Flying High with AIR

12/16/2005 12:00 am EST

Focus:

Jon Markman

Editor, Trader's Advantage

"If there is one corner of the economy that has really taken flight in the past six months, it is the aircraft assembly business," notes Jon Markman, editor of the exceptional swing trading service, StockTactics Advisor. Here, he looks at a "swing trade" in the sector.

"The recent US durable-goods report showed that manufacturing of all big-ticket items jumped 3.4% in October, but that number would have been far more paltry had it not been for a stunning 50.4% leap in civilian aircraft orders. This was mostly new orders from world airlines for the newest planes from Boeing, a company whose stock continues to gather strength. But let's not get picky. When a single niche of the vast US economy shows that kind of growth, it is seen in ways you might not expect.

"There are many larger cap beneficiaries of this trend. But there are also many smaller beneficiaries, such as AAR Corp. (AIR NYSE), a $690 million company that provides maintenance and supply-chain assistance to commercial and military clients and makes pallets and other transportation materials for military commands. AAR is a pretty interesting outfit. It recently scored a number of big aircraft maintenance outsourcing and supply-chain management wins that have led analysts to repeatedly lift estimates.

"After getting crushed in the post-9/11 rout of anything to do with the aircraft industry - sinking from the $17.50 area in early 2001 to $2.95 by late 2002 – the stock has rebounded dramatically of late. At the start of November, shares jumped 25% to a new two-year high on solid volume, and they have only in the past couple of days slowed down. This is not just some flash-in-the-pan momentum move. The stock is cheap by almost any metric, with price/earnings and price/sales multiples well below those of industry peers and its own estimated forward growth rate.

"And the news flow has been very positive, with recent wins including a pallet contract for the US Air Force, reconfiguration of 737-300/500s for ATA Airlines and a Royal Air Force AWACS, a couple of contracts with Mesa Air for supply-chain help, component assistance for BAE Systems and success with its new and refurbished jet engine sales and commercial jet leasing arms.

"As analyst Arnold Ursaner of CJS Securities noted, most of these contracts will gun revenue for five to 10 years, providing unusual earnings visibility for investors. Ursaner noted that since much of the new work will simply leverage existing overhead, gross margins are likely to get a big boost. He said commercial revenue is up 25% year over year, military revenue is up 16%, and certain segments - such as maintenance, repair, and overhaul - are poised to provide 50% growth next year and 20%-plus after that.

"Like many companies, AAR is looking for growth in Asia. It opened sales offices in Tokyo and Shanghai recently with an eye toward providing airline and military operations there with its supply-chain, component distribution and maintenance expertise. Ursaner notes that China's main airline isn't much bigger than Delta Airlines, and that more air travel is likely to develop between its many underserved major cities -- especially going into the 2008 Olympic Games.

"Back at home, the company was chosen by United Airlines to be its exclusive maintenance provider for 737 aircraft. That will all be done at AAR's new Indianapolis facility. A few weeks ago, Sidoti & Co. analyst Tyler Hojo lifted his price target for the company to $26, about 30% higher than the current price, as he raised 2006 and 2007 estimates to 82 cents and $1.46, respectively, from 74 cents and $1.05. That's a big jump. Despite expectations of strong growth, he's only modeling a 2007 P/E multiple of 18, so if the company comes to deserve a multiple in the 22 range, then the target would be more like $32.

"SG Cowen analyst Jay Khetani concurs with those targets, going as far as to estimate $2 in earnings per share in 2008. He believes there is a sizable secular shift underway as airlines and the military try to cut costs by outsourcing their maintenance and supply-chain work. That's the kind of long-term upside that turns heads, as it apparently did for AAR Vice President James McDonald, who bought 6,000 shares on the open market in mid-October at $15.49. He turned a nice 30% profit in a month and a half, but his flight is probably not even half over. Late-coming traders may wish to wait for shares to come back and test their breakout at $18.50 before taking a seat."

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