Hey everyone,
Short summary this quarter with no separate lesson, as I’ve got an opinionated rant to make instead.
This quarter was simultaneously boring, to an excruciating degree, but at the same time intensely active. Let’s dive in and explore.
First off, our standard financial summary. I selectively highlighted all of the earnings (profit) lines, because they all declined appreciably from Q1 of 2016. Note that we can see the effects of the share repurchase program in this table too. Adjusting for the share count difference between Q1 of 2016/2017, Earnings Per Share would instead be $1.07, for a 17% year over year decline (coinciding with net income). Is that a good or bad thing? Well, you can think of EPS as “How much profit the company made for each share held by an investor,” so a higher number is better, and since keeping the share repurchase cash in the bank wouldn’t have done anything to offset the lower earnings, it seems like an effective use of that cash on behalf of the shareholders.
For posterity, here’s the cash position:
Not too much really sexy here. Improving cash flow and free cash flow, indicative of continued improvement in operational efficiency.
Before I jump into the call details and summary, let me preface with this: there’s nothing nasty or even surprising at all in the financials. We expected Q1 (and I’m also going to predict Q2) to be a little more lax, as 747 and 777 demand wanes and 737/A350 rates don’t pick up the slack until later this year or next. Case in point, the financial guidance our bosses provided at the end of 2016 remained unchanged this quarter. Our performance was fine, we’re just in a small production yawn. I’m not going to race out and buy a Ferrari due to expecting a massive bonus, but I’m not packing my bags for life on the street either.
However, if you’ve been watching Spirit’s share price, you might be tempted toward concern. We took a huge $5/share (8.5%) beating on the market after earnings. Boring results aside,something must have tripped investors to engage in a miniature selloff.
Let’s get into the call and find out what.
Tom Talks
- 737 rate increases from 42 to 47 per month expected to materialize by the end of Q2
- A350 rates increasing to 10 per month by 2018
- Regarding Boeing negotiations – they’re ongoing, we believe they’re still constructive, but they’re taking longer than we expected and at present there’s a big gap between us
Sanjay Talks
- Significant operational improvements drove a big jump in adjusted free cash flow
- Dividend and share repurchase programs are continuing on as expected
- Many results impacted by lower deliveries of 737/777 and higher deliveries of A350
Usually, I don’t pause to discuss the executive intros. Sometimes I don’t even include them. They’re typically a fly-by summary of the quarter, highlighting some milestones and setting the stage for discussion. But this quarter… whoa.
It’s no secret that the Boeing pricing contract is a big deal. It’s been on the analysts’ minds for, well, almost as long as I can remember doing these write-ups. It has typically been the focus of a question or two, which is usually answered with a reassurance that things are going well, and then forgotten about.
You may recall that last quarter, it was one of the major issues. This quarter, it was almost the entire content of the call. Seriously, I can’t understate how much of the call it occupied. Nearly every analyst used their question to quip about the negotiation. It was the focus of most questions, but even the few that were on a different subject took a jab at it. Here’s why it’s such an important issue, stolen from myself last quarter:
The pricing negotiation affects how much “top line” revenue we get paid when we deliver products to our customers. That’s one of the most important components in our profitability. Of course there are things we can control internally – production costs, materials, labor, scrap, etc. – but all that is just one component of our doing profitable business. When we finalized the Airbus pricing agreement, we took a $135M forward loss to account for it, but it was celebrated because while it meant slightly lower long-term revenue and profit, it also meant significantly higher stability.
If revenue is your paycheck, operations are your budget. You can scrimp and save and make adjustments here and there, often to great effect. Searching for better supply chain partners is like searching for a better insurance rate. Reducing scrap and rework is like cooking more meals at home instead of eating out. Refinancing your corporate debt is reasonably analogous to refinancing your house. All of these are good things that can make a real difference.
But if your paycheck disappears, there’s a problem. Regardless of operational or budgetary efficiency, without revenue, there’s no fuel to propel the rest. That’s why these long-term pricing contracts are important. If they don’t go well, it’s like getting your salary cut.
So, what did it do to our stock price to say that there’s a “big gap” in these negotiations that have a major impact on our revenue stream?
You can track almost to the minute Mr. Gentile’s opening statement where he talks about the negotiation gap and the ensuing steep decline in share price that resulted. Volume skyrockets, and value starts to drop – by the end of the day, it was down about $5/share or 8.5%.
Now, that seems bleak, but I’m not worried or upset about it in the least. Let’s talk about why I think this is a huge overreaction from the market, and why the negotiations, though vital, aren’t at as much risk as this market action would lead you to believe. Preface: I’m a stress engineer with an MBA, not an analyst/CFO/CEO, so prepare appropriate grains of salt as needed.
First, know that both companies have to play ball. Yeah, sure, we know that Spirit is vulnerable to Boeing, considering they’re our largest customer. But let’s not be blind to the fact that Boeing needs us too. There’s absolutely no way they can easily turn the lights off at Spirit and go find somebody else to build 50 737s every month. We’re not just living on Boeing’s good graces; Spirit has a very strong market position of our own. That doesn’t mean we can spit in our largest customer’s face, but it does mean that they can’t allow themselves to become too disconnected from us or disinterested in our success either.
Second, the financials don’t indicate doom. In fact, on the days leading up to earnings, I saw several articles praising Spirit for our frequent beating of expectations and speculating that we might be a good candidate for an earnings beat. Those are really good signs on their own, meaning we’ve regained some shareholder trust from darker days, but it’s also critical to note that our actual financials were fine this quarter. Looking at the price graph above, in the early morning trading hours, as the market digested our financials alone, which are released before the market opens, shares ticked up slightly before evening out and eventually being hammered during and after the call. Also of note is that we maintained our 2017 financial guidance. We knew this would be an odd quarter as 777 and 747 demand sunset, and 737 doesn’t pick up the slack until Q3 (and to a smaller extent, A350 throughout 2017/2018). Lastly, our STIP score of 0.95 is reflective of being pretty close to on track to internal expectations for the quarter (it’s easy to say this in retrospect, but based on the financials, I think 0.95 is perfectly fair).
Ultimately, we have to remember that share price isn’t always an accurate reflection of performance. This works both ways. Share price is an odd mix of the rational and the subjective, of mathematics and hype. Spirit always seems to go way up or way down on earnings days, regardless of how the earnings themselves look or how much foresight we provide on things that may impact us. It doesn’t necessarily make sense, but a lot of things in the stock market don’t. For an opposite example, see Tesla, who recently became the most valuable US automaker by market capitalization, but has the distinct problem of, you know,not making any cars. Their share price is supported almost entirely by hype. At some level it’s understandable – it’s hard to not find Elon Musk inspiring, or Tesla’s products and ideas really, really cool, but as it stands, they just don’t make any money. Sometimes markets don’t make sense. Sometimes the subjective overtakes the rational in big, glaring ways. It may not be fair or right, but it’s the world we live in. In either case, our share price doesn’t affect how our actual business is doing, so we can continue along and shrug off a wild reaction.
Anyway, that’s pretty much it. I’m even skipping the Q&A this quarter because of how repetitive it was. Several analysts tried to tease out ways to proceed with the negotiations or discern impacts if we settle in certain ways. What if we just used the interim pricing as a baseline? How much would it impact us if we took Boeing’s current offer on the table? Is it a problem for our future relationship with Boeing if we have this contentious negotiation now? What are our legal options to pursue for settling this in court? So on and so forth.
There were a couple of good miscellaneous questions. We learned that we’re making good progress on the A350 production learning curve, and expect to reclaim a few hundred million dollars over the course of the program. Sanjay reaffirmed that 737 picks up the slack from 777 after Q2, and of course A350 and 777X help keep us engaged on twin-aisles long-term.
Tom answered a question on the middle of market plane everyone keeps dreaming about, saying that we’re working our own R&D projects that will allow us to make really unique, advanced offers to our customers. I really liked hearing this approach. It seems like we’re setting ourselves up to be the “premium” offering, allowing us to compete on quality and features that we’ve designed in-house, rather than just racing to the bottom on price. Good strategy in my opinion, and I’m excited to see it played out over the next number of years.
Sanjay answered a fun financial question on margin dilution on 777. As we make fewer of them, our margin decreases, which you wouldn’t necessarily expect (it all costs the same, right?). He threw out the term “fixed price absorption,” which basically means that as we produce fewer, we use the mandatory tools, facilities, and resources less, making them less profitable. In simple terms, if you own a $20 toaster and make 40 pieces of toast in the quarter, your toaster cost you $0.50 per piece. But if you lower production to 10 pieces per quarter, your product “absorbs” $2.00 of the cost of the toaster per piece. It was an interesting little aside.
And that’s what I have to say for the quarter! As a closing remark, I think there’s a lot less reason to worry than the share price indicates. Chief Technology Officer John Pilla in his engineering newsletter dropped a breadcrumb that there are some new work packages just over the horizon. Tom and Sanjay maintained financial guidance, indicating that we’re on plan through a brief yawn. The market may be in a tizzy over the Boeing negotiations, but the financials are just fine and we know that Boeing can’t just ditch us. All signs point to things being fine… but 2017 will certainly be an interesting year in many ways, so stay tuned to find out what’s next!