AAR CORP - Quarter Report: 2014 February (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 February 28, 2014

 

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.

 

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

Smaller reporting company o

 

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 February 28, 2014, there were 39,568,550 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 February 28, 2014

Table of Contents

 

		Page
Part I — FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets	3
	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
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
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 February 28, 2014 and May 31, 2013

(In millions, except share data)

 

		February 28,			May 31,
		2014			2013
		(Unaudited)
Assets:
Current assets:
Cash		$	114.7		$	75.3
Accounts receivable, less allowances of $6.4 and $8.7, respectively		310.1			297.4
Inventories		506.8			453.7
Rotable spares and equipment on or available for short-term lease		116.7			129.2
Deposits, prepaids and other		67.3			60.1
Deferred tax assets		11.3			18.0
Total current assets		1,126.9			1,033.7
Property, plant and equipment, net of accumulated depreciation of $408.9 and $354.5, respectively		336.0			361.7
Other assets:
Goodwill		262.6			255.6
Intangible assets, net of accumulated amortization of $33.8 and $25.1, respectively		170.4			157.8
Equipment on long-term lease		68.4			64.7
Capitalized program development costs		113.4			124.9
Investment in joint ventures		30.6			31.8
Other		104.8			106.7
		750.2			741.5
		$	2,213.1		$	2,136.9

 

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 February 28, 2014 and May 31, 2013

(In millions, except share data)

 

		February 28,			May 31,
		2014			2013
		(Unaudited)
Liabilities and equity:
Current liabilities:
Current maturities of long-term debt		$	87.8		$	86.4
Accounts payable		160.5			149.3
Accrued liabilities		142.3			153.3
Total current liabilities		390.6			389.0
Long-term debt, less current maturities		626.6			622.2
Deferred tax liabilities		143.2			138.2
Other liabilities and deferred income		64.6			68.0
		834.4			828.4
Equity:
Preferred stock, $1.00 par value, authorized 250,000 shares; none issued		—			—
Common stock, $1.00 par value, authorized 100,000,000 shares; issued 44,680,804 and 44,691,437 shares at cost, respectively		44.7			44.7
Capital surplus		433.8			431.6
Retained earnings		631.8			584.9
Treasury stock, 5,112,254 and 5,309,252 shares at cost, respectively		(98.1		)	(100.1		)
Accumulated other comprehensive loss		(25.2		)	(42.5		)
Total AAR stockholders’ equity		987.0			918.6
Noncontrolling interest		1.1			0.9
Total equity		988.1			919.5
		$	2,213.1		$	2,136.9

 

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 and Nine Months Ended February 28, 2014 and 2013

(Unaudited)

(In millions, except per share amounts)

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Sales:
Sales from products		$	279.8		$	289.7		$	914.2		$	909.0
Sales from services		194.6			230.5			615.4			674.5
		474.4			520.2			1,529.6			1,583.5
Cost and operating expenses:
Cost of products		241.8			262.3			796.8			801.8
Cost of services		153.9			181.7			478.4			527.8
Selling, general and administrative		45.6			41.8			144.4			145.9
		441.3			485.8			1,419.6			1,475.5
Earnings from joint ventures		0.6			3.2			2.6			5.8
Operating income		33.7			37.6			112.6			113.8
Loss on extinguishment of debt		—			—			—			(0.3		)
Interest expense		(10.7		)	(10.2		)	(32.2		)	(31.6		)
Interest income		0.3			0.4			0.9			1.1
Income before provision for income taxes		23.3			27.8			81.3			83.0
Provision for income taxes		5.3			9.3			25.3			28.3
Net income attributable to AAR and noncontrolling interest		18.0			18.5			56.0			54.7
Income attributable to noncontrolling interest		(0.1		)	(0.1		)	(0.2		)	(0.3		)
Net income attributable to AAR		$	17.9		$	18.4		$	55.8		$	54.4
Earnings per share — basic		$	0.45		$	0.47		$	1.41		$	1.37
Earnings per share — diluted		$	0.45		$	0.46		$	1.40		$	1.35

 

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 and Nine Months Ended February 28, 2014 and 2013

(Unaudited)

(In millions)

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Net income attributable to AAR and noncontrolling interest		$	18.0		$	18.5		$	56.0		$	54.7
Other comprehensive income (loss), net of tax:
Currency translation adjustments, net of tax of $0.2 and $0.1 for the three months ended February 28, 2014 and 2013, respectively, and $0.8 and $0.1 for the nine months ended February 28, 2014 and 2013, respectively		4.2			0.7			16.0			13.0
Unrealized gain (loss) on derivative instruments:
Unrealized gain (loss) arising during period, net of tax of $0 and $0 for the three months ended February 28, 2014 and 2013, respectively, and $0.2 and $0 for the nine months ended February 28, 2014 and 2013, respectively		0.3			0.4			0.6			—
Pension and other post-retirement plans:
Amortization of actuarial loss and prior service cost included in net income, net of tax of $0.2 and $0 for the three months ended February 28, 2014 and 2013, respectively, and $0.5 and $0 for the nine months ended February 28, 2014 and 2013, respectively		0.2			—			0.7			—
Other comprehensive income, net of tax		22.7			19.6			73.3			67.7
Comprehensive income related to noncontrolling interest		(0.1		)	(0.1		)	(0.2		)	(0.3		)
Comprehensive income attributable to AAR		$	22.6		$	19.5		$	73.1		$	67.4

 

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 Nine Months Ended February 28, 2014 and 2013

(Unaudited)

(In millions)

 

		Nine Months Ended
		February 28,
		2014			2013
Cash flows from operating activities:
Net income attributable to AAR and noncontrolling interest		$	56.0		$	54.7
Adjustments to reconcile net income attributable to AAR and noncontrolling interest to net cash provided from operating activities:
Depreciation and amortization		59.2			60.4
Amortization of stock-based compensation		6.3			8.0
Amortization of debt discount		4.6			8.1
Amortization of overhaul costs		26.1			20.6
Deferred tax provision		4.7			23.0
Earnings from joint ventures		(2.6		)	(5.8		)
Changes in certain assets and liabilities:
Accounts and notes receivable		(10.1		)	1.5
Inventories		(37.0		)	(21.5		)
Rotable spares and equipment on or available for short-term lease		6.0			5.0
Equipment on long-term lease		(10.1		)	0.8
Accounts payable		9.6			(24.1		)
Accrued and other liabilities		(18.3		)	11.1
Other, primarily program and overhaul costs		(17.7		)	(54.0		)
Net cash provided from operating activities		76.7			87.8
Cash flows from investing activities:
Property, plant and equipment expenditures		(21.2		)	(23.9		)
Proceeds from sale of equipment		1.4			11.8
Payments for acquisitions		(16.1		)	(16.5		)
Proceeds from aircraft joint ventures		—			15.4
Other		(0.6		)	(0.7		)
Net cash used in investing activities		(36.5		)	(13.9		)
Cash flows from financing activities:
Short-term borrowings, net		20.0			25.0
Proceeds from borrowings		—			7.3
Reduction in borrowings		(18.0		)	(109.3		)
Reduction in equity due to convertible bond repurchases		—			(0.5		)
Cash dividends		(8.9		)	(9.9		)
Purchase of treasury stock		(1.0		)	(8.4		)
Stock option exercises		5.2			0.8
Tax benefits from exercise of stock options		1.0			0.1
Other		(0.3		)	(0.6		)
Net cash used in financing activities		(2.0		)	(95.5		)
Effect of exchange rate changes on cash		1.2			1.3
Increase (decrease) in cash and cash equivalents		39.4			(20.3		)
Cash and cash equivalents, beginning of period		75.3			67.7
Cash and cash equivalents, end of period		$	114.7		$	47.4

 

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 Statement of Changes in Equity

For the Nine Months Ended February 28, 2014

(Unaudited)

(In millions)

 

														Accumulated
														Other			Total AAR
		Common			Capital			Retained			Treasury			Comprehensive			Stockholders’			Noncontrolling			Total
		Stock			Surplus			Earnings			Stock			Income (Loss)			Equity			Interest			Equity
Balance, May 31, 2013		$	44.7		$	431.6		$	584.9		$	(100.1	)	$	(42.5	)	$	918.6		$	0.9		$	919.5
Net income		—			—			55.8			—			—			55.8			0.2			56.0
Cash dividends		—			—			(8.9		)	—			—			(8.9		)	—			(8.9		)
Stock option activity		—			1.6			—			4.9			—			6.5			—			6.5
Restricted stock activity		—			0.6			—			(1.9		)	—			(1.3		)	—			(1.3		)
Repurchase of shares		—			—			—			(1.0		)	—			(1.0		)	—			(1.0		)
Other comprehensive income, net of tax		—			—			—			—			17.3			17.3			—			17.3
Balance, February 28, 2014		$	44.7		$	433.8		$	631.8		$	(98.1	)	$	(25.2	)	$	987.0		$	1.1		$	988.1

 

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

February 28, 2014

(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, 2013 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 February 28, 2014, the Condensed Consolidated Statements of Income and the Condensed Consolidated Statements of Comprehensive Income for the three- and nine-month periods ended February 28, 2014 and 2013, the Condensed Consolidated Statements of Cash Flows for the nine-month periods ended February 28, 2014 and 2013, and the Condensed Consolidated Statement of Changes in Equity for the nine-month period ended February 28, 2014.  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, 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 the 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 to 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.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

Included in accounts receivable as of February 28, 2014 and May 31, 2013, are $19.6 million and $28.4 million, respectively, of unbilled accounts receivable related to the KC10 supply agreement.  These 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 non-current assets on the Condensed Consolidated Balance Sheet as of February 28, 2014 and May 31, 2013, are $10.8 million and $9.9 million, respectively, of costs in excess of amounts billed for the flight-hour portion of the same KC10 supply agreement.  We expect to recover costs in excess of amounts billed through future billings and by identifying additional costs savings opportunities over the life of the program.

 

Note 3 — Accounting for Stock-Based Compensation

 

Stock Options

 

In the first nine months of fiscal 2014, as part of our annual long-term stock incentive compensation, we granted 1,027,515 stock options to eligible employees at an average exercise price of $25.43 and weighted average fair value of $10.24.  The fair value of stock options is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

 

		Nine Months Ended
		February 28, 2014
Risk-free interest rate		1.4	%
Expected volatility of common stock		49.1	%
Dividend yield		1.2	%
Expected option term in years		5.2

 

The total intrinsic value of stock options exercised during the nine-month periods ended February 28, 2014 and 2013 was $3.8 million and $0.3, respectively.   Expense charged to operations for stock options was $1.0 and $1.0 million during the three months ended February 28, 2014 and 2013, respectively, and $2.6 and $2.6 million during the nine months ended February 28, 2014 and 2013, respectively.

 

Restricted Stock

 

In the first nine months of fiscal 2014, as part of our annual long-term stock incentive compensation, we granted 60,808 shares of performance-based restricted stock and 60,808 shares of time-based restricted stock to eligible employees.  The grant date fair value per share was $25.43.  In June 2013, we also granted 45,000 shares of time-based restricted stock to members of the Board of Directors with a grant date fair value per share of $20.68.  Expense charged to operations for restricted stock was $1.2 and $2.3 million during the three months ended February 28, 2014 and 2013, respectively, and $3.7 and $5.4 million during the nine months ended February 28, 2014 and 2013, respectively.

 

Note 4 — Inventory

 

The summary of inventories is as follows:

 

		February 28,			May 31,
		2014			2013
Raw materials and parts		$	113.9		$	83.9
Work-in-process		84.8			84.0
Purchased aircraft, parts, engines and components held for sale		308.1			285.8
		$	506.8		$	453.7

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 5 — Supplemental Cash Flow Information

 

		Nine Months Ended
		February 28,
		2014			2013
Interest paid		$	30.9		$	24.7
Income taxes paid		9.2			20.2
Income tax refunds received		6.6			5.9

 

Note 6 — Financing Arrangements

 

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

 

		February 28,			May 31,
		2014			2013
Revolving credit facility expiring April 24, 2018 with interest payable monthly		$	140.0		$	120.0
Secured credit facility (secured by aircraft and related engines and components) due April 23, 2015 with floating interest rate, payable monthly		32.3			39.2
Note payable due March 9, 2017 with floating interest rate, payable semi-annually on June 1 and December 1		30.0			40.0
Notes payable due January 15, 2022 with interest at 7.25% payable semi-annually on January 15 and July 15		332.8			333.4
Convertible notes payable due March 1, 2014 with interest at 1.625% payable semi-annually on March 1 and September 1		68.4			65.9
Convertible notes payable due March 1, 2016 with interest at 2.25% payable semi-annually on March 1 and September 1		45.1			43.5
Other(1)		65.8			66.6
Total debt		714.4			708.6
Current maturities of debt		(87.8		)	(86.4		)
Long-term debt		$	626.6		$	622.2

 

(1)         Included in Other at February 28, 2014 and May 31, 2013, respectively, is (i) a note payable due March 15, 2014 of $0.1 million and $1.2 million, (ii) a mortgage loan (secured by Wood Dale, Illinois facility) due August 1, 2015 of $11.0 million and $11.0 million, (iii) convertible notes due February 1, 2015 of $29.7 million and $29.4 million, and (iv) an industrial revenue bond (secured by property, plant, and equipment) due August 1, 2018 of $25.0 million and $25.0 million.

 

The 1.625% convertible notes due March 1, 2014 were retired for $68.4 million cash in accordance with the terms of the indenture on March 3, 2014, the first business day following the maturity date.

 

During the nine-month period ended February 28, 2013, we repurchased $6.4 million par value of our 1.625% convertible notes due March 1, 2014,  $5.5 million par value of our 2.25% convertible notes due March 1, 2016 and $11.0 million par value of our 1.75% convertible notes due February 1, 2026.  The 1.625% notes, 2.25% notes and 1.75% notes were repurchased for $6.1 million, $4.9 million and $11.0 million cash, respectively, with a total loss of $0.3 million after consideration of unamortized discount and debt issuance costs.  The losses on the debt repurchases for the 1.625%, 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

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

At February 28, 2014, the carrying value of our 7.25% bonds, 1.625% convertible notes and 2.25% convertible notes was $443.3 million and the estimated fair value was approximately $471.4 million.  These debt issuances are classified as Level 2 in the fair value hierarchy.  This classification is defined as a fair value determined using market-based inputs other than quoted prices that are observable for the liability, either directly or indirectly.

 

At February 28, 2014, the remaining variable rate and fixed rate debt had a fair value that approximates the carrying value of $268.4 million.  These debt instruments are classified as Level 3 in the fair value hierarchy which is defined as a fair value determined based upon one or more significant unobservable inputs.

 

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 levels, fixed charge coverage ratio, leverage ratio, sales of assets, additional financing, purchase of our shares and other matters.  We were in compliance with all covenants under our financing arrangements as of February 28, 2014.

 

Convertible Notes

 

As of February 28, 2014 and May 31, 2013, the long-term debt and equity component (recorded in capital surplus, net of income tax benefit) consisted of the following:

 

		February 28,			May 31,
		2014			2013
Long-term debt:
Principal amount		$	148.3		$	148.3
Unamortized discount		(5.1		)	(9.5		)
Net carrying amount		$	143.2		$	138.8
Equity component, net of tax		$	75.3		$	75.3

 

The discount on the liability component of long-term debt is being amortized using the effective interest method based on an effective rate of 6.82% for our 1.625% convertible notes, 5.00% for our 1.75% convertible notes; and 7.41% for our 2.25% convertible notes.  For our 1.625%, 1.75%, and 2.25% convertible notes, the discount is being amortized through their respective maturity dates of March 1, 2014, February 1, 2015, and March 1, 2016.

 

As of February 28, 2014 and 2013, 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						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Coupon interest		$	0.8		$	0.8		$	2.5		$	2.8
Amortization of deferred financing fees		0.1			0.1			0.3			0.4
Amortization of discount		1.5			2.3			4.4			7.9
Interest expense related to convertible notes		$	2.4		$	3.2		$	7.2		$	11.1

 

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.  We utilize two derivative financial instruments to manage our variable interest rate exposure over a medium- to long-term period.   We have a floating-to-fixed interest rate swap and an interest rate cap agreement, each hedging $50.0 million of notional principal interest under our revolving Credit Agreement.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

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 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 February 28, 2014, all of our derivative instruments were classified as cash flow hedges.  The fair value of the interest rate swap and interest rate 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 at February 28, 2014 and the Consolidated Balance Sheet at May 31, 2013.

 

Derivatives designated				February 28,			May 31,
as hedging instruments		Balance Sheet Classification		2014			2013
Interest rate cap		Long-term assets		$	0.1		$	0.1
Interest rate swap		Long-term liabilities		(2.9		)	(3.6		)

 

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 on the Condensed Consolidated Statement of Comprehensive Income for the three-month periods ended February 28, 2014 and 2013 was an unrealized gain of $0.3 million and $0.4, respectively.  The impact of the interest rate swap and interest cap agreement on the Condensed Consolidated Statement of Comprehensive Income for the nine-month periods ended February 28, 2014 and 2013 was an unrealized gain of $0.6 million and zero, respectively.  The unrealized gains and losses were 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 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 used 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 time-based restricted stock awards are deemed participating securities since

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

these shares are entitled to participate in dividends declared on shares of common stock.  During periods of net income, the calculation of earnings per share for common stock excludes income attributable to unvested restricted stock awards from the numerator and excludes 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- and nine-month periods ended February 28, 2014 and 2013.

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Basic EPS:
Net income attributable to AAR and noncontrolling interest		$	18.0		$	18.5		$	56.0		$	54.7
Less income attributable to participating shares		(0.4		)	(0.7		)	(1.2		)	(2.0		)
Less income attributable to noncontrolling interest		(0.1		)	(0.1		)	(0.2		)	(0.3		)
Net income attributable to AAR available to common shareholders		$	17.5		$	17.7		$	54.6		$	52.4
Basic shares:
Weighted average common shares outstanding		38.6			38.2			38.6			38.4
Earnings per share — basic		$	0.45		$	0.47		$	1.41		$	1.37
Diluted EPS:
Net income attributable to AAR and noncontrolling interest		$	18.0		$	18.5		$	56.0		$	54.7
Less income attributable to participating shares		(0.4		)	(0.6		)	(1.2		)	(1.9		)
Less income attributable to noncontrolling interest		(0.1		)	(0.1		)	(0.2		)	(0.3		)
Add after-tax interest on convertible debt		—			0.8			—			3.2
Net income attributable to AAR available to common shareholders		$	17.5		$	18.6		$	54.6		$	55.7
Diluted shares:
Weighted average common shares outstanding		38.6			38.2			38.6			38.4
Additional shares from the assumed exercise of stock options		0.5			0.2			0.5			—
Additional shares from the assumed conversion of convertible debt		—			2.2			—			2.9
Weighted average common shares outstanding — diluted		39.1			40.6			39.1			41.3
Earnings per share — diluted		$	0.45		$	0.46		$	1.40		$	1.35

 

At February 28, 2014 and 2013, respectively, stock options to purchase 170,000 shares and 888,536 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

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

Note 9 — Program Development Costs

 

Our Cargo Systems unit was selected in June 2005 to provide cargo loading systems for the Airbus A400M Military Transport Aircraft (“A400M”).  During fiscal 2013, we delivered initial production units to Airbus, and the first revenue-producing unit was delivered in the first quarter of fiscal 2014.  We expect our portion of the revenue from this program to be approximately $250 million through fiscal 2020, based on current sales projections of the A400M and the agreed-upon fixed pricing for the items that we are now responsible for under the amended contract.

 

As of February 28, 2014 and May 31, 2013, we have capitalized, net of reimbursements, $133.7 million and $130.9 million, respectively, of costs associated with the engineering and development of the cargo system.  Capitalized costs are broken out between current and non-current assets on the Condensed Consolidated Balance Sheets.  Current assets include $20.3 million and $6.0 million in Deposits, prepaids and other at February 28, 2014 and May 31, 2013, respectively and non-current assets include $113.4 million and $124.9 million in Capitalized program development costs at February 28, 2014 and May 31, 2013, respectively.  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 made certain judgments and estimates concerning expected revenues and the cost to manufacture the A400M cargo system.  Differences between actual results and our assumptions may result in our not fully recovering our program development costs, which could adversely affect our operating results and financial condition.

 

Note 10 — Business Segment Information

 

We report our activities in two business segments: Aviation Services and Technology Products.   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 and performance-based logistics programs, aircraft component repair management services, and aircraft modifications.  The segment also includes repair, maintenance, and overhaul of aircraft and landing gear and expeditionary airlift services.  Cost of sales consists principally of the cost of product, direct labor, overhead, and aircraft maintenance costs.

 

Sales in the Technology Products segment are derived from the engineering, designing, and manufacturing of containers, pallets, and shelters used to support the U.S. military’s requirements for a mobile and agile force and system integration services for specialized command and control systems.  The segment also manufactures heavy-duty pallets and lightweight cargo containers for the commercial market, in-plane cargo loading and handling systems for commercial and military applications, and steel and composite machined and fabricated parts, components and sub-systems for various aerospace and defense programs.  Cost of sales consists principally of the cost of material to manufacture products, 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, 2013.  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 assets and certain expenses related to corporate activities are not allocated to the segments.  Our reportable segments are aligned principally around differences in products and services.

 

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AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

February 28, 2014

(Unaudited)

(Dollars in millions, except per share amounts)

 

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

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Sales:
Aviation Services		$	367.8		$	408.2		$	1,186.2		$	1,197.2
Technology Products		106.6			112.0			343.4			386.3
		$	474.4		$	520.2		$	1,529.6		$	1,583.5

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Gross profit:
Aviation Services		$	59.4		$	59.0		$	196.2		$	187.8
Technology Products		19.3			17.2			58.2			66.1
		$	78.7		$	76.2		$	254.4		$	253.9

 

The following table reconciles segment gross profit to consolidated income before provision for income taxes.

 

		Three Months Ended						Nine Months Ended
		February 28,						February 28,
		2014			2013			2014			2013
Segment gross profit		$	78.7		$	76.2		$	254.4		$	253.9
Selling, general and administrative		(45.6		)	(41.8		)	(144.4		)	(145.9		)
Earnings from joint ventures		0.6			3.2			2.6			5.8
Loss on extinguishment of debt		—			—			—			(0.3		)
Interest expense		(10.7		)	(10.2		)	(32.2		)	(31.6		)
Interest income		0.3			0.4			0.9			1.1
Income before provision for income taxes		$	23.3		$	27.8		$	81.3		$	83.0

 

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