AAR Corp: Good Earnings, and It's Going to Get Better

AAR Corp’s (AIR) recent earnings report and analyst conference call was nice and boring, just the way I like earnings reports to be. Within the “boring” report, there were some interesting highlights and year over year improvements to the company’s margins, bottom and top line, and overall improvements in the business, that further strengthen AAR’s position in the marketplace and my investment thesis for shares of AAR corp.

Let’s Start With The Numbers

We’ll start by taking a look at each of AAR’s segments' growth year-over-year as reported in the company’s latest earnings release on December 18th for the Q2/’08 period ended November 30th, 2007:

Q2: 2007-2008 Sales / Gross Margin Per Segment Comparison (In Millions):

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

But those margin decreases were more than offset by the gains in the MRO segment, and the Aviation Supply Chain segment, leading to an overall gross margin increase from 18.8% to 19.4%, which is huge for a mature business like AAR.

In addition, sales increased an incredible 27.2% year over year, with margins also expanding! This is a sign of a healthy business.

The bulk of this gain was in the MRO division, because the new facilities in Indianapolis was brought up to speed, and all the problems ironed out, to yield better turnover and higher margins.

Now, let’s take a look at the Income Statement for the same reporting period.

Q2: 2007-2008 Sales/Income/EPS Figures Comparison (In Millions):

Again, comparing year-over-year increases from Q2 2007/2008, AAR has across the board, increased all its important metrics.

In addition, top and bottom line are growing at about the same rate, which is good to see. It means AAR isn’t falling behind in its capital structure. Also that expenses are being kept under control while sales grow, thus allowing AAR to keep its margins intact.

In other words, AAR isn’t sacrificing margins for higher sales; it is doing both at the same time, growing total sales, and keeping the profit from those increasing sales the same year over year.

Finally, shares were hardly diluted at all from year to year, which is another positive I like to see.

However a word of caution on this note: as previously stated, because of AAR’s debt, and recent acquisition strategy, it is more than likely that it will need to issue more debt and/or shares to increase its capital position. So this metric might deteriorate in the near future, but be sufficiently offset via the gains made through these acquisitions and accretive gains that these acquisitions will make to its top and bottom lines.

So for the coming year, I see it as a wash between increasing number of shares and dilution, and increased revenue and earnings per share.

Margin Trends

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

Here are the margin trends for the last 6 quarters:

AAR is doing a great job of expanding its margins. The slight blip in this trend in Q1/08 was because of one-time problems in its MRO division that have since been remedied, as evidenced by the sharp margin improvement in Q2/08.

AAR has 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.

I feel AAR’s margins will improve and expand going forward even more, 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.

As long as AAR continues to improve its operations at its flagging acquisitions and cleans things up some more, I believe it will continue to be on a strong upswing as one look at their last 6 quarter margin trend proves.

Conference Call Highlights

While the conference call and earnings highlights were “boring” in that there was nothing earth-shattering, or revelatory in them that would significantly change my investing thesis either positively or negatively, there were still some important points made in the call that I will highlight below:

Comments on Sales:

• 21% of AAR’s 27% total growth was organic. This means its core businesses are still contributing in a healthy way towards growth.
• 25% of AAR’s revenue is coming from outside of the U.S.
• No impact in its leasing segment from the credit crisis.

Comments on Margin Improvement:

• Operating margin improvement: while AAR reached 10.1% operating margins this quarter (which was a short term goal of the company), longer term, it is still looking at 12%. But that time frame is more nebulous, and a few years out.

The company will intend to expand these margins through sales growth, SG&A leverage, by improving underperforming businesses, and by increasing income from its leasing business.

Comments on all 4 Segments:

Aviation Supply chain segment:

• There was a $75 million inventory bump this quarter, which it believes will lead to double digit growth in this segment (as opposed to 8% this quarter), due to extra sales from those purchases. The inventory was mainly from purchases of older aircraft that it will be disassembling for parts.
• As far as the component business, the company is not as tight with that as it would like to be, and will continue to “attack” that side of the business to improve it.
• Aviation Supply Chain: “Pipeline is strong” stated CEO David Storch when asked if he could comment on any new products or contracts that might be coming through for their aviation supply chain segment.

He also stated that growth will accelerate, and that there is nothing “wrong” with the business. They are merely focused on high quality sales instead of volume.

When asked why things were slowing down, management said they could have had more sales in this segment this quarter, but didn’t because they were focused on margin improvement.

Maintenance, Repair and Overhaul [MRO]:

• Strong growth, sales grew 54%, from prior year. This was a HUGE increase, mainly because of sales ramping at the Indianapolis facility.
• Issues were addressed from last quarter that depressed margins in their MRO segment in both the Oklahoma and Indianapolis facilities.
• The operating efficiency question came up again in terms of the facilities in Indianapolis [MRO].

Last quarter management stated that they were running at a 4, when asked how efficient this facility was operating on a 1-10 scale.

This time when asked the same question, management wouldn’t give a number, merely saying that things were greatly improved over last quarter, and that they got the results they were expecting. However, they said, there are still opportunities to improve and reduce span time, and to get better.

• Indianapolis facility usage: still has room to grow (hanger space still available), and they said there are possibilities to expand that side of the business, through things like line maintenance, which do not consume hanger capacity. There are other “ideas” to further expand and grow.
• Between 7-9 Bays out of 10 are being used, and lines have been added for certain customers.
• CEO David Storch was asked about comments he made concerning increased MRO demand coming from Europe into the U.S. because of the weakening dollar, at the CSFB Conference a few weeks back.

When asked to clarify, he stated that it used to be that U.S. carriers would outsource their MRO operations to Europe, and more recently, Asia, but that that trend might be turning around because of the weakened U.S. dollar.

He said that while there is nothing definitive or imminent, there has been interest from the part of European carriers about potential MRO operations by U.S. contractors, like AAR.

Structures and Systems:

• Sales increased 28%, margins improved as AAR benefited from a more favorable product mix sold than last quarter.

Sales and Leasing:

• AAR has a much larger portfolio of aircraft than last year, and sold 2 aircraft and purchased 1 aircraft giving it a total of 39 aircraft, 29 in joint ventures, 10 in AAR Portfolio.

Comments on Recent Acquisitions:

• AAR’s CEO said they were excited about the Summa Technology acquisition. The acquisition will serve as a hub for its parts manufacturing business.
• Summa will contribute about $25 million in gross revenue per quarter. On a margin basis, this acquisition would not be accretive or dilutive to the margins in its structures and systems segment.

Further, integration will be easier than its other recent acquisitions because it’s a “launching pad” for the company in terms of parts manufacturing. Also the level of integration will be modest early on, and more synergies exist between Summa and AAR's other business segments than existed with its other acquisitions, making this a smoother transaction overall.

• As they become more comfortable integrating more businesses like Summa, acquisitions will become an important part of AAR's growth strategy going forward.
• AAR will continue to “look” at more acquisition possibilities.
• It has completed 3 acquisitions in the last year. Success in one, one was not so good, and the latest one is looking great. The company will use how these acquisitions go as a marker for possible future acquisitions.

Bottom Line

There really isn’t much more to say.

AAR had a good/great quarter, its earnings increased across the board, margins improved, and the business just keeps humming along.

I still feel there is significant upside potential in the shares.

If you haven’t already bought shares of AAR Corp., consider a medium to large purchase at these levels (around $30 or so), and look to add more on any weakness in the coming weeks and months.

Disclosure: Author has a long position in AAR Corp.