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

Okay. I think we are ready here. I'm Doug Harned, Bernstein's aerospace and defense analyst. And I'm really happy to have with us is again, Tom Gentile, the CEO of Spirit AeroSystems. And Tom, I think you may have a forward-looking statement message there first.

Yes. Thank you, Doug. I just need to remind everyone that any projections or goals that we may include in our discussion today are likely to involve risks, which are detailed in our SEC reports. So that's the only statement I had to make on that.

Okay. Great. Well, Tom, to start, obviously, the last year has been an unusual one. Maybe we can start by you taking us through how you've navigated this last year through the pandemic? And where do you see Spirit right now as we move into a recovery?

Right. Well, last 18 months has really been a very challenging one for Spirit, really the whole commercial aerospace sector. We had 2 crisis that we were dealing with. The MAX grounding was something that was impacting us all of 2019. And as we get to the end of 2019, Boeing suspended production. So we already knew we were going to be in a crisis. And then, of course, the pandemic hit. So we saw our deliveries drop by 60% from 2019 to 2020. MAX dropped 90%. And as you may know, we make 90 -- or 70% of the structure on the MAX, and it represented 50% of our revenues in 2019. So we produced 606 units of MAX in 2019. In 2020, we produced just 71, so almost a 90% drop. Our revenue in 2019 was almost $8 billion. And in 2020, it was $3.4 billion. So we had a number of things that we had to do. First and foremost, we had to keep our employees safe because we had to continue producing not only for our commercial customers, but also for our defense customers. But we then had to align our costs to lower levels of production. We reduced our commercial headcount by 8,000, and we cut $1 billion in cost in 2020, which was about 40% of our total on an annualized basis. We also had short our liquidity. So we've raised $2.1 billion in the bond market. That really helped give us a cushion. But we cut our capital expenditures. We suspended our dividend to just $0.01. We also had canceled our acquisition of Asco. That's saved us $420 million. We negotiated in advance with Boeing, delayed an advance repayment to Boeing. And then we also renegotiated our acquisition of Bombardier's aerostructure assets from $500 million to $275 million. So in total, about $3.2 billion of cash actions. And we ended 2020 with about $2 billion in cash, so a nice cushion. We continue to invest in productivity and innovation, particularly on our factory floor so that we can emerge from this crisis stronger and achieve our historic margin targets of 16.5%. And we continue to diversify. Now the Bombardier acquisition gave us more Airbus content. We do the entire integrated composite wing for the A220 now in Belfast. We also more than doubled our aftermarket business, and we even got some business -- jet business. So that helped our diversification. So coming into 2021, things are starting to get better. Some very good news was when the FAA recertified the MAX and then it has to recertify it. So Boeing is delivering that again. In 2021, we're going to deliver 160 or so units of the MAX. So more than double what we did in 2020. We also are seeing the Airbus content on the narrow bodies continue to outgrow. We're at 40 now when Airbus came out last week with some projections about where they're going. So narrow-body looks like its recovering faster with domestic air traffic recovering faster. In China and in the U.S., that's having a very good impact on narrow bodies. And for Spirit, that flipped because 85% of our backlog is narrow bodies. And those are more mature programs for us. So better margins. We are still seeing softness in wide bodies. The 787 is down to about 5 units right now. The A350 is down to about 3 units right now. And we expect that to remain soft. But one thing we are doing with the excess wide-body capacity that we have is repurposing it to defense. And that will help us grow our defense programs. We've won some classified programs on defense, and that's positioning us well. Last year, we grew 20% on defense. This year, we're going to grow 15%. It will be a $1 billion business in the mid-20s at typical defense margins. And then in terms of diversification, our aftermarket is also growing. I said the Bombardier assets doubled our activity in aftermarket. By 2025, we think that will be a $500 million business at accretive margins. And we've done a couple of other deals even this year to help grow the business. So as we look forward, last year was a tough one in terms of cash usage. We used $870 million last year. Next year, things will be better. We've projected between $200 million and $300 million of cash usage this year, net of the $300 million cash tax benefit we expect from our net operating losses last year. And then we still think we're on track next year as production rates hold to be cash flow positive next year. So that's what the current projections are. So we feel we're very well positioned coming out of the pandemic, but it was definitely a difficult 18 months.

Well, maybe to start -- we'll start a little bit on the narrow bodies. You mentioned on the A320neo, the fact that Airbus did come out and say they want suppliers to be ready to produce at 64-month at the end of 2023 and maybe 75 a month at the end of 2025. Those are big numbers. Was this a surprise? I mean what do you think about Spirit having to respond to those kind of rate increases?

Those are definitely challenging, but we were already capacitized for those rates before the pandemic. We had all the infrastructure in place, all the capital, all the tooling, even trained workforce, and we had done rate studies even higher than that. And these were not inconsistent with the scenarios that we were working with Airbus. They haven't committed that to a formal schedule per se, but they said they want us to be ready for that. And what that means is, because we have the infrastructure, the capital and the tooling, what it means is we have to be prepared with the labor, to recall the people, to get them recertified, retrained and ready and then also on the material, not only the raw materials and the forgings, but also what we get from our supply chain. And so there's a lot of work for us to do to make sure our supply chain is ready to deliver those numbers. And we have a very rigorous rate readiness program in place with them to ensure that they are.

Well, on the Boeing side, Dave Calhoun was with us an hour or so ago, and we were talking about rates there. And they've talked about 31 a month in early 2022 for their production rate. But as he's characterized it, the rate going higher, a lot of that depends on what happens with China and U.S. relations with China, it will have a big effect on where their rate would go. So from a Spirit standpoint, if you look at Airbus big rate increase plan, Boeing, we don't know exactly, it may depend on other things. What is the lead time that you need in these situations to respond, if rates taken up?

Right. Well, we have a scenario that's already in place, both with Boeing and Airbus. So we know what the current trajectory is. And that can change of course. And as Boeing said, what happens in China could impact future rates for the MAX. But typically speaking, we've always worked with Boeing, Airbus. We need about 6 months lead time to go up in rate between 5 and 10 on the narrow-body programs. And now that's a typical time. This is anything but a typical time. It's been a very dynamic environment. But that would be normally what we would work with Boeing and Airbus is about a 6-month lead time to go up rate. But we have a scenario with both of them that takes us out through 2023 in terms of what their current thinking is. And that can change, but that's what we're planning today.

Well, if we think back to when the world is very different, back -- 2018, the time -- back when you were going first from 47 to 52 on the MAX, and you planning to go up to 57, you had a lot of challenges in there from 47 to 52. When you look at where Spirit is today and presumably Boeing will get back to 52 and 57, even if we don't know exactly when, how do you see Spirit prepared to respond to that?

Well, we're in much better shape, Doug, this time around. First of all, all the infrastructure is in place, all the capital is in place, all the toolings in place. Last time, we were literally installing it as we were going up in rate. The other really big difference now versus 2018 is we were still shifting back then between the NG and the MAX. So if you recall, we were 100% NG until June of 2017 is when we delivered the first MAX. And we were rolling up the MAX rate during that whole period of time as we are increasing rate overall. So we didn't shift to 100% MAXs until January of 2019. So there was not only increase in rate, installation of tooling and capital, but we were also switching the models, which was quite disruptive at the time. We're a 100% MAX now, except for P8s. P8s are still NG, but those are only a couple a month. And so with all the capital in place, with all the tooling in place, being 100% MAX, and with the workforce already being trained, now in some cases, when we recall people who have to retrain them, but they've already been through it once. We're in much better shape. The other thing that's different is, we've done a lot during this slow period to completely redesign our factories. So for example, plant 2, which is where we build the fuselage. It's been growing up over a period of time as rates went up, things got close where they fit at that time. What we've done now is we've completely reimagining the plant and we've redesigned it. So for example, we took the entire forward fuselage. We call it Section 41. We've taken that out of plant 2 and moved across the street into what was our 767 building. And it's now completely linear flow. So it's much more efficient. And then what will happen is that forward fuselage will come into plant 2 as finished unit and go right into integration. We've done the same thing with the wing box. We've taken the wing box out of plant 2 and moved it down to Tulsa and also to one of our suppliers and put them in completely linear plants so that they're much more balanced. And the finished wing box will now come in ready for integration. And we're moving around several other of the toolings so that plant tool flows in a much more lean, consistent fashion, and that will drive a lot of productivity. In addition, we've invested a lot in digitization, automation and robotics to improve productivity. So with all those changes, the increase in rate will go much smoother this time than it did last time.

Well, but I do remember the last time around, you had about a half a dozen suppliers that had some challenges as well. So how does the supply chain fit into this? My sense was in the Airbus announcement that some of that was directed at some suppliers that, smaller suppliers than you that had to make some capital investments in order to be able to take rate up. Do you -- what do you see in terms of the supply chain challenge?

The supply chain, it's going to be challenging, but we've done a lot of work on the supply chain as well. So first of all, we provided a lot of support to the suppliers during this period. So we provided close to $2 billion of support to almost 600 suppliers through inventory purchases, raw material purchases, contract extensions, vendor financing. So we've done a lot. In some cases, where suppliers were weak, we've either move the work to other suppliers that are stronger or we've dual-source it or we've in-sourced it. So we've taken those kinds of actions. But as we go forward, we're working very closely with our suppliers, as I mentioned on these rate readiness methodology. So we're looking at not only to make sure that their infrastructure, capital, and tooling is in place, but that they're hiring labor in advance and on time. And if they placed a long lead orders for material far enough in advance so that they're ready when the rates go up. So we're working very closely with the supply chain to ensure that they're ready.

Well, if we switch over to wide bodies, as you said, I mean, the wide-body recovery is slower, that kind of is, what it is. At this stage, the 787 and A350 for you are in forward loss positions. With a slow recovery, how do you think about when you can get now to cash positive positions on these programs, either in terms of the rate you need or just time?

Great. Well, so first of all, there's a little bit of a silver lining in the fact that wide-bodies are going to take longer to recover. Because as you mentioned, our 2 big wide-body programs, A350 and 787 are forward loss positions. But they're going to be a smaller percent of our overall production because narrow bodies are going to be going up and are going to be disproportionately larger, and those have better margins. So from that standpoint, the mix shift between narrow bodies and wide bodies is going to be a positive one for us. So that's one thing. In terms of the programs themselves, so let's take 787. We have said that the plan was by lining unit 1405 we have a price increase agreement with Boeing at that time to greaten the price up a up to where the cost was expected to be. Now with lower rates, it obviously is going to be a little bit more challenging. But because the rate is lower, we also have more time. We don't expect to hit line unit in 1405 now until 2025 at this point. So we have more time to drive the cost reduction savings. Now we do have excess capacity right now because the rates are lower. And they're probably going to stay lower for longer. And that's where we are repurposing some of that excess capacity to defense work to absorb the fixed cost. And that will also help the profitability of the 787 program. So we're still planning for 787 to be positive cash flow and positive margin after line unit 1405. On A350, it's a similar story, slightly different numbers. It's also on a forward loss. Because the rates are lower. But same thing, we are not only looking at defense work, but we want some business network that we're putting into our Kinston facility. And we're also in-sourcing some of the sub details that we used to do in the supply chain, we're putting those into Kinston to, again, absorb some of the fixed costs. So we expect that, that program will return to profitability, probably in the '23 to '25 time frame.

Now you've said that you're targeting about $1 billion in revenue from defense in the mid-2020s.

Right.

Can you give us a sense of what the key components of that are?

Right. Well, first of all, we have a couple of military derivatives on Boeing commercial programs. You got the P-8, which is essentially a submarine chaser. That's a 737. So we have a very significant work still on that, of course. We're going to make 70% of the structure. And then the KC-46 is a version of the 767, and we do the forward fuselage to fix leading edge of the wing, highlighting itself for that. So those are our 2 very good base programs. In addition, we've got the CH-53K. We built the entire forward fuselage for that, and we integrate the entire fuselage for Sikorsky. That's a heavy-lift helicopter for the marines. And then we won a 6 suppliers on the B-21 program, which is the new bomber. And we've also won a few classified programs with some of this excess capacity that I mentioned before. So it's really just those programs getting further into their development and production basis, which will deliver the $1 billion by the mid-20s at normal defense rates. But we also see a lot of opportunity to continue to grow. We made an acquisition of a company called FMI at the beginning of 2020 that specializes in 3D carbon -- 3D woven carbon-carbon composites, which is used in high-temperature applications for things like hypersonic missiles. So in terms of defense growth, we see not only new generation aircraft like the CH-53K plane and the B-21, but we also see hypersonics and even space. And then the other thing is attritable drones. The group that we bought the Belfast, Bombardier, they won a program with the U.K. Defense, Ministry of Defense called Mosquito, which is to develop an attritable drone, a loyal wingman. So similar to Skyborg in the U.S., and we're actually going to be the prime on that. So those are some of the things that are going to help us achieve the $1 billion by the mid-20s. So we think we can actually even do better than that.

If that -- I was thinking over that time, I mean, P-8 I would expect to come down some, and then -- so these other programs, these CH-53K, then presumably will grow. And then -- anyway, that's kind of -- I was trying to figure out where...

It's a program to add B-21 in it. There's a few that were competing for, like the V-280, we're working with Bell, which will be for the Army's Future Vertical Lift, the FLRAA program, the future long-range assault aircraft. So those are all there. The one thing I mentioned in our last earnings call is the programs that we're on. If just by virtue of them getting further into their production phase, that will get us to the $1 billion by the mid-20s. But it represents, if you look at the program of record of those programs that we've already won, there are $6 billion over time in terms of the program of record. That's how much sales they represent for Spirit. So we already had very good programs, and we think there's an opportunity for us to continue to expand and get our new programs as well.

Now you've talked about that these would be accretive to margins, which I would expect right now. But if you get back to your goal of 16.5%, and I would assume that at that stage, these would not be accretive. But...

That is correct. I mean defense programs are solid. They're more consistent. They're a little bit less volatile sometimes than commercial program. But the margin is typically for a defense program are more like 12% to 14%. So that wouldn't be where we are in terms of our target overall for the company of 16.5%, but aftermarket would be accretive to the 16.5%. The new work that we're doing on business jets will be accretive to the 16.5%. So those things will help offset the fact that the defense programs will be a little bit less, but very solid and very consistent going forward.

And so then on the aftermarket, I mean, you've got -- there is supply aerodynamics, you've got Bombardier, you have these acquisitions that have added to the aftermarket. Can you talk a little bit about what you're trying to achieve there? And what kind of margin lift you might be able to get from those are?

Right. Well, before we get the Bombardier acquisition, our aftermarket consisted mostly of spare part sales to Boeing. And we did a little bit of MRO, and the MRO focused on repairs to Boeing products mostly. And it was things like inlets, fan cowls, nacelles and thrust reversers. So very specialty. When we bought Bombardier, they were flipped. They did much more MRO, much less spare part sales. And their MRO focused on Airbus. So flight control surfaces, nacelles and thrust reversers. So similar to products of Airbus and mostly in Europe. So what we did immediately is we served across holiday is we put the Boeing repairs in Europe, and we also brought the Airbus repairs more to the U.S. Then the acquisition, as you mentioned, of Applied Aerodynamics with us in Dallas, maybe rate over here. So very similar to the type of things that we did with nacelles when we were able to that into U.S. and Dallas and then also to Europe. And then the third thing we did is we expanded with a joint venture in Taiwan with EGAT, and that gave us now a kind of an Asian base so we could do Boeing repairs, Airbus repairs and radome repairs. And so what we'll look for now as we go forward is we can expand more geographically. We will be looking for a base in China, perhaps one in the Middle East. And we'll also be looking to expand the types of repairs that we do that are consistent with radomes and nacelles and other structures like that. So that's the growth plan.

Yes. So when you describe this, I mean I think of this universe is having -- there is the repair business, which is more of a service-type business. And then there's the spare parts business, which often can carry with it very high margins. How would you characterize the mix of these businesses?

Well, we're going to be about half-half as we go forward. Half spare parts and half repair. Now the repairs that we do, though, you're right, repairs are often lower margins than spare parts. But the repairs we do are I would call specialty repairs, so they tend to have better margins. And our overall aftermarket business, as we said, is going to be accretive to our overall margins for Spirit. And what we said is by 2025, it should be about $500 million at accretive margins.

Yes. And when you look at that, I would expect because some of this, maybe you can describe what the mix is. But to the extent it's not large commercial aircraft, you may see a faster recovery than you would on the aftermarket for a lot of large commercial aircraft work.

That's true. In some of the aftermarket that we have that we acquired with Bombardier is business jets, but there is still a lot of commercial aftermarket. While the commercial aftermarket has been softer as this year started, you are starting to see how the airlines bring their fleets back in service. We're seeing cycles go up. So I only expect the aftermarket activity will pick up. And by the way, there'll be a lot of aftermarket to get the airplanes ready to fly after coming out of their retirement. And so that's something, particularly on the structures that we're seeing as the planes come back into service, there's a fair amount of work to get them back ready to flying condition.

Well, when you look at your long-term targets, so you've talked about the targets kind of like they used to be, the 16.5% operating margin, free cash flow margin, like 7% to 9% sales. Can you walk through how you see getting to those margins and kind of the time frame of the path to get there?

Right. Well, as production rates start to increase, particularly on the narrow bodies, that helps because that helps absorb a lot of our fixed costs. At the same time, we took out $1 billion worth of the cost, and about 3% to 5% of that, I would say, is permanently taken out fixed cost reduction that won't come back. So that gives us a bit of a tailwind. We've made a lot of improvements in the supply chain as we go up in rate. And that will be a benefit. And so then all of the changes that I was talking about in our factory, we've automated things, we've automated our warehouse, we've automated things like our floor beam assembly. We've changed the flow of the plant, not only in our fuselage plant, but in many of the other facilities as well. We've automated quite a few things and digitize. So all of those things will make us more productive as rates go up. So what we said is when we get back up to about 42 aircraft per month on the MAX, that's a fairly stable level for us and at that point, that will be sometime in 2023. We think according to the current plans that we have, that would be a time when we could achieve a 16.5% margins.

Okay. And -- - go ahead. Go ahead. Sorry.

Oh, I was just going to say, the other thing that we've said is we do have a focus on delevering. And during the pandemic, I mentioned that we took out $2.1 billion of additional debt. Our goal is over the next 3 years to pay down $1 billion of that. We pay down $300 million in February. We have another maturity in 2023, and we have a term loan that is about $400 million that we can pay down without penalties. So as we start to get cash flow positive, we'll start to pay down that debt as well, so that we can return to investment grade.

I guess one thing, when you talk about reducing costs, and those costs won't come back, this is something that -- I mean I don't know if I can think of a company that hasn't made that argument. Everybody is saying, we're taking that cost and then we're going to be much more efficient on the other end. Yet, a lot of times, when we look at the past 2 downturns before, we had heard that as well, but the costs ultimately either did come back or pricing kept the margins down. So we didn't really ever see that. And so how do you get comfortable in projecting perhaps higher margins in this recovery?

Yes. Well, first of all, pricing, we did a lot of work in 2018 and 2019 with Boeing and Airbus to really solidify all of our programs with them, not only -- we always had sole source like a program, but we have to agree the pricing, and we did do that. So in other words. [Technical Difficulty]

Tom, I don't know if your there? Okay...

Doug, sorry about that. Can you hear me now?

Yes. Yes.

Yes. So -- we're back. So just to reiterate, we said, how can we be sure of the margins? And the one thing is this pricing is set on all of our programs, the Boeing and Airbus, we have pricing that goes out for many years. On the MAX, for example, it goes out in 2023, it's indexed to rate. On the 787, it goes out to line unit 1805. We're line unit 1115 right now. On the A350, it goes out to line unit 1600 and so forth. So we got the pricing set. The other thing we've done is we've made a massive effort on supply chain to get our pricing set, in many cases, all the way up to 2033 as well, back-to-back contract. So we've really solidified a lot of the cost and driven a lot of supply chain productivity. And then I talked about all the changes that we've made to our factory to not only automate and digitize, but also the change flow. And then on top of that, we took out the fixed cost of the 3% to 5% of $1 billion. So those are the reasons why I have a fair degree of confidence that we're going to hit the margin targets that I've articulated.

Well, then that would -- that would also suggest, when you get to 42 a month on the MAX, because I think anybody that expects the world to get normal again would believe that, that's going to go up to 52 to 57, that would suggest you could even do better beyond that point of 42 a month. Is it fair?

As you know, there's always some headwinds that you have to overcome. And as I said, the pricing on the MAX is tiered to volume. So as the volume goes up on the MAX, the price goes down as you would expect, because we're spreading it out in those fixed costs over more units. And that's perfectly appropriate. But that closes some of the headwinds that we have to offset. So 16.5%, we think is a good margin target. Of course, as rates go up, the total dollars of cash that we generate will go up.

Yes. Yes. Well, if you -- if we go to some of your acquisitions, and particularly, the Bombardier one. In this announcement of [ 64 ] a month, your Airbus also said they want to be at 14 a month on the A220.