Well, it finally happened. After more than 4 years of writing quarterly earnings reports summaries for all of you fine people, I broke my streak last quarter.
Of course, at 4 times per year, that means the streak was only 17 emails long, but let’s stick with 4 years – that sounds much more impressive.
Either way, I’m back this quarter!
In many ways, this quarter was a return to normalcy for Spirit’s financials. As many of you are undoubtedly aware, there has been a dedicated focus over the first half of the year getting caught up on 737 deliveries to prove ourselves at the increased rate and also deliver consistently to Boeing, both on-time and with high quality. There have also been significant cost and supply chain efforts that support rate readiness and can directly impact the bottom line. This quarter shows some of these things making good progress, resulting in incremental gains to revenue and net earnings. We’re right in between the excitement of the Asco acquisition announcement and the upcoming fervor on new program efforts, trying to get our feet firmly planted on our existing core business before things inevitably change again.
All that to say this was a relatively mundane quarter, with nothing in particular for us or the analysts to really hone in on. The questions were diverse without a very strong central theme, which is usually a good indicator that business is just ordinary. And ordinary can be great sometimes. Still, there were plenty of items of interest to dig into, so let’s have at it.
Let’s start with a look at the financial summary.
Again, what we see here is veeeery slight improvement year over year in revenues ($1.837B vs. $1.826B) as well as adjusted earnings per share ($1.63 vs. $1.57). It is worth stating though that the bump in EPS is also partly attributed to share repurchases. If we normalized this quarter’s EPS (with 111M outstanding shares) to 2Q17’s 118.2M outstanding shares, it would show up as a slight decrease, down to $1.53 per share compared to $1.57. Here you see the eternal conundrum with share repurchases – it’s an activity that can prop up earnings per share, but it doesn’t affect net income (earnings) upstream.
Since these terms can be obscure, it bears repeating what they really mean. Revenue is a measure of what we sold in the quarter. We shipped 453 airplanes (a new record) this quarter. What our customers pay us for those shipments is our revenue or “sales” (the terms can be technically different in some cases but are largely synonymous). In simple terms, more planes and/or higher prices means more revenue. Gross income is revenue minus the cost of the planes we sold. Operating income additionally takes away day-to-day operating expenses – if Spirit was just a factory with no enterprise-level activity, operating income would be very close to net income. Net income (earnings) is the net total after running the whole enterprise. Of course, each of those has valuable information on what all of the costs in the business are, but ultimately, if there’s no bottom-line earnings, there’s no business.
So what is earnings per share (EPS)? Well, the math is easy: net income divided by number of outstanding shares on the market ($145M / 111.0M shares = $1.31/share). But what does it mean? To a shareholder, it means how much profit the company returned on your behalf. Whether by increasing earnings (making more money) or increasing consolidation (buying back shares to spread the earnings out less), increased earnings per share is favorable to an investor. However, if the earnings themselves are not increasing, it’s worth noting, because this relationship is not a two way street. Doing better business and creating more earnings obviously increases EPS, but increasing EPS doesn’t always mean the business is doing better.
This is not to say that Spirit is in trouble or it’s a dire sign that our share-adjusted net income went down slightly year over year. It’s only to remind us that EPS and adjusted EPS are useful metrics, but are not perfect and complete indicators of the health of the business. As with many things, there’s some nuance behind the number.
Having rambled on about terminology long enough, let’s change gears. Q2 of both 2017 and 2018 were a little funky in terms of one-time events, so we ought to spend some time recapping these big, impactful items. The slide below spelled it out very well.
You probably recall last year in Q2 when Spirit took a huge forward loss that was actually considered a good thing for the company, as it secured long-term pricing in our partnership with Boeing. This quarter, we had some additional unique, out-of-sequence items related to the Asco acquisition. Both of these are quantified in the above image. For reference, “GAAP” stands for Generally Accepted Accounting Principles, and is the measure that public companies have to report. Those are the “true” earnings for the quarter, though again, there’s some nuance.
Why do all this adjusting and fidgeting? Luckily, this is a business concept that is easily explained with a personal budget metaphor. When you plan or calculate your budget at home, you probably do so on a monthly basis, as a lot of typical expenses occur monthly. You have your income at the top, your expenses in between, and your savings – the net of your revenue and expenses – left over at the end of the month. As with a business, if your savings (net income or earnings would be the accounting equivalent) are negative month after month, there’s a problem. But sometimes a big anomaly moves you way positive or way negative for the month. Paying for a home project or a surprise expense like replacing an air conditioner might be a one-time event that pushes your savings way negative for the month, and a bonus or a tax return might push you way positive. But you still want to know the trend – what the month would have looked like if it were a normal month without a gigantic one-off that dwarfs everything else. Spirit does the same thing. Understanding the true bottom line, irregularities included, is clearly important. Seeing the underlying trend is also vitally important in controlling and predicting the future of the business, so adjustments like these are made to illustrate that trend.
Finally, let’s talk about cash.
There are quite a few interesting tidbits in the cash report above.
First, the 4% year over year increase in cash flow from operations tells us that the business is getting more efficient on an operational front – meaning aggregate costs are going down. Now, we don’t have a breakdown here, but that could be driven by any piece of our cost structure – direct labor, expedite costs, supply chain costs, rework costs, and more. Additionally, it may not necessarily be costs, but favorable changes to payment terms – if we pay our suppliers later or our customer pays us earlier, it improves our cash position. Whatever the sources are, and I’m sure there’s a very complex interplay of all those factors and more at work here, growing cash from operations tells us the business is getting more efficient on the most fundamental level. Profit and earnings are vital, but they’re just numbers on paper. An improving cash position is a good sign that earnings are well-earned and executed, not just booked in a spreadsheet somewhere.
Second, a 29% increase in Property, Plant, and Equipment (PPE – a different one than your safety glasses) shows that Spirit is spending money to improve the facilities and prepare for rate. Naturally, this costs money, but you can’t grow without this investment.
Third, the debt maneuver related to the Asco purchase can be seen in the bottom line – we nearly doubled our debt, using some of that for share repurchases and of course a large chunk for the purchase of Asco. For reference, at the end of Q1 we had $438M in cash (see 2018_Q1_8K.pdf), so we’ve grown that by $155M. I would expect that in the next few quarters we pocket a bit more cash, having pulled the trigger on this restructuring and on the Asco acquisition. But expect share repurchases or other investments before we hit $1B in cash. I’m saying that out of total and complete speculation, because over the years I’ve found it funny how Spirit consistently avoids breaching the billion dollar cash mark. Maybe intentionally, maybe not, but since I get to predict things for free, there it is.
Very quickly before getting to the call itself, a note on this debt repositioning since I didn’t talk about it last quarter. This is an area where a business’s budget is arguably different than a personal one. As with a personal budget, there’s often a good reason to utilize debt, an appropriately sized mortgage being a good example, but generally debt is an unnecessary risk that doesn’t add to your financial health. Sure, you could probably take out an unsecured loan at 5% interest and return 7-8% in the market over time, but a personal budget typically has a much lower appetite for risk. Businesses, on the other hand, exist for risk. An investment in a company is a way to leverage your money into something that will take risk for you, and you want your investments to be growing and taking an appropriate amount of leverage if necessary to achieve that growth. Businesses can easily be over-leveraged, sure, but they can also be considered under-leveraged. Therefore, Spirit’s move to align with market ratios is something that certain investors probably applauded.
Now, there’s a lot of personal and business philosophy that we could talk about on this topic. Ultimately, what I would say is that some healthy level of leverage in a business is necessary. We want companies to take measured risks to grow, so we don’t have to take on that risk personally. Spirit used this debt repositioning exercise to buy back shares as well as invest in an acquisition to fuel future growth. Both of these are generally good uses of money, and if the business case makes sense, using leverage to execute them also makes sense. We could debate exactly the right level of debt, but in the end we all want good returns, and that takes some level of risk and leverage.
Phew! Not sending a summary last quarter has made me extra wordy. Enough from me, let’s hear what the real experts had to say, and ask, about Spirit this quarter.
Executive Highlights
- Last quarter, we raised debt to buy ASCO and accelerate some share buybacks. The ASCO acquisition is on track to close in the second half of 2018. The share repurchase plan is unchanged, with no additional plans for repurchases in 2018.
- 737 deliveries were up 24% vs. this quarter last year, and 32% from Q1. This represents very good recovery and provides a template for what our performance will look like at full rate.
- We’ve won some new work statements in fabrication and defense. We can’t say what they are at the moment, but they represent our continued growth strategy and engagement with our customers.
Q&A
- Q: I’d like to ask about the narrow-body rate studies that both OEMs have talked about. What would you need from a capital standpoint to support? How high could you go in rate without a substantial investment? If you need to make a big investment, when would that be?
o Tom: With regards to rates, we’re looking to and talking to the OEMs on that, but we have looked at lots of various scenarios assessing our rate readiness levels. From a footprint perspective, we’re comfortable with the brick and mortar that we have. These kinds of rate increases can take around 2 years to incorporate, so we’re preparing for lots of possibilities, but we’re very comfortable with our infrastructure and space being able to support whatever the rates end up being.
o Travis: This is an interesting question in that it looks to the future and addresses some of the market movements that have occurred this year. With Airbus buying a majority share in the C-Series (now the A220) and Boeing partnering with Embraer, the narrow-body market is evolving and could potentially grow rapidly. As the two major OEMs square up for a faceoff in this market space, their supply chains – which Spirit is a big player in – will be put to the test. It’s a little early to talk about specifics, but this will be an interesting question to watch over the coming years.
- Q: 737 recovery – where are we at on the NG to MAX transition, what the mix is, and what is the timing?
o Tom: MAX is obviously increasing and NG declining. Overall for the year we expect about 50/50. But the good news is we’re getting through the learning curve, we’ve been hiring people and they’re getting up to speed. We’re still working a little bit on consistency; we’ve caught up on total deliveries, but we’re not quite hitting a regular, comfortable cadence, and we’re catching errors too late that require fixing and then expedited freight. Executing a rate increase is about a 2 year process, so we’re right in the thick of it.
o Travis: The question wasn’t really all that vital, but Tom’s answer brought up a great subject. In my comments earlier, I mentioned improving cash flow being a solid indicator of operational efficiency. While ours has improved slightly, Tom is saying it’s not nearly where it should be. We’re still doing extra work (with the associated high cost) to try to make our deliveries consistently on-time and with high quality. We stand to improve on a lot of those factors, and if we can, they’ll directly impact the bottom line. This is where we really do control our destiny, and where focusing on quality, delivery, and cost on a daily basis makes a huge difference.
- Q: What’s left to close the ASCO acquisition?
o Tom: We got approval from the US government for the merger. Customer approvals are in work and almost buttoned up. The European Commission has some holidays and will be starting in September with approvals.
- Q: Talk more about how we’re managing our suppliers right now. Are we reducing the number of troublesome or lagging suppliers?
o Tom: We have a broad supply base of over 600 direct suppliers, and we work with them regularly. One of our key metrics is on-time delivery and maintaining adequate buffer stock. We’ve deployed SWAT teams and employed some dual-sourcing to help our suppliers get back on track. There are a few trouble suppliers we’re still working with, but the list is shrinking.
o Travis: In the same way that Spirit is sprinting to enable rate increases, our suppliers down the line are too. Some are exceeding, some are lagging. It’s pretty amazing how much global effort comes from Boeing or Airbus deciding they want a few more airplanes a month. Once they make that decision, hundreds of companies around the world have to mobilize to make it happen, and it all has to come together at once. I’ve had the distinct pleasure of working in and doing shadowing rotations with lots of different groups, and it’s highlighted to me just how many different things have to go right to make this business work. Frankly, I’m amazed that any airplanes ever get built. Just a little soapbox moment this question prompted. I’ll get back down now.
- Q: Given the margins in the first half of the year, it looks like we’d have to have a very strong back half of the year to hit your guidance. Are supplier recovery or other one-time bumps included in the guidance?
o Sanjay: Yes, there’s some upside baked in for supplier recovery. Just as our customer holds us accountable, we have to hold our suppliers accountable, and so there are some assertions in our guidance. Ultimately, we’re shooting for margins we’ve achieved in the past. We don’t have to break any records to hit those numbers, we just have to keep working toward the recovery plan that we’re making good progress on, and it’s already limiting some of the extra costs we’ve incurred in the first half of the year.
o Travis: This is directly related to the previous question. In some cases, our suppliers have been the cause of our issues and late work, and when that happens, we need to chase them down for the financial impact it causes us. In other cases, it’s work inside Spirit’s walls that has been the cause of late deliveries or quality problems. To control our overall business, we have to be diligent on both – controlling the inputs from our suppliers and all related costs, going after them for recovery where appropriate, and also controlling our own internal processes and procedures to make sure we’re not impacting quality, cost, or delivery. If we can get both facets under control better than ever before, we’ll make profit like never before.
- Q: On 737, when do we get to 100% MAX? Is there any impact on your deliveries from Boeing’s delays on the engine side or other things that may filter over to you?
o Tom: There will always be a few NGs, but next year the transition is mostly complete. On the Boeing side, our focus is getting our product to them so we don’t cause any disruption, and the other things don’t really impact us. They’ve been working very well with us, and communication with Boeing has probably never been higher regarding operational and factory efficiency, so we’re strongly tied into their demand and schedule, and they’re providing a lot of support back to us.
o Travis: Two thoughts on this. One is the analyst’s comment on engine suppliers causing some disruptions. This hails back to my thoughts a few questions ago about the difficulty of making sure everything is there at the right time to make an airplane. It’s incredibly difficult and complex, and Boeing doesn’t get paid until they actually provide a whole airplane, so as the top of the food chain they take on a huge amount of integration risk in buying, say, a fuselage from Spirit but having to wait for an engine from somewhere else. Luckily, Tom is saying these disruptions have not yet affected us and we’re staying tied in with Boeing’s demand so the risk doesn’t trickle down to us. More importantly than that though is Tom’s statement that communication and sharing with Boeing has never been higher. This is a great sign in general, springboarding from the long-term pricing agreement last year. A rocky relationship with your biggest customer is a big concern. It’s certainly comforting to hear that that relationship is on the up and up again. Credit is due to anyone who interfaces with the customers, from the bottom of the organization up to the top.
- Q: With the price stepdown on A350, is it still a positive margin program on a unit basis?
o Sanjay: Yes, and it’s a good tailwind for the future.
o Travis: Oh man, the emotions attached to this quick question and quick answer. Think back to 2013-14, when the A350 was a gigantic drag on the profit, with huge forward losses and concerns over the viability of Spirit’s overall business. It got about 10 seconds of airtime for this question, only for Sanjay to say that it’s now a positive program and a tailwind that supports our business. Some credit needs to be given here. Forward losses and block accounting can be confusing and frustrating, and can really suck when there’s an enormous hit to your profits dropped on a single quarter. But the fact that this question took 10 seconds to answer and was actually a positive thing is a testament to why we do them. We had to swallow the pill 5 years ago, but because we did, A350 can now be a profitable program for the company. This means a lot more to Spirit than the quick conversation this quarter would imply.
- Q: There are a number of forward loss reversals on the 787. Can you talk about what’s driving those reductions and how much more opportunity is there for the future?
o Sanjay: We’ve focused on making our supply chain more efficient, and that has driven solid block savings. There’s also some benefit to rate increases and absorption that we’ll start to see.
o Tom: We’ve also gotten a bump from working together with Boeing on Value Engineering changes, and there are more identified and yet to come to fruition.
o Travis: This hits right at home. Over the last 9 months, I’ve seen just how hard supply chain has worked to claw back savings for the 787 and optimize the sourcing strategy. Coming over here, I’ve learned that (not surprisingly), there is a lot of knowledge and a ton of skilled, wonderful folks in this organization. I think some of the difficulty in appreciating supply chain’s perspective is that all the credit comes up front – the savings and any associated kudos are booked when a contract is renegotiated or a new one is written, and from there, you only hear about the failures and misses that slip through. Sometimes I honestly forget what year it is, because we deal so much in long-term contracts and frankly trying to predict the future, and predicting the future is never perfect. Anyway, I’m soapboxing again. Supply chain has done a lot of strategic optimizing over the last year and that will start to show up in cash figures on the 787 very soon, if it’s not already. There’s more work to be done, but also, to Tom’s point, there are a lot of major projects that require engineering engagement and collaboration to achieve even further significant savings. There has also been a ton of effort put in by the operations teams in making the factory more efficient and reducing build hours and optimizing processes, and those have paid dividends as well. We’ll see how it all turns out in the end, but in the meantime, it’s nice to see these signs of progress.
- Q: Boeing and Embraer’s partnership makes Embraer a potential strong supplier to Boeing. Are you concerned that they could steal some of Spirit’s thunder as a preferred Tier 1 supplier, especially as we start talking about the possible middle of the market program?
o Tom: Right now, we’re putting some of our best engineers to work on defining what we can do for our customers’ next upcoming models. We have world-class engineers, best-in-class design capabilities, advanced architectures and manufacturing processes, and we’re pouring into R&D to grow our capabilities even further. Today, we’re on the best programs, we have complex pieces, and we’re industrializing at unprecedented rates and scale. With our experience and capabilities, we think we have a large head start on any other partners in the world as we look to the next generation of aircraft.
o Travis: This was one of those great last-minute questions that pop up every now and then. Tom’s answer really stands on its own, so I won’t add to it. It will be interesting to see how these conceptual programs that we’re spending time and money talking about will affect Spirit’s business over the next several years.
- Q: On NMA (middle of market program), how do you see yourselves on the offering? You’ve greatly improved your cost structure, but how do you see yourselves against other potential competitors? Also, is this a need-to-have program? How does it shape the portfolio moving forward?
o Tom: We’re trying to collect our thoughts on what factors provide maximum value for the next generation of aircraft. We bring skilled design engineering, a trained workforce, lots of capital, and several other advantages. For us, any program we consider has to meet our business case requirements. There is no program that is an absolute must-have if there’s no business case. Based on our scale and structure, we think we can bring great cost advantages, but it always has to make sense both for us and the customer.
o Travis: This right here folks is what Spirit has learned over the last decade of its existence. Tom added some more words of confidence on Spirit’s value proposition, but critically, he underscored that anything we commit to has to make sense for us. When Spirit was in its infancy, we took on programs that we felt like we “had to have” in order to grow, to please our customers, to broaden our business, and to prove that we could exist as a standalone company. In the end, we’re probably better off for that effort, but there were definitely some questionable times in between. Tom’s answer is indicative of the discipline that comes from hard-learned lessons. Yes, we need to grow and continue to fight for our place in the business landscape. But we’re not going to sign up to just anything. We are our own business with our own interests to protect. Every day that goes by, we understand that a little better.
Man, every time I finish one of these, I feel like I’ve said WAY too much. Nobody ever tells me this, but in case you need permission, it doesn’t hurt my feelings if you got bored and wandered off at some point in this message. As always, I hope it’s useful and somewhat enjoyable, as much as this subject can be, and I hope it provides a better understanding of the business, which affects all of our lives as employees and stakeholders.
Since Sam Marnick beat me to the punch in releasing the STIP score, I will only comment to say that 0.75 seems to be sensible and fair based on the financials. The good news is, a lot of the factors to lift that score up are fully within our power. Let’s see what we can do through the end of the year.
Ahhhh, it’s good to be back. Thanks for reading, see you again next quarter!