By John Persinos via Investing Daily
Aviation mechanics are the unsung heroes that keep a fleet in the air. They’re indispensable for the continual and safe operation of any type of aircraft.
But this breed of wrench-turner doesn’t come cheap. Maintenance, repair and overhaul (MRO) accounts for approximately 11 percent of an airline’s employees and up to 15 percent of its operating expenses, making MRO second only to fuel as an overhead cost in aviation.
During the Great Recession of 2008-2009, MRO was an easy—but myopic—target of cost cutting for beleaguered aircraft operators. Now, as the global economy recovers, the need to tackle deferred maintenance combined with greater airline activity is boosting the MRO sector’s bottom line.
According to the aerospace consultancy SAI, the commercial MRO industry generated $49.5 billion in revenue in 2012, an increase of 5.7 percent from 2011. That number is expected to reach $68.4 billion in 2022, for a 10-year compound annual growth rate of 3.3 percent (see chart, below).
Other MRO growth factors include emerging market prosperity—especially in Asia, where the expanding ranks of middle class consumers in countries such as China, South Korea and Indonesia are buying more airplane tickets and compelling fleets to add new aircraft.
The purest play on these trends is AAR Corp (NYSE: AIR), which provides MRO products and services to commercial, government and defense clients.
The company engages in the purchase, sale, lease, repair, and overhaul of airframe parts, including avionics and electronic, fuel, and hydraulic components. AAR supports its MRO services by providing customized inventory supply and management programs.
With facilities located throughout the United States, AAR is the second-largest independent MRO provider in North America; the largest is TIMCO Aviation Services, a private company.
Based in Wood Dale, Illinois, AAR also ranks among the top 10 MRO companies in the world and represents the best direct investment available on increasing demand for MRO services.
Huge, diversified multinational companies have subsumed the vast majority of MRO operations and turned them into subsidiaries. Those MRO shops that haven’t been purchased tend to be operated as in-house divisions of major airline carriers or manufacturers.
For example, AAR competitor United Technologies Corp (NYSE: UTC) is a sprawling conglomerate with fingers in many different industrial pies, of which MRO is only one part.
AAR already is benefiting from the worldwide pick-up in aerospace, as well as the widespread decrepitude of a global aircraft fleet that’s crying out for belated upkeep.
AAR reported second quarter fiscal year 2013 revenue of $512.8 million and earnings of $17.8 million, or $0.44 per diluted share. This compares to year-ago revenue of $482 million and earnings of $17.6 million, or $0.43 per diluted share.
Commercial revenue increased 28 percent over the prior year’s second quarter, rising to 60 percent of consolidated revenue compared to 50 percent in the same period last year. This growth was driven by strength at the company’s airframe maintenance centers, parts supply and engineering services businesses.
Revenue from government and defense customers represented 40 percent of consolidated revenue and declined 15 percent from the second quarter of last year.
AAR also serves an experienced provider of maintenance inspections to the world’s airline fleets. As budgetary cutbacks in the US diminish the capabilities of the FAA and other regulatory agencies, airlines will straighten up and fly right by leaning on AAR’s inspectors.
Most of the globe’s regional aviation markets are active again, with emerging economies leading growth. MRO demand is particularly pronounced in China, which has made its aerospace sector a national priority and is pouring billions into the development of an indigenous aircraft-manufacturing base.
However, while Latin America, the Middle East, Africa, Asia and China are currently growing faster, North America and Europe will be increasingly compelled to renew older aviation fleets that are less efficient, guzzle too much fuel and are less safe.
The Razor’s Edge
The aviation industry, particularly the MRO sector, is in the midst of unprecedented consolidation. Driving these mergers and acquisitions is the need for increased operational efficiencies and lower labor costs.
The pressure on aviation companies to eliminate bureaucratic redundancies and shift operations to lower-cost sources such as AAR has never been more intense.
AAR has been in the vanguard of this push for consolidation. Over the years, it has aggressively pursued acquisitions of smaller MRO vendors, including Telair International GmbH, Nordisk Aviation Products AS, and Summa Technology.
AAR’s efforts at greater automation and integration in the MRO supply chain, and its elimination of redundant processes, are pushing down its MRO costs and speeding the turnaround of its contract work.
Even under the best conditions, airlines struggle with razor thin profit margins. They typically earn an average net profit of between 1 percent and 2 percent, compared to above 5 percent for US industry as a whole. That makes it imperative for them to keep a lid on costs.
In response to recent hard times, increasing numbers of airlines shuttered their own repair centers and fired “excess” mechanics in favor of outsourcing their MRO work to less-expensive, third-party facilities such as AAR.
The chronic worldwide shortage of sufficiently trained mechanics also pushes more and more clients into AAR’s direction. This outsourcing trend has been underway for at least the past decade; the severe global recession only accelerated it.
Major US domestic carriers now spend about two-thirds of their increasingly scarce maintenance dollars on subcontracted repair stations in the US and abroad, including facilities in Asia and Latin America. This figure compares to about 37 percent in 1996. AAR has picked up the lion’s share of this work and is expanding its already significant footprint in developing markets.
Moreover, AAR is capitalizing on the emergence of “green” aviation, particularly in light of the euro zone’s push toward stricter mandates to reduce the industry’s carbon footprint. The company has implemented numerous fuel-saving aerodynamic improvements, such as winglets and body strakes, for all types of aircraft. The company also is making MRO procedures more energy efficient.
AAR is now trading at an attractive valuation. With a trailing price-to-earnings (P/E) ratio of only 10, the company’s growth prospects make the stock a bargain, especially compared to AAR’s peer group of aerospace defense products and services, which sports a trailing P/E of 17.
Analysts’ consensus calls for AAR’s earnings to grow by more than 12 percent this year. For investors concerned about market turmoil and fiscal uncertainty in the US, this stock provides outsized growth potential with limited downside.
Courtesy John Persinos at Investing Daily - profitable advise for smart people (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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