Description

Although TDG was written up on VIC nine months ago, I think the idea is worth revisiting as the share price declined after negative reports from Citron Research. Citron has raised questions surrounding TDG’s pricing strategies and its high debt level (among other things). I believe these two issues are the most important so they will be the focus of this writeup. The other allegations can be discussed in the comments section. In spite of the fact that TDG is a controversial stock with a highly leveraged balance sheet, I want to revisit the idea as I own it and it is one of the few opportunities I currently see. So, at the risk of getting booed off the stage, here goes….

As TDG has been written up previously, I won’t delve into a lot of background. CFL41’s writeup provides a good description of TDG and the industry. The primary issue I want to discuss is pricing, which is the main area of controversy. TDG is a roll up whose subsidiaries sell aerospace components into the defense, commercial OEM, and commercial aftermarket segments. The company claims that it owns the intellectual property for 90% of its products and is the sole source supplier for 75%. Due to its position as a sole source supplier and the legitimate industry barriers to entry, TDG has pricing power. Critics argue that the company has abused this by both hiking prices on legacy products at high rates as well as substantially increasing prices after acquiring products. These pricing actions are controversial because investors question for how long TDG can squeeze its customers. There have also been questions about whether TDG’s pricing actions are covering up organic declines in overall product volumes. Given that TDG is levered 6.8x gross, there is little room for error, especially if overall volume is declining organically. However, as explained below, I don’t believe TDG’s pricing strategies are overly aggressive, especially considering its strong competitive position.

Pricing

The company has said the following regarding pricing and volume:

• Although TDG is secretive (it has never publicly broken out volume vs. price as far as I know) the company has made statements in the past addressing the issue. For example, on the most recent conference call, when asked about the breakdown between volume and price regarding organic revenue, CEO Nick Howley stated, “As I told you, the prices, the weighted-up prices are higher than inflation. We think of inflation as 3%. But it's not miles higher.” Mr. Howley has made similar statements in the past.
• Anecdotally, at the investor day held last June, a friend who was there asked Mr. Howley if aftermarket organic volume growth was in-line with growth in revenue passenger miles (RPM) over the long-term. Mr. Howley responded that it was probably between long-term growth in RPMs and growth in the number of planes in the sky.
•  In the 2016 10-K, the company states on page 27: “The increase in the dollar amount of cost of sales during the fiscal year ended September 30, 2016 was primarily due to increased volume associated with sales from acquisitions and organic sales growth.” This clearly implies that organic volume growth was positive in FY 2016. 10-Ks from previous years use the same language.
• In addition, a couple of days after the initial Citron report, the Jefferies analyst stated that according to her customer survey, TDG customers experienced annual price increases of 3.6% on average.

While this information is worth considering, what do the numbers say?

• If TDG was aggressively raising prices annually, especially if volume was declining, you would expect to see net sales per employee increasing over time. However, this has not been the case. Over the past decade, TDG’s revenue per employee has increased at a CAGR of less than 0.9%. Over the past three years, this figure has increased at a CAGR of 2.6%. On the Q1 2016 conference call, Mr. Howley stated that TDG reduced headcount by 4% to 5% during the quarter due to a potential slowdown in OEM production rates. Accounting for this reduction, net sales per employee increased at a CAGR of 1.4% over the past three years. If TDG was raising prices at alarming rates on an ongoing basis, likely the growth in net sales per employee would be increasing to a greater extent. In addition, given the modest growth in sales per employee, it seems highly unlikely that overall volume is declining organically. TDG is aggressive at managing its cost structure, so if volume was declining, headcount would be reduced, leading to a higher level of sales per employee if combined with aggressive price hikes.  
• On a related note, if TDG was pricing its products at significantly higher prices than competitors, its revenue per employee should be higher. Admittedly there aren’t direct comparables as TDG is a sole source supplier; however, Heico’s Flight Support Group (FSG) is probably the best as it is the largest supplier of aftermarket second-sourced aircraft components and it claims to provide significant savings compared to OEM prices. The comparison is not perfect as FSG focuses on aftermarket engine components and also includes MRO and distribution businesses, yet the comparison is still relevant. Over the past decade, TDG’s net sales per employee has averaged 110% of the level of FSG. However, there has been variability in this number, especially for FSG. For example, from 2011 to 2014, FSG’s net sales per employee was higher than that of TDG. There is give and take that goes into this number including mix, volume, etc., yet, at a high level and over a long period of time, TDG’s net sales per employee has been comparable to that of FSG.
• Similar to net sales per employee, net sales per sq. ft. should shed light on TDG’s pricing policies if they are completely out of whack. However, over the past three years and decade, sales per sq. ft. have increased at CAGRs of 2.9% and 2.6%, respectively. Compared to Heico’s FSG, net sales per sq ft. was identical in 2016. I think this data also invalidates the idea that overall volumes are declining. If volumes were declining sharply, TDG would likely reduce its footprint (not to mention its headcount), which if coupled with aggressive pricing, would lead to sharply higher revenues on a per square foot basis.
• If Mr. Howley’s comment during the analyst day was correct, there should be some correlation between organic revenue growth and growth in RPMs, at least over the longer term as results from year to year can be lumpy. To test this, I examined historical RPM data from the US Bureau of Transportation (https://www.transtats.bts.gov/Data_Elements.aspx?Data=1) regarding RPMs for all domestic US flights as well as foreign flights either originating or landing in the US. Over the past seven years, average annual growth in RPMs was 4.1% compared to 7.4% average annual organic growth in the commercial aftermarket for TDG. The commercial aftermarket is the area where TDG has the greatest pricing power and should have the highest correlation to growth in RPMs. The results over the past three and five years are similar. Assuming volume growth is in-line with or slightly lower than growth in RPMs, this implies annual pricing in excess of 300 basis points, which is in the ball park compared to the previously mentioned comments by Mr. Howley.

Acquisitions

In addition to ongoing pricing, probably the biggest area of controversy is post-acquisition price increases. TDG has historically been an aggressive acquirer, purchasing 43 businesses for over $7.35 billion since its IPO in 2006. Over that time period, revenue has increased organically and via acquisitions from $435 million in 2006 to $3.17 billion in 2016 for a CAGR of 22%. EBITDA and EV have compounded at slightly higher rates. In seeking suitable acquisitions, the company looks for several characteristics including sole source products in commercial or defense aerospace, high aftermarket sales, and individual products with “relatively” low revenues. Ideally TDG finds these characteristics in companies that have bloated cost structures and/or have historically not recognized the pricing power inherent in the product. Once an acquisition is made, the company’s stated operating strategy is focused on three specific drivers: winning new business, productivity and cost improvements, and value-based pricing. TDG’s euphemism of “value-based pricing” means it examines acquisitions on a part-by-part basis to determine the extent to which prices can be raised. This is one reason TDG looks for products with relatively low total revenue, as the lower the revenue the greater extent to which prices can be raised without a significant overall cost increase for the customer, both in absolute terms and relative to an overall maintenance budget. The February 2017 investor presentation points out that 90% of TDG’s total aftermarket commercial revenue comes from individual products with less than $2 million in annual revenue. Understandably, the company hasn’t provided much color around the process of value-based pricing. What little has been discussed is from the company’s analyst days and conference calls.

• For example, in the 2012 analyst day presentation (slide 83), the company provides an example of how it bridges the gap between pre-acquisition and target EBITDA five years out. This example indicates that half of the growth is due to price hikes (both nominal and real), nearly 40% is due to productivity improvements, and the remainder is due to volume growth via winning business on new planes. The company could have pulled these numbers out of thin air, BUT if they are even in the ballpark, then cost cutting/productivity plays a much greater role in the success of TDG’s acquisition program than the company gets credit for. For example, in order to put some numbers to this, if you assume that over the five year period after an acquisition that prices rise by 3% annually, volume is flat, and operating costs decline by a 1% annually, then by year five, EBITDA doubles (assuming a 20% initial EBITDA margin). If you assume this hypothetical acquired company has $20 million in EBITDA on $100 million in revenue, then 3% annual price increases for five years result in $16 million of additional revenue falling to the bottom line and 1% annual cost reductions result in another $4 million to the bottom line in the fifth year. I’m not suggesting that TDG only raises prices by 16% in the five years after an acquisition, rather the point is that because even relatively mild rates of growth combined with absolute reductions in expenses lead to significant increases in profitability, TDG doesn’t have to double or triple prices for things to work out.
• Historically the company has been very aggressive at cutting costs after an acquisition. According to Slide 53 from the 2012 analyst day presentation, after TDG acquired AmSafe, it closed three facilities, reduced headcount, eliminated the corporate staff and was considering additional consolidations at that time.
• More recently, in May of 2015, TDG acquired the aerospace assets of Pexco LLC, which at the time included 300 employees and facilities in Yakima, WA and Huntington Beach, CA. On the Q4 2016 conference call, COO Kevin Stein gave the following update regarding Pexco: “To-date we have been able to close the Huntington Beach manufacturing facility and combine all operations into Yakima. We reduced headcount in Yakima to align with our productivity targets; evaluated value based pricing opportunities and exited non-core production. We believe that this team will continue to perform at expectations and that significant value generation opportunities exist for the future. This business should run at or above the average EBITDA margins of TransDigm.”  Obviously, by taking this much cost out of the business, prices wouldn’t have to increase by a huge amount to realize a significant increase in EBITDA margins.
• On the same call, Mr. Stein also gave an update on the acquisition of Breeze Eastern, which was publicly traded. Mr. Stein stated: “To help our productivity initiatives, we closed the standalone Virginia facility in September and centralized all engineering and product development at the main New Jersey location. This rationalization across the business has allowed a 23% headcount reduction at Breeze-Eastern since acquisition.” Although the VA facility was much smaller than the one in NJ, undoubtedly the facility closure and headcount reduction will result in a significant reduction in operating expenses.

These cost cutting examples raise the question as to how TDG is able to do this. How could all these companies be so poorly managed before they were acquired? Frankly, I don’t know the answer to this but I do have some thoughts. First, as TDG’s subsidiaries are highly decentralized, there aren’t large opportunities for the common synergies touted in most acquisitions. Almost all corporate functions such as HR, supply chain, marketing, etc. are performed at the subsidiary level. However, all of TDG’s subsidiaries are organized on a product line basis. As a result, in the past TDG has been able to completely plug acquisitions into existing subsidiaries which obviously results in tremendous savings. Second, based on its SEC filings and management commentary, the company’s stated strategy has not changed one iota since its 2006 IPO. This focused strategy being repeatedly applied to 43 acquisitions since 2006 (and more since the founding in 1993) has resulted in a very well-oiled machine. The company is simply a very good operator and a ruthless cost cutter. Lastly, some of the acquired companies were likely not managed to maximize profit to the fullest extent. Whether this be due to corporate inertia, reluctance to reduce headcount, or a lack of focus on pricing power, there has obviously been room for improvement. Keep in mind that Breeze was a public company prior to its acquisition and TDG managed to reduce its workforce by nearly a quarter.

Getting back to the comparison with Heico, over the past decade, the operating cost per employee of Heico’s FSG segment has averaged 134% of TDG’s total operating cost per employee, and this excludes the allocation of corporate costs for FSG. The results are very similar when looking at operating costs per square foot. In 2016, FSG’s ratio was 135% of that of TDG. I think TDG runs a very tight ship where every cost is scrutinized, whether it be an FTE or scrap metal. In an industry with structural advantages such as aerospace components, it would be easy to allow bloat and inefficiency in the cost structure. Yet, despite the advantages bestowed by barriers to entry, TDG manages costs as if it were operating in a highly competitive and commoditized industry. TDG’s margins are a combination of both pricing power and strong operational management.

Regarding pricing, it’s also important to consider that for many of the parts that TDG acquires, volume growth is negative and the rate of decline increases as time goes by. This happens naturally when an aircraft is no longer being produced and older planes are retired. In these instances, it becomes more expensive to maintain the manufacturing capabilities and the supply chains for these types of components. TDG has stated that as part of its acquisition strategy, it looks for companies with suboptimal pricing policies. In these situations, where the price is significantly below what it would cost a customer to get a part second-sourced and when volume is declining, TDG has significant room to implement “value-based pricing.” TDG has real pricing power which it implements on an ongoing basis as well as after making acquisitions. Certainly in some instances price hikes post acquisition are likely very high, but this is likely most common for very low volume parts and those with declining volumes.

Financial Returns

If TDG was regularly implementing extreme price hikes while slashing costs, its ROIC should be extremely high. However, this is not the case. Calculating ROIC by dividing NOPAT by the sum of book debt and equity, the average ROIC over the past decade is 14%. To view it another way, if you sum the total amounts spent on acquisitions and capital expenditures over the past three, five, or ten years and compare that total with the increase in EBITDA during the corresponding period, the result is a pre-tax return ranging from 17% to 18.5%. While these returns are in excess of TDG’s cost of capital and are strong in an absolute sense, these levels don’t indicate the excessive economic profits that you might expect if TDG was doubling or tripling prices across the board in the first year after an acquisition.

Leverage

Other than its pricing policies, another knock on the company is its debt load. On a TTM and forward basis, net debt/EBITDA is approximately 6.3x and 5.8x, quite high relative to most standards. However, given TDG’s margins and growth, the company’s ability to service the debt is more important than the absolute level of a given ratio. For example, even under a very draconian scenario of 0% revenue growth and 500 basis points of EBITDA margin degradation over the next five years, I model cumulative free cash flow generation of $3.1 billion (for reference, TDG has guided to FY 2017 FCF generation of $800 million). This cash plus current cash on the balance sheet is sufficient to completely retire upcoming maturities in 2020 and 2021. The 2022 maturities would necessitate a partial refinancing. Assuming TDG refinanced $1 billion of the $2.7 billion due in 2022, by the end of that year, net debt/EBITDA would stand at 4.3 and interest coverage would be 4.1, both vast improvements from 2017. I realize this exercise is highly speculative given an uncertain future; however, I think it demonstrates that, even with negative developments, the company’s debt is not as burdensome as it appears. Admittedly, you wouldn’t want to own the equity in this scenario and the debt can lead to a bumpy ride. However, given TDG’s competitive strengths, I view no revenue growth and a 500 basis point decline in margins as highly unlikely. This would be a complete and total reversal from its prior 11 years as a public company. As discussed in the next section, by assuming more realistic assumptions, TDG can likely pay off every maturity through 2023.

Valuation

At a current price of $236, the stock represents a compelling value. With annual free cash flow of approximately $800 million, TDG is trading at a levered free cash flow yield of 6.4%, which is a bargain relative to its trading history as well as to the overall market. For a baseline scenario, I use a discounted cash flow model which assumes 4% organic growth (based on current mix and 2% growth for defense and commercial OEM and 7% for commercial aftermarket), no acquisitions and stable margins, which results in a value of $285. Importantly, in this scenario the company will generate sufficient cash (including cash currently on the balance sheet) to pay off every debt maturity through 2023, after which its net debt ratio would stand at 1.5x. From delevering alone, the reduction in interest expense by 2022 results in additional free cash flow of $300 million. In this scenario, I believe the stock can compound between 8% and 10% over the next five years through both growing free cash flow and a tailwind from delevering. However, it is extremely unlikely (outside of some majorly adverse scenario) that TDG would reduce its outstanding level of indebtedness. More likely the company will continue to operate as it has since its IPO by maintaining its leverage ratio in a narrow band (i.e. between 4 and 6 times) and adding incremental leverage as EBITDA grows, for both acquisitions and special dividends. Starting with a 6.4% free cash flow yield and MSD organic growth gets to double digit compounding, and assuming a continuation of  the acquisition program, future returns from this point could compound at a mid-teens rate.

Conclusion

I think in some ways, TDG has been a victim of its own success. It’s easy to look at the 45% EBITDA margins and assume that the company just takes advantage of its customers by jacking up prices. However, there is more to the story. While TDG no doubt prices aggressively for certain parts in certain situations, I don’t think its pricing strategies are so far out of line as to endanger the company’s future or cause it to alter its business model. The company does not get enough credit for running a very tight ship and being exceptional operators. The operational effectiveness combined with a robust acquisition program, opportunistic balance sheet management, and favorable industry conditions (including organic growth and barriers to entry) has resulted in exceptional long-term results. I believe all these favorable factors are still in place and the current controversy has created a great opportunity to purchase a high-quality, defensible business with pricing power at a price that allows for double digit compounding going forward. 

Catalyst

• Additional reports from Citron subjecting the company to more scrutiny
• Share buybacks and additional insider purchases
• Future acquisitions