Better late than never!
On Friday, February 2nd, Spirit hosted our 4th quarter 2017 and full year earnings call. I have a feeling it’s been a confusing quarter for some observers. Inside Spirit, our final STIP score for the year was a respectable 1.60, which would signify strong, above-average performance. However, from an outside perspective, Spirit’s share price took an unmitigated beating of nearly 10% in response to our earnings. So what’s the deal, and how does it really impact us day to day? I’ll try to answer that with this summary. Keep in mind it’s one man’s opinion, and I’m open to interpretation and hearing your thoughts in response too.
Since this is a full-year wrap up and comes with forecasted guidance for 2018, the writeup will probably be a bit longer than normal. I know. It won’t hurt my feelings if you skip around a bit or read this in parts.
All that said, let’s get started!
Financial Summary
Ordinarily, I would highlight at least one of these numbers that I thought was critical in telling the story of the quarter. This quarter, there’s only one number that mattered to the street, and it’s not on any of the standard results tables we look at.
What you’re looking at in Table 1 is an increase in revenues (people are buying more of our airplanes) and a decrease in year over year earnings, but with a good cause – the primary cause of the decline in earnings is attributed to the adjustment we made for the Boeing master pricing agreement. Keep in mind we took that big forward loss that we considered a tradeoff: we gave up on earnings now for much more certainty of our business with our largest customer in the future.
Taking out the one time effect of the Boeing MOU forward loss, we had a respectable 17% increase in adjusted earnings per share. That means all things considered, we saw strong improvement in not only demand for our product (growth in revenue), but also in the execution of our internal business (growth in adjusted earnings). That’s all good news!
The story told by Table 2 is twofold. First, there’s an increase in capital expenditures (you’ll hear this on the call as “Cap Ex” or “PPE” for Property, Plant and Equipment). This increased spending accounts for rate readiness investments as well as productivity and facility investments. Growth in this category largely means we’re investing for the future, which is naturally a smart thing to spend money on. The second factor is the 28% increase in adjusted free cash flow, which means that after smoothing out one-time cash events related to pricing agreements and stuff, Spirit is generating more cash than last year even after investing more money for the future.
At this point, you may be saying, “Okay Travis, that all sounds pretty good, so why the reaction from Wall Street?” Fair question. The story from these two tables is why our company STIP score was a very solid 1.60. The next two pieces of the puzzle are why we took the 10% stock price beating.
Table 3 shows our forecasted guidance for critical earnings metrics next year. The past several years, Spirit has proven good on their philosophy of forecasting accurate but conservative guidance, then revising it upwards as we move through the year. Still, this is the first glance that investors have at how Spirit will perform in the upcoming year.
What we’ll learn later in the Q&A portion is that what we forecasted wasn’t exciting enough to the investment community. You can call it a Wall Street quirk, but forward looking statements like this can be more impactful than reports of actual earnings. At some level, sure, it’s a bit silly for people to sell out of a stock because earnings were good but not better than expected or because forecasts aren’t as high as desired. On the other hand, the point of owning shares in a company is for the value of that company, and therefore the shares, to rise in value. What we’ve done so far is great. But if we’re not going to increase in value, why own our stock?
So that’s part of the reason. But the more direct reason that the market reacted like it did, in my estimation, is a line squirreled away in the Fuselage Segment results. See below:
This $21.7M is the number that really carried weight. The word of the quarter, you probably found out if you listened to the Q&A, was “headwinds.” That word was specifically said nine times on the call, with many more indirect references to the same idea. Yes, we showed solid results for the 2017 wrap-up. Our forecast for 2018 was a little softer than what the market wanted, but we’re usually fairly conservative in our guidance so that shouldn’t have hurt that much. But a whiff of weakness on 737, our bread and butter, was cause for major alarm. This $21.7M worse-than-expected performance on 737 indicated to investors that for all of the advantages of rate increases, we’re not staying on top of it as well as we could be. The 737 is our foundation, and any tiny sign of instability there starts setting off alarms.
Our leadership is well aware of this. Many of their opening comments as well as answers to questions asked on the call alluded to how we’re proactively working on training and capital to make 737 rate increases seamless and profitable. As it turns out, growth is good, but growth is also hard. How we handle the strain of that growth going forward will tell the next chapter of our company’s story.
To be completely fair, I also attribute some of the market’s reaction to our earnings to just plain bad luck. We happened to report earnings during the market’s biggest downturn in the last 4 years, so everyone was already skittish and nervous. We’d been riding the market up for the last 3 months, then we provided a squeamish market a tiny shadow of doubt and they ran with it.
The long and short is that we performed well in 2017 and have a good, but challenging 2018 ahead of us. Sometimes the stock price movement is a good reflection of performance, and sometimes it’s just not. What we need to do from here is focus on executing our growing business and let the analysts do their own thing.
Alright, you’ve listened to me yammer on. Those are my general thoughts on the quarter, laden as usual with opinion and guesswork. Now let’s turn to the call itself!
Executive Intros
Tom Gentile:
- In 2017, we exceeded our provided guidance on revenue and earnings, with adjusted free cash flow at the high end. This was driven by a new record of 1651 deliveries.
- This year we returned $549M to our shareholders – $502M in share repurchases and $47M in dividends. We actually returned over 100% of our free cash flow to shareholders.
- We’re looking down the barrel at a lot of rate increases. That’s great because it means we’re on desirable, growing programs, but it does present unique (and costly) challenges. We’re trying to be more proactive in 2018 about planning for upcoming rate increases.
- One major highlight from the year was the long-term pricing agreement with Boeing, which removed uncertainty on revenues and reset the relationship with our largest customer.
- We’ve started strategic initiatives with major customers and suppliers, as well as investing in technical knowledge and capacity.
- For anyone curious how Spirit is spending their tax bill savings: we intend to reinvest the savings from tax reform in high return capital expenditures and R&D to support our growth expenses, as well as workforce development and productivity initiatives.
Sanjay Kapoor:
- We’re experiencing unprecedented levels of rate increases on our core programs. Of course that’s a good thing, but it comes with costs. We had significant additional costs in hiring, training, and overtime, as well as disruptions due to supply chain pressure and quality initiatives. All of these things pay off in the long term, but are naturally costly today.
- Capital expenditures grew by $20M this year ($254M up to $273M). This increase is due to rate increases but also investments in productivity and competitive positioning.
- In 2017 we repurchased half a billion dollars of our shares, and the board has authorized up to a billion more. Our first priority is to invest in ourselves. We’ll continue to look for strategic acquisitions, but absent those opportunities, we’ll continue to return value to shareholders through repurchases and dividends.
- This quarter we adopted some accounting changes (ASC 606 and ASC 715). This will affect how we report revenues and earnings in the future, and will have different implications for different programs. For instance, 787 will continue to reflect zero margin performance because the forward loss reflects costs greater than revenues that are still actually in the future. In contract, the A350 forward loss activity is behind us, so there will be an adjustment to retained earnings, but A350 will operate with a positive margin going forward.(Travis Note: The ASC 606 changes and retained earnings are complicated subjects that will require a little extra explanation. Since this is already going to be a long summary, I’m forgoing the mini-lesson at the end and will expound on some of these topics in the Q&A. I also want to thank Meredith DeZorzi, who reached out to me last quarter and was kind enough to meet and explain some of the changes to me. Meredith, I apologize if I butcher the explanation J).
- In 2018, we’re utilizing around $75M from the tax reform benefit in R&D and technology development to put us in a stronger position for the next generation of military and commercial programs and invest for our long-term success.
Tom and Sanjay painted a pretty positive picture of 2017, and an optimistic, but honest assessment of our challenges heading into 2018. Many of the things they talked about will drive the conversation in the Q&A, specifically what we’re doing with the benefits of tax reform, how we’re addressing the difficulties of rate increases, and what some of our overall strategies for growth are moving forward.
Let’s get to it!
Q&A
- Question: You said you’re investing an additional $75M in CapEx and R&D due to tax reform. Last quarter said we were making sufficient investments and we need to be careful with how we deploy CapEx. How does the tax bill change that strategy from before?
o Tom: What we’re really doing is accelerating initiatives we were planning but didn’t have focus on before. For instance, rate increases are expensive, so we’re investing earlier in some automation to help support that. There are also some infrastructure plans for systems to increase productivity (WiFi, uninterrupted power). R&D is another area we’ve really doubled down in the coming year.
o Travis: Considering the concerns for the quarter, this was an interesting question to lead off with. And it’s a prudent question, too. What the analyst is asking is how important can these extra investments be if we weren’t already going to make them before tax reform landed. We got some more money, so the plan is to just throw it at stuff we didn’t think was important enough to spend on before? Tom’s response is that it let us do things we already planned to do but earlier, not like we just imagined up some things to spend money on. This was a good question and I encourage you to read or listen to Tom’s full response if you get the chance.
- Question: This quarter you showed $32M in forward loss reversals, and $19M of negative cumulative catches. What were the sources?
o Tom: Negative catch is unfortunately on 737 – primarily due to rate increase challenges. Reversals are related to 787 program increase to 14 APM.
o Travis: 3 or 4 questions in, the 737 rate increase “headwinds” topic had already been asked about in one way or another a couple of times. It was clearly top of mind, and not without reason. This would be like McDonald’s saying there was a concern next year about ground beef supply. Even if there’s plenty of Coca Cola and fries available and sales are increasing, everyone is obviously going to be a bit concerned about the core product if there’s a sign of weakness.
- Question: Can you talk about profitability across segments over the near and medium term?
o Tom: Let me provide a high-level comment. In our industry, you have to run fast just to stay in the same place. We have a lot of supply chain initiatives and have reset prices on over 20,000 parts, so we have a lot of savings yet to materialize in the next 10 years. As those things kick in, they will naturally offset some of the headwinds that we will see across segments.
o Sanjay: Due to the accounting changes (discussed later), there may be some more variability every quarter now, because the accounting blocks are across much shorter windows of time. On A350, they should be positive though, since we’re going to book profit on that going forward.
o Travis: Tom went a little aside here. At this point, it was already becoming clear that there were only two real questions this quarter: what are we doing to address rate increase difficulties, and how are you utilizing tax reform? Tom and Sanjay had both mentioned several times about the proactive training, hiring, and productivity investments we’re making on 737, as well as the R&D efforts to make us more competitive with current and future work going forward. Here he goes outside the question a bit to mention another leg of the headwind mitigation effort: supply chain strategy. Since this is my new world, I can give a little bit more detail than before.
On our major programs, there are several thousand part numbers built by hundreds of suppliers all around the world. Some we make ourselves, some we buy from others and assemble, some we get straight from Boeing to assemble before we deliver, and so on. Each of these thousands of parts are on a contract that has some end date depending on how we originally negotiated the deal. What these initiatives are doing is trying to achieve savings by finding a more competitive supplier for a bunch of parts, but one major constraint is that we have to abide by our existing contracts. So when Tom says that these initiatives will “kick in” over time, he’s referring to the fact that some contracts will expire sooner, and those parts will go to more suitable suppliers and we’ll start saving money quickly, while other deals won’t show up in the numbers until later down the road. How the schedule and magnitude of those changes intertwines with the rate increases and price step-downs will impact our performance quarter by quarter.
- Question: You’ve talked a lot about fabrication, defense, and Airbus as some of your opportunities for inorganic growth. Have we given up on mergers and acquisitions (M&A)?
o Tom: We recognize that there’s a lot of activity among suppliers on the market, but we definitely have a specific focus and want to be strategic. Our main criteria are Airbus content, military content, low cost country footprint. And we’re keeping our options open. That being said, corporate valuations are at multi-year highs. If we can find something that fits our needs not only strategically but at the right price, we’ll move on it. But otherwise, we’ll keep investing in ourselves with share repurchases as well as strengthening our internal business.
o Travis: Ah, fun answer! A real world, living example of someone not getting caught up in the hype and trying to buy high instead of buying low. Acquisitions are big, sexy ordeals in the business world, but they’re also very difficult to properly execute – look at some of the high profile acquisitions in the last two decades and ask yourself how they worked out (hmmm, might make for a great mini-lesson). What Tom is saying here is essentially cool your heels Wall Street, we know acquisitions are saucy and what-not, but we’re not so enamored with the idea that we’re going to jump in if we can’t find a good deal. We still have plenty of opportunities for good investments without making some big commitment to buy another company at the highest market value it’s ever been.
- Question: How does ASC 606 really affect you?
o Sanjay: It will reduce our revenues very slightly, something in the range of $30M (
o Travis: Okay, the time has come. ASC 606 is a set of accounting changes that is a response to some of the confusion around forward losses, cumulative catch-ups, and all that time-distorting accounting voodoo. As I understand it, under the old rules, we booked revenue based on the contract pricing with our customer and booked costs based on a ratio to those revenues. Cumulative catch-ups (positive or negative) occurred when we squared up our true costs with what we had accounted for. And the justification was usually over a relatively large number of shipments.
The new system changes it so that we will track cost on a per-unit basis instead of as a ratio against revenue. Instead, revenue will be calculated from the true cost. Additionally, the blocks over which these calculations are made will be much shorter – on A350 in fact they will be unit-by-unit, while on 787 there will still be short blocks to smooth out irregularities.
If you never quite understood the whole cumulative catch-up system, well, know that the people whose job it is to interpret this stuff had issues with it too, hence the change in accounting standards. I still had questions after talking to an expert on the subject, and there were a few questions that she also shrugged at. We don’t make the rules, but we still have to understand and abide by them as best we can.
Having said that, here’s why the new system should result in smaller surprises. Profits should now be stable, with cumulative catch-ups made to revenue instead ofearnings. Think about it this way – you might think you care about your salary, but what you really care about is your take-home pay. If some change happened and it kept your salary the same but took $200 away from each paycheck, you’d be farmore concerned than if your salary got adjusted but your take-home pay stayed the same. Your take-home pay – your earnings – is what you live on. Your salary – your revenues – only really matters to you via how it drives your take-home pay. Investors in Spirit will see this change the same way. They should be far less sensitive to adjustments in revenue than they were to adjustments in earnings, because it’s not messing with the dollars that make the most difference.
Now, there will be some one-time adjustments when switching over to this new system. We will make adjustments to our retained earnings, which is a simple but often confusing accounting subject. Retained earnings are a running record of the earnings a company has kept over time. In other words, if money isn’t spent as part of the business or redistributed to investors, it goes into retained earnings.
This means that (ideally) retained earnings continue to grow and grow over time, but there isn’t a whole lot of practical information you can glean from it. It’s sort of like the year-to-date pay on your pay stub. At one time, you had access to that money, but since then, you’ve spent it, saved it, invested it, etc. When we switch to the new accounting system, we will reduce our retained earnings, but that will let us book profits on A350 from here on. It’s sort of the anti-forward loss – we’re taking profits from the past and shifting them into the future to be consistent with the new approach. It would be sort of like taking money from your savings account to increase your take-home pay. Sort of.
What does it ultimately mean for the average Spirit employee? Nothing much. Hopefully our earnings will be more consistent due to this change, and one-time adjustments won’t be as heavily scrutinized because they’ll be to top-line instead of bottom – messing with the dough instead of the pie.
Now, my warning is that I may have drastically misrepresented something here. Blame it on my lacking as a student, not the knowledge of my informant. If anyone wants to correct or clarify it for me, I’d be happy to get together and listen! In the meantime, I hope this has been a bit of a helpful explanation.
Whew. I think that’s going to be it for me this quarter. I apologize for how late I was to get this out. I will commend the leadership team though on their increased transparency; many of these topics were discussed with candid feedback from our executives on the recent webchat. At some point, these summaries may become irrelevant since you can just ask leadership directly and get their answers, and that would be okay too. In the meantime, I’ll continue to give my spin and hope it’s added value.
Congratulations on a great 2017 everyone, and here’s to a great 2018. See you next time!