TDG - TransDigm Group: Good Fundamental Long-Term Holding

Summary

• Strong expansion in the commercial aftermarket drove TransDigm Group Incorporated's fiscal Q1 2023 results, and there is still room for growth as air travel continues to improve globally and China reopens.
• TransDigm Group has a solid business model and portfolio, enabling the company to adjust prices and keep margins stable or even increase them in times of inflation.
• TransDigm is sitting on ~$3.3 billion cash, which I expect will be used wisely to create shareholder value.

Recommendation

Stronger-than-anticipated expansion in the commercial aftermarket drove TransDigm Group Incorporated (TDG) results in fiscal Q1 2023 . As the effects of China's reopening begin to take hold, I continue to have a very optimistic outlook on the Commercial aftermarket. As of now, Asia-Pacific international air traffic is still below pre-covid levels, and China's domestic air traffic is also substantially lower. This means there is still considerable room for expansion.

TransDigm Group has also done exceptionally well in terms of the business itself. It has been relatively unscathed by supply chain and inflation headwinds, and it has managed to hedge itself from rising interest rates. To this day, I still think TDG is a good fundamental long and one of the best business models ever conceived.

Latest earnings highlights

Sales increased by 15% y/y organically, with Defense showing growth of 3%, commercial aftermarket of 31%, and commercial OEM of 20%. EBITDA margin increased to 50%, an increase of 270bps year/year and 20bps q/q. The $377 million in operating cash flow was higher than the $349 million estimated by consensus. For FY23, TDG guided revenue between $6.07 billion and $6.24 billion, EBITDA between $3.06 billion and $3.16 billion, and adjusted EPS between $21.47 and $22.87. TransDigm Group Incorporated management has also reiterated that they anticipate commercial OEM growth in the mid-teens % y/y, aftermarket revenue growth in the high-teens % y/y, and Defense growth in the low- to mid-single digits % y/y.

China reopening

Air travel in China and the rest of the Asia-Pacific region is on the rise after periods of horrific experience, which is good news for TDG's commercial aftermarket business. I anticipate a sizable increase in air travel as a result of China's reopening, which will in turn boost TDG's commercial aftermarket business by a noticeable amount.

The rapid recovery of air traffic in China and the Asia-Pacific region, which may necessitate aftermarket work before flying passengers due to the low volume of air traffic in the past, seems to have convinced most investors that the outlook I described is accurate, in that, expected growth in air travel will increase the need for aircraft servicing and replacement components. While I welcome China's gradual reopening, I am concerned about the pace at which air traffic will recover - which might cause TDG to miss certain very bullish assumptions made by investors. That said, the fact that there is so much latent demand from tourists, however, has me favoring the prospect of growth here (in and out of China).

Commercial aftermarket

As air travel continues to improve around the world, the commercial aftermarket has done well. Bookings continued to exceed shipments, contributing to a 31% increase in aftermarket revenue year over year. With global RPKs still below 2019 levels, I see room for expansion in the commercial aftermarket, and this is something I view as positive. Given the positive effect it has on the business mix, I expect that the aftermarket's sustained expansion will act as a boon to margin.

Strong business model supports long-term holdings

I believe the most important benefit that TransDigm Group offers its investors is the peace of mind that comes from knowing that the company has a solid business model and will endure for the long term, with its value rising steadily (as it represents a bigger part of the industry). In my opinion, the firm has a very defendable business model, and management has shown that it can generate substantial shareholder value. TDG's portfolio contains 90% proprietary products and 75% sole-sourced products, enabling the company to adjust prices and keep margins stable or even increase them in times of inflation. As a result, TDG is much less risky to keep in the portfolio than a high-growth software company, even during periods of uncertainty, barring extreme events like the pandemic (even so, the stock price has recovered strongly since then).

Capital allocation

TransDigm Group Incorporated has $3.28 billion available as of 1Q23. There is no doubt that management has been keeping an eye on the market for any potential targets despite Covid and a high rates environment.

One possible event that could happen is TDG could declare a dividend this year. I expect a dividend instead of share buyback because TDG stock is trading at a significant premium to where it was a few months ago (in fact, it is near its 10-year high). TDG's capital allocation strategy has consistently provided a positive return for shareholders, so there isn't much room for criticism. I believe the fact is if one were to invest in TDG, one must believe that management will use capital to make strategic acquisitions, which will increase earnings growth.

Summary

In conclusion, TransDigm Group Incorporated's strong performance in 1Q23 was primarily driven by the expansion in the commercial aftermarket and the company's resilient business model. With the effects of China's reopening starting to take hold, there is still considerable room for growth in the commercial aftermarket. As air travel continues to improve globally, the commercial aftermarket is expected to expand further, providing a positive impact on TDG's margins. Overall, TransDigm Group Incorporated is a solid long-term investment with a defendable business model that provides investors with peace of mind.

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