AAR Corp.

Good afternoon, everyone, and welcome to the AAR's Fiscal 2020 Second Quarter Earnings Call. We're 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 AARP's President and CEO, John Holmes.

Great. Thank you very much. And good afternoon, everyone. We really appreciate you all being here to join us today to discuss our second quarter FY20 results. In the second quarter FY20, sales grew by 13.7%. from $493.3 million to $560.9 million. Our adjusted diluted earnings per share from continuing operations increased from $0.60 a share to $0.64 per share. We had a great quarter, and I am really pleased with our overall results. Once again, we saw exceptionally strong performance from our trading activities as we continued to use our global network to source the highest demand material to support our long-term customer contracts. We saw strong results from our distribution activities as well, having benefited from the maturation of contracts secured over the last several quarters. We also continued to see solid growth from our government programs activities. The WASP and landing gear PBL contracts in particular are performing very well operationally and are allowing us to build solid past performance as a foundation to capture more government opportunities. The second quarter was also our fourth consecutive quarter of improved performance in our MRO business. The actions taken to address the shortage of mechanics, such as enhancing our recruiting efforts, partnering with various schools, and repositioning elements of our workforce across our network have paid off, and we are seeing benefits of those actions now. In addition to the strong financial performance, we also announced several new awards during the quarter. Our Aaron Mars subsidiary, a provider of component repair cycle management solutions, announced two new contracts. The first was with Alaska Airlines for Airvolution, which is a software platform that enables the customer to increase efficiency and reduce costs by increasing visibility into their component repair cycle. Airvolution is our first software as a service offering, or SaaS, and I'm thrilled to have Alaska using our platform. In addition to this award, we continue to see very significant revenue growth for our other businesses, through the digital channels that we have built over the last two years. Aramar also signed a contract with JetBlue to provide component value engineering to help reduce repair costs. We're excited about these two awards as they represent new services to existing customers, which validates our integrated services model. Finally, we expanded our component repair services agreement with BAE Systems to include a wider range of components for its regional jet support programs. BAA cited our consistent cost savings and the high quality delivered by our Amsterdam facility as the basis for this expansion. Before turning it over to Sean, I would like to provide an update on the sale of our airlift COCO business, which is in discontinued operations. I'm pleased to share that we have completed the sale of all of our DOD contracts and are awaiting regulatory approval for one remaining foreign contract, which we expect to receive soon. Once received, the exit of our airlift COCO business in discontinued operations will be complete. With that, I'll turn it over to our CFO, Sean Gillen.

Thanks, John. Our sales in the quarter of $560.9 million were up 13.7% or $67.6 million year over year. This included a $69.1 million or 14.9% increase in aviation services revenues driven by execution on new contract awards and strong demand in our parts supply activities. Gross profit increased 9.7% or $7.6 million to $85.9 million. Gross margin within aviation services remained relatively flat at 16.1% for the quarter, which was favorably impacted by improvement in MRO and offset by some mix in government services and increased costs in certain commercial PBH programs. While we did see increased costs in certain programs, some of the increase can be attributed to improving the operational turnaround time by more quickly closing repair orders. We are taking actions to address these increased costs, such as optimizing our vendor network and inventory pool, as well as insourcing repair work. Consolidated gross margin was 15.3% versus 15.9% in the prior year period, primarily due to expeditionary services. Our mobility activities had a softer quarter due to a contract war not being finalized in the period and some operational challenges, including raw material inflation and warranty issues. Our composite activities also had weaker performance due to mixed labor inefficiency and higher freight costs. While overall performance should recover in the second half of the year, we are taking action to reduce overhead as well as evaluating opportunities to reduce fixed costs. SG&A expenses were 10.2% of sales versus 10.0% in the prior period, which was largely driven by investigation and compliance-related costs. Excluding investigation and severance costs, which totaled $3.3 million, SG&A would have been 9.6% of sales in the quarter. Our income tax expense during the quarter was $6 million, resulting in an effective tax rate of 23%. Net interest expense was $1.8 million compared to $2.4 million last year due to lower borrowings and rates. During the quarter, our cash flow provided from operating activities from continuing operations was $19.9 million, which improves $35.3 million from the prior year, excluding the impact of the accounts receivable financing program, which was relatively flat this quarter. During the quarter, we returned $6.7 million to shareholders via a dividend for $0.075 per share, or $2.6 million, and repurchased 100,000 shares for $4.1 million. The balance sheet remains strong with net debt at $160.1 million and net leverage at 0.9 times. Before handing the call back to John, I want to provide an update on the Department of Justice investigation at Airlift regarding potential violations of the False Blames Act. which we disclosed in 2018 and with which we have been cooperating. We have recently entered into settlement discussions with the DOJ. We are happy to take a step towards resolving this matter. However, there is no assurance that any settlement will be achieved. We will keep you updated as these discussions progress. Thank you for your attention, and I will now turn the call back over to John.

Great. Thank you, Sean. Due to the strong performance in the first half of the year, we are updating our FY20 guidance and now expect sales to be between $2.15 billion and $2.225 billion. We now expect adjusted earnings per share from continuing operations to be in the range of $2.50 a share to $2.65 a share. Compared to our prior financial guidance, the midpoint of our revised sales guidance increased from $2.15 billion to $2.188 billion. And the midpoint of our revised adjusted diluted earnings per share from continuing operations increased from $2.55 a share to $2.58 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 FY20. We will continue to reassess our guidance and modify it if necessary as the year progresses. As it relates to the cadence of our earnings over the balance of the year, we would expect to have modest sequential growth in the third quarter and then more significant sequential growth in the fourth quarter. In closing, our parts supply activity has continued to deliver exceptional performance. We're executing well on our government program's wins, and we're very pleased with the recovery that we see in the MRO activities. We've got a strong balance sheet, full pipeline of new business opportunities, and we look forward to a very successful second half of FY20. And with that, I'll turn it back over to the operator for questions.

Thank you. If you'd like to ask a question, please press star then 1 on your touchtone telephone. One moment, please. Our first question comes from Robert Springer of Credit Suisse. Your line is open.

Hi, guys. Good afternoon. Hey, Rob. How are you doing? Good, thanks. Nice quarter. Some nice cash flow here. I wanted to go back. You just talked about the midpoint of your revenue guidance, the 2188. And that implies about 6.5% growth for the year, if I'm doing the math right. But you're about 15% so far this year. So a couple things here. One, I'm thinking maybe the back end is a little conservative, though the moving parts, I don't know if something's rolling off. You've added a fair amount of work. And then I wanted to talk about that in terms of the two segments because sort of no matter what Expeditionary does, in the second half and it's flattish for the year, you know, one would expect or it seems you're implying that the growth in aviation services softens a bit. You did say the cadence into Q3 is maybe soft and then you strengthen in Q4. So all that together, how does the second half look?

Yeah, well, you know, again, we're real proud of the first half. It's been a great start to the year. And as we think about the second half, you know, you do come up against tougher comps versus last year because that was about when we started to see some recovery in the MRO business. So, you know, that drives a bit of it. You did mention expeditionary services. As Sean mentioned, we are expecting a recovery in the second half, although it will likely be below the plan that we originally developed when we presented the guidance originally. But, you know, overall, we're happy that we're in a position to have raised the guidance overall for the year. And, you know, this represents the best view of the opportunities that we see at this time.

So could you conceivably see – does Expeditionary get better at any point? What's the long-term objective there?

So Expeditionary, you know, right now we're focused, as we said, on improving the performance of that business. Part of what happened this quarter was situational. We had some operational issues that we've worked through. And then we've also seen some awards get delayed from the government, and we expect those to come through during the second half of the year. Depending on when those hit, you know, obviously will drive the performance in the second half of the year. But, you know, as we've talked about, Rob, for a long time, our focus as a company, generally speaking, has been growing significantly and building out the aviation services segment. And that's where the investment, that's where the focus has been. And that's where you've seen the growth. So that's the long-term future of the company.

Yeah, I was going to say, even with the tough comps, if I just use your numbers, you're really implying no absolute increase in the back half of the year. And again, with these contracts that you've been feathering in all along, I'm just going to take that as conservatism. And then the So that's a comment more than a question. Last question, though, on the software-as-a-service contracts that you mentioned, very interesting, this Airvolution and so on. Who are you competing with on these?

That is a great question, and I like our answer. There's nothing like that in the market. It's the only application that gives you the type of visibility that – the type of visibility that we do into the component repair supply chain. And it also allows customers to share data. You know, we need more customers to get on the platform and share their data with us. But in an anonymized way, on an individual component level, customers can now compare the price that they're paying against the community. And that's a feature that we're seeing a great deal of interest in. So, I mean, from a financial standpoint, you know, it's a very small contributor to the overall results right now, but it's our first foray into an actual software program, and we're really excited that Alaska is on board.

And do you have any partners on this product? Is this developed in-house? Are there any other folks that are, you know, doing the technical side for you?

Well, yeah, we definitely have technical partners that help us develop the platform. But, you know, those are more kind of on a consulting basis as opposed to, you know, any significant commercial relationship. And we have a number of technical partners that are helping us build out the rest of the digital solutions. And, you know, as I mentioned, we're seeing a really significant increase of revenue through the digital channels that we've developed for our traditional businesses over the last couple of years.

Okay. Thanks very much. I'll jump out and come back later.

Thanks, Rob.

Thank you. Our next question comes from Ken Herbert of Canaccord. Your line is open.

Hi. Good afternoon, Sean and John. Hey, Ken. Hey, I just wanted to first ask your gross margins within aviation services. You called out some headwinds from some of your government services contracts. But then also, it sounds like on commercial programs, you've seen some higher than expected costs there. I wanted to see if you could parse that out between those for us. And then specifically on the commercial program side, it sounds like this is a business that's maybe not getting as much capital as it has in the past. Can you talk about some of the maybe the headwinds you're seeing in that business, whether it be pricing or higher costs, and maybe how we should think about that business for you longer term.

Sure. You know, as we think about gross profit, you know, there were some, you know, the positives are continued exceptional performance out of the parts businesses and the recovery in MRO. The two areas that were, you know, offsetting to that, as Sean mentioned, One was, as you mentioned, government programs. Now, we don't see headwind in government programs. We actually see a great deal of growth and very strong performance out of that area of the company. But the way those work, they're dilutive to the gross profit number but accretive to our operating margin. So that mix there is a pretty meaningful impact this quarter, and we would expect it to be an impact going forward given the growth of that business. On commercial programs, we've talked the last several quarters about the market there, and we have seen increased competition, and the pricing has been driven down as a result for that market. We continue to compete, but as we've talked about, we have certain return requirements. If we can't meet those return requirements, we're not going to take the deal. On existing contracts, we have seen some costs headwind on certain of the contracts. As Sean mentioned, we're working to address those. Some of that, though, is timing and situational that you saw in this quarter, and that's because in certain of the contracts, in order to improve operational performance, we accelerated the whip, and so that had the effect of pulling costs forward, which we saw in this quarter. And also because of the accounting changes that took place last year, a number of these contracts are now on a cash basis as opposed to managed over time. So you do see fluctuations in income in any given quarter as a result of cost changes. But as you pointed out, we haven't announced the new win in that area in a little while. And it's still an important part of our portfolio. Having said that, we've been able to achieve what we believe is very significant growth across the company, double-digit growth now for six quarters in a row. And that's being driven by other areas outside of commercial programs.

Okay. No, that's helpful. It makes a lot of sense. It seems like a very competitive market. And as we look at the guidance increase again, just a question again within aviation services and the growth there, it's fair to assume then that the parts business, trading and distribution, and maybe some on the government side with those contracts is obviously driving the increase or is on the top line or is maybe better performance on the MRO, a material piece of that as well?

It's all of the above. Very strong performance out of trading. Very healthy year-over-year growth there. continued strong performance from the new parts business, very nice growth out of the government programs area as those contracts have matured. And as you pointed out, the recovery in the MRO business is meaningful as well.

Okay. And if I could, just one final question. I know you've talked more recently about government services and the opportunities, and it sounds like WASM and the PBL contract are going well. within aviation services. Can you provide any data, John, on maybe the bids you're seeing, the opportunities, maybe what might be flowing through in terms of your bid pipeline or your backlog? I mean, it sounds like now there's obviously a real high focus on these types of contracts from your customer base here in the United States in particular. And I'm just wondering, maybe are you capturing more as a scenario where we should continue to see or expect strong growth? And maybe just a little bit about some of your activity underneath the two contracts you talk about moving forward for that business.

Sure, sure. A couple thoughts there. Yes, you should expect to see continued growth out of that government services business. And we have a very full pipeline. And the point that we made on past performance is the more we win, the more we're able to win. because we build more experience, which allows us to bid on more types of work. So that is widening the aperture of the types of things that we can pursue. On top of that, we've really successfully made the migration from a subcontractor to a prime contractor over the last four or five years. And that, again, is helping us bid these larger programs. And we're also taking advantage of the fact that we just won, as you know, two quarters ago, the C-40 contract to sell two aftermarket aircraft to the government. And that is a great example of the government accessing the aftermarket. And on that, you know, the original solicitation that came out for those two aircraft was originally written for only the purchase of two new aircraft. And we worked, you know, in D.C., to allow, uh, that solicitation to, to allow, um, uh, the sourcing of two used aircraft. And ultimately we're successful in winning that, you know, that we believe is going to open up more doors for us, not just for used aircraft sales, but for also used part sales. And, uh, we see a lot of opportunity, you know, coming, uh, there, I was just at a DOD, uh, maintenance symposium. I gave a keynote speech, uh, last week there. And, uh, You know, we talked a lot about the DOD making better use of well-established aftermarket solutions as it looks to go ahead and increase the sustainment and the readiness of the fleet, but doing that in a more cost-effective way. And there was a lot of interest as we gave these commercial examples and their application to the government environment. So we remain very excited about the growth prospects for us in government services. Great. Thank you very much. Nice quarter. Thanks, Jim.

Thank you. Our next question comes from Michael Ciamale of SunTrash. Your line is open.

Hey, good evening, guys. Thanks for taking the questions. Nice quarter. John, can we go back to maybe just to close the loop on, I think, what Rob was talking about on the digital solutions. Do you compete at all? I know Honeywell's got, I think, their GoDirect trading.

Yeah, GoDirect.

What's the difference between... Yeah, what's the difference? How are you guys differentiating your solution versus their solution? I mean, theirs just seems to be a part store, I guess. But are you guys doing anything radically different to entice more customers to sell that solution? Can you just maybe articulate a little bit there?

Sure. There's a handful of digital initiatives that we've got. Some are external and some are internal. Quickly, in the internal, we've done a lot of work to put more information and take advantage of data that we collect from our heavy maintenance activities and our power by the hour activities and our part sales activities and use that data to get more information in front of our employees real time so that we can capture sales more quickly. From an external standpoint, we do have our parts store We're seeing a lot of traffic through that store. We've seen, you know, very, very healthy month-over-month increases of traffic through that store. And we've seen a broader acceptance of small and large customers in terms of transacting business digitally as opposed to, you know, phones and emails. So we're excited about that. You know, I wouldn't want to, you know, necessarily compare us to, You know, there's a lot of people out there. As you mentioned, there's Honeywell Go Direct, there's E-Plane, there's, you know, there's AeroBuy. You know, there's all kinds of different platforms out there. One of the reasons we are successful is because this is what we do. You know, this is a core business for us, and we're taking what we do and what we do very, very well and applying it to a digital channel. So I remain very excited about what we're seeing there.

Got it. That's helpful. And then just on the strength in the parts trading, I mean, you know, clearly we continue to see this robust activity in the aftermarket. It looks like, you know, shop visits, overhauls, everything on the schedule into next year. Looks like that strength continues. Are you seeing any incremental upside from the grounding of the max? I mean, is that creating more tightness around three, seven parts of availability and giving you more pricing power? Can you just maybe give a little color? on how that's factoring into the performance of trading, if at all?

Yeah, no, I mean, net to max is a positive for us. You know, and we've said before that it's, you know, neutral is slightly positive right now, but it's definitely positive over the long term because it extends the life of the current generation platforms. As it relates to material availability, there's no question 737 material is very, very tight. but we are the best in the world at sourcing that material and sourcing it at the right price. As a matter of fact, we just closed on two aircraft actually recently, and we're really happy that we made that buy and we're able to get our hands on that because that's great material that will help us in the second half. So the fact that we are, you know, we're the largest in the world for this, We've got the best network of buyers and sourcing team around the world, and we've got the balance sheet capacity and flexibility to close faster than anybody we compete with. That's giving us an edge in that market. On top of that, we also have the best set of contracts, particularly with the engine shops, for long-term supply agreements. So when we go out and we find the right material, we've got the capital to deploy quickly, and we know we've got it sold because we've got the contracts. Got it. That's helpful to know.

And then just to nitpick maybe a little bit on the aviation margins. I mean, I'm assuming all of this parts trading activity is margin accretive to some of the other services and revenue generating activities in the aviation business. The margins have been flattish down slightly year over year. I think you did talk about some of the turn times and looking at costs there and insourcing. But how do we think about any potential operating leverage in aviation services? I mean, I would imagine the parts trading can't continue to stay this active. You know, should we think about you guys having some levers to pull to either sustain the margins or drive some upside, you know, once parts trading sort of normalizes?

Well, I would say just on parts trading, I mean, we expect this heightened level of activity to continue for a long time. And that was well before the max, you know, grounding happened because of the contracts that we have, the forecasts we see from the shop, and the bow wave of maintenance visits that's expected to occur over the next couple of years. So we feel very good about that business and the continued strength for many quarters to come. In terms of, you know, overall margin, you know, it's a big focus of ours. We – We, you know, are focused on improving that number. You know, MRO is not yet back at the level that it was two years ago. You know, we're headed that way. Each quarter we make a little bit of improvement, but that is still, you know, depressed from where it was a couple of years ago because our labor costs increase and we, you know, have not yet passed that entire cost on to the customer. The customers are being very supportive. They've got their own cost pressures and they're working with us. but we still have some work to do there. On top of that, we did bring in a lot of new talent, and that talent takes a while to get trained and get good at what they do and ultimately become more efficient on the floor. And as that happens, we expect to see continued margin improvement in MRO. And then as Sean mentioned on the commercial programs fund, there are definitely some cost challenges that we've seen recently there, and we're taking a number of actions to address those. And as we work through that, we would expect to see margin improvement there too.

Got it. Helpful. I'll jump back in the queue. Thanks, guys.

Thanks, Mike. Thank you. Again, if you'd like to ask a question, please press star then 1. Our next question comes from Josh Sullivan of Seaport Global. Your line is open.

Hey, good afternoon. How do you feel about the inventory in your trading business? You know, you talk about that bow wave of maintenance, coming up, do you still feel the need to build that inventory in your network, or is it that network that you have that you feel like you can trade on a spot basis that's giving you confidence?

We have been making continued investments in the inventory, so that investment has actually grown over the last few quarters. The turns have also improved, so we're seeing material come in and go out. But candidly, the demand is so significant that that, you know, wherever we can find material, we get it, and often we're able to move it, you know, very quickly. So, you know, we have investment plans, et cetera, but those investment plans have to be flexible when we come across opportunities to get our hands on the right stuff. Got it.

And then just another follow-up on the SaaS strategy. How is price discovery going? Are these trials still, or have you firmed up pricing and margin at this point?

I'm sorry, on what exactly?

On the SaaS strategy. Oh, SaaS.

Oh, okay. Yeah, I would characterize that as very, very early, very early. So we've got a launch customer. We have multiple other customers that we're talking about right now. And I would say, to use your words, we are in the phase of price discovery. Got it.

And then just one last one on the MRO market. Where is utilization on MRO shop visits year over year at this point?

We are... Well, for us, we are up year over year. We're sold out for the rest of the year. And, you know, we have seen customers, you know, move work around largely as a result of schedule changes due to the max. But, you know, we, from our standpoint, we're at a very high utilization.

And I would say, you know, our utilization, you know, last year was constrained by labor rather than pure capacity. And so our labor position is better. So we're at a higher utilization, but the constraint continues to be labor overall in that market.

I think that's a good point. You know, the macro environment for labor has not improved year over year. It's our position within that environment, thanks to the actions that we've taken, have allowed us to make this recovery. Thank you. Great. Thanks, Josh.

Thank you. Again, ladies and gentlemen, if you'd like to ask a question, please press star then 1. One moment, please. I'm showing no questions at this time.

Well, great, everyone. We really appreciate your time and your interest in our company, and we wish everybody happy holidays.

Ladies and gentlemen, this does conclude today's conference. Thank you for participating. You may all disconnect.