Greetings everyone!

By now I’m sure the official communications from our leadership have reached your inboxes, and it’s time for my usual sideshow. This was an encouraging quarter in both the financial numbers and the conversation with analysts. Let’s dive in and find out why!

Starting with the standard view, I have a lot more highlighting than usual, and there’s a lot to dissect here. The first highlighted line (Revenues) shows that in aggregate, we have done more business than last year. That’s driven up by 737 rate increases (which is once again the story of this quarter), and dragged down a bit by declining 777 sales as well as the accounting changes we talked about in previous quarters. All else being equal, more sales is a good thing.

Now, I’m going to create my own little chart here, because in some ways the year over year story is helpful, but especially for this quarter, it’s going to be more illustrative to see Q3 of 2018 vs. Q2 of 2018 instead.

The real tale of the tape here is that our net income (bottom dollar) after everything is accounted for improved by 17% over the previous quarter. This is very healthy improvement quarter to quarter, but it could have been even higher. From Q2 to Q3, revenues decreased very slightly, but Operating Income (the basic business – sales minus cost of goods sold, general and administrative, R&D, and importantly labor) was up ever so slightly. That indicates that the operations themselves are more efficient, making more money from less revenue. This is a good indicator that our recovery efforts are coming to fruition. Look for this relative ratio to be higher next quarter; if the Operating Margin is better than 12.3%, which it probably should be, then that’s a good tell that labor costs related to the schedule recovery are dwindling and we’re back at a stasis point. This is what Tom’s comments about returning to a stable operation (with accompanying margins) are referring to. It will mean we’ve digested the rate increase and are ready for another year of strong and steady production like we experienced in 2016. To underscore this, look at the cash flow summary below:

Yeesh. As it turns out, stuff is expensive. We’re spending hard cash on overtime and expedite to get the factory back to schedule, on top of proactive investments like R&D to position us for future programs and infrastructure growth to make sure we’re prepared for whatever may be to come. Look for this cash flow position (referred to as cash conversion rate if shown as a percentage against revenue) to improve as we reduce immediate cash draws like OT and expedite and as some of our cash flow efforts like extended payment terms start to come home.

This has been a tough year for Spirit. Not bad by any stretch, just… difficult. Many of us have seen or even been part of the focused efforts to return Spirit’s operations to a healthy pace, so we all know the level of effort and associated cost that has gone into that. Now, we see it starting to pay off. Hopefully we will look back at this quarter as the turning point, with more and better performance to come.

Since Sam Marnick was quick on the draw with this quarter’s STIP score, I get to sound off on it. I think 0.75 is perfectly fair considering the earnings. Looking at them in a vacuum, I would have guessed a marginal increase from Q2, perhaps in the 0.80-0.85 range, however, I could also have seen Q1 and Q2 being lower than 0.75. Now that we’re seeing the light again, we have a good chance at making up some lost ground in Q4. Since I’ve so far been allowed to speculate for free, I would imagine a Q4 and final 2018 score in the range of 0.80-0.90. Don’t write any hot checks for in-ground pools based on that; it’s just a way for me to attach numbers to cautious optimism. Achieving that will still take full effort through year-end, and each of us have our part to play to ensure quality, delivery, and efficient operations. I should say that in case you didn’t listen to the call, Tom and especially Sanjay expressed strong gratitude and appreciation for all of the hard work done by the Spirit team. What you don’t hear if you don’t listen to the calls is the tone, which can really tell a good story. In my interpretation, our top leadership gave a lot of credit to all of Spirit for turning this around. They didn’t have to; the analysts don’t necessarily care where the earnings come from. It means something that our top bosses mentioned it on the call, so well done to you all.

In all, a much better quarter by the numbers than we’ve had so far this year, but still not quite peak performance. Let’s work toward a solid Q4 to cap off the year and give us some momentum to springboard into 2019.

Now let’s jump to the call with executive summaries from Tom Gentile and Sanjay Kapoor followed by the ever-entertaining Q&A.

It may not be reflected in my notes, but this quarter’s executive summaries were a little more meaty than usual, and I recommend listening to them if you get the chance. You can find an audio recording of the earnings webcast here: Spirit Q3 Earnings Webcast

…or by searching for Spirit AeroSystems earnings webcast and following the usual Google breadcrumbs. Here are the highlights:

Tom Gentile

• Main focus was to recover on deliveries, and we succeeded. We’re now fully recovered to schedule, shipping in proper firing order, with no expedite costs.
• Focus for the remainder of the year is on operational efficiency.
• Supplier disruptions are shrinking, as well as traveled work and overtime.
• Continuing to focus on rate readiness on A320, 787, and of course 737. We’ve already hired 90% of the people required to support rate 57, and bringing them on early will reduce overtime demands and increase quality. We’re also preparing the supply chain by continuing to address disruptive suppliers and proactively in-sourcing or dual-sourcing parts.
• ASCO acquisition is continuing. There was a concern raised by the European Commission, but we’re addressing it and it doesn’t affect the economics of the deal or expected synergies once the acquisition is complete.
• Working to commercialize Joule Forming, a new Spirit-trademarked process for shaping titanium, as well as starting qualification of Spirit’s first 3D printed component with Norsk.

Sanjay Kapoor

• Revenue up year/year, driven by 737 (160 737s this quarter) and defense activity, and a slight drag from 787 based on the accounting change earlier this year.
• EPS steady but boosted by share repurchases. ASCO acquisition costs will be a slight drag through the next few quarters as we finalize the deal.
• Now that we’re back on schedule, we expect 737 to come through very strongly in Q4 due to reduced overtime, expedite, etc.

It doesn’t really come out in my quick bullet points, but I want to underscore the optimism and gratitude that our leadership expressed. I would also add excitement to that list. Tom’s comments on some of the technological advances that we’re starting to talk about openly are pretty fun to listen to, and I know my engineering friends probably appreciate that.

Let’s head to the analyst Q&A!

Q&A

• Question: What does a normalized margin look like? Will we approach that in Q4? Will we sustain or improve that as we tackle rate increases next year?

o   Tom: Around 16% was a normalized margin back when we were in a more stable place operationally circa 2016. With tax reform and accounting changes, we would expect them to eventually be higher than they were at that point in time. Check out our segment improvements from last quarter to now – we’re at about 15.6%, and we expect to see some more improvement in Q4. Maybe another 1.5% overall increase next year considering the dissipation of some of the headwinds we’ve seen in 2018. There are lots of changing variables, some pressuring us and some helping us, but we’re ultimately aiming to get back to that stasis point of 16% or so we had a few years back.

o   Travis: It’s no coincidence that this was asked first. There were also several other questions on margins, far more this quarter than on schedule recovery. This means the “surge” is over for now and investors have become confident in the recovery and are now more interested in normal operational drumbeat.

• Question: Regarding the ASCO acquisition, what’s the extent of the one-time accounting stuff? Will we expect 2019 to be a “GAAP” year, or an “adjusted” year?

o   Sanjay: Yep, we’ve been figuring that out already over this year. We’ll make sure when we provide guidance in 2019 to provide clarity associated with this. I’m a little hesitant to commit to one or the other because there are still lots of balls in the air. Regardless, we’ve tried to increase our transparency and be very clear about what we’re including and not, and you can trust that behavior will continue whatever happens next year with ASCO.

o   Travis: This question has a lot of echoes of the past several years. I like the way the analyst phrased it – a “GAAP” year would be a year with no significant one-time events, whereas an “adjusted” year would be, well, like probably a majority of our years that have had one thing or another happen that we had to adjust out in the earnings to show the trends rather than being wildly variable due to one-offs. As our first major acquisition, ASCO seems as good a reason as any to ask about this, but what the analyst really wants to know is if we’ll have a “normal” year for once, or if we’ll have more adjustments to make. Sanjay’s answer was entirely appropriate, and it speaks to Spirit’s maturity. The big problem years ago wasn’t necessarily the big one-time events; people involved in this industry know that it’s a little more capital-intensive and subject to major movements than, say, selling groceries. What Sanjay said addressed the real problem: surprises. Neither his nor Tom’s offices come equipped with a crystal ball for telling the future, but what they can do to honor the company’s stakeholders is be as transparent and forthcoming as possible. Analysts know enough about finance to work their way around adjustments, but every investor hates surprises.

• Question: In terms of the step to 52, it seems like model mix was a big factor. Can you speak to what you could improve as you go to 57, and how it would be different than what you did at 52? Lessons learned?

o   Tom: Biggest lesson is getting ahead of it more, particularly with suppliers. To address that, we’ve increased outside assessments of suppliers to measure their rate readiness and are also proactively dual-sourcing more things to alleviate supply constraints. Second is hiring. We’ve always been hiring, but we’re already looking at staffing and training for 57, giving us more time to train new people as well as reducing contractors sooner. Third is balancing the production line. Next year we’ll have 3 lines, each producing 19 APM. Within that, we’ll have 2 surge days of capacity. At 52, we had 2 lines at 21 APM and a 3rd at about 10, so we had an imbalance that caused factory disruption. So we’ve attacked it proactively, with labor, factory layout, and suppliers. A very multifaceted approach.

o   Travis: This was a really good, thorough answer from Tom, addressing the severalthings Spirit is proactively doing to ease the pain of future rate increases. We know that getting to 52 APM has been a challenge not only for us, but for many of our suppliers, so we’re going in and trying to help them be more efficient, which is mutually beneficial. If we run into hard constraints or suppliers that aren’t improving fast enough, we can split the production of some parts between them and another supplier, or supplement with Spirit fabrication (which we’re trying to grow as a standalone business anyway). Advance hiring is fairly obvious, as is “balancing the lines,” which is kind of like making sure we don’t have a wobbly wheel before getting on the highway. All in all, I liked this answer because it shows that Spirit’s approach to this problem wasn’t a cheap “one variable at a time” thing to try to squeeze out short term benefit at the expense of the long. We leaned into all of the things that caused us problems getting to 52 in order to do advanced prep for 57 and potentially beyond.

• Question: When do we now expect ASCO to close, and what was the issue if not divestiture related?

o   Tom: It’s actually related to some historic structures that Airbus had set up in Europe a while ago, called Belairbus. These consortiums let Airbus deal with combined entities rather than individual bodies. It doesn’t present an issue for us, we just have to review the old and new situation and make sure all parties are satisfied with how it works out.

o   Travis: There’s a whole lot of history to unpack with this one, going essentially back to the formation of Airbus in 1970. I’d rather not delve into it here, but for some bonus reading, check out this blurb on the Airbus consortium and this Wikipedia article on the history of Airbus.

• Question: How is the ramp-up of defense business going?

o   Tom: Well, the goal is to get it to $1B over time, and we’re at about half of that ($530M this year). CH-53K is good, B-21 will continue to grow. We’re working with the primes on new opportunities that are coming up, and also trying to do some expansion of fabrication into Tier 2 work.

• Question: Since the ASCO acquisition is on a new schedule, what costs should we expect to linger longer than expected?

o   Sanjay: 3 types of costs ongoing – interest expense on the financed portion of the acquisition, integration related costs (legal or other diligence), mark-to-market the hedge. All of it adds up to maybe $0.11 per quarter in EPS drag as we showed this quarter.

o   Tom: We slowed the process down deliberately – rather than pushing onto a Phase 2 where the European Commission would have turned us down, we instead chose to proactively withdraw our application, address the issues from Phase 1, then resubmit. It may stretch somewhat into next year, but we’re confident that it will close and we’re working productively toward closure.

o   Travis: In short, Spirit is spending a few extra million bucks a quarter to properly deal with the regulatory closure of the ASCO acquisition, so it’s costing us a little more as it stretches later into the year and possibly into next. The real reason I wanted to keep this question was because anyone who has their MBA probably had their ears perk up at the “mark to market” term. In this case, it’s being used as a completely legitimate hedge against currency and valuation fluctuation and is just a device to make sure the economics of our deal doesn’t change over the time it takes to close (see this link). However, mark to market accounting has some history with the Enron scandal, so it’s one of those things that gets talked about as a cautionary tale like the Challenger disaster does in engineering courses. I highly recommend Enron: The Smartest Guys in the Room, for a solid take on the matter. That being said, please don’t start any rumors about Spirit behaving like Enron or something. Just one of those curiosities for anyone who wants to dig a little deeper on a nerdy subject.

• Question: If Boeing decides to increase rate to 63 or similar, does that affect the earlier comments about margin progression?

o   Tom: We’re always studying and preparing for things, but Boeing hasn’t announced anything regarding 63, so we’ll wait for them to tip us off. We would definitely have to hire people 6-9 months in advance of Boeing deciding to increase rate, but we don’t know anything about a change in rate right now, and we don’t expect it to affect our margin projections.

o   Travis: Again, we would all benefit from a crystal ball. There may be more to this question than I’m picking up, but my naïve hunch is that we’re emerging from a difficult rate readiness exercise, and the analysts want to know if we’re better prepared for the next one even if we don’t know what it is or when it will be. Tom’s earlier answer on the three-pronged approach to proactively handling the rate is probably sufficient for this as well, just interesting that there’s already whispers on the wind about what lies beyond 57 APM.

• Question: Still struggling with relative significance of switch to MAX, supply chain, hiring, etc., and how each of those factors played into the delays we’ve been experiencing. Sounds like we’ve fixed some, but are they really fixed for the future?

o   Tom: In rank order of importance: supply chain, hiring practices, NG to MAX transition. We work very efficiently when we have the parts. When work travels, it breaks that down, lowering pace and quality. Suppliers have had a number of various issues – equipment, hiring, raw material, operations – and those affect certain suppliers more than others. There were 13-15 suppliers that were really chronic, and we’ve worked that down significantly. On hiring, we’re lucky to operate in an area that has a very strong skill base of mechanics. Still, we’ve shifted ahead on hiring and training, as well as aligning with some local institutions to increase training and build the pipeline. The model switch from NG to MAX hasn’t been super impactful on our schedule.

*phew*

In summary, Q3 showed some good results, but primarily served as a transition point between the heavy lifting of rate increases and sustained efficient production we hope to see in the coming quarters. Analyst questions shifted from rate preparation to future margins and other growth areas (including the ASCO acquisition), showing that they’re less worried about today and more interested in how bright the future is.

Tom and Sanjay continue to express confidence and appreciation for the Spirit team, and while we’re picking up momentum, there’s always more ahead of us. And that’s a good thing; challenges are why they pay us.

This quarter I recommend the mini-lesson Nike: Just Do It?, which asks in an objective manner if it’s worth it for a company to engage in potentially divisive social issues.

See you next time!

Well, it finally happened. After more than 4 years of writing quarterly earnings reports summaries for all of you fine people, I broke my streak last quarter.

Of course, at 4 times per year, that means the streak was only 17 emails long, but let’s stick with 4 years – that sounds much more impressive.

Either way, I’m back this quarter!

In many ways, this quarter was a return to normalcy for Spirit’s financials. As many of you are undoubtedly aware, there has been a dedicated focus over the first half of the year getting caught up on 737 deliveries to prove ourselves at the increased rate and also deliver consistently to Boeing, both on-time and with high quality. There have also been significant cost and supply chain efforts that support rate readiness and can directly impact the bottom line. This quarter shows some of these things making good progress, resulting in incremental gains to revenue and net earnings. We’re right in between the excitement of the Asco acquisition announcement and the upcoming fervor on new program efforts, trying to get our feet firmly planted on our existing core business before things inevitably change again.

All that to say this was a relatively mundane quarter, with nothing in particular for us or the analysts to really hone in on. The questions were diverse without a very strong central theme, which is usually a good indicator that business is just ordinary. And ordinary can be great sometimes. Still, there were plenty of items of interest to dig into, so let’s have at it.

Let’s start with a look at the financial summary.

Again, what we see here is veeeery slight improvement year over year in revenues ($1.837B vs. $1.826B) as well as adjusted earnings per share ($1.63 vs. $1.57). It is worth stating though that the bump in EPS is also partly attributed to share repurchases. If we normalized this quarter’s EPS (with 111M outstanding shares) to 2Q17’s 118.2M outstanding shares, it would show up as a slight decrease, down to $1.53 per share compared to $1.57. Here you see the eternal conundrum with share repurchases – it’s an activity that can prop up earnings per share, but it doesn’t affect net income (earnings) upstream.

Since these terms can be obscure, it bears repeating what they really mean. Revenue is a measure of what we sold in the quarter. We shipped 453 airplanes (a new record) this quarter. What our customers pay us for those shipments is our revenue or “sales” (the terms can be technically different in some cases but are largely synonymous). In simple terms, more planes and/or higher prices means more revenue. Gross income is revenue minus the cost of the planes we sold. Operating income additionally takes away day-to-day operating expenses – if Spirit was just a factory with no enterprise-level activity, operating income would be very close to net income. Net income (earnings) is the net total after running the whole enterprise. Of course, each of those has valuable information on what all of the costs in the business are, but ultimately, if there’s no bottom-line earnings, there’s no business.

So what is earnings per share (EPS)? Well, the math is easy: net income divided by number of outstanding shares on the market ($145M / 111.0M shares = $1.31/share). But what does it mean? To a shareholder, it means how much profit the company returned on your behalf. Whether by increasing earnings (making more money) or increasing consolidation (buying back shares to spread the earnings out less), increased earnings per share is favorable to an investor. However, if the earnings themselves are not increasing, it’s worth noting, because this relationship is not a two way street. Doing better business and creating more earnings obviously increases EPS, but increasing EPS doesn’t always mean the business is doing better.

This is not to say that Spirit is in trouble or it’s a dire sign that our share-adjusted net income went down slightly year over year. It’s only to remind us that EPS and adjusted EPS are useful metrics, but are not perfect and complete indicators of the health of the business. As with many things, there’s some nuance behind the number.

Having rambled on about terminology long enough, let’s change gears. Q2 of both 2017 and 2018 were a little funky in terms of one-time events, so we ought to spend some time recapping these big, impactful items. The slide below spelled it out very well.

You probably recall last year in Q2 when Spirit took a huge forward loss that was actually considered a good thing for the company, as it secured long-term pricing in our partnership with Boeing. This quarter, we had some additional unique, out-of-sequence items related to the Asco acquisition. Both of these are quantified in the above image. For reference, “GAAP” stands for Generally Accepted Accounting Principles, and is the measure that public companies have to report. Those are the “true” earnings for the quarter, though again, there’s some nuance.

Why do all this adjusting and fidgeting? Luckily, this is a business concept that is easily explained with a personal budget metaphor. When you plan or calculate your budget at home, you probably do so on a monthly basis, as a lot of typical expenses occur monthly. You have your income at the top, your expenses in between, and your savings – the net of your revenue and expenses – left over at the end of the month. As with a business, if your savings (net income or earnings would be the accounting equivalent) are negative month after month, there’s a problem. But sometimes a big anomaly moves you way positive or way negative for the month. Paying for a home project or a surprise expense like replacing an air conditioner might be a one-time event that pushes your savings way negative for the month, and a bonus or a tax return might push you way positive. But you still want to know the trend – what the month would have looked like if it were a normal month without a gigantic one-off that dwarfs everything else. Spirit does the same thing. Understanding the true bottom line, irregularities included, is clearly important. Seeing the underlying trend is also vitally important in controlling and predicting the future of the business, so adjustments like these are made to illustrate that trend.

Finally, let’s talk about cash.

There are quite a few interesting tidbits in the cash report above.

First, the 4% year over year increase in cash flow from operations tells us that the business is getting more efficient on an operational front – meaning aggregate costs are going down. Now, we don’t have a breakdown here, but that could be driven by any piece of our cost structure – direct labor, expedite costs, supply chain costs, rework costs, and more. Additionally, it may not necessarily be costs, but favorable changes to payment terms – if we pay our suppliers later or our customer pays us earlier, it improves our cash position. Whatever the sources are, and I’m sure there’s a very complex interplay of all those factors and more at work here, growing cash from operations tells us the business is getting more efficient on the most fundamental level. Profit and earnings are vital, but they’re just numbers on paper. An improving cash position is a good sign that earnings are well-earned and executed, not just booked in a spreadsheet somewhere.

Second, a 29% increase in Property, Plant, and Equipment (PPE – a different one than your safety glasses) shows that Spirit is spending money to improve the facilities and prepare for rate. Naturally, this costs money, but you can’t grow without this investment.

Third, the debt maneuver related to the Asco purchase can be seen in the bottom line – we nearly doubled our debt, using some of that for share repurchases and of course a large chunk for the purchase of Asco. For reference, at the end of Q1 we had $438M in cash (see 2018_Q1_8K.pdf), so we’ve grown that by $155M. I would expect that in the next few quarters we pocket a bit more cash, having pulled the trigger on this restructuring and on the Asco acquisition. But expect share repurchases or other investments before we hit $1B in cash. I’m saying that out of total and complete speculation, because over the years I’ve found it funny how Spirit consistently avoids breaching the billion dollar cash mark. Maybe intentionally, maybe not, but since I get to predict things for free, there it is.

Very quickly before getting to the call itself, a note on this debt repositioning since I didn’t talk about it last quarter. This is an area where a business’s budget is arguably different than a personal one. As with a personal budget, there’s often a good reason to utilize debt, an appropriately sized mortgage being a good example, but generally debt is an unnecessary risk that doesn’t add to your financial health. Sure, you could probably take out an unsecured loan at 5% interest and return 7-8% in the market over time, but a personal budget typically has a much lower appetite for risk. Businesses, on the other hand, exist for risk. An investment in a company is a way to leverage your money into something that will take risk for you, and you want your investments to be growing and taking an appropriate amount of leverage if necessary to achieve that growth. Businesses can easily be over-leveraged, sure, but they can also be considered under-leveraged. Therefore, Spirit’s move to align with market ratios is something that certain investors probably applauded.

Now, there’s a lot of personal and business philosophy that we could talk about on this topic. Ultimately, what I would say is that some healthy level of leverage in a business is necessary. We want companies to take measured risks to grow, so we don’t have to take on that risk personally. Spirit used this debt repositioning exercise to buy back shares as well as invest in an acquisition to fuel future growth. Both of these are generally good uses of money, and if the business case makes sense, using leverage to execute them also makes sense. We could debate exactly the right level of debt, but in the end we all want good returns, and that takes some level of risk and leverage.

Phew! Not sending a summary last quarter has made me extra wordy. Enough from me, let’s hear what the real experts had to say, and ask, about Spirit this quarter.

Executive Highlights

• Last quarter, we raised debt to buy ASCO and accelerate some share buybacks. The ASCO acquisition is on track to close in the second half of 2018. The share repurchase plan is unchanged, with no additional plans for repurchases in 2018.
• 737 deliveries were up 24% vs. this quarter last year, and 32% from Q1. This represents very good recovery and provides a template for what our performance will look like at full rate.
• We’ve won some new work statements in fabrication and defense. We can’t say what they are at the moment, but they represent our continued growth strategy and engagement with our customers.

Q&A

• Q: I’d like to ask about the narrow-body rate studies that both OEMs have talked about. What would you need from a capital standpoint to support? How high could you go in rate without a substantial investment? If you need to make a big investment, when would that be?

o   Tom: With regards to rates, we’re looking to and talking to the OEMs on that, but we have looked at lots of various scenarios assessing our rate readiness levels. From a footprint perspective, we’re comfortable with the brick and mortar that we have. These kinds of rate increases can take around 2 years to incorporate, so we’re preparing for lots of possibilities, but we’re very comfortable with our infrastructure and space being able to support whatever the rates end up being.

o   Travis: This is an interesting question in that it looks to the future and addresses some of the market movements that have occurred this year. With Airbus buying a majority share in the C-Series (now the A220) and Boeing partnering with Embraer, the narrow-body market is evolving and could potentially grow rapidly. As the two major OEMs square up for a faceoff in this market space, their supply chains – which Spirit is a big player in – will be put to the test. It’s a little early to talk about specifics, but this will be an interesting question to watch over the coming years.

• Q: 737 recovery – where are we at on the NG to MAX transition, what the mix is, and what is the timing?

o   Tom: MAX is obviously increasing and NG declining. Overall for the year we expect about 50/50. But the good news is we’re getting through the learning curve, we’ve been hiring people and they’re getting up to speed. We’re still working a little bit on consistency; we’ve caught up on total deliveries, but we’re not quite hitting a regular, comfortable cadence, and we’re catching errors too late that require fixing and then expedited freight. Executing a rate increase is about a 2 year process, so we’re right in the thick of it.

o   Travis: The question wasn’t really all that vital, but Tom’s answer brought up a great subject. In my comments earlier, I mentioned improving cash flow being a solid indicator of operational efficiency. While ours has improved slightly, Tom is saying it’s not nearly where it should be. We’re still doing extra work (with the associated high cost) to try to make our deliveries consistently on-time and with high quality. We stand to improve on a lot of those factors, and if we can, they’ll directly impact the bottom line. This is where we really do control our destiny, and where focusing on quality, delivery, and cost on a daily basis makes a huge difference.

• Q: What’s left to close the ASCO acquisition?

o   Tom: We got approval from the US government for the merger. Customer approvals are in work and almost buttoned up. The European Commission has some holidays and will be starting in September with approvals.

• Q: Talk more about how we’re managing our suppliers right now. Are we reducing the number of troublesome or lagging suppliers?

o   Tom: We have a broad supply base of over 600 direct suppliers, and we work with them regularly. One of our key metrics is on-time delivery and maintaining adequate buffer stock. We’ve deployed SWAT teams and employed some dual-sourcing to help our suppliers get back on track. There are a few trouble suppliers we’re still working with, but the list is shrinking.

o   Travis: In the same way that Spirit is sprinting to enable rate increases, our suppliers down the line are too. Some are exceeding, some are lagging. It’s pretty amazing how much global effort comes from Boeing or Airbus deciding they want a few more airplanes a month. Once they make that decision, hundreds of companies around the world have to mobilize to make it happen, and it all has to come together at once. I’ve had the distinct pleasure of working in and doing shadowing rotations with lots of different groups, and it’s highlighted to me just how many different things have to go right to make this business work. Frankly, I’m amazed that any airplanes ever get built. Just a little soapbox moment this question prompted. I’ll get back down now.

• Q: Given the margins in the first half of the year, it looks like we’d have to have a very strong back half of the year to hit your guidance. Are supplier recovery or other one-time bumps included in the guidance?

o   Sanjay: Yes, there’s some upside baked in for supplier recovery. Just as our customer holds us accountable, we have to hold our suppliers accountable, and so there are some assertions in our guidance. Ultimately, we’re shooting for margins we’ve achieved in the past. We don’t have to break any records to hit those numbers, we just have to keep working toward the recovery plan that we’re making good progress on, and it’s already limiting some of the extra costs we’ve incurred in the first half of the year.

o   Travis: This is directly related to the previous question. In some cases, our suppliers have been the cause of our issues and late work, and when that happens, we need to chase them down for the financial impact it causes us. In other cases, it’s work inside Spirit’s walls that has been the cause of late deliveries or quality problems. To control our overall business, we have to be diligent on both – controlling the inputs from our suppliers and all related costs, going after them for recovery where appropriate, and also controlling our own internal processes and procedures to make sure we’re not impacting quality, cost, or delivery. If we can get both facets under control better than ever before, we’ll make profit like never before.

• Q: On 737, when do we get to 100% MAX? Is there any impact on your deliveries from Boeing’s delays on the engine side or other things that may filter over to you?

o   Tom: There will always be a few NGs, but next year the transition is mostly complete. On the Boeing side, our focus is getting our product to them so we don’t cause any disruption, and the other things don’t really impact us. They’ve been working very well with us, and communication with Boeing has probably never been higher regarding operational and factory efficiency, so we’re strongly tied into their demand and schedule, and they’re providing a lot of support back to us.

o   Travis: Two thoughts on this. One is the analyst’s comment on engine suppliers causing some disruptions. This hails back to my thoughts a few questions ago about the difficulty of making sure everything is there at the right time to make an airplane. It’s incredibly difficult and complex, and Boeing doesn’t get paid until they actually provide a whole airplane, so as the top of the food chain they take on a huge amount of integration risk in buying, say, a fuselage from Spirit but having to wait for an engine from somewhere else. Luckily, Tom is saying these disruptions have not yet affected us and we’re staying tied in with Boeing’s demand so the risk doesn’t trickle down to us. More importantly than that though is Tom’s statement that communication and sharing with Boeing has never been higher. This is a great sign in general, springboarding from the long-term pricing agreement last year. A rocky relationship with your biggest customer is a big concern. It’s certainly comforting to hear that that relationship is on the up and up again. Credit is due to anyone who interfaces with the customers, from the bottom of the organization up to the top.

• Q: With the price stepdown on A350, is it still a positive margin program on a unit basis?

o   Sanjay: Yes, and it’s a good tailwind for the future.

o   Travis: Oh man, the emotions attached to this quick question and quick answer. Think back to 2013-14, when the A350 was a gigantic drag on the profit, with huge forward losses and concerns over the viability of Spirit’s overall business. It got about 10 seconds of airtime for this question, only for Sanjay to say that it’s now a positive program and a tailwind that supports our business. Some credit needs to be given here. Forward losses and block accounting can be confusing and frustrating, and can really suck when there’s an enormous hit to your profits dropped on a single quarter. But the fact that this question took 10 seconds to answer and was actually a positive thing is a testament to why we do them. We had to swallow the pill 5 years ago, but because we did, A350 can now be a profitable program for the company. This means a lot more to Spirit than the quick conversation this quarter would imply.

• Q: There are a number of forward loss reversals on the 787. Can you talk about what’s driving those reductions and how much more opportunity is there for the future?

o   Sanjay: We’ve focused on making our supply chain more efficient, and that has driven solid block savings. There’s also some benefit to rate increases and absorption that we’ll start to see.

o   Tom: We’ve also gotten a bump from working together with Boeing on Value Engineering changes, and there are more identified and yet to come to fruition.

o   Travis: This hits right at home. Over the last 9 months, I’ve seen just how hard supply chain has worked to claw back savings for the 787 and optimize the sourcing strategy. Coming over here, I’ve learned that (not surprisingly), there is a lot of knowledge and a ton of skilled, wonderful folks in this organization. I think some of the difficulty in appreciating supply chain’s perspective is that all the credit comes up front – the savings and any associated kudos are booked when a contract is renegotiated or a new one is written, and from there, you only hear about the failures and misses that slip through. Sometimes I honestly forget what year it is, because we deal so much in long-term contracts and frankly trying to predict the future, and predicting the future is never perfect. Anyway, I’m soapboxing again. Supply chain has done a lot of strategic optimizing over the last year and that will start to show up in cash figures on the 787 very soon, if it’s not already. There’s more work to be done, but also, to Tom’s point, there are a lot of major projects that require engineering engagement and collaboration to achieve even further significant savings. There has also been a ton of effort put in by the operations teams in making the factory more efficient and reducing build hours and optimizing processes, and those have paid dividends as well. We’ll see how it all turns out in the end, but in the meantime, it’s nice to see these signs of progress.

• Q: Boeing and Embraer’s partnership makes Embraer a potential strong supplier to Boeing. Are you concerned that they could steal some of Spirit’s thunder as a preferred Tier 1 supplier, especially as we start talking about the possible middle of the market program?

o   Tom: Right now, we’re putting some of our best engineers to work on defining what we can do for our customers’ next upcoming models. We have world-class engineers, best-in-class design capabilities, advanced architectures and manufacturing processes, and we’re pouring into R&D to grow our capabilities even further. Today, we’re on the best programs, we have complex pieces, and we’re industrializing at unprecedented rates and scale. With our experience and capabilities, we think we have a large head start on any other partners in the world as we look to the next generation of aircraft.

o   Travis: This was one of those great last-minute questions that pop up every now and then. Tom’s answer really stands on its own, so I won’t add to it. It will be interesting to see how these conceptual programs that we’re spending time and money talking about will affect Spirit’s business over the next several years.

• Q: On NMA (middle of market program), how do you see yourselves on the offering? You’ve greatly improved your cost structure, but how do you see yourselves against other potential competitors? Also, is this a need-to-have program? How does it shape the portfolio moving forward?

o   Tom: We’re trying to collect our thoughts on what factors provide maximum value for the next generation of aircraft. We bring skilled design engineering, a trained workforce, lots of capital, and several other advantages. For us, any program we consider has to meet our business case requirements. There is no program that is an absolute must-have if there’s no business case. Based on our scale and structure, we think we can bring great cost advantages, but it always has to make sense both for us and the customer.

o   Travis: This right here folks is what Spirit has learned over the last decade of its existence. Tom added some more words of confidence on Spirit’s value proposition, but critically, he underscored that anything we commit to has to make sense for us. When Spirit was in its infancy, we took on programs that we felt like we “had to have” in order to grow, to please our customers, to broaden our business, and to prove that we could exist as a standalone company. In the end, we’re probably better off for that effort, but there were definitely some questionable times in between. Tom’s answer is indicative of the discipline that comes from hard-learned lessons. Yes, we need to grow and continue to fight for our place in the business landscape. But we’re not going to sign up to just anything. We are our own business with our own interests to protect. Every day that goes by, we understand that a little better.

Man, every time I finish one of these, I feel like I’ve said WAY too much. Nobody ever tells me this, but in case you need permission, it doesn’t hurt my feelings if you got bored and wandered off at some point in this message. As always, I hope it’s useful and somewhat enjoyable, as much as this subject can be, and I hope it provides a better understanding of the business, which affects all of our lives as employees and stakeholders.

Since Sam Marnick beat me to the punch in releasing the STIP score, I will only comment to say that 0.75 seems to be sensible and fair based on the financials. The good news is, a lot of the factors to lift that score up are fully within our power. Let’s see what we can do through the end of the year.

Ahhhh, it’s good to be back. Thanks for reading, see you again next quarter!

Better late than never!

On Friday, February 2^nd, Spirit hosted our 4^th quarter 2017 and full year earnings call. I have a feeling it’s been a confusing quarter for some observers. Inside Spirit, our final STIP score for the year was a respectable 1.60, which would signify strong, above-average performance. However, from an outside perspective, Spirit’s share price took an unmitigated beating of nearly 10% in response to our earnings. So what’s the deal, and how does it really impact us day to day? I’ll try to answer that with this summary. Keep in mind it’s one man’s opinion, and I’m open to interpretation and hearing your thoughts in response too.

Since this is a full-year wrap up and comes with forecasted guidance for 2018, the writeup will probably be a bit longer than normal. I know. It won’t hurt my feelings if you skip around a bit or read this in parts.

All that said, let’s get started!

Financial Summary

Ordinarily, I would highlight at least one of these numbers that I thought was critical in telling the story of the quarter. This quarter, there’s only one number that mattered to the street, and it’s not on any of the standard results tables we look at.

What you’re looking at in Table 1 is an increase in revenues (people are buying more of our airplanes) and a decrease in year over year earnings, but with a good cause – the primary cause of the decline in earnings is attributed to the adjustment we made for the Boeing master pricing agreement. Keep in mind we took that big forward loss that we considered a tradeoff: we gave up on earnings now for much more certainty of our business with our largest customer in the future.

Taking out the one time effect of the Boeing MOU forward loss, we had a respectable 17% increase in adjusted earnings per share. That means all things considered, we saw strong improvement in not only demand for our product (growth in revenue), but also in the execution of our internal business (growth in adjusted earnings). That’s all good news!

The story told by Table 2 is twofold. First, there’s an increase in capital expenditures (you’ll hear this on the call as “Cap Ex” or “PPE” for Property, Plant and Equipment). This increased spending accounts for rate readiness investments as well as productivity and facility investments. Growth in this category largely means we’re investing for the future, which is naturally a smart thing to spend money on. The second factor is the 28% increase in adjusted free cash flow, which means that after smoothing out one-time cash events related to pricing agreements and stuff, Spirit is generating more cash than last year even after investing more money for the future.

At this point, you may be saying, “Okay Travis, that all sounds pretty good, so why the reaction from Wall Street?” Fair question. The story from these two tables is why our company STIP score was a very solid 1.60. The next two pieces of the puzzle are why we took the 10% stock price beating.

Table 3 shows our forecasted guidance for critical earnings metrics next year. The past several years, Spirit has proven good on their philosophy of forecasting accurate but conservative guidance, then revising it upwards as we move through the year. Still, this is the first glance that investors have at how Spirit will perform in the upcoming year.

What we’ll learn later in the Q&A portion is that what we forecasted wasn’t exciting enough to the investment community. You can call it a Wall Street quirk, but forward looking statements like this can be more impactful than reports of actual earnings. At some level, sure, it’s a bit silly for people to sell out of a stock because earnings were good but not better than expected or because forecasts aren’t as high as desired. On the other hand, the point of owning shares in a company is for the value of that company, and therefore the shares, to rise in value. What we’ve done so far is great. But if we’re not going to increase in value, why own our stock?

So that’s part of the reason. But the more direct reason that the market reacted like it did, in my estimation, is a line squirreled away in the Fuselage Segment results. See below:

This $21.7M is the number that really carried weight. The word of the quarter, you probably found out if you listened to the Q&A, was “headwinds.” That word was specifically said nine times on the call, with many more indirect references to the same idea. Yes, we showed solid results for the 2017 wrap-up. Our forecast for 2018 was a little softer than what the market wanted, but we’re usually fairly conservative in our guidance so that shouldn’t have hurt that much. But a whiff of weakness on 737, our bread and butter, was cause for major alarm. This $21.7M worse-than-expected performance on 737 indicated to investors that for all of the advantages of rate increases, we’re not staying on top of it as well as we could be. The 737 is our foundation, and any tiny sign of instability there starts setting off alarms.

Our leadership is well aware of this. Many of their opening comments as well as answers to questions asked on the call alluded to how we’re proactively working on training and capital to make 737 rate increases seamless and profitable. As it turns out, growth is good, but growth is also hard. How we handle the strain of that growth going forward will tell the next chapter of our company’s story.

To be completely fair, I also attribute some of the market’s reaction to our earnings to just plain bad luck. We happened to report earnings during the market’s biggest downturn in the last 4 years, so everyone was already skittish and nervous. We’d been riding the market up for the last 3 months, then we provided a squeamish market a tiny shadow of doubt and they ran with it.

The long and short is that we performed well in 2017 and have a good, but challenging 2018 ahead of us. Sometimes the stock price movement is a good reflection of performance, and sometimes it’s just not. What we need to do from here is focus on executing our growing business and let the analysts do their own thing.

Alright, you’ve listened to me yammer on. Those are my general thoughts on the quarter, laden as usual with opinion and guesswork. Now let’s turn to the call itself!

Executive Intros

Tom Gentile:

• In 2017, we exceeded our provided guidance on revenue and earnings, with adjusted free cash flow at the high end. This was driven by a new record of 1651 deliveries.
• This year we returned $549M to our shareholders – $502M in share repurchases and $47M in dividends. We actually returned over 100% of our free cash flow to shareholders.
• We’re looking down the barrel at a lot of rate increases. That’s great because it means we’re on desirable, growing programs, but it does present unique (and costly) challenges. We’re trying to be more proactive in 2018 about planning for upcoming rate increases.
• One major highlight from the year was the long-term pricing agreement with Boeing, which removed uncertainty on revenues and reset the relationship with our largest customer.
• We’ve started strategic initiatives with major customers and suppliers, as well as investing in technical knowledge and capacity.
• For anyone curious how Spirit is spending their tax bill savings: we intend to reinvest the savings from tax reform in high return capital expenditures and R&D to support our growth expenses, as well as workforce development and productivity initiatives.

Sanjay Kapoor:

• We’re experiencing unprecedented levels of rate increases on our core programs. Of course that’s a good thing, but it comes with costs. We had significant additional costs in hiring, training, and overtime, as well as disruptions due to supply chain pressure and quality initiatives. All of these things pay off in the long term, but are naturally costly today.
• Capital expenditures grew by $20M this year ($254M up to $273M). This increase is due to rate increases but also investments in productivity and competitive positioning.
• In 2017 we repurchased half a billion dollars of our shares, and the board has authorized up to a billion more. Our first priority is to invest in ourselves. We’ll continue to look for strategic acquisitions, but absent those opportunities, we’ll continue to return value to shareholders through repurchases and dividends.
• This quarter we adopted some accounting changes (ASC 606 and ASC 715). This will affect how we report revenues and earnings in the future, and will have different implications for different programs. For instance, 787 will continue to reflect zero margin performance because the forward loss reflects costs greater than revenues that are still actually in the future. In contract, the A350 forward loss activity is behind us, so there will be an adjustment to retained earnings, but A350 will operate with a positive margin going forward.(Travis Note: The ASC 606 changes and retained earnings are complicated subjects that will require a little extra explanation. Since this is already going to be a long summary, I’m forgoing the mini-lesson at the end and will expound on some of these topics in the Q&A. I also want to thank Meredith DeZorzi, who reached out to me last quarter and was kind enough to meet and explain some of the changes to me. Meredith, I apologize if I butcher the explanation J).
• In 2018, we’re utilizing around $75M from the tax reform benefit in R&D and technology development to put us in a stronger position for the next generation of military and commercial programs and invest for our long-term success.

Tom and Sanjay painted a pretty positive picture of 2017, and an optimistic, but honest assessment of our challenges heading into 2018. Many of the things they talked about will drive the conversation in the Q&A, specifically what we’re doing with the benefits of tax reform, how we’re addressing the difficulties of rate increases, and what some of our overall strategies for growth are moving forward.

Let’s get to it!

Q&A

• Question: You said you’re investing an additional $75M in CapEx and R&D due to tax reform. Last quarter said we were making sufficient investments and we need to be careful with how we deploy CapEx. How does the tax bill change that strategy from before?

o   Tom: What we’re really doing is accelerating initiatives we were planning but didn’t have focus on before. For instance, rate increases are expensive, so we’re investing earlier in some automation to help support that. There are also some infrastructure plans for systems to increase productivity (WiFi, uninterrupted power). R&D is another area we’ve really doubled down in the coming year.

o   Travis: Considering the concerns for the quarter, this was an interesting question to lead off with. And it’s a prudent question, too. What the analyst is asking is how important can these extra investments be if we weren’t already going to make them before tax reform landed. We got some more money, so the plan is to just throw it at stuff we didn’t think was important enough to spend on before? Tom’s response is that it let us do things we already planned to do but earlier, not like we just imagined up some things to spend money on. This was a good question and I encourage you to read or listen to Tom’s full response if you get the chance.

• Question: This quarter you showed $32M in forward loss reversals, and $19M of negative cumulative catches. What were the sources?

o   Tom: Negative catch is unfortunately on 737 – primarily due to rate increase challenges. Reversals are related to 787 program increase to 14 APM.

o   Travis: 3 or 4 questions in, the 737 rate increase “headwinds” topic had already been asked about in one way or another a couple of times. It was clearly top of mind, and not without reason. This would be like McDonald’s saying there was a concern next year about ground beef supply. Even if there’s plenty of Coca Cola and fries available and sales are increasing, everyone is obviously going to be a bit concerned about the core product if there’s a sign of weakness.

• Question: Can you talk about profitability across segments over the near and medium term?

o   Tom: Let me provide a high-level comment. In our industry, you have to run fast just to stay in the same place. We have a lot of supply chain initiatives and have reset prices on over 20,000 parts, so we have a lot of savings yet to materialize in the next 10 years. As those things kick in, they will naturally offset some of the headwinds that we will see across segments.

o   Sanjay: Due to the accounting changes (discussed later), there may be some more variability every quarter now, because the accounting blocks are across much shorter windows of time. On A350, they should be positive though, since we’re going to book profit on that going forward.

o   Travis: Tom went a little aside here. At this point, it was already becoming clear that there were only two real questions this quarter: what are we doing to address rate increase difficulties, and how are you utilizing tax reform? Tom and Sanjay had both mentioned several times about the proactive training, hiring, and productivity investments we’re making on 737, as well as the R&D efforts to make us more competitive with current and future work going forward. Here he goes outside the question a bit to mention another leg of the headwind mitigation effort: supply chain strategy. Since this is my new world, I can give a little bit more detail than before.

On our major programs, there are several thousand part numbers built by hundreds of suppliers all around the world. Some we make ourselves, some we buy from others and assemble, some we get straight from Boeing to assemble before we deliver, and so on. Each of these thousands of parts are on a contract that has some end date depending on how we originally negotiated the deal. What these initiatives are doing is trying to achieve savings by finding a more competitive supplier for a bunch of parts, but one major constraint is that we have to abide by our existing contracts. So when Tom says that these initiatives will “kick in” over time, he’s referring to the fact that some contracts will expire sooner, and those parts will go to more suitable suppliers and we’ll start saving money quickly, while other deals won’t show up in the numbers until later down the road. How the schedule and magnitude of those changes intertwines with the rate increases and price step-downs will impact our performance quarter by quarter.

• Question: You’ve talked a lot about fabrication, defense, and Airbus as some of your opportunities for inorganic growth. Have we given up on mergers and acquisitions (M&A)?

o   Tom: We recognize that there’s a lot of activity among suppliers on the market, but we definitely have a specific focus and want to be strategic. Our main criteria are Airbus content, military content, low cost country footprint. And we’re keeping our options open. That being said, corporate valuations are at multi-year highs. If we can find something that fits our needs not only strategically but at the right price, we’ll move on it. But otherwise, we’ll keep investing in ourselves with share repurchases as well as strengthening our internal business.

o   Travis: Ah, fun answer! A real world, living example of someone not getting caught up in the hype and trying to buy high instead of buying low. Acquisitions are big, sexy ordeals in the business world, but they’re also very difficult to properly execute – look at some of the high profile acquisitions in the last two decades and ask yourself how they worked out (hmmm, might make for a great mini-lesson). What Tom is saying here is essentially cool your heels Wall Street, we know acquisitions are saucy and what-not, but we’re not so enamored with the idea that we’re going to jump in if we can’t find a good deal. We still have plenty of opportunities for good investments without making some big commitment to buy another company at the highest market value it’s ever been.

• Question: How does ASC 606 really affect you?

o   Sanjay: It will reduce our revenues very slightly, something in the range of $30M (

o   Travis: Okay, the time has come. ASC 606 is a set of accounting changes that is a response to some of the confusion around forward losses, cumulative catch-ups, and all that time-distorting accounting voodoo. As I understand it, under the old rules, we booked revenue based on the contract pricing with our customer and booked costs based on a ratio to those revenues. Cumulative catch-ups (positive or negative) occurred when we squared up our true costs with what we had accounted for. And the justification was usually over a relatively large number of shipments.

The new system changes it so that we will track cost on a per-unit basis instead of as a ratio against revenue. Instead, revenue will be calculated from the true cost. Additionally, the blocks over which these calculations are made will be much shorter – on A350 in fact they will be unit-by-unit, while on 787 there will still be short blocks to smooth out irregularities.

If you never quite understood the whole cumulative catch-up system, well, know that the people whose job it is to interpret this stuff had issues with it too, hence the change in accounting standards. I still had questions after talking to an expert on the subject, and there were a few questions that she also shrugged at. We don’t make the rules, but we still have to understand and abide by them as best we can.

Having said that, here’s why the new system should result in smaller surprises. Profits should now be stable, with cumulative catch-ups made to revenue instead ofearnings. Think about it this way – you might think you care about your salary, but what you really care about is your take-home pay. If some change happened and it kept your salary the same but took $200 away from each paycheck, you’d be farmore concerned than if your salary got adjusted but your take-home pay stayed the same. Your take-home pay – your earnings – is what you live on. Your salary – your revenues – only really matters to you via how it drives your take-home pay. Investors in Spirit will see this change the same way. They should be far less sensitive to adjustments in revenue than they were to adjustments in earnings, because it’s not messing with the dollars that make the most difference.

Now, there will be some one-time adjustments when switching over to this new system. We will make adjustments to our retained earnings, which is a simple but often confusing accounting subject. Retained earnings are a running record of the earnings a company has kept over time. In other words, if money isn’t spent as part of the business or redistributed to investors, it goes into retained earnings.

This means that (ideally) retained earnings continue to grow and grow over time, but there isn’t a whole lot of practical information you can glean from it. It’s sort of like the year-to-date pay on your pay stub. At one time, you had access to that money, but since then, you’ve spent it, saved it, invested it, etc. When we switch to the new accounting system, we will reduce our retained earnings, but that will let us book profits on A350 from here on. It’s sort of the anti-forward loss – we’re taking profits from the past and shifting them into the future to be consistent with the new approach. It would be sort of like taking money from your savings account to increase your take-home pay. Sort of.

What does it ultimately mean for the average Spirit employee? Nothing much. Hopefully our earnings will be more consistent due to this change, and one-time adjustments won’t be as heavily scrutinized because they’ll be to top-line instead of bottom – messing with the dough instead of the pie.

Now, my warning is that I may have drastically misrepresented something here. Blame it on my lacking as a student, not the knowledge of my informant. If anyone wants to correct or clarify it for me, I’d be happy to get together and listen! In the meantime, I hope this has been a bit of a helpful explanation.

Whew. I think that’s going to be it for me this quarter. I apologize for how late I was to get this out. I will commend the leadership team though on their increased transparency; many of these topics were discussed with candid feedback from our executives on the recent webchat. At some point, these summaries may become irrelevant since you can just ask leadership directly and get their answers, and that would be okay too. In the meantime, I’ll continue to give my spin and hope it’s added value.

Congratulations on a great 2017 everyone, and here’s to a great 2018. See you next time!

Hello everybody, and welcome to November, and Spirit’s 3^rd quarter financial summary!

As is tradition, let’s start by taking a quick look at the numbers.

Here’s the earnings and margin summary:

And the cash flow summary:

I highlighted the numbers I did because this quarter’s call focused a lot on “margin dilution” and what that meant for our future. You can see that our operating margin and net margin (highlighted on the first table) were down against last year from both a running 9 month perspective and a 3Q16 vs. 3Q17 perspective. Margin is why companies exist. It’s proof of our value proposition in the marketplace. A reduction is always going to be a bit concerning.

To allay your fears, our leadership had reasonable answers for why these numbers slipped. A lot of the slide in margins is because of our efforts to improve the future. We’re running expensive cost and quality initiatives that hurt our numbers now, but square us up to be more competitive, more profitable, and a higher quality partner in the future. That type of thinking should speak to all of us. It means our strategic direction isn’t focused on maximizing quarterly results at the expense of the bigger picture.

As a tacky metaphor, think of the lower margins this quarter like the feeling you get the day after a hard workout. You’re a little sore, a little weak, a little stiff, but you know you’ve done something that will make you stronger once you’ve recovered. Spirit’s cost savings and product quality initiatives are tough now, but are the exact kinds of activities we need to be doing to be healthier in the future.

I highlighted the free cash flow numbers in the second chart to illustrate another key takeaway: even during some major efforts to prepare Spirit for the future, we’re still bringing home good money. Margins may be the heart of a business, but cash is the blood, and Spirit’s is plenty healthy. This quarter’s financial results were just okay. But it brings the promise of better results in the future. It should be fun to watch.

Now let’s turn to the call.

Tom and Sanjay Introductions

The introductions were brief and positive as usual. They highlighted Spirit’s push for fabrication and defense work to be major growth areas, and they gave the standard fly-by on programs that are growing and shrinking. In this quarter, it was much the same as it has been recently: 737, 787, and defense were growth areas which were partially offset by lower 777 and aftermarket activities.

Overall, Tom and Sanjay were congratulatory to the Spirit team and seemed enthused for the future.

Before we jump into the Q&A, I have a quick disclaimer. I’m not sure if I just wasn’t on my game during the call or whether the content was truly above my level, but the Q&A this quarter seemed pretty broad and theoretical. I didn’t capture the usual amount of good questions and answers, and a couple of items are going to require some further study on my part to explain properly.

What you should take away from this though, as always, is the tone of the conversation. I wouldn’t have missed a question as unambiguous and dire as “Will Spirit still be open in the next 6 months?” Typically when the conversation leans far into the future, or heavily into strategy and theory, it means there isn’t overwhelming concern about the present.

Let’s go through the questions I did catch, with the executive responses and some limited feedback from me, then we’ll be on our way!

Q&A

• Why will cash flow be weak in Q4 based on current guidance? And why did we have margin dilution in all the sectors?

o   Sanjay: Cash flow is due to higher capital expenditures to support rate growth, as well as some of the initiatives I’ll mention in a second. Margin dilution is partly due to some one-time aftermarket kinds of things. We’ve also been pouring lots of effort into supply chain initiatives that haven’t yet materialized in the numbers, but should start to appear in 2018. We’re currently supporting lots of rate increases and lots of ToW (Transfer of Work) activity as we optimize supply chain. We will see some inventory growth as we see rate increases and see some added inventory from supply chain activity.

o   Travis: The Q4 cash flow question was interesting from a simple math point of view. The analyst who asked this question took our provided 2017 full-year cash flow guidance, subtracted our actual performance through Q3, and noticed that Q4 is due for a decrease. Fun little Finance 101 problem. The margin dilution question goes back to my opening comments. Margin is a company’s heart, so a reduction is always concerning. Luckily, Sanjay gave us the answer to the preeminent question of this quarter’s call. Our margin is low now because we’re currently shouldering the burden of organic growth (rate increases) and cost savings efforts (supply chain, ToW) at the same time. The low margins this quarter aren’t a sign of weakness, they’re a sign of active preparation for the future.

• This quarter we had $5M in negative adjustments. Is that a systemic problem?

o   Sanjay: $5M is pretty much noise. That’s spread across all programs, so sometimes we realize risks or miss opportunities, and sometimes we avoid risks and realize opportunities.

o   Tom: 737 rate increases actually caused some of the drag, where 737 is usually a boon. Part of that was also a refocus on quality with the Flawless Fuselage initiative causing some minimal disruption, but to increase the product quality. We’ve learned lots of lessons from this and expect it to be even stronger next year.

o   Travis: Ah, right, I haven’t mentioned Flawless Fuselage/Factory yet. This is, of course, another effort that isn’t free, but that is clearly part of Spirit’s positioning and value in the marketplace. One way to look at reduced earnings, if they’re not due to loss of revenue or growth in costs, is as reinvestment. We’re “burning” some of our earnings to improve quality (Flawless Factory), to get ready for more business (rate increases), and to focus on saving costs (SCM/ToW initiatives). Nonetheless, Sanjay’s right. $5M for Spirit is just noise. Sometimes it’s in our favor, sometimes it’s not, but it’s not an indicator of some giant lurking problem.

• Are we worried about margins as we’ve got rate increases, some margin dilution this quarter, some price step-downs associated with the MOU, etc.?

o   Sanjay: Rate increases are expensive to capitalize up front, but we do eventually get productivity gains via fixed cost absorption with rate increases. Supply chain efforts are similar – expensive up front, but big potential savings for a long time. So we’re actually looking at some long-term margin increases if all of our initiatives come home, which we’re pretty bullish on.

o   Travis: Pretty much the same question as before. Keep in mind that repeated questions or slightly rephrased versions of the same question are really good tells of what’s bugging the analysts. It might make for a boring call to hear the same question twelve times in an hour, but that’s your clue that it’s the top-of-mind issue. To add just a little more to Sanjay’s already rational explanations on the lower margins this quarter, we should all keep in mind that Spirit’s long-term cash flow conversion goal was very recently increased. That means we expect our ultimate bottom line to look more favorable in the future.

• On your billion dollar defense target, is that coming from products we’ve already won and will grow to that goal, or does that goal depend on winning new work or taking it from competitors?

o   Tom: Current programs over time get us to the billion. Still, we’re continuing to pursue organic growth initiatives to expand that and get defense up to a 15% share of our business even faster.

For anyone keeping score, the major topics of the call were supply chain initiatives and margin realization, which we’ve discussed above. Spirit is undergoing a bit of a transition again, but unlike last time, where we made some tough choices to potentially save the company, this time the transition is to move from a solid foundation to an even stronger place.

Stock price is an imperfect indicator, but it’s a good thing to look at for calibration. In the case of this quarter, it told a pretty fair story.

On earnings day, while Wall Street was digesting our financial results, which were admittedly pretty tepid on their own, our price was down. To be sure, there wasn’t a great deal to go all “buy frenzy” about in the numbers. But as it settled, everyone realized investing for the future is actually a pretty worthwhile reason to have temporarily lower margins, and the stock recovered in the following days back to where it was before (and beyond).

And that’s it for the quarter!

Below is a little essay I started some time ago and have finally gotten ready for people to read. I hope you find it interesting and inspirational.

Why Small Changes Matter

See you next quarter!

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 3^rd 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 3^rd 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!

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!