Earnings Call Transcript - AIR Q3 2021

Operator, Operator

Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2021 Third 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 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.

John Holmes, CEO

Great. Thank you very much, and good afternoon, everyone. I appreciate you joining us today to discuss our third quarter fiscal year 2021 results. I would like to begin the call by once again recognizing our employees. Their unwavering commitment, professionalism, and flexibility have allowed us to continue to support our customers without interruption over the past year. I'm grateful for their loyalty and sacrifices and thank them all for what they have done and continue to do for AAR. Turning to the quarter. Our sales decreased 26% year-over-year from $553 million to $410 million, and our adjusted diluted earnings per share from continuing operations decreased 45% from $0.67 per share to $0.37 per share. Our sales to commercial customers decreased 42%, and our sales to government and defense customers increased 4%. For the quarter, sales to government and defense customers were 49% of our total sales. As we mentioned on the last earnings call, we expected relatively stable revenue, which is what we saw in this quarter with sales up 2% sequentially. In MRO, we did see a sequential increase in hangar activity due to increased demand supporting anticipated leisure travel. In our commercial parts activities, revenue was relatively stable, but we were encouraged to see orders across a broader range of customers during the quarter than what we saw in Q2. Our government businesses, which have performed very well over the past year, continued their strong performance, delivering another quarter of year-over-year growth. Regarding profitability, our adjusted diluted earnings per share from continuing operations were up 19% sequentially, reflecting our continued margin improvement progress. On an adjusted basis, which excludes the benefit of the CARES Act, our gross margin improved sequentially from 13.9% to 16.1%, and our operating margin improved from 4% to 5%. We have now more than doubled our adjusted operating margin over the past two quarters while operating in a stable revenue environment. We are also proud to have fully reinstated salaries and 401(k) benefits at the beginning of the third quarter, which had been a priority for us as we look to attract and retain top talent. Even with the compensation restoration, we were still able to deliver a full point of adjusted operating margin improvement. That improvement reflects the operating leverage that we have created through cost reductions, efficiency gains, and portfolio reshaping over the last year. Turning to cash, once again, we were cash flow positive in the quarter even while making investments in new business wins. We generated $18 million from operating activities from continuing operations and remain in a strong balance sheet position with 1.1 times net debt to adjusted EBITDA. Speaking of new business, we also continue to secure and execute new wins during the quarter. We expanded our distribution relationship with GE subsidiary Unison on a five-year program from the U.S. Air Force to provide and repair an overhaul of S-16 accessories and extended our support of the Navy's H-60 Seahawk platform for an additional seven years. We also began operations on our previously announced Honeywell 737 MAX EBAS contract. With that, I'll turn it over to our CFO, Sean Gillen, to review this quarter's results in more detail.

Sean Gillen, CFO

Thanks, John. Our sales in the quarter of $410.3 million were down 25.8% or $142.8 million year-over-year, driven by the reduction in commercial passenger flying activity due to COVID-19. Sequentially, sales were up 1.7%, with commercial sales up 7% driven by MRO volumes and government and defense sales down 3.3% driven by the scheduled reduction in activity and our program to deliver two C-40 aircraft for the U.S. Marine Corps. Gross profit margin in the quarter increased to 21% from 11.8% in the prior year quarter, driven primarily by the CARES Act payroll support. On an adjusted basis, excluding the CARES Act support and other items, gross profit margin was 16.1%, consistent with the 16% in the year-ago quarter despite the significant decline in sales. Sequentially, adjusted gross profit was up meaningfully from 13.9% to 16.1%, reflecting the actions we have taken to reduce our indirect costs and drive efficiencies. Regarding expeditionary services specifically, gross profit margin increased to 17% from 0.4% in the prior year quarter, driven by the divestiture of the composites business and improved performance at the mobility operation. SG&A expenses were $44.9 million for the quarter. On an adjusted basis, SG&A was $42.8 million or 10.4% of sales, down $9 million from the prior year quarter, reflecting the reduction of our overhead cost structure. With respect to our accounting for the CARES Act payroll support, we fully recognized our deferred credit in Q3, and we will no longer have income associated with the CARES Act support. We have an $8.8 million promissory note associated with the CARES Act, which we expect to repay during the fourth quarter. Also, we continue to have certain foreign subsidiaries that are eligible for stimulus provided by foreign governments. Consistent with prior quarters, government subsidies, including the CARES Act, are reflected in our GAAP income primarily as a reduction in our cost of sales; however, we exclude these benefits from our adjusted results. Other adjustments during the quarter included $4 million of loss provision and exit costs for commercial programs contracts, $1.5 million of which reduced sales. In addition, there was a gain of $4.3 million related to a legal settlement that we have excluded from our adjusted results. Also during the quarter, we reached a tentative agreement with the Department of Justice to settle the investigation of airlift under the False Claims Act for approximately $11.5 million. As such, we recognized a charge in the quarter of $4.2 million in discontinued operations. As a reminder, we completed the exit of our airlift business in the fourth quarter of last year. In the quarter, we generated $17.6 million of cash in our operating activities from continuing operations. We reduced inventories by $21 million from our second quarter as we continue to focus on working capital management. Our net debt at quarter end was $108.4 million, down from $112.1 million at the end of Q2 and from $171.1 million at the end of Q3 of last year. In addition, our accounts receivable financing program has decreased by $37.2 million over the last year, from $85.6 million at the end of the year-ago quarter to $48.4 million. Our overall leverage and liquidity remains strong with net debt of 1.1 times adjusted EBITDA, unrestricted cash of $99.2 million, and unused capacity under our revolver of over $400 million. Thank you for your attention, and I will now turn the call back over to John.

John Holmes, CEO

Great. Thank you, Sean. Overall, we are encouraged by the widely reported recent increases in demand for domestic leisure travel, and we remain optimistic about the broader commercial market recovery. We expect modest sequential improvement in Q4 and continued improvement thereafter as the vaccine is distributed and current travel restrictions which are impacting some of our larger international customers are lifted. As that occurs and our revenue recovers, we remain committed to leveraging our current cost structure to drive continued margin improvement. In addition, our balance sheet puts us in a very strong position to be able to fund growth. We expect to make investments in our USM and distribution activities as well as to continue to invest in our technology and digital initiatives. These actions, along with the continued strength of our government business and the early signs of a recovery in our commercial market, give us increasing confidence that we will emerge from the pandemic as an even stronger and more profitable company. With that, I'd like to turn it over to the operator for questions.

Operator, Operator

Our first question comes from Robert Spingarn of Credit Suisse. Sir, your line is open.

Robert Spingarn, Analyst

Nice quarter from you guys. And John, I wanted to talk a little bit about some of the trends here, maybe just sequentially. I know you don't like to break out the businesses too much, but if we think about the sequential performance from Q2 to Q3 in terms of the commercial business parts versus MRO. I think you said - was it a 2% growth overall in commercial between the two quarters?

John Holmes, CEO

That is 7% sequential.

Robert Spingarn, Analyst

I'm sorry, 7%. How do we think about that in those two different businesses? What's stronger?

John Holmes, CEO

Yes, sure. So we did see elevated. In MRO, we saw elevated maintenance activity going from Q2 to Q3. And in the parts business, it was relatively stable; typically you do see maintenance activity pace ahead of parts requirement because repairing aircraft generates parts requirements. So that's not surprising to us necessarily, but the growth primarily came from the MRO segment. In the part side, though, as I mentioned, we are encouraged that we saw a broader customer base returning to the market on the part side both in new parts sales and USM part sales. If we look at the prior couple of quarters, there was quite a bit of activity being driven out of the freighter and cargo market, and we thought the name, candidly, that we hadn't seen in a while from the passenger market come back in the quarter. All of that still added up to relatively stable performance, but it was encouraging to see some of those customers come back.

Robert Spingarn, Analyst

Yes, on the USM, I mean, what else can we say about part-out activity based on what you've seen and trends there?

John Holmes, CEO

Yes, and that would kind of vary by asset type. So if we look at the freighter market, the engines and airframe that support the freighter market, we got very strong demand, and the supply at this point because of all the conversions going on is actually relatively tight. If we look at the broader narrow-body market, the current generation A320s, current generation 737NG, we are seeing increasing interest from customers that previously did not have an interest in USM as well as, I mentioned, customers that we haven't heard from in a little while coming back into the game. So we expect increases in USM demand there, but we do think differently than what we see in the freight and cargo market. We see more supply becoming available in the broader narrow-body market.

Robert Spingarn, Analyst

Yes, I was going to ask you, how is the supply on the passenger side, is it there or are airlines or owners making decisions to part out some of these NGs or maybe COs or I imagine older aircraft as well? They are sitting there in the desert?

John Holmes, CEO

Yes, I think overall that activity - the line from grounding to retirement from part-out has taken a bit longer to occur, than we might have thought a couple of quarters ago, but we still believe you're going to see increased material availability over time. Our focus, certainly as we want to pay attention to those macro trends, but our focus is on our own agreements to give us proprietary access to material to support the demand that we see ourselves, and the Fortress deal that we announced last quarter is an example of that.

Robert Spingarn, Analyst

Okay. And just one more on this, if you look at the fleet of aircraft that you cater to in your commercial business. Is there any way to estimate what percentage of those are flying domestically here in the United States versus those that fly international routes?

John Holmes, CEO

We'd have to look at that.

Robert Spingarn, Analyst

And then, Sean, just on the margins. I wanted to ask you if you could just delve into some of the improvement. It sounds like it's overhead driven; you've taken out a fair amount of overhead. How much of that reduction is going to be sustainable through the recovery?

Sean Gillen, CFO

Yes, we would anticipate that the vast majority of overhead reduction is sustainable through the recovery and are committed to that reduced overhead cost structure. We are seeing some efficiency improvement in our operations, but then there's also the reduced indirect, and that shows up in the gross profit. And then the reduction in SG&A, you can see in the quarter as well. So some of that will come back as volumes recover, but we do think that the vast majority will stick.

Robert Spingarn, Analyst

So you should be able to hit higher margins than before at some point when we get well into this recovery volumes are there?

Operator, Operator

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

Ken Herbert, Analyst

I just wanted to start out and put you on the spot a little bit. Are fourth quarter revenues going to be up for you? I mean you're going to anniversary, obviously, the significant drop you saw in the fourth quarter of fiscal '20. So how should we think about the sequential movement into the fourth quarter? Do we see positive revenue growth for the first time?

John Holmes, CEO

As we mentioned, we expect a modest improvement sequentially from Q4 to - from Q3 to Q4 and not ready to necessarily call year-over-year improvement, but it's pretty close.

Ken Herbert, Analyst

Okay, that's helpful. And just to follow up on the MRO discussion. Are you - with - it sounds like you're seeing an uptick in backlog. How would you - how would you think about sort of where you are at your hangers now in terms of utilization or maybe lines that are booked here through the fourth quarter? I mean how do we think about any excess capacity you may have or how is that trending?

John Holmes, CEO

Yes, so overall we're encouraged by the levels of demand that we're seeing for hangar space right now. One thing that we mentioned before that we do have some international activity that is pacing behind what we're seeing in the U.S. and as you know, we have a couple of fairly meaningful operations up in Canada, and Canada has been closed like what you're seeing over in Europe. So those operations still have a ways to go to get back to pre-COVID levels, but in the U.S., we're definitely seeing a recovery pacing ahead. We are, as John indicated, very focused on our operating efficiency. What we've driven over the last several quarters is a much more efficient, productive, and higher quality operation in our MRO facilities than what we saw before COVID. And so we're being very thoughtful and very disciplined about how we bring back work across the network so that we preserve the gains that we've made in the past few quarters. One of the points on MRO - you have a mix of work that is being done right now to prepare for what we expect will be a busy summer travel season, the leisure travel season, but you've also got some deferred maintenance that is starting to come through. As we think about Q4 going into Q1, it's likely that you wouldn't see the typical seasonal decline in the hangars that you have historically because airlines, at least in the U.S., are going to use that time most likely to catch up on some deferred maintenance.

Ken Herbert, Analyst

Okay, that's helpful. Is the demand such that, John, you were able to see any relief in labor rates or how do we think about pressure there and the supply-demand balance?

John Holmes, CEO

So far, it's been relatively consistent throughout the entire pandemic.

Operator, Operator

Our next question comes from Joseph DeNardi of Stifel. Your line is open.

Joseph DeNardi, Analyst

Sean, just a quick one for you. You mentioned adjusted gross margins were 16.1%. Can you give us that on kind of commercial versus defense? Like is commercial a little bit below that and defense is a little bit above that? Is that the right way to think about it?

Sean Gillen, CFO

That's right. Commercial is a little bit below. Defense is a little bit above. You'll see some of that detail in the Q that will be filed here shortly.

Joseph DeNardi, Analyst

And then, John, you spoke about this a little bit, but can you just talk about kind of your exposure domestic versus international on the commercial side? As you mentioned, it seems like U.S. airlines are kind of getting capacity back to pre-COVID levels a little faster than international. Where are you on U.S. commercial relative to pre-COVID, and where are you on international commercial relative to pre-COVID at this point?

John Holmes, CEO

Sure. Historically, the business mix has been relatively 65% domestic and 35% international. As it relates to the domestic, we still have a ways to go to get back to where we were relative to pre-COVID levels, and that's across both MRO and the parts business in particular. The international segment, as you mentioned, is pacing far behind due to the restrictions that are in place. China, China's domestic is almost back to pre-COVID levels, but the Rest of Asia is very, very soft, and Europe remains very, very soft relative to pre-COVID levels.

Joseph DeNardi, Analyst

And then just on the Fortress deal, it's clear that kind of you all view that as pretty important. I suspect some investors are struggling to quantify that opportunity exactly. So can you just kind of give your best shot of that? Like if you had the agreement in place pre-COVID, what would that have meant for the business? Like how much would that have helped maybe? Thanks.

John Holmes, CEO

Yes, I appreciate you asking that. I don't want to get into specifically quantifying that deal, but suffice to say, it would have been a meaningful contributor to us, and we expect it to be a meaningful contributor to the trading results for the USM result. Fortress has been a great partner for many years supporting that joint venture with them was really a nice next step in the relationship, and we have received the first set of material from them. So it will be, I would say, a small contributor this quarter, and we expect growth going into next fiscal year.

Operator, Operator

Our next question comes from Michael Ciarmoli from Truist Securities. Your line is open.

Michael Ciarmoli, Analyst

Thanks for taking my question, and nice results here. Maybe just back to the, I think, what Rob was asking on the margins. I mean, the adjusted gross margin 16.1% is really a strong number there, and it sounds like you're not getting any benefit from lower labor rates. Can you just maybe give us a sense? I mean, John, if we look back a year ago, you were doing $100 million more plus in revenue, and the gross margins were pressured. Obviously, there were some labor challenges, but structurally, you talked about more efficiencies. I mean, what specifically is driving that? I mean, if I look at it now, it sounds like you've got a little bit of a mix headwind with stronger MRO. Presumably, when some of that parts volume kicks in, it seems like you shed more runway here with parts, with volumes maybe more efficiencies with the market getting in line. But can you give us maybe dig a little bit deeper and tell us exactly how you're putting up these margins with the topline pressures?

John Holmes, CEO

Sure. Absolutely, and again, we're very, very pleased with the progress that we made in a short amount of time. And as you know, we've been taking a number of actions across the company and in a number of different areas to drive this margin improvement, including exiting underperforming product lines, underperforming contracts. We consolidated a number of facilities and then we've just taken ISG&A headcount out. We've also deployed technology in certain areas. These were initiatives that were underway pre-COVID that are now kicking in and helping drive efficiencies. So we definitely see more runway as it relates to the margin improvement as we see revenue recovery. In the MRO business, for example, you mentioned the labor; yes, definitely not coming through labor rate relief. We have really focused on as we retool the labor force, making sure that we hung on to and took care of our most experienced mechanics, and we've got to focus now on limiting the amount of contract labor that we use in the operation so that we have the most experienced employee base who are able to turn a higher quality product and do it more efficiently than what we saw before. And so in the MRO business, which historically had been one of our lower margin performers, received nice gains there in terms of our income performance. And then you're absolutely right, as the parts business starts to return, that historically has been a higher margin business for us. And once that starts to kick in, at the revenue line, you'll see that flow through operating margin as well.

Michael Ciarmoli, Analyst

Got it. That's helpful. What about just on those parts on USM? You mentioned more supplies coming available. Any detail you can give on pricing at all? I mean, are we talking more supply potentially flooding the market, or is it still fairly price competitive and a challenge to get your hands on the good material out there, whether it's some of the legacy narrow-body or current generations? Anything you could say there on pricing?

John Holmes, CEO

Yes, I wouldn't want to get into that, just for competitive reasons, but I would just say that you really see a lot of variation between asset types at the moment.

Michael Ciarmoli, Analyst

Okay. You mentioned some international facilities and locations you have and other potential government subsidies. Are you planning on taking any other subsidies going forward?

John Holmes, CEO

Here in the U.S., and that represents the majority of the subsidies we've taken. We were eligible to receive additional CARES money under the original program as well as under the new program. Given the strong performance of the company and our cash generation, we elected not to participate in those two U.S. options. Canada and our facility in the Netherlands, for example, there are programs still available there, and we continue to evaluate whether or not we'll avail ourselves of those going forward.

Michael Ciarmoli, Analyst

Last one for me. Just, you've got a lot of unused capacity; I think you said $400 million. What are you seeing in the marketplace for potential assets out there? Do you think there are some good opportunities? Are you looking to be sort of a consolidator here, or how are you looking at the marketplace?

John Holmes, CEO

Yes, we're paying very close attention to what's available, what would be coming available, what we would like to be available. To the extent that we find the right opportunity, we feel good about being in a strong position to execute.

Operator, Operator

Our next question comes from Josh Sullivan of The Benchmark Company. Your line is open.

Josh Sullivan, Analyst

Can you just talk a little bit about customer mix? I mean just as you've seen some of the recovery. Have you seen any change in new customers or old customers? Just curious what that might look like at this point?

John Holmes, CEO

Sure. In the parts business, the majority of the activity over the last couple of quarters has really been driven by the cargo market. We don't see that changing because that's going to be a strong market for some time, but in this quarter, for the first time in a while, we saw meaningful inquiries and, in some cases, actual orders out of our larger historical passengers. So we see them kind of re-entering the fray, if you will, in the parts business. In the MRO business, as we mentioned, the Canadian operations have been quieter than the U.S. operations, but you are seeing the domestic to support domestic leisure travel, that activity increasing here in the U.S. in the MRO market.

Josh Sullivan, Analyst

And just one on the defense. Sorry, go ahead.

John Holmes, CEO

And the government - as you've seen from the numbers, the government business has remained very strong this entire time. We put up three quarters in a row of year-on-year growth in the government business, and we remain very encouraged by the pipeline of opportunities that we see there.

Josh Sullivan, Analyst

And then, just one last one, I mean are you expecting any additional State Department funding to flow into their contract vehicle just as budgets come together here? Do you have any visibility into that?

John Holmes, CEO

Unclear, unclear right now, but no meaningful change expected one way or the other at this moment.

Operator, Operator

Our next question comes from Joseph DeNardi of Stifel. Your line is open.

Joseph DeNardi, Analyst

Thanks, Sean. I think, pre-COVID, you guys had been talking about maybe 10% to 11% SG&A as a percent of sales. Is that still kind of how you're looking at the business going forward?

Sean Gillen, CFO

Yes, I think that's right. Obviously, as the recovery occurs and my comments on keeping this cost structure you will see improvement on that once we start to see the topline recover.

Joseph DeNardi, Analyst

Okay. And then maybe John or Sean just on the DOJ settlement. Is that kind of done and gone at this point, or are there any contingencies or any other kind of considerations to keep in mind with that going forward?

John Holmes, CEO

Once we reach final agreement with the government, it will be done and gone, but we felt a little bit of work to do to finalize the settlement.

Operator, Operator

The next question comes from Ken Herbert of Canaccord. Your line is open.

Ken Herbert, Analyst

I just wanted to follow up. In prior quarters, you talked about more outsourcing by airlines, sort of coming out of a crisis like this. Are you expecting sort of a similar playbook now, and I guess my question would be, if you do expect more outsourcing by the airlines, especially around the MRO side, is your comment around being more selective in the work you take on maybe implying that for you it's not as much now about sort of topline growth in MRO and taking advantage of those opportunities as it is making sure it's the right opportunity to maybe air on the side of margin expansion?

John Holmes, CEO

It's definitely the latter. I wouldn't necessarily relate those two things to more work hitting the market as a result of outsourcing, but the latter is true. We are very focused on maintaining and expanding the margin gains that we've seen over the last few quarters, and that leads to just being a bit more selective about the work we take on and really focusing on increasing the throughput on a smaller footprint than we had pre-COVID. As you remember, we did close one of our sites; unfortunately, it was a difficult decision to do, but that has allowed us to achieve more efficiency across the remaining network.

Ken Herbert, Analyst

And as you think about the increased focus maybe on margins, does it ever reach a point where maybe the benefits of the MRO business in terms of customer face time and the other synergies you've talked about, maybe you're no longer quite worthy investment? I mean how do we think about the potential for a more significant shift and mix of the business moving forward?

John Holmes, CEO

We still believe in the connection between the MRO business and the rest of our businesses and certainly feel even better about that as we look to continue to improve the margin performance of the MRO businesses. That's a very dynamic market, and so we are always going to be on our toes there in terms of how we win and how we perform and what goes on there from a competitive standpoint, but we are still fans of the connection between MRO and the parts of the programs business.

Operator, Operator

Thank you. I'm showing no further questions at this time. I will turn the call back over to Mr. Holmes for any closing remarks.

John Holmes, CEO

Great. Well, thank you, everybody. I really appreciate the time and the interest. Stay safe and look forward to talking to you again next quarter.

Operator, Operator

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