Defer, Defer, Defer

Posted on February 7, 2016 by Travis Lane

There are two basic types of accounting. What you’re probably most familiar with is called Cash Basis. In Cash Basis accounting, the amount of money left over at the end of the accounting period is the “profit,” or possibly “loss” if it’s negative. This is most likely how you do your personal finance. You may not think of it as accounting per se, but it’s keeping track of where your money goes over time, hopefully so you can make good choices with it, same as a business wants to do. Your bills most likely occur each month, so it makes sense to plan around how much you’ll make that month (your personal “revenue” line), then deduct out bills (“expenses”) and choose what to do with the rest – save, spend, invest, etc. There are only so many fundamental things you can do with money, and your list – spend, save, give, invest – is the same as a business.

Cash Basis is used in the business world, but it’s exceedingly rare, perhaps absent, among publicly traded companies. Instead, they Accrual Basis. With Accrual Basis, revenues are counted as they areearned and expenses counted as they are used. Why? Companies almost always have big investments that need to be made that would distort the trending performance of their business. The simplest example is a building. If a company buys a 100 million dollar building, it’s going to destroy the quarter they did that in, because it’s a huge one-time expense. But then, as they use the building, it seems to be free – until they have to do maintenance, or expand their property, or anything else. Cash basis would result in huge spikes and dips in profitability, and wouldn’t really represent the ongoing nature of business. Instead, Accrual Basis would depreciate their owned assets as they’re used, smoothing out the cost of a building, or expensive equipment, over the course of its useful lifetime. That lets us compare the cost of the stuff against the revenue that it helps us generate over time. This is actual, useful, relevant data.

There’s no question that Accrual Basis is superior for most businesses of reasonable size. There’s also no question that it leads to some interesting complexities that can confuse people without an accounting education… like, you know, most of the employees of most businesses. In today’s lesson, I want to talk about just a few of these concepts that seem to “distort time.” Hopefully after this, you won’t have to ask yourself, “With all these deferrals and catch-ups and depreciations, what actually happened this quarter?” It really does make sense, but you can’t be blamed for thinking it’s not clear. Let’s work on closing that gap, using a few common time-distorting concepts to illustrate.

Deferred Revenue

Another named for Deferred Revenue is “Unearned Revenue.” All this means is that somebody paid us in advance for work that we have yet to do. We don’t want to account for it in our profits and cash flows just yet, because it would make the quarter we were paid in look really good, but then as we do all the work over a number of quarters, it will drag all of those quarters down. This is a good reason to generate an “Adjusted” figure to better represent the trend, rather than all the ups and downs that are more random. See the example below:

Here, we’re paid $192M up front for work that we have yet to do. Sure, we’re heavy by $192M in cash, but if we account for it all now, we’ll be appearing to do work “for free” over the next several quarters. We chose a slightly annoying time distortion by using deferred revenue over a performance wrecking cash-basis method where we would have a big quarter now, but be $50M worse off for each of the next 4 quarters.

Just to even things out (like in all math, your equations have to balance), we will add $192M worth of liabilities to offset the advanced payment cash. Liabilities are most often thought of as debts; all debts are liabilities, but not all liabilities are debts. Some liabilities are services that we have to provide, as in this case. See below (read right to left for chronological order):

You’ll notice that the difference isn’t exactly $192M, since this is the growth in deferred revenue over a whole year (Dec 2014 to Dec 2015), but that $192M is in there prominently. Since that revenue is considered a “liability,” we can claim it as a benefit whenever we feel appropriate by reducing the deferred balance to equalize whatever gain we want. We’ll use this to claim profits as we actually produce the products we owe the customer, resulting in a more accurate depiction of our performance on each unit.

Deferred Inventory

Alright, deferred revenue was the slow pitch to start. Another major type of deferral that we hear about often is Deferred Inventory. This one is a bit more complicated… I’m gonna have to use a shoddily hand-drawn graph, so buckle up.

Deferred inventory is a feature of large-scale manufacturing. In the earnings calls, you’ll hear a lot about “accounting blocks” and “learnings curves.” This is because the first time you make a massive, high-tech product like an airplane, well, you kinda suck at it. We do our best to estimate how many units need to be produced before we start sucking a little less, then a little less, and so on, until we really hit our stride. Each of these ranges of less-suck-ness may become an “accounting block.” As in, we really suck on units 1-20, suck a little less on 21-40, and after 100 or so we’ve actually gotten pretty reliable and good. This is because we’re progressing down the learning curve over the entire course of production – across and within accounting blocks, we hope to be getting better at what we do.

When we take on a major project, we’d ideally like to estimate the overall profitability of the entire program. From beginning of design to last unit off the press, how much money will our company make? Those estimates exist, and deferred inventory, along with forward losses and catch-ups, is how we adjust those estimates to reality. Let’s dig deeper.

So what is deferred inventory? Time for the first shoddy drawing:

In a sentence, deferred inventory is the difference between how we really performed and how we expected to perform. Our estimate for line unit (S/N is for serial number above) 12, say, is based on some assumed learning curve. If unit 12 costs more than we expected it to, that overrun is unit 12’s deferred inventory. It’s added to the deferred inventory balance for the program.

Deferred inventory will metaphorically sit there and rot (unlike physical inventory, deferred is “just a number”) until we make a unit that costs less than estimated. If we do better than expected, it reduces the deferred inventory balance.

Now the trickier parts. If we believe we will never, over the entire course of the program, make gains that will deplete some of the deferred inventory, we have to write it off as profit we won’t ever earn. This is what’s known, affectionately, as a “negative cumulative catch-up,” or “forward loss.” The counter to this is the positive cum. catch, in which we beat estimates by more than we ever thought we would, and we can write additional profit.

Hopefully, that helps clarify what’s really going on when the analysts and executives talk about growth in deferred inventory, or deferred cost per unit. They’re talking at the absolute highest levels of any program. The deferred inventory balance is a measure of our overall performance on a per-unit, or at least per accounting block (several unit) basis. And the forward losses/catch-ups are adjusted profitability for the lifetimes of whole programs. So it’s quite a big deal.

Again, if it seems confusing, or manipulative of the numbers… well, it is. But it’s the best way to resolve some of the complexities of accrual basis accounting applied to large-scale manufacturing, and accrual basis really is the superior method of accounting for large businesses. It’s not complexity for complexity’s sake; it’s complexity that exists to represent reality as best as possible in a very complex situation with many moving parts.

Depreciation

Okay, so the heavy stuff is over. Let’s look at one more quick example and call it a day. One of the big three financial statements is the Statement of Cash Flows. It can be a little weird the first time you encounter it, because it works backwards from net income, adding back in expenses until you get to cash flow from operations. In other words, you’re adding money you spent; ordinarily you expect to subtract it.

Whatever. There are two basic kinds of costs in business: variable and fixed. Variable costs are those that depend on how many units are being built. Simplest example? Hamburger patties are a variable cost. You need to buy one patty for each burger you sell. Fixed costs are the “barrier to entry” items. The grill you cook a burger on is a fixed cost. You need it to get in the game.

Each type of cost has its advantages. Variables costs are nice because they’re flexible. You can get exactly as many burger patties as you need. On the downside, you don’t ever escape those costs. The variable cost of burger #1 is the same as burger #1,000,000. Fixed costs kinda stink because they’re often costly up front, but they benefit massively from repeated use. A grill makes burger #1 very expensive to make (cost of a patty plus an entire grill), but by burger #1,000,000, the fixed cost component gets divided out over a million units and is basically free.

When businesses have to make big, expensive, up-front purchases like buildings, machinery, tooling, equipment, etc., it can absolutely wreck their financials for the period in which they bought it. So, while the cash hit happens whenever cash changes hands, the profit can be smoothed out using depreciation.

There are many different methods and approaches to calculating depreciation, but it doesn’t really matter for illustrating the point: by “distorting time” with depreciation methods, the overall trend of profitability can be shown instead of a huge loss up front followed by gains. If the restaurant estimates that their grill will last 5 years, they can assume reasonably well that by depreciating the grill’s cost over that time frame, they’ll get a pretty accurate measure of profit as they move along. Depreciation prevents burger #1 from showing up on the profit and loss statement as costing $600, and instead makes each burger, from #1-#1,000,000, cost about the same.

While accrual basis accounting can have some funky features like those listed above, you can pretty easily build a case for its superiority for larger businesses. If something doesn’t make sense, look for how it affects the timeline and the trendline of the business. And if you can’t quite figure it out, well, you can always defer the topic to another day.

Spirit AeroSystems – Q4 2015

Posted on February 7, 2016 by Travis Lane

Hey everybody. Welcome to the 2015 wrap-up. Forewarning: since this wasn’t just a quarterly report but a year-end summary, and because all parts of the call were really good, I have a lot to talk about. If it’s too much, feel free to break it into sessions, send it straight to the trash, or compose anonymous, vitriolic emails to me about my excess. But I hope you find it enjoyable and maybe a bit educational too.

In many of these earnings call write-ups I’ve said how sometimes what you want to hear as an employee of Spirit isn’t what you want to hear from a “let’s talk about finance” perspective. Good performance is often, frankly, pretty boring, and doesn’t tend to bring up a lot of fun or interesting topics. Now, as I’ve always tried to qualify, I’ll take good and boring numbers over exciting and poor. But it sure would be nice to have both now, wouldn’t it?

Well, I’m happy to say that that’s exactly what this quarter delivered! There are ordinarily a number of questions I zone out for, especially as the session drags on, and the introductory statements from the executives are usually pretty stoic. Not to say they aren’t fine orators, just that the introductions are just that, and usually breeze through the highlights rather than diving deep into the substance of the call (my apologies to Mr. Lawson and Mr. Kapoor if I’ve inadvertently insulted a blossoming corporate comedy sketch). I mentioned last quarter that Mr. Kapoor has started really providing pretty outstanding insight in his opening bit, and that trend continues here, where his summary even gave me a detail or two to teach you folks about.

Okay first off, the “too long; didn’t read” version: performance continued to improve in the 4th quarter, and Spirit’s 2015 full year results show marked improvement in the growth and stability of the company. There shall be bonuses.

If there’s any of you who just read these to see if the bonus will be good or not (can’t say I blame you), there you have it. Actually, you engineers are some crafty folks — someone emailed me the final STIP score before the call even started. You people are hilarious in your dedication and skill in finding stuff out.

Before getting into the call, I will also say (because this quarter I’ve abandoned any pretense of brevity) that many of you are becoming quite savvy with the financial statements. I don’t know if I can claim any credit at all for inspiring people to look into the finances, but it encourages me every time someone shares an observation, comment, or thought. This stuff is good for you to understand as you progress through your career (at least that’s what my business professors said), and it’s good for Spirit to have more people understanding the heartbeat of the business. So keep digging in!

Alright, the results. Let’s start off with the usual summary table:

As we look at this, there are a couple of things to note:

2014 was a pretty good year — recall that the operating loss in the Q4 comparison was primarily attributable to the Gulfstream divestiture shenanigans. But 2015 was better still.
The reduced revenue in 2015 is due to two major factors: elimination of Gulfstream programs, which, though they weren’t profitable still generated revenue, and the Boeing 787 price stepdowns (more on that later). In other words, the reduced revenue is not a worrisome figure.
13% operating margin is… really good.

Let’s also take a peek at free cash flow — how much actual cash is left after making necessary investments in our growth and other such things:

This also tells us a few things:

We’re improving in big ways on converting the money people pay us for stuff (revenue) into money we get to keep and choose what to do with (free cash flow).
PPE (Property, Plant, & Equipment) increased pretty significantly in 2015. This is a leading indicator of rate increases, which means the company’s business is growing. We might be concerned about this number in a vacuum, but we also know from many calls now that the expanded costs are to fuel rate increases, and we like doing more business in stuff we know is profitable.
We’re hanging steady around a billion dollars in cash. It’s a more philosophical thing, but it seems to me that our leaders are targeting a certain debt-equity ratio (one of the tons of measures of financial well-being), and they’ll probably increase investments like share repurchases to maintain it. That’s just a guess based on their actions so far with the surplus cash we’ve been generating the last several quarters.

Last thing before getting into the call itself (yes, we’ve only just begun!) is looking back at the company’s performance versus its estimates (guidance). These figures are from the updated guidance provided after Q3:

And notes on this one:

The original guidance from February of 2015 was minimally different — $3.60-$3.80 EPS and $600M-$700M FCF.
Revenues were $6.64B, right in the middle of the guidance.
Adjusted EPS was $3.92 per share, right in line with the upper end guidance. Our non-adjusted EPS was higher, but included the one-time deferred tax asset… whatever. A bit more on this in a minute.
Adjusted FCF was $738M, again right in the middle of the guidance, and slightly above the original guidance provided at the beginning of the year. If the “adjusted” figures are starting to raise your eyebrows, stay tuned. They really do make sense, I promise. I’ll talk about them in the mini-lesson, Defer, Defer, Defer.

Okay, the numbers say we did pretty well. We’re actually getting to keep some of the massive piles of money our customers pay us now. The business is growing nicely — not too fast, but at a healthy and sustainable rate. Now we’ll turn to the call to see what our leaders, and the analysts scrutinizing our stock, think are the big issues and questions facing us moving forward!

Mr. Lawson and Mr. Kapoor’s introductory statements were the usual highlights, going over the vital numbers and adding a few comments on major developments and such. Some of the points were notable though and deserve a little expanding upon for those less versed in finance-ese.

A350 deferred inventory balances per shipset decreased from $2.3M to $1.2M between Q3 and Q4. What this means is that the amount we’re “over budget” on each A350 is decreasing, rapidly. $1.2M might still sound like a lot of money, but it’s actually really darn good. An analyst goes on later in the call to ask if Airbus is going to want to renegotiate pricing, insinuating that our improvement is so good it might make them think they didn’t get a good deal.
On the topic of deferred inventory, overall 787 deferred inventory (not per unit, but total) increased by $7M. This is also not too bad. We lost some revenue due to price stepdowns (Boeing pays us less per plane in this accounting block), but we made up for almost all of it with production performance improvements.
Our “adjusted” Earnings Per Share (EPS) was $3.92 versus non-adjusted of $5.66. Most of that difference is due to the deferred tax asset valuation allowance, which isn’t worth going into here, but basically is a one-time gain related to the Tulsa divestiture. This is a great opportunity to remind you what the analysts are looking for in Spirit’s numbers. We want to remove significant one-time events in order to see what the overall trend is in the performance. Let’s use a personal finance example that’s relevant right now: tax returns. If you get a substantial tax return, it’s going to significantly help your budget out in the month that you receive it. But you also shouldn’t base your financial health on that, because the difference between your income and outflow is a truer measure of your actual performance on a continuing basis. We want to recognize this distinction and provide that insight to illustrate what the future might hold without some of the more odd events that have occurred.
Last thing from the executive intros: we received $192M under the interim pricing agreement for 787 that we considered “deferred revenue.” That means we got paid for work that we haven’t actually done yet; another name for deferred revenues is “unearned revenues.” We got cash but we also have a liability of work that we have to provide that offsets it. More description of this in the mini-lesson.

Alright, so the big bosses think we did pretty well, and gave us some info on top of the numbers to expound on it. This quarter our leadership gave us an excellent appetizer. Now let’s turn to the main course of the call — analyst Q&A.

This quarter, I wanted to do something new. To help illustrate what I’m always trying to get across about how the nature of the analyst questions is as important as the questions (or answers) themselves, I actually wrote down every single question so I could categorize them. The topics asked about more frequently are likely to be those that represent the largest concerns someone looking at Spirit critically might have. It’s not a perfect method, but it’s helpful to paint a picture of what to listen for in the Q&A section. Here’s the count:

Financials (Numbers Question/Clarification): 7
A350 Production: 4
Mature Boeing Program Rates: 4
787 Pricing/Contract/Production: 3
New Business/Future Opportunities: 3
Executive Search: 1

Now, given that it’s a call centered around the financials, it’s not surprising that the top category usually has something to do with the numbers. I double counted some questions since they had a numbers-based question but also related to something else. But peel away the given top category (earnings calls are gonna be about the financials), and you start to see what people are asking about: A350 (specifically production costs), 787 (specifically Boeing pricing contracts), Spirit’s capability to support rate increases (737) and not be harmed by rate decreases (777/747), and a little bit about what kinds of things are in the future. Those are our hot spots. So what did they ask, and how did Spirit’s top brass answer? Let’s find out!

Question: So uhhhh, we heard you’re looking for a new Chief Operating Officer. Talking about succession maybe. Sup?
- Answer: (Mr. Lawson jokes that Sanjay answered the last question so well that he should take this one too.) Lawson says we’ve done a lot of executive team building — 89 of the top 98 jobs are people that are new to the company or new to the position (I’m… not sure if we should be proud of that number or not). He mentions that it’s interesting that this time around, looking for qualified executives piqued peoples’ interest. He says we’ve slowed down searching at the executive level, but we’re still looking to build talent. We don’t have an existing succession plan, but we do want to build something comprehensive. He mentions that his contract, which was part of the speculation, is auto-renewing, so that component isn’t a big deal. Succession planning is a good thing, but there’s nothing imminent. Mr. Kapoor tosses in that the number of Saturdays that Larry is here hasn’t changed recently or anything.
- Travis: It was interesting to hear this question on the call after this Reuters article got the rumor mill churning. I had a whole spiel on this when people kept asking me about it, but the short of it is this — executives are people too. People have strengths and weaknesses. Having a top position in the company open leaves the possibility for someone to be acting in a weak subject when we could instead have someone there who’s strong in that area. They teach you in business class to “hire your weakness.” I don’t traipse about with Spirit’s execs a lot, so it’s not my place to say who among them might be strong or weak in various facets. The point is, searching for an executive, even as part of a succession plan, doesn’t mean that Larry Lawson is fixing to abandon us at his first chance. It may simply be a smart move to plan for the future. It may be to cover a gap in the skill set of the head honchos. Or it may in fact be to replace Mr. Lawson when his contract expires. People, even executives, also have their own lives, goals, priorities, and plans. What’s important is to not get caught up on undetermined futures that may or may not come to pass. If Lawson does leave soon, all we can do is judge him on what he did while here, which, if you go strictly by the financials, has been a lot of good. People can (and certainly will) talk about whatever other aspect of his leadership they like, but these summaries are about the earnings, and there’s been substantial improvement there under Lawson’s tenure. And I’ll leave my potentially career-ending speculation at that.
(So uhhhh, back to the numbers…) Question: In the 2016 guidance numbers, we would’ve expected higher cash flow given your numbers for the last two years. Why is 2016 lower?
- Answer: Mr. Kapoor answers that we’re working against a pretty big headwind due to the deferred revenue we’ve received (as discussed earlier and more in the mini-lesson). Other major factors include a need for working capital as A350 production rates increase, and 777/747 rate reductions will impact our cash flow too.
- Travis: George Shapiro, my favorite Spirit analyst, asked a great question. It always excites me when Shapiro’s name is mentioned in the call because you just know he’s going to ask some unbelievably technical, numbers-based question. Engineers listening into the call would resonate with this guy. Anyway, Sanjay’s answer is thorough and gives some important factors to remember as we start on 2016. We’ve got rate decreases on mature programs that would ordinarily generate lots of cash, we’re ramping up on developing programs that consume a lot of cash, and we’ve got this deferred revenue situation where we’re working “for free” against a pre-payment we’ve already received. So keep those in mind as we go through 2016.
Question: We’re 50 units or so into A350. We’ve been hearing that 100 units is the sort of “stability point” when it comes to getting things working smoothly. What’s the status on that?
- Answer: Mr. Lawson says it’s becoming even more clear as our deferred inventory per plane comes down that the most important component in the cost picture is rate. He continues to be confident in the production learning curve and stable costs.
- Travis: Lawson alluded to fixed costs in his explanation of why rate is so important. He brings up a great point and a concept I’m not sure I’ve discussed before. If building an A350 requires $100M in tooling, then to build the very first airplane, you need $100M in stuff before even thinking about materials and, you know, the actual airplane. That is a fixed cost. But as you make more and more of them, those fixed costs get sort of amortized over the number of planes you’ve made… at 50 planes in, if you’ve used the same tools, then it’s cost you $2M per plane. These massive fixed costs are what we mean when we say that Spirit is a “high capital business.” Apple can design a phone and send orders to existing manufacturers in China that already make phones for a dozen other phone companies. We’ve got to cough up 9-digit money to build airplane #1. As for how A350 is doing, another analyst later on would ask if Airbus is going to want to renegotiate because our current deferred inventory cost per plane is already better than break-even. The program has had its struggles, but it’s improving a lot, based on these numbers. We’ve gone from $26M per unit in deferred at the end of 2013 to $13M at the end of 2014 to $1.2M now. It’s not totally free from concern, but Spirit is starting to do what Spirit does — make lots of expensive planes pretty darn well.
Question: Can you give us an apples-to-apples comparison between 2015 and what we expect in 2016?
- Answer: Sanjay says that 2016 will be a lot “cleaner” with fewer one-time events (in other words, fewer “adjustments” and stuff needed to show the trends). There are still variables, like the need for working capital, and the deferred revenue stuff, but year over year, we’re making good improvements. That’s why the baseline free cash flow is improving so well over the scope of years. We have a long-term goal of 6-8% for cash flow conversion.
- Travis: I had to bring this one up for the cash flow conversion thing. It was funny to hear a target number out of them, because several quarters prior, Larry said they didn’t have a particular goal for cash flow conversion. It’s nothing vital, it just made me chuckle a bit that they’ve decided on a target for it. For the record, cash flow conversion could also be called “cash margin,” just like the different tiers of “profit margins” we’ve discussed before. In 2016 “adjusted free cash flow margin” (AFCF / Revenue) was 11.1%, but the 2016 guidance estimates a little below 6%. Be looking for that number in future earnings calls. It’ll be fun to see how it evolves as things smooth out.
Question: The step up in share repurchases was a little faster than expected. Has there been a change in philosophy on that? Or on M&A opportunities?
- Answer: Lawson responds simply with the phrase, “9 P/E”. Lawson knows how well his business runs. He says sometimes he wishes he could ask the analysts questions. We’re the best investment we can make right now.
- Travis: Ohhhhh my gosh, this was such a great answer from Lawson. First, remember that share repurchases are generally a good thing, so it’s a good sign that we’re ramping that activity up faster than expected. Now, to the fun stuff. P/E is price-to-earnings ratio, probably the most common indicator of whether a company’s stock is over- or under-priced. When you buy a stock, what you’re buying is a hope of future earnings. If the share price is low compared to the earnings, then you’re potentially getting those future earnings at a good value. A P/E ratio of 9 is pretty low compared to the broader market and historical averages. I don’t know about aerospace specifically, but Lawson is basically saying we’re underpriced, and his quip about wanting to ask the analysts questions during the calls was basically saying, “Why aren’t you sending investors our way? We’re waaaaay stronger than our current stock price indicates.” Bold. Direct. Awesome. Another finance term you may have missed in this question — M&A. M&A stands for “mergers and acquisitions.” Another question would be centered around this as well, asking if we were considering cash deployment to M&A to supplement our growth outlook. In other words, are we thinking about maybe buying other companies to support our growth? For me, this is an exciting thing to be in the air. Lawson says that they’re still looking at options. We’re in a cash and cash flow position now to where we can do share repurchases and think about M&A (buying other companies out) because we’re not highly leveraged. Lawson says it needs to be the right situation, so we’ll see what the future holds. I’m happy with their stated approach so far. We’re in a position now where we could start doing exciting, sexy M&A stuff, but our leaders aren’t doing that just to grow for growth’s sake. It needs to make sense to our overall business. So while it’s exciting to start hearing about these things, they should be done carefully and correctly, and it seems that they’re being properly cautious while still looking into really neat stuff for our future.

Oooooooookay, since this post is already massive, it’s time for me to sign out for the (financial) year. It’s been a ton of fun writing these and having you all read them. I appreciate so much the support I get, and the implied recognition when people send me questions or comments on Spirit stuff. 2015 showed continued improvement, and 2016 will have its challenges, but seems promisingly headed in the right direction.

If you’re not quite tired of me yet, head on to the mini-lesson Defer, Defer, Defer, that fleshes out some of the financial concepts from this call a bit more thoroughly.

Thanks again for the opportunity to share some of this stuff with you. I hope I can continue to provide value (and maybe a little entertainment) through these summaries. And I always welcome questions and comments if you have them.

Until next time!