running a tight ship in term of shareholder dilution and acquisitions, we will see returns from here on out of anywhere from 15-30% per year, with less risk than some of the other picks in my portfolio.

That being said, I believe AAR Corp. is a steady and greatly run company that should be added to your portfolio as a buffer to more risky stocks, not to mention the outperformance against the overall market that is to come going forward.

Disclosure: Author has a long position in AIR