UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

 

FORM 10-Q

 

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended February 28, 2005

 

or

 

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to               

 

Commission File No. 1-6263

 

 

AAR CORP.

(Exact name of registrant as specified in its charter)

 

Delaware		36-2334820
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
One AAR Place, 1100 N. Wood Dale Road Wood Dale, Illinois		60191
(Address of principal executive offices)		(Zip Code)
(630) 227-2000
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     ý     No     o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes     ý     No     o

 

As of March 31, 2005 there were 32,437,968 shares of the registrant’s Common Stock, $1.00 par value per share, outstanding.

 

 

AAR CORP. and Subsidiaries
Quarterly Report on Form 10-Q
For the Quarter Ended February 28, 2005
Table of Contents

 

Part I – FINANCIAL INFORMATION
	Item 1. Financial Statements
	Condensed Consolidated Balance Sheets
	Condensed Consolidated Statements of Operations
	Condensed Consolidated Statements of Cash Flows
	Condensed Consolidated Statements of Comprehensive Income
	Notes to Condensed Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial
	Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
Part II – OTHER INFORMATION
	Item 6. Exhibits
	Signature Page
	Exhibit Index

 

2

 

PART I, ITEM 1 – FINANCIAL STATEMENTS

 

AAR CORP. and Subsidiaries
Condensed Consolidated Balance Sheets
As of February 28, 2005 and May 31, 2004
(In thousands)

 

		February 28, 2005			May 31, 2004
		(Unaudited)			(Audited)
Assets:
Current assets:
Cash and cash equivalents		$	32,091		$	41,010
Accounts receivable, less allowances of $6,564 and $6,310, respectively		120,082			104,661
Inventories		199,279			206,899
Equipment on or available for short-term lease		47,215			40,346
Deposits, prepaids and other		13,877			11,714
Deferred tax assets		28,621			27,574
Total current assets		441,165			432,204
Property, plant and equipment, net		72,380			81,866
Other assets:
Investments in leveraged leases		9,336			9,541
Goodwill, net		44,443			44,421
Equipment on long-term lease		70,605			84,271
Investment in aircraft joint ventures		10,811			—
Other		58,727			56,989
		193,922			195,222
		$	707,467		$	709,292

 

The accompanying Notes to Condensed Consolidated Financial
Statements are an integral part of these statements.

 

3

 

AAR CORP. and Subsidiaries
Condensed Consolidated Balance Sheets
As of February 28, 2005 and May 31, 2004
(In thousands)

 

		February 28, 2005			May 31, 2004
		(Unaudited)			(Audited)
Liabilities and stockholders’ equity:
Current liabilities:
Short-term debt		$	1,606		$	1,896
Current maturities of long-term debt		703			760
Current maturities of non-recourse long-term debt		31,496			736
Accounts payable		65,349			57,582
Accrued liabilities		60,720			70,287
Total current liabilities		159,874			131,261
Long-term debt, less current maturities		200,204			217,434
Non-recourse debt		—			31,232
Deferred tax liabilities		19,270			17,628
Retirement benefit obligation		683			683
Deferred income and other		12,027			9,370
		232,184			276,347
Stockholders’ equity:
Preferred stock, $1.00 par value, authorized 250 shares; none issued		—			—
Common stock, $1.00 par value, authorized 100,000 shares; issued 34,647 and 34,525 shares, respectively		34,647			34,525
Capital surplus		175,338			172,681
Retained earnings		156,496			146,776
Treasury stock, 2,386 and 2,280 shares at cost, respectively		(37,336		)	(36,030		)
Unearned restricted stock awards		(978		)	(1,376		)
Accumulated other comprehensive income (loss) -
Cumulative translation adjustments		487			(1,647		)
Minimum pension liability		(13,245		)	(13,245		)
		315,409			301,684
		$	707,467		$	709,292

 

The accompanying Notes to Condensed Consolidated Financial
Statements are an integral part of these statements.

 

4

 

AAR CORP. and Subsidiaries
Condensed Consolidated Statements of Operations
For the Three and Nine Months Ended February 28/29, 2005 and 2004
(Unaudited)
(In thousands except per share data)

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Sales:
Sales from products		$	168,474		$	132,053		$	455,944		$	378,860
Sales from services		23,747			22,133			64,823			66,882
Sales from leasing		5,480			5,047			17,155			21,892
		197,701			159,233			537,922			467,634
Costs and operating expenses:
Cost of products		143,734			109,299			386,504			321,636
Cost of services		18,019			19,131			50,085			55,937
Cost of leasing		5,213			4,247			15,601			16,877
Selling, general and administrative and other		21,182			20,429			61,460			58,890
Equity in earnings of aircraft joint ventures		198			—			206			—
		187,950			153,106			513,444			453,340
Operating income		9,751			6,127			24,478			14,294
Interest expense		(4,163		)	(4,688		)	(11,860		)	(14,297		)
Interest income		438			284			1,103			1,200
Income before provision for income taxes		6,026			1,723			13,721			1,197
Provision (benefit) for income taxes		841			(522		)	977			(706		)
Income from continuing operations		5,185			2,245			12,744			1,903
Discontinued operations, net of tax:
Operating loss		(364		)	(233		)	(798		)	(971		)
Loss on disposal		(2,226		)	—			(2,226		)	—
Loss from discontinued operations		(2,590		)	(233		)	(3,024		)	(971		)
Net income		$	2,595		$	2,012		$	9,720		$	932
Earnings (loss) per share-basic:
Earnings from continuing operations		$	0.16		$	0.07		$	0.39		$	0.06
Loss from discontinued operations		(0.08		)	(0.01		)	(0.09		)	(0.03		)
Earnings per share - basic		$	0.08		$	0.06		$	0.30		$	0.03
Earnings (loss) per share-diluted:
Earnings from continuing operations		$	0.15		$	0.07		$	0.37		$	0.06
Loss from discontinued operations		(0.07		)	(0.01		)	(0.08		)	(0.03		)
Earnings per share - diluted		$	0.08		$	0.06		$	0.29		$	0.03
Weighted average common shares outstanding - basic		32,258			32,168			32,249			31,999
Weighted average common shares outstanding - diluted		36,417			34,077			36,334			32,694

 

The accompanying Notes to Condensed Consolidated Financial
Statements are an integral part of these statements.

 

5

 

AAR CORP. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
For the Nine Months Ended February 28/29, 2005 and 2004
(Unaudited)
(In thousands)

 

		Nine Months Ended February 28/29,
		2005			2004
Cash flows from operating activities:
Net income		$	9,720		$	932
Adjustments to reconcile net income to net cash provided from operating activities:
Depreciation and amortization		21,112			19,821
Deferred taxes		(596		)	(776		)
Loss on sale of business, net of tax		2,226			—
Changes in specific assets and liabilities:
Accounts receivable		(10,229		)	(46,276		)
Inventories		(5,479		)	22,534
Equipment on or available for short-term lease		1,489			1,747
Equipment on long-term lease		18,431			663
Accounts payable		7,009			8,312
Accrued liabilities and taxes on income		(5,135		)	(1,745		)
Other, primarily pension contributions and prepaids		(10,519		)	(3,815		)
Net cash provided from operating activities		28,029			1,397
Cash flows from investing activities:
Property, plant and equipment expenditures		(9,463		)	(7,474		)
Proceeds from disposal of assets		7			43
Proceeds from sale of business		7,700			—
Proceeds from sale of facilities, net		—			16,922
Investment in leveraged leases		205			323
Other, primarily investment in aircraft joint ventures		(11,657		)	(1,011		)
Net cash provided from (used in) investing activities		(13,208		)	8,803
Cash flows from financing activities:
Proceeds from borrowings		—			88,959
Reduction in borrowings		(23,706		)	(76,239		)
Financing costs		(34		)	(3,217		)
Other		2			—
Net cash provided from (used in) financing activities		(23,738		)	9,503
Effect of exchange rate changes on cash		(2		)	28
Increase (decrease) in cash and cash equivalents		(8,919		)	19,731
Cash and cash equivalents, beginning of period		41,010			29,154
Cash and cash equivalents, end of period		$	32,091		$	48,885

 

The accompanying Notes to Condensed Consolidated Financial
Statements are an integral part of these statements.

 

6

 

AAR CORP. and Subsidiaries
Condensed Consolidated Statements of Comprehensive Income
For the Three and Nine Months Ended February 28/29, 2005 and 2004
(Unaudited)
(In thousands)

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Net income		$	2,595		$	2,012		$	9,720		$	932
Other comprehensive income - Foreign currency translation		(58		)	968			2,134			1,735
Total comprehensive income		$	2,537		$	2,980		$	11,854		$	2,667

 

The accompanying Notes to Condensed Consolidated Financial
Statements are an integral part of these statements.

 

7

 

AAR CORP. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
February 28, 2005
(Unaudited)
(In thousands)

 

Note A – Basis of Presentation

 

AAR CORP. and its subsidiaries are referred to herein collectively as “AAR,” “Company,” “we,” “us,” and “our” unless the context indicates otherwise. The accompanying condensed consolidated financial statements include the accounts of AAR and its subsidiaries after elimination of intercompany accounts and transactions.

 

We have prepared these statements without audit, pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”). The condensed consolidated balance sheet as of May 31, 2004 has been derived from audited financial statements. To prepare the financial statements in conformity with accounting principles generally accepted in the United States of America, management has made a number of estimates and assumptions relating to the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. Certain information and note disclosures, normally included in comprehensive financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted pursuant to such rules and regulations of the SEC. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our latest annual report on Form 10-K.

 

In the opinion of management, the condensed consolidated financial statements reflect all adjustments (which consist only of normal recurring adjustments) necessary to present fairly the condensed consolidated financial position of AAR CORP. and its subsidiaries as of February 28, 2005 and the condensed consolidated results of operations and comprehensive income for the three- and nine-month periods ended February 28/29, 2005 and 2004, and the condensed consolidated cash flows for the nine-month periods ended February 28/29, 2005 and 2004. The results of operations for such interim periods are not necessarily indicative of the results for the full year.

 

Note B – Discontinued Operations

 

On February 17, 2005, we sold substantially all of the assets and certain liabilities of our engine component repair business, located in Windsor, Connecticut. The engine component repair business was a unit within the Maintenance, Repair and Overhaul segment. We received as consideration cash of $7,700 and acquired inventory having a value of approximately $1,200, subject to certain adjustments. As a result of the transaction, we recorded a pre-tax charge of $3,505 ($2,226 after-tax), in the third quarter ended February 28, 2005 representing the loss on disposal. Of the $3,505 pre-tax charge, severance charges were $287 and closing costs related to the transactions were $473. The remaining portion of the charge of $2,745 represents the difference between proceeds and the net book value of the assets sold.

 

Revenues, pre-tax operating loss and pre-tax loss on disposal for the three- and nine-month periods ended February 28/29, 2005 and 2004 for the discontinued operation are summarized as follows:

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Revenues		$	1,411		$	1,918		$	5,898		$	5,150
Pre-tax operating loss		(562		)	(358		)	(1,229		)	(523		)
Pre-tax loss on disposal		(3,505		)	—			(3,505		)	—

 

8

 

Note C – Income Taxes

 

During the third quarter of fiscal 2005 ended February 28, 2005, we recorded a favorable federal income tax adjustment of $496. The benefit is a result of the completion of the fiscal 2004 federal tax return in February 2005, upon which we determined that we qualified for additional tax benefits related to export activities. Similarly, we recorded a $604 federal income tax benefit during the third quarter of last year which primarily related to additional tax benefits from export activities in fiscal 2003.

 

During the second quarter of fiscal 2005 ended November 30, 2004, we recorded a favorable federal income tax adjustment of $1,575. In October 2004, the American Jobs Creation Act of 2004 (the “Act”) was signed into law. The Act included a number of federal income tax reforms, including an extension of the foreign tax credit carryforward period from five years to ten years. In previous fiscal years, we had established a deferred tax valuation allowance of $1,575 against foreign tax credits expiring in fiscal year 2006. As a result of the new ten-year carryforward period established by the Act, we now expect to utilize the foreign tax credits and recorded a $1,575 credit to the provision for income taxes during the second quarter of fiscal 2005.

 

Note D – Stock-Based Employee Compensation Plans

 

We have an employee stock option plan which we account for under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No stock-based employee compensation cost related to our stock option plan is reflected in net income, as each option granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of Statement of Accounting Financial Standards (“SFAS”) No. 123 to the Company’s stock option plans (in thousands, except per share amounts).

 

			Three Months Ended February 28/29,						Nine Months Ended February 28/29,
			2005			2004			2005			2004
Net income as reported			$	2,595		$	2,012		$	9,720		$	932
Add: Stock-based compensation expense included in net income as reported, net of tax			82			101			226			223
Deduct: Total compensation expense determined under fair value method for all awards, net of tax			(704		)	(680		)	(2,091		)	(2,246		)
Pro forma net income (loss)			$	1,973		$	(2	)	$	7,855		$	(1,091	)
Earnings (loss) per share – basic:	As reported		$	0.08		$	0.02		$	0.30		$	0.03
	Pro forma		$	0.06		$	—		$	0.24		$	(0.03	)
Earnings (loss) per share – diluted:	As reported		$	0.08		$	0.02		$	0.29		$	0.03
	Pro forma		$	0.06		$	—		$	0.24		$	(0.03	)

 

9

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in the nine months ended February 28/29, 2005 and 2004:

 

		Nine Months Ended February 28/29,
		2005		2004
Risk-free interest rate		3.7	%	3.1	%
Expected volatility of common stock		66.0	%	67.4	%
Dividend yield		0.0	%	0.0	%
Expected option term in years		4.0		4.0

 

Note E – New Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) addresses the accounting for transactions in which an enterprise exchanges its equity instruments for employee services. It also addresses transactions in which an enterprise incurs liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of those equity instruments in exchange for employee services. For public entities, the cost of employee services received in exchange for equity instruments, including employee stock options, is to be measured based on the grant-date fair value of those instruments. That cost will be recognized as compensation expense over the service period, which would normally be the vesting period. SFAS No. 123(R) is effective as of the first interim or annual reporting period that begins after June 15, 2005. We will adopt the provisions of SFAS No. 123(R) in the second quarter of fiscal 2006 ending November 30, 2005 and anticipate that adoption of the standard will result in approximately $1,500 of pre-tax compensation expense in fiscal 2006 for current unvested stock options.

 

Note F – Revenue Recognition

 

Sales and related cost of sales for product sales are recognized upon shipment of the product to the customer. Our standard terms and conditions provide that title passes to the customer when the product is shipped to the customer. Service revenues and the related cost of services are generally recognized when customer-owned material is shipped back to the customer. We have adopted this accounting policy because at the time the customer-owned material is shipped back to the customer, all services related to that material are complete as our service agreements generally do not require us to provide services at customer sites. Furthermore, the serviced units are typically shipped to the customer immediately upon completion of the related services. Sales and related cost of sales for certain long-term manufacturing contracts and for certain large airframe maintenance contracts are recognized by the percentage of completion method, based on the relationship of costs incurred to date to estimated total costs under the respective contracts. Lease revenues are recognized as earned. Income from monthly or quarterly rental payments is recorded in the pertinent period according to the lease agreement. However, for leases that provide variable rents, we recognize lease income on a straight-line basis. In addition to a monthly lease rate, some engine leases require an additional rental amount based on the number of hours the engine is used in a particular month. Lease income associated with these contingent rentals is recorded in the period in which actual usage is reported to us by the lessee, which is normally the month following the actual usage.

 

10

 

Note G – Inventory

 

The summary of inventories is as follows:

 

		February 28, 2005			May 31, 2004
Raw materials and parts		$	43,529		$	45,823
Work-in-process		23,267			20,419
Purchased aircraft, parts, engines and components held for sale		132,483			140,657
		$	199,279		$	206,899

 

Note H –Joint Ventures

 

During the first quarter of fiscal 2005 ended August 31, 2004, we invested in a limited liability company, which is accounted for under the equity method of accounting. Our investment in the limited liability company was made under an agreement with a global financial institution. Our membership interest in this limited liability company is 50% and the primary business of this company is the acquisition, ownership, lease and disposition of certain narrow-body commercial aircraft. Aircraft that are acquired by the company are purchased with cash contributions by the members of the company, and debt financing which is non-recourse to the members of the company. Total assets and debt of the limited liability company at February 28, 2005 were $41,674 and $23,485, respectively. Our equity investment in this company is $10,811 at February 28, 2005.

 

During the first quarter of fiscal 2005 ended August 31, 2004, we also invested in a joint venture company with a different party. The joint venture company owns an aircraft on lease to a foreign carrier. This aircraft was subject to a note payable to a major financial institution that was guaranteed by AAR; during the third quarter of fiscal 2005, we paid the debt of $6,022 in full. We consolidate the financial position and results of operations of this joint venture. The equity interest of the other partner in the joint venture is recorded as a minority interest, which was included in other non-current liabilities at February 28, 2005. The minority interest in the joint venture was $957 at February 28, 2005.

 

Note I – Supplemental Cash Flows Information

 

		Nine Months Ended February 28/29,
		2005			2004
Interest paid		$	13,323		$	14,731
Income taxes paid		440			552
Income tax refunds received		1,071			962

 

Non-cash operating and financing activities are excluded from the consolidated statement of cash flows. During the nine-month period ended February 28, 2005, non-cash operating and financing activities related to the consolidation of the joint venture company were as follows:

 

Assets consolidated		$	8,494
Debt guaranteed and consolidated		6,464

 

11

 

Note J – Common Stock and Earnings per Share of Common Stock

 

The computation of basic earnings per share is based on the weighted average number of common shares outstanding during each period. The computation of diluted earnings per share is based on the weighted average number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options and shares issued upon conversion of convertible debt.

 

In the third quarter of fiscal 2005 ended February 28, 2005, we adopted the provisions of Emerging Issues Task Force Issue No. 04-08 “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share” (“EITF No. 04-08”) which requires companies to account for contingently convertible debt using the “if converted” method set forth in SFAS No. 128 “Earnings Per Share” for calculating diluted earnings per share. Under the “if converted” method, the after-tax effect of interest expense related to the convertible securities is added back to net income, and the convertible debt is assumed to have been converted to equity at the beginning of the period and is added to outstanding common shares. For comparative purposes, diluted earnings per share information for all periods since the convertible debt securities were issued in February 2004 have been restated as required by EITF No. 04-08.

 

12

 

The following table provides a reconciliation of the computations of basic and diluted earnings per share information for the three- and nine-month periods ended February 28/29, 2005 and 2004.

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Income from continuing operations		$	5,185		$	2,245		$	12,744		$	1,903
Loss from discontinued operations, net of tax		(2,590		)	(233		)	(3,024		)	(971		)
Net income		$	2,595		$	2,012		$	9,720		$	932
Basic shares:
Weighted average common shares outstanding		32,258			32,168			32,249			31,999
Earnings (loss) per share – basic:
Earnings from continuing operations		$	0.16		$	0.07		$	0.39		$	0.06
Loss from discontinued operations, net of tax		(0.08		)	(0.01		)	(0.09		)	(0.03		)
Earnings per share - basic		$	0.08		$	0.06		$	0.30		$	0.03
Net income		$	2,595		$	2,012		$	9,720		$	932
Add: After-tax interest on convertible debt		306			114			924			114
Net income for diluted EPS calculation		$	2,901		$	2,126		$	10,644		$	1,046
Diluted shares:
Weighted average common shares outstanding		32,258			32,168			32,249			31,999
Additional shares from the assumed exercise of stock options		555			564			481			247
Additional shares from the assumed conversion of convertible debt		3,604			1,345			3,604			448
Weighted average common shares outstanding – diluted		36,417			34,077			36,334			32,694
Earnings (loss) per share – diluted:
Earnings from continuing operations		$	0.15		$	0.07		$	0.37		$	0.06
Loss from discontinued operations, net of tax		(0.07		)	(0.01		)	(0.08		)	(0.03		)
Earnings per share - diluted		$	0.08		$	0.06		$	0.29		$	0.03

 

At February 28/29, 2005 and 2004, respectively, stock options to purchase 3,094 and 3,254 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share, because the exercise price of these options was greater than the average market price of the common shares during the interim periods then ended.

 

13

 

As of February 28, 2005, we had $67,000 of convertible senior notes outstanding. The notes were issued in February 2004 and are due February 1, 2024 unless earlier redeemed, repurchased or converted, and bear interest at 2.875% payable semiannually on February 1 and August 1.

 

The notes are convertible into shares of AAR common stock based on a conversion rate of 53.7924 shares per $1,000 principal amount of notes, which is equivalent to an initial conversion price of approximately $18.59 per share, under the following circumstances: (i) on any business day up to the maturity date, if the closing sale price of our common stock for at least 20 trading days in the 30 consecutive trading day period ending on the eleventh trading day of any fiscal quarter is greater than 120% of the applicable conversion price on the eleventh trading day of that quarter; (ii) at any time after February 1, 2019, if the closing price of AAR common stock on any trading day after February 1, 2019, is greater than 120% of the then applicable conversion price; (iii) at any time until February 1, 2019, during the five consecutive business day period in which the trading price for a note for each day of that trading period was less than 98% of the closing sale price of our common stock on such corresponding trading day multiplied by the applicable conversion rate; (iv) we call the notes for redemption; (v) during any period in which the credit rating assigned to our long-term senior debt by Moody’s Investor Services is below Caa1 and by Standard & Poor’s Rating Services is below B, the credit rating assigned to our long-term senior debt is suspended or withdrawn by both such rating agencies, or neither rating agency is rating our long-term senior debt; or (vi) specified corporate transactions occur.

 

We may redeem for cash all or a portion of the notes at any time on or after February 1, 2008 at specified redemption prices. Holders of the notes have the right to require us to repurchase in cash all or any portion of the notes on February 1, 2010, 2014 and 2019. In each case, the repurchase price payable will be equal to 100% of the principal amount of the notes to be repurchased, plus accrued interest and unpaid interest and liquidated damages, if any, to, but not including, the date of repurchase.

 

Note K – Impairment Charges

 

The components of the fiscal 2003 and fiscal 2002 impairment charges were as follows:

 

		For the Year Ended May 31,
		2004			2003			2002
Engine and airframe parts		$	—		$	2,360		$	56,000
Whole engines		—			3,000			11,400
Loss accruals for engine operating leases		—			—			8,500
		$	—		$	5,360		$	75,900

 

Prior to September 11, 2001 we were executing our plan to reduce our investment in support of older generation aircraft in line with the commercial airlines’ scheduled retirement plans for these aircraft. The events of September 11 caused a severe and sudden disruption in the commercial airline industry, which brought about a rapid acceleration of those retirement plans. System-wide capacity was reduced by approximately 20%, and many airlines cancelled or deferred new aircraft deliveries. Based on management’s assessment of these and other conditions, in the second quarter ended November 30, 2001 of fiscal 2002, we reduced the value and provided loss accruals for certain of our inventories and engine leases which support older generation aircraft by $75,900, of which $57,900 was related to the Inventory

 

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and Logistic Services segment and $18,000 was related to the Aircraft and Engine Sales and Leasing segment.

 

The fiscal 2002 writedown for the engine and airframe parts was determined by comparing the carrying value for inventory parts that support older generation aircraft to their net realizable value. In determining net realizable value, we assigned estimated sales prices taking into consideration historical selling prices and demand, as well as anticipated demand. The $11,400 writedown during fiscal 2002 for whole engines related to assets that are reported in the caption “Equipment on or available for short-term lease” and was determined by comparing the carrying value for each engine to an estimate of its undiscounted future cash flows. In those instances where there was a shortfall, the impairment was measured by comparing the carrying value to an estimate of the asset’s fair market value. The loss accruals for engine operating leases were determined by comparing the scheduled purchase option prices to the estimated fair value of such equipment. In those instances where the scheduled purchase option price exceeded the estimated fair value, an accrual for the estimated loss was recorded (see Note L).

 

During the fourth quarter of fiscal 2003, we recorded additional impairment charges related to certain engine and airframe parts and whole engines in the amount of $5,360. The fiscal 2003 impairment charge was based upon an updated assessment of the net realizable values for certain engine and airframe parts and future undiscounted cash flows for whole engines. Of the $5,360 impairment charge recorded during fiscal 2003, $2,360 related to the Inventory and Logistic Services segment and $3,000 related to the Aircraft and Engine Sales and Leasing segment.

 

A summary of the carrying value of impaired inventory and engines, after giving effect to the impairment charges recorded by us are as follows:

 

		February 28, 2005			May 31, 2004			November 30, 2001
Net impaired inventory and engines		$	45,600		$	51,500		$	89,600

 

Proceeds from sales of impaired inventory and engines for the nine-month periods ended February 28/29, 2005 and 2004 were $5,900 in each period. Proceeds for the twelve-month period ended May 31, 2004 were $7,300.

 

Note L – Aviation Equipment Operating Leases

 

From time to time we lease aviation equipment (engines and aircraft) from lessors under arrangements that are classified as operating leases. We may also sublease the aviation equipment to a customer on a short- or long-term basis. The terms of the operating leases in which we are the lessee are typically one year with options to renew annually at our election. If we elect not to renew a lease or the lease term expires, we generally will purchase the equipment from the lessor at its scheduled purchase option price. The terms of the lease agreements also allow us to purchase the equipment at any time during a lease at its scheduled purchase option price.                                       During the nine-month period ended February 28, 2005, we exercised our purchase option on four engines. The acquisition price was $8,021 and the engines were reflected in Inventories and Equipment on or available for short-term lease on the Condensed Consolidated Balance Sheet. The scheduled purchase option values of currently leased aviation equipment were $20,847 at February 28, 2005 and $30,097 at May 31, 2004.

 

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In those instances in which we anticipate that we will purchase aviation equipment and the scheduled purchase option price will exceed the fair value of such equipment, we record an accrual for loss. The accrual for loss was $2,107 and $5,800 at February 28, 2005 and May 31, 2004, respectively. The reduction in loss accrual is attributable to the buyout of leases and the subsequent sale of the underlying aircraft engines.

 

Note M – Segment Reporting

 

We are a leading provider of value-added products and services to the global aviation/aerospace industry. We report our activities in four business segments: Inventory and Logistic Services; Maintenance, Repair and Overhaul; Manufacturing; and Aircraft and Engine Sales and Leasing.

 

Sales in the Inventory and Logistic Services segment are derived from the sale of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and military markets, as well as the distribution of new airframe parts purchased from various original equipment manufacturers and sold to commercial and general aviation customers. Cost of sales consists principally of the cost of product (primarily aircraft and engine parts) and overhead (primarily indirect labor, facility expenses and insurance).

 

Sales in the Maintenance, Repair and Overhaul segment are derived from the repair and overhaul of a wide range of commercial and military aircraft engine and airframe parts, landing gear and components, aircraft maintenance and storage, and the repair, overhaul and sale of parts for industrial gas and steam turbine operators. Cost of sales consists principally of cost of product (primarily replacement aircraft parts), direct labor and overhead.

 

Sales in the Manufacturing segment are derived from the manufacture and sale of a wide array of containers, pallets and shelters used to support the U.S. Military’s tactical deployment requirements, in-plane cargo loading and handling systems for commercial and military applications and advanced composite materials and components for aerospace and industrial use. Cost of sales consists principally of the cost of product, direct labor and overhead.

 

Sales in the Aircraft and Engine Sales and Leasing segment are derived from the sale and lease of commercial aircraft and engines and technical and advisory services. Cost of sales consists principally of cost of product (aircraft and engines), labor and the cost of lease revenue (primarily depreciation, lease expense and insurance).

 

The accounting policies for the segments are the same as those for the Company. Our chief decision making officer evaluates performance based on the reportable segments. The expenses and assets related to corporate activities are not allocated to the segments.

 

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Gross profit is calculated by subtracting cost of sales from sales. Selected financial information for each reportable segment is as follows:

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Sales:
Inventory and Logistic Services		$	72,010		$	61,148		$	200,828		$	192,142
Maintenance, Repair and Overhaul		53,179			47,981			149,021			151,174
Manufacturing		51,759			44,246			143,069			101,212
Aircraft and Engine Sales and Leasing		20,753			5,858			45,004			23,106
		$	197,701		$	159,233		$	537,922		$	467,634

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Gross profit:
Inventory and Logistic Services		$	14,250		$	10,639		$	37,851		$	30,794
Maintenance, Repair and Overhaul		6,962			5,354			17,623			18,378
Manufacturing		9,591			9,540			27,099			19,155
Aircraft and Engine Sales and Leasing		(68		)	1,023			3,159			4,857
		$	30,735		$	26,556		$	85,732		$	73,184

 

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PART I, ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

AAR CORP. and Subsidiaries
Management’s Discussion and Analysis of Financial
Condition and Results of Operations
February 28, 2005
(In thousands)

 

General Overview

 

We report our activities in four business segments: Inventory and Logistic Services; Maintenance, Repair and Overhaul; Manufacturing; and Aircraft and Engine Sales and Leasing.

 

Sales in the Inventory and Logistic Services segment are derived from the sale of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and military markets, as well as the distribution of new airframe parts purchased from various original equipment manufacturers and sold to commercial and general aviation customers. Cost of sales consists principally of the cost of product (primarily aircraft and engine parts) and overhead (primarily indirect labor, facility cost and insurance).

 

Sales in the Maintenance, Repair and Overhaul segment are derived from the repair and overhaul of a wide range of commercial and military aircraft engine and airframe parts, landing gear and components; aircraft maintenance and storage; and the repair, overhaul and sale of parts for industrial gas and steam turbine operators. Cost of sales consists principally of cost of product (primarily replacement aircraft parts), direct labor and overhead.

 

Sales in the Manufacturing segment are derived from the manufacture and sale of a wide array of containers, pallets and shelters used to support the U.S. Military’s tactical deployment requirements, in-plane cargo loading and handling systems for commercial and military applications and advanced composite materials and components for aerospace and industrial use. Cost of sales consists principally of the cost of product, direct labor and overhead.

 

Sales in the Aircraft and Engine Sales and Leasing segment are derived from the sale and lease of commercial aircraft and engines and technical and advisory services. Cost of sales consists principally of cost of product (aircraft and engines), labor and the cost of lease revenue (primarily depreciation, lease expense and insurance).

 

The table below sets forth consolidated sales for our four business segments for the three- and nine-month periods ended February 28/29, 2005 and 2004.

 

		Three Months Ended February 28/29,						Nine Months Ended February 28/29,
		2005			2004			2005			2004
Sales:
Inventory and Logistic Services		$	72,010		$	61,148		$	200,828		$	192,142
Maintenance, Repair and Overhaul		53,179			47,981			149,021			151,174
Manufacturing		51,759			44,246			143,069			101,212
Aircraft and Engine Sales and Leasing		20,753			5,858			45,004			23,106
		$	197,701		$	159,233		$	537,922		$	467,634

 

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During fiscal 2004 and the first nine months of fiscal 2005, the worldwide airline industry experienced an increase in available seat miles and revenue passenger miles, and improved load factors. Although U.S. carriers have made progress reducing their non-fuel costs, the impact from historically high fuel costs and a highly competitive pricing environment, coupled with weak balance sheets, may cause further U.S. airline restructurings, which may have a negative impact on our operating environment.

 

Results of Operations

 

Three-Month Period Ended February 28, 2005

(as compared with the same period of the prior year)

 

Consolidated sales for the third quarter ended February 28, 2005 increased $38,468 or 24.2% over the third quarter of last year. The increase in sales over the prior year was attributable to sales increases in each of the Company’s four reportable segments driven primarily by a 40.8% increase in sales to commercial airline customers. The increase in sales to commercial airline customers reflects improved demand for parts support due to increased passenger traffic as well as successful sales and marketing efforts.

 

In the Inventory and Logistic Services segment, sales increased $10,862 or 17.8% over the prior year period reflecting increased demand for engine and airframe parts, principally from European and Asian customers.

 

In the Maintenance, Repair and Overhaul segment, sales increased $5,198 or 10.8% over the prior year representing increased demand for aircraft maintenance, landing gear repair and component overhaul.

 

In the Manufacturing segment, sales increased $7,513 or 17.0% due to continued strong demand for specialized mobility products supporting defense customers and increased sales of cargo systems and composite structures primarily due to successful marketing efforts.

 

Sales in the Aircraft and Engine Sales and Leasing segment were $20,753, an increase of $14,895 over the prior year period reflecting the sale of the Company’s interest in certain aircraft for approximately $15 million at essentially book value.

 

Consolidated gross profit was $30,735 which represents a $4,179 increase over the prior year period reflecting the increase in consolidated sales, as well as an improvement in the gross profit margin within the Inventory and Logistic Services and Maintenance, Repair and Overhaul segments as a result of favorable product mix and increased volume.

 

Operating income increased $3,624 from the prior year as a result of increased sales, partially offset by higher selling, general and administrative expenses. Our selling, general and administrative expenses increased $753 or 3.7% compared to the same period in the prior year principally due to higher selling expenses from increased personnel costs. As a percentage of sales, selling, general and administrative expenses declined from 12.8% to 10.7%. Net interest expense declined $679 or 15.4% due to lower overall outstanding borrowings.

 

During the third quarter of fiscal 2005, upon completion of our fiscal 2004 Federal income tax return, we determined the Company qualified for additional tax benefits of $496 related to higher than estimated margin on fiscal 2004 export activities. Similarly, we recorded a $604 benefit during the third quarter of last year which primarily related to additional tax benefits from fiscal 2003 export activities.

 

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Income from continuing operations was $5,185 or more than double the prior year due to the factors discussed above.

 

During the third quarter of fiscal 2005, we sold our engine component repair business which is classified as discontinued operations in the Consolidated Statement of Operations. During the third quarter of fiscal 2005, the loss from discontinued operations was $2,590, or $0.07 per share and is comprised of the operating loss, net of tax, of $364 and the loss on disposal, net of tax, of $2,226.

 

Net income was $2,595 for the third quarter of fiscal 2005 compared to $2,012 in the prior year.

 

Nine-Month Period Ended February 28, 2005

(as compared with the same period of the prior year)

 

Consolidated sales for the nine-month period ending February 28, 2005 increased $70,288 or 15.0% over the prior year period. The increase in sales was primarily attributable to continued strong demand for our specialized mobility products supporting defense customers as well as a 22.8% increase in sales to commercial airline customers. The increase to commercial airline customers reflects improved demand for parts support due to increased passenger traffic and successful sales and marketing efforts.

 

Sales in the Inventory and Logistic Services segment increased $8,686 or 4.5% compared to the prior year period primarily due to higher demand for engine and airframe parts, principally in the Asian and European markets. Lower sales to general aviation customers as we de-emphasized certain lower margin products and lower sales of logistics support to our defense customers compared with record sales in the prior year period partially offset the engine and airframe parts increase.

 

In the Maintenance, Repair and Overhaul segment, sales decreased $2,153 or 1.4% as we experienced decreased demand for industrial gas turbine overhaul services and lower sales at our aircraft maintenance facility on a year to date basis. Increased demand for landing gear repairs and component repair services partially offset the reductions within the segment.

 

In the Manufacturing segment, sales increased $41,857 or 41.4% compared to the prior year period as we experienced increased sales at all of our business units within the segment. We continue to experience strong sales to the U.S. Military for products supporting defense efforts and expect this trend to continue into future quarters. We also experienced increased demand for cargo systems and composite structures to airline customers within the segment primarily due to successful marketing efforts.

 

Sales in the Aircraft and Engine Sales and Leasing segment increased $21,898 or 94.8%, which was primarily driven by the sale of our interest in certain aircraft for approximately $15 million at essentially book value.

 

Consolidated gross profit increased $12,548 or 17.1% compared with the prior year. The increase in our gross profit is primarily attributable to the increase in sales and a slight increase in the gross profit margin to 15.9% from 15.6% in the prior year. The gross profit percentage increased primarily due to the mix of products sold within the Inventory and Logistics Services segment largely due to reduced levels of low margin sales in the general aviation market and operational efficiencies obtained within the Manufacturing segment.

 

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Operating income increased $10,184 compared with the prior year primarily due to the increased sales, partially offset by higher selling, general and administrative costs. During the nine-month period ended February 28, 2005, our selling, general and administrative costs increased $2,570 or 4.4% primarily due to added resources to support company-wide growth. As a percentage of sales, selling, general and administrative costs declined from 12.6% to 11.4%. Net interest expense decreased $2,340 or 17.9% due to lower overall outstanding borrowings, lower weighted average interest rates and a first quarter $995 gain recorded on the early retirement of debt, partially offset by $500 of additional interest expense associated with outstanding litigation.

 

During the third quarter of fiscal 2005, upon completion of our fiscal 2004 Federal income tax return, we determined the Company qualified for additional tax benefits of $496 related to higher than estimated margin on fiscal 2004 export activities. Similarly, we recorded a $604 benefit during the third quarter of last year which primarily related to additional tax benefits from fiscal 2003 export activities.

 

During the second quarter of fiscal 2005 ended November 30, 2004, we recorded a favorable federal income tax adjustment of $1,575 or $0.05 per share. In October 2004 American Jobs Creation Act of 2004 (the “Act”) was signed into law. The Act included a number of federal income tax reforms, including an extension of the foreign tax credit carryforward period from five years to ten years. In previous fiscal years, we had established a deferred tax valuation allowance of $1,575 against foreign tax credits expiring in fiscal year 2006. As a result of the new ten-year carryforward period established by the Act, we now expect to utilize the foreign tax credits and recorded a $1,575 credit to the provision for income taxes during the second quarter of fiscal 2005.

 

Income from continuing operations was $12,744 or an increase of $10,841 over the prior year due to the factors discussed above.

 

During the third quarter of fiscal 2005, we sold our engine component repair business which is classified as discontinued operations in the Consolidated Statement of Operations. During the nine-month period ended February 28, 2005, the loss from discontinued operations was $3,024 or $0.08 per diluted share and is comprised of the operating loss, net of tax, of $798 and the loss on disposal, net of tax, of $2,226.

 

Net income was $9,720 for the nine-month period ended February 28, 2005 compared to $932 in the prior year.

 

Factors Which May Affect Future Results

 

Our operating results and financial position may be adversely affected or fluctuate on a quarterly basis as a result of general economic conditions, geo-political events, the commercial airline environment and other factors, including: (1) possible declines in demand for our products and services and the ability of our customers to meet their financial obligations; (2) possible declines in market values for aviation products and equipment; (3) difficulties in re-leasing or selling aircraft and engines that are currently being leased; (4) lack of assurance that sales to the U.S. Government, its agencies and its contractors (which were 34.6% and 33.8% of total sales for the nine month periods ended February 28, 2005 and February 29, 2004, respectively), will continue at levels previously experienced; (5) access to the debt and equity capital markets and the ability to draw down funds under financing agreements; (6) inability to comply with restrictive and financial covenants contained in certain of our loan agreements; (7) changes in or inability to comply with laws and regulations that may affect certain of our aviation related activities that are subject to licensing, certification and other regulatory requirements imposed by the FAA and other regulatory agencies, both domestic and foreign; (8) competition from other companies, including

 

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original equipment manufacturers, some of which have greater financial resources than us; (9) exposure to product liability and property claims that may be in excess of our substantial liability insurance coverage; and (10) the outcome of any pending or future material litigation or environmental proceedings.

 

Liquidity and Capital Resources

 

Historically, we have funded our operating activities and met our commitments through the generation of cash from operations, augmented by the periodic issuance of common stock and debt in the public and private markets. In addition to these cash sources, our capital resources include secured credit arrangements, which include an accounts receivable securitization program and a secured revolving credit facility. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively affected by a number of factors, including general economic conditions, airline and aviation industry conditions, geo-political events, including the war on terrorism, and our operating performance. Our ability to use our accounts receivable securitization program and revolving credit facility is also dependent on these factors. Our ability to generate cash from operations is influenced primarily by our operating performance and working capital management. We also have a universal shelf registration on file with the Securities and Exchange Commission under which, subject to market conditions, up to $163,675 of common stock, preferred stock or medium- or long-term debt securities may be issued or sold.

 

At February 28, 2005, our liquidity and capital resources included cash of $32,091 and working capital of $281,291. As of February 28, 2005, $11,600 of cash was restricted to support letters of credit. At February 28, 2005, we had $50,000 available under our accounts receivable securitization program; no accounts receivable were securitized as of that date. The amount available under this agreement is based on a formula of qualifying accounts receivable. At February 28, 2005, we had $26,207 available under our secured revolving credit facility; no amounts were outstanding as of that date. The amount available under the revolving credit facility is also based on a formula of qualifying assets. As of February 28, 2005, unrestricted cash and amounts available to us under our secured credit arrangement and accounts receivable securitization program totaled $98,135.

 

We continue to evaluate other financing arrangements on commercially reasonable terms that would allow us to improve our liquidity position and finance future growth. Our ability to obtain additional financing is dependent upon a number of factors, including the geo-political environment, general economic conditions, airline industry conditions, our operating performance and market conditions in the public and private debt and equity markets.

 

In July 2005, non-recourse notes of $31,496 mature and therefore have been classified as current on the February 28, 2005 Condensed Consolidated Balance Sheet. We expect to renew the lease agreement on the aircraft that secures the notes and to refinance the existing non-recourse notes with the lender on terms more favorable than those contained in the current lease and note agreements. As of February 28, 2005, our equity investment in the aircraft was $1,058.

 

During the nine-month period ended February 28, 2005, we generated $28,029 of cash from operations, primarily due to $21,112 of non-cash depreciation and amortization and approximately $15 million received from the sale of our interest in certain aircraft, partially offset by an increase in accounts receivable and inventory and cash contributions to our pension plan.

 

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During the nine-month period ended February 28, 2005, our investing activities used $13,208 principally reflecting capital expenditures of $9,463 and investments made in aircraft joint ventures of $10,811, partially offset by proceeds from the sale of the engine component repair business of $7,700.

 

During the nine-month period ended February 28, 2005, our financing activities used $23,738 of cash primarily due to the early retirement of notes for $19,660 and other scheduled principal payments.

 

Contractual Obligations and Off-Balance Sheet Arrangements

 

A summary of contractual obligations and off-balance sheet arrangements as of February 28, 2005 is as follows:

 

		Payments Due by Period
																				After
		Total			2/28/06			2/28/07			2/28/08			2/28/09			2/28/10			2/28/10
On Balance Sheet:
Debt		$	200,907		$	702		$	734		$	48,249		$	28,866		$	200		$	122,156
Non-recourse Debt		31,496			31,496			—			—			—			—			—
Bank Borrowings		1,606			1,606			—			—			—			—			—
Off Balance Sheet:
Aviation Equipment Operating Leases		22,083			7,147			14,936			—			—			—			—
Garden City Operating Lease		32,125			1,380			1,414			1,449			1,486			1,523			24,873

 

Critical Accounting Policies and Significant Estimates

 

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. Management has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the consolidated financial statements. The most significant estimates made by management include adjustments to reduce the value of inventories and equipment on or available for lease, allowance for doubtful accounts and loss accruals for aviation equipment operating leases. Accordingly, actual results could differ materially from those estimates. The following is a summary of the accounting policies considered critical by management.

 

Allowance for Doubtful Accounts  Our allowance for doubtful accounts is intended to reduce the value of customer accounts receivable to amounts expected to be collected. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, and the customer’s current and expected future financial performance.

 

Inventories  Inventories are valued at the lower of cost or market. Cost is determined by the specific identification, average cost or first-in, first-out methods. Provisions are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions. We have utilized certain assumptions when determining the market value of inventories, such as historical sales of inventory, current and expected future aviation usage trends, replacement values and expected future demand. Principally as a result of the terrorist attacks of September 11, 2001 and its anticipated impact on the global airline industry’s financial condition, fleet size and aircraft utilization, we recorded a

 

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