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!

Howdy folks! It’s earnings time again at Spirit, and it’s the special one that not only has the 4^th quarter results, but also the year-end summary.

For folks who enjoy finance and numbers, this is “The One with Bonus Information.” For those of us who just enjoy bonuses, this is “The One That Matters.”

Let’s start with the usual summary, and throw in some of that delicious bonus information. We now know Spirit’s full-year performance, so we can compare ourselves against our financial guidance and see how we did!

And for good measure let’s throw in the cash statement too:

Okay, there’s a lot to unpack here, and I’ll try to keep it quick.

The word on the street regarding this quarter is… not good. Our shares were down between 4-6% all day, which is of course never a good look. However, myself, my finance buddies, and (most importantly) Spirit’s Chief Financial Officer, have a more… nuanced perspective. Frankly, I find the sharp drop in share price to be a bit of an overreaction.

Before opinion, data. Here’s how Spirit’s full-year numbers stacked up against our latest revised guidance and our original 2016 guidance. Let’s also include what we said for our 2017 guidance to see how we expect these to change this year as well.

Remember that we adjusted earnings guidance as a result of the A350 long-term pricing agreement in Q2, and that while we took a forward loss to do so, it was generally hailed as a good thing. Our stock was up 7% or so on that earnings day, despite a forward loss, despite lowered earnings guidance, because the deal signaled stability. This resulted in the creation of an “Adjusted EPS” flagnote with a difference of $0.86/share from GAAP earnings (Generally Accepted Accounting Principles – the Big Book of Formulas that companies have to use when presenting accounting info).

Our “official” earnings guidance is the second row above – we started the year expecting $4.15+ (Q1), lowered it by $0.86 or so to account for the A350 write-off (Q2), then raised it a little to account for better performance (Q3), and finally, closed it off in Q4 by beating our adjusted target and coming right in line with our official one. Confusing? Well, it’s all part of being honest – we adjusted our expectations as business items changed. Ultimately, we performed pretty well and reported it as honestly as possible.

So, why did our shares go up when we took the forward loss and lowered guidance, but down when we performed on-target to prior guidance? If it was a problem, why wasn’t it a problem then but it is now?

I have no idea.

Maybe someone smarter than me will reach out after reading this and inform me, as they often do. Maybe Wall Street is just a fickle mistress. One article led with “Spirit AeroSystems profit falls about 22 percent”, which is… true-ish; Q4 2016 net income was down 22% against Q4 2015, though our adjusted EPS in 2016 was 16% higher than 2015, so it’s not exactly like our profits are in freefall.

Alright, real talk. What I suspect is happening isn’t so much about the current numbers, but about the forecast. It’s not that we performed badly in 2016, it’s that the impacts of certain market shifts are at least as heavy, if not heavier, than the analysts predicted. A more telling article gives the following reasons for the gloomy outlook:

• Quarterly revenue was hurt by lower “pricing terms” for Boeing’s 787 program and fewer production deliveries on the 747 and 777 programs
• Boeing cut production of its cash cow 777 jetliner by 40 percent this year as it focuses on newer models
• Spirit also forecast 2017 profit and revenue below analysts’ estimates (our guidance was revenue of $6.8-$6.9B and earnings of $4.60-$4.85, analysts expected $6.92B of revenue and $4.86 of earnings)

We’ll dig into a few of these issues in the Q&A, but that’s my speculation on what’s happening. 2016 was fine, but 2017 looks like it might be a little soft, especially early on. What we inside Spirit are taking into account are the things on the horizon: 777 is declining, but we’re positioned for when 777X hits the market (we’re cannibalizing our own business, which is a good thing). We have rate increases on core programs, and we have new stuff that we’re looking at all the time. Markets don’t necessarily care about that. If we’re going to enter some doldrums in early 2017, investors are within the bounds of rationality to go elsewhere and come back when the wind is at our back again.

Yyyyyyyeah. Little bit heavy for an intro, huh? Luckily, the Q&A section is short this quarter. Let’s meander through the call and head boldly forward into 2017.

Executive Intros – Tom Gentile and Sanjay Kapoor

• From the results, you can see we hit well within our 2016 guidance.
• Big milestone: we achieved cash positive production on A350s! This even got its own slide in the earnings call presentation – see Slide 10 of SPR_2016_Q4_Presentation. This also means we’re now working to reduce the deferred inventory balance on the program, which is a great line to cross.
• We suffered a $0.14/share earnings decline due to Kinston hurricane recovery and the voluntary retirement program. Spirit’s a neat company but we don’t control the weather. Expect some positive adjustments for an insurance settlement someday.
• We made fewer 747 and 777 deliveries as demand for those is sunsetting. (This was a major theme of the call)
• Higher A350 deliveries, yay.
• Higher non-recurring revenues on development programs. (Hey, engineers made the company some money!)
• Achieved 6-8% target of revenue to free cash flow generation. (Like margins, cash flow conversion rate is a quick metric for tracking how efficiently Spirit’s financial machinery converts payments from customers – revenue – into money we can use – cash. We started talking about this rate a number of years ago theoretically, and now it has some actual parameters we try to hit)
• Volatility related to the Presidential election caused some caution in our cash deployment. (Heh, we’ve probably all had about enough of this subject, but basically, Spirit didn’t want to make any kind of drastic investing moves in the always-turbulent environment of election season)

Overall, pretty positive, nothing dramatic or overly exciting. But apparently the analysts had some fire in their bellies. Let’s get to the Q&A.

Analyst Discussion

Before getting to the actual questions and responses from our top brass, here’s a simple version of what analysts were asking about. It seemed, to me, a much narrower range of topics than recent quarters, but a bit more critical. Again, not sure where it was coming from, but that was the sense I got.

Top issues:

• There was quite a lot of heat on the Boeing long-term pricing agreement. I don’t know how long an agreement of this magnitude typically takes, so I can’t opine on it, but it seems like the analysts have gotten sick of being stiff-armed on the subject for a healthy handful of quarters. Tom/Sanjay seemed resigned to indicate that it has indeed gone on for quite a long time, but unfortunately no resolute news yet.
• What are we going to do with the $600M expected for capital deployment? Specifically, are we closing in on any ideas for mergers/acquisitions? I’ll discuss this in the questions, but I did observe that Tom and Sanjay spoke with a lot more specificity when the subject came up, so I’m inclined to believe that they’re getting a better idea of what they want to do in this arena. Stay tuned.
• What’s the outlook for the near-term future as 747 and 777 slow down? I think this is why our price was down. It seems like we’ve got a lull coming first half of 2017 until some of our other programs speed up or come online.

Q&A:

• Question: Your presentation says you’ve got $600M in cash deployment scheduled in 2017 – what’s the plan for that? Any inorganic opportunities?

o   Tom: We still feel that share repurchases are a good investment as we believe we’re underpriced compared to our peers. We’re looking to be more consistent, rather than opportunistic, to maximize shareholder return. We are still looking at inorganic stuff this year, including some vertical integration for higher margin tier 2 fabrication stuff and maybe some military stuff.

o   Travis: This was a pretty big one. Quick reminder: inorganic growth means mergers/acquisitions, where organic growth is adding to our usual business. Until now, our Commanders have kinda kicked around dirt in the merger and acquisition department, with a sort of “some of this, some of that” vagueness. But throughout this call, we started to hear some details. They look to be focusing in on utilizing our current fabrication expertise to start building parts that aren’t necessarily fed into larger subcomponents headed to our big OEM customers. It seems likely that we’re leaning toward vertical integration – building and selling more parts rather than expanding our major program assembly portfolio. With our “regular business” we’ll probably keep bidding programs like we always have, so count on this to be additional scope, not a replacement.

• Question: Boeing pricing negotiation.

o   Tom: It’s still an active negotiation. It’s still ongoing. We do know it’s been going on a long time and we want to get it done. We can and are working to control our internal costs and value so that whatever comes out of it, we’re prepared to do as well as we can.

o   Travis: No news here really, but another quick reminder on why this is important. 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. Still, it illustrates how important and influential to our success these agreements are.

• Question: On making investments, talk more about vertical integration and 3^rd party fab, and how it translates into a long-term strategy.

o   Tom: We’re already one of the largest parts fabricators in the world. It’s all internally consumed though. However, in both commercial and defense markets, there’s some opportunity to sell those abilities outside our current scope. That market tends to be high margin, another plus. It also helps us with getting to an optimal supply chain setup. Regarding timing, we’ve already started on this, with some tangible revenue expectations in place for when we enter that business.

o   Sanjay: It’s also in line with what we already do. In many cases we already have the equipment, the space, and the experience. The market is there and we can already play. It’s potentially both a revenue and a margin booster.

o   Travis: There you have it. The reason we’re looking to expand vertically (doing more Tier 2 business alongside our regular Tier 1 stuff) is that, well, we already do it. We’ve already got the knowledge, experience, equipment, and space. And it seems like a good market to be in, with plenty of activity and lots of profit to capture.

• Interjection from Sanjay: He jumps into the conversation to say he’s been reading reports this morning. He hammers that various things happen quarter to quarter, that our guidance has been good, and that you have to look at the trends and segment margins to eliminate some of the concern over what happens on any given day.

o   Travis: This was an interesting deviation. Reading over this, I don’t think I’ve captured how antagonistic some of the questions were… and of course our share price being down 5-6% was its own sign. But Sanjay was completely right to jump in here. We hit our guidance, disclosed everything the best we could, and explained some of the dynamics in play over the long term. The analysts wanted a miracle; we gave them reality. Reality we had accurately predicted for them, no less, but I guess it wasn’t enough. I’ve ranted before on my irritation with the staunch focus on quarterly results over trending data, so I won’t do it again. But it bit us here. Such is life.

• Question: Okay so when we talk about next year’s guidance, we’re saying that 777 is declining, and 737 is increasing, but there’s some mismatched timing?

o   Tom: Yeah, we suffer from lower 777 rates through the full year and only benefit from about 6 months of 737 increase. So 2017 is uneven, but it’ll even out in 2018.

o   Travis: Here we have what I believe is the smoking gun with respect to the share price drop. It wasn’t bad numbers, it was the expectation of a soft open to 2017. Shareholders are well within their rights to take a walk if they believe business won’t be booming for the next 6 months.

• Question: Can we discuss revenue on B-21? Will we see defense impacts in 2017, or later?

o   Tom: No, it’s classified. Capital investments have been incorporated into guidance though. These programs have a lot of ramp time, so don’t expect material changes quickly. However, looking at 3^rd party business, we can capture that more immediately and that constitutes some growth outside of our current business.

o   Travis: The analysts’ last gasp for things that might make the first half of 2017 rosy. How about that secret defense thing you’ve been doing? Tom says it won’t affect us materially (aka notably or tangibly) until later on. Though our 3^rd party efforts (maybe including an acquisition or something) might close the gap a bit.

And that’s that!

At this point, we have confirmation in the form of our STIP score that the execs thought we did a fine job internally in 2016. If you were looking for confirmation that STIP is not secretly tied to stock price, here you go.

We did well, and the market reacted strongly to some of the risks we’re facing early this year. It happens. We know what’s on the horizon, and it looks pretty swell too. So we’ll keep doing our thing and see what 2017 brings!

You may also read the short mini-lesson titled “The Sweet Spot.” It was inspired by a question sent to me in a prior quarter, which I appreciate.

Thanks again… let’s go do 2017!

Whew, what a quarter.

This quarter’s call was equal parts entertaining and encouraging. There’s a lot to talk about, even if the call itself ended early (!!!), so let’s jump in!

Financial Summary

Let’s start with the top-level summaries that Spirit provides.

When looking at the year over year results here, it’s important to remember that Q3 2015 was buoyed up by a big one-time event in the deferred… tax… asset… thing. That’s why net income and earnings per share look like they’re way down in spite of better performance. The company provided the adjusted line (highlighted by me) to illustrate this. Cue usage of the term “lumpy.”

You may also note that the share count between the quarters is noticeably different. This is what we bought with our share repurchase program. It compounds the effects of our growth in net income by spreading those earnings out over fewer shares. The results are… well, see our stock price and STIP score.

Moving on to cash and liquidity, we see here Spirit’s continued aversion to having a billion dollars in the bank. Not that the share repurchases aren’t legitimate or helpful – we can see that in the first table – just that I continue to find it funny that whenever we would push past a billion in the bank, we throw down some cash somewhere. In this quarter, we spent $332M to repurchase 7.4M shares – without that purchase we’d have been at $670M (current balance) + $332M (share repurchase) = $1.002B. Lookie there.

This quarter, we once again positively revised our full-year guidance. What I’m about to do here is far from scientific, but it’s some interesting back-of-the-napkin math for you.

We revised our revenue guidance up 1.5% at the midpoints ($6.75B / $6.65B = 1.015), which is a pretty modest increase, but earnings per share (net income) increased by 5% ($3.725 / $3.55 = 1.049), and free cash flow by 10% ($412.5M / $375M = 1.10). Here’s a table, because table:

Keeping in mind what the various numbers mean (revenue is what we’re paid, earnings are what we keep, cash flow is what we bank), that’s telling us that we’re becoming more internally efficient. We’re growing our profits and cash flows at an outsized rate compared to revenue growth. In other words, capturing more of our revenue as profit rather than expense. All of those cost reduction efforts we’ve been talking about can be seen right there. Bullseye.

We’ll talk about this more throughout the summary, but the new dividend was obviously a big deal. We’ve talked about dividends a bit in the past, and how they, along with share repurchases, are a way of giving money back to shareholders and proactively controlling both internal financial metrics like earnings per share and external ones like share price. Mr. Gentile doubled down on Larry Lawson’s old message: we’re seriously undervalued in the market. Mr. Lawson engaged in the share repurchases to use our cash flow to strengthen our financials and show his faith in our consistency. Tom’s administration hammered down what Larry had committed to, then committed to more, and then kicked in a dividend, as if to say, “Still don’t think we’re underpriced? Watch this.” It was bold, and I dig it. Clearly, the street did too.

My overall thoughts out of the way, let’s get to the call!

Tom Talks

• In the press release and in his speech, Tom’s first statement was this: “We remain committed to a balanced and disciplined approach to capital deployment by utilizing all the different mechanisms in an opportunistic and timely way.” In non-CEO speak: $600M in shares wasn’t enough? Okay, double it, add a dividend, full steam ahead.
• Tom posits that it’s fitting to offer a $0.10 quarterly dividend to celebrate Spirit’s 10 years as a public company. It’s a cute number to start with. $0.40 annualized dividend yield on a $50+ share price is pretty meager, but it definitely sends a message.

Sanjay Talks

• Mr. Kapoor starts in on the numbers, first highlighting a 7% revenue increase year over year ($1,594 to $1,711), primarily from A350 and 767 deliveries
• Adjusted earnings per share experienced a 30% y/y increase ($0.89 to $1.16). Lower share count from repurchases helps in this, of course, but so does internal performance (net income). With the adjustment, year over year net income increased from about $125M to $145M (16%). We both increased the numerator and decreased the denominator of the earnings per share equation. Sweet.
• We nearly tripled our free cash flow y/y ($76M to $214M). Main drivers were capital expense budget and schedule, plus 787 and A350 performance.

Pretty straightforward and brief executive introductions, per the norm.

On to the questions. I didn’t parse out anything, so this is a commentated dump of my notes from the call.

Q&A

• Question: How big is the new 787 block and what kind of margin are we expecting on that?

o   Sanjay: 500 units. Can’t tell you program margins dude =P.

o   Travis: If you were playing Earnings Call Bingo, here’s your free space – analyst asks about a proprietary internal number that we won’t share publicly, gets told we won’t share it publicly.

• Question: There was a small-ish one-time benefit on A350. What was it? How do we see the program turning cash positive in 2017?

o   Tom: It basically comes down to efficiency and a lot of the cost savings efforts we’ve undertaken. It’s representative of a maturing program in a maturing business.

He continues to talk about some of the specifics in Kinston manufacturing and efficiency.

o   Travis: I don’t have good quotes from Mr. Gentile on this, but I don’t want to undersell it. Tom sounds like he’s impressed with the business, and really enjoys the details. His answer demonstrated a rapidly increasing knowledge of the business at a working level, and honestly, a passion for a lot of the initiatives we’re undertaking.

• Question: Regarding cash usage this quarter – completing Lawson’s share repurchase program, initiating a new one, announcing a dividend; it seems like things are going even better than you thought. What gave you the confidence to make these new moves on cash deployment?

o   Tom: Rate increases on 737, 787, and A350 give us lots of embedded, organic growth. We’re also pushing hard on cost reductions via supply chain sourcing and utilizing our buying power for raw material purchases, so that gives us a great cash outlook in the future. But over and above that, looking on the horizon we see promising new work with a high likelihood. We’re also exploring inorganic growth that would give us higher access to Airbus programs.

o   Travis: I’d like to say that the difference in Tom’s knowledge is notable between his first quarters and this one. He’s confident and well-informed, even at a highly granular level. Sometimes it’s easy to think of executives/CEOs… differently. Whether that means some sort of secret cabal, figureheads with no real impact, or whatever else, it’s been very cool to observe the real world and listen to Tom through the handful of quarters he’s been our top officer. I feel like I’ve bragged on Sanjay quite a bit in the last few quarters, but it’s Tom’s turn this time. He’s showed the transition from new hire to deep engagement at the executive level, and is now showing skillful knowledge of the business while maintaining the air of humility that I think a lot of us saw when he came in. Whether CEO or first level engineer, there’s an associated learning curve for anything worth doing. We’re seeing Tom go through that in real time, and it’s been a treat.

• Question: How should we look at dividend policy (and generally cash deployment), especially when talking about “inorganic growth” like you just said.

o   Tom: We still feel like we’re really undervalued, are confident with cash flow now and in the future, and as we’re always saying, “opportunistic.” We’re looking at horizontal, getting more Airbus work, and also some military work. Looking at low cost countries, expanding work with suppliers, and getting more from current partners.

o   Travis: phew. There was a lot here. We’ll talk about what he means by horizontal/vertical more in the mini-lesson, but what he’s saying here is that we’re full bore on almost every growth outlet a company can pursue. We’re bidding new work across the spectrum, looking at merger and acquisition opportunities, digging into our supply chain, and more. This is Tom’s “Keep your eyes on Spirit, big things are coming” pitch.

• Question: We’ve heard about working on supply chain agreements; how far are we into that process? Talking different terms or just pricing?

o   Sanjay: Supply chain is an obvious place to look for savings, because it’s a massive bucket. But it does move very slowly; we’re talking thousands of part numbers, suppliers, contracts. Over time, we’re trying to implement a “clean sheet” approach, where we do analysis on what we think things should cost if everything was perfect, which lets us have an honest talk with suppliers about closing that gap. It gives us leverage to talk to them, but also to help them get to where we think they should be. Those improvements very gradually work their way into our performance.

o   Tom: I see these clean sheets as reverse engineering. We look at every part we buy and ask all kinds of questions about what it should cost. For some examples, in one situation, we saved 35-40% by consolidating parts under one supplier instead of scattered over several. In another, we moved a part to a low cost country supplier. In another we brought down raw material costs by leveraging Spirit’s economy of purchasing scale. And in another, we insourced a part that we could do better than the supply base. Overall, we’re 30-40% into the journey, with a detailed, gated process in place for the future.

o   Travis: This was another detailed look at exactly how we’re employing our strategy. Sanjay points out that looking at supply chain is smart, because the vast majority of our costs come from there. In other words, you can save money by skipping Starbucks, but if you’re car-poor it won’t make much of a difference, so start with the big stuff. Tom lays out that we’re not just arbitrarily outsourcing or switching things up; it’s a tactical process that has led to a mixed bag of actions. We’re constantly trying to do the best thing we can with every single part.

• Question: M&A strategy. Trying to get a sense of the scale of the opportunity we’re considering.

o   Tom: Not just to grow for the sake of growing, but to add to our strength as a company. For horizontal, if we could find a company to get on a very attractive program within our core competencies, we’d look at it. Also looking at something that would get us into a low cost area like Southeast Asia or Mexico. Looking at improving our fabrication business, securing our supply chain, and capturing some of that available margin.

o   Travis: Once again, a whole lot here. It sounds to me like we’re still relatively early in the search for an M&A target. I interpret this as we’ve developed some criteria for what constitutes a solid growth opportunity via merger/acquisition. That’s more than knowing we want to start thinking about M&A, but less than having specific targets identified. I could easily be wrong, but I wouldn’t guess we’d hear Spirit making a tender offer on anything in Q4 2016. Partway through 2017 might be plausible. Boy, how I’d love to be a fly on the wall during these discussions though!

• Question: What does organic growth look like beyond rate increases and defense programs? Expand aftermarket as profit lever?

o   Tom: We’re bidding on a number of Airbus programs and some business jet and military too. A number of packages are out for bid. Aftermarket specifically, sure, it could grow.

o   Travis: Reminder – organic growth is the natural sorts of things we would expect, like rate increases on solid programs, securing more business from our existing customers, etc. Inorganic is when we do sort of a “step” function and buy some other company or start up something completely new. Mr. Gentile does seem to say we’re still pushing hard for organic growth and bidding on a number of programs, though the focus of this quarter has been the inorganic growth and what to expect in the future with that. In other words, Spirit still has pretty solid growth prospects, even if we don’t do something big and dramatic.

• Question: 737 deliveries down slightly in the quarter, what’s today’s rate, and was there anything unusual in the quarter? Also what rate we’re capitalized at (ready for)?

o   Tom: 42/month today, which, as a trivia fact, is almost double the rate from when we spun off from Boeing. On track for 47 early next year, and the capital is already in place. Deep into planning for 52/57 – capital is in the long-term plan. Some discussion still, but on track.

• Question: Talking bidding aggressively for Airbus work, how do we leverage lessons learned on A350, 787, and Gulfstream products in not getting ahead of ourselves on our bids?

o   Tom: We’ve learned a lot. Part of it is estimating. Some is based on program management and change control too. When I look at early contracts, they weren’t really “optimal.” We’re better at not only terms and conditions, but also change control and program management. There were some painful lessons, but we learned from them, and we’ll be able to apply those lessons going forward.

Tom doesn’t criticize the leadership early on, because they grew the company and got us on some really great programs, but we learned a lot of lessons and we’ll know to look for those mistakes in the future.

o   Travis: I just love Tom’s tone. The question was pretty skeptical, but completely justified. Long ago, there was excitement about Spirit’s growth prospect with new customers and an explosion of hot new programs. Then we got in trouble because we had committed to too much, too fast. Jeff Turner openly admitted as much in a prior call. Tom grasps both sides. He celebrates the growth that the original leadership obtained while accepting the tough lessons learned from overexpansion, and he does it with humility and steadiness. It’s really a confidence builder.

After that last question, something really bizarre happened: we ran out of questions. Sanjay asked if Tom had any closing remarks to fill the last 8 minutes or so. He offered a few quick points in summary, and we signed off. Oh, I also just have to note, the phrase deferred inventory wasn’t mentioned a single time. What a time to be alive.

Fewer questions typically means there’s less to criticize. It’s an important time in Spirit’s history… sort of an “All roads led to this moment” type of feel. We’ve been in some tough places, survived them, and came out stronger. We’re steadying our feet again, and preparing to make another leap into the next phase. What happens next? Tune in next time J.

Much of the conversation from this quarter focused around Spirit’s intentions in the realm of mergers and acquisitions (M&A). The mini-lesson “When Two Companies Love Each Other…” digs a little deeper into some of the common terms you might hear on that subject, and explains some of the opportunities and risks of these activities. Enjoy!

Happy earnings day, all!

Boy, what an exciting quarter this was! For a number of quarters now I’ve talked about how boring good performance can be. Appreciated, preferred, but a little uninteresting. This quarter was the best of both worlds – good performance and positive news coupled with some interesting financial concepts and a new personality to study in Mr. Gentile.

I’ll warn you, because of the richness of some of the ideas covered in this quarter’s call, this might be a little longer than the norm. Hopefully I’m able to add value and clarity. If not, file it under TL;DR (Travis Lane; Didn’t Read) and I’ll see you next time.

Financial Summary

Here’s the quick financial overview, then we’ll dig in:

This shows declines in incomes reflecting a one-time item occurring within the quarter, but otherwise continued strong performance.

I’ll also include the cash flow table for you to refer back to when the mini-lesson makes you curious about it:

This quarter reflected our continued evening-out on the financial front, showing a pretty good trendline from Q2 of last year on important metrics. We raised our guidance (estimates) for free cash flow, and also our earnings per share (EPS) after taking out an adjustment for a one-time item. Don’t worry, I know you’re all wondering about that “one-time item,” and I won’t leave you hanging.

Now let’s take a break before the actual details of the call to talk about the elephant in the room: the $135.7M forward loss on A350.

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. Ummmm… what now?

Context is key. Gathering context is the reason I suggest you listen to the earnings calls even if you don’t fully understand them. Breaking slightly from convention, I’m going to lead with an explanation of why this forward loss isn’t a dire sign, then fill in some of the details via the Q&A. I want to take this approach because a large portion of the questions focused on this subject, and it would be rather deep and piecemeal to try to splice a coherent understanding from just the questions below. Let’s jump in.

We need to preface with a reminder of terminology. Note that these graphs are all rough representations, not actual program performance. (Professional driver on a closed course.)

Deferred inventory 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.

Although we’ll cover more details in the Q&A, that’s the gist of the whole quarter. We took a little loss, but it was in exchange for massive gains in long-term stability (as well as cash flow). Nothing is ever final; time is rather immutable and its realities become emergent. Spirit will never be completely finished with forward losses and cumulative catch-ups, because we will never be perfect at predicting the future. But we can be pretty confident that we’re improving, and that our position going forward is as steady, or steadier, than it was before.

Now let’s get to the actual earnings call.

Executive Comments

Hey, there’s a new voice! Let’s welcome Mr. Gentile to his first earnings call session with Spirit. Tom introduced himself and laid out some of his priorities for Spirit moving forward. Other than that, he mostly said the usual stuff – talked about the Airbus contract, mentioned that deferred balances and growth on A350 and 787 are stable or improving, talked about Spirit achieving an investment-grade credit rating in the quarter (which saved us a handful of millions in refinancing debt to lower rates), and celebrated our first quarter delivering more than 400 units (I think I heard 408).

Mr. Kapoor added a few points, reinforcing our $47B backlog which gives around 7 years of revenue visibility, the $10M in annual interest we’re saving from our refinancing efforts, and the change of the A350 accounting block from 400 to 800 units. He also mentioned that Mr. Lawson’s retirement package was responsible for a one-time $0.11/share impact. Career goals: get a retirement package significant enough that it registers on a corporation’s quarterly earnings. For the curious, I’ll save you the effort of calculating: $0.11/share comes out to around $14.3M. Maybe if I run into Mr. Lawson around town he’ll buy me a Coke.

As Tom was getting warmed up this quarter, Sanjay did a lot of the heavy lifting on the call today. It’s been funny over Mr. Lawson’s tenure to hear the change in his diction and voice. When he first arrived, he was pretty heavy-laden, as was Mr. Kapoor. The calls tended to be of a much more serious and conciliatory tone, and there were definitely moments where they were notably concerned or disarmed a bit. As time went by, they both adjusted to the chair, and their confidence grew. There were fun moments on the calls, a few jokes, and a lot more polish. In my estimation, as a complete outsider, Mr. Gentile seemed to reflect a bit of the “New CEO” nerves on the call, which I found funny in contrast to Sanjay’s practiced evenness. That’s not to say Tom was jittery or presented poorly, just that the new-ness was there. Having said that, new CEO, new opportunity for me to get fired for personal observations on earnings analysis!

In all seriousness, I’m excited to see how things develop under a new captain. I have high hopes for what Spirit can become under Mr. Gentile, and I’m appreciative of his communication and character thus far. We’ll see what the future holds!

Now, ordinarily, the Q&A is the real content of the earnings call. This quarter, it was definitely good, but it was very dense, inspiring the separate section above. What you’ll find here is a lot more of the specifics of the stuff we did, so read on for more granularity.

Q&A

Due to the unusually high concentration of questions on pricing contracts with Airbus and Boeing and the fact that I’ve already discussed that key topic above, I’ve parsed the Q&A portion pretty heavily. If you’d like my full notes on the Q&A session, send me an email and I’ll pass it along.

As a side note before beginning, keep in mind I am far from an expert on these things. If I’ve made mistakes or misrepresentations, feel free to tell me. I try to learn as much as I can from compiling these reports, and I’m always open to input from those that know the subjects better than me. This quarter’s subject matter is pretty heavy, and I am naught but a stress engineer by day. There’s your disclaimer. Let’s rock.

• Question: How are the Boeing contract negotiations going?

o   Sanjay: We really can’t divulge the details of negotiations. However, for confidence, reference the successful, mutually beneficial agreement with Airbus this quarter.

o   Travis: After an incredibly slow start, we finally got to last quarter’s hot topic. And once again, we can’t openly discuss the terms of ongoing contract negotiations, or even details of finalized inter-business contracts. I swear, Mr. Kapoor could probably save himself some effort by recording that response and just playing it on repeat during the earnings calls. I get it – it’s a big deal and deserves follow-up, but… man. They’re not gonna tell ya secrets, guys.

• Question: On the Airbus agreement, now that we’ve stretched the block from 400-800 units, how do we feel about stretching out the timeframe for reclaiming deferred inventory?

o   Tom: Now that we have visibility over the full, extended block, we did our reassessment of the overall program, which resulted in the adjustments we made within this quarter.

o   Sanjay: There’s about $450M in cash that we would expect to recover over the next 700 units, which amortizes out to about $600k reclaimed per shipset over the block. We feel like this agreement is a really good result going forward, not only relationally with a major customer, but also financially via future cash flow gains and revenue certainty.

o   Travis: We went from slow-pitches to heaters reeeeeeal fast here, and it’s here where the dirty details start getting airtime. Refer to my explanation above of what our deferred inventory balance is. In short, it’s how much we’ve overrun our estimates so far. Our goal is to work it down to zero by program completion. Well, as part of our adjustments this quarter, we changed our estimates from half the program or so (400 units) to the entire program (800 units) because we now have contractually guaranteed revenue commitments from the customer – we know enough to make valid predictions over a longer timeframe. The analyst asking this question is wondering if our performance is worse than we expected, because we’re now burning down our deferred inventory over 800 units instead of 400. Read on for a further answer.

• Follow-up comment: Prior to this quarter’s adjustment, we would’ve expected to reclaim the $700M deferred balance over 300 units, and now we had an additional forward loss after having 400 extra units to use.

o   Sanjay: Keep in mind that we’re now incorporating not only cost but also revenue impacts over the 800 unit block, so this paints a fuller picture and we feel that all things considered, it’s a very solid result.

o   Tom: We felt it was most transparent to convey the full impact over the total 800 unit block rather than parsing it out over 2×400 units. Also note on deliveries we’re seeing declines in deferred inventory additions, and we should be positive by the end of the year.

o   Travis: The analyst asked a really good question. We’re spreading the same amount of butter over twice the toast – do we have a shortage of butter? Sanjay’s answer to his follow-up here, as I understand it, is basically saying that incorporating the last 400 units didn’t make much of an impact because we were already pretty close to the eventual agreement with our original estimates. In other words, our deferred inventory burn-down plan remains relatively unchanged over the next 300 units that were part of the original block, and the additional 400 units are pretty close to projections.

• Question: (Again on A350) Are we going to stay cash positive once we turn the corner, or is it going to be impacted by future price changes?

o   Sanjay: We expect to get cash flow positive and stay cash flow positive. We do expect to recover $450M over the block still, which amortizes out to some $600k per unit on average.

o   Travis: At one point, Tom said there’s a good chance we could be “positive” within 2016, and certainly within 2017. Referring to the deferred inventory chart above, what he means is that we’ll cross that transition point where we’re no longer addingto our DI balance on a unit basis, but instead subtracting from it (which is good). Now, cash flow positive as Mr. Kapoor answered would indicate profitability rather than deferred inventory, so I may be off-base. Either way, Sanjay believes throughout the twists and the turns of the program, once we achieve positive cash flow, we’ll stay there, and that’s the critical part of the message.

• Question: R&D declined slightly this quarter – why?

o   Sanjay: Mostly just timing of various expenses, nothing specific.

o   Tom: Reinvesting is a priority for us. We can probably even do more. Expect more internal reinvestment going forward.

o   Travis: This was a quick, tangential question, but it deserves inclusion. I’m intrigued to see what Tom’s directives will be on internal investment, and if his approach to retained earnings will vary from Mr. Lawson’s. It’s very early, but it’s worth highlighting so we can all keep an eye on how it develops.

• Question: 787 accounting block discussion – in the absence of a firm contract, are there going to be any surprises when we land a final contract?

o   Sanjay: This is why we didn’t put interim pricing assumptions in cash flow guidance. We separated those out to remind people they’re tentative, but they are based on realistic numbers.

o   Travis: He’s asking if when we sign the deal with Boeing, we’ll get an accompanying forward loss adjustment like A350 did this quarter. The answer is… well of course it’s a possibility. We don’t know until we know. However, Sanjay has been heavily emphasizing that the Airbus agreement was a positive, and that the forward loss adjustment was pretty minor when you consider the scope — $135.7M over 700 aircraft is less than $200k per unit that we adjusted for. It’s just not that bad. But, yeah, there might be a similar situation with Boeing. It shouldn’t be anything to fret over though.

• Question: Normally when you extend the accounting block, you get a benefit. My assumption since we have a loss is that we’re giving up a little bit on price with Airbus?

o   Sanjay: (sighs) True, but keep in mind we talked about pricing over the entire block, not just the short term. We’re relatively stable.

o   Travis: It’s pretty natural to have price stepdowns later in a program’s maturity. We made the forward loss adjustment because we did “give” a little in contract negotiations. But again, it’s to the tune of $200k per unit. It’s money, yeah, but it’s not big money that we need to be concerned about.

• Question: Based on calculations, I figure your non-recurring costs were about $60M this quarter? Is that accurate?

o   Sanjay: Not quite that high… we’re active on 737 MAX, 777X, and more. As we develop things, we have “lumpy” costs like tooling and studies, but we’re doing really well on development programs and meeting our commitments. (Good job, engineers)

o   Travis: Included this mostly to remind everyone that the engineering side matters too, and not just production. We know that engineers improve the end-product by designing it well, but we often feel a step removed from the bottom line financial data. Mr. Kapoor treated our current engineering efforts like a point of pride and called it out as a success. So good job.

• Question: 787 deferred balance growth was $1M last quarter and nothing this quarter, what’s with the efficiency? Is it getting to 12 units a month that de-risks the program?

o   Sanjay: We laid out a plan years ago and now it’s coming to fruition. (Sanjay credits the whole team, all 16,000 that have worked hard on our programs).

o   Travis: Another short one, the analyst was pretty impressed with our gains in production efficiency on 787. Sanjay says… yeah, we told you that was our plan, and we executed to it. Maybe stop asking me about Boeing contracts and have some faith.

• Question: (asked about both 787 and A350 by separate analysts) Looking at OEM’s deliveries of final products, it seems Spirit is delivering a lot more to them than they’re pushing out. Is that going to affect us or do we have conservatism baked into our plans to account for this?

o   Tom: Their deliveries are downstream, but they’re still requiring our upstream product at the rate we’re used to.

o   Sanjay: We should absolutely expect our production and delivery rates to stay steady and consistent.

o   Travis: Analysts are concerned that the OEMs are creating a logjam at the final assembly stage, and that that backup could cause them to delay receipt of Spirit’s units, costing us time and money. I’m not the person to answer things like this about the intricacies of supplier/OEM release schedules, but the two guys at Spirit’s helm probably are, and they don’t seem to think it’s an issue at all.

• Question: It’s unusual, you’d almost call it “extraordinary” to extend an accounting block – why not take a big loss now instead of extending that into the next?

o   Tom: We thought it would be best to give the full picture over 800 units. We could have addressed risk and made adjustments within 400 units, but it would have left uncertainty on the table regarding the back half.

o   Sanjay: We have orders and contracts for more than 800 units. We have certainty for costs and revenues for that whole block. It’s true that we rarely change blocks, but it’s been very methodical, with oversight from the board and from our auditors. We just thought this was the best way to communicate our current positions with respect to the information we have now.

o   Travis: This has been the theme… why did we change so much about how we’re reporting financials on A350? The answer seems to be full transparency, which is a reasonable answer considering the nature of the pricing agreement. As we’ve explored in this writeup, there are lots of complexities associated with something of this magnitude and timescale. The takeaway is that Spirit is moving forward with production, customer relations, and financial integrity. It’s an analyst’s job to prod and pry and ask the hard questions with a bit of a cynical approach, looking for problems that could cost their investors. Spirit’s reasoning seems sound and valid, and is a continuation of the stability that we’ve gradually seen added over the last several years.

Boy, this feels like it’s even longer than usual… brevity really is not my strong suit. I think it’s justified – I’ve had many people already asking me about the forward loss even though the STIP and share price tell a pretty positive story, so hopefully the extra explanation has been valuable in understanding what’s going on.

I had another pre-written mini-lesson for the quarter based on something I wanted to study on my own time, so I’m going to go ahead and include it, but if this has already been an overwhelming “summary,” I wouldn’t blame you for putting it on hold or giving it a miss. If that’s the case, thanks for reading and see ya next time! If you’re sticking around, let me think of a tie-in here…

If you think Spirit’s finances are complicated or seem to be “fudged” sometimes (I hear this sentiment frequently enough to know you’re out there), part of it may be because you haven’t seen what real manipulation looks like. So this quarter, I submit for your comparison and consideration the mini-lesson Enron: A Story of Forensic Accounting.

Hey folks, Spirit announced 2016 first quarter earnings on April 29^th. I had some family business to attend to and was out immediately after the call and most of the following week, so I’m even tardier than usual. I’m going to be fairly brief on the earnings call portion, but don’t worry, you’re not being shortchanged. It was a pretty run-of-the-mill call, and the biggest takeaway for me was Mr. Lawson flexing a bit of his military knowledge regarding the bomber program and its impact for our future. He offered some pretty good insights into the differences between military and commercial programs from a high-level perspective. The “lesson” this quarter is a bit off the beaten path. I assigned myself a little homework project on something I was curious about and thought it might make for an interesting take on business in general. Hope you enjoy. Let’s jump in!

Financial Summary

The numbers here are pretty cut and dry. Revenues were slightly down, because of some seasonal delivery oddities and rate decreases on stuff like 747, but operating income (money made from selling planes after taking out part and labor costs) was up, which is probably indicative of more programs transitioning into a production mode rather than design. In spite of operating income being up, net income was down, which is probably because we’re keeping money sort of “in circulation” to support rate increases and other buildup projects.

The most obvious difference in the high-level financials was free cash flow. My good friend, Spirit analyst George Shapiro, who I love because he always asks super technical financial questions (he seems like he might’ve been an engineer in another life), painted a little clearer picture: after removing a lot of one-time items that were included in Q1 of 2015, the real difference in trending free cash flow is about a $50M downtick. Mr. Kapoor attributes this to “working capital,” which I’ll explain a bit more in the Q&A portion, but is basically just what I said – keeping money warm on the bench and ready to jump into the action when needed instead of sending it to the showers and calling it “free cash.”

Overall, the numbers show a few things. One is a transition into production mode on several programs. One is an increase in investment in future growth (“working capital,” as mentioned, but also an $11M increase in purchases of property, plant, and equipment vs. Q1 of 2015, as shown). And of course, aside from these things, Spirit’s continued improvement in stable, predictable earnings.

Now let’s quickly hear what our leadership had to say, then we’ll jump to analyst Q&A.

Executive Introductions

• Larry mentions the A350 deferred inventory improvement. Last quarter we had brought it down to $1.2M per plane. This quarter, it was $400k per plane. It’s really getting to a good point pretty quickly!
• He mentioned that during the quarter we achieved “investment grade” credit ratings. To put it in personal terms, it’s sort of like getting your credit score above 800. It might not really make a huge difference in your everyday life, but it’s a good barometer of your performance, and can have some small practical impacts like lower rates if you need to borrow.
• Sanjay noted that revenue was weighed down by fewer 737 and 747 deliveries (one seasonal, the other systematic), but was partially compensated by higher A350 and A320 deliveries. It’s kind of an interesting point, because we’re seeing a little bit of transition happening out of the 747 “jumbo” era and into the era of the new lean programs like A350.
• Free cash flow was lower because of seasonality (Q1 is kinda slow) and also because of incentive payouts – all those greedy engineers wanting their bonuses 😉
• We had a few small, favorable cumulative catchups on mature fuselage programs.

I’ll talk about this a bit more in my commentary on the Q&A portion, but this quarter we get to learn something about how Wall Street operates. By any measure, it was a fine quarter. We met expectations, we delivered on our guidance, and we didn’t have any surprises except a few small positive ones. You would think that would mean the stock price would go up, or at least stay about the same. We actually took a small hit on the day of earnings. Why? Analysts have a bit of an obsession about companies beating expectations. They like it when companies upwardly revise their guidance a couple of times like they’re doing even better than they expected. This can cause companies to issue overly conservative guidance and then positively revise it to stay in favor.

But really, we (and by “we” I mean on a huge scale – not just “we, Spirit” but American business, corporate employees, investors, banks) put a lot of weight on quarterly reports. Quarterlies are a fine snapshot of the health of a business at the most fundamental financial level. Financial reports are important. But some of the culture around these things can get a little silly, like the beat vs. meet expectations and guidance thing we saw this quarter. Last quarter, Lawson’s jab at the analysts was the “9 P/E” thing, where he basically said we’re underpriced and being undersold. Well, this quarter, my jab is that the whole “beating guidance is the new meeting guidance” culture is counterproductive if our goal is to get accurate representations of a business’ finances each quarter. Side thought, if you get frustrated about your manager “raising the bar” on your performance reviews, well, right or wrong, even your CEO isn’t immune to that treatment.

Anyway, I can’t complain too much since I love writing these reports for you fine people, so I’ll leave that at that and hop off my pedestal. To the Q&A!

Q&A

• Question: Guidance question – seems based on Q1 that estimates should be higher. What’s the negative drag?
  • Sanjay: Rate ramp-ups can be expensive, so we retained some conservatism since we sometimes have to expedite or do extreme things to meet our commitments. Also share repurchases are not included in guidance (could be a positive factor
  • Travis: So here’s what I was just ranting about… and it’s not surprising that it’s the first question. We met our estimates for the quarter, so why isn’t our annual forecast better? Mr. Kapoor says, well, we gave you an accurate forecast and here’s proof that we know what we’re talking about. Then he gave some of the factors that went into this quarter’s numbers and some expectation of significant events later in the year. Ah well. You did what you could do, buddy. Quick reminder: we talked about share repurchases in a recent quarter, but keep in mind that if we buy back shares, it means fewer shares to divide things like profits into, meaning higher earnings per share (EPS), all else constant. So there’s potential that our numbers show improvement as the repurchase program kicks in, and Sanjay briefly reminds us of that here.
• Question: A350 cost progression looks good. When is break-even expected? Have Airbus delivery delays affected our work?
  • Larry: The front end of the line runs faster than the back end (our production goes faster than Airbus’ final assembly). We haven’t seen any slowdown from plan in regards to demand/delivery from our customer. At this point, we’re still very rate sensitive (he mentioned this last time) because each “step” unit is huge on both revenue and utilization of fixed cost. We do pay a little extra early on for expediting cost to react to unknowns early in production. The proof is in the pudding though – look at our deferred curves over the last year
  • Travis: Our analysts keep worrying about Airbus getting behind on their deliveries and more or less gumming up the end of the pipeline. And… so far it continues to not be a problem for our production or a concern for our top brass. Mr. Lawson’s answer touches on several financial concepts we’ve talked about before. Notably, it’s all stuff that they mentioned in their executive introductions this quarter. It’s almost like they were smart enough to anticipate what the questions would be. Hm. Larry basically says, again, we’re keeping some extra money in the game to deal with unexpected stuff that can happen, and we’re early enough in the program that single units still matter. Dividing tool, machine, and plant costs by 3 instead of 2 makes a huge incremental difference; dividing by 20 instead of 19 makes much less.
• Question: Address the possibility of taking a “step function” in recovering costs. (he’s asking about how we’ve taken relatively small catchups against the big historical losses we’ve taken on some programs).
  • Larry: Don’t expect any large changes, especially losses
  • Travis: I feel for Mr. Lawson here. A lot of the work Larry and Co. did early on was a clean-sweep on program estimates and costs. This was a bit of a silly question, since we spent like 8 quarters talking about making sure we had everything estimated and accounted properly. I’m going to sound like a fool if we ever have a huge forward loss, but Lawson spent a great deal of time and effort on arrival to level-set the finances of every program. He put great pains into making sure we were going to have smooth numbers going forward. Not to say that he would be able to fix every deficit we ever had, no one would, simply that we would much more firmly know where we actually stand on an ongoing basis rather than constant, major surprises. It seems like the last few quarters that has really come to fruition in the numbers, and now they’re asking him if we’re going to get any happy surprises on writing off former losses! A year ago you were asking for stability, and now that you’ve got it, you want big surprises!
• Question: Cash flow Q1-15 vs. Q1-16 when taking corrections into account looks like about a $50M loss – is that correct? Also, the favorable cumulative catch-ups come from what programs?
  • Sanjay: A little inventory build-up on 787 and A350, but it’s representative of rampup. So it’s working capital. Also a big impact from incentive payouts. Not really any particular program on cumulative catches
  • Travis: It’s a pretty self-explanatory term, but “working capital” basically means money that’s ready to go if something unexpected happens. The technical definition of working capital is “current assets less current liabilities.” In accounting terms, “current” generally means an asset or liability that can be turned within a year. Inventory is typically a current asset, so Sanjay’s answer that we’ve got more inventory and less cash is another accurate way of saying that the money is at work. To use a personal finance metaphor, I increased my “working capital” last year because I expected my air conditioner to go out. Instead of spending or investing that money, I kept it ready to jump into the game because I had some inclination that I would need that money at the ready to respond to needs in the short term. Spirit’s doing the same thing.
• Question: Where do we see Tom’s responsibilities focusing and where does that leave you (Larry) focusing?
  • Larry: We’re a manufacturing company. And an engineering company, but manufacturing is the biggest thing financially. That means our ability (and efficiency) in meeting delivery commitments is the most critical piece of our business. Tom is going to be in charge of that. Ideally, my meetings start going down when he gets ramped up
  • Travis: This question intrigued me. And with all the rumors about Tom Gentile being brought in to be groomed to be Lawson’s replacement (you guys’ rumor mill is funny), it was an interesting question from an analyst. I won’t speculate about Spirit’s leadership plans; part of an executive’s job is ensuring continuity, and they’re people that are allowed to have their own life plans too. But I will expound on Larry’s answer. Basically, we build stuff. The top job managing how we build stuff was open. That’s a huge gap. We brought in someone who we thought was a great fit to manage how we build stuff, so the guy whose job it is to strategize and plan stuff can do that, instead of always managing how we build stuff. Is Tom a future CEO candidate? Eh, sure. But for today, it really is as simple as we had a huge hole in our executive team, and we finally filled it with someone we hope is going to do a great job.
• Question: Larry said would be disappointed if we didn’t win some more defense projects longer term. Do you have a target mix for the company in, say, 5 years?
  • Larry: I don’t ever really see defense being more than 20% of the company. Especially unless we expanded the things that we do with rate and design and stuff. For it to become a bigger part, we’d have to do some M&A (buy some defense companies and integrate them into Spirit). Attractive M&A companies are ones that have high rate on long-term programs, but military work is an additional bonus. Discussions on Trainer and Unmanned are always in the air, but for us also M&A
  • Travis: Suuuuper interesting answer. Ya’ll remember when Lawson signed on as CEO and it seemed like everyone was talking about the company becoming Lockheed 2.0? In this answer, Lawson concretely says his target mix for military-to-commercial is no more than 20:80. What this tells me is that, yeah, he’s got lots of experience and connections with military stuff, but he’s here to advance Spirit within our core competencies, which is designing high quality aircraft and then building a crapload of them. It’s been several years now he’s been our CEO, and this question says a lot for me. When he came on, people seemed worried about the company becoming “Larry Lawson presents Spirit AeroSystems,” but what we’ve seen is still Spirit AeroSystems, shaped by new leadership, but essentially the same core company.
• Question: During the quarter, there was some news on aftermarket arrangements with Boeing. What was the arrangement in the past and what will it be going forward?
  • Larry: We don’t describe contract terms, but we sold parts and provided services to the market and to Boeing. Now, we’ll sell all the parts to Boeing. Our business will continue. Boeing thinks it can capture some of a growing market, we think it’s just representative growth for a larger fleet with less retirements. I’ve never said “It’s my objective to grow aftermarket.
  • Travis: Mr. Lawson pretty much covered it. Boeing thinks they’re getting some great deal on a big growing market segment. Spirit execs just think aftermarket is growing because the overall market is growing. It’d be like investing in iPhone cases when you could just invest in Apple. The overall market drives auxiliary markets; those auxiliary markets rarely grow on their own. Either way, we’re retaining our business in that space with small changes, and it’s not a huge deal in the scope of our portfolio anyway.
• Question: On B-21, can you sell analysts/shareholders on why we should be excited about this? It’s low volume, if it goes like other DoD programs it’ll be overbudget, etc.
  • Larry: (lightheartedly) Seems to me the defense guys are doing quite well when you look at their share price. First, it doesn’t expose you to losses, so there’s no real commercial risk. Margins aren’t as attractive as what you end up with on the commercial side, but then there’s huge investments you have to make using your own coin on commercial programs. I’ve seen (and run) a lot of big DoD programs. The service has been incredibly disciplined on this one; never seen this level of discipline on defined requirements. What are the benefits though – as I mentioned, I’d be disappointed if it didn’t lead to more future business. It should show that we’re a capable partner for this type of business moving forward. On its own, it’s fine, not huge. Honestly can’t think of negatives unless someone’s thinking of really small margin dilution
  • Travis: We saved the best for last. Since Mr. Lawson’s answer was so good, I’m just not gonna add much. Neat to hear the differences between military and commercial highlighted by someone who really knows both markets. Commercial has more risk and more reward, military less. B-21 is cool, but on its own, it’s just okay. Hopefully it’s a starting point to get Spirit into more new and exciting stuff in the future.

Well, I ended up taking more space than I thought I would, so I’m gonna tie it off there. As reflected in the STIP score, it was a good quarter, and we did our part. The stock market may have disagreed, but hey, forget ‘em. We keep doing our thing, and Spirit’s in a great – and improving – position moving forward.

This quarter’s “lesson” was actually born out of a curiosity, rather than inspired by our financials. I often find myself asking questions that I can’t immediately find an answer to, but then think, “Hm, maybe I have the skills to just answer it myself.” It’s not directly Spirit related, but I think it’s well enough in the corporate finance realm that you’ll find it useful for learning, and hopefully just interesting in general.