TransDigm Group (NYSE:TDG) is stretching beyond its comfort zone with its $4 billion acquisition of aerospace rival Esterline Technologies (NYSE:ESL), paying up for an asset that has been a modest performer. And although the strategic rational makes sense, the company is going to have to tread carefully in the quarters to come to make this purchase work for shareholders.
TransDigm is no stranger to M&A, using more than 60 acquisitions since its formation in 1992 to build a portfolio of aerospace components, but it has never done a deal this big. Given that the buyer is paying a hefty 38% premium to Esterline's Oct. 9 close for what is arguably a "fixer-upper," it's no surprise that TransDigm shares traded down 10% in the three days following the announcement.
It's a tall challenge, but the TransDigm management team taking on that challenge is one of the best in the business. Here's a breakdown of what the Esterline deal means for TransDigm, and what investors should expect.
A better fit than meets the eye?
TransDigm has a reputation for focusing on proprietary parts that can command pricing power, allowing the company to generate adjusted margins approaching 50%. Company executive chairman W. Nicholas Howley in a statement announcing the deal said Esterline, a $2 billion sales maker of displays, sensors, and other components for commercial, business and military jets, is "highly complementary to our existing business."
Howley said the target's "core aerospace and defense business consists of primarily proprietary, sole source products with significant and growing aftermarket exposure."
He may be right, but you'd never know it from looking at Esterline's earnings reports. Esterline expects to generate $280 million of pretax operating earnings in fiscal 2018 on sales of about $2 billion, for a 14% margin, and the company states that aftermarket, or spare part, sales are only 10% to 12% of total revenue. Aftermarket sales tend to be higher-margin than selling to new plane manufacturers, and they hold up better when new plane sales slow.
Howley during a conference call discussing the deal said he believes the discrepancy in aftermarket sales comes down to how revenue is classified, suggesting that Esterline might not consider sales that go through distributors to be aftermarket. TransDigm believes that at least 25% of Esterline's aerospace revenue is from non-OEM sources.
He also argued that Esterline's product portfolio contains more proprietary and sole-sourced content than the market believes, implying that there are ample opportunities to apply the TransDigm selling model to Esterline's base.
Critics have argued for years that TransDigm's margins are not sustainable, because they will tempt competition that will, over time, erode the company's sole-source offerings. Bulls, myself included, counter that that argument underestimates how complex, and expensive to replicate, these manufacturing processes are. If Esterline does indeed have a strong collection of sole-sourced offerings within its portfolio, Howley and his team are likely to be able to get the most out of them.
Getting bigger, faster
The deal continues a period of consolidation among commercial aerospace suppliers, fueled largely by a push by Boeing and Airbus to squeeze costs out of the supply chain.
Last year, United Technologies announced a $30 billion deal to acquire Rockwell Collins, and one-time Boeing subsidiary Spirit AeroSystems bought Asco Industries for $650 million. Boeing, meanwhile, spent $3.2 billion to buy distribution firm KLX, and it has announced a number of joint ventures designed to bring part of the supply chain in-house.
The Esterline deal would grow TransDigm revenue by about 50%, broadening its exposure to various commercial platforms. There also appear to be opportunities to cut costs. Esterline's SG&A expenses total about 19% of sales, compared to TransDigm's 12%. TransDigm also seems likely to recoup at least 25% of the $2 billion in loans it is taking out to fund the purchase by selling off some of the less-proprietary assets in the Esterline portfolio.
The deal should also add nearly $200 million in annual free cash flow to TransDigm, giving it additional funding to pay down the new borrowings it's taking on.
Stay the course
TransDigm's model is often compared to that of a private equity firm, with both focused on buying businesses and extracting better results via improved management, cost cuts, and the benefits of scale. Long-term holders have benefited, with shares of the company up 45% over the past year -- even after the recent declines -- and up more than 985% over the past 10 years.
The Esterline deal does change the near-term outlook for TransDigm, likely removing the possibility of a one-time year-end dividend and instead shifting the focus to whether Esterline can be integrated successfully. The deal is much bigger than most of the projects TransDigm management has taken on, but it fits well with the company's playbook.
My bet is that TransDigm will succeed in bringing Esterline into the fold. If so, the market concerns are creating a great time to buy into this historical outperformer.