TransDigm (NYSE: TDG) is primarily a manufacturer of aerospace components and devices focused on both the military and commercial end-markets including ignition systems, AC/DC electric motors, and cockpit systems. An important recent M&A event to note is the Company’s acquisition of Esterline in 2019 to supplement its current product portfolio with a strong advanced materials, avionics, and control systems offering
To highlight, the business is not fully reliant on new aircraft builds specifically. A key dynamic to note is that post design wins, Transdigm is virtually guaranteed a strong stream of aftermarket revenues given that the long aircraft life that can stretch beyond 30 years. This in turn necessitates a steady stream of replacement parts at oftentimes a higher margin. With aftermarket making up nearly 50% of sales in 2020, this drives a strong business that does not necessarily require a strong recovery new aircraft sales. This is very pertinent given COVID related headwinds still on the horizon.
Unsurprisingly, the primary end-market that TransDigm sells into (Commercial Aerospace) is cyclical and is dependent on many factors including the growth in travel, the size of the OEM base, and most recently, the negative impact of a global pandemic on the transportation sector. And although the defense segment is arguably more counter-cyclical, it is still dependent on the whims of political budgetary pressures. However, everything is relative, and given the significant headwinds COVID has posed on commercial aviation, the large Defense component of Transdigm business (~25-30% of 2019 net sales revenues as seen below) helps bring a degree of revenue stability and visibility while commercial aviation recovers.
Another key thing to note is that Transdigm does not sell commodity/non-proprietary components. This naturally increases the value of Transdigm to its end-customers and gives the company significant pricing power as well as the advantages of being oftentimes the sole-source provider. This in turn drives strong profitability with the company reporting EBITDA margins in the 40% range. The benefits of this can be seen this fiscal year where the consolidated company remained profitable despite the significant COVID-related headwinds amongst the commercial aviation customer base.
Just as important, given the macro environment with COVID related headwinds, is liquidity. Given that the company has demonstrated its ability to remain profitable and Free Cash Flow positive, this is less of a concern but is something that investors should still consider. Here, the company has nearly $4.8B in cash on the balance sheet, which should be more than adequate for the company to get through this crisis particularly given that there is no near-term debt maturities. More importantly, just given the company’s history as well as strong liquidity position, it is very likely that they will engage in opportunistic M&A. This would naturally drive a degree of in-organic growth that could drive a nearer term re-rate to the stock.
From an overall financial perspective, the company has performed relatively well based on FY20 results (seen below). Although sales were hit due to COVID, the company was able to maintain the vast majority of its revenue scale and more importantly maintain its profitability. This was helped in no small part by the company’s strong EBITDA margin profile in the 40% range.
Ultimately, the company has executed well through COVID. And although new sales were hit, I believe that the commercial end market will eventually return. The question is more of when and I believe that the company has sufficient liquidity to reach that inflection point. From a valuation perspective, the stock is arguably expensive from an EV/EBITDA perspective (see below) even though EBITDA was down ~9% YoY in FY20 vs FY19. However, this is balanced by positive recent events including strong defense bookings as well as a resurgence in aftermarket volumes with leisure/business travel showing signs of improvement. Despite this, I am still cautious given the resurgence in COVID cases, and believe that the stock is fully valued at this time.
From a competition perspective, the company competes primarily with GE, Crane, Honeywell, and Raytheon. However, the company has strong win-rates against these players given its strong product offering, operating history, and track record of execution. Additionally, we note that the company focuses on non-commodity/specialized products where there are less competitive pressures as well as higher margins.
The key risk here remains COVID. Ultimately for the stock to move appreciably higher, we ultimately need to see travel return and aerospace manufacturers to ramp up again. The timing of that is simply unclear particularly given that we are entering a 2nd COVID wave.
Another key risk is M&A risk. Given that the company will likely engage in M&A to grow the top and bottom lines given their historical track record and philosophy, there will always be risk that a possible integration will not go smoothly.
Valuation and Conclusion:
As mentioned earlier, TransDigm has performed well despite COVID with strong revenue stability, strong liquidity, and the maintenance of profitability. However, the company’s valuation on a EV/EBITDA has also strongly recovered and has hit pre-COVID levels despite material headwinds on the horizon with the 2nd COVID wave currently ongoing. Thus, I remain neutral at this time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.