In a world full of amazing tech gadgets and near-miraculous medical breakthroughs, it is hard to get too excited about airplane parts. But one under-the-radar aerospace supplier has generated returns for investors over the years that put all but the best tech investments to shame.
TransDigm Group (TDG 0.20%), an assembly of parts businesses few have heard of, has more than quadrupled the performance of the S&P 500 over the past decade when factoring in dividends. Since the beginning of 2010, the stock is up more than 1,900%.
That's in the past, but TransDigm's formula for delivering market-beating returns shows no signs of slowing. TransDigm through the years has made investors rich. Here's why it is still an intriguing investment today.
Software-like margins from spare parts?
TransDigm's stated goal is to "provide private equity like returns with the liquidity of a public market." Like private equity firms, the company uses cash and debt to roll up small companies and unwanted divisions of aerospace rivals.
The company is a collection of 48 semiautonomous units all focused on making parts that are both rare and necessary, avoiding more commonplace parts like fasteners that can be commoditized in favor of items that have patent protection or are hard to replicate. About 90% of sales come from what TransDigm calls "unique, proprietary products."
It also focuses on spare parts over supplying new airplanes, with most of its earnings before interest, taxes, depreciation, and amortization (EBITDA) coming from the so-called aftermarket. If an airline customer desperately needs a certain unique part to fly 250 people from Seattle to New York, the customer is not likely to be price sensitive when sourcing that part. That's TransDigm's edge.
The net result is that TransDigm is profitable at levels almost unheard of in the aerospace business, generating an EBITDA margin of 52% in the most recent quarter. And about 80% of TransDigm's total costs are variable, meaning the company can quickly trim costs in the event demand falls.
TransDigm critics have called those margins unsustainable, but the company has been able to consistently generate steady returns for more than two decades.
EBITDA Margin (TTM) data by YCharts.
What could go wrong?
Though TransDigm has been able to swat away criticism about the sustainability of its margins, its profit levels have attracted other unwanted scrutiny. Defense sales account for a significant portion of TransDigm's total revenue, and in recent years, the company has been the subject of multiple government inquiries concerning its pricing strategy.
The most recent probe ended with a whimper, but investors should be aware the questions are unlikely to go away.
As part of its private-equity style strategy, TransDigm carries a lot of debt used for acquisitions. As of Sept. 30, the company had $19.9 billion in total debt, or about 4.8 times its EBITDA. That's enough to set off some alarms, but it is worth noting that the company has no major debt maturities until 2026 and so therefore has no immediate need to refinance into the current higher-rate environment.
The company's board felt confident enough about its balance sheet that it authorized a $35 per-share special dividend in September while also committing $1.385 billion in cash to acquire the Electron Device business of privately held Communications & Power Industries.
Why TransDigm can go higher from here
Perhaps the biggest risk to the bull case on TransDigm is if the company runs out of targets to acquire, putting a cap on growth. It would appear the company is nowhere near reaching that point.
TransDigm expects to grow sales by 14% to 17% in its fiscal 2024, well above its pandemic-influenced 8.87% compound annualized growth rate since 2020. The Electron Device acquisition appears to be textbook TransDigm, with the target generating about 70% of its $300 million in sales from the aftermarket and almost all of it coming from proprietary products that can't be easily copied.
TransDigm will likely never be a household name, and its products are unlikely to ever be buzzworthy like an Apple phone or virtual reality (AR) headset. But sometimes these "boring" stocks can be portfolio all-stars.
The numbers don't lie: Investors who have ridden along with TransDigm over the years have enjoyed exciting returns.
