A New Wide-Moat in Aerospace

Despite the run-up in

Since the company's founding in 1993 and its IPO in 2006, Transdigm's management has judiciously allocated capital to M&A, shareholders, and internal projects, which has resulted in returns consistently above the cost of capital. Management successfully integrates multiple acquisitions each year, explicitly targeting firms with wide moats, and it typically doubles EBITDA within five years at acquired companies. Total returns to shareholders stand at over 1,000% from 2006 until today versus 149% for the iShares US Aerospace & Defense Index.

Transdigm's moat rests on switching costs and intangible assets. Its aerospace products meet FAA certification requirements and must also pass a separate aircraft manufacturer qualification process. Aftermarket sales, which account for over 75% of profitability, remain particularly sticky. Consolidated EBITDA margins typically hover around 46%, but we estimate aftermarket EBITDA margins above 60%. Due to its moat Transdigm enjoys pricing power through the entire business cycle and the highest margins in our aerospace coverage universe. Given the company's moat and capital stewardship, we expect excess returns to invested capital to continue for at least the next two decades.

Intellectual Property, Need for Parts Among Its Assets Transdigm's wide economic moat rests on intangible assets in the form of intellectual property on its products, particularly in the aftermarket where this IP effectively blocks competitors. In addition, switching costs emanate from the inclusion of Transdigm parts in an aircraft's design by plane manufacturers and through FAA certification of these parts. Finally, the low overall dollar value of the company's parts versus the high cost of failure for aircraft reinforces these switching costs.

Transdigm's moat has also resulted in ROICs above the cost of capital even when including goodwill (roughly 50% of total assets) sitting on the balance sheet. This ROIC performance results in solid pricing power in the market, something the company managed to maintain even during the last economic downturn. We forecast ROIC including goodwill to average 14.3% from fiscal 2016 to 2020. However, if we strip out the company's acquisitions in 2016 and the unannounced future acquisitions that we model (adjusting our goodwill, revenue, and profitability projections) we arrive at an average annual ROIC of 18% over the next five years. We're nearly certain that Transdigm will earn excess returns for the next 10 years, and we expect returns above the cost of capital to continue even past this time period.

Turning to returns on new invested capital, our projections call for an average RONIC of 21% from fiscal 2016 to 2020 versus an average of 35% over the preceding five years. We anticipate earnings before interest growth of 15% from fiscal 2016 to 2020 to accompany this RONIC, compared with a 29% EBI growth rate from 2010 to 2015. Post our explicit five-year forecast, we model returns above the cost of capital lasting for the next two decades. Transdigm's wide moat rating underpins this assumption, noting that we do expect returns on new invested capital and EBI to slow due to the impact of scale (Transdigm will not achieve such rapid growth as it becomes larger) and the niche aerospace and defense markets Transdigm serves.

The company's strategy explicitly seeks to reinforce its moat by maintaining a significant exposure to the aerospace and defense aftermarket, a large portfolio of proprietary products, and a sole source position on most products. The aftermarket, which we forecast at roughly 55% of fiscal 2016 sales, includes spare and repair part sales primarily to airlines and parts distributors. Switching costs in the aftermarket remain high because of the high cost of an aircraft failure as well as the costs and time associated with re-certifying an aircraft with the introduction of new parts. Moreover, high proprietary content via IP makes it difficult for competitors to copy Transdigm products or even service them because they cannot access the technical data. Because of this IP and captive aftermarket, we estimate sole source contracts--where Transdigm is the only company available to perform the work--will account for about 80% of revenue in fiscal 2016. Finally, we note that although EBITDA margins in the aftermarket are predictably high, we estimate equipment sales still generate EBITDA margins of in the range of 25%-30%. This is impressive, particularly when you consider that engine manufacturers like Rolls Royce and

Safran SAFRY realize similar aftermarket margins but sell their equipment at a loss.

The company's economic moat also rests on the rigorous aerospace supplier selection and qualification process, which takes place when an aircraft manufacturer like

FAA certification represents another intangible asset that Transdigm, like many other aerospace companies, enjoys. Once the FAA certifies an aircraft, it also certifies the bill of materials for the aircraft, which includes Transdigm's parts. This FAA regulatory regime effectively creates switching costs for Transdigm since a customer trying to re-certify an aircraft with new parts would need to expend a significant amount of time and resources. In addition, a new entrant wanting to certify a part and offer it to Transdigm's customers would find this strategy uneconomical without immediately having significant scale since most parts sell for a low dollar amount but would require a fairly costly and lengthy certification process.

Low Dollar Value of Parts Plus High Cost of Failure Equals an Advantage for Transdigm The dollar amount of Transdigm's products as a percentage of aircraft value also sets the company apart from other aerospace players of its size and reinforces the company's switching costs. Only 10% of commercial aftermarket revenue comes from parts with total annual sales above $2 million, which means that Transdigm remains a relatively small supplier to its customers and that customers typically don't change suppliers due to price increases. This also serves to partially insulate Transdigm from Parts Manufacturer Approval products, which are non-OEM spare parts but certified for use by the FAA onboard aircraft. The economics for these PMA parts typically work best for high-volume low-priced parts. While Transdigm's business remains focused on lower-priced parts, these parts are not typically high volume, as evidenced by their low total annual sales levels.

Although we think our reasoning mostly holds true for airlines and parts distributors, we do note that Boeing included Transdigm in its recent partnering for success initiative that sought price concessions from suppliers. In any event, the low value of Transdigm's parts coupled with the high cost of failure for commercial and defense aircraft means that customers are often reluctant to change suppliers due to price increases. This feature of the business came through in a pronounced way during the last downturn when the company managed to move prices up on spares and repair parts in the commercial aftermarket even in the face of weak air traffic demand and belt-tightening at airlines.

Based on our discounted cash flow valuation we arrive at a Transdigm fair value estimate of $310 per share. The primary drivers of our valuation are growth within each of Transdigm's end markets, the ability of the company to successfully continue its serial acquisition strategy, and EBITDA margin performance within the Power & Control and Airframe segments. Our forecasts incorporate what we view as a natural slowing in Transdigm's previously blistering growth primarily due to scale. We anticipate revenue increasing at an annual average rate of 12.5% from 2016 to 2020 and EBITDA growing 13.3% over the same time period compared with over 20% average annual growth for both of these metrics from 2000 to 2015. Our stage II assumptions for returns on newly invested capital and earnings growth post-2020 also reflect this declining trend but still stand at 20% and 5.5%, respectively.

We model organic growth averaging about 4% per year from 2016 to 2020. Commercial aftermarket revenue grows at an average annual rate of 5.3% over the next several years and commercial equipment sales to increase at an average annual pace of 4% per year. Defense revenue will not keep pace with the commercial side of the business, growing slightly less than 2% per year, which is aligned with our outlook for the U.S. defense budget. We include unannounced acquisitions and, assuming Transdigm's acquisition spend and the sales multiples mirror recent years, we expect new acquisitions to add roughly $1.0 billion to sales by 2020.

We anticipate adjusted EBITDA margins to expand by roughly 70 basis points from 2016 levels to 47% by 2020. We model midcycle EBITDA margins of 47% as well, which compares with average EBITDA margins of 46.8% over the past five years and peak margins of 49.2%. A mix shift toward aftermarket content, Transdigm's continued success increasing EBITDA of acquired companies, and sustained pricing power due to proprietary products will fuel margin expansion.

Profitability assumptions result in annual average adjusted EPS growth of 15% from 2016 to 2020. This profitability performance translates into adjusted operating cash flows doubling to $1.1 billion in 2020. The company historically trades above 20 times P/E and above 14 times EV/EBITDA. Based on our fair value estimate our terminal multiple for the former stands at 23.5 times, while the latter stands at 14.9 times.