AAR CORP quarterly report, Q3 FY2021

AAR CORP. Form 10-Q Summary

Reporting period: Quarter and nine months ended February 28, 2021; fiscal year ending May 31. The filing is unaudited. AAR operates through Aviation Services, including supply-chain and MRO activities, and Expeditionary Services, primarily manufacturing activities.

Financial performance and key metrics

Metric	Q3 FY2021	Q3 FY2020	9M FY2021	9M FY2020
Sales	$410.3 million	$553.1 million	$1,214.7 million	$1,655.5 million
Operating income	$39.7 million	$5.3 million	$64.5 million	$56.2 million
Income from continuing operations	$31.1 million	$2.6 million	$31.6 million	$39.8 million
Net income	$28.1 million	$2.3 million	$21.8 million	$20.9 million
Diluted EPS	$0.79	$0.06	$0.61	$0.59
Operating margin	9.7%	1.0%	5.3%	3.4%

Q3 sales declined 25.8%, while nine-month sales declined 26.6%, primarily because COVID-19 sharply reduced commercial aviation activity.
Aviation Services sales decreased 26.5% in Q3 and 27.7% for nine months. Commercial sales fell 42.1% in Q3 and 46.2% for nine months, while government and defense sales increased 4.8% and 9.9%, respectively.
Expeditionary Services sales declined 9.6% in Q3 and 6.1% for nine months, largely reflecting the sale of the Composites business.
Consolidated gross profit was $86.0 million in Q3, versus $65.3 million in the prior-year quarter, producing an estimated gross margin of 21.0% versus 11.8%. For nine months, gross profit was $204.1 million versus $232.8 million, with estimated margins of 16.8% and 14.1%, respectively.
Q3 SG&A declined 22.7% to $44.9 million, but increased to 10.9% of sales from 10.5% because sales declined faster than expenses.

Cash flow, balance sheet, debt and liquidity

Cash provided by operating activities was $82.6 million for nine months, including $85.0 million from continuing operations, compared with $8.9 million of total operating cash used in the prior-year period.
Operating cash flow benefited from inventory reductions and $48.5 million of CARES Act Payroll Support Program grants, partially offset by a $25.0 million Unison license payment.
Investing activities provided $2.3 million from continuing operations, compared with $20.0 million used in the prior-year period. The change included $10.0 million of proceeds from terminated split-dollar life insurance policies and lower capital expenditures.
Financing activities used $397.2 million from continuing operations, primarily reflecting repayment of the precautionary revolving-credit draw taken in fiscal 2020.
At February 28, 2021, cash and cash equivalents were $99.2 million and restricted cash was $13.4 million. Total cash, cash equivalents and restricted cash were $112.6 million.
Working capital was $640.7 million. Total debt was $207.6 million before $1.6 million of debt issuance costs, compared with $602.0 million before costs at May 31, 2020.
The $600 million revolving credit facility had $174.5 million outstanding and approximately $20.3 million of letters of credit, leaving reported availability of $405.2 million. The facility matures September 25, 2024. A $24.3 million term loan is due November 1, 2021, and the Payroll Support Program note had a carrying amount of $8.8 million.
AAR was in compliance with its financing covenants at February 28, 2021. The filing also reports $11.6 million of other outstanding letters of credit and $10.2 million of foreign credit lines.

Material changes versus the prior comparable period

Commercial aviation remained materially depressed because of COVID-19 and reduced passenger flight hours. Management implemented hiring, compensation, spending, furlough, workforce-reduction, facility-closure and contract-restructuring measures.
Government and defense demand increased, supported by recently awarded contracts, partly offsetting the commercial decline.
AAR sold its Composites business on August 31, 2020, recognizing a $19.5 million loss. The transaction included $1.0 million of net cash proceeds and potential earn-out consideration of up to $6.5 million based on sales targets.
The company recognized $52.3 million of government workforce subsidies in gross profit for the nine-month period, including the CARES Act grant and foreign-government subsidies. These subsidies materially supported reported margins.
Nine-month results included $7.0 million of impairment charges, $8.3 million of severance and furlough-related costs, a $1.2 million inventory reserve for an exited product line, and a $4.5 million charge for minimum repair-volume guarantees.
Net contract assets changed from a $27.5 million net contract liability at May 31, 2020 to a $47.7 million net contract asset at February 28, 2021, primarily due to timing differences between performance, billing and collections.
Remaining performance obligations were approximately $700 million, with approximately 50% expected to be recognized over the next 12 months.

Outlook, risks, contingencies and unusual items

Management expects long-term strength in Aviation Services and favorable commercial aftermarket trends, but commercial recovery remains uncertain and depends on aircraft utilization, passenger traffic, fleet decisions and COVID-19 developments. Vaccine distribution was cited as a potential driver of recovery.
Commercial aviation volumes and flight hours remain a central operating risk. Other risks include government-contract execution, supply-chain and MRO demand, interest rates, foreign exchange, credit losses, financing-market conditions and covenant compliance.
AAR recognized a $3.0 million Q3 loss from discontinued operations and a $9.8 million nine-month loss. These results included increased reserves relating to a tentative settlement with the Department of Justice concerning alleged False Claims Act issues at Airlift Group.
The tentative DOJ settlement is approximately $11.5 million, subject to a definitive agreement and other contingencies. A $12.8 million reserve, including legal fees, was recorded at February 28, 2021. If not finalized, the DOJ and qui tam plaintiff could pursue litigation, including potential treble damages and penalties.
The company continues to cooperate with government reviews concerning self-reported potential Foreign Corrupt Practices Act and other legal violations related to activities in Nepal and South Africa. The filing states that the potential outcome cannot currently be predicted.
The CARES Act promissory note carries restrictions for approximately two years, including limitations on dividends, share repurchases, employee compensation and certain workforce actions.
AAR had no material change to the risk factors reported in its fiscal 2020 Form 10-K. Management concluded that disclosure controls and procedures were effective as of February 28, 2021.

Important facts for investors to verify

Whether commercial aviation activity and flight hours recover sufficiently to support Aviation Services revenue and margins without continued government subsidies.
The sustainability of reported profitability after excluding CARES Act and foreign-government workforce subsidies, divestiture effects and other unusual items.
The final terms and timing of the DOJ settlement, the adequacy of the $12.8 million reserve and the status of the Nepal and South Africa investigations.
Refinancing or repayment plans for the $24.3 million term loan due November 1, 2021 and compliance with revolving-credit covenants.
Collections on past-due receivables of $6.5 million from former commercial program customers, net of an $8.7 million allowance.
The conversion and timing of the approximately $700 million backlog into revenue and cash flow, including customer options and long-term program assumptions.