AAR Corp (AIR) 2020 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2020 First Quarter Earnings Call. We are joined today by John Holmes, President and Chief Executive Officer; and Sean Gillen, Chief Financial Officer.

Before we begin, I would 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, 2019. In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events.

At this time, I would like to turn the call over to AAR's Chief -- President and CEO, John Holmes.

Great. Thank you very much, and good afternoon, everybody. I really appreciate you all being here to -- and joining us today to discuss our Q1 FY '20 results.

Our positive momentum continued with another quarter of double-digit sales growth. In the first quarter of FY '20, sales grew 16% from $466.3 million to $541.5 million. Our adjusted diluted earnings per share from continuing operations increased from $0.54 per share to $0.57 per share.

We continue to see exceptional performance from our parts supply and government programs activities. In MRO, as you know, we took several actions last year to address labor shortages such as enhancing our recruiting efforts, partnering with various schools and repositioning elements of our workforce across our network. We are pleased with the positive impact of these actions, which resulted in our third quarter of improvement in MRO.

We are also pleased with the support that we received from our customers to better level-load the maintenance schedule throughout the year. This allowed us to keep more of the workforce in place during the slower summer season.

During the quarter, we were awarded $118 million contract from the Naval Air Systems Command in support of the U.S. Marine Corps for the procurement, modification and delivery of 2 C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO and engineering teams to deliver a creative solution to the U.S. Marine Corps. The ability to deliver an overhaul versus factory-new solution not only differentiates AAR from our competitors in the defense space but also demonstrates our ability to once again apply commercial best practices to deliver a more cost-effective solution to the U.S. government. We begin work under this contract -- we began work under this contract this past quarter, and we expect to deliver the aircraft in our fiscal 2021.

Subsequent to the quarter end, we announced a new parts distribution award from Leach Corporation (sic) [Leach International Corporation], which is a wholly-owned subsidiary of Transdigm. As part of this agreement, AAR OEM solutions will be the company's main distributor for electromechanical and solid state switch gears to OEMs for new production as well as to the -- both the commercial and military aftermarkets. This is an important win for the company and reaffirms the strength of our value proposition in parts supply and distribution.

We also announced a new agreement with Mitsubishi Heavy Industries Aero Engines to supply PW4000 engine parts in support of their engine overhaul business. This is our largest commercial contract in Japan to date, and we're particularly proud about this win because it allows us to support the demand for engine parts in this growing market.

We continue to execute on our growth strategy, and we're pleased with the progress as we continue to secure and execute on new business wins. And we're very excited about the strong start to FY '20.

With that, I'll turn it over to our CFO, Sean Gillen.

Thanks, John. Our sales in the quarter of $541.5 million were up 16% or $75.2 million year-over-year. This included a $73.4 million or 17% increase in Aviation Services revenues driven by execution on new contract awards and strong demand in our parts supply activities. The C-40 award contributed approximately $19 million of sales in the quarter.

Gross profit increased 14.6% or $10 million to $81.6 million. Gross margin was 15.1% versus 15.3% in the prior year period primarily due to Expeditionary Services. Gross margin within Aviation Services, however, improved from 15.3% to 15.6%. I would note that the C-40 award, while relatively in line with operating income margins and accretive to ROIC, is a bit dilutive to gross margin.

SG&A expenses were 10.7% of sales versus 10.3% in the prior period, which reflects increased investigation and compliance-related costs mentioned in the previous quarter as well as some additional sales in quality resources. Excluding the investigation and severance costs, which totaled $3.6 million, SG&A would have been 10.1% of sales in the quarter. Regarding the investigation, we have received request for information from the government agencies involved, which we are fully cooperating with. Beyond that, we cannot provide further detail at this time.

Our income tax expense during the quarter was favorably impacted by tax benefits of $1.4 million related to the vesting of restricted shares and stock option exercises. This compares to a similar tax benefit of $2.5 million related to stock compensation in prior year's quarter.

Net interest expense was $2.1 million compared to $1.6 million last year. During the quarter, our cash flow use from operating activities from continuing operations was $30 million, which improved $20 million from the prior year, excluding the impact of the accounts receivable financing program, which was flat in this quarter. The cash use in this quarter was primarily driven by investments in inventory to support our parts supply activities as well as some normal seasonality in MRO.

We feel good about the strength of the balance sheet. Net debt ended the quarter at $163.4 million with net leverage below 1 turn. In addition, I am pleased to share that we entered into an extension of our revolving credit facility, which will add an additional 3 years to the term and $100 million of borrowing capacity. Our lowest pricing will also decrease from LIBOR plus 100 basis points to LIBOR plus 87.5 basis points with no other significant changes. Details of the extension will be filed this week.

Finally, we are still on target to close the sale of our COCO business before the end of calendar 2019. The exit of this business is consistent with the realignment of our strategy to GOCO.

Thank you for your attention. And I will now turn the call back over to John.

Great. Thank you, Sean. We're very pleased with our Q1 results. And as you saw in the earnings release, we are reaffirming our FY '20 guidance for sales to be between $2.1 billion and $2.2 billion and adjusted earnings per share from continuing operations to be in the range of $2.45 a share to $2.65 a share. We continue to expect SG&A expenses to be approximately 10.5% of sales and anticipate an effective tax rate of 24% in FY '20.

We will continue to reassess our guidance and modify it, if necessary, as the year progresses. We are really excited about the strong start to the year. Our parts supply activity has continued to deliver exceptional performance. We are executing on our government programs wins, and we're very pleased with the recovery that we see in the MRO business. We have a full pipeline of new business opportunities, and we look forward to a very successful FY '20.

Thank you for your time and interest in AAR. At this point, we'll turn it back it over to the operator for questions.

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

I wanted to start and maybe I missed it. And I appreciate that nice turbo run-through of the quarter, nice and compact. I just wanted to ask about the Expeditionary margins and what's happening there? The C-40 is not there, right? That's in Aviation Services.

Yes, that's correct. The C-40 is in Aviation Services. In Expeditionary, we saw margin compression year-over-year primarily due to product mix than what we shipped in the quarter. And we also saw an increase in raw material costs for our manufacturing business up in mobility, and that had an adverse impact on the margins in that business.

So when we think about the year -- I don't know, maybe this is for Sean. How -- what do those margins do within your -- what's contemplated in your guide for the next 3 quarters?

Yes. I think we haven't gotten into the specifics on that. But I think for the balance of the year, we would expect some recovery in the margins and then in the back end of the year to have kind of a strong year and get back to where it was closer to last year.

Okay. And then just on the outsized growth, if I could call it that, in Aviation Services, obviously quite good, in the mid-higher teens there. Could we maybe talk about that or deconstruct that a little bit in the parts supply, which sounds like it's a real growth area for you versus the traditional businesses? Is that the right way to think about this and these more aggressive contract acquisition? And perhaps talk about how that drives the growth going forward in Aviation?

Yes. Sure. So the growth came from a lot of areas in the company. And again, we're really excited about the strong start to the year. Parts supply, as we talked about in the last several quarters, has really performed exceptionally well. And that's both parts supply in the aftermarket business, the trading business, as well as parts supply in the new parts business, the distribution business. And we've announced a number of contracts, including 2 that we just referenced with Mitsubishi as well as with Leach in those businesses, new and aftermarket parts. We've announced a number of contracts over the last several quarters. And so those contracts, they take a little while to ramp up. But once they do, they really contribute. So that's been driving a lot of growth.

Also in the quarter, we had a very nice improvement in our MRO business. Last year, if you recall, our summer was particularly slow, which led to a number of issues that we then felt throughout the year as we look to go back in the labor markets to get technicians back on board. We had a very nice recovery in this summer, and that was a real nice contributor to the growth. And that also sets us up well for the balance of the year because if we think about where we were a year ago at this point in time, we were in the market recruiting for lots of technicians because we're coming off of a soft summer. Given the fact that we've had a stronger summer, our demands for technicians at this point are much less than they were a year ago. So we're set up well there.

And then as Sean mentioned, the C-40 win, we're in early days of that contract, and it's not -- we don't have a full picture yet on how that revenue will pace quarter-to-quarter throughout the next 2 years. But as Sean said, we recognized about $18 million in the quarter -- this quarter, and that obviously contributed to the revenue growth as well.

So if all in, that's about a $70 million-plus increase, $18 million of it is C-40, the other $50-odd million, if I wanted to think about parts supply versus kind of the core business. Because the parts supply is growing, if I understand correctly, from a very small base. So everything you add, Leach and so forth, is meaningful.

No. I wouldn't -- we don't want to get into specific growth of the specific operating units. But parts supply is not growing off of a small base. They have...

It's not. Okay.

It's not. No, it's a meaningful base, and it's been meaningful growth on a meaningful base for several quarters now.

Is there anything we can say about that other $50-odd million, whether it's MRO, parts supply? How do we think about that?

Yes. No, again, I don't think we want to get into details on that element of it. But I would reiterate that we saw a very nice recovery in MRO, and we continue to see parts supply, both new and aftermarket, do extremely well.

Last thing is in the past or last quarter, we didn't talk so much about cash flow guidance because of the investment in new opportunities like parts supply. Has that continued to be the case? You're not done at this point there?

It does. And we'll note that we did see -- as Sean mentioned, we did see a nice improvement in cash flow. We were still consumers of cash this quarter. We consumed about $30 million of cash. But if you take out the impact to the accounts receivable securitization, that's a $20 million improvement over last year. Seasonally, we do see cash consumption in the first quarter largely as a result of MRO, but we are very focused on cash generation. And we expect to see improved cash generation as we move throughout the year, similar to what we did last year. But again relative to guidance, we want to give ourselves the space.

The demand for parts in the aftermarket is extremely strong right now, and one of our most significant differentiators is our ability to move quickly and close on large buys of material. And so we want to give ourselves the flexibility to do that.

And then your point on distribution is right on. When you win these distribution contracts, typically, there is an upfront buy of material and that cash goes out. And as I said before, it does take a little while for those programs to ramp up. But once they do, they become nice contributors to margin as well as turn cash flow positive.

Our next question comes from the line of Joseph DeNardi with Stifel.

John, to the extent that the labor market and MRO is driven by supply growth, I mean this year, domestic airline supply is probably growing 3%. Next year, it's probably going to grow closer to 7% with the MAX coming back. So why shouldn't there be kind of additional strain again put on the labor market next year as the growth rate accelerates? Or do you think you've kind of properly derisked that portion of the business for the foreseeable future?

I think we've done a nice job in derisking, and I think your points are right on. The macro environment has not improved for what we do. But we've been, as we talked about throughout last year, very aggressive in terms of the kinds of things that we're doing to get out ahead of labor market. And a lot of that is developing proprietary relationships with tech schools, et cetera, so that we can develop our own pipeline of talent. And that is working. There's an additional ramp-up there because that allows you to get fresh talent in the door, and we're seeing some success there, which contributed to the results this quarter and will contribute throughout the year. But with that fresh talent, there is a bit of a learning curve when you get them in. And that learning curve translates to increased productivity in the hangars. So we've got a good team kind of in place. We're definitely in the market now because we will have more demand in the second quarter versus the first quarter as we do every year. So we're in the market right now recruiting for talent. But once we get through this quarter, we'll have largely the team in place that we'll need for the year to handle the workload that we have.

As it relates to growth next year, we do have floor space. So we have -- in a few of our facilities, we do have floor space available. And to the extent that we have demand for customers -- and I should mention that we're extremely proud of our customer base in MRO. We've got a blue-chip customer base that are extremely supportive of us. They recognize the value of the service that we provide. They worked very closely with us throughout the summer to keep us fuller in the hangars than they did last year, so that we wouldn't have the labor challenges in the rest of the year as we saw last year. And a lot of them that did that are actually MAX operators. So even though they were under significant pressure to have their fleet working harder, they were still able to support us by keeping us fuller during the summer when they needed the aircraft. So thinking about next year, to the extent that we see demand for the customer base that we have and we can layer in additional lines of maintenance, we're certainly going to continue to extend these recruiting techniques that have been working to meet additional demand in the hangars that we have available floor space.

Okay. That's helpful, John. And then just in terms of kind of the pipeline of good-sized opportunities, I mean, just given what you booked recently, are there similar bigger-type opportunities out there that you're targeting in the nearest term?

Yes. So I would say that the pipeline -- and we gave a little -- we gave some numbers on that back in July at the Investor Day, I would say that, that pipeline is as strong as it was when we talked about it back in Investor Day. And there are definitely meaningful opportunities out there, particularly on the government side that could have positive impacts in the way that C-40 will. But the challenge for the government business is it's difficult to predict when those are going to occur. So to say that we've got opportunities in the near term, yes, there are plenty that could hit anytime now. There are bids that have been out there for a while, but it's difficult to predict when those will happen.

Okay. And then, Sean, just on the M&A pipeline, if you could just kind of maybe talk about that qualitatively? What it looks like, if it's changed all over the past quarter or 2? And whether the opportunities are more on the commercial or defense side of the business?

Yes. I'd say the pipeline continue to be pretty active but consistent with what it's been, at least, in the last couple quarters. There's some assets in market -- there are some assets that we think are interesting that could be coming to market. And I'd say the split is pretty balanced between commercial and government. I think we see the opportunity to add to both parts of our business. And as we've talked about at the Investor Day, we're really looking to add IP to the business, whether it would be in kind of the parts supply distribution business or enhancing some capabilities on the government side. So I'd say it's active and pretty well-balanced across the portfolio.

Our next question comes from the line of Ken Herbert with Canaccord.

John, I just wanted to first, again, follow up on the MRO business. Did you hit the inflection you talked about? And was that business profitable in the fiscal first quarter?

Yes, yes and yes. And as it relates to inflection, it was a big improvement in the first quarter versus last quarter. And that improvement is not only important as it relates to the results for the quarter itself, but as I mentioned earlier, it sets us up well for the rest of the year, being able to maintain that team throughout the summer and being in the market now. We're still in the market for mechanics as we enter the busy season here, but we're in the market for a lot fewer than we were last year. So we're in an important time right now as we go out there and recruit. We're very encouraged by the results that we're seeing, even as we start the second quarter. And yes, I think we're off to a very good start.

Okay. Very helpful. And as I look, there's a lot of growing or a lot of speculation that with the MAX returning to service at some point in the next period of time here and with what's happened with narrow-bodies and new deliveries, that there's going to be a real step-up in retirements maybe in calendar '20 and into '21. And I know that generates puts and takes in your business when I think about certainly the parts trading and maybe some lower demand for some of the new material perhaps on the distribution side. But can you just talk about how we should think about that, if there is a step-up in retirements and the impact of the various pieces of Aviation Services, whether it'd be sort of a net positive or where the risks might be?

Yes. I think that's a great question, and we're certainly thinking about that dynamic. I think overall, we would characterize it as a net positive because today, there is -- particularly on the aftermarket parts supply around engines, there is considerably more demand and more demand forecasted for the next several years for current-generation 737 [shop] business. And to the extent that we're able to get more material and we will be able to get more material as we see more retirements in that fleet, we've got demand for it. And we're the largest in the world for that market. We've got, as we keep saying, tremendous balance sheet capacity, which we're excited about and want to maintain. And our goal would be to be in a position where we can move quickly as material becomes available, and we've got outlets for that material. So that's the biggest driver overall of all of this. Our heavy maintenance contracts are -- for that fleet, they are longer-term and they carry us several years out. So we feel good about the planned maintenance visit there. But generally speaking, I would say that we view that as a net positive.

Okay. And then if I could just finally, and maybe I don't expect you to get too specific on this, but as I think about your comments around parts supply, and there is strong demand for material today, both new material through distribution and, of course, maybe alternative materials through the parts trading side, it seems like it's clearly a favorable environment from a pricing standpoint. And I'm just wondering if you can disaggregate a little bit some of the trends you're seeing on pricing within parts supply versus volume. And maybe even just to sort of -- if you're seeing any changes sequentially or you're getting better pricing sequentially, without maybe giving more specifics as to how the growth breaks out. But any color around the price versus volume and trends you're seeing would be very helpful.

Yes. I wouldn't want to get -- and you got it, I wouldn't want to get too specific just for competitive reasons. But given the tightness of availability of material in the market, you definitely have had some pricing favorability out there. And you've also seen that in terms of the price that you pay for assets. And that, again, is where we believe we excel is our ability to find material, make the buy right, which often comes down to speed of being able to close transactions and then command the best price availability that you can in the market. So in terms of trends, that's -- we've seen that over the last several quarters. This quarter, in particular, I don't know that we saw necessarily any sort of meaningful change from where we were in Q3 and Q4. And I don't know that we'd necessarily see a change in the near term there as well.

Okay. And just one final clarification. Within trading, as I think about your agreement, say, with Delta and other large customers, what percentage of your trading business do you sell into sort of your long-term contracts versus sort of spot market or book-and-ship, if I could think about it that way?

Yes. I don't know that we want to get into that specific, but what I can tell you is that it's been a focus of ours to increase the amount of business under contract in the trading business. And so that's a much greater percentage of that business than it was a few years ago, but I wouldn't want to get into specifics there.

Our next question comes from the line of Michael Ciarmoli with SunTrust.

Great quarter. This is Jorge on for Mike. You've talked a lot about the 3 major things ongoing, kind of the 3 megatrends, the 737, what's going on with the DoD, and we seem to have a lot of airline pressure. I guess, I wanted to start my questions with what was announced last week. It looks like we're going to have entire retirements of squadrons out of the Air Force, a $25 billion cut into the budget. Do you have any opinion on what kind of impact that has on AAR, positive, negative, at all?

Yes. We don't have a strong view on that at the moment. For the contracts that we are on and for the contracts that we plan -- are bidding, none of that would have an impact to anything that we're looking at. What we can say is that we think that AAR's solutions for the government, and the C-40 is really an outstanding example of this, if the government is looking to save money going after solutions like what we just offer with the C-40, is a wonderful opportunity for them. And as we mentioned, that's a situation where the government came out. They wanted to buy 2 aircraft. They were planning to buy new aircraft. AAR was able to present a solution that allowed them to buy used aircraft and actually get those delivered sooner than they would have if they had brought new aircraft for considerably less. And you can bet that we're going to take that example and market it all over the place to the U.S. government as an opportunity for them to save money. And not just in whole aircraft purchases, and we believe that there is more out there like this, but also as it relates to just used serviceable material as a source of savings in all areas of procurement. So that's a big part of our strategy.

Were there any PBL opportunities with the sale of the aircraft in terms of the maintenance also? Or was that not offered as you pursued the C-40 opportunity?

That's a great question. It was not offered in this particular case, but I will point out that we do have another C-40 contract with the Navy where we perform the maintenance and certain supply chain services as well. So while it wasn't part of this transaction, it's something that we've done successfully elsewhere.

Yes. It sounds very exciting. It almost seems like the cost-reduction focuses are a tailwind for AAR. Would you characterize it that way?

Yes, I would. I would.

Okay. Would you say that, that also applies with the pressure on -- that we're seeing with the airlines right now? We've had, I think, a slew of airline bankruptcies in the last 30 days. Is that also an emerging tailwind for AAR?

We certainly are keeping our eye on that and the creditworthiness of our customers. And obviously there's been some news just in the last few days in a couple of airlines. So that's definitely something we're focused on. I am in touch with our customers almost every day and often at very senior levels. And while they're seeing -- and I'm thinking about North America in particular, while they're definitely seeing pressure in certain areas, their businesses are still historically extremely strong. And the day-to-day demand both for parts and for maintenance out of the customers is also very strong.

Coming back to your point, I do think, yes, as our customers look for more cost-effective solutions versus buying from OEMs or other suppliers, the aftermarket solutions that AAR offers represent a great opportunity to get quality products and services at better cost.

Excellent. Just going to Leach, on the electronic power side, is this your first distribution agreement in this kind of product set? Or do you service other products like this with other companies?

Yes, again, great question. There is a few firsts with this deal. Most notably, this is actually the first where we are distributing parts that will be used in new OEM manufacturing. So we kind of moved the one step-up in the supply chain here where we're distributing parts that will actually be -- where the customer base is not end users like the airlines or the government. The customer base is -- actually in this case, the majority of the customer base is going to be OEMs that use the parts in their own manufacturing process. So that opens doors for us, and we're excited about that. We've already started ramping up nicely on that contract, and it should bring with it other opportunities as well.

Great. So would you expect that then to expand with other Transdigm subsidiaries? Or would that -- is that in the cards, do you think?

Well, I certainly would hope so. Transdigm, as you know, with their operating model, they are fairly decentralized. So the subsidiaries make their own decisions. But certainly, we're focused on being successful with the contract we just signed with Leach. And we would do the best we can to leverage that success with other companies like Leach and certainly other companies within the Transdigm Group.

Okay. Excellent. Just wrapping up. Adjusted EBITDA margin -- excuse me, adjusted EBITDA guidance still in the $165 million to $170 million range?

No. So we didn't give adjusted EBITDA guidance for this year. Guidance for the year is sales, EPS and we gave some color on SG&A and tax.

Okay. I think that is it, and I look forward to hearing about your next military acquisition.

We have a follow-up question from Robert Spingarn.

I just wanted to ask about the SG&A guide, the 10.5%, and whether or not that contemplates any more of these non-GAAP costs, in other words, what you saw the first quarter?

Yes. So the 10.5% would exclude any of those kind of compliance and investigation costs.

I'm showing no further questions in the queue.

Okay. Well, with that, we really want to thank everybody for their participation in the call and your time and interest in AAR. Thank you.

Ladies and gentlemen, that concludes the conference call. Thank you for participating. You may now disconnect. Everyone, have a wonderful day.