October 2015 - QuarterSense

Another quarter has come and gone, and with it comes the latest update on Spirit’s performance. While the earnings call was pretty benign, I did pick up on some trends in what Spirit’s analysts have been laying down. I know I’m already late this quarter, so let’s dive right in. Here’s the usual summary of financial results:

I usually talk about how the question and answer session is the real meat and potatoes of the conference. While that’s still true this quarter as always, Mr. Kapoor’s introductory statement had a lot of really good information in it. Here were some of the highlights:

Just for clarification, he confirmed that the earnings per share (EPS) metric excluded the one-time shenanigans from the deferred tax asset valuation. As I’m not an accountant, I can freely admit that that whole deal is way out of my league, so I’m glad that it seems to be concluding. And although Sanjay as our Chief Financial Officer obviously comprehends the nature of the deal far better than I, he joked a bit and said he would be glad to say the term “deferred tax asset valuation” for the last time. I had to giggle when he said that. Here it is in the Appendix of the earnings release (guidance is $3.80-$3.95 after this quarter’s revision):
Last quarter we revised our free cash flow guidance for the year upwards; this quarter we moved EPS upwards. These upward revisions are an indicator of two things. First, that Spirit’s financial guidance to Wall Street for the year was conservative at first (something engineers can certainly relate to), and second, as the year has gone by, we’ve become more confident in achieving the uncertain cash flow and earnings numbers that we thought we could achieve internally.
You may notice that as of the end of Q3, we’re actually in our target range for year-end free cash flow (target is $700M-$800M, with $753M achieved through the nine months ended in Q3). Mr. Kapoor addressed this by noting that the guidance doesn’t include certain revenues that are flaky due to interim contract pricing on the 787. We’re also ramping up capital expenditures (stuff like tools, equipment, renovations) to prepare for rate increases on a number of programs. And lastly, we repurchased $46M worth of shares in Q3; there’s no schedule, but over the next several quarters expect to see some free cash diverted to the share repurchase program.
Oh, P.S. We have a billion dollars in cash now.

Sanjay’s final comments were on increases in deferred inventory on the 787 and A350 programs. As this keeps coming up, I’m going to talk in more detail about deferred inventory next quarter. If I get a ton of feedback from you guys, I’ll put something together before next quarter’s call, so let me know. It’s a big topic, and I’ve only come to really grasp it in the last few months thanks to the help of some great, knowledgeable folks (thanks to Craig Bayless in particular).

Anyway, deferred inventory (DI just for convenience) is basically excess manufacturing cost above and beyond the planned cost per unit. As long as we can recover it in the future, it sits in the DI balance for the program. When we come in under cost for a unit, the DI shrinks. Here’s the fun part: if it becomes clear that we will never recover those costs, the unrecoverable amount becomes what we all affectionately know as a forward loss. I now understand why the analysts, still timid from historical “corrections” to our profitability, are very very attentive to growth in DI. This quarter, 787 added $25M to their DI balance ($800k/unit over 31 units), while A350 added $16M ($2M/unit over 8 units). While that’s not something to celebrate, of course, Mr. Lawson assures us that this is typical for the developmental stages of these programs, and that we’re on plan regarding manufacturing learning curves.

On that note, let’s turn to the analyst Q&A session!

There were two major trends in the analyst questions, emerging from the mixed bag of topics that always gets discussed during this majority portion of the conference.

The first was the deferred inventory issue. In response to one question, Mr. Lawson mentioned that when A350 started, we were running over cost by $28M/unit on the A350, and this quarter we’re down to $2M per, and that that alone represents tremendous progress. He says that considering all factors, we should be able to beat the 100 airplane “stability point” where we more or less know what to do when building these things and can do it consistently.

One analyst asked about Spirit’s accounting method of utilizing deferred inventory/forward losses/cumulative catch-ups (the opposite of forward losses, issued when we outperform planned costs per unit) rather than just accounting block-by-block or quarter-by-quarter or something. I’m willing to bet many of you have asked the same kind of question. Larry and Sanjay answered that pretty well, so here ya go. For one, it’s mentioned that we’re taking a lot fewer of these accounting ups and downs than historically, and that the dollar amount on them is smaller all the time (this is a true statement if you dig through the financials). We have a pretty strong concept of our costs now. Another piece of the answer came later when an analyst asked about missing one A350 delivery this quarter. I really appreciated Larry’s answer on this one. He clarified that the long-term outlook is that the program has strong demand and backlog. Let me riff on this for a minute. This is one of those things where, as a business culture, our focus on quarterly results doesn’t always paint the whole picture. Larry’s answer acknowledged this. It’s a bit of a ticky-tack question to ask about one plane here, one plane there, when we’re planning to build a full production run of dozens to hundreds of planes. Yes, it matters for quarterly results (especially early in a program’s life), but eh… it’s a rather small impact long-term.

The second major trend was our contracts and pricing agreements with customers. I’m a little embarrassed that I’ve been missing this for so long. There are usually questions on how contract negotiations are going, and I sort of just put them on my mental backburner and wait for more interesting questions. Well it finally clicked for me this quarter. After our top brass answered the analyst about using forward losses and cumulative catch-ups, saying that we’re using those less, but that they’re a good way to bundle the big numbers associated with airplane making and that we have pretty good cost control now, the analyst mentioned that he wasn’t as concerned about uncertainty in costs like historical write-offs have been based on, but about pricing.

See, cost control is what Spirit does. The stuff that goes on inside our facilities, we have policies and procedures to control, we have people who get experienced and better at their jobs, we can hire new people in, increase training, decrease overhead, whatever. We have a great deal of control over that part of the business. What the analyst is concerned about is the higher-level business-to-business workings that determine how much revenue our programs generate. We can control costs as well as we want, but if there’s no money coming in, our margins aren’t going to be there, and we won’t be profitable. So while I’ve been more or less dismissing this issue, it occurs to me now that it’s literally what drives the top line of Spirit’s earnings.

At any rate, Mr. Lawson seems quite confident that the negotiations are favorable to all parties, and that we have symbiotic relationships with our customers and partners. Due to the nature of these discussions, there’s very little he can disclose, and that makes sense. But it will certainly be an item for the Spirit analysts, and all of us, to listen for in the future.

One last question that I found particularly interesting. An analyst asked Lawson where growth was going to come from as our business stabilizes and even our big development programs mature. Of course there was the normal bit about “organic” growth happening via rate increases on existing programs and leveraging relationships with current customers. And there are always opportunities for “inorganic” growth through new business opportunities and securing work on new programs. But for perhaps the first time I’ve heard, Lawson mentioned the possibility of acquisitions in the future. At least for a nerd like me who just digs business finance, I’ll be watching closely to see if there are any plans on that front. Our company gobbling up other companies might incite some of that excitement that’s been lost since the forward losses have slowed down, without all the stress and worry over losing my job.

Okay folks, as with every quarter, thank you for your time reading this! While I started doing this just for the fun of it and as a service to those immediately near me, and still keep writing on our earnings because I enjoy it, I do always appreciate feedback, questions, comments, and your own observations. I have a list that grows every quarter of those who want to receive future emails directly from me. If you want to be on it, just email me. Also, each quarter I get lots of chat conversations and emails during and surrounding earnings calls, which I am always honored by (and hope I can answer or respond to well). Some of you are becoming quite shrewd with the financial data! I don’t know how much credit I can take for that, but if it’s even a tiny portion, I’ve accomplished what I originally set out to do. Maybe in the future, I’ll even be able to take a quarter off or something!

Ah, yes, mini-lesson. This quarter, Spirit passed one billion dollars in cash. While this is definitely a good situation… well, let’s say I’m glad to hear about some ways we’re planning to spend the free cash flow that we’re hauling in. Learn more in this quarter’s lesson, Can a Company Have Too Much Cash?

Ever since I started writing these mini-lessons, I’ve focused on the importance of cash flow, cash reserves (savings), and cash utilization. And while these are certainly vital topics in understanding ongoing corporate finance as well as business growth (and its limiting factors, in the case of “Can a Company Grow Too Fast?“), there is indeed a flip side. Many companies never achieve the financial breathing room required to even wonder if they have “too much” cash, and while it’s a much better problem to have than not enough, a large enough stash can indeed be a negative for a company’s finances. Today, I’ll share a couple of reasons why that’s the case.

1) The company isn’t reinvesting in itself enough

In many ways, corporate finance can be understood using similarities to personal finance. In personal finance, it’s always good to have an emergency fund. You want to save up a financial cushion for when a car needs repairs, when the air conditioner goes belly up, or someone is unexpectedly let go. Savings are wise not only for emergencies, but for general liquidity — a “finance-ese” term for being able to access cash easily for whatever reason.

But cash, even though it feels good and secure and stable, is a terrible vessel for large percentages of your money. Due to inflation, cash actually declines in value over time. Even if it were stable and never lost value, almost nobody has both the income and the financial discipline to save 50% of their earnings for retirement. Once you’ve built up some emergency cushion and some “general liquidity” savings, there are better uses for your money. Debt should be paid off, because it works against you at whatever the interest rate is. You should also invest, since over the long-term, good investments will outpace inflation and actually make you money.

For companies, it’s very, very similar. Cash is great, because companies have emergencies and experience unplanned events just like you do in your personal life. They also get opportunities for things to buy that might not be necessary, but that are beneficial to have.

But at some point, that cash is just rotting away when it could be doing something. In the case of a business, that “something” is usually obvious: if we put that money back into the business, via equipment, or marketing, or personnel, we would expect to get a rate of return equal to our profit margins on that money. Or we have debt that, just like personal debt, works against us at whatever the interest rate on the loan is.

Cash for the sake of cash is worthless. If it’s not protecting against the unknown or allowing rapid response to emergent opportunities, it might as well be put to use to eliminate debt or invest in endeavors with some level of return.

2) The company expects a dimmer future

Last summer, when I was young and naive and finishing my MBA, I learned about the “harvest strategy.” The harvest strategy is employed when a business (or part of a business) has matured to a point of saturation, and there is little or no growth opportunity remaining. In this case, reinvestment is foolish; there’s no growth, market share, or profitability to be gained by pouring extra cash in, so instead, we’ll just rake in the rest of what we’re making and move on. In the case of diversified companies, that money might be channeled into another product line or division. In the case of small companies or those specific to a single product or industry, they may just save up the cash until they close the doors and withdraw their wad.

If industry, market, or competitive trends remove the benefit of reinvestment, cash becomes a more attractive option. Cash also becomes a more attractive option if the business is souring. Most likely the only reason my dear BlackBerry still exists today as an independent company is because ex-co-CEO Jim Balsillie kept the company debt free and cash rich (for an interesting business biography on the rise and fall of BlackBerry, I recommend Losing the Signal, by McNish and Silcoff). Again, using similarities to personal finance, if your company has announced layoffs, it can be prudent to save as much as possible in order to deal with the temporarily heightened uncertainty.

However, both of these options are reserved for companies in decline. If a company’s cash reserves are growing and analysts are asking what the plan is, you want to listen closely. The responses can indicate what the leaders of the business think about their future — vital information to anyone interested in the company, from an investor or an employee standpoint.

3) The company becomes a takeover target

There are about a thousand similes I could use here to illustrate this, and none of them are particularly kind, so grant me some leeway. At times, big companies can be like schoolyard bullies. If they see a smaller kid carrying around a lot of cash (or maybe a particularly desireable lunch), they can strongarm the victim and use it for themselves. Sure, they could pick on a kid with a nice, expensive backpack or a pair of high-end shoes that they could take, resell, and come out with the same gain, but that’s a whole lot more work. If they can get what they want directly, it’s to their benefit.

That’s a weaker analogy than I usually come up with. Sorry for my shortcoming. Big companies are not necessarily mean-spirited, and takeovers are not necessarily hostile or singly beneficial. But hopefully it’s good enough to illustrate the point.

If a company has too much cash, due to underutilization, declining business, or just lack of direction, well, somebody else can use that money better. Instead of letting it waste away in the corporate coffers, they’ll put it to use. In fact, since they’re the new owners of the company, maybe they’ll just reinvest it to get returns equal to the company’s margins, as mentioned before.

Apple is famous for its cash hoard, but then, they’re also basically immune to takeover at this point because of their growth rate and profitability, as well as their multiple hundred billion dollar valuation. But a small or medium company with a big loaf of cash can start looking really tasty to bigger fish.

4) The company isn’t rewarding shareholders

A top goal for any company is to make money for its owners. If the company is publicly traded, that means that the owners of its stock are the “real” ultimate owners of the business. While it’s in everybody’s best interest for the company to keep enough money to operate and grow, at some point, if the business is working well, some of that money should go back to the owners! Whenever the fundamentals are in order and the company clearly has the income to maintain business as usual and grow at a healthy pace, shareholders will start asking for a cut of the profits they’re entitled to. For a more thorough discussion of some of the ways companies can give back to their shareholders, see this article.

Month: October 2015

Spirit AeroSystems – Q3 2015

Can a Company Have Too Much Cash?