What AAR Corp's Results Mean to the Aviation Sector

The aerospace industry is highly cyclical. It always has been and always will be, which is why Fools need to keep an eye out for any early warning signs of a downturn. Given that aviation services company AAR Corp (AIR 0.21%) recently reduced its full year guidance, are conditions are about to worsen for Boeing (BA -2.87%), and its aviation suppliers?

What happened to AAR Corp?
Essentially, the key takeaway from AAR Corp's results is that its problems in the quarter were more stock specific than emblematic of any kind of trend change in the industry. However, the devil is in the details, and there are a few things for aerospace investors to look out for. AAR Corp is a long-term Boeing supplier, so its commentary on the marketplace matters.

AAR Corp reports in two separate segments, and both saw lower sales in the quarter. Aviation services includes supply chain services, management, repair and overhaul (MRO), and airlift services. Technology products designs and manufactures structures and systems into the commercial and defense industries.   As a rough guide, the company generates nearly 40% of its revenue from defense, with 29% coming from aviation services and 10% from the technology products segment.

Source: Company Presentations

The bad news is that aviation services sales declined by more than $40 million, or 10%, due to a $24.3 million reduction in MRO sales. The following table outlines the composition and reasons for the decline within MRO.

Source: Company Presentations

The first two issues look stock specific and relate to the completion of some AAR Corp programs, and the failure to replace these revenues in the quarter. However, the landing gear decline is seen as a consequence of hitting the 10-year anniversary of weak aircraft sales. It's an indication that sales could remain weak over the short term, but since Boeing and Airbus aircraft sales picked up after 2004, investors can expect some improvement in future for AAR Corp.

Meanwhile, the slowdown in U.S. defense spending is pressuring its airlift operations, although AAR Corp inked a deal in December with Eaton Corporation (ETN 1.90%) in order to distribute Eaton's fluid distribution products to the U.S. Defence Logistics Agency. As defense spending slows, there is a need for consolidation in the industry and Eaton's five year deal with AAR Corp makes sense.

Now the good news
Ultimately, AAR's management is seeing a shift in its revenue mix, with supply chain activity coming to the forefront. Quoting from the recent earnings statement:

As the near term demand for airlift and certain MRO services decline, we see an increase in supply chain activity, including new deals signed during and after quarter end, that will contribute to future revenues

Indeed, the company was active in signing deals including an undisclosed U.S. airline, the afore mentioned Eaton deal, and the acquisition of inventory and customer contracts from Belgium's Sabena Technics. Altogether, these deals are believed to be worth $215 million to $230 million in annual revenue, figures that approximate to around 10% of 2013 revenue.

While, these deals are good news, they also contain an element of risk. AAR Corp's plan is to move into pooling inventory in order to make it "available for multiple aircraft" instead of focusing on individual customers. It's a nice idea, but it makes the company subject to significant risk if the market turns down sharply. A UK company with a similar idea, Aero Inventory, fell into administration in 2009 after the downturn exposed its failure to generate sufficient cash flows from its business models.

From an industry perspective, however, the strength in supply chain services indicates that the commercial aviation market remains strong. In fact, the willingness of airlines to outsource supply chain services is contributing to that strength because it helps them to reduce costs.

The bottom line
All told, AAR Corp's problems appear to be company-specific, and Boeing investors should not be unduly worried by the disappointment. On the other hand, the weakness in its MRO activities and products like landing gear indicates that not all areas of aerospace are firing on all cylinders at the moment.

As for AAR Corp itself, the company's stock could remain in the doghouse until it's clear how its prodigious cash flow conversion rates are affected by having to invest in servicing the new deals and purchasing inventory. This is something to keep an eye out for.

Aviation looks set for long-term growth, what else?