Spirit had their 2nd quarter earnings report today, and it came alongside some exciting news: over the next two years, Spirit plans to repurchase $350M worth of their shares! Hooray! Who cares? Well… both Spirit’s investors and employees should care, since it means good things for both of them! I’ll talk a bit more about the share repurchase in the mini-lesson, but for now, you should know that it’s a good sign.

Before that, let’s talk about the call. As always, it’s worth listening even if you don’t necessarily understand all of the financial terminology, so if you missed it live this morning, I encourage you to listen to it on replay. As we usually do, let’s start with the handy financial results summary:

Some things to immediately note. Revenue (money paid to us by customers) was down compared to this quarter last year. Two things primarily accounted for that. First, the Gulfstream divestiture. When we said we “weren’t making money” on the Gulfstream business, what we really meant was “not making profit.” We were getting paid for the work we were doing, and now we’re no longer doing it. Of course, without the drag on our profits, our margins are looking fantastic, meaning we’re a more efficient and profitable business overall, so we shouldn’t exactly mourn the loss of that revenue. Second, the 787 program experienced a price step-down, causing lower revenues. We talked about this loooong ago when the forward losses were coming out, because it was already costing us more to make those early planes than we sold them for, and if we didn’t fix that imbalance by the time the step-down hit, we’d have been in a whole new world of hurt. But it seems that we’ve come down the learning curve and are on a better course, so, while we like being paid lots of money, this loss of revenue seems expected and not worthy of concern.

On the rest, you’ll notice that even with reduced revenues, we saw incremental improvement on Operating Income (money left over after taking out the cost of planes that we built, sales, administration, and R&D), as well as net income (money left over after everything is accounted for). Our six month running net margin is almost 10%… which is really, really solid. Also noteworthy is that we paid less interest this quarter due to Mr. Kapoor’s refinancing efforts. Our interest expense in Q1 2015 was $17.9M; in Q2 2014 it was $20.8M. This quarter, it was $12.1M. Now if only I could refinance my house and put $5.8M in my pocket…

The last component is cash flow, of course. Profit is more or less in the aether, but how is Spirit’s savings account doing?

Check out the cash balance at the end of the quarter. Uh, we’ve got almost a billion dollars in cash on hand. We generated $230M in free cash flow — money that’s left over at the end of the month — this quarter alone, and we stuffed $209M of it in the bank. And with our updated forecast, we plan to generate nearly half a billion more by year end. And this isn’t numbers on paper, it’s real folding money. Alright, digital numbers in a bank account, but you get the picture. Pretty cool.

While in previous quarters I’ve harped on and emphasized the importance of cash, there actually is a point where you can have too much. It’s a topic I’ll probably explore more thoroughly in a future lesson, but in short, the increases in Property, Plant, and Equipment (which are like home improvement projects for the company) and the share buybacks Spirit announced are intelligent uses of our beginning-to-be-excessive cash hoard.

As for the analyst questions, they were once again relatively tame and cordial, with a bit of company humor mixed in. Our boys at the helm were notably comfortable, a position that’s largely justified when sitting on numbers like we produced. I’ll share a couple of my favorite questions and answers and call it a quarter. As a side note, I take rather detailed notes of the Q&A section of the earnings calls; if anyone would like those notes leave me a comment or an email and I’ll provide them. Here we go:

• Question: A350 deferred inventory per unit has been steadily decreasing… is it stabilizing or is there more improvement to come? Larry: Some of the big, early expenses are gone and change management is coming down, so some of the gains have been realized. However, what Spirit does best is go down the learning curve and get better as the rate increases. We’ll see further progress on unit cost and delivery as we start ramping up production. Travis: Deferred inventory is something that I came to fully understand just last quarter. I’ll probably compose another mini-lesson on that at some point. For now, know that deferred inventory is the precursor to forward losses, and that higher deferred inventory is bad. The biggest threat of deferred inventory comes early on in the production phase of programs when we’re trying to learn how to build stuff. Our top brass seems to believe that A350 production is on track and will continue to improve. The threat isn’t over, but it’s starting to shrink a bit.
• Question: What’s the breakdown of capital expenditures? Where does the PP&E money go? Larry: $200M goes to maintenance expenses (he didn’t specify, but I assume that’s in a full year… either way, it’s a LOT!). This year we’ll probably spend $325-$375M on automation and improvements above and beyond simple maintenance. In the future, we would consider increasing capital expenditures considerably if it makes sense from an investment standpoint. Travis: When we talk about investing in ourselves, it’s not just share repurchases, it’s our home base too. I just found this to be an interesting question and absolutely crazy to think how much Spirit spends on keeping its high-capital business intact.
• Question: A lot of previous questions have focused on the elephants in the room — A350, 787, Gulfstream — but how are the young programs doing? A350-1000, 737-MAX, 777X, and 787-10? Larry: “Our deliverables are delivering.” He thinks they’re all tracking to plan pretty well. These are all derivatives and you expect your ability to fulfill a derivative to be better than the original. We now have experience with Airbus, and we’re through the original 787, and the 737 and 777 are part of our longstanding business. So far, our young development programs seem pretty promising. Travis: Aha, now we know what people will be asking about when A350 and 787 are making the kind of money that 737 does currently. I was glad to hear this question because it indicates that the analysts are relatively satisfied with the company’s direction and performance on what were some of our toughest programs ever. They’re ready to move on to the future. Cool.
• Question: It seems operations are under control and steady. So where do you want to take the company? Where do you see Spirit 5 years from now? Larry: Our goal has been to stabilize operations and be #1 in the industry. Our main goal is to deliver a high-quality product on time, whether the product is engineering or hardware. We do want to grow the business in line with stuff that fits with us. We’re looking at defense and would like that to be a bigger part of our business, but overall we have pretty tight definitions of what our business is and what we do. Our priorities are, in order: reduce costs, support increased rates for our customers, return value to shareholders, and pursue acquisitions if they make logical sense and it’s mutually valuable. Travis: I thought this was a really neat question and answer. I do wish though, that he had instead asked 5, 10, 20, 50 years out. I don’t suspect Mr. Lawson will be our CEO in 2065 (though in 2015 we drink to his well-being), but I am curious what he thinks Spirit is capable of over corporate eons. Maybe I’ll get my answer next time.

And that’s it! It was another great quarter… I suspect we’ll be hearing from Sam Marnick shortly with the STIP score, and I’d be extremely surprised if it was less than 1.1. But like always, don’t hunt me down with torches and pitchforks if I’m wrong.

In the meantime, good job everyone, I’ll bug you again next quarter!

Suggested Mini-Lesson

Returning Value to Shareholders

When I arrived at work this morning, I already had several emails and chats asking me about the share repurchase program that Spirit announced. Instead of responding one at a time, it made the most sense to just write up a thorough article explaining it to everybody! In short, share buybacks are one of the major ways that companies give back to their loyal investors. Check out the article, and feel free to email or comment with any questions!

It’s that time again! Spirit announced our 2015 first quarter earnings, and they were dressed to impress. This quarter there were a couple of unifying themes among the analyst questions that we’ll discuss, and a few mighty fine answers from Mr. Lawson and Mr. Kapoor. I’m not in the business of making stock buy/sell/hold recommendations, but the gist of this is that I like where these gentlemen have the company headed. And just to throw a nifty fact in, Spirit stock was around $20 when Mr. Lawson became CEO in 2013; it now sits around $50. So that’s neat.

Before we get to the “themes” of the call, let’s quickly talk the numbers.

Revenue (money we got paid by customers) was up just slightly this quarter compared to last year — but keep in mind, we lost $50M of revenue from the Gulfstream divestiture, so if we account for that, revenue was up a solid 4% year over year (Q1 of 2015 vs. Q1 of 2014). Operating margin (discussed in the mini-lesson) was a solid 13.5%, and net margin was 10.4%. Those are some stellar numbers. Not that anyone is comparing but uhhhh, Boeing’s operating margin for Q1 2015 was 9.1% and net margin was 6.0%. I’ll just… leave those numbers there and let ’em simmer.

We also had massive free cash flow this quarter — $384M. As a reminder, free cash flow is essentially money with no name. We’ve paid our bills, bought materials, paid salaries, everything, and at the end of the period we found ourselves with $384M sitting around. Like we’ve been doing lately, we saved this money. Spirit could now write a $750M check (up from $378M at the end of last year, so they saved $372M of this quarter’s $378M free). If you’re paying attention, you might be wondering how free cash flow, which is usually the lowest number when we talk about earnings because the most things are taken out before you get there, was higher than both net income and operating income. The secret is that $170M of that was cash kickbacks from the Tulsa sale (didn’t Sanjay tell you it would be a net positive?), and a few other one-time events that contributed to that huge number. This is why our guidance of free cash flow for the year is still $600M-$700M when we did over half of that this quarter alone. The “trending” free cash flow from this quarter is closer to $200M.

Okay, pretty solid numbers! Good margins (whose meaning will be discussed in depth in the mini-lesson), and, even if it was a little puffed up from some one-time stuff, great free cash flow. So, let’s get down to the fun part: what were Spirit’s analysts wondering about?

First off, there was a lot of giggling and joking around on this call. These are the kinds of intangibles that make listening to the call worthwhile even if you sometimes get lost in the accounting terminology. Bad quarters don’t result in the lighthearted exchange of chummy business jokes. That’s always a good sign when everyone’s in decent spirits (puns). Another thing I’ll say on the tone of the call is that it’s clear to me that Sanjay Kapoor has a brilliant financial mind. In early calls right after he joined the company, which were coincidentally some of the toughest quarters to talk to analysts, his presentation was rough around the edges and he didn’t seem 100% comfortable. Today, he blew me right out of the water. He now knows the business inside and out and has made some really intelligent moves that are starting to pay off in real ways.

Without a doubt, the biggest question on the analysts’ minds was how A350 is coming along. At least 4-5 questions were asked specifically about that program. So, how do our executive leaders think it’s going? Larry responded to one question by pointing out that we’re on ship-set #33, and we’re making plan as far as production, and that typically you don’t get a really solid idea of how costs and productivity are coming until #100. He didn’t express great concern over the program at any point, even though the analysts were grilling it. This is just “Travis” opinion, but having listened to these calls regularly over the last few years, it seems like the 787 got the exact same questions and level of attention when it was in this phase of its life cycle. It’s late in the development, so there’s lots of non-recurring costs like tooling and engineering that haven’t shown any real, considerable profit. But… I mean, ramping up manufacturing and delivering to customers is what Spirit is a world-class rock star at. Sure, there are risks this early, and everyone’s excited to start seeing some profitability out of the program. But everything about our leadership’s presentation today, and answers to the numerous A350 questions, bespoke utter confidence in our ability to make the program successful in the future.

A few more points. Spirit’s cash pile has been a topic of much discussion in the last few quarters since our earnings and cash generation are smoothing out. Lawson chuckled when one of the analysts asked about it in a more-or-less indirect way (he asked what our strategy for capital deployment was — how much cash do we want on the balance sheet). Larry’s answer was that returning capital to shareholders was a priority, and some of the things Sanjay has structured allow us to do that in the future in one or several forms, but he wasn’t ready to say anything concrete. He emphasized that we’re focused on reinvesting in ourselves — and his money is where his mouth is; a talking point today was the deployment of $100M of capital expenditures on automation tools and factory layout improvements. The shareholders… they want dividends. Badly. They see that big hoard of cash and think it’s about time they got in on the game. And that’s okay. Larry and Sanjay realize it’s something they’ll need to do in the future. But I’m very glad they’re staying so focused on the health and stability of the business first. I also think they’re making intelligent long-term decisions. One analyst asked about other ideas in improving our costs and mentioned outsourcing specifically. Lawson said what we do is “skill and scale.” That surety of supply and quality are our reputation, and we have people who can give us that. That we want to make sure we do things right. I’m encouraged by this. Outsourcing and make/buy decisions can appear to shave costs out, but can be detrimental long-term, and our leadership recognizes that. This doesn’t mean stuff won’t ever be outsourced, or bought instead of made, or whatever. But it does mean that we’re not going to make snap decisions based on a cost-benefit analysis that shows a short-sighted savings but costs us long-term, or on our quality and reputation.

Finally, Lawson made some more comments that were worth mentioning. The question wasn’t super relevant, something about A350 and how worrisome it was. Lawson basically went back to basics and described the nature of the aerospace industry, and it’s good for us all to remember. Where Spirit makes its money is at high rates of production. When you can take aaaaall the expensive costs of designing and building an airplane and start to spread it out over a lot of units, those costs become less gargantuan. It takes a billion dollars to build plane #1. Design, tooling, supply chain, certification… yeesh. But then when you start to divide it out over 50 planes, or 100 planes, or 1000… well, it starts to make a lot of sense. Many of Spirit’s “troublesome” design programs are transitioning to a production mode, where we recoup costs. We eliminated some programs that we didn’t think had as promising a future, because Spirit’s aggressive expansion in its early years left it in a cash crunch, and what’s left is turning into a lean, consistent, solid portfolio.

As my fellow engineer/MBA friend Nic Hovey said, “We rounded the corner from good performance last year to predictable performance this year.” I think that pretty much says it all.

Suggested Mini-Lesson

What’s in a Margin?

Oh, and hey, on the mini-lessons, I’m starting to write them ahead of time, so I can produce the quarterly reports more quickly. If there’s something really really good from the earnings call, or something of vital importance, I’ll write one to match. So expect to see the mini-lessons be a little more generic and less Spirit-specific. Love it? Hate it? Let me know!

Introduction and Q4 Earnings

My friends and I are avid fans of strategic, nerdy board games. We’ll regularly play a game of Settlers of Catan, Power Grid, Dominion, or a handful of other similar games that test strategic prowess, strength of friendship, and occasionally, table flipping abilities.

Among our regular stash of games is one called Pandemic. Pandemic is unique in that it’s a cooperative game; it’s all the players working together against the board. In Pandemic, the players are simultaneously balancing two difficult tasks: traveling around the world mitigating outbreaks of diseases, and working towards cures. The game is won when the players discover cures for each of the four diseases on the board. The game is lost a number of ways – by having too many outbreaks, by running out of cards to draw, or by having too much of any single disease on the board. There are lots more ways to lose than win.

In Pandemic, one of the hardest things to do is get to a point where you can focus on cures rather than treatment. All too often, we get wrapped up in reacting to the short-term issues that we have to take care of to not lose, and don’t get to focus on the long-term actions we need to take to win. There have been many frustrating games where the players managed the short-term issues just fine, but ended up losing because we took too long to get into gear on curing stuff. Or games where it’s a constant scramble to manage the short-term outbreaks and problems, and over time, we just never gain traction and are eventually overwhelmed. But sometimes, with a properly organized team and a good strategy, we manage to work together and beat the board; we strike the proper balance between short-term and long-term needs and win the game.

This game has some extremely strong parallels to the business world. (Surprise, surprise – I’m not just peddling board games.) There are plenty of companies that fail, and the ways they can fail are far more plentiful than the ways they can succeed.

Some will stumble along so focused on the “urgent” tasks that they never get around to the “important but non-urgent” ones needed to win. They may stick around for a while, but they’ll never be great, and eventually they’ll fade or settle into relative obscurity or irrelevance. Others will bump along, putting out fires as usual but never working towards the future, until they’re overcome by something that they can’t put out immediately, and their lack of preparation for the future sinks them. Perhaps the most ironic are companies that grow too fast, with a grand vision for the future but too hasty a plan on how to get there, and are sunk by the important short-term considerations that they think are unimportant distractions. We’ll talk more about how this is possible in the mini-lesson that follows.

Like winning in Pandemic, growing and sustaining a successful business requires a balanced, focused approach. And there are lots of ways it can go awry.

I started with this metaphor because between last quarter and this one, I get the sense that Spirit is shifting their focus. They’ve taken great pains to reduce costs, focus on trouble areas, and build themselves financial margin with strong cash flows. They’ve cleaned up the board. And now, they can start to think about finding the cures – about how they’re going to really win and not just survive.

In this earnings call, as usual, the theme of the questions and the atmosphere of the room were far more telling than the actual questions or answers. Mr. Lawson even alluded to this a bit in his concluding remarks. I’ve said it before… the good quarters tend to be pretty boring, but I’m okay with boring. So I’ll quickly cover some of the major themes of the call, give you the mini-lesson, gather some feedback, and call it a year.

• The first half of the questions were almost all asking about Spirit’s cash flow guidance for 2015. Spirit’s guidance was $600M-$700M in free cash flow for 2015 (see slide 8 of the attached file). This is double what we did in 2014. The questions focused on how we would achieve that in spite of increased capital expenditures (purchases of property, equipment, etc. – see slide 7 of attached file), and in spite of revenues similar or slightly less than 2014 due to the disposal of a large portion of the business. This was really the only significant concern the analysts had with the numbers, which is a strong indicator of our current performance. Very little was said about 2014 except for congratulations and compliments.
• There were several questions and comments about “derisking.” The analysts wanted to know what the high-risk areas and programs of Spirit were now that Tulsa and Gulfstream has been removed. To use engineering parlance, Spirit addressed the lowest margin, and the analysts wanted to know the next most critical item. A350 was mentioned a number of times (along with 787), and our leaders were relatively dismissive, but be looking for more A350 questions as things develop in the future.
• Fellow engineer Phil Snell had a very poignant meta-observation: there was much less back and forth between the analysts and Messrs. Lawson and Kapoor. In more negative quarters, analysts will ask “compound” questions with multiple parts, or ask clarifying questions as follow-up, or will even jump back into the call queue to ask more. The fact that they pretty much asked one and done questions signals that there just wasn’t much to criticize in our numbers.
• Regarding the atmosphere of the call, it was actually pretty comical. Jokes were exchanged between the analysts and our leadership, Sanjay gave an interesting anecdote about some private discussions he and Larry had had, and Mr. Lawson on several occasions seemed like he was about to jump out of his seat with excitement answering the questions. Several times he gave lengthy, chatty answers about Spirit’s future goals and potential. He was confident and excited. It was easy to listen to.
• During his closing remarks, Larry said that he could tell from the questions that they were getting into the precision aspects of the math and the business. This signifies that there’s confidence in the broader picture. It also supports what I’m always telling you – the nature and themes of the questions are far more important than the questions themselves. Specifically, he was surprised that there were no questions on the business cycle, but he went ahead and addressed it, saying that the underlying demand and economic conditions support our large backlog, which supports our future growth and performance.

As for the numbers, there just wasn’t a whole lot to say – we performed well and it showed. As such, I’ll say just a couple of things.

First, Spirit did indeed split out the effect of the Tulsa sale. In this quarter’s numbers, you’ll notice a lot of flag notes saying things like “Excludes Cash Transferred on Gulfstream Divestiture,” and “Non-GAAP financial measure.” GAAP stands for “Generally Accepted Accounting Principles,” and any time something is provided that isn’t in The Big Book of Corporate Accounting, we have to reconcile what it is and why it’s there.

As an example, you can see in the picture below that our actual free cash flow (FCF) for the quarter was -$53M, but the non-GAAP “adjusted free cash flow” was +$107M – you may notice that’s exactly $160M greater than the actual FCF, which is the amount we paid out for the Tulsa sale.

In my Special Report regarding the Tulsa sale, I predicted Q4 FCF of -$80M to -$100M. I was off because I accounted for the same cash flow and capital expenses as in Q3. Even though our capital expenses (property, plant, and equipment) increased by $42M from Q3 to Q4, our cash flow from operations, when taking out the Tulsa sale, increased by $74M (from $119M to $193M, where $193M = $33M + $160M). This accounts for $32M in real gains between Q3 and Q4 that my assumptions ignored. Good. I like when things are better than I expect.

Second, my neighbor Mike Truex pointed out that Spirit beat their original guidance for 2014 for earnings and cash flow, and came right in line with their revised, more upbeat guidance. The original 2014 guidance from the 2013 Q4 and year-end report is shown below:

But you may remember that twice last year, Spirit positively revised their 2014 guidance. The final guidance they provided is shown below:

And how did we do against that guidance?

We exceeded the earnings and cash flow expectations of even the final guidance, and destroyed the original guidance. Well done, all!

My final comment is something that both Larry and Sanjay said at different times on the call. When the analysts were questioning the effect of big one-time events on the company, both gentlemen highlighted the importance of taking a yearly, longer-term approach rather than focusing on the ups and downs of a single quarter. I was very proud of how strongly they both emphasized this. They said that their guidance was the trending performance of the company over large blocks of time rather than individual quarters. This is great perspective, and I was glad they said it outright.

See, Wall Street has a fetish with quarterly reports. They put waaaaaay too much stock (ha!) in that tiny snapshot of a company’s broader performance. If a company beats estimates for the quarter, their shares do well. If they don’t, they sink. This is endemic to the way our economy and markets function. It’s not evil, it’s not making Main Street poor, it’s just a bit misguided and means that there’s often misplaced attention and unnecessary hype. Our leadership emphasizing the importance of the longer, broader perspective is very healthy. The nature of this business is super high capital and very slow. Things just don’t smooth out quarter to quarter like they do over a span of years. It’s encouraging that our executives have this vision and long-term focus. And, as we’re all recognizing, it’s starting to work wonders.

Suggested Mini-Lesson

Can a Company Grow Too Fast?

Hey everyone,

I’ve been getting a ton of requests to do a special write up on the sale of Spirit’s Tulsa facility (Triumph’s Tulsa facility?) and its impact on the 2014 STIP score. I appreciate that many of you asked me directly or asked me through Matt Joyce as a proxy. I’m honored by your recognition.

Some of what’s happening is very complex. Additionally, a lot of what I’ll say regarding the STIP score in this email is pure speculation or personal opinion. Please don’t come at me with pitchforks and torches if the STIP score is low.

If there’s anyone left who hasn’t heard the news, Spirit sold its Tulsa facility and the historically troublesome Gulfstream programs to Triumph. We made a $160M cash payment to Triumph as part of the deal. Our CFO Mr. Sanjay Kapoor stated that we will be net cash positive over 2014-2015 after accounting for a $240M-$250M deferred tax asset valuation.

From a broad perspective, I think a lot of Spirit employees and our analysts see this as a good thing. The main question for employees is how it will impact our 2014 STIP score since we made a big cash payment out as part of the deal. There are two main things we need to think about: the financial impact of the transaction and how it impacts the factors that play into our STIP score, and the philosophy of the STIP payout in the first place.

The Finances

First, let me point out that in the Q3 results, I mentioned just how much of the free cash flow generated in Q3 that Spirit stuffed in a bank account and sat on. We used that as the lesson for the quarter and talked about what the company could do with that money. I said:

Our free cash flow for the quarter was $75M. Out of that, we socked away $71.2M, or 95%. And those numbers are after we spent $44M on property, plant, and equipment. Wow.

Now, we have to ask, “What could we do with that cash, and future free cash that we bring in?”

In general, there are only a few options.

1. We could improve the company’s finances by building up our savings or paying off debt.

2. We could invest back in the business by advertising, buying new equipment, expanding our product lines, or upgrading facilities.

3. We could give back to our stakeholders, including employees, shareholders, and local community.

Although the Tulsa deal was… different than I expected, in the sense that we paid to dispose of business, what we stuffed all that cash away for was probably to lessen the pain of this transaction. In other words, our senior leaders were probably at the negotiating table and saw how the Tulsa sale was shaping up, and decided it would be prudent to save up for the payment they anticipated making when the sale was finalized. While the $160M will probably eat our cash flow from Q3 and Q4, we’ll probably still be cash positive for the year since we saved so much in Q3 and will probably do the same in Q4. I would expect, therefore, a Q4 cash flow between negative $80M and $100M – if we matched our free cash flow from Q3 in Q4 and paid the $160M in full, that’s what we’d see. If that’s the case, we’re looking at 2014 total free cash flow of $94M-$114M, based on my assumption about our Q4 result and the nine months running cash flow for 2014 from our 3^rd quarter report:

Alright, so knowing that free cash flow is one of the three factors in our STIP score, how does that compare with, say, 2013?

Well, we lost $20M in cash in 2013, so anything positive is an improvement. Here again, I don’t know the targets, but it would take more than $160M to push us negative for the 2014 fiscal year. I’m betting we’re still in decent position.

The other pieces of the STIP score are EBIT and EBIT as a % of sales. Here’s where it gets interesting.

In the Q4/2013 summary, I described what exactly a forward loss is. As a refresher, here’s the chart I used:

As time has passed and those “estimates” have been overcome by whatever financial reality we experienced, some of that forward loss has been realized, but much of it is still, indeed, in the future. What’s gone is gone, but, depending on how we do our accounting, we may be able to reclaim the losses that we haven’t actually incurred yet, since we’ve disposed of the source of those losses and won’t incur them in reality. Here’s that graphically:

Luckily, the announcement of the Tulsa sale came with pro forma (estimated) financials that split out the effect of the Tulsa sale (“The Transaction” as it’s ominously referred to) and show what performance would have been like if we hadn’t been exposed to those losses. Remembering that EBIT is equivalent to Operating Income, take a look at this:

So what we actually reported as our EBIT for the 12 months ended 12/31/2013 was negative $364.3M. $530.1M of that was due to business we exited with “The Transaction.” We would’ve generated +$165.8M without that exposure.

To me, this sends the signal that they are indeed planning to making a positive cumulative catch-up adjustment, meaning we’ll get back the un-incurred portion of the forward losses. And that balloons our EBIT (and as a consequence, EBIT%sales) enormously. Generally, that’s good for our bonus.

Now, like I said, a lot of assumptions here, so don’t get too excited, but I think the impact to cash flow, while negative, won’t be catastrophic, and EBIT is actually more likely to rise than fall as a result of the sale. Coupled with a strong first three quarters in 2014, I would still suspect the STIP will be solid. But please, don’t pull a Clark W. Griswold Jr. and write a hot check on a new pool based on what I just said.

I said there would be a second thing to consider, so let’s jump to that now.

The Philosophy of the STIP

The idea of the STIP is to reward consistent, good performance of the employees by giving them a bonus related to the company’s success, which they’re a primary driver in. The moves to tie the STIP score with not only company, but program and individual performance signal this as well, and I think what they created is philosophically consistent with that, even if the sub-systems aren’t perfect (buy hey, what is?).

The performance and sale of the Tulsa facility are very far removed from any impact that you, as a first-level employee, can have. As my fellow MBA and friend Nic Hovey wisely pointed out, the Tulsa sale was a strategic decision, not a performance issue.

As such, I think the best way to handle the STIP score for employees this year, for better or worse, is to generate two sets of financial data, one that includes the sale of the Tulsa facility and one that doesn’t. It’s fairly likely that we’ll do this anyway; the Tulsa sale is a significant one-time event, and it really skews the data if you’re looking at it to glean our company’s trending performance. I realize part of the allure of the STIP score is to generate one score for the entire company (at least, for the 70% of the score that comes from the company’s performance), but the truth is that at the executive level, the job descriptions and influence are very different from ours. Maybe in cases where there’s a significant standalone event like acquisition or disposal of business, there should be a “performance score” based on the trend and a “strategic score” based on the overall results.

I should mention, as I say this, that I think it was probably a good strategic decision and that our leadership should be rewarded for that. I don’t have anything against Mr. Lawson or any of our other management; I want them to be paid abundantly well for their good efforts and decisions and I hope they feel the same about me/us. The reality is that their sphere of influence is much different than mine, and it should be acknowledged. If management makes good strategic decisions and the workers don’t execute, the reward structure should match that. If the workers execute well within a bad business setup, rewards should match that. If everyone knocks it out of the park, let’s all share the bounty. Lawson’s got tons more experience than me, a lot more knowledge, and far more stress due to his position. He should be paid accordingly as long as he’s making good decisions at his level. The same is true for all employees.

Final Thoughts

I apologize if I soapboxed too much for anyone. Overall, I would not be surprised if the STIP was still a 2.0, and I would be very surprised if it was <1.0. For one, the Tulsa sale shouldn’t negatively impact our financials enough to sink 2014, as detailed above. Second, since we don’t know what the STIP targets are or exactly how it’s calculated, for good or ill, whoever dishes out that score has the ability to fudge it a bit anyway. And like I mentioned in the last report, think it would be wise to have a good payout this year considering the mistrust that a huge letdown would cause after 3 quarters of expecting something big. Third, I believe that the Tulsa sale was a strategic and not performance related event, which is likely to be acknowledged by top management in some form or another.

But, I’m not the decision maker. Don’t write that pool down payment check until you hear from someone with more corporate muscle than me.

Good luck, happy new year, and see you all in a month for the year-end summary!

Ready for some horrible, completely unfunny, Halloween-based jokes about the earnings call Friday?

Spirit spared the tricks and gave us all treats.

Spirit is all dressed up for a scary-good quarter.

Spirit’s financial results are rising from the grave.

The full moon is out and Spirit has turned into an earnings monster.

Having now sacrificed all dignity and credibility with those terrible half-baked jokes, let’s dig into Spirit’s 3^rd quarter earnings. The short summary for those who don’t want to read the rest is in the form of a single question:

What will you do with your bonus?

At this point it would take financial Armageddon for us to not have a respectable STIP payout this year. As I’ve said the last few quarters, don’t come at me if that happens; we’ve certainly seen it in the past. However, because Spirit has raised their financial guidance three times this year, the amount of egg we’ll have on our face if we drop a bomb in Q4 it would probably cause heads to roll at a very high level. That’s speculation from a mere peon, but the level of trust that it would shatter would be monumental. Given that, I’m choosing to believe that Q4 will be mostly good as well, and I’m preparing my bank account for a big deposit early 2015 :). I will also note that since I’ve started sending these out at large, we haven’t had a major forward loss. I am prepared to take a disproportionate amount of credit based on this correlation.

First, let’s go over what was said in the call, then we’ll look at a summary of the financials, and finally I’ll do my best to explain anything that stands out. Click here for a good summary; if you read one thing (other than this email of course), this is probably the best resource. It mixes plain-English statements about our performance with supporting financial data.

Earnings Call with Larry Lawson and Sanjay Kapoor

Points of interest from Mr. Lawson’s and Mr. Kapoor’s presentations:

• As of this quarter, Onex is now fully divested and owns no shares. This is a new era for Spirit as a company, as control of the board is now fully public without a majority shareholder holding the reigns.
• Happy Halloween to you too, Mr. Kapoor J
• Operating margins are ridiculously good now. Both gross and net. As a reminder, here’s what operating margins are: they’re the amount of profit (revenues minus expenses) that we made compared to the amount of revenue we brought in. Gross profit margin (also “operating income as a % of revenues”) is an indicator of how good we are at our core business of turning metal into airplanes and selling them for more than it costs us to make them. Net profit margin (also “net income as a % of revenues”) also indicates how strong we are at our core business, but includes some other factors like debt-load and taxes. 9.9% net margin is pretty darn impressive, and we should celebrate that. Good job everyone J.
• $0.16 of $1.20 earnings per share (EPS) were from favorable cumulative catchups. It’s sort of (but not exactly) the opposite of a forward loss. We made unexpected improvements in the last quarter that caused our performance to exceed our own expectations. Again, congratulations!
• One noteworthy expense that we should expect in the future is investment in facilities to support rate increases. This will be an expense that will affect our cash flow, but will reap long-term benefits. To illustrate this on a smaller scale: my grandpa used to own a trucking company – this would be like him buying a new truck on loan with a monthly payment. It would cost him money in the short term while he was making payments on it, but it would enable him to do more or faster business.
• Spirit saved a lot of the free cash flow we had available this quarter. Like, in a literal sense, put it in a savings account. I’ll talk about this later.
• For my friends on the A350, the immediate financial impact from staffing down, both overseas and locally, was apparent this quarter. That’s not to say anything about the long-term impact, but it certainly made this quarter look different.
• From this isolated quarter, it seems that the wing segment has balanced out, even without a sale of Tulsa or an offloading of the troublesome Gulfstream programs.

Okay, so as usual, the interesting stuff was in the analyst questions. And to reiterate my standard warning, it was a good quarter, and good quarters tend to be boring. I prefer positive and boring to negative and interesting, but it does make it that much more difficult to write an engaging summary.

Analyst Q&A:

• Q: Lawson’s grand cost improvement strategy… what inning are we in?

o   A: Lawson says we’ve shifted from labor-focused cost improvements to supply chain and overhead. He said to expect more marginal improvements in the future. He also mentioned (likely accurately) that the full financial impacts of the cost saving strategy are yet to be felt or fully manifest in the financial statements.

o   Travis: In layman’s speak, that means that there aren’t likely to be mass layoffs in the immediate future, and that Lawson believes we have a roughly right-sized workforce at the moment. To answer in the vernacular of the original question, I guess I’d say 7^th inning stretch. But that’s coming from some guy, not your CEO. Your mileage may vary.

• Q: Regarding the strong results for this quarter, is this a new baseline we should expect? Is there something specific that made these results so good?

o   A: Mr. Lawson says again to expect marginal and steady improvement in the future as we run out of changes and non-recurring costs.

o   Travis: Our business is maturing, or at least, entering a period where a majority of our current programs are mature. We have some major programs like A350 and 787 exiting the bulk of their developmental period and transitioning to a production environment. Spirit is pretty great at that part, and simply by definition, we need to make planes to make money, so it makes intuitive sense that as our programs mature, we’ll shift into an earnings mode.

• Q: Spirit’s accounts receivable increased notably this quarter. Is there something behind that?

o   A: Sanjay says it’s a timing issue. Which it is.

o   Travis: This was kind of a surprising question for an analyst to ask, I felt, and Mr. Kapoor’s answer was as succinct and accurate as it needed to be. In fact, I only included it to give a short little lesson. Accounts receivable is like a tab for products and services that Spirit has provided. Accounts receivable (A/R, AR) count toward our assets and revenues, but not to our cash, as we haven’t collected yet. This goes back to what I talked about last quarter, where we could be “profitable” but still “cash negative.” Though that wasn’t the case for us this quarter, in a high-capital industry, these things do tend to shift. A personal example to put it in context is “magic month” – the month when you get 3 paychecks instead of 2. Since there are 52 weeks in a year, 26 paychecks, an average of 2 per month leaves 2 checks unaccounted for. Due to nothing more than timing, your personal cash inflow for those two months of the year will be 1.5x your normal, even though you’re doing the same work every day and week.

• Q: Since our cash flow is improving and stabilizing, what do we plan to do with all that cash?

o   A: Larry chuckles. As he said in his introduction summary, we may invest in equipment or supply chain improvements to become more efficient, we may invest for growth, or we may do some dividends/share repurchases. Ultimately, it’s in the future, and we’ve been focused on the operational side, so we don’t have a firm and specific plan for use of the cash.

o   Travis: Ooh. Question of the day. Well done. The guy asking essentially wanted to know if Spirit shareholders could expect a dividend policy given our improving cash flows. If you don’t know what a dividend is, it’s a cash payment that the company rewards to stockholders for each share they have. For instance, Exxon Mobil (XOM) issued quarterly dividends of $0.69 per share in 2014. Dividends are a way for a company to keep investors interested when their capital appreciation (stock price, essentially) is limited in growth. Microsoft, as an example, is used worldwide on a huge majority of computing systems… they really can’t grow that much anymore and are a cash generating machine. Now, regarding Larry’s answer. Ready for my CEO-speak? Don’t put the dividends cart before the operations horse. We have to reliably and consistently make high cash flows before we think about utilizing them for activities outside our current core business. Mr. Lawson may have given a non-answer, but it was the correct one in my opinion. We’re still focused on stabilizing Spirit and making it a reliable, lean, efficient business, and it’s a bit premature to be asking about dividends. Still, a very good question to ask to prime our senior leadership for the future, because if we keep seeing results like this quarter, the dividend question will only come up more and more. It also inspired the short lesson for this quarter that you can find below.

• Q: What is Larry’s goal for our cash flow conversion rate?

o   Travis: Honestly, I don’t even remember what response was given to this question, because to me, the question itself is indicative of our performance. When we start fielding philosophical questions in the earnings call, you know we’re doing well. Who really cares what Lawson’s philosophy on FCF conversion is? If we were on a sinking ship, we wouldn’t be stargazing, pondering philosophy. That’s why these kinds of questions are always encouraging to me. As a lesson, what is “cash flow conversion”? Just like our operating margin (operating income / revenue) shows how good we are at our core business, and our net margin (net income / revenue) shows both how good we are at our core business and how well we’re structured financially, cash flow conversion (cash flow / revenue – currently around 4%) shows how good we are end-to-end, from revenue to the bank. Cash is king. How much revenue and profit we make are moot unless we generate cash. Fun fact, this was one of the major “forensic accounting” red flags that got Enron caught. They advertised their growth in revenues and profits, but they never had any cash. It tipped savvy analysts off to the fact that they were artificially inflating revenues, but in the actual here-and-now, they were flat broke. If you’re interested in a great read about that, check out this link. In particular, see Table 3 for what I’m talking about with cash flows being a clue to funky accounting.

One more comment on the call, and it’s just my personal opinion so you can skip it if you’d like. Honestly, I’m getting to like this Lawson guy. I only spend an hour with him every quarter, and even then we’re not exactly talking as close friends, but his demeanor and his answers on these calls have been pretty appropriate, with few notable missteps. I don’t work close to him at all, but he mostly talks in plain English and gives straightforward answers as much as possible. He doesn’t come across as cocky the way some sort of “pump and dump” turnaround CEO might. I tend to ignore the staged videos and interviews because they can be scripted and edited. The calls are live and are high pressure. They’re as close as I can get to seeing him at work, and more and more I like what I see. Sure, I’m making a ton of guesses here, and I could be wrong, but I think we’re in pretty good hands, and hopefully we’ll start seeing the benefits to our own bottom dollar very soon.

Suggested Mini-Lesson

Where Does the Cash Go?