Month: August 2017

FedEx: Luck

Posted on by Travis Lane

In the early 1970s, Fred Smith founded Federal Express (FedEx) with a novel, new idea on shipping: an end-to-end model where one carrier was responsible for delivery from pick-up all the way to final destination. The business took off quickly until the fuel crisis slammed it, causing it to start hemorrhaging over a million dollars a month.

Smith lobbied his investors for more capital to stay in business, but was unsuccessful. He was waiting for a flight home after this critical rejection when an idea struck him. Knowing that they were well short of being able to make payroll and fuel the delivery planes with the cash they had, Smith devised a noble strategy: put it on black.

He grabbed a flight to Las Vegas and turned the company’s last $5,000 into $27,000 at the blackjack table. This allowed them to stay in business and operational for another week. Shortly after, and just in time, he was able to secure another $11M in capital from investors. The rest is history.

(For more on Fred Smith and the blackjack story, see here and here.)

There’s no denying that luck plays a role in business. We might call it by different names – macroeconomics, unknown unknowns, Black Swan events, whatever – but the gist is that there are things that we don’t control that we still must react to for our business to survive. We often hear about successes, but rarely failures. Survivorship bias is a particularly nasty flaw in human cognition and social study. Dead companies tell no tales.

Is there any real way to prepare for events we can’t control, and often don’t even know are coming? Famed business researcher Jim Collins’ team (of Good to Great and Built to Last fame) set out to answer this question in the book Great by Choice: Uncertainty, Chaos, and Luck – Why Some Thrive Despite Them All.

While the original work (and his others) are all worth the read in full, here are three behaviors and characteristics of companies that survived and even thrived in turbulent times when competitor companies in the same situation faltered and failed.

  • Consistency: Successful companies adhered to what Collins calls the “20 Mile March.” In good times and in bad, they were determined to grow at a steady, sustainable pace. Often, this meant exercising discipline in slowing growth during favorable times so that it could be realized in down times. The great companies would often lag behind their competitors who courted massive growth in good times, but left no reserves for the bad. They would then catch and pass them for good with their steady, unflappable pace.
  • Calibration: As Collins calls it, “firing bullets, then cannonballs.” With a limited amount of resources (people, capital, and time chief among them), companies that want to survive turbulence need to calibrate their efforts by starting small and gathering objective, tangible data before investing fully in a new and exciting concept. Going small at first helps refine your aim when the stakes are low and you have little organizational inertia to overcome. Only after aiming should you fire the cannonball – dedicate a heavy amount of resources – on a project or idea.
  • Conservatism: Plan for the worst, hope for the best, as they say. Collins calls it “productive paranoia.” Planning and strategizing conservatively – as if something will go wrong – gives you options whether events turn out in your favor or against. If you bring extra oxygen up the mountain, you can choose to wait out the storm and try for the summit tomorrow, instead of being forced to either fail to achieve the goal or die trying due to impossible conditions.

Smith’s blackjack ploy makes for great print, but many a company has died relying on that kind of luck explicitly or implicitly. In business and in life, assessing and planning for risk helps us survive and thrive through uncertain times.

Spirit AeroSystems – Q2 2017

Posted on by Travis Lane

Hey folks! It’s that time again… earnings time. And what a pleasant surprise we have before us this quarter.

We’ll start with the usual handful of charts, then talk about what all the buzz is about.

Each quarter I try to highlight something of note just from the raw numbers. What I liked seeing here is that compared to the same quarter of last year, we made more profit on less revenue (both highlighted above). I’ll talk about this more below, but this speaks well to our progress in shaving cost and becoming a more efficient business.

Another takeaway is that after spending $50M in the quarter on capital (property, plant, equipment), we still had more cash left in our envelope at the end of the period. If performance improvements trickleaaaaaaaall the way down to cash flow, that’s a good sign that there are no big stumbling blocks in our financials.

And here’s the cherry on top: we’re confident enough now in our performance so far this year that we’re telling investors and the public that we’ll make more than we previously said we would. A $50M (10%) increase in Free Cash Flow and a $0.40 (8%) increase in adjusted earnings per share is nothing to sneeze at. Those are stark improvements in operational efficiency over what we predicted at the beginning of the year. Kudos to everyone on that!

Okay, now, on to the gritty details. Let’s set up a few dominos here.

Last quarter, the earnings call focused almost exclusively on the “big gap” between Spirit and Boeing on our pricing agreement. When Mr. Gentile revealed that negotiations weren’t proceeding well in the call, Spirit’s stock price plunged into freefall almost immediately. We shed over 10% of our value that day, probably that half-hour. Over the last 3 months, Spirit’s stock recovered to roughly the place where it was before Gap Day, even a little higher, and when Tom announced that we now have an understanding regarding pricing with Boeing, shares shot up well over 10%.

Now, we have to keep in mind that share price isn’t tied to financial performance via some algorithm. The numbers matter for sure, but the share price incorporates more factors: investor confidence, certainty in the business, perceived short and long term opportunities, and more. This quarter’s task, as I take it, is to explain to non-finance people why a big third-of-a-billion dollar loss is less impactful than a handshake agreement with a customer.

Luckily, we’ve done this before. In fact, exactly one year ago, during Q2 of 2016. Which means I get to be extremely lazy and copy what I said then, as it’s essentially the same event, but bigger. The following section is from my Q2 2016 writeup:

We’re all a little sensitive to the term “forward loss” from some catastrophic results experienced a few years back. We’re tuned to the idea that the words “forward loss” precede layoffs, executive shakeups, declining share prices, and general pandemonium. And yet, Spirit’s shares were up about 7% on the day after accounting for this news. Our leadership is claiming solid and exciting results.

We need to preface with a reminder of terminology. Note that these graphs are all rough representations, not actual program performance.

Deferred inventory (DI) is a bucket that we keep track of that says whether we’re ahead or behind on our estimated production costs for a program. Each and every unit we produce will either add to or take away from the deferred inventory balance. If it cost more to make than forecast, it will add to DI and vice versa. Deferred inventory is a representation of our internal performance – our cost controls in supply chain, our build efficiency, and our cost estimate accuracy.

Revenue is what our customer pays us for each unit we deliver. Gross profit is our revenue (what we’re paid) minus what it cost for us to produce it (cost of goods sold).

A forward loss is taken when some of the deferred inventory balance is judged to be unrecoverable. In other words, as we’ve learned more about our production schedule, internal costs, and revenues from the customer, we found out that we can’t make up for some of that balance, and we write it off against our profits in order to adjust to the revised expectations. Put another way, due to a change in either revenue or cost estimates, the area under the curve between those two figures became smaller. Remember, it’s not a cash charge, it’s only an adjustment made in the current quarter to square us up with our future expectations.

Now, ordinarily, less profit is a sad time. As we’ve experienced in the past, forward losses are not a fun occasion. And really, all else equal, we’d have been happier without this forward loss. But, the context for this one is what makes it alright. Let’s dig into that now. I’d like to draw you an analogy.

Since 1928, the S&P 500 stock index has had a compounded annual growth rate of around 10%, meaning if you put money in the S&P in 1928, you could pretty closely calculate your present value using the basic compound interest formula and plugging in 10% for the rate. However, that smooth, parabolic curve is… not quite what has actually happened. Some years have been down more than 40%, and others have been up by more than 50%. 10% is the compounded rate, but it’s not the constant return you’d get every year. There was a whole lot of volatility involved. As someone with a 401k, or an IRA, or a college fund for your kids, would you trade 1% of long-term returns in exchange for eliminating the ups and downs of the market?

If you’re in a bond fund or a stable value fund, your answer is almost certainly yes. Even some of the more intrepid investors would probably trade a bit of their overall return for far fewer headaches and fingernail biting along the way. It’s pretty universal that people prefer certainty over uncertainty. Even if we understand the mathematics in our rational brains, the emotional brain is always there nudging us toward stability.

Well, this is pretty close to what Spirit has done here. Certainty and stability are the reasons our shares are rallying and we’re celebrating a good quarter in spite of taking a 9 figure forward loss on one of our most critical new programs.

By reaching a contractual pricing agreement with Airbus, we have secured our revenues on that program going forward. The forward loss didn’t necessarily come from poor performance, but from aligning with what we are now legally entitled to receive in payment for our services. We adjusted our profits to account for going from 10% return (with crazy volatility) to 9% (steadily every year). But you can still retire pretty nicely on 9% annually. You’ll have a little less money in the end, but a lot fewer sleepless nights. It’s more or less analogous.

Long, I know, but important. Replace “Airbus” with “Boeing,” and you have roughly the same idea of what happened this quarter. We booked $353M in future losses (no money came from our bank account for this charge), but we now have much more security and certainty with our largest customer. That’s a big, big deal. And beyond that, as I’ll talk about for the rest of the write-up, taking out that one-time exchange of profit for certainty (a worthwhile investment), the financial performance was better than expected. This means there were a lot of good signs for us this quarter!

Executive Intros

Messrs. Gentile and Kapoor gave their normal introductions and talked primarily about the MOU (Memorandum of Understanding) with Boeing regarding pricing. Note that this is not a signed contract, but more of a final draft that will be polished and signed at a later date. The day that the ink hits the paper will probably be another good day for Spirit.

Apart from that, Tom and Sanjay said a few things worth highlighting. Tom pointed out that after adjusting for the one-time loss stemming from the pricing agreement, we made $1.57 per share in net earnings… a 30% increase over this quarter of last year.

I didn’t see it calculated, but the adjusted net margin also went from 8.5% to 10.2%. And we did this on the same revenue – slightly less, actually.

What does that mean? Well, revenue is how much business you do (how much money you get in sales), so we’re holding steady year over year there, due to increasing 737, 787, and A350 rates set against declining 747 and 777 rates. But, an increase in net margin means that we’re doing more efficientbusiness. We’re making more money off of the same amount of sales, which speaks to the business maturing and bodes very well for how we’ll perform at scale when rates increase more across our portfolio of programs.

Sanjay underscored this by saying we’re raising our free cash flow conversion goal from 6-8% to 7-9%. What is free cash flow conversion? Remember that profits are on paper, but cash is real. Free cash flow is a measure of cash from operations (how much goes in and out of the bank in order to make the whole business run) minus reinvestment (capital expenditures). It means our business is running more efficiently even including reinvestment and growth. It’s the ultimate bottom line, so to raise our target here means a lot of other things must be going well.

Finally, Tom mentioned that we don’t currently believe there are any good targets for mergers and acquisitions, so we’ll probably pour a bit more into share repurchases with that spare cash we’re generating. When a good investment comes along (better than we believe we can get by buying our own stock, anyway), we’ll be ready to act.

Alright, on to the Q&A!

Q&A

Whereas last quarter, the entire Q&A section revolved around a single item, this quarter we got a diverse spread of questions covering a broad number of topics. It’s always a good sign when there’s not a big, ugly elephant in the room. Another good sign is when a lot of the questions are future oriented; how do you plan to grow, what’s your vision for x, y, z, how does next year look, and so on. Here are some highlights, with the usual commentary where applicable.

  • Q: Just last quarter we heard there was a big gap between you and Boeing. What happened here? This came together really quickly. Once it’s finalized, how do you see it changing the way we work with Boeing on an operating basis going forward? Is there a next shoe to drop regarding pricing?

o   Tom: Over the last few weeks, things came together. We always had a framework, and we just had to fill it out. The deal focuses on 737 and 787, but these are very complex deals and include a dozen major provisions. There are still some legal terms to finalize, but we expect it to be done in Q3. Operationally, we’ve always had a healthy relationship. Now that the commercial issues are resolved, we expect to rejuvenate and improve the operational relationships even more. You can see some of those benefits already in the advanced studies agreement. On the next shoe to drop, we would just say there’s a new level of certainty that we haven’t had before.

o   Travis: Prepare for rampant speculation, and please take this with a huge grain of salt. Tom talked in his weekly email following the call (“Art of the Deal”) about the many teams involved in making this deal happen. I know these folks have been working hard for a long time to make this deal happen, and I don’t mean to slight their efforts. But going from a “big gap” to having something almost ready to sign is a lot of movement very fast. My suspicion? After last quarter’s beating, some folks at the highest echelons of the company decided it was time to put this topic to rest, and there was perhaps a renewed urgency in coming to a deal, even if it meant making a few concessions. This is one way that shareholders can send a message. If shareholders are bailing on the company, it will get the Board of Directors attention. That’s capitalism, folks. Shareholders were not happy with where we were at, and very likely inspired real action. Of course we would prefer not to have taken a loss associated with it, but it’s to our benefit to have it done. It also means we can look to the future and to improving our relationship with our biggest customer. The joint advanced studies agreement is a sign of this renewal.

  • Q: The forward loss is mostly concentrated on the extension of the block. If we didn’t extend the block, is it safe to say that it would’ve been fairly neutral?

o   Sanjay: That’s fair to say. The loss is conservative because with that extended block we’re forecasting out quite a long time (~5 years). We believe we can reclaim some of that in operational and cost savings over that long time frame.

o   Travis: In the introduction, while discussing the details of the pricing agreement, Tom mentioned that we extended our pricing block from ~1,000 units to ~1,500 units. Sanjay intimated that most of the loss comes from those added units. Because it’s free for me to offer guesses, I’m going to further speculate that the extension of the block (and associated stepdown pricing, if applicable), was a concession on Spirit’s behalf. It puts the onus on Spirit to realize gains in operational efficiency, sourcing, and cost savings that will hopefully cancel out those losses when we get to line units beyond what we had planned. In other words, we don’t expect to realizethe bulk of the $353M loss until several years from now, and we made conservative estimates on our performance. If we can do better – and you’d better believe we’ll try – we can reclaim some of those losses over time.

  • Q: (My call cut out here, but I assume that the question was about where we see our growth areas going forward)

o   Tom: Presently, defense is only 5% of our work and it could be much higher. As you can see, we’re working our relationships with both Boeing and Airbus and seeing big improvements. We also see external 3rd party fabrication as a big opportunity; we’re one of the biggest fabrication houses in the world, but it’s all consumed internally, going into products that we make and sell. All of those are top-line growth (revenue) areas, but we also have major operational and supply chain improvements that should benefit our bottom line and margins.

o   Travis: Pretty self-explanatory. Look for growth in defense, broadening our work with Airbus and Boeing, and 3rd party fabrication (using our existing tools to make stuff that we sell directly rather than always using as a component of a plane we sell).

  • Q: Can you quantify some of the drivers of the increased cash flow guidance? (This analyst also congratulated us on “growing up”)

o   Sanjay: They’re mostly operational improvements. We’ve done this for a few years, where we set guidance conservatively, but have more aggressive internal targets. When we get deeper into the year and know how things are going, we can adjust guidance upwards if we’re realizing some of those higher goals.

o   Travis: Again, pretty straightforward. We have conservative financial guidance we estimate for the public, and higher internal goals that we aim for. If we hit them, we adjust the public guidance. The bigger takeaway here is as I mentioned above – we’re making more profit on the same revenue, which indicates Spirit is getting better at doing the stuff we do inside our walls.

  • Q: Can you talk a bit more about the Boeing aerostructures study? Is this related to the middle of market (MoM) aircraft?

o   Tom: There is no agreement to be on MoM – that’s in the future and we will certainly compete to be a partner. Here’s a couple of examples of what this aerostructures study means. We signed an agreement with Norsk Titanium on 3D near-net titanium printing. This allows us to reduce the material costs considerably (80-90% of a block is currently wasted, this would let us reduce that waste by 75%). We’ve talked about technical exchanges in terms of production systems – Boeing has adapted a Toyota system to great effect, and we might learn from that too. In the past we’ve talked about lots of technical ideas in the propulsion world that have waned, but this might open the door to more of that in the future.

o   Travis: My apologies for not representing this well. Basically Tom says that both Spirit and Boeing, independently, have some really cool ideas and technologies that we’re working on for our own benefit, as well as some joint ventures that have been tabled while the relationship has been frosty. This study agreement may open the door to us sharing tech with Boeing, them sharing their tech with us, and reopening some of the mothballed ideas that we wanted to work on together.

  • Q: $180M in “other” from cash flow from operations?

o   Sanjay: Reclassification of the interim pricing that we’re returning to Boeing – see the negative $270M above it.

o   Travis: An interesting little financial maneuver. Before we had this pricing agreement, Boeing still had to pay us something for our product. The money they gave us under this interim pricing, however, was never booked as cash, because we knew we’d have to pay it back when a pricing agreement was reached. The statement of cash flows is an important, but slightly weird financial statement. What you see below and what the question was about was an exchange of “interim cash” which we held but didn’t book, for “real cash”:

  • Q: Spirit has always done well operationally, but the financial side has been a thorn in your side. How do we know that this next big program, whatever it is, will be profitable? Doesn’t it also beg the question if we shouldn’t be doing fewer share buybacks and instead be doing more for the future?

o   Tom: A350 and 787 go all the way back to our divestiture from Boeing. We had much less experience on bidding work, how to execute on programs, and how to develop things in the early phases. No doubt we struggled on these two, but we now have a path forward. In terms of capital deployment, we try to be balanced. Just because we’re doing share buybacks doesn’t mean we’re not investing for the future. The share buybacks have been a good investment as our shares have historically been underpriced. Still, we’ve invested $250M or so each year on rate increases, site improvements, and R&D, and we’re about to triple our R&D budget (not necessarily on our own coin) to help position us as an indispensable partner for the future.

o   Travis: A really good question, probably echoing what some of you have thought. Spirit really has grown tremendously in our expertise not only in building airplanes, but in executing and managing a business. There were some growing pains, to be sure, and in our business, those kinds of pains can linger around for years. But we’ve learned a lot of lessons.

*phew*

Since this was a pretty long ordeal already, I wrote up a quick finance/business lesson here – FedEx: Luck. You’re welcome to enjoy it or tune out for next time. Either way, thanks for reading, and I’ll see you again next quarter!