February 2017 - QuarterSense

Ahhh, economics. The dismal science.

The problems with economics are many. It’s not an observation of immutable natural law like physics or chemistry. Nor does it heal the sick like medicine. Heck, it doesn’t even inspire or entertain like literature or music. Perhaps that’s why it’s the black sheep of the Nobel Prize family… whereas Physics, Chemistry, Medicine, and Literature have their respective Nobel Prize in ______, economics has The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, named as if Nobel were posthumously trying to distance himself from the field and could only barely tolerate his name being tacked onto the prize at the very end.

Okay, it’s easy to make fun, but I do it from a warm heart. I love economics, or at least, what economics has evolved into over the last several decades as the field began to question one of its oldest, most defining, and most impractical assumptions. They say beauty is in the eye of the beholder, so let’s behold some history and see whether you think it’s lovely or ugly.

See, classical economics tends to assume rational agents, operating with perfect logic to maximize their value from an economic system. There’s even a name for this concept – Homo economicus – the Economic Man who behaves with flawless rationality to optimize his outcomes.

To paraphrase from the sage wisdom of the flop 2002 kung fu parody Kung Pow:

I’m sure on some planet your assumption is impressive. But your weak link is: This is Earth.

Real people don’t always behave rationally. Even when doing so is fairly simple. We had a phenomenal example of this in JC Penney’s change to pricing strategy in 2012. Remember that? They ditched the fake “sales” and went with “fair and square” prices, where they simply listed a regular price instead of the same price listed as a “sales price” against the inflated “normal value.” Sales plummeted, and they abandoned the strategy. Homo economicus would not care whether a $10 shirt was on sale from $40 or whether it was always just a $10 shirt. But Homo sapiens looooove a deal. Brand value and loyalty, pricing and marketing strategies, and much more of those business “tricks” exist because humans aren’t purely rational. Studying them as if they are is foolishness.

From this realization, the field of economics started to evolve. It took some inspiration from psychology, sociology, and neuroscience, and put the “human” back in economics, morphing into behavioral economics. It creates the same kinds of economic models as the classical version of the field, but makes some adjustments so that the models work for humans as opposed to emotionless robots.

Why in the world am I telling you this? Let’s step back a minute and take a question I received from a reader:

A question regarding the revenue, income and cash flow and the customer… at what point does the customer point to these numbers and say “enough is enough” and ask for discounts on the product we supply?

There seems to be a happy medium where you are keeping the investors happy, but still keeping customers happy with acceptable prices for your product. Not sure if there is a universally accepted sweet spot. Maybe the answer is not quite that simple.

-Dustin Tireman

Good question, Dustin. I’ll give you the simple, classic econ answer, and the more nuanced, completely unscientific, Travis’ behavioral econ answer and let you decide what you prefer.

Classical economics would basically have a chart for you to build or reference. It might be complicated, but it would tell you the exact optimal price to hock your product at. Something like this:

Yawn.

These kinds of things have their uses, conceptually and practically. But it’s not the final, “real” answer in the real world that we occupy. With physics, you can break out a calculator and determine how far a ball will fly or how much weight a pulley can lift if you have enough information. Business is messier. It’s both the beauty, and the curse, of business studies. There isn’t an equation to give you an exact answer.

That isn’t to say there’s not a strong, rational component. Our customers can calculate the cost of buying our product from us versus making it themselves. If we can sell a product for $100 and make a $90 profit, but it would cost our customer $500 to make it themselves, that’s an easy sell. They don’t care about our 90% profit margin, because it’s still an 80% discount to the alternative.

But that’s where the human side comes in. If they know that we make 90% profit margins on what we sell to them, they’ll raise an eyebrow. They’ll know it’s possible to do it much cheaper, and they might invest in the ability to make their own stuff or look for another company to buy from at a lower price.

What could we do to avoid that? Well, we could adjust our prices to a lower margin, sure. We could also prevent them from knowing exactly how much profit we get on those products. One way to do that would be to aggregate products across the business into a more central margin, so that the whole picture looks more equitable. We might still sell some products at a 90% margin, but if the customer is happy paying that, and across our entire business they see a fair margin, say 12%, they won’t dig into it. This creates the tug of war between information we legally have to disclose to shareholders and information we will absolutely never disclose. Corporate margins that include a rollup of all programs, we have to publish. But we will never publish margins on a specific program or product if we can avoid it, because it open the window for that critical eye to whittle our profits down.

And doing this is not deceptive. Every time you go to the store, you know you’re paying a profit premium. Whether you buy a pair of pants, a bag of oranges, a car, a television, you know that you’re paying some company more than they paid to make that. But if you think it’s a fair price for whatever reason, rational or otherwise, you’ll buy it. If not, you won’t. Win-win.

So, the “behavioral” answer to optimal pricing in the real world isn’t so much an equation or a chart (though they may be helpful), it’s more conceptual. Your price should be:

Greater than the minimum amount you would be willing to do business for
Less than the amount that would piss your customers off enough to walk away

The grey area in between? That’s business.

Beautiful? Ugly? I’ll leave that for you to behold.

Howdy folks! It’s earnings time again at Spirit, and it’s the special one that not only has the 4^th quarter results, but also the year-end summary.

For folks who enjoy finance and numbers, this is “The One with Bonus Information.” For those of us who just enjoy bonuses, this is “The One That Matters.”

Let’s start with the usual summary, and throw in some of that delicious bonus information. We now know Spirit’s full-year performance, so we can compare ourselves against our financial guidance and see how we did!

And for good measure let’s throw in the cash statement too:

Okay, there’s a lot to unpack here, and I’ll try to keep it quick.

The word on the street regarding this quarter is… not good. Our shares were down between 4-6% all day, which is of course never a good look. However, myself, my finance buddies, and (most importantly) Spirit’s Chief Financial Officer, have a more… nuanced perspective. Frankly, I find the sharp drop in share price to be a bit of an overreaction.

Before opinion, data. Here’s how Spirit’s full-year numbers stacked up against our latest revised guidance and our original 2016 guidance. Let’s also include what we said for our 2017 guidance to see how we expect these to change this year as well.

	2016 Results	2016 Original Guidance	2016 Last Adjusted Guidance	2017 Guidance
Revenue	$6.79	$6.6 – $6.7	$6.7 – $6.8	$6.8 – $6.9	(billions)
Earnings Per Share	$3.70	$4.15 – $4.35	$3.65 – $3.80	$4.60 – $4.85	($/share)
Adjusted EPS	$4.56	$4.15 – $4.35	$4.30 – $4.50	$4.60 – $4.85	($/share)
Free Cash Flow	$420	$350 – $400	$400 – $425	$450 – $500	(millions)

Remember that we adjusted earnings guidance as a result of the A350 long-term pricing agreement in Q2, and that while we took a forward loss to do so, it was generally hailed as a good thing. Our stock was up 7% or so on that earnings day, despite a forward loss, despite lowered earnings guidance, because the deal signaled stability. This resulted in the creation of an “Adjusted EPS” flagnote with a difference of $0.86/share from GAAP earnings (Generally Accepted Accounting Principles – the Big Book of Formulas that companies have to use when presenting accounting info).

Our “official” earnings guidance is the second row above – we started the year expecting $4.15+ (Q1), lowered it by $0.86 or so to account for the A350 write-off (Q2), then raised it a little to account for better performance (Q3), and finally, closed it off in Q4 by beating our adjusted target and coming right in line with our official one. Confusing? Well, it’s all part of being honest – we adjusted our expectations as business items changed. Ultimately, we performed pretty well and reported it as honestly as possible.

So, why did our shares go up when we took the forward loss and lowered guidance, but down when we performed on-target to prior guidance? If it was a problem, why wasn’t it a problem then but it is now?

I have no idea.

Maybe someone smarter than me will reach out after reading this and inform me, as they often do. Maybe Wall Street is just a fickle mistress. One article led with “Spirit AeroSystems profit falls about 22 percent”, which is… true-ish; Q4 2016 net income was down 22% against Q4 2015, though our adjusted EPS in 2016 was 16% higher than 2015, so it’s not exactly like our profits are in freefall.

Alright, real talk. What I suspect is happening isn’t so much about the current numbers, but about the forecast. It’s not that we performed badly in 2016, it’s that the impacts of certain market shifts are at least as heavy, if not heavier, than the analysts predicted. A more telling article gives the following reasons for the gloomy outlook:

Quarterly revenue was hurt by lower “pricing terms” for Boeing’s 787 program and fewer production deliveries on the 747 and 777 programs
Boeing cut production of its cash cow 777 jetliner by 40 percent this year as it focuses on newer models
Spirit also forecast 2017 profit and revenue below analysts’ estimates (our guidance was revenue of $6.8-$6.9B and earnings of $4.60-$4.85, analysts expected $6.92B of revenue and $4.86 of earnings)

We’ll dig into a few of these issues in the Q&A, but that’s my speculation on what’s happening. 2016 was fine, but 2017 looks like it might be a little soft, especially early on. What we inside Spirit are taking into account are the things on the horizon: 777 is declining, but we’re positioned for when 777X hits the market (we’re cannibalizing our own business, which is a good thing). We have rate increases on core programs, and we have new stuff that we’re looking at all the time. Markets don’t necessarily care about that. If we’re going to enter some doldrums in early 2017, investors are within the bounds of rationality to go elsewhere and come back when the wind is at our back again.

Yyyyyyyeah. Little bit heavy for an intro, huh? Luckily, the Q&A section is short this quarter. Let’s meander through the call and head boldly forward into 2017.

Executive Intros – Tom Gentile and Sanjay Kapoor

From the results, you can see we hit well within our 2016 guidance.
Big milestone: we achieved cash positive production on A350s! This even got its own slide in the earnings call presentation – see Slide 10 of SPR_2016_Q4_Presentation. This also means we’re now working to reduce the deferred inventory balance on the program, which is a great line to cross.
We suffered a $0.14/share earnings decline due to Kinston hurricane recovery and the voluntary retirement program. Spirit’s a neat company but we don’t control the weather. Expect some positive adjustments for an insurance settlement someday.
We made fewer 747 and 777 deliveries as demand for those is sunsetting. (This was a major theme of the call)
Higher A350 deliveries, yay.
Higher non-recurring revenues on development programs. (Hey, engineers made the company some money!)
Achieved 6-8% target of revenue to free cash flow generation. (Like margins, cash flow conversion rate is a quick metric for tracking how efficiently Spirit’s financial machinery converts payments from customers – revenue – into money we can use – cash. We started talking about this rate a number of years ago theoretically, and now it has some actual parameters we try to hit)
Volatility related to the Presidential election caused some caution in our cash deployment. (Heh, we’ve probably all had about enough of this subject, but basically, Spirit didn’t want to make any kind of drastic investing moves in the always-turbulent environment of election season)

Overall, pretty positive, nothing dramatic or overly exciting. But apparently the analysts had some fire in their bellies. Let’s get to the Q&A.

Analyst Discussion

Before getting to the actual questions and responses from our top brass, here’s a simple version of what analysts were asking about. It seemed, to me, a much narrower range of topics than recent quarters, but a bit more critical. Again, not sure where it was coming from, but that was the sense I got.

Top issues:

There was quite a lot of heat on the Boeing long-term pricing agreement. I don’t know how long an agreement of this magnitude typically takes, so I can’t opine on it, but it seems like the analysts have gotten sick of being stiff-armed on the subject for a healthy handful of quarters. Tom/Sanjay seemed resigned to indicate that it has indeed gone on for quite a long time, but unfortunately no resolute news yet.
What are we going to do with the $600M expected for capital deployment? Specifically, are we closing in on any ideas for mergers/acquisitions? I’ll discuss this in the questions, but I did observe that Tom and Sanjay spoke with a lot more specificity when the subject came up, so I’m inclined to believe that they’re getting a better idea of what they want to do in this arena. Stay tuned.
What’s the outlook for the near-term future as 747 and 777 slow down? I think this is why our price was down. It seems like we’ve got a lull coming first half of 2017 until some of our other programs speed up or come online.

Q&A:

Question: Your presentation says you’ve got $600M in cash deployment scheduled in 2017 – what’s the plan for that? Any inorganic opportunities?

o Tom: We still feel that share repurchases are a good investment as we believe we’re underpriced compared to our peers. We’re looking to be more consistent, rather than opportunistic, to maximize shareholder return. We are still looking at inorganic stuff this year, including some vertical integration for higher margin tier 2 fabrication stuff and maybe some military stuff.

o Travis: This was a pretty big one. Quick reminder: inorganic growth means mergers/acquisitions, where organic growth is adding to our usual business. Until now, our Commanders have kinda kicked around dirt in the merger and acquisition department, with a sort of “some of this, some of that” vagueness. But throughout this call, we started to hear some details. They look to be focusing in on utilizing our current fabrication expertise to start building parts that aren’t necessarily fed into larger subcomponents headed to our big OEM customers. It seems likely that we’re leaning toward vertical integration – building and selling more parts rather than expanding our major program assembly portfolio. With our “regular business” we’ll probably keep bidding programs like we always have, so count on this to be additional scope, not a replacement.

Question: Boeing pricing negotiation.

o Tom: It’s still an active negotiation. It’s still ongoing. We do know it’s been going on a long time and we want to get it done. We can and are working to control our internal costs and value so that whatever comes out of it, we’re prepared to do as well as we can.

o Travis: No news here really, but another quick reminder on why this is important. The pricing negotiation affects how much “top line” revenue we get paid when we deliver products to our customers. That’s one of the most important components in our profitability. Of course there are things we can control internally – production costs, materials, labor, scrap, etc. – but all that is just one component of our doing profitable business. When we finalized the Airbus pricing agreement, we took a $135M forward loss to account for it, but it was celebrated because while it meant slightly lower long-term revenue and profit, it also meant significantly higher stability. Still, it illustrates how important and influential to our success these agreements are.

Question: On making investments, talk more about vertical integration and 3^rd party fab, and how it translates into a long-term strategy.

o Tom: We’re already one of the largest parts fabricators in the world. It’s all internally consumed though. However, in both commercial and defense markets, there’s some opportunity to sell those abilities outside our current scope. That market tends to be high margin, another plus. It also helps us with getting to an optimal supply chain setup. Regarding timing, we’ve already started on this, with some tangible revenue expectations in place for when we enter that business.

o Sanjay: It’s also in line with what we already do. In many cases we already have the equipment, the space, and the experience. The market is there and we can already play. It’s potentially both a revenue and a margin booster.

o Travis: There you have it. The reason we’re looking to expand vertically (doing more Tier 2 business alongside our regular Tier 1 stuff) is that, well, we already do it. We’ve already got the knowledge, experience, equipment, and space. And it seems like a good market to be in, with plenty of activity and lots of profit to capture.

Interjection from Sanjay: He jumps into the conversation to say he’s been reading reports this morning. He hammers that various things happen quarter to quarter, that our guidance has been good, and that you have to look at the trends and segment margins to eliminate some of the concern over what happens on any given day.

o Travis: This was an interesting deviation. Reading over this, I don’t think I’ve captured how antagonistic some of the questions were… and of course our share price being down 5-6% was its own sign. But Sanjay was completely right to jump in here. We hit our guidance, disclosed everything the best we could, and explained some of the dynamics in play over the long term. The analysts wanted a miracle; we gave them reality. Reality we had accurately predicted for them, no less, but I guess it wasn’t enough. I’ve ranted before on my irritation with the staunch focus on quarterly results over trending data, so I won’t do it again. But it bit us here. Such is life.

Question: Okay so when we talk about next year’s guidance, we’re saying that 777 is declining, and 737 is increasing, but there’s some mismatched timing?

o Tom: Yeah, we suffer from lower 777 rates through the full year and only benefit from about 6 months of 737 increase. So 2017 is uneven, but it’ll even out in 2018.

o Travis: Here we have what I believe is the smoking gun with respect to the share price drop. It wasn’t bad numbers, it was the expectation of a soft open to 2017. Shareholders are well within their rights to take a walk if they believe business won’t be booming for the next 6 months.

Question: Can we discuss revenue on B-21? Will we see defense impacts in 2017, or later?

o Tom: No, it’s classified. Capital investments have been incorporated into guidance though. These programs have a lot of ramp time, so don’t expect material changes quickly. However, looking at 3^rd party business, we can capture that more immediately and that constitutes some growth outside of our current business.

o Travis: The analysts’ last gasp for things that might make the first half of 2017 rosy. How about that secret defense thing you’ve been doing? Tom says it won’t affect us materially (aka notably or tangibly) until later on. Though our 3^rd party efforts (maybe including an acquisition or something) might close the gap a bit.

And that’s that!

At this point, we have confirmation in the form of our STIP score that the execs thought we did a fine job internally in 2016. If you were looking for confirmation that STIP is not secretly tied to stock price, here you go.

We did well, and the market reacted strongly to some of the risks we’re facing early this year. It happens. We know what’s on the horizon, and it looks pretty swell too. So we’ll keep doing our thing and see what 2017 brings!

You may also read the short mini-lesson titled “The Sweet Spot.” It was inspired by a question sent to me in a prior quarter, which I appreciate.

Thanks again… let’s go do 2017!

Month: February 2017

The Sweet Spot

Spirit AeroSystems – Q4 2016