Shares of TransDigm Group (NYSE:TDG) climbed 64.7% in 2019 according to data provided by S&P Global Market Intelligence, easily outpacing the S&P 500 index. The company, although a longtime Wall Street favorite, was facing potential headwinds coming into the year, and the stock rallied as evidence mounted that TransDigm's momentum was not slowing.
TransDigm is a collection of aerospace and defense spare part and component businesses with a reputation for generating software-like gross margins thanks to its focus on controlling costs and its position as the only vendor able to quickly supply hard-to-find parts needed to keep airplanes flying.
But the company's core business, and its ability to sustain those margins, was called into question in 2018 as Congress asked the Pentagon's inspector general to launch a detailed probe into TransDigm's pricing strategies. Investors were also concerned that TransDigm, although a seasoned acquirer, had bitten off more than it could chew with its $4 billion purchase of underperformer Esterline Technologies.
Esterline did weigh on earnings, with gross margins falling 1,200 basis points year over year due to acquisition-related expenses. But those margins still came in at 45.9% in the company's fiscal third quarter. And TransDigm in 2019 recouped more than a quarter of the total purchase price by divesting lower-margin Esterline businesses, making the deal more compelling.
The Pentagon probe continues, but management is quick to note that direct sales to the U.S. government make up between 6% and 8% of total annual revenue. And the company was able to work out a new long-term agreement with key customer Boeing, demonstrating that even large, powerful customers see value in TransDigm's offerings despite the company's lofty margins.
Even after TransDigm's impressive run, the stock is still reasonably valued compared to similar aerospace highflier Heico, and TransDigm should have ample cash available in 2020 to either do additional M&A or pay a dividend similar to the one-time payouts of $30 and $32.50 per share it announced in 2019.
TransDigm was one of the top-performing aerospace companies of the last decade, and it shows no signs of slowing. This is the first stock I'd recommend for anyone who wants to invest in the aerospace and defense sector.