Instead of my usual format where I comment point for point on the earnings call, I want to talk about some highlights and explain some concepts in context in an attempt to teach more than just inform. As always with these quarterly write-ups, comments on the usefulness of my email are encouraged and more than welcome. This is something that affects every employee deeply and is probably not understood or explained at the level I think it should be. On top of that, I love teaching and helping people grow, and I hope these emails do exactly that.
To hit the high points, Spirit accounted for a $587M forward loss, mostly attributed to the 787 program (which I think was a surprise to those of us on A350). However, on the positive side (and Mr. Lawson was keen to emphasize this given his focus on cash flow), our adjusted free cash flow was a positive $57M for the year. So what do these things really mean, and what do they have to do with each other? More importantly, how do they relate to the future of Spirit Aerosystems?
Understanding “Profit” and What the Forward Loss Is
First of all, the forward loss. It was the big thing on everyone’s mind, including Spirit’s securities analysts, so a lot of their questions revolved around it. To understand what this actually is, you have to know that profit is perception. Profit is just a number. Profit doesn’t fill out your paycheck or pay for your equipment or whatever else; it’s just a comparison between inflow and outflow.
Looking at a snapshot in time, profit is easy to understand. Take how much money you made and subtract how much money you spent in order to generate that money. Profit is just revenues minus expenses. If you sold $1,000,000 worth of product and all associated costs (the price you bought the product or raw materials at, salary of your employees, cost of rent and equipment, etc.) came to $900,000, you would have made $100,000 in profit. There are some more accounting nuances involved, but that’s the basic description. You guys are smart, number-oriented people, so that’s probably old news to you.
What gets a little more twisted is when we talk about future profits, because there are lots of moving variables. When we make estimates, we make lots of assumptions. This is natural and expected. When the estimates are wrong, we have to adjust, because we have to be able to set honest goals for our company’s performance as well as give reasonable guidance to shareholders. It’s actually the law for public companies. But of course, when we make predictions, we can be wrong. And sometimes, we’re wrong to the tune of $587M. The forward loss is acknowledging this gap between an older estimate and a newer one. Check out the illustration below.
So a forward loss can happen when we don’t improve as fast as we thought we would. It’s pretty common, in manufacturing as in life, that the first time you do something is the slowest. You’re figuring out how to do things and just trying to get it done at all. As you keep going, you get a little more practice and the process becomes quicker and cheaper. When you understand the process, you can make changes to do it better and faster. After you’ve done a bunch, you get some sort of equilibrium where you really can’t feasibly improve anymore. This is where programs like 737 are at and why they’re so profitable – we can churn them out fast, consistent, and cheap. New programs are harder to predict and carry significant penalties for not improving as quickly as planned. In a sentence, the money lost in a forward loss claim is not like a check that Spirit writes, it’s future profits that we won’t make based on our current performance and improvement numbers.
Why take a forward loss? In accounting terms, taking the penalty for a forward loss now, in one big chunk, allows us to “officially” base our estimates on the revised curve. Essentially, instead of taking diminished profits over time and saying “Oops” on every unit that rolls out the door, we say a BIG “Oops” up front and move on with our lives.
One of the analysts on today’s call asked a very good question when he noticed that the profitability curves for 787 specifically seemed to indicate less profit in early 2014. We took this big forward loss to account for 787, so why is it still estimated to be less profitable in 2014?
The answer is that the graph above only illustrates cost, which is only half of the inputs of the profitability equation. The other is revenue – money we make from the sale of the product. Spirit has negotiated stepped pricing with Boeing, meaning we get paid less and less for later airplanes. This is why efficient production is so important; both cost and profit need to be improving, and since the revenue side of the equation actually decreases over time, cost has to decrease even faster in order for profit to increase. Confused? Here’s a happy graph.
In this example, you can see profit changing as a function of both revenue (sell price/unit) and cost. At point (A), we have high costs because we’re early in the production phase, and we also have high revenues that we’ve negotiated with our customer to sustain us while we figure it out. At point (C), our revenues are lower, but our profit is the best it’s ever been, thanks to improvements in the production process. What we’re coming up on, and what the analyst was concerned about, was point (B), which we apparently have happening soon, where revenues are declining, and thanks to our missed improvement curves, our costs are still high. Hopefully these two graphs illustrate why becoming cheaper and more efficient in manufacturing have such a huge impact on our profitability. The last graph illustrates where Spirit seems to be and why the forward losses are such a concern.
The purple dotted line shows a new cost/unit curve where we don’t improve as much as we thought we would. You can see that this significantly eats into the profit of the overall program (the area between revenue and cost along the entire duration of the program). Now at point (C), when we should’ve been making a ton of profit per unit, we’re still barely scraping by. I didn’t illustrate it, but it’s possible that the lines cross, and you take an actual loss on each unit. As in, Boeing pays us $100M for each fuselage and it costs us $110M total to make them.
Why Does it Matter?
Well, obviously if we cross the streams and we spend more than we make, we’ll be out of business fast, just like a household that spends more than it makes will eventually run out of cash and miss its bills. But let’s assume that that doesn’t happen, and ask why our profit and profit margin matter. If we’re making money and paying our employees, who cares about profit?
We all probably understand that wildly profitable companies are better than their unprofitable or marginally profitable neighbors, but it may not be clear why. Ponder the following question:
Why do people buy stocks?
A stock is just a little piece of paper (or these days, more likely just pixels on a computer). You can’t eat it, you can’t use it for shelter, you can’t rub it on your body to prevent sunburn. It represents nothing more than a little sliver of ownership in a public company. Again, who cares? Why own a piece of a company?
Well, to make money, right? Stocks are supposed to have good returns – we’re all staking our retirement and wealth on stocks going up in value over time. But what makes that happen?
To put it simply, you buy stock in order to share in the future profits of a company. This can happen in many ways: the company can pay dividends to shareholders, the company itself can increase in value by gaining market share, improving their processes, creating a new product, etc. But if the company isn’t doing those things, people won’t want to be associated with it. They won’t want to own it. And this creates a death spiral – without support from investors, the company will then become unable to make big investments, create new products, improve their efficiency. And when that happens, a company can capitulate to irrelevancy or death. As a public company, we need people to want to be in business with us, to invest in our stock so that we can make big moves and grow. If we have no prospect of future profits, that won’t happen, and we’ll be bought out, become irrelevant, or shut the doors.
How Does Profit Impact Cash Then?
During the call, a neighbor of mine asked a great question: if we took this big forward loss, why did Spirit’s cash and debt balances barely change at all? This really illustrates the difference between profit and future profits. If, in the 4th quarter of 2013, we sold $1.5B worth of planes and it cost us $1.4B (and if the transactions in both directions were in cash), we would have $100M in real money to do whatever with – put into savings, buy new equipment, give bonuses to employees, or offer dividends to shareholders. The forward loss will have practically zero impact to cash presently, but as the “forward” part of the loss becomes the present, it will have a profound impact. For past losses, they’ve announced a quarterly cash flow impact. It might sound something like this:
“Our forward loss of $600M (profit) will manifest itself as a $20M impact to quarterly cash flow over the next 4 years.”
Analysts requested such an impact to cash flow from Chief Financial Officer Sanjay Kapoor, and as far as I could tell he dodged it, which was frustrating to me, and, I believe, to the analysts.
So What’s the Future of Spirit?
As always, you can’t determine this from a single quarter. Unfortunately, I think there’s a significant lack of trust in Spirit. Spirit has projected positivity and growth several years running, and has disappointed fairly consistently. This shows up in the stock price, in the analyst ratings, and in your bonuses. Remember that you buy a stock to be part of the future profits the company is going to generate. If you don’t think there will be, you won’t invest. If you don’t trust the company’s leadership for whatever reason, for instance being burned with big, billion dollar surprise losses too many times, you probably won’t invest. As one analyst asked, how can we be sure we’re really done with these losses, especially when we’ve been told we were done before? Both performance and trust determine who wants to be on board. We need to perform to prove ourselves and stay trustworthy as a company.
In spite of this, there are several positives. For one, as Mr. Lawson pointed out, Spirit’s backlog is enormous, and our revenues are steadily increasing. We might have screwed some things up, but we’ve got a pretty good cushion to get it right, given the amount of work we have in the pipeline. We’re also cash positive, which indicates that some of the cost savings measures and quality focus metrics are having an effect. And, though there’s a lot of uncertainty about Spirit’s new leadership, we have to all keep in mind that Spirit is a pretty big company, and it’s going to take some time to steer this massive ship. Great transitions aren’t always obvious when they’re happening, and I’m encouraged that Mr. Lawson has a vision but doesn’t project himself as the hero CEO who’s going to swoop in and get this thing working right away. Those guys rarely move companies into a fruitful future.
So, as we saw this quarter and with the 2013 summary, there are going to be bumps along the way. I won’t lie and say things are super rosy. Each loss like this does eventually affect Spirit’s bottom line, affects our job security, affects investor confidence. There’s reason for concern, but not reason for panic. Spirit has many things going for it, and lots of signs of life. We’ll see if our new leadership’s vision begins to manifest in earnest in 2014.
Please feel free to distribute this email to anyone you believe will find it useful or interesting. Thanks for reading,
