Hey everybody. Welcome to the 2015 wrap-up. Forewarning: since this wasn’t just a quarterly report but a year-end summary, and because all parts of the call were really good, I have a lot to talk about. If it’s too much, feel free to break it into sessions, send it straight to the trash, or compose anonymous, vitriolic emails to me about my excess. But I hope you find it enjoyable and maybe a bit educational too.

In many of these earnings call write-ups I’ve said how sometimes what you want to hear as an employee of Spirit isn’t what you want to hear from a “let’s talk about finance” perspective. Good performance is often, frankly, pretty boring, and doesn’t tend to bring up a lot of fun or interesting topics. Now, as I’ve always tried to qualify, I’ll take good and boring numbers over exciting and poor. But it sure would be nice to have both now, wouldn’t it?

Well, I’m happy to say that that’s exactly what this quarter delivered! There are ordinarily a number of questions I zone out for, especially as the session drags on, and the introductory statements from the executives are usually pretty stoic. Not to say they aren’t fine orators, just that the introductions are just that, and usually breeze through the highlights rather than diving deep into the substance of the call (my apologies to Mr. Lawson and Mr. Kapoor if I’ve inadvertently insulted a blossoming corporate comedy sketch). I mentioned last quarter that Mr. Kapoor has started really providing pretty outstanding insight in his opening bit, and that trend continues here, where his summary even gave me a detail or two to teach you folks about.

Okay first off, the “too long; didn’t read” version: performance continued to improve in the 4th quarter, and Spirit’s 2015 full year results show marked improvement in the growth and stability of the company. There shall be bonuses.

If there’s any of you who just read these to see if the bonus will be good or not (can’t say I blame you), there you have it. Actually, you engineers are some crafty folks — someone emailed me the final STIP score before the call even started. You people are hilarious in your dedication and skill in finding stuff out.

Before getting into the call, I will also say (because this quarter I’ve abandoned any pretense of brevity) that many of you are becoming quite savvy with the financial statements. I don’t know if I can claim any credit at all for inspiring people to look into the finances, but it encourages me every time someone shares an observation, comment, or thought. This stuff is good for you to understand as you progress through your career (at least that’s what my business professors said), and it’s good for Spirit to have more people understanding the heartbeat of the business. So keep digging in!

Alright, the results. Let’s start off with the usual summary table:

As we look at this, there are a couple of things to note:

• 2014 was a pretty good year — recall that the operating loss in the Q4 comparison was primarily attributable to the Gulfstream divestiture shenanigans. But 2015 was better still.
• The reduced revenue in 2015 is due to two major factors: elimination of Gulfstream programs, which, though they weren’t profitable still generated revenue, and the Boeing 787 price stepdowns (more on that later). In other words, the reduced revenue is not a worrisome figure.
• 13% operating margin is… really good.

Let’s also take a peek at free cash flow — how much actual cash is left after making necessary investments in our growth and other such things:

This also tells us a few things:

• We’re improving in big ways on converting the money people pay us for stuff (revenue) into money we get to keep and choose what to do with (free cash flow).
• PPE (Property, Plant, & Equipment) increased pretty significantly in 2015. This is a leading indicator of rate increases, which means the company’s business is growing. We might be concerned about this number in a vacuum, but we also know from many calls now that the expanded costs are to fuel rate increases, and we like doing more business in stuff we know is profitable.
• We’re hanging steady around a billion dollars in cash. It’s a more philosophical thing, but it seems to me that our leaders are targeting a certain debt-equity ratio (one of the tons of measures of financial well-being), and they’ll probably increase investments like share repurchases to maintain it. That’s just a guess based on their actions so far with the surplus cash we’ve been generating the last several quarters.

Last thing before getting into the call itself (yes, we’ve only just begun!) is looking back at the company’s performance versus its estimates (guidance). These figures are from the updated guidance provided after Q3:

And notes on this one:

• The original guidance from February of 2015 was minimally different — $3.60-$3.80 EPS and $600M-$700M FCF.
• Revenues were $6.64B, right in the middle of the guidance.
• Adjusted EPS was $3.92 per share, right in line with the upper end guidance. Our non-adjusted EPS was higher, but included the one-time deferred tax asset… whatever. A bit more on this in a minute.
• Adjusted FCF was $738M, again right in the middle of the guidance, and slightly above the original guidance provided at the beginning of the year. If the “adjusted” figures are starting to raise your eyebrows, stay tuned. They really do make sense, I promise. I’ll talk about them in the mini-lesson, Defer, Defer, Defer.

Okay, the numbers say we did pretty well. We’re actually getting to keep some of the massive piles of money our customers pay us now. The business is growing nicely — not too fast, but at a healthy and sustainable rate. Now we’ll turn to the call to see what our leaders, and the analysts scrutinizing our stock, think are the big issues and questions facing us moving forward!

Mr. Lawson and Mr. Kapoor’s introductory statements were the usual highlights, going over the vital numbers and adding a few comments on major developments and such. Some of the points were notable though and deserve a little expanding upon for those less versed in finance-ese.

• A350 deferred inventory balances per shipset decreased from $2.3M to $1.2M between Q3 and Q4. What this means is that the amount we’re “over budget” on each A350 is decreasing, rapidly. $1.2M might still sound like a lot of money, but it’s actually really darn good. An analyst goes on later in the call to ask if Airbus is going to want to renegotiate pricing, insinuating that our improvement is so good it might make them think they didn’t get a good deal.
• On the topic of deferred inventory, overall 787 deferred inventory (not per unit, but total) increased by $7M. This is also not too bad. We lost some revenue due to price stepdowns (Boeing pays us less per plane in this accounting block), but we made up for almost all of it with production performance improvements.
• Our “adjusted” Earnings Per Share (EPS) was $3.92 versus non-adjusted of $5.66. Most of that difference is due to the deferred tax asset valuation allowance, which isn’t worth going into here, but basically is a one-time gain related to the Tulsa divestiture. This is a great opportunity to remind you what the analysts are looking for in Spirit’s numbers. We want to remove significant one-time events in order to see what the overall trend is in the performance. Let’s use a personal finance example that’s relevant right now: tax returns. If you get a substantial tax return, it’s going to significantly help your budget out in the month that you receive it. But you also shouldn’t base your financial health on that, because the difference between your income and outflow is a truer measure of your actual performance on a continuing basis. We want to recognize this distinction and provide that insight to illustrate what the future might hold without some of the more odd events that have occurred.
• Last thing from the executive intros: we received $192M under the interim pricing agreement for 787 that we considered “deferred revenue.” That means we got paid for work that we haven’t actually done yet; another name for deferred revenues is “unearned revenues.” We got cash but we also have a liability of work that we have to provide that offsets it. More description of this in the mini-lesson.

Alright, so the big bosses think we did pretty well, and gave us some info on top of the numbers to expound on it. This quarter our leadership gave us an excellent appetizer. Now let’s turn to the main course of the call — analyst Q&A.

This quarter, I wanted to do something new. To help illustrate what I’m always trying to get across about how the nature of the analyst questions is as important as the questions (or answers) themselves, I actually wrote down every single question so I could categorize them. The topics asked about more frequently are likely to be those that represent the largest concerns someone looking at Spirit critically might have. It’s not a perfect method, but it’s helpful to paint a picture of what to listen for in the Q&A section. Here’s the count:

1. Financials (Numbers Question/Clarification): 7
2. A350 Production: 4
3. Mature Boeing Program Rates: 4
4. 787 Pricing/Contract/Production: 3
5. New Business/Future Opportunities: 3
6. Executive Search: 1

Now, given that it’s a call centered around the financials, it’s not surprising that the top category usually has something to do with the numbers. I double counted some questions since they had a numbers-based question but also related to something else. But peel away the given top category (earnings calls are gonna be about the financials), and you start to see what people are asking about: A350 (specifically production costs), 787 (specifically Boeing pricing contracts), Spirit’s capability to support rate increases (737) and not be harmed by rate decreases (777/747), and a little bit about what kinds of things are in the future. Those are our hot spots. So what did they ask, and how did Spirit’s top brass answer? Let’s find out!

• Question: So uhhhh, we heard you’re looking for a new Chief Operating Officer. Talking about succession maybe. Sup?
  • Answer: (Mr. Lawson jokes that Sanjay answered the last question so well that he should take this one too.) Lawson says we’ve done a lot of executive team building — 89 of the top 98 jobs are people that are new to the company or new to the position (I’m… not sure if we should be proud of that number or not). He mentions that it’s interesting that this time around, looking for qualified executives piqued peoples’ interest. He says we’ve slowed down searching at the executive level, but we’re still looking to build talent. We don’t have an existing succession plan, but we do want to build something comprehensive. He mentions that his contract, which was part of the speculation, is auto-renewing, so that component isn’t a big deal. Succession planning is a good thing, but there’s nothing imminent. Mr. Kapoor tosses in that the number of Saturdays that Larry is here hasn’t changed recently or anything.
  • Travis: It was interesting to hear this question on the call after this Reuters article got the rumor mill churning. I had a whole spiel on this when people kept asking me about it, but the short of it is this — executives are people too. People have strengths and weaknesses. Having a top position in the company open leaves the possibility for someone to be acting in a weak subject when we could instead have someone there who’s strong in that area. They teach you in business class to “hire your weakness.” I don’t traipse about with Spirit’s execs a lot, so it’s not my place to say who among them might be strong or weak in various facets. The point is, searching for an executive, even as part of a succession plan, doesn’t mean that Larry Lawson is fixing to abandon us at his first chance. It may simply be a smart move to plan for the future. It may be to cover a gap in the skill set of the head honchos. Or it may in fact be to replace Mr. Lawson when his contract expires. People, even executives, also have their own lives, goals, priorities, and plans. What’s important is to not get caught up on undetermined futures that may or may not come to pass. If Lawson does leave soon, all we can do is judge him on what he did while here, which, if you go strictly by the financials, has been a lot of good. People can (and certainly will) talk about whatever other aspect of his leadership they like, but these summaries are about the earnings, and there’s been substantial improvement there under Lawson’s tenure. And I’ll leave my potentially career-ending speculation at that.
• (So uhhhh, back to the numbers…) Question: In the 2016 guidance numbers, we would’ve expected higher cash flow given your numbers for the last two years. Why is 2016 lower?
  • Answer: Mr. Kapoor answers that we’re working against a pretty big headwind due to the deferred revenue we’ve received (as discussed earlier and more in the mini-lesson). Other major factors include a need for working capital as A350 production rates increase, and 777/747 rate reductions will impact our cash flow too.
  • Travis: George Shapiro, my favorite Spirit analyst, asked a great question. It always excites me when Shapiro’s name is mentioned in the call because you just know he’s going to ask some unbelievably technical, numbers-based question. Engineers listening into the call would resonate with this guy. Anyway, Sanjay’s answer is thorough and gives some important factors to remember as we start on 2016. We’ve got rate decreases on mature programs that would ordinarily generate lots of cash, we’re ramping up on developing programs that consume a lot of cash, and we’ve got this deferred revenue situation where we’re working “for free” against a pre-payment we’ve already received. So keep those in mind as we go through 2016.
• Question: We’re 50 units or so into A350. We’ve been hearing that 100 units is the sort of “stability point” when it comes to getting things working smoothly. What’s the status on that?
  • Answer: Mr. Lawson says it’s becoming even more clear as our deferred inventory per plane comes down that the most important component in the cost picture is rate. He continues to be confident in the production learning curve and stable costs.
  • Travis: Lawson alluded to fixed costs in his explanation of why rate is so important. He brings up a great point and a concept I’m not sure I’ve discussed before. If building an A350 requires $100M in tooling, then to build the very first airplane, you need $100M in stuff before even thinking about materials and, you know, the actual airplane. That is a fixed cost. But as you make more and more of them, those fixed costs get sort of amortized over the number of planes you’ve made… at 50 planes in, if you’ve used the same tools, then it’s cost you $2M per plane. These massive fixed costs are what we mean when we say that Spirit is a “high capital business.” Apple can design a phone and send orders to existing manufacturers in China that already make phones for a dozen other phone companies. We’ve got to cough up 9-digit money to build airplane #1. As for how A350 is doing, another analyst later on would ask if Airbus is going to want to renegotiate because our current deferred inventory cost per plane is already better than break-even. The program has had its struggles, but it’s improving a lot, based on these numbers. We’ve gone from $26M per unit in deferred at the end of 2013 to $13M at the end of 2014 to $1.2M now. It’s not totally free from concern, but Spirit is starting to do what Spirit does — make lots of expensive planes pretty darn well.
• Question: Can you give us an apples-to-apples comparison between 2015 and what we expect in 2016?
  • Answer: Sanjay says that 2016 will be a lot “cleaner” with fewer one-time events (in other words, fewer “adjustments” and stuff needed to show the trends). There are still variables, like the need for working capital, and the deferred revenue stuff, but year over year, we’re making good improvements. That’s why the baseline free cash flow is improving so well over the scope of years. We have a long-term goal of 6-8% for cash flow conversion.
  • Travis: I had to bring this one up for the cash flow conversion thing. It was funny to hear a target number out of them, because several quarters prior, Larry said they didn’t have a particular goal for cash flow conversion. It’s nothing vital, it just made me chuckle a bit that they’ve decided on a target for it. For the record, cash flow conversion could also be called “cash margin,” just like the different tiers of “profit margins” we’ve discussed before. In 2016 “adjusted free cash flow margin” (AFCF / Revenue) was 11.1%, but the 2016 guidance estimates a little below 6%. Be looking for that number in future earnings calls. It’ll be fun to see how it evolves as things smooth out.
• Question: The step up in share repurchases was a little faster than expected. Has there been a change in philosophy on that? Or on M&A opportunities?
  • Answer: Lawson responds simply with the phrase, “9 P/E”. Lawson knows how well his business runs. He says sometimes he wishes he could ask the analysts questions. We’re the best investment we can make right now.
  • Travis: Ohhhhh my gosh, this was such a great answer from Lawson. First, remember that share repurchases are generally a good thing, so it’s a good sign that we’re ramping that activity up faster than expected. Now, to the fun stuff. P/E is price-to-earnings ratio, probably the most common indicator of whether a company’s stock is over- or under-priced. When you buy a stock, what you’re buying is a hope of future earnings. If the share price is low compared to the earnings, then you’re potentially getting those future earnings at a good value. A P/E ratio of 9 is pretty low compared to the broader market and historical averages. I don’t know about aerospace specifically, but Lawson is basically saying we’re underpriced, and his quip about wanting to ask the analysts questions during the calls was basically saying, “Why aren’t you sending investors our way? We’re waaaaay stronger than our current stock price indicates.” Bold. Direct. Awesome. Another finance term you may have missed in this question — M&A. M&A stands for “mergers and acquisitions.” Another question would be centered around this as well, asking if we were considering cash deployment to M&A to supplement our growth outlook. In other words, are we thinking about maybe buying other companies to support our growth? For me, this is an exciting thing to be in the air. Lawson says that they’re still looking at options. We’re in a cash and cash flow position now to where we can do share repurchases and think about M&A (buying other companies out) because we’re not highly leveraged. Lawson says it needs to be the right situation, so we’ll see what the future holds. I’m happy with their stated approach so far. We’re in a position now where we could start doing exciting, sexy M&A stuff, but our leaders aren’t doing that just to grow for growth’s sake. It needs to make sense to our overall business. So while it’s exciting to start hearing about these things, they should be done carefully and correctly, and it seems that they’re being properly cautious while still looking into really neat stuff for our future.

Oooooooookay, since this post is already massive, it’s time for me to sign out for the (financial) year. It’s been a ton of fun writing these and having you all read them. I appreciate so much the support I get, and the implied recognition when people send me questions or comments on Spirit stuff. 2015 showed continued improvement, and 2016 will have its challenges, but seems promisingly headed in the right direction.

If you’re not quite tired of me yet, head on to the mini-lesson Defer, Defer, Defer, that fleshes out some of the financial concepts from this call a bit more thoroughly.

Thanks again for the opportunity to share some of this stuff with you. I hope I can continue to provide value (and maybe a little entertainment) through these summaries. And I always welcome questions and comments if you have them.

Until next time!

Another quarter has come and gone, and with it comes the latest update on Spirit’s performance. While the earnings call was pretty benign, I did pick up on some trends in what Spirit’s analysts have been laying down. I know I’m already late this quarter, so let’s dive right in. Here’s the usual summary of financial results:

I usually talk about how the question and answer session is the real meat and potatoes of the conference. While that’s still true this quarter as always, Mr. Kapoor’s introductory statement had a lot of really good information in it. Here were some of the highlights:

• Just for clarification, he confirmed that the earnings per share (EPS) metric excluded the one-time shenanigans from the deferred tax asset valuation. As I’m not an accountant, I can freely admit that that whole deal is way out of my league, so I’m glad that it seems to be concluding. And although Sanjay as our Chief Financial Officer obviously comprehends the nature of the deal far better than I, he joked a bit and said he would be glad to say the term “deferred tax asset valuation” for the last time. I had to giggle when he said that. Here it is in the Appendix of the earnings release (guidance is $3.80-$3.95 after this quarter’s revision):
  
• Last quarter we revised our free cash flow guidance for the year upwards; this quarter we moved EPS upwards. These upward revisions are an indicator of two things. First, that Spirit’s financial guidance to Wall Street for the year was conservative at first (something engineers can certainly relate to), and second, as the year has gone by, we’ve become more confident in achieving the uncertain cash flow and earnings numbers that we thought we could achieve internally.
• You may notice that as of the end of Q3, we’re actually in our target range for year-end free cash flow (target is $700M-$800M, with $753M achieved through the nine months ended in Q3). Mr. Kapoor addressed this by noting that the guidance doesn’t include certain revenues that are flaky due to interim contract pricing on the 787. We’re also ramping up capital expenditures (stuff like tools, equipment, renovations) to prepare for rate increases on a number of programs. And lastly, we repurchased $46M worth of shares in Q3; there’s no schedule, but over the next several quarters expect to see some free cash diverted to the share repurchase program.
• Oh, P.S. We have a billion dollars in cash now.
  

Sanjay’s final comments were on increases in deferred inventory on the 787 and A350 programs. As this keeps coming up, I’m going to talk in more detail about deferred inventory next quarter. If I get a ton of feedback from you guys, I’ll put something together before next quarter’s call, so let me know. It’s a big topic, and I’ve only come to really grasp it in the last few months thanks to the help of some great, knowledgeable folks (thanks to Craig Bayless in particular).

Anyway, deferred inventory (DI just for convenience) is basically excess manufacturing cost above and beyond the planned cost per unit. As long as we can recover it in the future, it sits in the DI balance for the program. When we come in under cost for a unit, the DI shrinks. Here’s the fun part: if it becomes clear that we will never recover those costs, the unrecoverable amount becomes what we all affectionately know as a forward loss. I now understand why the analysts, still timid from historical “corrections” to our profitability, are very very attentive to growth in DI. This quarter, 787 added $25M to their DI balance ($800k/unit over 31 units), while A350 added $16M ($2M/unit over 8 units). While that’s not something to celebrate, of course, Mr. Lawson assures us that this is typical for the developmental stages of these programs, and that we’re on plan regarding manufacturing learning curves.

On that note, let’s turn to the analyst Q&A session!

There were two major trends in the analyst questions, emerging from the mixed bag of topics that always gets discussed during this majority portion of the conference.

The first was the deferred inventory issue. In response to one question, Mr. Lawson mentioned that when A350 started, we were running over cost by $28M/unit on the A350, and this quarter we’re down to $2M per, and that that alone represents tremendous progress. He says that considering all factors, we should be able to beat the 100 airplane “stability point” where we more or less know what to do when building these things and can do it consistently.

One analyst asked about Spirit’s accounting method of utilizing deferred inventory/forward losses/cumulative catch-ups (the opposite of forward losses, issued when we outperform planned costs per unit) rather than just accounting block-by-block or quarter-by-quarter or something. I’m willing to bet many of you have asked the same kind of question. Larry and Sanjay answered that pretty well, so here ya go. For one, it’s mentioned that we’re taking a lot fewer of these accounting ups and downs than historically, and that the dollar amount on them is smaller all the time (this is a true statement if you dig through the financials). We have a pretty strong concept of our costs now. Another piece of the answer came later when an analyst asked about missing one A350 delivery this quarter. I really appreciated Larry’s answer on this one. He clarified that the long-term outlook is that the program has strong demand and backlog. Let me riff on this for a minute. This is one of those things where, as a business culture, our focus on quarterly results doesn’t always paint the whole picture. Larry’s answer acknowledged this. It’s a bit of a ticky-tack question to ask about one plane here, one plane there, when we’re planning to build a full production run of dozens to hundreds of planes. Yes, it matters for quarterly results (especially early in a program’s life), but eh… it’s a rather small impact long-term.

The second major trend was our contracts and pricing agreements with customers. I’m a little embarrassed that I’ve been missing this for so long. There are usually questions on how contract negotiations are going, and I sort of just put them on my mental backburner and wait for more interesting questions. Well it finally clicked for me this quarter. After our top brass answered the analyst about using forward losses and cumulative catch-ups, saying that we’re using those less, but that they’re a good way to bundle the big numbers associated with airplane making and that we have pretty good cost control now, the analyst mentioned that he wasn’t as concerned about uncertainty in costs like historical write-offs have been based on, but about pricing.

See, cost control is what Spirit does. The stuff that goes on inside our facilities, we have policies and procedures to control, we have people who get experienced and better at their jobs, we can hire new people in, increase training, decrease overhead, whatever. We have a great deal of control over that part of the business. What the analyst is concerned about is the higher-level business-to-business workings that determine how much revenue our programs generate. We can control costs as well as we want, but if there’s no money coming in, our margins aren’t going to be there, and we won’t be profitable. So while I’ve been more or less dismissing this issue, it occurs to me now that it’s literally what drives the top line of Spirit’s earnings.

At any rate, Mr. Lawson seems quite confident that the negotiations are favorable to all parties, and that we have symbiotic relationships with our customers and partners. Due to the nature of these discussions, there’s very little he can disclose, and that makes sense. But it will certainly be an item for the Spirit analysts, and all of us, to listen for in the future.

One last question that I found particularly interesting. An analyst asked Lawson where growth was going to come from as our business stabilizes and even our big development programs mature. Of course there was the normal bit about “organic” growth happening via rate increases on existing programs and leveraging relationships with current customers. And there are always opportunities for “inorganic” growth through new business opportunities and securing work on new programs. But for perhaps the first time I’ve heard, Lawson mentioned the possibility of acquisitions in the future. At least for a nerd like me who just digs business finance, I’ll be watching closely to see if there are any plans on that front. Our company gobbling up other companies might incite some of that excitement that’s been lost since the forward losses have slowed down, without all the stress and worry over losing my job.

Okay folks, as with every quarter, thank you for your time reading this! While I started doing this just for the fun of it and as a service to those immediately near me, and still keep writing on our earnings because I enjoy it, I do always appreciate feedback, questions, comments, and your own observations. I have a list that grows every quarter of those who want to receive future emails directly from me. If you want to be on it, just email me. Also, each quarter I get lots of chat conversations and emails during and surrounding earnings calls, which I am always honored by (and hope I can answer or respond to well). Some of you are becoming quite shrewd with the financial data! I don’t know how much credit I can take for that, but if it’s even a tiny portion, I’ve accomplished what I originally set out to do. Maybe in the future, I’ll even be able to take a quarter off or something!

Ah, yes, mini-lesson. This quarter, Spirit passed one billion dollars in cash. While this is definitely a good situation… well, let’s say I’m glad to hear about some ways we’re planning to spend the free cash flow that we’re hauling in. Learn more in this quarter’s lesson, Can a Company Have Too Much Cash?

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

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

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

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

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

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

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

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

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

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

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

Suggested Mini-Lesson

Returning Value to Shareholders

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

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

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

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

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

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

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

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

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

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

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

Suggested Mini-Lesson

What’s in a Margin?

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

Introduction and Q4 Earnings

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And how did we do against that guidance?

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

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

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

Suggested Mini-Lesson

Can a Company Grow Too Fast?

Hey everyone,

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

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

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

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

The Finances

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

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

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

In general, there are only a few options.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Philosophy of the STIP

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

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

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

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

Final Thoughts

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

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

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

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

Spirit spared the tricks and gave us all treats.

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

Spirit’s financial results are rising from the grave.

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

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

What will you do with your bonus?

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

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

Earnings Call with Larry Lawson and Sanjay Kapoor

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

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

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

Analyst Q&A:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Suggested Mini-Lesson

Where Does the Cash Go?

We’ve probably all heard the overall news: Spirit knocked it out of the park in Q2, at least as far as the financials are concerned. Even those who are uninitiated in the financial realm could probably discern that result from two data points: Spirit stock (SPR) skyrocketed $4.28 (13.15%) on the day of the call, and our current STIP score was announced to be a big fat 2.0 for the quarter.  You don’t have to be an accountant to know that those are… pretty good signs.

It might sound a bit masochistic, but the good quarters are generally less fun to listen to than the bad ones. All in all, I’d rather be bored and secure than intrigued and unemployed, but it does certainly take the edge off of these earnings reports when everything seems to be sunshine and roses.

The call itself was expectedly uneventful. I don’t know Mr. Lawson at all on a personal basis, but if you ask me, there was a hint of swagger in his opening presentation, almost like, “Yeah, we did pretty dang good, huh?” Mr. Kapoor seemed comfortable and relaxed throughout the presentation and questions, and seems to have settled in rather well as CFO. Honestly, even the analyst questions that usually provide some unique perspective were pretty dry this time. One of them joked around with Lawson about Spirit’s results being a relief in an otherwise bleak earnings season. If you watch the market, you’ll know it’s dropped quite a bit in the last week due to some less than stellar earnings from other companies, so Spirit’s results were a small breath of fresh air.

One interesting tidbit that wasn’t directly mentioned in the call is that due to Spirit’s stock buyback (where they, as a company, purchased some of their stock off the market, making existing shares more valuable and competitive), Onex is no longer majority owner of the company. While this doesn’t change the day-to-day operations or even really impact our financial results, it is definitely a step in us becoming a “big boy” company. I believe, and this may be incorrect, that Spirit should now be on the Fortune 500 list based on our gross revenue, and the only thing preventing us from appearing on that list was that we were majority owned by another company. Could be wrong, and it’s not really that critical anyway, but I found it noteworthy.

Since there wasn’t a tremendous amount of heady content to fret over this quarter, and since almost everyone I know likes extra money, I thought this quarter I’d dig into the new STIP score calculation and reiterate a few basic financial concepts along the way. Plus, I know us engineers like our math and minutiae, and this will appeal to those tendencies more than my past write-ups.

Spirit’s official STIP page details the new weighting for calculating the overall company STIP score, which accounts for 70% of your overall year-end bonus. The metrics are:

I think I complained about the lack of visibility in this score in a previous quarter. This new method has remedied that, in my opinion, as I’m actually now able to make a reasonable, if not 100% accurate calculation, which I’ll demonstrate shortly. There are still some assumptions which aren’t clear to me that can affect our score tremendously, but if we don’t post losses (*cough*) they won’t become relevant. For instance, one assumption you could make is that negative metrics (say, negative cash flow), don’t negatively affect the score other than by creating a 0 for that category. In other words, if we met Revenue and EBIT targets exactly, but had negative cash flow equal to our projections, would our score be .25 + .25 + 0, or .25 + .25 – .5? Don’t know. Another question is whether the score reported quarterly is based solely on the quarter or if it’s a running total. Marshall Warren (a fellow engineer) asked Sam Marnick about this, and she had the following to say:

“The score reflects where the end of year performance is expected to be based on our performance to this point in the year. This means the score could change next quarter or in the final quarter if our performance deteriorates.” –Sam Marnick, CAO

To me, that sounds like the score we get each quarter is more of a projection of how the whole year will end up based on what we know so far. It’s a little less defined than I’d like, but it’s still a marked improvement, and as long as we stay positive, I think I can get reasonably close on the score. The last big assumption I made is that the target for a 1.0 score is Spirit’s original financial guidance for the year. Given enough data points we could back these out, but since we only get 4 data points a year (and 3 unknowns, right?), I’m just going to assume around it and hope it’s close.

Here’s how I calculated it, and time will tell if I’m at all in the ballpark:

• I took the high end of the 2014 guidance ranges from the Q1 earnings release (note that I used EPS instead of EBIT… they’re not the same thing, but I don’t have a projection for EBIT here and the ratio should be fairly constant):

1 – 2014 Financial Guidance:

• I then took each quarter’s performance from the consolidated results on the earnings releases:

2 – Q1 Consolidated Results:

3 – Q2 Consolidated Results:

• Aaaaand I slapped it into a spreadsheet and put in my assumed equations for calculating the score:

4 – STIP Calculations:

Now, the trick was to make the future projection based on current performance that Sam Marnick told us about. What I did there was take the latest quarter and assume performance would be exactly identical for Q3 and Q4. The only number that really matters is the end of year – the payoff is only based on the final one, so that’s bold and highlighted red. Future quarters for which I made predictions and don’t have official data are in yellow:

5 – End of Year Predicted STIP:

I feel pretty good about the 1.91 because Spirit’s internal projections for the back half of the year are probably higher than the results for Q2, otherwise they might not have positively revised their guidance as they did (again) this quarter. Also, that .09 gap could be partially eliminated if I used the lower end of the financial guidance instead of the higher. At the same time, my final metrics are over their updated full-year financial guidance, even updated. I’ll keep watching and maintaining this spreadsheet (it’s only 3 cells per quarter =Þ) and keep folks apprised of my findings. For now, we can celebrate the 2.0 and hope that it continues with solid performance into the future!

The final interesting point on the STIP score, and one that I remain cautiously optimistic about, is that 75% of the score is unlikely to be impacted by any forward losses that may occur in the current fiscal year. As we’ve seen before, forward losses directly impact earnings, but have no direct bearing on revenue and only long-term bearing on free cash flow. While I’m still uncertain exactly how the math for this works, using their calculation metrics it seems likely that the score will remain high, even if we get surprised by another big write-off. But I could be wrong, so don’t come after me with torches and pitchforks because I can’t predict the future.

Suggested Mini-Lesson

To close, we should reiterate what all these concepts we talked about actually mean. See the mini-lesson Burger Joint Basics for more!

Iiiiiit’s time for another quarterly earnings call! I’m writing this intro before the earnings call starts, and based on the published financial statements I think it’s safe to say this will be a much easier message for me to write… and for you to read… than the last set of results.

Here’s a link to a great summary of the financial statements with the usual comparisons to Q1 of the previous year. It’s still in financial-ese, and I’ve got a neat story for you to illustrate another financial concept, so keep reading, but also give that link a peek. Remember that Q1 of 2013 our STIP score was something like 1.70, indicating that the reported financials were solid compared to our forecasts and goals. Keeping that in mind, let me draw your attention to the lines Operating Income, Net Income, and Net Income as a % of Revenues on Table 1.

Now, let’s get to the call.

Summary of the Earnings Call

As always with the earnings calls, you could probably discern the performance from the tone of voice and interaction between our CEO/CFO and the analysts even if you didn’t speak English. If you were listening for such things, you’d have noticed that Mr. Lawson and Mr. Kapoor were very much at ease and much warmer than they were compared to defending the dire performance of last quarter. The analysts didn’t ask grilling questions or probe a specific troublesome topic. There was even a little laughter after Larry made a joke about 8-K SEC statements. No, nobody else got it either. Yes, it was kinda funny. Another funny moment was when an analyst was asking about the Tulsa sale and referred to it as “This……. asset.” His opinion on the site was pretty clear and the awkwardness warranted a chuckle.

Overall it was an impressive quarter. Compared to Q1 of 2013:

• Sales grew 20%
• Operating income (money we make from our “core business” of selling airplanes) grew 35%
• Net income (also called “profit”) nearly doubled at 89%
• Net income as a percent of revenues (or “profit margin” – how effective we are at turning sales into profit) grew from 5.6% to 8.9%

These are all really, really solid numbers and reflect tons of improvement not just in sales, but in the efficiency of our business. So good job :).

Some of my buddies made very good observations about the results and about the analyst impressions. Michael Kuchinski pointed out that our earnings per share (it’s just our net income divided by number of Spirit stock shares that exist) of $1.07 for the quarter is nearly half of our projected EPS for the entire year. Well done, Mike – an analyst asked about this very same thing, questioning if our 2014 guidance had some conservatism in it given the Q1 performance. Sanjay’s response was a little laugh; it seems like yes, we’re hoping to meet and exceed that guidance, at least if we keep pace with first quarter performance. You may also have noticed that they positively revised our free cash flow guidance for the year – as shown below (the blue slash and revised figure of $200M is theirs, the obnoxious red arrow pointing to it is mine).

Now, let’s balance this positivity out a little bit. A very insightful observation was also made by Nic Hovey, who caught onto a major trend in the analyst questions. There wasn’t a big central topic to talk about like a forward loss, so the questions were more widespread, but what Nic pointed out that they had in common was questioning the reliability of Spirit’s forecasts. It was a great quarter no doubt, but we’ve had great quarters before and then been burned. We’re not risk-free or out of the woods just yet. We know this intuitively as employees, and it’s clear that the people who analyze our company on a full-time basis feel the same way.

Every quarter since Mr. Lawson has taken the reigns of Spirit, he has constantly harped on Spirit’s free cash flow. I talked about this a little bit in the last email, but wanted to expand on the topic for your learning pleasure this quarter.

To introduce the topic, I’ll relay one of the analyst questions that touched on it.

The analyst noticed that our accounts receivable increased. Accounts receivable (A/R or AR) are like checks written to us that haven’t cleared yet. We provided the goods or services and know the recipient will pay us, but we haven’t got the cash in hand yet. The analyst was wondering if this was due to non-payments particularly from Gulfstream and if we should be concerned about our inability to collect these bills. In short, Sanjay said that the AR growth was due to increased volume and payment structures and it was nothing to be concerned about. But this topic, this accounts receivable and cash flow thing, it’s a good one, so let’s learn a bit more.

Suggested Mini-Lesson

You’ll notice that in this quarter, we had a nice income — $154M in net income (profit). That means that we sold our stuff for more than it cost us to make it, by 8.9% (our profit margin) on average. Great! So uh… why was our cash flow from operations only $45M? And uhhhhh… why was our free cash flow negative $8M?

One part of the answer is exactly what Mr. Kapoor said; when you’re talking about hundreds of millions of dollars, those checks can clear kinda slow. But why free cash flow is such a focus for Mr. Lawson, and why it’s wise for him to focus on that, is a great topic. For this, see the story of the lemonade stand.

Instead of my usual format where I comment point for point on the earnings call, I want to talk about some highlights and explain some concepts in context in an attempt to teach more than just inform. As always with these quarterly write-ups, comments on the usefulness of my email are encouraged and more than welcome. This is something that affects every employee deeply and is probably not understood or explained at the level I think it should be. On top of that, I love teaching and helping people grow, and I hope these emails do exactly that.

To hit the high points, Spirit accounted for a $587M forward loss, mostly attributed to the 787 program (which I think was a surprise to those of us on A350). However, on the positive side (and Mr. Lawson was keen to emphasize this given his focus on cash flow), our adjusted free cash flow was a positive $57M for the year. So what do these things really mean, and what do they have to do with each other? More importantly, how do they relate to the future of Spirit Aerosystems?

Understanding “Profit” and What the Forward Loss Is

First of all, the forward loss. It was the big thing on everyone’s mind, including Spirit’s securities analysts, so a lot of their questions revolved around it. To understand what this actually is, you have to know that profit is perception. Profit is just a number. Profit doesn’t fill out your paycheck or pay for your equipment or whatever else; it’s just a comparison between inflow and outflow.

Looking at a snapshot in time, profit is easy to understand. Take how much money you made and subtract how much money you spent in order to generate that money. Profit is just revenues minus expenses. If you sold $1,000,000 worth of product and all associated costs (the price you bought the product or raw materials at, salary of your employees, cost of rent and equipment, etc.) came to $900,000, you would have made $100,000 in profit. There are some more accounting nuances involved, but that’s the basic description. You guys are smart, number-oriented people, so that’s probably old news to you.

What gets a little more twisted is when we talk about future profits, because there are lots of moving variables. When we make estimates, we make lots of assumptions. This is natural and expected. When the estimates are wrong, we have to adjust, because we have to be able to set honest goals for our company’s performance as well as give reasonable guidance to shareholders. It’s actually the law for public companies. But of course, when we make predictions, we can be wrong. And sometimes, we’re wrong to the tune of $587M. The forward loss is acknowledging this gap between an older estimate and a newer one. Check out the illustration below.

So a forward loss can happen when we don’t improve as fast as we thought we would. It’s pretty common, in manufacturing as in life, that the first time you do something is the slowest. You’re figuring out how to do things and just trying to get it done at all. As you keep going, you get a little more practice and the process becomes quicker and cheaper. When you understand the process, you can make changes to do it better and faster. After you’ve done a bunch, you get some sort of equilibrium where you really can’t feasibly improve anymore. This is where programs like 737 are at and why they’re so profitable – we can churn them out fast, consistent, and cheap. New programs are harder to predict and carry significant penalties for not improving as quickly as planned. In a sentence, the money lost in a forward loss claim is not like a check that Spirit writes, it’s future profits that we won’t make based on our current performance and improvement numbers.

Why take a forward loss? In accounting terms, taking the penalty for a forward loss now, in one big chunk, allows us to “officially” base our estimates on the revised curve. Essentially, instead of taking diminished profits over time and saying “Oops” on every unit that rolls out the door, we say a BIG “Oops” up front and move on with our lives.

One of the analysts on today’s call asked a very good question when he noticed that the profitability curves for 787 specifically seemed to indicate less profit in early 2014. We took this big forward loss to account for 787, so why is it still estimated to be less profitable in 2014?

The answer is that the graph above only illustrates cost, which is only half of the inputs of the profitability equation. The other is revenue – money we make from the sale of the product. Spirit has negotiated stepped pricing with Boeing, meaning we get paid less and less for later airplanes. This is why efficient production is so important; both cost and profit need to be improving, and since the revenue side of the equation actually decreases over time, cost has to decrease even faster in order for profit to increase. Confused? Here’s a happy graph.

In this example, you can see profit changing as a function of both revenue (sell price/unit) and cost. At point (A), we have high costs because we’re early in the production phase, and we also have high revenues that we’ve negotiated with our customer to sustain us while we figure it out. At point (C), our revenues are lower, but our profit is the best it’s ever been, thanks to improvements in the production process. What we’re coming up on, and what the analyst was concerned about, was point (B), which we apparently have happening soon, where revenues are declining, and thanks to our missed improvement curves, our costs are still high. Hopefully these two graphs illustrate why becoming cheaper and more efficient in manufacturing have such a huge impact on our profitability. The last graph illustrates where Spirit seems to be and why the forward losses are such a concern.

The purple dotted line shows a new cost/unit curve where we don’t improve as much as we thought we would. You can see that this significantly eats into the profit of the overall program (the area between revenue and cost along the entire duration of the program). Now at point (C), when we should’ve been making a ton of profit per unit, we’re still barely scraping by. I didn’t illustrate it, but it’s possible that the lines cross, and you take an actual loss on each unit. As in, Boeing pays us $100M for each fuselage and it costs us $110M total to make them.

Why Does it Matter?

Well, obviously if we cross the streams and we spend more than we make, we’ll be out of business fast, just like a household that spends more than it makes will eventually run out of cash and miss its bills. But let’s assume that that doesn’t happen, and ask why our profit and profit margin matter. If we’re making money and paying our employees, who cares about profit?

We all probably understand that wildly profitable companies are better than their unprofitable or marginally profitable neighbors, but it may not be clear why. Ponder the following question:

Why do people buy stocks?

A stock is just a little piece of paper (or these days, more likely just pixels on a computer). You can’t eat it, you can’t use it for shelter, you can’t rub it on your body to prevent sunburn. It represents nothing more than a little sliver of ownership in a public company. Again, who cares? Why own a piece of a company?

Well, to make money, right? Stocks are supposed to have good returns – we’re all staking our retirement and wealth on stocks going up in value over time. But what makes that happen?

To put it simply, you buy stock in order to share in the future profits of a company. This can happen in many ways: the company can pay dividends to shareholders, the company itself can increase in value by gaining market share, improving their processes, creating a new product, etc. But if the company isn’t doing those things, people won’t want to be associated with it. They won’t want to own it. And this creates a death spiral – without support from investors, the company will then become unable to make big investments, create new products, improve their efficiency. And when that happens, a company can capitulate to irrelevancy or death. As a public company, we need people to want to be in business with us, to invest in our stock so that we can make big moves and grow. If we have no prospect of future profits, that won’t happen, and we’ll be bought out, become irrelevant, or shut the doors.

How Does Profit Impact Cash Then?

During the call, a neighbor of mine asked a great question: if we took this big forward loss, why did Spirit’s cash and debt balances barely change at all? This really illustrates the difference between profit and future profits. If, in the 4^th quarter of 2013, we sold $1.5B worth of planes and it cost us $1.4B (and if the transactions in both directions were in cash), we would have $100M in real money to do whatever with – put into savings, buy new equipment, give bonuses to employees, or offer dividends to shareholders. The forward loss will have practically zero impact to cash presently, but as the “forward” part of the loss becomes the present, it will have a profound impact. For past losses, they’ve announced a quarterly cash flow impact. It might sound something like this:

“Our forward loss of $600M (profit) will manifest itself as a $20M impact to quarterly cash flow over the next 4 years.”

Analysts requested such an impact to cash flow from Chief Financial Officer Sanjay Kapoor, and as far as I could tell he dodged it, which was frustrating to me, and, I believe, to the analysts.

So What’s the Future of Spirit?

As always, you can’t determine this from a single quarter. Unfortunately, I think there’s a significant lack of trust in Spirit. Spirit has projected positivity and growth several years running, and has disappointed fairly consistently. This shows up in the stock price, in the analyst ratings, and in your bonuses. Remember that you buy a stock to be part of the future profits the company is going to generate. If you don’t think there will be, you won’t invest. If you don’t trust the company’s leadership for whatever reason, for instance being burned with big, billion dollar surprise losses too many times, you probably won’t invest. As one analyst asked, how can we be sure we’re really done with these losses, especially when we’ve been told we were done before? Both performance and trust determine who wants to be on board. We need to perform to prove ourselves and stay trustworthy as a company.

In spite of this, there are several positives. For one, as Mr. Lawson pointed out, Spirit’s backlog is enormous, and our revenues are steadily increasing. We might have screwed some things up, but we’ve got a pretty good cushion to get it right, given the amount of work we have in the pipeline. We’re also cash positive, which indicates that some of the cost savings measures and quality focus metrics are having an effect. And, though there’s a lot of uncertainty about Spirit’s new leadership, we have to all keep in mind that Spirit is a pretty big company, and it’s going to take some time to steer this massive ship. Great transitions aren’t always obvious when they’re happening, and I’m encouraged that Mr. Lawson has a vision but doesn’t project himself as the hero CEO who’s going to swoop in and get this thing working right away. Those guys rarely move companies into a fruitful future.

So, as we saw this quarter and with the 2013 summary, there are going to be bumps along the way. I won’t lie and say things are super rosy. Each loss like this does eventually affect Spirit’s bottom line, affects our job security, affects investor confidence. There’s reason for concern, but not reason for panic. Spirit has many things going for it, and lots of signs of life. We’ll see if our new leadership’s vision begins to manifest in earnest in 2014.

Please feel free to distribute this email to anyone you believe will find it useful or interesting. Thanks for reading,