TransDigm Group (TDG 2.65%) delivered better-than-expected earnings in its fiscal third quarter, with the company making a strong case that the coronavirus pandemic is not going to cause this long-running growth story to run out of steam.
The pandemic has crippled airlines, some of TransDigm's most important customers, and caused revenue to plummet. But investors should take comfort in the company's ability to generate outsized profits and continued strong margins despite these issues.
Here's how TransDigm managed to outperform despite the COVID-19 crisis, and what shareholders should expect in the future.
Margins held up despite revenue declines
TransDigm on Aug. 4 reported fiscal third-quarter adjusted earnings of $1.54 per share, well ahead of the $0.97 per share consensus, on revenue of $1.02 billion that met expectations. Revenue was down nearly 33% year over year, mostly because airlines are buying a lot fewer parts with flight schedules being slashed.
Commercial aerospace aftermarket revenue -- sales of replacement parts to users, rather than new parts to manufacturers -- fell 52% last quarter. That's TransDigm's most important business. Still, the company was able to generate an earnings before interest, taxes, depreciation, and amortization (EBITDA) margin of 41.5% in the quarter.
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That margin is relatively weak for TransDigm compared to years past, but almost comically high compared to most aerospace manufacturers. TransDigm said earlier this year that nearly 80% of total costs were variable, and the company's recent results indicate that it had success adjusting spending based on demand.
TransDigm is run like a private equity firm, buying up small aerospace businesses and letting them run with some amount of autonomy. The company has been able to generate software-like margins by focusing on spare parts that are either patent-protected or have characteristics that make them hard to commoditize.
Skeptics have questioned the sustainability of TransDigm's margins for years, but the strong performance during the pandemic seems to indicate the company's pricing power is more resilient than some had feared.
About 90% of TransDigm's net sales are generated by proprietary products, and about 75% are from products for which the company is the sole-source provider. With margins holding up through the pandemic -- which is shaping up to be the worst crisis in U.S. aviation history -- this goes a long way toward dismissing a key bear argument against the company.
The balance sheet is fine
One of the criticisms of TransDigm heading into the downturn was the company's relatively high debt load. As of June 30, TransDigm had $4.55 billion in cash on its balance sheet, but $20.04 billion in debt.
The debt is an issue, costing the company more than $1 billion in interest expense annually. But with no maturities until 2024, the debt shouldn't ground the company, even if the aerospace slump lasts for years.
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TransDigm tapped debt markets for an additional $1.5 billion in cash early in the third fiscal quarter, which company executive chairman Nick Howley on a post-earnings call with investors called "an insurance policy for these uncertain times." As of now, he doesn't expect the company to need that added cash and is already thinking about what to do with the balance that is building up.
I believe again absent some large dislocation or additional sort of national shutdown or international shutdown, I think we will continue to pile up cash, and we will develop very substantial firepower. When we feel more comfortable and we feel like we got a little clearer view of the world, then we'll decide what to do with that.
Howley didn't give any indication on the call that he views the debt as a problem, saying TransDigm's "last choice" when it comes to deploying any excess cash is debt repayment. He said acquisitions are the clear priority, followed by returning cash to shareholders.
TransDigm is keeping an eye out for deals, but it's far from certain the company will find one. Given the current aerospace climate, now is not an opportune time to sell unless you have to. If conditions stabilize and no acquisitions can be found, TransDigm could be positioned to pay a special dividend to shareholders as soon as later this year.
TransDigm is a long-term winner
We're not out of the woods yet. Most expect the aftermarket to rebound faster than new plane sales, because airlines will likely return parts of their existing fleets to service before committing to purchase new aircraft. However, a recovery could still be years away. Some of TransDigm's most lucrative products go on the older planes in the fleet that might never return to service.
There is also room for improvement in the quarters to come. Defense sales fell 13% last quarter, which TransDigm attributed to operating hiccups in certain businesses and foreign order delays. If so, that revenue could simply be pushed into future quarters as the issues are resolved.
Until airlines fully recover, it is going to be hard for TransDigm to generate the sort of growth that made it among the top-performing aerospace stocks of the last decade. But the company's quarter should be a relief to anyone who was worried about the pandemic leaving long-lasting scars, or permanently altering the investment case.
TransDigm is, and looks to remain, one of the best-performing companies in aerospace. It's more than capable of riding out this period of turbulence.
