AGB 2020.4 - TransDigm Group (TDG)
All About the Reinvestment Rate (Acquisitions)
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TransDigm Group
Roll-up business models usually fail in two ways. In the first way, the acquired assets don’t produce a high enough return to justify the cost of acquisition, even when factoring scale advantages. In this case, the cash flows produced from the acquired assets less the payments on the new debt are only slightly positive or even negative. Management teams of these roll-up models think that bigger is better, regardless of the quality of the revenues.
In the second way, the acquired assets aren’t defensible during an economic downturn and the once predictable cash flows are hampered like the rest of the economy. The internal downside model scenario isn’t conservative enough and the company has trouble servicing its debt. As you can see in both cases it’s the debt that ends up crushing the value of the equity.
But TransDigm isn’t your typical roll-up model. The company aims to acquire companies that sell proprietary aerospace products and which are often times the sole source provider of aftermarket products. Under the TransDigm model, these companies have the potential to become high margin businesses over time and produce very predictable cash flows, even in economic downturns. Even though the acquisition multiples are high, TransDigm is able to deploy value based pricing and an effective cost reduction methodology to reduce the implied acquisition multiple.
For each of its business units, TransDigm operates lean by removing layers within middle management at most of its subsidiaries and operating in a decentralized model. After an acquisition is made, cost cutting and realignment of incentives are put in place so that the company can achieve higher profits per employee. Typically, cost cutting after an acquisition leads to low morale and can significantly destroy productivity. But through the TransDigm operating model, talented employees are empowered and incented to treat the company like owners which leads to steady and improved productivity.
As its management team says on every earnings call, “TransDigm is unique in the aerospace industry.” TransDigm operates a straight forward yet high returning business model under these 5 pillars:
Proprietary aerospace products with significant aftermarket (sustainable high margins)
Value-based operating strategy (increase revenues)
Decentralized organization (lower costs)
Disciplined acquisition strategy (grow base to deploy operating strategy)
Efficient capital structure (optimize capital allocation)
The company’s revenues are comprised of half aftermarket and half OEM. Two thirds of the business is exposed to commercial aerospace and one third is related to defense. But more than three quarters of the EBITDA come from the aftermarket segment. TransDigm has been a prolific acquirer of aerospace assets, absorbing over 65 businesses since the company was founded in 1993.
TransDigm believes that EBITDA can grow 15%-18% per year on average (11% from organic growth, 3% from operating and financial leverage and 3% from acquisition). Of course being exposed to a growing end market helps as well. This latest commercial aerospace cycle has been one of the longest in history with 17+ years of expansion starting in 2002.
Why is it a good business?
TransDigm learned early on that selling products that service the aerospace industry had the potential for long-term, high cash flow generation. This is especially true for aftermarket parts. A typical airframe program life cycle lasts 60-70 years. After design, testing and approval, the aircraft manufacturer will produce a new aircraft for 30-35 years and airlines will continue to utilize the aircraft for 30-35 years even after production ends. The aftermarket businesses starts to take off after 10 years into the program’s life cycle and dominates the profit pool.
With the exposure to aftermarket parts and selling proprietary and sole source products, TransDigm has many cornered resources within Aerospace. These parts are typically below $1,000 in selling price, but are critical to the overall aircraft. Many times, TransDigm is the only supplier of the part, which allows the company to leverage pricing power over the buyers. These buyers worry less about overpaying for small parts (even with prices increasing annually) because they don’t move the needle as much as the parts that are priced in the $100,000 to $1M range.
This market dynamic has resulted in TransDigm consistently achieving margins that are one of the highest in the industry. For FY19, TransDigm’s EBITDA margins were 46% even after acquiring Esterline (the largest in company history), which had much lower margins at deal close at 16% EBITDA. Without the Covid related downturn in travel and aerospace in 2020, TransDigm’s margins would have been even higher in FY20.
High margins means the company has options with its free cash flow and capital allocation is very important. TransDigm’s first priority is to invest back into its existing business lines. This comes in the form of R&D and Capex but these expenses are small as a percentage of revenue and cash flow. Over the past 10 years, TransDigm’s average R&D and Capex combined was 3.5% of revenues or 7.5% of EBITDA.
The second priority for the cash is to acquire similar businesses (proprietary products with high aftermarket content) within aerospace. Typically these assets have the potential to be as profitable as TransDigm but are mismanaged from a pricing and cost perspective. To increase the asset base to which TransDigm can operationally improve over time, the company deploys its precise and methodical acquisition strategy. TransDigm analyzes hundreds of companies every year to see if any potential targets are reasonably priced. The most important criteria is whether the potential target has proprietary products and enough margin improvement potential under the TransDigm model. Once an acquisition is completed, TransDigm undergoes a 120 day process to establish work culture, decentralize the organization, identify and empower key people, and implement productivity plans.
If TransDigm isn’t able to find meaningful acquisitions, the company will move to the third priority, returning cash back to shareholders in the form of buybacks and special dividends. Since 2010, the company has paid out special dividends 6 times amounting to $143/share.
The fourth priority is to pay down debt, but with ever declining interest rates, the company has elected to refinance instead of paying down much debt.
Returns on capital?
TransDigm has been a serial acquirer of aerospace businesses from the beginning. Almost all of the capital deployed by the company has been through acquisitions. Over the past 10 years, the capital spent on acquisitions has averaged 45% of revenues and 95% of EBITDA. Acquisitions have ranged from $500M-$2B during heavy acquisition years and surpassed $4B in FY19 for the acquisition of Esterline, the largest to date.
Typically, TransDigm acquires companies for multiples of 3x EV/Revenue and 12x EV/EBITDA. Those acquisition multiples (if we assume EBITDA is a decent proxy to cash flow) imply a low return of 8.3%. But as we can see from the Esterline acquisition, TransDigm dramatically improves the target’s EBITDA following the acquisition and thereby lowers the acquisition multiple.
As soon as the Esterline deal closed, the company assigned tenured TransDigm executives to the integration team. After analyzing the business units, the company determined that two assets (Souriau and EIT) were non-core and would be later sold for $1.1B. Cost cutting efforts were realized by closing the Bellevue headquarters and removing redundant corporate functions. The result of the integration efforts were impressive, with EBITDA margins improving from 16% at closing to over 30% in less than a year. The implied acquisition multiple declined from 12x to 6.5x EV/EBITDA, which gets Esterline acquisition to a much better return profile of 15%.
Over the past 10 years, TransDigm has returned between 10%-13% on its capital spent annually. The company states that its own internal acquisition model requires a 20+% return for them to do a deal. And through value based pricing, systematic cost cutting and alignment of incentives, many times the returns look even better than initial internal projections.
So why is the total company return of 10%-13% less than the acquisition model return of 20%? The first reason is that there are times when acquisitions don’t turn out the way the models predict. The Schroth Safety Products acquisition is an example. In 2017, TransDigm acquired Schroth for $90M or 2.1x EV/Revenue. Shortly after close, the DOJ investigated the acquisition for competition concerns. Because it was a small deal and TransDigm didn’t want an investigation dragging on for months, they reached an agreement to sell the business in 2018 for a $29M loss.
The second reason is that organic growth for the company is lower than their acquisition target of 20%, implying that the return on capex + R&D are below that of M&A. Over the past 10 years, organic revenue growth has averaged 6% and if we assume slightly better earnings growth due to operating and financial leverage, we estimate that organic earnings growth is 8%-9%. Even though the company is spending a large portion of its capital into acquiring new businesses that have potential to reach 5-year IRRs of 20%, the lower returning base business is getting larger with every deal.
The third reason is that debt refinancing cost money. While these costs are removed from EBITDA calculations, they occur very frequently and it’s good to look at their impact to the overall financials. Since 2010, TransDigm has refinanced its debt almost every year and has incurred a cash cost of $318M, or $32M annually. This amounts to 1.3% of TransDigm’s FY19 EBITDA. If you remember, capex + R&D averages to be 7.5% of annual EBITDA. Even with this cost, the refinancing activity was very beneficial to the company, saving hundreds of millions of dollars in interest payments.
Reinvestment potential?
Reinvestment rate is the most important driver of intrinsic value growth for TransDigm. While the rate of return on incremental capital invested is decent at 10%-13%, without a high reinvestment rate, the intrinsic value of the company would be close to market average. A 50% reinvestment rate would only imply a 5%-6.5% annual rate of growth for intrinsic value, which would mean we wouldn’t be writing about it on AGB.
TransDigm laid out its addressable market at its Analyst day in 2018 and we hope that the company will present updated data during its next Analyst day. Of the $700B in annual global airline opex + capex, about 10% is related to maintenance. Of that 10%, a little less than half is related to parts or $29B. The other half is related to personnel, improvements, etc. Of $29B market, TransDigm’s commercial aftermarket business in 2017 was roughly 4% of the market. Assuming that the market has remained steady, TransDigm’s commercial aftermarket business now at $1.5B for FY20 would imply 5.4% market share.
As generalists, we don’t know enough about the global aerospace industry to be able to identify specific acquisition targets. However, we can estimate that on average, the reinvestment rate of the company will continue to be above 100% of operating cash flows as long as there are opportunities to acquire at reasonable prices and the cost of debt remains low. With the impact from Covid on global air travel, TransDigm hasn’t been able to identify any meaningful acquisition targets this year so far. The company mentioned on its F20Q3 earnings call that companies with proprietary aftermarket businesses don’t sell during downturns unless they have to. It’s also worth mentioning that the company is also still in the middle of its integration of Esterline.
With the company’s high level of reinvestment between 110% and 120% of operating cash flow, we estimate that intrinsic value growth for TransDigm has been 12%-15%, annually over the past 10 years. The reinvestment rate related to the Esterline acquisition was very high, so even though the company hasn’t been able to identify a meaningful acquisition in FY20, intrinsic value growth should continue for the near future.
It is also worth mentioning that for fast growing roll-up model like TransDigm, the acquisitions have to get larger over time to keep up with the pace of growth. This would imply that increases in market share is non-linear and the fact that growth will eventually need to slow down as TransDigm becomes a larger part of the overall market.
What else is important?
Inspector General audits
For investors that have studied TransDigm in the past, we are all familiar with the IG audits related to price increases for sales to government entities. Investors have reason to be wary because we’ve seen price increase strategies at other companies blow up before. The most famous case of this is Valeant Pharmaceuticals.
Certain short sellers have pointed to the similarities between Valeant’s acquisition and pricing strategy to that of TransDigm. Up until its collapse, Valeant acquired patents and rights to existing drugs and then raised prices in many cases by thousands of percentage points. Then Valeant would push these high priced drugs onto consumers using specialty pharmacies. Many times the company itself would create these pharmacies to circumvent anyone flagging the high prices to the consumers and the insurance companies. The consumers needed these drugs to go about their daily lives so they went along with the purchases and typically the insurance companies would end up footing most of the bill. Interestingly, this roll-up story didn’t end with debt crushing the equity, but rather short sellers pointing out the nefarious nature of the scheme, which prevented future price increases and investigations by government entities.
TransDigm acquires aerospace parts companies that are many times critical to commercial and defense aircraft programs. Then TransDigm raises prices, also sometimes by thousands of percentage points. There have been short reports claiming that TransDigm owns or influences distributors to also raise prices to imply collusion against the government, but it hasn’t been proven to be the case. Now, we can’t say that there’s no risk here, but we will point out that the IG has done many investigations into the price gouging of certain parts supplied by TransDigm but has always only asked for a refund. The CEO and CFO of TransDigm testified before a senate committee multiple times.
The key difference between Valeant and TransDigm is that Valeant was orchestrating an elaborate insurance scheme because their customers didn’t have means to pay for the outrageous price increases while TransDigm’s customers can afford to pay their high prices for certain aerospace parts, even if they don’t like it.
And to put the government business into perspective, sales to U.S. government entities makes up 6-8% of annual revenues, 2% of which are sold through brokers or distributors. And while some of the price increases have been egregious, TransDigm has come to terms with the government each time usually with a request for a voluntary refund.
Debt fueled growth
TransDigm has been able to fund its acquisition strategy through internal cash flow generation but has also taken out a lot of debt. Since FY10, TransDigm’s net debt level has outpaced its revenue and EBITDA growth. The 10-year compounded annual growth rate for revenues and EBITDA are 20% and 19%, respectively. Net debt has grown at a CAGR of 26% during the same period.
While that could seem like a problem at first glance, TransDigm’s ability to service the new debt hasn’t changed. The net debt/EBITDA rate has remained steady since FY13 because the EBITDA margin for the acquired businesses are improved dramatically post the deal close. However, the cost of debt has come down for TransDigm, freeing up more free cash flow. In FY10, the average interest rate of its debt was above 7%. At FY19, the average debt was 5.8%.
Global air traffic trends
Covid has set global passenger traffic growth back many years. IATA is now projecting a recovery back to 2019 traffic levels by 2024. While there are many factors at play, lower traffic generally means fewer planes in the air and less maintenance required. TransDigm’s management even said on the F20Q3 earnings call that the most important metric to monitor going forward is the number of planes in the air and then the capacity of the plane rides.
The aftermarket business should take a bigger hit than OEM business because older planes will be retired and newer planes will need less maintenance going forward. However, once we get back to passenger traffic growth again, that should revert back.
Optionality
For TransDigm, we can’t identify any areas of optionality other than an unexpected large acquisition. Esterline was an acquisition that was much larger than most investors were hoping for and the margin improvement has also been better than expected. Because TransDigm’s business model is unique, we believe that it wouldn’t make sense for another aerospace company to look to acquire TransDigm.
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