Value Investors Club / AAR CORP (AIR)

Description

AAR Corp (NYSE: AIR)

Shares: 34.3mm

Price: $35.5

Market Cap: $1,218mm

Net Debt: $147mm

TEV: $1,365mm

Summary: AAR Corp is a sum-of-parts (good company/bad company) story that has a strong catalyst in

2017. The Aviation Services segment is a growing business with a high incremental ROI worth more than

the total enterprise value. The Expeditionary Services segment has been a disaster for three years and has

produced consistently negative EBITA over that time. The Expeditionary Services business is being valued

at a negative value even though the long journey regarding the INL/A contract should come to a close

soon. That, combined with the guidance as to the profitability of the Expeditionary Services business, will

provide the catalyst to a revaluation.

The basic thesis is that the Aviation Services business is worth $1.4bn, and the Expeditionary Services is

worth $600mm once the INL/A contract is implemented.

Background: AAR has gone through significant changes over the past several years, and its valuation has

suffered due to the confusion. 2018 (or FY 2019) will finally see this confusion clear. First, AAR has

significantly simplified its businesses to two segments. It sold off or closed non-core businesses. Second,

the Expeditionary Services business is extremely lumpy and a core contract (Afghanistan) volume

plummeted three years ago. Management had expected the two major wins (Falklands and INL/A) to bring

the business back to profitability a year ago, but legal fighting by the incumbents (esp regarding the INL/A

contract) has delayed this resurrection.

Financials:

The financials are complicated for several reasons:

1) The cash flow statement is difficult to follow. The best way to understand is that Depreciation

plus Amortization of Overhaul Costs is essentially maintenance capex. Further, Amortization of

Overhaul Costs are completely associated with the Airlift business.

2) SG&A is not broken down between the segments. We offer a detailed analysis below. If anything,

we believe that this over-allocates SG&A to Aviation Services.

3) There is an extreme amount of operational leverage in the Expeditionary Services business model

as many resources have been kept after the contract loss three years ago with the expectation of

quickly ramping up with a new contract win.

4) The Aviation Services segment is lumpy and the Expeditionary Services segment is extremely

lumpy. Single contract wins and losses can significantly change growth rates and add non-

recurring expenses.

a. The Aviation Services is rolling off the KC-10 contract while rolling on the Air Force landing

gear contract and several other new wins. FY 2018 will be a flat year due tothe lumpiness,

but there will be 5+% top-line growth over time.

5) In particular, 2017 SG&A included an abnormal amount of non-recurring SG&A due to the INL/A

contract.

a. Management has discussed this, and there is over $20mm of non-recurring SG&A.

Aviation Services

Let’s start with this segment because its financials are straightforward:

Revenue FY 2017: $1,485mm

Gross Profit: $246mm

SG&A: $130mm

EBIT: $116mm

Amort of Intangibles: $5mm

Depreciation: $26mm

EBITA: $121mm

EBITDA: $147mm

Unlevered FCF (at 35%): $80mm

Tangible Invested Capital: $700mm

ROIC: 11.4% (but incremental ROIC much higher)

Note that all bottom-line numbers include full stock compensation expenses. All these numbers can be

derived straight from the financials with a little guidance from management except the SG&A attributed

to this segment.

The Aviation Services results over the past few years have been strong even with the recent loss of the

KC-10 business. And management remains optimistic about the growth and scale of this business into the

future.

Here is what we know about SG&A:

- FY 2017 SG&A of $196.7mm includes a large amount of non-recurring expenses, particularly

related to INL/A litigation and the downscaling of the Lake Charles facility. The normalized SG&A

is $174mm (compare with $173mm in 2016 and $172mm in 2015). Management has addressed

this point.

- The “normalized” SG&A for Expeditionary Services in 2015-2017 did not scale down after the

extreme reduction in the Afghanistan services. Note that SG&A did not drop even as the

Afghanistan contract Management has confirmed this point. So management has been running

the Expeditionary Services overhead as though still a $600mm revenue business.

- The best comp for Airlift sub-segment of the Expeditionary Services segment is a private company

(Delta Tucker Holdings) that happens to be the incumbent on the INL/A contract. Luckily, they

publish full financials. The SG&A here is about 7% of revenue. The comps for the Mobility sub-

segment of the Expeditionary Services segment suggest a slightly higher SG&A as percentage of

revenue. I have been using a blended 8% rate after the Expeditionary Services gets back to

$600mm of revenue. Management will not confirm these numbers.

- My best guess is that Expeditionary Services is running at about $44mm SG&A (8% of $550mm)

while the Aviation Services segment has about $130mm of SG&A. And I have intended to assign

the vast majority of true corporate costs, including investor relations, etc. to the Aviation Services

segment.

There are several comps for the Aviation Services segment, but the best comp is KLX Inc. KLX Inc is also a

good company (Aerospace) bad company (Oil Services) structure. The ROI in the Aerospace distribution

segment is 10.2%. Growth rates between the two aviation businesses are similar. Valuing the oil services

at book value gives us a valuation of 12.2x EBITA ($258mm LTM EBITA; $3.2bn TEV after taking out Oil

Services) for the Aerospace business. Applying this comp to AAR gives us a value for the Aviation Services

business of $1.4+bn.

Cubic Corporation is another comp. Based on FY 2016 numbers, it trades at 13.5x EBITA, but FY 2017

numbers are worse and so the multiple is higher. But this is mitigated if we take out GATR acquisition,

which is at a different development stage as they paid 5x revenue for GATR in FY 2016. If we take out

GATR and use FY 2016, we get a little over 12x EBITA.

I like to value from unlevered FCF and growth rates. This business should continue to grow at over 5% top-

line and due to operational leverage, closer to 10% bottom line. Given the current multiples in the market

(especially the Russell 2000 that include the probability of a tax rate cut), this business should trade at 18x

unlevered FCF. This gets us $1.4+bn.

Expeditionary Services

The basic thesis here is that we are getting the Expeditionary Services business for free or even a discount.

What is this business worth?

Several data points:

The TBV of this segment is about $300mm.

Management insists that once the INL/A contract goes into effect and scales, the economics of this

business will make a lot of sense and will be a very good use of capital.

The INL/A contract will generate over $300mm of revenue once scaled. And revenue for the Expeditionary

Services segment will be over $600mm and driven largely by the Falklands and INL/A contracts. The last

time we saw comparable revenue and the business running at scale, the segment’s EBITA was about

$70mm.

There is tremendous operational leverage in this business. The FY 2013-2015 financials demonstrate the

downside of that operational leverage. Revenue dropped $200mm and gross profit dropped $100mm.

We will see the reverse effect in FY 2019. We expect an EBITA in the Expeditionary Services business once

both Falklands and INL/A are fully implemented of high double digits.

Due to its extreme lumpiness and the high non-recurring costs to win these long-term contracts, this

business does not deserve a high multiple, and expect a $600mm valuation (8x $75mm EBITA) for the

Expeditionary Services business.

Risk

The main risk is that the INL/A contract does not cleanly begin in 2017. Dyncorp figure outs how to tie up

the INL/A contract longer and AAR continues to burn value in the Expeditionary Services segment. Even

cleanly losing and then selling/winding down the Expeditionary Services segment would increase the value

over today. But the market will clearly not give positive value here until the segment’s future is resolved.

And the disaster is that INL/A is lost and AAR management begins another multi-year process of securing

a new contract while Expeditionary Services continues to produce negative EBITA.

Catalyst

The first catalyst is the Court of Claims ruling on the Dyncorp case. This is expected before the end of

October, but the ruling has been delayed once. The AAR management is on record as being extremely

confident they will prevail. The GAO has already ruled in their favor, and these government contract

protest cases are rarely given more than cursory consideration. If AAR had acted egregiously, this would

have been noted by the GAO, and it is important to note that the record is the GAO ruling.

The second catalyst is the guidance where for the first time, both segments are operating at scale and the

operational leverage of both segments is apparent. Management has been silent in addressing the

potential profit here, and we believe that the INL/A contract will return the Expeditionary Services group

to the profitability it enjoyed several years ago.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

See above.

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			2017	2018
Price:	35.25	EPS	0	0
Shares Out. (in M):	34	P/E	0	0
Market Cap (in $M):	1,218	P/FCF	0	0
Net Debt (in $M):	147	EBIT	0	196
TEV (in $M):	1,365	TEV/EBIT	0	7