AAR CORP AIR
September 14, 2017 - 12:08am EST by
straw1023
2017 2018
Price: 35.25 EPS 0 0
Shares Out. (in M): 34 P/E 0 0
Market Cap (in $M): 1,218 P/FCF 0 0
Net Debt (in $M): 147 EBIT 0 196
TEV ($): 1,365 TEV/EBIT 0 7

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

AAR Corp (NYSE: AIR)
 
Shares: 34.3mm
Price: $35.5
Market Cap: $1,218mm
Net Debt: $147mm
TEV: $1,365mm
 
Summary: AAR Corp is a sum-of-parts (good company/bad company) story that has a strong catalyst in
2017. The Aviation Services segment is a growing business with a high incremental ROI worth more than
the total enterprise value. The Expeditionary Services segment has been a disaster for three years and has
produced consistently negative EBITA over that time. The Expeditionary Services business is being valued
at a negative value even though the long journey regarding the INL/A contract should come to a close
soon. That, combined with the guidance as to the profitability of the Expeditionary Services business, will
provide the catalyst to a revaluation.
 
The basic thesis is that the Aviation Services business is worth $1.4bn, and the Expeditionary Services is
worth $600mm once the INL/A contract is implemented.
 
Background: AAR has gone through significant changes over the past several years, and its valuation has
suffered due to the confusion. 2018 (or FY 2019) will finally see this confusion clear. First, AAR has
significantly simplified its businesses to two segments. It sold off or closed non-core businesses. Second,
the Expeditionary Services business is extremely lumpy and a core contract (Afghanistan) volume
plummeted three years ago. Management had expected the two major wins (Falklands and INL/A) to bring
the business back to profitability a year ago, but legal fighting by the incumbents (esp regarding the INL/A
contract) has delayed this resurrection.
 
Financials:
 
The financials are complicated for several reasons:
 
1) The cash flow statement is difficult to follow. The best way to understand is that Depreciation
plus Amortization of Overhaul Costs is essentially maintenance capex. Further, Amortization of
Overhaul Costs are completely associated with the Airlift business.
2) SG&A is not broken down between the segments. We offer a detailed analysis below. If anything,
we believe that this over-allocates SG&A to Aviation Services.
3) There is an extreme amount of operational leverage in the Expeditionary Services business model
as many resources have been kept after the contract loss three years ago with the expectation of
quickly ramping up with a new contract win.
4) The Aviation Services segment is lumpy and the Expeditionary Services segment is extremely
lumpy. Single contract wins and losses can significantly change growth rates and add non-
recurring expenses.
 
a. The Aviation Services is rolling off the KC-10 contract while rolling on the Air Force landing
gear contract and several other new wins. FY 2018 will be a flat year due tothe lumpiness,
but there will be 5+% top-line growth over time.
5) In particular, 2017 SG&A included an abnormal amount of non-recurring SG&A due to the INL/A
contract.
a. Management has discussed this, and there is over $20mm of non-recurring SG&A.
 
Aviation Services
 
Let’s start with this segment because its financials are straightforward:
 
Revenue FY 2017: $1,485mm
Gross Profit: $246mm
SG&A: $130mm
EBIT: $116mm
Amort of Intangibles: $5mm
Depreciation: $26mm
EBITA: $121mm
EBITDA: $147mm
Unlevered FCF (at 35%): $80mm
Tangible Invested Capital: $700mm
ROIC: 11.4% (but incremental ROIC much higher)
 
Note that all bottom-line numbers include full stock compensation expenses. All these numbers can be
derived straight from the financials with a little guidance from management except the SG&A attributed
to this segment.
 
The Aviation Services results over the past few years have been strong even with the recent loss of the
KC-10 business. And management remains optimistic about the growth and scale of this business into the
future.
 
Here is what we know about SG&A:
- FY 2017 SG&A of $196.7mm includes a large amount of non-recurring expenses, particularly
related to INL/A litigation and the downscaling of the Lake Charles facility. The normalized SG&A
is $174mm (compare with $173mm in 2016 and $172mm in 2015). Management has addressed
this point.
- The “normalized” SG&A for Expeditionary Services in 2015-2017 did not scale down after the
extreme reduction in the Afghanistan services. Note that SG&A did not drop even as the
Afghanistan contract Management has confirmed this point. So management has been running
the Expeditionary Services overhead as though still a $600mm revenue business.
- The best comp for Airlift sub-segment of the Expeditionary Services segment is a private company
(Delta Tucker Holdings) that happens to be the incumbent on the INL/A contract. Luckily, they
publish full financials. The SG&A here is about 7% of revenue. The comps for the Mobility sub-
segment of the Expeditionary Services segment suggest a slightly higher SG&A as percentage of
 
revenue. I have been using a blended 8% rate after the Expeditionary Services gets back to
$600mm of revenue. Management will not confirm these numbers.
- My best guess is that Expeditionary Services is running at about $44mm SG&A (8% of $550mm)
while the Aviation Services segment has about $130mm of SG&A. And I have intended to assign
the vast majority of true corporate costs, including investor relations, etc. to the Aviation Services
segment.
 
There are several comps for the Aviation Services segment, but the best comp is KLX Inc. KLX Inc is also a
good company (Aerospace) bad company (Oil Services) structure. The ROI in the Aerospace distribution
segment is 10.2%. Growth rates between the two aviation businesses are similar. Valuing the oil services
at book value gives us a valuation of 12.2x EBITA ($258mm LTM EBITA; $3.2bn TEV after taking out Oil
Services) for the Aerospace business. Applying this comp to AAR gives us a value for the Aviation Services
business of $1.4+bn.
 
Cubic Corporation is another comp. Based on FY 2016 numbers, it trades at 13.5x EBITA, but FY 2017
numbers are worse and so the multiple is higher. But this is mitigated if we take out GATR acquisition,
which is at a different development stage as they paid 5x revenue for GATR in FY 2016. If we take out
GATR and use FY 2016, we get a little over 12x EBITA.
 
I like to value from unlevered FCF and growth rates. This business should continue to grow at over 5% top-
line and due to operational leverage, closer to 10% bottom line. Given the current multiples in the market
(especially the Russell 2000 that include the probability of a tax rate cut), this business should trade at 18x
unlevered FCF. This gets us $1.4+bn.
 
--
 
Expeditionary Services
 
The basic thesis here is that we are getting the Expeditionary Services business for free or even a discount.
What is this business worth?
 
Several data points:
 
The TBV of this segment is about $300mm.
 
Management insists that once the INL/A contract goes into effect and scales, the economics of this
business will make a lot of sense and will be a very good use of capital.
 
The INL/A contract will generate over $300mm of revenue once scaled. And revenue for the Expeditionary
Services segment will be over $600mm and driven largely by the Falklands and INL/A contracts. The last
time we saw comparable revenue and the business running at scale, the segment’s EBITA was about
$70mm.
 
 
There is tremendous operational leverage in this business. The FY 2013-2015 financials demonstrate the
downside of that operational leverage. Revenue dropped $200mm and gross profit dropped $100mm.
We will see the reverse effect in FY 2019. We expect an EBITA in the Expeditionary Services business once
both Falklands and INL/A are fully implemented of high double digits.
 
Due to its extreme lumpiness and the high non-recurring costs to win these long-term contracts, this
business does not deserve a high multiple, and expect a $600mm valuation (8x $75mm EBITA) for the
Expeditionary Services business.
 
Risk
 
The main risk is that the INL/A contract does not cleanly begin in 2017. Dyncorp figure outs how to tie up
the INL/A contract longer and AAR continues to burn value in the Expeditionary Services segment. Even
cleanly losing and then selling/winding down the Expeditionary Services segment would increase the value
over today. But the market will clearly not give positive value here until the segment’s future is resolved.
And the disaster is that INL/A is lost and AAR management begins another multi-year process of securing
a new contract while Expeditionary Services continues to produce negative EBITA.
 
Catalyst
 
The first catalyst is the Court of Claims ruling on the Dyncorp case. This is expected before the end of
October, but the ruling has been delayed once. The AAR management is on record as being extremely
confident they will prevail. The GAO has already ruled in their favor, and these government contract
protest cases are rarely given more than cursory consideration. If AAR had acted egregiously, this would
have been noted by the GAO, and it is important to note that the record is the GAO ruling.
 
The second catalyst is the guidance where for the first time, both segments are operating at scale and the
operational leverage of both segments is apparent. Management has been silent in addressing the
potential profit here, and we believe that the INL/A contract will return the Expeditionary Services group
to the profitability it enjoyed several years ago.
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

See above.

    sort by    

    Description

    AAR Corp (NYSE: AIR)
     
    Shares: 34.3mm
    Price: $35.5
    Market Cap: $1,218mm
    Net Debt: $147mm
    TEV: $1,365mm
     
    Summary: AAR Corp is a sum-of-parts (good company/bad company) story that has a strong catalyst in
    2017. The Aviation Services segment is a growing business with a high incremental ROI worth more than
    the total enterprise value. The Expeditionary Services segment has been a disaster for three years and has
    produced consistently negative EBITA over that time. The Expeditionary Services business is being valued
    at a negative value even though the long journey regarding the INL/A contract should come to a close
    soon. That, combined with the guidance as to the profitability of the Expeditionary Services business, will
    provide the catalyst to a revaluation.
     
    The basic thesis is that the Aviation Services business is worth $1.4bn, and the Expeditionary Services is
    worth $600mm once the INL/A contract is implemented.
     
    Background: AAR has gone through significant changes over the past several years, and its valuation has
    suffered due to the confusion. 2018 (or FY 2019) will finally see this confusion clear. First, AAR has
    significantly simplified its businesses to two segments. It sold off or closed non-core businesses. Second,
    the Expeditionary Services business is extremely lumpy and a core contract (Afghanistan) volume
    plummeted three years ago. Management had expected the two major wins (Falklands and INL/A) to bring
    the business back to profitability a year ago, but legal fighting by the incumbents (esp regarding the INL/A
    contract) has delayed this resurrection.
     
    Financials:
     
    The financials are complicated for several reasons:
     
    1) The cash flow statement is difficult to follow. The best way to understand is that Depreciation
    plus Amortization of Overhaul Costs is essentially maintenance capex. Further, Amortization of
    Overhaul Costs are completely associated with the Airlift business.
    2) SG&A is not broken down between the segments. We offer a detailed analysis below. If anything,
    we believe that this over-allocates SG&A to Aviation Services.
    3) There is an extreme amount of operational leverage in the Expeditionary Services business model
    as many resources have been kept after the contract loss three years ago with the expectation of
    quickly ramping up with a new contract win.
    4) The Aviation Services segment is lumpy and the Expeditionary Services segment is extremely
    lumpy. Single contract wins and losses can significantly change growth rates and add non-
    recurring expenses.
     
    a. The Aviation Services is rolling off the KC-10 contract while rolling on the Air Force landing
    gear contract and several other new wins. FY 2018 will be a flat year due tothe lumpiness,
    but there will be 5+% top-line growth over time.
    5) In particular, 2017 SG&A included an abnormal amount of non-recurring SG&A due to the INL/A
    contract.
    a. Management has discussed this, and there is over $20mm of non-recurring SG&A.
     
    Aviation Services
     
    Let’s start with this segment because its financials are straightforward:
     
    Revenue FY 2017: $1,485mm
    Gross Profit: $246mm
    SG&A: $130mm
    EBIT: $116mm
    Amort of Intangibles: $5mm
    Depreciation: $26mm
    EBITA: $121mm
    EBITDA: $147mm
    Unlevered FCF (at 35%): $80mm
    Tangible Invested Capital: $700mm
    ROIC: 11.4% (but incremental ROIC much higher)
     
    Note that all bottom-line numbers include full stock compensation expenses. All these numbers can be
    derived straight from the financials with a little guidance from management except the SG&A attributed
    to this segment.
     
    The Aviation Services results over the past few years have been strong even with the recent loss of the
    KC-10 business. And management remains optimistic about the growth and scale of this business into the
    future.
     
    Here is what we know about SG&A:
    - FY 2017 SG&A of $196.7mm includes a large amount of non-recurring expenses, particularly
    related to INL/A litigation and the downscaling of the Lake Charles facility. The normalized SG&A
    is $174mm (compare with $173mm in 2016 and $172mm in 2015). Management has addressed
    this point.
    - The “normalized” SG&A for Expeditionary Services in 2015-2017 did not scale down after the
    extreme reduction in the Afghanistan services. Note that SG&A did not drop even as the
    Afghanistan contract Management has confirmed this point. So management has been running
    the Expeditionary Services overhead as though still a $600mm revenue business.
    - The best comp for Airlift sub-segment of the Expeditionary Services segment is a private company
    (Delta Tucker Holdings) that happens to be the incumbent on the INL/A contract. Luckily, they
    publish full financials. The SG&A here is about 7% of revenue. The comps for the Mobility sub-
    segment of the Expeditionary Services segment suggest a slightly higher SG&A as percentage of
     
    revenue. I have been using a blended 8% rate after the Expeditionary Services gets back to
    $600mm of revenue. Management will not confirm these numbers.
    - My best guess is that Expeditionary Services is running at about $44mm SG&A (8% of $550mm)
    while the Aviation Services segment has about $130mm of SG&A. And I have intended to assign
    the vast majority of true corporate costs, including investor relations, etc. to the Aviation Services
    segment.
     
    There are several comps for the Aviation Services segment, but the best comp is KLX Inc. KLX Inc is also a
    good company (Aerospace) bad company (Oil Services) structure. The ROI in the Aerospace distribution
    segment is 10.2%. Growth rates between the two aviation businesses are similar. Valuing the oil services
    at book value gives us a valuation of 12.2x EBITA ($258mm LTM EBITA; $3.2bn TEV after taking out Oil
    Services) for the Aerospace business. Applying this comp to AAR gives us a value for the Aviation Services
    business of $1.4+bn.
     
    Cubic Corporation is another comp. Based on FY 2016 numbers, it trades at 13.5x EBITA, but FY 2017
    numbers are worse and so the multiple is higher. But this is mitigated if we take out GATR acquisition,
    which is at a different development stage as they paid 5x revenue for GATR in FY 2016. If we take out
    GATR and use FY 2016, we get a little over 12x EBITA.
     
    I like to value from unlevered FCF and growth rates. This business should continue to grow at over 5% top-
    line and due to operational leverage, closer to 10% bottom line. Given the current multiples in the market
    (especially the Russell 2000 that include the probability of a tax rate cut), this business should trade at 18x
    unlevered FCF. This gets us $1.4+bn.
     
    --
     
    Expeditionary Services
     
    The basic thesis here is that we are getting the Expeditionary Services business for free or even a discount.
    What is this business worth?
     
    Several data points:
     
    The TBV of this segment is about $300mm.
     
    Management insists that once the INL/A contract goes into effect and scales, the economics of this
    business will make a lot of sense and will be a very good use of capital.
     
    The INL/A contract will generate over $300mm of revenue once scaled. And revenue for the Expeditionary
    Services segment will be over $600mm and driven largely by the Falklands and INL/A contracts. The last
    time we saw comparable revenue and the business running at scale, the segment’s EBITA was about
    $70mm.
     
     
    There is tremendous operational leverage in this business. The FY 2013-2015 financials demonstrate the
    downside of that operational leverage. Revenue dropped $200mm and gross profit dropped $100mm.
    We will see the reverse effect in FY 2019. We expect an EBITA in the Expeditionary Services business once
    both Falklands and INL/A are fully implemented of high double digits.
     
    Due to its extreme lumpiness and the high non-recurring costs to win these long-term contracts, this
    business does not deserve a high multiple, and expect a $600mm valuation (8x $75mm EBITA) for the
    Expeditionary Services business.
     
    Risk
     
    The main risk is that the INL/A contract does not cleanly begin in 2017. Dyncorp figure outs how to tie up
    the INL/A contract longer and AAR continues to burn value in the Expeditionary Services segment. Even
    cleanly losing and then selling/winding down the Expeditionary Services segment would increase the value
    over today. But the market will clearly not give positive value here until the segment’s future is resolved.
    And the disaster is that INL/A is lost and AAR management begins another multi-year process of securing
    a new contract while Expeditionary Services continues to produce negative EBITA.
     
    Catalyst
     
    The first catalyst is the Court of Claims ruling on the Dyncorp case. This is expected before the end of
    October, but the ruling has been delayed once. The AAR management is on record as being extremely
    confident they will prevail. The GAO has already ruled in their favor, and these government contract
    protest cases are rarely given more than cursory consideration. If AAR had acted egregiously, this would
    have been noted by the GAO, and it is important to note that the record is the GAO ruling.
     
    The second catalyst is the guidance where for the first time, both segments are operating at scale and the
    operational leverage of both segments is apparent. Management has been silent in addressing the
    potential profit here, and we believe that the INL/A contract will return the Expeditionary Services group
    to the profitability it enjoyed several years ago.
     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    See above.

    Messages


    SubjectQuarter
    Entry09/20/2017 01:35 PM
    Memberstraw1023

    The quarterly results and the acquisition announcement were a nice synopsis of this company (both good and bad) over the past 3 years.

    On the positive side, the Aviation Services revenue was much stronger than expected. I need to iterate that these revenues have lumpiness and Q1 is seasonally a smaller quarter so that lumpiness can have outsized percentage effects, but to grow the top line over 10% while losing the KC-10 revenue is a significant positive. With the roll-on of the Air Force landing gear contract, the Aviation Services will not see the expected flat fiscal year with the loss of the KC-10 contract.

    On the not-sure side, the acquisition (and related Air Canada deal) makes a lot of sense as there are lots of potential scale effects here, but no one knows until we see actual numbers. 

    On the negative side, the SG&A, gross margin and cash flow are as maddening and opaque as ever. I am still trying to piece together the comments on the call (they were asked specifically about these matters) and the 10Q on this matter, but there is lumpiness in expenses and cash flow as contracts roll on and off. And arriving at a normalized SG&A and margin is difficult and management seems to do its best to not lend any transparency to the exercise. But given that KC-10 was a low-margin contract and that they knocked the cover off the ball on revenue, I expected better bottom line numbers.

    And of course, we learned nothing about the INL/A contract, which should have a bigger effect than all the above. And Expeditionary results were the usual level of terrible. But these items were expected.


    SubjectDyncorp's Final Protest Rejected
    Entry11/01/2017 10:55 AM
    Memberstraw1023

    https://www.prnewswire.com/news-releases/federal-court-upholds-state-department-award-of-aviation-services-contract-300547344.html

     

    The real catalyst here will be the forecast going forward including this contract. I expect management to give some color on this in the next month or two although the numbers may be for a ramp period.

     

     


    SubjectQuarter
    Entry12/21/2017 10:08 PM
    Memberstraw1023

    The Aviation Services blew away my numbers. They had 13% growth (3% of this was in-organic from Air Canada). So 10% organic growth and this includes a 6% loss from the KC-10 contract going away. And the AS pipeline of new contracts (including Air force contract) is favorable. In my write-up, I had assumed that FY 2018 would barely beat FY 2017 due to the loss of the KC-10 contract. Organic gross profit in H1 has grown $10mm y-o-y ($2mm was due to Canada acquisition). Combine this with lower tax rate, and I now have FY '18 unlevered FCF in Aviation Services of $110mm (not including acquired Canadian biz, which seems like it will add about $10-15mm gross profit from the numbers given; of course, these contracts also add to SG&A) versus the $80mm in FY 2017. Half of the difference is due to organic growth. The other half is due to lower tax rate.

    The bad news was not news. Management has been stating that they would be winding down COCO contracts and that troop contracts would be winding down soon. So they will be selling helicopters, but mgmt has also been warning that market is soft. So they are taking a $1 per share after tax write-down of helicopters. This is the price of exiting a bad business.

    In the aftermarket, the stock dropped to $39.50 from $44, but I am confused as to why. The Aviation Services news was very positive and the Expeditionary news was what was expected.

    At $39.50, you can buy the Aviation Services business for 11x unlevered FCF and get the Expeditionary business for free.

    We will be given a preview of FY 2019 at the January meeting. The INL/A contract will take 2-3 quarters to ramp so the contribution in FY 2018 will be minimal, but we should have a much better idea of the economics AIR faces with the FY 2019 preview. This is the catalyst for which I have been waiting.


    SubjectRe: Quarter
    Entry12/22/2017 08:46 AM
    Memberstraw1023

    sorry, typo . . . I meant to say "you can buy the Aviation Services business for 13x unlevered FCF . . . " not 11x.

    At $39.50, this is cheaper today than it was when I wrote this up at $35.25 and since then, Aviation Services results have trounced expectations and they pushed the INL/A contract past the finish line. And we have a catalyst in a few weeks.

     

     

     

     

     


    SubjectRe: Author Exit Recommendation
    Entry02/28/2018 01:01 PM
    Memberstraw1023

    We have reduced long position as the event (FY 2019 guidance including INL/A contract announced Jan 11 @ Investor Day) was disappointing. Total return was about +25%, but AIR got large benefit from corporate tax reduction.

    The Aviation segment continues to exceed all expectations.

    The accounting and guidance is opaque and it is difficult to break out two segments, but based on the EBITDA guidance in the Jan 11 presentation, it seems to me that the Expeditionary segment has gone from money-losing to break-even. We had the Aviation segment producing about $180mm of EBITDA in FY 2019, and the total guidance is $185mm mid-point. So this implies expeditionary going from negative $20mm to +$5mm EBITDA. I.e. the INL/A contract only adding about $25mm of EBITDA. This is disappointing. These new GOCO contracts like INL/A are capital-lite, but the Expeditionary segment is not earning a reasonable cost of capital and remains a drag on valuation.

    At this price ($43.30) buying Aviation Services for 14x FCF from Aviation Services business, which continues to grow. This values Expeditionary at zero. I think this is cheap multiple for Aviation Services, but not compelling. So two ways to win: multiple expansion for Aviation Services to reflect its strong growth and market position; and mgmt making Expeditionary worth something or selling.

    But the obvious catalyst has passed and so I am removing idea from VIC.


    SubjectRe: Re: Author Exit Recommendation
    Entry03/21/2018 11:42 AM
    Memberstraw1023

    For anyone still following, yesterday's announcement that they would be selling the COCO business is a significant positive. I had hoped they would do this a few years ago. Hopefully, they will get some cash for the aircraft and be done with this horrible business. Interestingly, they left guidance unchanged after removing this business. I would have thought EBITDA would actually rise and revenue would of course fall.

     

    Otherwise, the Aviation business continues to chug along nicely. Supply/Trading was a positive while MRO was a bit slower growth than I had hoped.

    It is significant to note that the remaining business deserves a higher EBITDA multiple because they are getting rid of capital-heavy COCO business. I get about $120mm of unlev FCF based on FY 2019 guidance. And hopefully they can get a couple bucks a share for the COCO aircraft and contracts.

      Back to top