How Will The Recent Airline Cutbacks Affect AAR?

It’s about that time again when earnings season is upon us with some companies reporting their earnings mid-stream.

Our portfolio recommendation AAR Corp. (AIR), which provides products and services to the aviation, aerospace, and defense industries worldwide, will be reporting earnings for their Q1/2009 fiscal year Tuesday September 16, 2008 after the market closes.

What will be interesting to see is how the recent slowdown and cutbacks by the airline industry, and specifically certain customers that used AAR for their maintenance, repair and overhaul (MRO), affected AAR’s business prospects and earnings outlook.

Analysts still feel very strongly about this stock, with not one analyst downgrading it ever since I’ve been following the company for over a year now, and even today, William Blair started AAR at an outperform.

In this post I’ll go over the important aspects that we need to be aware of before AAR announces earnings and then break them down into the following parameters:

• What went right in the quarter: What were some of the positive developments that occurred within the company in the last 3 months.
• What went wrong in the quarter: What were some of the negative developments that occurred within the company in the last 3 months.
• What I want to see: All things considered, what I realistically want to see from the company as it relates to their business.
• What we need to see: At the minimum, what we need to see for our investing thesis to still hold and an investment in this company to be prudent.
• What we’ll probably see: After weighing what’s been going on for the last 3 months, what we can realistically expect when they do announce their earnings.
• Bottom Line: What it all means, and what you should do.

What Went Right In the Quarter?

No news = Good news?

It’s been crickets as far as AAR is concerned.

To me that’s good news, as it means that management has put its head down, and concentrated on simply executing the business.

The one small bit of good news that there was in the quarter, came early in the quarter when AAR announced that one of the 3 remaining service lines at their Indianapolis MRO facility was filled as of August 1st, 2008.

You’ll recall that as of the last earnings conference call, CEO David Storch stated that AAR had successfully replaced 2 out of the 3 open maintenance lines at their Indianapolis facilities with other customers (as a result of the defection of United Airlines (UAUA) grounding their entire 737 fleet), 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.

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.

Other than some minor contract wins from the government in their Structures and Systems segment, AAR has been busy servicing the customers they have and filling any holes that appeared as a result of further customer defections.

What Went Wrong in the Quarter

Airline industry takes a nosedive

Is it me or are the airline’s cutbacks in flights and personnel nothing more than self inflicted pain?

I realize that fuel costs have risen astronomically, but it seems that airlines are cutting back flights even though demand remains strong, and most planes are filled to the brim.

Either way, the bottom line as far as AAR is concerned, is that these cutbacks have had, and will continue to have, a direct impact on AAR’s sales and bottom line.

We saw that impact directly when United Airlines completely grounded their fleet of 737’s, of which AAR was the primary MRO provider.

In fact, AAR was utilizing 3 out of their 10 bays specifically for United Airlines planes only.

As I mentioned above, they already quickly filled those gaps with planes from Fedex, UPS and other companies, and filled their last bay August 1st.

This should mitigate some of the revenue and profit shortfall, but it should be noted that whenever AAR services a new plane, customer, or service type, there are bound to be some inefficiencies and I wouldn’t be surprised to see AAR’s margins come down as a result.

The same occurrence has transpired at AAR’s other MRO facilities as well in Oklahoma and Hot Springs, Arkansas.

From what I have been reading, AAR has done a decent job at filling the loss of some customers at these MRO facilities, but most likely will not be able to close the gap entirely right away.

As far as AAR’s other business segments are concerned, we’ll have to see how their Aviation Supply Chain segment does as a result of possibly lower demand for parts, both new and refurbished, as well as their Aircraft Sales and Leasing segment that buys and sells older aircraft, the type that are out of favor now, and also leases them to overseas customers.

I feel that all the lowered expectations concerning AAR’s business have already been priced into the stock (down from the mid $30’s, 6-8 months ago), and at this point, with AAR trading at near book value, it’s been all gloom and doom.

Finally, the good news is that even though analysts are still very bullish on the stock, they have ratcheted down their estimates for both top line and bottom line growth, which I feel is warranted.

The good news for us is that as a result of these lowered expectations, any positive news out of AAR, or any measurable beating of those estimates will cause the stock to rise in the face of weakness in the overall Aerospace and Defense sector.

What I Want to See

Decent Quarterly Results

I want to see AAR continue their positive business trends in which they have ratcheted down expenses in an attempt to generate cashflow.

The last 2 quarters AAR has not only been cash flow positive, but free cash flow positive as well, and have paid down some of their debt related to their acquisition spree of the last few years.

In tougher times like this, and because AAR is a cyclical business, it is incumbent upon them to conserve capital, generate cash, pay down debt, and when the storm clears, as it always does, be in a position to leverage their business model further and once again ratchet up their growth and tap into some of their revolving credit to secure more acquisitions, and so the cycle goes.

For now, stay the course.

Growth will obviously be slower because AAR is no longer in an acquisition mode, but so long as expenses are kept in check, and we see slight up-ticks to both the top and bottom line, I think that Wall Street and I will be more than happy all things considered.

What We Need To See

No Surprises

I think I’ve had enough earnings and mid-quarter surprises to last me a lifetime over the last few months.

Even if AAR misses on earnings or their top line slightly, and margins deteriorate a little bit, that will be tolerable if not expected by the market, me included.

Anything above and beyond that in this climate with the continued cyclicality of AAR’s business would bode well for the company and the stock.

What We’ll Probably See

Steady as she goes

AAR has a stellar track record.

Even in the face of past downturns in the airline industry, 9-11, higher fuel costs, and all the other garbage that affects them in bad times, they have always come out on top, and better for the wear.

Remember also that AAR makes almost 30% of their revenue from the U.S. and other governments in their structures and systems segment, as well as a little in their MRO and Aviation Supply Chain, so even with a shortfall in the airline industry, AAR is well diversified and should continue to do extremely well in their other segments.

My best guess is that AAR’s results will fall somewhere within acceptable parameters for our continued investment in a company that is closer to a bottom than a top.

Bottom Line

Despite problems, still solid

AAR is a best-in-breed company that is well diversified across many market segments.

This diversity has helped them to sustain their competitive advantages while other players have succumbed to the commodity spikes and declines in the overall airline industry.

There is no denying that AAR is a cyclical business, the question is, in what stage of that cycle are we in now?

I’m not one for calling any sort of bottoms, but there’s never anything wrong with bottom fishing for great companies that will be the first to explode when things do turnaround.

AAR is the best company in this space to back that belief on.

I feel that we are much closer to the bottom than the top or middle of this correction in the airline industry.

We all need to fly, and that will never change.

The moment that the economy stabilizes and consumers feel more confident in their spending power, they’ll come back to the traditional vacations and travel arrangements that they’ve gotten used to.

In fact, I would even argue that actual travel demand has fallen only slightly relative to the capacity reductions by the major airlines.

We’ll see how this plays out and how long it takes to stabilize and start to tick up, but I believe that AAR is the one company that is in a great position to take advantage of that trend, and also maintain its current business fundamentals to weather the storm.

Posted in Categories: Airlines, Contributor, External Research, Stocks, USA.

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