Thesis and Summary:

At current levels, we believe that Spirit AeroSystems (NYSE: SPR) presents a compelling risk/reward profile. Specifically, we believe that SPR: 1) is cheap on an absolute basis; 2) is very cheap on a relative basis (with appropriate hedges liquid and easily borrowable); 3) possesses multiple potential near-term catalysts – including the possible sale of the Company at $35/share.

Despite the YTD increase in share price, we believe that investors remain cautious of SPR and the Company remains misunderstood. In our view, the YTD increase in share price is largely related to market and aerospace industry performance/rerating and SPR has very material idiosyncratic elements that either remain misunderstood or are likely on the fix and for which SPR has not been given credit.

Although SPR is one company with one set of financials, SPR’s business is a veritable tales of two cities. The discord enables the opportunity.  

SPR’s ‘Core Programs’ represent mature commercial aerospace platforms such as the Boeing 737 and the Airbus 320 and account for ≈85% of Spirit’s revenues. For SPR, the Core Programs are highly stable and highly cash generative. SPR’s Core Programs represent a revenue backlog of ≈$30bn.

SPR is also involved in certain ‘Development Programs.’ The most well publicized development program is the Boeing 787, a program with which both Boeing and SPR have had their share of troubles. Other development programs include the Airbus 350 and Gulfstream 650 and 280.

On October 25, 2012, Spirit announced a pre-tax charge of $590mm (≈$2.85/share after-tax) relating to cost overruns on the development programs. From the time management began indicating a charge to the day the charge was announced, Spirit shares declined from $26 to $15.

Shares have since recovered and, to be sure, the ideal time to have invested in SPR was immediately following announcement of the charge. However, as said, we believe that SPR’s recovered share price is largely a function of market and industry performance/rerating and that a significant hangover from SPR’s charge continues to exist.

Since August 31, 2012 (selected as the last date prior to SPR management making indications at industry conferences that SPR might have to take a charge relating to the Development Programs), SPR’s aerospace peers are up an average of 51% (median: 55%; min: 28%). Since that same date, SPR is up 5%, or 17% adjusted for the after-tax value of the charge.

At its current price, we believe that the market is assuming SPR’s Development Programs contribute negative value to SPR. At conservative run-rate Core Programs profitability levels and allocating all central SG&A and interest expense to the Core Programs and assuming that SPR’s Development Programs are worth $0, SPR is trading at 7.2x EBIT (10.5x NOPAT) and 9.5x net income. Mean peer multiples are 60% higher. As we will discuss, we believe that SPR’s Development Programs are most likely worth considerably more than $0.

(Brief) Business Overview:

SPR is a Wichita, KS based supplier of aerostructures to Boeing, Airbus, Gulfstream, and other commercial and military aerospace OEMs. Aerostructures include various components of an aircraft’s airframe such as the fuselage and wings.

SPR was formerly the internal aerostructures business within Boeing. In February 2005, private equity firm Onex acquired the business from Boeing. Onex proceeded in April 2006 to merge the SPR Boeing operations with the aerostructures division of BAE Systems which served as a major aerostructures supplier to Airbus.  Onex took SPR public in November 2006.

SPR is an integral supplier to both Boeing and Airbus. SPR is under contract to provide aerostructures products for approximately 97% of the aircraft under Boeing and Airbus backlog. SPR is the sole-source supplier for 97% of the products they sell to Boeing and Airbus.

Onex remains SPR’s largest shareholder, with ≈15.6% ownership.

Valuing the Core Programs:

SPR’s Core Programs are composed of 4 Boeing programs (B737, B747, B767, and B777) and 4 Airbus programs (A320, A330, A340, and A380). The B737, B777, and A320 programs represent 90%+ of Core Programs revenue and EBIT.

The table below presents our calculation of Core Programs revenue and EBIT based on 1Q13 run-rate production for each of the programs. The estimates for segment level margins are based on analyzing reported margins and making the appropriate adjustments for forward losses and cumulative catch-ups:

Currently, the OEMs (and therefore SPR as well) are increasing production rates for both the B737 and A320 programs. At those targeted production rates, SPR is positioned to generate an incremental ≈$95mm in EBIT assuming flat margins.

At current levels, at run-rate $800mm in Core Programs segment EBIT and assuming the Development Programs are worth $0, SPR is trading at 7.2x EBIT and 9.5x PE. At $890mm in segment EBIT, SPR is trading at 6.3x EBIT and 8.2x EPS. Those multiples are low on an absolute basis and very low on a relative basis.

On an absolute basis, we believe that 8.3x-9.7x EBIT (with all centralized SG&A allocated to the Core Programs business) is appropriate [12.0x-14.0x NOPAT - corresponding to 11.3x-13.5x net income assuming all debt/interest cost is allocated to the Core Programs business].  At run-rate $800mm in segment EBIT, that implies $29-$35/share for the Core Programs business. At $890mm in segment EBIT (i.e. assuming targeted production rates), the valuation range moves to $33.50-$41/share.

On a relative basis, the multiples we are applying are highly conservative. Presented below is a valuation table for SPR’s comparables [note, for purposes of calculating EV/NOPAT we have assumed all companies have an effective 31.0% tax rate as SPR]. As the table indicates, the mean/median multiples for SPR’s peers are significantly higher than the high-end multiples we are applying for SPR:

Valuing the Development Programs:

At its current price, we believe that the market is assuming SPR’s Development Programs contribute negative value to SPR. In our view, SPR’s Development Programs are most likely worth considerably more than $0.

SPR operates under block contract accounting. To explain the accounting system, we’ll use SPR’s first block of the B787 as an example [a ‘block’ is a pre-determined set of units for a particular airplane].

SPR’s initial B787 block is 500 units and SPR generates $11.0mm in revenue per unit.

Contract accounting requires that SPR’s income statement recognize the cost of each unit in the block as the same – therefore, the average cost of each unit in the 500 unit block is recognized as cost of goods sold. In reality (i.e. on a cash basis), however, things are very different. For a development program such as the B787, the actual cash cost of early units is going to be much higher than the average cash cost of units across the block and the actual cash cost of later units is going to be much lower than the average cash cost of units across the block.

For the B787, total revenue for the initial 500 unit block is ≈$5,500mm (500 * $11.0mm). SPR is assuming (and its accounting reflects) 0% margin across the entire block. That means that total cash costs for the entire block will also be $5,500mm [in fact, they will be slight higher due to the $200mm in charges or ‘forward losses’ that SPR has recognized on the block]. Therefore, on the income statement, COGS for every unit will be $11.0mm. However, on an actual cash cost basis, early units will cost more than the average $11.0mm and later units will cost less than the average $11.0mm. Accordingly, under contract accounting, in the early stages of a development block, accounting ‘profits’ are much higher than actual cash losses; in the later stages of a development block, accounting profits are much lower than actual cash profits.

The concept that drives the reduction in per unit cash costs across a block is the concept of a ‘learning curve’. The learning curve concept is critical where complex manufacturing processes exist (such as in aerospace). The learning curve concept tells us that as a manufacturing process is repeated (people are trained, processes streamlined, procurement and logistics integrated, etc.) the cost of producing the same product declines.

We can see the concept of the learning curve in practice by studying SPR’s B787 program. For 1Q13, SPR’s cash production cost per unit for the B787 were $11.65mm vs. cash revenue per unit of $11.0mm (i.e. at run-rate levels, SPR is losing $650K in cash for every B787 produced; however, the income statement COGS for each units is $11.0mm). As the table below presents, SPR has made tremendous progress on bringing down its cash cost per unit as it has produced more cumulative B787 units and as the monthly production rate of the B787 has increased:

At quarter end, SPR had produced a cumulative 116 B787s out of the initial 500 unit block. Therefore, if SPR makes no incremental progress on further reducing cash costs per unit for the B787, SPR would burn an incremental $250.7mm (384 * $.65mm) on the remaining unit in the first block.

In our view, it is highly likely that SPR will continue to make progress on reducing cash costs per unit for the B787 and that in the very near future cash costs per unit will drop below $11.0mm and therefore SPR will begin generating cash on every B787 produced (of course, the income statement will continue to book no profit at 0% margins).

SPR balance sheet assumes that will happen as well. As of 1Q13, the ‘Inventory, net’ line on SPR’s consolidated balance sheet included $606.2mm in ‘Deferred production costs’ related to the B787. ‘Deferred production costs’ represent the excess above average cash cost that SPR incurs on units in the early stages of a production block. In the early stages of a development production block, ‘Deferred production costs’ grow as the cash cost of each unit is above the average cost of all units in the production block. Once SPR crosses the cash breakeven point on a per unit basis (i.e. once cash cost per unit for the B787 declines below the $11.0mm average), the ‘Deferred production costs’ balance will begin to amortize down. The $606.2mm of ‘Deferred production costs’ means that SPR anticipates that for the balance of the program, aggregate cash costs will be $606.2mm less than aggregate cash revenues and therefore SPR will generate $606.2mm in cash for the remaining portion of the first B787 block. Of course, that assumes that SPR achieves its assumed learning curve targets.

The concept of a learning curve says this: every time production doubles the production cost of a unit should declined by X%. For example, if it cost $10 to produce unit number 10,  assuming an 80% learning curve it should cost $8 to produce unit number 20 (80% learning curve means that costs should decline by 20%; hence, a higher learning curve means cost reduce less and a lower learning curve means costs reduce more).

In order to value SPR’s Development Programs, it is necessary to perform a full learning curve analysis for the B787, G650, G280, and BR625 programs where a range of learning curves is used for scenario analysis. The worst case scenario is where SPR makes no incremental progress from current cash cost run rates (i.e. the aforementioned incremental $250.7mm cash burn in the B787); the best case scenario is where SPR performs in line with its internally anticipated learning curves and thereby fully recovers its ‘Deferred production costs’ balance.

A350 Charge

We did not, however, perform a learning curve analysis on the A350 program because it is too early in the program to make meaningful inferences from run-rate production cost levels. For that reason and because of the sheer size of the program, the A350 program carries considerable uncertainty and potential risk.

In our view, there is little question that SPR is going to have to take a charge on the A350 program (SPR already reduced the program to zero margin in 1Q13). And we believe that both the buy and sell side widely anticipate that a charge will be taken on the program, quite possibly in 2Q13.

We believe that it is helpful to think about the potential magnitude of a charge on the A350 program on a relative basis to the charge taken on the B787 program.

To date, SPR has taken cumulative charges on the B787 program of $200mm [net of the positive impact of the contract amendment, see 2Q11 10Q]. That means that over the life of the first 500 unit B787 block, SPR expects that cumulative cash costs will exceed cumulative cash revenues by $200mm (hence, the $200mm charge means that the block is in a ‘forward-loss’ position).

There are key differences between the B787 and the A350 program that should mitigate the potential charges on the A350 program vs. the B787 program:

-          Cumulative revenues on the first B787 block are ≈$5,500mm (500 * $11.0mm) vs. cumulative revenues on the first A350 block of ≈$2,000mm (400 * $5.0mm) – i.e. the B787 program is much larger.

-          The B787 program was notoriously delayed and required numerous redesigns. The B787 was delayed 3 years – but really it was delayed 3 times for 12 months each. Had SPR been able to anticipate those delays (which were the fault of Boeing), it would have made different decisions about capital and labor allocation and thereby avoid expenditures which ultimately necessitated the charges taken. To date, the A350 program has progressed, to a far greater degree, on schedule.

-          SPR bore all risks associated with its components on the B787 program and therefore all the consequences of delays and redesigns; there is significantly more ‘risk sharing’ embedded in A350 program contract that should relieve SPR from shouldering the entire burden on delays and redesigns.

-          From an accounting perspective, SPR has actually split the A350 program into 4 blocks – a non-recurring and recurring block for both the wing and fuselage. This could help to isolate any charges and therefore not allow them to be perceived as bleeding through the entire production block (though actual cash economics do no change).

In short: while we do anticipate SPR taking a charge on the A350 program and we anticipate it will be material, we do not believe that it will be an amount that upsets the very compelling risk/reward profile of SPR at current levels.

787 Value

Over the long term, we believe that the B787 program is going to be solidly profitable for SPR. Our valuation for the program is based on a long-term DCF analysis that assumes the program turns profitable on the second block in 2017 and SPR generates long-term 10% margins (conservative) on the program. All future cash flows are discounted at a 10% discount rate.

Consolidated Valuation:

The analysis below values the Core Programs and the Development Programs separately per the methodology discussed. Note: we believe the downside scenario (100% learning curve) where SPR makes no incremental progress on further reducing cash costs per unit is extremely unlikely and regard the more realistic downside case as a midpoint scenario between a 95%-90% learning curve.

Potential Near-Term Catalysts:

Disposal of G650/G280/BR625 and A350 programs

In March 2013, Spirit announced the hiring of a new CEO, Larry Lawson. Prior to joining SPR, Lawson was vice president of the Lockheed Martin Aeronautics business segment where, amongst other things, he helped get the F35 program back on track. We viewed the hiring positively and discussions with industry participants yielded highly encouraging commentary. Most significantly, on the Company’s 1Q13 conference call in May, the CEO expressed his intention to explore all possible options for the Company’s Development Programs.

In June 2013, Spirit announced the hiring of Heidi Wood as senior vice president, strategy. Prior to joining SPR, Heidi was a Managing Director at Morgan Stanley where she lead aerospace/defense research from 1999-2012. We believe that Heidi was brought in to help evaluate strategic alternatives for SPR’s Development Programs.

In June, it was reported that SPR has reached a deal with Airbus to sell its Saint Nazaire A350 plant to the OEM [http://www.bloomberg.com/news/2013-06-19/airbus-weighs-purchase-of-spirit-plant-in-france-to-protect-a350.html].

Based on discussions with SPR and other industry observers, we believe it is highly likely that SPR reaches some resolution around its Gulfstream programs and the A350 program in the near term (sale of the programs to the OEMs or large cash payment (in the case of the Gulfstream Programs) to help make SPR whole). Insofar as the market is currently assigning negative value to the Development Programs, a simple disposal of these programs – even with no cash inflow – would materially reduce SPR’s risk profile and thereby serve as a meaningful catalyst.

Sale of entire company

Last Wednesday, an article was published in the Daily Mail citing fairly specific information around a bid for SPR from UK based automotive and aerospace components company GKN plc for $35/share [http://www.bloomberg.com/news/2013-06-19/airbus-weighs-purchase-of-spirit-plant-in-france-to-protect-a350.html]. GKN is an $8.2bn market cap / $10.0bn enterprise value company. It is leveraged at just ≈1.0x net debt / EBITDA. In July 2012, GKN acquired the Volvo’s aerospace business for ≈$850mm. GKN has stated publicly that it is interested in further aerospace acquisitions.

CEO comments from February 2013 conference call: “And we will look at opportunities as they come along, but we have plenty to be doing just now. We've got great growth coming in our businesses but, if opportunities come, you can't always choose the timing, as we saw last year with Volvo, we would look at the appropriate things. We've said very clearly that Aerospace remains our priority area.”

In our original work on SPR, our discussion with industry participants all pointed to GKN as the most likely acquirer of SPR, should SPR be perceived to be in-play.

We would absolutely not underwrite an investment in SPR predicated on the view that GKN is going to acquire SPR in the near-term for $35. However, we believe there is a legitimate chance that the acquisition does occur and that the current share price does not price in that possibility.

Risks:

-          The most significant near term risk is that SPR does announce a very material charge on the A350 program when it announces 2Q13 earnings on August 6

-          Intermediate term: additional charges on the various development programs without any favorable resolution for the programs in sight

-          Longer term: the current aerospace cycle has been very long and robust, and orders continue to grow at both Boeing and Airbus. The sustainability of this cycle is certainly a risk, although we believe it can be largely hedged out through shorting Boeing, Airbus (EADS), or the suppliers. Almost all peers are trading at all time highs and industry downturn and/or multiple contraction would impair share prices.