AAR: A Falling Tide Sinks All Boats

While a rising tide lifts all boats, the opposite also holds true.

Such has been the case with PeakStocks.com portfolio recommendation AAR Corp. (NYSE: AIR), which provides products and services to the aviation, aerospace, and defense industries.

Lately the words “aviation”, “aerospace” and “defense” have been about as popular as uttering the phrase “oil prices are higher”.

You can’t always escape the boom or the hammer that befalls a certain industry or sector, even if it appears that AAR is more protected from these concerns than other companies within its industry.

As a result of this and AAR’s upcoming earnings release in about 2 weeks, I am downgrading AAR’s shares to a HOLD if only temporarily, and for new money, until we get more clarification as to what’s going on with the industry, the companies that depend on AAR for business, and AAR’s business prospects for their 2009 fiscal year.

New to the AAR story?

• Read my last company update here.

or you can:

Click here to read my complete AAR Corp. research report.

Turning the Tide

As I wrote in my last company update, AAR has been fighting some sever headwinds, no pun intended.

Some of the reasons that I listed in detail in that report include:

• Overall market malaise and deterioration
• Aerospace and defense sector out of favor
• Concerns over higher fuel costs affecting AAR’s customers, and in turn AAR
• Possible political ramifications of upcoming elections

In that same report, I went over each point in detail in addition to my rebuttal of why these factors were more or less likely to weigh down shares of AAR corp. further, or whether the market was overacting and didn’t quite understand the AAR story entirely.

Again, you can read my last company update here.

The bottom line in all of this, is that there are indeed concerns about AAR, even stated by AAR’s management team in their last 10-Q:

“Over the last several weeks, certain U.S. air carriers have announced a new wave of cost reduction initiatives, including headcount reductions, route consolidations and capacity reductions. These initiatives are principally in response to persistently high fuel costs and softening economic conditions in the U.S.

In addition, certain air carriers have ceased operations. These and other factors may have a disproportionate effect on our U.S. regional airline customers given their size and route structure dependence on alliances with major carriers and the major carriers’ initiatives to reduce U.S. domestic capacity.

We are closely monitoring the effects of these factors in the industry, particularly on Mesa Airlines (Nasdaq: MESA), our largest regional airline customer, as it relates to their contract dispute to operate scheduled route service for one of their largest airline partners and other financial pressures they are experiencing.

There has been significant tightening in the credit markets which may affect our ability or our customers’ ability to raise debt or equity capital. There is also uncertainty over the direction of the U.S. economy as a result of slower growth rates, higher unemployment and the weak housing market. We are monitoring economic conditions for their impact on our customers and markets and assessing both risks and opportunities that may affect our business.

These factors may have an adverse impact on our growth rates and our results of operations and financial condition.”

My Take: This was written back in early April, almost 3 months ago, and feels like it could have just been written yesterday!

In addition, when AAR released this 10-Q as well as that quarter’s earnings release, AAR announced stellar earnings that beat analysts estimates.

Since that time, even with this statement as a backdrop, as well as the analyst conference call that AAR held, all of the analysts following this company have kept their ratings intact, AND kept their estimates the same as well.

AAR is covered by 8 analysts, so this isn’t as if one or two analysts are being hoodwinked and don’t see the forest for the trees.

I also kept advocating buying shares in AAR Corp during the last few month’s turmoil because, as I mentioned in my last company update, I believed that the market had overreacted to the potential disruption to AAR’s business because they are a fully diversified company that gets 50% of their revenue from government sales that don’t depend on the US economy, in addition to further expansion initiatives and acquisitions that would appeal to more international customers that would begin to utilize AAR’s services because of the falling dollar.

Since that time, AAR has not issued so much as a peep relating to either profit warnings or any other negative press release to speak of, and there have been no comments one way or another from management and my talks with management.

I still feel that AAR is going to be OK and in fact, survive better than most in this industry, but until we know more, and because earnings are going to be released on July 9th, I feel it is prudent to wait and see what management has to say, and what has transpired in the last year.

Current Price Point Presents More Opportunity

There’s also another reason for my downgrade.

AAR’s stock has slipped about 50% from my aggregate recommended purchase price of $30 per share.

Even if AAR reports amazing earnings, blows the socks off of the estimates, tells the world that they are in the best shape ever and are growing like gangbusters, it’s highly unlikely that AAR’s stock will double in one day back to our original $30 purchase price.

What this means for us is that since we already own shares, if the share price rises, it’s likely it will not offset our losses in one day or even one week.

It’s going to take awhile for the industry to recover in the market’s eyes, and for shares to come back.

So, at this point, before I advocate buying another installment of AAR’s shares to further cost- average our position, there is no harm in waiting untill after earnings are released and seeing where AAR stands with its most recent quarter, and more importantly, where AAR sees their business headed in the next year or so.

At that time, unless the stock doubles, which of course would be entirely fine with me, we’ll be able to purchase more shares freely at price points that will still reduce our overall purchase price and allow us to further scale into shares of AAR.

Bottom Line - Downgrade to Hold

Valuations of companies in the Aerospace and Defense sector have been absolutely pummeled in the last 6-8 months or so, and AAR is no exception.

Even if you look at the expected growth multiple of AAR and its current valuation, as dirt cheap as it is, it simply is a reflection of what Wall Street is willing to pay for these companies right now.

I feel that this stock has been unfairly punished as it offers a diversified revenue stream from 4 different segments, and because it garners 50% of its revenue from the US government, which, with continued war efforts around the globe, will need to continue to spend money to support troops, and the kinds of parts and services that AAR offers.

We are at an inflection point.

AAR is either going to rise significantly from here or continue it’s downtrend, all depending on the next round of earnings and what management says on the next earnings call.

In light of that fact, I feel it’s prudent to not put new money into AAR’s shares at present, hold onto your shares if you have them, and stay tuned to see what management has to say this time around.

Finally, even if AAR’s shares explode after earnings, we can still buy more at a favorable price point to either cost average your position further if you already bought AAR in the past, or start a new position with plenty of upside potential even after a post-earnings rise in share price.

In fact, my hesitation is only modest, as I fully expect that AAR will weather this current downturn well, and that the shares definitely will then qualify for my Double Thesis and have the ability to double in price within a year or so as the market and sector recover.

In the mean time, let’s wait 2 more weeks, and learn all we can before putting more money to work.

Comments

[maelstrom]

Nice analysis and spot on.

[Radiohead]

Does it concern you at all that you are downgrading after a chart that looks like this finance.yahoo.com/q/bc... ????? Especially after being a bull through the whole downtrend??? I realize you're putting a hold on it now, but you aren't doing anyone any favors by being a typical sell-side research analyst... This was just a poor call on your part and it hit you like a ton of bricks.....

[PeakStocks.com]

Hey Radiohead,

I appreciate the feedback, and you are correct in calling my out in my "downgrade" but notice that I did not say sell shares.

I am merely warning others to hold off on purchasing shares of AAR until after earnings are released in a couple more weeks, regardless of how undervalued the stock looks.

If you own shares, hold on to them, because whatever happens after earnings, it really won't change things much, even if the stock rises or falls significantly, because I am already down 50%, so the effects of even a 10% move up or down doesn't change things, and will thus allow us more time to consider what was said and delivered on the call, before making out next move.

If it is indeed the case that AAR is having more problems than I think they will, it's time to move on, kiss our money goodbye, and put the rest of the money to better use in something else.

If that happens, I'll own up to the mistake, and move on.

Chris