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

So thank you and welcome to our interview with Spirit AeroSystems. Delighted to have with us Tom Gentile, their CEO. Tom, welcome. And I guess you have a comment to make before we start. So why don't you go ahead?

Yes, Cai, good morning and thank you for having me. We're really excited to have this discussion. Just before we get started, we have our safe harbor statement. So any of the projections or goals that we include in the discussion today will involve risks, and those are detailed in our news releases and in our SEC filings. So with that, Cai, we'll get right to your questions.

Terrific. Thank you. So I hate to start with a blue eye -- a green-eye shade question, but it's a question that Myles started off with on your call. Help us calibrate the underlying kind of profitability gross margin. I mean you reported a gross margin of 0.8%, but the items that were not directly related to the quarter looked like they were the CARES Act benefit, the defense charge, $47 million of forward losses. And if we exclude that, we're somewhere 2.5%, 3%. But I have not excluded your excess capacity costs or COVID costs since I assume they're kind of there, part of your ongoing costs. Is that the right way to think about this? Or is there something else we should keep in mind?

Yes, Cai, I think you've identified a lot of the key factors. It's -- there's still a lot of moving parts, clearly, in the results because of COVID and because production rates are increasing. But -- so generally speaking, what we reported was kind of 22%, and that compared to a negative 3.7% from fourth quarter of 2020. So there was sequential improvement in results. And that's continuing. But there are still excess costs. So in the quarter, there was $45 million still of excess costs. For the full year 2021, there was about $220 million in excess costs. Now with narrow-body rates going up, particularly the MAX rates going up, those excess costs start to go down. So we do expect that those will halve between '21 and '22. So that will help in terms of margins. But the biggest driver of margins is going to be production rates. And if you look at the production rates from 2020 to 2021, it's a big improvement. Overall on 737, we went from about 61 -- or 771 aircraft per month in -- or 71 total aircraft in 2020 to 162 in 2021. And in Q4, I think the numbers were 57 in Q4 '21 versus just 19 in Q4 of 2020. So a big increase. We'll start to see increases as well in 2022. We don't know yet the exact amounts, but that will help drive improved margins. The other thing that's driving improved margins is just all the changes that we've made to our operations. So when production rates were slow, we made a lot of improvements to our plant. We moved big sections out of our main plant so that we improve flow. We digitized a lot of things, including our crew displacements. We digitized our workflows to track parks through the plant. We've put in place a lot of automation and digitization, including the new global digital logistics center, a digital warehouse, a new floor being an automated production line. So we've made a lot of improvements, and that will also drive this margin increase over time particularly as rates increase.

Right. So one of the things -- so I keep on going back to is you have this gross margin target of 16.5%. So if and when, you've made the point, the rate gets back to 42 a month, then obviously it's probably '23, '24, somewhere out there, and, obviously, we understand, that all your other assumptions are met. But the question that interests me is, if the 737 rate is 38 a month, 10% less than the bogey, by '24, is your margin going to be lower like 14.5%, 15%? Is it a linear step-up to the 16.5%, linear, more or less, with the 737 rate?

It's not exactly linear, but it does improve as the rates go up because we have better fixed cost absorption.

Right.

And so that is -- and there's no doubt that the narrow-body production rates are a big driver of our economics in the near term, particularly the MAX because it's still -- the MAX is still our biggest program, and 85% of our backlog is still narrow body. What I would say in terms of the rates is we get better in terms of performance as the rates go up because we absorb more fixed costs. But there's a few other dynamics that are in there. We've got a lot of productivity initiatives in the plant, as I mentioned, but also a lot of productivity initiatives in our supply chain. And those are going to continue to kick in. And that's not exactly linear, so that's why it's a little choppy as we [ saw ]. The other thing, though, that we've mentioned is that the 737 contract, the pricing, is tiered to production rates. And 42 is kind of a threshold. So if production rates are lower than 42, we get a little premium. Once they go above 42, Boeing gets a discount. And so that's another dynamic that is playing in them. So they're not exactly linear, but there's no doubt that as production rates increase, the margins will increase. And what we've said is when we're stabilized at 42 for 6 months or so, that's when we think that the overall margins for Spirit will be in the 16.5% range.

Got it. So yes, I am aware of the reset you have on the 737 pricing. But -- so if you get to 48 a month, do you still -- so you're 6 over the 42. And obviously, I'm assuming you still are -- productivity is good. You can hire the folks. Does the rate go above 16.5%? Or is it basically capped because of the [ rheostat ]?

That's really what happens, is we start to get those headwinds. And so the improvements in fixed costs, some of that is offset because of the discount that we would give to Boeing. So while the rate would stay at about 16.5%, obviously the absolute dollars go up because the rates would increase.

Right. Right, right. So it looks like you're sort of somewhere in the neighborhood of 21 a month now. You're 5 below Boeing. They've indicated 31 a month in "early '22."

Right.

Do you expect your rate to move up and sync more or less with Boeing? I think at one point, you said you're going to trail them by about 5. Or do you have -- normal times, I think you'd have like a 3- to 6-month lead over where they are. So how should we think how your rate moves up in -- versus Boeing's rate?

Right, right. Well, Cai, as you'll recall, if you go back to March of 2019 when the MAX was first grounded, Boeing continued to produce at 42 a month, but we produced at 52 a month. Now they took delivery of all those in a beta form, but we started storing 10 units a month back in March of 2019. That ended up getting to a buffer of 140 by really the end of 2019. And that's when Boeing stopped production. So we've been burning that up. We're about 95 right now in terms of that buffer. So we burned off quite a few. And the plan has always been to continue to lag Boeing in production during this rate round until we burn that buffer down to about 20. And then we would keep that 20 as a permanent cushion to the production system. And the plan is to seize this year to burn it down to 20. So we were at, call it, 100 at the turn of the year. We wanted to lag them by about 80 units this year. So the simple math that I've done in the past is, let's say Boeing produced at 31 a month the whole year. That would be 372. We want to burn off 80. So that would put us in the kind of 290 range. And those are probably kind of good surrogate numbers in the absence of any further clarification from Boeing. But that's how we plan to do it. So we are going to light up -- but the plan is, as we look forward, we would probably catch up at 42. When they go to 42, we would follow shortly thereafter. And from then on, we would be synced at the same [ level ].

Right. Right, right. So 42 is a nice number. And it's below 52, but it's 2x from where you are today. What are the key challenges you see in kind of moving up to that rate?

Well, it is a challenge. Now the one good thing, though, is we've already been [ there ]. So we have all of the infrastructures. We have all the capital. We have all the tooling, the trained labor. Now we laid them off, but we're recalling them. So we've already done that, and that should -- now in addition to that, we've made a lot of improvements since we were there back in 2019. So I talked about the plant flow redesign, all the digitization, all the automation, all the robotics. That will all help us be more productive. So that's good. But as we go on, the two big issues that we'll have to continue to address, one is labor. We've got to get all the people back, and we may even have to bring in some new hires. Now the good news is, we still have a recall list, and we've been able to get about a 75% recall rate. So in Wichita, just as an example, we laid off about 5,200 people. We've recalled already about 2,300 of those. About 1,000 of them took retirement, and then a few others dropped out of the list. So we still have about 1,500 that we can recall. So for most of the rate increases this year, we'll just be tapping into that recall list. We don't have to start getting new hires probably until sometime later this year. So that's good. But we're cognizant of the challenges of the labor market right now. The other thing is material. And we've got to make sure that we have the material orders and the flow for raw material as well as detailed parts. Now a good thing is we did build up a lot of inventory in 2020 with all the rate decreases. So we have all that inventory that we can essentially destock a little bit to go up in rate. And we have plenty of lead time with our suppliers. So that's good. We also have a pretty significant internal fabrication capacity with machining, and we can leverage that to make sure that we can keep pace with the material increases as the rates go up. So those are the 2 big challenges, our labor and material. The infrastructure, the capital, the tooling, that's already there. We've already been through those rates. We've made a lot of improvements. And I think because we still have this recall pool, we're fairly well covered on the labor and the big issue would be material.

Great. Thank you. So 787, the rate's currently "paused." How do you expect your rate to correlate with Boeing's once deliveries begin? How should we think those things will kind of sync up?

Right. Well, I mean, and Boeing said on their earnings call that they have about 110 units that they produced and not delivered. And they're going to prioritize delivery over new production. So we expect once they do start delivering again and producing again, that they'll keep their production rates fairly low until they've made a dent into the deliveries of that 110. So we've taken that into account in terms of our plans. So this year, we're fairly low numbers for 787 production compared to where we were last year and the previous years. And once Boeing starts producing, we will be in lockstep with them on the new production, but we expect it to be pretty low until they've made some progress on their deliveries. Now all that said, and we've mentioned this before, on 787, we lose money and lose cash on each delivery because we're in a forward loss position. So it's over $1 million per unit. And $450,000 of that is the advanced repayments. So while delivery rates are low, that's actually good for our cash position. Obviously, we would prefer to deliver and not keep extending the block. But all of the current schedule changes are built into the current block that we have, and those were all part of the forward losses that we took in 2021. So that's the story on 787. We'll match Boeing's production rates once they start delivering again. We expect them to be low, though, until they make progress on delivering those 110 units that they have stored.

So you had mentioned several times you'll lose money on every 787. On the other hand, if the rate moves up, it does absorb some overhead. So if we think weighing those 2 issues one against the other, is it better for 2022 results that 787 stays at a very low rate? Or is it better for your results if it moves up another 10 or 20 units, whatever?

Well, for 2022, it's better because we'll have [ a better ] cash position. But ultimately, we want to deliver 787s. We don't want to keep extending the block. Right now, the pricing with Boeing is at line unit 1405, we negotiated a price increase, which is not unusual in the aerospace industry. But the plan was, is at that point, the price would go up to where our cost is and we'd be breakeven at 1405. But we don't want to keep extending the block forever. But where the block is, we've already taken those forward losses. And so for 2022, it's better to deliver fewer units. But we want to get back with Boeing to delivering 787s. It's a great aircraft. The airlines love it. It's got great range, great fuel efficiency. And the orders are very strong at it. So we want to see Boeing get back to deliveries. We want to get to delivering 787s for them.

Got it. And so 777, I mean, that's the first program where I've heard Boeing moved the rate up as opposed to hold it steady or push it to the right. So we're going to move from 2 to 3 per month up. How does that -- when do you guys start to move up? Because usually, you have to sort of lead by 3 to 6 months. And how does the transition to the 777X and the XF impact your profitability on the program?

Right. Well, we're profitable on the 777. It's a mature program, and we've driven a lot of costs out over the years. So it's profitable. We've negotiated the delta rates and prices with Boeing. That was back in 2018 that we did that deal. And so as the rates go up, that's good for Spirit in terms of profitability on the 777X and the 777X freighter. We also have quite a bit of engineering work that we'll be doing for Boeing on the freighter. So there'll be some nonrecurring engineering opportunity over the next year or so. It is good that the rates are going up. We are a little ahead of Boeing just because of the production cycle, I mean, obviously, because we're upstream. But we're in lockstep with them on rate. So when they go to 3, we'll go to 3. We'll just be 3 or 4 months ahead of them just because of where we are in the production system. And at the time, we think that's a great aircraft. But now with a freighter version of it, that's good. And we are profitable on it. So as the rates go up, that will be better for Spirit.

And refresh my memory. Is there much of a difference between the current 777 and the X in your work?

[indiscernible] is no, well, there's no difference in terms of the work scope. It's just the wing is bigger. But we -- well, we make the slats and flaps on the wing. So there's some changes on that. We make the pylon. And we also make the whole nacelle and the thrust reverser. That is a massive difference because the GE9X is a lot bigger engine. I mean it's only 4 inches bigger in diameter. It goes from 128 inches to 132. But when you look at the size of the inlet, the fan cowls and the whole thrust reverser, it's just orders of magnitude bigger. So there's a lot of changes there. On the 4Q slide section there, there's not much change between the 777-300ER and the 777X. But there are some because of all the gauge differences and the loads. And then there was some delta pricing on that, and we negotiated that with Boeing back in 2018.

But, I mean, so currently, it's a mature product. As you move toward the X, it's not mature, but you have -- you've negotiated pricing. Should we expect that the profitability on that program basically takes a little bit of a dip as toward the X? Or does it just kind of continue right on?

Yes. Now incrementally, it takes a little bit of a dip in the early years because there's a learning curve on some of the new things that we're producing. But the plan is, is to get it back up to the previous margin rates over time as we move down the learning curve.

Got it. And how will your A320 rate build versus Airbus? Because they're talking about going to the mid-60s out there, I think, by '23.

'23, yes. We're in lockstep with them on that. So all through last year, we were at 40, then 43, 45. This year, they're talking about being in the upper 50s by the end of the year, getting to 65 by Q1 or Q2 of '23. And we're -- we'll be in lockstep with them on the 320. As you know, with the -- with Airbus A320, we build a lot of wing components. So we built the leading edge of the wing, the trailing edge and the spoilers. So it's about 60% of the structure. And we follow Airbus. I mean we lag them a little bit just because of the delivery cycles again and timing. But we follow them in rate. We're lockstepping them.

So they're in-sourcing a lot of their structures business. At least that's their objective. Is that a threat to Spirit? Or -- I mean, because obviously, what you do -- is the wing a little bit different? Or net-net, do you see new opportunities with Airbus?

Right. Well, in some ways, Cai, I would say it's not too much different. What they were really talking about is STELIA and PAG. And PAG is really their German structures business and STELIA is kind of their French structures business. Now what they've said is they're going to have Airbus Atlantic, which is going to combine STELIA with some of their pre-final assembly lines in France. And then they'll do something similar in Germany with PAG. They've just started to announce it. But we do most of our work with Airbus on the wing. Now we did do the center fuselage section of the A350, but we'll keep that. So nothing really changes with the PAG and STELIA work scope. We didn't really compete against them. And they never outsourced it really. So they're not really in-sourcing it. They're just basically saying they're not going to outsource it now. But they may outsource some of their fabrication in Germany, but nothing fundamentally changes. And the focus for us on Airbus going forward is really thinking about their next generation of aircraft. They've been working on the Wing of Tomorrow for several years. We're a big part of that program. When we acquired the Bombardier assets in Belfast, we inherited the entire 220 wing. That's an all-composite wing. And it's not just the structure, but, I mean, we do all its systems. So all the fuels lines, all the tubes and the ducts and the hydraulics. And so it's a fully integrated wing when we deliver it, and they just essentially snap it up. So that gives us a really significant work scope with them on the Wing of Tomorrow, a composite wing. And we're working with them -- if they were to ever re-wing the A320 or A321 family line, we would hope to get some work on that. And so that's one thing. And then as they think about their next generation of aircraft more sustainable, and they're talking about hydrogen power for some of their smaller aircraft, we're also working with them on those types of initiatives as well. But I think the initiatives with PAG and STELIA don't change anything for us because that already existed. And all they've said is they're not going to outsource it now, they're just going to keep it part of core Airbus.

Got it. Got it. And so update us on the Bombardier acquisition. How is it doing? I mean where are you on the 600 bps margin lift you expect over 3 years and basically up...

Yes. The acquisition is going very well. It was a good fit. The structures that they had, it gave us more Airbus content. So the entire A220 wing plus the fuselage on the 220, the center fuselage, so the 3 sections, also gave us significant new business jet content on all the Bombardier business jets. We become one of their largest suppliers. It gave us a lot of aftermarket on Airbus content in particular in Europe. So they need to give us some defense work. They won a defense project with the Ministry of Defence in the U.K. called Mosquito, which is the loyal wingman attributable drone program. So that was a -- it was a great strategic fit. And we made a lot of progress on the integration last year, completed substantially all of it. There's a few kind of minor, little things to do, but substantially all of it is done. We also closed the pension program. That was good. We're in the process of renegotiating the labor contract. But then on the supply side situation, we've made a huge amount of progress. We buy a lot of the same things they do. They integrated very well into our supply chain. We ran a couple of ways. We're looking at the facilities and we're going to consolidate some of the facilities in Belfast to streamline some things. So the combination of all those initiatives is really keeping us right on track to achieve the 6% synergies. And the goal is -- as you know, when we announced the program in the first quarter of 2020 -- or 2021, excuse me, we announced a $375 million forward loss through 2025. But at 2025, as production rates increase, it'll get back to breakeven and then profitable. And right now, we're at about 4 aircraft per month on the 220. That's going to 5 and 6 in '22. And what they've said is they'll get to 14 by the middle of the decade. And so we're on track for that. So overall, I'd say it's a very good strategic fit. We've made a lot of good changes during the course of the year to integrate it. And we're on track to achieve the 6% synergies going forward, and we'll be back to breakeven on the 220 once we get into the middle of the decade, hopefully before but certainly by the middle of the decade.

Got it. So you had mentioned that you're renegotiating a labor contract. Is that in Canada? What percent of that workforce is? When does the contract expire? And some color on that.

It's -- this is the Belfast workforce. It is just -- the contract is due. The last one was in 2020, so it's due for a refresh, and we're in negotiations with them on that. We don't have any employees in Canada. All the employees [ either are ] in Belfast, Morocco and in Dallas. .

Got it. Okay. And how is your supply chain doing? Lead times? Prices? Inflation a big issue?

Yes. Well, the supply chain is doing fine. I mean it's obviously been a challenging time during the past couple of years. But I'd say a couple of things. One, everybody got through it, finally made a lot of changes. We saw very few bankruptcies, only 2 or 3 bankruptcies during the course of the period. We did, as I mentioned, provide a lot of help to suppliers in the way of extended contracts, buying raw material, converting material from vendor owned to Spirit owned. So we probably provided $2 billion of support to over -- almost 500 suppliers. So that was a lot of support that we did. The other thing that happened is there was the Jobs Act that came through Congress in the last COVID relief act. And so there were about 500 suppliers that got $625 million. Spirit actually got $75 million from Jobs Act. So that helped the supply chain quite a bit. And actually, there's a third wave of the Jobs Act that's going to get announced today. So a few more companies will get some support. And so all of our contracts tend to be long term, 5 years. We -- all of our material is locked in. Each year, we renegotiate about 20% of the contracts, but we're in good shape. As I mentioned, a lot of the contracts, we extended, in some cases, all the way up to 2033, which is when our 737 MAX contract goes, too. And so that's given us essentially a natural hedge on inflation. And it's locked their supplying as well. So it was really a win-win. We were able to lock in the contract long term. That gives us a hedge on inflation, and it gives them a long-term commitment, which they can use with their banks to keep their funding and liquidity healthy.