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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon, ladies and gentlemen and welcome to AAR's Fiscal Year 2019 Third Quarter Earnings Call. We are joined today by John Holmes, President and CEO; and Sean Gillen, Vice President and CFO.
Before we begin, I would like to remind you that 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, 2018. 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 President and Chief Executive Officer, John Holmes.
Great. Thank you very much and good afternoon. We appreciate you all joining us to discuss our third quarter FY19 results.
Before we begin, I would like to welcome Sean Gillen, our new CFO. Sean joined us on January 7, and prior to AAR, he was most recently Vice President and Treasurer of USG Corporation, and had previously spent 10 years in investment banking at Goldman Sachs. We're very pleased to have Sean on the team.
Now turning back to the quarter, consolidated sales grew significantly, up 16% from $456 million in the prior period to $530 million in this quarter. Adjusted diluted earnings per share from continuing operations, our growth was even stronger, up 61% from $0.49 to $0.79, inclusive of a $0.19 tax benefit in the quarter. We also had a strong cash generation this quarter as we delivered $58 million of operating cash flow from continuing operations. We continue to see strong performance from our parts supply and program activities; and in parts supply, our strategic investments have enabled us to capitalize on the continued robust parts demand we are currently seeing, and the multiple new distributorships that we have won are contributing to sustained growth. Our programs activities remain strong, most notably with continued solid execution on our WASS contract. As a result, our aviation services segment grew 16% year-over-year.
Sales in our expeditionary services segment have also increased 18% due to other recent contract awards. This strong performance was partially offset by labor shortages at our MRO and mobility systems operations. As you know, the labor market across the U.S. is extremely tight and our more labor-intensive activities have struggled to find enough qualified labor to meet the demand from customers. We've been impacted by these labor shortages in MRO during the last several quarters, and while we saw sequential improvement in MRO in Q3, it was not at the level that we had anticipated. In mobility, as we ramped up production and fulfilled recent contract awards, we met with similar labor challenges. We've taken several actions to address these labor shortages but we expect to see continued sequential improvement. We've also been having productive conversations with our MRO customers about sharing these increased labor costs.
Subsequent to the quarter we announced a new international site in Costa Rica within the WASS program. This program continues to perform very well and we are happy with this expanded scope. We also announced another contract award for the production of cargo pallets for the U.S. Air Force which will be fulfilled by AAR Mobility Systems. Also subsequent to the end of the quarter, the company entered into a definitive agreement to sell certain contracts and assets of our COCO business. The sale is subject to certain regulatory approvals, and we expect it to close before the end of calendar 2019. In addition, we have entered into separate agreements to sell the majority of our idle assets. In conjunction with these agreements, we recognized a non-cash after-tax impairment charge of $58.5 million in discontinued operations. As you're aware, the rotary-wing and certain fixed-wing markets have remained under significant pressure from ongoing decline and demand from the U.S. Department of Defense as well as an excess supply of aircraft coming from the softness in the offshore oil and gas market.
As we exit the COCO business, this will complete our strategic shift from the asset-heavy COCO model to the asset-light GOCO model which will be a focus of our growth going forward.
With that, I'd now like to turn the call over to Sean to discuss the financials in a bit more detail.
Thanks, John. I will take a few minutes to discuss the company's Q3 financial performance in more detail. As John said, our sales in the quarter of $530 million were up 16% year-over-year. Our consolidated gross profit increased 9.9% year-over-year to $85.3 million driven by the Aviation Services segment. Gross margin was 16.1% versus 17.0% in the prior year period, primarily due to the aforementioned labor shortages, as well as the mix in expeditionary services. SG&A expenses were 10.3% of sales during the quarter, compared to 11.7% last year reflecting the improved leverage of our cost structure to support our double-digit sales growth. We anticipate that full year SG&A will be around 10% of sales as previously indicated.
Third quarter results included a reduction of income tax expense of $6.5 million or $0.19 per diluted share. This is primarily related to the recognition of previously reserved income tax benefits. Adjusted income from continuing operations was $27.6 million or $0.79 per diluted share inclusive of the $0.19 income tax benefit. This compares to $17.3 million or $0.49 per diluted share in the prior year quarter. Note that in the prior year quarter, tax benefit of $0.43 per diluted share was excluded from adjusted EPS because it was due to the Tax Cuts & Jobs Act legislation. In this quarter, the tax benefit of $0.19 per diluted share is included in adjusted EPS because it is due to normal course annual tax adjustments. This this is consistent with past practice.
Net interest expense for the quarter was $2.4 million compared to $2.2 million in the prior year due to an increase in underlying interest rates. During the quarter, our cash flow from operating activities from continuing operations was $57.6 million compared to $50.3 million in the prior year quarter. The prior year quarter included a benefit from our accounts receivable financing program of $63 million, while the current quarter included a benefit of $4.3 million. The strong cash flow generation reduced net debt $45 million during the quarter to $150 million, resulting in net leverage of 0.92x.
With that, I will now turn the call back to John.
Thanks, Sean. As we enter the labor market to recruit in January after the holiday flying season, we experienced greater-than-expected difficulty in recruiting experienced labor to meet the strong customer demand in our MRO facilities. While we're seeing a positive impact from the many actions we have taken to address this issue, it is not at the rate that we expected. Based on the impact to Q3 and the expected impact to Q4, I would like to provide an update to our full year 2019 guidance. We expect sales in the range of $2.01 billion to $2.03 billion, adjusted EBITDA in the range of $165 million to $170 million, and adjusted diluted earnings per share from continuing operations inclusive of the income tax benefit of $0.19 in the range of $2.50 to $2.57.
At the midpoint of these ranges, the updated guidance reflects annual revenue growth of 15.5%, adjusted EBITDA growth of 14.5%, and adjusted EPS growth of almost 42%. Had we not experienced these labor challenges, we would have been well within the original guidance range. I do want to note that this updated guidance assumes no meaningful impact, positive or negative from the grounding of the Boeing 737 Max fleet. As you know, this is a dynamic situation that we are actively monitoring and we are working with our customers closely to assess any changes. While we continue to experience these challenges in our labor intensive businesses, we are exceptionally pleased with the overall growth of the company. Our parts supply and program activities continue to outperform and we are excited by the full pipeline of opportunities that we see both in our commercial and government markets.
I'm excited to have Sean on the team and we are working closely looking at our businesses and strategy for the focus on delivering sustainable growth, margin improvement and consistent performance. We are also very well positioned with a strong balance sheet, we can deploy capital to support our growth strategy. Thank you for time and interest in AAR. At this point, I will turn it back to the operator for questions.
[Operator Instructions] Our first question comes from Michael Ciarmoli with SunTrust.
So just on the guidance, just so I am clear; was the tax benefit already contemplated in the $2.50 to $2.80 for the full year?
No. So that tax benefit was not contemplated as part of the original $2.50 to $2.80 guidance.
Okay, got it. And then just on Costa Rica for the INL WASS contract; can you give us any color of how that -- I guess, first, how that contract has been performing? It seems like there was no disruption from the government shutdown. And maybe what the potential revenue and operating income benefit could be at that additional site as once you guys get that up and running?
First of all, the contract is performing very well operationally. The customer is extremely happy. We're in regular contact with our counterparts at the State Department, and they are very pleased with the performance. So this new site will go live later in this quarter and will be fully up and running in the first quarter for FY20. And it's -- we have ranges on what the site will do as it relates to revenue, it's not as large as some of the other sites like Afghanistan for example, but it is -- it will certainly be a positive impact to the program. And I think as we said in the last quarter, there are additional sites being contemplated but this is the first one that's been definitized.
Got it. Helpful. And then just last one, and I will jump back in the queue. John, can you remind us where you are on the -- there was the protest for the worldwide logistics support services; right before your call started, it looked like Leidos was awarded the contract. Can you just remind us, are you now a part of that team or where do things stand with that program?
I'm seeing that announcement. There is -- the protest is over, they ended up adding more participants to the IDIQ. There are, I believe, multiple task orders that are out to bid, and we have few bids in on those task orders and we expect to hear at this point any time. I'll get information on Leidos award.
Thank you. Our next question comes from Ken Herbert with Canaccord Genuity.
John, I just wondered if you could provide any more detail on the MRO headwinds, and maybe any quantification around what that did in the quarter or maybe how much of a sequential improvement you saw? And then, as part of that, do you expect this to be sort of fully flushed through in fiscal '19 or how is the visibility look on -- specifically the MRO side of the waiver issue?
So we go in and out of the market and I’d certainly appreciate question. We go in and out of the market at various times during the year, and one of those entry points, if you will, is January after the aircraft come back from the holiday flying season. And so, now that we're in the market and the aircraft are in work, we have good visibility for the rest of FY19 because we don't have another entry and exit point if you go to the market, so that's why we feel comfortable issuing the guidance. As it relates to quantifying the impact, it's significant, and we try to frame that for you just in terms of -- again, had we not had this waiver headwind, we would have been well in that original guidance range that we issued back in January of last year. So, it definitely has been a significant impact to the company.
And can you quantify the INL contribution in the quarter or maybe what was organic growth for the business?
Yes, we -- I mean, again, we view INL as organic, it's a win, so we view all the growth this quarter as organic growth. And we -- for the first couple of quarters of INL, we had broken that out just to give everybody a sense of the ramp up, but on an going forward basis, it's part of the company, and so we're not going to be breaking that out but it's contributing as expected.
I mean, I know you alluded to this and I know it's early, but I know you certainly have significant exposure to flydubai in particular, another MAX customers on the programs side of business in particular, and I'm sure as well from distribution. I mean, any initial commentary you can provide on conversations with your customers there and are you seeing any disruption to the business yet or is really the adjustment to the guide largely just reflective of the labor issues within mobility in MRO, and you're not seeing anything yet on the programs side?
Yes, I know. Great question on the MAX. Certainly, we're in -- we have a number of MAX customers around the world as you know. You mentioned, flydubai which is a program customer. The MAX grounding, certainly depending on how long it lasts could really impact the company in a couple of ways. On the potential downside, it would mean that aircraft that we anticipate coming in for maintenance into our hangars, those could fly to the right because those aircraft have now been put into operation or extended their service to fulfill routes that previously had been operated by the MAX. Conversely, the fact that 737NGs current generation 737NGs, current generation A320s might be flown more to make up for routes that previously have been served by the MAX, that's going to drive likely depending on how this goes on, that's going to drive increased parts requirements and those are bread-and-butter fleets for us, so that can be a positive. So it's early, we're in active dialogue with all of our MAX customers, and it’s something we're watching very closely.
Thank you. Our next question comes from Robert Spingarn with Credit Suisse.
Just looking at the labor shortages, is this specifically just a labor shortage or is it a pricing issue? In other words, are you able to get your customers, you've talked about this in the past -- to the pricing level you need in order to compensate the labor?
The recent activity of the customers as it relates to potential pricing changes in this issue has definitely improved significantly over the last couple of quarters and we've had -- we have had some success for the couple of our major customers in repricing our agreements to account for higher labor cost on our end. However, this is a timing issue, and this is a bit of a moving target. One of the things we saw when we went back into the market in January is that rates that we felt good about, that would attract labor in certain sites actually were not as attractive as we thought. So we ran a bit of back and forth between what it took to get experienced technicians and what it takes too -- and what we are able to get from the customers; so that's an ongoing dialogue.
And it's also not just a rate discussion, we -- it's really about the experience of the labor force. So we've been able to attract bodies if you will, good people, but they are just not as experienced and not as efficient as the labor force we would have had say a year ago, and so that efficiency certainly plays a role in the profitability inside the operation as well.
And then, I wanted to ask you -- because I don't recall you mentioning it but is there any update on India?
Yes. India is still an ongoing project. We had -- we actually did make quite a bit of progress this past quarter, there were some -- various issues that had slowed down the construction of the facility, we got through those, we're back on-track now, we're still on an active dialogue with the launch customer and I still view that as the calendar 2019 Go Live event.
And when are you going to be able to give us some kind of -- to quantify that opportunity?
Overall, it will be -- it's a startup, right, so there will be some startup costs that we'll incur once we get going but ultimately we view this as an accretive operation to the portfolio given the price that we'll be able to charge over there relative to the cost of labor. And as we get closer and certainly as we announce the -- as we're in a position to announce the launch customer, we can provide more information on all that.
And then just going back to the question; this is another version of the INL question and the growth, but can -- at some level can you parse apart aviation services and give us an idea of how growth differs between parts, programs, MRO, INL so forth? There is so much in there now, clearly, INL is a big driver here because it's new; can we put this to get an idea what everything is doing?
If we go back to the Q1 and Q2, we had broken that down a bit more and overall, we saw and we -- because we're within the segment, we want to get away from that. But overall, we saw similar performance, similarly, very strong performance in the part fly businesses as we did in the first half of the year. So to go back -- if you go back and you look at what we had disclosed prior, we're kind of in that range, and we could see that continuing, I mean, this is -- those businesses are doing extremely well at the moment and we're encouraged by all of the demand that we're seeing, both in the aftermarket parts market and the new parts distribution market.
And then how do we think about just to put all this stock on labor shortage and so how do we think about MRO; is it growing?
MRO has declined from last year.
And based on what everything you said, the hiring situation and so on; at what point do you expect it to inflect up?
We're working on that and we are writing our plan, and we're starting to write our plan for FY20. And we will be having an Investor Day at the beginning of FY20 and at that point we'll provide guidance for the full year. And one point just -- Rob, just as you think about aviation services, and we'll talk more about this when we have our Investor Day; we view this as a bundled services offering, so this is a big part of our value proposition and how we're driving growth in the market. It is the part supply related to our parts program related to the MRO, we view all of those is working together to offer a bundled solution to the customer. And as you know, that model has been quite successful if you look at the growth in aviation services over the last several years.
Sure. But of course, the hallmark of this whole thing is that it's all been growing and the idea was that third-party outsourcing on the labor side would be a trend that continues. And it sounds like you're sticking with that, you've just got this hiccup with the labor but I guess we also wanted to make sure it isn't something structural about third-party?
No, I don't see it as structural. I think you're exactly right, I think this is a moment in time in the market and we're in the process of finding a new equilibrium between the rates that we charge the customers and the rates that we have to pay in order to feel the qualified team of mechanics.
And then just to put a finer point on it now that you've told us that MRO contracted; how many quarters has that been the case?
That's been the case this fiscal year.
The whole fiscal -- so, all 3 quarters?
Yes.
Thank you. And our next question comes from Larry Solow with CJS.
Most of my questions actually have been answered but I'll ask a couple in certain different ways. So, on the reduction of the guidance so that the $15 million, $20 million EBITDA you're reducing I guess [ph]. It looks like it's -- I think a couple of questions to that. Is it solely from the labor shortage, so really, exclusively MRO and maybe a tiny bit in mobility or is everything else -- and everything else, for us the business sounds like doing well, that is all sorts of [indiscernible] expectations?
Yes, Larry, you've got that right. I mean, the -- it's coming from the labor businesses which are the hangars, and mobility is the manufacturing, that's what's driving it.
And mobility is still doing pretty well…
Yes, exactly. I mean, the overall growth of the company is still -- we've still got mid-teens growth and again, the programs businesses and the parts businesses continue to perform well about the expectations that we had.
And the outlook for the programs businesses, a lot of them just remind us, obviously adding new program wins is great but a lot of these programs are still sort of not fully ramped, so it seems like there is some visibility on them assuming the environments -- aviation environment [indiscernible], they should ramp further?
That's correct. Several of our customers that we have contracts with, their fleets will grow and so we'll see additional ramp on business that we've already won. And that's with the programs businesses, we've also over the last couple of quarters continue to sign a number of new parts distribution businesses with different OEMs and those are all in various stages of ramping up as well, and that's another area of the company, the new parts distribution area of the company which is contractual on the buy. In other words, we have contracts -- long-term supply contracts with the OEMs but in a lot of cases, it's also contractual on the sell; in other words, we have long-term supply agreements locked up with the airline customers that we serve or the government customers that we serve. And so that's a nice sustainable growth business that's more easy to forecast.
And then on the INL contract, I know you guys -- you rather not quantify and I understand. Is it fair to say it's sort of running in that plus or minus $200 million annualized revenue number?
It will be a little below that this year. So if you look at the last couple of quarters that we did disclose, we're in the high 40s. So it will be below the $200 million for this fiscal year.
And then on Costa Rica, I know -- again, I think this is your sixth site, right? You had five sites already, is that correct [ph]?
It's the fifth operating site.
So there were four sites. So we're out -- is it half the size plus or minus, is that a good way to look at it, they are average of the other four or…
Yes, we prefer not to get into that but it will not be the largest site.
But it's more than a rounding, I mean it sounds like it's double-digit millions in annual sales at least or contribution.
Fair.
Fair enough. How about just a color on proceeds that you expect from -- to share the COCO assets? I guess, maybe we can figure out what you had valued in your balance sheet before and what you wrote off? But -- could you share anything in terms of what you expect from proceeds of that -- is that a material number or not?
Not yet, we're -- we still have some assets that we're looking to sell. So once that's all wrapped up, we'll disclose those amounts.
And then it seems like you've gotten sort of plus for Q4 similar performance, at least in the top line and maybe a little better on the bottom-line, that looks like -- the range is from -- do my math correct?
Yes, that's right.
And then we surely assumes a normalized tax rate is like 24% mid-20s?
Yes, 23% to 24% is what we think on the tax rate.
Just last question; you guys -- I think you announced, you had got some [indiscernible] similarly, the Asia. Could you just help us, I'm sure this is more of a longer term opportunity but actually what that market could be for you guys in say 3 to 5 years or something?
On the government side we've actually got a lot of good things going on in Japan, we do quite a lot of new parts distribution to the JMOD, the Japanese Ministry of Defense. And we've got -- because of that we have a growing of footprint in Japan in terms of an office there. And we have had contracts with various Japanese commercial customers over the year, having the ability to issue tags on repair parts, attendance to some of these other opportunities that we have in Japan is a positive. So it's a target market for us, the store [ph] has been a really good market for AAR. We saw some -- it kind of ran away from us in recent years but we've had a renewed push and get in the JCAD [ph] approval is a good step in the right direction.
Thank you. And our next question, we do have a follow-up from Ken Herbert with Canaccord.
I just wanted to follow-up on -- again, this MRO; I don't mean to keep harping on this but presumably, the business in these airlines are going somewhere and as you've sort of had a bit of a disruption, do you expect any issues at higher prices sort of winning some of this work back or sort of taking share as you're able to bring the talent on? Or I guess, how do we think about that and sort of timing issue or these customers ideally not representing any sort of permanent section but how do we think about that competitive dynamic as we're able to bring the people back on?
It's important to note that as we've been going through this over the last few quarters, we have not lost a single customer. We have had work or lines of work that we have had to turn away at certain of our facilities because we just didn't have the labor to handle them but the customers, overall, are sticking with us; and not only are they sticking with us, they are very supportive of AAR, we deliver a quality product, we're the largest in North America as you know, and we are a vital part of this part of the aviation aftermarket support system. And so the dialogue that we've been having is one around, "what do you think you need from us in order to feel the teams so that we can keep the work with you", and we've received a lot of support in that regard.
In terms of where the work is going, there is a number of larger and smaller MROs in North America, that work has been kind of moved around based on things that we've had to turn down depending on where we were in the labor retention area but the customers are supportive. And it's also important to note that we've got -- we do have long-term contracts in place with most of our larger MRO customers and so we've got mechanisms to keep the work.
And I'm assuming most of the work or the lines that you haven't been able to support have been either regional jet or narrow-body aircraft, correct?
That's correct.
Just one final question; you used to talk at the beginning of the fiscal year around roughly sort of 50% cash conversion on the EBITDA or did it ever take sort of $90-ish million for the full year? I mean, clearly these issues have -- maybe pushed that to the right but can you just provide any update on expectations for the fourth quarter in terms of what is typically a very strong quarter for you in terms of cash generation; how we should think about the fourth quarter or think about the full year conversion if you can sort of update that, that would be great. Thank you.
I think we expect in Q4 as you mentioned is usually a pretty strong quarter for cash flow, so I think we'd expect continued strong cash flow growth in Q4 but as it relates to kind of the full year and that 50% EBITDA target, that's not something that we think we're going to be in but we think we'd be cash flow positive for the year as we've mentioned previously.
Thank you. Speakers, I'm showing no further questions in the queue. I'll turn the call back over to you.
Okay. Well, again, we appreciate everybody's time and interest, and we look forward to wrapping up our fiscal year. Thank you very much.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect and have a wonderful day.