# AAR CORP (AIR) FY 2023 MD&A

Verbatim Item 7 Management's Discussion and Analysis from AAR CORP's 10-K for fiscal year 2023.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1750/000110465923082069/air-20230531x10k.htm
Accession: 0001104659-23-082069
Filing date: 2023-07-18
Report date: 2023-05-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/AIR/
All MD&A years: /company/AIR/mda/
Previous year: /company/AIR/mda/fy2022/ (FY 2022)
Next year: /company/AIR/mda/fy2024/ (FY 2024)

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollars in millions)

Background and Forward-Looking Statements

The following discussion and analysis of our financial condition and results of operations, and quantitative and qualitative disclosures about market risk should be read in conjunction with our consolidated financial statements and the related notes included in this Form 10-K. For a discussion of the comparison of fiscal 2022 and 2021, refer to Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended May 31, 2022 (filed July 21, 2022).

Management’s Discussion and Analysis of Financial Condition and Results of Operations contain certain statements relating to future results, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may also be identified because they contain words such as ‘‘anticipate,’’ ‘‘believe,’’ ‘‘continue,’’ ‘‘could,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘intend,’’ ‘‘likely,’’ ‘‘may,’’ ‘‘might,’’ ‘‘plan,’’ ‘‘potential,’’ ‘‘predict,’’ ‘‘project,’’ ‘‘seek,’’ ‘‘should,’’ ‘‘target,’’ ‘‘will,’’ ‘‘would,’’ or similar expressions and the negatives of those terms. These forward-looking statements are based on the beliefs of management, as well as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties, including those factors discussed under Item 1A, “Risk Factors,” that could cause actual results to differ materially from those anticipated. Should one or more of those risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

General Overview

We report our activities in two business segments: Aviation Services comprised of supply chain and maintenance, repair and overhaul (“MRO”) activities and Expeditionary Services comprised of manufacturing activities.

The Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance-based logistics programs, customer fleet management and operations, and aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and overhead.

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The Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support the U.S. military’s requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead.

Our chief operating decision making officer (“CODM”) is our Chief Executive Officer and he evaluates performance on our operating segments using gross profit as the primary profitability measure. Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our operating segments are aligned principally around differences in products and services.

Change in Operating Segments

During the first quarter of fiscal 2024, our CODM implemented changes in how he evaluates the business, allocates resources, and assesses performance. Specifically, this new structure results in the separation of our Aviation Services segment into three new operating segments: Parts Supply, Repair & Engineering and Integrated Solutions. Beginning with the first quarter of fiscal 2024, we will report under this new structure using the following four operating segments:

[[GREPCENT_TABLE]]
[["","\u25cf","Parts Supply, primarily consisting of our sales of used serviceable engine and airframe parts and components and distribution of new parts;"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","Repair & Engineering, primarily consisting of our maintenance, repair, and overhaul services across airframes and components, including landing gear;"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","Integrated Solutions, primarily consisting of our fleet management and operations of customer-owned aircraft, customized performance-based supply chain logistics programs in support of the U.S. Department of Defense (\u201cDoD\u201d) and foreign governments, flight hour component inventory and repair programs for commercial airlines, and integrated software solutions including Trax; and"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["","\u25cf","Expeditionary Services, primarily consisting of products and services supporting the movement of equipment and personnel by the U.S. and foreign governments and non-governmental organizations."]]
[[/GREPCENT_TABLE]]

In conjunction with the re-alignment, our CODM will evaluate each segment’s performance based on operating income instead of gross profit as the CODM believes operating income is a more comprehensive profitability measure for each operating segment. These changes will be initially reflected in our condensed consolidated financial statements for the quarterly period ended August 31, 2023 and are not reflected herein.

Business Trends and Outlook

In fiscal 2023, we established new partnerships, expanded our service offerings, and enhanced our approach to safety to best serve our customers across the world. The global recovery in air travel drove an increased demand for our services, enabling us to achieve strong results across our portfolio, particularly in used serviceable material and new parts distribution. Our actions to reduce costs and improve operating efficiency were reflected in our improved profitability during fiscal 2023.

Our sales to commercial customers in fiscal 2023 increased by $245.0 million, or 22.6%, over the prior year reflecting the recovery in commercial air travel following the height of the impact of COVID-19 as well as growth from recently awarded new parts distribution contracts. Our sales to government customers in fiscal 2023 decreased by $74.5 million, or 10.1%, from the prior year as we completed certain government programs, including our Afghanistan contracts.

We were also successful in winning new long-term agreements in both our commercial and government markets. We were awarded a significant expansion of our exclusive agreement with Unison Industries which broadens our distribution of select Unison ignitor plugs, ignition leads, harnesses, and related spare parts. We also extended our distribution relationship with Leach International Corp to supply electromechanical and solid-state switch gears to the electronics end-market. In our commercial programs activities, we were awarded a multi-year, flight-hour component support contract with flydubai for their growing Boeing 737 MAX fleet.

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In our government market, we were awarded a firm-fixed price contract from the U.S. Air Force to produce Next Generation All Aluminum Cargo Pallets with a total contract value, including option periods, of $173.5 million. We were also awarded a contract from the Norwegian Defence Logistics Organisation to provide commercial common parts for the Royal Norwegian Air Force P-8A fleet.

During the fourth quarter of fiscal 2023, we acquired Trax USA Corp. (“Trax”), a leading independent provider of aircraft MRO and fleet management software which was founded in 1999. The acquisition price was $120 million in cash, plus up to a $20 million earn-out payment based on adjusted revenue in calendar year 2023 and 2024. Trax offers critical software applications to a diverse global customer base of airlines and MROs supporting approximately 5,000 aircraft. Trax’s comprehensive solutions support the entire spectrum of maintenance activities and create the system of record required by airlines and MROs. The Trax acquisition adds established, higher-margin aviation aftermarket software offerings with recurring revenue to our portfolio and provides opportunities to cross-sell products and services.

During fiscal 2023, we continued our strong focus on working capital management with cash flows from operating activities from continuing operations of $23.8 million which included significant investments in inventory, rotable assets, and licensing arrangements to support further growth. Borrowings outstanding under the Revolving Credit Facility were $272.0 million at May 31, 2023 with an availability on the facility of $336.9 million.

Over the long-term, we expect to see strength in our aviation products and services given our offerings of value-added solutions to both commercial and government and defense customers. We believe long-term commercial aftermarket growth trends are favorable. As we continue to invest in the pipeline of opportunities in the government market, our long-term strategy continues to emphasize investing in the business and capitalizing on opportunities in both the commercial and government markets.

Results of Operations – Fiscal 2023 Compared with Fiscal 2022

Sales and gross profit for our two operating segments for the years ended May 31, 2023 and 2022 were as follows:

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[[/GREPCENT_TABLE]]

​

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[[/GREPCENT_TABLE]]

​

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Aviation Services Segment

Sales in the Aviation Services segment increased $152.9 million, or 8.8%, over the prior year due to a $238.9 million, or 22.1%, increase in sales to commercial customers. The increase in sales to commercial customers was primarily attributable to increased sales of $91.1 million related to new parts distribution activities and $71.4 million in our MRO activities as commercial passenger air traffic continues to recover from the impact of COVID-19. In addition, sales increased $43.2 million in our aftermarket trading activities which included whole asset sales of $74.0 million in fiscal 2023 compared to $66.6 million in the prior year.

During fiscal 2023, sales in this segment to government and defense customers decreased $86.0 million, or 12.9%, from the prior year. The decrease in sales to government and defense customers was primarily attributable to the completion of certain government programs, including Afghanistan contracts.

Changes in estimates and assumptions related to our programs accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In fiscal 2023, we recognized net favorable cumulative catch-up adjustments of $8.3 million compared to net favorable cumulative catch-up adjustments of $10.0 million in fiscal 2022. These adjustments primarily relate to our long-term, power-by-the-hour programs where we provide component inventory management and repair services to commercial customers as well as certain long-term government programs.

Cost of sales in Aviation Services increased $95.3 million, or 6.6%, over the prior year which was largely in line with the sales increase of 8.8% discussed above.

Gross profit in the Aviation Services segment increased $57.6 million, or 19.4%, over the prior year. Gross profit in this segment on sales to commercial customers increased $67.9 million, or 37.7%, over the prior year primarily due to the COVID-19 recovery discussed above. Gross profit margin on sales to commercial customers increased to 18.8% from 16.7% in the prior year period primarily from our actions to reduce both our fixed and variable cost structure.

Gross profit on sales to government and defense customers decreased $10.3 million, or 8.8%, from the prior year with the gross profit margin increasing to 18.5% from 17.6%. This increased gross profit margin is primarily due to higher recoveries on indirect costs and improved profitability on short-term contracts where revenue is recognized over time as the work progresses with our customer.

Expeditionary Services Segment

Sales in the Expeditionary Services segment increased $17.6 million, or 23.7%, over the prior year primarily due to higher volumes for our mobility products. Gross profit in the Expeditionary Services segment decreased $0.7 million, or 4.5%, from the prior year primarily due to changes in the mix of products sold. Gross profit margin decreased to 16.3% from 21.2% in the prior year primarily as a result of changes in the mix of products sold.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $28.2 million, or 13.9%, over the prior year primarily due to investments to support the sales growth as our commercial activities continue the recovery from the impact of COVID-19. These investments include $7.0 million of acquisition and amortization expenses for Trax which was acquired in the fourth quarter of fiscal 2023. As a percent of sales, selling, general and administrative expenses increased to 11.6% from 11.1% in the prior year largely due to our investments to support sales growth.

Interest Expense

Interest expense increased $9.8 million in fiscal 2023 reflecting the impact of both higher interest rates and higher average borrowings to fund investments in the business, including our acquisition of Trax in the fourth quarter of fiscal 2023. Our average borrowing rate was 5.11% in fiscal 2023 compared to 1.09% in the prior year.

Income Taxes

Our fiscal 2023 effective income tax rate for continuing operations was 25.9% compared to 25.3% in the prior year. The increase in our effective tax rate is primarily due to higher non-deductible expenses in fiscal 2023 compared to the prior year.

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Liquidity, Capital Resources and Financial Position

Our operating activities are funded and commitments met through the generation of cash from operations. Our ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital. In addition to operations, our current capital resources include an unsecured revolving credit facility under the Credit Agreement referred to below and an accounts receivable financing program. Periodically, we may also raise capital through common stock and debt financings in the public or private markets. We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance future growth on commercially reasonable terms. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively affected by a number of factors, including the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance.

At May 31, 2023, our liquidity and capital resources included working capital of $746.4 million inclusive of cash of $68.4 million.

On December 14, 2022, we entered into a new credit agreement with various financial institutions as lenders and Wells Fargo Bank, N.A. as administrative agent for the lenders (the “Credit Agreement”). The Credit Agreement provides for a $620 million unsecured revolving credit facility (the “Revolving Credit Facility”) that we can draw upon for working capital and general corporate purposes. Under certain circumstances, we may request an increase to the lending commitments under the Credit Agreement by an aggregate amount of up to $300 million, not to exceed $920 million in total. The Credit Agreement expires on December 14, 2027.

On December 14, 2022, and in connection with our entry into the Credit Agreement, we terminated our revolving credit facility under the credit agreement dated April 12, 2011, as amended, (the “2011 Credit Agreement”) with the outstanding borrowings under the 2011 Credit Agreement at the date of its termination rolled over to the Credit Agreement.

Borrowings outstanding under the Revolving Credit Facility under the Credit Agreement at May 31, 2023 were $272.0 million and there were approximately $11.1 million of outstanding letters of credit, which reduced the availability under this facility to $336.9 million as of May 31, 2023. There are no other terms or covenants limiting the availability of the Revolving Credit Facility.

In the first quarter of fiscal 2021, we received $57.2 million from the U.S. Treasury Department through the Payroll Support Program under the CARES Act. This funding included a $48.5 million cash grant, which was to be used exclusively for the continuation of payment of employee wages, salaries and benefits for employees of certain MRO facilities, and a low interest 10-year senior unsecured promissory note of $8.7 million. In fiscal 2021, we recognized the full amount of the grant as contra-expense within Cost of sales and Selling, general and administrative expenses. The Promissory Note was re-paid in full during the fourth quarter of fiscal 2021.

As of May 31, 2023, we also had other financing arrangements that did not limit availability on our Revolving Credit Facility including outstanding letters of credit of $11.6 million and foreign lines of credit of $9.2 million.

We maintain a Purchase Agreement with Citibank N.A. (“Purchaser”) for the sale, from time to time, of certain accounts receivable due from certain customers (the “Purchase Agreement”). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million and Purchaser may, but is not required to, purchase the eligible receivables we offer to sell. The term of the Purchase Agreement runs through February 22, 2024, but, the Purchase Agreement may be terminated earlier under certain circumstances. The term of the Purchase Agreement is automatically extended for annual terms unless either party provides advance notice that they do not intend to extend the term.

We have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing, and de-recognize the sold receivables from our Consolidated Balance Sheet.

Receivables sold under the Purchase Agreement during fiscal 2023, 2022, and 2021 were $171.6 million, $283.3 million, and $440.6 million, respectively. Amounts remitted to the Purchaser on its behalf during fiscal 2023, 2022, and 2021 were $173.8 million, $306.9 million, and $476.3 million, respectively. As of May 31, 2023 and May 31, 2022, we had collected cash of $1.3 million and $5.4 million, respectively, which was not yet remitted to the Purchaser as of those dates and was classified as Restricted cash on our Consolidated Balance Sheets.

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At May 31, 2023, we were in compliance with all financial and other covenants under each of our financing arrangements.

On December 16, 2021, our Board of Directors authorized a renewal of our stock repurchase program, under which we may repurchase up to $150 million of our common stock with no expiration date. During fiscal 2023, we repurchased 1.2 million shares for an aggregate purchase price of $50.1 million. No repurchases were made during the three-month period ended May 31, 2023. Since inception of the renewal authorization, we have repurchased 2.2 million shares for an aggregate purchase price of $92.4 million. The timing and amount of repurchases are subject to prevailing market conditions and other considerations, including our liquidity and acquisition and other investment opportunities.

Cash Flows – Fiscal 2023 Compared with Fiscal 2022

Cash Flows from Operating Activities

Net cash provided by operating activities–continuing operations was $23.8 million in fiscal 2023 compared to $89.8 million in fiscal 2022. The decrease from the prior period of $66.0 million was primarily attributable to an $18 million license fee payment to Unison Industries for an amendment of our distribution agreement and increased investments in inventory and rotable assets to support future growth.

Net cash used in operating activities–discontinued operations was $0.5 million in fiscal 2023 compared to $14.6 million in fiscal 2022. The decrease from the prior year of $14.1 million was primarily attributable to the payments related to our settlement of the U.S. Department of Justice’s False Claims Act investigation.

Cash Flows from Investing Activities

Net cash used in investing activities was $138.0 million in fiscal 2023 compared to $16.5 million in fiscal 2022. The increase in cash used from the prior period was primarily related to our acquisition of Trax in the fourth quarter of fiscal 2023.

Cash Flows from Financing Activities

Net cash provided by financing activities was $137.7 million in fiscal 2023 compared to a use of cash of $59.8 million in fiscal 2022. The increase in cash provided was primarily related to additional borrowings under our Revolving Credit Facility in the current year period to fund the Trax acquisition and investments in inventory and rotable assets to support sales growth.

Contractual Obligations and Off-Balance Sheet Arrangements

A summary of contractual cash obligations and off-balance sheet arrangements as of May 31, 2023 is as follows:

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[[/GREPCENT_TABLE]]

Notes:

[[GREPCENT_TABLE]]
[["1","Interest was determined using the interest rate in effect on May 31, 2023."]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["2","Purchase obligations arise in the ordinary course of business and represent a binding commitment to acquire inventory, including raw materials, parts, and components, as well as equipment to support the operations of our business."]]
[[/GREPCENT_TABLE]]

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[[GREPCENT_TABLE]]
[["3","Our contribution policy for the domestic plans is to contribute annually, at a minimum, an amount which is deductible for federal income tax purposes and that is sufficient to meet actuarially computed pension benefits. For our Netherlands pension plan, our policy is to fund at least the minimum amount required by the local laws and regulations."]]
[[/GREPCENT_TABLE]]

We routinely issue letters of credit and performance bonds in the ordinary course of business. These instruments are typically issued in conjunction with insurance contracts or other business requirements. The total of these instruments outstanding at May 31, 2023 was $22.7 million.

Critical Accounting Policies and Significant Estimates

Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States. Management has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the Consolidated Financial Statements. The most significant estimates made by management include those related to assumptions used in accounting for business combinations, assessing goodwill impairment, adjustments to reduce the value of inventories and certain rotable assets, revenue recognition, allowance for credit losses, and assumptions used in determining pension plan obligations. Accordingly, actual results could differ materially from those estimates. The following is a summary of the accounting policies considered critical by management.

Business Combinations

When we acquire a business, we allocate the purchase price by recognizing assets acquired and liabilities assumed based on their estimated fair values at acquisition date with any excess of the purchase consideration when compared to the fair value of the net tangible and intangible assets acquired recognized as goodwill. A preliminary fair value is determined once a business is acquired, with the final determination of fair value completed no later than one year from the date of acquisition.

The determination of the estimated fair value of assets acquired and liabilities assumed requires significant judgment and estimates, including the selection of valuation methodologies, estimates of future revenues, costs and cash flows, discount rates, and selection of comparable companies. We engage the assistance of valuation specialists in concluding on fair value measurements in determining the fair value of assets acquired and liabilities assumed in business combinations.

The fair value of the intangible assets is estimated using several valuation methodologies, including the income-based or market-based approaches, which represent Level 3 fair value measurements. The value for customer relationships is typically estimated based on a multi-period excess earnings approach. The more significant inputs used in the customer relationships intangible asset valuation include (i) future revenue growth rates, (ii) projected gross margins, (iii) the customer attrition rate, and (iv) the discount rate. The value for developed technology is estimated based on a relief from royalty approach. The more significant inputs used in the developed technology intangible asset valuation include (i) future revenue growth rates, (ii) profitability, (iii) technology obsolescence, (iv) market royalty rates, and (v) the discount rate. The useful lives are estimated based on the future economic benefit expected to be received from the assets.

Transaction costs are not included as components of consideration transferred but instead, expensed as incurred.

Goodwill

Under accounting standards for goodwill and other intangible assets, goodwill and other intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible.

The accounting standards for goodwill allow for either a qualitative or quantitative approach for the annual impairment test. Under the qualitative approach, factors such as macroeconomic conditions, industry and market conditions and company-specific events or circumstances are assessed to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. When the quantitative approach is utilized, we compare the fair value of each reporting unit with the carrying value of the reporting unit, including goodwill. If the estimated fair value of the reporting unit is less than the carrying value of the reporting unit, we would be required to recognize an impairment loss for the excess carrying value of the reporting unit’s assets.

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As of May 31, 2023, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and MRO) and one comprised of our Expeditionary Services segment. In fiscal 2023, 2022, and 2021, we utilized the qualitative assessment approach for all reporting units. Under this approach, we considered the overall industry and market conditions related to the aerospace and government/defense markets as well as conditions in the global capital markets. We also considered the long-term forecasts for each reporting unit, which incorporated specific opportunities and risks, working capital requirements, and capital expenditure needs. The fair value of our reporting units is also impacted by our overall market capitalization and may be impacted by volatility in our stock price and assumed control premium, among other items. We concluded it was more likely than not that the fair value of each reporting unit exceeded its carrying value at the respective measurement dates, and thus no impairment charges were recorded in those fiscal years.

Inventories

Inventories are valued at the lower of cost or net realizable value. Cost is determined by the specific identification, average cost or first-in, first-out methods. Write-downs are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions. We have utilized certain assumptions when determining the market value of inventories, such as inventory quantities and aging, historical sales of inventory, current and expected future aviation usage trends, replacement values, expected future demand, and historical scrap recovery rates. Reductions in demand for certain of our inventories or declining market values, as well as differences between actual results and the assumptions utilized by us when determining the market value of our inventories, could result in the recognition of impairment charges in future periods.

In conjunction with reclassifying rotable assets as inventory held for sale, we recognized rotable asset impairment charges of $1.0 million and $1.4 million in fiscal 2022 and 2021, respectively.

Revenue Recognition

Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer.

Our unit of accounting for revenue recognition is a performance obligation included in our customer contracts. A performance obligation reflects the distinct good or service that we must transfer to a customer. At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations. In some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated. If the contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocate the transaction price based on their relative standalone selling prices.

The transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified. Some contracts contain variable consideration, which could include incremental fees or penalty provisions related to performance. Variable consideration that can be reasonably estimated based on current assumptions and historical information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Variable consideration that cannot be reasonably estimated is recorded when known.

Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. The majority of our sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment. In connection with certain sales of products, we also provide logistics services, which include inventory management, replenishment, and other related services. The price of such services is generally included in the price of the products delivered to the customer, and revenues are recognized upon delivery of the product, at which point the customer has obtained control of the product. We do not account for these services separate from the related product sales as the services are inputs required to fulfill part orders received from customers.

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For our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer. Revenue is recognized based on the relationship of actual costs incurred to date to the estimated total cost at completion of the performance obligation. We are required to make certain judgments and estimates, including estimated revenues and costs, as well as inflation and the overall profitability of the arrangement. Key assumptions involved include future labor costs and efficiencies, overhead costs, and ultimate timing of product delivery. Differences may occur between the judgments and estimates made by management and actual program results.

Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. These changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services.

When contracts are modified, we consider whether the modification either creates new or changes the existing enforceable rights and obligations. Contract modifications that are for goods or services that are not distinct from the existing contract, due to the significant integration with the original goods or services provided, are accounted for as if they were part of that existing contract with the effect of the contract modification recognized as an adjustment to revenue on a cumulative catch-up basis. When the modifications include additional performance obligations that are distinct, they are accounted for as a new contract and performance obligation, which are recognized prospectively.

Under most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed.

Shipping and handling fees and costs incurred associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in Cost of sales on our Consolidated Statements of Income, and are not considered a performance obligation to our customers. Our reported sales on our Consolidated Statements of Income include sales and related non-income taxes. We also utilize the “as invoiced” practical expedient in certain cases where performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing to the customer.

The timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each reporting period. Contract assets consist of unbilled receivables or costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers. Contract liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract. These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract assets and contract liabilities are determined on a contract-by-contract basis.

Allowance for Credit Losses

We maintain an allowance for credit losses to reflect the expected uncollectibility of accounts receivable based on past collection history and specific risks identified among uncollected accounts. In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, and our customers’ current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to undergo an extensive credit check prior to delivery of products or services.

We perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers.

Impairment of Long-Lived Assets

We are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. When applying accounting standards addressing impairment of long-lived assets, we have utilized certain assumptions to estimate future undiscounted cash flows, including current and future sales volumes or lease rates, expected changes to cost structures, lease terms, residual values, market conditions, and trends impacting future demand. Differences between actual results and the assumptions utilized by us when determining undiscounted cash flows could result

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in future impairments of long-lived assets. In our Expeditionary Services segment, we consolidated manufacturing facilities and recognized impairment and related charges of $2.6 million during fiscal 2021.

We maintain a significant inventory of rotable parts and equipment to service customer aircraft and components. Portions of that inventory are used parts that are often exchanged with parts removed from aircraft or components, and are reworked to a useable condition. We may have to recognize an impairment of our rotable parts and equipment if we discontinue using or servicing certain aircraft models or if an older aircraft model is phased-out in the industry. In light of declines in commercial airline volumes and commercial program contract terminations driven by the impact of COVID, we evaluated future cash flows related to certain rotable assets supporting long-term programs and recognized asset impairment charges of $2.3 million and $5.8 million in fiscal 2022 and 2021, respectively.

Pension Plans

Effective May 31, 2022, our Union and U.S. Retirement Plans were merged (collectively, the “Merged U.S. Plan”). We are planning to terminate the Merged U.S. Plan in the first half of fiscal 2024 upon the anticipated transfer of the Merged U.S. Plan’s obligations to a third-party. The Merged U.S. Plan is in an overfunded position of $8.7 million and we do not anticipate making any contributions to the Merged U.S. Plan in conjunction with the termination. We expect to recognize a non-cash pension settlement charge related to the actuarial losses in Accumulated other comprehensive loss, upon settlement of the obligations of the Merged U.S. Plan. This charge is expected to occur in fiscal 2024, with the specific timing and final amounts dependent upon several factors.

Our total pension plan assets exceed our total projected benefit obligation by $4.6 million as of May 31, 2023 with the overfunded position primarily attributable to the Merged U.S. Plan.

The liabilities and net periodic cost of our pension plans are determined utilizing several actuarial assumptions, the most significant of which are the discount rate and the expected long-term rate of return on plan assets.

We use discount rates to measure our benefit obligation and net periodic benefit cost for our pension plans. We used a broad population of Aa-rated corporate bonds as of May 31, 2023 to determine the discount rate assumption. All bonds were denominated in U.S. Dollars, with a minimum outstanding of $50.0 million. This population of bonds was narrowed from a broader universe of over 500 Moody’s Aa-rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10th percentile and the bottom 40th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension plan liabilities. This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments and settlements for the Merged U.S. Plan. The discount rate is the single level rate that produces the same result as the spot rate curve.

We establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market, as well as analysis of current market and economic information and future expectations. For our Merged U.S. Plan, we have invested the majority of the plan assets in fixed income investments in anticipation of the upcoming termination of the Merged U.S. Plan. The asset return is expected to correspond to the changes in the discount rate and the valuation of the pension obligation to mitigate the risk of a significant reduction in the current overfunded position.

In calculating the net pension cost, the expected return on assets is applied to a calculated value on plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future.

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