AIR

AAR CORP. 10-Q Summary: Quarter Ended August 31, 2005

Business Context and Reporting Period

This filing covers the quarterly period ended August 31, 2005, for AAR CORP., a diversified provider of products and services to the global aviation and aerospace industry. The company operates through four segments: Aviation Supply Chain, Maintenance, Repair and Overhaul (MRO), Structures and Systems, and Aircraft Sales and Leasing. The financial statements are unaudited.

Key Financial Metrics

Note: Debt figures include short-term debt, current maturities, and long-term debt. Free cash flow is estimated as operating cash flow less capital expenditures ($4,695).

Material Changes vs. Prior Period

• Revenue Growth: Sales increased 21.9% year-over-year, driven by a 24.8% increase in the Aviation Supply Chain segment and a 78.4% surge in the MRO segment. The MRO growth was primarily due to the opening of the Indianapolis airframe maintenance facility in January 2005.
• Profitability: Operating income rose 69.4% to $10.99 million, and net income more than doubled to $5.26 million. Gross margin improved to 17.4% due to favorable inventory mix and operational efficiencies.
• Cash Flow Deterioration: Operating cash flow turned negative at ($21.7) million, compared to positive $5.6 million in the prior year. This was primarily caused by a $22.75 million cash investment in long-term lease equipment for a new supply chain program and a $23.9 million increase in inventory levels.
• Segment Performance: While most segments grew, Aircraft Sales and Leasing sales dropped 73.1% as major aircraft activity shifted to unconsolidated joint ventures.

Outlook, Risks, and Management Commentary

Management Commentary: Management attributes the sales increase to improved demand for engine and airframe parts, increased outsourcing by carriers, and strong defense demand. The company notes that the effective tax rate increased to 28% from 23.3% due to higher pre-tax income and the phase-out of export tax benefits.

Liquidity: As of August 31, 2005, the company held $24.4 million in cash and cash equivalents (with $9.97 million restricted). Total available liquidity, including credit facilities, was approximately $95.7 million. The company recently refinanced a mortgage loan for $11 million at a 5.01% fixed rate.

Risks and Contingencies:

• Industry Volatility: High fuel prices and airline bankruptcies (e.g., Delta, Northwest) pose risks to fleet reductions and demand for maintenance services.
• Impairment Risk: The company maintains significant inventory and equipment values. Historical impairment charges (totaling over $80 million since 2001) highlight the risk of further write-downs if market values decline or demand drops.
• Lease Obligations: The company has significant off-balance sheet operating lease commitments ($15.99 million) and potential loss accruals on aviation equipment if purchase option prices exceed fair value.

Investor Verification Checklist

• Inventory Valuation: Verify the assumptions used for net realizable value of the $227 million inventory, particularly regarding older generation aircraft parts.
• Working Capital Trends: Monitor the sustainability of the $23.9 million inventory build-up and its impact on future cash flow.
• Joint Venture Exposure: Review the financial health of the unconsolidated aircraft joint ventures, which now handle the majority of aircraft sales activity.
• Debt Covenants: Confirm compliance with financial covenants given the recent refinancing and the company's reliance on credit facilities for liquidity.
• Lease Loss Accruals: Assess the $2.1 million accrual for losses on aviation equipment operating leases and the sensitivity of this figure to market rate changes.