Description

AAR announced the sale of Telair, its cargo systems subsidiary, for $725mm, or 13x trailing EBITDA, last week.  Despite selling a business that comprised 25% of EBITDA for 40% of the entire company’s enterprise value, AAR shares are virtually unchanged from their close prior to deal announcement.  We thought the shares were cheap before the deal announcement.  Factoring in accretion from the deal, the current valuation simply makes no sense to us.  Shoddy sell-side analysis and a general lack of familiarity with the business has led to, what we believe, is a compelling “fat pitch” opportunity which we detail below.

Summary

AAR Corporation, the leading outsourced aircraft maintenance, repair & overhaul (MRO) provider in the US and the third largest globally, provides FAA-mandated MRO work and supply chain management to airline operators, cargo carriers, and the military.  AAR is a high-quality, cash-generating business that has suffered through a number of headwinds (no pun intended) over the last 3-4 quarters which have obscured attractive dynamics taking place in their business.  AAR is underfollowed and misunderstood, a fact that has become more apparent after shares traded down following the announcement of the highly accretive sale of subsidiary Telair.  In addition to economic upside from the Telair deal, we believe subsiding headwinds elsewhere in AAR can drive 25% EBITDA growth over the next 8 quarters.  Comps for each of their respective businesses trade anywhere from 8-12x, yet pro forma for the Telair transaction, AAR is now trading at 6.3x trailing EBITDA.  Using an 8.0x multiple on FY 2017 EBITDA, we value AAR shares at $55, or over 75% upside from current levels.

Fuzzy Math and The Sale of Telair

620 – 425 = 0

This is the math the market is applying to the Telair deal.  And while some may dismiss this as exaggeration, we think you may re-consider after talking to some of the sell-side analysts that cover AAR.

First some background.  Telair manufactures aircraft cargo loading systems and comprises the vast majority of AAR’s Commercial Technology Products segment.  Telair has been a great business for AAR since it was acquired in December 2011 for $280m.  It’s one of two players in a duopoly that has benefited from increasing aircraft production, recently growing revenues at 20% annually at 20%+ EBITDA margins.

Rumors first surfaced in early December of a sale for Telair in the $700-800mm range.  The deal that was ultimately announced was in-line with those expectations: the business is being sold to Transdigm for $725mm, or 13x LTM EBITDA.  In addition, AAR announced that it would seek to divest itself of its unprofitable Precision Machining business.

From what we can tell, this is a homerun deal.  Based on our call work, we believe AAR could be selling this business at near-peak cycle earnings.  The sale also divests AAR of a cargo systems contract for the Airbus A400M, a program which would have been an earnings drag going forward.  The transaction revalues $57mm of EBITDA that was previously being capitalized at 7.5x to 13x.  If those reasons aren’t enough, flipping a business they acquired for $280mm only three years ago for $725mm isn’t too bad.

So after trading a business valued at $425mm for over $620mm in after-tax cash proceeds, why is AAR worth the same as it was before the deal was announced?  We reached out to three of the five sell side analysts that cover AAR to get some color.  Here’s a sample of the fuzzy math we encountered in their analysis:

·         One of the analysts called the deal dilutive because earnings would be lower.  When we pointed out that he failed to account for most of the cash proceeds from the transaction in his valuation, his response was: “well, we don’t know what they’ll do with it yet”.

·         Us: “They’ve traded a business valued at $425mm for over $600mm in cash, AND you’re now applying a higher multiple on the remaining businesses.  How could you be getting to the same target price?”  Analyst: “I see your point.”

·         When we asked another analyst why he wasn’t making any adjustments to interest expense in his pro forma eps calculation used to formulate his target price (his assumption was cash would be used to pay down debt), his response was: “because the interest savings will be offset by the make-whole payments they need to make to prepay the debt.”  We almost felt badly mentioning that one is a one-time cost while the other an ongoing earnings savings.

To drive the point home, one of the sell side analysts we spoke with wasn’t even sure which businesses were in which segments.  Now, part of this is due to poor disclosure by the company (which we discuss in more detail below), but in general this business is underfollowed and neglected.  The market has missed this deal and the potential for material earnings growth over the next few years.  Pro forma for the Telair transaction, AAR now trades at 6.3x LTM EBITDA, which is lower than the 7.5x it was trading for before this deal was announced.  For reasons we dive into below, we believe AAR shares are significantly undervalued at these levels.

Segment Breakdown

Disclosure for AAR is poor.  The Company offers a somewhat unhelpful view of their business segments in source filings, choosing to divide their business into Aviation Services and Technology Products although there are 9 different sub-segments according to our analysis.  We are all for short reads, but the entire “Business” section of the 10K is four pages.  We note that current management is aware of this lack of disclosure and is strongly considering improvements in the future.  We’ve done a substantial amount of call work to get a sense for how revenues break down by service.  We’ve also crosschecked this against historical filings where disclosure was a little more forthcoming.  To be clear this was a mind numbing exercise and while we have faith in our final result, it is not exact.  We’ve also confirmed with management that these estimates are all in the ballpark and good enough for purposes of understanding earnings trajectory from here.  Note, we don’t break out the Technology businesses by service since the Technology Commercial piece is being sold anyway and the Technology Defense piece is too small for precision to matter.  Here is our lay of the land (pro forma for the announced sales of Telair and Precision Machining):

Why We Like AAR

The aircraft MRO industry is a classic outsourcing story that has been catalyzed by the bankruptcies of the major American airline operators over the last 15 years.  The re-organized airlines were able to come out from under the onerous labor agreements that precluded many of them from making key outsourcing decisions sooner.  It made sense to outsource MRO work since scale providers like AAR can often do what is a labor-intensive function faster and at up to half the cost with non-union employees.

AAR has consistently taken share within this growing market, becoming the leading aircraft MRO in the US with solid results over the last ten years.  AAR benefits from reasonably high barriers-to-entry as reputation and track record are paramount given the high cost-of-failure nature of the work, or as a banner in AAR’s Miami facility reminds employees, “Passengers & Crew Stake Their Lives on Our Work”.  We’ve spoken with five of AAR’s largest MRO customers, all of whom agree that it’d be difficult to switch work away from AAR, with one major customer commenting “even if we wanted to switch, there really aren’t many MROs out there that can handle the type and volume of work we need.”  All have said they plan to spend more with AAR over time.  In addition, favorable long-term lease agreements with the airports that own the hangars and low capex requirements mean that this otherwise low margin business generates a respectable low-teens after-tax return on capital.  Going forward, we believe a number of recent headwinds are subsiding and positive dynamics are emerging, setting AAR up well for the next several years.  First the positive dynamics that are emerging:

·         A highly valuable Supply Chain Management business that’s on fire – AAR Supply Chain is one of the largest players in the secularly growing aircraft supply chain industry and, as one of only a handful of scale players, is taking market share.  This business deals primarily in the distribution, management, and maintenance of new and aftermarket rotable parts for airlines, MROs, and parts brokers.  Like most distribution businesses, it benefits from scale and requires little capex to fund growth.

This is a fantastic business; comps fetch EBITDA multiples in the 12-14x range, including the sale of AAR competitor Wencor in 2014 for 12.5x-14x EBITDA and Aeroturbine in 2011 for 11x-12x EBITDA.  Pro forma for the Telair and Precision Business sale, we estimate that Supply Chain will make up over 50% of AAR’s total EBITDA.  But most investors won’t know that because, inexplicably, the company decided to recast its business segments two years ago, lumping Supply Chain together with MRO and throwing them both into a non-descript new segment called Aviation Services. 

We think it’s only a matter of time before the Supply Chain business shines through this fog, helped by what we expect will be better segment disclosure.  The business has been on fire lately – revenues have grown 15-20% year-over-year the last several quarters and are expected to continue to grow at the same rate for the balance of the year, although we are not modeling this.  We spoke with one of AAR’s largest supply chain competitors to get a better sense for what’s behind the acceleration, and his comment was that while AAR was the “goliath” in this space for a long time, they had recently taken their eye off the ball as they turned their attention to their Defense businesses.  He added, however, that AAR had “re-awakened” and that they’re back with a vengeance.  A few of the big moves AAR has been making as part of this renewed focus in the past year include: 1) winning big contracts from Delta and Air Canada which added critical mass and important reference accounts, and 2) the acquisition of a Brussels facility in March 2014 that opened the door for AAR to establish new supply chain relationships with European and Middle Eastern carriers.  Our call work suggests that this business should continue to grow at a 10-12% CAGR and ultimately reach 20-25% gross margins from the high-teens, contributing roughly $39m of the $59m of incremental gross profit we are projecting in FY2017 versus LTM.

·         American Airlines is the last airline to emerge from Chapter 11 and they’re probably going to start outsourcing – American emerged from bankruptcy via a merger with US Airways in December 2013.  American, which is the largest US airline, hasn’t outsourced its MRO work in any meaningful way yet.  While there is still some pushback from folks within American, we believe the economics of outsourcing, which can halve the costs of maintenance, make it inevitable and many who we spoke with in the industry agree.  American has already closed facilities in Kansas City and Dallas.  When and if American outsources in earnest, we believe AAR should win its fair share.  Since this opportunity is impossible to quantify, we are not modeling the capture of any American Airlines MRO business, and instead view it as an attractive free option.

·         Ramping up of AAR’s facility in Lake Charles, Louisiana – AAR’s sixth hangar was brought online last year and adds nearly 30% of capacity to AAR’s airframe maintenance business.  Importantly, this facility is built to handle widebody aircraft, almost all of which have historically been sent out of the country for maintenance due to much lower labor rates overseas (primarily Asia).  Labor rate differentials have narrowed and numerous people within the industry we’ve spoken with agree that widebody work is coming back.  The Lake Charles facility positions AAR well to capture this opportunity.  Management has stated that this facility can ramp to full capacity in 2-3 years.  We are modeling only an incremental benefit from Lake Charles over the next few years to be conservative.

·         Low oil prices are a tailwind – we don’t pretend to know where oil prices are heading, but as long as they’re low, airlines will fly older planes that require more maintenance for longer (some are even considering re-activating idled planes).  Any impact on passenger miles flown will also clearly be positive.

Recent Storm Clouds are Parting

So if AAR has been on a roll, why haven’t recent results reflected that?  Well, AAR isn’t all MRO and Supply Chain.  Over the last 5 years, it’s grown into other businesses, both organically and via M&A.  Three of these businesses have been causing the company a ton of heartburn over the last 3-4 quarters, but we believe these headwinds, which have obscured some of the good things that have been happening, are subsiding.

Airlift at an Inflection Point

Despite now only representing ~10% of overall revenues, Airlift has been the biggest headline risk to the AAR story over the last year.  Airlift operates a fleet of fixed and rotary wing aircraft and is contracted by various militaries (primarily the US DoD) to transport people and supplies to bases around the world.  Acquired by AAR in 2010 for $200m, Airlift had a great run during heightened operational readiness and aircraft activity in Afghanistan.  Only a few years ago, Airlift was operating over 40 active aircraft, 38 of which were based in Afghanistan.  But since US withdrawal from the Afghan war theater, Airlift results have fallen off a cliff.  This business has come down with the US drawdown in this region – Airlift is now down to 19 active aircraft and Defense Aviation Services revenues have declined 28% year-over-year the last two quarters.  While bad enough, management has done a terrible job of providing guidance for this business, leading to several “miss and lower” quarters its last fiscal year.

There are a couple of reasons why we believe this business has or is close to bottoming: 

·         Of Airlift’s 19 active aircraft, only 7 are now in Afghanistan.  Based on our call work, we believe this number reflects what will be the ongoing aircraft needs for the US military’s new baseline of Afghan activity going forward.  In short, we believe Afghanistan declines are bottoming. 

·         Protests related to two Africa Command contracts have only recently been dismissed and activity on these contracts is now underway.  In addition, a recently awarded 10-year contract with the UK Ministry of Defense is starting to ramp.  We believe these contracts could add 3-5 active aircraft to Airlift in the near-term.

·         17 of Airlift’s idled aircraft are up for sale.  Management expects to net $80mm of proceeds over time, none of which we’ve accounted for in our model.

During the Telair sale conference call, management lowered Airlift guidance once again.  While Airlift will likely suffer a few more hiccups near-term as it ramps up work in Africa and reaches a steady-state in Afghanistan, we do believe this business is close to stabilizing, removing what has been the biggest headwind and distraction to the overall business in recent quarters.  We are assuming Airlift rises from 19 active aircraft position to 23 by the end of FY2016 (6 quarters from now), with no additional active aircraft beyond that point (versus the 30 aircraft management ultimately believes it can achieve and the 40 it achieved at peak).  This represents incremental gross profit of roughly $5m through FY2017.  Above and beyond our forecast of 23 active positions, we believe each active aircraft can generate an incremental $2-3mm in run-rate gross profit.

Landing Gear Services Is Coming out of a Cyclical Downturn

Landing Gear maintenance runs on a 10-year cycle mandated by the FAA.  In other words, aircraft are required to come in 10 years after they’re delivered for landing gear maintenance, so there is relatively clear visibility on future business based on historical deliveries.  This means that during fiscal years 2013 and 2014, AAR’s Landing Gear MRO, which runs out of a 128,000 square foot facility in Miami, was working through an air pocket that the industry suffered in 2002-2004 when aircraft deliveries dropped cumulatively 30% following 9/11.  We spoke with the facility manager in Miami who confirmed that, indeed, the facility has been running at ~55% utilization, approximately 30% below normalized utilization of 80%.  While the revenue impact was significant, the margin impact was magnified; unlike the airframe maintenance business which has a large contracted labor component, labor costs in the Landing Gear facility are more-or-less fixed.  In fact, we believe this business may now be close to break-even, which would explain the margin decline in the Commercial Aviation Services segment in 2013-2014.  The good news is, after bottoming in 2004, aircraft deliveries grew nearly 50% from 2005-2007.  Assuming 70% incremental gross margins on this business, which we believe generated roughly $130mm in LTM revenues, getting back to 80% utilization could translate to $25mm of incremental gross profit over time.

Engineering Services Declines Have Also Stabilized

The Engineering Services business is lumped into the Commercial Aviation Services segment and comprises approximately 10% of segment revenue.  This business involves the outsourced engineering and design of aircraft interiors, as well as the implementation of those designs.

In 2013, AAR won a big contract to re-engineer the cabin interiors of a fleet of Boeing 717 aircraft Delta purchased from Airtran.  Management execution issues, however, led to a decline in backlog and when this contract rolled off, there was no new work to step into the gap.  This led to revenue declines in this business of over 50% year over year in FY2014.  This upcoming quarter marks the anniversary of the Delta/Airtran contract completion, and with a new contract win from Hawaiian Air, Engineering Services is expected to stabilize sequentially.  To be conservative we are modeling no growth in this business for AAR going forward despite this generally being a growing niche in the industry.

Valuation

We think, pro forma for the sales of Telair and Precision Machining, AAR can generate 25% EBITDA growth through the end of FY2017.  Our bridge from LTM to FY2017 is below:

Per management, the Telair business incurred approximately $20mm of program development cost amortization related to the A400M contract that was not being added back to most estimates of EBITDA (convention in the aerospace industry).  These costs leave with the sale of Telair.  Our estimate of current LTM EBITDA and the $57mm of Telair LTM EBITDA adds these costs back.

Applying an 8x multiple to our $220mm EBITDA estimate for FY 2017 implies a share price of $55; over 75% upside from current levels.  Our 8x multiple is also roughly in-line with the midpoint of where AAR has traded over the last five years. 

Sum of the Parts

A sum of the parts analysis supports our 8x multiple and suggests it could even be conservative.  While there are no great comps for AAR as a whole, there are a decent set of comps and precedent transactions for each of AAR’s business lines.  We went back to historical filings when disclosure was actually a bit better to make some assumptions on D&A allocation, while for SG&A we simply make a rough allocation by share of revenue.  Again, not perfect, but we think we’ve arrived at a reasonably accurate picture of the EBITDA mix of the various businesses.  As our analysis shows, AAR is currently trading 2 to 2.5 turns of EBITDA below where it should be.

A few points to note:

·         We are valuing Airlift at $200mm, or what AAR paid for it when it acquired the business in 2010.  While the business has declined, AAR has also invested over $150mm in aircraft that have some realizable book value.  We think $200mm for Airlift is a fair, if not conservative, estimate.

·         We are crediting the Technology Commercial business for the $5mm of EBITDA loss we estimate the Precision Machining is currently generating, but none of the expected proceeds from the planned sale of the business.

Catalyst

Rebound in any or all of Airlift, Landing Gear Services, and Engineered Services businesses

Market recognition of the valuation impact of the Telair sale

Debt paydown and/or buyback with Telair proceeds

Improved segment disclosure