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March 25, 2020, 6:04 a.m. EDT

10-Q: AAR CORP

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(EDGAR Online via COMTEX) -- Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions)

General Overview

We report our activities in two operating segments: Aviation Services comprised of supply chain and maintenance, repair, and overhaul ("MRO") activities and Expeditionary Services comprised of manufacturing activities.

The Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance-based logistics programs, customer fleet management and operations, and aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and overhead.

The Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support the U.S. military's requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. This segment also designs and manufactures advanced composite materials for commercial, business and military aircraft. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead.

Our chief operating decision making officer (Chief Executive Officer) evaluates performance based on the operating segments and utilizes gross profit as a primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments.

The accounting policies for the segments are the same as those described in Note 1 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended May 31, 2019 except for our revised accounting policy for leases. On June 1, 2019, we adopted ASC 842, which amended the existing accounting standards for lease accounting. Prior periods have not been restated for ASC 842 and continue to be reported under the accounting standards in effect for those periods. A discussion of our revised accounting policy for leases is included in Note 10 to the Condensed Consolidated Financial Statements.

Business Trends and Outlook

Consolidated sales for the first nine months of fiscal 2020 increased $166.4 million or 11.2% over the prior year primarily due to an increase in sales of $175.5 million or 12.5% in our Aviation Services segment. While we are uncertain of the magnitude and length of any impact from the coronavirus ("COVID-19") on the aviation industry, we expect to see continued strength in our Aviation Services segment over the long-term given its offerings of value-added services to both commercial and government and defense customers. We believe long-term commercial aftermarket growth trends are favorable. However, our results of operations are affected by the amount of commercial aircraft flying and flight hours. The current COVID-19 pandemic has decreased the amount of commercial aircraft flying and flight hours, and has created economic disruption.

We believe the impact of COVID-19 will negatively affect our revenues and results of operations. However, in the fourth quarter, we will be taking actions to reduce our fixed costs and overhead by consolidating facilities with the goal to improve our operating efficiencies. Further, in response to the impact of COVID-19, we have taken actions including reducing executive compensation, freezing new hiring, reducing or eliminating all non-essential spend, furloughs and, unfortunately, reducing our workforce. We expect the cost of these fourth quarter actions to be approximately $15 to $20 million with the payback of these actions realized within one year. We remain prepared to take additional action as warranted to respond to the evolving airline demand environment.

Our cash on hand plus unused capacities on our Revolving Credit Facility was $432 million at February 29, 2020. In addition, we had availability of $92 million under our uncommitted accounts receivable financing program at that date.

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        Results of Operations
        Three Month Period Ended February 29, 2020
        Sales and gross profit for our two business segments for the three- and
        nine-months ended February 29, 2020 and 2019 were as follows:
                                              Three Months Ended February 29/28,          Nine Months Ended February 29/28,
                                              2020            2019         % Change        2020            2019       % Change
        Sales:
        Aviation Services
        Commercial                         $     353.7     $     350.8          0.8 %  $    1,053.8     $    983.0         7.2 %
        Government and defense                   176.6           146.5         20.5 %         520.3          415.6        25.2 %
                                           $     530.3     $     497.3          6.6 %  $    1,574.1     $  1,398.6        12.5 %
        Expeditionary Services
        Commercial                         $       5.5     $       6.8       (19.1) %  $       17.6     $     23.3      (24.5) %
        Government and defense                    17.3            25.4       (31.9) %          63.8           67.2       (5.1) %
                                           $      22.8     $      32.2       (29.2) %  $       81.4     $     90.5      (10.1) %
        








                                                 Three Months Ended February 29/28,            Nine Months Ended February 29/28,
                                                2020           2019          % Change         2020           2019         % Change
        Gross Profit (Loss):
        Aviation Services
        Commercial                           $      32.8     $    52.5           (37.5) %  $    143.1     $    141.8             0.9 %
        Government and defense                      32.4          29.2             11.0 %        87.8           81.9             7.2 %
                                             $      65.2     $    81.7           (20.2) %  $    230.9     $    223.7             3.2 %
        Expeditionary Services
        Commercial                           $     (1.3)     $     1.0          (230.0) %  $    (3.2)     $      2.5         (228.0) %
        Government and defense                       1.4           2.6           (46.2) %         5.1            8.6          (40.7) %
                                             $       0.1     $     3.6           (97.2) %  $      1.9     $     11.1          (82.9) %
        


Three Month Period Ended February 29, 2020

Aviation Services Segment

Sales in the Aviation Services segment increased $33.0 million or 6.6% over the prior year period due to a $30.1 million or 20.5% increase in sales to government and defense customers. The increase in sales to government and defense customers was primarily attributable to growth from new contracts recently awarded.

During the third quarter of fiscal 2020, sales in this segment to commercial customers increased $2.9 million or 0.8% over the prior year period. Sales were reduced by $9.8 million related to the impact of restructuring actions, which included the exit of one customer contract and restructuring of two other customer contracts.

Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In the third quarter of fiscal 2020, we had net favorable cumulative catch-up adjustments of $2.5 million. In the third quarter of fiscal 2019, we recognized favorable cumulative catch-up adjustments of $0.8 million. These adjustments primarily relate to our long-term, power-by-the-hour programs where we provide component inventory management and repair services and certain long-term government programs.

Cost of sales in Aviation Services increased $49.5 million or 11.9% over the prior year period primarily related to contract loss provisions and related costs of $14.9 million for the restructuring activities impacting certain contracts.

Gross profit in the Aviation Services segment decreased $16.5 million or 20.2% from the prior year period. Gross profit on sales to commercial customers decreased $19.7 million or 37.5% from the prior year period primarily due to the restructuring

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activities discussed above. The gross profit margin on sales to commercial customers decreased to 9.3% from 15.0% primarily from the contract restructuring costs of $14.9 million.

Gross profit on sales to government and defense customers increased $3.2 million or 11.0% over the prior year primarily driven by recently awarded government contracts. Gross profit margin on sales to government and defense customers decreased to 18.3% from 19.9% as the gross profit margin on these recent contract awards is lower than our existing government and defense activity.

Expeditionary Services Segment

Sales in the Expeditionary Services segment decreased $9.4 million or 29.2% from the prior year period primarily due to the timing of contract awards.

Gross profit in the Expeditionary Services segment decreased $3.5 million or 97.2% from the prior period primarily due to operational challenges impacting profitability in the current year period. Gross profit margin decreased to 0.4% from 11.2% to primarily as a result of these operational challenges.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $3.3 million over the prior year period. As a percent of sales, selling, general and administrative expenses increased to 10.5% from 10.3% in the prior year period. These increases are primarily attributable to increased costs over the prior year quarter for investigation and remediation compliance costs of $1.6 million.

Income Taxes

Our effective income tax rate for continuing operations was 7.1% for the third quarter of fiscal 2020 compared to an income tax benefit in the prior year period. The current year quarter included excess tax benefits from stock options exercises of $0.6 million which favorably impacted the effective tax rate. The prior year quarter included a tax benefit of $4.7 million related to the recognition of previously unrecognized uncertain tax positions and a tax benefit of $1.8 million related to tax provision to federal income tax return filing differences.

Nine Month Period Ended February 29, 2020

Aviation Services Segment

Sales in the Aviation Services segment increased $175.5 million or 12.5% over the prior year period primarily due to a $104.7 million or 25.2% increase in sales to government and defense customers. The increase in sales to government and defense customers was primarily attributable to new contracts awarded recently, including the $118 million contract for the procurement, modification and delivery of two C-40 aircraft we received in early fiscal 2020.

During the nine-month period ended February 29, 2020, sales in this segment to commercial customers increased $70.8 million or 7.2% over the prior year period. The increase was primarily due to higher volumes in our MRO activities as our actions to attract and retain the necessary skilled labor have allowed us to capture the customer demand for these services.

Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. During the nine-month period ended February 29, 2020, we had net favorable cumulative catch-up adjustments of $4.4 million. During the nine-month period ended February 28, 2019, we recognized net favorable and unfavorable cumulative catch-up adjustments of $4.1 million. These adjustments primarily relate to our long-term, power-by-the-hour programs where we provide component inventory management and repair services and certain long-term government programs.

Cost of sales in Aviation Services increased $168.3 million or 14.3% over the prior year period, which was primarily related to the higher volumes in our MRO activities partially offset by the contract restructuring charges.

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Gross profit in the Aviation Services segment increased $7.2 million or 3.2% over the prior year period. Gross profit on sales to government and defense customers increased $5.9 million or 7.2% over the prior year primarily driven by the new government contract awards. Gross profit margin on sales to government and defense customers decreased to 16.9% from 19.7% as the gross profit margin on these recent contract awards is lower than our existing government and defense activity.

Gross profit on sales to commercial customers increased $1.3 million or 0.9% over the prior year period primarily due to the increased volume and improved profitability in our MRO activities partially offset by the contract restructuring charges across three commercial program customers. The gross profit margin on sales to commercial customers decreased to 13.6% from 14.4% primarily from the increased profitability in our MRO activities partially offset by the reduced gross profit margin in our commercial program activities.

Expeditionary Services Segment

Sales in the Expeditionary Services segment decreased $9.1 million or 10.1% from the prior year period primarily due to the timing of contract awards. Gross profit in the Expeditionary Services segment decreased $9.2 million or 82.9% from the prior period primarily due to operational challenges impacting profitability in the current year. Gross profit margin decreased to 2.3% from 12.3% primarily as a result of these operational challenges.

Provision for Doubtful Accounts

In the second quarter of fiscal 2019, we recognized a provision for doubtful accounts of $12.4 million related to the bankruptcy of a European airline customer. The provision included impairment of non-current contract assets of $7.6 million, allowance for doubtful accounts of $3.3 million, and other liabilities of $1.5 million.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $21.2 million or 13.9% over the prior year period. As a percent of sales, selling, general and administrative expenses increased to 10.5% from 10.2% in the prior year period.

Income Taxes

Our effective income tax rate for continuing operations was 19.4% for the nine-month period ended February 29, 2020 compared to 7.6% for the prior year period. The prior year period included a tax benefit of $4.7 million related to the recognition of previously unrecognized uncertain tax positions and a tax benefit of $1.8 million related to tax provision to federal income tax return filing differences.

Liquidity, Capital Resources and Financial Position

Our operating activities are funded and commitments met through the generation of cash from operations. In addition to operations, our current capital resources include an unsecured Revolving Credit Facility and an accounts receivable financing program. Periodically, we may also raise capital through common stock and debt financings in the public or private markets. We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance future growth on commercially reasonable terms. 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 the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance. Our ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital.

At February 29, 2020, our liquidity and capital resources included cash of $37.0 million and working capital of $672.8 million.

We maintain a Revolving Credit Facility with various financial institutions, as lenders, and Bank of America, N.A., as administrative agent for the lenders. On September 25, 2019, we entered into an amendment to our Revolving Credit Facility which extended the maturity of the Revolving Credit Facility to September 25, 2024, increased the revolving credit commitment to $600

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million, and modified certain other provisions. Under certain circumstances, we have the ability to request, but our lenders are not required to grant, an increase to the revolving credit commitment by an aggregate amount of up to $300 million.

Borrowings under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 87.5 to 175 basis points based on certain financial measurements if a Eurodollar Rate loan, or at the offered fluctuating Base Rate plus 0 to 75 basis points based on certain financial measurements if a Base Rate loan.

Borrowings outstanding under the Revolving Credit Facility at February 29, 2020 were $185.0 million and there were approximately $20.3 million of outstanding letters of credit, which reduced the availability of this facility to $394.7 million. There are no other terms or covenants limiting the availability of this facility. Subsequent to the end of the quarter, we elected to draw down on the Revolving Credit Facility in an amount equal to $165 million with the majority of that draw remaining in our cash accounts. We elected to borrow such amounts as a precautionary measure in light of economic and market uncertainty presented by COVID-19.

As of February 29, 2020, we also had other financing arrangements that did not limit our availability on the Revolving Credit Facility including outstanding letters of credit of $11.6 million and foreign lines of credit of $9.5 million.

We maintain a Purchase Agreement with Citibank N.A. ("Purchaser") for the sale, from time to time, of certain accounts receivable due from certain customers (the "Purchase Agreement"). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million and Purchaser may, but is not required to, purchase the eligible receivables we offer to sell. The term of the Purchase Agreement runs through February 22, 2021, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual terms unless either party provides advance notice that they do not intend to extend the term.

We have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing, and de-recognize the sold receivables from our Condensed Consolidated Balance Sheet.

At February 29, 2020, we complied with all financial and other covenants under our financing arrangements.

Cash Flows from Operating Activities

Net cash used in operating activities-continuing operations was $0.5 million in the nine-month period ended February 29, 2020 compared to cash provided of $16.4 million in the prior year period. The decrease from the prior period of $16.9 million was primarily attributable to working capital changes, including customer invoice collection timing.

Cash Flows from Investing Activities

Net cash used in investing activities-continuing operations was $20.0 million during the nine-month period ended February 29, 2020 compared to $13.3 million in the prior year period. The increase from the prior period was primarily related to higher expenditures for property and equipment in the current year period.

Cash Flows from Financing Activities

Net cash provided from financing activities-continuing operations was $52.6 million during the nine-month period ended February 29, 2020 compared to cash used of $0.4 million in the prior year period. The increase was primarily related to additional borrowings in fiscal 2020 on our Revolving Credit Facility.

Critical Accounting Policies and Significant Estimates

We make a number of significant estimates, assumptions and judgments in the preparation of our financial statements. See Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2019 Form 10-K for a discussion of our critical accounting policies. There have been no significant changes to the application of our critical accounting policies during the third quarter of fiscal 2020.

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Forward-Looking Statements

This report contains certain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on beliefs of our management, as well as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated, depending on a variety of factors, including those factors set forth under Part II, Item 1A of this Quarterly Report on Form 10-Q and under Part I, Item 1A in our Annual Report on Form 10-K for the year ended May 31, 2019. Should one or more of those risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

Mar 25, 2020

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