RYAOF - Spirit AeroSystems Stock Could Surge - But Major Issues Remain

2023-10-18 13:47:50 ET

Summary

• Spirit AeroSystems Holdings, Inc., a critical supplier in the aerospace industry, is facing ongoing quality issues that are affecting its major customer, Boeing.
• These problems have led to a dip in Spirit AeroSystems' stock performance and financial strain.
• If the company can effectively address its operational issues and streamline its supply chains, it may see significant growth and potentially double in value over the next four to five years.

Introduction

Before the pandemic, the aerospace segment was one of the best places to be. Interest rates were low, supporting procurement of ultra-high ticker items (airplanes), global geopolitical tensions were somewhat subdued, China's domestic aerospace industry was insignificant, and we had no pandemic (this one is obvious).

The period between 1985 and 2019 was the strongest for commercial aerospace. Annual growth was 3.7%, exceeding the GDP growth of most developed nations. The biggest difference between comparable periods shown in the graph below is the rapid growth in the years after the Great Financial Crisis. Especially the emerging Chinese middle class fueled global air traffic.

If we assume that these numbers hold, we could see more than 25,000 billion revenue passenger kilometers by 2025, more than twice what we saw before the pandemic hit in 2020.

In general, I prefer to invest in suppliers of OEMs like Boeing ( BA ) and Airbus ( EADSF ). Suppliers often have better pricing power, less competition risk, and more innovative power.

Over the past ten years, suppliers of smaller parts like TransDigm Group ( TDG ) and HEICO Corporation ( HEI ) have outperformed Boeing by a mile. Spirit AeroSystems Holdings, Inc. ( SPR ) , the star of this article, has underperformed BA by a mile, losing a third of its value over the past ten years! SPR shares are now trading at their 2020 lows...

In this article, I'll dive into SPR to assess the risk/reward. After all, I have 27% aerospace & defense exposure.

Finding out how suppliers are doing is important, even if it's a stock that is very unlikely to ever be a holding of my portfolio.

So, let's get to it!

A Critical Supplier

Buying toilet paper, printing paper, and pens for an office is a low-risk procurement job. After all, there are countless suppliers who can deliver these goods.

Spirit isn't such a supplier.

Headquartered in Wichita, Kansas, Spirit is a leading global manufacturer of aerostructures specializing in aluminum and advanced composite solutions.

The company's core products include fuselages, wings, nacelles, and various structural components for commercial airplanes, military platforms, and business/regional jets. They also provide aftermarket services for maintenance, repair, overhaul, and engineering solutions.

Spirit AeroSystems operates in three principal segments: Commercial, Defense & Space, and Aftermarket.

Because it's one of the select players in the world capable of building complex fuselages and related products, it has a major footprint in the industry.

The company's largest customers are Boeing and Airbus, representing a substantial portion of its revenues, especially in the Commercial segment.

In 2022, approximately 65% and 27% of Commercial segment net revenues came from contracts with Boeing and Airbus, respectively.

Here's a list of some of the programs it supplies:

• Airbus A220
• Airbus A320
• Airbus A350 XWB
• Airbus A380
• Boeing 737
• Boeing 747-8
• Boeing 767
• Boeing 777, 777X
• Boeing 787.

Hence, it makes sense that the stock price of Spirit is highly correlated to the stock price of Boeing. If Boeing is doing well, Spirit is doing well.

However, we also see that SPR has started to underperform. Its stock price is back at the 2020 lows - this time without a pandemic.

This is because SPR has issues that make it less attractive than other suppliers.

SPR's Issues

Ryanair ( RYAAY ) is one of Boeing's best customers, as the low-price airline exclusively uses 737 airplanes.

Now, it's getting annoyed by the ongoing problems it keeps encountering with Boeing.

As reported by Bloomberg (emphasis added):

Boeing advised the Irish discount specialist at a meeting this week that it will only be able to deliver 14 of the 27 aircraft due by late December , Ryanair Chief Executive Officer Michael O’Leary said in an interview Wednesday in London. The setback is the result of quality lapses at Spirit AeroSystems Holdings Inc. , which builds the jet’s frame, he said.

[...] The timing of deliveries of the remaining 43 aircraft scheduled to arrive by next April is “in the lap of the gods”, O’Leary said Wednesday. Boeing aims to push back some of the handovers into the peak summer period next year, while Ryanair wants the planes sooner. The disruption is particularly vexing for Ryanair as it needs all the capacity it can get to benefit from the post-pandemic travel boom, the CEO said.

[...] Spirit AeroSystems recently discovered a drilling irregularity in the aft pressure bulkheads that helps maintain cabin pressure, affecting some Max 7, 8 and -8200 models — the high-density version ordered by Ryanair. The inspections are more complicated than for a separate issue found earlier this year, requiring X-ray probes of hundreds of holes per plane, Brian West, Boeing’s chief financial officer, said this month.

On September 7, during the Jefferies Industrials Conference, the company gave its own take on these issues.

Spirit acknowledged quality issues but assured they were actively working on resolving them. The company highlighted its Quality Management System, which continuously identifies and rectifies quality issues.

And for us, it looks like we have about 39 units to replace -- to inspect and repair. We've already inspected through X-ray 15 of those.

What we have to do is about 1,000 holes in the aft pressure bulk head, 500 of them are machine-enabled, so it could be suspect. So we X-ray all of those, and then we look to see on the X-ray could they be suspect. And if they are, what we do is drill out the fastener, inspect the hole.

If there's no issue with the hole and often there isn't, we just put in the same size fastener. If there is an oblong hole, what we do is we oversize it, drill it out again, so it's a little bit bigger and then put in a larger fastener.

So we expect to be done with the repairs of the units in our factory by the end of November. Now for Boeing, it may take a little bit longer because they have, in many cases, completed aircraft.

The 250, there's maybe 65% or 70% of those that could require inspection and repair. But for us, what they've agreed is we had 29 in WIP. We are going to complete the production on those 29.

We set up essentially a separate factory across the street where we're going to have 8 repair lines and we'll do X-ray on 2 of those and then repair on 6. And so we will be able to flush through our 39 relatively quickly, and then we'll deliver those to Boeing. -SPR.

As the quote above shows, repairs are expected to be completed by the end of November.

If the company is able to put these issues behind it, it could be looking at a much brighter future.

At this point, 85% of the company's backlog consists of narrow-body programs like the 737 and A320 programs.

In order to deal with high demand, SPR expects to maintain a production rate of 42 aircraft per month in 2024, which aligns with Boeing's production rates.

As a result, SPR is expected to be free cash flow breakeven in the second half of 2024, which would eliminate a lot of worries.

These worries not only include problems related to the 737 but also supplier problems leading to material shortages.

Spirit AeroSystems has faced additional costs due to supply chain disruptions, and they've had to cover approximately $200 million in charges related to supply chain challenges in the last 18 months.

It also incurred forward losses from the 787 program, totaling $1.4 billion, and issues in Airbus' A350 program.

The 787 this year, we're saying we're at 40 to 45 total deliveries. We're right now at about 5 aircraft per month. At one time, that was at 14 aircraft per month before the pandemic. And Boeing has said they want to get back to 10 per month, possibly higher, but at least 10 per month toward the end of next year. We're working with Boeing on how we achieve that. But again, that program is another one that's been under pressure. It's a composite program, and we worked very hard with it. - SPR.

While demand is pretty good, the company hasn't gotten a handle on the learning curve, meaning it is dealing with higher costs than initially expected.

It's actually losing money on finished orders in some areas.

That's one of the reasons why higher revenue is not resulting in higher free cash flow.

During its Q2 2023 earnings call , the company mentioned that it is mitigating these issues through supplier support, early employee hiring, and other measures.

Where's The Value?

Prior to the pandemic, Spirit was trading at roughly 8x EBITDA.

The difference is that before the pandemic, SPR generated more than $1 billion in annual EBITDA.

2025 is the first year EBITDA is expected to come close to that, as the company is expected to generate $910 million in 2025E EBITDA.

It is also expected to generate more than $200 million in 2025E free cash flow ("FCF"), which would translate to a 12% FCF yield and potentially result in a net debt peak at roughly $1.5 billion (2.2x 2024E EBITDA).

Using this FCF and EBITDA growth trajectory, the company could return 120% through 2025 if it is indeed able to become profitable on key programs again.

The current consensus price target is $26, which is 50% above the current price. No analyst has given the stock a target as high as my $38 target.

I get that, and I have to say that this isn't an article to push anyone into SPR.

SPR obviously has issues. It isn't as profitable as it should be. It has problems that annoy its customers, and it isn't expected to generate serious free cash flow until 2025.

While the company also isn't at risk of bankruptcy, investors need to be careful.

A recovering production rate and smoother supply chains could come with tremendous gains. However, I prefer to invest in aerospace companies that have more consistent growth and less dependence on major programs.

It also needs to be said that despite its expected recovery, SPR is expected to see subdued margins, even in 2025.

With all of this in mind, I do believe that SPR has the potential to double.

However, it could take at least four to five years, and it requires the company to make serious improvements in in its operations.

Only buy SPR if you're looking for a high-risk turnaround play. I prefer to stick to more proven suppliers in other areas of the supply chain.

Takeaway

While Spirit AeroSystems presents potential for significant growth, it comes with inherent risks and challenges.

The company, a critical supplier in the aerospace industry, faces ongoing quality issues affecting its major customer, Boeing.

These problems have led to a dip in stock performance and financial strain.

However, if SPR can effectively address its operational issues and streamline its supply chains, it may see significant growth, potentially doubling in value over the next four to five years.

Investors considering SPR should weigh the risk-reward scenario carefully, recognizing the need for the company to demonstrate improved operational efficiency and overcome current challenges for sustained growth.

Investing in proven suppliers with more consistent growth might be a safer bet than Spirit AeroSystems Holdings, Inc. within the aerospace sector.

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