- 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.
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).
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.
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.
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.
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.
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.