Greetings everyone!
By now I’m sure the official communications from our leadership have reached your inboxes, and it’s time for my usual sideshow. This was an encouraging quarter in both the financial numbers and the conversation with analysts. Let’s dive in and find out why!
Starting with the standard view, I have a lot more highlighting than usual, and there’s a lot to dissect here. The first highlighted line (Revenues) shows that in aggregate, we have done more business than last year. That’s driven up by 737 rate increases (which is once again the story of this quarter), and dragged down a bit by declining 777 sales as well as the accounting changes we talked about in previous quarters. All else being equal, more sales is a good thing.
Now, I’m going to create my own little chart here, because in some ways the year over year story is helpful, but especially for this quarter, it’s going to be more illustrative to see Q3 of 2018 vs. Q2 of 2018 instead.
The real tale of the tape here is that our net income (bottom dollar) after everything is accounted for improved by 17% over the previous quarter. This is very healthy improvement quarter to quarter, but it could have been even higher. From Q2 to Q3, revenues decreased very slightly, but Operating Income (the basic business – sales minus cost of goods sold, general and administrative, R&D, and importantly labor) was up ever so slightly. That indicates that the operations themselves are more efficient, making more money from less revenue. This is a good indicator that our recovery efforts are coming to fruition. Look for this relative ratio to be higher next quarter; if the Operating Margin is better than 12.3%, which it probably should be, then that’s a good tell that labor costs related to the schedule recovery are dwindling and we’re back at a stasis point. This is what Tom’s comments about returning to a stable operation (with accompanying margins) are referring to. It will mean we’ve digested the rate increase and are ready for another year of strong and steady production like we experienced in 2016. To underscore this, look at the cash flow summary below:
Yeesh. As it turns out, stuff is expensive. We’re spending hard cash on overtime and expedite to get the factory back to schedule, on top of proactive investments like R&D to position us for future programs and infrastructure growth to make sure we’re prepared for whatever may be to come. Look for this cash flow position (referred to as cash conversion rate if shown as a percentage against revenue) to improve as we reduce immediate cash draws like OT and expedite and as some of our cash flow efforts like extended payment terms start to come home.
This has been a tough year for Spirit. Not bad by any stretch, just… difficult. Many of us have seen or even been part of the focused efforts to return Spirit’s operations to a healthy pace, so we all know the level of effort and associated cost that has gone into that. Now, we see it starting to pay off. Hopefully we will look back at this quarter as the turning point, with more and better performance to come.
Since Sam Marnick was quick on the draw with this quarter’s STIP score, I get to sound off on it. I think 0.75 is perfectly fair considering the earnings. Looking at them in a vacuum, I would have guessed a marginal increase from Q2, perhaps in the 0.80-0.85 range, however, I could also have seen Q1 and Q2 being lower than 0.75. Now that we’re seeing the light again, we have a good chance at making up some lost ground in Q4. Since I’ve so far been allowed to speculate for free, I would imagine a Q4 and final 2018 score in the range of 0.80-0.90. Don’t write any hot checks for in-ground pools based on that; it’s just a way for me to attach numbers to cautious optimism. Achieving that will still take full effort through year-end, and each of us have our part to play to ensure quality, delivery, and efficient operations. I should say that in case you didn’t listen to the call, Tom and especially Sanjay expressed strong gratitude and appreciation for all of the hard work done by the Spirit team. What you don’t hear if you don’t listen to the calls is the tone, which can really tell a good story. In my interpretation, our top leadership gave a lot of credit to all of Spirit for turning this around. They didn’t have to; the analysts don’t necessarily care where the earnings come from. It means something that our top bosses mentioned it on the call, so well done to you all.
In all, a much better quarter by the numbers than we’ve had so far this year, but still not quite peak performance. Let’s work toward a solid Q4 to cap off the year and give us some momentum to springboard into 2019.
Now let’s jump to the call with executive summaries from Tom Gentile and Sanjay Kapoor followed by the ever-entertaining Q&A.
It may not be reflected in my notes, but this quarter’s executive summaries were a little more meaty than usual, and I recommend listening to them if you get the chance. You can find an audio recording of the earnings webcast here: Spirit Q3 Earnings Webcast
…or by searching for Spirit AeroSystems earnings webcast and following the usual Google breadcrumbs. Here are the highlights:
Tom Gentile
- Main focus was to recover on deliveries, and we succeeded. We’re now fully recovered to schedule, shipping in proper firing order, with no expedite costs.
- Focus for the remainder of the year is on operational efficiency.
- Supplier disruptions are shrinking, as well as traveled work and overtime.
- Continuing to focus on rate readiness on A320, 787, and of course 737. We’ve already hired 90% of the people required to support rate 57, and bringing them on early will reduce overtime demands and increase quality. We’re also preparing the supply chain by continuing to address disruptive suppliers and proactively in-sourcing or dual-sourcing parts.
- ASCO acquisition is continuing. There was a concern raised by the European Commission, but we’re addressing it and it doesn’t affect the economics of the deal or expected synergies once the acquisition is complete.
- Working to commercialize Joule Forming, a new Spirit-trademarked process for shaping titanium, as well as starting qualification of Spirit’s first 3D printed component with Norsk.
Sanjay Kapoor
- Revenue up year/year, driven by 737 (160 737s this quarter) and defense activity, and a slight drag from 787 based on the accounting change earlier this year.
- EPS steady but boosted by share repurchases. ASCO acquisition costs will be a slight drag through the next few quarters as we finalize the deal.
- Now that we’re back on schedule, we expect 737 to come through very strongly in Q4 due to reduced overtime, expedite, etc.
It doesn’t really come out in my quick bullet points, but I want to underscore the optimism and gratitude that our leadership expressed. I would also add excitement to that list. Tom’s comments on some of the technological advances that we’re starting to talk about openly are pretty fun to listen to, and I know my engineering friends probably appreciate that.
Let’s head to the analyst Q&A!
Q&A
- Question: What does a normalized margin look like? Will we approach that in Q4? Will we sustain or improve that as we tackle rate increases next year?
o Tom: Around 16% was a normalized margin back when we were in a more stable place operationally circa 2016. With tax reform and accounting changes, we would expect them to eventually be higher than they were at that point in time. Check out our segment improvements from last quarter to now – we’re at about 15.6%, and we expect to see some more improvement in Q4. Maybe another 1.5% overall increase next year considering the dissipation of some of the headwinds we’ve seen in 2018. There are lots of changing variables, some pressuring us and some helping us, but we’re ultimately aiming to get back to that stasis point of 16% or so we had a few years back.
o Travis: It’s no coincidence that this was asked first. There were also several other questions on margins, far more this quarter than on schedule recovery. This means the “surge” is over for now and investors have become confident in the recovery and are now more interested in normal operational drumbeat.
- Question: Regarding the ASCO acquisition, what’s the extent of the one-time accounting stuff? Will we expect 2019 to be a “GAAP” year, or an “adjusted” year?
o Sanjay: Yep, we’ve been figuring that out already over this year. We’ll make sure when we provide guidance in 2019 to provide clarity associated with this. I’m a little hesitant to commit to one or the other because there are still lots of balls in the air. Regardless, we’ve tried to increase our transparency and be very clear about what we’re including and not, and you can trust that behavior will continue whatever happens next year with ASCO.
o Travis: This question has a lot of echoes of the past several years. I like the way the analyst phrased it – a “GAAP” year would be a year with no significant one-time events, whereas an “adjusted” year would be, well, like probably a majority of our years that have had one thing or another happen that we had to adjust out in the earnings to show the trends rather than being wildly variable due to one-offs. As our first major acquisition, ASCO seems as good a reason as any to ask about this, but what the analyst really wants to know is if we’ll have a “normal” year for once, or if we’ll have more adjustments to make. Sanjay’s answer was entirely appropriate, and it speaks to Spirit’s maturity. The big problem years ago wasn’t necessarily the big one-time events; people involved in this industry know that it’s a little more capital-intensive and subject to major movements than, say, selling groceries. What Sanjay said addressed the real problem: surprises. Neither his nor Tom’s offices come equipped with a crystal ball for telling the future, but what they can do to honor the company’s stakeholders is be as transparent and forthcoming as possible. Analysts know enough about finance to work their way around adjustments, but every investor hates surprises.
- Question: In terms of the step to 52, it seems like model mix was a big factor. Can you speak to what you could improve as you go to 57, and how it would be different than what you did at 52? Lessons learned?
o Tom: Biggest lesson is getting ahead of it more, particularly with suppliers. To address that, we’ve increased outside assessments of suppliers to measure their rate readiness and are also proactively dual-sourcing more things to alleviate supply constraints. Second is hiring. We’ve always been hiring, but we’re already looking at staffing and training for 57, giving us more time to train new people as well as reducing contractors sooner. Third is balancing the production line. Next year we’ll have 3 lines, each producing 19 APM. Within that, we’ll have 2 surge days of capacity. At 52, we had 2 lines at 21 APM and a 3rd at about 10, so we had an imbalance that caused factory disruption. So we’ve attacked it proactively, with labor, factory layout, and suppliers. A very multifaceted approach.
o Travis: This was a really good, thorough answer from Tom, addressing the severalthings Spirit is proactively doing to ease the pain of future rate increases. We know that getting to 52 APM has been a challenge not only for us, but for many of our suppliers, so we’re going in and trying to help them be more efficient, which is mutually beneficial. If we run into hard constraints or suppliers that aren’t improving fast enough, we can split the production of some parts between them and another supplier, or supplement with Spirit fabrication (which we’re trying to grow as a standalone business anyway). Advance hiring is fairly obvious, as is “balancing the lines,” which is kind of like making sure we don’t have a wobbly wheel before getting on the highway. All in all, I liked this answer because it shows that Spirit’s approach to this problem wasn’t a cheap “one variable at a time” thing to try to squeeze out short term benefit at the expense of the long. We leaned into all of the things that caused us problems getting to 52 in order to do advanced prep for 57 and potentially beyond.
- Question: When do we now expect ASCO to close, and what was the issue if not divestiture related?
o Tom: It’s actually related to some historic structures that Airbus had set up in Europe a while ago, called Belairbus. These consortiums let Airbus deal with combined entities rather than individual bodies. It doesn’t present an issue for us, we just have to review the old and new situation and make sure all parties are satisfied with how it works out.
o Travis: There’s a whole lot of history to unpack with this one, going essentially back to the formation of Airbus in 1970. I’d rather not delve into it here, but for some bonus reading, check out this blurb on the Airbus consortium and this Wikipedia article on the history of Airbus.
- Question: How is the ramp-up of defense business going?
o Tom: Well, the goal is to get it to $1B over time, and we’re at about half of that ($530M this year). CH-53K is good, B-21 will continue to grow. We’re working with the primes on new opportunities that are coming up, and also trying to do some expansion of fabrication into Tier 2 work.
- Question: Since the ASCO acquisition is on a new schedule, what costs should we expect to linger longer than expected?
o Sanjay: 3 types of costs ongoing – interest expense on the financed portion of the acquisition, integration related costs (legal or other diligence), mark-to-market the hedge. All of it adds up to maybe $0.11 per quarter in EPS drag as we showed this quarter.
o Tom: We slowed the process down deliberately – rather than pushing onto a Phase 2 where the European Commission would have turned us down, we instead chose to proactively withdraw our application, address the issues from Phase 1, then resubmit. It may stretch somewhat into next year, but we’re confident that it will close and we’re working productively toward closure.
o Travis: In short, Spirit is spending a few extra million bucks a quarter to properly deal with the regulatory closure of the ASCO acquisition, so it’s costing us a little more as it stretches later into the year and possibly into next. The real reason I wanted to keep this question was because anyone who has their MBA probably had their ears perk up at the “mark to market” term. In this case, it’s being used as a completely legitimate hedge against currency and valuation fluctuation and is just a device to make sure the economics of our deal doesn’t change over the time it takes to close (see this link). However, mark to market accounting has some history with the Enron scandal, so it’s one of those things that gets talked about as a cautionary tale like the Challenger disaster does in engineering courses. I highly recommend Enron: The Smartest Guys in the Room, for a solid take on the matter. That being said, please don’t start any rumors about Spirit behaving like Enron or something. Just one of those curiosities for anyone who wants to dig a little deeper on a nerdy subject.
- Question: If Boeing decides to increase rate to 63 or similar, does that affect the earlier comments about margin progression?
o Tom: We’re always studying and preparing for things, but Boeing hasn’t announced anything regarding 63, so we’ll wait for them to tip us off. We would definitely have to hire people 6-9 months in advance of Boeing deciding to increase rate, but we don’t know anything about a change in rate right now, and we don’t expect it to affect our margin projections.
o Travis: Again, we would all benefit from a crystal ball. There may be more to this question than I’m picking up, but my naïve hunch is that we’re emerging from a difficult rate readiness exercise, and the analysts want to know if we’re better prepared for the next one even if we don’t know what it is or when it will be. Tom’s earlier answer on the three-pronged approach to proactively handling the rate is probably sufficient for this as well, just interesting that there’s already whispers on the wind about what lies beyond 57 APM.
- Question: Still struggling with relative significance of switch to MAX, supply chain, hiring, etc., and how each of those factors played into the delays we’ve been experiencing. Sounds like we’ve fixed some, but are they really fixed for the future?
o Tom: In rank order of importance: supply chain, hiring practices, NG to MAX transition. We work very efficiently when we have the parts. When work travels, it breaks that down, lowering pace and quality. Suppliers have had a number of various issues – equipment, hiring, raw material, operations – and those affect certain suppliers more than others. There were 13-15 suppliers that were really chronic, and we’ve worked that down significantly. On hiring, we’re lucky to operate in an area that has a very strong skill base of mechanics. Still, we’ve shifted ahead on hiring and training, as well as aligning with some local institutions to increase training and build the pipeline. The model switch from NG to MAX hasn’t been super impactful on our schedule.
*phew*
In summary, Q3 showed some good results, but primarily served as a transition point between the heavy lifting of rate increases and sustained efficient production we hope to see in the coming quarters. Analyst questions shifted from rate preparation to future margins and other growth areas (including the ASCO acquisition), showing that they’re less worried about today and more interested in how bright the future is.
Tom and Sanjay continue to express confidence and appreciation for the Spirit team, and while we’re picking up momentum, there’s always more ahead of us. And that’s a good thing; challenges are why they pay us.
This quarter I recommend the mini-lesson Nike: Just Do It?, which asks in an objective manner if it’s worth it for a company to engage in potentially divisive social issues.
See you next time!