Transdigm TDG
December 07, 2006 - 1:16pm EST by
spike945
2006 2007
Price: 25.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,275 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Compounder
  • Aerospace Parts
  • Rollup

Description

Transdigm is not the sexiest investment case that you’ll ever come across. It has a controlling shareholder, who has not indicated when (if ever) they will sell, and the stock is not that liquid as a result.  It is highly levered, and yet is tied to a cyclical industry.  It’s a rollup whose returns on capital don’t appear to be outstanding, and management is not very communicative.  Valuation on current earnings is not that compelling. There’s no immediate catalyst.  So what’s the point? 
 
I submit that if you dig under the surface of Transdigm you will find that it has a marvelous niche, much higher returns on capital than it would appear at first blush, and a demonstrated ability to deploy capital at high rates of return.  I believe that it is not nearly so cyclical as many other firms in its industry due to its differentiated model.  This business should compound value steadily for the holder for many years. For those willing to pay a reasonable price (14x 2007 FCF) for a great business, TDG is a stock to buy on any dips and hold for the long term.
 
The company IPO’d earlier this year and after an initial rise to $25, has bounced from $22-$26. It is still majority owned by Warburg Pincus.
 
Business description: (excerpted from the 10-K):
Transdigm is a leading global designer, producer and supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft in service today.
 
Our business is well diversified due to the broad range of products that we offer to our customers. Some of our more significant product offerings, substantially all of which are ultimately provided to end-users in the aerospace industry, include:
(1) ignition systems and components such as igniters, exciters and spark plugs used to start and spark turbine and reciprocating aircraft engines;
(2) gear pumps used primarily in lubrication and fuel applications;
(3) mechanical/electro-mechanical actuators and controls used in numerous actuation applications;
(4) NiCad batteries/chargers used to provide starting and back-up power;
(5) power conditioning devices used to modify and control electrical power;
(6) rods and locking devices used primarily to hold open cowlings to allow access to engines for maintenance;
(7) engineered connectors used in fuel, pneumatic and hydraulic applications;
(8) engineered latching and locking devices used in various bin, security and other applications;
(9) lavatory hardware and components;
(10) specialized AC/DC electric motors and components used in various defense and commercial applications; and
(11) specialized valving used in fuel, hydraulic and pneumatic applications.
 
Each of these product offerings consists of many individual products that are typically customized to meet the needs of a particular aircraft platform or customer.
 
We estimate that over 90% of our net sales for fiscal year 2006 were generated by proprietary products for which we own the design. These products are generally approved and certified by airframe manufacturers (who often certify only one manufacturer’s component design for a specific application on an aircraft), government agencies and/or the FAA and similar entities or agencies. In addition, for fiscal year 2006, we estimate that we generated approximately 75% of our net sales from products for which we are the sole source provider.
 
Most of our products generate significant aftermarket revenue. Once our parts are designed into and sold as original equipment on an aircraft, we generate net sales from recurring aftermarket consumption over the life of that aircraft. This installed base and our sole source provider position generate a long-term stream of aftermarket revenues over the estimated 30-year life of an individual aircraft. We estimate that approximately 60% of our net sales in fiscal year 2006 were generated from aftermarket sales, the vast majority of which come from the commercial and military aftermarkets. These aftermarket revenues have historically produced a higher gross margin and been more stable than sales to OEMs.
 
End markets are commercial aerospace (72%) military aerospace (24%) and other (4%) applications.
 
The company’s website and 10-K go into more detail on the business.  The key takeaways are that the company is widely diversified into a lot of relatively unglamorous, low-dollar items which are nonetheless for the most part safety-critical, proprietary and non-commodity.  These items are mostly FAA certified (providing a barrier to entry) and in many cases safety-critical (we could probably exclude the lavatory fittings from this classification), and for 75% of the sales they are the sole source provider.  They also have a huge bias to the aftermarket, which is highly profitable and not that cyclical. 
 
Transdigm is essentially a collection of small manufacturers who have the same profile (proprietary content, aftermarket focus), have established themselves in these niches, have a history of design wins across all major platforms for their products, and whose niches are generally too small to be of significant interest to major aerospace players. The company has an excellent record of finding, buying and rolling up these smaller manufacturers, improving profitability, applying sales targets and return requirements and steadily growing both sales and margins.  Adjusted EBITDA has historically been over 40% of sales, and marginal return on investment measured as (EBITDA-Capex)/capital invested has been over 40% as well.
 
Why are high margins sustainable – what are the barriers to entry?
  • Requirement for FAA certification on most parts.  This is a time consuming (and relatively expensive) process (about 6 months to a year according to TDG).  In addition, the part must log flight hours.  Small manufacturers often cannot afford to spend the money required to achieve this certification to become a second source supplier. 
  • Difficult to dislodge an existing sole-source provider. You have to undercut TDG significantly on price in order to make it worth the while of an end user to certify the part for use.  There are patents to be worked around. There is a significant investment of engineering, design, prototyping, testing (and the certification) that has to be recouped, now on thinner margins.  On the aftermarket parts, TDG has already recovered this investment and the return on the marginal part is very high for them.  You likely can’t win on price.
  • Difficult for smaller competitors to win bids for new OEM parts.  On new OEM bids, there is the barrier of the sales cycle.  For a new airframe, it often takes 3-7 years from winning the bid to recover the costs invested.  For smaller firms focused on one or two products (often with structurally lower profit margins than TDG), that kind of payback period can be a big strain.
  • In addition, for certain parts or assemblies, using non-OEM parts can void the terms of an aircraft lease, may void insurance terms, and can expose the airline to significantly higher litigation risks if there is an accident.
  • Reputation.  Price is not the sole concern.  TDG (and its subsidiaries) has a reputation for delivering quality parts on time and customer support.  Their brands are known. For many airlines and OEMs, its not worth trying to save a few dollars on a valve (even if you could) if you can’t trust the supplier to deliver the right product on time, and be sure that it works.  It simply costs too much to have a plane grounded.  One of the ways that TDG has been able to get price increases is to shorten the lead times for parts dramatically, improving turnaround and lowering customer needs for working capital. 
  • Introducing lean manufacturing processes helps them to do this without losing control of their own working capital.
  • While second sourcing qualification does occur, given the hurdles above, it is harder to justify for low-dollar items such as those that TDG focuses on. 
 
How cyclical is the business?
60% of sales and a larger proportion of EBITDA comes from aftermarket sales.  This is driven largely by total revenue passenger miles flown (RPMs).  Given that TDG is on every airframe, and has increased its BOM on the newer airframes like the 787 and A380, the firm is relatively agnostic on what planes are flying, just that they fly and that RPMs increase.  The introduction of new airframes etc. doesn’t really hurt TDG.
 
The Bureau of Transportation Statistics gives the government’s statistics for international revenue passenger miles. http://www.bts.dot.gov/xml/air_traffic/src/datadisp.xml  I downloaded the data for January 1996-August 2006. It includes the period after 9/11 when RPMs fell and took three full years to recover.  Even including that, the growth over the entire period is over 3%, using rolling 12-month data.  Since January 2002 growth has annualized at over 5%, and since January 2004, I get over 10% growth.  The trough in RPM on my chart was September 2002, a fall of 14% from September 2001.  Transdigm’s business shrank $13mm, excluding acquisitions during this period, on a sales base of $200mm.  There was $10mm of new business, and if you further exclude that, sales fell $23mm, or 11.5%. Pricing and new business help to make up the delta.  While recession, terror attacks and other factors could reduce revenues in future, over time it is reasonable to expect RPMs to grow about 3-5%.  Add on a couple of percent for new business and something for pricing, and organic revenue growth should 8%.
 
How does Transdigm add value to the acquired business?
Essentially TDG corporate controls capital allocation, but allows the separate divisions to operate with a high degree of autonomy.  The company focuses on its three core value drivers (from the 10-K):
 
(1) pricing each of its products to fairly reflect the unique value provided by that product;
(2) obtaining profitable new business by proactively working with customers to apply its technical capabilities to solve specific customer problems; and
(3) striving to continually improve productivity.
 
Historically, execution of these value drivers has enabled TransDigm to consistently deliver solid financial performance even in difficult economic environments. 
 
Essentially TDG focuses on implementing lean manufacturing, focusing on turnaround time and (critically) pricing for the value that creates.  They drive the sales process aggressively. Many of the smaller jobshops that they acquire may not be pricing efficiently.  Some may not have focused on new business wins, being content to milk the existing business for cash rather than invest for the future, or they may not have been able to afford the investment (as discussed above).  TDG management actively drives this process – looking for new niches, new customers, increased BOM, and measuring management on new sales and their profitability.  To some degree, there may be some ability for TDG to open doors to new customers, but management emphasizes that this is not usually the case.  TDG will also review operations and invest capital for new equipment, systems and automation where necessary – capex that may have been avoided or deferred.  In some cases they will relocate operations within an existing facility if it will reduce overall costs. 
 
Management of each of the businesses are incentivized based on specific goals and metrics including sales growth and ROIC.  There is also an options pool based on overall corporate performance.
 
BY THE NUMBERS
 
Margins and returns on capital.
Transdigm’s 10-Ks break out revenues into organic and acquired (Ks available as far back as 1999).  There is data to 1995, but there’s only so much space and I’m sure the formatting will get screwed up anyway.  The company also gives “EBITDA, as defined” which adjusts for various one-time and non-recurring charges that have occurred over the years.  These include merger expenses, integration costs, non-cash and deferred comp costs, purchase accounting adjustments and various kitchen sinks et al.  No doubt views about what is and is not recurring will vary, but I use this as a reasonable starting point for evaluating management as capital allocators. (Note the company’s fiscal year ends September 30th).
 
 
1998
1999
2000
2001
2002
2003
2004
2005
2006
Total
Revenue
110.9
130.8
150.5
200.8
248.8
293.3
300.7
374.3
435.2
 
Adj EBITDA
43.5
50.6
54.0
72.3
97.5
124.4
139.1
164.2
194.4
 
EBITDA Margin
39%
39%
36%
36%
39%
42%
46%
44%
45%
 
Acqs
0.8
(41.6)
(0.8)
(169.1)
-
(52.0)
(21.5)
(63.2)
(24.0)
(371.4)
Capex
(5.1)
(3.0)
(4.4)
(4.5)
(3.8)
(5.2)
(5.4)
(8.0)
(8.4)
(47.7)
 
 
 
 
 
 
 
 
 
 
 
Acquired Rev
19.5
14.9
20.8
34.3
60.6
10.6
12.8
40.0
20.9
234.4
Organic Rev
91.4
116.0
129.7
166.5
188.2
282.7
287.9
334.3
414.3
 
Organic Growth
17.0%
4.6%
-0.9%
10.6%
-6.3%
13.6%
-1.8%
11.2%
10.7%
173%
 
 
 
 
 
 
 
 
 
 
 
Cabin security Rev
 
 
 
 
10.6
24.1
(28.8)
 
 
 
Adjusted Organic
91.4
116.0
129.7
166.5
177.6
258.6
316.7
334.3
414.3
 
Adj Organic Growth
17.0%
4.6%
-0.9%
10.6%
-11.5%
3.9%
8.0%
11.2%
10.7%
164%
 
 
 
 
 
 
 
 
 
 
 
RPMs
2.9%
3.9%
8.1%
-0.3%
-14.0%
2.7%
14.3%
10.4%
3.8%
133%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Change in EBITDA
19.0
7.0
3.4
18.2
25.2
26.9
14.7
25.2
30.2
169.9
Acquisition costs
-
-
1.3
-
1.5
1.2
1.2
1.4
1.0
7.6
Change in Inv. Capital
4.3
44.6
6.4
173.6
5.4
58.4
28.1
72.5
33.4
426.6
EBITDA/Inv. Capital
443%
16%
54%
11%
471%
46%
52%
35%
91%
39.8%
 
CAGRs 1998 – 2006
Organic Revenue                                  6.3%
Organic Revenue ex-cabin security        5.6%
RPMs                                                  3.2%
 
So it looks like they are decent capital allocators, the business is not very capital intensive, and they have achieved organic growth ahead of RPMs.  Yet the overall ROIC does not appear to be that impressive. Measured as (EBITDA-Capex) / (Book Equity plus Debt) the result is just under 16%:
 
$MM                           2006                2005
Equity                           363.0               333.1
Debt                             925.0               890.0
Cash                             61.2                 104.2
Invested Capital            1,226.8            1,118.7
Average Invested Capital = $1.172B
(EBITDA -Capex) FY06 = $186
Pre-tax ROIC                  = 15.87%
 
Not bad, but not heroic either.  Why is this so far below the incremental returns achieved?  That dates back to July 2003, when Warburg Pincus acquired Transdigm from Odyssey Partners for $1.1 Billion.  The structure of the transaction resulted in $650 million of new goodwill being recorded on the balance sheet.  Other goodwill on the balance sheet refers to acquisitions done by TDG and should be included in ROIC to measure management’s ability to allocate capital, but this one unfairly penalizes them.  Subtracting the $650 million, ROIC looks a lot better – about 35.5%.
 
Are these returns sustainable?
Part of the business is military, and while management is clear about the fact that that business has probably peaked for now, their guidance for 2007 is for business to be flat.  Commercial aerospace is definitely in a sweet spot, but looks likely to continue to grow as the international market for air travel (and thus RPMs) grows apace.  Transdigm claims to have a larger BOM on newer planes than older ones as they bid for more of the business (part of adding value to acquisitions). As the 787 and A380 come on line, Transdigm’s margins on OEM parts and aftermarket for those planes should increase as we roll out of the investment /design /qualification phase and into production and aftermarket.  In addition, management continues to find acquisitions, most recently acquiring CDA Intercorp for $45MM in October.  Management has indicated that it expects to grow revenues in the high single digits organically and increase operating margins. They speak of 3,500 potential acquisition targets (though the real number is lower when commodity products, which they avoid, are culled)
 
                       
Estimates:
For 2007 my numbers are the midpoint of management’s guidance, including the recent acquisition.  In their short public life so far, they have under-promised and over-delivered (raised and beat 2006 #s, gave 2007 guidance in Oct, already raised in Nov.), but we’ll use the midpoint for now. 
 
2008 onwards are my own estimates of 8% organic revenue growth with contribution EBITDA margin same as for the overall.  I think margin expansion overall is likely, and what management expects, but I won’t price that in. 
 
The company does have a cash balance of $60MM, but given the recent $45MM purchase, I zero that out for EV calculations.  FCF is calculated as Net Income, plus D&A, less capex.  Growth WC has been about 25% of sales, but I adjust the year-end cash balance for this amount.  This shows each year’s FCF as it would be in steady state.
I assume that all FCF (after WC charge etc is used 50% for acquisitions and 50% for repayment of debt (assumed 7.5% interest).  Acquisitions are assumed to be done at 2x Revenues (above historical levels) and to contribute at 40% EBITDA margins (in fact it takes a year or two to get there).  I maintain capex at 2% of sales.  I bumped sharecount up to allow for all options (incl. non-exercisable). The result is as follows:
 
 
2006
2007
2008
2009
2010
Revenues
435.2
493.9
555.7
626.6
708.0
Adj. EBITDA
194.2
220.6
247.1
277.5
312.2
D&A
16.1
17.3
17.6
17.8
18.1
Interest
76.7
69.4
66.4
63.4
59.4
Tax at 39%
39.5
52.2
63.6
76.6
91.5
NetIncome
61.4
81.7
99.5
119.7
143.2
FD EPS
1.30
1.63
1.96
2.32
2.73
Capex
8.4
9.9
11.1
12.5
14.2
Est FCF
69.2
89.1
106.0
125.0
147.1
FCF/Sh
1.46
1.78
2.08
2.42
2.81
EV/EBITDA
11.0
9.6
8.4
7.4
6.4
EV/EBITDA-Capex
11.5
10.0
8.8
7.7
6.7
Shares
47.2
50.0
50.8
51.3
51.9
Share Price
25.5
25.5
25.5
25.5
25.5
Mkt Cap
1,205
1,276
1,296
1,309
1,322
Debt
925
885
845
792
730
Acqs
 
45
45
53
63
Cash
61.0
50.4
56.4
57.7
59.4
EV
2,130
2,110
2,085
2,044
1,992
 
Valuation
If we assume that acquired growth ends in 2010, but allow the company to keep paying down debt (4% after tax) and give 4-5% organic revenue growth with no operating leverage, we get a 9% overall FCF growth.  The company could of course also buy back its shares too.  With its reduced leverage I would expect the company to get a 16-20x multiple on FCF.  Discounting back to 2007 at 10% I get:
 
Exit Multiple     2010 value       2007 value       Upside from current
16x                  $45.4               $34.1               34%
18x                  $51.0               $38.4               50%
20x                  $56.7               $42.6               67%
 
Further upside would come from doing more acquisitions, doing share repurchases at the current stock price instead of paying down debt, continuing 8% organic growth beyond 2010, greater operating leverage.
 
In the downside case, you’re paying 14.3x 2007E FCF for the current business.
 
Risks
  • Warburg Pincus overhang. WP owns 30.6 million shares.  That leaves you with an overhang that will eventually be sold down, but my experience with seeing WP in ACGL is that they will hold on until they get fair value.  They also act as a brake on any potential management excess.
  • Illiquid stock.  Largely due to WP, average volume is about $1.5 million.
  • Financial leverage – the company has refinanced its debt and will pay down debt over the next year or two.  We think that the leverage is appropriate given the recurring cashflow streams, and there is 3x EBITDA-Capex interest coverage.
  • Terrorism / war. 9/11 definitely rocked the industry and would most likely hurt RPMs if it happened again.  Upside would be the acquisition opportunities that arise.
  • Rising Fuel Prices / Recession.  Fuel has not reined in RPMs given the global expansion, but it could happen.
  • Bad Acquisition / Competition from Private Equity.  Acquisitions are part of the growth story, and though they mostly do small deals, and recently have not been involved in auctions, you can’t rule out the chance of overpaying. WP presence should help.
  • Aerospace Cycle.  In many ways this is not the risk that is portrayed to be.  TDG will profit more from a fleet of older planes than a fleet of new ones, given the same RPMs.
  • Reduced military spending.

Catalyst

Catalysts:

Further accretive acquisitions
Continued margin improvement
Continuing to increase BOM on new airframe
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