AAR CORP - Quarter Report: 2012 August (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the Quarterly Period Ended August 31, 2012

 

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)

 

 

 

(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  x  No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

As of August 31, 2012, there were 39,940,227 shares of the registrant’s Common Stock, $1.00 par value per share, outstanding.

 

 

Table of Contents

 

AAR CORP. and Subsidiaries

Quarterly Report on Form 10-Q

For the Quarter Ended August 31, 2012

Table of Contents

 

				Page
Part I — FINANCIAL INFORMATION
	Item 1.	Financial Statements
			Condensed Consolidated Balance Sheets	3-4
			Condensed Consolidated Statements of Income	5
			Condensed Consolidated Statements of Comprehensive Income	6
			Condensed Consolidated Statements of Cash Flows	7
			Condensed Consolidated Statement of Changes in Equity	8
			Notes to Condensed Consolidated Financial Statements	9-19
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		20-23
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		23
	Item 4.	Controls and Procedures		23
Part II — OTHER INFORMATION
	Item 1A.	Risk Factors		24
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		24
	Item 6.	Exhibits		24
	Signature Page			25
	Exhibit Index			26

 

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PART I — FINANCIAL INFORMATION

 

Item 1 — Financial Statements

 

AAR CORP. and Subsidiaries

Condensed Consolidated Balance Sheets

As of August 31, 2012 and May 31, 2012

(In millions, except share data)

 

		August 31,			May 31,
		2012			2012
		(Unaudited)
Assets:
Current assets:
Cash		$	67.7		$	67.7
Accounts receivable, less allowances of $6.9 and $8.2, respectively		282.8			302.1
Inventories		466.0			461.2
Rotable spares and equipment on or available for short-term lease		140.1			138.6
Deposits, prepaids and other		55.0			71.1
Deferred tax assets		22.0			22.6
Total current assets		1,033.6			1,063.3
Property, plant and equipment, net of accumulated depreciation of $308.4 and $298.4, respectively		374.3			382.9
Other assets:
Goodwill		253.8			262.6
Intangible assets, net		164.7			155.0
Equipment on long-term lease		69.7			73.1
Investment in joint ventures		49.4			49.9
Other		224.8			208.9
		762.4			749.5
		$	2,170.3		$	2,195.7

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Condensed Consolidated Balance Sheets

As of August 31, 2012 and May 31, 2012

(In millions, except share data)

 

		August 31,			May 31,
		2012			2012
		(Unaudited)
Liabilities and equity:
Current liabilities:
Short-term debt		$	0.6		$	0.6
Current maturities of long-term debt		107.6			122.2
Accounts and trade notes payable		176.5			201.4
Accrued liabilities		131.9			149.0
Total current liabilities		416.6			473.2
Long-term debt, less current maturities		679.4			669.4
Deferred tax liabilities		122.6			115.9
Other liabilities and deferred income		69.6			71.2
		871.6			856.5
Equity:
Preferred stock, $1.00 par value, authorized 250,000 shares; none issued		—			—
Common stock, $1.00 par value, authorized 100,000 shares; issued 44,840,546 and 44,849,196 shares at cost, respectively		44.8			44.8
Capital surplus		423.4			423.6
Retained earnings		557.0			541.8
Treasury stock, 4,887,819 and 4,576,368 shares at cost, respectively		(93.3		)	(90.4		)
Accumulated other comprehensive loss		(51.3		)	(55.2		)
Total AAR shareholders’ equity		880.6			864.6
Noncontrolling interest		1.5			1.4
Total equity		882.1			866.0
		$	2,170.3		$	2,195.7

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Income

For the Three Months Ended August 31, 2012 and 2011

(Unaudited)

(In millions)

 

		Three Months Ended
		August 31,
		2012			2011
Sales:
Sales from products		$	327.5		$	331.4
Sales from services		223.0			154.1
		550.5			485.5
Cost and operating expenses:
Cost of products		284.1			290.4
Cost of services		176.1			119.4
Selling, general and administrative		53.3			43.1
		513.5			452.9
Earnings from joint ventures		1.4			0.2
Operating income		38.4			32.8
(Loss) on extinguishment of debt		(0.2		)	—
Interest expense		(10.6		)	(7.5		)
Interest income		0.4			0.1
Income before provision for income taxes		28.0			25.4
Provision for income taxes		9.7			8.8
Net income attributable to AAR and noncontrolling interest		18.3			16.6
(Income) loss attributable to noncontrolling interest		(0.1		)	—
Net income attributable to AAR		$	18.2		$	16.6
Earnings per share — basic		$	0.46		$	0.41
Earnings per share — diluted		$	0.45		$	0.41

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

For the Three Months Ended August 31, 2012 and 2011

(Unaudited)

(In millions)

 

		Three Months Ended
		August 31,
		2012			2011
Net income attributable to AAR and noncontrolling interest		$	18.3		$	16.6
Other comprehensive income, net of tax:
Currency translation adjustments, net of tax expense of $0.6 and $0, respectively		4.3			0.1
Derivative instruments unrealized losses, net of tax benefit of ($0.2) and ($1.4), respectively		(0.4		)	(2.5		)
Total other comprehensive income, net of tax		3.9			(2.4		)
Comprehensive income		22.2			14.2
Less: Comprehensive income attributable to noncontrolling interests		(0.1		)	—
Comprehensive income attributable to AAR		$	22.1		$	14.2

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

For the Three Months Ended August 31, 2012 and 2011

(Unaudited)

(In millions)

 

		Three Months Ended
		August 31,
		2012			2011
Cash flows from operating activities:
Net income attributable to AAR and noncontrolling interest		$	18.3		$	16.6
Adjustments to reconcile net income attributable to AAR and noncontrolling interest to net cash provided from operating activities:
Depreciation and amortization		20.3			15.8
Amortization of stock-based compensation		2.9			2.6
Amortization of debt discount		2.9			3.2
Amortization of overhaul costs		5.9			0.9
Deferred tax provision		5.6			2.8
Tax benefits from exercise of stock options		—			(0.8		)
Loss on extinguishment of debt		0.2			—
Earnings from joint ventures		(1.4		)	(0.2		)
Changes in certain assets and liabilities:
Accounts and notes receivable		20.7			(9.0		)
Inventories		(4.3		)	(36.8		)
Rotable spares and equipment on or available for short-term lease		(1.5		)	(8.3		)
Equipment on long-term lease		1.3			19.5
Accounts and trade notes payable		(25.6		)	5.0
Accrued and other liabilities		(3.4		)	(5.1		)
Other, primarily program and overhaul costs		(8.7		)	(31.8		)
Net cash provided from (used in) operating activities		33.2			(25.6		)
Cash flows from investing activities:
Property, plant and equipment expenditures		(11.0		)	(41.8		)
Proceeds from sale of equipment		11.0			—
Payments for acquisitions		(16.5		)	—
Other		(0.4		)	(0.5		)
Net cash used in investing activities		(16.9		)	(42.3		)
Cash flows from financing activities:
Proceeds from borrowing		20.0			50.0
Reduction in borrowing, net		(27.6		)	(3.1		)
Reduction in capital lease obligations		—			(0.5		)
Reduction in equity due to convertible bond repurchases		(0.3		)	—
Cash dividends		(3.0		)	(3.0		)
Purchase of treasury stock		(6.1		)	(1.0		)
Stock option exercises		—			2.9
Tax benefits from exercise of stock options		—			0.8
Net cash (used in) provided from financing activities		(17.0		)	46.1
Effect of exchange rate changes on cash		0.7			(0.1		)
Decrease in cash and cash equivalents		—			(21.9		)
Cash and cash equivalents, beginning of period		67.7			57.4
Cash and cash equivalents, end of period		$	67.7		$	35.5

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Changes in Equity

For the Three Months Ended August 31, 2012

(Unaudited)

(In millions)

 

														Accumulated
														Other			Total AAR
		Common			Capital			Retained			Treasury			Comprehensive			Shareholders’			Noncontrolling			Total
		Stock			Surplus			Earnings			Stock			Income (Loss)			Equity			Interest			Equity
Balance, May 31, 2012		$	44.8		$	423.6		$	541.8		$	(90.4	)	$	(55.2	)	$	864.6		$	1.4		$	866.0
Net income		—			—			18.2			—			—			18.2			0.1			18.3
Cash dividends		—			—			(3.0		)	—			—			(3.0		)	—			(3.0		)
Exercise of stock options and stock awards		—			0.8			—			—			—			0.8			—			0.8
Restricted stock activity		—			(1.0		)	—			3.2			—			2.2			—			2.2
Repurchase of shares		—			—			—			(6.1		)	—			(6.1		)	—			(6.1		)
Other comprehensive income, net of tax		—			—			—			—			3.9			3.9			—			3.9
Balance, August 31, 2012		$	44.8		$	423.4		$	557.0		$	(93.3	)	$	(51.3	)	$	880.6		$	1.5		$	882.1

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 1 — 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, 2012 has been derived from audited financial statements.  To prepare the financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”), 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 GAAP, 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 August 31, 2012, the condensed consolidated statements of income, the condensed consolidated statements of comprehensive income,  and its cash flows for the three-month periods ended August 31, 2012 and 2011 and the condensed consolidated statement of changes in equity for the three-month period ended August 31, 2012.  The results of operations for such interim periods are not necessarily indicative of the results for the full year.

 

Note 2 — 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.  Sales of certain defense products are recognized upon customer acceptance, which includes transfer of title.  Under the majority of our expeditionary airlift services contracts, we are paid and record as revenue a fixed daily amount per aircraft for each day an aircraft is available to perform airlift services.  In addition, we are paid and record as revenue an amount which is based on number of hours flown.  Sales from services 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, 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 certain large airframe maintenance contracts and performance-based logistics programs are recognized by the percentage of completion method, either based on the relationship of costs incurred to date to estimated total costs or the units of delivery method.  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.

 

Certain supply chain management programs we provide our customers contain multiple elements or deliverables, such as program and warehouse management, parts distribution and maintenance and repair services.  We recognize revenue for each element or deliverable that can be identified as a separate unit of accounting at the time of delivery based upon the relative fair value of the products and services.

 

Included in accounts receivable as of August 31, 2012 and May 31, 2012, are $30.7 million and $36.2 million, respectively, of unbilled accounts receivable related to a defense supply chain support agreement.  These

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

unbilled accounts receivable relate to costs we have incurred on parts that were requested and accepted by our customer to support the program.  These costs have not been billed by us because the customer has not issued the final paperwork necessary to allow for billing.

 

In addition to the unbilled accounts receivable, included in Other on the condensed consolidated balance sheet as of August 31, 2012 and May 31, 2012, are $28.9 million and $27.9 million, respectively, of costs in excess of amounts billed for the same defense supply chain support agreement.  We expect to recover costs in excess of amounts billed through future billings over the life of the program.

 

Note 3 — Accounting for Stock-Based Compensation

 

Stock Options

 

In July 2012, as part of our annual long-term stock incentive compensation, we granted 958,180 stock options to eligible employees at an exercise price of $12.90 and weighted average fair value of $4.6 million.  The fair value of stock options is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

 

		Three Months Ended
		August 31,
		2012		2011
Risk-free interest rate		0.6	%	1.5	%
Expected volatility of common stock		51	%	46	%
Dividend yield		2.3	%	1.0	%
Expected option term in years		5.4		5.7

 

The total intrinsic value of stock options exercised during the three-month periods ended August 31, 2012 and 2011 was zero and $3.3 million, respectively.   Expense charged to operations for stock options during the three-month periods ended August 31, 2012 and 2011 was $0.7 and $1.1 million, respectively.

 

Restricted Stock

 

In July 2012, as part of our annual long-term stock incentive compensation, we granted 53,280 shares of performance-based restricted stock and 65,780 restricted shares to eligible employees.  The grant date fair value per share was $12.90.  We also granted 45,000 restricted shares to members of the Board of Director with a grant date fair value per share of $11.56.  Expense charged to operations for restricted stock during the three-month periods ended August 31, 2012 and 2011 was $2.2 million and $1.5 million, respectively.

 

Note 4 — Inventory

 

The summary of inventories is as follows:

 

		August 31,			May 31,
		2012			2012
Raw materials and parts		$	97.0		$	101.3
Work-in-process		76.7			64.7
Purchased aircraft, parts, engines and components held for sale		292.3			295.2
		$	466.0		$	461.2

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 5 — Supplemental Cash Flow Information

 

		Three Months Ended
		August 31,
		2012			2011
Interest paid		$	10.6		$	3.2
Income taxes paid		3.1			1.9
Income tax refunds received		5.5			4.9

 

Note 6 — Financing Arrangements

 

A summary of the carrying amount of our debt is as follows:

 

		August 31,			May 31,
		2012			2012
Revolving credit facility expiring April 12, 2016 with interest payable monthly		$	300.0		$	280.0
Revolving credit facility (secured by aircraft and related engines and components) due April 23, 2015 with floating interest rate, payable monthly		31.2			33.0
Revolving credit facility subject to annual review in March with interest payable quarterly		0.6			0.6
Note payable due July 19, 2012 with interest at 7.22%, payable monthly		—			8.4
Note payable due March 15, 2014 with floating interest rate, payable monthly		2.2			2.6
Note payable due March 9, 2017 with floating interest rate, payable semi-annually on June 1 and December 1		45.0			50.0
Note payable due January 15, 2022 with interest at 7.25% payable semi-annually on January 15 and July 15		172.1			172.1
Mortgage loan (secured by Wood Dale, Illinois facility) due August 1, 2015 with interest at 5.01%		11.0			11.0
Convertible notes payable due March 1, 2014 with interest at 1.625% payable semi-annually on March 1 and September 1		69.4			68.5
Convertible notes payable due March 1, 2016 with interest at 2.25% payable semi-annually on March 1 and September 1		42.4			46.1
Convertible notes payable due February 1, 2026 with interest at 1.75% payable semi-annually on February 1 and August 1		88.7			94.9
Industrial revenue bond (secured by trust indenture on property, plant and equipment) due August 1, 2018 with floating interest rate, payable monthly		25.0			25.0
Total debt		787.6			792.2
Current maturities of debt		(108.2		)	(122.8		)
Long-term debt		$	679.4		$	669.4

 

During the three-month period ended August 31, 2012, we repurchased $5.0 million par value of our 2.25% convertible notes due March 1, 2016 and $8.0 million par value of our 1.75% convertible notes due February 1, 2026.  The 2.25% notes were repurchased for $4.4 million cash and the 1.75% notes were repurchased for $7.9 million cash, with a total loss of $0.2 million, after consideration of unamortized discount and debt issuance costs.  The losses on the debt repurchases for the 2.25% and 1.75% convertible notes are recorded in Loss on extinguishment of debt on the condensed consolidated statements of income.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

At August 31, 2012, the face value of our debt was $806.3 million and the estimated fair value was approximately $799.1 million.

 

The fair value amounts of our long-term debt securities are estimated using significant other observable inputs including quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.  This debt is classified as Level 2 in the fair value hierarchy.

 

We are subject to a number of covenants under our financing arrangements, including restrictions which relate to the payment of cash dividends, maintenance of minimum net working capital and tangible net worth levels, fixed charge coverage ratio, sales of assets, additional financing, purchase of our shares and other matters.  We are in compliance with all financial covenants under our financing arrangements.

 

Convertible Notes

 

As of August 31, 2012 and May 31, 2012, the long-term debt and equity component (recorded in capital surplus, net of income tax benefit) consisted of the following: 

 

		August 31,			May 31,
		2012			2012
Long-term debt:
Principal amount		$	216.3		$	229.3
Unamortized discount		(15.8		)	(19.8		)
Net carrying amount		$	200.5		$	209.5
Equity component, net of tax		$	74.8		$	74.8

 

The discount on the liability component of long-term debt is being amortized using the effective interest method based on an effective rate of 8.48% for our 1.75% convertible notes; 6.82% for our 1.625% convertible notes and 7.41% for our 2.25% convertible notes.  For our 1.75% convertible notes, the discount is being amortized through February 1, 2013, which is the first put date for those notes.  For our 1.625% and 2.25% convertible notes, the discount is being amortized through their respective maturity dates of March 1, 2014 and March 1, 2016.

 

As of August 31, 2012 and 2011, for each of our convertible note issuances, the “if converted” value does not exceed its principal amount.

 

The interest expense associated with the convertible notes was as follows:

 

		Three Months Ended
		August 31,
		2012			2011
Coupon interest		$	1.0		$	1.2
Amortization of deferred financing fees		0.2			0.2
Amortization of discount		2.8			3.2
Interest expense related to convertible notes		$	4.0		$	4.6

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 7 — Derivative Instruments and Hedging Activities

 

We are exposed to interest rate risk associated with fluctuations in interest rates on our variable rate debt.  During the first quarter of fiscal 2012, we entered into two derivative financial instruments in order to manage our variable interest rate exposure over a medium- to long-term period.  We use a floating-to-fixed interest rate swap to hedge interest on $50 million of notional principal balance under our revolving credit agreement. We also use an interest rate cap agreement on $50 million of notional principal interest under our revolving credit agreement.

 

We do not hold or issue derivative instruments for trading purposes and are not a party to any instruments with leverage or prepayment features.  In connection with derivative financial instruments, there exists the risk of the possible inability of counterparties to meet the terms of their contracts.  We mitigate this risk by performing financial reviews before the contract is entered into, as well as on-going periodic evaluations.  We do not expect any significant losses from counterparty defaults.

 

We classify the derivatives as assets or liabilities on the balance sheet.  Accounting for the change in fair value of the derivatives is a function of whether the instrument qualifies for, and has been designated as, a hedging relationship, and the type of hedging relationship.  As of August 31, 2012, all of our derivative instruments were classified as cash flow hedges.  The fair value of our interest rate swap and our interest cap agreements represents the difference in the present values of cash flows calculated at the contracted interest rates and at current market interest rates at the end of the reporting period.

 

We record the fair value of assets and liabilities in accordance with the hierarchy established by the authoritative guidance for fair value measurements.  The fair value of our interest rate derivatives are classified as Level 2, which refers to fair values estimated using significant other observable inputs including quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.  The following table summarizes the classification and fair values of our interest rate derivative instruments reported in the condensed consolidated balance sheet as of August 31, 2012.

 

				Derivative			Derivative
Derivatives designated				Assets			Liabilities
as hedging instruments		Balance Sheet Classification		August 31, 2012			August 31, 2012
Interest rate cap		Long-term assets		$	0.2		$	—
Interest rate swap		Long-term liabilities		—			(5.0		)

 

The following table summarizes the classification and fair values of our interest rate derivative instruments reported in the condensed consolidated balance sheet as of May 31, 2012.

 

				Derivative			Derivative
Derivatives designated				Assets			Liabilities
as hedging instruments		Balance Sheet Classification		May 31, 2012			May 31, 2012
Interest rate cap		Long-term assets		$	0.2		$	—
Interest rate swap		Long-term liabilities		—			(4.5		)

 

We include gains and losses on the derivative instruments in other comprehensive income.  We recognize the gains and losses on our derivative instruments as an adjustment to interest expense in the period the hedged interest payment affects earnings.  The impact of the interest rate swap and interest cap agreement for the three-month periods ended August 31, 2012 and 2011 was an unrealized loss of $0.4 million and $2.5 million, respectively, recorded in accumulated other comprehensive income (loss).  We expect minimal gain or loss to be reclassified into earnings within the next 12 months.

 

Note 8 — Earnings per Share

 

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

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options, shares issuable upon vesting of restricted stock awards and shares to be issued upon conversion of convertible debt.

 

We use the “if-converted” method in calculating the diluted earnings per share effect of the assumed conversion of our contingently convertible debt issued in fiscal 2006 because the principal for that issuance can be settled in stock, cash or a combination thereof.  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 into common shares at the beginning of the period.

 

In accordance with ASC 260-10-45, Share-Based Payment Arrangements and Participating Securities and the Two-Class Method, our unvested restricted stock awards are deemed participating securities since these shares are entitled to participate in dividends declared on common shares.  During periods of net income, the calculation of earnings per share for common stock exclude income attributable to unvested restricted stock awards from the numerator and exclude the dilutive impact of those shares from the denominator.  During periods of net loss, no effect is given to the participating securities because they do not share in the losses of the Company.

 

The following table provides a reconciliation of the computations of basic and diluted earnings per share information for the three-month periods ended August 31, 2012 and 2011.

 

		Three Months Ended
		August 31,
		2012			2011
Basic EPS:
Net income attributable to AAR and noncontrolling interest		$	18.3		$	16.6
Less income attributable to participating shares		(0.6		)	(0.6		)
Less income attributable to noncontrolling interest		(0.1		)	—
Net income attributable to AAR available to common shareholders		$	17.6		$	16.0
Basic shares:
Weighted average common shares outstanding		38.5			38.9
Earnings per share — basic		$	0.46		$	0.41
Diluted EPS:
Net income attributable to AAR and noncontrolling interest		$	18.3		$	16.6
Less income attributable to participating shares		(0.6		)	(0.5		)
Less income attributable to noncontrolling interest		(0.1		)	—
Add after-tax interest on convertible debt		1.2			1.5
Net income attributable to AAR available to common shareholders		$	18.8		$	17.6
Diluted shares:
Weighted average common shares outstanding		38.5			38.9
Additional shares from the assumed exercise of stock options		—			0.4
Additional shares from the assumed conversion of convertible debt		3.2			4.0
Weighted average common shares outstanding — diluted		41.7			43.3
Earnings per share — diluted		$	0.45		$	0.41

 

At August 31, 2012 and 2011, respectively, stock options to purchase 1,489,672 shares and 210,000 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because the exercise price of each of these options was greater than the average market price of the common shares during the interim periods then ended.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 9 — Acquisitions

 

On December 2, 2011, we acquired Telair International GmbH (“Telair”) and Nordisk Aviation Products, AS (“Nordisk).  Telair is a leader in the design, manufacture and support of cargo loading systems for wide-body and narrow-body aircraft with established positions on the world’s most popular current and next-generation passenger and freighter aircraft.  Telair operates from facilities in Germany, Sweden and Singapore.  Nordisk designs and manufactures heavy duty pallets and lightweight cargo containers for commercial airlines from facilities in Norway and China.  The purchase price of the acquisition was $280 million paid at closing, plus or minus a working capital adjustment.  During the fourth quarter of fiscal 2012, the working capital adjustment was finalized, which increased the purchase price to $296.5 million.  The $16.5 million was paid in the first quarter of fiscal 2013.  The businesses operate as part of our Structures and Systems segment.

 

On October 11, 2011, we acquired Airinmar Holdings Limited (“Airinmar”), a sophisticated repair, outsourcing and warranty claim manager.  Airinmar operates as part of our Aviation Supply Chain segment.  Total consideration is estimated to be $43.5 million, which included $23.2 million cash paid at closing, and a potential earn-out payment of $20.3 million.  The potential earn-out payment is based upon Airinmar achieving certain EBITDA (earnings before interest, taxes, depreciation and amortization) levels over a two-year period, as well as retaining certain key customers.  In accordance with accounting principles generally accepted in the United States of America, a liability of $20.3 million was recognized as an estimate of the acquisition date fair value of the earn-out and was included in Other non-current liabilities on our consolidated balance sheet as of February 29, 2012.   During the fourth quarter of 2012, this estimate was reduced by $3.4 million and this change in the fair value of the earn-out was recognized in earnings.

 

During the current period, we completed the final purchase price allocation for Airinmar and the results are as follows:

 

Cash		$	3.7
Accounts receivable		8.0
Prepaid expenses		0.9
Property, plant and equipment		0.6
Deferred tax assets		5.3
Goodwill and identified intangibles		42.4
Accounts payable		(6.7		)
Deferred tax liabilities		(5.3		)
Accrued liabilities		(5.4		)

 

For Telair and Nordisk, we are continuing the review of our fair value estimate of assets acquired and liabilities assumed during the measurement period, which will conclude as soon as we receive the information we are seeking about facts and circumstances that existed as of the acquisition date, or learn that more information is not available.  This measurement period will not exceed one year from the acquisition date.  At the effective date of the acquisition, the assets acquired and liabilities assumed are generally required to be measured at fair value.

 

Our fair value estimate of assets acquired and liabilities assumed is pending completion of several elements, including the finalization of an independent appraisal and valuations of fair value of the assets acquired and liabilities assumed and final review by our management.  The primary areas that are not yet finalized relate to the fair value of property and equipment, intangible assets and income and non-income related taxes.  Accordingly, there could be material adjustments to our consolidated financial statements, including changes in our depreciation and amortization expense related to the valuation of property and equipment and intangible assets acquired and their respective useful lives among other adjustments.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

The final determination of the assets acquired and liabilities assumed will be based on the established fair value of the assets acquired and the liabilities assumed as of the acquisition date.  The excess of the purchase price over the fair value of net assets acquired is allocated to goodwill.  The final determination of the purchase price, fair values and resulting goodwill may differ significantly from what is reflected in the consolidated financial statements.

 

The preliminary purchase price allocation for Telair and Nordisk is as follows:

 

Cash		$	1.5
Accounts receivable		47.1
Inventories		54.5
Prepaid expenses		4.1
Property, plant and equipment		17.0
Deferred tax assets		34.3
Goodwill and identified intangibles		223.9
Notes payable		(1.6		)
Accounts payable		(14.7		)
Deferred tax liabilities		(34.3		)
Accrued liabilities		(27.5		)
Other long-term liabilities		(7.8		)

 

Note 10 — Program Development Costs

 

In June 2005, we announced that our Cargo Systems business was selected to provide cargo handling systems for the new Airbus A400M Military Transport Aircraft (“A400M”).  Our portion of the revenue from this program is expected to exceed $300 million through fiscal 2021, based on sales projections of the A400M.  As of August 31, 2012 and May 31, 2012, we have capitalized, net of reimbursements, $101.7 million and $91.9 million, respectively, of costs associated with the engineering and development of the cargo system.  Sales and related cost of sales will be recognized on the units of delivery method.  In determining the recoverability of the capitalized program development costs, we have utilized certain judgments and estimates concerning expected revenues and the cost to manufacture the A400M cargo system.  Differences between actual results and the assumptions utilized by us may result in us not fully recovering the value of the program development costs, which would unfavorably impact our financial condition and results of operations.

 

Note 11 —Aircraft Portfolio

 

Within our Aviation Supply Chain segment, we own commercial aircraft with joint venture partners as well as aircraft that are wholly-owned.  These aircraft are available for lease or sale to commercial air carriers.

 

Aircraft Owned through Joint Ventures

 

As of August 31, 2012 and May 31, 2012, we had ownership interests in 18 aircraft with joint venture partners.  As of August 31, 2012 and May 31, 2012, our equity investment in aircraft owned with joint venture partners was approximately $41.3 million and is included in Investment in joint ventures on the Condensed Consolidated Balance Sheet.  Our aircraft joint ventures represent investments in limited liability companies that are accounted for under the equity method of accounting.  Our membership interest in each of these limited liability companies is 50% and the primary business of these companies is the acquisition, ownership, lease and disposition of certain commercial aircraft.  Aircraft are purchased with cash contributions by the members of the companies and debt financing provided to the limited liability companies on a limited recourse basis.  Under the terms of servicing agreements with certain of the limited liability companies, we provide administrative services and technical advisory services, including aircraft evaluations, oversight and logistical support of the maintenance process and records management.  We also provide remarketing services with respect to the divestiture of aircraft by the limited liability companies.  For the three-month periods ended August 31, 2012 and 2011, we were paid $0.2 million and $0.2

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

million, respectively, for such services.  The income tax benefit or expense related to the operations of the ventures is recorded by the member companies.

 

Distributions from joint ventures are classified as operating or investing activities in the condensed consolidated statements of cash flows based upon an evaluation of the specific facts and circumstances of each distribution.

 

Summarized financial information for these limited liability companies is as follows:

 

		Three Months Ended
		August 31,
		2012			2011
Sales		$	8.8		$	9.5
Income before provision for income taxes		2.9			0.6

 

		August 31,			May 31,
		2012			2012
Balance sheet information:
Assets		$	164.8		$	169.6
Debt		71.2			75.6
Members’ capital		87.7			88.8

 

Wholly-Owned Aircraft

 

In addition to the aircraft owned with joint venture partners, we owned two aircraft at August 31, 2012 and at May 31, 2012, for our own account that are considered wholly-owned.  Our investment in the two wholly-owned aircraft, after consideration of financing, is comprised of the following components:

 

		August 31,			May 31,
		2012			2012
Gross carrying value		$	23.9		$	25.2
Debt		—			(8.4		)
Net AAR investment		$	23.9		$	16.8

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

Information relating to aircraft type, year of manufacture, lessee, lease expiration date and expected disposition upon lease expiration for the 18 aircraft owned with joint venture partners and two wholly-owned aircraft is as follows:

 

Aircraft owned with joint venture partners

 

				Year				Lease Expiration		Post-Lease
Quantity		Aircraft Type		Manufactured		Lessee		Date (FY)		Disposition
2		767-300		1991		United Airlines		2016 and 2017		Re-lease
16		737-400		Various (1)		Malaysia Airlines		Various (2)		Sale/Re-lease
18

 

Wholly-owned aircraft

 

				Year				Lease Expiration		Post-Lease
Quantity		Aircraft Type		Manufactured		Lessee		Date (FY)		Disposition
1		737-300		1997		Small Planet Airlines		2015		Re-lease
1		A320		1997		Donbassaero Airlines		2017		Re-lease
2

 

(1)   Five aircraft in 1992; eight aircraft in 1993; two aircraft in 1994; and one aircraft in 1997

 

(2)   Twelve aircraft in 2013 and four aircraft in 2014.  The joint venture partners entered into LOIs for the sale of 13 aircraft and an additional aircraft is under contract.

 

Note 12 — Business Segment Information

 

We report our activities in four business segments: Aviation Supply Chain; Government and Defense Services; Maintenance, Repair and Overhaul; and Structures and Systems.

 

Sales in the Aviation Supply Chain segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components principally to the commercial aviation market.  We also offer customized inventory supply chain management programs and aircraft component repair management services.  Sales also include the sale and lease of commercial aircraft and jet engines and technical and advisory services.  Cost of sales consists principally of the cost of product, direct labor, overhead (primarily indirect labor, facility cost and insurance) and the cost of lease revenue (primarily depreciation and insurance).

 

Sales in the Government and Defense Services segment are derived from the sale of new and overhauled engine and airframe parts and components, customized performance based logistics programs, expeditionary airlift services, aircraft modifications and engineering, design, and integration services to our government and defense customers.  Cost of sales consists principally of the cost of the product (primarily aircraft and engine parts), direct labor, overhead and aircraft maintenance costs.

 

Sales in the Maintenance, Repair and Overhaul segment are principally derived from aircraft maintenance and modifications, engineering services, painting, and the repair, overhaul and exchange of landing gear.  Cost of sales consists principally of the cost of product (primarily replacement aircraft parts), direct labor and overhead.

 

Sales in the Structures and Systems segment are derived from the engineering, design and manufacture of containers, pallets and shelters used to support the U.S. military’s requirements for a mobile and agile force, heavy-duty pallets and lightweight cargo containers for the commercial market, complex machined and fabricated parts, components and sub-systems for various aerospace and defense programs and other applications, in-plane cargo

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

August 31, 2012

(Unaudited)

(Dollars in millions, except per share amounts)

 

loading and handling systems for commercial and military applications and composite products for aviation and industrial use.  Cost of sales consists principally of the cost of product, direct labor and overhead.

 

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, 2012.  Our chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure.  The expenses and assets related to corporate activities are not allocated to the segments.  Our reportable segments are aligned principally around differences in products and services.

 

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

 

		Three Months Ended
		August 31,
		2012			2011
Sales:
Aviation Supply Chain		$	148.7		$	161.1
Government and Defense Services		150.6			150.0
Maintenance, Repair and Overhaul		105.5			93.2
Structures and Systems		145.7			81.2
		$	550.5		$	485.5

 

		Three Months Ended
		August 31,
		2012			2011
Gross profit:
Aviation Supply Chain		$	23.7		$	26.2
Government and Defense Services		25.9			27.4
Maintenance, Repair and Overhaul		13.0			10.2
Structures and Systems		27.7			11.9
		$	90.3		$	75.7

 

Note 13 — Subsequent Event

 

Beginning in the second quarter of fiscal year 2013, we expect to report our aviation services businesses in one segment and our manufacturing and systems design businesses in a second segment.  The new aviation services segment will include our legacy Aviation Supply Chain, Government and Defense Services, and Maintenance, Repair and Overhaul segments and the new manufacturing and systems segment will include our legacy Structures and Systems segment.

 

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