Hello everybody, and welcome to November, and Spirit’s 3rd quarter financial summary!
As is tradition, let’s start by taking a quick look at the numbers.
Here’s the earnings and margin summary:
And the cash flow summary:
I highlighted the numbers I did because this quarter’s call focused a lot on “margin dilution” and what that meant for our future. You can see that our operating margin and net margin (highlighted on the first table) were down against last year from both a running 9 month perspective and a 3Q16 vs. 3Q17 perspective. Margin is why companies exist. It’s proof of our value proposition in the marketplace. A reduction is always going to be a bit concerning.
To allay your fears, our leadership had reasonable answers for why these numbers slipped. A lot of the slide in margins is because of our efforts to improve the future. We’re running expensive cost and quality initiatives that hurt our numbers now, but square us up to be more competitive, more profitable, and a higher quality partner in the future. That type of thinking should speak to all of us. It means our strategic direction isn’t focused on maximizing quarterly results at the expense of the bigger picture.
As a tacky metaphor, think of the lower margins this quarter like the feeling you get the day after a hard workout. You’re a little sore, a little weak, a little stiff, but you know you’ve done something that will make you stronger once you’ve recovered. Spirit’s cost savings and product quality initiatives are tough now, but are the exact kinds of activities we need to be doing to be healthier in the future.
I highlighted the free cash flow numbers in the second chart to illustrate another key takeaway: even during some major efforts to prepare Spirit for the future, we’re still bringing home good money. Margins may be the heart of a business, but cash is the blood, and Spirit’s is plenty healthy. This quarter’s financial results were just okay. But it brings the promise of better results in the future. It should be fun to watch.
Now let’s turn to the call.
Tom and Sanjay Introductions
The introductions were brief and positive as usual. They highlighted Spirit’s push for fabrication and defense work to be major growth areas, and they gave the standard fly-by on programs that are growing and shrinking. In this quarter, it was much the same as it has been recently: 737, 787, and defense were growth areas which were partially offset by lower 777 and aftermarket activities.
Overall, Tom and Sanjay were congratulatory to the Spirit team and seemed enthused for the future.
Before we jump into the Q&A, I have a quick disclaimer. I’m not sure if I just wasn’t on my game during the call or whether the content was truly above my level, but the Q&A this quarter seemed pretty broad and theoretical. I didn’t capture the usual amount of good questions and answers, and a couple of items are going to require some further study on my part to explain properly.
What you should take away from this though, as always, is the tone of the conversation. I wouldn’t have missed a question as unambiguous and dire as “Will Spirit still be open in the next 6 months?” Typically when the conversation leans far into the future, or heavily into strategy and theory, it means there isn’t overwhelming concern about the present.
Let’s go through the questions I did catch, with the executive responses and some limited feedback from me, then we’ll be on our way!
Q&A
- Why will cash flow be weak in Q4 based on current guidance? And why did we have margin dilution in all the sectors?
o Sanjay: Cash flow is due to higher capital expenditures to support rate growth, as well as some of the initiatives I’ll mention in a second. Margin dilution is partly due to some one-time aftermarket kinds of things. We’ve also been pouring lots of effort into supply chain initiatives that haven’t yet materialized in the numbers, but should start to appear in 2018. We’re currently supporting lots of rate increases and lots of ToW (Transfer of Work) activity as we optimize supply chain. We will see some inventory growth as we see rate increases and see some added inventory from supply chain activity.
o Travis: The Q4 cash flow question was interesting from a simple math point of view. The analyst who asked this question took our provided 2017 full-year cash flow guidance, subtracted our actual performance through Q3, and noticed that Q4 is due for a decrease. Fun little Finance 101 problem. The margin dilution question goes back to my opening comments. Margin is a company’s heart, so a reduction is always concerning. Luckily, Sanjay gave us the answer to the preeminent question of this quarter’s call. Our margin is low now because we’re currently shouldering the burden of organic growth (rate increases) and cost savings efforts (supply chain, ToW) at the same time. The low margins this quarter aren’t a sign of weakness, they’re a sign of active preparation for the future.
- This quarter we had $5M in negative adjustments. Is that a systemic problem?
o Sanjay: $5M is pretty much noise. That’s spread across all programs, so sometimes we realize risks or miss opportunities, and sometimes we avoid risks and realize opportunities.
o Tom: 737 rate increases actually caused some of the drag, where 737 is usually a boon. Part of that was also a refocus on quality with the Flawless Fuselage initiative causing some minimal disruption, but to increase the product quality. We’ve learned lots of lessons from this and expect it to be even stronger next year.
o Travis: Ah, right, I haven’t mentioned Flawless Fuselage/Factory yet. This is, of course, another effort that isn’t free, but that is clearly part of Spirit’s positioning and value in the marketplace. One way to look at reduced earnings, if they’re not due to loss of revenue or growth in costs, is as reinvestment. We’re “burning” some of our earnings to improve quality (Flawless Factory), to get ready for more business (rate increases), and to focus on saving costs (SCM/ToW initiatives). Nonetheless, Sanjay’s right. $5M for Spirit is just noise. Sometimes it’s in our favor, sometimes it’s not, but it’s not an indicator of some giant lurking problem.
- Are we worried about margins as we’ve got rate increases, some margin dilution this quarter, some price step-downs associated with the MOU, etc.?
o Sanjay: Rate increases are expensive to capitalize up front, but we do eventually get productivity gains via fixed cost absorption with rate increases. Supply chain efforts are similar – expensive up front, but big potential savings for a long time. So we’re actually looking at some long-term margin increases if all of our initiatives come home, which we’re pretty bullish on.
o Travis: Pretty much the same question as before. Keep in mind that repeated questions or slightly rephrased versions of the same question are really good tells of what’s bugging the analysts. It might make for a boring call to hear the same question twelve times in an hour, but that’s your clue that it’s the top-of-mind issue. To add just a little more to Sanjay’s already rational explanations on the lower margins this quarter, we should all keep in mind that Spirit’s long-term cash flow conversion goal was very recently increased. That means we expect our ultimate bottom line to look more favorable in the future.
- On your billion dollar defense target, is that coming from products we’ve already won and will grow to that goal, or does that goal depend on winning new work or taking it from competitors?
o Tom: Current programs over time get us to the billion. Still, we’re continuing to pursue organic growth initiatives to expand that and get defense up to a 15% share of our business even faster.
For anyone keeping score, the major topics of the call were supply chain initiatives and margin realization, which we’ve discussed above. Spirit is undergoing a bit of a transition again, but unlike last time, where we made some tough choices to potentially save the company, this time the transition is to move from a solid foundation to an even stronger place.
Stock price is an imperfect indicator, but it’s a good thing to look at for calibration. In the case of this quarter, it told a pretty fair story.
On earnings day, while Wall Street was digesting our financial results, which were admittedly pretty tepid on their own, our price was down. To be sure, there wasn’t a great deal to go all “buy frenzy” about in the numbers. But as it settled, everyone realized investing for the future is actually a pretty worthwhile reason to have temporarily lower margins, and the stock recovered in the following days back to where it was before (and beyond).
And that’s it for the quarter!
Below is a little essay I started some time ago and have finally gotten ready for people to read. I hope you find it interesting and inspirational.
See you next quarter!