Spirit AeroSystems Holdings Inc (SPR) 2018 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Spirit AeroSystems Holdings, Inc.'s.

First Quarter 2018 Earnings Conference Call.

My name is Jamie, and I'll be your coordinator today.

(Operator Instructions) Please also note today's event is being recorded.

At this time, I'd like to turn the presentation over to Kailash, Vice President of Investor Relations, M&A and Strategy.

Please proceed.

Thank you, Jamie.

Good morning, everyone.

Welcome to Spirit's First Quarter 2018 Earnings Call.

I'm Kailash Krishnaswamy, and with me today are Spirit's President and Chief Executive Officer, Tom Gentile; and Spirit's Executive Vice President and Chief Financial Officer, Sanjay Kapoor.

After opening comments by Tom and Sanjay regarding our performance and outlook, we will take your questions.

(Operator Instructions)

Before we begin, I need to remind you that any projections or goals we may include in our discussion today are likely to involve risks, which are detailed in our earnings release, in our SEC filings and in the forward-looking statement at the end of this web presentation.

In addition, we refer you to our earnings release and presentation for disclosures and reconciliation of non-GAAP measures we use when discussing our results.

And as a reminder, you can follow today's broadcast and slide presentation on our website at investor.spiritaero.com.

With that, I would like to turn the call over to our Chief Executive Officer, Tom Gentile.

Thank you, Kailash, and good morning, everyone.

Welcome to Spirit's 2018 First Quarter Earnings Call.

This quarter is an exciting one for Spirit, and we have a lot to discuss, including all of the items on Slide 2. Most importantly, we are delighted to be announcing an agreement to acquire Asco Industries, a company we have been watching for a long time.

Asco has many great features that align very well to the strategic priorities we have discussed, including expanding our Airbus content, growing our defense business and strengthening our fabrication capabilities.

We will say a lot more about this exciting transaction in a moment.

In association with the Asco transaction, we also intend to refinance some of our existing debt to capture more favorable cost of borrowing, extend our maturities and bring our leverage in line with industry peers.

In addition, we intend to continue actively buying back our shares, which we feel remain undervalued.

Our board has authorized us to initiate an accelerated share repurchase program of $725 million on top of the $75 million of share repurchases we made in Q1.

We are very bullish on our stock, and we will continue to invest heavily in it.

Finally, our board has authorized a 20% increase in our quarterly dividend to $0.12 per share, in recognition of our commitment to return capital to our shareholders.

Before I describe these exciting announcements in more detail, I'm going to start with first quarter performance on Slide 3. We reported revenue of $1.7 billion; earnings per share of $1.10; operating cash flow of $167 million; and free cash flow of $118 million, a 66% improvement from 2017.

During the quarter, we worked very hard to enable our customers to meet their deliveries as production rates are increasing for key programs, including a model mix shift from the 737NG to the 737 MAX.

We are pleased to see those efforts were successful as our largest customer, Boeing, announced strong results last week.

Due to supplier disruptions, rate increases and these model mix changes, meeting these delivery schedules caused us to incur additional costs in Q1 related to overtime, expedited freight and surge resources.

To offset these items, we have put recovery plans in place, including expert SWAT teams deployed to those troubled suppliers, additional training and coaching for new employees, and a dedicated end-of-the-line team to expedite deliveries.

We are seeing the impact of those actions and expect to be fully recovered to schedules by midyear.

We are also seeing some residual impact in Q2, but the recovery plans will offset these challenges during 2018.

The impact on a quarter-by-quarter basis is what you see because of the shift to the revenue recognition system under ASC 606.

To provide some additional color about our progress, I want to talk about a few of the key factory health metrics showing improvement that give us confidence in the recovery plans.

First, we have about 600 direct material suppliers, and our focus has been on the 15 suppliers who were struggling that provide parts on the critical path on the 737 line.

Supply chain kit fill rate, which is a measure of the supply chain on-time delivery, on the 737 line has improved 20% since last year when we put these recovery plans into place.

Our line operates very efficiently when we have parts on time.

Second, improvement in on-time supplier delivery has led to improvement in another key metric: out of sequence jobs.

This measures the amount of work which does not occur in the normal station when parts are not available on time.

Since the recovery plans went into effect, this metric has also improved by more than 20%.

Third and lastly, the need for expedited shipments is gradually reducing as we continue to improve.

We expect to be fully recovered to our delivery schedules by midyear, as I said.

Our goal is to have no delayed deliveries for the second half of the year and therefore no expedited freight charges.

Like I mentioned in the past, production rate increases are a great opportunity for us, but they can bring some of these challenges as I've described.

We are taking the lessons learned over the last year or so and implementing robust plans for a much smoother transition as we move to 57 aircraft per month on the 737 line next year.

One exciting accomplishment during this past quarter was the delivery of our 10,000th 737 shipset to Boeing.

Spirit builds 70% of the structure for the 737, including the entire fuselage.

This milestone of 10,000 deliveries showcases our ability to deliver a world-class, highly successful product consistently to our customer.

It takes teamwork, dedication and commitment across generations of aviation employees to reach such an impressive milestone.

The A350 line also impacted first quarter performance.

Severe weather and a declared emergency in January in North Carolina disrupted production and resulted in increased costs from expedited air shipments.

The program is now fully recovered and has returned to normal sea shipments.

We have a planned buildup of additional product buffer stock this year that will enable us to absorb any similar small disruptions that are in the future.

Now turning to today's strategic announcements on Page 4. As you saw in our release this morning, we are very excited to announce the acquisition of Asco Industries, an exceptional company we have been monitoring for a long time.

On Page 4 of this presentation is the Spirit strategy that we shared at our Investor Day last year.

Asco is a compelling strategic fit for Spirit, as the acquisition expands our Airbus content on A320 and A350 wings; adds new defense content on the F-35; and broadens our fabrication business growth initiative.

Asco will also help us strengthen our supply chain with their specialized capabilities, which will help with our current recovery.

Slide 5 provides an overview of Asco, which has revenues of approximately $400 million per year.

Asco is a high quality, family-owned business based in Brussels, Belgium, with a successful history dating back to its origin in 1954, when it was founded to make parts for military vehicles.

Today, Asco is a recognized leader in high-lift wing devices, large structural parts and mechanical assemblies offering both design-to-build and build-to-print capabilities.

Wing components such as slat tracks and flap assemblies comprise the majority of the revenues, an area that aligns very well with Spirit.

Asco also has a diversified product range of flight-critical structural parts for Airbus and other OEMs.

It is highly regarded in every area in which it operates.

Asco has a longstanding relationship with major aerospace OEMs, especially with Airbus and Boeing for more than 20 years.

The acquisition will enhance Spirit's relationship with our current customers, increasing content on strong programs such as the Boeing 737, 777 and 787 and the Airbus A320 and A350.

Asco also opens the door to increase content with other OEMs, including Bombardier and Embraer.

Asco has a strong military presence, with existing work on the Lockheed Martin F-35 program and the Airbus A400M program.

We are excited to add the airscope military work to our growing defense programs.

As an example of that growth, during this past quarter, we delivered the fifth system demonstration test article for the CH-53K to Sikorsky, an important program for growing our defense work statement.

Asco also has well-established customer relationships in its markets, with high value and often sole-source products.

The company has life of program positions on many of its programs.

They also have a strong position on wing products, which is a close fit with the work we do on wings for Airbus and our other customers.

The company has a strong management team that has cultivated its customer relationships to grow work content on several large commercial and regional aircraft growth platforms, while simultaneously driving productivity.

Key Asco senior management, including CEO, Christian Boas, have made commitments to Spirit to ensure a smooth transition.

We could not be more delighted that Christian and his team will be joining Spirit.

Asco is a critical supplier to OEMs and Tier 1 manufacturers with an exceptional reputation for innovation, quality and delivery.

Asco also adds strength to our R&D efforts by bringing in product intellectual property to complement our process IP on both existing programs as well as next-generation aerostructures.

Turning to Slide 6, much like Spirit, they benefit from having a concentrated footprint, with 4 highly automated fabrication sites, with capacity to support rate ramps and new business growth.

Asco employs about 1,400 people across these 4 manufacturing sites, comprising over 1.5 million square feet, including Vancouver and Stillwater, Oklahoma, in North America, Gedern in Germany, and its headquarters in Zaventem, Belgium, in Europe.

These are highly automated state-of-the-art facilities with scale to support rate increases and future growth.

These facilities and the commercial capabilities that Asco has, with a demonstrated ability to win new work, will accelerate Spirit's efforts to grow our fabrication business.

On that front, during this past quarter, Spirit officially unveiled both our 5-Axis Machining Center of Excellence in Wichita and our 3- and 4-Axis Center of Excellence in McAlester, Oklahoma, in support of plans to grow our fabrication capabilities to more than $1 billion annually.

Our investment in fabrication capabilities through the acquisition of Asco and these new centers of excellence improves our competitive advantage for global fabrication work and also helps alleviate some of the supplier bottleneck issues that we've had in our supply chain.

On Slide 7, you can see a summary of the deal to acquire Asco.

The $650 million purchase price is inclusive of the assumption of debt.

The EBITDA multiple was 9.3x based on 2018 results.

The return on investment exceeds our internal threshold and the effective EBITDA multiple on the deal, after giving effect to $15 million of expected synergies, is less than 8x EBITDA and less than where Spirit currently trades.

The deal will be accretive to adjusted EPS in the first full fiscal year.

We anticipate the transaction to close in the second half of 2018 upon the completion of regulatory approvals and other customary closing conditions.

Asco will operate as part of our wing segment.

Detailed integration planning is already underway to ensure a smooth transition.

Now turning to our capital finance plans on Slide 8. We intend to fund the acquisition with new debt as part of a broader debt plan that takes advantage of the current interest rate environment to lower our cost of borrowing and extend our maturities.

We intend to refinance some existing debt, and our anticipated new debt structure will place our leverage more in line with industry peers at about 2x debt-to-EBITDA, which leaves us comfortably within our desired investment-grade rating.

We also intend to use a portion of the proceeds of our refinancing to fund a $725 million accelerated share repurchase plan during the second quarter of this year, in addition to the $75 million of shares we repurchased in the first quarter of 2018.

These actions will bring our total repurchases to $800 million out of our current $1 billion share repurchase authorization.

Our stock remains undervalued, and we have confidence in our long-term outlook.

At the same time we are investing in Asco to grow our business, we see an opportunity to invest in ourselves.

We have outlined our capital deployment strategy on Page 9.

We do not anticipate making any additional share repurchases in the remainder of this year beyond what I have just described, but we will be using the cash that we generate over the rest of the year to pay back some of our shorter maturity new debt, and to keep our debt-to-EBITDA ratio at a target of around 2x.

As I said earlier, we incurred substantially higher costs in the first quarter related to supplier disruption, overtime, expedited freight and surge resources, some of which will carry over into the second quarter as we continue to recover to our production schedule.

We are maintaining our full year guidance, as these operational challenges are offset by our remedial steps and the ASR.

In addition, we will continue to drive our operational recovery plans, and we'll update you throughout the year on their progress.

Finally, our board has authorized a 20% increase in our quarterly dividend to $0.12 per share.

That supplements our robust capital development -- deployment plans and is in line with our strategy of gradually growing our dividend over time as part of maximizing total shareholder return, further demonstrating our confidence in our long-term outlook.

This capital plan leaves us with sufficient flexibility to fund any organic growth investments or to pursue value-creating acquisitions if we can find them, while continuing to drive total shareholder returns.

Our plan for financing leaves us with plenty of flexibility to use our cash flow to retire debt as well.

In summary, the Asco acquisition is a terrific win for us.

We are delighted with the company and its team.

Asco, combined with our debt refinancing plans and our ASR share buyback initiative as well as our increased dividend, exemplifies Spirit's commitment to a balanced capital deployment strategy as well as our confidence in our long-term outlook.

The Asco acquisition is a compelling strategic fit that expands our Airbus and military content and also adds world-class R&D and manufacturing capabilities, positioning Spirit for long-term growth.

The fact that Christian Boas, whose family built and has owned Asco for more than 50 years, will remain with us following this acquisition is an additional benefit of the deal.

With that, I'll ask Sanjay to lead you through the detailed financial results.

Sanjay?

Thanks, Tom, and good morning, everybody.

Let me summarize our first quarter financials as well as our outlook for 2018.

So with that, please turn to Slide 10.

The revenue for the quarter was $1.7 billion, up 2% from the same period of 2017, primarily driven by higher revenue recognized on the 737 program due to increased recurring and nonrecurring activity; the adoption of ASC 606; higher production deliveries on the A320 program; and increased defense-related activity, partially offset by lower production deliveries on the 777 program and lower revenue recognized on the 787 program due to 606.

Backlog stayed consistent at $47 billion, which provides top line stability and growth in the future.

Moving to Slide 11.

First quarter reported earnings per share was $1.10 compared to $1.17 in the first quarter of 2017.

The decline compared with the same period last year was primarily due to lower margin recognized on the 737, lower production deliveries on the 777 program and net forward losses recognized on the 787 program, partially offset by higher nonrecurring activity on the 737 program.

As discussed last quarter, there are 2 primary factors that impacted earnings per share this quarter.

First, the forward loss recognized due to a change in pension accounting.

On our overfunded frozen pension plans, we generate pension income that was previously reported inside our segment reporting and now under ASC 715, this is reflected in other income, which has no impact on EPS on most programs except uniquely on the 787 program, which is in a forward loss position, and thus we recorded the entire value of this pension change up to line unit 1405 this quarter.

And we'll recover the corresponding offset in other income on an annual basis over the next few years.

The second factor is the shortened accounting contracts due to 606.

We are absorbing a higher percentage of near-term cost increases to support our rate increases as well as the substantially higher cost incurred due to our recovery efforts on schedule.

Under the legacy 605 GAAP, the impact of first quarter cost increases would have been spread out over a longer full-year accounting block.

As Tom mentioned, the 737 program is recovering, but we have exerted a lot of resources in this process and catching up to schedule has been costly in the quarter.

While we continue to make progress, comprehensive recovery will depend on improving our supply chain health as well as the collection of subsequent supplier claims.

Turning to free cash flow on Slide 12.

Free cash flow for the quarter was $118 million compared to $71 million in the same period last year, reflecting a 66% increase year-over-year.

The increase was primarily due to lower advanced payments -- repayments on the A350 program and timing of working capital.

While the focus remains on reducing the increased costs due to the 737 recovery in the next few quarters, we are also relooking at some of our capital investments for efficiencies as well as targeting working capital improvements, both in inventory and payment terms with our suppliers, to meet our cash flow commitments.

And we remain committed to our long-term objectives of 7% to 9% free cash flow to sales conversion.

Turning next to capital deployment on Slide 13.

In the first quarter, we repurchased 900,000 shares worth $75 million and also paid $12 million to shareholders through dividends.

Today's announcements, the Asco acquisition, the $725 million accelerated share repurchase plan and the 20% dividend increase are in line with the balanced capital deployment strategy we have been communicating over the last couple of years.

We plan to reset our capital structure shortly and are making meaningful investments in the purchase of Asco as well as plan to purchase a significant portion of our stock.

We are also committed to maintaining our investment-grade rating, and thus we'll repay some of the proceeds used to accelerate our share purchases during the remaining of this year.

This strategy should keep us in line for approximately 2x leverage to debt-to-EBITDA and is consistent with conservative industry averages.

Now let's look at our segment performance.

So for the Fuselage segment results, please turn to Slide 14.

Fuselage segment revenue in the quarter was $963 million, up 5% from $917 million in the same period last year, primarily due to higher revenue recognized on the 737 program due to 606; higher production deliveries on the A350 program; some increased defense work; and nonrecurring activity on certain Boeing programs, partially offset by lower production deliveries on the 777 program and lower revenue recognized on the 787 because of 606.

Operating margin for the quarter was 12.4% as compared to 15.9% in the same period last year, primarily due to lower margins recognized on the 737 and the 777 programs, in addition to the net forward loss charges recognized on the Boeing 787 program related to the pension accounting change.

On a normalized basis, after reversing change in estimate impacts, Fuselage segment margin was 14.1%.

Now turning to Slide 15 for our Propulsion segment results.

Propulsion segment revenue in the quarter was $395 million, down from $406 million in the same period last year, primarily driven by lower production deliveries on the 777 program and lower revenue recognized on the 787 program due to 606, partially offset by higher propulsion deliveries on the 737 program.

Operating margin for the year was 13.4% compared to 17.7% in the same period last year, primarily due to lower margins recognized on the 737 and the 777 programs.

On a normalized basis, after reversing change in estimate impacts, Propulsion segment margin was 14.4%.

For our Wing segment results, let's turn to Slide 16.

Wing segment revenue in the quarter was $377 million, up from $369 million in the same period last year, primarily due to higher production deliveries on the 737 and the A320 programs, partially offset by lower production deliveries on the 777 and lower revenue recognized on the Boeing 787 because of 606.

Operating margin for the quarter was 13.5% compared to 15.8% in the same period last year, primarily driven by favorable changes in estimate that were recorded during the first quarter of 2017.

On a normalized basis after reversing change in estimate impacts, Wing segment margin was 14%.

And so finally on Slide 17, we are reaffirming our guidance for 2018 with revenue to be between $7.1 billion and $7.2 billion; earnings per share to be between $6.25 to $6.50; free cash flow to be between $550 million to $600 million; and an effective tax rate of 21% to 22%.

Clearly, the first quarter results were significantly impacted by the extraordinary measures we took to ensure our delivery commitments to our customers and the disruption we absorbed due to our supplier issues.

Guidance is now dependent upon us accomplishing a sustained recovery of the 737 production line, which we have planned for the middle of this year, and the subsequent productivity initiatives, both internally as well as in our supply base, that are necessary to recover to our long-term plans.

Guidance also includes both the costs to be incurred in the quarter as well as the favorable impact to our planned ASR.

Also, our guidance does not include any impact of the Asco acquisition or the costs associated with that transaction, including financing costs.

We will adjust for those as we conclude that activity, which is likely to be later this year.

So with that, let me hand it back over to Tom for some closing comments.

Thanks, Sanjay.

We have summarized our key messages on Slide 18.

While it was a challenging first quarter due to rate increases and disruptions in our supply chain, our recovery plans are being implemented and are getting us back on track to our delivery schedules.

We continue to work with all of our customers to enable them to grow their production rates to meet the significant long-term 5% annual growth in air traffic.

With sizable work packages in all the major programs for Boeing and Airbus, Spirit is well positioned to benefit from these positive long-term trends for the industry.

The acquisition of Asco that we announced today will enable Spirit to accelerate our growth with Airbus, expand our military sales, increase our fabrication business and strengthen our supply chain to support our recovery plans.

As part of the funding for Asco, we are refinancing our debt and bringing our leverage in line with industry peers.

We are focusing a portion of the proceeds on an accelerated share repurchase, $725 million, and have increased our quarterly dividend by 20% to reflect the confidence we have in Spirit's long-term outlook.

With that, we'll be happy to take your questions.

.

(Operator Instructions) And our first question today comes from David Strauss from Barclays.

Tom, following up on the 737 issues, can you give us an idea of how many shipsets you're behind?

Just kind of eyeballing your deliveries, it looks like maybe you're 20 or 30 units behind as of today.

And what was it about this move that -- move from 42 to 47?

Or was it that combined with the derivative model of the 737?

What was it about this move that created the problems that prior move up -- moves up in rate hadn't caused?

Well, we got behind as many as 13 to 15 units.

We've cut that down to about 5, and we'll be caught up by June.

So that's just the dynamics of the recovery.

What really caused it, as I mentioned, is that the rate increase is not just going up in terms of the number of aircraft we're producing.

And we've gone from 42 to 47, now to 52.

So we're up 24%, and so that's a significant challenge in itself.

But we're really also shifting from NGs to MAXs.

And so you've got the NGs going down quite dramatically and MAXs are going up.

So this year, we will produce about half MAXs.

And there's a learning curve as you start to produce what's effectively a brand-new aircraft.

We're getting through that learning curve now as we've started to produce more MAXs, and we expect a much stronger second half of the year.

And then, in addition, the kind of challenges we're seeing, it flowed down into the supply chain, and many of our suppliers struggled with new capital that they were trying to get on, hiring people, and they got behind in their deliveries.

And so as a result, we had more traveled work in our shop, and I mentioned that those out of sequence jobs.

So if this part doesn't show up in the station where it's supposed to be, the aircraft -- the fuselage has to keep moving or the whole plant would get locked up.

So then later, we have to go back in to put that part in place down the line.

It takes longer to do it at that time.

And we also started to get a little bit of a backup at the end of the line.

That's why we put in the dedicated team at the end of the line to expedite deliveries.

But those things resulted in more overtime.

We had to get some contractors to come in and help us.

Boeing sent in, in fact, some of their most experienced mechanics to help us at the end of the line.

And then in addition to that, we had expedited freight.

We were shipping late from our plant, and so we had to put them on expedited trains.

And so that was really the cause of it and how it manifested itself in terms of additional cost.

Now, as I mentioned in my comments, all those things are turning around.

We are starting to ship with more lead time.

That will enable us in the second half of the year to reduce our overtime, release the contractors and also avoid expedited freight.

Our next question comes from Robert Spingarn from Crédit Suisse.

One for Sanjay, one for Tom.

Sanjay, could you give us some sense of the dollar magnitude in terms of the shortfall from the 737 delays, just some way to quantify what that shortfall was?

And then bridge us to why that doesn't impact your guidance, especially on free cash, unless it's just contained in the range?

And then, Tom, the question for me -- for you is, what's your appetite for further acquisitions of the type you just did?

And what is a ceiling for leverage for Spirit?

Thanks, Robert.

Let me go first, and then Tom can jump into the second question that you asked him.

At a very macro level, some of the headwinds that we faced in the first quarter are quite similar to what we faced in Q4 last year, so to give you a magnitude now.

We both said in our prepared comments, there is obviously a benefit of the accelerated share repurchase on the earnings per share calculation.

Everybody can do that calculation, obviously.

The delta is what you may have assumed we would do naturally in the rest of the year versus the impact of this acceleration.

And that fundamentally is offsetting the headwind that we are seeing on the 737 costs, both in the first quarter and probably lingering on a little bit into the second quarter.

We expect to be on track by the middle of the year, like Tom said.

And then Tom, just answering David's previous question, when we say we are about 5 units behind, we're kind of expediting that.

We're not sort of delaying loads, anything like that at our customers.

We're just expediting those units so that they get there well in time.

By June, we anticipate we caught up on sort of a normal basis, which by its default has buffer built into it.

Your second question was also -- was with cash flow.

Before you go there, are we talking about a $20 million, $30 million EBIT shortfall in the first quarter from everything you just described?

I'm not talking about earnings per share but absolute dollars on EBIT and cash flow, and then when that gets recovered and how?

Yes.

No, it does.

It does -- that is a range -- that's a fair range, Robert.

And so the recovery plans that we've laid out to try and get back on track, and as you know, we had built in certain -- we have rates going up in the latter half of the year that if we execute should provide a little bit of upside.

Internally, we've created numerous plans to cut back on areas that we think are a little bit discretionary.

And that's where I was going to take you with my cash flow comment, because while the impacts to the EPS due to the ASR will offset the impacts to EPS because of the headwind on the 737, as far as cash flow is concerned, again, in my prepared remarks, I think I was saying, we're looking at more efficiently managing our capital expenditure and also about some initiatives around working capital, both in terms of managing our inventory better in the latter half of the year as we stabilize as well as going and working with our suppliers on payment terms and collections and so on and so forth.

So that's the initiative we baked in as far as cash flow is concerned.

And getting to your second question regarding appetite for further acquisition and ceiling for leverage.

We remain committed to growth, and we're still focused on Airbus content, military content, low-cost country footprint as priorities.

However, having just completed the Asco acquisition, which is a company that is really perfectly aligned to the strategic objectives that we have outlined, our focus for the rest of the year is really on integrating that acquisition and really focusing on the recovery plans.

We've got to make sure we meet our deliveries to our customers.

We've got the rate break coming up with Boeing and also Airbus is going up on the narrowbody.

And we want to make sure we deliver on that.

So our focus for the rest of this year certainly is going to be on integrating Asco and recovering to our delivery schedules and meeting our commitments to our customers.

In terms of our capital structure, we've said for a long time that we thought 2x in terms of debt-to-EBITDA leverage was a good target.

It's the industry average.

We're going to be at that level as we get into -- toward the end of the year, and we feel comfortable in that range.

We're committed to being investment grade, and we want to stay there.

And so we will work very carefully in determining our future leverage ratios to ensure that we remain in that investment-grade area.

Our next question comes from Sam Pearlstein from Wells Fargo.

I was wondering if you could talk a little bit more about Asco.

If I just look, it looks like a couple of years ago, they were running probably at 10% higher in sales than what you're showing now.

So can you just talk about what's changed, what that's done to their margins?

And then when you think about their capacity, do they have the capacity for higher rates?

Or do you need to invest more in the facilities in order to drive that -- drive these rates higher?

Right.

Well, Sam, Asco has been a very strong performing company over the last few years, and they're constantly adjusting their portfolio.

They've cut out some of their low-profit programs.

But at the same time, they've won a lot of new work on very high-growth platforms for the future, including the Embraer 190, 195, the C Series, the F-35.

So as we look forward from now, from '18 going forward, we see 10%, 12% growth over the next couple of years.

So a very strong order book that's all starting to come in.

And we're very pleased about that, very excited to get that team on board so that we can combine it with our fabrication business and help supercharge the growth of that.

So that's how we're looking at it.

Their facilities are extremely efficient.

They're highly automated.

They're very concentrated; they only have 4 of them.

They do have a little bit of excess capacity.

We will be able to fill that up very quickly by absorbing some of our supply chain activities and helping to lower costs and improve delivery.

But beyond that, they do have room in their facilities in terms of bricks-and-mortar for expansion, but we would probably have to make some capital expenditures for equipment as it continues to grow.

And as part of your strategic look, is there any way you can look at their $400 million in sales and say what is the non-Boeing work?

So the military, Airbus, kind of the Embraer, Bombardier?

Boeing is about 20%, Airbus is about 50%, if you look out a couple of years from now.

Military is about 10% and growing.

So those are some of the rough numbers, and then they, as I mentioned, they've got some Bombardier and Embraer work as well.

Our next question comes from Doug Harned from Bernstein Research.

It's actually Finbar Sheehy standing in for Doug.

Wondering if you can give us any details of the cost synergies you expect to achieve from the acquisition of Asco.

How big and where from?

Right.

We've identified about 15% -- excuse me, $15 million of synergies, which is about 4%, and that's fairly typical range for these kinds of acquisitions.

The industry average is 4% to 6%, and so we're kind of right in that range.

Some of it will come from normal headcount reductions as we look at the indirect expense and overlap in some of the functional areas that you would typically see in an acquisition of this.

There is an opportunity in Stillwater to fill up the capacity.

That's one of their plants in Oklahoma.

We've already identified how we will do that very quickly.

So that will generate some synergies.

And then a big chunk, as you'd expect, is in supply chain.

They're a structures business just like we are.

We buy a lot of the same things.

We buy it at much higher scale, and so we've already looked at their purchases and identified opportunities to bring it more in line with what we purchase things at.

And that will be a big chunk of the synergies.

And then there's also some engineering and R&D synergies that we expect to get.

So the synergies that we've built, the $15 million, are all cost synergies.

We do expect that there'll be some revenue synergies, but we didn't count on those in terms of valuing the deal.

And just on the number of locations.

You mentioned that they had 4 operating locations.

You have a relatively limited number of locations yourself at the moment.

How do you think about the management bandwidth requirements of adding 4 more?

Well, 4 is a very manageable number.

They have -- first of all, they have a great operating team already, and that we will inherit.

So this will be part of our Wing segment, as Sanjay mentioned, and we will have our head of fabrication oversee these plants.

So we have a very detailed integration plan that we are already developing.

They're already extremely automated, well-functioning plants.

So integrating them operationally will be very straightforward.

And so we look forward to absorbing them into our overall fabrication activity.

Our next question comes from Jon Raviv from Citi.

What is the path to achieving guidance for this year?

It sounds like you have some things that you still have to achieve.

So just give us a sense for how much is in your control and not in your control for the year.

Right.

Well, I'll give you a high-level view.

So in terms of recovering, the recovery plans that we outlined show that we get to back to deliveries on schedule by the middle of the year.

And at that point, our overtime will start to come down, the expedited freight will go away, and the surge resources will go away.

So those things are all critical.

And then as Sanjay mentioned, we've also looked at our discretionary nonlabor expenses and really buckled down on those to take out all the discretionary items.

So that's really the path on the EPS side.

Now of course, we also have the ASR, and that will contribute on the EPS side.

On the cash side, it's really about managing our capital expenditures very efficiently, making sure we are only focusing on the right priorities and that we streamline them as much as we can and maybe even defer something if it's not mandatory.

And then working capital, as we look at inventory, accounts payable, accounts receivable, we have a number of initiatives across each of those areas.

So that's how we maintain and recover to guidance for the cash flow.

Sanjay, anything else to add to that?

No, I think Jon has a fair question.

I mean, at this stage, everything is sort of in our control, other than things like the weather, which sometimes can create havoc.

But we had 3 or 4 initiatives, primarily the initiatives are in our floors, in our factories, but the second big initiative is making sure that our supply chain gets healthy.

And like Tom said, we've got SWAT teams deployed out there.

We're making some good progress.

The good news here is that out of 600-odd suppliers, there are about 15 that need to get back on track.

And we are working that, whether we are working it with them directly or finding ways to offload work that they are currently doing to try and ease the pressure.

But those are the things that internally and externally kind of we are working on to make sure that we meet our commitments.

And just a follow-up in terms of the free cash flow, making up for the loss on the cost, those working capital and CapEx initiatives, are those onetime in a sense and then they'll -- the CapEx goes up again next year?

Or are we kind of accelerating some of those working capital things you've talked about in the past, with a mind to getting to 10% free cash flow margin over time?

The working capital in terms of inventory or working with supply chain financing, et cetera, obviously those sometimes have onetime benefits, but frankly, inventory then also helps with slow days and just makes our own factories a lot more efficient.

So it has kind of double benefits, not just in terms of cash but also in terms of the cost at which we execute in our factories.

Capital, just to give you a little bit more clarity, I mean we've got a fairly wide range in terms of capital expenditures for the year.

More likely than not, we are going to be at the lower end of those numbers.

Now we're not deferring anything, but we're taking advantage of certain sort of leasing opportunities.

Or we've actually -- you may have seen in the press in the last quarter, we benefited from working with the state and the city and the local governments to try and get an appropriate amount of help, which makes sense because of the employment that we are generating in Wichita and other places.

So you marry all that together, we think we have some better ways and more efficient ways to still go and execute what we need to.

And like Tom said, if there's something that's totally discretionary, that would have been a nice to have, we are sort of relooking at that in light of what we need to do to keep our commitments.

Our next question comes from Rajeev Lalwani from Morgan Stanley.

Would it be fair to say that the costs that you incurred or are going to incur in the first half of this year are temporary and shouldn't carry forward?

Or should we assume that some of the adjustments that you're making will carry forward and impact margins as we look beyond this year?

No, I think you'd be fair to assume that these are not going to carry forward.

These are events that are tied to initial disruptions as we went up in rate.

The supply chain disruption caused us to have more overtime, more surge resources and expedited freight.

As the schedules get back on track, all of that will go away.

So we're looking at a much stronger second half of the year and a recovery, therefore, in the margins and in the overall performance.

So these are not going to repeat as we go forward.

The corrections and the schedule recovery that we have will mean the second half of the year will be better than the first half.

And Sanjay, you provided some good color on looking at your capital spending, et cetera.

Do -- are you in a position maybe to provide some color on post-2018 spend if we're going to go back down to that $250 million or so level that we've been talking about before?

I think my comment there, Rajeev, would be pretty much the same.

As you know, we're going through this lumpy capital right now because for all the right reasons.

Our rates are going up.

And you know that next year, the rates are going up on the 737 to 57.

So next year is in line with this year in terms of capital, but I think we've given you some color on the fact that once the rates have stabilized, then our normal CapEx, which is close to our depreciation, isn't this large.

So over the long term, if the rates were to -- listen, we want the rates to keep going up because these are the best programs we have.

And we are happy to invest in these programs in terms of capital if the rates continue to go up, and there's always that discussion about further rate increases.

But once that's done, our capital -- our core capital is obviously significantly lower than what we are spending these days.

Our next question comes from Carter Copeland from Melius Research.

Tom, I just wanted to ask about, I noticed the change in the proxy and the incentive comps to emphasize free cash flow.

And I wondered if you might comment on what you think that means about the longer-term opportunity you see in cash versus margins or growth?

It was a decent size shift, so I wondered if you could comment on that.

And secondly, I'll just go ahead and ask the second.

Obviously, there's a lot of discussion around narrowbody rate expansion, rate studies, the timing on that.

Maybe just give us some color on when Spirit could be ready for a step to higher than announced rates and how you think about the capital steps associated with that.

When should we be thinking we begin to see that if we get those announcements out of Boeing and Airbus?

Okay.

So on the incentives, we did put emphasis on free cash flow because that's what we have talked a lot about, with all of you and with our investors and with our board, is the importance of free cash flow.

And we've said that we are targeting 7% to 9% and always, of course, trying to exceed that with our internal targets.

But we wanted to get all of our team aligned to those same objectives.

And so that's why we put the emphasis on that.

We feel confident in our long-term outlook.

Obviously, the first quarter, we incurred some additional cost.

But as our schedules recover, those costs will go away, and we will have a better back half of the year.

So the margins will get back to their normal levels, and we'll continue to push on that.

So that's the focus on free cash flow.

With regard to rates, we are focused right now on hitting this current rate break on the 737, which is getting to 52 and next year to 57.

The 787 is going up from 12 to 14 next year, so that is certainly keeping us busy.

And then on the Airbus side, similar discussions with the A320 and the A350 both going up.

So we are obviously working very closely with Boeing and Airbus and keeping track of what's going on.

The market still looks pretty strong, particularly on the narrowbodies.

If we look at the book-to-bill rate last year, it was 1.6.

So the backlog actually grew quite substantially on the narrowbodies.

So our focus is making sure we do the current rate breaks well, and the next one.

It generally takes us about 2 years to execute a rate break.

We will be working closely with Airbus and Boeing to understand what their plans are, and if they make any decisions, we will absolutely support them.

These are, as Sanjay said, these are our best programs.

And if the OEMs choose to go up in rate, we will do everything we can to support that.

We are very capable of doing it, we have the capital to do it, we have the expertise, and we would look forward to it.

So just to be specific, if both guys were supposed to go or plan to go to 63 a month on the narrowbodies in 2020, would that necessitate any investment on your part later this year or early in 2019?

Well, the rate break, as I said, it takes about 2 years to effect.

From the standpoint of our infrastructure, we have -- sufficient infrastructure, we have to make some marginal improvements and upgrades.

It would require some capital investment, of course, because there would be more rate.

We always discuss with our partners in terms of how we split those investments, and those discussions obviously haven't happened because there's been no decision yet.

Our next question comes from Noah Poponak from Goldman Sachs.

So it sounds like no change to the medium- to long-term margin targets by segment that you have given in the past, is that correct?

Yes, that's right.

And I guess in the second quarter of this year, as you have some of these challenges lingering, I mean, I hate to ask about one quarter, but just to get us honed in on sort of the transition from first half to second half, any incremental color you could give around where you see the margin transitioning through the second quarter compared to where you were in the first versus those longer-term margins?

Yes.

As we said, some lingering effects in Q2.

The recovery plans are still going on.

We still have higher overtime and some of the contractors and some expedited freight.

That starts to go away in the June time frame.

So the back half of the year, you'll start to see the improvement.

But we are going to have more deliveries in the second quarter as we catch up to the schedule.

So there's some lingering effects in Q2.

The bulk of the improvement you'll see in the back half of the year.

But we're very confident in terms of what that looks like as our recovery plans take hold.

And then, Sanjay, just as you perform the ASR in 2Q, and then I guess that is the full year's repurchase, one, can you just tell us what share count is in your earnings guidance range?

And then anything you can tell us about the shape of the share count as you look at what creep you have and the other moving pieces?

Well, no.

What I can tell you is we've announced that we're going to execute a $725 million accelerated share repurchase.

I mean, something of this magnitude we intend to put in place as quickly as we can.

So we hope to execute that normal, typical time, somewhere around 6 to 8 months and that will be the profile.

It's -- you can do your own math.

We'll initiate it pretty quickly.

Yes, we'll initiate it right away, but it will take 6 to 8 months to execute.

So if you're looking for a profile, that's -- your guess is as good as mine.

Our next question comes from Peter Arment from Baird.

I wanted to circle back just on the supply chain.

Thanks for all the details.

In particular, the 15 that were struggling, it sounds like they were just missing on dock dates, and it was probably very visible.

But how -- can you give us some insight into kind of the health of the other 585?

I mean, we're going up in rate.

Back to Carter's question, the rates might go even higher.

How are you feeling about the rest of the supply chain in terms of dealing with these higher rates?

Overall, pretty good.

We have, obviously, a lot of interaction with all of our suppliers.

We are constantly assessing their rate readiness.

So we're looking at their infrastructure, their capital, their tooling, their staffing, their training plans, all of their programming.

And so generally speaking, they're all keeping up with their schedules and their rate breaks.

And so it's something we monitor very closely.

And the 15 that got behind, some of it was because they ordered their equipment late, and it took them longer to get up to speed.

Sometimes it was a difficulty in hiring people.

So there's a whole variety of things.

What we've done is we put SWAT teams with some of our operations experts out at all of those 15 suppliers to help them recover.

But that said, this is something that's ongoing.

We have to keep working it every day.

Even though the other 585 are going well today, we've got to make sure they stay healthy, and we work with them to ensure that.

And just as a follow-up, were you able to look at Asco's supply chain and the health of that as you were looking at this transaction?

Yes.

I mean, a lot of their suppliers are suppliers that we already deal with.

So we had a very good handle in terms of the health of their supply chain.

What I mentioned in my comments though is because they bring some additional capacity and some specialized capabilities, both in processing and shot peening and heat treatment and chemical treatment and things like that, is we see it as helping us with the recovery and providing additional support to our supply chain.

And so that's why it's another reason we're very, very happy about the acquisition.

Our next question comes from Cai Von Rumohr from Cowen & Company.

So you mentioned supplier claims and you also have, I think, your insurance claim out for the [severe weather].

Give us some color on both of those and how much you expect to get this year to kind of get you home to your estimates.

Right.

Well, on the supplier claims, there has been disruption, and so we are going to assert with our suppliers to recover some of that, when it was through their actions that we incurred them.

So that's going to be a substantial amount.

And -- so I don't want to get into the exact details of that, but it will be a substantial amount.

And it will be something that we work on over the course of the year.

And by the way, it's no different from what our customers sometimes ask us if we are late.

Now on the insurance claim, the situation there is that we have tried to settle it.

We have not been successful.

We have initiated legal action, and that is carrying through.

At this point, it doesn't look like we will recover anything from that this year.

And so that will be next year.

That was some of the pressure that we did incur this quarter.

We are very confident in our claim.

We'll continue to try to settle it for a reasonable amount.

But we're not going to accept less than we consider fair.

And at this point, that's where we are.

So we have initiated the legal action, and we will see it through to its conclusion.

So the supplier claims, if they're a substantial amount, did you in your numbers in the first quarter or in your guide assume any recovery there?

Or is whatever you recover net of what you might have to pay Boeing going to essentially be gravy?

No, no.

We assumed it in our recovery plan and so it's part of our recovery plan.

And it's net, of course, what we would have other obligations for.

Our next question comes from Seth Seifman from JPMorgan.

So just a quick clarification to start.

When you say back on rate by midyear, that means 52 a month, right?

Yes, we'll definitely make the rate break, but it means that we'll catch up all of the behind schedule as well.

So we will be fully on schedule, and we will be on track with the 52 rate break, absolutely.

Right.

Okay.

And then secondly, and just one more small question.

When you talk about the Asco acquisition being accretive to, I guess it would be 2019 full year adjusted EPS, what's the adjustment for there?

Well, the adjustment, Seth, is now all the sort of deal amortization kind of costs, but let me answer that question maybe on a GAAP basis.

I think in the -- and so without any adjustments.

Then again, I know there has been some Q&A in the early morning commentary about what we are paying, et cetera.

Fundamentally, on an EBITDA perspective, we paid about 9.3x, after synergy it's 7.6x.

So we feel very good at this transaction that we've executed.

And on a GAAP basis, I mean, Year 1, obviously there will be some cost to recover that synergy.

So it's probably a little bit neutral, but obviously, immediately thereafter, it's going to be accretive to our cash, to our earnings per share and so on and so forth.

So I think we're pretty proud of this deal.

One other quick thing while I have you, and I know you asked a question about recovery and Tom, and if anybody else is listening on the call, listen, keep track of the number of deliveries we do.

You should see a very healthy improvement in the second quarter of the total number of deliveries that we make, particularly on the 737 program.

That will give you guys a very good indication that we're getting back on track.

So not only are we recovering, like Tom said, to the 52 a month, but we're also going to catch up on all of the ones that did not happen, were accelerated, didn't happen in the first quarter.

So you should see a very large spike in the amount of deliveries we do in second quarter.

Our next question comes from George Shapiro from Shapiro Research.

I wanted to pursue the normalized margins, Sanjay, that you talked about in the long term, because the reality is now you got the shorter pools, you've got more expenses, like you said they were.

So can you tell us how long the current pools are?

And what kind of the margins might be with the shorter pools relative to the longer-term numbers that you previously have talked about?

A very fair question, George.

I mean, we are all sort of working through sort of the shortened blocks that we have, particularly on our sort of contract that we recognize revenue over time.

And this includes some of the high-volume programs like the 737 and so on and so forth.

So what you see is some very significant volatility in the course of a quarterly result because these contracts or these blocks are around that those kinds of time frames, a little bit long, but they're no longer the sort of annual blocks.

So that's why you'll see some margin volatility in the first quarter, probably carrying on to the second quarter, but once these programs are working, they're high-volume programs, and you should see margins more consistent with what we used to do in the past.

Now, clearly, also on the 606, there are some benefits and there are some negatives.

On the benefits, as we all know, there's the benefit of that, programs like the A350, particularly on the fuselage segment, will generate margin and contribute equally.

So we've got the issue with the pension income that's naturally going to come out this year and next year and forever.

So there are some pluses and minuses, but with all of that, like Tom said, once we stabilize and once we execute to our recovery plan, you should start seeing margins that are consistent with sort of annual numbers that we've done in the past.

But you're going to be steadily raising rate this year and next year as well, so does that consider...

I agree.

That is a tailwind.

Okay.

And then just a quick one.

You only delivered 9, 777s in the quarter.

I thought you were delivering at 5 a month, even though Boeing is delivering at 3.5.

So is there any delays there?

Or why was the number so low?

No.

I mean it's really effectively 3.5 is what the delivery rate is right now, as they are going through the transition from the 777-300ER to the 777X.

So we're -- everything is right on schedule.

It's just that the deliveries right now are lower.

So that's -- as Sanjay said in his remarks, that's been a headwind for the year.

That will pick up in out years as that program picks up and the 777X gets into the market.

But Tom, I had thought that you were still going to deliver at 5, even though Boeing was delivering at 3.5.

George, that's not the case.

If there's been some communication around that, that's not true.

I mean, like Tom said, the total deliveries -- granted, we do, do a few more deliveries associated with the EDP units, these are the engineering units, but even if you add that, the rates are significantly down.

And we're not doing 5 a month.

But we are perfectly in line with Boeing on the 777 deliveries.

Yes, yes, yes.

Completely in line.

Our next question comes from Robert Stallard from Vertical Research.

Just a couple of quick ones from me.

First of all, Sanjay, on the cash flow statement, there's a reversal of a forward loss provision of $36.9 million.

I was wondering if you could explain what that is.

1

So Robert, there's been a whole bunch of changes, as you know, as part of the 606 because there were certain things that were in our deferred that made it into contract assets and contract liabilities.

Let me suggest to you, we are actually hoping to accelerate the filing of our Q and get it out this week.

You should see a lot of detail around that -- just to put your mind at ease, there's nothing new in there other than a reclassification from inventory.

So you'll get that when you read the Q, and you'll be able to see the details then.

And was that previously anticipated in your guidance for the year?

Yes.

Okay.

And then the second quick one.

On Asco, the cost synergies you've laid out, what sort of time frame do you think it will take to achieve the synergies?

We will achieve them over the course of the next year or so.

So we anticipate certainly 2020 we'll have full year run rate on them, but we'll capture them over the course of the first year.

So if we close by September, a year will be kind of up to run rate by the fourth quarter of 2019.

Our next question comes from Ken Herbert from Canaccord.

Just two quick clarifications really.

First on Asco, what percentage of the business or the mix is build-to-print?

That's something I don't have right at the tip of my tongue.

They do a lot of design-to-build.

They have the engineering capability to do that.

I'd say probably most of their work is build-to-print.

I don't have the exact percentage.

We'll get that for you, Ken, and we'll follow up.

That's helpful.

And then just, you made a comment, Tom or Sanjay, in your prepared remarks about some inventory build or buffer stock around the A350.

Is that a material amount?

Or are we just talking about a few shipsets?

Or is that -- I mean, can you just quantify that as part of the working capital build this year?

Yes, it's just a few shipsets.

The idea is that we don't want to be hand to mouth.

And I mentioned that the weather disruption in North Carolina threw us off kilter.

We had to get back on air shipments, which is expensive.

So what we want to do is have 4, 5 shipsets that are in buffer on the water, at the dock, so that if we do get weather disruption, we can absorb it without having to resort back to air shipments.

But it won't be material in terms of inventory.

Thank you all.

That concludes our earnings call for today.

Thank you for participating.

Ladies and gentlemen, that does conclude today's presentation.

We do thank you for joining.

You may now disconnect your lines.