TransDigm: The Contemporary Doppelgänger of Capital Cities

Transdigm is probably one of the largest companies in Cleveland that no one ever heard of.

--Nick Howley, CEO of TransDigm

At the end of Chapter 1 of the great book The Outsiders, William Thorndike introduced a contemporary doppelgänger of Capital Cities:

A contemporary analog for Capital Cities can be found in Transdigm, a little-known, publicly traded aerospace components manufacturer. This remarkable company has grown its cash flow at a compound rate of over 25% since 1993 through a combination of internal growth and an exceptionally effective acquisition program. Like Capital Cities, the company focuses on a very specific type of business with exceptional economic characteristics.

In Transdigm’s case, this area of specialization is highly engineered aviation parts and components. These parts, once engineered into a military or commercial aircraft, cannot be easily replaced and require regular maintenance and replacement. They are critical to the performance of the aircraft and have no substitutes, and their cost is insignificant relative to the overall cost of the aircraft. As a result, their customers—the largest military and commercial aircraft manufacturers—are more focused on performance than price, and the company has an attractive combination of pricing power and phenomenal margins (cash flow [defined as EBITDA, or earnings before interest, taxes, depreciation, and amortization] margins are north of 40 percent). Transdigm’s management team, led by CEO Nick Howley, realized these excellent economic characteristics in the early 1990s and evolved a highly decentralized corporate structure and operating system for optimizing the profitability of these specialized-parts businesses. Howley, like Murphy at Capital Cities, knows that his team will be able to quickly and dramatically improve the profitability of acquired companies, lowering the effective purchase price paid and providing a compelling logic for future acquisitions.

Since going public, the company has also pursued an unusual and aggressive capital allocation strategy (one that has caused a fair amount of comment and confusion on Wall Street), maintaining generally high levels of leverage, repurchasing shares, and announcing a large special dividend (financed with debt) in the depths of the recent financial crisis. Not surprisingly, returns for the shareholders have also been excellent—the stock has appreciated over fourfold since the company’s 2006 initial public offering.

Any company that is dubbed "contemporary doppelgänger of Capital Cities" is undoubtedly worth some serious time. Therefore, I set out on a journey to find out the qualities of TransDigm (TDG, Financial) that made it in the book. Below are my initial findings:

The Track Record

Distinguished Business Characteristics

• Niche market, high margin, strong cash flow
• Private equity-like business model
• Unique business strategy
  • TDG is in the proprietary aerospace businesses with significant aftermarket.
  • Management runs the businesses around a unique three-part value driver strategy.
  • Decentralized and highly incentivized organization with a compensation system that pays managers to think and act like owners.
  • Focused acquisition strategy.
  • Management teams pays a lot of attention to the capital structure and look at capital allocation and leverage as another way to create equity value.

Business Description

Transdigm Inc. was formed in 1993 in connection with a LBO transaction. TD Group was formed in 2003 to facilitate a LBO of Transdigm, Inc. The Company was owned by PE funds until its IPO in 2006.

Transdigm is a leading global designer, producer and supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft in service today. The business is well diversified due to the broad range of products TDG offers to its customers. About 90% of the sales were generated by proprietary products. In addition, TDG generated about 75% of net sales from products for which TDG is the sole source provider.

Most of TDG’s products generate significant aftermarket revenue. Once the parts are designed into and sold on a new aircraft, TDG generates net sales from aftermarket consumption over the life of that aircraft, which is generally estimated to be approximately 30 years. A typical platform can be produced for 20 to 30 years, giving TDG an estimated product life cycle of 50-60 years. Over 50% of net sales were generated from aftermarket sales, the vast majority of which come from the commercial and military aftermarkets. These aftermarkets revenues have historically produced a higher gross margin and been more stable than sales to OEMs.

TDG primarily designs, produces and supplies highly-engineered proprietary aerospace components with significant aftermarket content. TDG seeks to develop highly customized products to solve specific needs for aircraft operators and manufacturers.

Major products include:

• Mechanical/electro-mechanical actuators and controls
• Ignition systems and engine technology
• Specialized pumps and valves
• Power conditioning device
• Specialized AC/DC electric motors and generators
• NiCad Batteries and chargers
• Engineered latching and locking devices
• Rods and locking devices
• Engineered connectors and elastomers
• Specialized lavatory components
• Seatbelts and safety restraints
• Engineered interior surfaces

Segments:

Power & Control - The Power & Control segment includes operations that primarily develop, produce and market systems and components that predominately provide power to or control power of the aircraft utilizing electronic, fluid, power and mechanical motion control technologies. Major product offerings include mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices and specialized AC/DC electric motors and generators. Primary customers of this segment are engine and power system and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the original equipment and aftermarket market channels.

Airframe- The Airframe segment includes operations that primarily develop, produce and market systems and components that are used in non-power airframe applications utilizing airframe and cabin structure technologies. Major product offerings include engineered latching and locking devices, rods and locking devices, engineered connectors and elastomers, cockpit security components and systems, aircraft audio systems, specialized lavatory components, seatbelts and safety restraints, engineered interior surfaces and lighting and control technology. Primary customers of this segment are airframe manufacturers and cabin system suppliers and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the original equipment and aftermarket market channels.

Non-aviation- The Non-aviation segment includes operations that primarily develop, produce and market products for non-aviation markets. Major product offerings include seatbelts and safety restraints for ground transportation applications, mechanical/electro-mechanical actuators and controls for space applications, and refueling systems for heavy equipment used in mining, construction and other industries. Primary customers of this segment are off road vehicle suppliers and subsystem suppliers, child restraint system suppliers, satellite and space system suppliers and manufacturers of heavy equipment used in mining, construction and other industries.

Secular Trend and Transdigm’s Addressable Market for Commercial Aftermarket

1. The long term Passenger Revenue Miles growths of 5-6% will likely continue:

2. Capacity to Reinvest: The market potential for Transdigm still remains substantial – TDG currently only accounts for 4% of the market share in the Commercial Aftermarket field. We will be crazy if we think TDG can get 50% of the market, but a 10-15% market share does not look too unrealistic either. CEO Nick Howley has repeatedly said that the potential for deals is undeniable but what matters is what is out there for sale. TDG has a dedicated group of executives looking at potential acquisition targets actively.

TransDigm's Moats:

• Barrier to entry –The industry’s stringent regulatory, certification and technical requirements, and the investment necessary in the development and certification of products, create significant barriers to entry.
• Substitute threat – TDG’s products are mostly highly customized in order to solve specific needs for aircraft operators and manufacturers. The products TDG offers are also highly specialized. Therefore, the substitute threat is very low.
• Competition – competition islimited because of high barrier to entry and high switching cost.
• Pricing power – TDG has tremendous pricing power because their products, once engineered into a military or commercial aircraft, cannot be easily replaced. These parts are critical to the performance of the performance of the aircraft and have no substitutes, and their cost is insignificant relative to the overall cost of the aircraft. Therefore, TDG’s customers focus on more performance than price, which gives TDG a very attractive pricing power.
• Switching cost – As long as customers receive products that meet or exceed expectations and performance standards, they will have a reduced incentive to certify another supplier because of the time of the technical design and testing certification process. In addition, the availability, dependability and safety of TDG’s products create long term supplier relationships. This creates enormous switching cost for TDG’s customers.
• Surfing a wave – the long term tailwind of growth in revenue passenger miles work in TDG’s favor.

Value Creation

1. Organic growth through market growth and value drivers.

• Focus on profitable new business which management could see the results from a simple cash flow model to take emotion out of the decision-making process.
• Stay close to the customers so customers will call TDG first when they have a problem they need to solve. TDG is generally engaged from the engineering level to the procurement level at the customer to identify new businesses.
• Identify opportunities before the customer even knows what the solution is.
• Clear communications to customers so there are no surprises.

2. Acquisition

• Usually NOT for soft concepts like synergy, excess capacity, globalization and diversity reasons.
• Focus on proprietary niche aerospace products with significant aftermarket content.
• Typically pay 9-12 times EBITDA and aim for 50% multiple reduction through EBITDA expansion by eliminating excessive costs (mostly headcount, especially mid management level) and improving pricing.
• In 2013, TDG looked into 337 deals, evaluated 21, submitted letter of intent for 7 and closed only 5 deals.

3. Capital allocation decisions.

Let’s remind ourselves that there are only 7 ways in which excess capital can be allocated:

• They can plow the capital back in the business and generate organic growth.
• They can acquire other companies.
• They can pay dividends.
• They can repurchase shares.
• They can leave the cash in the bank or short term investments.
• They can invest the cash in equities or other types of investments.
• They can pay down debt or refinance debt.

TDG’s management stays away from leaving cash in the bank because of the ungodly low return. Management teams also avoid investing in the equities of other publicly traded companies because they can deploy cash better in acquisitions. Management team also recently took advantage of the low interest rate environment and refinanced its long term debt, which brought down average interest rates 50 bps.

Historically, TransDigm’s business generates an admirable amount of excess cash flow, which management has deployed principally in three ways out of aforementioned seven:

1) As discussed above, acquire other “proprietary aerospace businesses with significant aftermarket content.” Transdigm has been admirably successful in creating value through focused and disciplined acquisition. IRR ranges mostly between 15-20% for past acquisitions.

2) Special dividends to its owners. TDG has largely pursued the latter course when it has been unable to find acquisitions that clear its stringent qualitative and financial hurdles. CEO Nick Howley explained the rationale of paying special dividends against share repurchases in the following sentences: “Our view on that (share repurchases) has been the execution risk. In other words, if we go out and try and buy that amount of stocks back quickly, we will move the price or we will pay a significant premium to tender it or something like that. And we could do it faster, quicker and with less risk with a special dividend.” During the past 3 years, TDG has paid 3 special dividends in the amount of $12.85, $22.00 and $25 per share. The latest special dividend of $3.2 billion represented almost 27% of the beginning market equity value of 2012.

3) Plow the capital back in the business and generate organic growth. Management uses a hurdle rate of 15-20% when evaluating new business opportunities.

The result of great business model and great capital allocation skills is the unbelievable track record, which we shall gladly review again.

What About Incentives?

TDG’s executive compensation plan is unique in the following ways:

1. Very low on cash compensation and high on performance-based options.

2. No time vesting, no restricted stocks, 100% performance based vesting.

3. Performance vesting depends on the growth of Intrinsic Value of the business with minimum of 10% and target growth of 17.5%. Intrinsic Value is defined as:

Although the big picture looks promising, it's not easy to understand this industry and it is even harder to understand the math behind some of the capital allocation decisions made by management team. There is so much more about TransDigm to like. I think what I have laid out above can give readers a good starting points. It is undoubtedly very rare to see the combination of great business model, significant capacity to reinvest and a great capital allocator.