AAR Corp AIR CEO John Holmes on Q3 2020 Results

Good afternoon everyone. I really appreciate you all joining us today to discuss our Q3 FY20 results. Before I get into the details of the quarter, I'd like to make some comments regarding COVID-19 first. Our thoughts are with all of those who have been directly impacted, and our appreciation goes out to the health care workers around the world who are fighting on the front lines. As you know, this is an unprecedented situation for the global aviation industry. AAR enters this uncertain period from a position of strength. We have a diverse business mix with approximately 35% of sales from government customers and meaningful commercial sales to cargo carriers. We also have a strong balance sheet with less than 1x net leverage, significant liquidity, and strong customer relationships. That said, we expect a sizeable impact to our commercial airline business as a result of the decrease in commercial air traffic. To proactively address the anticipated impact of COVID-19, we are taking steps to ensure costs remain aligned with decreasing demand. These steps include a hiring freeze, reducing or eliminating all non-essential spend, reducing executive compensation, furloughs, and unfortunately reductions in our workforce. That said, we remain prepared to take additional action as warranted to respond to the evolving business environment. With respect to potential government assistance, I have been in direct contact with members of both the House and the Senate, as well as the administration, regarding potential support not just for the airlines but also for the broader aviation industry. As you know, we have worked diligently over the last several quarters to enhance our recruiting efforts, develop training programs, and partner with various schools to create a pipeline for technicians. Given our focus and success in building and retaining a skilled workforce, we are particularly supportive of all government measures aimed at preserving jobs. The safety and health of our people, as well as our customers and vendors, is a top priority. We're closely following CDC guidelines and have enacted remote working, social distancing, and related business continuity plans across all of our offices and facilities. These measures, combined with the overall business climate, create a great deal of uncertainty and stress for our people, and I really want to take this opportunity to thank the employees at AAR for their hard work, dedication, and flexibility as we go through this difficult time. I'm very proud to be part of the best team in aviation. Turning to our results, we had a record third quarter and I'm pleased with the overall performance. Sales were up 4% from $530 million to $553 million, and our adjusted diluted earnings per share from continuing operations increased from $0.62 per share to $0.67 per share. These strong results were driven by continued exceptional performance from our government programs, part supply, and MRO activities. We announced several new business wins which demonstrated AAR continues to be the partner of choice in the aviation services industry. Specifically, we announced plans to expand our airframe maintenance services with Air Canada to cover its A330 fleet. Additionally, AeroControlex, a large manufacturer of critical components to the aviation industry, selected AAR to be its exclusive global distributor for the APU lube pump product line. We have strong aftermarket expertise in these particular products and are already seeing results from the significant growth opportunity. Finally, we secured a $90 million sole source IDIQ contract with the Defense Logistics Agency for specialized shipping and storage containers as well as accessories. As described in the release, there are several restructuring actions that we have taken and will take to continue to improve the performance and strength of AAR. As we have previously discussed, we have seen increased costs on certain commercial programs contracts which were adversely impacting our financial results. We have taken decisive action to exit one contract and restructure two others, which will allow us to free up capital, improve cash flow, and increase margins. These actions resulted in a one-time, predominantly non-cash charge of $24.7 million. We have also made a decision to pursue several additional restructuring actions in our fiscal Q4 which involve consolidating facilities to further reduce costs. Before turning over to Sean, I'm pleased to share that subsequent to the quarter end, we completed the sale of our final contract within the C-130 airlift business as previously discussed. This completes the exit of that business as part of our strategic shift, and we are pleased to have that element of our plan complete. With that, I'll turn it over to Shawn, our CFO.

Thank you Sean. While we are pleased with our Q3 and year-to-date results which have tracked ahead of our previously raised guidance, due to the effects of COVID-19 on the commercial airline market we believe it is prudent to withdraw fiscal year 2020 guidance at this time. There's no question COVID-19 will have a meaningful impact on our commercial airline business. That said, volumes from our government customers are strong and are expected to continue to grow, and we have a substantial cargo business which we see potentially expanding in this environment. As for airlines, air travel will return and grow, and aircraft will return to service, and demand for aftermarket parts and services will be required. On that note, we believe there will be opportunities for AAR as capital constraints combined with low fuel prices will likely cause airlines to cancel orders for new aircraft and possibly extend the utilization of existing aircraft. Additionally, there will be greater demand for used material because airlines look to save money using aftermarket parts, and we as the largest aftermarket parts supplier in the world will benefit from increased supply as aircraft are retired. Moreover, we believe the competition in the aftermarket, which had grown in recent years due to the length of the up cycle, will decrease as our competitors struggle to survive or increasingly focus on their core activities. I want to reiterate that AAR is in a strong position. We are diversified across markets and geographies, and we have an exceptional balance sheet. I joined AAR just before 9/11 and I've seen what this company can do in times of adversity, and we are in an even better position today heading into this event. I'm proud to be part of such an amazing team and I'm confident that we will emerge even stronger. With that, I'll turn it over to the operator for questions.

Well, not sure if there's an algorithm, but let me try to take it piece by piece across the company. As we mentioned, on the government side in the past quarter, in the third quarter we saw significant growth, and at this point we see that continuing with the government business remaining strong and we expect continued growth there. Cargo as well, cargo through contracts that we have in our parts businesses that supply engine providers with parts for cargo customers, as well as some activity in the MRO business. We expect the cargo business to hold up and potentially expand as I mentioned. In terms of airline customers in MRO, we are in constant contact with all of our major customers and this is a very dynamic environment and really does change daily. Right now we have a fair amount of work in the hangars, they're largely full, but we anticipate a meaningful decline in that work as we head towards the summer. We're getting different information out of different customers at this time in terms of the schedules that they are putting together. The one encouraging part of all of that is that for many of our MRO customers, we are the main maintenance provider and they recognize the importance of keeping solid lines of work with companies like us, and the message is we'll do everything we can to keep you full. That said, we are expecting a meaningful decline in maintenance activity across the facilities as we head into the summer. Then in terms of the airline parts businesses, both new and used parts sales, it's early to tell. The business actually has been holding up up until just the last few days. We did see some decline out of Asia in the third quarter and that's continued, but the business was holding up. However, we have seen a decline just in the last few days and we are anticipating that business tracks with ASM.

It's not something we typically put out, but we typically see it between 10 and 15 percent of the commercial business.

Yeah, given the nature of our business, most of our cost is variable. For the part supply activities, our cost of sales is the inventory that we procure, that we have on the shelf or we buy in the market, and the other parts of it are shipping and sales, so it's really variable costs associated with activity. Where you have some greater fixed cost is on the infrastructure to support the hangars and the MROs. Again, a lot of the labor there is more variable in nature in terms of contracts and the people that support the activity. Then in commercial programs, some of the infrastructure to support the supply chain has a more fixed nature to it. So I think we have a highly variable cost structure across the whole company, with pockets of more fixed cost in the hangars and other areas.

Yeah, this is definitely an evolving situation. We're certainly in a mode right now where we are drawing down on existing parts inventories. As we see things settle out and as we see opportunities arise, we would look to potentially make investments, but right now we are very focused on the liquidity required to operate the business and using the stock that we have to satisfy demand.

I feel good about the actions that we took to address those contracts. They had been a headwind for us as we've indicated the last couple quarters. So those were in response to restructurings that occurred within our customers, and I'm happy that we were able to take those actions. They will provide an improvement in margin and an improvement in cash flow as a result of those actions. In the context of COVID-19, our power-by-the-hour contracts, as the name implies, are built on flying hours of the airlines, and we have seen reductions across all of the fleet that we support. Certain of those contracts have minimum flight hour protections in there, although we're certainly in uncharted waters in terms of how those protections will be enforced. So we're in a dialogue with all of our customers about how our program support going forward will look as they assess the impact on their own fleets as a result of COVID-19.

On the parts side, we really just in the last few days have started to see a decline in volume. It was actually holding up fairly well just into the last couple days, and we would expect as airlines ground fleets and look to cannibalize parts from aircraft that are on the ground, we would expect a meaningful decline in those day-to-day parts activities. In terms of the trading business, typically in the distribution business that's largely consumables and expendables, those aren't parts that would necessarily be cannibalized, but as airlines go through what they have on the shelf, we'll see a slowdown and then we could see some replenishment orders there. But I expect overall that volume on the new parts side to decrease as well. On the maintenance side, those are events provided the aircraft come back. Those are maintenance deferrals, and we would be working closely with our customers to make sure that we're in a position to handle the maintenance events when they start to put aircraft back into service. I would expect that activity to pace ahead of a recovery in the parts business.

Great question. The answer is, in the last few weeks we have seen some activity. Particularly out of China, about halfway through the third quarter we started seeing a meaningful decline in order volume out of China in particular, and a bit less impacted across all of Asia. But in the last two weeks, we have seen some increased activity. As a matter of fact, last week we received a multi-million dollar purchase order for a landing gear from a Chinese carrier, and that's a big order in any environment, particularly in this environment. So there definitely are signs of life with that market returning.

We typically don't split out those elements of the aviation services segment. But you know, if you look at aviation services, it's roughly a third, a third, a third: a third MRO, a third parts, and a third programs. In the programs, it's roughly split between government and commercial. So we would see the commercial power-by-the-hour programs tracking with ASM, and inside the parts business, with the exception of the government portion and the cargo portion, which I would put at a bit more than half, we would see the remaining half of the parts business tracking with ASM.

Yes.

Our commercial business is roughly about 40 percent international. So when we talk about ASM, I would weight that by geography — call it 40 percent international and 60 percent domestic. In the hangars, we have five in the US which service the domestic narrow-body market, two in Canada with a similar dynamic there, and then some landing gear facility in Miami and component repair facilities in New York and Amsterdam. So within MRO specifically, it's overweight towards the domestic US market and Canada.

The Q3 charge of $24.7 million is specific to the restructuring actions in the programs. The $15 to $20 million range estimate we provided for Q4 is for the Q4 actions — facility actions as well as people and overhead actions. That's split roughly evenly between facility actions and people actions. I would say that reflects a demand environment that tracks to some of the things we talked about here in terms of activity in the hangars and ASM. Should things deteriorate, we're watching the situation closely. It's still relatively early as we mentioned, and we would be ready to take additional action if needed.

In both situations, you had fleet changes that occurred at the customer that drove a pretty significant difference between what was expected when we signed the contract versus what we actually experienced. We've had negotiations with those customers in recent months to try to correct for that, and ultimately we ended up in a position where we needed to restructure the contracts and take a charge. That's the element on the customer side of it. On our side, we had a pretty rapid expansion in that business, as you recall — we signed up a lot of contracts with a lot of different operators in a lot of different environments, and it was a pretty stretched supply chain. These were some of the earliest agreements that we signed as we got into that business, and our pricing, our operations, and the contractual protections that we look for in those agreements evolved over that period. But these were earlier agreements in that regard.

We're taking a look at the liquidity position of all of our customers, and I wouldn't limit that statement to just our commercial power-by-the-hour contract holders. We're looking across the whole portfolio. Having said that, our largest customers we feel very good about their own financial management, and we've got very close relationships with them and are in very active dialogue with them in terms of our exposure and their plans. So overall I feel good about our AR portfolio. Having said that, we're certainly in an environment where you are going to see some failures, and we've done our own analysis on where those may occur and we're going to do everything we can to limit our exposure.

Sorry, Mike, I was just going to add that we do expect to see opportunities as a result of this market dislocation, in terms of potential asset acquisition opportunities and potential M&A. We do see clearing out some of the competition that has come into the market, both from small players that may exit completely and very large players that may decide they want to focus on other things. We've been here a long time, we've seen versions of these things before, and a big reason why we maintain such a strong balance sheet is so that we can come out of situations like this even stronger.

Definitely, the answer is absolutely. We want to time that correctly because we're in a mode here where we need to see how things are going to shape out, but absolutely. And I would mention, we've talked about this for several quarters now: the demand for aftermarket material has far, far exceeded the supply in the last several quarters. So obviously you're going to have a meaningful decline in demand and an increase in supply, but given our position and the relationships we have and the network we have to get our hands on the best material out there, we should be in a position to fulfill more of it as a percentage than we had been able to in the past as a result of more material coming on the market. Our job is to make sure we time that correctly and make the right investments to get our hands on that choice material before anyone else.

Yes, that could happen.

I wouldn't cite any asset class in particular at this point, but that's certainly something we're paying close attention to. A lot of the inventory that we carry is tied to long term contracts, and again, there was a bow wave of maintenance events where demand outstripped the amount of inventory that we could find. So even if you do see some early retirements or an overall decrease in demand, we feel pretty good about the inventory position that we've got right now.

I think it's important to remember that USM is a lower cost solution. In environments like this where airlines are really managing their cloths much more closely than they may have been before, you may see greater adoption of USM. That would be a fortunate development to the extent that we see greater USM on the right platforms become available on the market. That is a dynamic that we could see play out, and playing out in fast locations as well.

No, it's been as I mentioned. We had a very good quarter, and our defense government programs revenues were up meaningfully in the quarter, so it's largely business as usual. I'd add that the pipeline for us on the government side has continued to grow. Those awards take a long time due to the procurement process as well as the protest process inside the government, but we've built a great franchise. We're able to bid on more contracts than we ever have before because of our broad-based past performance portfolio, and I would expect to continue to see growth there, but it's going to come in chunks as these contracts are awarded over time.

I think that's a good point. I think you could see some net new work coming onto the market. Given the environment, as airlines look to alter a union agreement or another contract that might allow them to outsource work, this is certainly a backdrop to do that. So we could see net new work come on the market. I would also expect that you may see some of the domestic competitors not make it through, so you could see, at least for a period of time, a contraction in the amount of available hangar space. While we're very focused and, as I mentioned, we've been in dialogue with the government about potential aid to preserve a workforce, to the extent that there are new mechanics on the market, we could be in a position to bring on a workforce to expand capacity to the extent that's necessary. But there are so many moving parts right now it's difficult to forecast how all that is going to play out. Right now we just want to make sure that we've got our cost base right-sized to support the demand that we see over the next few quarters.

I think it's a little early to speculate on that. I do think a lot of that has to do with what actions the government takes and what potential aid may be out there to preserve workforce. To the extent that there's not a bailout, you may see a supply of labor come onto the market that we haven't seen in several years, and it could impact labor rates. But right now it's pretty early to tell.

No, not as a long-term strategy. We continue to believe that that, as well as the inclusion of all commodity inclusion, greater intellectual property generally defined in our portfolio whether that's PMA, DER, digital, etc., all of that is part of the long-term strategy. That said, as you can imagine, we are taking a look at all of our investment projects right now and we're going to moderate those or pace those with how we see the demand for the core services unfolding.

Our conversations with the government — I've been personally involved in a lot of these over the last several days — our points are that a bailout or aid package needs to address more than just the airlines. It needs to address the broader aviation services industry, because companies like ours, particularly around heavy maintenance, are a vital link in keeping the aircraft in the United States flying. Many airlines outsource those activities and no longer have the capability. Given the tightness in labor that we've seen over the last few years, we want to make sure that to the extent there is a decrease in demand and technicians are let go from various companies, including our own, that as other industries recover faster than aviation, we don't lose those technicians to other industries. We want to make sure we preserve that heavy maintenance capability in particular in America. So our conversations have been largely around providing aid to companies like ours, either in the form of grants or loans with forgiveness, that would be directed towards preserving the workforce.

Okay, well again, thank you everybody for your interest and support, and we really appreciate the time.