AIR

AAR CORP. 10-Q Summary: Quarter Ended August 31, 2008

Business Context and Reporting Period

This is a Quarterly Report (Form 10-Q) for AAR CORP., a large accelerated filer, for the three-month period ended August 31, 2008. The company operates in four segments: Aviation Supply Chain, Maintenance, Repair and Overhaul (MRO), Structures and Systems, and Aircraft Sales and Leasing. The report highlights a challenging macroeconomic environment characterized by high oil prices, softening economic conditions, and disruptions in financial markets, which have led to airline capacity reductions and potential liquidity constraints for customers.

Key Financial Metrics

Note: All figures in thousands except per share data.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated sales increased 17.6% ($53.9 million) year-over-year. This was driven by a 32.2% increase in defense sales (40% of total sales) and a 9.7% increase in commercial sales.
• Segment Performance:
  • Structures and Systems: Sales surged 52.6% due to the Summa Technology acquisition and strong demand for mobility products.
  • MRO: Sales rose 37.8% driven by the Avborne acquisition and increased landing gear overhaul volume.
  • Aviation Supply Chain: Sales grew 7.6% with improved gross margins (23.1% vs 22.4%).
  • Aircraft Sales and Leasing: Sales plummeted 86.3% as the company sold no aircraft from its portfolio this quarter, compared to two sales in the prior year.
• Profitability: Operating income increased 18.2%. Gross profit margins improved across most segments due to volume and favorable inventory mix.
• Cash Flow: Operating cash flow turned negative ($10.5 million used) compared to positive ($2.1 million provided) in the prior year, primarily due to increased inventory and equipment purchases to support growth, and reductions in accounts payable.
• Debt Activity: The company retired $12 million of convertible notes, recording a $1.1 million gain on extinguishment. Net interest expense increased 14.7% due to new convertible notes issued in February 2008.

Guidance, Outlook, and Risks

• Market Outlook: Management notes that U.S. carriers are implementing cost reductions and capacity cuts (impacting 10-15% of the fleet) due to high oil prices. This may reduce demand for parts and maintenance. However, the company expects defense demand to remain strong.
• Liquidity: The company maintains $76 million in cash and a $250 million unsecured revolving credit facility (with $11.5 million in letters of credit outstanding). No borrowings were outstanding under the facility as of August 31, 2008.
• Accounting Changes: The company is evaluating the impact of FSP APB 14-1 regarding convertible debt, which is expected to reduce diluted EPS by $0.12 to $0.15 per share in fiscal 2010 upon adoption.
• Risks: Key risks include the ability of airline customers to raise capital, general economic slowdowns, and the potential for additional inventory impairment charges if market values decline further.

Investor Verification Checklist

• Acquisition Integration: Verify the ongoing contribution of the Summa Technology and Avborne acquisitions to revenue and margin targets.
• Inventory Levels: Monitor inventory balances ($303 million) and potential future impairment charges given the economic downturn and airline fleet reductions.
• Convertible Debt Impact: Assess the future dilution impact of the $250 million convertible notes issued in February 2008 and the upcoming accounting standard changes (FSP APB 14-1).
• Working Capital Trends: Review the trend of negative operating cash flow caused by inventory buildup and determine if this is a temporary growth investment or a sign of slowing sales velocity.
• Defense Exposure: Confirm the sustainability of the 32.2% growth in defense sales, which now represents 40% of total revenue.