Good afternoon, ladies and gentlemen, and welcome to AAR's Fiscal 2022 Third 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. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Accordingly, these statements are no guarantee of future performance. These risks and uncertainties are discussed in the company's earnings release and the Risk Factors sections of the company's Form 10-K for the fiscal year ended May 31, 2021, and Form 10-Q for the fiscal quarter ended November 30, 2021.

In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events. Certain non-GAAP financial information will be discussed on the call today. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is set forth in the company's earnings release.

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

John M. Holmes - President and Chief Executive Officer

Great. Thank you and good afternoon, everyone. I appreciate you joining us today to discuss our third quarter fiscal year 2022 results. I want to start by saying that our thoughts are with those impacted by the conflict in Ukraine. We are both saddened and angered by Russia's unprovoked invasion and stand with all those who are suffering. Although we do very little work in either country, we have suspended all of our business with the sanctioned nations and territories.

That's said and turning to the quarter, our sales increased 10% year-over-year from $410 million to $452 million and our adjusted diluted earnings per share from continuing operations increased 70% from $0.37 per share to $0.63 per share. Sequentially, overall, sales grew 3.6%. In our commercial business, we had another strong quarter in MRO. Our parts activity started out slowly in the quarter, but gained momentum as the impact of the omicron variant declined. As we have discussed previously, part supply is our highest margin activity and it's recovery is paced behind MRO.

The parts momentum during the quarter gives us continued confidence in the eventual full recovery and ultimately more growth out of that activity. On the government side, we were able to drive sequential growth despite the headwinds we face as a result of the Afghanistan withdrawal. Regarding earnings, I'm particularly pleased that we delivered another quarter of margin expansion as our adjusted operating margin was 6.7%. Sequentially, this is up from 6.1% in the second quarter and continues to exceed pre-COVID levels despite our commercial sales remaining down more than 25%.

Turning to cash, we had another excellent quarter as we generated $16 million of cash from operating activities from continuing operations. We also repurchased $20 million of stock consistent with the share repurchase program we announced earlier in the quarter. Even after the share repurchases, our balance sheet remain strong at 0.4 times net leverage and we continue to be exceptionally well positioned to fund our growth.

Regarding new business, during the quarter, we announced a 10-year renewal of our component MRO contract to provide depot level maintenance for NATO's E-3A AWACS aircraft. Also subsequent to the end of the quarter, we announced a new exclusive distribution agreement with Collins Aerospace to supply deicers and supporting products to the global aftermarket. This is an important win because it's our first exclusive commercial distribution agreement with Collins and it also represents a move into the business jet market, where we see adjacent opportunities for growth. This most recent distribution win demonstrates both the value proposition that our offering brings to component OEMs and our ability to continue to drive market share gains in this activity.

With that, I'll turn it over to our CFO, Sean Gillen to discuss the quarter in more detail.

Sean Gillen - Vice President and Chief Financial Officer

Thanks, John. Our sales in the quarter of $452.2 million were up 10.2% or $41.9 million year-over-year. Sales in our Aviation Services segment were up 12.4%, driven by recovery in our commercial markets and sales in our Expeditionary Services segment were down $6.4 million driven by a delayed pallet order that we expect to now receive in Q4. Our commercial sales were up 28% year-over-year, while our government sales were down 8%. The decline in government sales was primarily driven by the wind down of our activity in Afghanistan and the natural completion of other government programs.

Our sales in Afghanistan in the quarter were $8 million and we currently expect to be down to approximately $1 million in the fourth quarter. Sequentially, our commercial sales increased 2.8% and our government sales increased 4.6%. Our MRO operations remained at near capacity and although we saw increasing parts volumes throughout the quarter, overall parts growth was limited by the slower start that John referenced.

On the government side, the sequential sales growth was driven by our ability to secure additional work in our government programs operations, which was more than sufficient to offset the reduction of activity in Afghanistan. Gross profit margin in the quarter was 17.8% versus 21% in the prior year quarter, which included the benefit of CARES Act Payroll Support. Adjusted gross profit margin was 17.3%, up from 16.1% in the prior year quarter and 16.7% in Q2. This margin expansion continues to be driven by the efficiency improvement and portfolio refinement actions that we took during the pandemic, as well as improved conditions in our commercial parts activities.

Gross profit margin in our commercial business was 20.1% and gross profit margin in our government business was 14.5%. In the quarter, commercial's margin benefited from intercompany procurement activity on behalf of government customers. SG&A expenses in the quarter were $48.9 million or 10.8% of sales, excluding adjustments of $1.7 million related primarily to investigation and remediation costs this would have been closer to 10.4% of sales. Net interest expense for the quarter was $0.6 million compared to $1 million last year, driven by lower borrowings. Average diluted share count for the quarter was 35.7 million. This reflects the repurchase of 0.5 million shares during the quarter. We expect to continue to execute on our previously committed plan to deploy the full $150 million authorization over approximately two years.

As John indicated, we generated cash flow from our operating activities from continuing operations of $16.2 million and we also reduced our accounts receivable financing program by $2.2 million in the quarter. This strong cash flow, largely funded the $20 million share repurchase in the quarter and our balance sheet remains exceptionally strong with net debt of $63.9 million and net leverage of 0.4 times.

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

John M. Holmes - President and Chief Executive Officer

Great, thank you, Sean. Regarding the environment, as I indicated earlier, we do not have meaningful sales in either Russia or Ukraine and so are not currently experiencing any notable business impact as a result of that conflict. However, we are certainly aware of the related increase in fuel prices and are monitoring the potential impact to our airline customers operating costs.

Domestically, we are continuing to observe tightness in this labor market and our attrition levels, particularly in the hangars have been higher than they were before the pandemic. However, we are fortunate that we took aggressive action beginning in 2019 to address our labor supply when we had started to experience labor shortages at that time. To date, those actions have allowed us to manage through the current environment more effectively than much of our competition and our customers continue to be supportive of moves that we need to make to navigate this tight labor market.

With respect to commercial demand, our largest North American and European commercial customers remain optimistic about the recovery of demand in the business and leisure travel market and we saw this translate into accelerating parts volume throughout the quarter. This increasing demand is encouraging and as a result, we expect to see continued recovery in our parts activities over the next several quarters.

In the immediate term, we expect modest sales growth sequentially in Q4 and a more meaningful inflection in our FY '23. Having said that, we recognize that we remain in a dynamic environment and new developments with respect to COVID may continue to impact this trajectory. Regarding margins, this quarter is a good representation of the full impact of the margin improvement actions we took during the pandemic and the potential for further expansion will depend on the mix and pace of the recovery.

Early in the pandemic, we took a series of actions to drive operating efficiency and balance sheet strength with a goal towards achieving higher margins even without a full recovery in sales. I'm extremely proud that we have delivered on that plan. We have now expanded operating margins for six straight quarters and we are one of the very few companies in commercial aerospace with a stronger balance sheet than we had prior to the pandemic. Our performance has positioned us to invest in our business both organically and inorganically and continue to deliver value for our customers, shareholders and other stakeholders.

With that I will turn it over to the operator for questions.

Question & Answers

Operator

[Operator Instructions] Your first question comes from the line of Ken Herbert from RBC. Your line is open.

Ken Herbert - RBC - Analyst

Hey, good afternoon. John and Sean.

John M. Holmes - President and Chief Executive Officer

Hey, Ken.

Ken Herbert - RBC - Analyst

Hey, John, just wanted to start off the up 28% in Aviation in the quarter. Can you just talk about the relative performance of MRO relative to the parts businesses?

John M. Holmes - President and Chief Executive Officer

Sure. Both of those were actually consistent with what we saw in Q3. So, in the parts business, as we indicated, we got off to a slower start, we saw volumes a bit down early in the quarter, which we assume was related to pull back from the omicron variant, as a result of the omicron variant and then throughout the quarter as the impact of that variant subsided, we saw accelerating parts volumes that ultimately - and that's continued through today ultimately were higher than what we saw in Q2.

But net-net, parts was about even quarter-over-quarter. The MRO business was consistent from Q2 to Q3, again the hangars there remain largely full and we're really happy with the performance there. The growth though quarter-over-quarter sequentially came from other areas of the commercial business. We saw a recovery in our commercial programs business. So, our customers in that area started to fly more hours, which translated to more revenue given the nature of the PDH programs and then we saw other strong performance in other areas of the MRO business out of component repair, as well as our landing gear operation.

Ken Herbert - RBC - Analyst

Okay. That's helpful. And if I could, on the aerospace side, can you just dig a little bit deeper into the potential risk to the business in the recovery from higher crude prices or fuel prices for your airline customers? I know on the one hand, it would obviously support usage of newer assets, which might create more USM feedstock, but obviously on the other hand, there is clearly just a risk to sort of their balance sheets and the operating model. So, can you talk through your expectations of how that could impact your business over the next few quarters?

John M. Holmes - President and Chief Executive Officer

Yeah, sure. And I think you highlighted. You've got a few different competing dynamics there. Certainly, it's a situation we're monitoring and it's a situation that AAR has seen many time over the decades that we've been in the industry. I would say that this is a pretty meaningful a function of how much of the fuel price increases the airlines are ultimately able to pass on to the consumer. We've talked to lots of our customers and there's varying views on how much of that will be able to be passed on. So, that's a factor that ultimately drives how they think about their expenses, but we are - as we think about the customers operating cost and to the extent that they see sustained increases, it's going to drive them to lower cost solutions and we are a lower cost solution.

Ken Herbert - RBC - Analyst

Okay. That's helpful. Just finally, if I could, maybe for Sean. I mean, the balance sheet, you could argue is significantly underutilized now, as we continue to see some recovery on the commercial side. How are you thinking about capital allocation and are there opportunities? Or do you feel like you should maybe put a little bit more on to the balance sheet as you think about an accelerating growth in any areas?

Sean Gillen - Vice President and Chief Financial Officer

Yeah, good question. And I think the capital allocation priorities remain the same. We do see increasing opportunity to invest organically and specifically in the parts business, so inventory has been providing cash over the past several quarters and I think that we're seeing opportunity, our new business wins in distribution as well as procurement activity in used serviceable material to invest in that.

I think there continues to be inorganic opportunity via acquisition. So, that will be - we think that could be an area for us to allocate capital. And then the repurchase. We did $20 million in the quarter, so got a good start to the new repurchase and we'll continue to look to put money to work there. But I think the balance sheet, as you say, is arguably under-levered, but we do think we have adequate and full opportunity to put money to work great.

Ken Herbert - RBC - Analyst

Great. All right, well, thank you very much.

John M. Holmes - President and Chief Executive Officer

Thank you, Ken.

Operator

[Operator Instructions] And your next question comes from the line of Michael Ciarmoli from Truist. Your line is open.

Michael Ciarmoli - Truist - Analyst

Hey, good evening, guys. Thanks for taking my questions and nice results. Maybe, John, just to go back to Ken's line of questioning on fuel. I mean, can you specifically indicate or tell us, are you seeing any behavioral changes from your customers at this point yet in terms of whether it's spending on discretionary upgrades or were they planning on doing maintenance visits or heavy visits on older planes that they're now thinking, with this current fuel environment, it might be better to retire those plants. Are you seeing any of that yet or having discussions with them around that?

John M. Holmes - President and Chief Executive Officer

A great question and the answer is really no. It's certainly top of mind for everybody, but the overriding conversation with our customer base right now and again I'm focusing on North America and Europe. It's really around being prepared for what our airline customers see as a very strong spring and summer. And the other thing we're getting is that there seems to be, I guess, a happy surprise around the pace of business travel returns and so the airlines right now are just focused on making sure that they've got enough equipment available and ready to support what they see as a very strong couple of quarters. So that's. the headlines.

Michael Ciarmoli - Truist - Analyst

Okay. Got it. No, that's a good segue too because I wanted to - I mean, the fiscal fourth quarters usually see some of your strongest. I think in some of your prepared comments, you kind of said you expect. I think you were just talking about parts continuing to recover with modest growth in the fourth quarter, but what about the entire business. Should we expect that pretty steep sequential increase 3Q to 4Q? And then, even if you can maybe give us some directional color on how to think about next year in this sort of uneven time with COVID? Do we expect that normal pull back in the fiscal first quarter or just given kind of the environment you think revenue growth keeps building sequentially?

John M. Holmes - President and Chief Executive Officer

Yeah, I think, again, good question. So, the comment related to overall modest improvement from Q3 to Q4. That was meant to be overall sales, modest increase from complete parts. And you've got a few different parts in there, you've got MRO, which we expect to have another strong quarter in MRO. And then you have continued momentum in the parts business. But also, we haven't talked a lot about government yet, but a government this will be another quarter of feeling the full impact of the withdrawal from Afghanistan, as well as the other, the natural completion of some of the other government programs.

And so, there's a lot of work that we need to do on the government side to make up for that. While we are, let's say, waiting, but focused on other longer-term government programs like the [Indecipherable] contract kicking in that will ultimately replace the lost revenue of Afghanistan. So, again, we're thinking about stronger performance at a commercial, but government is a bit of a mix at the moment, while we're in transition between the wind down from Afghanistan and the ramp up of other long-term programs.

And then thinking about next year, I think, we mentioned that we're expecting modest improvement overall from Q3 to Q4, but a more meaningful inflection in the results as we get into our next fiscal year and hopefully COVID is further and further in the rearview mirror. And as it relates to the first quarter, specifically, the biggest seasonal driver there is typically our MRO business. And at this point, we expect - and again all of subject to a dynamic environment. But at this point, we expect another strong summer as airlines continue to get aircraft ready to support the recovery in demand.

Michael Ciarmoli - Truist - Analyst

Okay, got it. Just a quick one on government. Are there - given what's going on with Russia and Ukraine, are there any opportunities for you guys? I know the WASS contract covers a lot of those Eastern European countries. I mean, are you seeing indications that you could see a scope increase there or increased revenues as a result of, I'll call it increased op tempo over there?

John M. Holmes - President and Chief Executive Officer

Yeah, I'd say, again another good question. I'd say there's really three areas that Ukraine could - that situation could provide positive tailwind for us. One is, we saw a pretty meaningful decline in our day-to-day parts business with the DLA as the new - as the Biden administration shifted priorities from spending on a sustained - shift the priorities from sustaining the current fleet to directing dollars towards the next generation development.

Obviously, given where we are in the world right now, having the current fleet in a better position to be ready to go, it would seem that that would be a priority and so you could see more sustainment dollars being spent, which will translate into more parts demand for us. We haven't seen that yet, but it's something we could anticipate. The other area is in our mobility business. You could see, to the extent that there's going to be troops moving around the world. You could see elevated demand for the shelters and containers that we manufacture. We have - again we haven't seen that yet. But if we look over the decade, what typically followed situations like this, we would expect to see some activity there depending on how this unfolds.

And the final thing and the third area that you've touched on is WASS. That is a program that's - a big part of it is flying diplomatic missions. Historically you've seen Democratic Administration, such as the one we're in, utilize diplomacy more and so you may see increased tempo out of that program as a result of increased diplomatic activity and that's another area where we could be positive benefit over time. Again, it's still very early, we haven't seen any meaningful movement in any of these areas. But those are the three key areas I think that could be impacted by a sustained - a prolonged conflict.

Michael Ciarmoli - Truist - Analyst

Got it. Very helpful. I'll jump back in the queue, guys. Thanks.

Operator

[Operator Instructions] And we have a follow-up question from Michael Ciarmoli from Truist. Your line is open.

Michael Ciarmoli - Truist - Analyst

Nobody else jumping on, I figured I get back on here. Two other follow ups. John. You mentioned the tight labor market. Any color about wages and passing those along to your customers and maybe thoughts on how that could impact margins? I mean, you sounded pretty confident in the operating margin story. Is that something that could create some headwind?

John M. Holmes - President and Chief Executive Officer

Yeah, I think, again a good question. A couple of thoughts there. Yes, to date, we've had very constructive dialog with our customers where we need to around potential adjustments to contract to support increases in labor. It's definitely a tight market, as I mentioned, I think we're managing that very well, but it's still very dynamic and it's something we're paying a lot of attention to.

And it varies by market. I mean, you might see tightness in one market and therefore we need to talk about raising wages in one area more than another depending on how recruiting is going and that in turn drives decisions or conversations with the customers, but so far, they've been supportive. If we think about that as it relates to margin, yes, as labor cost increase and to the extent we cannot pass them fully on to the customer, we could see some margin headwind in the MRO business, but on the flip side, our parts businesses, which are higher margin than MRO have not fully recovered. We're still down 20% to 25% there.

And as we said, given the anticipated continued recovery in the overall industry, we expect those businesses, the parts business, the higher margin businesses to get back to where they were pre-pandemic and ultimately exceed pre-pandemic levels, particularly in our new parts distribution business because we've signed and we just mentioned, the Collins agreement.

We've signed a number of new distribution agreements over the past few years and those are not yet fully reflected in the result. And the base of business and commercial parts distribution, ultimately will lead to growth as we fully recover. So, you got some competing dynamics there between potential headwinds with labor cost. But then potential tailwinds with growth in recovery in the parts business, which is higher margin.

Michael Ciarmoli - Truist - Analyst

Got it. And then last one I had, which another good segue, you mentioned. What created or caused you to finally break through with Collins? I think you said that was your first win on the distribution side. Was there anything that kind of puts you over the edge there or anything you could point to?

John M. Holmes - President and Chief Executive Officer

Thanks for asking that. We have had a coordinated effort with Collins and other large OEMs for some time now and the value proposition that we represent in the market as the largest independent distributor and I say independent because we're not part of an OEM like Boeing or Airbus that's gaining some traction. And as you've seen, we've had a steady drumbeat of meaningful wins over the last several years and that's starting to get noticed.

And the other thing I would say is that our salesforce, our team really focuses on becoming technically proficient in our OEM partners parts. And our goal is to go out there and help the OEMs that we partner with on exclusive basis displace competitive product. So, we're not a call center, we're not just holding inventory and waiting for the call, we're out there as a true extension of our partners. And we think that's a unique model in the industry and again it's getting some traction with the larger players like Collins.

Michael Ciarmoli - Truist - Analyst

Got it. Helpful. All right, thanks guys.

John M. Holmes - President and Chief Executive Officer

Thanks, Mike.

Operator

And we have another follow-up question from the line of Ken Herbert from RBC. Your line is open.

Ken Herbert - RBC - Analyst

Hey, John, just a quick question, it sounds like the commentary, you're pretty confident and optimistic about a positive inflection in '23 aerospace sales, if I heard you correctly. Is that correlated with maybe an inflection you're expecting to see on the parts side and surplus material in particular or can you provide any more sort of commentary as to what's behind that expected step up in '23?

John M. Holmes - President and Chief Executive Officer

Yeah. And again, so, yes, it's largely driven by our expectation around parts. We've been encouraged by the recovery in demand that we've seen of late, provided that we don't get some other curve ball thrown at us as an industry by COVID. We think that trend is going to continue. And going back to what I said earlier, given the fact that the parts businesses are still 20% to 25% down, there's room to sort of run there just out of recovery. And then, given the fact that we've won new lines like Collins in distribution, as those lines mature and older lines recover, we've kind of got built-in growth there based on the business we've signed up.

So, we feel good. I would expect that - so that's where the - we would look for the growth to come from. And then I would just go back to on the MRO side, the hangars are full, we're performing well and we're in a good spot there, but I was expecting a relatively stable performance out of MRO on the commercial side. given where we are in capacity.

Ken Herbert - RBC - Analyst

Okay. And then given the mix shift, it sounds like in '23 potentially with greater growth on the parts side relative to MRO, how should we think about incremental margins? It sounds clearly like your sort of the cost story near term has run its course and we need to see volume to really drive margins, but what kind of incremental should we think about for models as you see that mix benefit in '23?

John M. Holmes - President and Chief Executive Officer

Yeah, I think, we need to see how that plays out. We feel good about the full impact. We feel really good about the progress that we've made to be in this position ahead of pre-pandemic margins, while sales have not recovered. We're very proud of the progress that we've made there. Going forward, I think we need to see how the competing dynamics in terms of the pace of the parts recovery combined with how we address the potential labor cost headwind. We need to see how those dynamics play out. But I would say that we're very proud of the progress that we've made and as that unfolds and as the mix plays out, we, over time, expect to continue to expand our margins, but it's difficult to get more specific than that right now.

Ken Herbert - RBC - Analyst

Okay, fair enough. Thanks a lot.

Operator

[Operator Instructions]

John M. Holmes - President and Chief Executive Officer

Okay. Well, we really appreciate the time and the interest and we look forward to being back with you all in July to discuss the full fiscal year results.

Operator

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