I’m torn…

AAR Corp. (NYSE: AIR) reported earnings yesterday after the market closed and followed that up with their analyst conference call before the market opened today.

The reason I’m torn is because I honestly don’t know what to do with those results and AAR’s future prospects.

A part of me believes that the business is a lame duck, and will take so long to recover, that we won’t see any meaningful move in the company’s stock price for some time if at all.

The other part of me believes, especially at current levels, AAR’s stock is such a supreme bargain, that it won’t be long before value hounds come calling, and the overall market for the Aerospace and Defense industry, and consumer air travel in particular, come roaring back, and we could be in the midst of a nice little bull rush and reap the rewards of our patience in the turnaround that is ahead.

So why am I so baffled?

There’s many reasons, many of them chronicled within this post, that have led me to this place.

In this post I’ll break down AAR’s full earnings release, as well as their analyst conference call, and round out my post with what you should do with AAR’s stock.

New to the AAR story?

AAR Corp. provides products and services to the aviation, aerospace, and defense industries worldwide.

It operates in four segments: Aviation Supply Chain; Maintenance, Repair, and Overhaul (MRO); Structures and Systems; and Aircraft Sales and Leasing.

Through its Aviation Supply Chain and MRO segments, AAR provides everything from aircraft parts, maintenance and logistics support, to the actual maintenance and repair of aircraft at its 4 MRO facilities at various locations throughout the U.S.

In addition, through its Structures and Systems segment, AAR provides vital products and services to the U.S. military including specialized construction of mobile shelters and pallets, as well as support and products for various military aircraft and aircraft support, storage and maintenance functions.

Finally, through its Sales and Leasing segment, AAR buys, sells and leases used aircraft for itself, on behalf of others, and through joint ventures.

Want More?

• Read: My first post about the FAA shutting down AAR’s landing gear facilities here.
• OR: my second post detailing how AAR was cleared to reopen those facilities here.
• OR: My latest company analysis and quarterly earnings breakdown here.
• OR: Read why I recently added to my AAR position by clicking here.

Get updates you WON’T find on PeakStocks.com by following me on Twitter.

I’ll break down this report into 4 parts:

• Hit Me With The Numbers: Sales miss by 10%, margins decline, where’s the cash?
• Other Business Highlights: Weakness in Aviation Supply Chain, MRO
• Conference Call Highlights: Management Discusses Improving Business Trends
• Bottom Line: Buy On Valuation, Hold Otherwise

Hit Me With Some Numbers

Sales miss by 10% due to Sales and Leasing Segment, margins decline

(Growth from previous year’s Q3/analysts estimates where applicable):

• Quarterly sales of $338.8 million (down 10% from $376.6 million prior year/vs. $366.2 million projected by analysts)
• Quarterly income from continuing operations of $20.0 million (flat from prior year)
• Quarterly earnings per share from continuing operations of $0.48 (up 2% from prior year/vs. $.46 projected by analysts)
• Q3 Gross margin of 19.1% (up from 18.7% in the prior year, but down sequentially from 19.8% in Q2/09)
• Q3 Operating margin of 8.7% (down from 10.1% in the prior year, and down sequentially from 10.2% in Q2/09)
• Retired $6.5 million in convertible notes for $4.3 million, equating to a 9% yield to maturity
• Backlog decreased to $580 million from $600 million as of November 30th, which was up from $500 million at August 31, $465 million at May 31, and $310 million at August 31, 2007.
• Operating cash flow: (-$16) million
• Sales to Defense customers increased 3.6% down from 32% in Q2/09. Defense business now represents 44% up from 43% in Q2/09, up from 40% in Q1/09.
  

My Take: AAR tries to make a clear distinction between its sales this quarter compared to last quarter on an apples-to-apples basis.

In order to make that comparison however, AAR is stripping out results from its Aircraft Sales and Leasing segment, and then stating rather conveniently, that taking away those comparisons, AAR’ sales were essentially flat when compared to last year.

Let’s take this in 2 parts:

1) So, AAR is touting the fact that sales are flat? Is that really something to be proud of when AAR has garnered higher revenues in terms of sales from government orders and contracts, as well as their acquisitions over the last couple of years?

2) As investors, can we conveniently strip out one of AAR’s 4 business segments to gussy up the numbers?

Personally I don’t think so.

There’s no two ways about this: AAR’s sales have declined.

Business is slowing, airlines are not just cutting back on maintenance and overhaul procedures, but they are also decommissioning older aircraft at alarming rates, such that AAR’s services are being underutilized and might be for some time to come.

Further proof of this is the very fact that AAR in their press release stated that:

“In response to market conditions, we have deemphasized our Aircraft Sales and Leasing business. We have not acquired any aircraft for lease since November 2007 and are committed to further reducing our investment in our aircraft portfolio.”

Later on the company then states:

“Consistent with our reduced emphasis on this business, the Company is considering combining the activities of this segment with the Aviation Supply Chain segment beginning next fiscal year.”

In other words, not only is AAR unable to sell or lease these older aircraft, which I will remind readers was a booming business not too long ago whereby the CEO stated that he had never seen business this robust in this segment, but the company is now tacitly acknowledging that the business of buying, selling and leasing older aircraft may have seen its heyday and be coming to an end.

We cannot simply “remove” results from AAR’s declining segment to make their overall numbers look better, because odds are, this segment is in a secular decline, and therefore, never going to fully recover, and thus AAR’s results and expectations and outlook have to include this stark reality.

Bottom line: While the quarter was not as bad as analysts were obviously expecting, it wasn’t a good quarter either.

In addition, once again, as they always do, AAR makes their profit numbers by pushing the pencil around and taking some debt off the books which allows them to claim a tax gain which shows up on the bottom line.

The fact remains, AAR cannot hide that their top line numbers were weak, however they want to look at them, and more to the point as far as I was concerned when I previewed earnings a few days ago, where’s the cash flow?

AAR talked about expanding inventory, but I don’t see why inventory would be expanded when the company is facing deteriorating sales conditions?

AAR did not provide a cash flow statement with their earnings (the CEO mentioned that they spent $16 million in operating cash flow), and we’ll have to wait for the 10-Q to see the grimy details, but it looks like yet another quarter of negative cash flow.

I am not at all happy about this.

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