AAR Corp.

Good afternoon, ladies and gentlemen, and welcome to AAR's fiscal 2021 second 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 comments made during the call may include forward-looking statements as defined in the private security litigation format of 1995. As noted in the company's news release and the risk factor section, of the company's Form 10-K for the fiscal year ended May 31st, 2020, and Form 10-Q for the fiscal quarter ended August 31st, 2020. 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 President and CEO, John Holmes.

Great. Thank you very much, and good afternoon, everyone. I appreciate you all joining us today to discuss our second quarter fiscal 2021 results. Before we discuss the results themselves, I would like to thank all of our employees for the continued resiliency and courage they have shown over the last three quarters as we've navigated this pandemic. In particular, more than two-thirds of our people are essential workers, and they have continued to come to work every day, enabling us to continue to deliver for our customers. I'm very proud of our entire team. I also want to thank Congress once again for its work on the CARES Act, which has allowed companies like ours to preserve their skilled workforce. Regarding the business, as we indicated last quarter, overall we have seen our commercial volume stabilize and continued strong performance out of our government business. While we remain in a difficult and uncertain environment, we are encouraged by the stabilization as well as the positive developments regarding the vaccines, which not only will protect our people, but should also ultimately lead to more travel and a recovery in our commercial markets. With that, turning to the quarter, our sales decreased 28% year over year from $561 million to $404 million, and our adjusted diluted earnings per share from continuing operations decreased 52% from 64 cents per share to 31 cents per share. Our sales to commercial customers decreased 48%, and our sales to government and defense customers increased 13%. For the quarter, sales to government and defense customers were 52% of our total sales. Our aviation services segment grew 6% sequentially from our first quarter. This was a result of increased volume in our MRO business, which is decently higher in Q2 over Q1, as well as the continued strength of our government business. Our commercial parts volumes overall were relatively stable throughout the quarter and remained above the lows we saw in April and May. That said, I am particularly encouraged by our margin improvement progress. Over the last several quarters, we have reduced our footprint across the enterprise, decreased our indirect and overhead spending, exited or restructured several underperforming contracts, and divested a loss-making non-core business. You are now starting to see the results of these actions in our adjusted operating margins, which improved meaningfully from 2.5% to 4% sequentially on stable revenue. With respect to cash, we generated $28 million from operating activities from continuing operations and also reduced our accounts receivable financing program by nearly $7 million, further improving our already strong balance sheet position and putting our net leverage below one times EBITDA. We also continue to add significant new business that positions us for growth going forward. Our CFM56 partnership with Fortress solidifies the source of supply to meet growing demand for used serviceable material on the Dash 5B and the Dash 7B engine variants. We expect demand for USM to increase across the board as we emerge from the pandemic and to be particularly strong for these engine platforms. Also, our follow-on contract from the Navy to support the C-40 aircraft recognizes our performance over the last five years and provides for an expanded statement of work over the next five years. It's worth noting that this was the first time that this contract was awarded to an incumbent, which speaks to the high quality of our service. Additionally, our 10-year agreement with Honeywell to be a sole authorized service center for 737 MAX electronic bleed air system components positions us to support MAX operators worldwide so that aircraft is returned to service. These new contracts, along with others we have announced over the last several months, such as the Unison expansion and extension, represent nearly $1.7 billion in total contract value captured so far this fiscal year. This demonstrates the unique value of our aviation services offering, and these business wins will help accelerate our recovery coming out of the downturn. With that, I'll turn it over to our CFO, Sean Gillen, to review the quarter's results in more detail. Thanks, John.

Our sales in the quarter of $403.6 million were down 28% or $157.3 million year-over-year, driven by the impacts of the pandemic on commercial passenger flying activity. Sequentially, aviation services sales were up 5.9% or $21.4 million, while sales in expeditionary services were down 50% or $18.6 million. The sequential decline in expeditionary services was driven by two factors. First, the exit of the composites business was completed at the end of Q1, and this business generated $7 million of revenue in Q1 and zero in the current quarter. Second, as previously discussed, mobility had a particularly strong Q1 due to elevated shipments of pallets. Within aviation services, our government and defense business was up 19% or $30 million year-over-year, reflecting strong performance on existing contracts. In the quarter, as well as in Q1, our program to deliver two C-40 aircraft to the U.S. Marine Corps generated strong revenue due to elevated activity on the program. Gross profit margin in the quarter increased to 17.2% from 15.3% in the prior year quarter, driven by the CARES Act payroll support. On a sequential basis, gross profit margin was up from 12.1% in our first quarter reflecting the actions we have taken to reduce our indirect costs and to exit underperforming contracts and product lines. SG&A expenses were $43.4 million for the quarter. On an adjusted basis, SG&A was $38 million, or 9.4% of sales, down $13 million from the prior year quarter, reflecting the reduction of our overhead cost structure. Of this improvement, approximately $3.2 million was the result of temporary reductions in compensation and benefits, which we restored beginning on December 1st. As an update on our previous disclosure, we have been in settlement discussions with the Department of Justice regarding an investigation of airlift under the False Claims Act. During the quarter, we recorded 6 million of additional accrual and discontinued operations, which brings our total reserve for this matter to 8 million based on our latest settlement offer. We generated 27.6 million of cash in our operating activities from continuing operations for the quarter. This is net of a use of cash of 6.8 million as we continue to reduce the size of our accounts receivable financing program. Excluding the accounts receivable financing program, cash flow provided by operating activities from continuing operations was 34.4 million. Inventory decreased 12.7 million during the quarter. Our net debt at quarter end was 112.1 million, down 37 million from 149.3 million at the end of Q1. Our balance sheet and liquidity remain strong with net leverage of 0.95 times adjusted EBITDA, unrestricted cash of $110 million, and unused capacity under our revolver of approximately $390 million. As such, we're well positioned to fund what we expect to be unique opportunities to grow our business over the coming quarters. Thank you for your attention, and I'll now turn the call back over to John.

Great. Thank you, Sean. Overall, we are pleased with our results given the current environment and also pleased with the progress we have made in improving our operating efficiency. As I mentioned, for many reasons, we are encouraged by the multiple vaccines coming to market and the plans for distribution. As the vaccines are distributed and case numbers decline, we expect travel restrictions to be lifted and people to start flying again. Until then, we expect to be in a relatively stable revenue environment and we will continue to focus on driving cash flow as well as continued margin improvement. We will also remain focused on capturing new business, and I am confident that our strong balance sheet combined with the airline's increasing desire for our lower-cost, value-added services will lead to even more growth opportunities.

With that, I'll turn it over to the operator for questions. Thank you. As a reminder, to ask a question, you'll need to press star 1 on your telephone. To withdraw your question, press the pound key. please stand by where we compile the Q and a roster. Again, that is star one. If you'd like to ask a question. And our first question comes from Robert Spingarn from Credit Suisse. Your line is now open.

Hey, good afternoon. So, um, good, thanks. And nice, you know, margin improvement there, John, I want to talk about, uh, just, well, I've got a couple of things I want to go over, but, uh, How did the quarter look month by month? It looks like you've already seen trough at least by a little bit here. This was a little bit up from last quarter, so I assume we're done with that and we're heading north on the revenues. But how did that look quarter to quarter, month to month?

Yeah, it was actually fairly stable throughout the quarter. I would agree that we've seen the trough, the parts volumes, the MRO volumes that all come up from what we saw in the April and May timeframe. But, you know, heading into the June, July period, the volumes that we saw across the business were relatively stable in the months following.

Okay. And then to what extent can we glean anything from whatever conversations you're having with customers as they think about the return of max to service, the maybe modest increase in production rate of the max? You know, Airbus has talked about perhaps lifting the production rate on the A320, and obviously traffic we all think is going to come back here. Have they talked to you a little bit about how they expect the fleet to move in response to all of that? And how, if at all, does that affect your MRO schedule and your anticipation of more USM becoming available if new lift starts to replace old lift?

Yeah, you know, it really depends on the customers. You know, certainly you've seen some of the larger carriers that have MAXs on order. You know, they've gone ahead and started taking delivery of those MAXs. You know, customers that have MAX already in their fleet, you know, they've begun operating those. You know, so those customers appear to be committed to that path. You know, broader, though, as you know, you have seen a number of cancellations of the MAX, and the corresponding theme is that we have seen you know, customers at the same time, they're going to introduce new aircraft. They've also indicated to us that they do expect to hold on to some older aircraft longer than they would have anticipated over, you know, throughout COVID. All of them, though, I should say, have expressed, and again, this is customers that are, you know, current USM customers, as well as customers in regions like China that are not USM customers. We have seen an interest across the board in USM material. And during the quarter, we did start to see more aircraft become available for acquisition and ultimately for teardown. So, you know, that chain of events where you see an aircraft put on the ground, then ultimately retired, then ultimately sold potentially to someone like us who might tear it down, you've seen a bit more of that come into the market, and therefore we expect the supply to start increasing.

Now, are those aircraft that you're starting to see, are those COs and NGs, or are we talking about older airplanes that really, you know, overhauling those wouldn't make any sense, you know, the models that are going really out to pasture?

Yeah. No, we've – and I don't want to get too much into detail for competitive reasons, but, you know, we've seen a pretty wide range of opportunities, I would say.

Okay, and then just quickly a couple other things. Just if we end up a couple years down the road with a simplified fleet of let's call it A320s, COs and NEOs, 220s, 350s, and then on the Boeing side, MAX and NG, 777, 787, and everything else is gone. Is that better for third-party maintenance or worse?

I think overall, I would view it as a positive. Companies like ours exist to provide a necessary service. That maintenance capability has largely been outsourced by most of the carriers. Unless you see a compelling event for them to start insourcing that activity, we believe that the the volume of work will continue to exist for third-party maintenance providers and us in particular.

Okay. And then just last one on margins. You mentioned that you see continued margin improvement. I think if we go back to your previous higher margins, you were doing that a period of time. You had higher SG&A, and you also had some contract labor, which we assume is more expensive. So if we look forward and you don't have those two things, How do we think about what margins can do? Is there an incremental margin that you or Sean suggest we be using as we look at revenues rise here?

We would expect that we will come out of this crisis at higher operating margins than we were pre-COVID. And that's due to a number of factors, largely to the actions that we've taken. But your point on contract labor is right on. We've done a number of things to reset activities inside of our hangars, and we do not expect to be as reliant on contract labor going forward as we have been in the past. That's certainly a contributor. We have a number of other efficiency initiatives that we're in the process of implementing inside the hangars so that we'll be a lot more efficient as that volume of work comes back. But then additionally, there were a number of less profitable activities or unprofitable activities that existed at the company pre-COVID. And over the last three quarters, we've done a lot of work to eliminate that drag from our earnings. And as we recover the stronger performance out of our parts businesses, for example, as well as increased efficiency in the hangar, you'll start to see that come through in better margins.

Okay, excellent. Thank you.

Thanks, Russ. And thank you. And our next question comes from Joseph Denardi from Stiefel. Your line is now open. Okay, thanks. Good afternoon.

John, can you just talk a little bit about maybe the conversations that you've been having with some of your airline customers in terms of how they're thinking about capacity recovery and specifically how those conversations may have changed, you know, in the last few weeks after the vaccine news and kind of how they're thinking about summer 21 schedules and capacity?

Sure. You know, again, you're in a situation where the conversation varies by customer. But the general themes are there is a focus on summer 2021 readiness. And what was different about the quarter we went through versus our first quarter, you know, during the summer, if you recall, we went through another surge, not nearly as significant as the surge we're in now, but there was another surge. And at that point, we did see quite a bit of movement in the maintenance schedule and parts buying behavior out of the customer base. We did not see and have not seen that same movement in behavior as we've gone through this most recent surge. As the customers appear to be focused, you know, okay, we're going to have some ups and downs over the next few months, but at the end of the day, the vaccine will be distributed. There's pent-up demand for leisure travel, and we want to be ready for that in summer 21. So while I would say the level of expectation of increase in summer 21 travel over summer 2020 varies by customer, overall the customers expect to have a better summer in 21 than they did in 20, and they want to be ready for it.

Okay. And then can you just walk us through maybe the three legs of your commercial business, where each one is kind of on the road to recovery, and then – structurally what's changed about each of the three in terms of kind of how big they can be on the other side of this and whether they're going to be structurally smaller for a period of time, if that makes sense.

Sure. I mean, in terms of overall size, I would go back to what we mentioned earlier. We expect to be in a relatively stable revenue environment until you see a meaningful increase in flying activities. But at the same time, we remain very focused on continuing to improve our margins in that stable environment. If I take the three areas of the commercial business, In the parts business, both new and used parts, as we mentioned earlier, we've seen relatively stable activity. We have had what I would call kind of higher highs, if you will, during the last few weeks, which is encouraging. But still, overall, we would expect stable activity in the commercial parts business. Coming out of the crisis, as we've talked about, we definitely expect increased demand for the USM business. We're really excited about our partnership with Fortress. That's one of many initiatives we have going on right now on the USM side. But I would expect that business to potentially be structurally larger than it was pre-COVID, depending on how demand shakes out. Similarly, on the new parts distribution business, we continue to add new distributorship There are a number of opportunities out there that we are evaluating for new parts distributorships with different OEMs. Much like the airlines, the OEMs, they're taking a look at their approach to the aftermarket. And similarly, as they think about their cost structures, we are seeing some interest from OEMs that previously might not have considered a distribution partner. Now they are looking at a distribution partner. And so we're evaluating those opportunities. And we think that that business could also emerged larger thanks to new business wins, as well as same-store sales, if you will, increase on the agreements that we had prior to COVID. In the MRO business, I would say that we feel very good about the footprint that we have. We took out capacity, which was a very difficult decision, but we took out capacity by closing our Duluth facility, as well as rationalized our footprint inside of other facilities that are still in the network. And we believe that ultimately we'll get a better yield out of that footprint than we did pre-COVID because of some of the changes that we've made. And finally, on the commercial programs business, that's a business where we've made a lot of changes over the last several quarters, as we've talked about. We've exited or restructured underperforming contracts. The majority of that work is now behind us. We feel good about the remaining contract portfolio. and I believe we talked about this last quarter, but, um, now that market had seen a lot of pricing pressure, um, uh, pre COVID. And you've seen a number of the, uh, the participants in that market, um, you know, make moves either to exit the market entirely, or also like us exit underperforming contracts. And we, uh, we believe that you could see pricing in that market reset, uh, post COVID and to the extent that it does. And we believe that we can, uh, earn a return will be a participant in that market.

That's great. So, John, fair to say that kind of the highest margin leg for you all will be bigger and the two lower margin legs will probably be smaller for a period? Yes. Okay. And then just two quick follow-ups on MRO. Have you seen any indications from airlines that they may be able to outsource more than they were able to pre-COVID? in terms of concessions that they've been able to get? And then, you know, in terms of what you've done to rationalize capacity, is that enough to fix the margin challenge that you all had at MRO pre-COVID, or do you still face some of the challenges that you had, I guess, pre-COVID once we're through this? Thank you.

Sure. In terms of work, I mean, All of our customers are reevaluating their operating models. I mean, you have to going through a shock like we've been through. So we're having a variety of conversations, both with existing customers and, as you point out, with customers that may not have pursued an outsourced model to the extent that they may consider now. So, you know, there's a lot of moving parts there. And then as it relates to the operating efficiency inside of the hangars, yeah, we feel very good about the changes that we have made. We believe the footprint that we have is the right footprint to take the work that we expect to get over the next few quarters, as well as the increased volumes as the overall market recovers. And we do expect much greater yield out of the labor hours that we produce based on the efficiency that we've built in. You know, again, there's a lot of moving pieces there, and we're extremely grateful for the support of our customers through this, and we're very excited to continue to provide the maintenance services to them as they recover. Great. Thank you.

Thank you. And our next question comes from Ken Herbert from Canaccord. Your line is now open.

Hey, good afternoon, John and Sean. Hey, John, I just wanted to first see if you can provide or what other details you can provide on the agreement with Fortress for the CFM, the 5 and the 7B engines, and I guess specifically timing you expect to start to see some of the engines come through, assuming we start to see some demand at some point for the material, and how we should think about the ramp of this agreement as it relates into your broader sort of USM opportunity.

Sure. Thanks for asking about that. We're very excited about the partnership with Fortress. We've worked with Fortress for many years and have a great respect for what the team over there is doing in the industry. And this agreement really plays to both of our strengths. They've got a very large and growing engine lease pool, and we are the number one participant in the USM space. So the agreement basically calls for us to – to manage engines through a teardown process out of their engine pool, and we have complete control over that management. Some of the material will be sold back to Fortress for use in their own engine build, and the rest of the material will be sold by us into the aftermarket. And there are volume commitments between us and Fortress, And those volume commitments will be a meaningful increase through our aftermarket parts activity. And these are core engine platforms, as you know, so we're excited to be an even bigger participant in that market. As it relates to timing, we would expect volume to see volume later this fiscal year, and then it would grow throughout our FY22. Okay.

Okay. And as I think about, is this a – would you consider this sort of an asset-light agreement, or are you actually going to be committing working capital to maybe buy some of the engines and materials ahead of time?

It's an asset-light agreement. We'll be investing in repairs, but not the assets themselves.

Okay.

Okay.

Great. And as I think about, if we sort of walk back from a, you know, hopefully a summer or mid-21 recovery in traffic, and you think about airlines' behaviors, is it fair to say that you would see this first in your MRO schedules, and then maybe second in the surplus material, and then your distribution business might be the last to see the uptick as airlines actually start to buy material again? Or is there a better way to think about the cadence of the impact on your business ahead of what should be an improvement?

Historically, what you just said, I would agree with that. Coming out of this downturn, just because it's been so broad and extended, and because of the significant deferred maintenance, particularly on engines, that has built up over the last several months, You know, it's possible that we could see concurrent recovery between the parts business as well as the heavy maintenance business, or the parts business could lead the recovery. You know, right now the loading that we have in the hangars is relatively consistent over the next couple quarters. But as our customers have better visibility into their demand going into summer 21, you could see that change as well.

Okay, so it sounds like, based on that comment, I don't want to put words in your mouth, but it sounds like you don't view green time on engines in particular as sort of a major overhang to the pace of the recovery.

I think we're burning green time now. Yeah. And so, you know, we're looking at, you know, ultimately as that green time comes down, the deferred, you know, balance is growing, if you will. and that would require more parts sooner.

Okay, but I guess the question is that defer doesn't sort of spill into, they're not able to defer theoretically for much of 21 if you see a recovery at some point in earlier in 21. It sounds like that green time and that deferred opportunity will largely have run its course theoretically if we do get a recovery in mid-21.

Yeah, I mean, you've got a lot of moving parts there, but That could be true.

Okay. Perfect. All right. Well, thank you very much.

Thank you. And our next question comes from Michael Cermoli from Truist. Your line is now open.

Hey, good evening, guys. Thanks for taking the questions here and good margin performance. John, I guess just to maybe stay on Ken's line of questioning and that recovery, I know you said the revenues likely stay stable until we see a pickup in travel utilization, most likely takeoff and landings. You just kind of said that loading looks consistent, but if these airlines and your customers are going to be ready for, you know, let's knock on wood and normalize 21 summer, shouldn't we see a pretty big uptick in activity ahead of that? I mean, as you guys look at it, you know, do you think like the May quarter, you know, ahead of that, you know, busy flying season, you start to see that revenue inflection before we see, you know, the uptick and kind of all that pent up demand and traffic uptick?

You very well could. You know, our stable outlook right now reflects what the commitments are that we have. You know, to the extent that customers see increased booking and they see that demand increase, then you're absolutely right. There could be more demand. I don't know that any of our customers right now are expecting a return to normal levels of flying in summer 21. I think that, you know, they're expecting certainly an increase in 21 over 20. But, you know, I think many of them are still, you know, have modest expectations. Having said that, though, you know, I mean, the situation continues to evolve very quickly. I know our customers, they, you know, bookings and cancellations are happening in real time for them, and so they don't have a lot of visibility into demand. So I think as soon as they have a clearer picture of summer 21, you know, they absolutely, you know, could be calling for more maintenance and more parts.

Got it. Yeah, and by no means did I suggest a normal 21, but just maybe true. But I guess what – the customer conversations, I mean, things are, you know, with this surge, I mean, things are going to be bad here in December, might get worse in January, February. I mean, how are these conversations – can you give us any insight into how things are evolving? I mean, are there – you know, are there more areas of risk that you see? I mean, you talked about the loading, but I mean, are there pressure points at some of your customers or are they all pretty much planning for, okay, you know, capacity demands going to be weaker for the next couple of months, but we're, we're thinking beyond this short-term impact. So are they thinking, you know, more along the lines of, Hey, our plans are pretty stable and firm regardless of what happens, or is it just still totally fluid out there?

I think that, I think what you just said, um, you know, the next last thing that you said is, okay, it's going to be, it's going to be a bit of an up and down patch here for the next few months, but we need to look past that and be ready for summer 21. And I believe that at least the commitments that they have made to us, that they are based on what I'll call kind of a, you know, a conservative case of what they expect summer 21 flying to be. In other words, They're committing to us because they know that, for example, the maintenance business, we need to have solid lines of maintenance to keep the team together and keep them working. And so right now they've committed to a level of loading that, you know, they know they can hit. To the extent that they end up with a better summer, you know, they may require more maintenance. We just haven't seen that order book form up yet.

Got it. And then just back to the MRO, you talked about the footprint, the efficiencies there. uh, better yields. Is there also, I mean, at one point labor was extremely tight, you know, are you getting more experienced mechanics in there? Is there any, uh, benefit you're seeing from, uh, you know, just hourly wages you're having to pay or, or is it just, you know, strictly tied to those, those footprint, uh, reductions that's helping your yield there?

Yeah, good, good question. Um, you know, so far, uh, you know, wages have remained relatively stable. Um, we have, um, I think, done a really nice job of retaining and recruiting a much more experienced workforce. And that experienced workforce is delivering great results for our customers in terms of quality and turnaround time performance. And so, as I mentioned earlier, our reliance on contract labor is much reduced from where it was pre-COVID. And that is a ratio that we are really focused on preserving. And that's one of the reasons during this time that's, you know, the main reason we took CARES Act funding. It's, you know, we've done everything we can, whether we're furloughing people or, you know, in the worst case, we've had to let people go thinking maybe one day we'd be in the back. We've done everything that we can to treat our people, you know, the best as we can throughout this period. You know, as Sean mentioned, one of the decisions that we made a few weeks ago was to restore salaries and benefits for our workforce. so that at all levels in the company, whether you're in an office or in a hangar, your pay has been restored, and we can keep the team together. So we're doing everything we can to treat our people well, and I think that's going to serve us well in the marketplace as we go out and continue to build the workforce, and we'll be able to get the best talent available.

Got it. That's helpful. And then just the last one, just back to that fortress agreement, I think you talked about investing in repairs. You're also selling parts and any color on the margin profile. I mean, I would think obviously the part sales would be much higher margin. How should we think about the repair component there? Is it more, you know, higher margin than your typical MRO given it might be, you know, obviously engine accessory type repairs or, you know, sounds like it's going to be a margin accretive opportunity, but any more color you can share there?

Yeah, I would just say that, you know, we don't want to get into the margins and particular details around that specific agreement, but I would say, again, that we're excited about it, and it will, over time, become a meaningful part of our USM business. Okay.

Got it.

Thanks, guys. Thank you. And I am showing no further questions. I would now like to turn the call back over to management for further remarks.

Okay, well, thank you very much. We really appreciate everyone's time and interest. And stay safe and want to wish everybody a happy holiday.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.