There’s nothing that I could say to start off this post that would clarify AAR’s position in their market right now better than what CEO David Storch said to start the 4th quarter and full year 2008 earnings conference call:

“Based on questions we have been receiving over the last several weeks, we believe the market may not fully appreciate the spread of business we have here at AAR.

In many quarters we are merely seen as an airline aftermarket provider. While that was more true earlier in the decade, today AAR is a much broader company servicing a wider customer base.”

Therein lies the beauty of the diversification in AAR’s business, and their ability to leverage that business, even in tough times like now, to come out stronger and better positioned to take market share from competitors, as well as capitalize on their growing revenue to defense and overseas customers.

AAR Corp. (NYSE: AIR), provides products and services to the aviation, aerospace, and defense industries worldwide.

In this post I’ll be breaking down their full earnings release, as well as analyst conference call, and round out my post with the reasoning behind my upgrade.

I’ll break down this report into 4 parts:

• Hit Me With The Numbers: Sales, Earnings, Margins: All Up, Beat Estimates
• Other Business Highlights: Tons of Cash Flow, Operations Humming Along
• Conference Call Highlights: Cautious, but optimistic
• Bottom Line - Upgrade to BUY: Time to do some bottom fishing

(Growth from previous year’s 4Q or full-year 2007/analysts estimates where applicable):

• Record quarterly sales of $391.7 million (up 28% from prior year (13% organic)/vs. $372.7 million projected by analysts)
• Record quarterly income from continuing operations of $22.0 million (up 23% from prior year)
• Record quarterly earnings per share of $0.52 (up 23.8% from prior year/vs. $.51 projected by analysts)
• Q4 Gross margin improves to 19.6% (up from 18.2% prior year)
• Q4 Operating margin of 9.8% (down from 12.4% prior year)
• Record 2008 sales of $1.385 billion (up 31% from prior year (20% organic)/vs. $1.370 billion projected by analysts)
• Record 2008 income from continuing operations of $75.1 million (up 28% from prior year)
• Record 2008 earnings per share of $1.76 (up 23.9% from prior year/vs. $1.76 projected by analysts)
• 2008 Gross margin improves to 19.1% (up from 17.4% prior year)
• 2008 Operating margin improves to 9.7% (up from 9.0% prior year)
• Sales to Defense customers have increased 24% on a compounded annual basis over the past three fiscal years and represent 37% of consolidated revenues.
• Generated $44 million of cash flow from operations
• Double-digit sales growth in all four segments

AAR Focusing on Streamlining Operations

It was apparent on the conference call that AAR is preparing for a slow down in the airline business, but confident in their ability to weather the storm and to come out on the other side stronger and in better shape to propel sales growth and market share when things do turn around.

Aside from the loss of one customer in their Maintenance Repair and Overhaul (MRO) segment, United Airlines, which grounded all their 737’s, there were really no other hiccups or negative aspects at all to AAR’s business results.

Here’s a breakdown of their 4 business segments and notes on each:

• Aviation Supply Chain (44% of sales) — Sales up 12% to $606 million, and accounted for 44% of revenues. 42% of sales were to North American airline customers, 35% to international customers, and 23% to defense customers.

In 2008, sales to customers outside the US increased by 15% vs. 2007.

Growth in this segment was fueled by the AAR’s industry leading position and value proposition offering airline and maintenance providers cost-effective supply solutions.

AAR also increased its international business and benefited from strength in the company’s performance-based logistics programs for defense customers.

My Take: This segment is humming along with AAR better able to leverage their already best-in-class logistics and parts support with the ability to either source new parts for customers, or repair and overhaul used parts to save them money, an important consideration for the airline industry these days.

• Maintenance, Repair and Overhaul (MRO) (22% of sales)– Sales were up 42% to $301 million, and accounted for 22% of revenue.

Activities in this segment are more closely tied to the North American airline market with 81% of sales generated by US carriers, 8% international airlines and 11% defense customers.

The acquisition of Avborne Heavy Maintenance Inc., a few months back, enhances AAR’s ability to service more wide body planes, which typically belong to international carriers.

The CEO also stated that recent announcements by US carriers of capacity reductions have impacted AAR’s MRO segment.

The largest hit to AAR from this segment was as a result of United Airlines (Nasdaq: UAUA) grounding their whole fleet of 737’s, and thus no longer requiring maintenance on these planes.

Further, the CEO stated that they anticipate further reductions in capacity by some of their other customers at their Miami and Oklahoma City facilities.

As of the conference call, the CEO stated that they had successfully replaced 2 out of the 3 open maintentance lines at their Indianapolis facilities with other customers, and then the day after their earnings announcement and conference call, AAR issued a press release stating that they had also found a 3rd customer to utilize that last remaining MRO line at this facility that will begin on August 1st, 2008.

The CEO then stated that even with customer movement, they still expected sales growth in this segment for Q1/2009, as well as for the full year.

My Take: It was clear that AAR is seeing somewhat of a pullback from some of their customers in this segment, notably United, but with that being said, AAR is also replacing those lines with new customers just as fast as they are being vacated showing the strength of the type of service that AAR offers and the very nature of the downturn.

People still need to fly, and therefore, airlines and carriers still need working planes. The quickest, easiest and cheapest remedy to that situation is to hire an outside company like AAR to service those planes.

• Structures and Systems (28% of sales) — Sales were up 42% to $389 million accounting for 28% of total sales. Sales in this segment are mostly to defense customers, which accounted for 86% of total sales, and the rest coming from international (5%), and North American commercial sales (9%).

This segment still shows great promise according to management, and they are spending more money in capital expenditures, as well as acquisitions, to further grow this segment and anticipate higher sales going forward.

Total funded backlog for this segment is more than $300 million, excluding the A400 program, which has been delayed until early next year.

Sales growth in this segment reflects AAR’s leading position in specialized mobility products for defense and humanitarian customers and steady demand for cargo systems and composite structures.

In December 2007, AAR acquired SUMMA Technology, Inc. adding to their precision-machining and fabrication capabilities.

AAR also announced a significant expansion to its composites manufacturing capability by opening a 90,000-square-foot facility located at McClellan Business Park in Sacramento, California, which should be operational by August, 2008.

My Take: As AAR continues to diversify their business and begins ramping up production in this segment, we’ll see more sales skewed towards defense customers and less towards commercial customers.

This has already paid off handsomely for AAR and will continue to do so in the upcoming fiscal year.

• Sales and Leasing Segment (6% of Sales) — Sales were up $46 million and accounted for 6% of total sales for all of fiscal 2008.

AAR currently has 37 aircraft in their portfolio, 29 through joint ventures, and 8 that are wholly-owned. There were no aircraft sales this quarter.

Total investment in the aircraft portfolio including the joint ventures, is approximately $121.5 million.

They achieved a 15.5% return on their investment on their portfolio of aircraft in fiscal 2008.

All of the aircraft are fully leased with 24 of them being leased to carriers outside North America.

As for the older 737’s in their fleet, AAR believes that as they are retired from US service, they will be put to work in other countries and replace other older aircraft in those countries.

• Other Notes:
  • Inventory turnover increased to 3.3 from 2.6 last year.
  • Total Backlog: Has increased to $465 million from $315 million last year. This is usually pushed through within 12 months.

Cautious But Optimistic Tone

• More Color on FAA Landing Gear Violations: I had previously reported on a letter that AAR received stating that some of the ways in which they serviced their landing gear was deemed to be non-compliant with regulations.

On the conference call CEO David Storch stated that there was minimal to no customer impact at all as a result of their findings, and the hoopla surrounding the matter, and no financial penalties or rework as a result of the notice.

The landing gear center experienced no interruptions in service, and in fact, had record sales in the 4th quarter and for the entire fiscal 2008 year.

My Take: As I had previously stated in my final report on the matter, this fiasco had pretty much no bearing on AAR or their financial or operational condition, and looks to be behind them now.

• Mesa Airlines Discussion: AAR reiterated that Mesa Airlines (Nasdaq: MESA), one of their customers, stated in May 2008, that if they could not resolve one of their contract disputes with one of their customers, they may have to file for bankruptcy protection.

During fiscal 2008, sales to Mesa Airlines were approximately $73 million, of which $56 million was in the Aviation Supply Chain segment, and $17 in the MRO segment.

As of this conference call, AAR had inventory and other long term assets on their books, to support the Mesa airlines MRO and Aviation Supply Chain operations, in the amount of $55 million, and had receivables due of about $13 million.

As of this conference call, Mesa was still solvent and AAR is currently still supporting Mesa Airlines’ operations, but AAR is anticipating lowered sales volumes for fiscal 2009.

My Take: Overall, Mesa is a small player in the regional airline market, and as a total percentage of AAR’s revenue.

However, if AAR had to write down some of their assets related to Mesa, and/or couldn’t collect the money that was owed to them from Mesa, it would surely affect their cash flow and earnings on a one-time basis.

Let’s hope that Mesa can remain solvent, and figure out the problems that they are having with their current customers.

• Commenting on Liquidity: The CEO stated that as they increase their cash flow and liquidity position in the future, they will be looking to reduce their debt and/or acquire some of their stock on the open market as they deem appropriate.
• Commenting on the Commercial Airline Industry: As for the commercial airline industry, the CEO stated that it would be very difficult to predict the impact of $135-145 per barrel oil on this market going forward.

He offered no predictions neither positive nor negative, other than to say multiple times that AAR has been through this type of slowdown before, and has always come out ahead.

• Operating Margins: AAR is still focused on a 12.5% operating margin longer term, but may have to wait to achieve that with what’s going on now in the commercial airline market and as AAR tightens their focus, concentrates on taking market share, and looks to increase their liquidity.
• New Customers: An analyst asked about UPS (NYSE: UPS), FedEx (NYSE: FDX), etc. being targeted as new or existing customers at their Indianapolis MRO facilities, and the CEO stated that they are very important customers and that one of those customers has already filled one of the vacated bays at their Indianapolis facility that was left behind by United, and they are working with the others to garner more of their business.

Don’t Let The Current Stock Price Pass You By

There are 2 primary reasons why I am upgrading shares of AAR corp. to a buy again.

One reason has to do with a longer term view of market conditions, the commercial airline industry and AAR’s seasoned management and tenure as a best-in-breed company, and the other has to do with pure valuation.

I’ll start with the big picture analysis:

AAR has weathered many storms.

In the early 90’s they had PanAm, Eastern, etc., that went out of business (at the time they were a $300 million company), then after 9/11 they weathered another crisis where 3,000 aircraft were taken out of service (they were then a $1 billion company). And now they are a $1.4 billion company in terms of sales.

After each of those downturns, AAR came out stronger and in better shape, and I believe that, while we don’t know how long the current conditions will last, because of AAR’s leading position in the market in which they serve and their diversified businesses, they are perfectly positioned to take advantage on the way down, as well as on the way up.

As long as aircraft are operating, both in the US and internationally, you’re going to need someone to service them, provide parts for them, and to maintain them.

No matter how bad conditions get, people will still always fly, that’s a guarantee.

At the same time, because airlines are trying to cut costs and save on labor, they are outsourcing more and more of their MRO needs to providers like AAR.

Bad economic times bring about the bootstrapping that can boost AAR’s business going forward.

When things do turn around, AAR will already be entrenched as the incumbent for any new entrants and any other airlines that need the types of diversified services that AAR offers.

It’s funny how we don’t even remember or miss, PanAm, Eastern, et. al. The same will happen with any of the current crop of airlines that merge or do go out of business.

There will always be others there to take their place that are hungrier and learn from their mistakes or simply have deeper pockets.

On the military front, as long as the military spends billions of dollars to keep its armed forces operational and continuously needs new equipment and servicing of existing infrastructure and equipment, you’re going to need companies like AAR to handle the logistics, servicing and construction of the different facets of those operations.

AAR has grown their sales to defense customers and the US military, which is a steady stream of income with more visibility and stability, from 15.9% of sales in 2001, to 37% of sales in 2008.

Further diversification away from any one segment or customer base will continue to enhance AAR’s financial performance, and diversify their revenue stream to allow them to be in an even better position than they are today to weather any headwinds or outside forces.

Look for this diversification to continue.

Finally, AAR feels that they are in the best position to help customers when times are tough due to their full end-to-end services and their ability to anticipate the requirements of their customers and what they want and be able to deliver it to them quicker, and in a more cost-effective manner than competitors.

Let’s revisit my quote from CEO David Storch from the beginning of this post:

“Based on questions we have been receiving over the last several weeks, we believe the market may not fully appreciate the spread of business we have here at AAR.

In many quarters we are merely seen as an airline aftermarket provider. While that was more true earlier in the decade, today AAR is a much broader company servicing a wider customer base.”

Now for some numbers:

For those with a purely analytical bent, here are some numbers to chew on:

• AAR’s trailing P/E ratio is 7.91
• AAR’s FORWARD P/E for fiscal 2009 is 6.54
• AAR’s earnings are projected to grow 21% in 2009, and 14.5% in 2010
• Yielding a PEG multiple of .42 (using a 5-year EPS growth rate of 18.5% projected by analysts) for 2009
• AAR’s book value is $14.52 per share
• AAR generated over $60 million in cash flow in the last 6 months, has more than enough cash on hand and is generating free cash flow from operations despite external forces.

I could go on and on…

But I won’t.

Bottom Line:

Before AAR’s last earnings release I put them on watch and downgraded shares to HOLD because I wanted to see how the last quarter went and listen to forward guidance and the tone of the call.

While I can see that analysts and AAR’s management team have been cautious in their approach to this whole cyclical slowdown in the airline industry and surrounding economic times, their prudence could be our gain.

You see, the companies that usually rise in value the quickest at the slightest hint of a turnaround, are exactly this type of company: relatively small, relatively unknown, solid execution, management, and a service that is needed in good times and bad.

I don’t know when it will turn, but it will.

There will be a catalyst that will spark a turnaround, whether it be falling oil prices or increasing consumer demand for travel, and there will be a mad scramble to add shares of the “best-in-breed” companies in the recovering sector.

AAR is that company.

At these depressed levels AAR’s stock is more than just a value play, it’s a growth story.

Those looking for the classic “buy when others are fearful” mantra have their wish with AAR.

Dip your toes into the water, start a position, and be ready when the turnaround comes, whether it be in a few weeks, months, or even years, it will come.

Once the aerospace and defense sector comes back into focus, and fears subside, the best companies will have survived the downturn and be best positioned to capitalize on the turnaround.

With its seasoned management, long track record of coming out better after market downturns, and lean initiatives to make it through these tough times, AAR is poised to be a stealth stock in your portfolio lying in the weeds, ready to ride the next investor sentiment turnaround.

The key is to be in before that happens, not after. 

*As of 7-11-08. Except share price, all values in millions.