TransDigm Group (NYSE:TDG) was a high flier throughout the last decade, but the stock, like most aerospace tickers, has been hit hard so far in 2020. The COVID-19 pandemic has diminished travel demand and caused airlines to ground planes and seek out other ways to cut costs.
The stock's fall in 2020 has been dramatic, but even at its lows, TransDigm shares have significantly outperformed the S&P 500 over an extended time period.
The question for investors today is whether TransDigm can regain the altitude it has lost in 2020. Here's a deep dive into TransDigm to determine if the company is a good buy today.
A manufacturing machine aiming for private equity-like returns
TransDigm is a rollup of dozens of aerospace component businesses, with an emphasis on parts that are either protected from competition by patents, or only needed in low numbers, therefore difficult to commoditize. Management operates similar to a private equity firm: Doing lots of deals, taking on debt, and allowing the entities they buy to operate with a degree of autonomy.
The formula has helped the company generate software-like margins approaching 50%. Those sorts of returns have attracted criticism from customers, particularly on the defense side of the business, but on the commercial side airlines over the years have been willing to pay what is necessary to get the parts they need to keep their planes flying.
The pandemic has disrupted that model. Airlines are flying less, and are grounding significant portions of their fleets. That means less demand for spare parts. It's likely some of those planes never get airborne again, particularly the older, less fuel efficient models with lots of tough-to-source parts that TransDigm specializes in.
TransDigm generates about three-quarters of its EBITDA from the aftermarket, or spare part sales, with much of that driven by commercial aerospace and not defense. Until commercial aviation recovers, a process that will likely take years, it is going to be hard for TransDigm to generate the sort of returns investors enjoyed prior to the downturn.
Down but not out
TransDigm cut its workforce by about 15% in April, an acknowledgement that business will be slow to return. But there is at least some reason for hope TransDigm can bounce back faster than many other aerospace names.
With the company's emphasis on the aftermarket, and not new plane sales, it seems likely that TransDigm will see a recovery before companies like Boeing. Airlines have taken on billions in new debt during the crisis, and even as traffic returns, they are unlikely to commit to costly new aircraft. Rather, used planes, and with them demand for spare parts, will likely dominate the early stages of a travel return.
Nearly 80% of TransDigm's total costs are variable, meaning management has significant flexibility to adjust spending based on demand.
TransDigm does have a massive $20 billion in debt weighing on it, but the company has no maturities through 2024. And TransDigm has been building its cash reserves in recent months, even though company co-founder and executive chairman Nicholas Howley said on a May call with investors that "it's quite unlikely we need" much of the $4.2 billion in cash sitting on its balance sheet.
Given the uncertainty, investors should be glad TransDigm has that cash on hand. But if Howley is right, some of that cash could go toward acquisitions or returned to shareholders in other ways. TransDigm pays no regularly scheduled dividend, but has routinely declared one-time payouts, with shareholders receiving a total of $62.50 per share in cash between August 2019 and January 2020.
Is TransDigm a buy?
It's hard to imagine TransDigm truly getting airborne as long as airlines are down and out. The company does have a defense business to fall back on, but commercial aerospace, and in particular commercial aftermarket, has been the driver for TransDigm and there's little the company can do other than ride out the storm.
Prior to the pandemic, TransDigm was the top stock I'd recommend to investors wanting to buy into the commercial aerospace sector.
The pandemic has caused the near-term outlook to diminish, but the long-term TransDigm investment case is as valid today as it was back then. If you believe air travel demand will recover eventually, TransDigm will be one of the suppliers best able to profit from that recovery. And the stock, trading at 28 times earnings and less than four times sales, has rarely been more affordable in recent memory.
For those with a multi-year time horizon, TransDigm is the same great company it was just a few months ago, at a much-reduced share price. TransDigm remains a good buy today.