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Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2022 Second Quarter Earnings Call. We are 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. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Accordingly, these statements are no guarantee of future performance.
These risks and uncertainties are discussed in the company's earnings release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2021, and Form 10-Q for the fiscal quarter ended August 31, 2021. In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events.
Certain non-GAAP financial information will be discussed on the call today. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is set forth in the company's earnings release.
At this time, I would like to turn the call over to AAR's President and CEO, John Holmes.
Great. Thank you very much, and good afternoon, everyone. I appreciate you joining us today to discuss our second quarter fiscal year 2022 results. Before discussing the results, I would like to comment on the overall environment. As you know, we're now seeing the spread of Omicron variant, which is resulting in government restrictions that are impacting commercial passenger traffic. While the overall commercial passenger traffic market is recovering, the Delta variant and now the Omicron variant highlight that, that path to full recovery will not be a straight line. Despite this dynamic environment, we have remained focused on our own execution and are proud of the multiple quarters of margin expansion and strong cash flows that we have delivered.
Turning to this most recent quarter. Our sales increased 8% year-over-year from $404 million to $437 million, and our adjusted diluted earnings per share from continuing operations increased 71% from $0.31 per share to $0.53 per share.
Demand for our MRO services has remained strong. Even as our MRO customers deal with changes to the bookings and schedules, they have remained focused on keeping the maintenance supply chain running smoothly. Our customers have also been supportive in recent price negotiations as we look to address the tightness in the labor market together.
Parts supply, which is our highest margin activity, had stable volumes throughout the quarter albeit down from the levels we saw early in Q1 before the onset of the Delta variant. While overall, the supply chain that supports our own operations at AAR is functioning well, we have seen extended turnaround times from some of our repair subcontractors as well as freight delays, which did cause some sales to move from Q2 to Q3.
Regarding earnings, we delivered another quarter of margin expansion as our adjusted operating margin was 6.1% for the quarter. Sequentially, this is up from 5.5% in the first quarter despite a decline in sales. Even more importantly, our margin exceeded pre-COVID levels even though our top line is still down significantly. To illustrate this, our adjusted margin this quarter increased from 5.6% to 6.1% compared to 2 years ago prior to the pandemic, even though our adjusted revenue was down $127 million over that same period.
This year, this quarter's margin performance continues to validate the actions that we have taken over the past 2 years to drive efficiency in our operations, prioritize more profitable offerings and exit underperforming activities. We expect continued margin expansion as our commercial parts demand fully recovers.
Turning to cash. We had another strong quarter as we generated $16 million from operating activities from continuing operations. We also continued to reduce the usage of our accounts receivable financing program. Excluding the impact of the AR program, our cash flow from operating activities from continuing operations was $26 million. Over the last 6 quarters, we have generated a total of $142 million of cash flow from operating activities from continuing operations.
Regarding new business. During the quarter, we announced a 5-year renewal of flydubai to provide power-by-the-hour component support for a fleet of 33 737NGs. We also announced a sustainability initiative of Fortress Transportation and Infrastructure, under which we will contribute a percentage of all USM sales from our CFM56 partnership to purchase carbon offset credits on behalf of our customers. This initiative both reflect our commitment to helping our customers reduce their carbon footprint and the fact that USM is a low-cost green alternative to purchasing new parts.
Finally, subsequent to the end of the quarter, we announced a 10-year $365 million contract with the U.S. Air Force to provide depot-level maintenance and repairs primarily for the F-16 aircraft based in Europe. We've been supporting F-16 for decades, but this program takes that support to a new level. The complexity and duration of this contract is a meaningful step above our prior F-16 support and will build past performance that allows us to pursue other programs of a similar nature.
Before turning it over to Sean, I would like to also comment on the share repurchase program that we announced earlier this afternoon. As we've said before, our priorities for capital allocation are: first, organic investment in our business; second, the addition of synergistic capabilities via acquisitions; and third, with the return of capital to our shareholders. Our consistent cash flow generation and the strength of our balance sheet allow us to pursue all 3, and this share repurchase program is part of our plan for driving long-term shareholder value.
With that, I'd like to turn it over to our CFO, Sean Gillen, to discuss the quarter in more detail.
Thanks, John. Our sales in the quarter of $436.6 million were up 8.2% or $33 million year-over-year. Sales in our Aviation Services segment were up 8.9% driven by recovery in our commercial markets, and sales in our Expeditionary Services segment were down $1.3 million.
Our commercial sales were up 33%, while our government sales were down 15%. The decline in government sales was driven primarily by the level of activity on our program for the modification and sale of 2 C-40 aircraft to the U.S. Marine Corp in the year ago quarter. Sequentially, our commercial sales declined 3.6% due primarily to the impact of the Delta variant on our parts supply activities, and our government sales declined 4.7% driven by the wind-down of certain programs and the reduction of activity in Afghanistan.
Gross profit margin in the quarter was 18% versus 17.2% in the prior year quarter, and adjusted gross profit margin was 16.7% versus 13.9% in the prior year quarter. This significant margin expansion was driven by the efficiency improvement and portfolio refinement actions that we have taken and also reflects the benefit of closing out certain contracts in our commercial and government businesses.
Gross profit margin in our commercial businesses was 17.3%, and gross profit margin in our government businesses was 18.9%. The adjustments in the quarter applied to both the commercial and government end markets but were more heavily weighted towards commercial.
SG&A expenses in the quarter were $47.1 million or 10.8% of sales. Excluding adjustments of $1.1 million related to severance and investigation and remediation costs, this would have been closer to 10.6% of sales, in line with Q1 despite the decline in sales. SG&A is still approximately $10 million below the pre-COVID amount from Q2 of FY '20. Going forward, we do not expect SG&A to grow in proportion to revenue. As a result, as the commercial demand environment recovers and we continue to win additional government business, we expect to be able to drive SG&A to 10% of sales or lower.
Net interest expense for the quarter was $0.4 million compared to $1.3 million last year driven by lower borrowings. Average diluted share count for the quarter was 35.6 million versus 35 million for the prior year quarter. As John indicated, we generated cash flow from our operating activities from continuing operations of $15.9 million and also reduced our accounts receivable financing program by $10 million in the quarter.
During the quarter, we repaid our Canadian term loan of $24.7 million using our revolving credit facility, which further simplifies our debt capital structure. Our balance sheet remains exceptionally strong with net debt of $61.8 million and net leverage of 0.4x.
Regarding the share repurchase program, as indicated in our release earlier this afternoon, it's a $150 million authorization to acquire shares at management's discretion during open trading windows, and we intend to fully deploy the authorized amount over approximately the next 2 years.
Thank you for your attention, and I will now turn the call back over to John.
Great. Thank you, Sean. Turning to the quarter ahead. As of now, the Omicron variant has not impacted our customers' maintenance plans. As such, we expect MRO activities to remain at the current levels, which are near full capacity. Parts supply, which is our most international activity, is more likely to be impacted by the reinstatement of global travel restrictions, which could further extend the time line for full recovery. That said, we expect the impact of each new variant to diminish as we move forward. And although the timing is difficult to predict, parts demand, we expect will eventually return as operators move to restock their inventory.
Further, we expect to grow our business beyond just the scope of the recovery, given the incremental interest in USM and as we continue to secure new long-term exclusive distribution agreements.
On the government side, the F-16 program demonstrates our commercial best practices, are resonating with the government customer, and our pipeline is full, and we expect to be able to continue to expand our government programs portfolio.
Notwithstanding the uncertainty, we feel good about our backlog and parts supply, the loading in our hangars and our government pipeline. As such, we expect to see sequential growth in Q3 with sales approaching the levels we saw in Q1.
We are now entering our eighth quarter in a COVID world. We are very pleased with the performance that we've been able to deliver over that time, particularly our margin improvement and our ability to strengthen our balance sheet through consistent cash flow generation. Our launch of $150 million share repurchase program reflects our progress and our confidence, and you can expect continued execution from us over the coming quarters and years.
And with that, I'll turn it over to the operator for questions.
[Operator Instructions] Your first question as from the line of Ken Herbert of RBC.
I just wanted to start off, the 33% growth in the commercial business, can you -- it sounds like from your commentary that parts supply was maybe down sequentially or maybe not a big driver of that growth. Can you parse out that growth in the quarter from MRO relative to maybe the parts distribution and the parts trading side of the business?
Yes. It was actually spread fairly evenly. We saw, as we mentioned, at the end of Q4 and at the beginning of Q1, a real uptick in activity in parts in general. And then after Delta took hold, we saw that come down a little bit. But it was relatively stable throughout this quarter, which was up slightly from the prior quarter across both distribution and trading. And MRO was relatively stable, but -- and so most of the growth actually comes from the parts businesses.
Okay. And obviously, we keep getting these new variants and things seem to be pushing to the right in terms of the recovery. But what's your thinking now as to when we might see a more meaningful inflection in either distribution or, I guess more specifically, parts trading? And what are some of the indicators that you're tracking that are going to give you confidence or give you better visibility on when we expect that inflection to occur?
Well, I think you've gone through a large -- it's a great question. I think you've gone through, in large part, the destocking around the world. And parts demand for narrow-body aircraft, particularly here in North America, has recovered. The areas that we're waiting to see recover are the international markets. And again, parts is our most international business.
So once we have clarity on consistent borders being open and travel restrictions being lifted, that's when we would expect to see more continued, more consistent demand in the parts business. And unfortunately, the timing of that is obviously very difficult to predict.
But related to that, because you've seen the destocking largely complete and you've seen a preference in the USM -- towards USM material, we believe that once you get more consistent demand as markets fully reopen, there's going to be quite a run on these material because shelves are empty and airlines will have more confidence in consistent flying. So it's difficult to predict when that's going to occur, but we do expect when it does, it will be a pretty meaningful uptick.
And just one final question on that. As you think about the cycle, maybe not just the next few quarters, but the next couple of years, how much do you model or how much do you assume USM demand could outpace broader sort of aftermarket parts demand?
I wouldn't want to get into specifics on that. But we have seen, both from a market standpoint, I would say international markets such as Asia as well as just legacy carriers here in North America, a significant increase in interest in USM. And so again, it's difficult to predict the path and pace of that growth, but we know that it's there.
[Operator Instructions]. Your next question comes from the line of Michael Ciarmoli from Truist Securities.
John, maybe just on the Omicron variant, I mean, I guess as we look back, Delta and more specifically the response maybe seemed a bit mild versus what we're seeing here now with travel restrictions and everything else going on. How do we -- you said we'll see some growth sequentially back to -- in line with the fiscal first quarter. I mean how do you guys just think about that in response to what you saw with Delta and what we might see here on a go-forward basis with Omicron?
Yes. Great question. The comments about sequential growth are based largely on -- as I mentioned, we did have some sales slip from Q2 and now will occur in Q3. And so we're just looking at our backlog across the company, which gives us confidence that you're going to see sequential growth.
There's no question, I mean, you said it, the response to Omicron definitely was more rapid and more broad than what you saw with Delta. But we tend to agree with what other airlines have said publicly is that the impact of these -- of each new variant will be shorter as society and as industry and as governments are able to respond more quickly and then hopefully relax restrictions more quickly.
Delta was the first example of that. Obviously, we're seeing something -- we're seeing the next generation here with Omicron. But we're hopeful that each one of these cycles, if you will, these waves, the duration will be shorter than the prior. But the comment specifically related to quarter-over-quarter growth are tied to what we see right now in current backlog.
Got it. And what was the amount of revenue that slipped out of the current quarter?
If you go back to the guidance we provided, we said that it would be between -- this quarter that we would be somewhere between Q4 and Q1. And obviously, we're on the lower end of that. As those products shipped as planned, we would have been right in the middle of that guidance.
Okay. Got it. Got it. And then just one more maybe. You kind of mentioned international travel recovering as we think about your parts business, your distribution business. Is there a meaningful difference there in terms of narrow-body, wide-body exposure? I mean do we need to see the widebody utilization maybe not come all the way back, but see some overall improvement? Is that going to be a big driver of some of that parts business for you?
Some, it will be some. Most of our wide-body exposure in the parts business -- and I should say that we have more wide-body exposure in the trading business than we do in the distribution business. And most of the wide-body exposure in the trading business is cargo-related. There's some commercial, but that's less of an impact. What we're more interested in seeing is more sustained narrow-body travel around the world that would fuel the full recovery of the -- of both the parts trading business as well as the parts distribution business.
Your next question comes from the line of Ken Herbert from RBC.
John, just to follow up on the F-16 contract you announced, how much does that ramp? And how quickly and what's the sort of the fiscal '22 incremental contribution?
Yes, great question. I would view that as an FY '23 contributor. The ramp-up time for the contract was actually relatively compressed as these things go, but there is the potential that the contract is processed if we were to go through that process. That hasn't happened yet, and we don't have full visibility to that. But once it's clear, we would expect a fairly short ramp. But at this point, we wouldn't expect any meaningful revenue contribution until FY '23.
Okay. Helpful. And on the buyback authorization, I mean, you still identify organic growth and M&A as higher priorities for uses of capital. M&A hasn't been much of a part of the mix for quite a while, and I can appreciate maybe investment opportunities now organically maybe starting to increase but maybe limited as well. How quickly do you expect to ramp on the buyback on the authorization and how much usage there should we expect? Or are there really some nice opportunities in terms of other investments we should be thinking about?
Yes. Great question. And we -- as we mentioned, the capital allocation priorities are: first, organic investments; second, inorganic investment; third, return to capital to shareholders.
And given where the net leverage is in the company right now and the opportunity set that we see, we believe that we're in a position to execute on all 3. And so there are a number of organic investment opportunities, whether it's in the trading business or the distribution business, that we're looking at right now. M&A is something that does remain a focus of ours. And on the commercial side, it's been a tricky environment to pursue deals. But it is -- it does remain a part of our growth -- M&A does remain a part of our growth strategy.
As it relates to the timing of this, I mean, we fully intend to fully authorize -- or utilize this authorization. And at the pace, as Sean mentioned, we're going to commence this quarter. And then depending on market conditions as well as how opportunities unfold in the next few quarters, that will determine the ultimate place of employment -- deployment. But at this point, we chose that amount because it fits relative to the other opportunities that we see, and it's something that we think we can get done in a reasonable period of time.
Okay. That's great. And if I could, just one final clarification. I just wanted to confirm, you indicated that, as a result of Omicron, you haven't seen any change to your MRO schedules or backlogs. I just want to make sure I got that correctly.
That is correct. That is correct.
And again, we have a question from the line of Michael Ciarmoli of Truist Securities.
John, just as we think about labor in a tight labor market, how are you guys feeling? I mean we're going to get through the holidays here pretty quickly and then you're going to probably get into that busy kind of prep summer repair season. I mean it seems like maybe I'm an optimist that airlines globally would probably be looking even more aggressively to a hopefully close to back to normal '22 flying season. Do you feel comfortable with labor as you move into these potentially busy quarters?
Yes. Again, a great question. And this labor dynamic is something that we're paying an awful lot of attention to. And the short answer to your question is, it's really tight. But because of the initiatives that we -- it's really tight and I would say it is definitely tighter than it was pre-COVID. And I would characterize that as we're seeing pressure not just at the lower -- or not typically the mechanic hourly labor, but for up and down throughout the organization. And so it's a bit of broader base in terms of tightness. But because of the initiatives that we announced pre-COVID and have pursued through COVID, we think we're in a pretty good position.
The only thing I would say is that the customers have worked very closely with us to keep the hangars and the loading in the hangars relatively consistent. So what we used to experience with major dips during the summer and significant dips during the holiday season, which resulted in up and down moves in the overall labor force, the customers have worked with us to level load through those periods, which has allowed us to keep the labor force together.
And so it's a long answer to your question, but sitting here today, we feel good about the schedule that we have and our ability to meet the schedule and -- but it's a daily focus for us.
There are no further questions at this time. I would now like to turn the call over back to John.
Great. Well, thank you very much, everybody. We really appreciate the time and the interest, and we wish everyone a safe and happy holiday season. Thank you.
This concludes today's conference call. You may now disconnect. Thank you.