Transdigm's Business Model Remains a Success

Transdigm’s business reflects its private equity roots--the company had its initial public offering in 2006--and its units typically operate autonomously. The company also uses significant financial leverage, relying on a stream of aftermarket business to generate predictable cash flows. Management is a serial acquirer, aiming to improve operations at acquired firms and optimize the capital structure.

Transdigm’s moat rests on switching costs and intangible assets. Its aerospace products meet Federal Aviation Administration certification requirements and must also pass a separate aircraft manufacturer qualification process. Aftermarket sales, which account for over 75% of profitability, are particularly sticky. Transdigm enjoys the highest margins of any company in our aerospace coverage, translating into impressive returns on invested capital. It reports financials through power and control and airframe segments but in practice manages its business through 32 units. For fiscal 2016, we expect the firm to generate roughly 70% of sales from commercial customers--airlines and parts distributors (39% of total 2016 sales) and aircraft manufacturers like Boeing and Airbus (32% of 2016 sales) for equipment sales--and 30% from defense customers.

Transdigm generated excess returns every year over the past decade, and we expect it to continue to do so. We do foresee revenue and profit growth slowing from the blistering pace over the past decade due to scale effects and the niche aerospace markets in which the firm hunts for acquisitions. Still, we think long-term investors will be well served holding the name.

Wide Moat From Intellectual Property 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 resulted in returns on invested capital 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 maintained even during the last economic downturn. We forecast ROIC including goodwill to average 13.8% from fiscal 2017 to 2021. However, if we strip out the company’s acquisitions in 2016 and the unannounced future acquisitions that we model, we arrive at an average annual ROIC of around 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.

The company 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 stood 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 recertifying an aircraft with the introduction of new parts. Moreover, high proprietary content via IP makes it difficult for competitors to copy Transdigm’s products or even service them, as they do not have access to 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 2017. Although EBITDA margins in the aftermarket are predictably high, we estimate equipment sales still generate EBITDA margins of 25%-30%. This is impressive, particularly considering that engine manufacturers like Rolls-Royce and Safran realize similar aftermarket margins but sell their equipment at a loss.

Transdigm’s economic moat also rests on the rigorous aerospace supplier selection and qualification process, which takes place when an aircraft manufacturer like Boeing or Airbus designs a new aircraft. The desire of aircraft manufacturers to freeze their designs and reduce complexity in their final assembly lines means that design changes requiring new suppliers are rarely pursued once design freeze occurs several years before start of production. We particularly think switching costs for aircraft producers remain high during the critical initial production ramp-up that demands steep reductions in unit recurring costs. On mature programs--once production has stabilized--aircraft manufacturers can be more apt to make design changes and/or change suppliers.

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 effectively creates switching costs for Transdigm since a customer trying to recertify 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, as most parts sell for a low dollar amount but would require a fairly costly and lengthy certification process.

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 by the FAA for use 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 evidence by their low total annual sales levels.

Boeing did include 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 most recent 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.

Exposed to Both Commercial and Military Markets Transdigm's business is chiefly exposed to the health of the commercial aerospace market and, to a lesser degree, defense spending and military operations tempo. Transdigm's commercial equipment sales (31% of revenue) follow aircraft manufacturing, which is driven by global economic growth. The company's larger commercial aerospace aftermarket business (36% of revenue) typically tracks global revenue passenger kilometers, and after the financial crisis, this metric has been running at over 5% growth. During the last downturn, RPK year-over-year growth went negative, but Transdigm retained its pricing power thanks to its moat.

Defense accounts for roughly 33% of sales and tracks with U.S. defense spending and demand for spares linked to operations. Transdigm is also modestly exposed to the business jet and commercial helicopter markets, which combined account for about 15% of sales. Weak oil and other commodity prices have been driving demand down in the business jet (high-net-worth individuals) and rotorcraft (oil and gas exploration) markets.

Transdigm’s acquisition machine may not continue at the pace we have seen over the past decade. While we think overpaying for targets is unlikely, we do have concerns around the availability of viable targets and the potential for deals to be blocked on antitrust grounds. The former concern stems from the restrictive but value-creating criteria Transdigm uses for targets: low-dollar-value aerospace components, high aftermarket content, and significant IP. Antitrust concerns already materialized once in 2012. While no other antitrust issues have surfaced and Transdigm continues to close deals, we believe there are both natural and regulatory limits to Transdigm’s strategy.

Stewardship Is Exemplary We rate the company's stewardship of shareholder capital as Exemplary. Management remains focused on investing in and acquiring aerospace products with high aftermarket content and intellectual property behind them. It applies a three-prong strategy to optimize its businesses: capturing profitable new business, achieving year-over-year cost improvements, and pursuing value-based pricing. While this all sounds a bit motherhood and apple pie, the relentless focus of management on these pillars year in and year out impresses us.

We think Transdigm’s culture, born out of nearly 15 years under private ownership, seeks to disrupt the principal-agent problems inherent with public companies. Management maintains a large stake in the business, with more than 10% of the common shares outstanding. The company’s compensation philosophy emphasizes equity awards and attempts to constrain the cash component of executive pay to amounts below industry norms. Stock options only vest if management increases the company’s intrinsic equity value (EBITDA times a multiple less net debt) by 17.5% annually.