AAR CORP. Form 10-Q Summary
Reporting period: Fiscal third quarter and first nine months ended February 29, 2012, compared with the corresponding periods ended February 28, 2011. The filing is unaudited. Although the request metadata states “2011 Q3,” the filing covers fiscal 2012 third quarter.
Business Context and Reporting Period
AAR operates in four segments: Aviation Supply Chain; Government and Defense Services; Maintenance, Repair and Overhaul; and Structures and Systems. Commercial customers represented 53.2% of nine-month sales, while government and defense customers represented 46.8%.
During the period, AAR integrated the December 2011 acquisitions of Telair International GmbH and Nordisk Aviation Products AS into Structures and Systems, and the October 2011 acquisition of Airinmar Holdings Limited into Aviation Supply Chain. Beginning in the third quarter, the Amsterdam component repair business was reported in continuing operations rather than as a discontinued operation; management stated the impact was not material.
Financial Results and Key Metrics
| Metric | Q3 FY2012 | Q3 FY2011 | 9M FY2012 | 9M FY2011 |
|---|---|---|---|---|
| Sales | $534.2 million | $458.0 million | $1.502 billion | $1.317 billion |
| Operating income | $35.7 million | $34.7 million | $102.9 million | $96.3 million |
| Net income attributable to AAR | $20.7 million | $17.9 million | $54.8 million | $48.4 million |
| Diluted EPS | $0.50 | $0.44 | $1.33 | $1.21 |
| Operating margin | 6.7% | 7.6% | 6.8% | 7.3% |
| Net margin | 3.9% | 3.9% | 3.7% | 3.7% |
Consolidated gross margin declined to 16.3% in the third quarter from 17.2% and to 16.1% for the nine-month period from 17.0%. Interest expense increased because of acquisition-related borrowings. The effective tax rate was 18.8% in the quarter and 29.3% year to date, compared with 34.1% and 34.7%, respectively, in the prior-year periods.
The lower third-quarter tax expense included a $4.0 million reduction primarily related to state tax planning and the relocation of a significant business. Management expected an effective tax rate of approximately 34.5% in the fourth quarter.
Segment Performance
| Segment | Q3 Sales Change | Q3 Gross Margin Change | Key Driver |
|---|---|---|---|
| Aviation Supply Chain | +11.9% | 19.8% vs. 17.3% | Parts supply strength and favorable inventory mix |
| Government and Defense Services | -9.2% | 14.3% vs. 17.4% | Lower performance-based logistics activity and aircraft availability |
| Maintenance, Repair and Overhaul | +3.7% | 11.8% vs. 15.9% | Airframe share gains offset by lower high-margin engineering sales |
| Structures and Systems | +86.5% | 18.2% vs. 18.4% | Telair and Nordisk contribution and higher Mobility Products production |
Cash Flow, Debt and Liquidity
- Nine-month operating cash flow was $18.2 million, down from $59.9 million, primarily reflecting a $57.0 million inventory increase and $101.8 million of other uses, including program and overhaul costs.
- Investing activities used $361.1 million, including $298.1 million for acquisitions and $62.7 million of capital expenditures.
- Financing activities provided $343.9 million, principally from $379.0 million of new short- and long-term borrowings.
- Cash was $59.3 million at February 29, 2012, compared with $57.4 million at May 31, 2011. Reported working capital was $504.4 million.
- Total recourse debt was $821.0 million, including $221.7 million classified as current. Short-term debt was $201.6 million and long-term debt was $599.3 million.
- The unsecured revolving credit facility was increased to $580 million and expires April 12, 2016. Borrowings were $300.0 million, with $14.6 million of outstanding letters of credit reducing availability.
- A separate secured revolving facility had $60.5 million outstanding against a $65.0 million commitment. Foreign credit lines provided an additional $3.6 million of availability.
- In January 2012, AAR issued $175 million of 7.25% senior notes due 2022, using proceeds to repay acquisition-related revolver borrowings. On March 9, 2012, it entered into an agreement to borrow $50 million under a five-year unsecured term loan.
Material Changes, Outlook and Risks
- Revenue growth was substantially acquisition-driven in the third quarter: Telair and Nordisk contributed $55.3 million of quarterly sales. The acquisitions increased goodwill and intangible assets to $448.4 million from $181.1 million at May 31, 2011.
- The preliminary acquisition accounting remained subject to final valuation of acquired assets, liabilities, intangibles, contingencies and taxes. The filing states that material adjustments could affect depreciation, amortization, goodwill and reported results.
- Management cited global economic uncertainty, high oil prices, aviation-industry bankruptcies and the European debt crisis as risks to commercial customers.
- Defense funding faces pressure from the Budget Control Act and potential sequestration scheduled for January 2, 2013. Management expected defense-budget reductions could adversely affect Structures and Systems businesses supporting the Department of Defense.
- AAR had $96.9 million of capitalized A400M program development costs and was negotiating with Airbus regarding reimbursement and higher selling prices. Failure to recover these costs could adversely affect financial condition and results.
- Interest-rate exposure was managed with a $50 million floating-to-fixed swap and a $50 million interest-rate cap. The swap had a $3.8 million liability and the cap had a $0.4 million asset fair value at quarter-end.
- Management identified risks relating to inventory obsolescence, aircraft and equipment impairment, program profitability, revenue-recognition estimates, customer credit, foreign currency and pension assumptions.
- Management concluded that disclosure controls were effective as of February 29, 2012, and reported no material changes in internal control over financial reporting.
Investor Verification Checklist
- Verify whether post-acquisition revenue and margins from Telair, Nordisk and Airinmar meet integration and profitability expectations.
- Reconcile the significant increase in debt and assess compliance with revolving-credit and senior-note covenants.
- Monitor inventory growth, accounts receivable, unbilled receivables and the conversion of earnings into operating cash flow.
- Assess the final purchase-price allocation and potential adjustments to goodwill, intangible assets, depreciation and amortization.
- Evaluate exposure to defense-budget reductions, sequestration and lower government program activity.
- Track the outcome of AAR’s negotiations with Airbus regarding the A400M development costs and selling price.
- Confirm the sustainability of the unusually low third-quarter tax rate, given management’s projected fourth-quarter rate of approximately 34.5%.