AIR

AAR CORP. 10-Q Summary: Quarter Ended February 28, 2010

Business Context and Reporting Period

This is a quarterly report (Form 10-Q) for AAR CORP., a provider of aviation supply chain, maintenance, repair, and overhaul (MRO), and structures and systems services. The reporting period covers the three and nine months ended February 28, 2010. The company operates in three segments: Aviation Supply Chain, Maintenance, Repair and Overhaul, and Structures and Systems. The company is a large accelerated filer.

Key Financial Metrics

Material Changes vs. Prior Period

• Sales Decline: Consolidated sales decreased 8.6% ($29.2M) for the quarter and 6.9% ($72.5M) for the nine-month period compared to the prior year. Commercial sales dropped 14.5% (quarter) and 15.0% (nine months) due to airline capacity reductions and inventory drawdowns. Defense sales increased 4.3% for the nine-month period.
• Profitability Pressure: Operating income fell 21.9% for the quarter and 12.7% for the nine-month period. Gross profit margins declined in the Aviation Supply Chain (19.5% vs 25.4%) and MRO (12.3% vs 14.1%) segments due to lower volumes and pricing pressure. Conversely, the Structures and Systems segment saw gross profit increase 48.7% (quarter) and 35.1% (nine months) due to cost reductions and favorable product mix.
• Joint Venture Earnings: Earnings from joint ventures dropped 96.0% for the quarter and 97.9% for the nine months, primarily due to increased depreciation from reducing the useful lives of narrow-body aircraft and a smaller aircraft portfolio.
• Debt Reduction: The company retired $12.5M in par value of convertible notes during the nine-month period, resulting in a gain on extinguishment of debt of $913,000. Total borrowings were reduced by $70.2M.

Guidance, Outlook, and Risks

• Market Outlook: Management notes that while financial markets have calmed, airlines are moving slowly to add capacity. Continued cost reduction initiatives by carriers and tight credit markets remain headwinds. Defense demand is viewed as a growth opportunity, particularly in performance-based logistics.
• Backlog: Firm backlog decreased to approximately $365M from $492.5M at the end of the prior fiscal year, driven by a reduction in the Mobility Systems business unit. This figure excludes expected sales from the A400M program (~$325M) and the KC-10 program (~$60M-$70M annually).
• Key Risk - Mesa Air Group: Mesa Air Group, a significant customer, filed for Chapter 11 bankruptcy in January 2010. AAR wrote off pre-petition receivables and reduced the carrying value of Mesa equity shares to zero. AAR expects annual sales to Mesa to approximate $45M post-restructuring. There is a risk that if Mesa reduces its fleet or fails to emerge from bankruptcy, AAR's results could be negatively affected.
• Accounting Changes: The company adopted new accounting standards for convertible debt and noncontrolling interests effective June 1, 2009, requiring retrospective adjustments to prior period results.

Investor Verification Checklist

• Verify the impact of Mesa Air Group's bankruptcy on future receivables and the $39.2M in long-term lease assets supporting Mesa programs.
• Monitor the recovery of commercial aviation demand and its effect on the Aviation Supply Chain and MRO segments' gross margins.
• Review the timeline and revenue recognition for the A400M and KC-10 defense programs, which are not included in current backlog figures.
• Assess the sustainability of cost reduction initiatives in the Structures and Systems segment that drove margin expansion.
• Confirm the status of the $117.5M cash balance and the utilization of the $250M revolving credit facility (currently $0 outstanding).