Earnings Call Transcript - AIR Q4 2023

Operator, Operator

Good afternoon, everyone, and welcome to AAR's Fiscal 2023 Fourth Quarter Earnings Call. We're joined today by John Holmes, Chairman, 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. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Accordingly, these statements are no guarantee of future performance. These risks and uncertainties are discussed in the company's earnings release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2022 and Form 10-Q for the fiscal quarter ended February 28, 2023. In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events. Certain non-GAAP financial information will be discussed on the call today. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is set forth in the company's earnings release. At this time, I would like to turn the call over to AAR's Chairman, President and CEO, John Holmes.

John Holmes, CEO

Thank you. Good afternoon, everyone. I appreciate you joining us today to discuss our fourth quarter and full year fiscal 2023 results. For the full year, sales increased 9% from $1.8 billion to $2 billion. Our adjusted diluted earnings per share from continuing operations increased 20% from $2.38 per share to a record $2.86 per share, driven by both sales growth and our increase in adjusted operating margin from 6.3% to 7.5%. The strong performance reflects continued execution on our strategy to leverage our improved cost structure and capture growth in higher margin activity. For the fourth quarter, sales were up 60% year-over-year, from $476 million to $553 million. Sales to commercial customers increased 31%, while as expected, sales to government customers decreased 7% due primarily to the completion of certain government programs in the prior year quarter. Adjusted operating margin was 7.8%, up from 7% in the prior year quarter, and adjusted diluted earnings per share from continuing operations were up 15% from $0.76 per share to a record $0.83 per share. We saw further growth in our commercial cards activities as global air travel continued to recover. Additionally, as described in previous quarters, we saw engine green time availability continue to abate, which drove additional engine shop visits and associated demand for engine parts, representing the majority of our USM offering. USM supply remains tight, and our team continues to work to identify opportunities to acquire material to meet the robust demand. Further, our recent new parts distribution contract awards continue to ramp up. During the quarter, we did experience some delays from OEM due to supply chain issues, and we're working with our partners to receive the overdue material to ship against our backlog. In MRO, demand remains strong, and even though our hangars have been mostly full for some time, we were able to drive some additional volume through our footprint in the quarter. Labor availability remains tight, but our attrition levels have stabilized, and our partnerships with schools and other sources of talent continue to serve us well. In integrated solutions, although our government work was down, we saw better performance in our commercial power-by-the-hour programs, driven by increased flying internationally and the improvements that we've made to that operation over the last few years. With respect to cash, we generated cash flow from operating activities from continuing operations of $45 million. Our net leverage at quarter-end was 1.07x EBITDA, which was down from 1.35x at the end of Q3 on a pro forma basis for the Trax acquisition. As such, our balance sheet remains strong, and we have significant flexibility to fund our continued growth. Regarding new business, we announced in March that we had agreed to acquire nine Boeing 757-200 passenger aircraft equipped with 18 Rolls-Royce RB211 engines from American Airlines. This investment provides us with feedstock to supply used serviceable material on the RB211 engine side to the 757 cargo market, which continues to be strong. It is also an example of the type of asset acquisition that our parts supply team makes to support the demand for USM. In addition, I want to mention the announcement that we made yesterday regarding the expansion of our Miami airframe maintenance facility. Since making that announcement, we have received final approval from the Miami-Dade Board of County Commissioners for the project. Our agreement with both the Miami-Dade Aviation Department and United Airlines will increase our volume by 33% at that site. This project meets all of the criteria that we have previously outlined for MRO capacity growth, including expansion of an existing facility with government financial support, favorable local market dynamics, labor market dynamics, and a long-term customer commitment. We expect to break ground in our fiscal Q2, and construction will take approximately 24 months. AAR will be reimbursed by the Miami-Dade Aviation Department and expect a $50 million project cost. I would like to thank United Airlines, Miami-Dade County Mayor, Daniella Levine Cava; Miami-Dade Board of County Commissioners Chairman, Oliver Gilbert; and the Miami-Dade Beacon Council for their partnership in making this important development a reality. Finally, I want to highlight that beginning with Q1 of fiscal '24, we will be separating the reporting of what is currently our Aviation Services segment into three separate segments: Parts supply, prepared engineering, and integrated solutions. This operation better reflects the way we manage the company and how we view areas of growth. It will also provide enhanced disclosure and insight to the investment community and other stakeholders. With that, I'll turn it over to our CFO, Sean Gillen, to discuss the results in more detail.

Sean Gillen, CFO

Thanks, John. Our sales in the quarter of $553.3 million were up 16.2% year-over-year. Our commercial sales were up 30.7%, driven by growth across our commercial activities, while our government sales were down 7.1% due primarily to the completion of certain government programs in our previous fiscal year. We also saw a decline in defense distribution sales due to the timing of shipments from certain OEMs. Gross profit margin in the quarter was 19.5% versus 18.9% in the prior year quarter. Gross profit margin in our commercial business was 20%, and gross profit margin in our government business was 18.5%. The strong commercial margin reflects the improved performance of our commercial integrated solutions activity that John mentioned and the contribution from Trax, which is a higher margin offering. SG&A expenses in the quarter were $70.8 million, excluding certain Trax expenses and other items that are detailed in the earnings press release. This figure was $64.1 million or 11.6% of sales. This percentage is up sequentially but down year-over-year. In Q1, we expect a downward sequential cadence in SG&A similar to last year. Net interest expense for the quarter was $4.7 million compared to $0.6 million last year, driven by higher interest rates and borrowings. Our effective tax rate in the quarter was 23.2%, which was lower than we had anticipated due to certain state tax and other items in the quarter. We expect our effective tax rate to be approximately 25% to 26% in Q1 of FY '24 and approximately 27% for the full year FY '24. Cash flow from operating activities from continuing operations was $45.3 million. We ended the quarter with net debt of $203.6 million and net leverage of 1.07x EBITDA. In light of the Trax acquisition and other attractive opportunities to invest in our business, we elected not to repurchase stock during Q4. We continue to have $58 million remaining on our stock repurchase program, and we'll evaluate both usage of the remaining authorization and expansion of the program over the remainder of this fiscal year based upon alternative capital deployment opportunities. On that note, we are seeing attractive opportunities for investment in the USM market, and we expect to deploy capital in Q1, which we anticipate will drive a use of operating cash in the quarter. Regarding our resegmentation, we plan to file an 8-K today that provides financial results for the new segments for FY '22 on an annual basis and for FY '23 on a quarterly basis. The new parts supply segment will consist of both our used serviceable material and distribution activities. The repair and engineering segment will consist of airframe MRO, component and landing gear MRO, and engineering. And the integrated solutions segment will consist of our government programs and commercial power-by-the-hour component solutions, and our software solutions such as Trax and Airinmar. Our expeditionary services segment consisting of mobility systems will remain unchanged. In addition to the segment changes, we are changing our measure of segment performance from gross profit to operating income. We have frequently heard from investors and analysts on the desire for greater transparency, and we hope these changes will be well received. Thank you for your attention. I will now turn the call back over to John.

John Holmes, CEO

Great. Thank you, Sean. Looking forward, we expect the commercial market recovery to continue. Commercial air travel remains below pre-pandemic levels by most measures and in most markets. As you have heard from many major airlines recently, their outlook for growth remains strong. This all means that we remain optimistic about the demand for our services. Specifically, we expect interest in USM to remain robust. Although supply is constrained, it has been improving, and we expect it to continue to improve as airlines take delivery of new aircraft and retirements increase. Notably, we do not expect additional USM supply to negatively impact our profitability. Instead, we believe it will lead to more growth as the availability of USM is currently a growth constraint. In distribution, we expect to win more new lines with more OEMs, which will drive more growth. The continued market recovery and OEM supply chain improvement will also provide tailwinds. In Airframe MRO, we expect our hangars will remain largely full throughout the year, and we are excited to be adding more capacity when the Miami expansion comes online. Additionally, we do have capacity available to meet growing demand in our component and landing gear repair facilities. On top of that, we are also evaluating expansion at certain other of our airframe MRO locations where we have long-term customer interest and access to labor. Finally, in our government business, our F-16 program in Europe is not yet fully ramped and will be a more meaningful contributor in FY '24 and beyond. More generally, we remain confident that our value proposition in this market - our pipeline of opportunities will translate into additional growth over time. With respect to specific guidance, our operating environment remains exciting and dynamic, so we plan to continue our current practice of providing an outlook on a quarterly basis throughout FY '24. On that note, we expect to see Q1 sales to be in the low teens year-over-year driven by our commercial businesses and adjusted operating margins similar to what we just delivered in Q4. Looking ahead, we expect another year of margin expansion, albeit at a slower rate than the last two years. As you know, we are holding an Investor Day this Thursday in New York, and we look forward to seeing you there to discuss our growth strategy, long-term financial targets, and commitment to continuing to deliver shareholder value in more detail. Before taking questions, I would like to take a moment to thank our team for delivering an outstanding year in our customers and other partners for supporting us. We continue to make our MRO operations more efficient, added several key distribution wins, expanded support for our USM customers, added an important new capability with the acquisition of Trax, and extended and upsized our credit facility in a challenging market. The result has been nine consecutive quarters of adjusted operating margin improvement and record adjusted earnings while maintaining superb financial flexibility. Coming out of the pandemic, this success was not inevitable, and once again, I'm exceptionally proud of our team. With that, I will turn it over to the operator for questions.

Operator, Operator

Our first question comes from Pete Osterland with Truist Securities. Your line is open.

Peter Osterland, Analyst

Hi, good evening. I'm on for Mike Ciarmoli. Thanks for taking our question. So first, I just wanted to ask on the Miami facility expansion. Once construction there is complete, what's the time frame for ramping up operations fully? And how many new hires will you need to add in order to support that additional capacity?

John Holmes, CEO

Yes, great question, and thanks for joining in on the call. Given the fact that we're expanding at an existing site where we've been operating for quite some time, once construction is complete, we expect ramp-up to actually go very quickly. We anticipate hiring about 250 new people for this expansion. And again, one of the criteria for expanding in a site is that we feel we've got access to a very strong supply of labor, which is certainly what we have in Miami. So we will be recruiting that talent well in advance of going live.

Peter Osterland, Analyst

All right. Very helpful. Thanks. And then I just had a follow-up on the margin outlook for the coming year. Particularly given that you had some strong year-over-year growth this quarter, but SG&A, excluding the Trax expenses, the margin was about flat versus the prior year. I guess just what do you need to see in order to kind of see SG&A expenses improve and start to trend closer to the target you mentioned in the past of around 10% of sales? Does that still a viable target? Or are there any dynamics going on with wage inflation or anything else that has kind of changed the math there a bit?

Sean Gillen, CFO

Yes. I'd say that goal remains the target to be at 10% of sales. To get there, what we'll need to see is just continued leverage on the top line on both commercial and government sales. As I mentioned, Trax is slightly higher in SG&A, but it doesn't significantly move the needle for the whole company. Even in this inflationary environment, we still believe we can reach 10% of sales as we see more leverage on the top line.

Peter Osterland, Analyst

All right. Great. Thanks for taking the questions.

John Holmes, CEO

Thank you.

Operator, Operator

Thank you. Please standby for our next question. Our next question comes from the line of Ken Herbert with RBC Capital Markets. Your line is open.

Kenneth Herbert, Analyst

Hi, John and Sean, nice way to end the year. I wanted to first follow up, John, on some of your comments on the USM marketplace. It sounds like you're seeing more feedstock, and it clearly sounds like you've got some opportunities very near term in the first fiscal quarter. Can you provide any more sort of granularity on where you're seeing the opportunities and maybe how we should think about investments either in the first quarter or across fiscal '24, specifically in the USM area?

John Holmes, CEO

Yes. Great question, and I appreciate you being on the call. Generally speaking, we are seeing loosening in the USM supply and we have been able to deploy capital throughout FY '23, and as we start FY '24, we're presented with some unique opportunities. As you know, that's one of our big advantages in the market when these things come up. Although they are still rare, we can move quickly. Regarding specific asset types, I prefer to stay away from that, given competitive dynamics. However, we have a significant focus on engines, and we are engaging in discussions across the market, whether that includes lessors undergoing portfolio changes, airlines making fleet changes, or even brokers in the market that have available assets that meet contracts we have to support.

Kenneth Herbert, Analyst

Okay. Very helpful. And based on your comments, it sounds like as you invest and transfer some of this feedstock into USM, you don't expect any significant step down in pricing you're getting in the marketplace for the material, correct? I mean, it sounds like there's still enough of an imbalance that you should be able to negotiate prices on the USM at least through fiscal '24?

John Holmes, CEO

Yes. We definitely feel confident in maintaining our spreads throughout the year.

Kenneth Herbert, Analyst

Okay. Great. And if I could, just one final question. On the heavy MRO side, I mean, we continue to hear about capacity constraints and a number of large captive airline operations may be exiting the heavy MRO business to some extent. So I think your capacity additions make a lot of sense, and it sounds like there are other opportunities to possibly add capacity. How far out are you sold within or how's the backlog look maybe within the heavy MRO segment? It seems that if there was ever an environment for you to negotiate better labor rates, it would be right now. So can you comment on what you're seeing from that standpoint?

John Holmes, CEO

Yes. The commitment that we have from United that drove the Miami expansion, and any of the other customers we are talking to about potential other expansions, those are multiyear commitments. We're building permanent new capacity, and so we want to ensure that we align with that. We are absolutely seeing airlines, because they anticipate capacity shortages for some time, being willing to sign multiyear agreements with us. This is encouraging. Regarding labor rates, as we've discussed in the past, we have productive dialogues with our airline customers about labor rates. We have contract-based negotiations with customers to adjust our labor rates to reflect the market's labor costs. We've been able to expand margins in an inflationary environment through operational efficiencies and these negotiations.

Kenneth Herbert, Analyst

Okay. So is it fair to assume that as we get the new segmentation and see the repair business broken out, we should see some of that drop to your bottom line in terms of an area for margin expansion within that business specifically?

John Holmes, CEO

Yes, we can discuss more about that on Thursday when we meet. But broadly, you have visibility into the margins of that business. I would say that our focus on margin expansion will not come through price increases to the customer. It’s largely just to keep pace with rising labor costs. The margin expansion we expect over time will come from investments in the facility. For example, the Miami expansion provides us with a 33% increase in volume, and we are deploying technology across our hangars—such as paperless drilling inspections—to enhance efficiency inside the operation.

Kenneth Herbert, Analyst

Okay. Great. Thank you very much. I look forward to Thursday.

John Holmes, CEO

Thank you.

Operator, Operator

Thank you. Please standby for our next question. Our next question comes from the line of Josh Sullivan with The Benchmark Company. Your line is open.

Joshua Sullivan, Analyst

Hi, good afternoon.

John Holmes, CEO

Hi, Josh.

Joshua Sullivan, Analyst

Just to kind of follow up on Ken's question there. Looking at scheduled care needs at the MRO facilities and we hear about extended turnaround times. But when you look at the market, when do you think turnaround times kind of peak?

John Holmes, CEO

In terms of turnaround times in our own hangars, I mean, we're running a pretty steady operation for the last several quarters. So we feel that we're actually operating quite efficiently in hangars. Regarding component repair turnaround time, again, we feel good about the TAT that we've had in our own shops. We do outsource a lot of repairs, and we have seen those turnaround times increase. Predicting when that's going to peak and come down is difficult. However, we feel overall that the supply chain environment is improving, which should result in a better year than last year for turnaround times.

Joshua Sullivan, Analyst

Got it. And then maybe as far as Trax, any KPIs you can share that you've completed or you're looking to complete?

John Holmes, CEO

Nothing specific at this point. More generally, we’re roughly a quarter into the acquisition. It's going very well. The integration is on track or ahead of our plan. The team there remains extremely excited about the possibilities between our two companies. On Thursday, we'll provide more detail on the elements of the vision that we have for the Trax AAR combination, and I feel really good about it.

Joshua Sullivan, Analyst

Great. Thank you for the time.

John Holmes, CEO

Thank you.

Operator, Operator

Thank you. Please standby for our next question. Our next question comes from the line of Robert Spingarn with Melius Research. Your line is open.

Robert Spingarn, Analyst

Hi, guys.

John Holmes, CEO

Hi Rob, how are you?

Robert Spingarn, Analyst

Very good. Thanks. John, I wanted to ask you just all this talk about heavy maintenance and maybe just to simplify it. Would you say with the unionization we've seen and all the traction that labor is getting in this constrained environment, would you say that the wage spread between captive airline labor and your labor is widening?

John Holmes, CEO

I want to look at some data on that, but based on some of the increases we are seeing as a result of the new contract, I would say, yes.

Robert Spingarn, Analyst

Okay. So this just provides additional tailwind for you?

John Holmes, CEO

Yes. Again, we've just announced an expansion. There are other expansions that we're considering, and we're only doing that where we're getting long-term commitments from customers.

Robert Spingarn, Analyst

Right, right. And then in terms of increased rates coming out of the OEMs, Boeing and Airbus starting to get those ramps, have you seen any impact from that in your business as more aircraft come through? I understand they're nowhere near where they're going to be. I'm just curious to the extent to which you might be seeing an effect from that.

John Holmes, CEO

I would say nothing broad or trend at this point. The closest thing is we are seeing a slight loosening of supply in the USM market. We are seeing more opportunities arise. However, it's coming from all sectors—lessors, airlines, etc. So we assume that the slight increase in production that you're noticing out of the OEMs is driving some of the fleet movement providing opportunities for us to acquire assets.

Robert Spingarn, Analyst

Okay. And then Sean, for you, just with the parts distribution business impacting cash flows, if we were to exclude that or maybe look long term, is there a free cash flow conversion target that we should think about?

Sean Gillen, CFO

Yes. I mean, we thought about that over time as well. However, we're required to refrain from providing specific guidance on that, which is in terms of net working capital, as you mentioned, we'll see volatility from time to time. We'll be around new distribution agreements, which generally come with an upfront capital outlay or USM opportunities, as we saw back in our Q2 period. We moved more aggressively on some big opportunities. Outside of that, we are obviously focused on overall net working capital efficiency at AAR and AP as well, and continue to try to improve the cash flow profile of the company, which I think is part of the margin improvement we've shown pre-COVID up to today, and I think you're seeing some of that improvement in cash flow as well.

Robert Spingarn, Analyst

Okay. Thanks so much. I'll save the rest for Thursday.

John Holmes, CEO

Great. Thanks Rob.

Operator, Operator

Thank you. Please standby for our next question. We have a follow-up question from the line of Ken Herbert. Your line is open.

Kenneth Herbert, Analyst

Hi, Sean or John, can you comment on what percentage of the growth in the quarter was Trax or what that contribution was?

John Holmes, CEO

It was very modest this quarter, on track with expectations. It was very modest. We would reiterate that we expect Trax to be accretive to our FY '24 numbers.

Kenneth Herbert, Analyst

Okay. Great. And then I'm sure we'll get into more of this on Thursday. But as you look for fiscal '24, can you comment at least at a high level on expectations for revenue? Are low double digits a fair starting point as we think about the full year?

John Holmes, CEO

Yes. As we mentioned, we expect Q1 to be in the mid-teens growth over Q1 last year, low teens growth over Q1 last year. We’ll talk a little bit more about long-range growth targets when we're together on Thursday.

Kenneth Herbert, Analyst

Okay. Great. Thanks John.

John Holmes, CEO

Thank you.

Operator, Operator

Thank you. I'm showing no further questions in the queue. I would now like to turn the call back to management for closing remarks.

John Holmes, CEO

Great. Well, thank you very much. We appreciate the time and interest, everyone, and we look forward to seeing many of you on Thursday. Thank you.

Operator, Operator

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