Is TransDigm Stock a Buy?

Shareholders in aerospace-focused companies have had to endure a difficult year, and it's not over yet. The coronavirus pandemic hit the commercial aviation industry hard, and the recovery is proving more sluggish then most commentators expected in the spring. 

That said, aerospace supplier TransDigm (TDG 0.81%) has long been regarded as one of the best run companies in the industry and provides investors with a useful option to play a recovery, albeit a slow one. Let's take a closer look at the company. 

Image source: Getty Images.

TransDigm

With its industry-leading operating margin and a track record of growing earnings for investors, TransDigm stands out as a high-quality option for investing in the sector. As such, there's a case for arguing that the company is a good way to get exposure to the potential for a slow recovery in the aerospace market.

Data by YCharts

However, there are a few considerations that investors need to take before buying the stock:

• Is the excellent track record of generating returns for investors largely a consequence of being a highly acquisitive company in a bull market? If so, what happens if end-market growth becomes sluggish?
• TransDigm's margins are sky-high, but could they come under threat in a market slowdown likely to intensify competition?
• Why should TransDigm's valuation be higher than it was before the pandemic spread?
• How does TransDigm stack up against other aerospace suppliers like Heico or Raytheon Technologies?

Earnings growth and margin

The secret behind TransDigm's margins can be found in its business model. In the company's SEC filings, it said, "90% of our net sales for fiscal year 2019 were generated by proprietary products" and "we estimate that we generated approximately 80% of our net sales from products in which we are the sole source provider."

Once these proprietary products are established on an aircraft, they tend to generate substantive amounts of aftermarket revenue -- some 52% of the company's sales in 2019 came from aftermarket products.

Moreover, TransDigm tends to sell a plethora of relatively small ticket items -- at least when compared with, say, Raytheon Technologies' aircraft engines, cabins, and flight deck solutions or Boeing's aircraft -- and this kind of niche-market provision lends itself to good margin performance.  

The glass is half empty

On the other hand, TransDigm's margin is clearly there to be attacked, and in a weak market, the distributors and airlines that make up a large part of the company's customer base may well be more focused on cost-cutting in the future. For reference, Boeing is responsible for 11% of TransDigm sales via a distributor company it owns.

Moreover, if a valuation premium is built into the stock price as a result of TransDigm's history of earnings growth, then the premium could disappear if that earnings growth starts to stall. Let's put it this way: The company has been a niche market consolidator in a bull market -- a great thing when aerospace product demand keeps going up -- but it's fair to argue that if a bear market ensues, it makes sense for the market to take away that valuation premium.

Furthermore, it would be a mistake to ascribe a valuation premium to TransDigm's history of acquisitions. Making ongoing acquisitions is wonderful in a bull market -- deals can often look like a great value in a few years -- but it's the reverse process in a bear market. 

Valuation and other investment options

There's little doubt that TransDigm, alongside fellow acquisitive company Heico, is priced at a premium in the sector. For example, here's a comparison based on enterprise value (EV), which is market cap plus net debt, and earnings before interest, tax, depreciation, and amortization (EBITDA).

Data by YCharts

Moreover, the following table of Wall Street Analyst estimates for EV/EBITDA multiples shows that it won't be until 2022 that TransDigm starts to trade within the 16 times to 18 times the multiples it's been on in recent years. Meanwhile, another pure aerospace and defense company, Raytheon Technologies, looks like a much better value.

Data source: Marketscreener.com

Is TransDigm a stock to buy?

All told, aerospace-related stocks should trade at a discount to previous valuations to reflect the increased risk around growth prospects in the sector. However, TransDigm trades at a premium, on both current and forward expectations. That's something hard to justify in the current environment. Furthermore, other investment options in the aerospace sector, such as Raytheon Technologies, are a better value right now. As such, TransDigm is one for the watch list rather than a buy right now.