Description

Recommendation: Long SPR equity with a base case price target of $41/sh implying 41% upside from current trading levels ($29/sh)

Investment Thesis:

·        SPR trades at a wide discount to aerospace peers due to the stop-start nature of its ramp back from Covid and uncertainty around its cash generation profile. We believe the equity is attractive (41% return to a 1-year price target) even with conservative valuation and normalized margin assumptions.

·        We see a real upside case where SPR can capitalize on its critical role in the OEM supply chain, amend pre-Covid contracts with Airbus, and be worth $77+/sh.

·        New CEO Pat Shanahan joined in October and replaced many members of the leadership team; SPR’s relationship with BA has significantly improved under new management, proven out by a revised Boeing contract signed in November and a more collaborative response by BA/SPR to the recent Alaska Airlines door plug incident than prior issues.

·        SPR is an irreplaceable part of Boeing’s supply chain. SPR was carved out of Boeing and its factories are better suited to produce aerostructures for BA than any credible competitor (details below).

Company Overview:

·        Spirit AeroSystems is a leading aerostructures supplier. It spun off from Boeing in 2006 and derives its revenue primarily from Boeing and Airbus, then secondarily from defense contractors and other smaller customers (bizjets, aftermarket, etc.)

·        Due to its history as part of BA, the company retains a very high concentration in Boeing programs (BA was >75% of revenue, and the MAX alone was >50% of revenue pre-COVID)

·        SPR has been a special-situation story for a number of years due to dislocations on the 737 Max (the crashes / recertification in 2019, and Covid in 2020, negative-margin Boeing contracts that became unsustainable due to inflation that were addressed in 2023)

Recent Updates:

·        SPR equity/credit has been the subject of several previous VIC write-ups, but there are several updates we think are worth detailing including actions taken under the new management team, the revised contract with Boeing, de-risking the balance sheet, Airbus contract updates, and the recent door plug issue on the Max.

§  New management team: The SPR/BA relationship frayed during the ramp back from Covid under prior management. Pat Shanahan, former SVP of Supply Chain at Boeing, joined as CEO in October 2023 and replaced many senior leaders at SPR. The new CEO has made good progress towards repairing the relationship between SPR and BA, proven out in several recent situations.

§  Revised Boeing contract: In Oct 2023, SPR signed a new set of contracts with Boeing, which eliminated forward losses SPR expected to realize on the 787 (i.e., capitalized cash losses that don’t flow through earnings but do impact FCF). Boeing also committed to fund SPR capex to support the 737/787 ramp and agreed to eliminate SPR’s liabilities for previous manufacturing issues in exchange for marginally lower prices on the 737 in the out-years.

§  De-risking the balance sheet: SPR’s convert and secured bond deals in Nov 2023 mean the company has no material maturities until 2027 (there’s a $300mm 2026 bond addressable with balance sheet cash).

§  737 Max door plug incident: Without recapping all of technical details, what we’ve seen so far from NTSB points to issues with Boeing’s production tracking software/processes being responsible for the missing bolts that resulted in a door plug falling out of Alaska Airlines 1282. Despite the FAA temporarily capping the rate at which BA itself can produce 737s, BA has maintained the planned production rate increase it was set to roll out to its suppliers and is supporting its supply base including SPR. BA/SPR have also taken a more collaborative approach to this issue than prior ones with new management at the helm.

§  Airbus contract process: Management attention to the door plug issue pushed out finalization of a new Airbus contract past February 2024 but the new Airbus contract is well underway and we expect it to improve SPR’s run-rate FCF profile on the A220/A350 / reduce SPR’s forward losses on those programs

Valuation / Price Targets / Our Outlook

·        We see attractive base case returns with conservative assumptions on valuation and margins with attractive skew between our upside and downside cases:

·        In our base case, we value SPR on our estimate of 2027 FCF and an 8% forward FCF yield then discount back this implied future market cap to arrive at 2025 price targets

·        We view this FCF yield valuation as conservative; aerospace suppliers benefit from long-term organic growth tailwinds and trade at an average P/forward FCF yield of ~4%; even lower-quality suppliers like TGI trade at an 8% (TGI is closer to normalized FCF in 2025 due to more aftermarket work but has little IP and doesn’t have the scale/structural advantages SPR has as a BA supplier)

·        Our FCF forecast assumes SPR achieves “cash” EBITDA margins ~150bps below 2006-2019 average cash EBITDA margins and ~540bps below 2018 levels (last year when 737 production by Max issues).

·        We take conservative estimate of 52/mo rate on the Max

·        Our upside case assumes the supply chain is in a place where BA can fully utilize its production capacity and produces ~60 737s/mo and SPR achieves low-teens cash EBITDA margins (still below pre-Max crash/Covid level in 2018).

·        Our downside case reflects a scenario where 737 production rates never move beyond 42/mo (25% below sell-side expectations)

·        “Cash” EBITDA reflects EBITDA less changes in forward losses and contract assets/liabilities – we believe this is the best reflection of SPR’s underlying margin.

• • SPR uses a system called program accounting where it books expected losses on negative margin programs upfront (non-cash charge) and then these losses flow through the balance sheet/cash flow statement.

Investment positives:

·        True “needs to exist” business crucial to Boeing’s operations: SPR owns two large production facilities in Kansas for manufacturing 737/787 fuselages with a direct rail link to BA’s production facilities (only fuselage supplier with direct integration into BA’s supply chain; other Italian/Japanese suppliers have to fly large fuselage sections internationally.) BA has also offered support to SPR in the past, effectively preordering ~$348mm of fuselages in 2019/2020 in the aftermath of the Max crashes to help bolster liquidity

·        Advantaged 737 life-of-program contract: 737 fuselages are sole-sourced to SPR under a life-of-program contract. The contract also has dynamic pricing based on volumes, providing higher prices per shipset at lower levels of production to help absorb fixed costs

·        Industry tailwinds favorable: The market is undersupplied in narrowbody aircraft, particularly the 737 given how long the plane was grounded following the Max crashes; therefore SPR is relatively insulated from business cycle cyclicality and our concerns about the aviation/airline sector being recession-prone (see last section below)

Why does the opportunity exist / risk factors:

·        Uncertain FCF generation: SPR has seen a long period of dislocation after the MAX grounding, production stoppage, Covid, and subsequent supply chain/labor inflation. While cash losses have come down, uncertainty around near-term cash losses remains. Management has not given 2024 guidance.

• Mitigant: Given that BA is not providing guidance following the door plug incident and FAA review, SPR really can’t get ahead of its main customer by providing guidance on earnings and cash flow in 2024. That said, we see cash earnings continuing to improve in 2024 with potential upside depending on what shape a new deal with Airbus takes.
• Mitigant: Base case (with 41% equity returns to 1-year price target) assumes conservative “cash” EBITDA margins ~150bps below 2006-2019 average cash EBITDA margins and ~540bps below 2018 levels (last year when 737 production by Max issues).

·        Manufacturing quality issues: Manufacturing quality issues have impacted SPR throughout the ramp back from Covid and the 737 Max faces increased scrutiny.

• Mitigant: While manufacturing issues are hard to predict and we recognize that some issues will likely appear in the future, we think it’s worth noting that aircraft involved in the door plug incident was built while SPR was dealing with the effect of a union strike which has now been resolved with a new contract and that new management seems to be much more aligned with Boeing from a manufacturing process perspective.

·        Single-asset risk: SPR has high concentration on BA programs (BA was >75% of revenue, and the MAX alone was >50% of revenue pre-COVID)

o   Mitigant: This reliance works both ways; given SPR’s importance to BA’s key programs, BA is incentivized to ensure SPR’s long-term viability (as seen through pre-purchases of inventories, etc.)

o   Mitigant: BA will not replace the Max in the next decade – for BA to meet its own deleveraging goals and FCF targets, it cannot afford the capex required to launch a new program any time before the 2030s. BA management confirmed at investor days that Boeing will not launch a new aircraft program until the mid-2030s: “I don't think we're going to even get to the drawing board this decade” (David Calhoun, Boeing CEO at Nov 2022 Investor Day)

·        737 acceptance: Given the crashes/bad publicity, there had been questions in 2020/2021 around the long-term viability of the Max aircraft

o   Mitigant: Market acceptance of the plane post-recertification has been strong with major airline and lessor orders. Recertification in China was slow at first as Covid zero policies deferred new aircraft needs but China started taking deliveries of the Max in Jan 2024. This news was overshadowed by the door plug incident but is a positive signal that China will continue to be a major Boeing customer because it needs the flying capacity despite geopolitical tension.

o   Mitigant: Given airline demand, the first available slot for an A320 is in 2029.

·        737 Max-7 and -10 permitting issues: The 737 Max has 4 sub-variants – the Max-8 and -9 models are fully permitted and flying today. Due to the recent door plug incident, there’s expected to be more scrutiny/further delay in the approvel of these variants.

o   Mitigant: We’ve previously seen airlines converting Max-7 orders into the Max-8 variant (LUV did so in July 2023) and other airlines, e.g., WestJet, are reported to be considering the same. The supply/demand balance for aircraft today is pushing airlines to convert orders rather than give up their spot in line.

Industry / 737 backdrop

• Cyclicality: While not totally insulated from macro factors, we think there are a lot of mitigants that protect the outlook for aircraft deliveries (BA in particular) over the coming years:

• Today, we are already pretty close to prior cycle lows in terms of trailing 3-year deliveries % of the installed base; this helps protect downside to deliveries volume even in a recession. This is especially true if you consider that deliveries have been low since 2018 given the MAX grounding/COVID, so there should be pent-up demand
• Even in a weaker macroeconomic backdrop, there is going to be a need for new planes going forward; there is a massive fleet out there that needs to be retired, with 2,500+ planes with over 20 years of service
• There are strong financial/ESG reasons to buy new aircraft (these pressures are only growing in today's environment), as new planes are 25-40% more efficient than their replacements, with lower carbon emissions
• Boeing Commercial still has a current backlog of $441bn = 5.6k aircraft, and airlines
• BA has affirmed its 2025/2026 FCF goals despite delays caused by the door plug issue; the 737 achieving rate of 50+ aircraft/mo is a major driver of this target'

Disclaimer:

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

• New/revised contract with Airbus fixes cash-negative contracts
• FAA lifts temporary cap on 737 Max production rates at Boeing, BA suppliers take the next step in rate increases
• Cash margins improve with volumes / contract adjustments