With a ~$3.5 billion market capitalization, Spirit AeroSystems (NYSE: SPR) is the largest independent supplier of aerostructures i.e., fuselage components, engine components, and wing structures to both Boeing (NYSE: BA) and Airbus (EPA: EAD). BA is SPR’s largest customer, accounting for more than 80% of total annual revenues—specifically the Boeing 737 model contributes to more than 50% of SPR’s revenue. SPR’s customers include both commercial and military sectors. Though we are cautious on the outlook for the commercial aerospace industry, we agree that it has probably bottomed out and see SPR as being better positioned than competitors like Triumph (NYSE: TGI) and Goodrich (NYSE: GR) to ride the recovery.
Early this month, SPR hosted an investor day at its Wichita, Kansas headquarters. Management laid out 2014 financial targets projecting $6.3 billion of revenues with operating margins potentially reaching 12%. We think that margin can be reached given increased volumes, cost savings, and the benefits from new accounting blocks. Accounting blocks is airline speak for the number of aircraft a company needs to sell for a program to break-even. The impact for the 737 and 777 models will hit this year but the impact of the 747 and A320 models will not hit until early next year. Management projections imply about a 9% CAGR from 2011 to 2014 compared to the 6% CAGR during 2007-2011. Achieving high single digit growth over the next few years, successfully managing down inventory, and meeting those margin projections will boost free cash flow, warranting a higher stock price.
The company has not entirely but significantly de-risked the 787 and A350 development programs, which comprise a large chunk of its current business and pipeline. Management has learned lessons from the 787 development process, which was fraught with delays, and will be applying what it has learned to its other programs. We think that difficult learning experience will help the company manage further planned rate increases on “legacy platforms” i.e., BA’s 737. The increase from 31.5 per month to 38 per month, over the past year, for the 737 should be easily handled as SPR has been successful in years past in meeting BA’s expectations. BA has said that 42 per month is feasible given robust demand for the model, but we do not think an increase beyond 42 is likely to occur. With rising passenger demand and oil prices, original equipment manufacturer (OEM) production rates have been rising rapidly. OEMs manufacture products which are then purchased by a separate company and retailed under the purchaser’s brand. This means better volumes for SPR but only to the extent that the company can manage the rate increases while minimizing additional costs. The elephant in the room relates to how BA will handle the production of the 737MAX. Given that BA has not discussed its plans on how it will meet demand for the aircraft, we are not sure of the effects on SPR processes and production levels, so BA’s decision will need to be followed closely.
One thing to note is that SPR is significantly exposed to the 787 program and earns about $10 million per ship set delivered. Since the program has been delayed for the last three years, this has been a drag on revenues and earnings. However, we think that once production does ramp up, SPR will have upside leverage. The majority of issues surrounding 787 development were in the systems integration and test phase. To mitigate that financial risk, SPR has effectively divided the A350 contract into four different contracts: two are development contracts and two are production contracts. This will help shield profits tied to the production work from any potential delays. The total production goal is 120 planes per year and 3.5 for this month. Management has indicated that SPR is well-positioned to reach BA’s long-term production goal of 10 aircraft per month. Some risk does remain until BA signs off on the final design.
We see the risk profile improving and think that management will execute on the 787 program without any foreseeable delays. We share SPR’s excitement that the 737MAX will be similar to the 737NH, allowing SPR to use many of the same people and processes in manufacturing. Some of the other development programs like the Gulf Stream 280 and CH- 53K helicopter have seen some cost overruns, but management has stated that it has these programs under control now. Additionally, SPR has a healthy order backlog of approximately $31.8 billion. The 737 currently accounts for roughly 44% of the backlog, followed by the 787, which accounts for 19%.
Held by hedge fund managers John Osterweis, Daniel Arbess, Joshua Friedman and Mitchell Julis, and Paul Tanico, SPR trades at ~9.5x 2013 earnings whereas in the past, SPR has traded at an average forward multiple of ~10.7x. That puts it at a discount to TGI which trades at ~12.1x forward earnings and GR which trades at ~15.8 forward earnings and a significant discount to the KBCM Aerospace Suppliers index which trades at ~15.0x. On an EV/EBITDA basis, SPR shares are trading at 6.7x 2012 estimates, compared to its historic average of 4.5x (which includes Boeing interest free loans) and its peer group average of 8.3x. We think that the company is back on track to generate meaningful cash flow with a number of new development projects in its pipeline and is attractive from a valuation standpoint.