AAR Corp. (AIR) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the AAR Corp. First Quarter Fiscal Year 2013 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Greg Dellinger. Please go ahead.

Thank you, Stephanie. Good morning, ladies and gentlemen, and thank you for joining our first quarter fiscal year 2013 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, 2012. 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 very much, Greg, and good morning today. Joining me in Chicago in our office at corporate headquarters are Tim Romenesko and Rick Poulton. Yesterday afternoon, we reported results for our fiscal year 2013 first quarter. We are pleased with our performance as both sales and earnings per share came in at the top end of the previously announced guidance. As you know, we've been very focused on generating cash. And during the first quarter, cash from operations was a strong $33 million. We repurchased 475,000 shares on the open market for $6.1 million, and we also repurchased $13 million face value of our convertible bonds at attractive terms. We also reported improvement in both our consolidated gross profit and operating profit margins, and Rick will provide more detail around margin performance in his prepared remarks. During the quarter, we continue to win new business and expand relationships with existing customers. When excluding the aircraft sale from the prior year, organic sales growth to commercial customers was 13%, far outpacing the overall growth rate in the airline industry. We saw strength in our aviation services businesses, which include a strong summer quarter in our airframe maintenance facilities. Sales increased significantly over the prior year as we continue to execute against our one MRO strategy. We're in the process of opening a 4-line airframe maintenance facility in Duluth, Minnesota and secured our first customer with the work expected to begin in December. In addition to opening the Duluth facility, we were selected by other unnamed airlines for additional work in other facilities. Our parts supply businesses reported strong top line growth while experiencing reduced margins due to lower margin program activity. We had significant improvement in Airlift due to higher operational readiness and increased flying activity. Our team has done a good job, actually a great job with their motto, fix them and fly them, and are filling a vital need to our -- for our customers. We've received early indications from the customer of their interest in exercising options for large rotary wing contracts, which comes due in November 1 and December 1. We're very pleased with the results coming from the Telair and Nordisk acquisitions, and they're exceeding our expectations. Performance in our Mobility Products unit was also strong in the first quarter. As we have previously indicated, the unit will be faced with pressure the balance of the fiscal year as we're seeing reduced backlogs. Results at our Precision Systems business improved from the fourth quarter, and we are expecting continued improvement throughout the fiscal year. So I'll now hand the call over to Rick, who will provide further details on our financial performance during the quarter. After Rick's comments, I will provide some closing remarks. Rick?

Okay. Thanks, David, and good morning, everyone. As is customary, I'd like to provide a little more detail on our performance, including some comments around interest, depreciation and capital expenditures as well. So within our aftermarket aviation services businesses, our top line sales performance was quite strong. Our supply chain management businesses saw 16% year-over-year growth, and we exclude the 2 aircraft sales last year that we discussed in our release. This was driven by strong program volumes, including programs managed through Airinmar, as well as strong growth in our distribution agreements. Additionally, our repair and engineering services businesses also saw double digit year-over-year growth as we continue to win market share. Our airframe overhaul centers, in particular, remained very busy. And this is the third quarter in a row that each of the centers has reported higher year-over-year sales. It's on the back of this consistently strong demand that we feel very good about opening a new facility in Duluth that David mentioned. And finally, as it relates to our aviation services businesses, while our airlift and defense logistics businesses reported flat year-over-year sales, sales were up double-digit percentages on a sequential basis from Q4, as our flight hour volumes and aircraft demand remained strong. And we delivered significantly improved aircraft availability to accommodate that demand. Within our manufacturing and systems design businesses, our top line sales performance was also quite strong as it was up 79% on a year-over-year basis. Although a large portion of this increase is attributable to the acquisitions of Telair and Nordisk, organic growth was also strong at 9% on a year-over-year basis. If I move down to margins, consolidated gross profit margins of 16.4% were up 80 basis points year-over-year. And they also compared very favorably to consolidated margins in Q2, Q3 and Q4 of fiscal year 2012. The large driver of this improvement is the inclusion of Telair in our results, as well as the more efficient utilization of facilities and workforce in our airframe and overhaul businesses compared to last year. I'd also add that while it does not result in a significant year-over-year impact in Q1, we're very happy to see our margins in our Airlift business recover fully from their depressed levels of Q3 and Q4 last year. Our net interest expense for the quarter was $10.2 million, which is up from $7.4 million last year. The cash portion of this interest expense increased to $7.3 million from $4.2 million last year as a result of the increase in the borrowings we have to pay for our acquisitions. The noncash portion of interest expense was $2.9 million in Q1. And at the end of the quarter, we had approximately $806 million face value of outstanding debt obligations. As David mentioned, during the quarter we generated a very strong $33 million in cash flow from operations, and we had CapEx of $11 million. We're very pleased to deliver free cash flow conversion in excess of 100% of net income for the quarter, and free cash flow generation will continue to be a primary focus for the company throughout the year. Our depreciation and amortization, including amortization of stock-based compensation, was approximately $23 million during the quarter. And this resulted in EBITDA, or earnings before interest, taxes, depreciation and amortization, in excess of $61 million for the quarter. This is up approximately 20% on a year-over-year basis. Finally, I'd like to brief you on a change in our financial reporting, which we expect to implement beginning in our second quarter. As you know, we currently describe our company and report segment financial information along 4 segments. Increasingly, we are going to market as a much more integrated company, blurring the lines of our different entities and different segments, and it's becoming very common for us to sell a customer suite of services in the same program that may cross over several of our different business units. We see this as a competitive advantage for us in both of the breadth of the services we offer as well as the operating synergies we can create through having our multiple aviation services businesses work together. And so this new market reality change also reflects how we are evaluating results of the company and how we're thinking about the company. Beginning in the second quarter, we expect to report our aviation services businesses in one segment and our manufacturing and systems design businesses in a second segment. Before we report our second quarter results, we'll provide restated results for relevant prior periods, so that all of you can adjust your models appropriately. So with that, I'd like to turn the call back to David, who will provide some closing comments.

Excellent, Rick. Thank you. As you saw in our release, we did increase our EPS guidance somewhat modestly. And although we see continued strength in our commercial aviation services business, we are faced with headwinds at our Mobility Products unit. I am encouraged by our improved performance at certain key businesses. And as we've -- as you've heard from me, you've heard from Rick, you've heard before, we remain squarely focused on generating a significant amount of free cash flow to continue to pay down our debt and deleverage our balance sheet and return money to shareholders. So with that, I'd like to open up the call to any questions you may have. And yes, we're here ready to answer your questions.

[Operator Instructions] Our first question comes from Tyler Hojo from Sidoti & Company.

Just firstly, I get the updated earnings guidance, nice to see that. But wondering if you could talk a little bit about updated sales expectations, if there are any?

We had a broader, obviously, a broader range, Tyler, on the sales side. See the sales we had for Q1 are certainly on a linear basis are within the guidance we had out there. So we haven't really decided to make any update to that. If we feel it's appropriate to do so, we'll do that prospectively. But we're sticking with what we have out there.

Okay, that sounds good. And I guess, next, you gave us a little bit of update on the Duluth facility. Just wondering if maybe you could talk a little bit about how much capacity you're adding? What the revenue potential is for that facility? And if there's any differential just in terms of the margin dynamic that you're going to look to generate within that facility?

Tyler, no. We're excited about the prospects for Duluth. We think we can add someplace between 350,000 and 450,000 man-hours a year. So it depends on the mix of work that we -- that comes through the facility. We are expecting it to be a kind of a lower-cost facility. So we're optimistic about our opportunity for margin and delivering real value to the customers. The value proposition for our MRO business is very strong. Customers like the breadth of the offerings that we have from them, the flexibility, the ability to go to a variety of different locations, the benefits of having our engineering capability as well as our parts support. So it was a -- when the opportunity came to us, it was a natural. And we're excited to be in that facility.

Tyler, I'd just add just for context what Tim mentioned that man-hour opportunity is about a 10% delta to what we have, what we performed last year.

Okay, that's helpful. And just one more, and I'll jump back in the queue. Just a few days ago, I saw that you guys won a $75 million pallet repair contract. I don't think you put out a press release on it. But just wondering, is that kind of just a recurrence of existing sales, or is that something incremental for you guys?

Yes, that was a option exercise that our customer, current customer did. It's activity we've done for years, Tyler. The dollar amount is a ceiling that allows the customer to go that high. We don't expect volumes to be that high. The volumes we do expect under that contract are embedded in our plan and the guidance, we've already provided.

Our next question comes from Larry Solow from CJS Securities.

Just a first question on Aviation Supply. Your gross margin was a little bit under pressure, not so much year-over-year, but just in the general scheme of things. Anything unusual? Is the mix of the distribution lower margin, or is there anything in there that caused that?

Yes, I think mix is the operative word, Larry. Both distribution as well as some more program business that we do. We're very happy about that at an operating profit margin line, but on a gross margin line, doesn't compare as favorably as some of the parts transaction business.

Is this sort of -- looking out, is this sort of a better base to you as opposed to sort of the 18% full year number you did last year? Or is it still a choppy type number that should -- could be improved upon as the year progresses?

Yes, I guess I'd go to my comment. I'd like to start with my comment that we made. I mean increasingly, all of our businesses are going to market, much more integrated, Larry. And so what gets reported in one segment is not necessarily indicative of what a program value may be, because it may drive a lot of activity in other segments as well. So I think that's a large driver for why we're going to portray the company a little different manner as we go forward. But yes, suffice it to say, we like program activity. It's stickier business, and we think it gives us an opportunity to touch a lot of our various business units.

And so just in the sense that going forward, you're basically going to have 2 segments, essentially, that 2 reporting segments?

Correct.

And will you still give any color, maybe not the old style of breaking out how you do it today, but will it still -- will you still talk about or quantify some of the differences in the government and the commercial businesses and whatnot?

I think we'll be responsive to what investors need to make informed decisions. And we'll certainly talk about everything that -- anything that makes sense to talk about as a driver of the business.

Fair enough. Just lastly, quickly, just on the interest expense. It had a pretty good sequential drop over $1 million or anything. I know you retired from the converts, but I imagine that couldn't move the needle that much so fast. Anything else in there that I'm missing or...

On a sequential basis, no. I mean we did take out -- we bought back some of our bonds.

Last quarter, I guess, too, right. So...

That creates a little bit of a positive arbitrage for us. I can't think of anything else off the top of my head, Larry, that explains that.

All right. And if I could just squeeze one more in. Just on the precision parts on the AWS business. I know -- well, it seems like AWS certainly improved a lot sequentially in year-over-year, and I know precision parts also had been a thorn. Seems like that's probably part of the reason for the upside in the quarter, just a faster realization of some improvement. Is there still a lot -- is there still more low-hanging fruit? Are you still looking for further improvements in those businesses as we go out?

We're continuing to see improvement in our Precision Systems business. And -- but we're not where we need to be yet. So I guess the short answer is yes, we see opportunity for improved results coming out of that business. And Airlift, obviously, has come back strong, although we do still see opportunities for improved results there.

Our next question comes from Jon Braatz from Kansas City Capital.

Going back to Airlift. David, you mentioned that it's – obviously, you saw some nice improvement, but you have more opportunity on the upside. I wonder if you could touch base on that issue a little bit. How much more might we be able to see in terms of improvement at Airlift?

I think if you look at the existing fleet profile and the existing business mix, you have room for improvement. I would say it's, at this level, more modest than dramatic. I do believe, though, you will continue to see modest improvement. We have the demand -- the incoming demand for the service is fairly strong. We have to weigh what we -- how we manage the fleet against these opportunities. Most of these opportunities would be non-DoD related, which is something we're interested in as it relates to diversifying the mix inside that business. So I would be cautiously optimistic that there are good growth opportunities for that business. I'm pleased -- and I just was at the business on Monday, meeting with the leadership team and discussing kind of the future of the business. And what we really determined, John, was that we wanted to give the business starting back on June 1, we wanted to focus the next 6 months on meeting our commitments and supporting the existing customer, doing a better job of capturing the available revenue that we have. And that we then sit down at the end of November after a 6-month period and look at the investment opportunities, the business opportunities, the investment that goes with that opportunity and then make some determinations. But I would anticipate that through the balance of this fiscal year, we will continue to see steady improvement. The results will be -- will continue to be solid. And I think at some point in time, within this fiscal year, we'll probably make some determinations as to how we grow from here. Keep in mind, when we acquired the business, the revenues were approximately $175 million. And this year, we'll be looking at somewhere between, let's call it, $300 million and $340 million. So we've had some pretty meaningful growth in this 2.5 year period. And we stubbed our toe a little bit in the middle of -- at the end of last fiscal year. So we want to make sure we're on solid footing as we look at any dramatic expansion opportunities.

Okay. Going -- one other follow-up question going back to Duluth. Tim, is Duluth a drag on margins at this point, and do you -- were you able to sort of cut a deal in Duluth that was similar to Indianapolis in terms of leasing lines and so on and so forth?

Yes, we have a lot of flexibility on our lease in terms of kind of synchronizing our payments with the level of activity. And we also got -- had a good working relationship with the city and the state that made it attractive for us to come in there. They helped us with some of the start-up training. They helped us get the facility configured. So the impact on margins in the grand scheme of things is minimal as we start up.

Lastly, American Airlines has been in the news recently. Any new developments you see there that might be a precursor to some business flowing your way?

Nothing that's obvious at this moment. I think if you look at the – if the pass is a prologue to the future, then there would be an indication, at least, that there'll be more opportunities going forward than they have been in the past. So I would say stay tuned.

[Operator Instructions] Our next question comes from J.B. Groh from D.A. Davidson.

Could you maybe sort of give us your thoughts on sequestration? Which segments, I mean as they exist now, get impacted the most, and how you see that rolling out and how it impacts your thoughts on this guidance? And also, have you seen any sort of pull-through of defense spending near the -- into the fiscal year and that sort of thing?

Let me take a crack at sequestration. It is in our mind, so it is factored into our view of the balance this fiscal year. It's a very hard matter for us to handicap. The activities we have that support live action, if you will, we don't see being impacted in any fashion in terms of some of the longer-term programs. And I think one of the reasons why we've kind of dialed it back on the Mobility business is because of concerns around sequestration. I think it's really, it's a very troublesome concept. And yet, I don't think as we sit here today, I or too many other companies like us really have a lot of visibility. So there's no dialogue, per se, with us and the customer talking about any pullbacks or anything of that nature. We do not, unlike others, feel compelled to issue warn notices. We are not looking at issuing warn notices, at least as we sit here today. That's obviously subject to change in the event that we are notified or get some indication that some of our programs are under severe pressure. So that has not been the case yet. But it is in our minds, it is factored into our view on the balance of the fiscal year. And there is a degree of uncertainty surrounding that issue.

Okay. And then on the other question specifically, supply chain is there any pull-through there do you think or is...

No, we haven't seen any impacts there. We actually haven't seen any impacts in our business. I mean if you take a look at our defense results in the first quarter, they're up 1%. We are expecting, as we've indicated, based on backlogs, we are expecting our Mobility business to soften throughout the balance of the fiscal year.

I mean it's 10 days left in the month, obviously, J.B. But nothing unusual is happening now in terms of big push at the end of the year.

And I'm currently showing no further questions at this time.

Thank you very much for your participation, and I wish everybody a good day. Thank you.

Thank you. Ladies and gentlemen, that does conclude today's conference. You may all disconnect, and have a wonderful day.