TransDigm Stock: Preparing For Lift-Off (NYSE:TDG)

Little over a year ago, I last had a look at TransDigm Group (NYSE:TDG), concluding that shares were flying high as the company was riding out the storm. Over the past year, the company has seen its end markets stabilize, with an increased outlook for the defense markets providing some comfort here for the business, as shares continue to trade at nosebleed valuations as a testament to great investor respect in the way this business has been led.

The Business – Publicly-Traded Private Equity Play

TransDigm is a unique conglomerate within the aerospace business. The company clearly distinguishes itself from many peers by focusing on aggressive pricing strategies, employing high leverage in a model which creates great returns for long-term investors, albeit accompanied by quite some volatility at periods of time.

The company generated $5.2 billion in revenues in 2019, an important year as it is the base case ahead of the pandemic year of 2020, as the business was hugely profitable as it posted EBITDA of $2.8 billion, with margins in excess of 50%. A net debt load of $15 billion made that leverage ratios came in above 5 times, which in the case of TransDigm has actually been relatively low! Moreover, the company actually paid out a special dividend of $32.50 per share that year, equal to a $1.8 billion cash outflow, as the timing was very unfortunate, of course, (with the benefit of hindsight).

The luck of the business was that despite the big debt load, no large maturities were showing up, with covenants being quite good for the company itself. With results under pressure in 2020, for obvious reasons, the company was seeing a leverage ratio of around 7.5 times by year-end. Yet, despite the lingering uncertainty, the company continued its M&A strategy. This came as the company announced a near-billion deal to acquire Cobham Aero by the end of 2020.

With shares having recovered to $600 early in 2021, the company supported a $50 billion enterprise value at roughly 10 times sales, as the earnings multiple was quite elevated with earnings power having rebounded to $12 per share at the time. Still, quite a bit below the $20 per share run rate ahead of the pandemic. The high valuation multiple, and high leverage is tricky, certainly as there are public concerns on the sustainability of the >50% EBITDA margins as well, with pricing practices perhaps too aggressive. These concerns, despite the great track record of the business and management team, make that I could not commit to buying TransDigm at the time.

Stagnation Has Ended

Fast-forwarding little over a year in time, shares have hardly moved as they have traded in a $550-$650 range, now trading at $638 per share. The year 2021 was not too noteworthy. In March, the company announced a small divestment, having sold its ScioTeq and TREALITY business in a $200 million deal. Two months later, second quarter results revealed continued pressure from the pandemic with second quarter sales down 17% to $1.2 billion.

In August, the company became involved with a takeover attempt for British Meggitt PLC in a deal which might have come a bit too preemptive, given the situation at the time. Third quarter sales rose 19%, but these marked easy comparables as sales were flattish on a sequential basis at $1.2 billion, with fourth quarter sales up 9% to nearly $1.3 billion.

For the year ending September 2021, the company posted a 6% fall in sales to $4.8 billion as EBITDA fell 4% to $2.2 billion. Yet, the fourth quarter run rate already ran at $5.1 billion in revenues with EBITDA trending at $2.5 billion again. Higher financing rates made that earnings per share fell from $14.47 per share to $12.13 per share, but the run rate improved to $17 per share in the fourth quarter as net debt was rather flattish at $15.2 billion.

In February of this year, the company posted reasonable first quarter results. While revenues rose 8% on an annual basis, sales of $1.2 billion mark a small sequential decline, as adjusted EBITDA and earnings metrics have seen a small setback as well compared to a reasonable fourth quarter of last year. There were some green shoots as well, despite the lack of a guidance provided, as net debt inched down to $15.0 billion. And while no guidance was given, the increased political unrest creates for a better setup from the exposure to defense markets. After all, the company is split roughly even between Commercial OEM and defense markets, making it one of the prime beneficiaries of today’s unfortunate events.

Despite a relatively softer first quarter, the anticipation of improved performance from the defense market clearly gave the company confidence, as TransDigm has announced a bolt-on deal. In March, the company announced the purchase of DART Aerospace in a $360 million cash deal. The Canadian business provides highly engineered helicopter mission equipment solutions as its 400 workers are set to generate $100 million in revenues.

The resulting 3.6 times sales multiple is arguably low with TransDigm trading around 10 times sales, as TransDigm undoubtedly aims to bolster margins here as well. With no margin details announced, the profit contribution is now likely modest, as the impact on debt is very reasonable as well, with the deal set to add some 2% to pro forma sales.

Concluding Remarks

With shares trading dead flat over the past year, appeal logically seems to have improved, but the actual business of TransDigm is slow to pick up from the carnage induced by the pandemic. Fortunately, the pandemic is on its retreat, yet commercial aviation now faces headwinds from inflation and high fuel prices, while the defense market benefits from the political uncertainty, albeit not yet seen in the actual results.

Given all these factors, I see real stabilization and growth prospects again, yet the overall valuations remain nosebleed high while leverage remains high, yet confidence is high enough to pursue bolt-on deal-making. Amidst all this, I am still a bit cautious to get involved here, looking for a better entry point before getting involved.