September 14, 2017 - 12:08am EST by
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 (in $M): 1,365 TEV/EBIT 0 7

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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.
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
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
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
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
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.
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.
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.


See above.

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