AAR CORP. Fiscal 2019 Form 10-K Summary
Reporting period: Fiscal year ended May 31, 2019. The requested “2018 Q4” appears to correspond to the filing’s fourth quarter comparison; the filing reports fourth-quarter fiscal 2019 results versus fourth-quarter fiscal 2018.
Business Context
AAR provides aviation aftermarket products and services and government and defense support. Aviation Services generated approximately 95% of fiscal 2019 sales and includes parts supply, inventory management, flight operations, performance-based logistics, and maintenance, repair and overhaul. Expeditionary Services generated approximately 5% and primarily manufactures mobility products, containers, shelters, and composite materials.
Key programs reaching full operational capability included the 10-year Department of State INL/A Worldwide Aviation Support Services contract and the 15-year U.S. Air Force Landing Gear Performance-Based Logistics One program. AAR also agreed to sell certain contracts and assets of its Contractor-Owned, Contractor-Operated business, which was classified as a discontinued operation.
Financial Metrics
| Metric | Fiscal 2019 | Fiscal 2018 | Change |
|---|---|---|---|
| Sales | $2,051.8 million | $1,748.3 million | +17.4% |
| Gross profit | $329.5 million | $294.6 million | +11.8% |
| Gross margin | 16.1% | 16.9% | Down approximately 80 basis points |
| Operating income | $98.3 million | $86.0 million | +14.3% |
| Operating margin | 4.8% | 4.9% | Down approximately 10 basis points |
| Income from continuing operations | $84.1 million | $73.7 million | +14.1% |
| Net income | $7.5 million | $15.6 million | Down 51.9% |
| Diluted EPS | $0.21 | $0.41 | Down $0.20 |
| Operating cash flow, continuing operations | $60.5 million | $55.8 million | +$4.7 million |
| Total debt at May 31 | $142.9 million | $178.9 million | Down $36.0 million |
| Cash and cash equivalents at May 31 | $21.3 million | $31.1 million | Down $9.8 million |
Net income was reduced by a $76.6 million after-tax loss from discontinued operations, including a $74.1 million impairment charge related primarily to the COCO business. The continuing-operations effective tax rate was 5.5%, compared with 4.5% in fiscal 2018, reflecting tax benefits including state valuation allowance reversals and settlement of previously unrecognized tax positions.
Fourth-Quarter Results
| Metric | Q4 Fiscal 2019 | Q4 Fiscal 2018 | Change |
|---|---|---|---|
| Sales | $562.7 million | $473.5 million | +18.8% |
| Operating income | $29.3 million | $22.8 million | +28.5% |
| Income from continuing operations | $26.6 million | $18.1 million | +47.0% |
| Net income | $22.8 million | $12.0 million | +90.0% |
| Diluted EPS | $0.65 | $0.34 | +$0.31 |
Material Changes Versus the Prior Comparable Period
- Aviation Services sales increased 17.4% to $1,920.6 million, driven primarily by a 63.4% increase in government and defense sales to $578.3 million, largely from the INL/A WASS program.
- Commercial Aviation Services sales increased 4.7%, but related gross profit declined 4.1%. Commercial gross margin fell to 14.6% from 15.9%, primarily because of labor shortages at airframe maintenance facilities.
- Aviation Services gross margin increased to 20.4% from 20.2%, reflecting sales mix and stronger government and defense profitability.
- Expeditionary Services sales increased 16.6% to $131.2 million, while gross profit declined 16.1% and gross margin fell to 12.3% from 17.2% because of product mix and lower commercial volumes.
- Selling, general and administrative expense declined to 10.5% of sales from 11.9%, demonstrating operating leverage.
- Operating cash flow from continuing operations increased modestly despite higher investment in inventory and rotable assets. Cash used in financing activities was $47.3 million, including repayment of $25.0 million of industrial revenue bonds.
- Inventory increased to $523.7 million from $460.7 million, and rotable assets supporting long-term programs increased to $216.0 million from $183.4 million.
- ASC 606 revenue recognition was adopted using the modified retrospective method, reducing opening retained earnings by $20.4 million. Prior-year results were not restated.
Liquidity, Debt, and Commitments
- Cash, unused revolving credit capacity, and unused accounts receivable financing capacity totaled approximately $465 million at May 31, 2019.
- The $500 million revolving credit facility matures November 1, 2021. Borrowings were $120.0 million, letters of credit reduced availability by approximately $20.1 million, and reported revolving facility availability was approximately $359.9 million.
- A $22.9 million Canadian term loan also matures November 1, 2021. A $25.0 million industrial revenue bond was repaid in August 2018.
- A receivables purchase facility permits sales of up to $150 million. Receivables sold during fiscal 2019 totaled $744.2 million; $19.8 million of collected customer cash remained restricted pending remittance.
- AAR reported compliance with all financial and other debt covenants at May 31, 2019.
- Contractual obligations included $121.5 million of operating lease commitments, $384.6 million of purchase obligations, and $1.6 million of expected fiscal 2020 pension contributions.
Outlook, Risks, and Unusual Items
Management expected continued strength in Aviation Services during fiscal 2020, supported by commercial and government contract wins and favorable long-term aviation aftermarket trends. Management also stated that AAR intended to invest opportunistically to support growth while continuing to return capital to shareholders. Backlog was approximately $1.5 billion at May 31, 2019, with approximately 40% expected to be recognized over the following 12 months.
- The COCO business remained subject to a planned sale expected to close before the end of calendar 2019. The business generated a $76.6 million after-tax loss in fiscal 2019 and carried $29.2 million of assets and $29.2 million of liabilities at year-end.
- AAR identified material weaknesses in internal control over financial reporting involving inventory cycle counts, information technology general controls, and vendor payment information. KPMG issued an adverse opinion on the effectiveness of internal control over financial reporting, although it issued an unqualified opinion on the consolidated financial statements.
- The company’s remediation plan targeted full location-based inventory cycle-count coverage by August 31, 2019 and remediation of the identified weaknesses by the end of fiscal 2020. Remediation was not complete as of the filing date.
- The Department of Justice was investigating AAR Airlift Group under the civil False Claims Act concerning certain aircraft operations and maintenance contracts. AAR also self-reported potential Foreign Corrupt Practices Act and other legal violations related to activities in Nepal and South Africa. Potential outcomes were not predictable.
- Government and defense sales represented 33.0% of consolidated sales, including $546.2 million, or 26.6%, from the U.S. government and its contractors. These sales are exposed to appropriations, contract renewals, competitive bidding, termination rights, and payment delays.
- Other significant risks include commercial aviation cyclicality, airline customer credit risk, skilled labor shortages, fixed-price contract cost overruns, aircraft and parts valuation risk, cybersecurity threats, international operations, regulatory compliance, and interest-rate exposure.
Most Important Facts to Verify
- Whether the COCO asset and contract sale closed on expected terms and whether additional impairment or disposal charges were required.
- Progress and independent validation of remediation of the three material weaknesses in internal controls.
- Resolution, reserves, penalties, or operational effects related to the Department of Justice investigation and self-reported potential FCPA violations.
- Whether government and defense contract volume and funding remain sufficient to support the fiscal 2019 growth rate.
- Inventory and rotable-asset turnover, valuation assumptions, and the cash impact of continued growth investments.
- Availability under the revolving credit and receivables financing facilities, covenant headroom, and refinancing requirements before November 2021.
- Underlying commercial MRO margins and the company’s ability to resolve technician and labor shortages.