AAR CORP quarterly report, Q1 FY2020

AAR CORP. Form 10-Q Summary

Business context and reporting period

AAR CORP. reported results for the three months ended August 31, 2019, the first quarter of fiscal 2020. Operations comprise Aviation Services, including aviation aftermarket supply-chain and MRO activities, and Expeditionary Services, which primarily manufactures mobility, defense, and composite products. The filing is unaudited and should be read with the fiscal 2019 Form 10-K.

Financial performance and position

Metric	Q1 FY2020	Q1 FY2019
Sales	$541.5 million	$466.3 million
Operating income	$22.8 million	$22.4 million
Income from continuing operations	$17.1 million	$18.9 million
Loss from discontinued operations	$(12.7) million	$(3.8) million
Net income	$4.4 million	$15.1 million
Diluted EPS	$0.13	$0.43

• Gross profit was $81.6 million, or approximately 15.1% of sales, versus $71.2 million, or approximately 15.3%, in the prior-year quarter.
• Operating margin was approximately 4.2%, compared with 4.8% in the prior-year quarter.
• Continuing-operations earnings margin was approximately 3.2%, compared with 4.1%.
• Cash used in operating activities was $32.4 million, including $30.1 million from continuing operations, compared with $27.0 million and $32.9 million, respectively, in the prior-year quarter.
• Cash used in investing activities was $3.5 million versus $5.0 million. Cash provided by financing activities was $52.8 million versus $35.3 million, primarily reflecting higher borrowings.
• Cash, cash equivalents, and restricted cash totaled $58.0 million at August 31, 2019, including $39.9 million of unrestricted cash and $18.1 million of restricted cash.
• Working capital was $625.2 million. Total debt was $203.3 million, net of debt issuance costs, resulting in reported long-term debt of $202.2 million.
• Borrowings under the revolving credit facility were $180.0 million; outstanding letters of credit reduced reported availability to approximately $300.1 million. Management stated that cash, unused revolver capacity, and accounts receivable financing capacity totaled $422 million.
• Remaining performance obligations, or firm backlog, were approximately $1.4 billion, with approximately 40% expected to be recognized as revenue within 12 months.

Material changes versus the prior comparable period

• Sales increased $75.2 million, or 16.1%, led by Aviation Services, which increased 16.7% to $511.8 million. Government and defense Aviation Services sales rose 37.7% to $181.3 million, partly due to new contracts, including a $118 million C-40 aircraft contract.
• Commercial Aviation Services sales increased 7.8%, supported by higher MRO volumes and improved labor availability. Segment gross profit increased 19.2% to $80.0 million.
• Government and defense Aviation Services gross margin declined to 14.6% from 18.5% because newer contracts carried lower margins. Commercial Aviation Services gross margin improved to 16.2% from 14.0%.
• Expeditionary Services sales increased 6.5% to $29.7 million, but gross profit declined 61.0% to $1.6 million. Segment gross margin fell to 5.4% from 14.7%, primarily due to higher material costs.
• SG&A increased $9.9 million, and SG&A as a percentage of sales increased to 10.7% from 10.3%. The increase included $2.8 million of investigation and remediation compliance costs and $0.8 million of severance costs.
• Net income declined substantially because the discontinued COCO business produced a $12.7 million after-tax loss, including an $11.8 million asset impairment charge. The comparable prior-year loss was $3.8 million.
• Inventory increased to $553.6 million from $523.7 million at May 31, 2019. Long-term debt increased to $202.2 million from $141.7 million.
• AAR adopted ASC 842 lease accounting on June 1, 2019, recording operating lease right-of-use assets and liabilities and a $2.5 million increase to opening retained earnings. The adoption did not materially affect income or cash flows.

Guidance, outlook, risks, contingencies, and unusual items

• Management expects continued strength in Aviation Services during fiscal 2020, citing value-added commercial and government offerings and favorable long-term aftermarket trends. Management also expects to invest opportunistically in business growth and customer support.
• The COCO business is classified as discontinued operations. Management expects related sale agreements to close before the end of calendar 2019; the filing text does not provide certainty regarding final proceeds or additional losses beyond the recorded impairment.
• AAR is cooperating with a Department of Justice civil False Claims Act investigation involving AAR Airlift Group contracts in Afghanistan, Africa, and for the U.S. Navy. The filing does not provide a clear estimate of potential exposure.
• The company self-reported potential Foreign Corrupt Practices Act and other legal violations relating to activities in Nepal and South Africa to the DOJ, SEC, and UK Serious Fraud Office. Outcomes and potential costs were not predictable at filing.
• Disclosure controls were not effective as of August 31, 2019 because of material weaknesses in internal control over financial reporting. Inventory-count remediation was completed without material adjustments, while information-technology general controls and vendor-data-master controls remained under remediation, expected to be completed by the end of fiscal 2020.
• Key market risks include variable interest rates, foreign exchange movements, credit losses, aviation-industry conditions, economic conditions, geopolitical events, and government-contract execution. Management stated that a hypothetical 10% U.S. dollar devaluation would not have materially affected the quarter.
• The company was in compliance with its financing covenants at August 31, 2019. The revolving credit facility was amended on September 25, 2019 to extend maturity to September 25, 2024 and increase the commitment to $600 million, with potential increases up to $900 million subject to conditions.

Important facts for investors to verify

1. Whether the Aviation Services growth rate and MRO profitability are sustainable, particularly as newer government contracts carry lower margins.
2. Whether Expeditionary Services can recover from the material-cost pressure and restore its prior gross margin.
3. Final proceeds, closing timing, and any further impairment or operating losses from the COCO divestitures.
4. Potential financial, regulatory, or reputational consequences of the DOJ investigation and self-reported FCPA matters.
5. Progress toward remediating the material weaknesses in IT general controls and vendor-data controls, and whether disclosure controls become effective.
6. Working-capital requirements, inventory growth, operating cash conversion, and the impact of increased debt and variable interest rates.
7. Conversion and timing of the reported $1.4 billion backlog, including the portion dependent on government contracts and long-term performance obligations.