Month: May 2014

The Lemonade Stand — A Lesson on Cash Flow

Posted on by Travis Lane

Imagine some kids in your neighborhood got an entrepreneurial bug and wanted to start a lemonade stand. Well, for a child, a lemonade stand is a high capital business. They don’t have the money to buy 2×4’s to build the stand, the lemons and sugar to make their delicious beverage, or the cups to contain their tasty treat as they deliver it to their customers. They’ll probably turn to a parent to do the initial financing. In return, the stand would owe some of their profits back to the investor — dad can’t just shell out seed capital for a business without some promise of return. So the parent buys $20 worth of supplies to get the venture started, and the kids are off on their capitalist adventure.

The kids spend $10 to build the stand itself and the remaining $10 on supplies. After a weekend, they’ve had incredible success; their mix is just right and everybody in the neighborhood wants some! At $1 a cup, they’re able to sell 40 cups of lemonade — $40 generated from an initial investment of $10 (the $10 for the stand is property, plant, and equipment; this $10 is cost of goods sold). They write down their revenues ($40) and net income ($30), and then they come to their cash flow. Weeeeeell, some of the other kids in the neighborhood didn’t have $1 on hand, so they opened an IOU account. Some offered payment via trades in other goods (are baseball cards still valuable?) or services. When the lemonade stand owners count up their money at the end of the weekend, they find they only have $4, despite being massively “profitable.”

But that’s okay! They’re showing big profits and believe they can profitably expand the business, they’re just in a little cash crunch. They approach their investor again, show them the big profits, and tell them about their plans to continue and grow the core business. They’ve even thought about expanding into new business areas, like offering iced tea or building another stand in the next neighborhood over! This time, the investor raises a little eyebrow and wonders where the money went, but saw them selling lots of lemonade and still believes in the venture, so they offer some more financing… maybe at a higher interest rate though.

You can see where this is going, I’m sure. Without the cash flow to reinvest in the core operations, expand the business, and pay back investors, that investment money is going to dry up or come with major stipulations. Venture capitalists know how this process goes and take advantage of it. They’ve got the capital, and after a few cycles of fund requests, will tack on the condition that they’ll continue to invest but only if they gain an equity share in the company. In the end, they can acquire or control the business and turn it into a cash-generating machine once the owner is gone. This is also why large, mature firms will buy out smaller firms with growth potential. The large firms have cash but little opportunity for growth, and smaller firms are growth monsters but have no cash.

In short, the mark of a maturing business is sustainable free cash flows and balanced growth. Contrast this with fledgling businesses who have explosive growth opportunities but low liquidity. In one of his last quarterly meetings as CEO of Spirit AeroSystems, Jeff Turner mentioned that he believed they were positioned well and their programs were good ones to be on, but that they had expanded too quickly. Aha. Too much growth, too little cash. The replacement CEO’s primary focus became fixing that imbalance not only by tightening costs, but by reducing exposure to what he felt were less lucrative ventures, such as a lagging business center in Tulsa, OK. The “transition” the new CEO kept on about in his first months was to restore balance to the force growth and cash flow portions of his company by actually slowing down growth to get in a more favorable cash position.

A wise goal. It’s a cute lesson when your neighborhood kids run out of cash to buy lemonade, but it’s a little less cute when it’s a multi-billion dollar company.

Spirit AeroSystems – Q1 2014

Posted on by Travis Lane

Iiiiiit’s time for another quarterly earnings call! I’m writing this intro before the earnings call starts, and based on the published financial statements I think it’s safe to say this will be a much easier message for me to write… and for you to read… than the last set of results.

Here’s a link to a great summary of the financial statements with the usual comparisons to Q1 of the previous year. It’s still in financial-ese, and I’ve got a neat story for you to illustrate another financial concept, so keep reading, but also give that link a peek. Remember that Q1 of 2013 our STIP score was something like 1.70, indicating that the reported financials were solid compared to our forecasts and goals. Keeping that in mind, let me draw your attention to the lines Operating Income, Net Income, and Net Income as a % of Revenues on Table 1.

Now, let’s get to the call.

Summary of the Earnings Call

As always with the earnings calls, you could probably discern the performance from the tone of voice and interaction between our CEO/CFO and the analysts even if you didn’t speak English. If you were listening for such things, you’d have noticed that Mr. Lawson and Mr. Kapoor were very much at ease and much warmer than they were compared to defending the dire performance of last quarter. The analysts didn’t ask grilling questions or probe a specific troublesome topic. There was even a little laughter after Larry made a joke about 8-K SEC statements. No, nobody else got it either. Yes, it was kinda funny. Another funny moment was when an analyst was asking about the Tulsa sale and referred to it as “This……. asset.” His opinion on the site was pretty clear and the awkwardness warranted a chuckle.

Overall it was an impressive quarter. Compared to Q1 of 2013:

  • Sales grew 20%
  • Operating income (money we make from our “core business” of selling airplanes) grew 35%
  • Net income (also called “profit”) nearly doubled at 89%
  • Net income as a percent of revenues (or “profit margin” – how effective we are at turning sales into profit) grew from 5.6% to 8.9%

These are all really, really solid numbers and reflect tons of improvement not just in sales, but in the efficiency of our business. So good job :).

Some of my buddies made very good observations about the results and about the analyst impressions. Michael Kuchinski pointed out that our earnings per share (it’s just our net income divided by number of Spirit stock shares that exist) of $1.07 for the quarter is nearly half of our projected EPS for the entire year. Well done, Mike – an analyst asked about this very same thing, questioning if our 2014 guidance had some conservatism in it given the Q1 performance. Sanjay’s response was a little laugh; it seems like yes, we’re hoping to meet and exceed that guidance, at least if we keep pace with first quarter performance. You may also have noticed that they positively revised our free cash flow guidance for the year – as shown below (the blue slash and revised figure of $200M is theirs, the obnoxious red arrow pointing to it is mine).

4

Now, let’s balance this positivity out a little bit. A very insightful observation was also made by Nic Hovey, who caught onto a major trend in the analyst questions. There wasn’t a big central topic to talk about like a forward loss, so the questions were more widespread, but what Nic pointed out that they had in common was questioning the reliability of Spirit’s forecasts. It was a great quarter no doubt, but we’ve had great quarters before and then been burned. We’re not risk-free or out of the woods just yet. We know this intuitively as employees, and it’s clear that the people who analyze our company on a full-time basis feel the same way.

 

Every quarter since Mr. Lawson has taken the reigns of Spirit, he has constantly harped on Spirit’s free cash flow. I talked about this a little bit in the last email, but wanted to expand on the topic for your learning pleasure this quarter.

To introduce the topic, I’ll relay one of the analyst questions that touched on it.

The analyst noticed that our accounts receivable increased. Accounts receivable (A/R or AR) are like checks written to us that haven’t cleared yet. We provided the goods or services and know the recipient will pay us, but we haven’t got the cash in hand yet. The analyst was wondering if this was due to non-payments particularly from Gulfstream and if we should be concerned about our inability to collect these bills. In short, Sanjay said that the AR growth was due to increased volume and payment structures and it was nothing to be concerned about. But this topic, this accounts receivable and cash flow thing, it’s a good one, so let’s learn a bit more.

Suggested Mini-Lesson

You’ll notice that in this quarter, we had a nice income — $154M in net income (profit). That means that we sold our stuff for more than it cost us to make it, by 8.9% (our profit margin) on average. Great! So uh… why was our cash flow from operations only $45M? And uhhhhh… why was our free cash flow negative $8M?

One part of the answer is exactly what Mr. Kapoor said; when you’re talking about hundreds of millions of dollars, those checks can clear kinda slow. But why free cash flow is such a focus for Mr. Lawson, and why it’s wise for him to focus on that, is a great topic. For this, see the story of the lemonade stand.