TDG - TransDigm Group: Expectations Run High (Again)

2023-12-14 09:00:41 ET

Summary

• TransDigm is a publicly listed private equity play in aviation, combining M&A and aggressive pricing strategies.
• The company has seen a strong recovery in sales and earnings, with a 40% increase in share price since March.
• TransDigm has announced a special dividend and a major acquisition, but the high valuation and expanding margins raise concerns.

In March, I thought that TransDigm ( TDG ) was flying high again as the company enjoyed accelerating momentum, driven by a recovery in commercial aviation markets.

Leverage has come down a bit, comforting as the company operated (and to a lesser extent operates) with sky-high leverage ratios, and we of course found ourselves in a higher interest rate environment, albeit the company has extended maturities and fixed rates at appealing levels.

With interest rates down in recent weeks, continued M&A being announced and the organic performance being strong, I understand the enthusiasm among investors, which might have been carried away a bit too much.

An Aviation-Focused Private Equity Play

In essence, TransDigm is a publicly listed private equity play in aviation. The company very successfully combines an M&A strategy with an aggressive pricing strategy, all while the balance sheet is highly leveraged, creating volatility in uncertain times, but great long term returns for investors.

Pre-pandemic, the company reported a massive $2.8 billion EBITDA number on $5.2 billion in sales, posting unheard margins in excess of 50%, as the company torched along a $15 billion net debt load, with the company occasionally pursing more deals and paying out substantial special dividends at various intervals.

A $650 stock pre-pandemic traded with a >$200 handle soon after the outbreak of the pandemic. The pandemic of course had a big impact on the firm, certainly amidst leverage employed, as the period coincided with rising scrutiny of politicians on the pricing practices of the firm as well, creating a potential other overhang.

This overhang was rapidly ignored by investors as shares traded with a $600 handle again late in 2020, although the actual recovery in the results took a longer period of time.

Forwarding to November 2022, the company grew full year sales by 13% to $5.4 billion, essentially trading at par with the 2019 revenue numbers. EBITDA rose 21% to $2.6 billion, for margins near 50%, as the company posted adjusted earnings of $17 and change per share. Net debt of $16.4 billion, worked down to a leverage ratio of around 6 times.

Aided by bolt-on dealmaking and organic growth, the company guided for 2023 sales to advance to $5.99-$6.19 billion, with EBITDA seen up to $3.0-$3.1 billion, set to translate into earnings between $20.68 and $22.08 per share.

After a strong first quarter, the company hiked the full year sales guidance to $6.09-$6.15 billion, with earnings seen around $22.17 per share. The 57 million shares outstanding valued the business at a huge $55 billion enterprise valuation, with shares trading at $690 while the company operated with $16.2 billion in net debt.

Being really appreciative of the strong track record of the business, I was cautious amidst a roughly 30 times earnings multiple, high leverage ratio, higher interest rate environment and potential for scrutiny from politicians.

A Great Run Higher

Since March, shares have rallied another 40%, now trading at $1,000 per share, as investors digest lower interest rates, but moreover applaud the continued operating performance of the business and its M&A activities.

In May, TransDigm closed on the $725 million deal for Calspan, a deal announced earlier this spring with the transaction set to add $200 million in annual sales. The company furthermore reported a 20% increase in second quarter sales, as the strong performance made that the company hiked the full year sales guidance to $6.41-$6.50 billion, with full year earnings now seen at a midpoint of $23.75 per share.

Third quarter sales rose as much as 25% to $1.74 billion as the company hiked the guidance further, now seeing sales at a midpoint of $6.555 billion and earnings at a midpoint of $25.21 per share.

A Strong End To the Year

The good news show continued in November as the business posted a 23% increase in fourth quarter sales. This made that full year sales rose by 21% to $6.585 billion, with EBITDA reported at $3.40 billion and adjusted earnings reported at $25.84 per share.

Net debt was down to $15.9 billion, for a relatively low leverage ratio of 4.7 times, but this lower leverage ratio was temporary as the company announced a massive capital allocation move. The company announced a special dividend of $35 per share, equal to a two billion payout.

This huge dividend was accompanied by another substantial acquisition. TransDigm announced a $1.385 billion cash deal to acquire the Electron Device Business of TJC. The manufacturer of electronic components and subsystems for the aerospace and defense markets adds about $300 million in sales, for a 4.6 times sales multiple.

In comparison, TransDigm commands a $57 billion equity valuation at $1,000 per share, or about $73 billion enterprise valuation. This values the business at close to 10 times forward sales, with 2024 revenues seen between $7.48 and $7.68 billion, while earnings are seen between $26.61 and $28.55 per share.

Important to realize is that the deal for the Electron Device Business only is set to close in the third quarter of 2024, but none of its contribution is incorporated in the 2024 guidance.

Expectations Rise

Following the acceleration of sales and earnings growth, multiples have expanded as well. While the earnings improvement is great, the share price advancements have been greater, pushing up the multiple to 36 times earnings here.

This creates less of an appealing situation, even as the company continues to make interesting acquisitions, but I simply fear the too demanding valuation here as margins have expanded above 50% again. Once again, I have to congratulate management and investors on a great track record, as I continue to follow the business with amazement and appreciation.

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