Spirit AeroSystems: Progress, But Orders Still Inadequate (NYSE:SPR)

While there are certainly aerospace supplier stocks that have returned to, or surpassed, their pre-pandemic levels, Spirit AeroSystems (NYSE:SPR) is most definitely not among them, as the shares have given back a lot of the rally that they, and other suppliers like Hexcel (HXL), Howmet (HWM), and Safran (OTCPK:SAFRY), enjoyed from late 2020 to around mid-2021. Management here has been implementing a range of improvements, but they haven’t really taken full force yet, and the company continues to be undermined by a weak ramp in 737 MAX production at Boeing (BA).

I do believe that the company’s efforts to diversify further into defense and aftermarket sales will pay off, as well as efforts to broaden/diversify the customer base and incorporate more automation and digitalization in the manufacturing and logistics processes. I also believe that the shares are meaningfully undervalued based upon the long-term benefits of those improvements and the eventual production increases at Boeing. The trick, as it were, is that investors are going to have to be patient for a while longer and there are still downside risks to that production normalization thesis.

Waiting For Boeing To Bounce Back

Spirit management has actively worked to diversify the business beyond its former heavy reliance on Boeing (once around 85% of sales), including the acquisitions of certain Bombardier operations and Applied Aerodynamics. Revenue from Airbus (OTCPK:EADSY) has roughly doubled in just a few years, while defense and aftermarket have grown to about a quarter of the business.

Even so, Boeing remains a key customer, contributing around half of the company’s revenue, and the 737 MAX remains a key program. Unfortunately, due to a range of issues (some outside of the company’s control), Boeing has not been able to meet production and delivery targets – while Boeing started the year intending to ship 500 737 MAX planes, the company recently reduced its 2022 delivery forecast again to 375 (from a more recent target of 400), and even that target may prove a little ambitious.

A key for the Spirit bull thesis has been the significant margin and cash flow leverage that will unlock when 737 MAX production gets to around 40 planes per month. There have been hopes that that could happen in the second half of 2023, or at least in 2024, but recent trends don’t provide a lot of confidence and a global economic slowdown next year could throw a little more sand in the gears. Suffice it to say, Boeing’s upcoming Analyst Day, where they should discuss production/delivery plans for the 737, 787, and other programs, is well worth watching for those investors interested in Spirit.

Business with Airbus has been better, with the company delivering 180 shipsets to the company the last quarter and the A320 at a run-rate of around 60 units a month. Unfortunately, the content value here is only about one-sixth that of the 737 MAX, so it only helps just so much.

Diversification Can Be A Longer-Term Driver

One of the self-help angles here that I really like is the company’s ongoing efforts to diversify beyond Boeing commercial jets. The company has been working to add more regional/bizjet content, but the bigger push is in defense and aftermarket.

Spirit is already involved in multiple defense projects, including the B-21 Raider, F-35 Lightning II, and CH-53K King Stallion, but management has the ambition of more than doubling the contribution of this business as a percentage of sales (to a long-term target of 40%). I think such diversification would be helpful, as many aerospace suppliers with substantial defense businesses saw those segments at least partially offset weak commercial demand over the last two to three years, and it’s also a logical extension of the business, as the fuselage structures, propulsion systems, and wing systems that Spirit manufacturers for commercial aviation are often broadly applicable to military applications.

Of course, defense businesses have their drawbacks. Project design and award cycles can take a long time and tend to be all-or-nothing affairs. What’s more, they are subject to the whims of budgetary cycles and priorities that can change from administration to administration.

I likewise support the company’s efforts to expand further into aftermarket parts. Aftermarket parts are typically more lucrative for suppliers like Honeywell (HON), and OEMs like Boeing will often negotiate steep discounts for first-fit systems on the reasoning that those suppliers will later enjoy years (if not decades) of lucrative maintenance and replacement sales. This is already somewhat evident in Spirit’s results, as the adjusted margin for the Aftermarket segment was 14.7% in the last quarter, versus 2.2% in Commercial and 12.3% in defense.

The Outlook

The recovery in air travel has flattened a bit here of late, and traffic is still not back to pre-pandemic norms. With that, about 16% of the global fleet is parked, including close to 20% of the North American fleet, about 15% of the Latin American fleet, and 12% of the Chinese fleet. Looking at engine thrust data (which tells you something about aircraft usage), narrowbody thrust was still down about 16% versus 2019 levels in the third quarter of 2022, versus down 20% in Q2’22 and down 26% in Q1’22. I do have some concerns that a weaker global economic environment in 2023 could slow the recovery further, but I still regard a recovery in air travel to pre-pandemic norms as a “when, not if” event, and I’ve been expecting this for 2024 for some time now.

As I said, I like Spirit’s self-help efforts to diversify beyond Boeing in commercial aerospace, as well as diversify into markets like defense and aftermarket. On top of that, the company has been restructuring its operations, adding more automation and digitalization to improve efficiency and boost long-term margins. As Boeing production ramps, and as Spirit wins other projects, I believe these efforts will show in new peak margins several years down the line.

I expect revenue to accelerate significantly in 2023 and 2024, with the company regaining its former peak revenue level (on a trailing 12M run-rate) around mid-2025. I expect around 3% to 4% long-term annualized revenue growth from that prior peak, or low double-digit revenue growth from the starting point of 2021.

I’m expecting EBITDA margin to ramp to the mid-teens over the next four years, with a double-digit margin possible next year (if not for the full year, at least in the second half). Clearly a lot depends on Boeing’s production plans for 2023. I think double-digit FCF margins are possible in four or five years, but I’m reluctant to model that as a new normal, as that would be atypical for the industry. I do believe long-term FCF margins in the mid-single-digits (on a weighted average basis) is possible, though.

The Bottom Line

Discounted cash flow suggests a long-term annualized total return in the low double-digits from here, and that’s fairly attractive. I also value the shares on an EV/EBITDA basis where the multiple is driven by the company’s margins and returns (ROIC, et al); an 8.5x multiple based on my expected 2024 numbers applied to my ’24 EBITDA estimate discounted back two years gives me a fair value today of around $37.

There are still significant risks to this story, including weaker air travel demand (and correspondingly weaker aircraft demand) and the fact that the company can do little to influence core demand (it’s reliant on Boeing and Airbus executing on their plans). That said, I think the reward for the risk is enough to make this a name worth consideration.