TDG - TransDigm: Flying High Again

2023-03-19 10:59:08 ET

Summary

• TransDigm has seen some accelerating momentum as of recent, driven by a recovery in commercial aviation markets.
• Leverage has come down a bit as the company appears to manage its leverage situation very well.
• The company is confident enough to pursue some bolt-on deals here, as expectations remain a bit too demanding for me in this new interest rate regime.

About a year ago I concluded that shares of TransDigm ( TDG ) were preparing for lift-off. I arrived at this conclusion after the company has seen a year of stagnation with end markets recovering slowly from the pandemic.

At the time shares saw a modest boost as a result of its exposure to the defense sector, amidst the outbreak of the war between Russia and Ukraine.

A Publicly Traded Private Equity Play

The paragraph header is how I look at TransDigm, essentially a publicly listed private equity business focused on aviation. The company is an M&A roll-up story as it employs aggressive pricing strategies, employing higher leverage, creating quite some volatility in some uncertain periods of time.

In the year 2019 - ahead of the pandemic - the company posted $2.8 billion in EBITDA on $5.2 billion in sales, resulting in astonishing margins. Net debt of around $15 billion translated into around a 5 times leverage ratio, as the company paid out a huge special dividend ahead of the pandemic. High leverage is in part mitigated by company-favorable covenants, fixed interest rates and long term maturities, with shares trading at $650 pre-pandemic.

Despite the pandemic clearly having an impact, the company continued its M&A strategy with a billion deal for Cobham Aero announced by the end of 2020 as shares had recovered to the $600 mark already. These were high valuations given the leverage employed, and the fact that 2020 earnings only trended at $12 per share, while 2019 peak earnings came in around $20 per share. Besides the high valuation and leverage concerns, there was the concern on pricing scrutiny as well, with politicians getting involved on the matter as well. This is a long term concern of mine, as >50% EBITDA margins might not just come from operational efficiency, but from pricing practices as well.

By April 2022 shares traded at $638 per share as the 2021 results (for the year ending in September 2021) were quite flattish, as modest advancements were seen in the first quarters of 2022. Despite this, markets were upbeat given the defense exposure as the company announced a $360 million deal for DAR Aerospace in March 2022. Amidst the stagnation, I saw tailwinds from defense exposure, as the commercial aviation sector was slow to recover amidst higher fuel prices, as I was waiting for a better entry point to get involved.

What Happened?

Over the past year, the cautious stance initially played out as shares fell from $638 in April to lows around $500 in the summer and autumn. What followed was a big recovery to a high of $770 in recent weeks, with shares down to $690 at the moment of writing amidst the pullback in the market amidst the volatility on financial markets.

In May, TransDigm posted an 11% increase in second quarter sales, with margins on the bottom line recovering spectacularly as well. Third quarter sales rose as much as 15%, as the company paid out a special dividend of $18.50 per share along the way.

In November the company posted fourth quarter results as the company topped off the final quarter with 15% revenue growth with sales reported just over $1.5 billion, as full year sales were up 13% to $5.4 billion, matching the 2019 sales numbers now. Adjusted earnings rose more than 40% to $17.14 per share as EBITDA by rose 21% to $2.65 billion, as net debt inched up to $16.4 billion, for a leverage ratio in excess of 6 times.

The company reinitiated a guidance again, calling for 2023 sales to rise to a range of $5.99-$6.19 billion, seeing EBITDA between $3.0 and $3.1 billion, and adjusted earnings were seen between $20.68 and $22.08 per share, marking real progress.

The company started 2023 on a solid note with first quarter sales up 17% to $1.4 billion with earnings showing a more spectacular improvement. On the back of this, the company hiked the midpoint of the sales guidance from $6.09 billion to $6.15 billion, EBITDA from $3.05 billion to $3.11 billion, with earnings seen at a midpoint of $22.17 per share. This is driven by accelerated growth in commercial aviation, aided by lower fuel prices and the pandemic being on its retreat of course. Net debt was stable at around $16.2 billion, with leverage down to 5.2 times EBITDA.

The 57 million shares trade at $690, for a $39.3 billion equity valuation, or about $55 billion enterprise valuation.

Another Deal

While end markets - commercial aerospace and defense markets - appear to be doing alright, shares sold off a bit amidst the concerns in the banking sector, as TransDigm remains quite leveraged, although the company has recently extended its leverage profile a bit again.

In March, the company announced another deal, this time acquiring Calspan. The New York based business provides engineering testing and technology development services to the aviation industry, generating $200 million in sales in the process. That adds a little over 3% to pro forma sales, aiding the growth of the business.

No purchase price has been announced and while TransDigm typically trades at a high single digit sale multiple, I expect that this deal comes in below the billion mark. I want to stress the word ¨expect¨ here as no financial information has been released other than the revenue contribution.

Still Not Cheap

Following the continued momentum, shares of TransDigm trade at continued elevated valuations, as this is not too appealing to me, mostly because risk-free rates have moved up a lot. The company trades at a low thirty times earnings multiple as leverage is reasonably high.

It appears that TransDigm continues to operate just fine from an operational point of view as the latest M&A fuels a bit more growth, yet the issue is that valuations simply remain a bit too demanding, certainly in this interest rate regime.

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