Description

Quick Summary:

Each TransDigm subsidiary has characteristics of a local monopoly, and TDG is the sum of all those businesses with a nice macro tailwind and a world class capital allocator at the helm. TDG represents the ideal combination of a business with extremely high and consistent Owner Earnings, yet ample opportunities for high ROIC redeployment. These combinations are rare, and when found it tends to require a steep entry price to become a part owner. TDG is not an “obvious bargain”, however the company has the ability to compound at high rates for many years to come and this is often underappreciated by the market. The recent volatility around the Brexit creates an opportunity to build a long-term, core holding in an excellent business at a reasonable entry price.

TransDigm Group (TDG):

TransDigm Group Incorporate (NYSE: TDG) owns a collection of businesses that design and manufacture highly engineered aerospace components. TDG is not an airline, and they don’t make airplanes, however they have 31 operating groups which collectively manufacture thousands of small airplane parts. Think of critical latches, gauges, pumps and valves that are on nearly every airplane in the world. As their CEO Nicholas Howley likes to say, they are one of the biggest, most profitable industrial businesses that “you’ve never heard of”. The company’s strength lies in their revenue mix, as 90% of products are proprietary, ~80% are sole-source and about 55% of revenues come from aftermarket sales. Like many aerospace businesses, TDG sells OEM parts to Boeing/Airbus at a fairly low margin, but makes extremely high margins on the steady stream of aftermarket or “spare” parts. OEMs typically manufacture a plane for a 25 – 30 cycle, and then planes fly for 25 – 30 years, leading to a total selling window of 50 – 60 years for TDG components. TDG has Projected 2016 Revenue of $3,205 and EBITDA of $1,475 with a market cap of ~$13.4 billion. TDG is an excellent business and a compelling investment for a handful of key reasons:

Extremely High Barriers to Entry:

TDG is a collection of proprietary aerospace businesses, each with an exceptionally strong competitive position. Collectively the businesses produces a 100%+ pre-tax return on capital employed, which is steadily trending up over many years. While TDG has existed since 1993, many of the operating groups have histories that date back to the 1920’s and 1930’s. This is an industry that doesn’t change much, which is perfect for a long-term investor. The barriers to entry are a result of a mix of factors:

- Low-priced, but critical parts that are highly engineered and often “sole source”

o   They don’t do “build to print”, TDG owns and defends their Intellectual Property

o   Spare parts are a minor expense for airlines compared to Fuel and Personnel

-  Only 4% - 5% of TDG parts are in excess of $5,000 each

o   When OEMs seek to drive cost cuts they target bigger items like engines

o   Even the Department Of Defense admits they have very little negotiating leverage and typically accept the offered price (Source: http://www.gao.gov/assets/230/228420.pdf)

- Industry structure: OEM and Aftermarket are not two separate businesses, they are linked

o   In order to access the Aftermarket, one must make big up front investments and defer returns through the long OEM phase

- Industry psychology: for minor parts there is not a big gain to change suppliers, but it would be a very big loss if a plane is delayed or fails in flight because of a part (from same linked report)

- FAA / PMA Approval process: All parts on airlines must be approved by the FAA which typically takes 1 - 2 years

o   There is a misconception that the FAA process is the true source of the moat, however I think it is more supplemental with the industry structure and psychology as larger factors

Real Pricing Power:

Buffett is quoted as saying “The single most important decision in evaluating a business is pricing power” and “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business”. TDG is able to consistently raise prices 3% - 5% annually throughout the aerospace cycle due to each subsidiary’s entrenched competitive position.

Macro Tailwind:

Global air travel (measured by RPMs) has increased at ~6% annually for multiple decades, and is projected to continue to rise at ~6% for decades into the future.

- Over time demand for TDG aftermarket parts will correlate to growth in RPMs + Annual Price Increases, resulting in high single digit organic growth

o   Over short intervals demand can vary as airlines defer or over-order, but over a long period demand will match the “intrinsic value” of RPM growth + Pricing

World-Class Capital Allocators:

With 45% - 50% EBITDA margins and Capex of roughly 2% of sales, TDG generates consistent and large amounts of free cash flow. Fortunately for us as co-owners, the money is shipped to headquarters in Cleveland for CEO/Founder Nicholas Howley to allocate.

- If there was a capital allocator Hall of Fame, Howley would surely be a “first ballot” selection

o   Exceptional track record: 20% Revenue and 24.5% EBITDA CAGR over 20+ years

o   Howley takes no annual cash salary, all comp in performance linked shares/options

- TDG views the capital structure as another means to generate equity value

o   $3.0+ billion of cumulative special dividends since 2012, representing 50% of beginning market cap

o   Willing to buy back shares opportunistically, including in early 2016

- TDG typically runs leverage at 4x – 6x EBITDA, and today net debt sits at 6.0x TTM EBITDA

o   Mix of PE style debt with no amortization and high yield bonds, total cost at 5.4%

o   Maturities are pushed out to 2020 – 2024 with 75% of rates locked in or hedged out

o   Many will say this is an overleveraged company, however I think TDG fits the mold of certain businesses that are capable of utilizing debt as part of an ongoing “Public LBO”

Ability to Reinvest at High Rates for Many Years:

TDG is essentially an aerospace Private Equity (PE) shop imbedded in a highly profitable industrial company. PE is part of the company’s heritage, as TDG was PE owned from 1993 until their IPO in 2006. Through disciplined acquisitions TDG aims to achieve returns exceeding those of top quartile private equity funds while providing shareholders with the liquidity of the public markets.

- TDG has structural advantages as an acquirer over traditional PE or strategic buyers:

o   Compared to PE, TDG brings deep sector expertise, a “bench” of managers to install, and the ability to save on costs through consolidating factories and G&A savings

o   TDG employs the capital structure of a PE fund, enabling competitive bids versus strategics

- There is a well proven, consistent playbook post-acquisition leading to 20%+ ROE on deals

o   A TransDigm EVP is installed in a new acquisition for the first 180 days, getting TDG metrics, pricing, people and structure in place

o   Once the game plan and personnel are installed, TDG backs off and lets the operating group run autonomously like owners/entrepreneurs

- TDG only has about 4% of the total addressable market currently, creating a very long runway for further M&A

o   Over the last one, three, and five year intervals cash allocated to M&A has exceeded cash flow from operations highlighting the array of reinvestment opportunities available

o   TDG currently has $1.85B of “dry powder” available for acquisitions

TDG is Very Different from Valeant

Before making this investment I studied Valeant (VRX) very carefully, worried that from a high level TDG has similar characteristics. After thinking holistically about their respective business models I concluded they are fundamentally different:

- If every pharmaceutical company operated like VRX, the whole ecosystem would crumble

o   When it’s just one small obscure company slashing R&D and jacking up prices, it can work for a while

o   But the bigger you get, and the more people copying your model, eventually the whole system would implode

- There would be no future drugs, and the whole country would be worse off

o   VRX is failing because it deserves to fail, the whole system is better off if VRX doesn’t exist anymore

- TDG is more like 3G Capital or General Electric: they comprehensively run the acquired businesses better, while capitalizing them better, and capture the value from that

o   TransDigm inserts new management from within the TDG system, consolidates facilities, introduces detailed metrics, creates product line P&Ls, segments out pricing strategies by product lines, and pursues new business only if it is profitable.

o   TDG is consistently increasing volumes organically on new plane platforms. This along with cost efficiencies leads to doubling EBITDA for acquired companies in first 5 years

o   If every aerospace company copied them, it would just raise the bar for the entire industry

- Which is exactly what’s happening in the CPG industry with Kraft/Heinz and 3G

- It is easy to draw a quick connection between the two companies, I encourage you to read through TDG’s Analyst Days with a specific focus on how they operate companies post-acquisition and you will see that TDG is not a “revolutionary model” like VRX, but instead a sound organization that is extremely tight with the fundamentals and details of running an industrial company.

Decent Entry Price:

I believe TDG can compound earnings at 15%+ for years to come and investors buying today should be able to earn returns that match the underlying returns of the business. TDG is coming off a very strong Q2 with 4.5% organic revenue growth and 13% growth in the crucial commercial aftermarket segment. Howley continues to reiterate that TDG’s strategy is intact and nothing has structurally changed with their market or business model, giving me confidence over the near to medium term.

Currently TDG trades for 14.5x 2016 EV/EBITDA and 23x 2016 EPS, which appears to be a fully-valued entry price. However I believe the company can generate $3Bn+ of EBITDA five years out (FY 2021), and assuming a similar exit multiple along with selective repurchases, special dividends, and debt pay down the equity should compound at rates in excess of 15%. The slightly depressed multiple today results from general market volatility and concern around leveraged, highly acquisitive companies (there is a short “platform company” pitch circulating).

While the company rarely repurchases shares, lately TDG has opportunistically repurchased shares because they view the market quote as attractive. Additionally board member Robert Small has purchased over $100mm for his fund Berkshire Partners over the first half of this year. When one of the best capital allocators in the world decides the best use of funds is to repurchase the company’s shares, I believe it pays to take notice.

Disclaimer: The fund I manage and my personal account currently has a position in TDG but may buy, sell, cover, or otherwise change the form of investment at any time and for any or no reason.

Catalyst

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