Description

Quick Thesis:

(1)  I believe TDG can (and probably will) return >100% of its market cap in special dividends over the next eight years.

(2)  I believe TDG is an incredibly high-quality business that can grow EBITDA 8-10% per year for a very long time (maybe decades) without acquisitions and will be worth substantially more than the current market cap eight years from now (after paying dividends in excess of the current market cap).  I expect a total return of 18-20%/year over a ten-year hold from here.

(3)  Management is exceptional.

(4)  Coronavirus will have a VERY negative impact on earnings over the next 12-18 months, but TDG’s terminal value beyond that has not meaningfully changed (it might actually be higher).

(5)  TDG is highly levered, but it has (a) no debt maturities until 2023, (b) no financial covenants (except some restricting additional borrowing, dividends, asset sales, revolver draws, etc.), and (c) enough cash on hand to make all interest payments until 2023. I.e., unless air traffic in 2023 is substantially below 2019 as a result of the coronavirus, TDG will make it through this turbulence just fine (sorry, had to use that at least once…).

LARGE INSIDER BUYING: Not in any way core to the thesis, but last Wednesday Berkshire Partners (shareholder since 2008 and on TDG’s Board since 2010) purchased ~$115 million (increasing position size by 16%) at ~$470/share (13% higher than current price).

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I’m going to elaborate on the points to the thesis below in reverse order, starting with why it’s cheap right now… coronavirus + a lot of debt + a lot of operating leverage.

TDG’s gross debt to EBIDA was 7.0x and net debt to EBITDA was 6.1x as of 12/28/19. As a seller of aircraft parts, TDG’s debt to EBITDA ratios will probably balloon to double digits on FY2020 EBITDA and FCF might be much closer to $0 in FY2020 then the $1.2B analyst consensus (pre-coronavirus). But the 37% drop in the share price is way overdone. I don’t believe there is a meaningful risk of impairment long-term for the following reasons:

(1)  The debt is very well structured with the first maturity not until June of 2023. 2020 air traffic will certainly be much lower than 2019, but I’d put the odds of air traffic in 2023 being below 2019 at ~1% (basically the odds of another once in a hundred-year pandemic happening in 2023).

(2)  There are no financial covenants that need to be maintained as long as TDG doesn’t draw more than 35% of its revolver (currently undrawn).

(3)  TDG’s interest payments are about $1 billion per year and it has $2.33 billion in cash and can draw another ~$250 million under its revolver without triggering the 35%.

(4)  EBITDA is not going to collapse to zero. A number of airlines have already announced major capacity reductions, but the most conservative plan I’ve seen is Delta planning to cut capacity by 40%. I think it’s VERY unlikely that worldwide traffic falls more than 40% YoY at the peak of this pandemic. Furthermore, I think TDG will rapidly cut costs as they’ve done in the past and, more importantly, will raise prices much higher than they normally would this year. Therefore, a 40% decline in traffic (higher than I anticipate) might “only” be a 30% drop in revenue. Why? (a) To be discussed below, but TDG can basically pick it’s price, and (b) it actually has a good reason for raising prices this year, “sorry, our volume is down 50% and we have high fixed costs so even with these higher prices we’re making much less on this part this year.” Also, my guess is management at the major airlines will be distracted worrying about their balance sheets and capacity planning this year. Ironically, this cover to hike prices more than usual (and then not reduce them next year…) may increase the terminal value more than the loss of earnings in 2020.

That’s why I think TDG, despite its heavy debt load with a VERY ugly year ahead, will survive the coronavirus pandemic. Now what does TDG look like post-pandemic and why is it such a great business?

TDG is a global designer, producer and supplier of hundreds of thousands of small, highly engineered, low-dollar aircraft parts. It provides components for a large, diverse installed base of aircraft and as such is not overly dependent on any single airframe. It generates ~$6.25 billion in revenue, yet 90% of its revenue comes from parts that have less than $2 million in annual revenue (might be slightly different now, this was from the 2018 investor day), so it is also not overly dependent on any single product or customer.

Recurring Revenue: It generates recurring aftermarket revenue from maintenance over the life of an aircraft, which averages about 25-30 years. A typical platform can be produced for 20-30 years, giving TDG an estimated product life cycle in excess of 50 years. More than ¾ of its EBITDA is generated from higher margin, more stable (in non-pandemic years…) aftermarket sales.

Pricing Power: Most importantly, more than 90% of its sales are of proprietary products and ~75% of its sales are of products for which it is the only supplier (more on why below). Since TDG’s parts are critical to the performance of aircrafts, have no substitutes, and are very insignificant relative to the total cost of an aircraft, it has tremendous pricing power. This has enabled TDG to sustain and grow 50%+ EBITDA margins in its core business.

Organic Volume Growth: Since 1970, airline revenue passenger miles (RPMs) have grown by 5-6%/year and post-coronavirus I expect that trend to continue as a rising middle class and growing world economy demands more air travel. TDG’s unit volume should generally increase along with RPMs; as more miles flown translates to more aircraft maintenance. I expect TDG’s long-term volume growth to be 4-5%/year. Additionally, as discussed above, TDG benefits from significant pricing power. As a result, TDG is able to consistently increase prices by 3-4% annually, while simultaneously improving productivity each year. The net result is that TDG has historically seen 10%+ organic EBITDA growth annually. I expect this to continue in the future. 

Moat: Why is it the sole provider of so many parts? While TDG is a large company, its total revenue in the commercial aftermarket is only ~0.15% of global airline operating expenses. Maintenance in general is only ~10% of operating expenses. Once its products are spec’d on a new aircraft, it is very costly and time consuming to get another part FAA certified and approved by a customer, let alone a diverse group of global customers. A “high-revenue” part generates $1-2 million/year in annual revenue (remember, TDG has hundreds of thousands of parts), at ~50% EBITDA margins. This is incredibly attractive for the first mover, TDG, but unattractive for a potential entrant. Anybody considering competing with TDG likely has to spend a few hundred thousand dollars to design a competing product, then has to equip a factory where there are likely economies of scale, then has to set up distribution, then finally has to convince an airline to test out the product, then has to figure out how to sell it globally. TDG’s customers are not the airlines; they are the purchasing managers of the airlines who only care about job security. The old saying “Nobody ever got fired for choosing IBM” is very applicable in this case. And even if a new entrant in a particular product niche went through all that trouble and was successful in getting a few customers, the business economics wouldn’t make any sense, because in a best-case scenario they would split the market with TDG. But the most likely scenario would be that both the entrant and TDG would instantly lose pricing power, TDG would lower prices to send a signal to future entrants, and the entrant wouldn’t get sufficient volume or margins to justify the initial investment. PMA’s (generic replacement parts) are only available for 2.5-3% of all aircraft parts and for <2% of TDG’s parts. Heico, the largest PMA producer by far (also a great business), under indexes to TDG because TDG’s parts don’t generate enough revenue or volume to be worth copying. Heico also tries to limit market share to around 20% of volume by part to not collapse the OEM price umbrella. I.e., even when there is competition, the competition usually tries to leave TDG with most of the volume on a part as to not destroy the TDG pricing umbrella.

Special Dividends:  Assuming (1) no acquisitions, (2) constant leverage (6.1x net debt/EBITDA), (3) FCF drops to $0 this year, (4) FCF in 2021 equals FY2020 guidance pre-coronavirus (V-shaped recovery, not assuming any above-average pricing power this year), (5) EBITDA & FCF grow by 10%/year for the next six years, and (6) all excess cash is returned to shareholders via special dividends (as has been done over the last few years), then we’ll get more than 100% of the current market cap in dividends over the next eight years.

Exceptional Management: Since 1993, Nick Howley has made around 60 acquisitions with internally generated FCF and high levels of cheap (and well-laddered) debt, created a highly decentralized structure, opportunistically repurchased shares, and periodically financed very large special dividends with cheap well-laddered debt. Nick is laser focused on creating value for shareholders and I’m too lazy to update the # but last time I checked has grown enterprise value by 31%/year since 1993. Nick is the Executive Chairman now and Kevin Stein is his successor CEO. Kevin has been with the company since 2014 and has been COO since 2016. As far as I can tell, he appears to have the same focus on maximizing shareholder value.

Acquisitions: I’m not assuming any further acquisitions, but TDG was built through acquisitions. Management is always looking for the next acquisition with all the characteristics common in TDG businesses: high margins, proprietary content, sole source providers, low-dollar parts. As can be seen from the recent acquisition of Esterline, TDG is able to significantly increase EBITDA of acquired businesses through more efficient production, reduction of duplicated resources (sales force, management, etc.), and price increases, generating very high returns on equity for shareholders. The company’s hurdle rate for making investments is 17.5% and historically it has been a very disciplined buyer.  If they find any large acquisitions, they may return less in special dividends, but this would be a better outcome for long-term shareholders.

Catalyst

Coronavirus vaccine.