AAR Corp. (AIR) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the AAR Corp. Fourth Quarter and Fiscal Year 2012 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn today's conference call to Mr. Greg Dellinger with AAR Corp. You may begin, sir.

Thank you, Kevin. Good morning, ladies and gentlemen, and thank you for joining our fourth quarter fiscal year 2012 earnings conference call. Before we begin, I would like to remind you that comments made this morning may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. We ask that you refer to the disclaimer contained in our news release, as well as the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2011. In providing forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or the occurrence of anticipated or unanticipated events. And now at this time, I would like to turn the call over to our Chairman and Chief Executive Officer, David Storch.

Thank you, Greg, for your cheerful introduction, and good morning, everyone in attendance today. I'm sitting here in our Wood Dale headquarters with Tim Romenesko and Rick Poulton, and we'll go ahead and provide a little color, answering questions you may have to the results we published yesterday. And as you saw yesterday, we reported our fourth quarter fiscal year 2012 results. Some of the highlights. Sales were a record $563.3 million, which represented a 16% increase over the prior year. Diluted earnings per share before the impact of special items was $0.45, and after the effect of special items that we've identified in the fourth quarter, we -- our diluted earnings per share was $0.32. The full fiscal year sales surpassed $2 billion for the first time in the company's history, and diluted earnings per share was $1.65. We reported 16.5% organic sales growth to commercial customers for the fourth quarter and 15.4% organic sales growth for the full fiscal year. Sales to commercial customers now represent 60% of total sales and as reported in the fourth quarter. Our commercial parts businesses experienced double-digit sales growth for both the fourth quarter and full fiscal year driven by our industry-leading position. Recently, you may note that we were named Parts Supplier of the Year by Airline Economics magazine, which recognized our overall performance, strength and diversity as a supplier to the airline industry. The Maintenance, Repair and Overhaul segment reported double-digit sales growth in the fourth quarter as this brought on new customers and expanded relationships with existing customers. During fiscal year 2012, we sold over 4 million man-hours on our maintenance hangars, which is up from just around 3 million a couple of years back, and we experienced over 1,000 maintenance visits by 33 different customers. We captured new programs and increased the number of customers using multiple AAR facilities through our “One-MRO” concept. We're also named Best Airframe MRO Provider in the Americas by Aircraft Engineering, Technology and Maintenance magazine. On our March call, we discussed challenges at our Airlift operation around aircraft availability. We implemented a number of initiatives at Airlift to address this issue. We have seen meaningful improvement since the start of our new fiscal year. In the March to July time frame, we have seen a 50% improvement in our non-mission capable aircraft rate, and as a result, our operational readiness statistics has significantly improved, and we are meeting our customer commitments. We expect this improvement to continue for the balance of this fiscal year, and it will have a positive meaningful impact on our results. Sales to Government and Defense customers declined in the fourth quarter primarily due to reduced program activity in our Defense Logistics business and the previously discussed KC-10 contract adjustment. Subsequent to May 31, our Board of Directors authorized us to repurchase up to 50 million of our outstanding shares of common stock, $50 million worth I should say. Today, we have purchased 335,000 shares under the new authorization, an average acquisition price of $12.39 per share. We've not been in the market the past week or so leading up to our earnings announcements, but we'll continue and resume purchases shortly after the -- you have a chance -- the investor investment community has the chance to absorb our latest earnings release that we put out yesterday. I will now hand the call over to Rick, who will provide further details on the financial performance during the quarter. After Rick's comments, I will provide some closing remarks.

Okay. Thanks David, and good morning, everyon. As is customary, I'd like to provide a little more detail on the performance in each of our operating segments, and then I'll conclude with some comments around interest, depreciation and CapEx. So I'll start with our Supply Chain segment. In our Supply Chain segment, sales increased 21% compared to the year-ago period. We saw real increase in demand from our airline customers, mainly due to our improved product availability, and sales were also higher as a result of our growing distribution business. You should note that the year-over-year growth in this segment equaled or exceeded the year-over-year growth in any other quarter in fiscal '12 after excluding the effects of aircraft transactions earlier in the year. So there's good momentum in this business segment. Our gross profit margin in the Supply Chain segment was 18.2%, which, while down slightly from Q3, compares very favorably to the year-ago period, as well as Q1 and Q2 of fiscal '12. As we look ahead, we feel good about the investments we made in our Supply Chain business and our position in the market. In our Government and Defense Services segment, sales declined 21% primarily due to lower program activity in our Defense Systems and Logistics business, including the KC-10 contract charge that we talked about in our release. During the fourth quarter, we recorded that $9.5 million charge as a result of lowering our profit expectation on a portion of the KC-10 support contract. Once again, the adjustment represents the difference between the new profit margin expectation and the previous profit margin expectation for the period of performance that dates back to the inception of the contract, which goes all the way back to February of 2010. So the charge represents a cumulative catch-up adjustment. It is important to emphasize though that the KC-10 contract is still a profitable piece of business for the company. In addition, the improvements that David noted earlier that we are beginning to experience in our Airlift business are expected to deliver improvements to our financial results in these segment significantly bigger than the impact of the lower margin we will continue to record in the KC-10 contract going forward. Moving to our MRO segment. Sales increased 14% compared to the prior year, and our gross profit margin was essentially flat at 14.8% from the prior year period, but it was up 300 basis points from Q3. Each of our Airframe MRO centers reported higher sales in the period and remain encouraged by the demand environment. I'd like to remind everyone that as is typical at this time of the year due to the summer flying season, we would expect first quarter sales will be down in our MRO segment compared to the fourth quarter, but they should compare favorably on a year-over-year basis. In our Structures and Systems segment, sales increased 70% year-over-year mainly due to the impact of the acquisition of Telair and Nordisk. Our Mobility Products unit also had a very solid quarter. But during the period, we recorded a $3.7 million restructuring charge related to the 3 facilities we are closing, and this impacted our margins during the period. Our gross profit margin in the Structures and Systems segment, excluding these restructuring charges, was 16.8%. Moving down below the operating profit line. Our net interest expense for the quarter was $11.5 million, up from $8 million last year, and reflects the increased outstanding borrowings related to our acquisition. The cash portion of interest expense was $8.2 million, and our noncash portion of interest expense was $3.3 million. During our fourth quarter, we generated a strong $76 million in cash flow from operations, and our CapEx was $28 million. And our depreciation and amortization for the quarter was $23.8 million. Looking ahead, our CapEx plan for fiscal '13 is $55 million, which is significantly down from both fiscal '12 and fiscal '11. During our fourth quarter, we recorded a $3.3 million income tax benefit, which related to changes in book-to-tax return differences. Going forward, we would expect a normal effective tax rate of approximately 35%. So with that, I want to turn the call back over to David, who will provide some closing comments.

Thanks, Rick. We entered 2013 with solid momentum in most of our business supporting airline customers. We also have the full year -- the benefit of the full year operations from Telair and Nordisk, which are performing well and in excess of our acquisition expectations. We expect significant operating improvement at Airlift and stabilization in our precision machining businesses as the year progresses. It's also our Defense Logistics, Mobility Products businesses are expected to be down for the fiscal year. So as I put a wrap on this, I would say that we recognize that we had some execution challenges in fiscal year '12, but I want to let you know that we are all over this. And as a result of the experience that we have gone through, we are staying relatively conservative in our fiscal year '13 outlook and putting out -- we put out a range in our pre-release of $1.55 to $1.65, and we're going to go ahead and perform against that target. So with that, what I'd like to do is open this call up to any questions that you might have.

[Operator Instructions] Our first question comes from Lawrence Solow with CJS Securities.

I was wondering if you can just help me just parcel out sort of the Defense business, I guess, which is $900 million or so just based on the 60-40 split under your guidance. In terms of the pieces that are declining, is it fair to say that it's 3 pieces in your business and give or take, plus or minus they're about evenly between Mobility, Logistics and Defense? Is that fair to say? And then is it really the Mobility piece and part of Logistics that's declining? And then the second question would be I guess the worry is do they keep declining? Is it a multi-year thing? Do you have any sort of grasp on that? Is it just guesses at this point? I mean, how low could it go?

Yes, Larry. So I think the best way to think about our government defense stool, if you will, is with 3 separate legs, one being Airlift, two being our Defense Logistics businesses and three being our Mobility Products and other manufacturing businesses. Our Airlift business, I think we've talked about quite a bit. We expect to have solid demand in that business for the foreseeable future. And we expect increased and improved financial results from that business as a result of a lot of the operating improvements that we've talked about both on this call and previous calls. Our Defense Logistics business is the business where our KC-10 among other programs is, and that program, as you note, we've obviously lowered our margin expectations. That margin expectation goes forward with us going forward, but I think with that adjustment, demand remains pretty good for that business as we look ahead. So as we think about Q4 as a baseline for that business, we'll obviously be impacted by operating tempo of business. But otherwise, we think these assets that we support are important assets for our customer and should continue to operate notwithstanding what's happening with defense spending right now. And then the third business, the third leg of the stool, Mobility Products and other manufacturing, I think that's the business that has performed well for fiscal '12. But we do see some lower backlog, and we expect that to be down as we look ahead. And so all that total perspective I just shared is embedded in the guidance that we've given so far.

And I guess the Mobility business would probably concern, or at least some, in terms of is that declining because of cuts in defense spending? Is it also a demand issue as we sort of pull out of certain areas? I mean, I know there's always other theaters that will be in, but it looks like there's certainly a little less activity. So is that more of, what was it, overbuilt supply so there's -- it's not necessary to -- is it sort of just a pause in these types of stuff? Or is it -- is there no real way to define that?

Well, Mobility Products in specific, Larry, we think, are strategically still critical to our customer. So not a question that they become obsolete or anything like that.

Right, not obsolete, but do they become...

There have always been some ebbs and flows in demand for the products. And certainly, the amount of spending and funding available will help -- will drive some of those ebbs and flows. But again, we feel good fundamentally about that business for the long term, but we do expect a little slowing of demand in the near term.

Okay, fair enough. Just switching gears real quick, and then I'll move on. Can you just give a quick update? You mentioned your distribution sales are doing well as well on the Aviation Supply. Is that -- obviously, Unison. How is that contract performing?

Larry, Unison is a part of it, but I would say on balance, we're seeing new programs coming on board. We see a lot of interest in AAR as a distributor both on commercial and military product lines. So I think we're encouraged by our overall performance there with Unison being a part of it.

Our next question comes from Tyler Hojo with Sidoti & Company.

Just wanted to follow up with the last question on Airlift specifically. How much backlog visibility do you have into kind of a stable business through fiscal '13? And if there are some kind of major additional contract updates you need to get to, to perhaps get to flat this year, this fiscal year.

Our backlog or our contracts are good through fiscal '13, actually, through part of fiscal '14. And so we feel good about the visibility there. We're encouraged by the improvement in performance that we've seen over the last several months. As David said in his comments, we expect this performance to continue. In terms of new opportunities that are out there, we see a variety of different avenues that we're pursuing. Much of our attention of late has been on improvement in execution. But at the same time, we are now out there in the market, in the markets, looking for ways to diversify our offerings and get into markets that we see providing us opportunity out into the next several years.

Tim, how would you characterize those opportunities? I mean, is it pretty significant in terms of what's out there? Or is it pretty well tapped?

Well, there's a lot of money being spent in the areas that we're talking about. In some cases, the money has gone to operators that are non-U.S. based. We think that those are ripe opportunities for us to go after and capture. So I would say that the opportunity pool, or at least the opportunity pool, I would say, is extensive.

Okay, great. And just to clarify some of David's comments in the prepared remarks. The 50% improvement in, I guess it was aircraft readiness, does that bring you back to kind of where you need to be? Or is there still additional improvement that needs to take place from there?

There's still opportunity for better operational performance, which translates to better financial performance. So we see additional upside as the year progresses. In terms of meeting customer expectations, we're significantly improved. So now it's about operational improvement, managing our planning and our cost and our inventory levels and then translating that into improved financial performance.

Okay. But would it be fair to say that the heavy lifting has pretty much been done at this point?

I would say that we've experienced a significant improvement. But we're not giving up, and we see additional opportunities for improvement.

Okay, great. And just lastly for me, if you wouldn't mind kind of updating us on the aircraft portfolio. It looks like some JVs sold this quarter. And any expectations for additional sales in fiscal '13?

Yes, Tyler. We continue to prune the portfolio. As you know, we've been working that for quite a while now, and we would expect to have further JV items that get cleared up this year. Having said that, I think the emphasis will be on generating cash. I wouldn't expect a big P&L impact from those transactions, but you should expect to hear -- see more of the portfolio being addressed throughout fiscal '13.

Okay. And you mentioned cash, Rick. What are your free cash flow expectations for fiscal '13?

Well, you'll note from my CapEx comment, Tyler, that capital spending will be down significantly. And I would just tell you so the free cash should mirror that. And I'd rather not go out with a range right now, but you can do your own math. And I think we have the opportunity to have a pretty significant free cash flow this year.

Our next question comes from J. B. Groh with D.A. Davidson.

Actually, my questions have been asked and answered.

Our next question comes from Stan Mann [ph] with Mann Family Investment [ph].

I have some questions. A simple one on buybacks. You've got over 3 million shares left on your buyback. Do you expect to implement that over the next fiscal? Is that your expectations?

Stan, based on the cash that we generate from the businesses, we expect that over the balance of the fiscal year, that the repurchase would be spread out over the balance of the fiscal year. Yes, that's correct.

Okay. Is that included in your projection on your 2013 fiscal share buyback, reduction in shares and EPS?

Yes, and no. I mean, I think there is a little bit yes and a little bit no. I mean, I can't say that it's fully reflected in the numbers.

Okay. Because that's substantial buybacks. The total is in the area of 10%.

Right.

Okay. So it may not all be in there?

That's correct.

So the 50 dollar question is as follows. What do you see possible on upside, possible upside that has not been put into your 2013 projection or EPS?

I'd prefer not to go there. I prefer to go ahead and see our -- watch our performance. Maybe we can put more visibility to that as we put Q1 to bed in September and go from there, Stan.

Okay. In looking -- you've always had operating goals that were significant but were kind of hurt this last part of the year. Are you still, on your vision, looking at the operating margins moving up to 10%, 12%? Do you see that, the possibility of this business at this point in the future?

Do I see a possibility in the future of the business, yes, absolutely. So I believe that at this point in time, we have execution issues that we've addressed. We've been all over these execution issues. As we nail these, margins will improve. And I prefer at this stage at least to -- we do have internal goals. I prefer at this stage to go ahead, and as I've indicated, Stan, go ahead and put Q1 on the books and go from there.

Okay. Last question is D&A. Is it approximately going to be nearly $100 million in the 2013 fiscal?

Yes, Stan, it will be. It may even be a little higher.

[Operator Instructions] Our next question comes from Doug Carlson with Bank of America.

Just a quick question on the logistics business. I know that's been a little bit of drag. I think you touched on some of that in the call. If you could just kind of narrow down exactly what's the problem on the logistics business and how do you plan to bring that business up a bit in 2013?

Right. Just so we're clear, yes, when you think of our logistics business you have to think of 2 businesses, our Commercial Logistics business and our Defense Logistics business. Our Commercial Logistics business has been very strong, and you see growth rates far in excess of the industry or any other measurement. So let's make sure we're clear in that regard. As it relates to our Defense Logistics business, we've had less utilization by the customer. We've had a couple of programs go away, one program in particular. And we had a charge-off in terms of our expectation around the KC-10 profitability on the flight hour agreement aspect of that program. We do believe that the defense market is ripe with opportunities. Our organization is all over those opportunities, and we would anticipate over time that business will be performing very well as well. So when you think of AAR's logistics businesses, I would say on balance they're very strong.

Next question comes from Jim Altschul with Aviation Advisory.

Just something I wanted to throw out in light of what you're talking about in terms of a share buyback. Since the company has significantly increased its debt, do you think it might be prudent instead of buying back 3 million shares to use some of that cash to pay down some debt?

Absolutely, and we'll continue to do that as well. So we're hoping to generate enough cash to do both. If you look at the prior periods, we've taken our excess cash and we've bought down our convertible debt, and we've done that quite successfully at discounts, et cetera. So yes, as the opportunities present themselves to buy in debt, we will do that, yes.

I'm not showing any further questions. I'd like to turn the call back over to our host for closing comments.

With that, I think I appreciate your attention and participation today and look forward to our next conference call in September. Thank you.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.