Charlie Martin
Paradise Divide Capital
Charlie@Paradisedividecapital.com
27 November 2021
TransDigm
Introduction:
TransDigm Inc, TD Group, or TransDigm is a large, diversified designer, producer, and supplier of aircraft components. Their products are used in both commercial and military settings. TransDigm generates revenue two ways: with their original equipment manufacturing (OEM) segment and their aftermarket segment. They are able to do this because the average lifespan of an aircraft is 25-30 years, but the lifespan of their products is 50 years. As I will explore later, their aftermarket segment has significantly higher gross margins than the OEM segment, and subsequently generates the majority of their EBITDA.
As per TransDigm’s 10-K, they have 3 main categories of products that they sell: Power & Control, Airframe, and Non-aviation. The Power & Control category consists of products that “provide power to or control power of the aircraft utilizing electronic, fluid, power and mechanical motion control technologies.” The Airframe category includes products that “are used in non-power airframe applications utilizing airframe and cabin structure technologies.” Finally, the Non-aviation category is composed of products that are not used in the structure or build of the aircraft, but are aviation related. This includes headsets, seatbelts, fuel valves, and refueling systems.
TransDigm’s products typically are not large, expensive aircraft parts, but rather are small, but integral products for aircrafts. Their products rarely run over $100,000 and almost never over $1,000,000, and later I will show how this is a benefit to TransDigm.
Throughout this write up, I will lay out the bull/bear case for TransDigm, and I will evaluate the relative importance of each to TransDigm’s equity (NYSE: TDG). Instead of cash flow yield as our valuation metric, I will use EV/EBITDA. The idea behind that is that because of TransDigm’s M&A, their capital structure, and TransDigm’s management’s guidance enterprise value is more valuable than market capitalization because of the debt that TransDigm incurs and has incurred in M&A, and EBITDA is more accurate than cash flow because of TransDigm’s >100% reinvestment rate, mainly for M&A purposes, and the amortization and refinancing of their debt.
Pricing Power
I believe that TransDigm’s pricing power in their products serves as their greatest asset going forward. Of the 4.8 billion dollars of TTM revenue that TransDigm did, 3.84 billion of that was from products in which they are the sole source provider of that revenue. Because of this, they are able to not operate in a competitive market which drives down prices and margins, rather they have complete control over the price of their products and have the autonomy to increase prices and margins over time.
This is possible because of the type of products that TransDigm sells; mostly small, essential, but overlooked airplane parts. In commercial markets, which is over 92% of their revenue, Boeing and Airbus are the two main producers of aircrafts. The most popular Boeing aircrafts currently in use are the 737 and the 777, and they cost, on average across different variations, 114.7 million and 376.28, respectively. The most popular Airbus models are the A320 and the A330, which cost 101 million and 238 million, respectively. With costs for planes being so expensive, the cost for small parts that TransDigm produces are often overlooked. Most airlines aren’t willing to negotiate the price of a $700 airplane part if the total cost of the aircraft is in the hundreds of millions. This serves to the benefit of TransDigm because this means they can charge high prices for their products, and over time, they can increase their prices and their margins.
TransDigm is “able to get away” with high prices for their goods because of the quality and reliability of their products. In an aircraft that costs >$100 million, the airline or the manufacturer would rather purchase a <$10,000 product that is reliable and that they can trust for a higher price than an unproven competitor that might be less expensive.
TransDigm’s EBITDA margins are extraordinarily high as a result of their pricing power. In the TTM, TransDigm had an EBITDA margin of 42.28%. That is lower than the EBITDA multiple that they had in 2019 of 46%. This decline is almost 100% correlated to the decrease in air travel and purchases of airplanes due to COVID-19.
TransDigm’s M&A
The second most important thing to TransDigm’s business is their strategic M&A. Since the inception of TransDigm, Nicholas Howley, former CEO and now Executive Chairman, has spearheaded their M&A. Over the past 7 years TransDigm has mostly focused on horizontal M&A. They will typically purchase a company for ~3x EV/Revenue or ~12 EV/EBITDA. Upon purchasing that company, they will send their management to smooth out the operations of the business, increase the margins, and ultimately lower the implied EBITDA acquisition multiple. If this model sounds eerily similar to KKR, Apollo, or Carlyle leveraged buyouts, that is on purpose. Nicholas Howley has set out to run a company that operates like a private equity fund.
TransDigm uses a high amount of operating leverage to finance their M&A, just like a private equity firm might do. As of the end of 3Q 2021, TransDigm has a net debt to EBITDA ratio of 7.6x. To finance this amount of leverage on their balance sheet, TransDigm uses LIBOR loans at a 2.25% interest rate in Tranche E, F, and G. TransDigm has also issued mostly long-term debt, with the earliest maturity date being in 2024, and they have notes with maturities through 2027. For TransDigm, as the maturity date on their debt comes closer, they will tend to buy out the rest of the debt. As far as a capital allocation goes, TransDigm chooses not to pay down their debt, considering that they could get much higher returns in M&A than in paying down debt. With interest rates at all time lows, both the LIBOR rate and US corporate debt, there is no reason to allocate their capital to paying down their debt.
Since inception, TransDigm has acquired 64 businesses, and 49 of those have been since their IPO in 2005. Their largest acquisition came in 2019 with the acquisition of Esterline. The total value of this deal was $3.9 billion plus the repayment of Esterline’s debt. Like their other M&A, Esterline was acquired by TransDigm for an implied EV/EBITDA multiple of 12.3x and an implied EV/Revenue multiple of 2.0x. Through TransDigm’s acquisition of Esterline, they were able to further integrate horizontally in the aerospace and aircraft field, and they were able to ensure that they would be the sole source provider for many of the products that Esterline produced. Once acquiring Esterline, TransDigm realized that two business segments of Esterline--Souriau-Sunbank and Esterline Interface Technology--didn’t deliver a high enough EBITDA to justify holding, so they sold them off. They sold Souriau-Sunbank and Esterline Interface Technology for $920 million and $190 million, respectively.
I think that this example provides the perfect example of the effectiveness of TransDigm’s M&A strategy: they purchase 12x EV/EBITDA business to horizontally integrate as a sole source provider. Then through their excellent management, they were able to realize that parts of the acquired business were hurting, and they sold them off. Through this process, TransDigm’s management was able to significantly improve the EV/EBITDA multiple of Esterline all the way down to 6.5x EV/EBITDA.
TransDigm also doesn’t do M&A for the sole purpose of doing M&A. Nicholas Howley is a much better capital allocator than that. For example, in 2020 and 2019, TransDigm returned over $3.6 billion to shareholders in the form of special dividends.
TransDigm’s Moat
TransDigm’s moat consists of a mixture of economies of scale, “stickiness” that is baked into the aerospace industry, and intangible assets like their management and patents.
Economies of scale serve to TransDigm’s benefit because of the sheer amount of factories, people, and equipment that TransDigm has. TransDigm owns hundreds of different manufacturing facilities that have specialized people and equipment that produce highly specialized products. For a competitor to produce what TransDigm produces, they would have to incur a ton of upfront capital costs that TransDigm doesn’t have to deal with because they already own all of the factories. TransDigm also has upwards of 14,000 people working for them, most of them in the manufacturing process, which serves as a high human capital barrier that any competitor would have to compete with.
The next form of a “moat” that TransDigm has is the stickiness of the aerospace industry. The aerospace industry is characterized by long-term contracts. These contracts could be >30 years, and the implicit trust that these companies have between each other is even more sticky than the contact itself. When the airline or the aircraft manufacturer purchases a component from TransDigm, a contract that TransDigm would service that part is common. This gives TransDigm recurring revenue for the entire lifespan of the aircraft part. If such a contract doesn’t exist, a different servicer for the aircraft part does not have a specialized knowledge of that part, while TransDigm has that specialized knowledge and service ability of the aircraft part. Also, if the aircraft company has a long-standing relationship with TransDigm, and trusts its aircraft parts, it would take a lot for that airline or manufacturer to switch to a new company.
The final type of moat that I will talk about is the intangible moat that TransDigm has with their parents and their management. Most of the parts that TransDigm produces are under a patent, and because of this, their part is sometimes the only possible part that would work in the aircraft. This makes it impossible for them not to be the sole source provider of this part. The next intangible moat that TransDigm has is their rockstar management team. The management team is now headed by Nicholas Howley as Executive Chairman and Kvein Stein as CEO. Michael Lisman is a genius CFO for TransDigm, Jorge Valladeres a great COO and Bernt Iversen is a Nicholas Howley protegee heading the M&A for TransDigm. The decision-making skills of TransDigm’s management would make it very hard for a competitor to take market share from TransDigm.
Aftermarket Gross Margins and EBITDA
As I mentioned in the introduction, TransDigm serves not only as an OEM, but also sells their parts in the aftermarket. This allows for high gross margins for them, and it subsequently accounts for 90% of TransDigm’s EBITDA, while only being 49% of TransDigm’s revenue. TransDigm is able to sell their parts in the aftermarket with gross margins >70%.
There is not much else to say on this other than this is one of the most compelling facets of TransDigm’s business model, as they are able to sell their products after use and in the aftermarket.
Valuation and WACC:
Before diving into the DCF and the WACC calculations, I’ll start with some cursory valuation metrics and return metrics. As of market close on November 26, 2021, TransDigm trades at an EV/EBITDA multiple of 18.26x and an EV/Revenue multiple of 8.64x. I will refrain from street comps because TransDigm is so unique with the fact that they operate in a near monopoly and their aftermarket segment of their business. TransDigm is able to return ~9.9% of capital on a per annum basis and they have a 5.9% return on assets, also on a per annum basis. TransDigm regularly amoritzies their debt, given that interest rates have moved considerably lower since when the loans were originated. TransDigm’s EBITDA-CapEx/Interest Expense is 1.84x.
Given TransDigm’s cost of debt, equity, and the discount rate, they have a WACC of 9.1% and an implied share price of $740 given the projected 10 year growth of cash flows. This gives them a margin of safety of 32% to their intrinsic value. The DCF is far from perfect with TransDigm because they are so unique in their reinvestment of capital. Cash flows for TransDigm are significantly lower than their EBITDA as a result. Adjustments were made in the discounted cash flow to try to compensate for this difference, but it is still a very imperfect method of valuing this company.
Management Compensation and Incentive Alignment
One of the most important indicators that a business will be successful is the incentive alignment of the management team. This becomes more important when the founding team no longer is a part of the business. TransDigm has been able to do this effectively, as they have set a multi-faceted stock-based compensation program that not only rewards their management for strong stock performance, but also for fundamental metrics.
The stock-based incentives that management receives are entirely based on the performance of TransDigm based on their Annual Operating Performance (AOP) growth. The main metrics that TransDigm uses to access the AOP is growth of EBITDA, the post-acquisition EBITDA generation of acquired companies, and a strong capital structure.
TransDigm’s management has set a high bar for their performance in order for their options to vest: 10% AOP growth. Because of this, management is strongly incentivized to grow and also manage their existing business. I believe that this plan aligns management with the desires of shareholders and stakeholders of TransDigm.
TransDigm also makes the compensation structure to be mostly stock options, rather than cash. Their cash-based compensation is ~30% of what competitors pay in cash. I believe that this also increases alignment between management and shareholders because if their compensation is tied to the stock price, they are more incentivized to increase the stock price than if it was not tied to the stock price.
Future Execution Metrics Key for TransDigm
For TransDigm, there are a couple key things that need to happen for my bullish sentiment to be realized. This includes EBITDA growth, continuing smart acquisitions, being the sole source provider, good capital allocation and management, and retaining and creating new patents on their parts.
I would like to see at least >14% EBITDA growth on an annual basis. I would exclude periods when COVID-19 has seriously impacted TransDigm’s business. I think that with strong execution this number will be much higher; management's goal is 15-18% EBITDA growth, and I think that this is definitely attainable.
Secondly, I think that TransDigm should continue to make strategic horizontal acquisitions, and if one doesn’t present itself, they should not overpay or do a deal that doesn’t make sense for them. I don’t think that there should be a specific amount of acquisitions that TransDigm should do on a yearly basis--mostly because of cyclicality and inflating multiples could lead to a poor capital allocation decision. But, I would like to see >3% inorganic revenue growth due to acquisitions on a yearly basis.
For TransDigm’s business model to be in full effect, it needs to continue to be the sole source provider of many of its parts and services. Right now, TransDigm is the sole source provider of >80% of its revenue, and I would like to see the number stay the same or where it is. TransDigm’s model of increasing prices and margins only works if they are operating in monopolistic conditions. This includes the creation and retention of patents. If TransDigm can continue to make it so their patented product is the only product that would work on the aircraft, then TransDigm’s business model is working.
Finally, I think that this is implicit, but management needs to continue to hit their goals. TransDigm would be nothing without a smart and rational management team. This includes meeting or exceeding both the internal and external goals that management sets for their performance.
Downside Risk for TransDigm
The only downside risk, other than not meeting the things that I set out above, is government regulation of M&A and monopolies. If the government steps into M&A, that would significantly impact TransDigm’s “growth through acquisitions” strategy. In my view, this is not likely for a couple of reasons. One, TransDigm has a history of dealing with the DOJ, and they know how to settle a case or fight a case. Second, the FTC and the DOJ are not focused on a small to mid-sized aircraft parts manufacturer when it comes to antitrust and regulation of M&A, rather they are focused on big technology companies. If the government declares TransDigm a monopoly, that presents serious downside risk. Unlike big technology companies, TransDigm’s business is not better if they are fractured. Where shareholders of Amazon would probably derive more value from AWS being broken off from Amazon, TransDigm’s “private equity” model is only successful when their subsidiaries are under TransDigm’s umbrella. TransDigm gets much of its value when they smooth out the operations of an acquired company, thus lowering the implied EBITDA multiple at purchase. This point is talked about adobe in more depth.
As a shareholder in TransDigm, this is something that I and other shareholders are forced to reconcile with. While I assess the probability of a “break-up” of TransDigm as low, it is definitely something that any investor would have to keep in mind when investing in TransDigm.
Conclusion
This was a very fun and interesting company to dive deeper into. Full disclosure: I am long TransDigm’s equity, which is probably evident after reading this piece. This was not a solicitation to purchase shares in TransDigm, rather it was intended to be purely educational and informational. Whether this was your first time reading one of my write-ups or you have read every single one, I appreciate it greatly. Feel free to reach out to me with any questions you have. My email address is at the top of this piece, but you could also use cimartin01@bvsd.org to get in touch with me. Once again, thanks so much for reading!
I had never heard of TransDigm before. What other companies compete with them? It sounds like almost none! Great analysis. Thanks for the time and effort you put into this Substack.