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AAR Corp (NYSE:AIR)
Q2 2020 Earnings Call
Dec 19, 2019, 4:45 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, everyone, and welcome to the AAR's Fiscal 2020 Second Quarter Earnings Call. We're joined today by John Holmes, President and Chief Executive Officer; and Sean Gillen, Chief Financial Officer.

Before we begin, I would 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 in our news release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31st, 2019. In providing the 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 President and CEO, John Holmes.

John M. Holmes -- President and Chief Executive Officer

Great. Thank you very much, and good afternoon, everyone. We really appreciate you all being here to join us today to discuss our second quarter FY '20 results. In the second quarter FY '20, sales grew by 13.7% from $493.3 million to $560.9 million. Our adjusted diluted earnings per share from continuing operations increased from $0.60 a share to $0.64 per share. We had a great quarter, and I'm really pleased with our overall results.

Once again, we saw exceptionally strong performance from our trading activities as we continue to use our global network to source the highest demand material to support our long-term customer contracts. We saw strong results from our distribution activities, as well having benefited from the maturation of contracts secured over the last several quarters. We also continue to see solid growth from our government programs activities.

The WASS and Landing Gear PBL contracts, in particular, are performing very well operationally and are allowing us to build solid past performance as a foundation to capture more government opportunities.

The second quarter was also our fourth consecutive quarter of improved performance in our MRO business. The actions taken to address the shortage of mechanics, such as enhancing our recruiting efforts, partnering with various schools, and repositioning elements of our workforce across our network have paid off and we are seeing benefits of those actions now.

In addition to the strong financial performance, we also announced several new awards during the quarter. Our Airinmar subsidiary, a provider of component repair cycle management solutions, announced two new contracts. This was with -- the first was with Alaska Airlines for Airvolution, which is a software platform that enables the customer to increase efficiency and reduce costs by increasing visibility into their component repair cycle. Airvolution is our first software-as-a-service offering, or SaaS, and I'm thrilled to have Alaska using our platform. In addition to this award, we continue to see very significant revenue growth for our other businesses through the digital channels that we have built over the last two years.

Airinmar also signed a contract with JetBlue to provide component value engineering to help reduce repair costs. We're excited about these two awards as they represent new services to existing customers, which validates our integrated services model. Finally, we expanded our component repair services agreement with BAE Systems to include a wider range of components for its regional jet support programs. BAE sighted our consistent cost savings and the high-quality delivered by our Amsterdam facility as the basis for this expansion.

Before turning it over to Sean, I would like to provide an update on the sale of our Airlift COCO business, which is in discontinued operations. I'm pleased to share that we've completed the sale of all of our DoD contracts and are awaiting regulatory approval for one remaining foreign contract, which we expect to receive soon. Once received, the exit of our Airlift COCO business in discontinued operations will be complete.

With that, I'll turn it over to our CFO, Sean Gillen.

Sean Gillen -- Vice President and Chief Financial Officer

Thanks John. Our sales in the quarter of $560.9 million were up 13.7% or $67.6 million year-over-year. This included a $69.1 million or 14.9% increase in Aviation Services revenues, driven by execution on new contract awards and strong demand in our part supply activities.

Gross profit increased 9.7% or $7.6 million to $85.9 million. Gross margin within Aviation Services remained relatively flat at 16.1% for the quarter, which was favorably impacted by improvement in MRO and offset by some mix in government services and increased costs in certain commercial PBH programs. While we did see increased costs in certain programs, some of the increase can be attributed to improving the operational turnaround time by more quickly closing repair orders. We are taking actions to address these increased costs, such as optimizing our vendor network and inventory pool, as well as in-sourcing repair work.

Consolidated gross margin was 15.3% versus 15.9% in the prior year period, primarily due to Expeditionary Services. Our mobility activities had a softer quarter, due to a contract award not being finalized in the period and some operational challenges, including raw material inflation and warranty issues.

Our composite activities also had weaker performance due to mix, labor inefficiency, and higher freight costs. While overall performance should recover in the second half of the year, we are taking action to reduce overhead, as well as evaluating opportunities to reduce fixed costs.

SG&A expenses were 10.2% of sales versus 10% in the prior period, which was largely driven by investigation and compliance-related costs. Excluding investigation and severance costs, which totaled $3.3 million, SG&A would have been 9.6% of sales in the quarter. Our income tax expense during the quarter was $6 million, resulting in an effective tax rate of 23%. Net interest expense was $1.8 million, compared to $2.4 million last year due to lower borrowings and rates.

During the quarter, our cash flow provided from operating activities from continuing operations was $19.9 million, which improved $35.3 million from the prior year, excluding the impact of the accounts receivable financing program, which was relatively flat this quarter.

During the quarter, we returned $6.7 million to shareholders via a dividend of $0.075 per share or $2.6 million and repurchased 100,000 shares for $4.1 million. The balance sheet remains strong with net debt at $160.1 million and net leverage at 0.9 times.

Before handing the call back to John, I want to provide an update on the Department of Justice Investigation at Airlift regarding potential violations of the False Claims Act, which we disclosed in 2018 and with which we've been cooperating. We have recently entered into settlement discussions with the DoJ, we are happy to take a step toward resolving this matter. However, there is no assurance that any settlement will be achieved. We will keep you updated as these discussions progress.

Thank you for your attention, and I will now turn the call back over to John.

John M. Holmes -- President and Chief Executive Officer

Great. Thank you, Sean. Due to the strong performance in the first half of the year, we are updating our FY '20 guidance and now expect sales to be between $2.15 billion and $2.225 billion. We now expect adjusted earnings per share from continuing operations to be in the range of $2.50 a share to $2.65 a share. Compared to our prior financial guidance, the midpoint of our revised sales guidance increased from $2.15 billion to $2.188 billion and the midpoint of our revised adjusted diluted earnings per share from continuing operations increased from $2.55 a share to $2.58 a share.

We continue to expect SG&A expenses to be approximately 10.5% of sales and anticipate an effective tax rate of 24% in FY '20. We will continue to reassess our guidance and modify it, if necessary, as the year progresses. As it relates to the cadence of our earnings over the balance of the year, we would expect to have modest sequential growth in the third quarter and then more significant sequential growth in the fourth quarter.

In closing, our parts supply activity has continued to deliver exceptional performance. We're executing well on our government programs wins, and we're very pleased with recovery that we see in the MRO activities. We've got a strong balance sheet, full pipeline of new business opportunities, and we look forward to a very successful second half of FY '20.

And with that, I'll turn it back over to the operator for questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question comes from Robert Spingarn of Credit Suisse. Your line is open.

Robert Spingarn -- Credit Suisse -- Analyst

Hi guys. Good afternoon.

John M. Holmes -- President and Chief Executive Officer

Hey Rob, how are you doing?

Robert Spingarn -- Credit Suisse -- Analyst

Good thanks. Nice quarter, some nice cash flow here. I wanted to go back, you just talked about the midpoint of your revenue guidance, the $2.188 billion. And that implies about 6.5% growth for the year, if I'm doing the math right, but you're about 15% so far this year.

So, a couple of things here. One, I'm thinking maybe the back end is a little conservative, though the moving parts. I don't know if something is rolling off. You've added a fair amount of work. And then I wanted to talk about that in terms of the two segments, because, sort of, no matter what Expeditionary does in the second half and it's flattish for the year, one would expect or -- it seems you're implying that the growth at Aviation Services softens a bit. You did say the cadence into Q3 is maybe soft and then you strengthen in Q4. So, all that together, how does the second half look?

John M. Holmes -- President and Chief Executive Officer

Yes. Well, again, we're really proud of the first half. It's been a great start to the year. And as we think about the second half, you do come up against tougher comps versus last year, because that was about when we started to see some recovery in the MRO business, so that drives a bit of it.

You did mention Expeditionary Services. As Sean mentioned, we are expecting a recovery in the second half, although, it will likely be below the plan that we originally developed when we presented the guidance originally. But overall, we're happy that we're in a position to have raised the guidance overall for the year, and this represents the best view of the opportunities that we see at this time.

Robert Spingarn -- Credit Suisse -- Analyst

So, could you conceivably see -- I mean, does Expeditionary get better at any point? What's the long-term objective there?

John M. Holmes -- President and Chief Executive Officer

So, Expeditionary -- right now, we're focused, as we said, on improving the performance of that business. And part of what happened this quarter was situational, we had some operational issues that we've worked through. And then we've also seen some awards get delayed from the government and we expect to come those to come through during the second half of the year. Depending on when those hit, obviously, will drive the performance in the second half of the year.

But as we've talked about, Rob, for a long time, our focus as a company, generally speaking, has been growing and building out the Aviation Services segment, and that's where the investment, that's where the focus has been. And that's where you've seen the growth. So, that's the long-term future of the company.

Robert Spingarn -- Credit Suisse -- Analyst

Yes, I was going to say, even with the tough comps, if I just use your numbers really implying no absolute increase in the back half of the year. And again, with these contracts that you've been feathering in all along, I'm just going to take that as conservatism. And then -- so that's a comment more than a question. Last question, though, on the software-as-a-service contracts that you mentioned, very interesting this evolution and so on. Who are you competing with on these?

John M. Holmes -- President and Chief Executive Officer

That is a great question, and I like our answer. There's nothing like that in the market. It's the only application that gives you the type of visibility that -- the type of visibility that we do into the component repair supply chain and it also allows customers to share data. We need more customers to get on the platform and share their data with us. But in an anonymized way on an individual component level, customers can now compare the price that they're paying against the community. And that's a feature that we're seeing a great deal of interest in. So, I mean, from a financial standpoint, that's a -- it's a very small contributor to the overall results right now, but it's our first foray into an actual software program, and we're really excited that Alaska is on board.

Robert Spingarn -- Credit Suisse -- Analyst

And do you have any partners on this product? Is this developed in-house or are there any other folks that are -- do a technical side for you?

John M. Holmes -- President and Chief Executive Officer

Well, yes, we definitely have technical partners that help us do the -- help us develop the platform. But those are more kind of on a consulting basis as opposed to any significant commercial relationship. And we have a number of technical partners that are helping us build out the rest of the digital solutions. And as I mentioned, we're seeing a really significant increase of revenue through the digital channels that we've developed for our traditional businesses over the last couple of years.

Robert Spingarn -- Credit Suisse -- Analyst

Okay. Thanks very much. I'll jump out and come back later.

John M. Holmes -- President and Chief Executive Officer

Thanks Rob.

Operator

Thank you. Our next question comes from Ken Herbert of Canaccord. Your line is open.

Ken Herbert -- Canaccord -- Analyst

Hi, good afternoon Sean and John.

John M. Holmes -- President and Chief Executive Officer

Hey Ken.

Ken Herbert -- Canaccord -- Analyst

Hey, I just wanted to first ask your gross margins within Aviation Services, you called out some headwinds from some of your government services contracts, but then also it sounds like on commercial programs, you've seen some higher-than-expected costs there. I wanted to see if you could parse that out between those for us?

And then specifically on the commercial program side, it sounds like this is a business that's maybe not getting as much capital as it has in the past. Can you talk about some of the -- maybe the headwinds you're seeing in that business, whether it be pricing or higher costs and maybe how we should think about that business for you longer term?

John M. Holmes -- President and Chief Executive Officer

Sure. As we think about gross profit, there were some -- the positives are continued exceptional performance out of the parts businesses and the recovery in MRO. The two areas that we're offsetting to that, as Sean mentioned, one was, as you mentioned, government programs. Now, we don't see headwind in government programs, we actually see a great deal of growth and very strong performance out of that area of the company. But the way those work, they're dilutive to the gross profit number, but accretive to our operating margin. So, that mix there is a pretty meaningful impact this quarter. And we would expect it to be an impact going forward, given the growth of that business.

On commercial programs, we've talked the last several quarters about the market there. And we have seen increased competition and the pricing has been driven down as a result for that market. We continue to compete, we -- but as we've talked about, we have certain return requirements. If we can't meet those return requirements, we're not going to take the deal.

On existing contracts, we have seen some cost headwinds on certain of the contracts. As Sean mentioned, we're working to address those. Some of that though is timing and situational that you saw in this quarter and that's because in certain of the contracts, we -- in order to improve operational performance, we accelerated the web. And so that had the effect of pulling costs forward, which we saw in this quarter. And also because of the accounting changes that took place last year, a number of these contracts are now on a cash basis as opposed to managed over time.

So, you do see fluctuations in income in any given quarter as a result of those cost changes. But as you pointed out, we haven't announced a new win in that area in a little while and so -- and it's still an important part of our portfolio. Having said that, we've been able to achieve what we believe is very significant growth across the company. Double-digit growth now for six quarters in a row and that's not -- that's being driven by other areas outside of commercial programs.

Ken Herbert -- Canaccord -- Analyst

Okay. No, that's helpful. It makes a lot of sense. It seems like a very competitive market. And as we look at the guidance increase, again, just a question again within Aviation Services and the growth there. It's fair to assume then that the parts business, trading and distribution and maybe some on the government side with those contracts is obviously driving the increase? Or is on the top line? Or is maybe better performance on the MRO, a material piece of that as well?

John M. Holmes -- President and Chief Executive Officer

It's all of the above. Very strong performance out of trading, very healthy year-over-year growth there, continued strong performance from the new parts business, very nice growth out of the government programs area, those contracts have matured. And as you pointed out, the recovery in the MRO business is meaningful as well.

Ken Herbert -- Canaccord -- Analyst

Okay. And if I could, just one final question. On -- I know you've talked more recently about government services and the opportunities, and it sounds like WASS and the PBL contract are going well within Aviation Services. Can you provide any data, John, on maybe the bids you're seeing, the opportunities, maybe what might be flowing through in terms of your bid pipeline or your backlog? Or I mean, it sounds like now there's obviously a real high focus on these types of contracts from your customer base here in the United States, in particular. And I'm just wondering, maybe are you capturing more as a scenario where we should continue to see or expect strong growth? And maybe just a little bit about some of your activity underneath the two contracts you talked about moving forward for that business?

John M. Holmes -- President and Chief Executive Officer

Sure, sure. A couple of thoughts there. Yes, you should expect to see continued growth out of that government services business, and we have a very full pipeline. And the point that we made on our past performance is the more we win, the more we're able to win, because we build more experience, which allows us to bid on more types of work. So, that is widening the aperture of the types of things that we can pursue.

On top of that, we've really successfully made the migration from a subcontractor to a prime contractor over the last four or five years, and that, again, is helping us bid these larger programs. And we're also taking advantage of the fact that we just won, as you know, two quarters ago, the C-40 contract to sell two aftermarket aircraft to the government. And that is a great example of the government accessing the aftermarket.

And on that, the original solicitation that came out for those two aircraft was originally written for only the purchase of two new aircraft. And we worked in DC to allow that solicitation to allow the sourcing of two used aircraft, and ultimately, we're successful in winning that. That we believe is going to open up more doors for us, not just for used aircraft sales, but for also to use part sales and we see a lot of opportunity coming there. I was just at a DoD Maintenance Symposium, I gave a keynote speech last week there, and we talked a lot about the DoD making better use of well-established aftermarket solutions as it looks to go ahead and increase the sustainment and the readiness of the fleet, but doing that in a more cost-effective way. And there was a lot of interest as we gave these commercial examples of -- and their application to the government environment. So, we remain very excited about the growth prospects for us in government services.

Ken Herbert -- Canaccord -- Analyst

Great. Thank you very much. Nice quarter.

John M. Holmes -- President and Chief Executive Officer

Thanks Ken.

Operator

Thank you. Our next question comes from Michael Ciarmoli of SunTrust. Your line is open.

Michael Ciarmoli -- SunTrust -- Analyst

Hey, good evening guys. Thanks for taking the questions. Nice quarter.

John M. Holmes -- President and Chief Executive Officer

Thanks Mike.

Michael Ciarmoli -- SunTrust -- Analyst

John, just can we go back to -- maybe just to close the loop on, I think, what Rob was talking about on the digital solutions. Do you compete at all? I know Honeywell's got, I think their GoDirect trading -- what's the difference between -- yes, what's the difference? How are you guys differentiating your solution versus their solution? I mean, there just seems to be a part store, I guess, but are you guys doing anything radically different to entice more customers to sell that solution? Can you just maybe articulate a little bit there?

John M. Holmes -- President and Chief Executive Officer

Sure. There's a handful of digital initiatives that we've got. Some are external and some are internal. Quickly, in the internal, we've done a lot of work to put more information and take advantage of data that we collect from our heavy maintenance activities and our power-by-the-hour activities and our part sales activities and use that data to get more information in front of our employees real-time so that we can capture sales more quickly.

From an external standpoint, we do have our parts store. We're seeing a lot of traffic through that store. We've seen a very, very healthy month-over-month increases of traffic through that store. And we've seen a broader acceptance of small and large customers in terms of transacting business digitally as opposed to phones and emails. So, we're excited about that.

I wouldn't want to necessarily compare us to -- there's a lot of people there, as you mentioned, the Honeywell GoDirect, there's ePlane, there's AeroBuy, there's all kinds of different platforms out there. One of the reasons we are successful is because this is what we do. This is a core business for us, and we're taking what we do and what we do very, very well and applying it to a digital channel. So, I remain very excited about what we're seeing there.

Michael Ciarmoli -- SunTrust -- Analyst

Got it. That's helpful. And then just on the strength in the parts trading, I mean, clearly, we continue to see this robust activity in the aftermarket. It looks like shop visits, overhauls, everything on the schedule into next year, looks like that strength continues. Are you seeing any incremental upside from the grounding of the MAX? I mean, is that creating more tightness around 37 parts of availability and giving you more pricing power? Can you just maybe give a little color on how that's factoring into the performance of trading, if at all?

John M. Holmes -- President and Chief Executive Officer

Yes. No, I mean, net-net, the MAX is a positive for us. And we've said before that it's neutral to slightly positive right now, but it's definitely positive over the long-term, because it extends the life of the current generation platforms. As it relates to material availability, there's no question, 737 material is very, very tight. But we are the best in the world of sourcing that material and sourcing it at the right price. As a matter of fact, we just closed on two aircraft actually recently, and we're really happy that we made that buying and we're able to get our hands on that, because that's great material that will help us in the second half.

So, the fact that we are -- we've got -- we're the largest in the world for this, we've got the best network of buyers and the sourcing team around the world, and we've got the balance sheet capacity and flexibility to close faster than anybody we compete with, that's giving us an edge in that market. On top of that, we also have the best set of contracts, particularly with the engine shops for long-term supply agreements. So, when we go out and we find the right material, we've got the capital to deploy quickly, and we know we've got it sold because we got the contract.

Michael Ciarmoli -- SunTrust -- Analyst

Got it. That's helpful. And then just to nitpick, maybe a little bit on the Aviation margins. I mean, I'm assuming all of this parts trading activity is margin accretive to some of the other services and revenue-generating activities in the Aviation business. The margins have been flattish, down slightly year-over-year, I think you did talk about some of the turn times and looking at cost there and in-sourcing.

But how do we think about any potential operating leverage in Aviation Services? I mean, I would imagine the parts trading can't continue to stay this active. Should we think about you guys having some levers to pull to either sustain the margins or drive some upside once parts trading sort of normalizes?

John M. Holmes -- President and Chief Executive Officer

Well, I would say, just on parts trading, I mean, we expect this heightened level of activity to continue for a long time. And that was well before the MAX grounding happened, because of the contract that we have, the forecast we see from the shop and the bow wave of maintenance business that's expected to occur over the next couple of years. So, we feel very good about that business and the continued strength for many quarters to come.

In terms of overall margin, it's a big focus of ours. We are focused on improving that number. MRO is not yet back at the level that it was two years ago. We're headed that way. Each quarter, we make a little bit of improvement, but that is still depressed from where it was a couple of years ago, because our labor cost increased and we have not yet passed that entire cost on to the customer. The customers are being very supportive. They've got their own cost pressures and they're working with us, but we still have some work to do there.

On top of that, we did bring in a lot of new talent, and that talent takes a while to get trained and get good at what they do and ultimately become more efficient on the floor. And as that happens, we expect to see continued margin improvement in MRO. And then as Sean mentioned on the commercial program, there are definitely some cost challenges that we've seen recently there, and we're taking a number of actions to address those. And as we work through that, we would expect to see margin improvement there, too.

Michael Ciarmoli -- SunTrust -- Analyst

Got it. Helpful. I'll jump back in the queue. Thanks guys.

John M. Holmes -- President and Chief Executive Officer

Thanks Mike.

Operator

Thank you. [Operator Instructions] Our next question comes from Josh Sullivan of Seaport Global. Your line is open.

Josh Sullivan -- Seaport Global -- Analyst

Hey, good afternoon.

John M. Holmes -- President and Chief Executive Officer

Hey Josh.

Josh Sullivan -- Seaport Global -- Analyst

How do you feel about the inventory in your trading business? You talked about that bow wave maintenance coming up. Do you still feel the need to build that inventory in your network? Or is it that network that you have that you feel like you can trade on a spot basis that's giving you confidence?

John M. Holmes -- President and Chief Executive Officer

We have been making continued investments in the inventory, so that investment has actually grown over the last few quarters. The turns have also improved, so we're seeing material come in and go out. But candidly, the demand is so significant that wherever we can find material, we get it, and often, we're able to move it very quickly. So, we have investment plans, etc, but those investment plans have to be flexible when we come across opportunities to get our hands on the right stuff.

Josh Sullivan -- Seaport Global -- Analyst

Got it. And then just another follow-up on the SaaS strategy. How is price discovery going? Are these trials still or have you firmed up pricing and margin at this point?

John M. Holmes -- President and Chief Executive Officer

I'm sorry, what was the -- on what exactly?

Josh Sullivan -- Seaport Global -- Analyst

On the SaaS strategy with the digital initiative, yes.

John M. Holmes -- President and Chief Executive Officer

Okay. Yes. It's -- I would characterize that as very, very early, very early. So, we've got a launch customer. We have multiple other customers that we're talking about right now. And I would say, to use your words, we are in the phase of price discovery.

Josh Sullivan -- Seaport Global -- Analyst

Got it. And then just one last one on the MRO market, where is utilization on MRO shop visits year-over-year at this point?

John M. Holmes -- President and Chief Executive Officer

We are -- well, for us, we are up year-over-year. We're sold out through the rest of the year. And we have seen customers move work around, largely as a result of scheduled changes due to the MAX. But we -- from our standpoint, we're at a very high utilization.

Sean Gillen -- Vice President and Chief Financial Officer

And I would say our utilization last year was constrained by labor, rather than pure capacity. And so our labor position is better. So, we're at a higher utilization. But the constraint continues to be labor overall in that market.

John M. Holmes -- President and Chief Executive Officer

I think that's a good point. The macro environment for labor has not improved year-over-year. It's our position within that environment. Thanks to the actions that we've taken have allowed us to make this recovery.

Josh Sullivan -- Seaport Global -- Analyst

Thank you.

John M. Holmes -- President and Chief Executive Officer

All great. Thanks Josh.

Operator

Thank you. [Operator Instructions] I'm showing no questions at this time.

John M. Holmes -- President and Chief Executive Officer

Well, great, everyone. We really appreciate your time and your interest in our company and we wish everybody happy holidays.

Operator

[Operator Closing Remarks]

Duration: 30 minutes

Call participants:

John M. Holmes -- President and Chief Executive Officer

Sean Gillen -- Vice President and Chief Financial Officer

Robert Spingarn -- Credit Suisse -- Analyst

Ken Herbert -- Canaccord -- Analyst

Michael Ciarmoli -- SunTrust -- Analyst

Josh Sullivan -- Seaport Global -- Analyst

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