Description

It’s not uncommon with value investments to get a second bite at the apple.  Today I point your attention back to Spirit Aerosystems (SPR).  Written up no less than 5 times on VIC, it is once again a great opportunity (in my opinion).  While the outlook for Spirit has materially improved from its covid lows, a recent setback with quality has brought that stock back near those covid lows, despite the outlook for 2025 being little changed.  I think a purchase of SPR equity will result in significant upside over the next 2 years and beyond.

I wrote up Spirit bonds on 04/27/20 and I also said I thought the stock was a buy.  At the time the stock was trading at ~$19.  As a reminder Spirit used to be part of Boeing and was spun out as a separate company in 2005.  It is the primary supplier for the Boeing 737 MAX fuselage and also does business with Airbus on wings.  I postulated that for Spirit to work you needed them 1) to make it through the pandemic, 2) for the 737 Max to fly again, and 3) for demand for airplanes to return long term.  At this point I think it is safe to say that all of these things have happened and yet Spirit is on offer for a mere $23 per share.  

So why are we here today?  There are four main problems Spirit is facing.

1. Ramping the Boeing supply chain is hard. The ramp up of production has been painfully slow since Covid.  It turns out making airplanes with 600k parts is pretty hard and Boeing has struggled to get things running smoothly in the supply chain after shutting it down for so long.  Before the Max grounding Spirit was producing at 52 737 Max fuselages per month and earning over $6 per share in EPS.  Today we are at 30 fuselages per month with a plan to ramp to 42 by year end.  Eventually, if China starts accepting planes again Boeing should get back to well north of 50 planes per month (the original plan before the MAX was grounded called for 57 planes a month).  

2. Spirit recently discovered a quality problem that required a halt in production.  The company recently discovered a problem with two fasteners on parts made back to 2019.  It’s not a safety issue so for any planes already in the air it will be addressed as part of the regular maintenance schedule.  For parts not yet out the door, the fix is a couple days and $150k per unit.  The company expects to fix all existing units by July, while continuing production and the ramp up at Boeing’s behest.  Boeing was so eager for Spirit to stay on pace they provided them with $180 mil cash advance to keep ordering parts. Other suppliers provided an additional $100 mil as well.

3. The Spirit balance sheet has become more stretched. At the low production levels they have been at Spirit hasn’t been generating cash.  They really need to be at 40+ units per month to start generating significant cash.  In the meantime, they have been having to buy parts and ramp up hiring in advance of production increases.

4. Spirit has a labor negotiation with half their workforce (IAM workers).  The contract expires on June 23, 2023.  While the workers are no doubt looking for significant raises, Spirit’s balance sheet has become stretched.  This will no doubt be a tough negotiation, but Spirit is in a good position to say they aren’t making money because it’s true.  The management team has baked in wage increases similar to other players like Lockheed into their guidance. 

Again, I think all of these issues seem addressable.  Why do I think so?

1) With respect to ramping the supply chain, it has always been hard to do.  I was recently reading Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor by Edgar Wachencheim III and he has a whole chapter on Boeing from 2011-2014 when the 787 was ramping up.  Needless to say there were numerous problems with the supply chain then too, it’s almost uncanny how similar it all sounds.  Making a modern day plane is really hard work.  But, eventually, you come up the learning curve and the planes get made.  I think we are looking at the same story here with 737 MAX.  Obviously we had a total shutdown for almost two years so it’s like trying to start from scratch.  In addition the regulators now have a microscope out on the planes so you can imagine it’s that much harder.  I don’t think this time will be any different than last time.  Eventually, the supply chain will get sorted out and production will ramp.  This doesn’t require a great leap of faith, just a look back at history and the belief that it will rhyme.

2) The quality issue is disappointing.  Apparently it’s a couple fasteners on the fuselage where the tail attaches that are non-standard and hidden below a layer of glue.  Basically, no one would have ever known there was anything amiss unless an employee hadn’t spoken up.  So far SPR took a $31 million charge for the planes in their inventory (35-40 units out of 60+ on hand). There will no doubt be additional charges for the already delivered planes, but the magnitude is uncertain and will be spread out over time as the repairs occur.  The bottom-line is, this quality problem, while disappointing, isn’t the end of the world.  The immediate impact will be felt through July, and then it will be a headwind while the planes already out there cycle through the maintenance cycle.  At the end of the day, Spirit is a key supplier for Boeing and also Airbus.  Neither company can afford to have Spirit miss production deadlines if they want to meet their own production schedules.  They are both highly incentivized to work with Spirit though whatever issues arrive as the recent $280 mil cash advance (at no interest) shows.

3) The balance sheet seems manageable, though Spirit has much less flexibility than pre-covid.  The company currently has $568 million in cash.  The debt profile looks as follows:

The term loan doesn’t mature until 2027, so the real first issue Spirit has to deal with are the first lien notes maturing on 01/15/2025 (not that big a deal as only $20 million outstanding) and the $1.2 billion of second lien notes maturing 04/15/2025.  There is little doubt that these will need to be refinanced.  However, by then Spirit should be solidly cash flow positive and there is no reason to believe they won’t be able to refinance them.  Consider that the original bonds were issued during the depths of covid.  As it sits, while Spirit’s capital structure isn’t what it was, the bond market doesn’t seem too concerned.  Most of the capital structure is trading near par - the pieces below par are long dated bonds responding to interest rates.  To a certain extent as Spirit pays down debt in 2025 and beyond, it should accrue to the equity.  Boeing and others all extended Spirit $280 mil in cash advances interest free after the end of the quarter.  The bottom-line is Boeing and to some extent Airbus both need Spirit and if the capital markets fail to support the company as a last resort Boeing especially has already shown that it will.  For Boeing, Spirit is a “too big to fail” supplier.

4) Finally, the last thorny issue is a labor contract negotiation that kicked off on May 1.  The contract with the ITA runs out on June 23, 2023 and represents 55% of Spirit’s workforce.  You can track the progress here: https://www.spiritaero.com/negotiations/ The gist of it is that the workers are going to push for a raise and Spirit is anticipating one.  Given the financial shape of the company I think it will be hard for the Union to push back too hard in negotiations.  Spirit has said publicly there are precedents like a deal Lockheed did recently with the ITA, so there should be a pretty good guidepost to work with.  The bottom-line is that this issue will be behind Spirit soon.  Hopefully, before June 23rd for the sake of all the parties involved.

Conclusion

Spirit is facing a lot of short-term company specific issues.  But if you fast forward to 2025, most of those issues will be behind them.  The Max should be shipping hopefully more than 50 units per month, Airbus will probably have more of its production issues worked out and be ramping up too, the labor negotiation will be long gone, and Spirit will be throwing off meaningful cash to pay down and/or refinance its debt.

The long-term outlook for Spirit is quite bright.  Their backlog is $37 billion dollars.  That’s a lot of revenue.  Additionally, Boeing continues to get new orders for the MAX, RyanAir just put in a $40 billion dollar order this week.  The backlog is over 5,356 planes.  That’s like 8 years.  Airbus likewise continues to grow their backlog and has over 7,00 planes in backlog.  Boeing has said customers wanting new planes from here are going to get them delivered in the 2030s. Needless to say, demand for commercial aircraft is off the charts.  Making airplanes is hard.  Spirit is a key supplier to both players in the global duopoly.  With demand this strong, eventually the planes will get made and Spirit will get their fair share of earnings and cash flow from the production of the fuselage.

In 2019, Spirit had an EBIT margin of ~10% on $7.8 billion in revenue while producing 52 MAXs per month.  Assuming that Spirit gets back to that level of production in 2025 or 2026 there is no reason to believe revenue won’t be $8 billion (defense and aftermarket have both grown and they acquired the Airbus A320 wing business during 2020) and apply that same 10% margin and you have $800 mil of pretax income.  It should be noted that Spirit actually forecasted higher margins at volume in their 2022 analyst day, but why give them the benefit of the doubt at this point?  Debt has grown from 1.9 billion to 3.9 billion during covid.  Interest expense has gone up to $260 million per year from $100 million per year then.  So assume pretax income of $540 mil per year.  Given the recent losses, Spirit isn’t looking to be a taxpayer anytime soon, so that’s EPS power of $540 mil/105 mil shares = $5.14 per share.  Apply your favorite industrial multiple to that, maybe 16x?  Well, that would be an $80 stock.  As Spirit pays down debt interest expense should fall further and earnings power should also expand, somewhat offset by taxes in the out years.  Additionally, their plan to diversify their revenue base away from Boeing over time should also help expand earnings power and add resilience to the business.

Risks

Labor negotiations

Executing the production ramp

Debt refi in 2025

Disclaimer: The information contained herein is solely for research purposes and in no way represents a solicitation. Such information represents the views of the author as of the date submitted based on public information published or disseminated by the companies referenced below, including, but not limited to, through SEC filings, investor relations materials and public conference calls, or other third parties as of such date. Securities of the companies discussed herein have been and are currently portfolio holdings of the author or clients of the author’s firm. Such information does not constitute investment advice or a recommendation, and it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or other asset or to participate in any trading or investment strategy. Forward-looking statements reflect the views of the author as of such date with respect to possible future events. Actual results may differ materially from those in the forward-looking statements as a result of factors beyond the control of the author and you are cautioned not to place undue reliance on such statements. 

Catalyst

Conclusion of labor negotiations

Executing the production ramp

China starts accepting MAXs again

FCF generation starts later this year