AAR Corp (AIR) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to AAR Corp. second quarter earnings call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (OPERATOR INSTRUCTIONS) I would now like to hand the call over to John Bowman, Director of Investor Relations.

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 this morning as well as those factors discussed under item 1 A entitled 'risk factors' included in the Company's May 31, 2006 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 would like to turn the call over to our Chairman, President, and CEO, David Storch.

Thank you, John. Good morning, everyone. Joining me today in the Company's boardroom is our Chief Financial Officer, Tim Romenesko. The results for the second quarter of fiscal 2007 represents a record quarter of net income for the Company with exceptional earnings growth and margin improvement. Sales increased 13% to $246 million and income from continuing operations was $13.8 million, an increase of 75% from last year. Earnings per share were $0.33 per diluted share.

The Company's operating margin increased to 9.5% from 6.9% last year, bringing us closer to our near-term goal of 10%. In addition to achieving record results for the quarter, we won several significant new contracts including the just announced heavy maintenance and winglet installation contract with Southwest Airlines. Also a new supply chain program supporting Chautauqua Airlines, one of the more successful regional airlines, and a $68 million pallet order from the U.S. Air Force. We did not receive any revenue from these contracts during our second quarter as work begins on each during our third quarter.

In Aviation Supply Chain segment, the Company's largest segment, sales for the second quarter were $133.9 million and gross profit was $29.9 million, representing 24% sales growth and 32% gross profit growth on the year-over-year basis. In this quarter we saw the benefit from the Company's industry-leading position as an inventory solutions provider to the commercial and defense markets. Both our program and parts supply business was very strong during the second quarter.

Sales in the Maintenance, Repair & Overhaul segment were $44.5 million in the second quarter, an increase of 3% compared to the same quarter last year. Gross profit increased 24% to $6.1 million. Our landing gear and Oklahoma aircraft maintenance units drove the margin improvement for the quarter, reflecting robust demand by MRO services, and increased operational efficiencies. Sales this quarter at our Indianapolis aircraft maintenance facility were lower due primarily to fewer scheduled maintenance visits from a major airline customer. However, overall the outlook for this business remains very positive. We signed two new contracts during the quarter, one for heavy maintenance services and winglet installations, as I previously mentioned for Southwest Airlines, and another for heavy maintenance work and interior modifications for Northwest Airlines. The new agreements bring the number of base load customers at the Indianapolis facility to four, and that is up from one in the prior year at this time.

During November and December we operated in four hangars performing four lines of maintenance. In January we expect to operate in six hangars with six lines of maintenance. In February we expect to operate in seven hangars and provide eight lines of maintenance. In April we expect to operate in eight hangars providing 10 lines of maintenance.

Sales in our Structures and Systems segment were $64.3 million and gross profit was $8.8 million or 13.8% of sales. Sales were flat year-over-year and gross profit declined 10%. Demand for our mobility products remained steady but margin pressure persists due to the mix of products sold consistent with what we've been discussing the past few calls. During the quarter we began relocation of our Cargo Systems business to a new manufacturing facility in North Carolina. This new facility is providing us with greater manufacturing flexibility and capacity at a lower cost structure. We expect sales and margins in the Structures and Systems segment to increase in the fiscal fourth quarter as the Cargo Systems business completes its move to the new facility over the next 90 days. And improve further one's shipments for the Airbus A400M military transport begin in early fiscal 2008.

The Aircraft Sales and Leasing segment delivered another strong performance this quarter. Operating profit increased considerably as deal flow remained strong. AAR sold its interest in two aircraft and added two aircraft with a joint venture partner during the second quarter. The total number of aircraft held in joint ventures remained at 17 at November 30. We also own eight aircraft directly, two of which were purchased earlier this year, and we expect to sell these two aircraft during the third quarter at essentially book value.

Gross profit margin increased to 18.6% from 17.4% a year ago and we achieved a consolidated operating margin of 9.5% in the second quarter compared to 6.9% last year. This improvement was driven by increased volume, continued focus on higher margin activities, and operational efficiencies. We are approaching our near-term target of 10% and have raised the bar to a longer-term target of 12.5%. Net interest expense was $3.4 million in the second quarter, a decrease of $600,000 versus the prior year. We retired $3.4 million of our notes that are due in December 2007 during the second quarter, and we retired an additional $5 million of these notes so far in the third quarter.

On November 30, Moody's upgraded the Company's credit rating to Ba3 with a stable outlook. The Company generated $6.3 million of operating cash flow for the quarter, and capital expenditures were $8 million, nearly half of which was related to the new manufacturing facility in North Carolina. Depreciation and amortization was $7.9 million. The second quarter represents record earnings for the Company. Increased volume, continued focus on higher margin activities, and operational efficiencies all contributed to our results. Our balance sheet is extremely strong, having reached $450 million of shareholders equity, cash on hand of $117 million, and available credit lines of approximately $135 million.

We're in an excellent position to execute on our current book of business, attract new business, and supplement our organic growth with new and expanded capabilities. I want to thank you for your participation on the call today and we're ready to open up the lines for any questions you may have.

(OPERATOR INSTRUCTIONS) Arnie Ursaner.

Good morning. The question I have is twofold. One is you mentioned four clients starting up in your facility in January. You previously disclosed you had United Airlines. I believe you disclosed Northwest and you disclosed Southwest Airlines, but I don't think you disclosed the fourth. Can you perhaps shed some light on who that is?

The fourth customer needs to remain undisclosed from us, but if you were to visit the Indianapolis facility of course you would be able to see their colors on their aircraft. It is a well-known cargo operator operating here in North America.

Okay. And another, I think it is very important, positive that may have slipped through the cracks, the 12.5% operating margin goal that you discussed, we have been keeping an eye on you for a while. Was this the first time you have formally disclosed that number? And I will start with that question.

Yes.

Okay. And that would be well above previous peak historic multiples, operating margin for you. Can you give us a little bit -- two specific questions. What is the timeframe you hope to achieve it in?

Our current planning cycle, which is a three-year cycle.

Okay, and perhaps expand a little bit on what the types of things you need to do to get there.

I think, Arnie, all the things that we've been talking about on today's call; continue to drive revenue, look for more focus on those areas we can get greater margin throughput, and operating efficiencies. So if you look at our Cargo Systems move for instance to North Carolina, although it had a negative drag let's say on the current quarter's results, the objective there is to allow us to manage a much bigger business, a business that will be twice the size it has been historically,as a result of the A400M contract, we will be in a much lower cost environment. It should add to the operating income results in a way that will move the needle.

I will jump back in queue and I have a few follow-ups, but I will do them at a later time. Thank you.

Peter Arment.

A question regarding the Southwest deal. Congratulations on that, first of all, but regarding the lines of business, could you just give us maybe a little more color on how you expect that to roll out? You said 6, 7, and 8 bays you are rolling out. Is that all tied to Southwest or is it some other customers in there?

Southwest is a major contributor to the increased lines but not the only. It is a good blend of business from the customers we have signaled so far.

Is the revenue mix I mean, I assume the heavy maintenance side of it is a higher revenue contributor than the winglets. Is that a correct way to look at that?

Yes, that is correct.

But the volume in terms of the plane activity tied to the winglet, I assume given their enormous amount of aircraft they have, what is I guess the turn times you're expecting to have with that particular line of business?

You know, it's a good question. I'm not sure. I don't have those details in front of me, but I am being advised here ten days, 10 to 15 days let's say.

Okay, great. Just regarding quickly on the joint venture, it seems like it is going very well and your activity continues to increase. How do you view the marketplace right now in terms of going forward the next several quarters?

You're talking about the aircraft market, Peter? We are very bullish on the aircraft market. We think there are some great opportunities out there in the market and I think we have positioned ourselves well to capture those opportunities. So I think you'll continue to see favorable results coming out of that segment.

Okay, and we expect that just to flow through on the JV line?

Yes. Mostly.

Great, thank you.

Christine Min

Can you tell us how much of the equity in JV earnings line was related to sales versus leasing?

It was predominantly from sales activity, not 100%, but the majority was from sales activity.

Okay, and you sold two aircraft this quarter and then plan to sell another two in the next quarter. Can we assume that this level of activity is a fair rate going forward?

I think for the foreseeable future.

Okay, great. Thanks very much.

Tyler Hojo.

My question, I guess, you updated us a little bit on capacity utilization rates in Indianapolis. How about an update as far as what is going on as far as utilization of the Miami, Oklahoma, and I guess Malaysia, as well?

Okay, so Oklahoma and Miami both remain very busy and are being well utilized. We still have capacity, particularly in Miami. There is some capacity in Oklahoma and we're looking to expand the Oklahoma business. The things that Oklahoma does we are expecting some expansion maybe to come from outside of Oklahoma, but nevertheless we currently have adequate capacity to handle additional growth.Malaysia is really just kicking into gear still. We are continuing to invest in equipment to build that shop. Right now the shop is still acting more as a storefront than as a maintenance provider, but I would say by about next year this time it will be a more robust business in Malaysia.

Can you give us a sense of what your expectation is for the AIROD joint venture?

Yes, our expectations are that we, that AAR positions itself in that market as a major service provider for landing gear and based on what we're seeing so far that strategy seems to be working. We are attracting business from that region. We have committed to the customers that in time we will have a fully operational maintenance business there in Malaysia. We are walking before we run but as I have indicated, I believe about a year from now, we should be much more robust than we are today.

Okay, just one more for you. Going back to the Southwest contract, is there any reason to think that the margins should be different on the Southwest business as opposed to what you are doing with I guess Northwest and United?

I don't believe there is any meaningful difference. As we get more work into the facility we will become more efficient. As we gain more experience, everybody has got to keep in mind we opened up for business only two years ago, so the progress we have made in a relatively short period of time, I think has been spectacular, and we are still getting better every day, every month. I would anticipate that as we raise the bar or as we increase the revenue we will continue to raise the bar in terms of our operating income expectations.

Do you expect to have any issues as far as having enough workers as you ramp up from 6 to 8 over the next couple of months?

What you see in part of our results for this quarter is that we have been ramping up in anticipation of the work, so a little bit of a drag on second quarter results was due to the fact that we have been building workforce to accommodate this workload. And we, the management, we feel very confident that as the work comes in we will be in an excellent position from a workforce vantage point for numbers. And effectiveness, which means the ability for the mechanics to do the work, we feel we will be in a very good position.

Very good. I'll hop back in the queue. Thanks.

Eric Hugel.

Can you throw maybe a rough sort of revenue number out there on what you would expect on an annual basis the Southwest deal to bring in? Or give us some way to sort of think about it.

I think we prefer not to for a few reasons. One is I am not even sure if we are permitted to under our agreement with Southwest. I don't think from a competitive standpoint that would necessarily be smart. Let's suffice it to say that it is in line with what we have previously communicated in terms of revenues per base.

Okay. Can you maybe describe -- you did not describe it as exclusive or anything like that. Can we think about Southwest has a huge fleet, are those lines that they're going to be taking, so are they going to be completely utilizing those lines?

I think the way to look at it is that we have an opportunity here to really build a strong business around Southwest, so as we execute against the opportunity. Then I think it would be our goal to see us become a very major support arm for Southwest. We already perform landing gear maintenance for Southwest and we perform certain component maintenance for Southwest, all of which I believe they are fairly pleased with. That led them to putting aircraft into our maintenance facility. And our goal here is to perform and earn their respect through our performance, and in the process grow our business with them.

Can you maybe step back and look at it from an industry perspective, just from the MRO business as a whole in terms of the pricing environment? Are you seeing out there -- I'm sure there are still lots of very fragmented markets, still lots of players out there that like with American Airlines trying to build business in its hangars. Are there guys out there that you see bidding on programs to just cover their variable costs and are just bringing irrational pricing into the market still?

We may have seen that two or three years ago. We are not seeing that today. We're seeing a much more rational pricing environment for MRO activity. I think some of the major customers or major airlines who outsourced work, they started outsourcing work, say, two years ago, were somewhat disappointed by some of the selections they have made. I think there is a greater focus today on quality, turn times and performance. Pricing has seemed to solidify.

Can you maybe talk about capital deployment? I saw the other day that you went out and hired a gentleman to run your M&A strategic development or whatever you want to call it. Can you talk about acquisition criteria, maybe potential size or where you might go and what areas, military, commercial that you might be interested in?

Sure. When you think of the acquisition opportunities, when you think of our growth strategy, you are looking at say, let's refer to it as three different segments; thinking of aircraft and leasing acquisition strategy be more tied to specific transactions than to a business. Our supply chain business, as you can see, is growing at a very acceptable rate. There are certain holes we have in our strategy that we would like to fill. We're looking for geographic growth. We're looking for more component repair capability. Slight increase in some PMA opportunities, so there are some opportunities within the supply chain group that we would like to fill out through the acquisition process.

If you look at MRO, we have obviously we have made some moves in this regard with the Indianapolis facility, not necessarily an acquisition but we have assumed the lease of a very major structure. There are certain holes in our MRO strategy relating to different category of aircraft and geography. We will continue to explore opportunities along those lines.

In the Structures and Systems business, we look at that business from three different perspectives. One is we have our mobility business, which we will look to continue to grow and look for add-on capabilities that could be acquired as opposed to built from scratch. If you look at our Cargo Systems business, there are certain opportunities to expand our footprint in that market. Then we look at the overall parts market and we would like to be a bigger player in the production of parts, to be more of a player on this build cycle, let's say. So there's no shortage of ways for us to go ahead and expand our position ,and we are exploring a few of these.

Can you roughly define what size, the ballpark, between 50 to 100 million or something like that?

I think most of the stuff that we would be looking at would be smaller than that. There are situations that are larger but at this moment the things that we're kind of zeroing in on would be a little bit smaller. You would be looking at them as more product line extensions, businesses that would fit into existing -- our existing management structure. There are a couple of situations out there that might be a little bit bigger, but things I think that you should be counting on right now are of a smaller size.

My last question and then I will get back in line is, when you talk about your margin target, your 10% operating margin and 12.5% operating margin, can you talk about what kind of joint venture level activity you contemplate within those numbers? Obviously there are no sales associated with them.

Yes, the joint ventures in this quarter I believe added 1.1% to our operating margin. As we go forward, I think if we look in that range, I think that is about the right level. Keep in mind now we start talking about 10% operating margins when our operating margins were in the 5% range. And as we are approaching this 10% range, we are kind of raising the bar to this 12.5% and you get there in a few different ways. One is sales growth because we have shown that our margins on our incremental sales are far in excess of the 10 or even 12.5% that we're signaling. We have in the past sold off product lines or stopped doing work in areas that are not productive, so we will continue to look, with sharp focus to look for things that we're doing that we should not be doing. Also to invest in those things where we believe the margin opportunity is greater than that 12.5%, bringing us up to that 12.5% level. So between sales growth, sharp focus, operational efficiencies as demonstrated by our efforts down in this relocation from Detroit to North Carolina, that is how we get heading in that direction.

Great, thanks a lot.

Two questions. You spoke about having eight bays, work at eight bays in the March/April timeframe. I believe that is correct?

10, I'm sorry, 8 bays in April.

Okay. Is there enough business to sustain that level of work throughout the remainder of, let's say, calendar 2007?

We have good visibility through July and through July we should be sustaining that level.

Secondly I think you have options on 10 bays but I believe there are 12 bays available?

Yes, that's correct.

Are the remaining two, 11 and 12, should you see the business, can you get access to those 11th and 12th bays?

We have had discussions with the leaseholder. The leaseholder is an airline that uses those hangars for storage. Right now I would not be counting on that, but it is possible at some point in time.

Okay, great. Secondly can you at all quantify what maybe the relocation might have cost you in the quarter in terms of expenses and lost sales and whatever? I'm trying to get an idea of what maybe that might cost you in terms of bottom line results.

Think you're looking at about $0.5 million of sales that would have taken place had we not made the relocation.

$0.5 million in sales.

$0.5 million in sales that we can pinpoint and of course you need to be thinking in terms of management's focus on relocation as opposed to knocking on doors.

Okay. That's it. Thank you very much.

[Kevin Calmet].

You talk about in your press release the fact that you have had lower sales from one of your customers due to I guess less scheduled visits. I was wondering if you can quantify the revenue effect of that first of all.

I think approximately $2 million on a year-over-year basis.

Is that due to lower cycle times or lower cycles of the aircraft that will be made up for in subsequent quarters?

Purely schedule, purely a deviation in schedule. That particular customer will see a continued decline here for the next few months and that their schedule starts picking up on maintenance as we get further into calendar '07.

[Stan Mann].

Good job, gentlemen. Easy question, two questions. One, can you give me your quarterly EBITDA?

Yes, I will give you the components. Operating profit or EBIT was $23.422 million and depreciation and amortization was $7.861 million.

The second question, what are your expectations on paying down debt over this year and next year?

Our next major debt obligation comes due in December '07 and, having paid down $8 million in the last 90 days, we have a remaining balance of approximately $31 million. So as bonds become available at an attractive price, we will continue to pick them up between now and December, and whatever is left in December will be paid off at that point in time.

In December '07?

Yes.

Okay, good job.

Arnie Ursaner.

Kind of as a follow-up to one of the questions you had, you mentioned some of the expenses related to getting North Carolina, but can you perhaps step back and try to quantify what the total startup expenses you may have incurred in the last quarter was. And perhaps since a lot of this you're starting up a lot of new programs, what you might be incurring in the current quarter in the way of startup expenses.

Arnie, I think in terms of pure expense, I would not say it is significant. I think between the sales impact, the disruption and the expenses, it is probably in the range of $0.01 a share. We did get some benefit from grants and the like to help us offset some of the costs that we incurred.

Would you expect the same impact in North Carolina in the current quarter?

I think the recovery -- I think there will be some more in the third quarter. I think by the time we get to the fourth quarter we should have it all behind us.

And shifting gears, Beijing is building a $3 billion airport expansion and as part of that there is also talk of 40 additional airports being built in China by 2010. Given that you had kind of very small orders out of a couple of the Chinese airlines, as these airports ramp up and the demand ramps up, are you seeing some incremental demand likely coming from that region and perhaps attempt to quantify that for us?

Our part supply business we've seen some improved results and as we build our presence in China, we expect to see strong results. Asia still represents about 7% of our total sales today. You may recall that is up from 1% back in 2001, so Asia has become a much more important market for us. Our goal would be to see Asia be 15% of sales in say, towards the end of this planning cycle. That is going to be a result of having more presence in the region and as the region continues to mature the opportunities for a company like us become more real.

Perhaps I can follow-up with Tim off-line or you may want to go through it in the call now, as you ramp up in Indianapolis I know the structure of your deal is you actually incur the expenses when you have the need for the particular bays. Have you -- can you just walk us through the process of when you actually notify the party that you are taking them and when will the costs for that begin to incur?

Arnie, as David went through we will go from four bays in December to six bays in January. We will give 30 days notice and we will start paying the rent once the bay becomes available to us.

Are there startup expenses related to that or does it tend to kick in pretty quickly?

The startup expenses are some of the things that David had alluded to or spoken about. We have incurred basically startup expenses in the second quarter in preparation for these new customers, so now we will start to actually get the benefits of the costs that we have incurred to prepare for these customers.

Thank you.

Peter Arment.

Tim, just a couple quick follow-up questions. One was related to the tax rate, which seemed to be just slightly higher than we were expecting. What is a good assumption for you going forward?

I think as the earnings increase, Peter, the tax rate is going to continue to increase a bit. So I think in the 32% range, maybe slightly higher.

For the remaining quarters for the year?

Right.

David, just big picture if you could step back and there's been a lot of talk about airline consolidation. Could you just give us your thoughts on how that impacts AAR and how you are positioned either to benefit or going forward from that?

I believe there will be some airline consolidation. In short-term, we probably get somewhat affected depending on who the consolidator is and who the consolidatee might be and then longer-term it really doesn't make a difference. Short-term here would be an immediate change as a result of an acquisition, but what is happening in the market -- and that would be more from a historical perspective. What we are experiencing in the market today is there is a shortage of, particularly on the MRO side, there is a shortage of supply. It is mostly labor related more so than facility related, and I'm talking about trained labor, so in terms of an impact on consolidation, impact on AAR, I would not anticipate much.

So you don't see much.

No, I really don't. In the long term it is good for us and I think it will create opportunities as aircraft let's say move from one new venture to another venture, so if Delta and US Air were to combine for instance, it might cause certain aircraft to become available. Those aircraft would eventually become consumed elsewhere, so that would create opportunity for the company.

Right, great. And while I got you, on the A400M that's deliveries in calendar 2008. What kind of lead times are you shipping into that? Disregarding a year for year overall in terms of the A400M program, is that --?

We are expecting revenues to begin in fiscal 2008. As we get further down the road and Airbus firms up a little bit more in the schedule, we will get more information on that.

Okay, thanks, David.

Eric Hugel.

Can you just talk about in the mobility systems business? I understand the reasons why you are on the military and that sort of in that business for the diversification and the cash flow, but it looks like from what I understand the pallet business is very low margin. And you talk about the mix of that business dragging the overall margins in the segment down. Can you talk specifically about the mobility systems business? Is that business as the pallets ramp up, is that going to really meet your cost of capital in terms of the profits it is going to generate? And are there ways to improve the profitability if that just inherently is a relatively right now is a structural low profit margin business where all of the revenue growth seems to be?

Let me first off say that the pallet business is acceptable margins. It is lower margin than some of the other things we do in the mobility area, but is still very acceptable margins. The objective in our mobility business is to move from let's say being a manufacturer of product into a provider of services, so when you start thinking about our mobility you're going to start seeing us in a broader sense than you do today. You're going to see the areas that we are going to be focused on will be of a higher margin content. These would be things like being a consolidator so that when we build shelters for instance we will be able to put things into the shelters, and that process is a little bit higher margin than, say, the pallet activity. So the mobility business, AAR's business is this mobility area is a leading position. We feel we are fairly excited about the prospects for that business.

The U.S. DOD in particular is going to a more mobile, faster fighting capability and the products we build in many cases will allow them to achieve their objective. So we feel good about our position. Yes, the margins on the pallets are, A, acceptable and, B, a little bit less than some of the other things we do in that area. So when you get a $68 million order, the size of the order compresses the overall margins from that group of businesses, but the group of business margin is still very acceptable.

I guess you talked about that $68 million pallet order. That is starting to deliver into the third quarter, so we're going to see a step up there but we're not yet going to see -- I guess third quarter is still going to see the impact in that business from the landing gear business. So should we expect to see in terms of margins sort of a fall back down to maybe where we were in Q1 and then a nice pickup back in Q4? Is that what we should be thinking?

I think you're going to continue to see margin improvement come out of that segment sequentially.

Sequentially, okay. I guess finally can you maybe talk about I guess you briefly talked about it, but maybe in a little more detail what you are seeing in terms of opportunities, deal pipeline, maybe can you give us an update in terms of how things are going with Chautauqua on that deal that is just starting to kick off? And maybe an update on any feedback or how things are going with Mesa?

I think one way to look at the business is that we have 13% growth in the period and in the period we signed these three contracts, one with Chautauqua, one with Southwest, and one on the pallet contract. We received zero revenue from any of those contracts in this period where we had 13% growth. The revenues from those contracts begin in the third quarter. So as we ingest these agreements, I think you'll start seeing some meaningful sales growth again.

David, in the past couple of quarters you've broken out growth in defense versus growth in commercial. Do you have those numbers?

Yes, growth in commercial was 18%, 18.4%. Growth in defense was 7%.

Great. Thanks a lot.

At this time there appear to be no further questions. (OPERATOR INSTRUCTIONS) [Alfonso Rivera].

I just have a question. Do you have any intentions of doing any stock buybacks?

We have an authorization and as the opportunities present themselves, the answer would be yes.

There is nothing planned though right, for the near future?

Let me stand by my answer.

[John Sheely].

My question was just answered. Thank you.

There are no further questions.

Thank you very much for your participation today. I would like to wish everybody a happy and healthy holiday season. All the best.

Ladies and gentlemen, that does conclude the conference for today. Again thank you for your participation. You may all disconnect. Have a good day.