This Stock Makes the Skies Friendlier

04/09/2013 7:45 am EST

Focus: STOCKS

As the global economy improves, so does airline travel, and this company is king of keeping the skies safe, writes John Persinos of Personal Finance.

Maintenance, repair, and overhaul (MRO) accounts for approximately 15% of an airline's operating expenses, making MRO second only to fuel as an overhead cost in aviation. 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% from 2011. That number is expected to reach $68.4 billion in 2022, for a ten-year compound annual growth rate of 3.3%.
 
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 (AIR), which provides MRO products and services to commercial, government, and defense clients. AAR is the second-largest independent MRO provider in North America. AAR also ranks among the top ten MRO companies in the world, and represents the best direct investment available on increasing demand for MRO services.

AAR reported second-quarter fiscal 2013 revenue of $512.8 million and earnings of $17.8 million, or 44 cents per share, compared to year-ago revenue of $482 million and earnings of $17.6 million, or 43 cents.

Commercial revenue increased 28% over the prior year's second quarter, rising to 60% of consolidated revenue, compared to 50% in the same period last year. Revenue from government and defense customers represented 40% of consolidated revenue and declined 15% from the second quarter of last year.

Major US domestic carriers now spend about two-thirds of their increasingly scarce maintenance dollars on subcontracted repair stations, compared to about 37% in 1996. AAR has picked up the lion's share of this work, and is expanding its already significant footprint in developing markets.

Even under the best conditions, airlines struggle with razor-thin profit margins. They typically earn an average net profit of between 1% and 2%, compared to above 5% 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.

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.

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, Nordisk Aviation Products, and Summa Technology.

AAR is now trading at an attractive valuation. With a trailing price-to-earnings (P/E) ratio of only ten, 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% this year. For investors concerned about market turmoil and fiscal uncertainty in the US, this stock provides outsized growth potential with limited downside.

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