AAR Corporation (AIR, Financial) is a diversified provider of products and services to the worldwide aviation and government and defense markets. It is an integral piece of the airline industry with supply chain logistics, cargo carriers, and services to the Department of Defence.
According to the company’s recent 10Q, they recently sold of “Telair Cargo” systems business, to TransDigm Incorporation for $725 million, will dramatically alter their business and capital structure. The meagre of sell-side coverage is presenting a compelling long opportunity as many of the issues plaguing the business subside. It has been deduced that there would be a steady growth in an industry with large tailwinds. The company's performance should be reinforced by infusing strategic acquisitions which utilizes their large free cash flow.
Business outlook
AAR is one in all the premier companies within the area with robust market share in the US. The business lends itself to semi-permanent contracts that promote barriers to entry. After the consolidation in the airline industry, the top five airlines now comprise over 90% of the total domestic market. We believe that is continued to extend the company's competitive fosse as there are few players that can compete with that amount of volume.
After the deregulation in the airline industry, industry continues to move towards outsourced MRO, I deduce this can profit AAR from a long-term tailwind – both domestically, and in international expansion. There are some airlines like American Airlines who has not outsourced their MRO operations due to their captured subsidiary, AA-MRO. This is the commercial arm for the maintenance and engineering division. As the world's largest airline, I expect they will eventually turn out their MRO business into a separate entity and allow both AA and their MRO business to compete independently. If that happens, i believe then AAR will be more beneficiary.
Just like the automotive industry, the suppliers of aircraft aftermarket elements have seen a hefty increase in demand due to industry dynamics. This occurred with a consolidation inside the industry throughout and shortly once the recession as many exited the business, went bankrupt, or merged. There are now just a few large players in the space, benefiting staggeringly from scale and pricing power.
Reshaping of large premium and capital structure after Telair sale
The company recently sold off its Telair Cargo Group to TransDigm for $725 million in cash and generate net cash proceeds of approximately $600 million after cash taxes and other expenses. AAR bought the Telair business aback in 2011 for $280 million which they have originally grew through the consolidated cargo loading business duopoly. The business growth was extremely well at 20% per annum. I am convinced with the fact that, management proved themselves to be astute capital allocators by selling a growing asset where they generated a large premium selling price at 14x EBITDA generation.
According to the news published in the prnewswire management has already stated that they will use the sale proceeds to redeem its $325 million 7.25% senior notes beginning April. The redemption of these notes in addition to upped availability of their revolving credit facility to $500 million, I conclude interest expense savings of between $20 and $25 million per year, improving net income and free cash flow by 12% immediately.
In addition, the company discontinued two money-losing businesses including its Precision Machining segment as well as an unprofitable Airbus contract. The business should see an overall re-rating as it exchanged a $400-450 million business for approximately $600 million in addition to two unprofitable assets. I determine that market is missing the fact that earnings growth will be inflecting higher on lower interest payments and less headwinds from two unprofitable pieces.
Other businesses starting to inflect
A report from beforeitsnews.com revealed that the stand-alone MRO businesses have all seen their shares increase much more than AAR, I believe because of the other segment that AAR operates. The company's airlift business has been a low-margin, contract-based business that it acquired in 2010 when it purchased Aviation Worldwide Services.
In mid-March, the company was awarded a contract by the United Nations for airlift services in Central Africa. The contract is valued at $19 million. The purpose of the contract is to provide passenger and cargo air charter services in support of the MONUSCO operation in the Congo. This is a three-year contract starting in July 2015 with extended options. The market basically blew off the award as miniscule and likely low-to-no-margin.
However, I am convinced with the fact that, market is missing the potential for new opportunities for the company. It is the UN's first U.S. operator for such a contract and we think it could aggravate into additional business down the road, both within the UN charters and outside for other jurisdictions and authorities, including the U.S. government.
The airlift business, overall, has been struggling through a transition process as its Afghanistan mission winds down. They started last year's third quarter with 35 flying positions and ended last year's third quarter with just 25. Today, they have just 19 flying positions but expect to be at 21 by the end of their fiscal year (May 31). They are currently in rotation of assets and while the UN contract is just one flying position, it is the start of what we believe to be full rotation towards non-Afghanistan business. They also realized a two aircraft placement with the British Department of Defense which is a 10-year contract.
In addition, management is looking to offload some of its idled aircraft that are coming out of Afghanistan. But in the most recent call, it noted that it had some assets that it had classified for sale that it pulled back into inventory because it thinks there is a better opportunity picture for placing those particular assets. The airlift segment is approximately 10% of sales, but we believe will turn from being cash flow negative to positive and boosting overall margins.
Outside of airlift, the engineered services business has also seen some weakness as a large contract was completed and they didn't have any other wins to offset it. But, if you back out that one contract, we believe that the business is growing overall and likely to grow mid-single digits through 2018. They had recent wins with from Pratt & Whitney to enhance the U.S. Army contract to upgrade and overhaul auxiliary power units (APUs) for its UH-60 Black Hawk helicopters. In the interim, I estimate that company right-sizes the segment and boosts out the margins mitigating the organic top-line declines following the roll-off of that large contract.
Valuation
Backing out the Telair and Precision Manufacturing businesses, the company generated approximately $223 million in EBITDA. I conclude that re-portray business along with better airlift margins due to un-utilized asset sales, should carry stronger profitability. While I believe that next few quarters may still be a transition period as they continue to right the airlift business, we think by the end of fiscal 2018, they will be experiencing much stronger EBITDA growth and margins of around $254, which is not reflected in the current share price.
The Telair business was approximately 25% of the total EBITDA of the company and has been a strong growth driver over the last two years. We think the market is discounting the remaining piece of the business as stagnant growing. However, due mostly to enigmatic reporting by management, I envisage that MRO and supply chain businesses will provide a better overall growth direction and powerful incremental EBITDA on higher margins. Additionally, the airlift business will not be as large a drag on the consolidated results.
The company should go from a net debt position of approximately $576 million to a net cash position of between $30 and $60 million increasing to ~$100 million in fiscal 2016. The company has already started buying back shares including a $135 million modified Dutch auction tender of not less than $29 and not more than $32. If completed in full, it would reduce shares outstanding by approximately 10.7%.
The market appears to be discounting the recent Telair transaction and its effect on their capital structure and financial flexibility. While the airlift business is still right-sizing, I believe that, margins will increase as they sell excess capacity eliminating a further headwind from the business. My model assumes no further benefit outside of the UN and UK awards, which we believe provides an upside surprise potential. If the company sees further traction in the airlift operation, or their engineered services business which has also has been struggling as of late, shares will jump accordingly.
Conclusion
I conclude that AAR Corp. is largely being ignored for the larger distributors. The lack of any high-end sell-side coverage along with a few non-MRO pieces that are in transition, have clouded what is otherwise a very strong organic grower in a space that has significant secular tailwinds. I believe that company can grow EBITDA by 11%+ over the next three to four years on a pro-forma basis ex-Telair. But I think the bottom line can grow close to 25% per year when excluding interest expense savings and a massive share buyback program. My working result the shares are worth approximately $36.50 a piece by the end of next year for appreciation potential of 23.2%.
Disclosure
I don't have any investment in the aforementioned stock, nor do I get paid from the aforementioned stock company to write, and I have no plans to invest in the stock for the next 72 hours.
The above details are taken from the company filings 10K, 10Q and from some of the news website are considered whose reference link is already given in the findings.
