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Edited Transcript of AIR.N earnings conference call or presentation 21-Jul-20 8:45pm GMT

Q4 2020 AAR Corp Earnings Call

Wood Dale Aug 24, 2020 (Thomson StreetEvents) -- Edited Transcript of AAR Corp earnings conference call or presentation Tuesday, July 21, 2020 at 8:45:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John McClain Holmes

AAR Corp. - CEO, President & Director

* Sean M. Gillen

AAR Corp. - VP & CFO

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Conference Call Participants

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* Joseph William DeNardi

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst

* Joshua Ward Sullivan

The Benchmark Company, LLC, Research Division - Senior Equity Research Analyst

* Kenneth George Herbert

Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst

* Michael Frank Ciarmoli

Truist Securities, Inc., Research Division - Research Analyst

* Robert Michael Spingarn

Crédit Suisse AG, Research Division - Aerospace and Defense Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2020 Fourth Quarter Earnings Call. We are joined today by John Holmes, President and Chief Executive Officer; and Sean Gillen, Chief Financial Officer.

Before we begin, I would like to remind you that the comments made during the call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as noted in the company's news release and the Risk Factors section of the company's Form 10-K for the fiscal year ended May 31, 2019, and Form 10-Q for the fiscal quarter ended February 29, 2020.

In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events.

At this time, I would like to turn the call over to AAR's President and CEO, John Holmes.

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John McClain Holmes, AAR Corp. - CEO, President & Director [2]

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Great. Thank you, and good afternoon, everyone. I really appreciate you joining us today to discuss our fourth quarter and our full year 2020 results.

Before we get into those results, I'd like to begin by thanking the AAR team for its truly remarkable strength during these unprecedented times. In many cases, we have had to make difficult decisions in order to align our costs with a lower demand environment. And I'm really proud of my teammates for their professionalism and resilience as we work through the impact of COVID-19. I also want to thank our customers for their unwavering support and for recognizing the unique value that AAR continues to bring.

In addition, I'd like to comment on diversity and inclusion. These imperatives have been part of AAR's core values for decades. We have a long history, both internally and within our communities, of supporting and promoting underrepresented groups. However, the events in recent months have prompted us to broaden our efforts to try to understand systemic racism and discrimination and determine how we can continue to improve as a company and as a society. To that end, we are taking several additional steps that will enable us to rebuild our workforce with an even more diverse team as our industry recovers. Much as AAR has played an industry-leading role in addressing the shortage of skilled labor so too can we play a role -- a leadership role in building a more diverse and inclusive aviation workforce at all levels in the industry.

With that, I want to turn to our results. As you all know, the commercial aviation industry has been significantly impacted by the COVID-19 pandemic. In light of the challenging environment, I'm very pleased with our overall performance. Our sales for the year grew 1% from $2.05 billion to $2.07 billion. And our adjusted diluted earnings per share from continuing operations decreased 12% from $2.44 per share to $2.15 per share.

Although our earnings for the year were down from 2019 levels, our results reflect 3 quarters of record sales and earnings performance and the fourth quarter in which we were able to effectively navigate a historic decline in the commercial aviation industry due to the unprecedented grounding of the world's fleet.

Sales for the fourth quarter were down 26% from $563 million to $417 million. And adjusted diluted earnings per share from continuing operations were down 62% from $0.68 per share to $0.26 per share. We took numerous cost reduction actions early in the quarter to offset the impact, which we described in our May 21 8-K, including facility closures and consolidations, exiting unprofitable product lines and exiting or restructuring underperforming commercial programs contracts. These resulted in a pretax charge in the quarter of $27.9 million and bringing our cost structure into much better alignment with the current revenue base.

In addition, our agreement to divest our Composites manufacturing operation, which we announced a few weeks ago, was not profitable in FY '20 and is not core to our Aviation Services offering as a step towards further enhancing our profitability. We had launched the sale process earlier this calendar year and are pleased to have agreed on a transaction that furthers our multiyear strategy to focus on our industry-leading Aviation Services and reduce complexity in our operations. All of these actions, along with the actions we are continuing to take in the current quarter, produced permanent changes in our cost structure, which we expect to improve margins as our revenue recovers.

Even in this environment, we continue to pursue and win new business, and I want to highlight a few examples. During the quarter, we announced an agreement with BASF to distribute and maintain certain aircraft cabin air quality improvement products as well as $125 million sole source contract with the U.S. Air Force to produce and repair 463L cargo pallets. We also announced a joint venture with Sumitomo to provide supply chain solutions to the Japanese defense market and to distribute parts from Japanese OEMs to the global aftermarket.

In addition, subsequent to the quarter, we announced an extension and meaningful expansion of our agreement with Unison Industries, a subsidiary of GE Aviation. In this agreement, we serve as its exclusive worldwide aftermarket distributor for aviation, military, civil and land vehicle products. The agreement also includes repair services and is valued at more than $1 billion over 11 years. This award demonstrates the value of AAR's distribution model and connected businesses strategy as well as our ability to use our relative strength to extend and grow our business during the pandemic.

Before turning it over to Sean, I also want to touch on the expected agreement we announced yesterday with the U.S. Treasury under the Air Carrier Worker Support portion of the CARES Act. Under that agreement, we expect to receive $57.2 million to pay salaries, wages and benefits to the workforce currently employed in our U.S. airframe, landing gear, MRO operations. Of the $57.2 million, $48.5 million is a grant and $8.7 million is a low interest prepayable note.

As you know, over the last 2 years, we have worked to successfully build a technical workforce for AAR, and we have launched initiatives to bring new talent into our industry. This grant helps ensure that those efforts will continue, and I really want to thank Congress, and in particular, the Illinois, Oklahoma, Indiana -- and Indiana delegations as well as the administration for recognizing the essential services that our employees provide to the commercial aviation industry.

With that, I'll turn it over to our CFO, Sean Gillen.

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Sean M. Gillen, AAR Corp. - VP & CFO [3]

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Thanks, John. Our sales in the quarter of $416.5 million were down 26% or $146.2 million year-over-year, including a $7.5 million impact related to the exit of certain contracts. Sales to government and defense customers were 47% of consolidated sales versus 35% in the prior year quarter as our commercial activities were significantly impacted by COVID-19. Specifically, our commercial sales were down 40% year-over-year.

As John mentioned, we took a number of steps in the quarter to reduce our fixed cost and overhead, including closing our Goldboro and Duluth facilities, and exiting or restructuring underperforming contracts and product lines primarily in our commercial programs business. These actions resulted in a predominantly noncash charge of $27.9 million, which is recorded in the P&L, a reduction in revenue of $7.5 million, an increase in the cost of sales of $15.7 million, an increase in SG&A of $2.8 million and a loss from joint ventures of $1.9 million.

We are continuing to take additional actions in Q1 to reduce costs and improve margins. These include the Composites divestiture as well as continuing to address underperforming programs and additional footprint rationalization. We estimate that all of our actions will reduce ISG&A by over $50 million on an annualized basis. And we will remain disciplined about maintaining these cost savings, enabling margin expansion as demand recovers.

Gross profit margin in the quarter was 8.7% versus 16.8% in the prior year quarter. Excluding the charges, gross profit margin was 14.1% versus 17.0% in the prior year period, which reflects $0.9 million of adjustments in the prior year period related to facility repositioning costs.

Aviation Services gross profit decreased $53.2 million. Our government business across parts, repair and integrated solutions remained relatively stable, and we were able to emphasize our cargo end markets. However, demand in our commercial airline businesses was down as a result of the pandemic, including in both parts and maintenance services.

Within our heavy maintenance business, although we began the quarter with full hangers, work slowed throughout the quarter and remained at reduced levels, which we expect to continue during our seasonally low Q1.

In Expeditionary Services, gross profit decreased $5.1 million. We expect performance in this segment will improve as Mobility executes on the Air Force pallet contract and we complete the divestiture of Composites.

SG&A expenses were $47.3 million for the quarter. Adjusted SG&A was $46.5 million, down $10.8 million from the prior year quarter. This reduction was primarily driven by the COVID-19 related overhead cost actions we took.

During the quarter, we elected to draw the remaining available balance under our revolving credit facility as a precautionary measure, which resulted in net interest expense increasing $0.5 million to $2.6 million. We expect to repay the facility this quarter such that we maintain cash on hand going forward, consistent with historical levels.

In the quarter, we used $18.6 million of cash in our operating activities from continuing operations, primarily due to a decrease in accounts payable, partially offset by a decrease in accounts receivable, contract assets and inventory.

Also during the quarter, we returned $2.6 million to shareholders via a dividend of $0.075 per share. As a condition of accepting payroll funding from the U.S. Treasury under the CARES Act, we are not permitted to pay additional dividends through September 30, 2021.

Our balance sheet remains strong with net debt of $197.3 million and net leverage of 1.3 turns. We have no near-term maturities. And as of the end of the quarter, we had unrestricted cash of $404.7 million.

With respect to the CARES Act funding, we expect to receive the funds during our fiscal first quarter. Upon receipt, we will record an increase to unrestricted cash and corresponding liabilities for labor cost pursuant to the grant portion and for the unsecured note. The benefit will flow through the P&L. Specifically, as we incur salary, wages and benefit costs in our U.S. airframe and landing gear operations, we will offset the expense on the income statement until the funds are depleted, which is expected to take approximately 2 to 3 quarters. Similar to other government workforce subsidies, we will exclude the income from our adjusted earnings. Acceptance of the fund does not undo any of the cost actions taken in the fourth quarter.

Thank you for your attention, and I will now turn the call back over to John.

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John McClain Holmes, AAR Corp. - CEO, President & Director [4]

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Great. Thank you, Sean. Despite the impact of the COVID-19 pandemic, we are pleased with our Q4 and full year results, and I'm proud of the courage and dedication of our employees. Our government business continues to be healthy and growing, and we are having success placing more emphasis on our cargo end markets.

When the environment continues to be very dynamic, our commercial airline businesses have performed better than expected as a result of the early cost actions that we took in the quarter as well as our deep customer relationships. In addition, our liquidity and balance sheet remain strong, which we view as a competitive advantage, allowing us to secure new business. Our Unison win is a great example of this. However, we remain very focused on generating cash to preserve and enhance our liquidity position.

We expect to continue to make structural changes to our portfolio, which when combined with the actions we have already taken will improve the margins of the company as we recover. That said, the duration of the crisis remains very uncertain. And for that reason, we are not providing guidance for FY '21. We do expect sales in Q1, which is typically our lowest quarter based on seasonality, to be down sequentially from Q4, consistent with prior years.

Overall, we are confident in our ability to navigate the current environment, and we believe we have an opportunity to use our relative strength to emerge from the crisis even stronger, more profitable and better positioned for long-term growth.

With that, I'll turn it over to the operator for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Robert Spingarn of Crédit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [2]

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Understanding this is a dynamic time, yes, and obviously very difficult, one of the things, I think, would be helpful for investors is to see if we can figure out where trough is. And so in the context of your 40% decline in commercial, how do we think about the months in the quarter? And then you talked about this sort of seasonality on a sequential basis, but have you troughed? And can we talk about that separately for MRO versus parts?

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John McClain Holmes, AAR Corp. - CEO, President & Director [3]

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Yes. Sure. Good question. So from a parts standpoint, we felt the decline very early in the quarter. And I think the levels that we're at now, which are again better than what we expected, have been holding the last several weeks. And given the dynamic and the environment, it's difficult to call anything a trough. But we saw a decline, and they have been holding steady for the last several weeks. Now obviously, there's a lot of movement out there, particularly with the North American carriers in terms of the results of the recent surge and changes they may be making to their fleets. But so far, the last several weeks, the parts businesses, both distribution and trading, have held in there.

For MRO, throughout the quarter, we started the quarter with full hangers. And then throughout the quarter, we delivered aircraft. In many cases, those aircraft were not replaced by an additional aircraft. So we did see decline through the quarter. We are at a depressed level heading into the summer from where we would normally be. But seasonally, it's typically a low quarter for us. As it relates to MRO, we have a lot of dialogue with the customers right now about what the fall is going to look like. And I would say that's a very dynamic discussion. We're not yet clear on what the fall maintenance schedule will be. But we're confident that the customers are focused on keeping our facilities as full as possible, because they want to make sure that they're available to them as they see a recovery.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [4]

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Okay. I'd like to dig in a little bit in terms of how the customers are thinking about this. One of the ways that we look at it is the size of the parked fleet. So I guess the parked fleet got up to about 16,000, 17,000 aircraft early on in this thing and now has dipped below 10,000, so that's good news. Has that translated into more business? Or are those aircraft that are coming back in not in need of maintenance?

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John McClain Holmes, AAR Corp. - CEO, President & Director [5]

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We haven't seen it translate yet, but we do expect that there is a backlog of maintenance requirements that's building out there. And as the airlines look to manage their cash, we expect those maintenance events to convert. We do view that, though, with respect to potential retirements and the introduction of new aircraft into the fleet. And I think those dynamics are still playing out.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [6]

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Okay. And then this one other thing I wanted to ask you about was part outs and what, if anything, is happening there.

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John McClain Holmes, AAR Corp. - CEO, President & Director [7]

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Yes. So haven't seen a tremendous amount of activity there, and certainly, that's something we're looking at closely. If you think about the growth in our trading business in particular over the last several years, the constraint really to growth has been -- and we did grow, but the constraint to further growth has been availability of material. So we are looking forward to opportunities to part out aircraft and bring in more material to the market and capture a greater percentage there.

The other thing that we expect to see as we go through this, and our sales force is working very hard on this, is airlines that may not have been historical users use serviceable material. Given the pressure on cost, we may see more conversions of customers that typically have been OEM buyers look for alternative sources like USM. So as more material comes on the market as well as we can convert more customers take advantage of the cost savings that come with buying USM, we expect to see growth in recovery there.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [8]

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And on that point, on material coming to the market, you just said that the supply material is an important driver. Is that just not happening yet, because those who own the aircraft aren't yet sure what they want to do with them?

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John McClain Holmes, AAR Corp. - CEO, President & Director [9]

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Yes, I think that's a fair assessment. And just because aircraft are parked to retire does not necessarily mean they're going to go straight to part out. That takes time. And there is only a certain amount of available capacity out there in the market to part out aircraft. So there's a lot of factors at play in terms of how that new material or how that used material hits the market.

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Operator [10]

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Our next question comes from Joseph DeNardi of Stifel.

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Joseph William DeNardi, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst [11]

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John, just maybe along the lines of Rob's question, can you just maybe level set where things are now? Like what was the commercial business down in June or kind of where is it running now?

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John McClain Holmes, AAR Corp. - CEO, President & Director [12]

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Yes. I don't know that we want to necessarily comment on individual months, but we saw -- throughout the quarter, we saw a 40% decline in total, and certainly, that's accelerated between March and May. But the levels that we are seeing in June are slight -- or saw in June and are seeing in July are slightly better than what we saw in April and May, but still at a depressed level. So we're holding at the current position for the time being.

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Joseph William DeNardi, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst [13]

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Okay. Okay. And then maybe just kind of some more clarity around kind of the nature of your conversations with some of the airlines. I would imagine that some of them are obviously now under greater financial pressure, would be more interested in shifting risk and capital onto your balance sheet and taking advantage of that. Has that -- is that starting to present itself as an opportunity or not yet? And do you see that eventually as becoming one?

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John McClain Holmes, AAR Corp. - CEO, President & Director [14]

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Definitely see that potentially coming out from the airline. We actually already are seeing it from the OEMs. So in the distribution business, there's been a lot of discussions with OEMs at all levels in the supply chain of looking, to your point, to take advantage of our relative strength in exchange for long-term distribution agreements. We are exceptionally focused on our liquidity position and our cash position. So we're considering those deals very carefully. But we do view that as an opportunity to add strength to the distribution business, which has been a great success story for the last few years.

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Joseph William DeNardi, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst [15]

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Okay. And then maybe along the lines of the MRO business coming back, are you getting any kind of unusual requests from airlines in terms of how that work is financed? Are they asking you to extend them unusual terms, given their liquidity relative to yours?

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John McClain Holmes, AAR Corp. - CEO, President & Director [16]

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We went through a number of those discussions several months ago early in the quarter in terms of looking at extended terms for our airline customers. And that was pretty much. I wouldn't call that necessarily unusual. It was pretty much a universal request from all of our partners out there. And we -- in turn, we flowed that down to our supply base as well. So we have extended terms to our customers, and we've received extended terms from our supply base. And beyond that, we haven't seen any request that I would consider unusual.

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Operator [17]

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Our next question comes from Michael Ciarmoli of SunTrust.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [18]

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I know -- maybe I'm not sure if this is John or Sean. I know you guys aren't going to give any specific revenue guidance for the year. But I think you talked about taking $50 million of SG&A out of the business, probably implies $170 million. Is it fair to say you're sizing the business for maybe a $1.6 billion revenue run rate, just thinking about kind of how you've been running at SG&A? Is that a fair bogey to think about?

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John McClain Holmes, AAR Corp. - CEO, President & Director [19]

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I wouldn't think about the SG&A target necessarily in the context of revenue sizing. I would think about the SG&A target in -- really around improving our margins. As you can tell, we're taking a lot of action during this period of time, and we're taking quick actions to really change the structure of our cost base, as Sean mentioned, in many cases, on a permanent basis going forward. We've had a number of margin improvement targets for a long time, and we're really using this time to accelerate our efforts in that regard. I don't know, Sean, if you want to...

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Sean M. Gillen, AAR Corp. - VP & CFO [20]

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Yes. I would just add, Mike, my comment was over $50 million, and it's across ISG&A, so indirect spend, as well as SG&A. Just wanted to clarify that.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [21]

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Got it. Got it. And then can you just talk about -- you kind of talked about some of the conversations with the airlines. But can you maybe talk to some of the integrated program, the power-by-the-hour contracts? I mean it seems like we're going to be an environment here of reduced flying hours for quite some time. I think -- United just said they expect 65% capacity through this third quarter here. What are the implications on those existing contracts you have with your broad airline customers?

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John McClain Holmes, AAR Corp. - CEO, President & Director [22]

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Yes. So we also are prepared for an extended period of depressed flying. And that's the way we're modeling the business in the way we're sizing the business. As it relates to commercial programs in particular, that's a business that you did see significant decline in that business right away. Because just by definition, you build based on flight hours, and many of those customers had grounded all -- nearly all of their fleet during the period of time. As Sean mentioned, we did take some charges in that area, because those contracts, to the extent that they are flexible enough to work in this environment, we leave them in place. To the extent that the contract will not match the customers' operation and our requirements going forward, we're looking to restructure and stay with that customer. But in some cases, we've chosen to exit an agreement.

And as we've talked about for the last couple of quarters, that business, even before COVID, had been under pressure due to market dynamics and changes in costs in the supply chain. And once again, we're taking this opportunity to restructure that business so that when we come out of it, it's much more profitable going forward.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [23]

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Okay. Got it. That's helpful. And then I got one more here, and then I'll jump back in the queue. Inventory levels were up. If I think about just the total lack of flying, if someone like United's capacity is going to be down 65%, how do you think about burning down inventory if there's just a complete lack of flying hours, a lack of pull on any inventory in the broader supply chain if distributors are fully stocked? I mean, does this become a little bit problematic to move inventory if there's just not a lot of consumption out there? I mean, how are you guys thinking about maybe converting that inventory into cash under this depressed environment?

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John McClain Holmes, AAR Corp. - CEO, President & Director [24]

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No, great question. And converting inventory to cash is a very tough priority for us. You saw the inventory come up, because pre-COVID, there were a number of agreements that were signed that had investment requirements. And we, in almost all cases, lived up to those commitments to our partners, particularly in the distribution business. So that drove a lot of the inventory increase. We feel good about the position that we have. We feel good about the parts that we carry. The parts, in particular, in the commercial programs business, those are -- by definition, for those parts, the higher moving, higher consumed parts, just the way those contracts work. So it is material in a normal environment that would be high demand.

But as you point out, we are not in a normal environment. So we are redoubling our efforts to market that material very effectively, get creative in terms of the trading material that we have against other services that may be required from the customer base and looking to move it as best we can. But there's still, as we keep saying, a great deal of uncertainty out there in terms of how the overall fleet will unfold. And we may see certain asset classes where we would have expected a shorter life to actually get extended, because new aircraft deliveries aren't going to occur. So we're watching that as well.

And I do want to mention the point that I made to Rob Spingarn's question just around another effort we have underway is to convert customers to USM. This is a great time to -- when there's material available, particularly on our shelves within the market to really tap the benefits of buying used material that is often available at 30%, 60%, 70% of lift to customers that actually do have demand.

And just one more point on that. We are seeing -- if we look across different markets, we have seen a meaningful uptick in Asia. We are starting just in the last few weeks to see more activity out of Europe. Certainly, you've seen major changes here in North America. But that's another avenue is to go where the action is. And right now, we're redoubling our efforts in the market that are further ahead on the recovery as we look to move that material.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [25]

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Got it. And any pricing pressure on that material, John, either on your existing parts trading or just presumably a flood of parts out there where you kind of said you're getting creative and doing different things to market that material? Is pricing eroding in the marketplace?

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John McClain Holmes, AAR Corp. - CEO, President & Director [26]

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We've definitely seen pricing at the whole aircraft level decline, and we've seen some trades out there at meaningful discounts from where we saw pre-COVID. Certain higher dollar LRUs, we've seen a bit of that, but -- and we expect to see that. But nothing -- no kind of macro statistics I could give you at this point in terms of values at the part level.

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Operator [27]

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Our next question comes from Josh Sullivan of Benchmark.

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Joshua Ward Sullivan, The Benchmark Company, LLC, Research Division - Senior Equity Research Analyst [28]

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Just on the cargo business, how sustainable is the current strength? Maybe if you could just talk about what the pipeline or lead times look like for cargo conversions?

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John McClain Holmes, AAR Corp. - CEO, President & Director [29]

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Yes. I mean there's -- obviously, there's a lot of action out there in that market. And you certainly have the traditional cargo carriers, and we talk about our focus on it. We've got sales resources that previously had been covering dozens of commercial passenger accounts. Obviously, in many cases, their account base is shrunk or is just not as active as it was before. And we're redeploying those resources to focus on the cargo markets. And that's just not -- that's not parts, that's also heavy maintenance as well. We actually saw our first 747 cargo aircraft in our Miami maintenance facility. It's the first time done work on 747 in a really long time in that facility. And we just completed one and shipped it off, and we're looking to do more with that particular customer. So it's an area of focus and I think opportunity for us, again, not just on the maintenance side, but also on the parts side as well.

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Joshua Ward Sullivan, The Benchmark Company, LLC, Research Division - Senior Equity Research Analyst [30]

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And then just how is the conversation going with the airlines on their long-term MRO needs? I mean, at one point, pre-COVID market was very tight for labor, both for you and the airlines internally. But as far as the MRO outsourcing model as the airlines restructure, you're having those longer-term conversations about maybe what outsourcing can bring to them?

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John McClain Holmes, AAR Corp. - CEO, President & Director [31]

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Yes. Yes. I would say that, that is a very dynamic environment and definitely tracks with what you see out there in terms of their maintenance requirements are going to be aligned with the flying that they expect to do. And so certainly, no one's talking about bringing -- at least to my knowledge that we're talking to, no one's talking about bringing work in-house. Everybody is committed to the outsource model. And there is a real interest and focus on the part of our customer base of making sure that top-tier providers like AAR are around to service the aircraft when demand recovers.

That expectation, I would say, given recent events here in the U.S., has pushed out to the right versus where, I think, people were thinking it was going to be a month or 6 weeks ago. But everybody expects a recovery. Different customers have different expectations of the time line of that recovery, and they all recognize, though, that they're going to need an outsourced maintenance provider. And keeping our facilities full and running as best they can to make sure that we retain the workforce so that it's ready when they start to need maintenance at a greater scale is also a major focus of theirs.

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Joshua Ward Sullivan, The Benchmark Company, LLC, Research Division - Senior Equity Research Analyst [32]

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Got it. And then just one last one, following up on one of Rob's questions on part outs. Just with regard to your relationship with -- I believe it's Napier Park, are you anticipating the material use of that joint venture as those parts material become available? And then how large do you think that could potentially get?

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John McClain Holmes, AAR Corp. - CEO, President & Director [33]

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That is a great question. We are very excited about the partnership that we have with Napier. We've deployed only a fraction of that capital to date. And so there's a great deal of dry powder to go out and look for opportunities. That said, there's still so much moving in the market, it's difficult at this moment to tell what a good deal really is. And so we're paying very close attention to it. But we're also mindful that what we see today may look a lot different in a month. And we're approaching that market for acquisitions that ultimately could go to tear down or short-term lease very cautiously.

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Operator [34]

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Our next question comes from Ken Herbert of Canaccord.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [35]

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John, I wanted to ask if sitting here today, as you look at your fiscal second and third quarters for the MRO business, can you provide any quantification or commentary on how your backlog for MRO looks this year maybe just relative to prior years, specifically for the second and the third fiscal quarters?

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John McClain Holmes, AAR Corp. - CEO, President & Director [36]

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Yes. The backlog is less than it was, call it, a year ago. We're -- again, not to repeat, but we're encouraged by the dialogue that we're having from our customers in as much as there's going to be less work to go around. But they want to make sure that their top-tier providers like AAR get the work so that we can keep our operations running. We have both through -- obviously, we closed our facility in Duluth, and we have shrunk our footprint utilization at certain other facilities and unfortunately had to reduce our workforce. We have sized our MRO operation for a much smaller labor utilization going into this fiscal year than we would have had last fiscal year. And so against that smaller footprint, as a percentage, we're actually sold out approximately the same percentage that we would in a normal year. It's just on a much lower base.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [37]

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Got it. And if my calculations are correct, it looks like from -- with the facility closures from a man-hour basis, you've maybe taken your capacity down by somewhere in the 10% to 20% range?

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John McClain Holmes, AAR Corp. - CEO, President & Director [38]

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Yes, closer to the higher end of that range. Yes.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [39]

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Okay. Okay. Very helpful. And can you just remind us the split of your capabilities in MRO between wide-body and narrow-body? You mentioned the 47 (sic) [747] down at your Miami facility. And are you seeing any opportunity yet to maybe take share from cargo carriers that historically have sent the wide-body aircraft for MRO over to Asian or other lower cost markets?

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John McClain Holmes, AAR Corp. - CEO, President & Director [40]

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That is the dialogue we're having. We -- there are certain of our facilities, our facility in Rockford facility in Miami, for example, that are wide-body facilities. And we have had interest and we have that interest in repatriating that work. That's been a dialogue that's out there for a long time. But there are definitely, given the current environment, I'd say, renewed interest of bringing that some of that work back. So no particular deals in place there yet, but it is a conversation that we're having.

The one -- just to go back to your previous question, one point I would want to make. Our capacity in the MRO business is really -- is driven by the amount of labor available to it, not necessarily our footprint. So even though we've reduced our footprint, to the extent that we have demand and are able to secure labor to support that demand, we could actually see the same level of production off of this reduced footprint as we saw pre-COVID. And as Sean said, a number of the changes that we make, like rationalizing our footprint, position us to be more profitable coming out of this once we see demand return.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [41]

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Okay. That's helpful. And if you look, John, relative to -- I know this time is obviously very different. But as you look at the downturn now, there's a lot of speculation that as demand from the airlines for MRO and parts and services does start to come back, there will be significant green time availability, primarily on engines and other more capital-intensive assets. How much of a lag do you expect that to be or to create in the recovery? Is it a matter of weeks? Could it be a matter of quarters? I mean how are you thinking about that as you think about MRO and parts trading in other parts of your business?

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John McClain Holmes, AAR Corp. - CEO, President & Director [42]

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Yes. I would think about it at most a matter of quarters. But a lot of the airlines have -- they've already started to burn that green time, right? I mean they're moving engines from all of them, at least our customers went very quickly into a cash conservation mode. And so rather than sending engines to overhaul, they're swapping engines out on parked aircraft, et cetera, to the extent that there's removable LRUs that they can cannibalize. So that's already occurring. In some ways, we think that the opposite is there -- is actually a very significant amount of deferred maintenance that's building out there so that when we see a return to flying, you might actually see a much quicker and more dramatic uptick in parts requirements and maintenance requirements, because that green time is being burned as we speak.

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Kenneth George Herbert, Canaccord Genuity Corp., Research Division - MD and Senior Aerospace & Defense Analyst [43]

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Okay. Very helpful. Just one final question. Congratulations on the Unison renewal there. As I look at your distribution business, both on the military and the commercial side, with the new contracts you've added in over the last couple of quarters and renewals like this and potential for -- obviously, you talked about new potential OEM relationships in this climate. Can that business in fiscal '21 be flat relative to fiscal '20? Or can you just give any more sort of color around expectations for that business?

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John McClain Holmes, AAR Corp. - CEO, President & Director [44]

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We expect the government half of that business to be up in fiscal '20. Even with the new additions, depending on the timing, I would still say the commercial portion of that business, even with new wins, there would likely not be enough net new revenue to get the commercial business flat.

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Operator [45]

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Our next question comes from Joseph DeNardi of Stifel.

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Joseph William DeNardi, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst [46]

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John, just along the lines of the prior question. If it takes airlines until 2023 to get back to pre-COVID levels of flying and revenue perhaps, do you get back there before them, like the same time or after?

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John McClain Holmes, AAR Corp. - CEO, President & Director [47]

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I think it depends on how ultimately the fleet shakes out. So to the extent that you have more retirements in fleets that see more new aircraft deliveries and more retirements, we lag. To the extent that you see airlines recover and either defer or cancel new aircraft deliveries, and they've built up, as I said before, a pretty deferred -- a pretty significant amount of deferred maintenance, you could see an increase well before.

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Joseph William DeNardi, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Airline Analyst [48]

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Got it. And then when you look at that -- when you look across your exposure to aircraft type kind of across the business, obviously, there are aircraft types being exited in the U.S. pretty quickly. When you look at what's being retired, are there any surprises? And do inventory levels on the balance sheet reflect some of those risks currently?

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John McClain Holmes, AAR Corp. - CEO, President & Director [49]

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Yes. First of all, no surprises. As a matter of fact, we think one the larger ones, American, was -- that was announced many months ago and that was expanded a little bit, but that was kind of already out there. So no surprises. And certainly, whether it's the 747, you've seen a lot more retirements, obviously, in the wide-body, 777s, et cetera, that's less significant to us. So not as concerned about that. And you've got MD-80 or -- MD-80, MD-90 that have retired, again, no surprises there.

So I think so far, we're not seeing -- what we're seeing is tracking with what we would expect. And again, we're very eager, based on the -- particularly the engine support contracts we have with certain shops to get our hands on material that previously, prior to COVID, would not have been available to us so we can support demand. And albeit the overall demand will be depressed, but we expect to be able to support a greater percentage of that demand as things recur.

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Operator [50]

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Our next question comes from Robert Spingarn of Crédit Suisse.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [51]

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Just a follow-up to Joe's question there on the -- When I look at the $600-plus million in inventories on the books here, what you're saying, John, is not a rather insignificant piece of that would be the red programs. When I say red, I'm talking about some of the programs you just mentioned. So anything with 4 engines and MD-80s, 90s and 757?

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John McClain Holmes, AAR Corp. - CEO, President & Director [52]

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Yes, it's correct. The wide-body exposure is very limited. And we actually -- in the quarter, we wrote down our positions on the MD-80, 90, we wrote those positions off. There was some ATR material that we wrote off as well. So anything truly red, we've already taken action on.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [53]

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Just curious, what do you think of something like the 777s that came out of Delta that are 10 years old? I mean what's going to happen to airplanes like that? I understand in that specific case, they own them, they'll have to release them. But is there going to be a market for something like that, at least on a part out basis?

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John McClain Holmes, AAR Corp. - CEO, President & Director [54]

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Yes. I mean there could be. I think about, I don't know, 5 or 6 years ago when the 767 was dead and we couldn't give away ADC material. And then all of a sudden, Amazon started flying, and it became one of the hottest asset types around. There's a question. I mean that's a great aircraft and it's hard to predict where they might find a home, but we certainly would -- yes, like it's hard to predict whether it'll find a home, but we certainly would expect use for an aircraft of that type.

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Robert Michael Spingarn, Crédit Suisse AG, Research Division - Aerospace and Defense Analyst [55]

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Okay. And then, Sean, I have one for you and it touches on some of the things that have already been discussed. But in looking at the cash flow in the quarter, some of the working capital accounts moved differently than I might have expected, specifically receivables and payables. And then more -- the other thing I wanted to ask you about is how do we think about breakeven operating cash flow. What level of revenue supports a breakeven operating cash flow?

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Sean M. Gillen, AAR Corp. - VP & CFO [56]

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Yes. On the first part, in terms of the balance sheet and net working capital items in the quarter, accounts receivable, given the decline in the top line, we were able to work that down pretty significantly and have it be a big provider of cash. So I'd say some of that was in line with just activity declining in that kind of new AAR being put in, they were able to work down in the quarter. And then on accounts payable, I'd say, in a similar way, there was a lot less new purchasing activity, because we tried to really focus on cash flow generation. So this was taking things that weren't aged, but the payables were coming due and managing them at the end of the fiscal year. So that's the 2 biggest.

And then on contract assets, as the activity in the hangers come down, that kind of comes down in line with some of those activity, which is a net provider of cash because of that dynamic.

In terms of kind of where does the top line need to be in terms of breakeven, for us, we're kind of not giving guidance on that. But when we think about where the balance sheet is and the amount of inventory we have and focus on turning the inventory into cash, I'd say there's not a kind of bright line of where sales for the whole company needs to be as long as we can kind of continue to focus on inventory and limit new buys. Caveat being that as we take advantage of our relative position of strength for things like Unison and other items that come up, we're going to want to put some capital to work on new positions to expand our market share in this period of time.

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Operator [57]

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Our next question comes from Michael Ciarmoli of SunTrust.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [58]

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Sean, just to look -- I know you're not giving guidance again. But how are you guys thinking about the level of adjustments or charges on a go-forward basis? Anything that we should expect in the coming quarters, whether it's the ongoing facility, severance? Obviously, hard to predict the customer contract and customer bankruptcies. But just trying to get a sense of what we should expect here in terms of any nonoperational or nonrepeatable charges.

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Sean M. Gillen, AAR Corp. - VP & CFO [59]

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Yes. Good question, and we'll kind of stay away from forecasting or guiding on that. But there are activities that continue to take place in Q1. One, Composites, we included it in the 8-K. I mentioned previously that, that would be about $20 million charge associated with the divestiture of that business. And I would expect there's other kind of activities, whether it be head count or facility. And then we're reviewing the portfolio on some of these contracts. But I can't say today what that would look like.

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John McClain Holmes, AAR Corp. - CEO, President & Director [60]

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Sorry, I would just add that we're very focused on any action that we take, it results in a onetime event that, that action is going to have a meaningful improvement on the profitability of the company going forward.

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Michael Frank Ciarmoli, Truist Securities, Inc., Research Division - Research Analyst [61]

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Got it. Should we think about sequentially -- obviously, a tough environment. But given some of the cost actions, do gross margins improve sequentially? I mean it's going to be a lower volume quarter, but how should we think about maybe the gross margin profile here?

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John McClain Holmes, AAR Corp. - CEO, President & Director [62]

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I would say that over time, it will improve, but I would not expect sequential improvement. And again, the reason we're not giving guidance is because we are in such a dynamic environment right now.

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Operator [63]

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At this time, I'd like to turn the call back over to management for any closing remarks.

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John McClain Holmes, AAR Corp. - CEO, President & Director [64]

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Great. Well, thank you. Thank you, everybody, for the time and interest today. We really appreciate it, and we hope everyone stays safe out there. And we look forward to talking about our Q1 results in 90 days. Thank you.

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Operator [65]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.