Month: November 2016

When Two Companies Love Each Other…

Posted on by Travis Lane

It’s been an interesting quarter in the business world. I decided to write about mergers and acquisitions fairly soon after my last lesson, and the universe granted my wish and provided a whole host of relevant pairings to talk about, running the gamut from monumental (AT&T acquiring Time Warner) to mundane (high-end computer peripheral company Razer purchased THX – you know, the “Deep Note” people you remember only when you go to the movie theatre). In fact, in preparation for this post, I gathered half a dozen interesting M&A stories from this quarter alone. Maybe it’s a hot quarter for it, or maybe I’m falling prey to the frequency illusion. Either way, here’s some of what’s going on around us:

Mergers and acquisitions occupy their very own segment of the business world, not entirely separate and distinct from the more typical business topics of finance, accounting, strategy, management, and so forth, but not entirely part of them either. While it has tie-ins – companies wouldn’t be interested in going through M&A effort if it didn’t matter financially – it has its own set of benefits and opportunities, as well as unique risks and pitfalls.

In talking about this, I’m stepping into a dark and scary place, so I’m going to keep it as simple and high-level as possible, and provide some threads for you to pull on if you want to sink deeper.

To paint with a broad brush, the two major types of M&A strategies are horizontal integration and vertical integration. In today’s call, you probably heard the terms “horizontal” and “vertical” a number of times. Let’s quickly talk about each one.

Horizontal Integration

A horizontal merger is when two businesses do the same thing, and move forward doing that same thing together. This happens in the auto industry all the time. We build cars, you build cars, let’s see if we can work together to build more or better cars.

The financial upsides of horizontal integration are typically one or more of the following:

  • Economies of Scale: since we’re building more product, we can utilize our resources better.
  • Increased Market Access: for instance, if Company A was rocking it in North America, Company B in Europe, the new company can expand the combined global footprint.
  • Increasing Buying Power: instead of getting the bulk discount for 50,000 parts, we can negotiate a new discount for 100,000 parts.
  • Increased Market Influence: by owning more of the market, a company can more readily set prices and expectations; this can be a very powerful tool, so much so that regulatory agencies have the ability to block mergers under antitrust law if they would effectively kill competition in the marketplace and create a monopoly.

As we’ve talked before, generally, doing more business is good. Being more efficient is good. Having more influence is good. All of these things are possible positives from a horizontal merger. However, there are some complexities, both operationally and intangibly. Some of the risks or difficulties in executing a successful horizontal merger may be:

  • Cultural mismatch preventing the realization of operational efficiencies. Too much time can be spent fighting two opposing sets of “We’ve always done it this way” to actually integrate the two separate companies into a stronger whole. Mergers are also tough, and can impact morale, resulting in turnover, disengagement, and other problems that are difficult or impossible to put on paper.
  • Complexity leading to growth in overhead, rather than reduction. Ideally, going horizontal lets a company manage more business with the tools it already has, but the differences between two formerly distinct companies may be too complex to rectify into a more efficient structure.
  • Incongruent dependencies prevent cost efficiencies. For example, Company A can only obtain parts from Company X, while Company B can only obtain parts from Company Y. If their supply or partner bases are overly specific or constrained, it may keep the operations functionally separate after the merger intended to combine them.

Overall, a horizontal merger aims to do more of the stuff we’re already doing well. In the list above, Bass Pro Shops + Cabela’s and TD Ameritrade + Scottrade are clearly horizontal mergers, aimed at gaining market share, market access, and growing the underlying business by doing so.

Vertical Integration

With vertical integration, a company will buy another company at a different layer of the supply chain or value chain. In the automotive world, if horizontal is like Volkswagen buying Audi, vertical is like Volkswagen buying Car Trim GmbH, an interiors supplier and specialist company.

The stated benefits of a vertical merger are one or more of the following:

  • Guaranteed supply base: if you own the supplier, you have full visibility into their operations and priorities, and can control their output at a much finer level. This can let you dig into the details of processes that are difficult to obtain or entirely out of sight otherwise.
  • Capture margin: simply put, if you’re paying a supplier a 10% profit margin on their parts, when you own the company, you can drive those costs down internally or capture that margin if you continue to supply to other companies.
  • Indirect market control: if the supplier also works with your competitors, you can exert more control over pricing and pacing in the market by owning a key piece of the supply chain.

But nothing is ever perfect, or easy, or perfectly easy. Some of the risks and downsides of a vertical merger are:

  • Lack of knowledge or experience: familiarity with a supplier doesn’t necessarily translate into mastery of their business. With horizontal mergers, you’re already used to executing that business. Vertical mergers may force you to operate outside of your core competencies, with associated learning curve and costs.
  • Rigidity: one of the benefits of having an outside supply base is that you can be fluid with your supply chain choices. If another company is cheaper, or your current supplier sucks, or you can do the job better internally, you can switch over with comparatively less pain. If you’ve purchased a major element of your supply chain, you’ve made an expensive commitment to insourcing, leaving you less flexible to respond to market changes.
  • Difficult integration: as with horizontal mergers, or any merger for that matter, realizing the purported gains can be very tough, for a wide swath of reasons.

With a vertical merger, we want to go deeper into our business, not wider. AT&T + Time Warner is an example of a vertical merger – AT&T distributes content, Time Warner creates it. Verizon + Yahoo would be similar. Dick’s Sporting Goods + Golfsmith is another example, even if the bankruptcy element makes it a bit different.

Further Reading

The further this series of mini-lessons goes, the more complex it seems to get. My goal is always simplicity, and mergers and acquisitions are just one of those topics that aren’t simple any way you slice it. In spite of the title, while some mergers are well-received and mutually supported, there’s a whole genre of them that is bitter and painful. Often, major players in one or both companies disagree on the benefits, and it can be a nasty process to execute the merger or acquisition itself, much less successfully realize the stated gains. Nonetheless, I hope this has been a good first pass to get comfortable with some of the common terms thrown around in that realm and an understanding of what we’re trying to accomplish when we pursue M&A activity.

If you want to learn more, Investopedia has some really good articles that could easily lead to a 10+ tab session of Chrome if you want to dig a little deeper into this world:

Spirit AeroSystems – Q3 2016

Posted on by Travis Lane

Whew, what a quarter.

This quarter’s call was equal parts entertaining and encouraging. There’s a lot to talk about, even if the call itself ended early (!!!), so let’s jump in!

Financial Summary

Let’s start with the top-level summaries that Spirit provides.

When looking at the year over year results here, it’s important to remember that Q3 2015 was buoyed up by a big one-time event in the deferred… tax… asset… thing. That’s why net income and earnings per share look like they’re way down in spite of better performance. The company provided the adjusted line (highlighted by me) to illustrate this. Cue usage of the term “lumpy.”

You may also note that the share count between the quarters is noticeably different. This is what we bought with our share repurchase program. It compounds the effects of our growth in net income by spreading those earnings out over fewer shares. The results are… well, see our stock price and STIP score.

Moving on to cash and liquidity, we see here Spirit’s continued aversion to having a billion dollars in the bank. Not that the share repurchases aren’t legitimate or helpful – we can see that in the first table – just that I continue to find it funny that whenever we would push past a billion in the bank, we throw down some cash somewhere. In this quarter, we spent $332M to repurchase 7.4M shares – without that purchase we’d have been at $670M (current balance) + $332M (share repurchase) = $1.002B. Lookie there.

This quarter, we once again positively revised our full-year guidance. What I’m about to do here is far from scientific, but it’s some interesting back-of-the-napkin math for you.

We revised our revenue guidance up 1.5% at the midpoints ($6.75B / $6.65B = 1.015), which is a pretty modest increase, but earnings per share (net income) increased by 5% ($3.725 / $3.55 = 1.049), and free cash flow by 10% ($412.5M / $375M = 1.10). Here’s a table, because table:

Metric Prior Midpoint New Midpoint % Growth
Revenue $6.65B $6.75B 1.5%
Income $3.55 $3.725 4.9%
Cash Flow $375M $412.5M 10.0%

Keeping in mind what the various numbers mean (revenue is what we’re paid, earnings are what we keep, cash flow is what we bank), that’s telling us that we’re becoming more internally efficient. We’re growing our profits and cash flows at an outsized rate compared to revenue growth. In other words, capturing more of our revenue as profit rather than expense. All of those cost reduction efforts we’ve been talking about can be seen right there. Bullseye.

We’ll talk about this more throughout the summary, but the new dividend was obviously a big deal. We’ve talked about dividends a bit in the past, and how they, along with share repurchases, are a way of giving money back to shareholders and proactively controlling both internal financial metrics like earnings per share and external ones like share price. Mr. Gentile doubled down on Larry Lawson’s old message: we’re seriously undervalued in the market. Mr. Lawson engaged in the share repurchases to use our cash flow to strengthen our financials and show his faith in our consistency. Tom’s administration hammered down what Larry had committed to, then committed to more, and then kicked in a dividend, as if to say, “Still don’t think we’re underpriced? Watch this.” It was bold, and I dig it. Clearly, the street did too.

My overall thoughts out of the way, let’s get to the call!

Tom Talks

  • In the press release and in his speech, Tom’s first statement was this: “We remain committed to a balanced and disciplined approach to capital deployment by utilizing all the different mechanisms in an opportunistic and timely way.” In non-CEO speak: $600M in shares wasn’t enough? Okay, double it, add a dividend, full steam ahead.
  • Tom posits that it’s fitting to offer a $0.10 quarterly dividend to celebrate Spirit’s 10 years as a public company. It’s a cute number to start with. $0.40 annualized dividend yield on a $50+ share price is pretty meager, but it definitely sends a message.

Sanjay Talks

  • Mr. Kapoor starts in on the numbers, first highlighting a 7% revenue increase year over year ($1,594 to $1,711), primarily from A350 and 767 deliveries
  • Adjusted earnings per share experienced a 30% y/y increase ($0.89 to $1.16). Lower share count from repurchases helps in this, of course, but so does internal performance (net income). With the adjustment, year over year net income increased from about $125M to $145M (16%). We both increased the numerator and decreased the denominator of the earnings per share equation. Sweet.
  • We nearly tripled our free cash flow y/y ($76M to $214M). Main drivers were capital expense budget and schedule, plus 787 and A350 performance.

Pretty straightforward and brief executive introductions, per the norm.

On to the questions. I didn’t parse out anything, so this is a commentated dump of my notes from the call.

Q&A

  • Question: How big is the new 787 block and what kind of margin are we expecting on that?

o   Sanjay: 500 units. Can’t tell you program margins dude =P.

o   Travis: If you were playing Earnings Call Bingo, here’s your free space – analyst asks about a proprietary internal number that we won’t share publicly, gets told we won’t share it publicly.

  • Question: There was a small-ish one-time benefit on A350. What was it? How do we see the program turning cash positive in 2017?

o   Tom: It basically comes down to efficiency and a lot of the cost savings efforts we’ve undertaken. It’s representative of a maturing program in a maturing business.

He continues to talk about some of the specifics in Kinston manufacturing and efficiency.

o   Travis: I don’t have good quotes from Mr. Gentile on this, but I don’t want to undersell it. Tom sounds like he’s impressed with the business, and really enjoys the details. His answer demonstrated a rapidly increasing knowledge of the business at a working level, and honestly, a passion for a lot of the initiatives we’re undertaking.

  • Question: Regarding cash usage this quarter – completing Lawson’s share repurchase program, initiating a new one, announcing a dividend; it seems like things are going even better than you thought. What gave you the confidence to make these new moves on cash deployment?

o   Tom: Rate increases on 737, 787, and A350 give us lots of embedded, organic growth. We’re also pushing hard on cost reductions via supply chain sourcing and utilizing our buying power for raw material purchases, so that gives us a great cash outlook in the future. But over and above that, looking on the horizon we see promising new work with a high likelihood. We’re also exploring inorganic growth that would give us higher access to Airbus programs.

o   Travis: I’d like to say that the difference in Tom’s knowledge is notable between his first quarters and this one. He’s confident and well-informed, even at a highly granular level. Sometimes it’s easy to think of executives/CEOs… differently. Whether that means some sort of secret cabal, figureheads with no real impact, or whatever else, it’s been very cool to observe the real world and listen to Tom through the handful of quarters he’s been our top officer. I feel like I’ve bragged on Sanjay quite a bit in the last few quarters, but it’s Tom’s turn this time. He’s showed the transition from new hire to deep engagement at the executive level, and is now showing skillful knowledge of the business while maintaining the air of humility that I think a lot of us saw when he came in. Whether CEO or first level engineer, there’s an associated learning curve for anything worth doing. We’re seeing Tom go through that in real time, and it’s been a treat.

  • Question: How should we look at dividend policy (and generally cash deployment), especially when talking about “inorganic growth” like you just said.

o   Tom: We still feel like we’re really undervalued, are confident with cash flow now and in the future, and as we’re always saying, “opportunistic.” We’re looking at horizontal, getting more Airbus work, and also some military work. Looking at low cost countries, expanding work with suppliers, and getting more from current partners.

o   Travis: phew. There was a lot here. We’ll talk about what he means by horizontal/vertical more in the mini-lesson, but what he’s saying here is that we’re full bore on almost every growth outlet a company can pursue. We’re bidding new work across the spectrum, looking at merger and acquisition opportunities, digging into our supply chain, and more. This is Tom’s “Keep your eyes on Spirit, big things are coming” pitch.

  • Question: We’ve heard about working on supply chain agreements; how far are we into that process? Talking different terms or just pricing?

o   Sanjay: Supply chain is an obvious place to look for savings, because it’s a massive bucket. But it does move very slowly; we’re talking thousands of part numbers, suppliers, contracts. Over time, we’re trying to implement a “clean sheet” approach, where we do analysis on what we think things should cost if everything was perfect, which lets us have an honest talk with suppliers about closing that gap. It gives us leverage to talk to them, but also to help them get to where we think they should be. Those improvements very gradually work their way into our performance.

o   Tom: I see these clean sheets as reverse engineering. We look at every part we buy and ask all kinds of questions about what it should cost. For some examples, in one situation, we saved 35-40% by consolidating parts under one supplier instead of scattered over several. In another, we moved a part to a low cost country supplier. In another we brought down raw material costs by leveraging Spirit’s economy of purchasing scale. And in another, we insourced a part that we could do better than the supply base. Overall, we’re 30-40% into the journey, with a detailed, gated process in place for the future.

o   Travis: This was another detailed look at exactly how we’re employing our strategy. Sanjay points out that looking at supply chain is smart, because the vast majority of our costs come from there. In other words, you can save money by skipping Starbucks, but if you’re car-poor it won’t make much of a difference, so start with the big stuff. Tom lays out that we’re not just arbitrarily outsourcing or switching things up; it’s a tactical process that has led to a mixed bag of actions. We’re constantly trying to do the best thing we can with every single part.

  • Question: M&A strategy. Trying to get a sense of the scale of the opportunity we’re considering.

o   Tom: Not just to grow for the sake of growing, but to add to our strength as a company. For horizontal, if we could find a company to get on a very attractive program within our core competencies, we’d look at it. Also looking at something that would get us into a low cost area like Southeast Asia or Mexico. Looking at improving our fabrication business, securing our supply chain, and capturing some of that available margin.

o   Travis: Once again, a whole lot here. It sounds to me like we’re still relatively early in the search for an M&A target. I interpret this as we’ve developed some criteria for what constitutes a solid growth opportunity via merger/acquisition. That’s more than knowing we want to start thinking about M&A, but less than having specific targets identified. I could easily be wrong, but I wouldn’t guess we’d hear Spirit making a tender offer on anything in Q4 2016. Partway through 2017 might be plausible. Boy, how I’d love to be a fly on the wall during these discussions though!

  • Question: What does organic growth look like beyond rate increases and defense programs? Expand aftermarket as profit lever?

o   Tom: We’re bidding on a number of Airbus programs and some business jet and military too. A number of packages are out for bid. Aftermarket specifically, sure, it could grow.

o   Travis: Reminder – organic growth is the natural sorts of things we would expect, like rate increases on solid programs, securing more business from our existing customers, etc. Inorganic is when we do sort of a “step” function and buy some other company or start up something completely new. Mr. Gentile does seem to say we’re still pushing hard for organic growth and bidding on a number of programs, though the focus of this quarter has been the inorganic growth and what to expect in the future with that. In other words, Spirit still has pretty solid growth prospects, even if we don’t do something big and dramatic.

  • Question: 737 deliveries down slightly in the quarter, what’s today’s rate, and was there anything unusual in the quarter? Also what rate we’re capitalized at (ready for)?

o   Tom: 42/month today, which, as a trivia fact, is almost double the rate from when we spun off from Boeing. On track for 47 early next year, and the capital is already in place. Deep into planning for 52/57 – capital is in the long-term plan. Some discussion still, but on track.

  • Question: Talking bidding aggressively for Airbus work, how do we leverage lessons learned on A350, 787, and Gulfstream products in not getting ahead of ourselves on our bids?

o   Tom: We’ve learned a lot. Part of it is estimating. Some is based on program management and change control too. When I look at early contracts, they weren’t really “optimal.” We’re better at not only terms and conditions, but also change control and program management. There were some painful lessons, but we learned from them, and we’ll be able to apply those lessons going forward.

Tom doesn’t criticize the leadership early on, because they grew the company and got us on some really great programs, but we learned a lot of lessons and we’ll know to look for those mistakes in the future.

o   Travis: I just love Tom’s tone. The question was pretty skeptical, but completely justified. Long ago, there was excitement about Spirit’s growth prospect with new customers and an explosion of hot new programs. Then we got in trouble because we had committed to too much, too fast. Jeff Turner openly admitted as much in a prior call. Tom grasps both sides. He celebrates the growth that the original leadership obtained while accepting the tough lessons learned from overexpansion, and he does it with humility and steadiness. It’s really a confidence builder.

After that last question, something really bizarre happened: we ran out of questions. Sanjay asked if Tom had any closing remarks to fill the last 8 minutes or so. He offered a few quick points in summary, and we signed off. Oh, I also just have to note, the phrase deferred inventory wasn’t mentioned a single time. What a time to be alive.

Fewer questions typically means there’s less to criticize. It’s an important time in Spirit’s history… sort of an “All roads led to this moment” type of feel. We’ve been in some tough places, survived them, and came out stronger. We’re steadying our feet again, and preparing to make another leap into the next phase. What happens next? Tune in next time J.

Much of the conversation from this quarter focused around Spirit’s intentions in the realm of mergers and acquisitions (M&A). The mini-lesson “When Two Companies Love Each Other…” digs a little deeper into some of the common terms you might hear on that subject, and explains some of the opportunities and risks of these activities. Enjoy!