Earnings Call Transcript - AIR Q2 2021

Operator, Operator

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 Securities Litigation Reform Act of 1995 as noted in the company's news release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2020, and Form 10-Q for the fiscal quarter ended August 31, 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.

John Holmes, CEO

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 have 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 volumes 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 $0.64 per share to $0.31 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 seasonally 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 1x EBITDA. We also continue to add significant new business that positions us for growth going forward. Our CFM56 partnership with Fortress solidifies a source of supply to meet growing demand for used serviceable material on the -5B and the -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 its sole authorized service center for 737 MAX Electronic Bleed Air System components positions us to support MAX operators worldwide when that aircraft returns 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.

Sean Gillen, CFO

Thanks, John. Our sales in the quarter of $403.6 million were down 28%, or $157.3 million year-over-year, driven by the impact 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 none 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 1. 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 0.95x 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.

John Holmes, CEO

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 airlines' 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.

Operator, Operator

Thank you. Our first question comes from Robert Spingarn from Credit Suisse. Your line is now open.

Robert Spingarn, Analyst

Hey, good afternoon.

John Holmes, CEO

Hey, Rob, how are you?

Robert Spingarn, Analyst

Good. Thanks. It's nice to see the margin improvement. John, I have a few things I'd like to discuss. Can you tell me how the quarter performed month by month? It seems like you've already seen a slight increase here compared to last quarter. So I assume that's behind us now, and revenues are heading upward. But how did it look month to month?

John Holmes, CEO

Yes. It was fairly stable throughout the quarter. I would agree that we've seen the lowest point. The parts volumes and MRO volumes have all increased from what we observed in April and May. However, as we moved into June and July, the volumes we experienced across the business remained relatively stable in the subsequent months.

Robert Spingarn, Analyst

Okay. What insights can you share from your discussions with customers regarding the return of the MAX to service and the potential slight increase in the production rate of the MAX? Airbus has mentioned possibly raising the production rate of the A320. We all believe that traffic will return. Have customers spoken to you about their expectations for fleet movements in relation to this? Additionally, how might this impact your MRO schedule and the anticipated availability of more USM as new aircraft begin to replace older models?

John Holmes, CEO

Yes. It really depends on the customers. Some of the larger carriers with MAXs on order have begun taking delivery, and those with MAX already in their fleet are starting to operate them. These customers seem committed to that direction. However, there have been several cancellations of the MAX. At the same time, customers are planning to introduce new aircraft and expect to keep some older aircraft longer than they initially anticipated during COVID. All of them have shown interest in USM material, including both current USM customers and those in regions like China who are not USM customers. During the quarter, we noticed more aircraft becoming available for acquisition and ultimately for teardown. This process, where an aircraft is grounded, retired, and then potentially sold for parts, has increased in the market. Therefore, we anticipate the supply to start growing.

Robert Spingarn, Analyst

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

John Holmes, CEO

Yes, we have seen a wide range of opportunities in the market.

Robert Spingarn, Analyst

Okay. And then just quickly, a couple of other things. Just if we end up a couple of years down the road with a simplified fleet of, let's call it, A320ceos 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?

John Holmes, CEO

I think overall, it's a positive. Companies like ours exist to provide a necessary service. That maintenance capability has largely been outsourced by most of the carriers. Unless there's a compelling reason for them to start in-sourcing that activity, we believe that the volume of work will continue to be available for third-party maintenance providers, and us in particular.

Robert Spingarn, Analyst

Okay. And then just one last question about margins. You mentioned that you expect to see continued margin improvement. If we look back at your previous higher margins, you achieved those during a time when you had higher selling, general and administrative expenses and also some contract labor, which we assume is more costly. So looking ahead, without those two factors, how should we think about potential margin performance? Is there a specific incremental margin that you or Sean suggest we consider as revenues increase?

John Holmes, CEO

We would expect that we will come out of this crisis at higher operating margins than we were pre-COVID.

Robert Spingarn, Analyst

Okay.

John Holmes, CEO

Yes, that's due to several factors, mainly the actions we've taken. Your observation about contract labor is accurate. We've implemented various changes within our hangars, and we don't anticipate relying on contract labor as much moving forward as we have in the past. This is definitely a contributing factor. We are also rolling out several efficiency initiatives within the hangars to improve our effectiveness as work volume returns. Additionally, there were several less profitable or unprofitable activities that the company had prior to COVID. Over the past three quarters, we've worked diligently to remove that burden from our earnings. As we see stronger performance from our parts business and improved efficiency in the hangar, you'll notice better margins as a result.

Robert Spingarn, Analyst

Okay. Excellent. Thank you.

John Holmes, CEO

Thanks, Rob.

Operator, Operator

And thank you. And our next question comes from Joseph DeNardi from Stifel. Your line is now open.

Joseph DeNardi, Analyst

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 in the last few weeks after the vaccine news and kind of how they're thinking about summer of 2021 schedules and capacity?

John Holmes, CEO

Sure. The discussions with our customers vary, but there is a common emphasis on being prepared for summer 2021. Unlike the previous quarter, where we experienced a notable surge in demand during summer, the recent surge is different. Previously, we saw significant changes in maintenance schedules and parts volume from our customers, but this time, we have not observed the same level of change. Customers seem to acknowledge that there may be fluctuations in the coming months, yet they remain optimistic that vaccine distribution will occur, leading to increased demand for leisure travel. They are eager to be prepared for the summer of 2021. Overall, while expectations for increased travel compared to summer 2020 differ among customers, the general consensus is that they anticipate a better summer in 2021.

Joseph DeNardi, Analyst

Okay. And then can you just walk us through maybe the three legs of your commercial business? So 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?

John Holmes, CEO

Sure. Regarding the overall size, we anticipate remaining in a relatively stable revenue environment until there's a significant uptick in flying activities. At the same time, we're focused on enhancing our margins within this stable environment. In the parts business, both new and used parts have shown stable activity recently, with some encouraging higher peaks in the last few weeks. However, we expect overall stability in the commercial parts segment. After the crisis, we foresee rising demand for the used serviceable materials (USM) business. Our partnership with Fortress is one of several initiatives we have underway in this area, and I believe that business could potentially be structurally larger than it was before COVID, depending on demand trends. Likewise, in the new parts distribution sector, we continue to establish new distributorships. We are looking into various opportunities for new partnerships with different OEMs. Just like airlines, OEMs are reassessing their aftermarket strategies. Some OEMs that previously disregarded distribution partners are now considering them, and we are exploring these opportunities. We believe this segment could also grow due to new business wins and increased same-store sales from agreements we had prior to COVID. In the MRO business, we are pleased with our current footprint. We made the tough decision to reduce capacity by closing our Duluth facility and streamlining our operations in other facilities. We believe these changes will ultimately yield better results than we saw before the pandemic. Lastly, in the commercial programs business, we've implemented numerous changes over the past several quarters. We have exited or restructured underperforming contracts, and the majority of that work is now complete. We are confident in our remaining contract portfolio. Additionally, as we noted last quarter, this market faced significant pricing pressures prior to COVID. Many companies in this space have either exited the market or terminated underperforming contracts, similar to our approach. We anticipate that pricing in this market may reset post-COVID, and if we can achieve a favorable return, we will participate in it.

Joseph DeNardi, Analyst

That's great. So John, it's fair to say that kind of the highest margin leg for you all will be bigger and that the two lower margin legs will probably be smaller for a period?

John Holmes, CEO

Yes.

Joseph DeNardi, Analyst

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 the concessions that they've been able to get? And then 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?

John Holmes, CEO

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 there's a lot of moving parts there. And then as it relates to the operating efficiency inside of the hangars, yes, 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. 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.

Operator, Operator

And our next question comes from Ken Herbert from Canaccord.

Ken Herbert, Analyst

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?

John Holmes, CEO

We're very excited about our partnership with Fortress, which we've valued for many years. This agreement leverages both of our strengths. Fortress has a large and expanding engine lease pool, while we are the leading player in the USM space. The agreement involves us managing engines through a teardown process from their pool, with full control over that management. Some materials will be sold back to Fortress for their engine builds, while we will sell the remaining materials in the aftermarket. There are volume commitments in place that will significantly enhance our aftermarket parts activities, focusing on core engine platforms. We anticipate seeing volume from this agreement later this fiscal year, with growth expected throughout FY '22.

Ken Herbert, Analyst

Okay. As I think about this, would you consider this an asset-light agreement, or will you be committing working capital to potentially purchase some of the engines and materials in advance?

John Holmes, CEO

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

Ken Herbert, Analyst

Okay. Great. If we consider a potential recovery in traffic around the summer or mid-2021, can we expect to first notice changes in your MRO schedules? Then perhaps in surplus material, with your distribution business being the last to see improvements as airlines begin purchasing materials again? Or is there a different way to understand how the impact on your business will evolve leading up to the anticipated recovery?

John Holmes, CEO

Historically, I would agree with what you just said. Coming out of this downturn, due to its broad and extended nature and the significant deferred maintenance, especially on engines that has accumulated over the last several months, it's likely that we could witness a simultaneous recovery in both the parts and heavy maintenance businesses, or that the parts business could initiate the recovery. Currently, the workload in our hangars remains relatively steady for the next couple of quarters. However, as our customers gain better insight into their demand heading into the summer of 2021, we could see changes in this situation.

Ken Herbert, Analyst

It sounds like, based on that comment, you don't consider green time on engines to be a significant barrier to the speed of the recovery.

John Holmes, CEO

I believe we are currently using up green time. As this green time decreases, the deferred balances will grow, which means we will need more parts sooner.

Ken Herbert, Analyst

Okay. But I guess the question is that if there is a recovery earlier in 2021, then the deferred opportunity won't really carry over for much of the year. It seems that if we do see a recovery around the middle of 2021, the potential for green time and deferred opportunities will mostly be exhausted.

John Holmes, CEO

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

Operator, Operator

And our next question comes from Michael Ciarmoli from Truist.

Michael Ciarmoli, Analyst

Good margin performance. John, I guess just to maybe stay on kind of 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 take off and landings. And you just kind of said that loading looks consistent. But if these airlines and your customers are going to be ready for, let's knock on wood, a normalized '21 summer, shouldn't we see a pretty big uptick in activity ahead of that? I mean as you guys look at it, do you think like the May quarter ahead of that busy flying season, you start to see that revenue inflection before we see the uptick in kind of all that pent-up demand and traffic uptick?

John Holmes, CEO

Our current stable outlook reflects our commitments. If customers experience increased bookings and demand, there is certainly potential for more demand. However, I don't believe any of our customers are anticipating a return to normal flying levels in summer 2021. They expect some improvement in 2021 compared to 2020, but many still hold modest expectations. The situation is evolving rapidly, and our customers are dealing with real-time bookings and cancellations, which limits their visibility into demand. Once they have a clearer understanding of summer 2021, they could indeed begin to request more maintenance and parts.

Michael Ciarmoli, Analyst

Understood. While I didn't imply a return to normal in 2021, I did suggest some improvements. However, based on discussions with customers, it appears conditions may deteriorate in December and potentially worsen in January and February. Can you provide insight into how these conversations are progressing? Are there new areas of concern? You've mentioned the loading issues, but are your customers experiencing specific pressure points? Or are they mostly preparing for a weaker capacity demand in the coming months while maintaining a long-term perspective? Are they expressing confidence in their plans, or does the situation still feel uncertain?

John Holmes, CEO

I think what you mentioned about the upcoming months being a bit volatile is accurate, but it's important for us to look ahead to summer '21. From the commitments we've received, they appear to be based on a cautious expectation of what flying will look like in the summer. Essentially, they are making commitments because they recognize the need for a stable maintenance business to support our team. Right now, they’ve committed to a level of work they are confident they can manage. If summer turns out better than anticipated, they might need more maintenance services, but we haven't yet seen that demand reflected in orders.

Michael Ciarmoli, Analyst

Got it. Going back to the MRO, you mentioned the footprint, efficiencies, and improved yields. Has the situation with labor improved, allowing you to bring in more experienced mechanics? Are you seeing any advantages from the hourly wages being paid, or is the yield improvement solely due to the footprint reductions?

John Holmes, CEO

Yes, that's a good question. Up until now, wages have stayed quite stable. We have effectively retained and recruited a more experienced workforce, which is delivering excellent results for our customers in terms of quality and turnaround time. As I mentioned before, our dependence on contract labor has significantly decreased from pre-COVID levels, and we are focused on maintaining that ratio. This is also one of the reasons we utilized CARES Act funding during this period. We have done everything possible to treat our employees well, whether through furloughs or, in the worst cases, layoffs with the hope of bringing people back when needed. Recently, we made the decision to restore salaries and benefits for all employees across the company, ensuring that everyone, whether in the office or in the hangar, has had their pay restored. We are committed to treating our workforce well, and I believe this will benefit us in the market as we continue to build our team and attract top talent.

Michael Ciarmoli, Analyst

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. Any color on the margin profile? I mean I would think, obviously, the parts sales would be much higher margin. How should we think about the repair component there? Is it more higher margin than your typical MRO, given it might be obviously engine accessory-type repairs? Or it sounds like it's going to be a margin-accretive opportunity, but any more color you can share there?

John Holmes, CEO

I can’t provide details on the margins related to that specific agreement. However, I want to emphasize that we are excited about it, and it will, over time, become a significant part of our USM business.

Operator, Operator

And I'm showing no further questions. I would now like to turn the call back over to management for further remarks.

John Holmes, CEO

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.

Operator, Operator

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