TDG - Transdigm

[KCLarkin]

Given the hype, I was surprised at how low RoC is (at least based on valueline). Above average returns seem to be generated solely from copious cheap debt. Am I missing something?

[frommi]

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.

 

 

I don`t like the special dividends and the debt, too. But this is a high quality monopoly-like business with above average management and my bet is that it will fall less than the market in case of a correction. I wouldn`t bet the house on this one name, but it feels like it is much less crowded like for example VRX. But because i am concerned about a bigger market drop i hedge with low quality businesses with similar or higher valuations. (That has very well worked for me in august.)

[Picasso]

http://whalewisdom.com/filer/altarock-partners-llc

 

Funny to see the composition of that portfolio.  I feel like some of the posters on COBF have very similar top holdings to that fund manager.

 

Also, I probably have my proforma unlevered free cash wrong.  Based on Larry's estimate it's closer to a 6% free cash yield on 2017 figures.  That's also a 60% jump from 2014 figures.  It just seems like it's already accounted for a lot of the positives.  But the leverage works both ways and if it's still trading at a 4% unlevered yield then the stock is worth $350+ in less than a couple years. 

[giofranchi]

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.

 

Picasso,

of course I agree with you: TDG is selling for a high multiple these days, no doubt about that! And, if a more serious market correction is coming, that multiple will surely compress, no doubt about this either!

 

But my idea with a great business that grows fast is always the same: I want to own a meaningful amount, in case no market crash comes our way and its multiple doesn’t compress; at the same time leaving a lot of room to average down, should a market crash come our way instead and consequently should its multiple compress.

 

This way I’ll make money, if the business keeps growing its fcf at 20% yearly and its multiple stays high (basically unchanged). At the same time, I keep the opportunity to purchase a lot more, if a rare opportunity materializes.

 

This is my usual strategy simply because the period of time these great compounding machines trade at a lower multiple tends to be much shorter than the period of time they trade at lofty multiples… You might end up waiting a very long time before having the opportunity of buying them, if you require a low multiple at all costs… Furthermore, even if you get the chance of buying at a low multiple, if you are not willing to hold them at a higher multiple, you’d end up selling them pretty soon, imo leaving lots of money on the table.

 

You might believe it or not, but I have reduced my investment in VRX because I think government intervention introduces a risk I don’t feel able to evaluate with enough conviction, and I don’t like such a risk especially because VRX uses lots of leverage… In other words, I have reduced my investment in VRX because I think government intervention renders it a less predictable business… Later, when I had time to read what I could find about the history of government intervention in the pharma industry, I mustered much more conviction and I bought back a large part of what I had sold!

 

Cheers,

 

Gio

 

[thefatbaboon]

Hi Gio,

 

I read your comment about trying to avoid government risks with some skepticism.  First, most companies have latent or explicit regulatory risk.  Second, most investors are aware that these risks exist.  Indeed an investor would have to have lived in a hole if they did not recognize regulatory risk in the following:

 

Aerospace

Defense

Pharmaceuticals

Healthcare

Insurance

Banking

Housing

Tobacco

Telecom

Cable

Utilities

Pipelines

Rail

Jones Act Shipping

Energy - Oil, Gas, Nuclear, Coal, Renewables

 

In Transdigm I would imagine the regulatory risk is that they make it easier to introduce competitive spares.  Assuming 17% cagr in Transdigm's EV, in a few years Transdigm will have an enterprise value above Precision, Rolls and everyone else in Aerospace except Boeing and Airbus.  In around 15 years Transdigm will be passing those guys!  Is it reasonable that the company that sells seat belts, faucets, plastic panelling etc is the most valuable enterprise in Aerospace simply because of a regulatory quirk that prevent competition?!  And that there are investors (Gio!) chatting here today and almost using TDG as an example of absence of regulatory risk. 

 

I like TDG and I think Howley is a great CEO but let's not kid ourselves that this company (and most others) doesn't face regulatory risk. I'm not a Valeant investor but I actually think I am more comfortable with regulatory risk in Valeant than I am with Transdigm where I do have an investment.  We have so much track record of regulation in Healthcare and Pharma to analyze, '90s Clinton chatter etc, a seemingly permanent divided government that can't pass anything, and Valeant sells mainly self-pay.  In contradistinction I have no idea how to handicap the risk of a day when technology permits easy and safe spare manufacture and enough big airline companies pressure the FAA to allow them. 

 

 

Regulatory risk is BY FAR the biggest fear i have with Transdigm.  They make the lowest tech, most easily knocked off stuff, and purely on account of a regulatory quirk they are on track to be the most valuable business in Aerospace within a couple of decades.  It's like the guy who makes the plastic casing for iPhones becoming bigger than Apple, Samsung and all the wireless carriers.

 

 

(Probably the only investment I have where I don't worry about significant regulatory risk is Outerwall.  Can't think of a reason the government would interest themselves in Coinstar or Redbox! Maybe Discovery Communications too. Everything else I own, and nearly everything else I have ever owned over the last 20 years, has, and has had, an important amount of regulatory risk to analyze and handicap.)

[giofranchi]

I read your comment about trying to avoid government risks with some skepticism.  First, most companies have latent or explicit regulatory risk.  Second, most investors are aware that these risks exist.  Indeed an investor would have to have lived in a hole if they did not recognize regulatory risk

 

Well, given how the market responded to the government intervention risk, it is not clear at all to me that many investors were perfectly aware of it!

Reading all the bear arguments in the VRX thread, and believe me I have done so!, government intervention was at the bottom of the list (if in the list at all!), until it went to n.1 all of a sudden!

Of course, I also make many mistakes: I must admit that, if I had thought about the government intervention danger at all, I had dismissed it as a very low probability without giving it further thought.

Later further thought is exactly what I have given to this subject, after I was caught off guard…

 

Cheers,

 

Gio

 

[giofranchi]

And that there are investors (Gio!) chatting here today and almost using TDG as an example of absence of regulatory risk. 

 

No, you misinterpreted what I said… I never meant to say that TDG faces no regulatory risk… where did you get that? ???

 

Gio

[giofranchi]

Regulatory risk is BY FAR the biggest fear i have with Transdigm.  They make the lowest tech, most easily knocked off stuff, and purely on account of a regulatory quirk they are on track to be the most valuable business in Aerospace within a couple of decades.  It's like the guy who makes the plastic casing for iPhones becoming bigger than Apple, Samsung and all the wireless carriers.

 

Of course I think the whole industry will grow handsomely. Who will grow fastest I cannot say, but I like to invest with a great capital allocator in a great industry. We will see!

 

Anyway, thank you! Again I must admit I hadn’t thought about regulatory risk for TDG… Perseverare diabolicum! ;)... And surely it is better to think about it, before anyone else starts worrying!

 

First thought: seat belts, faucets, plastic panelling etc surely don’t attract so much public attention as drugs do.

 

Cheers

 

Gio

 

[giofranchi]

Hi Gio,

 

I read your comment about trying to avoid government risks with some skepticism.

 

For full disclosure, with VRX I have committed another error: I have not followed what I usually do and, instead of averaging down, I averaged up… Meaning that I bought more as the stock price was going up… Not a meaningful amount, but combined with the effect of a rising stock price, it made VRX one of my largest holdings. Surely a larger percentage of my portfolio than I should have allowed given its valuation.

A mistake I have paid for! Now I hope I have learnt my lesson too! ;)

 

Ok, enough with a topic that doesn’t have anything to do with TDG!

 

Cheers,

 

Gio

 

[Larry]

Just some comments.

 

I dont know what you count as high tech, but they dont exactly only make things like plastic parts and seat belts. You can look up their presentation but their power segment is about 50% if im not mistaken. Quote from their webpage:

TransDigm Inc., is a leading global designer, producer and supplier of highly engineered aircraft components, systems and subsystems for use on nearly all commercial and military aircraft in service today.

I have the impression that there are pretty highly engineered stuff among their products that you need to keep the plane flying. Of course there is regulatory risk, I dont really know to comment on that.

 

One of Weitz's funds owns Transdigm and I remember them commenting they estimate TDG is able to rise prices 4-5%/year. Now assume RPM grows at 5% and you get some margin improvement, you're looking at low teens of organic EBITDA growth and this is what they have communicated with their presentations and this is what they have achieved during past 20 years. Of course their size becomes a matter after some time, but I think they still have a nice runway as they only hold 4% of commercial aftermarket which is growing at pace of RPM's. They're also not trying to build an empire or anything. They are willing to shrink their equity with special dividends and (so far small share repuchases). Like Liberty mentioned, when there was volatility in high yield bond markets during the financial crisis, they delevered to 3.0. During 2003-2008 their average Net Debt/EBITDA was about 4,5. So if they dont feel comfortable with the situation, they've been taking the leverage down.

 

After 9/11 when air traffic was stalling and their aftermarket was presumably flat to modestly down, they were still able to expand their margins. Then there was recession. Of course those kind of events can happen again, but other than that I see no reason why air traffic and therefore need for their parts shouldnt grow. This is just a case where you have to be comfortable with the way they operate regarding leverage, I think they've done well even during times when debt has been more expensive and I see no reason why that would not be the case in future. Of course they might think differently if rates go significantly up and I think they will just take the leverage lower then.

 

[thefatbaboon]

I exaggerated by emphasizing the basic goods they sell - they also produce actuators and electronics etc.  My point was to draw attention to the regulatory kink that exists that is responsible for a lot of TDG's competitive position.  Not all of it.  The "kink" is that a lowish cost item (like a seat belt or a panel switch) that ends up on the approved spec list for a plane model is not economic to replace with a competitive product because getting that item approved is expensive and time consuming.  This kink protects TDG from price competition.

 

You don't need to quote the pricing and volume stuff to me.  I know it well, and that is why I am an investor. The predictability of RPM growth together with the regulatory "kink" and a good capital allocator is very attractive and allows for the 5% price + 5%volume + 5% acquired model.  I just think it's interesting that this isn't extrapolated forward in the context of the rest of the aerospace industry.  Maybe we will be here in 20 years and Transdigm will be the big kahuna, the most basic tech part of the aerospace industry will become the most valuable part.  Or maybe at some point the regulators will allow a more cost effective way for others to compete with TDG on price. I think the margin on a lot of what TDG makes might be competed away instantly.

 

Personally I don't care a hoot about the debt levels.  Its the most magical thing when one can leverage a fcf stream that has predictable growth.

 

(One other thing, about that 4% of the commercial aftermarket thing that they trot out in their presentations...That's fine, but they should break it out because there are some big fish in that pond. Maybe they mean to imply that they're going to be building engines soon and then fulfilling aftermarket for their engines.  But if they don't intend to buy GE, Safran, United Tech or Rolls then they should probably take out a lot of that stuff from their possible market.) 

[Liberty]

In Transdigm I would imagine the regulatory risk is that they make it easier to introduce competitive spares.  Assuming 17% cagr in Transdigm's EV, in a few years Transdigm will have an enterprise value above Precision, Rolls and everyone else in Aerospace except Boeing and Airbus.  In around 15 years Transdigm will be passing those guys!  Is it reasonable that the company that sells seat belts, faucets, plastic panelling etc is the most valuable enterprise in Aerospace simply because of a regulatory quirk that prevent competition?!

 

Not to split hairs, but TDG can't reinvest all the cash that they generate, hence the big special dividends and sometimes the share buybacks. It's possible to imagine that the per-share value would grow at 15% for a while (including dividends) without having the absolute dollar market value of the company grow nearly as quickly. Meanwhile, if it's true that hundreds and hundreds of millions of people in Asia, South-America, and eventually Africa will become able to afford flying, the aerospace industry as a whole will become quite a bit bigger than it is now. TDG's relatively size might go up, but I don't think it has to be nearly as dramatic as you say.

[Picasso]

Isn't an acquisition just a reinvestment of generated cash?  The special dividends/leverage were more of a kind of public investor recap.  Seems like you can't have it both ways (they can't reinvest most of their cash flows vs. they will find more deals in the future) unless I'm missing something.

 

For example, all the special dividends could be accounted for by looking at most of the debt outstanding. 

 

Say what you will about the stock, but I just can't believe their debt yields 6% or less on CCC.  6%!  The historical default rate on CCC paper is like 32%.  No wonder they levered up as much as they have, I would too.

[Larry]

thefatbaboon: Just to be clear, I wasnt directing the volume + pricing stuff to you, im sure you are a good investor and familiar with this. There was some talking of pricing on one of the previous pages and people were thinking how much they are able to hike their prices and I think someone thought it would be somewhere around inflation or 2-3%, I just directed that comment made by Weitz funds to that discussion, I should have probably made it more clear there.

 

It will be interesting to see their guidance (which comes out next month) for FY16 and thoughts. Aftermarket has been a bit lumpy for last couple of years, a few quarters back they were flat for some time and then suddenly they were running extra heated year ago with aftermarket growing in high teens. Defence has also been picking up lately.

[DeepSouth]

Isn't an acquisition just a reinvestment of generated cash?  The special dividends/leverage were more of a kind of public investor recap.  Seems like you can't have it both ways (they can't reinvest most of their cash flows vs. they will find more deals in the future) unless I'm missing something.

 

For example, all the special dividends could be accounted for by looking at most of the debt outstanding. 

 

Say what you will about the stock, but I just can't believe their debt yields 6% or less on CCC.  6%!  The historical default rate on CCC paper is like 32%.  No wonder they levered up as much as they have, I would too.

 

If bondholders didn't have PTSD from getting primed for div recaps the bonds would trade even tighter. The credit market isn't stupid, this is pretty much a uniquely well positioned/advantaged business in the HY market. Rigidity in rating agency models simply disallow a levered business in a broadly cyclical industry (despite TDG's FCF's being more or less noncyclical) to be rated for its true economic risk.

[cmlber]

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).

 

If you're worried about a bad mark in the short term, you're right, that's a risk.  If you hold for five years and it grows by 7%/yr with no acquisitions and rerates to a 6% unlevered FCF yield, you'll still eek out a small profit.  And what are the odds that there are no acquisitions in five years? 

 

I plan to hold for decades.  If you hold it long enough and shut your eyes, you'll do well even if the multiple compresses significantly. 

[Liberty]

Isn't an acquisition just a reinvestment of generated cash?  The special dividends/leverage were more of a kind of public investor recap.  Seems like you can't have it both ways (they can't reinvest most of their cash flows vs. they will find more deals in the future) unless I'm missing something.

 

That's what I meant by reinvestment: Internal + M&A.

 

I think there's a balance between how much they spend on M&A + internal growth and how much they return. That's how it worked out since IPO, and the results have been fine. There are thousands of businesses they could potentially buy, many of them private and family controlled. Some they are just waiting for the owners to want to sell. If for a while they don't find enough things that are ready to be bought and that meet their criteria and they don't want to delever, they'll do a dividend or buybacks. Maybe some years the pipeline will be more active and they'll use all their capital on M&A, and maybe at some point the debt situation will be less attractive and they'll delever.  I think that flexibility is great, and I trust that they'll allocate their capital where it gets a good return.

 

I think the regulatory risk is real, but I see a similarity with the pharma world: The FAA, like the FDA, has a huge incentive to keep things very onerous, because the career risk is with letting through something bad rather than in blocking something good. Safety and public perception matters a lot more than price; nobody wants to see a plane crash because regulations were loosened up or because some airline tried to save a few bucks on a cheaper part (which is also why TDG focuses on parts that are relatively cheap compared to the total costs of operating a plane -- you might pick a different type of engine if one vendor offers you a deal that will save you millions, but you probably won't switch to a different valve or actuator that costs a few hundred bucks... it wouldn't even show up in the bottom line after the rounding error).

[frommi]

 

I think there's a balance between how much they spend on M&A + internal growth and how much they return. That's how it worked out since IPO, and the results have been fine. There are thousands of businesses they could potentially buy, many of them private and family controlled. Some they are just waiting for the owners to want to sell. If for a while they don't find enough things that are ready to be bought and that meet their criteria and they don't want to delever, they'll do a dividend or buybacks. Maybe some years the pipeline will be more active and they'll use all their capital on M&A, and maybe at some point the debt situation will be less attractive and they'll delever.  I think that flexibility is great, and I trust that they'll allocate their capital where it gets a good return.

 

If they had just paid back debt instead of the dividends they would have had even greater flexibility in the future. Especially for investors that have to pay taxes on the dividends that was a bad decision. (and for future investors it was bad, too.)

For the investor that was not taxed for whatever reason it is like taking on unnessary leverage. Would you take a 6% loan in the current environment to invest in the stock market?

 

[Liberty]

 

I think there's a balance between how much they spend on M&A + internal growth and how much they return. That's how it worked out since IPO, and the results have been fine. There are thousands of businesses they could potentially buy, many of them private and family controlled. Some they are just waiting for the owners to want to sell. If for a while they don't find enough things that are ready to be bought and that meet their criteria and they don't want to delever, they'll do a dividend or buybacks. Maybe some years the pipeline will be more active and they'll use all their capital on M&A, and maybe at some point the debt situation will be less attractive and they'll delever.  I think that flexibility is great, and I trust that they'll allocate their capital where it gets a good return.

 

If they had just paid back debt instead of the dividends they would have had even greater flexibility in the future. Especially for investors that have to pay taxes on the dividends that was a bad decision. (and for future investors it was bad, too.)

For the investor that was not taxed for whatever reason it is like taking on unnessary leverage. Would you take a 6% loan in the current environment to invest in the stock market?

 

The special dividends were mostly (90% for the last one, iirc) classified as "return of capital", so taxation was pretty efficient.

 

These guys act like public "private equity". The leverage is part of their model, and accounts for a lot of the value created in the past decades. If you're waiting for them to pay down the debt, it probably won't happen. Just like Malone wouldn't pay down the debt at his cable companies. I'm sure leverage levels will keep oscillating over time, though.

[frommi]

The special dividends were mostly (90% for the last one, iirc) classified as "return of capital", so taxation was pretty efficient.

 

These guys act like public "private equity". The leverage is part of their model, and accounts for a lot of the value created in the past decades. If you're waiting for them to pay down the debt, it probably won't happen. Just like Malone wouldn't pay down the debt at his cable companies. I'm sure leverage levels will keep oscillating over time, though.

 

I don`t, i already accepted the fact that the debt is there and the way they operate. Maybe my dislike is just that i didn`t get them because i am late in the stock, but i probably paid less for the stock because of that. So maybe i just shouldn`t bother.

[thefatbaboon]

thefatbaboon: Just to be clear, I wasnt directing the volume + pricing stuff to you, im sure you are a good investor and familiar with this. There was some talking of pricing on one of the previous pages and people were thinking how much they are able to hike their prices and I think someone thought it would be somewhere around inflation or 2-3%, I just directed that comment made by Weitz funds to that discussion, I should have probably made it more clear there.

 

It will be interesting to see their guidance (which comes out next month) for FY16 and thoughts. Aftermarket has been a bit lumpy for last couple of years, a few quarters back they were flat for some time and then suddenly they were running extra heated year ago with aftermarket growing in high teens. Defence has also been picking up lately.

 

There's also some passing commentary from Nick here and there in conf calls that support Weitz and your mid single pricing.  Most recently I think Nick was pushed on it at one point in last quarter's conf call and he pretty much as good as said that there had been no volume growth in commercial aftermarket...from which one could infer that he'd increased price mid-single.  I'm not too worried about lumpiness...at the end of the day if the planes are flying at some point the inventory movements are going to average out and spares are going to get consumed.

 

As is probably clear from what I've written here by far my biggest concern with TDG is to develop a better understanding of regulation and a better understanding of non-regulatory based competitive advantages.

[giofranchi]

As is probably clear from what I've written here by far my biggest concern with TDG is to develop a better understanding of regulation and a better understanding of non-regulatory based competitive advantages.

 

Well then, has anyone a good link to post and to share with other board members interested in TDG about the history of government intervention in the aerospace industry?

 

Thank you!

 

Gio

 

[Guest Schwab711]

http://www.firstaviation.com/uploads/2015-10-21-AeTR-PR-Aviation_Week_Sole_Source.pdf

[thefatbaboon]

http://www.firstaviation.com/uploads/2015-10-21-AeTR-PR-Aviation_Week_Sole_Source.pdf

 

Interesting, thanks

[giofranchi]

http://www.firstaviation.com/uploads/2015-10-21-AeTR-PR-Aviation_Week_Sole_Source.pdf

 

Interesting, thanks

 

+1

 

Cheers,

 

Gio