The Business - An Overview
Transdigm is an aerospace company. But as a holding company for 34 different aerospace businesses, it’s actually a composite -- this, as we discuss later, is a critical ingredient of its strength as a business. All of these businesses under the Transdigm umbrella essentially do the same thing: supply various parts on commercial, private, and military airplanes and helicopters. Most of the companies have substantial sales in the aftermarket to replace worn-out airplane parts; they excel at doing so in no small part because they almost always own their own intellectual property and are sole source providers.
Transdigm initially supplies plane makers such as Boeing or Airbus with parts that go directly onto new planes. Then, as the parts wear out and need replacement over time, the customer changes from airplane manufacturer to airplane owner, and Transdigm sells aftermarket parts to the airlines. With 25-30 year production cycles for any certain platform (a Boeing 777, for example) and also 25-30 year useful lives for the planes themselves, Transdigm has a long product life cycle of 50-60 years; this makes customers sticky and revenues stable.
Aerospace manufacturing is a very regulated industry -- every single part on an airplane must be approved for safety by the FAA. The need for FAA approval, as well as the complexities of assembling an airplane, mean that in many cases an airplane manufacturer will choose one supplier for any given part. If that part is susceptible to wear and needs replacing, the same company generally also sells it in the aftermarket, as it is the only one with FAA approval on that specific part for that specific airplane.
The Competitive Lifecycle - Winning a Position on a Plane
The key for Transdigm, or any other supplier, is to initially win a spot on supplying parts for an airplane: if you win that business, you can supply that part for its whole 50-60 year life cycle and usher in decades of revenue and profits. Obviously, this is a lucrative position, inviting competition; however, in the aerospace industry, and especially with the products that Transdigm tends to sell, in most cases the current supplier wins a spot on the next generation platform. Let’s take a look at why that’s the case.
For any aerospace product, whether it is a cabin seat or a jet engine, there are to begin with usually only a few select suppliers. One might specialize in supplying a part for a Boeing 737 MAX while another might supply that same part for the Airbus A320neo. When, say, Boeing is starting to think about building an updated version of one of its aircraft platforms, it has these few suppliers to choose from. However, it more often than not chooses the current supplier -- since that supplier already has done the engineering work, likely received FAA certification on a similar aircraft and not to mention has a business history with the manufacturer. For many parts, if the previous supplier has effectively met the manufacturer’s needs with good service, engineering support, and on-time deliveries, then that supplier will win the contract for the next aircraft.
All of that being said, the market for some parts are more competitive than others. For example, the market for engines -- which Transdigm companies do not make -- is extremely competitive. Let’s take a quick look at the engine market as a contrast to the markets typical for Transdigm’s parts.
There are three large suppliers for jet engines: CFM International (a joint venture between GE and Safran), Pratt & Whitney, and Rolls-Royce. These companies make enormous revenues, with Pratt & Whitney making $14 billion in 2015, as an example. Additionally, the engine’s performance is absolutely critical to the total cost equation of operating an airplane: fuel is the greatest share of an airline’s expense, so small improvements in engine capabilities bring in material fuel savings over time, which are critical for airlines to operate efficiently. Each of these companies needs to continuously innovate and improve its offerings, as airplane manufacturers have large incentives to choose the best and cheapest engine. A great plane with an inferior engine is just an expensive plane for an airline operating it and therefore is unacceptable for an airline, and therefore Boeing or Airbus. Each company spends billions on R&D in the attempt to out-innovate each other and win lucrative, long-term supply contracts.
Now contrast jet engines with one of Transdigm’s business units. With ~$3 billion in revenues company-wide and 34 business units, the typical Transdigm business has just under $100 million in annual revenues -- or less than 1% of Pratt & Whitney’s. For a specific example, we can use Schneller, one of their subsidiaries that manufactures laminates. While it is essential for safety to have well engineered and fire resistant laminates, they are not as critical to the overall cost equation or performance as the engines, and companies like laminate manufacturers are the type that Transdigm tends to focus on -- niche providers with very strong market positions. In the engine market, executing well for a customer can still sometimes not be enough to win a position on the next plane if your competitor out-innovates you. But in the more niche product lines that Transdigm operates in it is the incumbent supplier that tends to win. The only times that manufacturers switch suppliers -- be it away from Transdigm products or to Transdigm products -- are if there are serious underperformance issues in on-time delivery or product quality.
Management at Transdigm has a very good track record in engineering, support, and performance metrics. Niche markets can sometimes hide bad managers because it can be easier to retain business even with mediocre performance. However, when you pair excellent managers with niche markets, as they do at Transdigm, you tend to get extraordinary results.
The Competitive Cycle - Selling Into The Aftermarket
In the aftermarket for airplane parts it is getting onto the airplane that is the difficult part. If you own a business with high aftermarket sales, which Transdigm tends to do, you can sell the same parts when they inevitably wear out to the airlines. Since you were the supplier that manufactured that part in the first place, many times you are the only one that can provide it in the aftermarket, which leads to incredibly high margins and profitability along with a steady cash flow stream.
The value proposition for competing suppliers is even more bleak in the aftermarket than it is when you’re trying to win a position on a new plane -- 90% of Transdigm parts have aftermarket revenue of less than $2 million per year. Since the biggest 15 airlines make up about half of the total flying, that means that the customers that spend most on a typical part only spend around $65,000 per year ($2 million divided by 15 airlines times half of the flying airlines). If they thought that the prices were too high and they could save 10% by going with another supplier, they would need to find another supplier, have them re-do the engineering, obtain FAA registration, and ramp up production. All of this effort to save $6,500. It’s just very obviously is not worth the cost and effort to switch suppliers in such cases.
We have identified Transdigm’s business as micro-economically attractive; the next step is to make a broad estimate of how quickly their addressable market might grow.
Transdigm’s business can be broken up most broadly into its commercial and military segments. We will start by looking at the commercial sector. Transdigm’s commercial volumes generally correlate with the amount of aggregate miles that passengers fly per year – if total commercial flying doubles, world airlines will need about 2x the number of planes, meaning in turn that they will need 2x the number of Transdigm parts. This relationship could break down if airplanes were generally getting bigger, but they are remaining stable. In fact, over time, airlines are tending to use smaller, narrow body planes because they are more fuel efficient and save on unit costs; if anything, a stable increase in commercial passengers leads to a proportionally greater increase in the demand for airplanes and, in turn, airplane parts.
So the first thing we’ll do to estimate the market growth rate is to take a look at aggregate commercial flying per year, or RPMs. Here is a long-term chart:
As you can see, the market has grown a solid 5% year-in and year-out, with only a three minor dips in the last 45 years – the recession in the early 1990’s, 9/11 in 2001, and the great recession in 2009. It should further be noted that these dips were pretty minor – many industries can see volumes dip by 50%, not 5%, in down years. While past market growth obviously does not ensure future market growth, most projections generally call for similar growth in the many years to come as flying not only continues to trend up in developed countries but also explodes upwards in developing countries as incomes rise and consumers can afford to fly in far greater numbers. Coming back to the question of how quickly the market might grow, we’ll use an estimate of 4-5% over time.
On the military side, these markets haven’t grown as smoothly as commercial travel, and those growth rates tend to depend much more on governmental budgetary fluctuations. While military spending has grown in the past, it is not obvious to me that it will continue to grow at high rates into the future, and in fact could go down; so we’ll use a volume growth rate of 0%, erring on the side of conservatism because of the uncertainty.
Last, along with volumes, let’s look at prices. The price of aftermarket parts has increased above the rate of inflation by a couple of percent for about the past 40 years. While price increases above inflation cannot continue in perpetuity in any industry, even if they can occur for another few decades that could give an enormous boost to Transdigm and other aftermarket suppliers. Informed opinions on whether prices will increase or decrease differ and I claim no special insights on this matter. Given this fact, and as our goal is to make a relatively conservative guess about the company’s growth rate, I’ll just assume a range of 0-2% pricing growth over inflation.
Putting it all together – 4-5% commercial volume growth, 0% military growth, and pricing growth at 2-4% (assuming 2% inflation) – we can work out an approximate revenue growth rate. When we factor in the proportion of Transdigm’s business with each sector (67% of their business is commercial and 33% military), we would get an estimated growth rate of around 5-7%, or 3-5% after taking inflation into account. While those kinds of growth rates might make a growth investor yawn, 5-7% growth over long periods of time is well above the rate for most companies and can lead to tremendous returns if managed correctly.
Management & Operations
The next area of importance is critical – we know that the microeconomics of the business are enticing and that the markets are generally growing, but how well is the company executing? Here are three important questions that I look at:
1. Is the company generally pleasing customers and winning positions on new airplanes?
Yes – the last year is actually an opportune time to examine this question, as aerospace markets have been a little bit soft and some companies are reporting revenue and volume declines -- so it has been a tough time in the market generally and thus good company performance cannot be explained away by easy market conditions. Sure enough, throughout this period, and for many years before that, the company has rarely lost positions on planes and has posted good revenue growth.
2. Is the cost structure bloated or lean?
Transdigm is the leanest company in the industry, with EBITDA margins approaching 50% -- well above peers. The company has a decentralized organizational structure, much like Berkshire Hathaway. It has a very small number of employees at headquarters and gives large autonomy to its operating units, which are run by their respective CEOs. The only layer in between is a group of five executives who oversee groups of 6-8 companies each. Costs are slim at headquarters, and that cost discipline in turn trickles down into each business line, which all have lean staffing and low levels of overhead.
3. How is the culture throughout the organization?
At the analyst day, I talked with a few of the CEOs who run the individual business lines, and they all said that they love working for Transdigm. They stressed that this satisfaction was in large part due to the fact that if they run their businesses well, then they almost never hear from headquarters, giving them a large amount of autonomy in decision making. They are also paid well if they perform well -- a structure that extends throughout the businesses, ensuring a performance based culture where business units are incentivized to work hard and do well.
The company has a strong record of not only running the businesses efficiently, but also investing enough in personnel to continue winning business and increasing revenues. After checking not only with management but also the people on the ground, they too said they think that the company is well run, and that they are given autonomy and happy to work there.
Management – Capital Allocation
The company has a tremendous business and runs it well, but what does it do with the excess profits? This is where the company really sets itself apart from its competition: they largely focus on using cash flow to acquire businesses (although sometimes they will pay out dividends if they don’t perceive any good opportunities). Transdigm not only likes to acquire companies but also, simply put, has been one of the best -- if not the best -- acquirers in recent years. Their track record, when you look at both revenue and EBITDA, speaks for itself:
Revenue and EBITDA have grown at whopping rates of 20.1% and 24.5% per year, respectively, for 23 years. That record of intrinsic value growth is almost unprecedented in recent US business history -- in fact, it happens to tie Berkshire Hathaway’s performance over its first 23 years.
Let’s take a look at a typical Transdigm acquisition to get a better sense of their sound investment strategy – in 2015 they bought Breeze-Eastern Corporation, which had trailing twelve months revenue of $86 million and EBITDA of $10.8 million, for a total purchase price of $206 million. Now, some companies excel in acquisitions by buying companies when they are undervalued – think, again, of Berkshire Hathaway, for example. Transdigm takes a different tack: they often pay a premium -- in this case they paid 20x EBITDA, which is very high (Transdigm usually trades around 15x EV/EBITDA, and most companies trade much lower than that, so a 20x multiple seems very high). But their trick is that they have proven that they can often run these businesses at 50% EBITDA margins; the premium they pay is thus actually a great deal for them when you consider the operational improvements they can make to greatly improve margins. If they can do that at Breeze-Eastern, that drops the effective purchase price to only 4.8x EBITDA, as they will be earning ~ $43 million, or 50% margins on $86 million in revenue. With the whole company trading at ~15x EBITDA, they can effectively triple the value of their $200 million investment. In short, the acquisition overvalued for normal market players is still undervalued for Transdigm.
Transdigm has done 15 of these transactions since 2010, and they have had tremendous results with all of them. The only few times where they didn’t hit their financial targets like they wanted to were a couple of business jet deals done right before the financial collapse in 2008, which led to much lower than projected sales.
Cash Flow Profile and Capital Structure
As we talked about previously, matching the capital structure to a business’s cash flow profile is critically important: too much leverage can lead to inevitable bankruptcies, while not enough leverage or undisciplined balance sheet management can drastically affect long-term returns.
So let’s take a look at Transdigm’s revenues and margins over time:
As you can see, the company operates an extremely stable business, with revenues, EBITDA, and free cash flow all increasing every year for a decade. That is something that you generally don’t see in any industry, and is a result of the company’s sound execution and large aftermarket presence, which is generally much less sensitive to economic cycles -- if a part wears out, you need to replace it or you can’t fly. You can also see that EBITDA margins remained remarkably steady, as did free cash flow conversion. Even during one of the worst economic climates of the past 100 years (2008-9), the company was able to increase revenue and profit, and even pay a large special dividend during the depths of the market downturn.
With cash flows that are so steady, it makes sense to operate the company with some debt, as you will be able to service your interest payments even in poor economic climates. Some might still consider the company to be very highly leveraged, as it debt usually sits around 5-6x EBITDA (many companies operate at roughly 2x and any more than that is often considered risky). However, 2009 provided a good test case on whether Transdigm was over-levered, and the company was able to pay out a large dividend during that time, showing their financial strength. That should give investors confidence that the debt isn’t a problem; it is an indicator of their broader advantage.
Comparisons to other leading companies
When looking at a company, I like to try to draw comparisons to other companies as a further check to see if I can glean anything from the contrast. Does the company have certain traits in common with companies that have been wildly successful? What about with companies that have failed? When you do this with Transdigm, you can see how the core tenets of their business -- focusing on the aftermarket, having a niche focus but also strong monopolistic power, and all of this executed with well-incentivized decentralized operations -- are often the same ones that are the main drivers of success for other leading companies. Let’s take a look at a few:
1. Aftermarket focus
Let’s compare the airplane market to a similar one, the automotive aftermarket. In the automotive space, AutoZone and O’Reilly have been two of the best performing companies in the world over the last twenty years; this despite the fact that they operate in retail, which is traditionally fiercely competitive. One factor that has enabled them to succeed: they sell aftermarket parts. If you’re selling, say, water pumps, you generally want to be selling replacement water pumps instead of original ones to (say) Toyota – there is much less price competition and profits can be much higher.
2. Niche products focus
Core Labs is a small oil field services company that has been one of the best performers in any industry since the 1990s. In fact, before the recent oil price bust, they had outperformed Apple since their IPO; no small feat. Their secret is that they operate in many niche businesses in the energy industry with small overall dollar amounts but enormous profit margins and returns on capital. They have developed the expertise in those fields, and it doesn’t make sense for, say, a Schlumberger to go after it because it would take a lot of effort for a small and uncertain reward. Even in their few business lines where they do compete directly, they have high market share. The dollar amounts are inconsequential in relation to the total project, and so producers generally choose whatever product performs best, not which one is absolutely cheapest. But those small dollar amounts add up to enormous revenues for Core Labs.
3. Decentralized operational structure
Warren Buffett might be famous for his stock picking, but these days his excellence mainly lies in identifying good businesses with outstanding managers, and then giving them almost complete autonomy to operate. This strategy has produced impressive results, with many fully owned companies executing far better than their rivals. A good example is Clayton homes, a Berkshire Hathaway subsidiary, which has overcome a structural decline in the manufactured home market along with the mortgage meltdown to post impressive financial results.
4. A combination of near-monopoly microeconomics, a growing market, excellent operations, and acquisitiveness ...
Near monopoly businesses are rare, underlying markets that have a long runway for growth are rare, excellent operators are rare, and companies that make smart acquisition are rare. But all of these factors sometimes line up, and history tells you that those are the ones you should own – two prominent examples are TCI and Capital Cities. Both of those companies shared a lot of the underlying characteristics of Transdigm, and each was a top performer until they were bought out, making their shareholders enormous sums of money.
Generally, if a company executes well and has one trait in common with a wildly successful business, then that means good things. Transdigm has a few things going for it that could each, in isolation, lead it towards success. Charlie Munger calls these situations, where you have lots of things pointing you to the same conclusion, lollapaloozas -- where the different factors are additive towards each other and can create truly outstanding long-term results.
Putting It All Together
We’ve taken a look at the microeconomics of the business, the growth rate of the company’s markets, its operational efficiency, its capital structure, and its capital allocation decisions. As you can see, this is an excellent company, but even excellent companies can make poor investments if their prices are too high.
Let’s take a quick look at a valuation to see if shares are generally on the cheap or expensive side. My method will be to first value the company using all conservative assumptions, then we’ll value it again with different inputs to try to come up with a plausible valuation range.
The first step in any valuation is to find current owner’s earnings: how much income would the investment produce if you bought the whole company tomorrow. Going back to the table of revenue, EBITDA, and free cash flow, we can see some definite patterns. First off, the EBITDA margin tends to stay in the high 40% range. Second, free cash flow conversion averages something like 45% of EBITDA. To support this, management mentioned at their most recent analyst meeting that EBITDA margins on their existing businesses are currently running right around 50% and could even go a little bit higher. EBITDA margins for the whole company are a little bit lower than that because of lower EBITDA margins from very recent acquisitions. We’ll use a run-rate of 49% EBITDA margins. Next, we’ll look a little more critically at free cash flow conversion, as not verifying the numbers can lead to valuation mistakes.
Here are numbers and estimates for free cash flow conversion for this year:
As you can see, those numbers get you to about a 45% FCF margin. If you compare those numbers to earnings they will be higher, with a lot of the difference coming from some non-cash amortization charges due to acquisitions. Those aren’t “real” costs, and you can confirm that in their financials by seeing that capex, on average, replaces the depreciation charge, and that over time the company hasn’t needed to invest extra to cover the acquisition related amortization charges.
So with all of that information, we can see that EBITDA should be about 49% of revenue with owner’s earnings at 45% of EBITDA, so if we know the last 12 months’ worth of revenue, we can estimate owner’s earnings. Taking into account all of its recent acquisitions, the company has ~$3.4 billion in pro forma revenue. Multiplying by the aforementioned ratios, we get to about $750 million in earnings.
The last step is to assign a multiple. I generally compute fair value as the price that would get you to about a 10% return over time. A shortcut is that the current yield + the growth rate needs to equal 10%. So with a conservative growth rate of 5% taken from a previous section, we would need shares to yield 5%, or a multiple of 20x owner’s earnings. That gets us to a value of around $15 billion, or $269 / share.
Very importantly, that valuation assigns no value to the company’s ability to take on new debt as earnings increase or to make accretive acquisitions. Allowing for accretive acquisitions and an increased debt load would dramatically increase the valuation. And if we allowed for business performance to be a little bit better - remember that we used the conservative side of the growth estimate - the valuation would increase even more.
When the business is perceived to grow so quickly that it stretches normal valuation frameworks and earnings multiples, I like to make a quick discounted cash flow model to help me think about value a little bit better.
Here’s a DCF model with the following assumptions
- Current EBITDA - $29.8 / share, assuming $3.4 billion in pro-forma revenues and normal margins
- EBITDA growth rate - 6%, using the middle of the estimated range
- Debt / EBITDA ratio - 6x, in line with historical numbers
- Dividend / buyback payout ratio - 100%, i.e. no acquisitions
- Discount rate - 10%
- Terminal multiple - 15x EV / EBITDA or 20x owner’s earnings at 6x debt / EBITDA
That value gets you to about 19x EV/EBITDA, or about 30x earnings. While those are both high multiples, 30x earnings is not that high for a well run company in a growth industry, say Visa or O’Reilly Automotive as good comparables. I wouldn’t necessarily pay that price myself, but it’s not that crazy.
Last, we’ll look at what discount rate the current price of ~$290 “prices in” with the previous assumptions. If the company produces the amount of earnings, growth rate, and terminal multiple in the above example, investors would make ~14% returns by buying the stock at around $290. And again, we have assumed that the company makes no accretive acquisitions, so the actual returns could be somewhat higher -- remember that the business has historically grown at closer to 25% than 14%, so 14% is certainly in the realm of possibility.
Transdigm has almost everything an investor could want: near monopoly positions in its markets, growing revenues, steady earnings, and excellent management. Shares don’t look too expensive, and that’s without the effects of the numerous accretive acquisitions that the company will most likely make over time.
Disclosure: My clients and I are long TDG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am a registered investment adviser. However, this commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.