Transdigm: Management Knows How to Make Money, but What About the Debt?

This airplane parts company was one of the top 10 performers of the past decade Continue reading... Read More...

Recently, Barron’s magazine published a list of the top 10 stocks over the past decade, stocks that beat even Amazon.com Inc. (NASDAQ:AMZN) and Google parent Alphabet Inc. (NASDAQ:GOOG).

Third on that list was TransDigm Group Inc. (NYSE:TDG) with a total return of 2,015% between Jan. 1, 2010 and Dec. 31, 2019. It was beaten by only two other companies, MarketAxess Holdings Inc. (NASDAQ:MKTX) with a 3,015% return and Netflix Inc. (NASDAQ:NFLX), which returned 3,693%.

Just a few months into the decade of the 2020s, though, the TransDigm share price has fallen dramatically:

Should we buy this previously great stock now that it has plunged so precipitously? That’s a subject for discussion below, but first a little bit about the company. TransDigm described itself this way in its 10-K for 2019:

“We believe we are a leading global designer, producer and supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft in service today. Our business is well diversified due to the broad range of products we offer to our customers. We estimate that approximately 90% of our net sales for fiscal year 2019 were generated by proprietary products.”

The key phrase in that description is “aircraft components,” or in other words, a producer of parts for an industry that has come to a halt as fast as a fighter landing on an aircraft carrier. When the industry does recover, will it try to keep costs down by keeping its planes longer (good for TransDigm), or will it keep its planes longer and cannibalize parts from all those excess planes parked in the desert (bad for TransDigm)?

To understand the basics about the company, we must also know that it emerged out of a merger and has since done many acquisitions. To finance those acquisitions, it has significantly leveraged itself.

The most recent acquisition was that of Esterline for almost $400 million. That brought in a significant backlog of orders; the backlog grew from $2.026 billion on Sept. 30, 2018 to $3.437 billion a year later. Those orders are subject to cancellation or deferral and may not show up as revenue this year or next.

There is more to the financials than just debt, which we will now explore using the Macpherson model, the basic screen used by GuruFocus contributor and fund manager Thomas Macpherson. This helps him shortlist stocks for more intense scrutiny. It comprises four parts: a moat (competitive advantage), financial strength, profitability and a margin of safety.

Moat

There are two criteria for a moat:

A 10-year median return on capital of 15%. According to the current GuruFocus Summary page for TransDigm, the company’s ROC is 14.8% (compared to 8.67% for its weighted average cost of capital).
A 10-year median return on tangible equity (ROTE) of 15%. The company has negative tangible equity, mainly because of goodwill created when it bought other companies for more than their market prices.

Financial strength

Again, there are two criteria of interest:

A cash-to-debt ratio of at least 100 (screens out almost all companies with debt).
A GuruFocus rating of at least 9 for financial strength.

This screenshot shows that TransDigm misses both targets:

How heavy is that debt? Total debt per share at the end of 2019 was $316, which is more than the current share price of about $304 per share. Its total liabilities at year’s end were $19.1 billion ($17.6 billion of that was in long-term debt) while its total assets were $16.3 billion.

Profitability

And the right side of the screenshot shows how it meets the criterion (at least 9 out of 10) for profitability. Note the strength of the operating and net margins, as well the 18% revenue growth over the past three years (due in part to acquisitions made with the help of borrowed funds).

Valuation

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Because of the depth of the price fall, TransDigm has a spot on the Undervalued Predictable screener list. Undervalued means the market price is less than the company's intrinsic value (and fair value). Predictable means the company has consistently grown its revenue per share and earnings before interest, taxes, depreciation and amortization over the preceding 10 years.” data-reactid=”68″>Because of the depth of the price fall, TransDigm has a spot on the Undervalued Predictable screener list. Undervalued means the market price is less than the company’s intrinsic value (and fair value). Predictable means the company has consistently grown its revenue per share and earnings before interest, taxes, depreciation and amortization over the preceding 10 years.

2020 is likely to be an exception for the company and, in turn, that is partly responsible for the depressed stock price. How depressed?

On April 21, the share price was $303.76, down from the 52-week high of $673.51 and above the 52-week low of $200.06. The earnings-based discounted cash flow fair value was $315.43, just 3.7% above the current price. Thus, it is a weak undervaluation.

Altogether, the results of the Macpherson model test are weak as well. TransDigm’s moat, as measured by ROC, is 14.8%, slightly below the threshold of 15%. Its financial strength is low mainly because it has taken on quite a bit of debt, much of which has been used to make acquisitions. Profitability is excellent, while the undervaluation is so small as to be essentially meaningless.

Ownership

This chart shows how there was increasing interest among the investing giants until the Covid-19 virus and the market slump arrived (red bars for sells and green bars for buys):

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Eleven of the gurus followed by GuruFocus hold positions in TransDigm. Chase Coleman (Trades, Portfolio) of Tiger Global Management and Steve Mandel (Trades, Portfolio) of Lone Pine Capital each hold more than a million shares, while the other nine have fewer than 400,000 shares each.” data-reactid=”89″>Eleven of the gurus followed by GuruFocus hold positions in TransDigm. Chase Coleman (Trades, Portfolio) of Tiger Global Management and Steve Mandel (Trades, Portfolio) of Lone Pine Capital each hold more than a million shares, while the other nine have fewer than 400,000 shares each.

Almost two-thirds of its 53.7 million shares are owned by institutional investors, and 0.63% are owned by insiders. President and CEO Kevin Stein does not show up among the insiders with stock holdings.

Dividends and buybacks

TransDigm does not pay a regular dividend, but does pay special dividends occasionally. In 2019, it paid them twice, for a total of $62.50. It also paid special dividends in the low $20s in 2013, 2014, 2016 and 2017.

It has not bought back any shares in the past decade, but did issue a million new shares in 2019.

Conclusion

Mixed messages come out of this analysis of TransDigm, the airplane parts company that now finds itself out of favor with investors. Management knows how to make money for their shareholders, lots of money, but has gone into a recession with a heavy debt load.

Given its outstanding performance in the past decade, this is not a company to bet against in the longer term. Certainly, the short term will be bumpy as long as most air fleets are grounded, but sooner or later they will get back into the air, wearing out parts that TransDigm is best positioned to provide.

Value investors will mostly shy away from its stock until its debt comes down, but hardcore bargain seekers may see this as a time to get in line for potential capital gains and special dividends.

Disclosure: This article is only an introduction to the company and investors must do their own due diligence. I do not own shares in it and do not expect to buy any in the next 72 hours.