Spirit AeroSystems – Q1 2016

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

Financial Summary

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

q1-2016-1

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

q1-2016-2

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

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

Executive Introductions

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

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

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

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

Q&A

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

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

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