Description

Spirit AeroSystems – Long

Summary: Spirit AeroSystems is a late stage turnaround story. We believe Spirit Aerosystems is an underappreciated good business with a long runway for growth undergoing a transition from what we’d describe as a bloated Boeing lackey with sub-par management focused on value-destructive diversification and product-based management to a lean Boeing partner led by an A+ turnaround expert using program-based management to maximize ROIC. We believe a) earnings growth will outpace the industry, b) FCF conversion will improve materially, and c) Spirit’s perceived riskiness will fade with time and execution.

Business Description: Spirit was a manufacturing division of Boeing spun out in 2005 by Canadian private equity group Onex. Boeing remains 84% of sales. It’s the sole source supplier of mission critical, highly engineered parts to large aircraft OEMs. Product examples: body of aircraft (fuselage) + structure that holds the engine in place (nacelle). Spirit is the sole-source supplier for the life of the aircraft program, which can extend multiple decades.

Valuation: The business trades at <11x Consensus 2016 EPS. Peers (excluding Triumph Group as they seem to be dealing with a unique set of headwinds) trade at 14-17x 2016 EPS. Like some in its peer group, we expect SPR to eventually trade at a slightly premium to the market due GDP+ organic topline growth and long term revenue visibility (7 year backlog currently). However, we do not anticipate this happening until the company has delivered several more years of healthy, predictable operating results and management has proven to be thoughtful stewards of capital.

We value the business on 2018 earnings. SPR is trading 9x Consensus 2018 earnings and <7x our 2018 earnings. While FCF conversion may only be 60% in 2016 (per guidance), we anticipate FCF conversion in 2018 to be 100%+ and 90-110% thereafter. Our 2018 EPS is ~35% higher than Consensus. 55% of the delta is driven by higher earnings, while the rest is driven by capital allocation. The capital allocation portion is largely driven by the amount of FCF allocated rather than the method. We assume the business remains nearly unlevered, but that it returns 100% of FCF to shareholders via repurchases at increasingly high share prices ($58/sh average over the next 2 years). We believe optimal leverage is 2-3x turns of EBITDA, but view the balance sheet becoming more efficient as a call option.

Without multiple expansion, we think the investment is +60% over a two year hold on our base case #s. If Spirit receives a peer multiple, the +60% becomes +130%.

Organic Growth Formula:

We believe Spirit sells into a stable duopoly that serves an increasingly healthy customer base. Commercial air traffic growth has averaged 5% per year over the past several decades. Global air traffic growth was 6.5% in 2015 and should continue to increase at a healthy clip due to the rising global middle class. The growth in supply of new aircraft should approximately equal air traffic growth over time. Additionally, Spirit’s business mix is weighted towards faster growing aircraft programs (737 is 50% of sales and should continue to gain share of air traffic miles flown), so its topline should grow faster than the industry. For reasons outlined below we expect FCF margins to increase gradually but significantly over time leading to mid-teens FCF growth CAGR for the next decade before capital allocation.

Why Does the Opportunity Exist? Upon spinning out of Boeing, Spirit attempted to diversify. In order to diversify they needed to bid on new aircraft programs. SPR bid on and won Gulfstream and Airbus A350 business. Coincidentally, BA was launching a new program, the 787. These three programs were clean sheet design programs (i.e. starting from scratch). Spirit’s core competency was producing planes that had been around for decades at a low cost, not estimating run rate production costs six years out for complex products they had never built before. The result of an inexperienced team taking on three significant clean sheet projects all at once? Spirit being marred by massive cost overruns causing large accounting write offs for its first half decade as a publicly traded company. Spirit persistently missed its annual guidance. Despite two years of the new management team not only meeting but beating their promises, Spirit’s history continues to act as an overhang. In addition, the market…

·          Underestimates Spirit’s bargaining power with key customer Boeing

o   We believe Spirit enjoys strong contractual protection via the master pricing agreement signed upon the spin.

o   Spirit remains Boeing’s lowest cost alternative by a healthy margin due, in our opinion, to its scale, know-how, and labor rates (long term labor agreement in place).

o   Boeing deeply values quality and on-time delivery. Spirit has delivered on both over time, which can’t be said for other aero structure suppliers to BA.

o   Spirit is responsible for delivering about 70% of the structure of Boeing’s cash cow program, the 737. We feel it would be extremely risky and would take multiple years to replicate this asset. Per Spirit’s 10-K the insurable value of the assets owned by Spirit is $5.1Bn. If you add SPR’s cash, receivables, inventory, and other assets, you get to replacement value of $9Bn vs. Spirit’s current EV/market cap of $6Bn. Based on our understanding of the insurer’s methodology, the insurable value estimate is likely materially understated.

o   Punchline: Spirit is well positioned to negotiate fair and equitable pricing with Boeing.

·          Doesn't understand the degree to which Spirit was mismanaged prior to new management

o   Our research suggests the company never made the transition from Boeing cost-center to ROIC-focused for-profit organization. Capital was treated as someone else’s money, and internal accounting systems and contracting methods were in desperate need of change.

o   The new CEO has been uniformly described by our research as the perfect man for the Spirit turnaround job. He is a cash ROIC-focused, skilled negotiator who doesn’t let anything get in the way of aggressive cost cuts and the shaking down of a company’s suppliers. The C-level team has been overhauled, program and product managers have been replaced, purchasing has been centralized, excess headcount has been removed, and some production has been shifted to lower cost areas. Of Spirit’s top 98 jobs 89 people are new to the company or new to the job since the new CEO arrived in March 2013.

o   Punchline: The cost reduction opportunity is significant, and should help alleviate any pricing pressure from Boeing should it arrive.

·          Doesn't appreciate the operating leverage inherent in the business model

o   New programs (i.e. the ramping of the 787 and the A350 programs at 0% GAAP margin) have obfuscated the benefits of operating leverage on legacy programs.

o   Spirit discloses margins by product, not program, and thus the sell-side models Spirit by product, not program.

o   During its 2006 IPO road show, old management described incremental margins as being in the “mid-20s.” Our research confirmed this commentary.

·          Underappreciates the cash flow implications of Spirit's new programs reaching their production phases.

o   While new programs, in which SPR invested $Bns, have contributed $0 of GAAP earnings, by our estimates they’ve reduced operating cash flow (not to mention free cash flow!) by well over $100M/year for the past several years.

o   While the exact path is unclear, the new programs should be FCF positive in aggregate in 2018 and beyond.

The foundation of our conviction is confidence in the CEO, who oversaw the F-22’s turnaround while at Lockheed Martin. Under his management margins increased from mid-single digits to mid-teens via negotiating equitable pricing with its key customer, eliminating fat from the production processes, and renegotiating pricing with suppliers. He is following this exact same playbook at Spirit. As discussed above, he seems well on his way to optimizing the business’s operating performance. However, the biggest cost opportunity is yet largely untapped. Spirit intends to consolidate supplier count from 1,000 suppliers to 300 suppliers. They’ll be giving fewer suppliers more business in return for better pricing. Our understanding is that the first wave of consolidation will take place at the end of 2016 , so this initiative will be a 2017 and beyond tailwind.

Lastly, leadership strikes us as thoughtful capital allocators. They repurchased 5% of the company during the last 4 months of 2015, and after purchasing another 1% of the company in January the company announced a new repurchase authorization for ~10% of the company. The CEO during the Q4’15 earnings call stated, “Nine times P/E, when I look at my options, given the volatility of the marketplace, I know how well my business runs. And so I just – it's the best investment, I think, we can make, and let's leave it at that…We haven't stopped looking [for acquisition targets]. We're out there looking every day, and, it's like anything else. Life is a choice of alternatives. You go to the grocery store and you look up there and you decide, hey, am I going to buy A or B? I mean, it's – well, sometimes, I mean, you buy A and B…just to be blunt, we can do a share repurchase. We can deploy capital and still pursue M&A. We're not a highly levered company. And so one doesn't preclude the other.”

Path to Profitability: Spirit and Boeing have been negotiating pricing for all of SPR’s Boeing business for multiple years now. We expect a long term pricing deal to be completed this year (related capital expenditures need to be made relatively soon in order for Boeing to meet its 2018 and beyond production rate targets), and for the deal to lift a key overhang on the stock.  Outside of the Boeing renegotiation, we believe the market’s view of business quality and earnings power will improve over time as the company executes. Capex is currently elevated as the company needs to spend ahead of production increases in 2017 and 2018 ; it’ll likely remain elevated in 2017. However, over the next few years production increases on mature programs plus capex decreases plus supplier consolidation plus improved new program cash flow (completion of repayment of Airbus advances in 2017 + scale benefits of ramping production) should drive significant FCF growth.

Key Risks:

·          Customer risk: Spirit is currently working on a long term pricing contract for all of its Boeing business. This is an opaque process. While we’re confident in Spirit’s ability to negotiate equitable terms, the captive supplier dynamic has the potential to create situations where basic economic principles do not work as expected.

·          Cycle risk: Spirit is highly leveraged to the aircraft “OEM cycle” and the cycle (or the lack there of in our opinion) gets A TON of attention. We could dedicate multiple pages to the topic, but we’ll try to be relatively brief.

o   The OEM industry has traditionally been marked by cyclicality. Despite a seven year backlog, market participants obsess over each calendar year’s book-to-bill ratio. Historically, when book-to-bill is below 1.0x, trading multiples have compressed. Many expect 2016 to be the first year since 2009 where book-to-bill was below 1.0x. There is tangible evidence that the OEM industry has become less cyclical. In what was the deepest economic recession seen globally since air travel has been a mature industry, the ’08-‘09 cycle saw nearly no decline in deliveries compared to historical declines of 40-50% in past cycles. Why? The industry has consolidated from a four player market to a two player market, and supply growth has lagged demand growth for over a decade. As a result, a backlog of demand has built up and this backlog should comfortably support production in periods of reduced new plane orders.

o   The backlog has increased dramatically in the past decade and has never been longer, so we think it’s only reasonable for orders to stop materially exceeding deliveries every year. While new plane orders will continue to be cyclical, new plane deliveries are what matter and deliveries should not be cyclical. We believe the size of the backlog, air traffic growth, global load factors (how tight is the market?), and airline profitability are more important indicators of the industry’s health than this year’s plane orders.

o   Market health factors:

§  Air traffic growth: Above historical normal levels. Emerging market continues to enjoy robust air traffic growth despite GDP growth deceleration.

§  Backlog: At historical highs.

§  Load Factor: Continues to hit new record highs. ~82% vs. LT average in the mid-60s. The market has never been tighter.

§  Airline profitability: The airline industry is enjoying another record year of profitability. In addition, financing costs remain near historically low levels.

§  Deferrals and cancellations: Continue to run below long term averages.

§  Used plane prices: Narrowbody plane (70%+ of SPR earnings) prices remain at healthy levels by all accounts. Widebody pricing picture is more mixed.

o   Won’t lower oil reduce demand for the new fuel efficient planes? Our research suggests lower oil prices will marginally reduce replacement demand over the next couple of years, but history suggests lower oil prices will be a material tailwind to growth demand (see mid-1980s, the last supply-driven oil price shock). We are more concerned about the Zika virus and terrorism than we are about low oil prices. Not to mention, airlines are purchasing assets with 25 year useful lives that won’t be delivered for 3-8 years. Our research suggests they do not let short term moves in oil prices, even dramatic ones, materially impact long term fleet planning decisions.

·          Write Off risk: One of the new programs, the A350, continues to carry material write off risk. SPR recognizes the program at 0% GAAP margins for the first 200 deliveries, as it anticipates to be cash flow neutral over the course of this first block of deliveries. In reality the program is cash flow negative for a period of time on the front end, and then should turn cash flow positive as SPR comes down the cost curve. We believe production increases are the most important per unit cost driver due to the inherent fixed costs, and are unfortunately out of SPR’s control (issues at other suppliers and/or soft end market demand could lead to slower production increases, for example). While the company is free cash flow negative it builds “deferred production inventory” (i.e. negative cash margin) which it unwinds upon turning cash flow positive. Despite very impressive cost reductions over the past year SPR is not on pace to recover the entirety of the deferred inventory for the program. However, there is a reason for this: SPR’s bill of materials has increased materially due to Airbus-driven design changes, yet SPR’s ship set price has not changed. Fortunately, Airbus acknowledges the increase in bill of materials. While it’s unclear where exactly SPR’s A350 shipset pricing will settle, it’s comforting to know that SPR’s auditors in preparing the 2015 10-K deemed a price increase “probable” and did not believe SPR needed to incur a write-off in Q4’15 earnings. While the A350 will remain at 0% GAAP margin until the 201^st ship set is delivered (2017 or 2018), SPR’s deferred production inventory level of $550M implies significant positive cash flow from the program between now and then.

Disclosure:

We and our affiliates are long Spirit AeroSystems and may buy additional securities or sell some or all of our securities, at any time. We have no obligation to inform anyone of any changes in our views of Spirit AeroSystems. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Execution over the next 1-3 years