From the Undervalued Predictable screener at GuruFocus comes Transdigm Group Inc. (TDG, Financial), a $14.9 billion company.
The undervalued portion of the screener searches for companies using discounted cash flow, both on a free cash flow basis and on an earnings basis. The objective is to find companies that trade at a price below intrinsic or present value.
On predictability, GuruFocus rates stocks from 1-Star to 5-Star, with 4- and 5-Star companies considered the most predictable. Behind the rankings are the consistency of their revenue per share and EBITDA (earnings before interest, tax, depreciation and amortization) over the preceding 10-year period.
Having passed those two hurdles, we go on to ask whether Transdigm is worth further investigation by value investors.
About Transdigm
In its 10-K for fiscal 2017, the company describes itself as a global designer, producer and supplier of highly engineered aircraft components for use on commercial and military aircraft. The Cleveland, Ohio-based company was formed through a leveraged-buyout transaction in 1993 and went public on the New York Stock Exchange in 2006.
It operates in three segments:
- Power Control: Systems and components that provide power to or control power of an aircraft (electronic, fluid, power and mechanical motion technologies).
- Airframe: Systems and components used in non-power applications of aircraft (latching and locking devices, cockpit security, audio, seat belts and engineered interior surfaces).
- Non-Aviation: Products such as safety restraints for ground transportation, refueling for heavy equipment and mechanical/electro-mechanical actuators and controls for space applications.
Many of the products it makes and sells are proprietary, protected by patents. Revenue for calendar 2017 was $3.538 billion.
Great company?
Warren Buffett (Trades, Portfolio) famously urged investors to look for great companies at great prices. To flesh out that idea, this article uses Thomas Macpherson’s criteria, as laid out in Searching for Compounding Machines and Seeking Wisdom: Thoughts on Value Investing.
Macpherson, too, searches for great companies at great prices, and has criteria for doing an initial scan. Survivors of the initial screen then go on to further, intense scrutiny, as he winnows down the initial survivors.
His criteria for a great company are:
- A competitive moat.
- Financial strength.
- Profitability.
For the competitive moat, Macpherson uses:
- 10-year median return on capital, minimum 15% - GuruFocus explains, “Return on Capital measures how well a company generates cash flow relative to the capital it has invested in its business. It is also called ROIC %. The reason book values of debt and equity are used is because the book values are the capital the company received when issuing the debt or receiving the equity investments.”
- 10-year median return on tangible equity, minimum 15%.
Median ROC came in at 11.70%, well below the threshold of 15%, by 3.3%.
Because Transdigm has negative book value and tangible book value, that metric is unavailable.
As a substitute, we turn to Vuru.com, which gives the company strong marks for its economic moat, albeit on different terms than Macpherson:
In discussing the earnings call of May 10, 2016, Sean Stannard-Stockton of Ensemble Capital quoted Transdigm management as saying:
“If TransDigm went bankrupt and died and all our plants caught on fire, ultimately the airline industry would find a way to survive. So, it’s not that there is no way to get around us. But there is a significant entry barrier, there is a significant cost, there is a significant qualification.
There is also the issue that we own the IP [intellectual property], so you got to find the way around that. It’s a substantive barrier that we frankly have not seen any material change in. Now, is it impossible? If you don’t care about the costs, you can always find the way around most anything. But I don’t see any fundamental change in the switching cost characteristics here.”
Turning to financial strength, Macpherson looks for:
- Cash-to-debt, minimum value of 100.
- Financial strength, minimum value of 9.
As this screenshot of the GuruFocus dashboard shows, Transdigm falls well short of these criteria:
Cash-to-debt is a small fraction of 100, and the overall financial strength rating is just 3. This is a highly leveraged company.
The third of Macpherson’s criteria for a great company is profitability, and more specifically a GuruFocus profitability rating of at least 9.
The following screenshot shows Transdigm meets this criterion, with a slew of green down this section of the dashboard:
Summing up Transdigm's results, we could say it is borderline on the competitive moat, a clear fail on financial strength and a pass on profitability. For value investors, heavy leverage would likely make this stock unacceptable.
Great price?
To determine whether a stock is priced appropriately, Macpherson looks for undervalued stocks using these three types of discounted cash flow (DCF) analysis:
- Cash flow-based earnings
- Earnings-based
- Free cash flow-based
Why the emphasis on cash flow? He explains: “Free cash flow is arguably the hardest of numbers to cheat on when reporting financials. Financial reporting today means earnings might be earnings, but cash is still cash.” This comes from the first of three articles about DCF, starting here.
Macpherson gets these measures from the bottom of the All-in-One-Screener page at GuruFocus. Access them by entering the stock name or symbol near the top of the page and click on the "Go" button; after the page refreshes, go to the bottom and click on the "Valuation" tab.
For Transdigm, the output looks like this (on March 5); click on the image for a larger size:
The first two measures are also available in the Undervalued Predictable screener (if the stock meets the criteria for that screener). This is how they appear:
What do these numbers mean? All three are used to estimate the intrinsic or present value of a company. DCF refers to discounted cash flows, a process by which all future cash flows are estimated, then discounted by the cost of capital and the result is a present value (PV).
- DCF free cash flow obviously uses cash flow; as Macpherson points out, cash flow is the most reliable metric.
- DCF earnings is an alternative way of getting to present value, but uses earnings rather than cash flow.
- Projected free cash flow (FCF): Because earnings-based DCF does not work with inconsistent revenue and/or earnings, GuruFocus developed this measure. Transdigm is a predictable company, so little or no weight should be given to this metric.
In the case of Transdigm:
- The DCF-free cash flow shows a present value of $371, while Transdigm closed at $285.57 (March 5), thus putting the current price 23% below the estimated present value. By this measure, this is an undervalued stock (and one of the reasons it made the Undervalued Predictable screener).
- The DCF-earnings number comes in at $275, while, as noted, the current price is $285.57. In this measure, the current price is considered 4% overvalued.
- The Projected FCF is calculated at $91.59, while the share price is $283.74, producing a ratio of 3.10; this indicates the company's shares are overvalued. Note, though, the company’s free cash flow has been relatively consistent, so we give it little weight.
For a different perspective, this GuruFocus table shows how Transdigm’s free cash flow has grown over the past 10 years, five years and 12 months:
Summing up, Transdigm would be considered undervalued according to the first measure, DCF-free cash flow, with a 23% margin of safety. On DCF-earnings, the stock is slightly overvalued, while projected free cash flow is not relevant given a history of consistent free cash flow growth. Overall, give Transdigm a pass on valuation.
Other considerations
Transdigm is held by 10 investment gurus: Chase Coleman (Trades, Portfolio), Steve Mandel (Trades, Portfolio), Andreas Halvorsen (Trades, Portfolio), Ron Baron (Trades, Portfolio), Alan Fournier (Trades, Portfolio), PRIMECAP Management (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Pioneer Investments (Trades, Portfolio), Frank Sands (Trades, Portfolio) and George Soros (Trades, Portfolio). Coleman holds the largest tranche, almost 2 million shares.
Wallace Weitz (Trades, Portfolio), writing in a commentary for the Weitz Value Fund in April 2017, said of Transdigm: “The company’s levered balance sheet, while married with historically consistent cash flows, increases the company’s sensitivity to potential declines in profitability.”
Baron of Baron Funds, writing in August 2016, said: “TransDigm recently held an analyst day that highlighted the incredible success the company has had and the cash flow machine they have built. By the way, equity value of the company has compounded at 33% for the 24 years since founding and the enterprise value of the company has grown from $50 million to $23 billion!”
Conclusion
There is much to like about Transdigm Group. It continues to be on the growth path noted by Baron and has the potential to reward investors—if it can stay on that path. Tariffs imposed on steel and aluminium would undoubtedly push up its prices. And even more concerning is the leverage it uses; so far it has accelerated growth, but if interest rates go up, can it continue to outperform?
It’s also that leverage that will concern prudent investors. Transdigm met the profitability and undervaluation criteria Macpherson uses, but the debt load is a bridge too far for value investors.
Disclosure: I do not own shares in any of the companies listed, and do not expect to buy any in the next 72 hours.
I am usingThomas Macpherson's criteria for great companies and great prices on my own initiative, and Macpherson has not been involved in the development or writing of this article. Any errors or misinterpretations of his work are mine alone.
