Spirit AeroSystems – Q4 2014

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.

18

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:

19

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

20

And how did we do against that guidance?

21

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?