Spirit AeroSystems (NYSE:SPR) released disappointing headline results last week, driven by forward losses on existing Airbus programs. While such charges can be large and lumpy, the underlying performance of the business has been solid.
The reality is that shares of Spirit typically trade at non-demanding earnings multiples. The same applies to the shares at this moment, going for merely 10 times earnings. The company reported cumulative earnings of $4 billion over the past decade, as that number included roughly $2 billion in these forward program losses. These charges make that earnings can be volatile, but over time the cumulative earnings power of Spirit has been very good.
Even if we assume that these losses are recurring going forward, averaging at $200 million a year, the valuation looks appealing enough as shares remain very cheap until things potentially go really wrong. Fortunately, many of these charges are non-cash and Spirit operates with a strong balance sheet, alleviating some of these concerns.
I think that some shares could be picked up at $40, as buybacks are set to continue, although investors should be aware of the tail risks of this investment given the nature of the business.
The Business
Spirit has been active in the US since 1927 and quickly became part of Boeing (BA). This company sold Spirit in 2005 which in 2006 saw its IPO as a stand-alone company.
Spirit was originally completely reliant upon Boeing, being its only customer. In 2006, Spirit bought the Aerostructure business from BAE Systems, establishing a base in Europe as well, making Airbus among its customers.
Ever since the company is a main supplier for the Boeing B737, B787, Airbus A350 and A320 as well as A380. Note that the company supplies other programs of these two players as well. It furthermore has smaller relationships with Sikorsky and Mitsubishi, among others.
While Airbus has over time grown to become a customer representing 11% of sales, Boeing continues to be the main customer, responsible for 84% of sales. Half of total sales are generated from fuselage systems as propulsion systems and wing systems each make up around a quarter of sales.
The high reliance on Boeing creates a risk, but note that the business is the sole supplier to Boeing, making switching costs from both sides very high. While an event to break all relationships would be very unlikely given the past history, and the interdependence, a potential break would be devastating for obvious reasons.
As would be a crash resulting from faults related in Spirit's products, or grounding of entire fleets which could hurt demand for a particular series. Other risks include new series of planes as well as the effective management of plane programs which are being terminated. The long term nature of the programs create some visibility as well with the backlog of $47 billion being equivalent to 7 years of revenues.
Developments Ever Since
While Spirit has, and continues to be reliant upon Boeing, this is not necessary a bad thing given the long term success of that business. With sales totaling $3.2 billion at the time of the 2006 IPO, revenues have doubled to $6.8 billion in 2014, having been fairly stable ever since.
The business typically posts gross margins of 15-17%, which is not high but still allows for operating margins of 8-12% amidst a low cost base. The exception was 2012 and 2013 when the company posted disappointing results on the back of charges taken in relation to the B787 and other programs.
While shares IPO'd at $26 in 2006 and initially moved up, shares fell to the single digits during the economic crisis. Following a few difficult years, shares hit a high of $55 during 2015, before selling off to current levels in the $40s on worries about global demand and program costs.
That said the 7% compounded growth rate over the past decade (as sales have doubled in combination with a flat outstanding share base) has been very lucrative with operating margins peaking at 13% in 2015.
The Current Valuation, Opportunities After A 25% Pullback?
Spirit reported decent second quarter results, with sales advancing by 8% to $1.83 billion as a result of strong Airbus demand. While the quarter has been strong, the company sticks to its sales guidance calling for revenues of $6.6-$6.7 billion this year.
The company did report disappointing margins as a result of a new agreement on the A350 XWB program. The company recorded a forward loss of $136 million this quarter on this program. As a result of this charge and other items, operating earnings were down by $147 million to merely $83 million for the quarter.
If these items are not considered, earnings per share did increase by 11% to $1.21 per share. This growth is driven by topline sales growth and a 8% reduction in the outstanding share base. Share repurchases created a drag on cash flows, although net debt is limited at $400 million, with cash holdings standing at $800 million.
The underlying strength is seen in the full year guidance, as Spirit raised the adjusted earnings guidance by fifteen cents per share to $4.30-$4.50 per share. That is equivalent to roughly $565 million. If we assume interest costs of roughly $60 million a year, taxes of 30% and depreciation and amortization charges of $200 million, EBITDA easily surpasses the billion mark.
That shows that leverage is very contained. That is important. Just ask investors in Triumph Group (TGI) who suffer from high leverage, reliance upon military sales and large exposure to troubled OEM Bombardier.
Final Thoughts
It is hard to value a company like Spirit. On the one hand the business is predictable, tied in long term contracts. On the other hand, transition costs to new plane models can be costly at times, one-time charges resulting from that can be huge, and reliance on Boeing is a key concern as well, even if the relations are very good.
The reality is that the company trades at just 10 times earnings, is growing at a healthy rate, the balance sheet is strong and that cash flows are returned to investors. Spirit has chosen to return cash in the form of repurchases instead of dividends. This probably makes sense given the little demanding valuation multiples. Executives highlight the fact that they believe shares are undervalued on the conference call, with earnings yields approaching 10%.
While all of this sounds very upbeat, the reliance risks on major customers is a major concerns, as well as the long duration of these contracts. This is witnessed by the A350 XWB program which resulted in a sizable $136 million charge. Remember, that is over a dollar per share and this is a relative modest program in terms of revenue contribution. Many of the Boeing programs are much larger in terms of their revenue contribution. In the period 2012/2014 similar charges ran up to a cumulative $2 billion, equivalent to nearly 40% of the current market value of the firm.
It is obvious that while the company has a long term growth performance, trades at merely 10 times earnings. In combination with the very modest leverage and good cash flow conversion, shares look like a no-brainer. However, the specific risks and costs associated to Spirit's programs can be lumpy and large. For that reason shares are likely to appear cheap until the point at which a potential problem arises. Despite this inherent volatility, I am willing to accumulate a few shares if the $40 mark gets re-tested again.
