AAR Corp (AIR) 2010 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the AAR Corp. third quarter fiscal 2010 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Tom Udovich, Director of Investor Relations. Sir, you may begin.

Thank you, Devon. Good morning ladies and gentlemen. Thank you for joining our third quarter fiscal year 2010 earnings 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 yesterday as well as those factors discussed under item 1-A entitled risk factors included in the Company's 2009 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 and CEO, David Storch.

Thank you, Tom and good morning everyone. Joining me today in Chicago is Tim Romenesko, our President and Chief Operating Officer, and Rick Poulton, our Chief Financial Officer. We reported our third quarter fiscal year 2010 results yesterday afternoon and I hope that you all have had a chance to review our press release.

For the third quarter, the Company reported sales of $309.6 million, and net income of $9.9 million or $0.26 per diluted share. Overall, we met our earnings expectation for the third quarter and delivered very strong cash from operations. We achieved these results in the midst of what continues to be a fairly tough operating environment.

Although many airlines have started to report improving financial results, they continue to be conservative in their maintenance spending and capacity has not significantly recovered. As stated in our press release yesterday afternoon, we did see an increase in demand for part support as we progressed through the quarter, which also carried over into the first couple of weeks of March. We expect this trend to continue, albeit at a somewhat slow and gradual pace, as the economic environment improves and airlines begin to add capacity.

Sales to government and defense customers represented 48% of total sales during the third quarter. Although our growth rate in this market segment has slowed over the past couple of quarters, we believe the government and defense market remains a tremendous opportunity for the Company. We have unique capabilities in the performance-based logistics program area, and we have a very high market share in our manufactured products which support the military's mobility needs.

I am particularly pleased with our cash flow performance. For the first nine months of fiscal 2010, we have generated $95 million of cash flow from operations, and over the past 12 months we have generated $167 million in cash flow from operations. This has allowed us to reduce our debt obligations by $75 million since the fiscal year's beginning on May 31st, 2009. As we move forward, we will remain focused on generating positive cash, allowing us to seize opportunities as they emerge across our markets.

During the third quarter, we began work on seven new contracts announced last quarter, which Tim is going to talk about a little bit later. On Monday, we announced that Bombardier Aerospace selected the Company to design and manufacture composite flat-track bearings for the wings of the new C-Series family of commercial aircraft. The work will be performed by AAR Composites in our Sacramento facility, and could be worth more than $90 million over the life of the program, based on the number of aircraft delivered.

Now I would like to turn the call over to Tim to provide some additional details regarding our recent program wins and operating performance.

Thank you, David and good morning everyone.

During the third quarter we started executing on a number of contracts announced last quarter as well as some programs that were not announced. During the third quarter we started heavy maintenance program for Hawaiian Airlines and Allegiant Airlines at our Miami MRO facility. Both of these programs will fully contribute in the fourth quarter. We also expanded our relationship with Alaska Airlines at our Oklahoma City facility and started heavy maintenance work for an unannounced regional carrier at our Hot Springs facility. I visited the facility recently with our new customer, and they are very pleased with our performance as we go through the normal startup of a program of this sort.

Also within our MRO segment, our landing gear operations started performing Airbus family overhaul for a major US carrier. This was an important win for our landing gear facility. One of our goals has been to increase the amount of engineering content across the Company. During the third quarter, we started work on a major engineering services program, revenues from this program were less than $1 million in Q3, and are expected to be at about that level for Q4. This program, however, ramps up nicely in June, and will contribute meaningfully in fiscal 2011.

In supply chain, we launched the KC10 program on February 1st. The program launch requires a tremendous amount of effort as we transition from the prior contract holder. I'm appreciative of the effort of our team and our business partners who are working hard on the launch of this program. The program contributed approximately $2 million of revenues in Q3, and will increase significantly in Q4 as it ramps to full operational status.

I would also like to provide an update on the A400M program. By way of background, in June 2005, we were awarded the design and manufacture of the cargo and cargo delivery systems for the A400M cargo plane. Our revenues per aircraft is approximately $1.8 million, and based on the initial orders for 180 aircraft, the projected revenue for the system is approximately $325 million. Last week, Airbus reached an agreement with the member countries to move forward with the program. We expect revenue from the program to begin in fiscal 2012.

I will now hand the call over to Rick Poulton, who will provide additional details on our financial performance during the quarter.

Thanks, Tim. Good morning everyone.

As indicated, commercial markets remained generally soft during Q3 and this pressured the supply chain and MRO segments. Exacerbating the impact of this softness was the impact from Mesa Air Group's bankruptcy filing during the quarter as we had to write off both billed and unbilled pre-petition amounts, as well as we began to experience somewhat lower volumes from Mesa.

Within our supply chain segment, sales decreased 14% year-over-year, and 9% from the second quarter. The sales decline in the segment due to Mesa was approximately $3.5 million, when we compare it to both Q2 as well as last year, or approximately 250 basis points of the total sequential decline. Margins in supply chain were 19.5%. These margins were negatively impacted by approximately 200 basis points as a result of Mesa. So excluding this Mesa impact, margins remained pretty consistent with Q2's segment margins of 21.7%.

In our MRO segment, sales and margins declined from prior year, but were essentially flat with Q2. During the quarter, the MRO segment benefited from previously mentioned new programs that Tim talked about, and these predominantly offset the loss of volume from Mesa as well as lower volume from a leasing Company that has been winding down some of its lease return work. As we look ahead to the fourth quarter, we would expect a similar pattern, whereby softer demand from Mesa and some other customers will offset some of the increase that will be realized from the new programs previously discussed.

Third quarter sales in our Structures and Systems segment declined slightly, both on a year-over-year basis as well as from Q2. We saw continued strong demand for our specialized mobility products during the period, including our highest margin container products. Sales declined, however, for our composite structures and cargo systems businesses within the segment. Margins for the segment improved to 22.6% from 14.8% last year, and 21.1% in Q2.

Gross margins continued to be favorably impacted by an advantageous product mix and our cost reduction and process improvement initiatives. As we stated last quarter, we expect margins will remain strong in this segment for the balance of the fiscal year. But they will begin to decline from the current levels as we lose some of the benefits of favorable product mix.

Moving now to the segments, down the P&L, SG&A expenses declined from both the prior year and Q2 to $36 million. This amount includes $1.5 million in expenses incurred by our joint venture, AAR Global Solutions, as well as approximately $1 million in write-offs related to bankrupt air carriers. We continue to see the expenses related to Global Solutions decline, and we would expect them to settle in at a run rate of approximately $1 million per quarter. Interest expense for the quarter was $6.5 million, down from $7.5 million last year. I want you to recall that interest expense now reflects both our cash interest expense as well as the non-cash accretion related to the new accounting standard for convertible debt. Our cash interest expense was $3.6 million in the quarter or just slightly over half of the total, and that's down from $4.3 million last year. Depreciation and amortization for the quarter was $9.1 million, and our CapEx was $5.7 million in the quarter.

The vast majority of the $0.10 diluted earnings per share unfavorable impact the Company realized during the quarter as a result of Mesa's chapter 11 filing reflects the Company's loss on pre-petition services that were provided to Mesa that remain unpaid, as well as a $1.9 million loss the Company recorded on the equity shares we received from Mesa as part of the contract restructuring. Just to repeat, we did not purchase these shares but rather they were granted to us as part of a contract restructuring. As we look ahead, based on our understanding of Mesa's restructuring plan, we expect business with Mesa will return to normal historic margin rates, albeit at lower volumes of approximately $40 million to $45 million annually down from the $70 million annually we had seen recently. I would now like to turn the call back over to David to close us out.

Okay. Thanks, Rick, and Tim. In closing, we will work very hard at increasing our market share and generating more cash from operations. Furthermore, we stand ready to invest in areas where we do see opportunity. Thank you all for joining the conference call today, we would now like to open up the line for any questions you may have.

Thank you. (Operator Instructions). One moment for our first question. Our first question comes from Larry Solow of CJS Securities.

Hi. Good morning, guys. Could you maybe give use a little more color on the commercial trend on your outlook. I know it sounds like things are improving a little bit, maybe a little bit less than expected, but at least directionally in the right way. As load factors start to rise, is there any way historically to look at when you think capacity may start to come back, or at least spending may start to come back, and how long can inventory draw down, I guess inventory drawdowns can stop, but how long can minimal spending continue, and I know your expectations where the capacity will start to rise in the latter half of 2010. Do you still feel that way?

We are seeing an uptick in our commercial aviation activity. We saw that beginning in the month of February. We've seen it continue through the month of March. And we expect that trend to continue. In terms of capacity being added to the system, I think as load factors continue to rise and there's all indications that that's what's taking place, you'll start seeing aircraft come back into the system, not just here in the United States, but elsewhere around the globe as well. We think that there's a stronger feeling today than there may have been, say, three months ago.

Got it. And then in terms of the gross margin, that segment, is sort of a 22% -- you've historically been in the 22 to 24% range. I imagine as volumes increase a little bit or return back to normalized levels, do you think you can kind of fit comfortably in that range? Is the KC10, once fully ramped, those margins similar to your averages in that segment?

So Larry, so let's start by just -- I'll reiterate what I said earlier. Excluding the Mesa effect in the quarter --

Right.

We were right around 21.5, same place as we were in Q2. So you're in the zip code of what I think you're asking about in terms of 22. Certainly, if you look back over the last couple years, I think we've demonstrated pretty consistent pattern in that range that you're talking about. KC10 will be I think a little bit margin dilutive at the gross margin level. Margin neutral as we look at it from an operating margin perspective. So as that ramps a little bit, that will put a little pressure on the segment margin but I think structurally we obviously had a big fall-off in our first quarter, if you just look at this historically and then we came back quite a ways in the second quarter. You saw kind of a repeat performance in Q3, and what you're hearing from us is we still don't feel the markets have recovered back to where we think will recover to. With stronger markets, that should help margins a little bit and then pressuring that will be a little bit on the ramp on KC10.

Then on the defense side, excluding the KC10, which obviously should help your growth a little bit, sales were sort of flat this year, this quarter, and I guess structure and systems sales which was mostly defense was also flat. Do you think we've kind of peaked out or do you still see growth potential going forward excluding obviously the KC10 deal.

Well, clearly the backlog at our mobility systems business has peaked, but as the KC10 ramps up, that throws off a significant amount of repairs across the Company. So that will offset some of the forecasted decline at mobility.

Larry, I would add, though, recognize we made some comments about AAR Global Solutions. That is all really designed to serve government and defense customers. It's an area we continue to invest in, and remain optimistic that there's opportunities there. So I think we still remain bullish about the government and defense space.

Got it. Great. Okay. Great. Thank you very much.

Thank you. Our next question comes from Tyler Hojo of Sidoti & Company.

Good morning, guys. Maybe you could talk a little bit more about Global Solutions. I think during the last conference call, you indicated some progress there and a number of bids outstanding. I believe you won one in Afghanistan. Could you give us an update there in terms of maybe proposals outstanding and if you've had had any more successes?

Yes, Tyler, we did have another success, but we're -- it's a little premature in terms of further discussion, only because we're not quite certain yet what the size is of this -- of a win that we've be verbally advised of. But we continue to see opportunities. We continue to refine the business model. And we remain pretty -- still feel pretty good about the market segment and we think we'll get some traction some time between now and the end of the calendar year.

Okay. Great. Would you say there's as many proposals outstanding today as there was three months ago?

I would say there are more outstanding today than there were three months ago.

Okay. Fair enough. Great. And then just one more from me. Certainly, it seems like you guys have had some pretty good successes on the composite business. And I guess, maybe it would be helpful for me if you could talk a little bit about the margin profile of that business, and if it's different than kind of the overall structure business and it certainly seems like you're on track to hit your $100 million annual goal there, but maybe if you could just update us on your thinking there.

I think as it relates to margins let's hold off for now in terms of communicating a margin target for that specific business. We are competing for other opportunities in that market, and it is kind of in a ramp-up mode, so it will be a little bit premature for us to speculate on margins. The margins in the existing composite business that we have are fairly consistent with what we see in our structures group, but as we see that the volumes increase, we would hope we get more efficient and we get margin through-put, but my preference at this stage, this is early on in some of the wins that we have recently announced, let's talk about that in, say, another couple of quarters out as we get a little bit more practical experience.

Tyler, I would just pile on to that, just for context. When we talked about our $100 million annual goal for the composite business, which we continue to strive for, that's sort of tripling the size of the business from where we started. And you can imagine the scale benefits that could occur with that type of growth. So I think that's why we need to settle in at those higher levels before we can really talk to you about sustainable margins.

I mean, is it safe to say -- I think last time you updated us it was about $30 million to $40 million annually. Is that still kind of where we're at?

Right.

Thanks a lot.

Thank you. Our next question comes from Troy Lahr of Stifel Nicholas.

Thanks. You guys are going to be ramping up on a lot of programs in a lot of areas over the next couple quarters. Can you maybe just talk about where some of the challenges are and how comfortable that you feel that you're not going be coming back to us in one or two quarters saying we're ramping up, but we're struggling here and there? Can you give us some of your comfort levels?

I mean, historically, as you start bringing new business in, particularly in the MRO area, there's an adjustment period, a phase-in period, to get used to the customers' specific requirements and for us to adjust to their nuances. And we have obviously -- we've done this enough times to know, and have enough visibility in terms of -- we can't quite predict exactly where the challenges will be. We just know that there will be challenges, and we have recently had some significant success in attracting new business, so I think we'll continue to see certain challenges in that regard. But we do anticipate, for instance, as we get into the fourth quarter versus the third quarter, that some of the challenges we saw in the third quarter, we'll have more of a handle on and we'll have better operating results as a result of that experience.

Same thing on the KC10. This is a very large program. There was an incumbent supplier to that program who wasn't too pleased that they lost the program, and they've made the hand-off a little bit more challenging than you would like to see. But that being said, we started the program in February. We understand today where many of the challenges are and it might be a little tough here in March and April, but I think as we get to May and as we get out into next fiscal year, we'll get past the transition phase, and we'll get into the normal operating environment where the Company excels.

So you're correct in identifying the fact that we've had some meaningful wins here, and you are correct that many of these programs do have startup challenges. Some of those startup challenges are behind us, and some of those startup challenges still remain in front of us.

And then just to clarify. On the MRO side, are you doing really anything different with some of these new carriers that you really haven't done before or is it just same work you've done in the past, same type of aircraft, so really no major surprises on the MRO side?

In the case of Alaska, for instance, it's the same aircraft, so there is no surprises, just getting additional through-put so that should be very easy for us, if you will. In the case of Hawaiian, we'll be working on their 717s. We have 717 proficiency for the work we've been doing with AirTran. However, they'll have their special requirements, which will be different than AirTran's special requirements and so there will be an adjustment period that goes along with that.

In the case of Allegiant, we have work on two different types of work with Allegiant. One is their normal annualized heavy check maintenance, where we have some experience, but we're also bringing their aircraft that they've recently acquired from SAS, we're putting those aircraft onto their operating certificate, and that type of work has surprises because you're not sure exactly what you're getting, or in this case what they're getting and that takes a lot of hand-holding and a lot of hard work to make that work, that transition work, if you will. So yes, I think that, again, we have enough experience in this to know that there are surprises and yet we don't know exactly where the surprises are, but we do have our arms around it and we're not expecting any major surprises.

Okay. Thanks. And then lastly, at Structures and Systems, could you drill down a little bit and be more specific on kind of what is rolling off there and then also why was composite down? I would have thought with the work that you're bringing in there that that would be ramping up. Is that just kind of a one quarter timing issue here?

First, on the mobility, we've been wrapping up some of our contracts for containers and shelters. So now that gets reloaded, and there's some contract opportunities that are in front of us but right now we're working down the backlog, at least for the time being. And then in terms of composites, we're getting ready for some of the new work, but we're still in the engineering and design phase there and, again, we're working off of deliveries from previously issued awards.

Okay. Is F35 composite work, is that still an option for you guys or is that door closed?

The door's not closed. I guess it still is an option, yes.

Okay. Thanks, guys.

Thank you. Our next question comes from Eric Hugel of Stephens.

Hey, good morning, guys.

Good morning.

Can you give us a sense -- you talked about I guess on the aviation supply chain business, sales were obviously weaker than expected. On the -- you started to talk about -- you talked about late in the quarter, starting to see things pick up. Can you give us a sense as to sort of maybe where things are today, if you looked at sort of the run rate in that business relative to maybe where you were in Q1 or Q2, are we still below Q1, Q2 run rates? I'm trying to sort of think about as we move into Q4, X, I know we're going to get a bump-up from KC10 but just sort of a general sense as to where the activity rate is there.

We would be ahead of both Q1 and Q2 at this point in time in the quarter. Keep in mind, it's March 17th, so it's pretty early in the quarter. We would be ahead of where we were, say, in December and September.

Okay. And then on top of that, we'll start to see KC10. You did about $2 million this quarter. Can you sort of give us a sense, a guesstimate as to if that should be somewhere maybe in the $8 million to $10 million range in Q4?

Or higher. Probably higher than that. As we talked about just for everybody's benefit, we think it's a $60 million to $70 million year opportunity for us. There is a ramp-up so eventually we'll get to a normal quarterly run rate of somewhere between $15 million and $18 million. I don't think we'll be quite there for Q4 but it will be above the range you asked.

So you could easily see an aviation supply chain quarter in the fourth quarter over $150 million, that sort of potential?

I mean, let's just talk about -- we did 122 this quarter, we're talking about a delta on KC10 of let's just say $10 million in round numbers, so you can do the math from there.

Moving on to the MRO side of the business, Q4 for you guys is usually your strongest quarter, as airlines sort of get their aircraft ready for the summer flying season. Are you guys expecting that sort of same dynamic, given all the deferrals and all the maintenance issues this quarter or should we expecting a number still relatively in line with what you did in Q3 and Q2?

We're looking to be busier in the fourth quarter, we are seeing a lot of work coming in. I will say, though, Eric, that the hours that we're putting on the aircraft are a little less than you might have seen historically. But the short answer is we look to have kind of modest sequential revenue increase in MRO.

Okay. And on the Structures and Systems business, sort of that step-down, as we move into Q4, does that pick back up? Was there timing related to that or you talk about burning down backlog, should we expect a continued decline there in sales in the fourth quarter?

I think what you're hearing from us, Eric, is we're burning down some backlog. I'll repeat what Tim said is there are opportunities to reload some of that, that we're working on right now. We do expect still a strong performance out of our mobility business and the segment in the fourth quarter, but we don't typically do predictions of revenue on a segment basis. So I don't want to give you --

Fair enough. In the Structures and Systems, just trying to get my arms around the gross margins. Can you sort of give us a sense how much of that gross margin, just relative, if you sort of put in a more normal mix, are we talking about sort of a high teens number or are we talking about a low 20% number, can you sort of ballpark that for us, where should we be thinking about on a normal mix basis?

Well, you know, you've followed us for a while, Eric, so I don't have to tell you if you look back historically what sort of normal might be, if you looked at the historical numbers. I think we've had a couple of very good quarters in a row. I think we've been upfront by saying we don't think that is a sustainable level for the long term. I also don't expect it to fall off a cliff from where it is. I think when you say high teens, that's probably the right place to think about it.

And could you give us an update on the aircraft portfolio, where do things stand, any additions, any subtractions, sort of where are we in terms of leases coming up and renewals and all that fun stuff?

We're in pretty good shape. We have -- the fleet is very similar to where it was at the last discussion, so we are in negotiations on some lease extensions that we expect to be successful with. So really no real change to that market at this stage.

Just to be clear, no additions or subtractions during the quarter.

So I mean, maybe to sort of just wrap it up in a general sense, I mean, it sounds like conditions are improving, you're talking about aviation supply chain business picking up in the quarter. I guess was last quarter, two quarters ago, your expectations were for the remainder of the year to see sequential earnings growth each quarter. That plan remains on track?

Yes, I think that's a good summation and I think the phrase we used last quarter, modest sequential improvement, is kind of what we would say again this time.

Great. Thanks a lot, guys.

Thank you. Our next question comes from J.B. Groh of DA Davidson.

Thanks, guys. Most of my questions have been answered. On the MRO side, have you noticed any things coming out of storage in terms of customer requests, that kind of thing? There's been a lot of talk of kind of pent-up demand on the MRO side with planes being stored and underutilized and that kind of thing. Do you sense anything there?

Yes, we're seeing some of that kind of activity. We're seeing new aircraft coming into customers' fleets. We're working with a customer right now actually on some additions of aircraft into their fleet. So yeah, we are seeing some of that right now.

Okay. Thanks. All my other questions were answered. Just want to say that the PAC10 planes you did for Horizon, huge hit up here. So thanks a lot.

Thank you. Our next question comes from Jon Braatz of Kansas City Capital.

Gentlemen. Most of my questions have also been answered. But Rick, you had mentioned that there was in the SG&A, $1 million of bad debt write-off. Was that Mesa or was that something other than Mesa?

Predominantly Mesa, Jon. There was one other much smaller carrier that also added to that number.

Rick, when we look at the $0.10 charge in the quarter from Mesa, how did that break down in terms of -- obviously you wrote off the stock and then you had the bad debt, but anything elsewhere you can tell us where it all appeared?

Yes, it showed up as well really in the margin performance in structures and -- excuse me, in supply chain as well, Jon. I tried to provide some of those details but I mean, we --

You had had mentioned 200 basis points.

On the margin side, right. And we also had a revenue reduction. What in effect happened is we had had some work in process related to our supply chain support of Mesa, where we had incurred the costs of making some repairs and some other services, but were not able to bill those. So the costs were in our cost of sales but we didn't bill it on the revenue line, and so you sort of have the impact hitting you in many different places on our P&L.

Absent the revenue reduction going forward, all the costs associated with the Mesa filing is now behind us?

Yes, subject to their restructuring plan.

Okay.

Obviously, Jon. We continue to obviously support them and we continue to have an inventory position to support that as well, but subject to their restructuring plan, we do think all the kind of one-time type of charges are behind us. We've signaled to you what we think the new volumes from Mesa will be. And that's all we know at this point in time.

Okay. All right. Thank you very much, Rick. Rick, one other question. Do you see any opportunity to, as you did last year, repurchase any of the debt?

Well, we obviously have a very strong liquidity position right now, Jon, so we have the means, but I would say, when we were very active buying back debt a year ago, it was because of very advantageous market conditions. Those same market conditions don't exist, so it's certainly not the same business case that it would have been a year ago, but we definitely for the right opportunity, we would certainly be ready to strike if that made sense.

Okay. Very good. Thank you.

Thank you. (Operator Instructions). Our next question comes from Stan Mann of Mann Family Investments.

Hi, gentlemen. Just one question. In prior calls you mentioned you were going to utilize the high cash flow for debt paydown. Now you mentioned acquisition. Can you kind of expand on that? Was there something in the cooker or it's far off, or are you going to continue emphasizing debt paydown?

So Stanley, there's a fair amount of deal flow and stuff that we're looking at today. Obviously we're staying very disciplined. We worked hard to go ahead and generate the cash that we have and to earn the cash position that we currently have, so we are looking at some opportunities and some stuff is pretty far down the pipeline, if you will, or process, I should say, and yes, we'll see what happens.

Okay. Thank you.

Okay. Thank you.

Thank you. I'm showing no further questions at this time, gentlemen.

Well, thank you very much for participating today and have a very pleasant Saint Patrick's Day. Bye-bye.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Thank you and have a nice day.