I became interested in aircraft parts supplier TransDigm (TDG) because I’m a big fan of Mark Massey of AltaRock Partners; at year end, it was his largest position (~21% of the portfolio).
A few things stand out about TransDigm. First, the company has an astounding track record. It has reported long-term revenue growth in excess of 20% per annum with earnings and cash flows growing even more quickly. Second, the company’s financials are best in class: EBIT margins have consistently been around 40%, well ahead of peers. Third, the valuation seems reasonable. After falling ~20% from its highs in September 2016, TransDigm trades for less than 20x adjusted earnings (assuming you accept management’s calculations). If the company can continue to find acquisition targets, with even a fraction of the synergies it has achieved on past deals (which I’ll discuss in more detail in a minute), the stock is cheap at current levels.
And yet, with all that said, my conclusion to date has been to stay away. That decision was made somewhat grudgingly because the numbers look enticing. Yet as I’ve thought about the situation more and more, I’ve concluded that I still have too many lingering concerns about the company.
My first issue has to do with one of the positive attributes I mentioned above: outsized profitability. As I noted earlier, TransDigm has operating margins of 40%. By comparison, it’s difficult to find a single publicly traded competitor (or even a subsidiary of a larger corporation) that has consistently reported EBIT margins of more than 20%. We’re talking about a huge discrepancy between TransDigm and other aircraft parts suppliers. You’d think their competitors would spend a lot of time trying to understand and replicate TransDigm’s strategy; apparently, they haven’t been able to do so (or don't care to). It’s still not 100% clear to me why that’s the case.
That concern is compounded by the fact that TransDigm’s primary growth driver has historically been acquisitions. Since 2009, when the company started disclosing its breakdown in annual revenue growth to investors, inorganic growth has accounted for the majority each and every year. Over the past five years, TransDigm’s free cash flow has only covered about half of the company’s cumulative M&A spend; this has required significant debt issuance (total debt exceeds $10 billion), with notable help from lower borrowing costs in the current interest rate environment.
As noted at the most recent Investor Day, the company has historically paid 9x to 13x EBITDA for its targets. After the deal closes, management has a target to double EBITDA within five years (effectively cutting the multiple in half). During the Q&A, management argued it has never missed this target (on 50-plus deals). It has done so by focusing on three buckets: higher prices for aftermarket parts, controlling operating expenses, and some efficiencies (for example, using excess capacity in existing facilities to improve utilization rates). I’ll focus on the first two.
As we’re thinking about price increases for aftermarket parts, it’s important to understand exactly what TransDigm is selling to its customers. Here’s CEO Nick Howley at the Investor Day event:
"Proprietary products [where TransDigm owns the intellectual property] generate about 90% of our sales, 75% to 80% of our sales come from products for which we believe we are the sole source provider. What I mean by sole source is we're the only supplier in the world of that product."
My translation: We are essentially the only game in town, which allows us to push through higher prices to end customers. This position is reinforced by TransDigm’s widely diversified, low-dollar value product portfolio (the idea being that it can hang under the radar without too much attention). The financials support this conclusion. Based on disclosures in the company's Investor Day slide deck, I estimate TransDigm’s OEM sales have EBITDA margins of roughly 25% compared to EBITDA margins on aftermarket sales of roughly 65%. TransDigm has the ability to push through meaningfully higher prices in the aftermarket – and it hasn't been shy when doing so.
Let’s also take a look at the company’s efforts to control operating expenses. Here’s Chief Operating Officer Kevin Stein on the topic of employee turnover at the Investor Day event:
"Probably 15% to 20% every year or two are culled from the ranks of presidents and staff, and that's critical because these jobs aren't meant for everyone. Sometimes we put people into the right positions and, for whatever reason, they don't deliver the value to the shareholders, and they need to be removed. And we certainly do that in a very respectful manner, but that's a natural and important part of driving value creation."
Here's Howley on the same topic:
"We're aggressive at that. I mean, we give people – we pay them a fair amount of equity, and we expect it to be focused on value generation. And if that's not working, we don't peck somebody to death, we replace them."
I have no issues with a performance-driven culture that encourages employees to think like owners. Where I become a bit concerned is when I see overwhelming negative comments like these on employee review site GlassDoor.com (granted, from a small number of users):
"Very focused on making 'the number' – does not care what it takes to make it."
"Hemorrhaging good talent. So focused on making annual sales target."
"Upper management only cares about how much money they can make and about themselves and how wealthy they are going to become."
"The guys know how to make money. From the inside it is gloomy."
"They only care about money, not people's lives. The greed is so self-infused that they don't even realize they are going to kill people flying."
"Senior management only cares about themselves and the money. TransDigm is way too focused on getting their stock value up any way possible."
It’s important to ensure that the power of incentives doesn’t cause an overwhelming focus on the (short-term) financial results above all else. My concern after reading the proxy statement (and reviewing the work of The Capitol Forum) is that the high bar for compensation at TransDigm may be too aggressive. I worry about the sustainability of the operating model – and the ability to scale as the numbers keep getting larger – if current practices are continued (admittedly, management has pointed to ship set data which suggests strong representation on new OEM platforms).
Conclusion
In John Huber’s most recent Saber Capital investor letter (you can read it here), he said something that really resonated with me:
"As I've learned over the past few years watching debacles such as Valeant (VRX, Financial) and SunEdison (SUNEQ, Financial), a business with good economics that is coupled with a business model that extracts value from its customers (rather than adds value to its customers) is not a good business. The financial metrics might appear attractive, but a parasitic relationship with customers usually ends up destroying shareholder value at some point."
I worry that the business model, despite the attractive economics, is one that extracts value from customers (particularly after M&A). TransDigm is focused on buying “undervalued” aircraft parts and jacking up aftermarket rates. It’s unclear where it truly adds value for its customers.
The strategy has worked for a long time – and it may very well continue working in the years to come. In that scenario, that likely means shareholder returns in excess of 15% per annum (and possibly much higher). Based on what else I’m seeing, those are mouthwatering returns.
While fully recognizing that potential, I’m not willing to buy TransDigm. Simply put, I’m uneasy about some of the items discussed above – and worry there may be other issues I’m missing.
Maybe I’m overstating these concerns. In that scenario, TransDigm will likely work out well for investors. I can live with that outcome. There are no called strikes in investing. For now, I’ll keep the bat on my shoulder and wait for a pitch I’m more comfortable swinging at.
Disclosure: None.
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