AAR's (AIR) CEO David Storch on Q3 2016 Results - Earnings Conference Call Transcript

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AAR Corp. (NYSE:AIR) Q3 2016 Earnings Conference Call March 22, 2016 4:45 PM ET

Executives

David Storch - Chairman, President and Chief Executive Officer

Michael Sharp - Chief Financial Officer, Chief Accounting Officer, VP & Controller

Timothy Romenesko - Vice Chairman & Chief Operating Officer

Analysts

Larry Solow - CJS Securities

Robert Spingarn - Credit Suisse

Kevin Ciabattoni - KeyBanc Capital Markets

Operator

Good afternoon, ladies and gentlemen, and welcome to the AAR's Fiscal 2016 Third Quarter Earnings Call. We are joined today by David Storch, Chairman, President and Chief Executive Officer; Mike Sharp, Chief Financial Officer; Tim Romenesko, Vice Chairman and Chief Operating Officer of Expeditionary Services; and John Holmes, Chief Operating Officer of Aviation Services.

Before we begin, I'd like to remind you that comments made during the call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as noted in our news release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2015. In providing forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events.

At this time, I'd like to turn the call over to AAR's Chairman, President and Chief Executive Officer, David Storch.

David Storch

Thank you. Thank you very much and good afternoon to all and thank you for joining us today to discuss our fiscal year third quarter results. Overall, the businesses delivered good results in what is historically our shortest quarter due to the holidays we have in December and, of course, February, although this year we picked up one day so a shorter month than other months. I'll share some highlights on our business performance and I'll turn it over to Mike to provide more details on the financials.

Our Aviation Service business, we saw sales increase all organically of 9.7% and $30.8 million compared to the prior year. Distribution programs continued to deliver strong results driven by the ramp of recent contracts. We had a few key wins as well. Subsequent to the quarter-end, we were awarded a five-year, $105 million, firm fixed price contract by NAVAIR, for the procurement of contractor logistics support including commercial depot support and site support to the C-40A aircraft. We expect that work to commence approximately in 60 days and we're very excited about this winning this contract.

The C-40A is a 737 derivative. It's an aircraft we have lots of experience with and, as I indicated, we're pretty excited to have won this contract. We are pleased and honored that our government customers routinely turn to AAR for comprehensive solutions that rely our broad capability set, deep expertise, and scale. We believe we bring valuable commercial off the shelf programs to the government customer.

During the quarter we signed a power-by-the-hour contract with IBEX Airlines of Japan to support its fleet of CRJs. This win expands our presence in Asia and leverages the CRJ experience we currently have in North America supporting Mesa and Jazz. And on top of these wins, the pipeline for new business opportunities is strong and hopefully, in Q4, we'll be able to complete some of the transactions that are currently being negotiated.

Our MRO operations experienced double-digit growth, capacity utilization. Our hangar network continues to be strong. We also saw higher volumes in our landing gear repair, component repair and engineering business lines.

Moving over to Expeditionary Services, we saw sales decline of 8.1 million from the prior-year quarter. Mobility sales were down. Demand continues to be challenged there. But, as you know, we continue to be an industry leader with strong product offering and, if you look back in time, you'll note that from time to time that business does experience soft periods and then followed typically by periods of great strength.

We remain optimistic with what the future holds for that business, even though today we're in a soft period. We recently announced a five-year, $49 million contract with the U.S. Army for the next generation automatic test shelters, an extension of contracts we've had in the past and we're very excited to have won that contract.

Airlift revenue was up year-over-year. As we've talked about in the past, we commence operations on the Falkland contract. That begins April 1. We're operating two brand new AW189 helicopters. We've been spending the last few months in training, in preparation. There’s been a cost, if you will, that has been associated with those contracts against - costs associated with that contract running against our numbers in Qs 2 and 3 and, in Q4, that program turned positive. The aircraft are on site and all the necessary training and approvals are on schedule, so we're very excited. This will be our first search and rescue contract that we've had and we're pretty pleased with that as well.

In addition, we formally launched our Rotorcraft Services business, which offers a suite of aftermarket sport services from across AAR and is rooted in our experience as an operator of the helicopters in our airlift operation. There's pressure, there's pricing pressure coming out of the DOD on our airlift business. We expect that to continue as demand has compressed, but once again, we think in time the demand for that product, that service will improve and increase as well.

So overall, when you look at our operations, you look at our businesses, we feel very good about where we stand today. We feel good about the results that we experienced in Q3 and we come into Q4 with a fair amount of momentum.

So with that, I'll turn the call over to Mike.

Michael Sharp

Thanks, David. I will discuss our third quarter financial performance in more detail and start by saying that sales for the quarter were $402.8 million, up 6% over prior year. As David mentioned, Aviation Services sales increased $30.8 million or 9.7% higher over the prior year, while our Expeditionary Services segment reported a 13.1% decline in sales.

Diluted earnings per share from continuing operations was $0.31 and included a $1.6 million, or $0.05 per diluted share reduction in income taxes recorded in the third quarter, primarily associated with truing up certain deferred taxes.

The gross profit margin in Aviation Services was 16.8% this quarter compared with 15.9% last year. The increase in the gross profit margin was driven by improvement in certain of our supply chain programs, as well as within our MRO network, which benefited from higher sales. In the Expeditionary Services segment, the gross profit margin was slightly negative and reflects the decline in top line in the segment.

SG&A expenses in the period were 10.6% of sales compared to 11% last year. As I mentioned in our call back in December, overall, we feel good about our cost structure and the opportunity for improvement in this ratio will largely come from increasing sales.

Net interest expense was $1.6 million in the period compared with 6.4 million last year and reflects the significant decline in outstanding borrowings. Our effective tax rate for the period was 24.1% and, again, was lower due to the $1.6 million benefit. Going forward, we expect our effective income tax rate to approximate 35% to 36%.

Turning to cash, we generated $2 million of cash from operations this quarter, which reflects investments of nearly $15 million of inventory to support our supply chain activities. CapEx for the quarter was $43.6 million. This amount is unusually high and includes the purchase of one AW189 rotary wing aircraft that was also sold and leased back in the period. This particular helicopter will support the Falkland Islands contract. We also had other one-time investments in the quarter. Again, this CapEx was unusually high and we expect CapEx will return to a more normal level in Q4 in the $7 million to $10 million range.

Depreciation and amortization including amortization of stock-based compensation was $14.3 million. During the period, we paid $2.6 million of dividends and repurchased approximately 312,000 shares in the open market for $7.3 million. As of February 29, $84.1 million remains under the board authorized plan. As a result of the higher than normal CapEx, other investments in the business, and share buybacks, our net debt increased $145.3 million at the end of the period. However, our net debt to capital ratio remains a very low 14%.

Subsequent to the quarter end, we retired the remaining $25.7 million of our convertible notes. The annual book interest savings associated with the retirement is approximately $1.4 million and we will see one quarter's worth of this savings in the fourth quarter.

Thanks for your attention and I will now turn the call back over to David.

David Storch

Hey, thanks, Mike, and thank you, everyone for joining today's call.

In summary, it was a good quarter for the company. Aviation Services maintained very strong organic growth. We feel really good about that. We also feel good about our balance sheet position, and continue to evaluate opportunities to deploy capital to our shareholders' benefit.

With that, I would like to turn the call back to the operator for any questions you may have.

Question-and-Answer Session

Operator

Thank you, sir. [Operator instructions] Our first question comes from the line of Larry Solow of CJS Securities. Your line is open.

Larry Solow

Good afternoon. Thanks for taking the questions. David, in Aviation Services, another quality quarter about 10% growth on consecutive quarters. It seems to be driven by a good mixture across your businesses. Anything, trends during the quarter, you sound pretty optimistic. I mean, I know you had, at one point, thought this could be a - can maintain a sustainable high single-digit or even low double-digit top line growth. How do you feel about the business in general, and then specifically in the parts business, any commentary on that would be great. Thanks.

David Storch

So, Larry, I feel good about the business. I feel we're in a good position. The demand seems to be pretty robust. I feel good about our positioning. We're doing good work out of our shop so the heavy maintenance business has been relatively strong. The supply businesses in total have been strong. We had the trading business was a little soft in the quarter, but better than the quarter before. And we're entering the fourth quarter with good momentum across all the businesses. So we feel good about the prospects for our Aviation Services businesses.

Larry Solow

And this may be hard to measure or quantify, but maybe anecdotally with oil, although it's come back up a little bit, still I think the going belief is it'll remain well below it for the next at least near future, are you seeing some of these older planes stay on longer and with that, I guess, you would be a net beneficiary of that?

David Storch

I can't say that we're seeing anything unusual in that regard. So I believe that there is a mixture as new aircraft are coming into the system. I believe a percentage of those aircraft are for growth and a percentage are to replace some of the older aircraft. But at the end of the day, our business benefits from just having more aircraft in the system. So if you look at the Navy aircraft we'll be supporting, those are 737-700s, relatively modern aircraft, and if you look at the mix of most of our customers today, you'll see that there's a good blend of newer aircraft and older aircraft.

So I think as we move forward, I'm not sure if the price of fuel is playing a huge factor in this equation other than the airlines continue to do very well in this environment, and maintaining their schedules is important to them. So paying for the spare parts and the maintenance to be performed on a timely basis, I believe, is working in our favor. So there have been years past where airlines have deferred maintenance or they deferred inventory spend. I can't say that we're seeing that today.

Larry Solow

Okay. And on the Expeditionary Services, mobility has that taken another it looks like another leg down or is that fairly some further drop from year-over-year?

David Storch

Yeah. The mobility business has continued to surprise us to the negative. That being said, we did have a nice win on this one contract in the quarter. And I believe that business will be tough here, continue to be tough for the near term. At some point, the supplies are going to start diminishing the level of safety spares that the government maintains. And at that point, I would expect to see a pick-up in that business.

So if you look at that business from a 30-year horizon standpoint, going back, you will have noted these kinds of times where there was a downward pressure. So this will be similar to what we experienced in 1998, 1999, 2000, but again, we feel good about our leadership position in this field. We know that the product is necessary. It's just not being ordered today but it will be ordered and we'll be in a good position to deal with it. We're taking good actions around the cost side, so we're improving our competitiveness on a going-forward basis. And yeah, I think we're taking the right actions.

Larry Solow

Great. Just lastly, you guys had planned an Analyst's Day for April. Is that still in the works?

David Storch

Yeah, no, the April date, as it turned out, we had conflict in a few different things. I think now we're going back to October which is the timeframe we've historically held our Analyst's Days. We tried to see if we could do it in July, but we ran into conflicts there with June's quarter earnings results. I think that was the same problem in April, too, as I think about it. So the October period is, I think - we'll run into some September quarter pressure but we're going to hold it a little earlier in October. So that's what we're shooting for.

Larry Solow

Got you. Great, thanks.

David Storch

Yeah.

Operator

Thank you. Our next question comes from Robert Spingarn of Credit Suisse. Your line is open.

Robert Spingarn

Hi there.

David Storch

Hi, Rob.

Michael Sharp

Hey, Rob.

Robert Spingarn

So just sticking with Expeditionary. David, how do we think about - well, first maybe talk about the number of aircraft employed and what you expectations are, but then also some of the disappointment. It sounds like it's gotten a little incrementally worse than you would have expected and there's some pricing pressure. So how do we think about the number of aircraft going forward based on what you can see and then on the potential margins in this business, if this pricing pressure's going to stick around?

David Storch

So let me turn it over to Tim to address the number of aircraft and an overall snapshot as to how we see things today.

Timothy Romenesko

Yeah, so Rob, we are - we ended the quarter with the same 19 that we had on the first day of the quarter. Then we'll add three contract positions with the Falkland Islands contract. Its four aircraft but its three contract positions. The 189s are two aircraft to make one because of the location.

We'll have to see. We've got contract positions that are up, that have been rebid and we'll see if we're able to retain them. The pricing pressure is extremely difficult, and we're really not inclined to tie up our assets for long periods of time at this kind of pricing level. So we're being disciplined on our pricing and kind of taking a longer view. So we'll see. At the same time, we're also looking for the non-DoD kind of battlefield support, more search and rescue opportunities like the Falkland Islands to diversify our business.

Robert Spingarn

Is the pricing pressure demand driven or supply driven? Or is it both?

Timothy Romenesko

Well, there's excess capacity, right? There are players - if you know the helicopter market, you know that there's not very much good going on, right? The oil and gas aircraft are significantly under-utilized. The DoD aircraft are significantly under-utilized. Some of the firefighting are under-utilized. So there is plenty of assets out there. So, I guess it’s fewer requirements from our core customer combined with a glut of equipment available.

Robert Spingarn

Okay. So with that in mind, David, we've talked in the past. We've framed this business as being potentially an equivalent contributor to the other business. You know, when we do the math, if we back out the tax help, I think you earned about $0.26 in the quarter and maybe only $0.01 of that was dilution from expeditionary's loss, small loss. But to get up to where you've been in the past, for Expeditionary to contribute a like or a similar quantity of earnings, in cents per share, it sounds like a huge amount has to happen.

David Storch

Well, there's one contract in particular that happens will get us very close to that. So, I think we're defining the business in a broader sense, so we have a large contract that's been - we haven't talked about necessarily but it's been talked about that we're competing on that, if that were to come our way, that would go a long way to achieving what you just mentioned.

Robert Spingarn

Is that contract simply binary? You win it or you lose it or could you share it?

David Storch

Yes. No. Win or lose. It's binary.

Robert Spingarn

Okay. All right, thank you very much.

David Storch

Yeah.

Operator

Thank you. [Operator Instructions] Our next question comes from Kevin Ciabattoni of KeyBanc Capital Markets. Your line is open.

Kevin Ciabattoni

Hi. Good afternoon. Thanks for taking my questions.

David Storch

Sure, Kevin.

Kevin Ciabattoni

Congratulations on that C-40A contract. That's a nice win for you guys. I'm wondering if you can give us any color around the revenue cadence for the contract. It looks like the initial order was I think $2 million or $3 million, so obviously pretty small relative to the overall size of the contract, so, just kind of curious how you see that playing out over the next four to five years.

David Storch

Yeah, we believe the revenues will be more or less equal throughout the period. Now there will be other aspects which will contribute based on over and above, and things of that nature. But in essence, think of it as evenly distributed over the five-year period.

Kevin Ciabattoni

Okay. That's helpful. Any update, David, on the INL contract in terms of timing? I know last quarter you thought January, February, it seems like they're dragging their feet with that a little bit. I know there was a letter put out earlier this month, kind of calling on them to award that by the end of June/July timeframe. How are you guys seeing that today?

David Storch

Yeah, Kevin, it's out of our control. So it's in the hands of the government and we have reason to believe that they're inclined to make a decision in the next 30 to 45 days.

Kevin Ciabattoni

Have you gotten any insight into what's taking them so long to award that?

David Storch

No.

Kevin Ciabattoni

Okay. And then last one from me, on the Rotorcraft Services business, can you talk a little bit about maybe the markets you're primarily going after there and kind of what you see there in terms of a demand pipeline?

David Storch

Yeah. So we're basically saying, for the last 60 years, we've been heavily involved in the fixed wing business, supporting fixed wing operators. We really entered the helicopter market with the acquisition of the airlift business back in 2010. We've been pretty busy flying airplanes. We always thought all along that we would - part of our strategy was to move into support for these asset types, and now we have the time, if you will, and resources to go ahead and do so. So we'll be approaching a broad-based market. We'll be looking to be in the supply and the repair ends of this market. And we'll pick our spots, we'll shoot for higher margin opportunities and hopefully you'll start seeing some results coming out of this in the near term.

Kevin Ciabattoni

As a follow on to that, given the state of the rotorcraft market right now, I mean, you touched on it earlier, I guess I'd look and say, why now? What do you see is the advantage to getting into that market now just given the road bumps they're seeing there?

David Storch

Yeah, I actually think there's so much dislocation in that market right now that it's an opportunity for somebody to come in with a clean balance sheet and a clean set - a new set of eyes to look at that market opportunistically, and that's how we're approaching it.

Kevin Ciabattoni

Okay. Thanks.

David Storch

Yeah.

Operator

Thank you. Our next question comes from [ph] Stan Mann of Mann Family Investors. Your line is open.

Unidentified Analyst

Good afternoon. Good overall job. I have three questions, David.

David Storch

Okay.

Unidentified Analyst

One is, are there opportunities near-term for adding onto our Aviation Services and MRO business realistically?

David Storch

Adding on?

Unidentified Analyst

Yeah.

David Storch

So, think of the growth in two perspectives. If you look at the growth that you've seen here the last year or so, it's all been organically generated. And we have a very healthy pipeline, [ph] Stan, of opportunities. You'll see in the quarter we've made some investments in inventory to support some different activities that we have going on in that regard.

So we're still a relatively small player in a very big pond. So I think there's a fair amount - we have an ambitious leadership team. They're covering a lot of bases today and they see lots of markets that are still available for us to participate in. So I think look for organic growth in that give-or-take 10% range.

And you'll note that there's very few people in this industry growing at that rate organically. And matter of fact, you'd have a hard time pointing out any, at least, that are in the public domain that are growing at that rate organically. So we feel good about the organic growth prospects and the balance sheet is strong. I've indicated in the release today that we will look for acquisitions that make sense, and in that particular market, we're looking at a few different things. So I think our focus is on organic growth because it's fairly attractive, and secondly is look for acquisitions either bolt-on in nature or larger-scale in nature. And we have our eyes open for both.

Unidentified Analyst

Do you see anything near-term, specifically in bolt-on, in the area that we are where we're strong and growing? I have a reason for the logic that I'm trying to...

David Storch

I'd like to hear your reason before I respond.

Unidentified Analyst

Well my rationale is I'm wondering, don't fall off your chair, if it isn't time to possibly sell off or move out of this Expeditionary primarily government market, like the Telair spinoff, but create a core that grows consistently and doesn't depend on government bids. It would be seem to me that we could increase our company valuation dramatically by making a step out of an erratic business or a non-predictable. That' just...

David Storch

Yeah. So, [ph] Stan, if we were having this conversation five years ago, you would have said why don't you sell off your commercial business because you're doing so well in the defense market that why would you go ahead and minimize the progress you're making in that market by being in the commercial market? So I think if you look back in time and you've been a shareholder for a period of time, you'll note that we've had, by having this balance, we've been able to perform quite well through good times and bad times.

Now we're at an extreme point in time in that the Expeditionary businesses are at their low point, their absolute low point in the cycle. And our view is that this wouldn't be a good time to do what you just indicated because this isn't - we wouldn't be maximizing value. So we have long memories and even short memories, and these businesses are at leadership positions in their markets. It doesn't mean that we're married to these forever. Clearly, we're not.

But at the same token, I think that the strategy of maintaining this two-prong capability is the right strategy at this moment. It doesn't mean that we're not going to explore different possibilities. And we have, as you know, we have a very dynamic board group. And once a year, we do in-depth strategic reviews at every quarterly board meeting. We have discussion about the company's strategy. So we'll continue to look at what's best for our shareholders.

Unidentified Analyst

Okay. So last part is it seems to me we have a large potential stock buyback. I feel our stock is a bargain. I mean, so we have $80 million-something open, I believe, to buy in the buyback.

David Storch

That's correct, $81 million.

Unidentified Analyst

So at this point do you think that that could be a best investment option for us that we don't have M&A closed in, et cetera?

David Storch

Well, we invested $35 million or $40 million this quarter in ways that we think are going to grow the business. We also invested $7 million or so in share repurchases. I mean, my preference is to grow the business and to use our capital base to grow the business. But from time-to-time, when we deem it appropriate, we will look to opportunistically purchase the shares. But we're not looking at purchasing the shares as a strategy to growth. We're looking at the purchasing of shares as a way to balance out our performance and the use of our capital.

Right now, we're seeing some very interesting growth opportunities for the company, and we have in the period of time that we've been a net investor in the businesses and the way I'm seeing things today, I see us continuing to invest in the business as a priority to buying in the shares. It doesn't mean we're not going to buy any shares. It's just that my preference right now is to support the growth of the company and we're seeing some pretty attractive opportunities in this regard.

Unidentified Analyst

Well, I do trust your judgment. I just suggest that maybe we sometimes have too much patience.

David Storch

Got it.

Unidentified Analyst

But I'm a long-time holder...

David Storch

Got it.

Unidentified Analyst

And I see good things in areas that are not being recognized. That's the only reason for my comment.

David Storch

Got it.

Unidentified Analyst

But good job, good quarter and thank you.

David Storch

Thank you.

Operator

Thank you. As we have no further questions in queue, I'd like to turn the call over to David Storch for any closing remarks.

David Storch

Thank you very much for participating today and I wish everybody a good week. And look forward to chatting in 90 days from today. Be well. Bye-bye.

Operator

Thank you, sir. And thank you, ladies and gentlemen, for your participation. That does conclude your program. You may disconnect your lines at this time. Have a great day.

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