AAR Corp (AIR) 2019 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal Year 2019 Second Quarter Earnings Call. We are joined today by John Holmes, President and CEO; and Mike Milligan, Vice President and CFO. Before we begin, I'd like to remind you that the 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, 2018. 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 President and Chief Executive Officer, John Holmes.

Thank you very much, and good afternoon. We appreciate you all joining us and we are pleased to share our second quarter FY '19 results.

During the second quarter, consolidated sales grew significantly, up 17% from $421 million to $493 million and adjusted diluted earnings per share from continuing operations increased even more significantly, up 51% from $0.39 to $0.59 in the current quarter. This strong performance was driven by continued growth in our trading, distribution and programs activities. Adversely impacting these strong results was a noncash charge related to the bankruptcy of a European commercial program customer. As you know, 3 years ago, we made a major push in the commercial power-by-the-hour market and have been very successful in winning multiple contracts. This is one of the first agreements we signed as part of this effort and the contract have been underperforming for a period of time and we had worked with the airline to restructure our program. We had agreed to a deal and on the path to recovery, but unfortunately, the airline ceased operations at the end of our quarter. As you all know, we have a comprehensive process for continually monitoring our credit exposure and deferred cost position. And outside of this event, we are comfortable with the current strength and quality of our portfolio.

Elsewhere in the quarter, we continue to see exceptionally strong performance out of our trading, distribution and programs activities. Sales in our Aviation Services segment, excluding the impact of the KC-10 program wind down increased 21% year-over-year. We achieved the significant sales growth despite softness in our MRO business, which was primarily due to labor shortages at certain facilities. We've taken a number of actions to address this, including enhanced recruiting, increasing wages and adjusting pricing with our customers. We are starting to see positive results from these initiatives and expect an improvement in MRO in the second half of the year.

As you can tell from our release, it was a busy quarter for winning new business. We announced several new agreements, including a new contract with Zodiac Aerospace to deliver its products to global and commercial aerospace customers. This is our first distribution agreement with the unit of the Safran Group and we're excited about additional growth potential. We also announced a new distribution agreement with Ontic military, a unit of BBA Aviation to distribute electronic parts to military customers. And our trading group signed a new contract with Ameco, which is an engine repair JV between Lufthansa Technik and Air China formed in 1989. We will be providing engine repair and exchange services to Ameco.

On the government side, we were awarded a 5-year contract with the U.S. Marshals to provide maintenance and logistical support services for its fleet of 737 aircraft. Finally, we announced a new partnership with Napier Park Global Capital to manage late life commercial aircraft. Napier Park is a London-based private equity firm. It will be providing the majority of the equity capital for us to pursue late life leasing and trading transactions. We see many opportunities in this market and we're looking forward to leveraging our extensive MRO, leasing and trading experience as part of this new partnership. We are excited by the number of new business wins and the fact that they span so many of our product lines, which validates our integrated aftermarket strategy.

With that, I'd like to turn it over to Mike, who will talk about the financials in a bit more detail.

Thanks, John. I'll take a few minutes to discuss the company's Q2 fiscal year '19 financial performance in more detail.

As John said, our sales in the quarter of $493 million were up 17% year-over-year. Our consolidated gross profit increased 10.7% to $78.3 million, driven by gross profit increases in Aviation Services. We are pleased that our SG&A expenses were 10% of sales during the quarter compared to 11.6% last year, reflecting the improved leverage of our cost structure to support our double-digit sales growth. Adjusted SG&A expenses, excluding stock-based compensation, severance and restructuring charges were 9.7% of sales for the current quarter compared to 10.9% in the prior year quarter.

As John discussed, during the quarter, we recognized a $12.4 million pretax charge in our Aviation Services segment due to the bankruptcy of a European airline customer. The majority of the charge related to deferred costs that we expected to recover over the remaining term of the contract and the remaining balance was in accounts receivable. In total, across all of our commercial programs, the company is in a deferred credit position, meaning we have collected billings in excess of our costs.

Notwithstanding this airline failure, we remain highly confident in the quality of our diverse customer base. Adjusted income from continuing operations was $20.8 million or $0.59 per diluted share compared to $13.3 million or $0.39 per diluted share in the prior year quarter.

Our capital expenditures remained low for the quarter at $3.8 million, while depreciation and amortization was $10.4 million. Net interest expense for the quarter was $2.4 million compared to $1.8 million in the prior year, due to higher-average borrowings during the quarter and an increase in our underlying interest rates. While we continue to invest in our organic growth opportunities, we maintained low leverage of 1.2x net debt-to-LTM adjusted EBITDA, strong interest coverage and significant liquidity of more than $300 million of revolver availability plus cash. As previously discussed, we expect to be -- expected to be a net investor in our business units growth during the first half of the year. From the top down, our business units are highly focused on converting these investments into cash and we expect to be significantly cash flow positive during the -- both the balance of the year and for the full year overall.

With that, I'll now turn the call back over to John.

Thanks, Mike. Overall, we feel very good about the progress in the first half of the year and the outlook for our business. As I mentioned earlier, we have continued to experience labor shortages in our MRO business, which has negatively impacted our revenue. Even though we expect this to improve in the second half of the year, we're going to adjust our full year revenue guidance from a range of $2.1 billion to $2.2 billion to a range of $2.0 billion to $2.1 billion. While the lower MRO business has been soft, our higher margin trading, distribution and programs businesses have been stronger-than-expected, allowing us to maintain our adjusted EPS and adjusted EBITDA guidance of $2.50 a share to $2.80 a share and $180 million to $190 million, respectively.

Our revised guidance reflects annualized sales growth of 14% to 20% and slightly higher operating margins than our previous guidance. We're very encouraged by the full pipeline of opportunities that we see in both our commercial and government markets. Our balance sheet remains strong. And I'm excited about the momentum that we have going into the second half of the year.

Thank you for your time and interest in AAR. And at this point, we will turn it back over to the operator for questions.

(Operator Instructions) Our first question comes from the line of Robert Spingarn of Crédit Suisse.

John, could you talk a little bit about MRO? And it seems now the issue is labor. Before the issue was availability of aircraft to repair. So can we talk about what's trending up and down and how you think about that going forward?

Yes, sure. Yes, happy to do that. So labor has been a consistent theme for a few quarters now and we continue to make moves to address it. You're absolutely right, last quarter we talked a bit about open slots that we needed to fill in the back half of our year. We're happy that we have been able to fill the majority of those slots. We've still got a little bit of work to do at the tail end of the fourth quarter. But we've got a number of opportunities that we're chasing. So in terms of filling our maintenance gaps, that's looking better. In terms of the labor situation, we continue to have some shortages at a couple of our larger sites. The thing that has -- that's encouraging is the dialogue with our customers. As I mentioned, we've been successful in renegotiating 2 pricing agreements with a couple of our larger customers that certainly is good. And I would say the overall tone that -- with the customers has improved since we first started talking about this over the last couple of quarters. In other words, the market is becoming very aware of the challenge in the customers, valuing us as a supplier, valuing the service that we provide. They want to make sure that they're being good partner to us. So all of this -- it's a pretty -- it's a dynamic situation, but we're working all these initiatives in parallel. And for all those reasons, we're feeling better about the second half.

Is there any risk of margin compression in instances where the customers are unable to renegotiate with you in order to avoid losing the revenue you just have to deal with the higher cost labor?

Yes, we have seen some margin compression and that's showing up in our gross profit margin. And right now, in many cases, we're dealing with timing. In other words, we're collecting a certain amount. Our real costs have gone up and it just takes some time to work through these agreements with the customers. So we have seen it. I expect we'll see it here for a little bit. But net-net, the things are trending in the right direction.

And then just on -- you mentioned your move into the late life market, what's the latest -- what are the latest trends in aircraft retirements now, especially now that the narrow-body, the new narrow-body deliveries are recovering?

Yes, we've been seeing a number of opportunities in late life packages. And we trade in that world as a matter, of course, whole aircraft relatively frequently. What is good about the equity partnership that we signed with Napier is they will be providing the majority of equity capital for us to go after larger transactions. I mean, these are transactions that we come across all the time in ordinary course of business. And we're close to that market and we've got -- we believe those are going to be even more of them based on where we are in the cycle. And we expect to see more deals. And it's good to have equity capital alongside of us that we -- so we can pursue those larger transactions without doing it fully with our own balance sheet.

Okay. And then, you spoke to this just a little while ago in the monologue, but in terms of exposure to bankrupt airlines and so on, you said, you feel good about where you are with the rest of your portfolio, but are there provisions? And just from an accounting perspective, what kind of provisions do you actually have on the balance sheet? In other words, what is your actual true risk, if you were to have to write anything else of?

Rob, we will evaluate those on an ongoing basis. But at this point, we don't have any specific concerns that we reserved against. So we feel good about the quality of our customer base at this point in time. And to the extent that we -- we obviously were working with our airline customer in the past and working to address it. But it was unfortunate that they went through the bankruptcy process.

We -- yes, I think, it's important to know. This is the Rob, just one more thing on that. This is the first failure of any significance that we've had any meaningful exposure to in at least 10 years. So this is something we pay a lot of attention to as a matter, of course.

And then just as a final question, I know we already talked about the MRO and the demand that's out there from the summer, and so on. But in terms of the macro -- everybody is very focused on the macro environment and the fact that air traffic is maybe slowing just slightly. In your forward planning, are you getting any sense that the macro is affecting market demand at all for MRO-type activity or for any -- really any of the activity you have in Aviation Services?

We feel really good about the -- we feel -- the short answer is, we feel very good about the overall macro trends. And we're still seeing a lot of demand, particularly again in the parts -- the trading, the distribution, the program side. We still see demand in MRO. And even if you look at -- if you look at the Aviation Services segment, if you were to back out MRO from that, you would've seen that those other businesses, trading, distribution and parts were up 33% year-over-year. That's exceptionally strong growth in those areas.

Our next question comes from Larry Solow of CJS Securities.

Just a follow-up on that one, so the 33% growth is -- does that exclude the INL contract too?

No, that's all program.

Okay, right. So just -- so do you have a number for what INL did? I'm just trying to figure out what your sort of your core business did, excluding INL, and the KC-10 I can figure out myself. But just sort of...

Yes. Sure, sure. So INL did $43 million of sales in the quarter. But I think that it's important to note that we consider INL a core business. And...

No, no, absolutely, I'm just trying to figure -- for sure...

Yes, we can -- right, we consider INL core business and as part of an overall program strategy and there are several other GOCO opportunities that we're going to be chasing that are very similar to INL and some of them are quite meaningful in size. And one of the great things about AAR is, we've got this mix in our portfolio of government and commercial. And if you look at the results, we actually saw an increase in the government as a percentage of the sales this quarter. And we've got a long-term goal to get that closer to 50% government, 50% commercial. And again, we view wins like INL as part of that core business. But the short answer to your question is $43 million on INL for the quarter.

Absolutely, I didn't mean to discount. INL was a multi-year effort to win it and a significant -- your biggest contract by itself. So just a couple of questions on that. The $43 million, I think, a little bit -- this was the first quarter of that full ramp. Did it sort of reach that full ramp? Is that -- the number seems a little light, is there some quarterly volatility in that? And how about the underlying profit? Is it sort of meeting your expectations?

Yes. Good question. You're absolutely right. This was our first full quarter of operation in INL. And I might add that it's going extremely well. It's going extremely well. And we -- what we are learning now that we've been on a contract for a few months is that there is -- within a period, variability in terms of material consumption based on how they operate the aircraft. So that is -- as we are learning, we are going to see some variability in revenue. We still believe that overall it should be viewed as a $200 million a year customer or account. But we are going to see some variability as it relates to that material spend. From a profitability expectation, it is right in line with our expectations profitability wise.

Okay. And just touching, just to clarify the MRO piece. So I know that the labor has been an ongoing thing for several years and I think, demand has been there, it was just sort of a blip last quarter. I was just trying to clarify. This quarter, was it sort of -- was the demand there, but you just couldn't meet it because of labor? Or you're not able to sign contracts because -- until you have that labor in hand, sort of parse that out for me?

I think -- yes, I think, you've got that, right. The demand came back this quarter. And again, across all of our commercial businesses we saw strong demand and expect to see continued strong demand going forward. But you're absolutely right, we saw demand in certain cases, at certain of our sites we were not able to answer that demand because we couldn't get the mechanics. And it's not just about getting the mechanics, it's about getting the right level of experience to produce, again, quality aircraft at the right level of efficiency. And that's a big part of the equation as well.

Right. And you mentioned obviously, you see some of your initiatives working and you have to renegotiate contracts with 2 large customers, I guess, so that should, certainly move the needle, I guess, with your large customers. So you sound fairly confident that you'll maybe not be at capacity in the back half of the year, but hopefully getting close to that, is that a fair statement?

I mean, it's a -- we'll be better in the second half of the year than we are in the first half of the year in MRO. But I think it's important to reiterate that even with the slowness in MRO, we still had 51% earnings growth and excluding KC-10 wind-down, 21% top line growth. So again that should give you a sense for the momentum and the exceptional performance that we're seeing around the company.

Okay. And you mentioned a couple of -- several it sounds like opportunities on the GOCO side. Can you maybe not specifically share details, but give us any high-level tease or time lines or anything on that note?

Isn't large opportunity high-level tease enough?

Yes. Well, I've been -- you could always say that 5 years from now we could -- there could be...

Yes. So we have a couple of bids, significant bids that have been submitted and we have a couple more that we're expecting to see in the way of an RFP. And so the timing on the bids that have been submitted, we're obviously at the mercy of the government here. So we're hopeful that those will be announced sometime in the first calendar quarter of next year.

Okay, great. And obviously, that's a better tease. And then just last question, and I realize mobility is obviously a small piece of your business and far cry from what it was a few years ago. But the margin on the gross side is a little bit down sequentially, is there anything to look at?

Yes, on Expeditionary Services, the Mobility business itself is actually doing quite well. We've recently got another -- it's up year-over-year. We recently got some more funding for additional pallet orders come through, which we'd like to see. The softness there is actually out of our composites operation. There was a program that we had in place at this time, last year that has since completed. There are some other new programs that we have won. The start dates have just been delayed. So that's what's showing up in the softness inside Expeditionary Services.

Okay. So in between programs on the composite side.

(Operator Instructions) Our next question comes from the line of Ken Herbert of Canaccord.

I first just wanted to start out. When you look at the margins within Aviation Services, is the down year-over-year, is that all INL and sort of the impact of that ramp? Or was there -- I mean, I'd have thought the lower mix in terms of less MRO contribution in the quarter would have been more of a perhaps a positive for margins in the segment?

You're seeing a positive impact at the operating margin, but negative at the gross profit margin. That's predominantly MRO. We just have fixed cost that we haven't fully been able to leverage because we have not been at capacity. INL is a little bit of a factor in there, but the majority of it is because of the lower MRO volumes.

Okay, okay. So you're just -- you're sitting on the cost. And it sounds like, again, just to revisit this one more time. It sounds like in terms of the scheduling issues, that maybe bleeds a little bit into this quarter, but is largely wrapped up? Or is that wrapped up by the end of the fiscal year? Or does that get wrapped up sooner?

Yes, it's -- we filled the gaps through the middle of the fourth quarter. We've got a little bit to work to do at the very tail end of the year. But we've got a number of opportunities that we're looking to close those gaps. But definitely progress has been made since we talked about it last quarter.

Okay. That's great. And on the distribution business, it sounds like good growth there. Is it possible to parse out sort of the organic growth within that business versus new contracts or new sort of...

I'm sorry, which business, Ken?

Within the distribution business. Yes, sort of what you're seeing with customers or suppliers you've had for over a year versus the new customers or suppliers you're bringing on which is great growth. But I'm just wondering if you can give sort of an apples-to-apples growth in that business?

Yes, it's a mix of both. I mean, we've had long-term contracts that continued to expand particularly on the government side. We've had -- commercial has done very well as well, but we've also seen a nice uptick since the budget has been in place on the government side. And then the deals that we've announced are really just starting to kick in. So if you're thinking about it in terms of same-store sales, we've seen an increase certainly in same-store sales. But some of these deals that we've signed in the last 2 quarters are now starting to contribute as well.

Okay. That's great. And then just finally, on the programs business, I know you're seeing maybe a little bit more competition price wise here. And -- but clearly is a very attractive growth market. Can you just talk about maybe activity levels that you're seeing from airlines now, is the broader pipeline getting significantly bigger? Or do you feel like it's maybe stabilizing a bit? Just how would you talk about sort of bid and quote activity on the programs business?

Yes. Great question. I'd say overall it's been relatively consistent. We have seen some very aggressive pricing out of certain of our competitors. And we -- as you and I have discussed, we have a pretty disciplined approach to these things relative to our return requirements. And certainly, when we can hit those return requirements and win the business we do and otherwise we are happy to let it go to other people. But the overall pipeline has been relatively consistent in terms of opportunities over the last couple of years. And we're invited to every bid process. 3 or 4 years ago, I wouldn't have been able to say that, but when an airline sends out an RFP, we're on the list, alphabetically right at the top.

Okay. And just one final question, can you expound a little bit on the agreement? You just recently put in place the joint venture with Napier. It sounds like you're both maybe managing sort of some of their assets that are out on lease, and then, of course, having opportunity from an end-of-life standpoint. But could you just flesh that out a little bit for us. And then maybe if you can provide any sort of bracketing in terms of the potential revenue contribution and how we should think about it?

Sure. So Napier is a -- as I mentioned, it's a private equity firm, they've got a multibillion-dollar fund. They run, actually, out of both New York and in London. And we have partnered with them in the form of a joint venture. And they own no aircraft, at least in our -- that are part of the market or the asset types that we'll be chasing with them. They have no existing portfolio. So they're bringing money to the table. And as I mentioned it before, we are extremely active in these markets. We see lots of opportunities that come out of lessors and airlines, et cetera, but opportunities that candidly would be -- will be more significant that we would want to chase with our own balance sheet. Yet, we're in the market. We're very active and therefore we're seeing them. So that led us to go out and seek a financial partner and we found a great one with Napier. And so they will be providing the majority of the capital. We'll put in some of our own equity capital. And we'll go out, and we'll buy whole aircraft to trade potential aircraft to put on a very short -- very short-term lease, but then ultimately trade out of. And the target of that is, as we mentioned, late life aircraft. In terms of profitability and revenue, It wouldn't be right for me to necessarily comment on that right now. But we're excited to get going and starting to deploy the capital that we've lined up.

Okay. No, it sounds like interesting way to really leverage what you can bring to the table in terms of the industry expertise. Is this something that could theoretically be applied, or you could pursue with other entities as well, is this something that's scalable? Or is this really sort of a one-off opportunity?

Well, it's -- the answer is, yes, it scalable. And I think it's not only scalable with other parties, but Napier has -- they've got quite a bit more equity capital. They've allocated an exclusive amount to this particular joint venture, which is significant. But there is more capital behind that just with this partner that would be available to us as we get some success here. But, yes, and then beyond that, seeking other partners, I think, that's something that's a potential as well.

Our next question comes from Michael Ciarmoli of SunTrust.

John, maybe just to stay on that Napier topic, just one final question. How much, if at all, was fuel and oil prices a factor in sort of Napier's decision-making there? I mean, we've seen quite a collapse in oil and fuel prices here making those late life planes a little bit more attractive.

Did that factor into sort of this -- the formation of the JV or this entity at all?

Certainly, it was part of the discussion. I wouldn't say it was a driving factor by any means. We've -- even before oil went up and then came back down, again, we've been seeing meaningful opportunities over the past year plus, which is what led us to go out to the market and look for a partner so that we could participate in a more significant way. But certainly, the price of fuel and its impact on the longevity of these late-life assets is something that we're considering, I think, as a factor as we go out and do deals.

Got it. And I may have missed it. Are you guys targeting specific planes? I mean, are these wide-bodies, narrow-bodies, anything presumably more appealing? Or you're going after certain niche there?

We are -- we haven't disclosed that for competitive reasons. But we've got a very, I would say, defined view of the type of opportunities we want to pursue.

Got it. Okay. Most of my other ones have been answered. But just on the MRO, I think, this was -- maybe you talked about it as being MRO 30% of total revenues at one point. How big is MRO supposed to be for this year? And I'm assuming it's going to be down year-over-year? Or did it just not grow enough to meet your expectations? So I guess, 2 questions. Maybe the total percentage and will it actually be up year-over-year this year?

So MRO will be down year-over-year as part, and again, that's being offset by tremendous growth elsewhere in the business that we talked about. I think that's in terms of a percentage right now. I'll just -- I'll leave it at that. And as we go through the year, we can provide more color.

Okay. And then, this -- so taking $100 million out of the -- of revenue out of the business. I mean, do you -- just you're short on mechanics, so you presumably the work goes somewhere else to a competitor. Is this effectively you guys losing share? Or how do you get the work back? Presumably, once it leaves your facility, maybe someone else has a opportunity to establish relationship with a customer or it's done in-house. Presumably, if it's done in-house, it makes more sense economically to farm it out to an independent like yourself. But is this -- should we be thinking about this as sort of short term share loss that you have to go win back?

It would be -- it is effectively a share loss at the moment. But what I would characterize it as we have customers that have -- we have contracts with customers and those contracts give us a certain number of lines of maintenance. Now those lines of maintenance are constantly being adjusted by the customers based on changes to their fleet schedules and how they want to operate their aircraft. But we -- based on those contracts and the lines of maintenance that we have, when we are recovered from a labor standpoint and have capacity to take those lines back, they're still under contracts with us. So a customer might say, listen, I've got an aircraft to send to you. We'll say, well, listen, we can't take it now, but we can take the next one. That aircraft will go to somebody else on a one-off basis and when we've got the mechanics that can come back to us.

Got it. That makes sense. Last one for me. Just any update on the status of the sale of the airlift assets?

Yes, we are -- it's progressing. And as we said in the last call, our goal is to have that completed by the end of this fiscal year.

Okay. So that's still on track. Okay.

(Operator Instructions) Our next question comes from the line of Josh Sullivan of Seaport Global.

What are the thoughts on the M&A front at this point. Do you feel like you're the right size in all your verticals to win the pipeline opportunities? Is there a need to go out and acquire labor? Just curious on that thought process at this point.

Well, I mean, M&A in general, we're actively looking. The investments that we've been making have been obviously for organic growth. And again, we're very proud of the organic growth that we put up this quarter getting us to that $0.59 number. So that's where the focus is right now. That's where the focus is right now in terms of our capital. Having said that, there are a number of opportunities that we are aware of, that we've -- that we're tracking, that we may see come to market and it could be a good fit for us. But right now, the focus is on organic investment. And obviously, you're seeing in the results with the strong quarter.

Okay. And then is there any update on the -- was it the worldwide logistics support service contract you won in April? That had a pretty big potential value on it, just...

Yes, that has the $25 billion IDIQ. So that was processed and it was cleared the protest. They are now in the process of bidding task orders. It's clear that the government wants to get task orders awarded as quickly as possible and we're hoping to hear some news on that early in 2019.

At this time, I'd like to turn the call back over to John Holmes for any closing remarks, sir.

Well, again, we really want to thank everybody for the time and interest in AAR and appreciate all the questions today. And we hope everybody has a wonderful holiday.

Thank you, sir, and thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation, and have a wonderful day. You may disconnect your lines at this time.