TDG - Transdigm

[Guest Schwab711]

My biggest problem with TDG is whether conservative expected returns are 8%-10%. They've won contracts for nearly all of the highest-volume Boeing models lately (including their large bet on the Dreamliner's success). Thanks for posting these.

 

TDG's PneuDraulics acquisition is continuing a trend of increasing the % of parts supplied for aircraft instead of diversifying into different models (concentrating their revenue streams - I believe this is why results have been so exceptional). PneuDraulics's parts are used on the Boeing 787 (Dreamliner), Dassault 7X, Gulfstream G450/G550, and Gulfstream G650 (to name a few). These are pretty enviable designs to be supplying.

http://www.pneudraulics.com/products/custom.aspx

 

What's interesting to me is how heavily TDG has bet on the success of the 787 Dreamliner while still producing such outstanding results.  If you think the 787 will ultimately be commercially successful then TDG is a no-brainer buy (it has huge advantages in fuel efficiency, capacity, and value over any currently available aircraft design). Their continued earnings growth is in spite of the Dreamliner's repeated delays and failures. They supply a significant % of the total replacement parts for the Dreamliner, which represents investments of $100's mm that are barely contributing to total sales. TDG looks like a better company every time I learn something about them.

[giofranchi]

TransDigm Group Reports Fiscal 2015 Third Quarter Results

 

CLEVELAND, Aug. 4, 2015 /PRNewswire/ -- TransDigm Group Incorporated (NYSE: TDG), a leading global designer, producer and supplier of highly engineered aircraft components, today reported results for the third quarter ended June 27, 2015.

 

Highlights for the third quarter include:

•Net sales of $691.4 million, up 13.2% from $610.6 million;

•EBITDA As Defined of $312.9 million, up 13.5% from $275.6 million;

•Net income of $99.1 million, up 512.6% from $16.2 million;

•Earnings per share of $1.75, up from a loss per share of $1.66;

•Adjusted earnings per share of $2.26, up 11.9% from $2.02; and

•Upward revision to fiscal 2015 sales, EBITDA As Defined and adjusted earnings per share guidance.

 

http://www.transdigm.com/phoenix.zhtml?c=196053&p=irol-newsArticle&ID=2075297

 

 

Gio

FY_2015_Third_quarter_earnings_call_.pdf

[giofranchi]

http://seekingalpha.com/news/2688325-transdigm-group-misses-by-0_01-misses-on-revenue?app=1&uprof=25

 

Missed on revenues, but still a solid quarter imo. With 2.6% organic growth.

 

Gio

[Liberty]

What do you mean, "missed"? Are you into the analyst game now ;)

 

http://www.transdigm.com/phoenix.zhtml?c=196053&p=irol-newsArticle&ID=2075297

 

Net sales of $691.4 million, up 13.2% from $610.6 million;

EBITDA As Defined of $312.9 million, up 13.5% from $275.6 million;

Net income of $99.1 million, up 512.6% from $16.2 million;

Earnings per share of $1.75, up from a loss per share of $1.66;

Adjusted earnings per share of $2.26, up 11.9% from $2.02; and

Upward revision to fiscal 2015 sales, EBITDA As Defined and adjusted earnings per share guidance.

[giofranchi]

What do you mean, "missed"? Are you into the analyst game now ;)

 

No no! ;D ;D

 

Cheers,

 

Gio

[Guest Schwab711]

Again, probably stupid question, but how do you guys think about the debt structure here?  So, they did 450MM @ 6.5% due 2025.  As of 12/31/14 there is 3.9B of term loans.  Is it not a significant risk to not term out some of the term loan?  It seems like the Malone entities are working towards fixed rate leverage (e.g. SIRI balance sheet and the recent refinancings at VM).

 

I didn't really think about this question at first, but I think it might be more telling than I first thought. It seems like they have made a point to long-date their debt as much as possible over the last 24 months (at least one other recent offering was single-dated long-term) vs. more diversified terms. This move could be a simply interest rate bet or possibly related to when they expect to see after-market sales for dreamliners and the recent 777x models. I don't know the actual answer, but I'd guess internal treasury expectations are at least partially the reason (maybe this is overly optimistic).

 

As for EBITDA between OEM and after-market, I rechecked the annual reports and I did not see the actual mix either.

 

 

As a side game, here are my possible future acquisition targets for TDG (listed alphabetically):

ATRO

BZC

DCO

LMIA  (Presentation remind you of anyone? - http://files.shareholder.com/downloads/LMIA/0x0x828641/BD0D0F42-9CAF-403F-B0A2-159C22B0C10D/LMI_InvestorPresentation_May2015.pdf)

 

Since some folks have asked, here are some similar companies to TDG:

SPR (96% of rev from sole-source parts - somehow Morningstar doesn't think there is any moat here?)

TGI

[Liberty]

http://bearofburrardstreet.com/recent-transaction-purchased-transdigm-tdg/

[Larry]

Hello,

 

I have been reading this board for couple of years but only managed to register now. Im in my early 20's but have been investing for some years. I've had fairly large position in Transdigm for couple of years and have been following the company quite closely. This has been a very good thread so I hope to get to share some thoughts from now on as well. Some of my observations:

 

- The company is very well managed. I think Nick Howley is a very unique CEO and the management team as whole is experienced. Its true that COO Ray Laubenthal and CFO Greg Rufus decided to retire lately, but I wouldnt take too much of it. First of all, if im not mistaken Mr Laubenthal had been with the company from the very beginning (1993) and Mr Rufus had been with them for about 15 years, so like someone mentioned before its not like theyre running away. Laubenthal is also staying in board and he holds quite a lot of stock. There has been couple of high caliber external hires like Terry Paradie, but im sure they've done quite a lot of work regarding the recruitment, I was too a bit scared when I read of the Cliff's background (like Liberty mentioned).

 

- Im quite bullish about the future of air traffic. I think there is a huge runway. North America and Europe are probably not growing as fast, but there is a huge amount of countries with very high population and growing economies, just think of countries like Indonesia (population of 250m), not mentioning more well known emerging nations with large population. I see no reason why they wouldnt fly that much. Its true that there are going to be bumps on the road like we've had (9/11, global recession) but I think theres a lot of space just for the market growth. Airbus and Boeing both have some very interesting forecasts for air traffic growth for couple of decades. Considering this, I think Transdigm is going to do well. If we get 5% rpm growth (which I think is quite midpoint and might even be abit conservative) and put some pricing on top of that, you'll get to ~10% commercial aftermarket growth or atleast very close to that

 

- They've managed their acquisitions well. The point is not to buy these companies with high ebitda margins. The point is how to get the margins to grow and double one day. Like Howley has said they have no problems buying stuff that have low margins, of course it has to have high content of commercial aftermarket business and the products have to be proprietary, they are strict with this and I like that alot. So I prefer to see them do acquisitions if and when the m&a pipeline is reasonable.

 

- Considering recent acquisitions, they've been quite busy. Telair was fairly sizable one with 300m revenue and 60m EBITDA, they stated it most likely wont get all the way up to Transdigm average margins, but Im sure there still value. Then there were Pexco, Franke (smaller one) and now recently the PneuDraulics they just closed. So they've now deployed over 1,5b this year so far. So far they're all performing well according to last conference call (PneuDraulics hadnt closed at that time yet)

 

- About valuation. Some say TDG is quite expensive at there prices and I might agree on this. Im holding for the long term so I dont tend to think too much about this. Im sure if they do alright, I will get ok returns. Next year theres going to be quite nice growth because of the acquisitions. Some calculations: Year ago, they guided 2550m revenue for FY15, their FY ended in september. (so this guidance was without any acquisitions). If they are about at this point without the acquisitions, and the core grows at conservative 6% organic growth, we have about 2700m for the core TDG for FY16, then adding recent acquisitions, they dont disclose all the financials of the deals so have to try estimate some of them).  This is a bit hard but just throwing some numbers around, they are not meant to be precise at all, but I get them to somewhere around 3300m revenue with all the closed acquisitions (Telair was the only one of which they disclosed the financials). There's dilution to the margins from the acquisitions, but if they achieve 45% EBITDA as defined for the whole group for FY16 (and this might be conservative depending on how quickly the margins of new acquisitions move up, without this year's acquisitions, EBITDA as defined was about 47% last q if I recall correctly), thats 0,45x3300 = 1485m EBITDA as defined for FY16. Now in last investor day presentation there was a slide which showed their Free cash flow has been around 50% of EBITDA as defined, they're quite leveraged right now, but lets use 46%. 0,46x1485 would be 683 free cash flow for FY16. They have 56,6m shares outstanding right now, lets assume that goes up to 57,3m from the compensation, that would be 683/57,3 = 11,92 Free cash flow/share. With this, Price/FCF is about 18,6 (forward). Its not low but its not too extreme I think considering the quality of the company. Theyre quite leveraged right now (6,0), but assuming theres no acquisitions or other capital market activities, they will delever fairly quickly. So I think their debt is now at about 8400m, theyre going to have about 1b of cash when their latest numbers come out, but take 325m off for Pneudraulics which closed last q, their net debt at end of FY15 is 7725m. If my numbers are around right, net debt at the end of FY16 is 7042, EBITDA as defined 1485, so net leverage a year from now would be 7042/1485 = 4,7. So that will move down quickly and will leave room for a lot of activities for example if they continue to see m&a opportunities.

 

- This is not meant to be any kind of estimate for anything, I was basically just playing with numbers and throwing them around, because thats what I like to do, just decided to share them. I tried to be conservative enough. There are also some tax benefits with Pexco and Pneudraulics, and honestly I just dont really know how to calculate them so its a very simple model.

 

- I think the leverage is what scares most people out of Transdigm. I have been thinking about it too. Nick is clearly very comfortable with high leverage. They've been doing this for a long time though. Im not going to write my thoughts on Valeant here (I own some Valeant stock), but TDG has been around for a quite some time now and operated with debt succesfully (even though not that long as a public company), just mentioning Valeant because theres a lot of concern regarding if they can handle the debt or not and there has been ups and downs for TDG, for example 9/11 and the recession and they've weathered through them. So there has been cycles. People sometimes point to super large backlogs of Boeing and Airbus and say what happens when that goes down. Well It doesnt really matter. OEM is not where TDG makes their money. Aftermarket is the one. It would require a very large event if air traffic would stop, note that the installed base of planes is all around the world, because the customers are the airlines. So I think you can trust that the aftermarket will be there and the installed base of planes will grow over time (and the lifecycle of an airplane is quite long). You just have to trust the management with the leverage, if you are not comfortable with that, its hard to be with Transdigm. I havent checked lately but I think there was some volatility in high yield bond market lately. This of course concerns me a bit but they have quite good maturities and they can decide to delever if they dont see the situation as good as before, when they levered up and paid special dividends.

 

- Regarding their products, theres the risk/reward play. These parts are relatively small part of the whole cost base of airliners (theres some info in the latest investors day presentation on this), I just dont see airliners trying to save money by turning to TDG and trying to find substitutes, usually there even aren't any subtititutes because they're sole source providers for many of the parts. I think Howley said in some CC that if you do your job well and be there for the customer, rarely will they change you. And coming to this, of course the pricing power is there.

 

- I honestly havent dug much information about others like Heico, so I dont know if TDG competes with for example Heico really,  so would be interesting to know if theres risk.

 

- Its true that there might be some keyman risk. Nick Howley has been with the company from the very beginning and has played central role in its success. He is a bit over 60 now so I think he is going to stick around for some time atleast and im sure when he moves, he will continue with the board. There are some younger people who have been with the company for quite some time and surely there is talent, thats part of their culture as well.

 

- I just very much like the way they operate. Here is a quote from Nick Howley from a very rare article which im going to link at the end of this post. "

Flying under the radar is the way Howley, a Philadelphia native and a mechanical engineer who earned his MBA at Harvard Business School, prefers to operate.

 

“Until 2006 when we went on the New York Stock Exchange and were forced to become more public, I don’t think anyone even knew our company existed,” Howley says matter-of-factly. “I still don’t think most people know it exists.”

 

Magazine interviews, he adds, are “something we simply don’t do.”

 

 

So it has been pleasure to read this board for couple of years and now finally join in. I have enjoyed many of the posts made by regular users here on Cobff. I seem to have quite similar thoughts with Liberty and I see that we share quite some of the ideas and general philosophy regarding to investing. I have been following Constellation Software for couple of months (thanks very much to you for the idea, I hadnt heard of the company before) and it seems a very well managed company. They have a lot of traits that I like. One very major difference to TDG is that it seems Mark Leonard doesnt really like to operate with leverage. I havent jumped in yet but its a very interesting company. I dont know IT industry that well. but it seems they have a lot of recurring revenue and thats a quality I like very much.

 

English is not my first language (I come from northern Europe) so I might do a lot of grammar mistakes, sorry for that, but just try to hang on.

 

Heres a very unique piece on Transdigm, I dont think this has been posted here before (if so, please excuse me): http://ibmag.com/Main/Archive/2014_Business_Hall_of_Fame_W_Nicholas_Howley_12704.aspx

 

The article covers a lot of philosophy of Howley and the way Transdigm operates, I think its a very interesting article.

 

Thank you a lot for reading and sharing your thoughts!

 

 

[giofranchi]

Im in my early 20's but have been investing for some years.

 

Wow! So young!... You have taken the snowball metaphor quite literally!! Good for you! ;)

Welcome to the board, and thank you for your first, very thoughtful post!

 

Cheers,

 

Gio

 

[Liberty]

So it has been pleasure to read this board for couple of years and now finally join in. I have enjoyed many of the posts made by regular users here on Cobff. I seem to have quite similar thoughts with Liberty and I see that we share quite some of the ideas and general philosophy regarding to investing. I have been following Constellation Software for couple of months (thanks very much to you for the idea, I hadnt heard of the company before) and it seems a very well managed company. They have a lot of traits that I like. One very major difference to TDG is that it seems Mark Leonard doesnt really like to operate with leverage. I havent jumped in yet but its a very interesting company. I dont know IT industry that well. but it seems they have a lot of recurring revenue and thats a quality I like very much.

 

Great introductory post, Larry, welcome to the board!  :D

 

If you have any questions about CSU or anything else, feel free to private message me here or on Twitter and I'll do my best to help.

 

Out of curiosity, have you gone down the John Malone rabbit hole yet? (or is a spiderweb a better metaphor?)

[Larry]

Thank you to both of you for very warm welcomes! You can also reach me by pm if theres anything I can help or you want to discuss/know about, there isnt any kind of introduction board on Cobf so I just didnt know what to tell, just decided to post here as TDG is in my opinion a very interesting company and the one I think i've been following most closely.

 

Liberty: I have followed Malones "spiderweb" a bit for some time. He seems to be a very rational guy and I have enjoyed the interviews/videos I have seen of him online (there aren't that many). I also liked the piece of him on the "Outsiders" book, gave some good perspective on how TCI operated. However it is a very complex web and I have just followed it but havent jumped in. One thing as well that has prevented me is the tax code here in Finland, as there are spinoffs etc with Malone, im not entirely sure how is it with taxation so I have just felt it easier to pass. I have been following Sirius a bit and it seems well managed. They're producing tons of free cash flow and also growing nicely and buying back stock. Sometimes I have been thinking about buying in to Sirius, but havent done it. There can be different opinions but im not sure how ethical Malone would be towards minority holders (he's controlling Sirius through Liberty Media afterall). I have also followed Charter a bit and Tom Rutledge seems to have done some good work there. Maybe the closest I have come to Malone's companies is Directv (eventhough I think he had jumped out before I bought in 2 years ago, but it surely had Malones handprint regarding to capital allocation), I bought some stock of Directv in low 60's, they were growing (and I think still are) a lot in Latin america and Usa was producing tons of cash flow and at the same time they were buying a lot of stock (and levering modestly) and the stock traded at maybe 11 p/e. Sadly in next may At&T announced their plans to acquire the company, so I pocketed a nice gain but felt I would have enjoyed to see them as a stand alone company. Mike White did some great work at Dtv and bought back a lot of stock.

 

So yea, in short, Malone is an interesting guy but have decided to pass for now, there has been so much work even figuring out Valeant, altough you guys have had very good discussion and argumentation on that thread! But I will surely keep an eye on Malone and it will be interesting to see how Charter + twc plays out.

[60North Investments]

Off topic, just to reply to Larry regarding the Finnish taxation on spin-offs etc. You can google "arvopapereiden luovutusvoittojen verotus" and find the vero.fi page where those and other situations are covered quite well. I haven't found a tax reason to avoid investing in Malone co's.

 

Don't have anything to add to TDG other than thanks for the discussions people have had around it. An interesting company to buy especially in the next downturn.

 

-Another Finn in early 20s

[handycap5]

thanks for the thoughtful writeup. i really liked the article you linked to (but isn't it a little funny to say he never does magazine interviews during a magazine interview?).

 

TDG looks like a great company! but i will be surprised if it turns out to be a great stock starting now. i am very surprised how expensive it is. for $1 of enterprise value, i get only 14 cents of revenue! and margins are already 40%! they are unlikely to go higher. in my view, at current prices, revenue growth has to continue for many years (either organic or M&A) at very rapid rates to not be impaired. and the last many years has been a perfect (good) storm for these types of companies: 1) growing aerospace build rates and volumes, which will be somewhere above normal next few years, even using the Airbus/Boeing figures you cite, 2) cheap and available debt, 3) high willingness to pay up for "platform" companies (i.e. the outsiders book, anything bill ackman says, rear view mirror for companies of this ilk: PCP, CSU, JAH, DHR, ROP etc.) which is "reflexive" and allows further accretive acquistions, locking in employees with stock comp, etc. etc.

 

things can continue (and i can certainly be wrong), but i'm guessing the person who shows up late to this party, either now or sometime in the future, is likely to be disappointed.

 

but what do i know? group, please tell me why i am wrong...

[frommi]

thanks for the thoughtful writeup. i really liked the article you linked to (but isn't it a little funny to say he never does magazine interviews during a magazine interview?).

 

TDG looks like a great company! but i will be surprised if it turns out to be a great stock starting now. i am very surprised how expensive it is. for $1 of enterprise value, i get only 14 cents of revenue! and margins are already 40%! they are unlikely to go higher. in my view, at current prices, revenue growth has to continue for many years (either organic or M&A) at very rapid rates to not be impaired. and the last many years has been a perfect (good) storm for these types of companies: 1) growing aerospace build rates and volumes, which will be somewhere above normal next few years, even using the Airbus/Boeing figures you cite, 2) cheap and available debt, 3) high willingness to pay up for "platform" companies (i.e. the outsiders book, anything bill ackman says, rear view mirror for companies of this ilk: PCP, CSU, JAH, DHR, ROP etc.) which is "reflexive" and allows further accretive acquistions, locking in employees with stock comp, etc. etc.

 

things can continue (and i can certainly be wrong), but i'm guessing the person who shows up late to this party, either now or sometime in the future, is likely to be disappointed.

 

but what do i know? group, please tell me why i am wrong...

 

A company that is growing fcf at 20% is seldom really expensive. You just have to figure out if they can sustain that level of growth. If they double earnings in 3 years its unlikely that the p/fcf multiple compresses, and even if it does time will improve your margin of safety. Read Phil Fisher.

[Larry]

60°North Investments, thank you for your insight, I have to dig deeper into taxation of spin offs etc.

 

Handycap5, it may be a bit amusing with Howley saying they dont do interviews and then they just did that. I think the point is that he is not the guy who likes to pose for front covers of business magazines, I mean they've been extremely succesful company but they are not very well known and they want to keep it that way. I actually found that article by accident, I remember a bit less than year ago I was googling up Nick Howley to find more information about him and then checked search results for articles published within last couple of weeks and this came up.

 

- It looks expensive yes, but I remember looking their average P/FCF ratios for years back and it seems like it has sort of always been the case. The margins are in 40%'s yes, the core doesnt grow its margins as fast anymore but the new acquisitions will continue to creep up. So I see a case for organic revenue growth if they would stop acquisitions, defence and OEM tend to be more cyclical, but I think you can count on growing aftermarket. So if you get 5% rpm growth you put some pricing on top of that you will get close to 10% if not all the way up there. Remember aftermarket is the one they make money off. You speak about perfect storm for these types of companies, but remember that Transdigm makes its money on installed base of planes. They dont make much money on OEM. So think if high aeroplane build rates collapsed, there most likely would still be planes flying around that need replacement parts.

 

- Debt has been cheap and they've clearly taken advantage of it. Interest rates will surely go up one day, I dont really know how to comment on that, of course it will be more expensive to refinance, they've hedged the interest rates of their debt fairly well and their maturities look good. They might just not hit the debt market as aggressively as they've done now.

 

- I agree there has been a lot of discussion and praising of "platform companies". I just think Transdigm has done it well. They've been going for couple of decades now and managed to grow value through acquisitions. They are strict buyers regarding on price and proprietary/aftermarket stuff. So they arent just shooting around but they are making disclipined deals with clear path to creating value through operating the companies they acquire better (getting margins up, new business development), remember that commercial aftermarket is still pretty fragmented. I remember a slide from their presentation mentioning they hold about 4% of it right now.

 

- So I dont see TDG as a "party that you can be late of", I just see them as a very good company with talented team running it and hopefully they will continue to be that, I see no reason why they wouldn't

 

- And one thing to emphasize, I dont think they "must"  keep doing acquisitions. Like I said they can stop that and continue to do grow organically, trying to move the margins up little by little and I think you would still get a nice EBITDA growth. There was some analyst asking Howley what happens when they get too big (acquisitions are too small to move a needle etc) and he just answered that they would still be able to get decent organic growth and deploy capital to dividends and share repurchases, but they want to be levered anyway so they would just pay pop dividends to lever up to their target.

 

So I dont know if this helps but I tried to expand my thoughts and answer some of the concerns.

[handycap5]

very good. so why are you confident that operating earnings of $1.1B will double in the next three years and those earnings will continue to be capitalized at 20x EV/EBIT?

 

when prices and expectations are already high, as they are in this case, one can certainly find things workout spendidly, but one will find they are impaired if things don't. this one is too tough to call for me - certainly doesn't have the asymetry i am attracted to...

 

for what it is worth, in 2010, i took a chart book of largest 1000 US listed companies and looked at every non-oil company that had been able to grow earnings double-digits or greater for 10 years. it was ~5% of the companies.

 

and TDG was on the list, stock was $48 at the time. Berkshire Partners had just bought the stock in the open market after losing the initial PE bid to Warburg Pincus. quite a vote of confidence. if phil was still alive and in the business, he would have bought it then :)

 

frommi, either way, let's agree to circle back in October 2018 and see who was right (though we both can save face by arguing good decisions are distinct from good outcomes)!

[Liberty]

On thing to keep in mind about the debt: They've returned a lot of capital via special dividends (which are totally discretionary), so if they hadn't done those, they could have done the exact same number of acquisitions and reinvested the same amount in the business over the past 10 years but have a significantly lower debt load.

 

In other words, it's not entirely 'structural' debt that was required to build the company, but rather an opportunistic way to optimize the capital structure (Howley believes debt is mispriced, so he's taking advantage). Granted, it's not as conservative as some would like, but the cashflows are very reliable, the debt appears well structured (not my area of expertise, though), and they've proven over the years that they can delever pretty quickly if they need to.

[Larry]

The case for growth. I estimated that their EBITDA as defined would be 1485m for FY16 (0,45x3300)

Now FY17 without any acquisitions, I'll use 6,5% organic revenue growth which I think is conservative and estimate an EBITDA as defined margin of 47% for FY17 this would result to 1652m EBITDA as defined (this is without any acquisitions). During this they will make about 1500m of cash which they can for example pay down debt with so the FCF grows even faster, I dont think they will do that as they've stated they will deploy capital to acquisitions and secondly give extra back to shareholders and lastly pay off debt. So remember they've closed quite some deals this year which will be accretive. But yes, you have to have confidence that they will continue to find good deals. I think they will, but even if they dont, I dont think its going to be disaster. My own cost basis is lower than the stock price now, but I still see there is value if they will continue as succesfully as in the past.

 

By the way thank you for the concerns, it helps with my process too to have some doubts as well!

 

And yes very good point by Liberty. They've paid huge special dividends during a few years. And they've chosen to do that because they want to be levered.

[Picasso]

Platform stocks in general are expensive these days.  It wasn't that long ago when investors were paying 22x FCF for Valeant, now its at 14-15x estimated FCF.  Now add on the leverage and they trade within a wide band of valuation. 

 

If they stopped acquiring businesses and just paid out 100% of their taxed free cash flow in the form of dividends, what kind of returns would you expect?  Berkshire as a "platform" would be able to pay out a ton of cash.  Yet it trades at a meager valuation.  At least Transdigm pays out special dividends but when you consider the debt levels, that's probably tapped out for a while.  Right sizing the capital structure is one thing, 7x EBITDA is another.  Their bonds are CCC+ rated which is pretty damn low on the rated scale.  The bonds aren't trading at CCC+ yields but given that, I don't know how the current equity price is that great of a deal.  2.5x seems like a "win-win" area for durable businesses where right sizing the capital structure doesn't typically depress the equity valuation.  Pretty sure if you levered up Campbell Soup 7x you'd see it trade with a much lower multiple than peers. 

 

But the love for Outsider/platform stocks are high right now, so who knows when the market will look at this through a different lens.

[Liberty]

Their leverage oscillates a lot. I think it can be misleading to look at it near a peak and extrapolate it forward. They've been as low as 3x in 2009 and they reached their all-time highs recently, but the average since IPO is probably closer to 4-4.5x.

[DeepSouth]

Picasso,

 

I don't think it's fair to look at a single leverage metric as what's reasonable across industries and business models. This is a business which requires very little incremental capital (outside of M&A growth which isn't necessary to drive growth) which raises leverage levels that the business can comfortably service. At 2.5 turns, TDG (a ~noncyclical business) would be generating ~25% Fwd FCF/Debt. I think leverage metrics will tick down materially over the next 2 years FWIW.

 

Further, there are plenty of non cyclical consumer brands that operate with leverage similar to TDG and are well regarded in equity markets (QSR, KHC), and most of the PE industry is based on this capital structure model.

 

Lastly,

while the business would be richly valued if there were no further acquisitions (even though this is not probable in the near term), the business could still generate reasonable returns at a ~6% forward FCF/P yield with ~5% future organic FCF growth over the next decade. This organic growth should be reasonable: ~4.5% passenger mile growth, pricing growth, margin enhancement from optimizing last several acquisitions.

[Picasso]

I can understand the oscillations, but any company that has this much leverage typically gets a reduction in the public equity valuation.  It's probably accurate to think that the best returns in the equity come when it's underlevered (probably more to acquire, better prices on those acquisitions, less market thirst for returns) and less returns when it's highly levered.  That's sometimes flipped on its head if there's some big company issues and the debt might kill the company and so the high debt burden (if solved properly) can give very good returns.  But this is a situation where almost everyone agrees the future the bright and the sun will keep shining for decades.  So they've taken advantage of leverage to further maximize what the market is willing to capitalize (in this case a ton of capital at 6% rates). 

 

I don't know what the right price is for this business.  If they keep growing at high rates and the market still lets you sell out for 20x FCF with 4-5x leverage then you'll probably do really well.  I'm probably just nervous because paying 18x FCF with 7x leverage usually means something is bound to go wrong and the market will punish the story at some point.  Clearly the bond market isn't worried yet; 6% yields on CCC paper is crazy low.

[Picasso]

Well QSR and KHC are platform stocks as well, no?  They just happen to be funded with a lot of Berkshire capital otherwise they probably wouldn't have as much leverage as they do now.  The only reason KHC cost of debt is so low is because Berkshire owns equity and who wouldn't want to lend in front of Berkshire equity?

 

TDG and others like it are just public market versions of private equity.  It clearly works so I'm not saying the current leverage means this is a bad strategy.  But in normal market conditions the market doesn't usually give high valuations to highly levered stocks even if they have a easy time servicing the debt.  Maybe that's just a function of this low rate environment (what was TDG's cost of debt from 2009?) which makes it seem like a no brainer to lever up this way.  No one will question it until they suddenly do.

 

And again, I'm not bearish on this stock.  I just don't see that many ways to make enough money to compensate for the current valuation.

[cmlber]

For what it's worth, I'll add my 2 cents to this discussion.

 

Leverage obviously will boost TDG shareholder returns over time, but imo TDG will be a good investment even if it operated with no debt and never made another acquisition.

 

Forgive me if I'm slightly off on this, I've owned TDG for a while and don't really watch it closely, as I'll learn nothing from quarterly news, but last time I checked earlier in the year, it was at around a 4% unlevered free cash flow yield.

 

Over the last 20 years, they've done 10%/year organic growth.  They do it through a combination of RPM's increasing 5-6%/year (i.e. sell 5-6% more parts every year), price increases (2-3%/year is my guess), and cost savings (management tries to match inflation with cost savings).  The RPM portion of this organic growth engine is highly likely to persist for the next fifty years in my opinion.  As the world grows, incrementally the middle class demands more travel, and this is especially true in emerging markets.  Pricing I think will at a minimum increase with inflation.  So through volume growth and inflation based pricing increases, you get 7% organic growth every year.  4% fcf yield unlevered + 7% organic growth = 11% return every year with no leverage and no acquisitions.

 

Why do I think RPM's will keep growing by 5%/year?  Attached chart shows trips per capita for North America and Europe compared to India and China.  North America is 1.63 trips, Europe is 1.21, China is 0.30, India is 0.07.  There is A LOT of room to grow for those 2.6 billion people.

 

The natural argument is "it can't grow faster than GDP forever."  That's true, but it can grow fast for a long, long time.

 

I think this Buffett quote from the 1993 shareholder letter could be said today of TDG, just insert Transdigm for Coke and insert ___ million parts for ___ million cases.

 

“In 1938, more than 50 years after the introduction of Coke, and long after the drink was firmly established as an American icon, Fortune did an excellent story on the company. In the second paragraph the writer reported: "Several times every year a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late. The specters of saturation and competition rise before him."

 

Yes, competition there was in 1938 and in 1993 as well. But it's worth noting that in 1938 The Coca-Cola Co. sold 207 million cases of soft drinks (if its gallonage then is converted into the 192-ounce cases used for measurement today) and in 1993 it sold about 10.7 billion cases, a 50-fold increase in physical volume from a company that in 1938 was already dominant in its very major industry. Nor was the party over in 1938 for an investor: Though the $40 invested in 1919 in one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca-Cola stock would have grown to $25,000 by yearend 1993.” 

[Picasso]

All good points, but what happens when it or if it trades for 6% unlevered free cash?

 

On 2016 number, $750mm/.06 = $12.5B enterprise value.  Take out $7 billion of debt (assuming they earn the cash and paydown $1.5 billion of debt in the future) and it leaves $5.5B of equity value.  On 54 million shares, you're left with a stock worth $102 versus $220 today or more than 50% downside on a change from a 4% unlevered yield to 6%.  That's not a big shift in the whole scheme of things (and 6% is not some catastrophic unlevered yield).

 

If you end up with $1 billion of FCF at 6% and $7 billion of debt, you'll have an equity value of $182.  This could happen in a few years and you'll still lose money.

 

That's why I don't think it's as simple as assuming it will always trade at a 4% unlevered yield plus organic growth.  You can wipe out years of organic growth with a small movement in that market premium.  But clearly this is a great business, just wish it was less expensive all things considered.

 

And assuming you want to just value this on the equity, I find that most "platformy" stocks eventually shift from a levered view (look at free cash per share) to unlevered (look at free cash per enterprise value).