|Shares Out. (in M):||39||P/E||0||0|
|Market Cap (in $M):||1,203||P/FCF||13.7||11.2|
|Net Debt (in $M):||543||EBIT||140||109|
AAR announced the sale of Telair, its cargo systems subsidiary, for $725mm, or 13x trailing EBITDA, last week. Despite selling a business that comprised 25% of EBITDA for 40% of the entire company’s enterprise value, AAR shares are virtually unchanged from their close prior to deal announcement. We thought the shares were cheap before the deal announcement. Factoring in accretion from the deal, the current valuation simply makes no sense to us. Shoddy sell-side analysis and a general lack of familiarity with the business has led to, what we believe, is a compelling “fat pitch” opportunity which we detail below.
AAR Corporation, the leading outsourced aircraft maintenance, repair & overhaul (MRO) provider in the US and the third largest globally, provides FAA-mandated MRO work and supply chain management to airline operators, cargo carriers, and the military. AAR is a high-quality, cash-generating business that has suffered through a number of headwinds (no pun intended) over the last 3-4 quarters which have obscured attractive dynamics taking place in their business. AAR is underfollowed and misunderstood, a fact that has become more apparent after shares traded down following the announcement of the highly accretive sale of subsidiary Telair. In addition to economic upside from the Telair deal, we believe subsiding headwinds elsewhere in AAR can drive 25% EBITDA growth over the next 8 quarters. Comps for each of their respective businesses trade anywhere from 8-12x, yet pro forma for the Telair transaction, AAR is now trading at 6.3x trailing EBITDA. Using an 8.0x multiple on FY 2017 EBITDA, we value AAR shares at $55, or over 75% upside from current levels.
Fuzzy Math and The Sale of Telair
620 – 425 = 0
This is the math the market is applying to the Telair deal. And while some may dismiss this as exaggeration, we think you may re-consider after talking to some of the sell-side analysts that cover AAR.
First some background. Telair manufactures aircraft cargo loading systems and comprises the vast majority of AAR’s Commercial Technology Products segment. Telair has been a great business for AAR since it was acquired in December 2011 for $280m. It’s one of two players in a duopoly that has benefited from increasing aircraft production, recently growing revenues at 20% annually at 20%+ EBITDA margins.
Rumors first surfaced in early December of a sale for Telair in the $700-800mm range. The deal that was ultimately announced was in-line with those expectations: the business is being sold to Transdigm for $725mm, or 13x LTM EBITDA. In addition, AAR announced that it would seek to divest itself of its unprofitable Precision Machining business.
From what we can tell, this is a homerun deal. Based on our call work, we believe AAR could be selling this business at near-peak cycle earnings. The sale also divests AAR of a cargo systems contract for the Airbus A400M, a program which would have been an earnings drag going forward. The transaction revalues $57mm of EBITDA that was previously being capitalized at 7.5x to 13x. If those reasons aren’t enough, flipping a business they acquired for $280mm only three years ago for $725mm isn’t too bad.
So after trading a business valued at $425mm for over $620mm in after-tax cash proceeds, why is AAR worth the same as it was before the deal was announced? We reached out to three of the five sell side analysts that cover AAR to get some color. Here’s a sample of the fuzzy math we encountered in their analysis:
· One of the analysts called the deal dilutive because earnings would be lower. When we pointed out that he failed to account for most of the cash proceeds from the transaction in his valuation, his response was: “well, we don’t know what they’ll do with it yet”.
· Us: “They’ve traded a business valued at $425mm for over $600mm in cash, AND you’re now applying a higher multiple on the remaining businesses. How could you be getting to the same target price?” Analyst: “I see your point.”
· When we asked another analyst why he wasn’t making any adjustments to interest expense in his pro forma eps calculation used to formulate his target price (his assumption was cash would be used to pay down debt), his response was: “because the interest savings will be offset by the make-whole payments they need to make to prepay the debt.” We almost felt badly mentioning that one is a one-time cost while the other an ongoing earnings savings.
To drive the point home, one of the sell side analysts we spoke with wasn’t even sure which businesses were in which segments. Now, part of this is due to poor disclosure by the company (which we discuss in more detail below), but in general this business is underfollowed and neglected. The market has missed this deal and the potential for material earnings growth over the next few years. Pro forma for the Telair transaction, AAR now trades at 6.3x LTM EBITDA, which is lower than the 7.5x it was trading for before this deal was announced. For reasons we dive into below, we believe AAR shares are significantly undervalued at these levels.
Disclosure for AAR is poor. The Company offers a somewhat unhelpful view of their business segments in source filings, choosing to divide their business into Aviation Services and Technology Products although there are 9 different sub-segments according to our analysis. We are all for short reads, but the entire “Business” section of the 10K is four pages. We note that current management is aware of this lack of disclosure and is strongly considering improvements in the future. We’ve done a substantial amount of call work to get a sense for how revenues break down by service. We’ve also crosschecked this against historical filings where disclosure was a little more forthcoming. To be clear this was a mind numbing exercise and while we have faith in our final result, it is not exact. We’ve also confirmed with management that these estimates are all in the ballpark and good enough for purposes of understanding earnings trajectory from here. Note, we don’t break out the Technology businesses by service since the Technology Commercial piece is being sold anyway and the Technology Defense piece is too small for precision to matter. Here is our lay of the land (pro forma for the announced sales of Telair and Precision Machining):
Why We Like AAR
The aircraft MRO industry is a classic outsourcing story that has been catalyzed by the bankruptcies of the major American airline operators over the last 15 years. The re-organized airlines were able to come out from under the onerous labor agreements that precluded many of them from making key outsourcing decisions sooner. It made sense to outsource MRO work since scale providers like AAR can often do what is a labor-intensive function faster and at up to half the cost with non-union employees.
AAR has consistently taken share within this growing market, becoming the leading aircraft MRO in the US with solid results over the last ten years. AAR benefits from reasonably high barriers-to-entry as reputation and track record are paramount given the high cost-of-failure nature of the work, or as a banner in AAR’s Miami facility reminds employees, “Passengers & Crew Stake Their Lives on Our Work”. We’ve spoken with five of AAR’s largest MRO customers, all of whom agree that it’d be difficult to switch work away from AAR, with one major customer commenting “even if we wanted to switch, there really aren’t many MROs out there that can handle the type and volume of work we need.” All have said they plan to spend more with AAR over time. In addition, favorable long-term lease agreements with the airports that own the hangars and low capex requirements mean that this otherwise low margin business generates a respectable low-teens after-tax return on capital. Going forward, we believe a number of recent headwinds are subsiding and positive dynamics are emerging, setting AAR up well for the next several years. First the positive dynamics that are emerging:
· A highly valuable Supply Chain Management business that’s on fire – AAR Supply Chain is one of the largest players in the secularly growing aircraft supply chain industry and, as one of only a handful of scale players, is taking market share. This business deals primarily in the distribution, management, and maintenance of new and aftermarket rotable parts for airlines, MROs, and parts brokers. Like most distribution businesses, it benefits from scale and requires little capex to fund growth.
This is a fantastic business; comps fetch EBITDA multiples in the 12-14x range, including the sale of AAR competitor Wencor in 2014 for 12.5x-14x EBITDA and Aeroturbine in 2011 for 11x-12x EBITDA. Pro forma for the Telair and Precision Business sale, we estimate that Supply Chain will make up over 50% of AAR’s total EBITDA. But most investors won’t know that because, inexplicably, the company decided to recast its business segments two years ago, lumping Supply Chain together with MRO and throwing them both into a non-descript new segment called Aviation Services.
We think it’s only a matter of time before the Supply Chain business shines through this fog, helped by what we expect will be better segment disclosure. The business has been on fire lately – revenues have grown 15-20% year-over-year the last several quarters and are expected to continue to grow at the same rate for the balance of the year, although we are not modeling this. We spoke with one of AAR’s largest supply chain competitors to get a better sense for what’s behind the acceleration, and his comment was that while AAR was the “goliath” in this space for a long time, they had recently taken their eye off the ball as they turned their attention to their Defense businesses. He added, however, that AAR had “re-awakened” and that they’re back with a vengeance. A few of the big moves AAR has been making as part of this renewed focus in the past year include: 1) winning big contracts from Delta and Air Canada which added critical mass and important reference accounts, and 2) the acquisition of a Brussels facility in March 2014 that opened the door for AAR to establish new supply chain relationships with European and Middle Eastern carriers. Our call work suggests that this business should continue to grow at a 10-12% CAGR and ultimately reach 20-25% gross margins from the high-teens, contributing roughly $39m of the $59m of incremental gross profit we are projecting in FY2017 versus LTM.
· American Airlines is the last airline to emerge from Chapter 11 and they’re probably going to start outsourcing – American emerged from bankruptcy via a merger with US Airways in December 2013. American, which is the largest US airline, hasn’t outsourced its MRO work in any meaningful way yet. While there is still some pushback from folks within American, we believe the economics of outsourcing, which can halve the costs of maintenance, make it inevitable and many who we spoke with in the industry agree. American has already closed facilities in Kansas City and Dallas. When and if American outsources in earnest, we believe AAR should win its fair share. Since this opportunity is impossible to quantify, we are not modeling the capture of any American Airlines MRO business, and instead view it as an attractive free option.
· Ramping up of AAR’s facility in Lake Charles, Louisiana – AAR’s sixth hangar was brought online last year and adds nearly 30% of capacity to AAR’s airframe maintenance business. Importantly, this facility is built to handle widebody aircraft, almost all of which have historically been sent out of the country for maintenance due to much lower labor rates overseas (primarily Asia). Labor rate differentials have narrowed and numerous people within the industry we’ve spoken with agree that widebody work is coming back. The Lake Charles facility positions AAR well to capture this opportunity. Management has stated that this facility can ramp to full capacity in 2-3 years. We are modeling only an incremental benefit from Lake Charles over the next few years to be conservative.
· Low oil prices are a tailwind – we don’t pretend to know where oil prices are heading, but as long as they’re low, airlines will fly older planes that require more maintenance for longer (some are even considering re-activating idled planes). Any impact on passenger miles flown will also clearly be positive.
Recent Storm Clouds are Parting
So if AAR has been on a roll, why haven’t recent results reflected that? Well, AAR isn’t all MRO and Supply Chain. Over the last 5 years, it’s grown into other businesses, both organically and via M&A. Three of these businesses have been causing the company a ton of heartburn over the last 3-4 quarters, but we believe these headwinds, which have obscured some of the good things that have been happening, are subsiding.
Airlift at an Inflection Point
Despite now only representing ~10% of overall revenues, Airlift has been the biggest headline risk to the AAR story over the last year. Airlift operates a fleet of fixed and rotary wing aircraft and is contracted by various militaries (primarily the US DoD) to transport people and supplies to bases around the world. Acquired by AAR in 2010 for $200m, Airlift had a great run during heightened operational readiness and aircraft activity in Afghanistan. Only a few years ago, Airlift was operating over 40 active aircraft, 38 of which were based in Afghanistan. But since US withdrawal from the Afghan war theater, Airlift results have fallen off a cliff. This business has come down with the US drawdown in this region – Airlift is now down to 19 active aircraft and Defense Aviation Services revenues have declined 28% year-over-year the last two quarters. While bad enough, management has done a terrible job of providing guidance for this business, leading to several “miss and lower” quarters its last fiscal year.
There are a couple of reasons why we believe this business has or is close to bottoming:
· Of Airlift’s 19 active aircraft, only 7 are now in Afghanistan. Based on our call work, we believe this number reflects what will be the ongoing aircraft needs for the US military’s new baseline of Afghan activity going forward. In short, we believe Afghanistan declines are bottoming.
· Protests related to two Africa Command contracts have only recently been dismissed and activity on these contracts is now underway. In addition, a recently awarded 10-year contract with the UK Ministry of Defense is starting to ramp. We believe these contracts could add 3-5 active aircraft to Airlift in the near-term.
· 17 of Airlift’s idled aircraft are up for sale. Management expects to net $80mm of proceeds over time, none of which we’ve accounted for in our model.
During the Telair sale conference call, management lowered Airlift guidance once again. While Airlift will likely suffer a few more hiccups near-term as it ramps up work in Africa and reaches a steady-state in Afghanistan, we do believe this business is close to stabilizing, removing what has been the biggest headwind and distraction to the overall business in recent quarters. We are assuming Airlift rises from 19 active aircraft position to 23 by the end of FY2016 (6 quarters from now), with no additional active aircraft beyond that point (versus the 30 aircraft management ultimately believes it can achieve and the 40 it achieved at peak). This represents incremental gross profit of roughly $5m through FY2017. Above and beyond our forecast of 23 active positions, we believe each active aircraft can generate an incremental $2-3mm in run-rate gross profit.
Landing Gear Services Is Coming out of a Cyclical Downturn
Landing Gear maintenance runs on a 10-year cycle mandated by the FAA. In other words, aircraft are required to come in 10 years after they’re delivered for landing gear maintenance, so there is relatively clear visibility on future business based on historical deliveries. This means that during fiscal years 2013 and 2014, AAR’s Landing Gear MRO, which runs out of a 128,000 square foot facility in Miami, was working through an air pocket that the industry suffered in 2002-2004 when aircraft deliveries dropped cumulatively 30% following 9/11. We spoke with the facility manager in Miami who confirmed that, indeed, the facility has been running at ~55% utilization, approximately 30% below normalized utilization of 80%. While the revenue impact was significant, the margin impact was magnified; unlike the airframe maintenance business which has a large contracted labor component, labor costs in the Landing Gear facility are more-or-less fixed. In fact, we believe this business may now be close to break-even, which would explain the margin decline in the Commercial Aviation Services segment in 2013-2014. The good news is, after bottoming in 2004, aircraft deliveries grew nearly 50% from 2005-2007. Assuming 70% incremental gross margins on this business, which we believe generated roughly $130mm in LTM revenues, getting back to 80% utilization could translate to $25mm of incremental gross profit over time.
Engineering Services Declines Have Also Stabilized
The Engineering Services business is lumped into the Commercial Aviation Services segment and comprises approximately 10% of segment revenue. This business involves the outsourced engineering and design of aircraft interiors, as well as the implementation of those designs.
In 2013, AAR won a big contract to re-engineer the cabin interiors of a fleet of Boeing 717 aircraft Delta purchased from Airtran. Management execution issues, however, led to a decline in backlog and when this contract rolled off, there was no new work to step into the gap. This led to revenue declines in this business of over 50% year over year in FY2014. This upcoming quarter marks the anniversary of the Delta/Airtran contract completion, and with a new contract win from Hawaiian Air, Engineering Services is expected to stabilize sequentially. To be conservative we are modeling no growth in this business for AAR going forward despite this generally being a growing niche in the industry.
We think, pro forma for the sales of Telair and Precision Machining, AAR can generate 25% EBITDA growth through the end of FY2017. Our bridge from LTM to FY2017 is below:
Per management, the Telair business incurred approximately $20mm of program development cost amortization related to the A400M contract that was not being added back to most estimates of EBITDA (convention in the aerospace industry). These costs leave with the sale of Telair. Our estimate of current LTM EBITDA and the $57mm of Telair LTM EBITDA adds these costs back.
Applying an 8x multiple to our $220mm EBITDA estimate for FY 2017 implies a share price of $55; over 75% upside from current levels. Our 8x multiple is also roughly in-line with the midpoint of where AAR has traded over the last five years.
Sum of the Parts
A sum of the parts analysis supports our 8x multiple and suggests it could even be conservative. While there are no great comps for AAR as a whole, there are a decent set of comps and precedent transactions for each of AAR’s business lines. We went back to historical filings when disclosure was actually a bit better to make some assumptions on D&A allocation, while for SG&A we simply make a rough allocation by share of revenue. Again, not perfect, but we think we’ve arrived at a reasonably accurate picture of the EBITDA mix of the various businesses. As our analysis shows, AAR is currently trading 2 to 2.5 turns of EBITDA below where it should be.
A few points to note:
· We are valuing Airlift at $200mm, or what AAR paid for it when it acquired the business in 2010. While the business has declined, AAR has also invested over $150mm in aircraft that have some realizable book value. We think $200mm for Airlift is a fair, if not conservative, estimate.
· We are crediting the Technology Commercial business for the $5mm of EBITDA loss we estimate the Precision Machining is currently generating, but none of the expected proceeds from the planned sale of the business.
Rebound in any or all of Airlift, Landing Gear Services, and Engineered Services businesses
Market recognition of the valuation impact of the Telair sale
Debt paydown and/or buyback with Telair proceeds
Improved segment disclosure
|Subject||Re: couple Qs|
|Entry||03/05/2015 06:58 PM|
Thanks for the questions Nails. We’d caution that the business has changed a bunch in the last 10+ years. That said, we agree with you, ROIC hasn’t been great. What’s interesting, though, is that the company just added ROIC as one of two performance metrics under its long-term incentive comp plan, and we think it’s because management knows they can improve it.
We do not have an overly informed view of management and have not spoken with their CEO yet. We will, but we generally prefer to speak with customers, competitors, etc. to get more objective feedback. At this point we have a mixed opinion of the management team; some good and some bad.
"Good stuff" examples: the TelAir deal, the CEO owns $40m+ of stock (this could also be bad), decision to pay down debt/buy back stock with TelAir cash proceeds, and over the course of roughly 30+ calls, positive feedback albeit not stellar regarding the company and management (the worst adjective we heard to describe management was “stale” but everyone else had decent things to say).
“Bad Stuff” examples: repeated over-promising/under-delivering on the Airlift business which has clearly annoyed the sell-side, the disorganized disclosure issue, some customer losses here and there.
CFO John Fortson, a former Merrill banker, was hired in May 2013. He seems to be behind the new focus to redeploy capital away from underperforming assets and the implementation of ROIC as a measure of performance. For example, he told us they plan to sale/leaseback any new Airlift aircraft they purchase specifically to “drive ROIC”.
We want to be clear; this isn’t a bet on a stellar management team. It’s a bet on a company benefiting from subsiding headwinds, and as long as management doesn’t get in its own way, and market conditions don’t abruptly change, it should generate robust earnings growth and cash generation over the next few years. We think incremental returns on capital of 20%+ are achievable and that over time ROIC should trend more in-line with peers.
Finally, on Singapore Technology, their MRO, ST Aerospace, is definitely a great comp but it’s only a third of their overall business, so direct comparisons might be difficult.
|Entry||03/06/2015 04:30 PM|
I am new to this story, and the financials are difficult to follow, but . . .
Doesn't the Telair sale comprise more than what they acquired a few years ago for $280mm? It also includes the A400M program, which had $140mm of capitalized development costs and undoubtedly some non-capitalized costs and regular PP&E since 2005. Assuming this was not the worst deal ever, this program was going to spit out a fair amount of cash over coming years and had a fair amount of value.
Isn't this also why they only recognized $200mm of taxable gains on the sale, which is significantly less than $725mm - $280mm.
And doesn't this also reduce the normalized EBITDA multiple at which they sold because the A400 program EBITDA had not fully kicked in yet?
None of this really affects your thesis (the 13x EBITDA is rather irrelevant to me whether true or not), but just making sure I understand complex financials.
Can you help me understand this "amortization of overhaul costs" line?
I cannot figure out what capitalized outlay it is amortizing. My guess is that it somehow came from 2012 acquisition, but I am confused.
And finally, how do they amortize stock comp rather than just expensing it? Actual stock comp value seems lumpy looking at past three years. Any reason? Do you have an estimate of normalized actual stock comp value on a going forward basis?
|Entry||03/09/2015 02:40 PM|
Straw - thanks for your questions. Your take on the TelAir sale is correct. AAR spent and capitalized roughly $140m of development dollars on the A400 program. Going forward, the accounting for the A400 program would’ve included amortization expense of these capitalized costs (a non cash expense), as well as revenue and expense associated with the sale of A400 units (cash flow generation). Therefore, EBITDA going forward for the A400 program would’ve been minimal (note that convention in the aerospace industry is include A400 development type costs in EBITDA), but cash flow would’ve been positive. The company essentially decided to receive this cash flow in a lump sum payment upfront by selling the TelAir business, instead of running it and receiving that cash flow over time. Both the CFO and industry folks we spoke with believe that we may be nearing peak aircraft production levels and that selling Telair now was akin to selling at peak earnings. We don’t have a strong view on aircraft production cycles, but it’s additional color that went into the decision to sell Telair. You are correct that Transdigm is paying less than the 13x we cite in our writeup since they do not have to amortize any development costs.
|Subject||Re: Re: Questions|
|Entry||03/09/2015 04:19 PM|
Thanks for your reply.
But I remain very confused on the "amort of overhaul costs."
What owned aircraft are you referring? The four JV-owned aircraft and the two wholly-owned aircraft in note 9 of aircraft portfolio? But Airlift operates more aircraft (and you also say they have 17 idle aircraft to sell) . . . who owns them? Are they simply operating aircraft for others? Or where are these on the AIR balance sheet?
And where are these capitalized upgrades/maintenance costs coming through the cash flow statement? I want to make sure that this is not that accounting disgrace where capitalized leases do not pass through cash flow statement as they should . . .
What do you think the normalized annual all-in stock comp going forward is going to be?
|Subject||Re: Re: Re: Re: Questions|
|Entry||03/09/2015 05:19 PM|
jet and rii,
I was just on phone with IR. Very helpful.
Note 9 has nothing to do with the 40 aircraft they use in Airlift. This is the legacy aircraft leasing business. We need to remove this from EBITDA as these leases are all ending in next 4 years. They will monetize these aircraft by selling the parts. He felt the carrying value of the wholly-owned and JV were appropriate measures of part value.
The 40 aircraft they use in Airlift are 34 owned and 6 via cap leases. Note, only 21 are actually in use, and 16 are for sale. 7 are in use in Afghanistan.
The jump in amortization of overhaul costs in 2013 (from 2012) was due to the lumpiness of 'c' and 'd' checks on aircraft. There were a lot of these overhauls in 2012, in particular. These overhaul expenses were capitalized through the regular PP&E line of the cash flow statement.
I have no idea how to think about the Airlift business on a normalized basis. Lots of lumpiness in all respects.
|Subject||Re: Re: Re: Re: Questions|
|Entry||03/09/2015 05:35 PM|
It is not a big deal, but IR was very clear that amortization of overhaul costs had nothing to do with the six Note 9 aircraft.
As well, he insisted that overhaul costs went thru regular capex (PP&E) but despite his insistence, I agree with your interpretation -- it goes thru "other, primarily program and overhaul costs" . . . of course, it then shows up on PP&E!
So, if you are correct (and I think you are), it is capitalized via 'operating activities' and not regular PP&E capex (investing activities) but then shows in regular PP&E . . . I love this company's accounting . . .
I also failed to mention IR answer to my question about amortizing stock comp rather than expensing it like everyone else. He gave a very long answer. He revealed that this is discussed often among management.
He then revealed that this was result of mgmt dis-satisfaction that all their options ended up worthless and that vesting took much longer than other companies (50% after 4 years; 50% after 5 years).
Then, he went on long-winded explanation, and I would be lying if I said I understood. But I do understand that it is a mess.
When I asked for a "normalized" number, he said it was a great question, but that he could not offer an answer. I can value what they gave to mgmt each year so I do not think this is a huge deal, but it is a yellow flag.
|Entry||04/10/2015 09:36 AM|
jet + rii,
What are your thoughts on the latest numbers?
I have some questions:
- It seems like they have the "expected deal value" of Precision Systems Mfg at $27.2mm based on discontinued ops numbers on balance sheet less the disc ops numbers for Telair Cargo. Correct?
- The Aviation Services segment seemed to put up good numbers that square with your thesis, no?
- And the Expeditionary Services numbers were disappointing.
- One technical question: Does your "Defense Technology" segment fall into Aviation Services?
|Entry||04/10/2015 10:01 AM|
Is this a fair summary of where we are?
At stock price of $30 and pro forma for sale of Telair and sale of PSM for $27mm, we have a TEV of $1,073mm.
We have a solid Aviation Services group that is currently producing about $125mm EBITDA that you think will increase to around $175mm over next two years.
And we have Airlift and idle aircraft worth some difficult-to-figure amount.
But you think that the current TEV is supported conservatively by the current Aviation Services EBITDA and the improvements you see are gravy and whatever the airlift+idle-aircraft are worth is more gravy.
|Subject||Re: Re: Update|
|Entry||04/10/2015 12:13 PM|
Straw – thanks for the questions.
Your summary is in-line with our thinking. Valuing Airlift is difficult, but we think that the $200mm we assigned in our write-up is conservative. It’s what they paid for the business in 2010 and since then they’ve invested another $150mm, mostly in aircraft that should have some realizable sale value. We think that provides a reasonable valuation backstop for the business. The question mark is when and where we hit the bottom in terms of business operations.
The Aviation Services numbers were solid and came in a bit better than we were modeling (on better than expected margins). There seems to be momentum here. We estimate that about 85% of gross profits now come from the high-value pieces of this business, with 65% coming from Supply Chain (both Commercial and Defense) and about 20% coming from Commercial MRO.
As you noted, Expeditionary Services results were bad, driven by lower Airlift results. While active positions didn’t decline, in-line with our thesis, flight-hours/utilization dipped pretty dramatically. Management attributes this to: 1) transitioning of active aircraft to different positions, and 2) a worse than normal rainy season in Afghanistan, which grounded aircraft. Gross margins on the Airlift business were roughly 10% (after adding back one-time charges) versus 20% in the prior 2 quarters and as high as 27% last year (we backed into Airlift revenue and GP numbers through a combination of the old and new segment data). Revenue generated per aircraft was running at a steady $2.5-$3.0mm/quarter clip before dipping to $1.7mm this past quarter, so there were some disruptions to this business in this past quarter. To be clear, we think this business will still be bumpy over the next 2-3 quarters, but Airlift is now only about 10% of gross profits and they have been signing up contracts for additional aircraft, implying active position growth over the next few quarters (which we’re not modeling). They’re also aggressively selling idled aircraft in this business ($11-12mm for 4 aircraft, per the earnings call).
On your other questions:
- We agree with your expected deal value calculation for PSM
- Defense Technology falls into the new Expeditionary Services segment, not into Aviation Services.
The TelAir catalyst seems to have played out and this company needs to execute operationally for this to work.
|Entry||08/28/2015 10:15 AM|
jet and rii,
Any update here? Surprised by the price action relative to news?
This screams cheap to me here. We have added and now have this as a core position.
Thoughts? Am I missing a significant new risk?
|Entry||09/08/2015 02:04 PM|
Thanks Straw – we agree and we’ve been adding to our position here.
We've been surprised by the price action too, though we had a couple of worries coming out of last quarter's results that required follow up in order for us to get comfortable. First, despite strong earnings growth at Aviation Services, gross margins were down. In a call with management, we learned that commercial supply chain margins took a hit due to channel stuffing by an OEM partner, which forced AAR to take on elevated inventory in its distribution business. This may continue for a couple more quarters. In addition, at least one of our contacts believes there's overcapacity in the airframe maintenance industry that may lead to rate pressure. AAR's recent closure of its Hot Springs facility is likely a step toward addressing this potential issue. Ultimately, airframe maintenance isn't that important to the story here but it's something to keep an eye on.
Finally, we not only thought Airlift guidance was overly aggressive, but we were surprised CEO Storch provided it at all given that he had just finished saying he wouldn’t be discussing guidance. We believe he went rogue/off-script and it renewed some of our concerns about the management team.
That said, at these levels, we think the stock is now more than discounting these risks. We’re comfortable that any margin headwinds in supply chain will be temporary and that top-line momentum will continue to drive strong earnings growth. Importantly, our contacts for this business continue to be very positive on AAR's progress here. In addition, despite the noise in Airlift, the fact is they’re now growing aircraft positions, which bodes well for the long-term earnings power of the business. You can back into historical Airlift gross margins using old and new segment data (released in an 8K last week) and Airlift gross margins used to approach 30% at their peak. At these shares price levels, we think we’re getting a free call option on a business that, once stable, could generate very robust earnings. We also think expenses were a bit kitchen-sinked last quarter given all the noise and could provide some upside near-term. The company has less than a turn of net debt and is probably going to buy back stock (they have authorization for another 10%). Finally, low oil prices should continue to be a tailwind to the maintenance business as carriers keep older aircraft operating longer. We think the shares can ultimately double from here with limited downside.
|Subject||Re: Industry Question|
|Entry||09/17/2015 02:30 PM|
Thanks Zadig - we've tried to address each of your questions below:
|Subject||Overall thoughts and tax cash flow question|
|Entry||09/24/2015 06:52 PM|
overall thoughts on quarter and call?
I am struggling to understand why they have paid so much in cash taxes in Q4 and Q1, We do not have Q1 numbers exactly, Fortson said they made "a large tax payment" in Q1. And this adds to the oversized cash payment made in Q4 as well. I had thought this was going to reverse itself in Q1 but instead we have another large tax payment.
So I am confused. Will they get back the Q1 payment plus the $72mm of deferred tax assets added in Q4 quickly? My sense was that we simply had a timing mis-match, but now I am wondering if those tax assets are going to be slow to monetize.
This tax question is now about $100mm of TEV so it is not insignificant.
|Subject||Re: Overall thoughts and tax cash flow question|
|Entry||09/29/2015 01:59 PM|
|Subject||Re: Re: Overall thoughts and tax cash flow question|
|Entry||09/29/2015 02:33 PM|
View Fortson's leaving as negative. He understood the business and was very helpful in answering detailed questions. Viewed him as shareholder friendly. With that being said, do not expect change in course and as you say, it is about execution at this point.
I think this stock is getting caught in the great hedge fund unwind of 2015 (we had two great unwinds in 2014 so we were due).
The results and reporting remain very messy but we believe that to be bearish here, one needs to believe there is going to be a significant collapse of margins in the non-airlift biz, which we do not see despite some hiccups of late.
Still think this idea was early, not wrong.
I got answer on tax question. My TEV was off significantly because the sold businesses had much (extraordinary) lower tax basis than GAAP basis and so the cash taxes were much greater than I expected. As well, they had an after-tax expense of $30mm related to buying back debt far above par. These reduced net cash by over $100mm from where I had it, and these are not reversing.
At $17.75, have TEV of $785mm.
|Entry||12/17/2015 07:14 PM|
What are your thoughts?
- We finally had a very strong aviation services quarter. And trading/parts was not terribly strong so there is still more potential strength. And they sound quite optimistic about the back half of the year. Where are you getting Aviation Services EBITDA for this fiscal year? As we have discussed, there are so many moving pieces, but I am getting about $150mm EBITDA (including stock comp) now (but not sure how to assign SG&A between Aviation and Expeditionary).
- How are we to think about Expeditionary Services? It will basically be flat gross margin this year. I'd love for them to sell this turkey. It is a horrible business. And it now has a negative EBITDA.
- Bases on the Aviation Services, this stock is extremely cheap, but the Expeditionary Services is going to be assigned a negative value until they sell it. If they sold Expeditionary business for $100mm, this stock is worth over $40.
- We have discussed before, but what is the normalized stock comp being paid each year? They use this crazy amortization system that creates a very lumpy income statement effect. For example, Q1 had $2mm amortization of stock comp while Q2 had $14mm.
|Entry||12/18/2015 12:43 PM|
Hi Straw - we're happy with the Aviation Services results too. Both top-line and margins came in ahead of our expectations and it seems that there's positive momentum across the business (with the exception of trading, as you've pointed out). We’re a little lighter than you on EBITDA – we’ve got $143mm ($137mm after stock comp) for FY16, but don’t think that changes your higher level takeaway, which we agree with – the stock should be worth more based on this business alone.
|Subject||Re: Re: Update|
|Entry||12/18/2015 05:53 PM|
Right you are on the stock comp. I mis-read the transcript. But I do think that $8mm annualized is too light. I discussed this issue with managment a few months ago, and I need to review my notes.
Can you break out your $143mm? It seems like you are not giving much credit for business pickup in H2. And what percent of SG&A are you assigning to Aviation?
|Subject||Re: Re: Re: Update|
|Entry||12/21/2015 03:08 PM|
We’re probably being somewhat conservative on the 2H results.
Hope this is helpful.
|Subject||Re: Re: Re: Re: Update|
|Entry||03/23/2016 12:39 PM|
What are your thoughts after the results and the call?
- Aviation Services results and contract wins look very strong, stronger than expected. The stock remains quite cheap just based on the Aviation Services biz.
- The Exped biz is more confusing than ever. Margin pressure. Are you worried about INL contract? What is the mystery contract that they claim if they win will make Exped profitable? There is significant risk this goes more negative before it turns around.
I did not like mgmt answers regarding share buybacks, M&A, spinning or selling expeditionary.
|Subject||Re: Re: Re: Re: Re: Update|
|Entry||03/23/2016 02:14 PM|
Winning this contract would change the complexion of Airlift/Expeditionary rather quickly (and could help explain why Storch doesn’t want to exit the business now). We think there’s a high probability that AAR wins it, but even if they don’t, the downside seems limited to what we have now – a strong Aviation Services business dragged down by an Expeditionary business that continues to slowly bleed. We like the near-term skew here and have been adding.
|Subject||Re: Re: Re: Re: Re: Re: Update|
|Entry||03/23/2016 02:31 PM|
Thanks for the detailed update on Expeditionary. In light of your comments, I went back and re-read the transcript, and the management replies seem odd. But your comments make sense. And in light of the poor Exped results, the ILNA contract now becomes a huge part of the story. Without it, we continue to have an Aviation Services biz worth $35-40/shr and an Exped services biz worth an unknown amount that the market will continue to value as a negative.
What did you make of their capital allocation comments? Are they stepping back from returning all free cash flow to shareholders?
|Subject||Re: Re: Re: Re: Re: Re: Re: Update|
|Entry||03/30/2016 02:24 PM|
Straw - we don't have any great insight into their capital allocation comments except that it sounds like they're finding more opportunities to invest in the business organically. We do prefer that they buy back stock at these levels.
|Subject||Re: Re: Re: Re: Re: Re: Re: Re: Update|
|Entry||07/01/2016 02:08 PM|
Any new news (since March) on INL/A contract? Are you surprised at the delay? This was supposed to be granted formally to AAR in May.
|Subject||Re: Re: Re: Re: Re: Re: Re: Re: Re: Update|
|Entry||07/08/2016 12:58 PM|
Hi Straw – we’ve been doing a good deal more callwork on the INL/A situation and have learned that this contract has become a political football within the State Department. While there seems to be general agreement that AAR is best positioned to win the new contract once officially awarded (even among those with reasons to favor Dyncorp), this appears to be going through an abnormally prolonged and contentious process. At this point, while we’re still optimistic that AAR eventually wins this contract, the timing is unknown given the uncertainty surrounding how this process unfolds but we will continue to watch closely. On our other callwork surrounding Airlift, it sounds like status quo for the most part, but our guess is that if AAR somehow doesn’t win the INL contract, that could be the catalyst for the company to exit the business.
|Subject||Re: Re: Re: Re: Re: Re: Re: Re: Re: Re: Update|
|Entry||07/11/2016 02:07 PM|
Thank you for the update. Winning INL/A or losing and exiting would be a positive. Losing and hanging around would be a big negative.
|Subject||INL/A and Airlift|
|Entry||07/13/2016 11:28 AM|
I did not see anything negative regarding Aviation (both Q4 and outlook). Did you?
But Airlift news went from bad to worse. Do you know when the state department one-year extension became public? Notwithstanding mgmt comments, it does not seem to me that the State Dept is going to be in a hurry to decide this contract given the extension. This is the worst case scenario: continued drag on numbers with no chance of resolution for a couple of quarters. It also gives Dyncorp time to line up its political muscle to retain contract. As for selling Airlift, I am not sure what to make of mgmt's comments. Clearly, they cannot come out and say we are selling at this point.
|Subject||Re: INL/A and Airlift|
|Entry||07/14/2016 06:51 PM|
Straw – we agree with your assessment of the situation. At this point, it’s hard to have an opinion on the timing of an outcome for the INL/A contract. We’ve been told that this doesn’t preclude the State Department from canceling the extension and awarding the contract earlier, but it gives them room to breathe and puts them in less of a hurry to make a decision. We think this stock is worth more than where it’s trading today; all of the profitability is derived from the aviation services business which continues to perform well, while the airlift business muddles along at breakeven, so it would be helpful to separate the two to allow a fair valuation to be applied to aviation services. Our sense is that either the INL/A contract comes to fruition or the business is restructured.
|Entry||11/09/2016 01:04 PM|
Stock up on Trump election. Is this justified? It seem to me that the defense spending Trump has discussed (mainly weapons spending) will not affect AAR Corp. And some of the Airlift services could even be curtailed if Trump pulls back geographically. The aviation services and supply could get a slight bump. My guess is that this is just getting defense-stock bump, whether warranted or not. Thoughts?