Fireside Chat With AAR Corp.'s Investor Relations

There’s a saying for those who plan on buying stocks long term: Buy and Homework, instead of Buy and Hold.

To that end, there have been some recent developments to my recent AAR Corp. (NYSE: AIR) research report and buy recommendation post.

In this post, I talk about these recent developments for AAR Corp., and followed up with some questions to John Bowman the Director of Financial Planning & Analysis and Investor Relations for AAR Corp.

Credit Suisse Presentation

First off, AAR Corp., just presented at the Credit Suisse 2007 Aerospace & Defense Conference, and recently posted the transcript and presentation materials on their website.

This is a very insightful presentation, and will give you a better understanding of the company and allow you to get to know the CEO a little bit better as he makes the presentation.

You can listen to the webcast of the presentation here.

Fireside Chat With AAR’s Investor Relations

Summa Technology Acquisition

After AAR Corp’s recent earnings release and acquisition of Summa Technologies, I followed up with some questions to John Bowman, the Director of Financial Planning & Analysis and Investor Relations.

Below are the questions that I asked John Bowman (In Bold), his responses to those questions (paraphrased in italics) and My Take below some questions.

• Let’s talk about the recent acquisition of Summa Technologies, which was paid for in cash for $65 million, as well as your overall acquisition strategy.

Largest acquisition they’ve ever done, $65 million located in Huntsville Al., which allows them to expand in Huntsville which is an important defense contracting location, more military stuff in that area.

They look for accretive earnings right away for acquisitions within 1 year. $50-75 million range for acquisitions. Looking for margin improving businesses. They use EV/EBIDTA, PE ratios, and sales metrics to quantify purchases and whether they will be accretive to AAR.

• What does Summa do? What segment will they be a part of?

Summa Technologies will be a part of the Structures and Systems segment: leans heavily towards defense, lots of OEM (Original Equipment Manufacturer) stuff, manufacturing and engineering services: precision machining: making parts that are very precise in terms of standards, precision, and better quality. Expands customer base, and business for MRO, Parts and Structures and Systems, etc. Increases their OE base, which is better in the long run.

My take: As I understood it, this acquisition will allow AAR to serve more defense contractors for the US military as an OEM. This means that when parts are needed for certain pieces of equipment, whether for land or air, contracts will call for OEM parts only, and voila, AAR will be the de-facto OEM supplier with this arrangement.

They make things like missile canisters (at right), machined parts, pallets for palletized loading systems, etc. Check out their website here.

• Does this transaction move the needle at all? If so, how much %-wise or dollar-wise?

Yes it does. $62 million in sales per year from Summa , growing about 30% per year.

• Will this be accretive to earnings? If so, how much?

Yes, in the first year. Couldn’t say how much for EPS, but top line sales will increase immediately.

My Take: Estimates for AAR’s gross sales for fiscal ’08 are for around $1.25 billion dollars. With the Summa acquisition, this would immediately jump to around $1.31 billion, with the additional EPS that would be accretive, say at least $.06-.10 per share once all the kinks are ironed out in about a year’s time.

• What was the mix of cash used for the purchase? Did you tap your credit line, or is it all from cash you already had?

The purchase was made from credit line. They might need to raise more cash later this year.

My Take: It’s good that they didn’t issue shares and dilute shareholder value to make this purchase, but at the same time, because they already have well over $300 million in debt, and only about $80 million in cash on hand, odds are that they will be tapping into the equity markets later this year and thus will probably dilute shareholders somewhat. So the way I figure it, we are at a wash for this year and this acquisition. Whatever EPS gains that Summa will provide will be offset by the shareholder dilution. Consider it a net wash for ’08, but a big plus for ’09 and beyond.

• We talked about the Summa Technology acquisition, and how you said it was more of an “exit strategy” for management of that company more than because business wasn’t great, which you said it was.

I should have asked this, but if it is an exit strategy, then why is current management sticking around? How long are they sticking around? And what will be their motivation to make the business succeed if they indeed have “cashed in their chips” so to speak?

Founder leaving, but other people staying in place, solid management team is part of what attracted AAR to Summa in the first place and they will be keeping them in place. The major shareholder for Summa was in his 70s (Pony Lee) and wanted to retire. His management team will be staying on and is very interested in continuing to drive success with Summa as part of AAR.

• You said that this acquisition would improve your commercial vs. defense bent. How so? Isn’t this a Structures and Systems acquisition? Aren’t those mostly for Defense? Does this acquisition target more retail and commercial businesses? How so?

If that is the case, how much will this affect your defense vs. commercial throughput, which stands at about 30% now towards government?

They want more defense not less, and want to do more maintenance and operations which does not depend as much on deployment and war stuff but more on keeping the military up and running. This is what Summa will help them do.

Structures & Systems is largely defense. Summa is also largely defense and therefore drives an overall higher % of defense sales for AAR in total. AAR is currently about 2/3 commercial and 1/3 defense. Their goal, over time, is to increase the mix of defense sales, and the acquisition of Summa helps them meet that objective.

A lot of stuff they do is program related, supply chain etc., not relating to deployment, there is some risk, but not as much as one might think.

Defense and commercial MRO/Parts/Structures and Systems is mostly counter-cyclical, they want to make them more in balance because they are counter-cyclical.

My Take: They want more military not less because once they are involved heavily with the military and are a trusted OEM provider, or at least a trusted source of maintenance and overhaul, the government won’t look elsewhere, and it becomes a steady stream of income and business for a long time to come.

What I once thought might be a bad thing, actually can be a very good one because it balances out the cycles in their business, ie: when commercial is down, you have government propping it up, and vice versa.

International Sales and Possible Diworsification

• What is the breakdown of sales to International Customers?

25% INTERNATIONAL (18% Europe, 6% Asia, balance is rest of the world): Aviation/Supply Chain stuff, lots of parts (2/3 –3/4 of total international sales are from this segment), trying to really expand that side of the business. Landing gear stuff in Malaysia, etc.

My Take: This is good news. With the weakness in the US dollar right now, AAR is getting more and more business and service requests from overseas. It’s not becoming cheaper for other countries to outsource their MRO, and parts to US companies, which is good for AAR as they attempt to expand their overseas market.

• Is AAR biting off more than it can chew with all the recent acquisitions? How do you remain mindful of not losing focus on your core competency?

AAR is always mindful of that, and you have to be careful, but at present, the acquisitions have been small to medium and all within AAR’s core competency and have been synergistic with current business within AAR. Going forward, management is in place to make sure all business segments remain productive, and in-line and that there is no loss of focus on core competency.

• Hiring workforce is a major concern, especially in the Oklahoma MRO operations. What is AAR doing to alleviate this problem? Going forward, will this hurt future growth and sales as it has already done?

Says it hasn’t been a huge problem, but they feel good where they are at right now. Labor market is tight, but they don’t feel that it is inhibiting growth. In the past they had to turn people down, but not anymore that he is aware of.

Partnering with local colleges and having career days and things like that to get more awareness etc.

Let’s Talk About Some Numbers

• In the Fiscal Year 2005, MRO operations resulted in total sales of $111.93 million and in 2006 $182.26 million. This represented an increase of 62% or so, what caused this to increase so dramatically?

That was the ramp-up in Indianapolis.

• In addition, will AAR be building, acquiring, or otherwise be increasing their MRO capabilities in the near future (12 months)?

TBD: Got capacity at all 3 facilities…but have been thinking about expansion because that time is coming…maybe acquire, maybe add more line maintenance, engineering that don’t take up more space.

They still have a couple of hangers in Ind. And space in OK. Still room to grow.

My Take: Listening to the CEO at the recent presentation, he mentioned this, and talked about how they still have room to grow, and aren’t worried about finding more space if they need it. There are extra bays at the Indianapolis facility that are currently not being utilized and they can always get more room if/when they need it.

• From fiscal year ‘05-’07, the Structures and Systems segment saw margins decline from 18.2% in ‘05, to 13.6% in ‘07.

Why have margins fallen so quickly? Will they be stabilizing and/or increasing in the coming year, why or why not?

Margin decreased because of fewer containers and more pallets. Containers have higher margins. Going into 2007, they moved from MI, to NC so they had more costs with the move.

Expectations, growing margins going forward. Should start turning around right away, 11.8% in F1/08 should be the bottom.

My Take: This is the margin expansion that I initially referred to in my original investment thesis. I believe we are getting a nice discount in AAR share price because of the lower margins, but once AAR proves they have expenses and one-time items under control, this will seep to the bottom line, and reward shareholders handsomely.

• The gross margin leapt for 2006 for the Sales and Leasing Segment. Why was this? Were there multiple sales of aircraft?

We need to look at operating income, margins always move around a lot depending on the sales of the aircraft etc. With their joint ventures they use the equity method of accounting and take just their portion of the profit and report it on the earnings from joint ventures line.

They internally always try and get at least a 15% IRR (Internal Rate of Return) on the aircraft sales, but the ones they have sold lately have been higher.

• The margin trends for the Sales and Leasing segment went from 7.3% to 32.5%, to 9.1%…assuming the anomaly for 2006, are these margin trends going to continue? Why or why not?

Inconsistency in buying and selling aircraft make earnings/sales/margins lumpy. When they get an opportunity to buy or sell an aircraft that meets their internal projections, they do it, so from quarter to quarter, things move around quite a bit.

• From Fiscal Q1/07 to Q1/08, Supply Chain sales only grew 12% YoY, why is the growth slowing in this segment? Were the comps. more difficult because of something in the Q1′07 period? Is this something to be concerned about?

The law of large numbers, makes it harder and harder for the % increases to increase, but the absolute terms is higher.

But operating margins will expand thus dropping more to the bottom line.

• Margins fell across the board for all segments from Q1/07-Q1/08. Why? Is this expected to continue? Shouldn’t the scale that AAR has built up lead to higher margins not lower ones?

See conference call stuff about ramp-up and margin concerns because of the customer in Indianapolis taking more time to get things going and under control, etc. Things are looking good now. They are improving.

Some planes required more maintenance to fix them etc.

My Take: This all relates to their margin decline as spoken of previously because of difficulties that were quarter-specific, not a company trend. They should get these under control, and really take off from here.

Selling Planes To Make The Numbers?

• In addition, it appears that you sold off 2 planes in Q1/08 which accounted for a huge jump in the Sales and Leasing segment’s income, margins, and then the overall margins of the company.

Why did you decide to sell 2 planes? Without this sale, it appears that you would have badly missed your numbers and more than that, the overall margins of the other segments would have brought down the entire business prospects.

I would like to know how you determine when and why to sell airplanes, and if this is a normal occurrence to “make the numbers” on a quarterly basis?

Not at all. If you check their quarterly filings, they sell anywhere from 2-4 airplanes every quarter when their internal metrics are met and it is profitable to do so. They also make acquisitions of planes again, when the metrics favor them and their long term profitability models.

My Take: Indeed this is true. AAR has sold between 2-4 airplanes per quarter over the last 5 quarters. There’s not weird stuff going on here and no trying to “bilk” the numbers.

In addition, AAR buys between 2-6 airplanes every quarter as well, with the latest reported period, Q1/’08, seeing a whopping 21 airplanes purchased. Clearly this segment of their business is ramping up as previously reported in an earlier post, and going forward will provide higher margins and earnings power for not only this segment, but also the entire company. Things are good right now in the Sales and Leasing side of aircrafts.

Another Possible Acquisition?

• In researching competitors, I looked at Limco-Peidmont (Nasdaq: LIMC) in the MRO side of things. What are your thoughts on them as an acquisition partner since they do the same thing as AAR Corp. does and is even located within the same region, and has higher margins and cash-flow and would be accretive to earnings immediately?

They have outsourced some of their component repair to them, but they aren’t a direct competitor. He doesn’t think that they would be interested in them.

My Take: Hey you never know! At least I feel good about covering the possibility of an acquisition of this small MRO operator that is a publicly traded company.

Bottom Line

There was nothing alarming in my further research into questions that I had about the company. John Bowman has been straightforward with me, and always gives very detailed answers to all my questions, and after doing further research and due diligence, I am more confident than ever that AAR Corp. is a great investment and I look forward to holding my shares and keeping up with the latest company developments.

Disclosure: Author has a long position in in AIR