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Morningstar | SPR Updated Forecasts and Estimates from 31 Oct 2018

Spirit Aerosystems has addressed its production challenges on the 737 and its third-quarter earnings managed to beat estimates. We’re maintaining our $88 fair value estimate, noting that we include the acquisition of Asco in our model starting in 2019. At a price/fair value of 0.97 no-moat Spirit looks fairly valued, offering investors equitylike returns.

Revenue rose to $1.8 billion up 3.7% versus 2017 thanks to higher 737 deliveries in the fuselage and propulsion segments (160 shipsets this year versus 137 last year). Defense activities helped drive growth as well due to the ongoing CH-53K ramp-up, and we also think initial work may be getting under way on the classified B-21 bomber. Segment operating margins contracted 30 basis points to 14.9% this quarter, but a legal settlement caused operating margins including corporate and overhead costs to expand 70 basis points. Third-quarter adjusted EPS, which excludes 11 cents of Asco transaction costs, rose 44 cents to $1.70 due to nonoperating items. Adjusted free cash flow fell to $130 million from $240 million last year due to higher cash tax and the new 787 contract; Spirit made a risk-sharing payment to Boeing and faced a step-down in 787 pricing.

Spirit confirmed its 2018 guidance, which excludes any impact from the Asco deal. For the fourth quarter, management anticipates less-expedited freight charges, lower overtime, and settlement of supplier claims. However, we note that Boeing is making its own claims against Spirit for the 737 delays. Looking ahead to 2019, management believes it can reach what it views as normalized segment operating margins of 16.5%--achieved in 2016 after controlling for charges--during the first half of 2019. We note this target excludes Asco, which is facing regulatory scrutiny from the EU Commission. However, we think Spirit is more likely than not to close the deal and that the challenges faced aren't competition-related but rather center around the post-close  structure.

Operationally, we think rate 57 per month on 737 and a step up to 14 aircrafts per month on the 787 from 12 represent the most significant challenges for 2019. Unlike the rate break to 52 737s per month, which didn’t go smoothly, Spirit is trying to get ahead of this production increase by ensuring suppliers are prepared, sourcing to different suppliers, bringing some work in-house, hiring more aggressively in advance, and restructuring its final assembly lines. Specifically, Spirit is moving to three lines from two lines and building in surge capacity. We think Spirit is now in good shape to keep pace with Boeing’s targeted production rates for the 737 in 2019.