The sheer technical challenges involved in the design and manufacture of aircraft parts makes most aircraft OEMs --original equipment manufacturers -- concentrate most of their efforts in the actual production, while devoting very little attention to the highly profitable aftermarket business.TransDigm Group (NYSE: TDG) is one of the few notable aircraft OEMs that have been focusing more on their aftermarket business segment, and have in turn been handsomely rewarded.
TransDigm's stock has been flying high in the past four years after gaining 400%, while its total returns have grown more than 650% in the same time span.
High-margins aftermarket segment
TransDigm derives 45% of its total revenues from OEM, while the other 55% comes from its all-important high-margin aftermarket business segment. TransDigm makes highly unique airplane products; approximately 75% of its products are made by the company alone, meaning it essentially faces zero competition here.
TransDigm's increased focus on the high-margin aftermarket business has been paying dividends for the company and its shareholders. Aftermarket revenue streams have a stabilizing effect on sales, and this helps to provide some downside assurance in a highly cyclical industry like aerospace. The aftermarket business segment, coupled with the fact that the firm is the sole supplier of 75% of its products, gives TransDigm pricing power and above-average margins.
TransDigm has also been a major beneficiary of global aerospace trends. A recent report by IATA (International Air Transport Association) estimates that the global airline industry will have 3.6 billion passengers by 2016. The emerging economies of Russia, Asia, Latin America and the Middle East will be key contributors to passenger traffic growth. International freight volumes are projected to grow at 3% per annum over the long-term. Growth in passenger traffic will inexorably lead to airlines purchasing more aircraft, which could help improve business for TransDigm and its peers.
Smart accretive acquisitions
TransDigm is not known to be shy about making acquisitions and striking new deals. The company has consummated more than 30 deals since 2006, with four completed this year alone.
TransDigm is very choosy in the kind of companies it acquires in its bid to grow its top line. Its latest acquisitions all involve businesses with a high proportion of revenues derived from the aftermarket business.
TransDigm bought Aerosonic Corp for $39 million in late May. Aerosonic manufactures highly engineered military and commercial aircraft components. The company produces proprietary air data sensors and display components. TransDigm offered Aerosonic holders $7.75 per share under the terms of the deal, a good 60% premium to the then $4.84 price. The deal valued Aerosonic around 11 times TTM EBITDA.
Aerosonic is a profitable company, and the 1.25 times 2012 sales price paid by TransDigm represented a huge discount to TransDigm's own valuation of about 4.25 times 2012 revenues. A great deal no doubt.
The Aerosonic deal was funded by cash, and fit TransDigm parameters to a T. Aerosonic derives 60% of its sales from the high-margins commercial aftermarket sector. TransDigm's commercial aftermarket business segment has been experiencing sluggish growth, and it's not difficult to see why Wall Street gave its thumbs up to the deal, pushing the TDG stock to an all-time high the minute the news hit Wall Street.
A win with Arkwin?
Another notable TransDigm acquisition this year has been Arkwin Industries, which it acquired in June for $286 million in cash. Arkwin manufactures fuel and hydraulic systems for planes (Airbus and Boeing 737) and helicopters. The deal valued Arkwin at 8.7 times TTM EBITDA.
Although Arkwin Industries' 40% aftermarket sales are below TransDigm's preferred target of 50%, its management pointed out that the deal is accretive to TransDigm FY14 earnings in a healthy range of 5% -7%. The company is great fit for TransDigm, and at three times 2012 sales, the price TransDigm paid represented a significant discount to TransDigm's own valuation of 4.3 times 2012 sales.
Despite the acquisitions, TransDigm's top-line growth still comes largely from internally generated organic growth. Organic growth accounted for 11 percentage points of the company's 20% annual revenue growth.
Partnership for Success Program
TransDigm's investors raised a lot of hue and cry after news broke that Boeing had launched a new program to partner with its major aircraft parts suppliers, such as TransDigm and Spirit AeroSystems (NYSE: SPR). Boeing intends to partner with its suppliers in helping them redesign their supply chains; in turn, suppliers will charge Boeing lower prices when they renew their contracts.
At a casual glance, Spirit AeroSystems looks set get hurt the most by the Boeing program, since it derives 84% of its revenues from Boeing sales, compared to TransDigm's 13%.
But in my humble opinion, investors really don't have much to worry about, since both TransDigm and Spirit AeroSystems have plenty of bargaining power, and is highly unlikely they will be easily arm-twisted by Boeing. As I had pointed out before, TransDigm is the sole supplier of 75% of its products. As far as Boeing is concerned, TransDigm is the sole supplier of close to 100% of the aircraft parts it sells to Boeing.
Spirit AeroSystems, on the other hand, typically signs long-term contracts with Boeing that usually last the entire length of the aircraft programs. When you further consider the lengthy testing and certification period required before any new products from new suppliers can be approved by Boeing, and it would be pretty safe to say that it's going to be an uphill task for Boeing to switch suppliers. The high capital infusion required to build new aircraft parts manufacturing facilities provides another huge entry barrier for interested parties.
Although Boeing itself commands a huge clout on account of its size, its terms will have to be agreeable to both TransDigm and Spirit AeroSystems if the deal is to see the light of day.
TransDigm's focus on the high-margins aftermarket business provides it with a means to stabilize the cyclical and somewhat unpredictable aircraft parts business. The company has also been making hugely accretive acquisitions that will continue to benefit its shareholders long after the deals are done and dusted. The company's future certainly looks bright, given the huge anticipated growth in global passenger traffic.