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AAR Corp. (NYSE:AIR)

F3Q08 (Qtr End 02/29/08) Earnings Call

March 19, 2008 8:30 am ET

Executives

David Storch - Chairman and CEO

Rick Poulton - CFO

Tim Romenesko - President and COO

John Bowman - Director of IR

Analysts

Troy Lahr - Stifel Nicolaus & Company

Larry Solow - CJS

Tyler Hojo - Sidoti

Jon Braatz - Kansas City Capital

Alex Hamilton - Jesup & Lamont

Stan Mann - EMS

J.B. Groh - DA. Davidson & Co.

Eric Hugel - Stephens

Arnie Ursaner - CJS Securities

Operator

Good day, ladies and gentlemen, and welcome to the AAR Corporation third quarter fiscal 2008 earnings call. (Operator Instructions)

I would now like to introduce your host for today's presentation Mr. John Bowman, Director of Investor Relations. Mr. Bowman, you may begin, sir.

John Bowman

Thank you, Howard. Good morning, ladies and gentlemen, and thank you for joining this morning's conference call.

Before we begin, we would like to remind you that certain of the comments made today relate to future events, which are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Please refer to the forward-looking statement disclaimer contained in the press release issued last evening, as well as those factors discussed under Item 1A entitled "Risk Factors" included in the company's May 31st, 2007 Form 10-K. By providing forward-looking statements, the company assumes no obligation to update the forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

At this time, I'd like to turn the call over to our Chairman and CEO, David Storch.

David Storch

Thank you, John, and good morning to everyone. Joining me today is Tim Romenesko, our President and Chief Operating Officer, and Rick Poulton, our Chief Financial Officer.

Let me begin by saying that we had an exceptional quarter by virtually any measurement or dimension, where we experienced record quarterly sales, net income and earnings per share. Sales grew 39% to $376.6 million and income from continuing operations grew 31% to $20.3 million. Diluted earnings per share were $0.47 for the quarter, which included $0.01 loss per share on the early extinguishment of debt. While acquisitions contributed meaningfully to the results for the quarter, organic sales, which excludes sales growth from acquisitions, grew an impressive 25% year-over-year.

If you were to further back out the aircraft sales from both periods our growth rate would have been 19%. We achieved 10.1% operating margins and if you were to back out the effects of the acquisitions and the aircraft sales, margins on our organic business would have been 10.4%.

Sales were $151.2 million in the Aviation Supply Chain segment, an increase of 11.5% from last year, and gross margin improved 200 basis points to 24%. Gross profit increased 22% to $36.3 million. During this period, we generated sales from investments made in prior periods, which contributed to double-digit sales increase. Sales of our MRO segment grew 43% in the quarter to $74.8 million. Gross profit increased 53% to $11.1 million, resulting in a gross profit margin of 14.9%. Steady performance at our Indianapolis maintenance center and Landing Gear businesses, resulted in market share gains which drove the exceptional sales and earnings growth in this segment.

At the conclusion of the quarter, or I should say at the beginning of the new quarter, the fourth quarter, we completed the acquisition of Avborne, which will add a valuable dimension to our MRO position. The business is located at Miami International Airport, a very busy airport, with a high traffic pattern and access to international routes, and rounds out our MRO services by adding wide-body and Airbus capabilities.

We look forward to the opportunities this business brings and along these lines just last week, there was an aircraft at MIA that required a return-to-service maintenance, the aircraft was brought over to our facility. And this maintenance required landing gear repair, folks from our Landing Gear operation, about 10 miles away from MIA airport, came over to the airport and provided the repair on the landing gear, while our aircraft maintenance folks worked on the repair to the aircraft. And we're successful putting that aircraft back up into the sky same day. The customer, who is not a current customer of our heavy maintenance operations, was very pleased with the service we performed, and next week our folks would be meeting with this customer to talk about how we can capture more of their maintenance.

In the Structures and Systems segment, our organic sales growth rate was 17% fueled by strength in our mobility systems business and the overall sales growth rate in the segment was 75% after the impact of the Brown International and SUMMA acquisitions are included. Gross profit grew 84% to $16.4 million resulting in a gross profit margin of 14.8%.

During the quarter, we announced that we signed a lease to occupy 90,000 square feet in McClellan Business Park, formerly McClellan Air Force Base, in Sacramento, California for the manufacture of composite structures and parts and this is an area, where we are seeing increasing demand. We expect the business to come on line during the first quarter of our fiscal 2009.

Just to clarify, McClellan Air Force Base was closed as a result of the BRAC Base Realignment Act of 1994, and we have another operation at that air field. They became aware of this opportunity, and we were able to sieze upon it in this quarter. We will have a minimal investment and we expect that to have a very dynamic business out of that facility.

Our Aircraft Sales and Leasing segment delivered another strong quarter. As a reminder, results for our Aircraft Sales and Leasing business are reported two ways; first we purchase and sell aircraft for own account results of which flow through our income statement as sales and cost of sales. Second, we enter into aircraft transactions with partners, which are characterized as unconsolidated joint ventures and are reported within the earnings from aircraft joint ventures line our income statement.

During the third quarter, operating profit for the segment increased $3.1 million compared to year ago, even though you do see a reduction income on the face of P&L from aircraft joint ventures. The increase in operating profit of the segments reflects a gain from the sale of two of our aircraft from our own account. As of February 29th, we had a total of 37 aircraft, 29 of which are held in joint ventures and 8 of which are held in AARs fully owned portfolio.

Furthermore, I would like to comment that as a result of the financial market turmoil, we do expect more opportunities to emerge in this market. SG&A cost for the company increased in the quarter, as a result of the acquisitions and as we continued to invest in our business. However, as a percentage of sales SG&A cost declined to 9% versus 9.1% in the prior year.

Net interest expense increased to $6.1 million in the third quarter due to increased average borrowings and lower investment income. In February the company issued 250 million of convertible notes through a private placement. Proceeds after acquiring these associated note hedge and transaction fees were $215 million and were used in parts payoff the outstanding balance and our revolving credit facility, which slightly, largely related to the acquisition of SUMMA and the investments we have made in parts for our Aviation Supply Chain business.

In addition during the third quarter the remaining balance of the 2004 convertible notes of $16.4 million were converted to 880,000 shares of our common stock. These shares were already included in our share count. Subsequently, at the end of the third quarter we bought back 13 million of our 8.39% notes due in 2011. As a result of these actions, we expect interest expense to decline in the fourth quarter.

In closing I might say that we achieved double-digit sales growth in each of our segments, added a significant dimension to our Structures and Systems business mix, and strengthened our liquidity with recent financing. As we assess risk and seek opportunities like the rest of you, we're paying very close attention to capital market volatility, the economic environment in the United States and abroad, and rising oil prices and their impact on our industry and customer base.

With that, I'd like to thank you for participating on the call today, and open up the line for any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question or comment comes from the line of Troy Lahr. Mr. Lahr, your line is open.

Troy Lahr - Stifel Nicolaus & Company

Thanks. Structures and Systems had good margins. I guess you're seeing the favorable mix there towards containers. How much longer does that continue forward? Does that run forward next three quarters, four quarters, just give me some insight there?

David Storch

Yes. The mobility business has a very strong backlog. The mix is favorable. We're continuing to see opportunities for new business for new products. So, we feel good about the prospects. They're both from volume and mix for a while. Whether it's three quarters or nine quarters, I don't know, but the backlog is good for at least another year.

Troy Lahr - Stifel Nicolaus & Company

Okay. Thanks. And then, just that I'm clear you talked a little bit about outsourcing opportunities. We've been kind of waiting for some time to hear other Mesa or Chautauqua size transactions. Is the activity there increasing now that we're kind of getting into a tightening environment, the ongoing negotiation that you've had of this kind of an accelerated with some airlines or just can you update us there a little bit?

David Storch

I would say that there is a good amount of activity, some large, some medium and some small. And they run the gamut from the various customers we support. So, at this point, I think that the activity level --

Troy Lahr - Stifel Nicolaus & Company

Has it been kind of accelerating or just kind of been about the same?

David Storch

I'd say it's about the same. I think there are several opportunities that we're working on out there.

Troy Lahr - Stifel Nicolaus & Company

Okay. And then, just lastly, and then I'll jump back in the queue, can you maybe talk about the composite business that you acquired, how quickly do you think that ramps up, and maybe what markets are you targeting? I mean is this more commercial aerospace or defense type applications for composite work?

Tim Romenesko

It's not a business we acquired. It's a facility that was fully equipped by the US Air Force back in the '90s for composite manufacturing. So, we are a "let's see if you will" of a facility. It's a long-term lease. And as the lease progresses, the equipment inside the facility becomes the property of the company. The opportunities are in the commercial aerospace space, defense, as well as the business jet and general aviation segment. So, it's pretty much across the board.

We have, as you know, a composite business already in existence located in Clearwater, Florida. It's been very busy. It's somewhat limited by the number of autoclaves. In this particular lease, we pick up four additional autoclaves, two of which incidentally have never been turned on. So, the reason that we expect to ramp-up in our first quarter, which is beginning in June let's say, is because the facility needs to be reenergized, then reopen basically.

So, we see a fair amount of demand, or I should say excessive demand in this area. We have the talent we believe in-house. We've actually hired some additional folks to go ahead and build this into a very productive segment within AAR. To a certain extent, I think one way of looking at this business is very similar to how you might look at Indianapolis for MRO business. I think it's an opportunistic move by the company in an area that appears to be chockfull of demand.

Troy Lahr - Stifel Nicolaus & Company

Okay. Just so I'm clear then, I mean is some of the Clearwater work getting offloaded to this facility or all that work is going to stay at Clearwater?

Tim Romenesko

No, the work that's in Clearwater will stay in Clearwater, and this will be new work that we will attempt to attract. Now we might get that plan started by shifting some work elsewhere from AAR into the facility, at least, gets off and running. But once we get over the early stages, we do expect to attract new business.

Troy Lahr - Stifel Nicolaus & Company

Great. Thanks, guys.

Operator

Our next question or comment comes from the line of Larry Solow from CJS. Your line is open, sir.

Larry Solow - CJS

Good morning. Could you just maybe talk a little bit about the impact you're seeing around the major airlines cutting in domestic capacity? Recently Delta have made announcement yesterday. Would this capacity be switched to the international front or how's that going to play, how you think that will play out?

David Storch

If you take a look at the growth that we've experienced in our Aircraft Sales and Leasing segment, a lot of that growth has come from our ability to acquire aircraft in the US market, and then place those aircraft into international markets. Demand for air travel does not appear to be easing at this point in time.

As I indicated in my comments, we are obviously watching this to see what the effects of the US economy might have on domestic travel. So some of the older technology aircraft may be parked, but we do believe that if newer technology aircraft get parked they will be placed elsewhere. We view that as an opportunity both for our aircraft sales and leasing segment, as well as for our supply chain, and pass it our for MRO to put those aircraft back into service with another operator.

So, although we believe that you might have some comedown here in North America, we don't believe that worldwide travel or traffic numbers are declining.

Larry Solow - CJS

Okay. Now then a similar question just looking on the international front, would you say that -- I know we have discussed this before a lot, but with the continuing of the weakening dollar would you expect maybe more opportunities for international airliners to actually be bringing their planes in to North America for work?

David Storch

We have received some increase along those lines. We've yet to secure any business on the heavy maintenance side. We're hoping that having this Miami business will facilitate that opportunity and but time will tell. At this point in time the exchange rate obviously is favorable on this regard and it might lead to certain opportunities for the company. I would expect this, incidentally more obviously wide bodies than narrow bodies. Narrow bodies don’t have go across the ponds, but we might see some opportunities along these lines.

We clearly are seeing some benefits on other businesses from the exchange rate and we are working diligently on the structures and systems business in that regard. Keep in mind, all of our manufacturing capabilities is in North America, so we do see that as a potential opportunity for the company.

Larry Solow - CJS

Great, and if you could just lastly just discuss a little bit, I believe the SUMMA acquisition if I am not mistaken was like a $100 million annualized revenue. If you could just discuss that and then the Avborne acquisition and how Avborne maybe compares to Indianapolis and I know it is small to say, but I believe the capacity is probably not as small it looks on numbers basis. So if we can just kind of compare with the annualized or potential revenues for those two acquisitions. That will be great.

David Storch

SUMMA is a very exciting acquisition for the company and that puts another leg on our stool within our Structures and Systems group. Our Structures and Systems group even today consist primarily of the mobility activity, as well as specific manufacturing of products for cargo systems and then we have a composite leg and the SUMMA gives us what we believe is the foundation for an aircraft parts manufacturing piece of our Structures and Systems group. So you are correct in terms of the annualized revenue base.

We are hoping to be able to build from that. SUMMA has very good relations, very time-tested relationships with major OEs in the aircraft manufacturing business and we are hoping to capitalize on those and be able to hopefully as result of this move in to McClellan. McClellan will be able to benefit from some of the deep ties SUMMA has with maybe this OEs. So the SUMMA acquisition if you are correct in terms of the size, but I just to want to highlight the fact that it does bring us the potential, that we did not previously have within our Structures and Systems business. So SUMMA is not a bolt-on. SUMMA is kind of adding a leg to our stool.

As it relates to Avborne, Avborne is similar in terms of basic fundamental capability within the Indianapolis, other than SUMMA has, I mean Avborne had some success on Airbus airplanes and also wide-body aircraft, the hangars are built in such a way that they can accommodate wide-body aircraft and also Avborne gives us a location that we believe is a very important location as we round out our MRO capability here in North America. So, Avborne is more of a bolt-on than Summa might be, yet Avborne does bring us certain dimensions that we didn’t previously have.

Larry Solow - CJS

Okay. Great, thank you.

Operator

Our next question or comment comes from the line of Mr. Tyler Hojo from Sidoti. Your line is open.

Tyler Hojo - Sidoti

Good morning, guys. I guess this is just a follow-up to that Avborne question. I guess Rick, last conference call you provided kind of an annualized revenue figure for Summa. Would you guys be willing to do that for Avborne?

Rick Poulton

I think the number there is a little more challenging Tyler because of whether we decide to work narrow-bodies, wide-bodies, etcetera. So, I think we’ll hold back from providing that number now. I think the best thing you could do is you can interpolate a little bit on the square footage base. I think, you also know, what our acquisition prices, and can sort of hone in as a multiple of revenue from that. As we get maybe a firmer mix on where we will with the workload then maybe we will better positioned to give you some better guidance.

Tyler Hojo - Sidoti

That’s fair. And know you provided the square footage for Avborne. What is the current capacity utilization in that facility?

Tim Romenesko

Tyler, Avborne is busy, there are kind of lot of airplanes coming in out of there. But it is not a nose-to-tail shop like your custom to see in it Indianapolis. So, one of things that we expect to bring in there is maybe not all in place, but we should allocate more of the capacities in nose-to-tail.

So, it's very busy, when I was there last week I actually have 15 aircraft around the facility, but some are in there for overnight checks, some are in for two days check, some are in there for 60 days. So, it's little difficult to characterize at the same way you might characterize Indy.

Tyler Hojo - Sidoti

Okay. Thanks for the color, Tim. And just in terms of that kind of your longstanding, longer-term margin target that has been out there 12.5%. I didn't hear you guys kind of reconfirm it. Is that still intact?

Tim Romenesko

Yes.

Tyler Hojo - Sidoti

Okay, great.

Tim Romenesko

Yeah, as we make some of these acquisitions, there is, some of these acquisitions have margins below even the 10% that we're looking at and so we have some challenges. Yeah, we view there are many opportunities to go ahead and get margin improvement.

Tyler Hojo - Sidoti

Okay, good. And just a final one, a follow-up to the first questionnaire, just in terms of the supply chain opportunities out there, I think last conference call David you mentioned that your thought something relatively meaningful could hit kind of in the back half for your fiscal year. You still stick in to that or as it maybe pushed a little bit further out to the right or any comments that would be helpful.

David Storch

Of course, half of that first, second half of the year has gone away. We didn't make any announcement.

Tyler Hojo - Sidoti

Alright.

David Storch

So, obviously we're now in the last three months. There is a possibility of at least one of these hitting this quarter, but I'd push out some of the balance just based on the -- the overall gestation period I'd push out the balance in to next year, but if I have to say, as you recall last quarter's supply chain we had sales growth of less than 10% there was 8 in change I believe. This quarter we say we will come in above -- against the double-digits we came at 11.5. There is no shortage of opportunities in that business segment and some of them are program related, some are look like programs, but we're not calling them programs, let's put it this way the pace of business is very brisk.

Tyler Hojo - Sidoti

That's fine and actually just one more for you. It look like the MRO segment, the results were terrific there. Actually, one of your competitors came out late last week and they blamed some bad weather in Oklahoma for kind of a revenue miss in their Tulsa facility. Was there any kind of negative impact in the number?

Rick Poulton

Oh, we definitely saw the bad weather.

Tyler Hojo - Sidoti

Okay.

Rick Poulton

But no significant impact in our operations.

David Storch

We didn't have the magnitude that they seem to have had.

Tyler Hojo - Sidoti

Very, good. Thanks.

David Storch

Let me just reiterate, what you said incidentally that is the growth rate within our MRO segment was truly exceptional 43% growth rate that's all organic I believe it's around as we've talked about before, it's around execution, our MRO team is executing I think beautifully and customers are very satisfied with the work load and looking for AAR to take on more work if we can and I really would like to just congratulate Tim and his team in this regard, because they're doing heck of a job, it's not -- like this business is just hanging up there for somebody to grab and this is you're talking about 43% growth rate in a market that is relatively flat. And my sense is that this is all about our team performing and getting that kind of a growth rate.

Tyler Hojo - Sidoti

Great, thanks.

Operator

Our next question comes from the line of Jon Braatz. Mr. Braatz, your line is open.

Jon Braatz - Kansas City Capital

Last couple of weeks, we've been hearing some stories in the press about MRO work at Southwest or issues with maintenance operations at Southwest and there is stories in Asia about Asian MRO work. How do you view that? Is that a positive maybe from a long-term standpoint, is the FAA gets a little bit tougher or are there some other issues that might develop that in more paperwork or more work for you guys. But, how do you view all this talk about MRO, I mean, the maintenance work on aircraft both domestically and internationally?

David Storch

Yeah, the MRO business is a very detailed oriented business, obviously you're talking about safety of flight and we at ARR understand that. We've been in the MRO business through our Oklahoma operation for many years. We are very focus around the detail of the work that we do, having the paperwork, having the training in place as you recall, each of our technicians receives training, pretty much every year, the last three or four years, we've received the Diamond Award from the FAA for having every technician at AAR goes to training. Now, it's a very complex putting the aircraft through a maintenance cycle is a very complex process.

In the case of Southwest, managing a fleet as wide as they are is very complex. And I think everybody has pretty much reiterated its safety record as the world’s airlines is truly remarkable. There is a chain, if you will a safety chain. They are the major part of and this is an area that we stay very focused on and pay a lot of attention to the details, and the procedures, and the processes, and the paper work and all that kind of stuff. So, I think if you look at the world that we’re in is a kind of flight-to-quality, then I think quality providers will be in a very good position to benefit. Back here there are some folks who are not necessarily as adept or as detail-oriented as this business requires.

So, I feel very good, our head is down if you will, and we’re making certain that we have, we're doing all the things we're supposed to do and we're paying a lot of attention to this segment and it's really no different than we always have. I mean, this is as I said; it’s a very detail-oriented business and you got to pay attention to a lot of different things. And they are from time-to-time, they are slips and the important thing is that the organization has processes in place to capture these slips before they become a problem. So, I believe overall that in the general flight-to-quality lets say, as long as we continue to execute the way we are, we should be a beneficiary.

Jon Braatz - Kansas City Capital

Does the FAA have any, I guess mandate or a power to suggest, that airlines move from one provider to another or is it or kind of the sort of the mandatory type of call on the part of the FAA. So, this MRO provider is not meeting standards, you have to move.

David Storch

I believe that's within the power of FAA. The FAA has oversight and all of the licensed facilities that carry FAA designation. So they have the ability to monitor on a minutes notice. They have the ability to send staff and teams into facilities that have a certificate. They have the ability to go through their procedures to make sure they are operating within the regulations and if they deem them not to be operating within the regulations, they have the ability to pull their ticket.

Jon Braatz - Kansas City Capital

Okay.

David Storch

From time-to-time over the years, they have exercised that privilege.

Jon Braatz - Kansas City Capital

Right, okay.

David Storch

I think in terms of them officially recommending a vendor, one vendor versus another to their customers probably not in their purview. But I mean, you obviously listen when two guys are having a discussion. It probably might not be uncommon for somebody to give an opinion to somebody else and that can always happen.

Jon Braatz - Kansas City Capital

Okay, thank you very much.

David Storch

Okay.

Operator

Our next question or comment comes from the line of Alex Hamilton from Jesup & Lamont. Your line is open sir.

Alex Hamilton - Jesup & Lamont

Hi, good morning. Just, can you provide some sort of color on the sales and leasing market given the liquidity and credit concern? Has there been any change to liquidity, has there been any change to financing rate? That would be appreciated?

David Storch

Well, that's a complicated question. Let me try to answer this succinctly as I can. Clearly there is obviously at least US, maybe it is international liquidity crunch, which we are very well aware of. We are currently our fleet is fully leased. We have recently actually renegotiated a couple of leases in our favor, where the leases have rolled over and the new rate is at a higher number than the old rate.

In terms of the sales of assets in the quarter that we concluded, February 29, we were successful in selling two of our existing aircraft on a cash basis to the buyers who either had the money or financed it. And on the side of availability and I think what we are trying to signal in today's conference call, my comments was that we believe that the liquidity pressures on some of the players will create a certain amount of opportunity. And we are paying very close attention and talking with those who have been publicized to have liquidity problems on owned aircraft and those who might not be publicized but may in fact have liquidity concerns.

So we are fairly optimistic in this regard that as a result of some of the liquidity pressure that there will be aircraft opportunities for our aircraft sales and leasing business. Now we are raising our hurdle rate to take into consideration the overall risk environment. So we would anticipate kind of looking out for positive, maybe the option, the last choice let say, because we have to pay very close attention to the acquisition prices that we pay for these assets, keeping in mind our view at least of the risk profile of this market. So all of that -- what I am trying to say in this fashion, as I can say is that we are aware that there are owners of aircraft who have liquidity concerns, problems I should say and we believe we're in a good position to benefit from that.

Alex Hamilton - Jesup & Lamont

Great. Thank you.

Operator

Our next question or comment comes from the line of [Stan Mann from EMS]. Your line is open, sir.

Stan Mann - EMS

First, congratulations on a great quarter. I mean it is fantastic.

David Storch

Thank you.

Stan Mann - EMS

I have some couple of detailed questions financial. Can you give us the D&A, the regular D&A going forward and the acquisition D&A going forward. I have a couple of questions I am trying to model?

Rick Poulton

So D&As for the quarter was $10.4 million which brings you to our year-to-date, right at $30 million, just slightly shy of $30 million.

Stan Mann - EMS

Okay.

Rick Poulton

That reflects a full quarter of all the acquisitions we made, other than Avborne, which obviously just closed at the beginning of this quarter. So I think that rate for Q3 is a pretty good run rate, you have got adjust for current CapEx and then later on something for Avborne. I don't have that Avborne right now, but it tends to be the more labor intensive and capital intensive business, so it is...

Stan Mann - EMS

So it is not major. $1 million or $2 million in the quarter or something like that?

Rick Poulton

Yeah, the only caveat to that is we do have purchasing accounting to apply to the acquisition that will create some amortization. That wouldn’t otherwise have been in a P&L. So I don't have that number handy. But I mean you could do based on a purchase price and some general allocations you could probably estimate that probably of course easily.

Stan Mann - EMS

Okay, what about the net debt and the diluted shares going forward?

Rick Poulton

Diluted shares is something that what you see right now in the current quarter; should not change dramatically. You have a little bit of ups and downs for either stock repurchases on our part or some option exercises or things like that. But that’s pretty minor. It wouldn’t be until we got to a much higher stock price than we're now, that you would see any dilutive effects from the recent convert we get.

Stan Mann - EMS

Is that 35, is that a 35 area or…?

Rick Poulton

Little over 35, correct.

Stan Mann - EMS

And the dilution at that point would be…?

Rick Poulton

It comes in under a treasury stock method of accounting. So, it’s a function of what the actual stock price is at that time.

Stan Mann - EMS

Okay.

Rick Poulton

So, you shouldn’t see any real share change until you get into the $35 plus stock zone and it begins to come in slowly. On the net debt, you see from the press release, what our recourse debt looks like at this juncture. As David mentioned earlier, we did contract to, we entered into a repurchase agreement to buyback some money, some amount of our secured notes. And beyond that it’s a function of what we do with our cash and how we invest in our business. So, I think I am more comfortable telling you that gross debt, you can see that. And then we have a fair amount of cash on hand at the end of the quarter and will deploy that as we see business opportunities.

Stan Mann - EMS

Okay. Storch does it look like in India as far as buying or utilizing more space?

David Storch

Do you saying India.

Stan Mann - EMS

Indianapolis, Indi.

David Storch

Okay. What's the first item?

Stan Mann - EMS

Yes, kind of more space and activity etcetera. Are there similar bays that you were talking about.

David Storch

They are major contributor to the MRO results for the quarter. We are not at full capacity yet and we're getting good use of the space that we are currently occupying. There is some additional space for us to occupy. We are in discussions with the landlord about trying to figure out how to get more space at that airfield one way or another. So, at this point in time that business is strong. The demand is strong. I believe that some of the short-term capacity opportunities that we might see, that we can't handle there, part of our plan is that some outwork would be done down in Miami. So, Indianapolis is strong. We can tell we are seeing some benefits from some of the sideline activities including engineering services.

This is an area we highlighted. Stan, you might recall, couple of year back we started to get some traction here this quarter. We hope to build on that key segment of our business as well and sell more of our intellectual property to a customer base who is looking for those kinds of solutions.

Stan Mann - EMS

Is UAL a leasing agent there, I mean are they the owner of the rest of facility.

David Storch

No.

Stan Mann - EMS

So they are not.

David Storch

No. The owner of the facility and do not hold me to this, this is an airport authority. That is basically backed up by the state of Indiana, the city of Indianapolis and there are some bond holders that obviously have positions now in that facility as well. So, we deal with the airport authority and in fact we are looking right now for ways to even take on more space in the Indianapolis.

Stan Mann - EMS

Beyond that facility, in addition…

David Storch

And potentially there is a couple hangars in that facility that we do not control, they are controlled by others.

Stan Mann - EMS

Okay.

David Storch

The regional airline...

Stan Mann - EMS

Okay. The recent announcement of some of the airlines paring, cutting their capacity domestically, is that what’s giving you availability of aircraft to buy and you're leasing and purchase agreements?

David Storch

We haven't seen that yet. We saw that, we’ve see kind of steady -- that’s going to be steady piece of the business let say, if I go back to '03. So we saw some of the benefits back when the airlines were reducing capacity in the '03, '04, '05 time period. So we made some investment in assets during that time period, which we've been able to place elsewhere. In this current, let say, thrust we have not seen serviceable airplanes that hit the market. We have seen airplanes for disassembly that hit the market and we have procured some of those in prior periods.

Stan Mann - EMS

So the opportunities you're seeing are taking it on from the existing leasing companies because we -- AAR is more liquid and stronger than the current leasing agents?

David Storch

I think then that was part of the strategy behind our offering in February was to get us additional liquidity and put us in a stronger position to the benefit from this movement and I think the results are bearing out. Clearly, these markets are not growing at the growth rate that this company is achieving. So, we think we are in a unique position. Our niche continues to expand. We're looking at different opportunities in this regard, and I think having a strong balance sheet obviously position us to take advantage of those opportunities.

But at the same token, we're trying to do thing that don't require balance sheet. I mean the Indianapolis business, we have very small investments in Indianapolis yet, it's a major contributor today to our growth rate both sales and earnings. And I singled earlier about the moving to McClellan Air Force Base and also is a very minimal investment on our part, because we have a strong balance sheet, sometime when you have a strong balance sheet, you don't need to use it to go ahead and get some opportunities. So, I think that's part of our strategy as well.

Stan Mann - EMS

Right, the last question is; do we have anything going on in Asia as far as MRO?

Tim Romenesko

We have a landing gear venture in Malaysia.

Stan Mann - EMS

Right.

Tim Romenesko

That is, just coming into its own more or less not fully online, it's more or less today, more of a store front that eventually will be a full service repair facility. But no other than that stand at this moment, we do not have other physical facilities in that region. We do have sales offices throughout Asia that are managing the relationships with different Asian accounts and, but for the most part we are servicing those customers from our North American facilities.

Stan Mann - EMS

But that could be a stepping stone, a fiscal stepping stone into Asia?

Tim Romenesko

In time, we need to have more Asian content; more Asian mix in our business and it's something we're focused on with the weak the flip side to the weak dollar is the inability to move into some of these markets advantageously. So, for today at least, we're able to get some growth servicing these businesses from North America. But long-term, you're correct the company is going to need more capability in that region.

Stan Mann - EMS

Okay. Good job. Thank you.

Tim Romenesko

Thank you.

Operator

Our next question or comment comes from the line of Mr. J.B. Groh. Mr. Groh, your line is open, sir.

J.B. Groh - DA. Davidson & Co.

Good morning. Thanks for taking my call. I popped on late, so if you addressed this just differ and I'll dig it out of the transcript, but you adjusted lease rates a little bit. Could you maybe talk about trends there, do you still see those going up holding firm, you mentioned one renewal that you had that was at a higher rate, but could you maybe make more general comments there on overall lease rates?

David Storch

My sense is that with all of the stuff going on in the world today, that lease rates will probably stay fairly steady to where they are today. Some of the opportunities that we've recently experienced are from aircraft leases, maybe three to five years old and they were rolling over and keep in mind, five year ago lease was in the depths of a kind of aerospace recession or whatever you want call it and lease rates were historically at very low levels.

So, you're seeing some reset in that regard, coming out of that '03, '04 time period, maybe even '05 and as those mature and turnover I should say, the lease rates are more attractive. But I think from this point forward, I believe that the lease rates ones they, ones you're come off the bottom of that period, I just identified. I think the lease rates stay fairly constant.

Now, that's assuming that things stay relatively constant. So, if things where to get worse again, and you'd see a reduction in lease rates. But I think for right now, the aircraft are in short supply worldwide at this point of time, and the more efficient the aircraft is, the more in demand the aircraft is, so we've been focused on more efficient aircraft and making sure that we can keep those aircraft out with good credits and so far we've been pretty successful in that regard.

J.B. Groh - DA. Davidson & Co.

So, what are you saying is old lease rates rolling over you probably get a positive bump up, but as far as current rates are going, you look those to be steady and maybe you've got the fuel headwind that's probably causing those rates to the sort of stay in the same range they're now?

David Storch

I think that pretty much says it.

J.B. Groh - DA. Davidson & Co.

And maybe you can talk about your the market for used aircraft and I'd assume that moves not a lock step, but same sort of trend as maybe the overall commercial production and what your strategy is there, I mean I'm guessing that it's A320 family, 737NG type acquisitions.

David Storch

Yeah, I think we haven't yet moved into the NG arena. We are looking today at opportunities in that market, but yeah, the A320 is something we're trafficking in and most of our activity has been in the 737 Classic family, like for instance the acquisition of 18 aircraft from Malaysian Airline system those were 737-400 that were 1992 to 1997 vintage aircraft. And so if you look at the majority of our portfolio would be in that vintage, yet there is a movement for us at least to move that a little bit more current, if you will.

J.B. Groh - DA. Davidson & Co.

What's the average lease period that you have on the books?

David Storch

The average lease of, the kinds of deals that we're entering are mostly in the three to five year range and we do from time-to-time. We are acquiring, looking at aircraft that have longer lease period, maybe coming off of some of the 20 year, 25, 20 year leases, where we come in after the 50 year or something like that. So, but I'd say generally speaking the lease rates for the aircraft that we are trafficking in are in the 3 to 5 year range.

J.B. Groh - DA. Davidson & Co.

Great, hey thank you for your time and congratulations on the quarter.

David Storch

Thank you.

Operator

Our next question or comment comes from the line of Mr. [David Ratlis from Dulcet Company]. Your line is open, sir. Mr. Ratlis you may need to un-mute your phone, sir. Okay, we will return him to the queue. Our next question or comment is from Mr. Eric Hugel from Stephens. Your line is open sir.

Eric Hugel - Stephens

Good morning guys. Good quarter.

David Storch

Thank you.

Eric Hugel - Stephens

Hey, can you talk about, I know in the past Dave you talked about the Aviation Supply Chain margin sort of typically bouncing around in the 22 to 24 range, for now this is like the second quarter in a row that we've been at the 24 or sort of a high end of that range, is there something sort of structurally that you've changed, you've improved in this business or are we susceptible to sort of those numbers dropping back down?

David Storch

Well, we have a leading position in this market. We've been in this business since our founding. So, we understand the aircraft parts market as well as anybody else in the business. We've been able to benefit from our strong balance sheet position. We talked about back in the second quarter in particular, where we acquired fair amount of inventory and that inventory has starting to flow through our system.

We have meaningful sales coming out of the investments we've made in the second quarter. We continue to make investments in the third quarter and we've even continue to make investments in the fourth quarter in this business.

So, I believe that we've been able to make pretty attractive acquisitions of equipment, and I think you are seeing some of that benefit there in the margin. So how long that sustains itself is a tough question.

We're very pleased with the performance of that group and the 24, you are correct, is the upper end to the margins, yet there are still some elements to that business. Our component repair shops, for instance, there are some opportunities there to improve performance. We recently announced a contract for some Army helicopter component repair that should contribute to improved margins in that business.

But I think on balance, I think you pretty well said it. I think that we can fluctuate between that 22 and 24. We're running at the high end. How long it stays at 24, I can't really say. We haven't seen a change in trends, but it doesn't mean that there can't be circumstance or situations that may cause that to dip down.

Eric Hugel - Stephens

Okay. Fair enough. Can you talk about, I guess, in terms of your overall operating margin number, I mean you are at that now for a second quarter in a row. You've achieved that 10% sort of target that you had set out. You've got Summa now in the mix, and I'm assuming that there was some nice purchase accounting associated with that in this quarter, yet you still maintain that. You got Avborne coming online. I mean, is it your expectation that with some of these headwinds coming out, I guess, additional purchase accounting that you'd be able to maintain that 10% operating margin going forward?

David Storch

Yeah. Listen, as we make these acquisitions, they've been a little bit of a drag on the margins. So, as we try to normalize the business, my opening comments that the sales growth was 39% if you back out the acquisition. So if you just looked organically, sales growth was 25%, and then if you back out the year-over-year aircraft transactions, sales growth was 19%. We reported 10.1% operating margin, but if you backed out the acquisitions and you backed out the aircraft transactions, operating margins would have been 10.4%.

So, the acquisitions we've made have been a little bit of a drag on operating margins for some of the some reasons that you identified. And over time, as we integrate these businesses, it would be our goal to see the operating, these be contributors to our operating margin business. It might be a little tougher for the Avborne business because, by nature, the MRO business has tougher operating margins. But also keep in mind, there is less investments in those business. So, return on capital has been a better measurement for the MRO businesses.

Nevertheless, we would expect Tim has numerous initiatives going on around the company. We have lean initiatives in our Indianapolis business, in our landing gear business, in our components shops in New York, and hopefully, eventually in Amsterdam. So, we were looking for ways to drive efficiency through the company.

Going back to the performance, goals of the company, we recognize that the growth that we're getting today is largely, we believe, due to taking market share and we're taking that market share because we're performing. We're performing for the customer, but we also recognize, we need to perform for the shareholder. So, in that process we hope to continue down that path of getting to that 12.5% target.

It will be, it goes in is and goes out is, and as we absorb these acquisitions at first blush they are a drag, and then, hopefully, we're able to execute and get these margins going in the right direction.

Eric Hugel - Stephens

With regards to Summa, was there a significant amount of inventory step up that hit you this quarter that would pretty much washout during this quarter and you wouldn't have that headwind going forward?

David Storch

No, Eric, nothing that is isolated on a quarter.

Eric Hugel - Stephens

Okay. With regards to Southwest, I guess in the mix of all of these sort of maintenance troubles that they are sort of going through, one of the interesting things that they sort of announced was that they were planning on moving four lines of maintenance to El Salvador, which now they've shelved those plans, and they said all those lines were outsourced in the US to providers.

One, were any of those sort of planned lines of maintenance, anything that you guys are doing with them at Indy?

And two, are there potential discussion or is there an opportunity that you potentially see now that they are killing those plans to outsource those lines to El Salvador they're going to keep them domestic to get some more additional business there?

Tim Romenesko

So, Eric, the lines that were going to go were not coming out of Indy. Southwest is good customer and we're working with them everyway we can to support them. We've helped them get some of their aircraft back to service, and we're constantly talking to them about ways to be more helpful.

Eric Hugel - Stephens

The Southwest issues in terms of their maintenance lapses and check, that's all internal to Southwest. That does noting do with third party MRO providers, does it?

Tim Romenesko

Correct.

Eric Hugel - Stephens

Okay.

Tim Romenesko

As David mentioned, it's largely around the paperwork.

Eric Hugel - Stephens

Okay. Also, United, they are a sizeable customer at Indy. They're talking about taking 15 to 20 aircraft out of the mix. They're talking about older domestic aircraft, which to me means their 737s, 300s and 500s, their oldest aircraft in the fleet domestic and you are the exclusive provider of all that maintenance. Are there plans right now, are you in discussions about reducing the number of lines, and then you would have to fill in some additional lines? I know they are flying about 95 37's right now. So reducing 15 to 20 is not the end of world, but is there a potential here that as we get into the back half of the year that you're going to see a line reduction?

Tim Romenesko

There is always a potential. But right now that's not the nature of the conversations we're having with United. So we're prepared for that if that were to happen, but that's not what we're hearing.

Eric Hugel - Stephens

Okay. Tim, can give us an update on where things stand with the component repair business and getting those margins up? I mean we've been, I guess, slower than hoped for, for the last couple of quarters on the trek up from breakeven up to high single digit operating margins. Can you give us sort of a trend of where things are and how much far that we have to go?

Rick Poulton

David has touched on it in his comments. We've got a good start in that. We've won some business recently, some meaningful business. And I think you probably saw that release. We've strengthened the leadership of that business recently that we think is also going to have an impact. We're investing in some process improvement initiative there.

So, as David said, I think there is still plenty of upside there but we are starting at the early stages of seeing some improvement.

Eric Hugel - Stephens

Would you say that right now, that sort of business in terms of operating margin is mid single-digit?

Rick Poulton

Yes.

Eric Hugel - Stephens

Okay, great. And then the lastly, just sort of a numbers question, give CapEx for the quarter?

Rick Poulton

Eric, I say mid single-digit or about.

Eric Hugel - Stephens

Okay.

Rick Poulton

CapEx Eric is just under $80 million for the quarter.

Eric Hugel - Stephens

Great. Thanks a lot guys, good quarter.

Rick Poulton

Thanks.

Operator

(Operator Instruction) We have a follow-up from Troy Lahr from Stifel. Your line is open, sir.

Troy Lahr - Stifel

Thanks. Just a follow-up question on Indi, you guys talked a lot about still seeing good customer interest there looking to expand the facility. How is the labor market been there? Have you seen improvements there?

David Storch

I'd say modest improvements, but still I'd say relatively tight.

Troy Lahr - Stifel

Okay. So are wage rates still pretty higher now or have you seen wage rates come down a little bit?

David Storch

Well, that's so much around the wages I wouldn't say, wages have not come down. I think it's an industry-wide maybe even beyond industry-wide problem getting attracting skilled technical labor.

Troy Lahr - Stifel

Okay.

David Storch

Certainly not unique to Indianapolis.

Troy Lahr - Stifel

Sure. Okay. And then regarding SUMMA Technology, the integration, are you fully done with the integration or can you just maybe update us on that? Did you see any surprises, once you actually acquired the business, kind of maybe what you experienced with Rev Air bear how it cost you a little more to integrate some of that, anything going on like that in SUMMA?

David Storch

I think the integration has gone quite well. There has been some real solid positive that we have seen and really not any significant negatives.

Tim Romenesko

Troy, I would just add to that as David said, it's a additional leg on the stool, so the level of integration I think it's fair to say was a lot lower than it would been at Hot Springs acquisition.

Troy Lahr - Stifel

Okay. And then lastly at the MRO business, I guess couple of quarters ago, you had some problem aircraft contracts comes through, some problem aircraft. Any more of that do you think that's a kind of behind you and kind of understand what have been and you are on the same page with the customer now about what aircraft coming through your facilities?

Tim Romenesko

Yes.

Troy Lahr - Stifel

Can you elaborate or just--?

Tim Romenesko

No, I mean those issues are well behind us. I think they were a point in time a couple quarters ago and we are not experiencing those difficulties with those airplanes.

Troy Lahr - Stifel

Okay. Are you reworking any additional MRO contracts trying to get better pricing on any of those? I think you went though that in the past on one contract, just wondered is that ongoing?

Tim Romenesko

There is no specific contract kind of contract renegotiation going on. As we look at Avborne and bring on new customers, but I don't think is there anything going on right now in terms of renegotiating the contracts.

Troy Lahr - Stifel

Okay, thanks guys.

Operator

Our next question or comment is a follow-up from Mr. Tyler Hojo. Your line is open sir.

Tyler Hojo - Sidoti & Company

Two quick follow-up. Just in regards to the Indianapolis facility, how many bays are you currently utilizing?

David Storch

Tyler, it changes fairly frequently, but I think at last count we were booking out of eight bays. And we're getting ready to bring the paint bay on as well.

Tyler Hojo - Sidoti & Company

Okay. Great. And lastly, just in terms to your aircraft portfolio, I believe the last time you commented just in terms of the number of aircraft purchase pre-9/11 was the first quarter when there were six. How many are on the books as of today?

David Storch

Three. I didn't hear -- the question is on the pre-9/11 aircrafts on the books, three.

Tyler Hojo - Sidoti & Company

Three? Okay, great. Thanks.

Operator

Our next question or comment comes from Arnie Ursaner from CJS Securities. Your line is open.

Arnie Ursaner - CJS Securities

Hi, good morning. Two very quick questions. One is on the cash that you have on your balance sheet, can you give us a feel for if you have any exposure auction rate notes and what sort of rates you're getting on the cash.

Tim Romenesko

No auction rate notes.

David Storch

No exposure, Arnie, and what earnings on that cash, you know, somewhere between 300 and 375 bips.

Arnie Ursaner - CJS Securities

Okay. And just to be clear, on Southwest did you receive any emergency repair work on this recent announcement, and if so, did it displace other work that you already had in hand?

David Storch

Arnie, we helped Southwest in some of their outstations doing remote overnight inspections, so it didn't displace anything.

Arnie Ursaner - CJS Securities

But if you did work in their sites, you had to obviously take some of your key personnel to their site to do it?

David Storch

It was not disruptive to our operations in any way.

Arnie Ursaner - CJS Securities

Okay. Thank you very much.

Operator

Our final question will be from Mr. Larry Solow. Mr. Solow, your line is open.

Larry Solow - CJS Securities

Just one real quickie, any update on the Airbus A400 contract and is there any potential to see revenues in calendar 2008?

David Storch

It looks like it's going to be early '09, Larry, when deliveries begin. We're continuing to work with our prime contractor and with Airbus to get the cargo system design finalized and the manufacturing ramped up. So it looks like it's going to be early '09 when it starts to impact revenue throughout.

Larry Solow - CJS Securities

Great, okay. Thanks.

Operator

Gentlemen, we have no additional questions or comments in the queue at this time.

David Storch

Okay. Well, thank you very much for participating and hopefully we were helpful here today, so have a nice day. Bye-bye.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.

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Source: AAR Corp. F3Q08 (Qtr End 02/29/08) Earnings Call Transcript
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