AIR - AAR Corp. Stock: Not Undervalued But Has Space To Fly Higher

2023-11-29 06:55:01 ET

Summary

• AAR Corp. reported strong revenue growth in Q1 2024, with revenues increasing 23.2% to nearly $550 million.
• The company's commercial sales had a higher gross profit margin than government sales, challenging the belief that government contracts have higher margins.
• AAR Corp. is expected to announce Q2 2024 earnings on December 19th, with revenues estimated at $558.5 million and $0.80 in core earnings per share.

In September 2023, I initiated coverage of AAR Corp. ( AIR ) with a buy rating assigning 20% upside to the stock. Since then, the company has reported earnings which beat estimates and will be discussed in this report. I will also be providing an updated assessment on the stock price target, since the stock price increased 14.2% compared to the price at publication of my prior report. In some way, I would say that AAR Corporation is showing extremely well that aerospace stocks have a very strong ability to outperform as the broader markets returned just 2.2% over the same timeframe.

Q1 2024: Strong Revenue Growth For AAR Corp.

Important to keep in mind is that the quarter ending August 31 ^st is the first quarter of the 2024 financial year for AAR Corp. During the first quarter, revenues increased 23.2% to nearly $550 million driven by the commercial sales up 33.7% while government sales were up modestly. Gross profit margins were up 30 bps to 18.4% and what I find interesting is that the commercial business had a 19.3% gross profit margin which was 300 bps higher than the government sales gross profit margin. The reason why I am pointing this out is because generally there exists the thought flow that government contracts come with fat margins. The reality, judging from AAR Corporation’s results, seem to be somewhat different. The operating margins decreased from 7 percent to 4.6 percent driven by higher SG&A expenses. The SG&A expenses included a $11.2 million charge related to a Russian court judgment requiring AAR Corporation to pay for engines previously acquired at a fair value of $13 million of which $1.8 million was already recognized. The purchase of the engines was in 2016, but the court has now ruled against AAR Corp. The hostile environment is likely a contributing element to the court decision and whether and how AAR Corporation can eventually carry out the court order is not known due to the sanctions against Russia.

Furthermore, SG&A included expenses related to the acquisition of Trax. Adjusted SG&A would have been $59.6 million which would bring the adjusted operating margins to 7.3% compared to 6.9% in the prior year quarter. On net income level, earnings were impacted by higher interest expenses and a charge related to the termination and transfer of its pension plan. Adjusted earnings per diluted share including a <1% reduction in basic shares outstanding were up 28% exceeding top line growth. So, while we see net income down significantly, adjusted earnings were up quite significantly radiating the strength of the ongoing operations.

When Will AAR Corp. Report Q2 2024 Financial Results?

AAR Corp. is expected to announce Q2 2024 earnings on the 19 ^th of December with revenues estimates to be $558.5 million and $0.80 in core earnings per share. AAR Corporation did not provide a detailed guidance for the second quarter but did point at sequential growth in revenues. The YoY growth rates are expected to be in the mid-to-high teens with margins consistent with the comparable quarter last year and lower seasonality effects in the current years. What I will be keeping an eye on is the continued momentum in commercial sales, but I am actually more interested to see whether the government sales pick up.

What Is An Appropriate Price For AAR Stock?

Using the most recent balance sheet data and forward projections, I have increased my price target from $73.61 to $75.95 providing 9% upside from current levels. This keeps in mind that AIR stock tends to trade one year ahead of its earnings. The continued upside might be somewhat interesting given that we have removed stock repurchases from the 2024 and 2025 projections to be on the safe side while free cash flow generation is expected to be lower than anticipated earlier. At current prices, AAR Corp. stock might be a bit overvalued against 2024 earnings so any softening of share prices in my view would provide a nice entry point to position for 2025 as that is what I consider to be the target that the company should be trading on. Wall Street analysts have a strong buy rating on the stock with a $67.25 price target implying some downside, which is a bit of an odd combination but reflects the company’s overvaluation relative to 2024 earnings but significant upside compared to 2025 earnings.

Conclusion: Tapered Upside For AAR Corp.

AAR Corporation saw its first quarter results impacted by one-off items. Stripping these items from the results did show some margin expansion coupled to strong top line growth. My projections show that compared to my previous assessment the upside has reduced from 20% to 9%, but there is a good reason for that and that reason is that the stock price did increase significantly and we have assumed no stock repurchases as the $57.6 million available for share repurchases has not been used for two quarters. Either way, with all calculations on the stock done, I am increasing my price target from $73.61 to $75.95 and maintain my buy rating.

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