Description

I recommend selling/shorting SPR.

Despite the bull case for SPR being on cash flow improvements, SPR is now trading at 16x my CY16 FCF (18+x per FactSet). This is the higher than the Transdigm multiple (16x), and 2 turns higher than PCP, Boeing and Collins (13-14x). This is for one of the worst business models in aerospace given its poor returns on capital and extreme customer concentration to BA.

Why should SPR have higher operating margins than BA?

The bulls seem to be betting that SPR will beat cash flow estimates and in doing so would enjoy superior economics to their much more powerful customer who has a strategic initiative discussed on every conference called “Partnership for Success” or more appropriately by some buy-siders called “Partnership for Boeing’s Success.” (Boeing Commercial Aerospace division is more than 85% of SPR’s revenue.)

We think SPR will eventually trade at 12 x economic earnings of $2.50 or $30 per share and will give rationale below.

• The WHOLE argument/bull case for SPR is the turnaround story led by the new CEO Larry Lawson. I think the excitement is overdone. The business model here is worse than the CEO is good.

SPR was once the cost center of Boeing and therefore was good at on-time and quality delivery, but not an expert in running an independent entity, managing costs, and making money. The new CEO however, has been implementing more rigorous cost management analysis throughout the company. He has also been working hard at tracking the costs in greater details and identifying the costs derived from Boeing/Airbus’ design changes which helps seeking reimbursement / compensation from Boeing and Airbus for these specific cost overruns.

I appreciate the initiatives the new management team has been taking. However, with the stock up 140% since the CEO appointment announcement, vs. S&P up 33%, Boeing up 52%, and ITA up 53%, I think the excitement is overdone by the investor community. Key points:

• For the A350 program - the biggest growth driver for SPR, its incremental deferred production per unit / learning curve is in line with / above the B787 curve, which I believe is a very bad sign. The learning curve for A350 program should be in theory way below the B787 program, given the commonality of the two programs, and the fact that A350 program was launched more than 4 years later than B787 (and therefore Spirit had more than 4 years to optimize its technology, facilities and the supply chain), and the content Spirit makes for A350 program is easier than that on the B787s.

• I think the blame on the old management team has been overblown, and the inability to “control costs” is not a valid argument because of:

1. The aggressive usage of accounting assumptions is different than operational weakness which could in theory be fixed;

2. Management’s seeking for diversification from Boeing and therefore incurred technology issues and internal cost overrun;

3. The limited ability to migrate the Intellectual Property and Tooling from Boeing programs to non-Boeing programs, constrained by the initial Agreement with Boeing.

It was not (or not only) the real cost overrun that killed the margins and the stock in 2012 and 2013, it was actually (or primarily) the “accounting cost overrun” against the aggressive contract accounting assumptions that killed the stock.

I think the same dynamic is setting up again.

• SPR’s long term effort of shifting away from Boeing (and to Airbus especially) gives it less leverage in negotiation with Airbus and other OEMs. Boeing’s “Partnering for Success” Will Erode SPR Margins (Pricing) in the Years to Come.

• Similar to Boeing, Spirit uses program/contract accounting. However, there are some key differences between SPR’s contract accounting and BA’s program accounting:

• Boeing’s program accounting is created to cover (more or less) the entire backlog and/or their projected new orders over a relatively long time period (5-10 years).

• Spirit’s contract accounting typically covers 2 years of production for the mature programs (737, 777 etc.) and a fraction of Boeing and Airbus’ backlog for the new development programs such as 787 and A350, which is ~4-5 years’ coverage.

The difference is critical here, especially in evaluating the impact of Boeing’s partnering for success.

• For Boeing, the contract negotiation will be immediately adjusted to the program accounting assumptions and therefore reflected in the margins the immediately.

• For Spirit however, if the contracts are signed for 1-2 years out, then it will NOT be included in the current program accounting block, and therefore have NO impact on the current block margins. However, when the accounting block evolves as time flies, the new contract terms will be reflected in the new accounting block and therefore impact the margins 1-2 years out.

Boeing has already had ~2/3 of the PFS contracts signed, including 737/777/747 aero structures with Spirit, largely.

I don’t think the PFS contract has already been signed yet as the specs on 787-9/-10 have not been finalized yet. Especially if Airbus cuts pricing on A350, surely BA will pressure it’s easiest supplier to pressure.

I expect worse contract terms due to Boeing’s increasing focus on costs through its PFS program.

• For the mature programs (737/777/747), I think these contracts have already been signed for the next block and beyond (2016 and beyond), but haven’t been reflected in SPR’s contract accounting margins yet;

• For 787, I don’t think the new contracts have been signed yet before Boeing has a more detailed design for -9 and -10, but will happen in the near future as -9 is ramping up and -10 is in the final stages of getting out of the factory.

For Spirit margin, 1H 2015 is largely locked in post the big charges in 4Q13. However, in 2H15 into 2016, (1) the potential A350 charges, (2) the fact that Boeing’s PFS contracts will be reflected in the new accounting blocks and (3) the potential rising in R&D spending (See the next bullet point) will press SPR’s margins. While it’s hard to quantify the impact as I don’t know exactly what’s in the contract terms between Boeing and Spirit, I don’t think SPR’s operating margins should go much beyond Boeing’s margins for a sustainable amount of period, given it’s massive revenue exposure to Boeing and the fact that aero-structure is relatively a less technology intensive industry in the supply chain and therefore one of the top focuses where Boeing wants more benefits back through the PFS program. As a reminder, Boeing CEO Jim McNerney said publicly “we don’t think some suppliers with higher margins than we do take the comparable risks”.

As a reference, the Street is modeling 140bps gross margin expansion and 70bps operating margin expansion for SPR from 2015E to 2017E.

• SPR’s Earnings Quality is ~15-20% Lower than It Reported

I think SPR’s earnings quality is ~35% lower than it reported:

1. In 2012 and 2013, Spirit had $637M and $1,133M forward-loss charges on its major programs respectively; ex Gulfstream, the charges were $355M in 2012 and $604M in 2013.

However, I still think the likely ~$300M charge (and therefore accumulatively ~$420M charge) on A350 sometime in the next 3 years, compared to B787’s $600M+ charges. I therefore an annual charge of ~$110M is the run-rate annual charges ex Tulsa plant in the next 3-5 years, assuming all other mature programs will incur ~$10M annual charges only. The reason why Iw don’t think the run-rate charges will be minimal in the near term is also because the company is limited to its usage of Intellectual Property and tooling, per its agreement with Boeing, which I don’t think will change much any time soon. (See my Point C for details)

This $110M run-rate charge is a 70-80% improvement from 2012/13 because of the new leadership that would like to give credit too.

2. R&D as % of sales has been a straight line down and well below its most relevant peer Triumph Group, even with new programs ramps. I suspect that was one of the reasons why this company has overrun on costs (noticeably that a big portion of the cost overrun was because of the inability to adapt to the new technology)

I think over time, R&D should be back to the 1.5-2.0% level to pare up with TGI, which is an $80M+ headwind to EBITDA on a run-rate basis.

Specifically, the NG to MAX transition for 737, A350 ramp, and 787-8 to 787-9/-10 transition will cost R&D dollars in through 2017/2018. Beyond 2017/2018, the ramp on 777-X will be another big ticket spending on R&D.

3. Spirit doesn’t own most of the intellectual property and tooling used in the business. The company said this in the 10-K and said:

“Our business depends on using certain intellectual property and tooling that we have rights to use under license grants from Boeing. These licenses contain restrictions on our use of Boeing intellectual property and tooling and may be terminated if we default under certain of these restrictions. Our loss of license rights to use Boeing intellectual property or tooling would materially adversely affect our business.”

“Boeing retained title to tooling assets obtained as part of the Boeing Acquisition and provides such tooling to the Company at no cost, the Company treats the amortization of Boeing-owned tooling as a reduction to revenues as required by FASB authoritative guidance on consideration given by a vendor to a customer, including resellers of the vendor's product. These items are netted against revenues in calculating net revenues. In 2011, the Company recognized no reductions to gross revenues for Boeing tooling, as the tooling became fully amortized in 2010. Under an agreement with Airbus, certain payments that are also accounted for as consideration given by a vendor to a customer will be amortized as a reduction to net revenues beginning in 2012.”

These have at least two implications:

1. As the company is trying to diversify its customer base from Boeing, it will have limited ability in terms of intellectual property transfer and tooling usage. I think part of the reason why A350 learning curve is not well below the B787 curve 4-5 years later on easier mission is due to the handicap of transferring the IP and the usage of the tooling, according to the Supply Agreement with Boeing – I believe this (the Boeing agreement) is actually one of the key reasons why I think the new leadership will have limited ability to really turn around the business without the asset changes, business model changes, this Boeing agreement changes and customer base changes.
   Going forward, I believe the company will still need to diversify its customer base after the Tulsa plant sale, which may incur further cost overrun due to the Boeing agreement.

2. After 2011, the company has fully amortized these Boeing tooling and continued to obtain the rights to use them for free. However, at some point, the company will have to invest on its own and therefore incur more costs (either direct costs or depreciation) than it used to on a run-rate basis. I think that’s an at least 30-50bps headwind on margin, which is about ~$30M reduction on its run-rate profits.

4. I add back the $17.8M charges in workforce activities and subtract the $95.5M favorable cumulative catch-up adjustments occurred in 2013 to reset the 2013 base profits, because I think the charge in workforce activities is one-time and the cumulative catch-up adjustments should be included in my run-rate forward-loss charge assumptions detailed in point A above.

5. Pricing deterioration on Partnering for Success: I think on a run-rate basis in the next few years, pricing will be 0.5% worse on the new contracts which is not reflected in 2015E number – that is a ~$35M headwind to the profits.

6. I give the new leadership credit for 100bps margin expansion every year on a run-rate basis, mostly from supply chain optimization, internal improvement etc., which will be $70M tailwind to profits in 2015E, on a run-rate basis.

I understand that SPR will still print a 2015 number way above this run-rate adjustment of $2.50, due to the timing on A350 charges, R&D normalization, tooling cost materialization, Boeing’s PFS development etc. However, this run-rate EPS number gives a more apple-to-apple view when I compare SPR’s multiple with its Aerospace peers.

I think:

1. With a very unclear 2016 (and beyond) picture (Boeing’s PFS/Pricing pressures, A350 charges, contract wins, uncertainties of long term diversification strategies, and the new management’s proven ability),

2. The largely unchanged portfolio (85%+ revenue to Boeing, and will be even more with the potential Tulsa plant spin, the same Boeing agreement etc.)

3. Wide-body over-supply materializes, and

4. The fact that aero-structure market is very competitive (management used exactly the same word in their 10-Ks) and relatively less technology intensive compared to other top tier suppliers, I think it is unjustified that SPR is trading at a premium in this space, on a run-rate basis.

Top Line: Among the Highest Wide-body Exposure Will Limit SPR’s Growth.

With more than 38-39% of its sales exposed to wide-body, SPR is among the highest compared to its peers.

I think 787 production rate will be at ~10/m until at least 2017, 737 rate will grow to 45-46 by 2017, 47 in 2018, and 50+ into the decade end. I also think 777 rates will be cut to 90 in 2016, 70 in 2017 and 60 in 2018, A330 rate will be cut to 90 in 2016, 80 in 2017 and 70 in 2018, slightly higher than 777 rates on its new A330NEO launch, which will go into service around 2017.

On content value, I don’t think there are a lot of share shifts in aero-structure industry WITHIN any given program cycle. Spirit said this is a “very competitive business environment”, but “High switching costs may substantially limit our ability to obtain business that is currently under contract with other suppliers.”

I expect for Boeing’s mature programs such as 737, 747, 767 and 777, the content value will be in decline, more modest for 737 where pricing is strong, but worse in 777, 767 and 747 where there will be massive pricing pressures due to the over-supply. For 787, I expect ~1% growth in content value every year due to the mix shift from -8 to -9 and -10. For Airbus programs, pricing pressures will be mostly on A330 and A380, and relatively stable at A320. I see modest content value gain on A350 program.

Organic growth will slow down from 14.5% to 4.2% in 2015 and 3.1% in 2016. In 2017, the ramp in 737MAX and A320NEO will likely more than offset the production rate cuts at 777 and A330.

Accounting Aggressiveness Was One of the Key Reasons That Caused “Cost Overrun”. I Don’t Think Margin Expansion Will Be Easy to Materialize.

SPR’s contract accounting, just like Boeing’s Program Accounting, paints a very different picture for the outsiders to have knowledge about the real margin (expansion) at each business segment.

I don’t have a perfect approach to unveil this black box. However, I added back all the program accounting forward-loss charges, one-time non-repeat charges and catch-up favorable and unfavorable adjustments back to each segment since its IPO back in 2006. Some insights:

1. The SPR “Assumed” contract accounting segment margins have been depressed from 2006 to 2011 even when R&D spending declined from 3.3% of revenue in 2006, 1.4% in 2007 to 0.7% in 2011, and had favorable receivables made by Boeing to help transition to a stand alone company.

“In connection with the Boeing Acquisition, Boeing agreed to make non-interest bearing payments to Spirit in amounts of $45.5 million in 2007 (all of which was paid), $116.1 million in 2008 and $115.4 million in 2009, in payment for various tooling and capital assets built or purchased by Spirit. Spirit will retain usage rights and custody of the assets for their remaining useful lives without compensation to Boeing. Boeing also contributed $30.0 million, which was received by us in three installments in 2005 and 2006, to partially offset our costs to transition to a stand-alone company.”

From 2006 to 2011, while assumed contract accounting margins trended down, the company barely had any substantial charges related to major programs.

2. The company however, since 2010/11, started to assume aggressive margin expansions in their contract accounting, with Fuselage segment margin up from 14.8% in 2011 to 17.5% just two years later in 2013; Propulsion segment margin up from less than 14% in 2010 to 16.6% in 2013; Wing segment margin up from 7.5% in 2011 to 11.2% in 2013.

This period of aggressive use of contract accounting on margin expansion was exactly the same period when the company incurred massive charges on its major programs across all three reporting segments.

It’s very clear that the consensus “cost overrun” argument by the old leadership should be largely explained by this abuse of usage of its contract accounting, and not a pure cost overrun on real basis, which therefore should not be blamed 100% to the old management’s inability to control cost on real basis.

The rest of the consensus “cost overrun” was real, which was due to the introduction of non-Boeing programs, especially the Gulfstream G280/G650.

I don’t think the new management is completely free from these two major issues.

For the accounting assumptions, the new management has assumed lower margin on the Fuselage segment, however continues to assume very aggressive margin expansion on the rest two segments in the first half of 2014.

Street is modeling further margin expansion through 2017. (The buy-side seems to have even more aggressive margin expectations with some believe $4.00 EPS is achievable next year and the company will take off from there). I think the margin for the Fuselage segment will come down further on the ramp in A350 program – SPR is making the fuselage and leading wing edge for this new Airbus program; I therefore think both the Fuselage and the Wing segment margins will be hard go up. I also think the Propulsion segment will experience much less margin expansion or margin contraction as well, as this segment makes Rolls Royce parts which I believe will still be more challenging than what the management believes.

Even with assumed segment margin flat from here, I are still talking about ~300bps expansion from its low in 2011, when the company was really free of accounting “cost overrun”. I believe the first step for the new management team is to digest this 300bps margin expansion without charges, which means they should take out ~$1.8B cost out, or ~$960M out ex Gulfstream from 2011, on run-rate basis. (Cost should be $1.8B lower every year to justify this ~300bps margin expansion from 2011). Then the second step is further margin expansion from here.

I believe there are at least four other headwinds to margin expansion:

1. The fact that the company is still way too much levered (and will be more levered to Boeing) will limit its negotiation power with its customers (not just Boeing);

2. The agreement will Boeing on IP and tooling will limit its ability to develop any non-Boeing programs that may incur further charges;

3. R&D spending will at some point be less a tailwind/headwind, and

4. Deliveries growth is peaking this year, and will be decelerating since 2015 (from double digit to low single), which will provide less operating leverage to the bottom line.

My EPS estimates are lower than consensus in 2015 and 2016 with $3.00-$3.50 more likely than $3.50 to $4. However, I believe the economic earnings are more like $2.50. On this normalized basis, I think the stock should be trading at ~10-20% discount to its broader aerospace peers on concentrated customer base, the less technology intensive business, high competitive market, the agreement with Boeing on IP and tooling, and the future risk of diversifying from Boeing. I think ~12-13x on normalized basis represents the fair value to the company.

Catalyst

Weakness in widebody market

BA PFS commentary and developments

free cash flow and margin disappointments