AIR - AAR Corp.: The Defense Sector Could Boost This Company's Revenue

2023-03-29 06:58:12 ET

Summary

• The recent quarterly data beat expectations and the big news was the acquisition of Trax.
• AAR Corp. will follow the positive trend in the defense sector.
• AAR is currently undervalued compared to its peers.

AAR Corp. ( AIR ) is a leading provider of aviation services and is well-positioned to benefit from positive trends in both the commercial and government sectors. The company is set to leverage tailwinds from the growing defense and aviation sectors, thanks to its strategic positioning. Additionally, AAR Corp. has demonstrated significant improvements in key performance metrics, including margins, liquidity, and profitability in recent years, making it an attractive and potentially alternative investment pick within the Aerospace & Defense sector.

Some key highlights of Q3FY23

AAR recently released Q3FY23 quarterly data. Here are the highlights of the latest report :

Third quarter sales of $521 million, up 15% over the prior year

Third quarter GAAP diluted earnings per share from continuing operations of $0.62, compared to $0.63 in Q3 FY2022

Adjusted diluted earnings per share from continuing operations of $0.75, up 19% from $0.63 in Q3 FY2022

Third quarter cash flow provided by operating activities from continuing operations of $17 million

Acquired Trax, a leading provider of aircraft MRO and fleet management software

One of the big news items from the last quarter was the acquisition of Trax , a software and services provider for the aviation industry. Trax offers a suite of digital tools for managing and maintaining aircraft fleets, and the acquisition could become a good opportunity for AAR to expand its digital capabilities and provide more comprehensive services to its customers. However, the Trax acquisition increased AAR Corp's net leverage to 1.35x, but according to guidance, the company expects this ratio to decrease and generate cash in the fourth quarter, while growing adjusted EBITDA.

Another notable development concerns the company's gross profit margin. In the last quarter, it was 18.1%, an improvement from the same quarter of the previous year, when it was at 17.3%. This is a confirmation of a positive trend that began in 2021 and is still continuing. In fact, the LTM gross profit margin was 18.4%, well above the average of the last five years, indicating that AAR Corp has been able to effectively reduce costs and improve its operating efficiency.

Moreover, AAR improved its financial condition by reporting a net debt of $135.3 million, which is lower than the previous year. Additionally, the company continued its positive trend in terms of liquidity and solvency. The quick ratio was x1.15, compared to values below x1.00 in recent years, while the current ratio was x3.32, also above the historical average.

In conclusion, AAR Corp had a solid quarter with a strong gross margin performance. Furthermore, management is optimistic about the recovery in air travel and the opportunities across both the commercial and government markets.

The Defense sector appears to be very interesting

Although AAR's commercial customers sector has performed very well in recent years, driving growth, what seems much more interesting at the moment is the Defense sector. The company is well-positioned to exploit tailwinds and record excellent performances in the coming years.

In particular, I am personally very bullish on the defense sector for two reasons. The first concerns the increase in military spending in the NATO area. New information comes out every day about the increase in orders for new military assets, and the forecast of an increase in spending to 2% of GDP certainly offers many opportunities for future improvements. To learn more about my views on the topic, I leave a link to my article on the Direxion Daily Aerospace & Defense Bull 3X Shares ( DFEN ) where I explain the subject in more depth, while also bringing useful sources to the investor.

The second point concerns the profitability of companies in the sector. Having fixed government contracts and high entry barriers, established and stable companies in the defense sector generally perform very well and act as risk reducers, especially in a macroeconomic environment with quantitative tightening where young and low cash flow companies suffer.

AAR Performances

In terms of financial performance, it can be observed that over the past 5 years, AAR has closely tracked the basic trend of the Aerospace & Defense sector. I compared AAR with some of the major players in the sector, such as Lockheed Martin (NYSE: LMT ), Raytheon Technologies (NYSE: RTX ), and Boeing (NYSE: BA ), to check for any price anomalies.

It can be noted that the performances of these companies have been different, but with similar trends (except for Boeing, which has had different problems in recent years), with AAR registering a +24.05% return, outperforming the iShares U.S. Aerospace & Defense ETF ITA (BATS: ITA ), which had a +13.92% return. However, AAR did not perform as well as Lockheed Martin and Raytheon Technologies, which had respective returns of +39.84% and +30.35%.

The main difference in performance was due to the resilience of companies like Lockheed Martin, Raytheon Technologies, and the ITA ETF to the collapse caused by the COVID-19 pandemic in March 2020. AAR and Boeing had a larger drawdown in comparison. This is because companies like Lockheed Martin and Raytheon Technologies have the majority of their sales coming from government and defense customers (around 80-90%) as opposed to civilian customers (around 10-20%), while AAR has had an average of 50% sales for the government and 50% for the civilian field over the last three years (in 2020, 51.2% of consolidated sales came from the government and defense sector).

In 2020, the defense sector held up better, while the civil aviation sector was hit hard with very low growth, which had a greater impact on AAR. However, over the last 3 years, the trend has been different. The civil aviation sector has restarted, and this has had a very positive influence on AAR's performance. Indeed, looking at the performance, AAR has achieved a return of +268.10%, compared to +94.11% of Raytheon Technologies. To confirm this, Boeing has also performed better in the last 3 years thanks to the normalization of civil aviation, achieving a return of +63.90%, which is much better than its previous performances.

Bottom line

It can be noted that AAR has remained very close to the underlying trend of the Aerospace & Defense sector. Therefore, since I expect the outperformance of the sector to continue, I anticipate that AAR will continue to follow the bullish trend that has characterized it over the last 3 years.

Valuation and Conclusion

Based on my analysis, I have determined that the company is currently undervalued relative to its current price. Using a DCF model and making certain assumptions, I calculated the fair value to be $64.15. Firstly, I set the risk-free rate based on the US 10-year treasury yield and assumed a terminal growth rate of 3.00%, based on the fact that military expenditures of individual countries, as well as those of civil transport, grow in line with the GDP. The calculations gave me a beta of 0.91 and a WACC of 10.60%. By projecting the model over the next 10 years, I arrived at a company's NPV of $2,226.76. Note that, for practicality, I set the growth of the FCF starting from 2026 constant at 3.00%, which is the terminal growth rate. Please find attached the final tables with all the calculations used to determine the intrinsic value of AAR.

Considering the current price of $55.00, the stock has a potential upside of 16.64%. Moreover, when comparing using multiples, we also note an undervaluation, both in terms of the Price/Sales ratio and the EV/EBITDA ratio. Indeed, AAR's EV/EBITDA ratio is x12.7, compared to a market average of x13.6.

In conclusion, AAR Corp. is well-positioned to take advantage of a market that it can exploit well in 2023. The company has reported excellent results and has improved key performance metrics such as liquidity ratios, net debt, and gross margin. Furthermore, it appears to be undervalued with a decent upside potential. For these reasons, I give the company a "Buy" rating.

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