TransDigm (TDG): One of the widest moats I’ve found. When is 30x earnings cheap?

  • Management seeks P/E Returns of 15%-20% annually.
  • Special Dividends of $58.85 have been distributed over the last 2 years representing 26.75% (13.875% annual) yield at the current price of ~$220.
  • Approximately 75% of all sales come from sole source products which have Monopoly-like pricing power due after-market sales.
  • Each product line has an average lifespan of 50 years, 20-30 during an after-market period with tremendous profit margins.

Business Description

TransDigm (NYSE:TDG) is the leading global designer, producer, and supplier of highly-engineered aerospace components for nearly all commercial and military aircraft in service today. Even though TDG services the airline industry they have found a way to carve out a “wide-moat” by selling to niche markets. It is not uncommon for some of their products to be used in only a single aircraft model such that the market size for each individual part is miniscule. This is the foundation of TDG’s incredible competitive advantage.

TransDigm Inc. was formed in 1993 from a LBO and founding P-E firms brought TDG for IPO in 2006. The front-page flap of the 2013 AR management states, “We seek to provide our shareholders with private equity-like returns with the liquidity of a public market.” (Front-page flap 2013 AR). See below for a chart showing the cumulative returns realized by investors since inception (2006 IPO; source: Yahoo Finance) ex-dividends (4 special dividends from 2009-2014 totaling $67.50).

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TDG has a large diverse product line (49 different product lines acquired since 1993; p.28 2014 AR) with an estimated 90% of revenue generated from proprietary products. Additionally, they estimate that ~75% of all sales were generated from products where they are the sole source provider (patent-protected or no competition; p.1 2014 AR). These are the same rates as when TDG first went public in 2006 (acquisitions have never diluted TDG’s profitability). The sole source and proprietary metrics are the best predictor of future after-market sales, which currently amounts to 55% of revenue and is the most predictable and profitable revenue source.

TDG’s strategy is to acquire and optimize proprietary and sole source product lines because they are the greatest beneficiaries of the FAA approval process for part suppliers of commercial or military aircrafts. The process is extremely involved and time consuming; often times resulting in one manufacturer of smaller products (e.g. seat belts or seat cushions) since nearly each part needs to be certified to be included on an aircraft. No one part makes up more than a trivial percentage of the total costs (or even material costs) of an aircraft, providing little competition to the approved product manufacturer over the life of the aircraft model. An aircraft model’s lifespan averages 25-30 years of active production with an after-market span of 20-30 additional years for TDG (thus, the importance of sole source), giving an estimated product life of 50 years.

TDG stands to earn significant profit margins as the sole source producer of after-market products since the cost of replacing the product on the aircraft again represents a trivial amount of the overall maintenance cost (often just a few hundred dollars per unit). Since TDG has such a broad diverse product line, revenue passenger miles (RPMs; in billions) will drive revenue growth as a proxy for overall product demand. As you can see from a recent investor presentation, RPMs have grown at 5%-6% compounded since 1970, roughly doubling every 15 years.

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Airline Value Chain & Drivers of TDG Revenue Growth:

If the reader knows anything about the airline industry they will know that it is notoriously known that airlines have realized negative cumulative profits since Wilbur & Orville Wright’s initial flight. The FAA is not likely to relax their regulations for aircraft anytime soon (if anything, we’ll likely see more strict regulations on aircraft design), thus the reader could see how the “barriers to entry” slide above supports such excellent operating conditions for a portion of the global operating maintenance ($60.7B) portion of the total airline operating expenses ($686B). TDG’s stated plan is to consolidate the operating maintenance market through acquisitions and organic growth of current product lines (most recently acquiring Telair for $725m). With $900m in commercial after-market sales they have just 4% of their currently addressable market of $22.7B. This leaves significant runway for organic growth of current product lines.

Since RPMs are the ultimate driver of TDG’s after-market revenue, you may suspect this revenue source would be extremely choppy given the long history of volatility in aircraft deliveries. Yet this volatility is muted when viewing the total commercial installed base because retirements of aircraft generally follow deliveries, resulting in a small net positive in total active aircrafts for slow steady growth. The total active aircraft base has only experiences 3 short periods during the early 90’s, after 9/11, and during the Great Recession of 08/09. Each resulted in low-to-moderate decline of the overall base. However, past growth seems indicative of future results in this specific case as Boeing (NYSE:BA) currently plans for a 5% compounded growth in passenger and cargo traffic over the next 20 years. The growth in total active aircraft is generally proportional to RPMs.

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Valuation (all figures from 2014 AR):

*(Per share figures)

  • Diluted Shrs Out:~56,993,000
  • Market Cap: $11,529m ($219.83)
  • Total Debt: $8,313m
  • Enterprise Value (EV): $17,929m ($314.58)
  • Total Assets: $6,756m
  • Goodwill & Intangibles: $4,228m
  • Int Assets (Capital): $2,528m ($44.36)
  • EBITDA: $1,073m ($18.81)
  • Income from Ops: $928m ($16.28)
  • FCF: $507m ($8.90)
  • Adj NI (Refi Costs): $397m ($6.97)

*Note: ROE is not a relevant return metric due to the negative shareholder’s equity as a result of special dividends to optimize capital allocation

  • ROIC (Adj NI): 15.7%
  • ROIC (FCF): 20.1%
  • NI/MC: 31.5x
  • FCF/MC: 24.7x
  • EV/EBITDA: 16.7x

Once adjusted for one-time refinancing costs, Net Income Margins have been stable between 18.3% – 19.3% over the past 3 years and peaking in 2014.

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A large source of recent returns has been from special dividends dramatically lowering the cost-basis of TDG ownership for investors which provides some leverage for the stock’s rally over the past year. Special dividends will likely be a significant source of future returns given management’s promises to “maintain efficient capital allocation”. So when is a reasonable time frame for an investor today to see their first dividend? After 1Q15, TDG currently has a Net Debt (LT Debt)/ EBITDA ratio = (7.2B LT Debt – 1B cash) / ($1.1B TTM) = 5.6. Bringing it close to levels of recent acquisitions/dividends (and possibly lower if viewed by interest costs). TDG’s recent Telair acquisition will raise the ratio to 5.9 by increasing LT Debt $650m and PF EBITDA by ~$60m.

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Risks and Conclusion:

Even with the excellent operating conditions (or wide “moat”), TDG faces risks that have the potential to erode this competitive advantage. Inflation seems to present little imminent risk, but it may cause COGs to increase at a greater rate than price increases (estimated to average ~5% annually over the past 20 years). If TDG was unable to keep up with inflation it would likely be seen through a trend of eroding gross margins.

Other risks faced by TDG are declines in RPMs and, less likely, relaxed regulations by the FAA of aircraft part manufacturers. A decline in RPMs has historically only been witnessed temporarily during recessions. Assuming Boeing’s 5% growth prediction over the next 20 years is the midpoint, it seems unlikely that overall RPMs will not at least experience positive growth over the long-run since Boeing is projecting RPMs to be 2.4x higher or 140% total growth. There is likely little risk of a decrease in RPMs over any significant period of time as the airline carriers continue to drive down the price of flying. Since airlines scarcely survive accidents, the FAA’s regulations are meant to support the impeccable safety record the industry has realized (especially within the U.S.). As a result, when the infrequent accidents do occur they tend to create new regulations or foster increased public support for current ones. This trend insulates the operating environment from change, providing excellent protection of TDG’s competitive advantage.

Current valuation metrics are extremely high but there are reasons to believe that excellent long-term returns can be earned in spite of current price multiples (31.5x P/E, 24.7x P/FCF, and 16.7x EV/EBITDA). Realized CAGR for any stock investment is strictly determined by the following formula. Price multiple is just one component of returns and if an investor today sells their TDG stock at a 15x P/E multiple 10 years from now we can calculate the expected CAGR range given management’s expected internal returns of 15% – 20%. Note that it is impossible to realize greater than internal returns unless an investor realizes price multiple expansion over their holding period.

Where CAGR realized is determined by:

PM: Price Multiple Expansion/Contraction; 0 = zero change between purchase and sale

*PM = ((Sale PM – Purchase PM) / Purchase PM)

OR: Compound Operating Earnings Growth over period N years

N: Years stock purchase is held

Expected CAGR over 10 years is 7.3% – 12.0% assuming N = 10, OR = (.15,.20), and PM = -0.5. I believe this represents an extremely conservative outlook (P/E contraction of 50%). I currently do not have a position in TDG but I believe the current $220 share price is on the low-end of the FV range. Long-run P/E multiple has been roughly 25x (outside the Great Recession) which represents an excellent entry price of ~$175 (partially due to FCF out growing NI) and a price I would certainly be a buyer at. TDG’s outstanding “moat” provides a rare situation where 25x P/E is a “cheap” price to pay.

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My Best Investment Opportunity: Eldorado Artesian Springs Water

Summary

  • 10% FCF yield and trading at 6x operating income.
  • High depreciation with little need for re-investment means FCF will outpace NI for >5 years.
  • 95% gross margins for water delivery unit and 75% gross margins overall (vs 50% average for rivals).
  • 25% ROE and 25% ROIC and pricing power supports theory of local competitive advantage.

Business Description

Eldorado Artesian Springs (OTCPK:ELDO) is a small regional water bottler headquartered in Eldorado Springs, CO. They are the manufacturer and distributor of Eldorado Artesian Water and owner/operator of one of the best public pools in the Denver, CO area. However, the real money is in the 5-time award-winning artesian bottled water (and most recently, back-to-back silver medals) through home/business delivery and retail distribution. 97% of their revenue comes from water sales and they generate 75% gross margins, ~25% ROE and 15% ROIC (ROIC on margin revenue or “operating leverage” has been between 25% – 33%).

My thesis is extremely similar to a previous article that featured FICO because of their monopoly-like subsidiary that provides cash for a high growth and larger market size business (minus the buybacks). For FICO, the namesake credit scores unit generates excess profits that fund the market leading big data segment. In ELDO’s case, they have a market leading water delivery unit (~95% gross margins) that produces excess cash to help ELDO expedite their expansion strategy for distribution of their disposable PET bottles. ELDO has recently taken the lead in water delivery in Denver, CO (the only region they compete in) from Deep Rock (owned by DS Services). They have managed to take most of that market share from Deep Rock (NYSE:COT) specifically over the past 10+ years; COT is the largest water delivery company in the nation and 2nd largest in water revenue nationally (behind Nestlé’s brands (OTCPK:NSRGY) and ahead of Aquafina (NYSE:PEP) and Dasani (NYSE:KO)). The water delivery unit accounts for ~60% of total revenue and has 93.5% gross margins.

Risks

I would like to remind readers before too far into the article that ELDO has an extremely small market cap ($7m) and little liquidity ($2,500 $ Vol/day over the past 3 months). This investment does not make sense for most institutional and retail investors. Investors should be prepared to hold any investment for at least 3-5 years, thus they should not invest with any amount of money that may be needed in the short term. Beyond size and liquidity issues, in 2014 one of the 3 co-founders, Kevin Sipple, retired in May. He still serves as Chairman of the Board and it is unknown if he would consider selling his ~25% stake. Yet, if he were to sell, the increased float could certainly help liquidity (float is ~30% or a little over $2m in shares) but it may also represent a large drag on the share price as it represents over a year of volume. After amassing a large stake over the past year, I do believe if Mr. Sipple were to sell his stake it would result in a new benefit in terms of increased liquidity as demand for shares generally seems to outstrip supply. It is up to you as the reader to weigh these risks against the investment thesis below. Readers should understand that even if profitability were to increase, as I will suggest, the market may choose to ignore this indefinitely (although the price multiple would have to continually contract). Finally, the most common risk associated with water bottle sales is the waste factor. Recycling programs are being initiated in numerous states and recycling rates have been increasing. In fact, the total water bottle sales annually represent less thanone day’s worth of the nation’s tap water usage. Ultimately, I think this risk will diminish as recycling programs improve, supported by a recent reversion back to previous industry growth rates.

Business Operations/Financials

ELDO is extremely efficient operationally compared to their competitors which is the main reason their margins are generally 1.5x to 2x their competitors (industry average for gross margins is ~50%). ELDO’s closest competitor in water delivery is Cott and Crystal Rock (NYSEMKT:CRVP). CRVP has $75m in revenue (flat for last 3 years) with 14 bottling facilities for $5.4m/facility and DS Services (COT’s water segment) has 25 facilities and ~$830m in delivery revenues for $33.2m revenue/facility. This compares to ELDO which is able to earn ~$12.2m in water revenue from a single facility (organic growth ranging between 8% – 12% CAGR for last 10 years). The $33.2m revenue/facility represents the potential bull case for ELDO’s delivery unit. ELDO has a unique water source that allows them to sell their water at premium prices. As they expand their retail presence retailers will give them every opportunity to succeed as their premium price represents a higher revenue/sqft for stores. I will discuss the future growth strategy for ELDO in a later section.

Mentioned in the tailwinds section as “undervalued assets”, ELDO has senior water rights to Eldorado Springs and a 20% stake in a Mutual Ditch Company called FRICO. FRICO provided ELDO the flexibility to exercise their grandfathered senior water rights during a state of emergency as FRICO represents a 20% stake in a large water reservoir that can replace a depleted Eldorado Springs as their temporary water source. ELDO is the only water bottler in the state of Colorado that can operate in a state of emergency since laws were passed to reserve these senior rights for agriculture uses only. These water rights are likely worth millions to large water bottlers such as DS Services, Aquafina, and Dasani. These core investments are booked on the balance sheet at just $430k. Another (slightly larger) microcap stock (whose business model is untested at best), Two Rivers Water & Farming (OTCQB:TURV), is buying water rights (not senior) in the same geographical location for millions. This means that true BV is likely much higher than the reported amount and provides a margin of safety in case of a sharp decline in sales.

Competition

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The only other pure water delivery company that is publicly traded (with non-trivial sales) is CRVP, which earns just 45% – 50% gross margins. The difference in margins between ELDO and CRVP [as well as nearly all other competitors] is due to the difference in business model and pricing power, which I argue favors ELDO by a significant margin (private companies such as Fiji and Evian would make for excellent comps because of ELDO’s large market share in their region). For example, CRVP has a capital intensive business model (14 facilities nationally) compared to ELDO’s premium pricing, compact distribution model (supported by just 1 factory). ELDO also sells .5L – 1L and 1gl water bottles to grocery and convenience stores that represents ~37% of revenues (and growing). Unlike with the water delivery unit, selling disposable water bottles (PET) is highly competitive and with limited “shelf space” available, getting significant distribution has proven extremely difficult for nearly all regional bottlers. A similar distribution issue exists for new branded consumer goods products [competing with P&G and Unilever]. Thus, taking distribution from the beverage majors has proven impossible for nearly every small water bottler over the past 25 years. That is, everyone but Eldorado who has signed distribution agreements with every grocer of consequence in Colorado and recently, communities in bordering states. There is a multi-decade trend of 7% – 9% revenue growth for ELDO that has defied the standard fate for similar water bottlers. This seems to support the thesis that ELDO is different than most water bottlers because all of their revenue comes from such a compact region. Their water is offered to just 3% – 5% of the US population (depending on source), but their revenue/capita is higher than Evian and similar to Fiji [main premium water competitors]. Given the below, ELDO has at least 5% market share in Colorado (assuming CO has $250m in revenue (11th largest)) and possibly much higher (an educated guess would be ~8% of all CO water sales). I think the strong demand for their product locally provides more stability for their earnings as opposed to CRVP whose revenue comes from across the country. This is another piece of evidence supporting the idea that there exists a sufficient margin of safety to invest in the upside potential of ELDO.

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Water Delivery Segment

The water delivery unit grew approximately 12% in 2014 with FY14 revenue of $6.6m vs $5.8m in 2013. Gross margins also increased from 90% to 93.5%. Management mentions that potential gross margins for the segment is 95%+ (2014 annual report). These amazing margins are from sales of refillable 5/3gl water bottles meant for both commercial and residential use. ELDO was able to increase the average selling price within this segment by 7.9% and exhibited pricing power alluded to earlier due to the excellent customer service and water quality that was mentioned in the tailwinds section (operating costs decreased per account so the price increase was not due to input costs). With just 16,500 customer accounts and the recent addition of coffee/filter sales, ELDO has potential to increase revenue from an increase in customers, an increase in average revenue per customer, and future pricing power. The major risk for this segment is the shipping limitations given their business model. Management has readily admitted that their coverage is limited to the north so they must acquire new customers in their current coverage area. Also, there is a risk that current delivery competition will pick up market share (though the past decade has seen ELDO move from #2/3 to the clear #1).

PET Segment

The PET segment needs to continue to expand outside of the borders of Colorado. The strategy they’ve taken is to slowly expand distribution contacts with major grocers in the area (Walmart, Kroger, and Safeway). ELDO’s major hurdle will be entry into both the Arizona and Southern California markets (along with lesser neighboring markets in Utah, New Mexico, and Nevada). Safeway and Kroger represent 2 of the Big-3 grocers in Southern California that represent 40% – 50% of the grocery market. Walmart and Trader Joe’s have steadily increased share in these regions meaning ELDO has already secured distribution deals with at least 4 of the 5 major retailers in their expansion areas. A successful 2015 will see ELDO’s non-Colorado revenue become meaningful and end with at least one new agreement for future distribution in either Arizona or California.

Valuation

*NOTE: Below table includes actual revenues/costs as reported by ELDO. I have not been able to confirm with management yet how to reconcile the overlap in segments to the actual total revenue. Consider these numbers to beextremely accurate approximations

Segment Rev FY-2014 GM% FY-2014 Rev FY-2013 GM% FY-2013
Delivery 6,293,983 93.5% 5,665,496 93.4%
Retail 3,969,431 50.9% 3,227,882 48.8%
Rentals 929,297 54.2% 802,140 63.7%
Resort 170,586 54.2% 180,482 63.7%
Gross Profit 8,501,617 74.8% 7,492,194 75.9%
Total Rev 11,363,297 100.0% 9,875,000 100.0%

Relative-Peer Valuation:

  1. EV/EBITDA Valuation based on multiples of a recent acquisition by Cott Corporation of DS Services Group (Deep Rock): $1.25B acquisition at 7.1 adjusted EBITDA/10x unadjusted EBITDA or 16x EV/EBIT (rewards ELDO’s capital-light model)
  2. NOTE: The only adjustment I’ll at least present to readers for consideration is to reduce SG&A by ~$125k for what management described as ‘heavy growth investments’. I choose $125k because it was still influential yet conservative.
  3. ELDO has $4m in LT debt (due approximately equally in 2022 and 2032)

(All numbers in thousands – 000’s)

EBITDA (TTM): $1,634

Adj EBITDA :$1,755

EBIT : $885

10x EBITDA: $16,340 – $4,000 (LT Debt) => $12,340 MC => $2.04/shr

7.1x Adj EBITDA:$12,460 – $4,000 => $8,461 MC => $1.40/shr

16x EBIT: $14,160 – $4,000 => $10,160 MC =>$1.68/shr

Same Valuation Multiples based on FY2015 Earnings Power:

  1. The technique to estimate Operating Leverage should in theory be artificially low due to zero adjustments made by myself for multiple years of ‘heavy’ growth investments (including CRM purchase/installation and current projects)
  2. Conservative estimates of OL margins (margins of each additional $1 of revenue) are Gross Margins – 70.7%, EBITDA – 19.6%, EBIT – 16.2%, and Net Income of 10.4%
  3. NI-based ROIC ranges between 10% and 20%; EBITDA-based ROIC is ~30%, EBIT-based ROIC is ~23%, and ROE has consistently been 25%+ even with over 15% of the current equity covered by excess cash
  4. FY15 Earnings Power estimates assume 12% revenue growth (possibly aggressive) and the above OL margins (which seem conservative due to a lack of adjustments)
  5. LT Debt will decrease to approximately $3,800 by the end of FY2015 (March 31st, 2016)

I calculated the following operating results:

Revenue:$13,853

Gross Profit:$10,306 (74.4%)

EBITDA: $2,048

15E OI: $1,458

15E EBIT:$1,235

15E NI: $791 (~36% tax rate)

To arrive at the following estimated Fair Value that is neither conservative nor aggressive:

10x EBITDA $20,480 $3,800 $16,680 $2.76/shr
16x EBIT $19,760 $3,800 $15,960 $2.64/shr
10x OI $14,580 $14,580 $2.41/shr

ROIC (NI-based):13.2% (adj for excess cash; 11.3% without adj)

ROIC (EBITDA-based):29.3% (no adj for cash)

ROE: 28.3% (assuming all $791 ends up as shareholder equity)

This FV range is based on the acquisition multiples paid for a lower margin, lower return, and higher capital-intensive water company, DS Services. How high can acquisition multiples go for the lowest-cost and most efficient water bottler in the nation?

Thus, the current FV for ELDO is likely within the range of $1.40 – $2.76 with $2.00 a share (nearly mid-point) representing a very conservative estimate. For more optimistic investors, a FV of $2.50 – $2.75 may seem more reasonable (especially considering the tight grouping on earnings power estimates).

Potential Catalysts

Hopefully ELDO will consider either a substantial special dividend (possibly as large as $600k or $0.10/shr representing 10% yield) or a smaller regular dividend of say $0.01 quarterly. ELDO may also consider buying back any stake Mr. Sipple wanted to sell. This would ensure that the remaining co-founders/executives retained majority stake in the company. Mr. Sipple’s stake represents 25% of the company and could end up being an excellent opportunity to unlock value.

Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.