AAR CORP. Fiscal 2017 Third-Quarter Form 10-Q Summary
Reporting period: Quarter and nine months ended February 28, 2017, compared with February 29, 2016. The supplied metadata labels the period “2016 Q3,” but the filing is for AAR’s fiscal 2017 third quarter. Results are unaudited.
Business Context
AAR operates through two segments: Aviation Services, including aviation supply chain and maintenance, repair and overhaul activities, and Expeditionary Services, including airlift and mobility products and services for government, defense and other customers.
Financial Performance
| Metric | Three months ended February 28, 2017 | Prior year | Nine months ended February 28, 2017 | Prior year |
|---|---|---|---|---|
| Sales | $446.7 million | $412.1 million | $1,275.3 million | $1,230.3 million |
| Operating income | $21.4 million | $16.2 million | $58.0 million | $45.7 million |
| Income from continuing operations | $13.1 million | $9.9 million | $35.1 million | $26.5 million |
| Net income | $13.7 million | $4.8 million | $35.3 million | $35.7 million |
| Diluted EPS | $0.40 | $0.14 | $1.03 | $1.03 |
| Operating margin | 4.8% | 3.9% | 4.5% | 3.7% |
Quarterly sales increased 8.4% and nine-month sales increased 3.7%. Segment gross profit was $69.0 million for the quarter and $196.7 million for the nine-month period, compared with $59.3 million and $172.3 million, respectively, in the prior-year periods. The Aviation Services gross margin was 16.5% for the quarter and 16.2% for the nine months; the filing does not provide a consolidated gross margin percentage.
- Aviation Services: Quarterly sales increased 9.6% to $382.8 million, led by a 21.0% increase in commercial sales. Government and defense sales declined 15.6%, primarily from the wind-down of the KC-10 program. Segment gross profit increased 8.2% to $63.4 million.
- Expeditionary Services: Quarterly sales increased 1.6% to $63.9 million, while gross profit increased to $5.6 million from $0.7 million. The improvement primarily reflected higher mobility-product volumes, including the composite manufacturing product line reclassified into continuing operations.
- Taxes and interest: The effective tax rate on continuing operations was 34.5% for the quarter and 35.2% for the nine months. Interest expense declined to $1.5 million for the quarter and $4.0 million for the nine months, primarily because convertible notes were retired in fiscal 2016.
Cash Flow, Liquidity and Debt
- Cash used in operating activities was $11.2 million for the nine months, including $9.6 million from continuing operations, compared with $13.9 million and $12.8 million, respectively, in the prior year.
- Cash used in investing activities was $12.8 million, including $28.0 million of property, plant and equipment expenditures and $18.0 million of asset-disposal proceeds.
- Cash provided by financing activities was $3.4 million. The company paid $7.7 million in dividends and repurchased $16.6 million of common stock.
- Cash declined to $10.1 million at February 28, 2017 from $31.2 million at May 31, 2016. Working capital was $550.3 million.
- Total debt was $172.8 million, including $144.0 million drawn under the revolving credit facility and a $25.0 million industrial revenue bond. Long-term debt was $168.7 million.
- The revolving facility provides $500 million of commitments, with approximately $342.1 million available after borrowings and letters of credit. Including cash and unused revolving capacity, management reported liquidity of approximately $352 million, plus $9.2 million under foreign lines of credit.
- The revolving facility maturity was extended to November 1, 2021. AAR stated that it was in compliance with all debt covenants at February 28, 2017.
Material Changes and Unusual Items
- Commercial Aviation Services growth was partly offset by the loss of volume and profit from the KC-10 program. The prior KC-10 contract’s principal services were completed in January 2017; limited services are expected to continue for an unspecified period.
- AAR invested $76 million in rotable assets during fiscal 2017 to support new commercial airline programs and government programs. Management expects those programs to complete their ramp-up in fiscal 2018.
- AAR sold certain temperature-controlled container product-line assets for $5 million and recognized a $2.6 million gain. It also entered into a three-year manufacturing agreement with the buyer.
- The company retained its composite manufacturing operations in continuing operations and shut down its metal machining operation previously held for sale. Telair Cargo Group and the metal machining operation remain reported as discontinued operations.
- Discontinued operations contributed $0.6 million of quarterly income and $0.2 million for the nine-month period, compared with a quarterly loss of $5.1 million and nine-month income of $9.2 million in the prior year. The prior-year nine-month result included a $27.7 million gain from contingent consideration.
- Quarterly SG&A included $1.4 million of legal costs related to defense of the GASS contract award. Nine-month SG&A increased 9.7%, primarily from business-development investments.
Outlook, Risks and Contingencies
- Management described commercial aviation markets as healthy and cited new contracts with multiple commercial operators. It expects revenue and income from recently awarded programs to increase as they ramp up in fiscal 2018.
- The Department of State awarded AAR Airlift the GASS contract on September 1, 2016. The potential duration is up to 11 years, including options and phase-out, with a stated ceiling of $10 billion including task orders. A competing protest remained pending before the U.S. Court of Federal Claims, with a decision expected on or before August 9, 2017.
- DynCorp’s trade-secrets litigation was remanded for further proceedings after an appellate reversal of the dismissal. Discovery was scheduled to end September 1, 2017, with trial set for April 2, 2018. AAR stated that it believes the claims are without merit.
- An OIG investigation found no evidence that AAR used DynCorp information in its winning proposal and no evidence of harm; the Department of Justice and OIG declined further action. The Department of State contracting officer reaffirmed AAR’s status as a responsible contractor.
- Key operating risks include the KC-10 wind-down, weakness in government and defense markets, execution and funding of new programs, working-capital needs from asset investments, credit-market conditions, interest rates, foreign exchange and customer credit exposure. Management reported no material changes to the risk factors in the fiscal 2016 Form 10-K.
- No full-year financial guidance or quantified earnings outlook is provided in the filing.
Investor Verification Checklist
- Verify the timing and financial impact of the KC-10 program completion and any remaining billings, including $16.9 million of unbilled KC-10 receivables at February 28, 2017.
- Assess whether the $76 million investment in rotable assets and new customer programs produces the expected fiscal 2018 revenue and margin ramp.
- Monitor operating cash conversion, particularly the $75.7 million increase in equipment held for long-term lease and the decline in cash balances.
- Confirm the status and economic contribution of the GASS contract and the related Court of Federal Claims protest.
- Track DynCorp litigation, potential costs and any effect on the GASS award.
- Reconcile reported net income with prior-year discontinued-operation gains and other nonrecurring items when evaluating underlying earnings.
- Review debt-facility covenants, revolver utilization, share repurchases and liquidity available for future investments.