AAR Has Significant Upside Potential

| About: AAR Corporation (AIR)

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In AAR Corp's (NYSE:AIR) case, we think the firm is undervalued. We think it is fairly valued at $25 per share.

For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. AAR Corp posts a VBI score of 6 on our scale, reflecting our 'undervalued' DCF assessment of the company, its attractive relative valuation versus peers, and bearish technicals. We use Rockwell Collins (NYSE:COL), Goodrich (NYSE:GR), Precision Castparts (NYSE:PCP), and Spirit AeroSystems (NYSE:SPR) for our peer group analysis. We include Goodrich for information purposes, as it has been taken out by United Tech (NYSE:UTX).

Our Report on AAR Corp

Our report on AAR Corp and hundreds of other companies can be found here.

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Investment Considerations

Investment Highlights

AAR Corp's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.

AAR Corp's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

The firm's shares have underperformed the market benchmark during the past quarter. Although AAR Corp's valuation appears attractive, the company is currently exhibiting characteristics of a potential value
trap, and we'd still be cautious at these levels. There may be a better entry point yet.

The firm's shares are trading at an attractive level at this time, and we are taking a closer look at picking up some of them in the portfolio of our Best Ideas Newsletter. In the spirit of transparency, we disclose the performance of our Best Ideas Newsletter below:

The firm experienced an operating cash flow CAGR of about 85.5% during the past 3 years. We expect its operating cash flow growth to be better than its peer median during the next five years.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. AAR Corp's 3-year historical return on invested capital (without goodwill) is 7.8%, which is below the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. AAR Corp's free cash flow margin has averaged about 3.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At AAR Corp, cash flow from operations increased about 69% from levels registered two years ago, while capital expenditures expanded significantly more over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that AAR Corp's shares are worth between $19.00 - $31.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $25 per share represents a price-to-earnings (P/E) ratio of about 14.9 times last year's earnings and an implied EV/EBITDA multiple of about 6.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 8.6%. Our model reflects a 5-year projected average operating margin of 7.6%, which is above AAR Corp's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.5% for the next 15 years and 3% in perpetuity. For AAR Corp, we use a 8.6% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $25 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the
markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for AAR Corp. We think the firm is attractive below $19 per share (the green line), but quite expensive above $31 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate AAR Corp's fair value at this point in time to be about $25 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of AAR Corp's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $33 per share in Year 3 represents our existing fair value per share of $25 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: PCP is included in the portfolio of our Best Ideas Newsletter.

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