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AAR (NYSE:AIR)
Q3 2018 Earnings Conference Call
March 20, 2018 4:45 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, ladies and gentlemen, and welcome to the AAR's Fiscal Year 2018 Third-Quarter earnings call. We are joined today by David Storch, chairman and chief executive officer; John Holmes, president and COO; and Mike Milligan, vice president and CFO. Before we begin, I'd like to remind you that the comments made during the call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, as noted in our news release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2017. In providing forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events.

At this time, I would like to turn the call over to AAR's chairman and chief executive officer, Mr. David Storch. Mr. Storch, you may begin.

David P. Storch -- Chairman and Chief Executive Officer

Thank you, and good afternoon to all. Q3, as you can see, was another strong quarter for the company. As both sales and profitability increased sequentially and versus the prior-year period. Consolidated sales increased 12% from $407 million to $456 million.

Our gross profit margin increased to 17% from 16.3% in the prior year's quarter. We again experienced double-digit revenue growth in our aviation services businesses and benefited from investments we made in all of our supply activities. Our strategy in driving sales growth across all of our connected businesses through our best-in-class aviation services on track. Our differentiated capabilities provides the basis to continue on our existing growth trajectory as we progress through our long-term transformation.

Our teams are focused on execution to drive efficiencies and profitability. We expect this momentum to continue as we ramp up services on our recent contract awards, including the U.S. Air Force Landing Gear PBL and the State Department INL/A Worldwide Aviation Support Services programs. During the quarter, we continued on the INL/A efforts and expect to be at a full run rate by the end of fiscal year, and the Landing Gear PBL will kick in the April -- in April or this quarter.

So with that, I'd like to turn the call over to John. John will be followed by Mike, and I'll wrap up commentary before we open for Q&A. John?

John M. Holmes -- President and Chief Operating Officer

Great. Thank you, David. Good afternoon, everybody. As David mentioned, we had another solid quarter, especially in aviation services, which was led by strong performance in our industry-leading integrated supply chain solutions in part supply activities.

Within our aviation services businesses, sales increased 11.4% in the quarter over the prior year. We continue to see significant growth in our trading business as a result of strong demand and also our leading market position. Our distribution business also performed well as previously announced, OEM distributorship continue to ramp up. Our commercial programs group focused on executing on the large number of contracts we've secured over the last several quarters.

In MRO, the integration of our newly acquired Canadian operation is progressing well and the new sites have exceeded our expectations both financially and operationally. Elsewhere, at two of our other MRO facilities, we experienced some labor pressure as the market is tightening for skilled technicians. We're working to get a handle on this situation, and we have a number of initiatives under way. We continue to invest in each of these businesses to support the growth as well as to develop new capabilities, such as digital enhancements, all of which will further strengthen our competitive position.

We're also focused on the ramp-up, as David mentioned, of the Air Force Landing Gear PBL contract with our first job inputs in February, and we will fully go live on this important program on April 1. Within our expeditionary services segment, sales increased $5.5 million, or 22.5%, from the prior year, primarily reflecting the continued recovery in sales volumes for mobility products business. As previously discussed, as part of securing the WASS contract, we've been shifting resources to focus on the growing -- on growing the government-owned, contractor-operated, or GOCO, business. As a result, we've decided to pursue the sale of our contractor-owned contractor, or COCO, business, which was formerly included in the expeditionary services segment.

These moves are designed to deliver world-class service to our government customers as we pursue more GOCO contracts going forward. Regarding WASS, the transition is proceeding well, and we've recently begun performing certain critical functions for the Department of State. Overall, certain transitional elements have compressed, and we do not expect to see the full $50 million of transition revenue highlighted during Investor Day before we go live on May 1. The WASS contract contributed less than $3 million of revenue in Q3, and we expect that to be about $25 million in Q4.

As I mentioned, in the program we'll go live on May 1, at which point we expect to be at full run rate, and it will be a contributor to earnings. We're all very focused on delivering world-class service to the Department of State. I do want to mention some other recent awards as well that we announced during the quarter. We announced the seven-year contract from the Naval Air Systems Command, or NAVAIR, for airframe maintenance and AOG support of P-8A fleet for the U.S.

Navy, government of Australia, and other foreign military sales customers. AAR's work on the P-8A airframe, which is a 737 derivative, will be performed at AAR's MRO facilities in Indianapolis, Oklahoma City, and Miami. This is an important contract win for us. It's our first with the -- with NAVAIR and the P-8A fleet is large and growing.

We also announced during the quarter a new joint venture for the development of a heavy maintenance facility in central India. This new MRO facility will begin operations in FY 2019. We've already been investing in this venture and expect investments to continue over the next several quarters, and we're really excited to bring our brand and know-how to this important and growing market. Overall, we have a lot of momentum, and we're feeling really good about our prospects going forward.

And with that, I will now turn the call over to Mike.

Michael D. Milligan -- Chief Financial Officer

Thanks, John. Good afternoon. I'll take a few minutes to discuss the company's Q3 fiscal '18 financial performance in more detail. We experienced strong sales from continuing operations in the quarter of $456.3 million, up 12% or $49 million year over year.

Our sales growth was driven by the $44 million sales increase in our aviation services segment, specifically in parts trading and distribution, commercial programs, as well as MRO and Landing Gear services. KC-10 sales were $3.6 million in the quarter, down $20.7 million from $24.3 million in the prior year, and we'll have minimal sales going forward. Our expeditionary services sales increased $5.5 million in the quarter. These sales increases were generated by our mobility operations and the start-up of our transition services for the INL/A WASS contract.

Income from continuing operations was $31.3 million, or $0.90 per diluted share, impacted by a $13 million, or $0.38 per diluted share, tax benefit related to the estimated remeasurement impact from the U.S. tax law changes. Also our provision for income taxes was favorably impacted by a $1.8 million, or $0.05 per diluted share, estimated rate reduction to 30% from the current -- for the current fiscal year heading to 24% in fiscal year '19. With the ongoing focus of improving the profitability of our business units, consolidated gross profit in the quarter increased $11.1 million to 17% -- or 17% to $77.6 million.

Gross profit in aviation services increased $8.5 million, or 13%, driven by the strong performance of our parts supply units. Gross profit in expeditionary services increased $2.6 million from increased sales volumes and improved profitability at our mobility business. SG&A expenses were 11.7% of sales during the quarter, impacted by higher legal expenses and increased personnel-related costs, including higher technology spending as well as early retirement severance charges of $1.1 million, or $0.02 per share. Capital expenditures for the quarter were $4.8 million, and depreciation and amortization were $10.6 million.

Our net interest expense for the quarter was $2.2 million, compared to $1.3 million last year, due to higher average borrowings during the quarter and an increase in the underlying interest rate. We will continue to focus on improved cash conversion, increased liquidity and ample availability to take advantage of market opportunities. To provide additional financial flexibility, we entered into an accounts receivable working capital facility of up to $150 million. Our cash from operations -- cash flow from operations were positively impacted by this accounts receivable off-balance sheet financing, which generated $52 million in the quarter.

During the quarter, we returned $10.4 million to shareholders through dividends of $2.5 million, or $0.75 per share, and share repurchases of $7.9 million, or approximately 201,500 shares. Average diluted share count for the quarter was $34.5 million, compared to $34.2 million in the third quarter of last year. Thanks for your interest, and I'll turn the call back over to David.

David P. Storch -- Chairman and Chief Executive Officer

Thanks, Mike, and thanks, John. As you can see, we had another great quarter for the company. I'm very excited about the future, given the investments we've made and the leadership team that we have in place. In closing, we're affirming our guidance for fiscal 2019, which we previously announced at our Investor Day in January.

This guidance includes sales in the range of $2.1 billion to $2.2 billion, diluted earnings per share from continuing operations in the range of $2.50 to $2.80, and adjusted EBITDA in the range of $180 million to $190 million. We also expect Q4 to be an improvement over Q3. With that, I'll turn the call back to the operator for any questions you might have. Thank you.

Questions and Answers:

Operator

Thank you. [Operator instructions] Our first question comes from Ken Herbert with Canaccord.

Ken Herbert -- Canaccord Genuity -- Managing Director

Hi, good afternoon.

David P. Storch -- Chairman and Chief Executive Officer

Hi, Ken.

Ken Herbert -- Canaccord Genuity -- Managing Director

I wanted to see, Mike or John or David, for the INL contract. It seems like the ramps may be a little slower than you've been expecting. I can appreciate there's a lot here to get this going. But can you -- aside from what you provided here for the remainder of the estimate here for the fourth quarter, are you still on track as part you reaffirm the full year '19 guidance for what you talked about is the INL contribution? And can you just talk a little bit about the ramp and how you see that progressing through '19?And again, the overall numbers or overall contribution you're expecting from the contract in fiscal '19?

John M. Holmes -- President and Chief Operating Officer

Sure, Ken. It's John. I wouldn't describe the ramp is a slower. I would describe it as more compressed.

In other words, when the original task orders associated with the $50 million was put out, there was some assumptions made that certain functions would be taken over by AAR over time. The weigh stayed is a work with us and laid it out. Those functions are really be taken over in a very short period of time at the end of the transition period. And once those are taken over, we go live officially on the whole program on May 1, and at that point, we expect to be a full run rate which is consistent with the numbers we presented in January.

Ken Herbert -- Canaccord Genuity -- Managing Director

OK, great. And if I could just one follow-up on aviation services. I mean, you're still seeing very good growth. It sounds like on the part side of the business, can you just provide any more color specifically on the parts trading and distribution, may be where you're seeing the growth? Or are there any particular aircraft types or engines that you've seen the lot of activity in? And I guess now the comparisons and you start to anniversary of ops so much more difficult comps, how do you see growth through the remainder of this year into fiscal '19 for those businesses within aviation services?

John M. Holmes -- President and Chief Operating Officer

John again. Really the growth in the parts business has been across-the-board, both in the trading on the engineer frame side as well as in distribution across multiple of our distributorship line. And that covers -- and in distribution that covers both the commercial and government markets. So we grew the seen increased demand all over.

There's a couple of new programs that we have signed in those businesses that we expect to continue to ramp over the next several quarters. So we remain confident right now about the continued growth in those businesses.

Ken Herbert -- Canaccord Genuity -- Managing Director

OK, great. Thank you very much.

Operator

Thank you. Our next question comes from Rob Spingarn with Crédit Suisse.

Robert Spingarn -- Credit Suisse -- Managing Director

Hi, good evening.

David P. Storch -- Chairman and Chief Executive Officer

Hey, Rob.

Robert Spingarn -- Credit Suisse -- Managing Director

What's the sale of the COCO business? What contracts are going with that? And I assume all the assets the -- whatever aircraft are left, could you just walk through that a little bit?

David P. Storch -- Chairman and Chief Executive Officer

Yes, so we don't have a sale, per se, at this moment. But we'll be putting the businesses up for sale. And the contracts that are associated with that business are no longer reflected in our sales numbers.

Robert Spingarn -- Credit Suisse -- Managing Director

OK. And then if you could just clarify, with regard to the out -- your guidance, to the '19 guidance that stays the same despite this decision?

David P. Storch -- Chairman and Chief Executive Officer

Yes, correct.

Robert Spingarn -- Credit Suisse -- Managing Director

And why is that? If you hadn't come to this conclusion over time...

David P. Storch -- Chairman and Chief Executive Officer

We're seeing good growth in our businesses. And we feel good about the prospects for hitting those targets that we established.

Robert Spingarn -- Credit Suisse -- Managing Director

So the retained business has improved to offset the loss of the contribution from the sold business or the potentially -- the discontinued business.

David P. Storch -- Chairman and Chief Executive Officer

So the revenues are -- we feel that we can pick up the revenues through the growth of our other businesses. And the contribution margin from the business that we are looking to sell has been negligible.

Robert Spingarn -- Credit Suisse -- Managing Director

OK. All right. So at least from an EBIT perspective that makes some sense. Although, if the other businesses are...

David P. Storch -- Chairman and Chief Executive Officer

Yes, we've been -- Rob, so to be clear, we've been transitioning our interest and our energy around this new contract, which is obviously a very meaningful piece of business for the company. And we're eager to commence work on this contract and have gone ahead and reallocate our resources to make certain that we're successful in this regard. So that's what you're seeing here.

Robert Spingarn -- Credit Suisse -- Managing Director

I just want to make sure, I understand this though. So if the sales are an offset, you lose the COCO sales, you offset that pretty much wholly with better growth in the existing businesses. I assume you mean aviation services, primarily, and along with the GOCO business, which are profitable, and you're losing profit list sales. Shouldn't there be higher profit next year?

David P. Storch -- Chairman and Chief Executive Officer

Well, we're -- you're asking what the -- you're asking in relationship to the expectations that we established at the Investor Day, but what we're saying is yes, to your question about should we expect more profits last year? I think you can see by the numbers that we're putting out there that will be significantly more profitable next year.

Robert Spingarn -- Credit Suisse -- Managing Director

Not more than last year. More than your initial expectation for '19.

David P. Storch -- Chairman and Chief Executive Officer

Excuse me. Rob, the answer is that we'll be much more profitable next year than we are this year, and we will be -- we are forecasting that. We've communicated that, and that's what we're expecting.

Robert Spingarn -- Credit Suisse -- Managing Director

OK, I'll ask you the question offline. With regard to 18% growth that you saw in the quarter ex KC-10 in aviation services, can you talk a little bit more about how that trended throughout the businesses?

David P. Storch -- Chairman and Chief Executive Officer

I think John answered that question. I think we've had consistent growth across all of the businesses in that segment.

Robert Spingarn -- Credit Suisse -- Managing Director

OK. Thank you.

Operator

Thank you. Our next question comes from Larry Solow with CJS Securities.

Larry Solow -- CJS Securities -- Managing Director

Just a few follow-ups. The -- sounds like the MRO piece this quarter may be on an organic basis didn't quite grow as fast as the other pieces. Is that fair to say?

David P. Storch -- Chairman and Chief Executive Officer

Yes, I think that's fair to say. Yes, Larry.

Larry Solow -- CJS Securities -- Managing Director

OK. And then just to clarify not to be diverse, on the COCO piece that you're selling is -- that you announced your selling. It's profitable or not profitable, it's negligible either way, but it sounds like your last quarter, I know it was a little bit of a pain to earnings. Fair to say this quarter, it would've been negative to earnings.

So you pulled away a couple of cents that would have actually been negative?

David P. Storch -- Chairman and Chief Executive Officer

Yes, I think that's a good way to look at it. Yes.

Larry Solow -- CJS Securities -- Managing Director

Right. So and then your -- whatever may be 20 -- I don't know if you can quantify the sales impact -- but we can do it offline. OK, just and then I guess, rest of the remaining expeditionary services this quarter essentially is really just mobility and the $3 million of INL revenue?

David P. Storch -- Chairman and Chief Executive Officer

It's slightly less than $3 million by INL and mobility, that's correct.

Larry Solow -- CJS Securities -- Managing Director

OK. And was there some -- SG&A was a little higher than I thought it would be. I know there was a -- a severance there, was there some expenses for INL? Or was there some stuff in front of the Landing Gear contract? Any other reasons for the SG&A number being a little higher?

David P. Storch -- Chairman and Chief Executive Officer

Yes, in both regards the answer's yes. More so in INL. But yes, increased expenses in preparation for INL/A.

Larry Solow -- CJS Securities -- Managing Director

So the INL is actually -- you actually lost dilutive this quarter not just --

David P. Storch -- Chairman and Chief Executive Officer

I won't say dilutive, but I won't say was -- it was not additive.

Larry Solow -- CJS Securities -- Managing Director

OK. [Inaudible] $3 million offset that $3 million sales. OK. Sounds good, thanks, I appreciate it, David.

David P. Storch -- Chairman and Chief Executive Officer

Yup.

Operator

Our next question comes from Michael Ciarmoli with SunTrust.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

Hey, good evening, guys. Thanks for taking the questions. Just on sticking to this -- the COCO piece. What was the revenue run rate, the annual revenue run rate of the business that you're going to try and sell here?

David P. Storch -- Chairman and Chief Executive Officer

For which period are you referring to? Because the business went through a steady decline, if you will. So which period would you like us to address? And would you like to, I guess -- would you to discuss that offline.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

Well, I mean -- I just -- get back -- getting back to Rob's question, I mean I'll pick round numbers here. I mean, if you're swapping out $35 million or $40 million of no-margin business, and you're making it up with $35 million or $40 million of higher-margin aviation business, profitability will be greatly improve next year, yes. But it seems like there should be some potential incremental upside to the earnings guidance. And I think that's kind of, again, swapping out lower margin revenues with higher margin.

Do we see some potential upside to that earnings number that you've kind of laid out already and reaffirmed? I think that's what we're trying to hit on.

David P. Storch -- Chairman and Chief Executive Officer

Yes, so keep in mind then the earnings guidance we're giving you a range, right? I mean, you got a range in that regard. So I would say this action strengthens our confidence, let's say, in the potentially higher end of the range.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

That's perfect. And then, maybe just -- you touched on the labor pressure. Can you just elaborate, I mean, we've certainly got -- there's a lot of growth in the aftermarket. There's certainly more planes coming into service on a regular basis here.

Is this something -- I think, you talked about some initiatives, but can you pass these rates through to the t end customer or maybe just elaborate a little bit more on that dynamic?

John M. Holmes -- President and Chief Operating Officer

Yes, sure. It's something that has been going on for some time and this is certainly an industry dynamic not just an AAR dynamic. And right, so we're -- we have a number of recruiting initiatives going on. We have internal training initiatives where we're taking some of our more experienced workforce on certain sites to import to other sites to train out newly [indiscernible] technicians.

And then on the wage side, there's certain levels in the organization where we are looking into a compensation adjustments. And then on the broader sense, we are already in dialogue with certain of our customers about potentially having to adjust pricing as a result of the wage pressures. And the customers are very aware of this.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

Got it. So no immediate push back, I mean, it sounds like they're receptive to some of those price increases?

John M. Holmes -- President and Chief Operating Officer

We've started the conversations and they are -- they all understand the dynamic. And we're a very important provider to them and an important part of the supply chain. And they want to make sure that we're successful.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

OK, got it. And then last one. Just on the INL contract. I think you talked at the Investor Day about $200 million to $225 million but potentially talk that there could be room for some scope increases there.

How are you guys thinking about sort of the annual potential, even if it's not '19, beyond '19, do you see more runway for opportunity on that contract as you start to get up to full rate?

John M. Holmes -- President and Chief Operating Officer

We do. I think we're in the exact same position in that regard as we were at the Investor Day. The only thing that really changed, as I mentioned, was the timing of certain events during the transition period.

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

Got it. Got it. Alright, outstanding. Thanks, guys.

I'll jump back in the queue now.

Operator

Thank you. [Operator instructions] Our next question comes from Ben Klieve with Noble Capital Markets.

Ben Klieve -- Noble Capital Markets -- Analyst

Alright. Few questions here. First regarding the mobility business. I'm curious with this being a greater and greater relative contributor to us in the top line, if you could elaborate a bit on the level of fixed cost in this business now that the [Inaudible] is growing.

And kind of what we can look at from an operating margin perspective from that segment?

David P. Storch -- Chairman and Chief Executive Officer

Can you repeat the question, Ben? Because you cut out.

Ben Klieve -- Noble Capital Markets -- Analyst

I'm sorry, about that. So in the mobility business was it being a greater and greater contributor on the top line. I'm curious if you can elaborate a bit on the level of fixed costs in that business? And then the margin -- the operating margin potential in that business as it theoretically continues to grow here going forward.

David P. Storch -- Chairman and Chief Executive Officer

Well, the business, although it's up on year-over-year basis, it is not approaching historical levels at this time. In terms of the fixed cost to support that business, as that business does continue to see growth, we don't expect much in the way of additional cost. So as this business receives contracts, it is a petty profitable activity. It's a very profitable activity for the company.

Ben Klieve -- Noble Capital Markets -- Analyst

So you've crossed the threshold or break-even for this business --

David P. Storch -- Chairman and Chief Executive Officer

Yes. Yes.

Ben Klieve -- Noble Capital Markets -- Analyst

OK, perfect. And then question regarding the India MRO facility. So first John, I didn't catch what you said regarding the date in fiscal 2019? What was your comments around that date?

John M. Holmes -- President and Chief Operating Officer

Yes, late in 2019 or in fiscal 2019 is when we anticipate being inducting our first aircraft.

Ben Klieve -- Noble Capital Markets -- Analyst

OK, perfect. And then -- so looking in the late '19 or 2020, I'm curious if you can just elaborate a bit more one type facility is up and running. It really -- it sounds like a very high ceiling opportunity. I'm wondering if you can help us and understand what you see as the opportunity there from that facility.

John M. Holmes -- President and Chief Operating Officer

Sure. So it's the narrow-body facility, we're in negotiations with the two different baseload customers. We would have between four and six lines of narrow-body maintenance. Currently, those customers are sending their work out of the country, so they're interested in bringing that work back in the country to bring jobs to India.

We hope that'd be in a position to announce those contracts here relatively soon. And that -- in these two phases of the facility planned, the first investment phase is one hanger, and like I said, can take up to six narrow-body lines. The second phase would be a similar size hanger that would be able to take another four to six lines on the same side. So we've secured land to be able to construct both facilities.

And just to go back, we do expect to be able to conduct our first aircraft in the middle of FY '19.

Ben Klieve -- Noble Capital Markets -- Analyst

Perfect. OK. That's really exciting. That's great to hear.

That's all that for me. Thanks so much for taking my question. I'll get back in queue.

John M. Holmes -- President and Chief Operating Officer

Thanks, Ben.

Operator

Ladies and gentlemen, thank you for participating in the question-and-answer portion of today's call. I would now like to turn it back over to management for any closing remarks.

David P. Storch -- Chairman and Chief Executive Officer

Well, thank you very much for today's questions, and hopefully we were helpful. I wish everybody a nice evening, and speak to you soon. Bye-bye.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect and have a wonderful day.

Duration: 30 minutes

Call Participants:

David P. Storch -- Chairman and Chief Executive Officer

John M. Holmes -- President and Chief Operating Officer

Michael D. Milligan -- Chief Financial Officer

Ken Herbert -- Canaccord Genuity -- Managing Director

Robert Spingarn -- Credit Suisse -- Managing Director

Larry Solow -- CJS Securities -- Managing Director

Michael Ciarmoli -- SunTrust Humphrey Robinson -- Analyst

Ben Klieve -- Noble Capital Markets -- Analyst

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