Description

Spirit Aerosystems (SPR) is a manufacturer of aerostructures, specifically fuselage, propulsion and wing systems primarily for Boeing and Airbus, but especially Boeing. As a major Boeing supplier which draws over 50% of revenues from the grounded 737-MAX aircraft, the company is collateral damage to the ongoing delays that have kept that aircraft from gaining flight recertification.

In spite of Boeing’s poor crisis management skills, I believe odds favor that the plane will fly again. If it does, Spirit is likely worth about $94, or about 28% above current levels. If – and it is an if – there is no new material bad news, and recertification is granted sometime in 1H of 2020. I can’t say that there will be absolutely no new bad news of any sort, but perhaps the newly appointed CEO, David Calhoun, will seek to get that bad news out as fast as he can. Given the recent decline in Spirit’s stock, the stock price is probably now sensitive to good news, should the new Boeing CEO be able to begin generate some.

The approval process has now dragged into month ten. Though there is some circumstantial evidence of progress towards recertification, the only concrete news has been further delays with no explicit timeline to approval. Guestimates now are 1H of 2020. As the recertification process has spun its wheels, Boeing continued to manufacture planes, storing them everywhere they could, including the employee parking lots: https://www.cnbc.com/2019/06/26/boeings-grounded-737-maxes-took-over-the-employee-parking-lot.html

Granted, the company needs inventory to deliver against orders assuming recertification is granted. However, as with all inventory too much is a bad thing. That goes double when the widget happens to be among the largest manufactured items on the planet and built of complex and highly precise components and is sitting parked out in the weather deteriorating.

With 400 planes sitting parked outside deteriorating, it seemed reasonable that Boeing would need to lower production and recently Boeing finally ordered a MAX production halt beginning January 1. Following Boeing’s production halt Spirit has done the same. Boeing and Spirit stock began to anticipate the cut. The stocks have declined further with the news out and arguably this latest round of disappointment is in the stocks. Or more precisely, I believe it is mostly factored into the stock price of Spirit.  I am not offering any advice on Boeing, nor have I had nor do I have a position in BA.

Though the production halt can easily be interpreted in the practical terms of excess inventory sitting outside deteriorating in the weather, cash flow is, not surprisingly, an important consideration as well. It takes a lot of money to build a plane only to have it sit in a parking lot waiting indefinitely for final payment. Buyers of Boeing planes make down payments, but those payments have stopped thanks to the grounding. Boeing has run through much of those cash advances. For an excellent analysis of this cash flow bridge see this linked piece from Seeking Alpha. https://seekingalpha.com/article/4313294-boeing-737-max-production-halt-jet-maker-ran-out-of-cash

Boeing’s handling of this crisis has been poor for many reasons, not least of which was failure to fully and openly communicate with airlines what Boeing knew or suspected about problems with MCAS after the first crash. Then after the second crash Boeing seemed less than forthcoming about what it knew and when it knew it and broadly speaking, management came off as tone deaf and less than contrite. Even after all these failures of communication, Boeing was recently publicly chastised by the FAA for trying to press the regulator to rush the flight reapproval process and providing indications to the market that approval was soon forthcoming. Below are two Wall Street Journal editorials that address the Boeing leadership issue.

https://www.wsj.com/articles/boeings-fatal-lessons-11576628330?mod=searchresults&page=1&pos=1

https://www.wsj.com/articles/boeings-crisis-management-keeps-falling-short-11576518561?mod=searchresults&page=1&pos=2

To even the casual observer, it must have been puzzling regarding how long Boeing’s CEO managed to maintain his job. Granted, there may have been some initial benefit to having the person most aware of the very complicated details shepherding the company back through the approval process even if he was to be pushed out as soon as recertification was achieved. Put another way, it might be difficult for an outsider to come in cold and figure it all out when events are moving at light speed and the things that need fixing are some of the most detailed minutia of flight aeronautics all of which are highly specific to this company and this plane.

Finally, as widely reported, the Boeing board took action, at least to a degree. Boeing replace CEO Muilenburg with current Board of Directors Chairman, David Calhoun. (Though Calhoun does not officially take the position until mid-January.) https://www.wsj.com/articles/boeing-names-david-l-calhoun-to-replace-dennis-muilenburg-as-ceo-11577110365?mod=hp_lead_pos6  Calhoun has been a director since 2009, lead independent director since April 2018 and was appointed Chairman in October of this year when the company split the Chairman and CEO role. From the link above on Calhoun:

Mr. Calhoun, who is set to become CEO on Jan. 13, has been a Boeing director since 2009. He spent 26 years at GE, including running its aircraft engine business.

At Blackstone, he has confronted other major corporate crises. He is credited with turning around the fortunes of Nielsen Holdings PLC after being put in charge of the market research and measurement company.

He later became chairman of Caterpillar Inc. ’s board weeks after federal agents raided the heavy machinery maker’s Illinois headquarters. Both he and Mr. Muilenburg are on Caterpillar’s board.

Directors and executives who have worked with Mr. Calhoun have said his experience should help Boeing overcome its problems. Inside boardrooms, his personality looms large, and he became increasingly assertive inside Boeing’s boardroom as problems mounted this year, colleagues have said.

Replacing the outgoing CEO with a director present throughout both the development of the MAX and the crisis is hardly perfect optics. That’s the negative. Perhaps a retired airline CEO, a retired air force chief, or another Calhoun-like executive with critical supply chain experience would have been better. But what is done is done and there are positives; namely, time has grown even more critical to Boeing and Calhoun is familiar with the situation, the details, all the players, has experience in turnarounds and understands aerospace given his previous role with GE’s aircraft business.

By necessity, stakeholders are going to have to move from actively questioning the choice of Calhoun, to waiting to see exactly what he does. Calhoun may be able to begin enhancing his credibility by starting a process of selectively cleaning house, by ridding the company of executives most directly involved in the mistakes. Ideally, there will be some first hints of progress regarding recertification.

Benefits of a new CEO also include providing the FAA a new person in whom to hand over MAX recertification. If I myself was part of the regulatory approval process, in particular the FAA administer or someone in the same role in other jurisdictions, the last person to whom I would want to hand over recertification approval would be the Boeing CEO in charge through the debacle. Now, that will not be necessary.

Also, Calhoun could be an interim step whose main role is to provide able leadership by an executive up to speed on the crisis and to then move on at some point after recertification. This NPR transcript highlights this possibility:

“…well, you know, that gets to the big question of how long he's staying for. As a short-term stabilizer, he's a really good choice. He's deeply respected by a lot of people. He's got a great external presence. He'll be a good diplomat, which is perhaps what they need right now after the recent missteps. But in terms of somebody who changes the way the company operates and, well, gets relations between the commercial aircraft unit in Seattle and corporate headquarters in Chicago back on track, he's probably not the right choice for that.”

https://www.npr.org/2019/12/24/791044346/boeing-picks-new-ceo-to-restore-confidence-repair-relationships

Beyond flight reapproval, another benefit of a new Boeing CEO, will be that Boeing will be looking to deliver and take payment for the hundreds of planes in inventory, begin taking new down payments for existing orders, and hope to again secure new MAX orders into backlog for their planes. I suspect the last person to whom any airline or air lessor wants to give money or new orders as the former CEO who caused their companies such costs, disruptions and grief. Even if Calhoun is an interim CEO (though perhaps a couple years), now that issue is beyond them.

Regarding recertification, one could argue that the ever-extending recertification delays indicate that the technical problems are unsolvable or at least will result in a delay that is, even at this date, well beyond 1H 2020. For now, I don’t believe this is the case, but it is a risk. Given that I lack anything more than a generalist’s insight into aeronautical engineering and only have an outsider’s view of the regulatory matters associated with re-gaining flight approval I am certainly not an expert. I offer this disclaimer as a a caveat emptor, but do so with some tea leaf reading from selected regulator testimony that suggest the process is not off the rails, but merely going slow.

FAA administrator Stephen Dickson, in his December 11 congressional testimony, seemed to argue that the remaining recertification issues were less about solving technical issues, and more about downstream testing of the proposed solutions:

“Actions that must still take place before the aircraft will return to service include a certification flight test and completion of work by the Joint Operations Evaluation Board (JOEB), which is comprised of the FAA Flight Standardization Board (FSB) and our international partners from Canada, Europe, and Brazil. The JOEB will evaluate pilot training needs.”

https://www.wsj.com/articles/boeings-fatal-lessons-11576628330?mod=searchresults&page=1&pos=1

Administrator Dickson added these steps that would then follow a certification flight test:

“The FSB will issue a report addressing the findings of the JOEB and the report will be made available for public review and comment. Additionally, the FAA will review all final design documentation, which also will be reviewed by the multi-agency Technical Advisory Board (TAB). The FAA will issue a Continued Airworthiness Notification to the International Community providing notice of pending significant safety actions and will publish an Airworthiness Directive advising operators of required corrective actions. Finally, I am not going to sign off on this aircraft until all FAA technical reviews are complete, I fly it myself using my experience as an Air Force and commercial pilot, and I am satisfied that I would put my own family on it without a second thought.”

Testifying at this same hearing along with administrator Dickson was Matthew Kiefer a member of the FAA Technical Advisory Board. His testimony, in my view, is in line with a regulatory process that is focused on doing the job right, taking all the time needed to get it right, but is indicative of a process that is moving towards approval. From Kiefer’s submitted testimony regarding the Technical Advisory Board’s (TAB) work with Boeing:

“After these meetings, briefings and demonstrations the team gathered to assemble our findings and recommendations. Some of these we have determined are necessary before returning the aircraft to service. These recommendations/action items are being actively tracked internally to the TAB and with Boeing and the FAA. All recommendations that the team made for return to service have either been addressed and closed or are presently in work. The TAB is still working with Boeing to accept products to close the remaining action items. Once all of this work is complete the TAB will present a final report to the FAA…

…The TAB still has work to do to complete our assessment of the changes to the B737 MAX systems as we are awaiting more information on the development assurance, testing of the software, final safety assessments and final training for aircrew. Pending the team’s determination that the remaining review results meet our expectations, our team feels that the changes made to the flight control software in the B737 MAX should vastly improve the safety of the aircraft, in keeping with the highly successful safety record of the previous models of the Boeing 737.”

https://transportation.house.gov/committee-activity/hearings/the-boeing-737-max-examining-the-federal-aviation-administrations-oversight-of-the-aircrafts-certification

None of this assures that additional problems will not surface as Boeing attempts to address the remaining recommendations. Certainly, new problems have arisen in the past just as the Street was led to believe that recertification was close. However, the testimony suggests that the process is going slow, but is on track.

A factor that could delay, though not prevent, return of the aircraft to flight is if, in addition to software and/or hardware fixes, pilots are required to undergo training in a flight simulator instead of an iPad. Additionally, it may be that the task of figuring out the precise proper training procedures will itself be a material source of delay, regardless of how that training is access by pilots.

In the past couple weeks I noticed a few stories or opinion pieces that deal with the issue of over-automation in flight training and piloting planes. MCAS, though not the best way to design an airplane, is highlighting this factor as an industry-wide issue. MCAS is going to be the first time regulators are directly dealing with issues of over automation and it is adding to the time required to learn how to best train pilots.

For instance, the below linked Wall Street Journal opinion piece provides additional hints that an important remaining element of recertification may be a material change in the pilot training regime. It goes further, to suggest that the issue may be larger than the MAX and that pilot training in general will require, at least to some degree, less reliance on automation and more reliance on manual flying skills. It further hints at the need for emerging market pilots to be more experienced at manual flying and that too many of these pilots are too reliant on simulator flying.

WSJ: Pilots, Not the Plane, Keep the Boeing MAX Grounded

https://www.wsj.com/articles/boeing-vs-technological-chaos-11572998029?mod=article_inline

Unfortunately, I can’t find a link to another NPR story that interviewed an industry insider on the matter of automation and training. Not only did he underscore the need to ensure pilots can manually take over a plane, but he also pointed out that some emerging market pilots only have something like 300 hours of flight time in the 737 and much of it in simulators. He added this amount of training qualifies them to passengers, not pilots. Additionally, the fact that it is often emerging market airlines that did not purchase the optional MCAS safety features, cause risks of flying the MAX in emerging markets to increase. Granted, the safety features should have been mandatory. I am assuming they will be going forward. However, these factors are not likely to stop recertification of the plane.

Beyond identifying what exactly is the right new information to transmit to pilots to properly fly with MCAS, Boeing has stated it believes the plane can fly again without the use of simulator training. Specifically, the below report from Leeham News suggests (in the correction), that the airline manufacturer is, “urging regulators and pilots to go to sites where MAX MCAS flying characteristics may be witnessed and understood.”

https://leehamnews.com/2019/05/10/boeing-to-support-max-simulator-training-financial-analyst/

However, Boeing has lost so much credibility and there are enough offsetting voices in favor of simulator training, or at least suggesting it should be strongly considered, that I will assume it will be required. Among those recommending simulator training include Chesley “Sully” Sullenberger, who in 2009 landed a US Airways flight safely on the Hudson River in New York and was among those recently testifying before congress. In part in his congressional testimony, Captain Sullenberger said:

“…we must greatly improve the procedures to deal with uncommanded trim movement, provide detailed system information to pilots that is more complete, give pilots who fly the 737 MAX additional Level D full flight simulator training so that they will see, hear, feel, experience and understand the challenges associated with MCAS, such as Unreliable Airspeed, AOA Disagree, Runaway Stabilizer and Manual Trim. They must have the training opportunity to understand how higher airspeeds greatly increase the airloads on the stabilizer, making it much more difficult to move manually, often requiring a pilot to use two hands, or even the efforts of both pilots to move it. And in some cases, how it cannot be moved at all unless the pilot flying temporarily stops trying to raise the nose and relieves some of the airloads by moving the control wheel forward.”

Link to congressional testimony including Captain Sullenberger: https://www.youtube.com/watch?v=nA96utA5DIE&feature=youtu.be

Link to transcribed remarks: https://transportation.house.gov/committee-activity/hearings/the-subcommittee-on-aviation-hearing-on_--status-of-the-boeing-737-max-stakeholder-perspectives

Further evidence in favor of more training comes from the below linked December 22, New York Times article. It also highlights not only the need for additional pilot training, but perhaps a changed approach to that training to ensure pilots are fully able to respond to MCAS software issues. The article also serves as an compendium of Boeing’s missteps and overreaching throughout the process. From the article:

“…Boeing still faces serious hurdles. The company has not delivered a complete software package to the F.A.A. for approval. In recent simulator tests, pilots did not use the correct emergency procedures, raising new questions about whether regulators will require more extensive training for pilots to fly the plane or whether the procedures needed to be changed, according to two people briefed on the matter.”

NYT: At Boeing, C.E.O.’s Stumbles Deepen a Crisis

https://www.nytimes.com/2019/12/22/business/boeing-dennis-muilenburg-737-max.html?smid=nytcore-ios-share

Regarding non-U.S. flight recertification: Boeing’s mismanagement of the crisis – as well as the FAA’s in terms of the original flight approval – has put all foreign regulators in a position to be extra cautious about rubber stamping anything from Boeing or the U.S. FAA. For flight safety reasons and for public relations reasons these regulatory bodies may choose to insert a delay between when the U.S. provides flight recertification and when they do. I suspect their approvals would be forthcoming should the plane gain U.S. flight approval. These delays are not likely to stop production from resuming at Boeing and at Spirit. However, there have been reports that the FAA is trying to slow the process enough to give foreign regulators time to complete their own reapproval processes and to then grant reapproval in conjunction with the U.S. FAA.

What is the future for the 737 MAX plane? Most airlines are likely to accept future deliveries of the MAX because they lack alternatives for otherwise sourcing the aircraft needed to refresh and/or grow their fleets given the multi-year lead time from placing an order until delivery. In addition, for those with Boeing focused fleets it is far from optimal to begin adding Airbus planes even if they were available. Pilots, mechanics, flight crew and ground staff are trained and costs are optimized to build the fleet with more of the same aircraft. (Though some airlines have a mix of planes from, primarly, Boeing and Airbus.)

Due to the interconnected nature of the airline/Boeing relationship I also believe, that should the aircraft be returned to service, airlines will be actively working to reassure leery flyers of the plane’s safety. In the margin, this should help passenger sentiment as it is not the airlines that did anything wrong and flyers may extend some goodwill in terms of confidence to their carrier in spite of Boeing. This Barron’s interview with CEO of Brazilian airline, GOL, from earlier this year provides some insight into this dynamic. Note the positive things he has to say about the plane and how he implies his pilots knew how to deal with the MCAS issue all along:

“Barron’s: How has the 737 MAX grounding affected Gol operations?

Kakinoff: This is the seasonally weakest period of the year for Brazilian air travel, so we haven’t needed those planes yet. But we are looking forward to getting the plane back. It’s a great aircraft, with better fuel burn and superior range.

What was your experience with the 737 MAX before the grounding?

We’ve flown seven jets for more than 12,000 hours, without incident. The aircraft performance is great. [Gol] was flying the longest 737 MAX flight from Brazil to Orlando before the plane was grounded. Now we have to fly that route with a layover in the Dominican Republic.

You didn’t have any operating issues—has anything about the fallout surprised you?

We were caught by surprise that some pilots didn’t know about MCAS [short for the maneuvering characteristic augmentation system, an automated flight-control system on the 737 MAX]. We [in conjunction with Brazilian aviation authorities] highlighted the MCAS system from day one of pilot training, before we ever took delivery of the plane.”

https://www.barrons.com/articles/brazilian-airline-gol-ceo-boeing-737-max-51561410972

Thinking about this GOL CEO interview, there is also going to come a point at which this drags on that certain airlines start communicating to the FAA, that though they favor all due diligence to get this right, they also believe the plane is fundamentally safe and it’s time to get it in the air. Even the pilot’s union could begin doing the same thing. They have to be careful about how they phrase it and how they communicate it, but I would not be surprised if they did. At least it is a possibility.

Post 737 production shutdown, the Spirit story is now back to a question of when and if MAX will it be recertified and if it is, then when and at what rate will production return. Additionally, investors need to learn what will be the steady-state build rate and when will that rate will be reached. Fortunately, Spirit inventory is not the 400 Boeing has, as Spirit has delivered and been paid for most of their shipsets and has ~90 in inventory.

My numbers assume Spirit’s MAX shipsets drop to zero for the first six months of 2020. Though there is a material chance production begins anew prior to July. I am increasing deliveries to 42 per month in Q3 and Q4. This equates to 21 MAX shipsets per month for the full year 2020. For simplification purposes I am using 52 per month for full-year 2021. However, it is possible it will take longer than Jan 2021 to reach this level. I am not modeling production on the 57 per month that had previously been considered full production. In any case, run rate is key and I am using 52.

Based on the above production, should regulators grant approval for the 737-MAX to fly again, a decision which would drive Boeing and, in turn, Spirit to resume normalized MAX production levels, perhaps by 2021, then Sprit stock is likely worth ~$94, or ~28% upside in the next 1 to 2 years, up from a recent price of $74.00. This valuation assumes ~8.5 EV/EBITDA multiple. In the two years prior to the crash that precipitated the 737-MAX grounding took place the stock had been trading in a range of 10 to 12 EV/EBITDA and at times higher as the market anticipated a ramp in Boeing revenues. Should those multiples again be achieved it would offer upside beyond the 8.5x number I am using for my fair value. This ties back to 15x my 2021 earnings of $6.14.  Feel free to adjust the multiple and the fair value as you believe appropriate.

Granted, re-approval of the MAX for Boeing may mean just the beginning of dealing with the monetary, legal and reputational costs associated with what appears to be a rushed effort to bring a plane to market, but it should begin to be the end of the problems the issue has caused Spirit.  

Background on Spirit, in 2018: Boeing accounted for 79% of SPR revenue and Boeing 737s (all types, but primarily 737-MAX) were 73% of the total shipsets delivered to Boeing. Taken together and accounting for pricing mix, the 737-MAX, as noted above, represents approximately 50%+ of all Spirit revenue.

Spirit was spun (actually purchased) out of Boeing in 2005 which is why Boeing accounts for such a high percentage of the company’s business. Offsetting the customer concentration risk is that Spirit has supply contracts with Boeing that account for the life of the jets (and their commercial derivatives) for which Spirit currently supplies systems, though this agreement requires periodic updating of pricing schedules. To the issue of pricing, early in 2019 the company finalized agreements that extend most pricing agreements of original and spare parts through 2030 on the B737, B747, B767, and B777 programs. Pricing on the B787 program has been agreed upon out through production unit 2,205. Through Q1 of 2019, 840 B787 variant aircraft have been delivered. In 2018, 145 units were delivered, stepping up to 168 in 2019. At 168 per year that would take B787 pricing out into the year 2026. Though Spirit has a long-term contract, the pricing on those contracts declines as shipsets increase. Theoretically, these price declines coincide with Spirit running at higher efficiency as they learn and improve processes.

At the mid-year Paris Airshow, Boeing secured an intent to order 200 planes from British Airways parent, International Consolidated Airlines. This was the first order since the plane was grounded, though it is only a letter of intent and does not yet flow into backlog. Certainly, the discount to pre-grounding pricing secured by IAG must be impressive. Should the grounding order be removed, any new, near term orders will also be at significant discounts. It seems likely that airlines with options on planes will also seek to renegotiate price, if at all possible.

Upon a recertification event, Boeing will be extremely motivated to show evidence of new order wins. Lowering prices may prompt those orders as long as the safety cloud is lifted and the flying public is beginning to put the issue in the past. Airlines may, arguably, be a better business than they were a generation ago, but a plane seat is still mostly a commodity and owning an airline is not a guaranteed license to print money. Material discounts may soften airline management views in the direction of purchasing new planes from Boeing. A view towards a recovering orderbook would improve sentiment and provide some lift to Spirit.

Given all the costs associated with this event, margins and cash flow at Boeing will be impacted for some time to come. As long as the plane gets back in service, however, sorting out the costs and liabilities are Boeing’s problem, not Spirit’s. Spirit has contracts that include pricing and Spirit is not in culpable or liable for the crashes as the causes are unrelated to the structures they produce.

Pre-crash production levels for Spirit included producing 52 B737 shipsets per month. Prior to the grounding, the plan was to increase to 57 shipsets per month beginning in June of 2019, a level which Spirit had met through internal practice runs. As discussed earlier, I have lowered 2020 shipsets to 21/month (all in the 2H at 42/mo) and moved 2021 to 52 per month for the B737. I am further assuming 852 total Boeing shipsets and 836 Airbus shipsets for the 2021 out year. I am using an operating margin of 11.5%, which is roughly in line with the 11.6% achieved in 2018, which is below management targets (assumes all the disruptions prevents achieving much operating leverage). I put the tax rate at 22% based on guidance from the 2018 Q4 call. I am assuming $400M per year in revenues from the likely to be completed (but much delayed) ASCO acquisition, but only $100m in 2020 and then the full $400M in 2021. I have not included anything for the recently announced Bombardier acquisition.

Assuming ~$1217 in annual EBITDA in the twelve months beginning 2H-2020 at these production run rates and an 8.5 EV/EBITDA multiple I get a fair value of $94, or about 28% upside from current levels over the next one to two years. Valuation rises if Boeing takes Spirit to a B737 shipset production level of 57/mo (the goal prior to grounding) and then, still using 8.5 EV/EBITDA, I get a fair value of ~$106, or ~43% in roughly three years, assuming this higher production level is achieved in 2022. Further upside at the same multiple would come from improved margins if they drive operating leverage as they produce more shipsets or even if they improve production efficiencies at 52/mo shipsets.

Catalyst: Reports that the 737 to take first test flights in anticipation of flight approval. Eventually, flight approval by the FAA (which will trigger approvals with some countries, but not others). Finally, actual return to flight of existing MAX in airline fleets, and finally first deliveries. CEO change a helper, too.

Risks:

·       Regulators uncover further safety issues with the B737 or other Boeing aircraft and approval is delayed past they 1H 2020 target included in this report.

·       Regulators fail to re-approve the B737 for flight ever.

·       General recession or airline recession which causes airlines to refuse or be unable (due to bankruptcy) to accept aircraft deliveries.

·       MAX is recertified, but airlines refuse to buy the plane and forfeit deposits.

Catalyst

Evidence that the new Boeing CEO is making progress toward recertification of the 737-MAX and, eventually, actual certification.