Spirit AeroSystems Holdings, Inc. (SPR) Earnings Call Transcript & Summary

Good afternoon, everyone. Today, we're hosting Spirit AeroSystems with CEO, Tom Gentile; and CFO, Mark Suchinski. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. One logistical item, we will be taking questions from the audience, if you want to ask a question, please send one over through the webcast portal. So Tom and Mark, welcome. Thank you for joining us today, and I'll hand it over to Tom.

All right. Thank you, Kristine, and good afternoon, everybody. Nice to be here back at Laguna Beach, although virtually this time and not in person. But before I start, we do have a safe harbor statement. So any goals or predictions that we discuss today could involve risks, and all those risks are outlined in our SEC filings. So now I'll start and the way I often start is just remind everybody that we're not the airline, so if you thought we were Spirit Airlines, I'm sorry to disappoint you. We're expert aerostructures. So we build large structures for commercial military aircraft, things like fuselages and wings and nacelles. We stood out from Boeing back in 2005, but we're an independent public company. And we have significant work packages on all of the Boeing and Airbus programs. Our biggest program is the 737 MAX. We're a proud partner on the MAX. But obviously, that's been a difficult situation. We make 70% of the structure on MAX and historically, it represents 50% of our revenue. So when they got grounded last year after the second tragic crash, it was very difficult situation for Spirit. Boeing suspended deliveries at that time but we kept producing 52 aircraft per month, until in December, Boeing actually stopped production. At that point, we faced, at Spirit, a very significant challenge because it did represent half of our revenue. So we negotiated a new rate with Boeing at 216 aircraft for 2020, which was about a 60% reduction. Then when the pandemic hit, obviously, that was another challenge. And we renegotiated down yet again to 125 aircraft. And in June, we agreed a third production change with Boeing at 72 aircraft for 2020. But the pandemic also impacted wide-body production, particularly because of international travel. And so that 87 program has gone from 14 aircraft per month, it will be 6 next year. And 777 has gone from 5 aircraft per month last year to 2 next year. And of course, this is not just Boeing, Airbus is also impacted, and they reduced their production by 40%. So the combination of all those production hits and cuts really impacted Spirit. In the first quarter, our revenue was down 50%. In the second quarter, it was down 68%. And we burned a lot of cash in both of those quarters, particularly since some of the working capital, the inventory was already on order and we couldn't turn it out fast enough, so it accumulated. It will burn off in the future. But with production rates low right now, it's burning off less fast. So we said for the year, we'll probably burn about $800 million of cash this year. The good news is we started off with a very strong cash position. We did raise $1.2 billion in high-yield bonds. So we ended Q2 with $1.9 billion in cash, and we're confident in our projections that we'll have enough cash to get through this challenging period until we're cash flow positive again in 2022. Even if we do both of the deals that are pending at the full price, which we can talk about later. But the recovery has started. We saw some good numbers in terms of air traffic in September for Labor Day. But in April and March, we saw traffic down 96%. And so that's a challenge. On the narrow-body side, with domestic travel -- we expect domestic travel will recover first. China has already rebounded to about 90% of their pre-COVID levels. And that's good for narrow-body production. Most of our backlog, which is still over $42 billion is with narrow-body, the MAX and the A320. Wide-body is going to lag international travels, it's going to take longer to recover. So we think we could get back to production rates we were at in 2019, maybe by the end of '23 for narrow-bodies. But wide-bodies are going to take 12 to 24 months after that. So at Spirit, we've taken a number of actions to deal with these lower production rates. Obviously, we started with aligning our costs to lower production levels. With production down about 45% this year, we have laid off about 8,000 employees globally from our commercial workforce. We have also reduced executive pay by 20%. We put all of our salaried employees on 4-day work weeks starting in March for the rest of the year. We've reduced a lot of our indirect costs. So we've taken out on an annualized basis, about $1 billion worth of cost or 40%. We've also taken a number of actions to preserve liquidity. We cut our dividend down to $0.01. We suspended all share repurchases. We cut our capital expenditures by $125 million. We negotiated in advance with Boeing for $225 million. We also deferred the repayment of an advance to Boeing for $123 million from 2020 to 2022. And as I mentioned, we also were able to raise $1.2 billion of new capital. So we have a stable liquidity position, and it will get us through this current challenge. But we're also taking advantage of the slower production to invest in our productivity in our factories. We're digitizing warehousing. We're automating production systems using more robotics. We're streamlining the production flow. We're moving some of the subassemblies for the MAX out of our main factory into satellite operations so that we can improve the lean flow and reduce working capital. We're also investing in our wing capabilities. In Presswick, we're putting in place a new spoiler line that's carbon fiber composite using resident fused technology for our cap location. So that's helping us make a lot of improvements. We're continuing to invest in R&D. We're opening up a new innovation center in Presswick, Scotland. That will help us develop the work with Airbus for the Wing of Tomorrow. We're also investing with the nationals to research here in Wichita -- with Wichita State University. And so that's important for us is to continue investing. And then one thing the pandemic has shown us is that we do need to diversify. And so we are continuing to diversify in defense with the acquisition last year of FMI, which gives us leading capabilities in carbon-carbon fiber for high puncture surfaces. We are continuing to expand our defense work. We recently received an $80 million Title III grant, which will help us build more equipment for the Air Force. And we're looking to expand our aftermarket. That's another area where, historically, we have not been as strong as we would like. And that's -- the deals that we've announced, both Asco and Atlantic, which is the Bombardier's aerostructures business, will help us diversify. In particular, give us more Airbus content, more military and defense content, more composite capability, more aftermarket capability as well as low-cost country footprint. So those are the strategic reasons that we announced those deals. We're obviously working with both parties, meeting the conditions. The absolute deal has a long stop date on October 1, all the conditions are not yet met. If the conditions are not met by October 1, then that deal will terminate. The long stop date for the Bombardier deal is October 31, and we're working on that. Again, the conditions are not yet met. We are working with Bombardier, but we have until October 31, which is the long stop date. So a lot of challenges for Spirit, but we're optimistic about the industry overall. It's a long-cycle business. We were in a great super cycle. That's over. But we're starting a new super cycle. We look forward the next 5 years as production rates recover, Spirit is in a very good position. We've still got a great backlog. We're on all the programs for Airbus and Boeing. We've got great design and engineering capability. We're winning a lot of defense business. Last year, defense grew 30%. And we see a bright future for that. And we have a strong stable cash position with $1.9 billion of cash on hand, and we will be able to get through this period into a capital positive, again, in 2022. And all the productivity initiatives we're driving will help us regain our historic margins of 16.5%. And we'll be able to do that at lower levels of production than before because of all the investments we're making in automation and digitization and robotics. So with that, Kristine, we can take some questions.

Yes, sure. So thanks, Tom. That's a really helpful overview. I guess when you -- recognizing that production rates are dictated by your customer and really beyond your control, you've highlighted this $1 billion cost takeout that you've done. I guess, with that $1 billion, how should we expect this to play into long term margins? Are you going to be able to keep all of this $1 billion in savings when you get production rates to start to recover?

Well, a lot of the cost is related to, say, direct labor, mechanics that help build the planes. And so that's proportional to rate. So with rates down, a lot of direct labor comes out. And when we go back up, fortunately, we're able to recall those employees and the cost comes back with it. But a lot of the things that we're doing will be structurally different going forward. So we have reduced our overhead. We've streamlined all of our administrative functions. We have also digitized a lot of those functions. We've taken out a lot of the base costs in the factories. But the investments that we've made in digitization of the factories, things like workflow solutions, MES Robotics to help automate some of the production lines, like, for example, our floor beam assembly will be all automated when we go -- come back in terms of rate. Our warehousing is all digitized now and automated. So those things are permanent changes that will help us be more profitable and more efficient at lower levels of production. So some of it is variable with rate, but a lot of the changes that we made are going to be permanent reductions that will improve our efficiency and help us get to higher margins at lower rates. Now back in 2016, we were at rate 42 on the MAX and we had about 16% margins. But at that time, the 787 was at 12 APM, aircraft per month, and the 777 was at 8 and the A350 was at 10. So as we go forward, as I said, the wide-bodies are going to be a little bit of a headwind. But narrow-bodies, as they recover on the MAX and the A320 with the more efficiency, we should be able to hit those higher rates of margin at lower levels of production.

Tom, with that figure, right, to get to that 16.5% with digitization, automation, all these cost improvements that you've talked about. At what rate would you get to that 16.5%? And maybe it's a little too early, so I understand pinning you down on a number is not -- I mean you may be can give a good range, yes?

I mean we were at rate 6 -- we're at a margin of 16% in 2016, when we were at rate 42 on the MAX. Now as I said, when we get back to 42 on the MAX, we're going to have some more headwinds from twin isles. But our goal would be to be back at 16.5% margins when we get up into the 40s on the MAX and a little bit higher on the A320. But we see with the headwinds on the twin isle will be more efficient at lower levels of production. So I would say a good number for us to get back our historic margin targets of 16.5% would be when the MAX gets into the 40s.

I see. And you mentioned that, right, you have 8,000 employees that, unfortunately, were furloughed at this period. How do you think about your labor force in the long run? And how do you ensure that you don't lose any critical capabilities, especially as you ramp up once again?

Right. And you're absolutely right. This is critical. The employees are so important to the production process and to delivery, to quality, to safety. Now the good news is we were essentially already producing in a rate at 57 aircraft per month on the MAX and up to 62 on the A320. So we had already trained all the workers. All of the infrastructure was in place. All the capital was in place. All the tools was in place. We had hired all the workers and trained them. Now we had to lay off a lot of those, unfortunately. But we've done a couple of things. One thing we did is we were actually making [indiscernible] for a period of time from April -- right up until now. Bayer, which is the largest pure respirator company in the world called us up, asked us to help them make ventilators for their strategic stockpile and for international customers. They were making 25 a week. They wanted us to make 500 per day, and we've achieved that. And we've actually made about 15,000 ventilators already and shipped them to 20 different countries. That employed 1,000 people for the last 6 months or so. As that program winds down and the 737 rate increases, we're at about 7 today. We're going to be at 10 in January. We'll shift the people from that ventilator project right back to 737. So we were able to keep those people engaged and active and productive. That's one way. The other thing that we're doing is as we go up in rate, every rate break that we have over the next 3 years, we're going to be bringing all these people back that are required for that rate 3 months in advance. And so that gives us a chance to do all of the research in patients, get them comfortable back in the job, do on-the-job training. So that when the rate actually comes, they're absolutely ready to go. And so that's one thing that we're going to be doing. We're also working very closely with our suppliers. They have the same issue. They've got to make sure that their employees are back and trained and recertified well in advance of when the rate breaks are. So that's -- those are a few of the initiatives that we're taking to ensure that the workforce is ready, trained and in place before the rate breaks take place.

That's really helpful color. Maybe we could switch gears more to defense. I mean you've just highlighted diversification is important. Defense is an area of growth. Can you talk about how you change your approach to market to win more defense contracts? And I have a few follow-on questions to that about our defense contracts generally more profitable from start to finish versus commercial contracts? Are they positive for cash? And just understanding of the differences in contract terms for profitability, cash, reimbursement from customers and R&D and things like that versus your commercial business?

Right. So first, let's start with the go-to-market. How are we trying to win more military business? Right now, we have a situation where we have a lot of holding capacity because the commercial production rates are down. So we have infrastructure. We have capital. We have trained workforce, including engineers. And so those are immediately available. So part of our value proposition right now to our military customers is we have the capital in place. It's already invested and it's here ready to be used with the trained workforce and skilled engineers, many of whom already have security clearances. And so that's a very powerful value proposition, and we can price aggressively as a result of that. So we are seeing more wins on the military side, particularly with classified programs, which, unfortunately, we can't discuss. But the Title III grant from the Air Force and the Department of Defense was for $80 million. I think that's an example of the opportunity. The other thing is we made an acquisition last year of a company called FMI. And that -- what they make is something called 3D woven carbon-carbon composite. And what it is, is a very dense composite material that can withstand extreme heat, and it's used on flight control surfaces for things like hypersonic missiles. And FMI is really the leader in that market. With them as part of Spirit, we're able not to compete for business that we never really could afford. And we're a leader, we're able to put together very strong value propositions. And with hypersonic missiles growing in a major part of the defense programs going forward. That's been a huge advantage for us. Now defense business is different from commercial business. Defense business and types of contracts are -- it could be a fixed price contract. We don't do many of those. A lot of our programs are cost plus during the early years of development. And then later when they get into stable production, they convert to fixed price. But I think all of our defense contracts today that are in the development phase are cost plus. So that gives you a chance to learn and grow and develop. The margins are typical defense margins. They're stable. They're not as high as some of the best commercial margins. But they're very stable and they're solid. Unlike in commercial programs where you can drive productivity and improve your margins over time, defense margins tend to stay stable. It's very transparent. The defense department, as most people know, audit very regularly and vigorously, so they keep track of that. But we have worked very closely with our defense customers during the pandemic, they have worked with the Department of Defense to ensure that the supply chain had access to capital. So some of our big primes lowered their payment terms to 10 days so that we could get access to capital. And so millions of dollars flow through the supply chain, and some of it to us. So that really helped us out. And the Department of Defense led that charge Secretary, Alan Moore, was really the principal person and all the defense primes participated in that effort.

Great. And Tom, following up on your comments on FMI and 3D woven carbon fiber, is it a different end market for you? Is this the resin injected molding type business? Does that mean you can do carbon fiber type structures for different applications and what you're already doing on the airframe?

Well, yes, it is. It is a new end market for us. It gives us capabilities with material that we never had before. It's not resin transferred infusion. That's slightly different. What this is is it's 3D woven carbon-carbon. And it's like a loop. It's like weaving a rug, but they -- it's very fine fiber, carbon fiber fibers. And then they do a densification process where they put in essentially black car pitch and they go through multiple stages where they compress it, and they can create blocks, which you then machine. And these machine blocks of 3D woven carbon-carbon fiber are used on very high-temperature services. So surfaces that experience temperatures in excess of 5,000 degree Fahrenheit. And that's the kind of thing that hypersonic missiles that travel at 5 Mach would experience. And so this gives us an opportunity to compete for business for those applications, which we could never do before. But it fits very well to Spirit. It's all about materials, and structures, machining and making components. And what we're going to do is bring our ability to help industrialize these kind of things and scale them at very high rates of production. And that's the value that we can bring to a company like FMI and leverage their technology to enter new markets.

I see. So then with these kinds of opportunities and your focus on defense end markets. If we look forward, let's say, 3 years, 5 years, how big should we expect defense to be as part of Spirit going forward?

Right. Well, historically, in the last few years, it was about 5% of our business. This year, it's going to be about 18%. Now the reason is a little bit of it grew, but the commercial came down. So it wasn't quite the way we wanted to get it. But we think we offer a strong value proposition to our military customers with our commercial capabilities, our engineers, our materials, logistics, supply chain. And so we are growing our business very rapidly. Organically, we see a path -- originally, we were saying 15%. Now with commercial down a little bit, it's easily going to be 25%. Our long-term aspiration was for defense to be 40% of Spirit's business. That will take us several years, might require some more acquisitions. But we've got a strong head start. We're on some great programs today. For example, we're 1 of 6 suppliers on the B-21 program that was named by the Air Force. That's a very big, important program for the United States, and Spirit is proud to be on it. We make the whole forward fuselage for the CH-53K heavy lift helicopter for the Marines. We provide the -- I'd say work savings that we do for the military derivatives for Boeing commercial aircraft. So the PA is a version of the 737. And the KC-46 is a version of the 767, and we do the whole forward fuselage on the leading edge of the wing, the pylon and nacelle for that aircraft. So we've got a very solid base line of capabilities, and we see it as a natural adjacency in an area for us to grow. So 18% today and perhaps 40% is an aspiration in the future.