TransDigm Group was one of the top-performing industrial stocks of the last decade, soaring by 677% over that period. But the 2020s have brought new challenges, and the aerospace component supplier has been weighed down by the pandemic and its impact on aviation.
Investors ran for the emergency exits as the crisis unfolded, but with the end of the pandemic now hopefully in sight, it's an opportune time to take a fresh look at TransDigm and attempt to gauge whether the stock is a good buy today.
A lucrative collection of spare parts businesses
TransDigm makes a range of parts for defense and commercial aerospace customers, with about half of its net sales coming from the commercial aftermarket business -- i.e., spare parts. The components in and of themselves are not all that dynamic -- just a collection of specialized pumps, valves, motors, and other products -- but they're all hard to source, and they're vital to TransDigm's customers' operations.
Individual airplanes tend to be kept in service for decades, and specific models are often produced for more than 10 years. That's a lot of airframes, all of which need steady supplies of replacement parts. TransDigm specializes in parts that are either patent-protected, difficult to manufacture, or specialized enough that it doesn't make economic sense for rivals to commoditize production.
Nearly 90% of net sales in TransDigm's fiscal 2020 (which ended Sept. 30) came from proprietary products, and more than 75% came from products for which it is the sole supplier.
It all adds up to a tremendous business. TransDigm over the past decade has generated earnings before interest, taxes, depreciation, and amortization (EBITDA) margins north of 40%, operating with a private-equity-type model of buying small aerospace businesses and letting them run with some autonomy. Its specialty is reducing costs for those businesses, streamlining their supply chains and logistics operations, and using borrowings to boost returns.
What's the risk?
Critics for years have focused on TransDigm's debt. The company tends to lever up to buy new assets, and carries a substantial $22 billion in total debt, or about 9 times EBITDA. The fear has always been that its software-company-like margins are unsustainable, and that the balance sheet will be in serious trouble when those highly profitable sales slow.
Indeed, TransDigm shares lost about 40% of their value in March as the COVID-19 pandemic spread and it became clear that the company's airline customers would be hit hard. It's tough to imagine a more difficult stress test for this business than a health crisis that forces airlines to slash their schedules by more than half and permanently ground a lot of planes.
By in large, TransDigm got through 2020 with flying colors. Revenue did fall by 33% in its fiscal third quarter, which covered April through June, but the company was still able to generate an EBITDA margin of 41.5%. The following quarter was more of the same, with revenue down 24% year over year but EBITDA margins holding strong at 42.4%.
About 80% of TransDigm's total costs are variable, and the company was able to quickly adjust spending in response to falling demand.
TransDigm was also able to tap debt markets early in the crisis to add to its liquidity, which Executive Chairman Nick Howley described during the fiscal Q3 earnings call as "an insurance policy for these uncertain times." He said at the time that if the company saw conditions normalizing, those funds could go toward acquisitions, and TransDigm in November purchased Cobham Aero Connectivity for $965 million in cash.
Is TransDigm a buy?
The stock has recovered much of what it lost in the early days of the pandemic, but is still down slightly over the last 12 months. The airline industry's recovery will take years, and it is going to be hard for any aerospace supplier to fully bounce back until its customers do.
That said, TransDigm looks well-positioned to outperform Boeing (BA 4.50%) and suppliers focused on new planes for the foreseeable future. Airlines took on billions in new debt to survive the crisis, and as they gradually rebuild their schedules, they are likely to lean heavily on their existing fleets instead of placing large orders for new planes. That plays into TransDigm's focus on the aftermarket.
Company |
Forward P/E Ratio |
Forward P/S Ratio |
---|---|---|
TransDigm (TDG 0.24%) |
47.77 |
6.258 |
Heico (HEI 0.22%) |
55.41 |
8.769 |
Honeywell (HON 1.77%) |
25.89 |
4.2 |
General Electric (GE -0.03%) |
30.41 |
1.243 |
TransDigm is not cheap, trading at more than 47 times expected earnings and 6 times expected sales. But that's actually a discount compared to Heico, another best-of-breed aerospace supplier to which it is often compared. And the valuation is in line with TransDigm's averages over the past five years. With borrowing rates near historic lows, it is set up well to be an opportunistic acquirer, growing its business inorganically as it awaits a full recovery.
Any doubts I had about the sustainability of TransDigm's business were put to rest by the pandemic. The company continues to operate at a level well above most of its aerospace peers.
It's hard to know how the stock will perform in the next few quarters as investors react to the pace of whatever airline industry recovery develops. But for investors looking for top-quality operators that they plan to hold onto long term, TransDigm is the best aerospace company to buy.