Bottom Line

Transdigm (“TDG”) is a very high quality business that can compound earnings at least in the high teens (without accretive acquisitions) and likely north of 20% per year (with the types of accretive acquisitions they have made in their history).  Currently trading at 16x CY13 EPS, this presents favorable risk/reward.   

 Company Overview

TDG was formed in 1993 by the private equity firm Kelso & Co. In 1998 Kelso sold to another PE shop, Odyssey, who then sold to Warburg Pincus in 2003. TDG was IPO’d in 2006 and Warburg Pincus has since completely exited the stock. This private equity heritage is still evident in the way the business is run, with a focus on return on capital, M&A, and the use of leverage to create equity value.

TDG designs, produces and supplies engineered aircraft components for use on commercial and military aircraft. Virtually every plane and helicopter in the sky has TDG parts on it. We estimate that over 85% of EBITDA is derived from Aftermarket business and 75% of products are “sole source” (customers have no other options other than to buy from TDG).  TDG runs a decentralized organization in which sales, marketing and production are run autonomously in over 40 different locations. Each location has its own P&L and operational targets. Only M&A and corporate functions are run in the home office in Cleveland.

Competitive Advantages

TDG offers numerous defensible competitive advantages that translate into adjusted ROIC (i.e. truing up of acquisitions) of 20%+.

1. Sole source on vast majority of products, duopoly on most of the rest.
2. Most products require FAA certification, which requires 6-36 months and millions of dollars. When winning a bid, it can take 5+ years to recoup costs invested on developing the product.
3. Airline platform life can be in excess of 40 years – extremely sticky as OEMs typically only certify one manufacturer’s component for use on a given platform. Subsequent plane owners will not use a non-certified part as ramifications (FAA, insurance, litigation etc.) would be severe in case of failure.
4. Each SKU per platform features a very small TAM (TDG’s largest SKU does less than $3.5mm in sales, or less than 20 bps of total company revenue).
5. TDG’s brands and reputations matter, as the products are typically low cost & high value, so it is more important for a customer to know it will work than to try to save small amounts of money, even if possible.
6. We believe the above CAs are sustainable because:
   1. TDG penetrates the market through cheap/low margin OEM products that dictate the Aftermarket sales to Airlines (a different captive customer base).
   2. TDG doesn’t integrate the customer sales/point of contact and in addition it approaches different buyers at the airline.
7. While not exactly a typical competitive advantage – the company is run like a Private Equity business. Mgmt LT compensation scheme is pretty rare and is solely driven by increasing intrinsic value (calculated by applying a fixed multiple to EBITDA and backing into value per share), with a 17.5% annual bar for full vesting. They are aligned with shareholders – note the recent special dividend. They essentially recognized that the only way to get to their compounding for their comp was to do a dividend recap.

Segments

The Commercial AM is by far the most significant segment of TDG’s business. We believe that Commercial AM will grow 9.5% per year, driven by 4.5% growth in global Revenue Passenger Miles (RPMs) and 5% from pricing. 

From 1970 to 2011, Global RPMs increased at a 6% CAGR. Since 2000, though, Global RPMs have slowed a bit, growing at a 4.6% CAGR from 2000 to 2011. This period notably includes both 9/11 and the most recent recession, but also reflects maturation in developed markets.

TDG is extremely tight-lipped about its pricing policies. Given that it has a monopoly on 75% of its products and owns IP on another 15%, we assume that 5% annual pricing power is reasonably conservative. Sell side analysts believe that TDG extracts at least MSD to HSD pricing. TDG furthermore calls the 10% Commercial AM growth rate they guide to for FY12 to be a “stabilized” growth rate.

Performance During The Recession

TDG’s business proved relatively resilient in the most recent recession. Estimated on an organic basis, overall company EBITDA grew in every fiscal year. Excluding the benefit of a strong defense business during the recession, commercial organic EBITDA declined by 2% in FY09 but grew in every other fiscal year, resulting in a +2% positive CAGR from FY07 to FY10.  This was then followed by +24% organic growth in FY11.

The stock is volatile but over the recession years it significantly outperformed the market.

Scenarios

Downside: Commercial AM grows only mid single digits, and all defense business declines by 5% (including defense AM).

Base Case: Commercial AM grows high single digits (RPM + mid single digit pricing), Defense AM is flat.

Upside: Commercial OEM continues its high growth rate, Defense OEM is flat. FCF is used on accretive acquisitions.

Concerns

1. The valuation does not offer a huge margin of safety. TDG trades at ~16x P/E. If growth disappoints the base case, the multiple may compress.

2. There is a limited history available to analyze. TDG came public in 2006. Hence we can really only analyze performance in detail during the current aerospace cycle.

3. Future acquisitions may not be as successful as past ones. As TDG has grown it has drifted towards larger deals (McKechnie in Sep 2010 represented 25% of pro forma revenue, and AmSafe in Feb 2012 17%). Larger deals entail more risk.

4. For how long will the airlines allow TDG to kill them on Aftermarket pricing? Eventually it seems as though the AM customers should figure out a way to chip away at TDG’s pricing. However, TDG has a few things in its favor here: a decentralized structure, a wide array of products, low cost products, and most importantly a monopolistic control of 75% of products. Critically, the OEM customer base is entirely different from the AM customer base, meaning TDG can get its products onto platforms by selling cheap, creating a captive AM customer base with no choice but to buy from TDG.

5. TDG operates with meaningful debt. Current Net Debt/EBITDA is right at historical average since 2004 of 3.8x. Highest achieved was about 6x just prior to IPO. However, EBITDA/Interest coverage is >4x and the stable aftermarket business supports the leverage. Furthermore there are no significant debt maturities until 2017.