A lot of the headlines about TransDigm Group (TDG 0.54%) so far in 2019 have focused on the company's ongoing issues with the U.S. government, with Congress accusing the aerospace-component supplier of overbilling the Pentagon for some spare parts. But investors have largely ignored the controversy, sending TransDigm shares up 40% year to date heading into earnings season.
TransDigm's latest quarterly results validate the decision to ignore the noise and focus on operations. The company outperformed expectations, made progress integrating a key acquisition, and nudged guidance higher.
TransDigm has been one of the best aerospace stocks for investors to own over the last two decades, and the growth story doesn't appear to be waning. Here's a look at the company's latest results, a breakdown of its issues with the government, and a glance at what the future holds for this aerospace powerhouse.
The growth engine is humming
On Aug. 6, TransDigm reported fiscal third-quarter earnings of $4.95 per share, easily beating Wall Street's $4.30 consensus, fueled by organic sales growth of 11.8%. It's the third-consecutive quarter of double-digit organic revenue growth. Defense and commercial original equipment sales led the way with double-digit gains, and aftermarket (sales of replacement parts to airplane operators) was up 8%.
Gross margin fell 1,200 basis points year over year due to acquisition-related expenses but still came in at 45.9%. Free cash flow of $278 million was higher than the company's recorded net income, a sign of the power of this business as a cash generator.
Post-earnings, TransDigm raised its full-year revenue guidance slightly to $5.5 billion to $5.55 billion, better than the consensus $5.45 billion estimate. It also raised its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) target for the year by 3%, to $2.425 billion to $2.445 billion. That would ensure gross margin north of 40%, even in an acquisition-muddied transition year.
TransDigm will quickly return some of the cash it's generating to shareholders, announcing a special dividend of $30 per share -- or about 6% of the current share price -- to holders of record as of Aug. 16. The company doesn't pay a regular dividend but routinely returns excess cash to shareholders. In September 2017, for example, it paid a special dividend of $22 per share; in October 2016, it paid $24 per share.
Esterline is coming in line
While it's reassuring to see TransDigm's core businesses performing as expected, the most important part of the release involved the company's integration of its $4 billion purchase of Esterline Technologies. The bull case for the deal was that TransDigm would be able to apply its management prowess to Esterline's large (but underperforming) operations, allowing the company to generate its industry-leading margins over a wider revenue base.
We're still in the early days. Legacy Esterline businesses appeared to generate gross margins of only about 25% in the quarter, but TransDigm managed to grow sales in the units it acquired by 9% year over year.
In a post-earnings call with investors, TransDigm CEO Kevin M. Stein said that the integration is going according to plan:
Operationally we're getting more volume through the facilities. We've done some selective hiring in a few places. So operationally, productivity we're getting more out of the same milestone and we're able to do it at lower costs. We're finding some pricing opportunities. ... It's really on all legs of our value generation stool. It's productivity, it's price, it's value generation, it's driving more volume across the milestones and it's also winning new business as we go forward.
At the time the deal was announced, TransDigm estimated it would look to divest about 25% of Esterline's business, mostly the units that it deemed non-core or where it was tougher to replicate its model. In late July, the company announced the first of those deals, selling the Souriau-Sunbank Connection Technologies business to Eaton for $920 million.
After earnings, TransDigm announced a smaller, $190 million divestiture of Esterline Interface Technologies to KPS Capital. It's unclear whether any further divestitures are planned, but even if they're not, TransDigm has succeeded in both beginning to extract added value out of the parts of Esterline it's keeping while recouping a substantial portion of the purchase price via divestitures.
While another Esterline-sized deal in the near term seems unlikely, TransDigm is continuing to look at opportunities. The company, which has rolled up more than 60 aerospace suppliers since its formation in 1992, has a "decent pipeline of mostly small to mid-sized possibilities," according to executive chairman W. Nicholas Howley.
The probe will linger
TransDigm's Washington, D.C. headache isn't over yet. In June, Congress asked the Pentagon Inspector General to launch a new, more detailed probe into the company's pricing strategies. The initial probe led to no charges of criminal behavior but was a highly public scolding for TransDigm that led the company to, in its words, issue a $16 million "voluntary refund."
On the call, CEO Stein said TransDigm is unsure how long the current Pentagon IG audit will take, saying that it's "looking at a slightly larger pool of contracts." He said that TransDigm is cooperating and added, "we don't believe that there will be anything different in this process than in the last."
There's also a new Pentagon memo regarding showing cost and pricing data on contracts, which Stein said could delay some contract awards. He said, however, that would likely be handled on a case-by-case basis.
Investors need to be aware that this investigation is likely to linger for some time and could at least temporarily stunt growth in TransDigm's defense sector if Pentagon buyers use the probe to demand better pricing or delay procurement. There's also a real risk that TransDigm becomes a target during the upcoming 2020 presidential campaign cycle.
It's important to note that direct sales to the U.S. government make up between 6% and 8% of total TransDigm annual revenue, depending on how distributors are factored in. Even in a worst-case scenario, TransDigm can weather this storm.
Buy this winner
Since its founding, TransDigm has been one of the most reliable performers in aerospace. The Congressional scrutiny is a new risk, and the size of the Esterline transaction relative to most of TransDigm's previous deals was a new potential worry for investors. However, the latest results show that the formula TransDigm has used successfully for decades is still working.
The company should be able to deliver earnings gains well into 2020 as it boosts margins on Esterline product lines. Even after the special dividend, it still has upwards of $3 billion in available financial flexibility to either do additional deals, pay down some of its more than $17 billion in debt, or pay a special dividend in its new fiscal year.
TransDigm shares have gained more than 200% over the past five years and have a clear path to continue growing for years to come. The company isn't cheap for an industrial oncern, trading at 25 times expected earnings. Unlike most industrials, though, TransDigm has been able to generate software-like margins over an extended period of time.
TransDigm is the top stock I'd recommend to any investor who wants exposure to the commercial aerospace market. The company's latest earnings report gave me no reason to change that view.