TransDigm Group (NYSE:TDG) is a longtime outperformer, with its stock up more than 1,200% since the beginning of 2008. But the company, a maker of aerospace components, was hit hard last year during the pandemic.

On this clip from Motley Fool Liverecorded on May 13, Fool.com contributor Lou Whiteman talks with Industry Focus host Nick Sciple about TransDigm's recent quarter and what we learned from how the company was able to navigate the crisis. For buy-and-hold investors, there is still a lot to like about TransDigm. 

 

Nick Sciple: Let's move on to the last company we're going to discuss today. That's TransDigm. TransDigm is, for folks who aren't familiar with the company, one of the largest manufacturers of airplane component parts. It was impacted by the pandemic air travel cutback last year. What's going on with the company today?

Lou Whiteman: For people who have listened in before now, this is one of my favorite companies to talk about. It's a company that has both been a great performer, but there's also been a lot of criticism attached to it. The great thing about this last year is that I think a lot of the criticism, we had a trial under fire and the company has come out real well. This is company, as you say, they make mostly spare parts for commercial airplanes. That is their bread-and-butter business. They reported a quarter of $2.58 per share on revenue of $1.19 billion. That beat estimates by 3% and 2%. Organic revenue was down 20% year over year. That is the COVID effect. But even with commercial organic down 43%, the aftermarket, which is spare parts, down 39%, this is a company that still managed an EBITDA margin of 43.5%. You don't see 40% margins in most manufacturing businesses, especially most component part businesses.

TransDigm, the ticker is TDG, this is a stock that has grown by 1,000% in the last decade or so. Forever the criticism has been these margins aren't sustainable. But what we've seen now is through the worst aviation crisis in global industry history, the margins were sustainable, and in fact they held up better than the company thought. They have a lot of variable costs. They have parts that are very, very important, and it really seems like now the worst is behind us. Aftermarket demand was up 14% on a sequential quarter from fourth-quarter 2020. Orders were up 30%.

There's some concern that I have that maybe this is just restocking supplies. It's going to be like, think about it, now that airlines are flying again, they want to build back up their supplies. Management says this is sustainable. It's not just stockpiling. It's something we're going to watch, but I take them at their word. This is a company that is proving its need to the system in a very difficult operating environment. Everything I loved about TransDigm before, I love it more now, I think [laughs], coming off this and just seeing how they've gotten through this last year.

Sciple: I think one other thing to mention, folks talk about TransDigm as a very levered business model, and the fact that they were able to roll through the pandemic without that leverage biting them, I think, says something as well. Now, we can say that the Federal Reserve helped out lots of highly levered companies for whatever reason. That risk did materialize in the way many folks may have expected.

Whiteman: Yeah, and it's funny because it's a great point to make, and it's something that they are addressing. As a bull, I'm almost a little disappointed here, but I certainly understand it. This is a company, they don't pay a regular dividend, but they're always on the lookout for acquisitions. You can think of this as almost a private equity firm disguised as an operating company. They buy good businesses; they clean it up and leave it alone. They prioritize cash for acquisitions, but they have a history of doing very, very rich $35-, $40-, $50-a-share special dividends almost on an annual basis recently. A couple of years, they've done two of those. We're not going to see that for now. Special dividends, buybacks, they're putting that on hold. They want to, they call it recharge their balance sheet.

Net debt is currently about 8 times EBITDA, which is a little on the high side for them, but they have done some deals. But they think it's going to be a buyer's market in the next 18 to 24 months, and they want to be ready for that. This is a trust-the-jockey story because it's such a collection of parts, so I respect that, I like it when they buy, but I have been thinking with the way cash was piling up, that we were going to see a nice maybe even toward a $100-a-share dividend sometime later in the second half of this year. Apparently I was wrong to hope for that. That's not happening. So that's a good and a bad, but it does change my thinking, I guess, from coming into the quarter.

Sciple: We'll see what they do with that cash. Obviously, they were impacted by the pandemic. You could tell a story, too, for an acquisitive company. We've got the capital gains tax going up. Maybe there are some deals that are going to come to market that wouldn't have been there otherwise. Maybe the last thing on TransDigm, you mentioned these margins, which are remarkably high, especially when you think about it. This is used parts, and companies try to make generic parts and things like that. Why do you think TransDigm has surprised folks and been able to maintain such high margins for so long?

Whiteman: The analogy I'd use is the analogy of what we try and do with stocks. You pick the best companies, and then you get the outsize returns. TransDigm is very good at finding that rare spare part. What they're looking for is a business that makes parts that are in desperate need -- you can't fly the plane if you don't get this part -- but aren't high volume. There isn't really the business case for someone to commoditize it or cut it in or set up their own factory. They also have a lot of patented parts. It's that sweet spot of parts that for these airplane platforms that are both necessary but aren't high volume. They're not going to make napkins or something like that, or a consumable. That is their formula. They haven't always gotten it right, but they are also pretty good. Like they bought a huge business out of the United Kingdom last year. They sold off about half of it because they only wanted some of the parts out there. So they are very picky about what they buy.

Patent protections help. You always see their margins get thrown up against them because they do have a defense business. There was a short attack on them a few years ago that basically said, "This company that sells to the Pentagon is getting 40% margins." If you break it down, they do have a lot of defense businesses, but most of those are 5%-10% cost-plus things. They have a proven track record with these airlines that we can get you a part overnight that otherwise you would have to ground this plane and lose your revenue. They have these relationships; they have these parts that you can't easily replicate. Yeah, I mean, maybe the model won't work forever, but we're going on a decade plus now of it working just fine. I don't see any real reason to think that's going to go away.

Sciple: Yeah. I've heard a description of that. It's almost you shouldn't think of it as a product business as much as a service business, and the service says we have supply of these super-niche products available for you at all times. Whereas the product itself, maybe you're not willing to pay a 40% margin on it. You are willing to pay that margin to have the product tomorrow so you don't lose revenue for grounded planes and all those things. Yeah, there are these interesting companies where they're a product company where there's a service hidden inside of it that you don't really necessarily notice unless you understand the nature of the business and all those things.

Whiteman: If there's one bit of caution, I will say some of these parts, airplanes are becoming much more commoditized. Boeing and Airbus are getting a lot better at these things. A lot of the best parts are on planes that have been around for a long time. Some of those planes are the ones that have gotten retired because of the pandemic. There was a fear. I think that will cost them some of their potential growth years to come if some of these older air frames have a shorter-than-expected lifespan, it's still debatable. A lot of those planes will end up in developing markets even if they're not being used in the United States. But yeah, I mean, it's also a very hard business to replicate for that reason, though, too. You aren't seeing a lot of parts on the 737 MAX that have quite the attractive profile as some of the parts on, say, a 20-year-old 737.

Sciple: Last thing on TransDigm. You mentioned it's one of your favorite stocks. Still on that list of your favorite companies?

Whiteman: Absolutely. You were talking with Jim Gillies yesterday about, I think he said, what, a stock that he would just put away and not look at for 10 years. It's scary to say that with an aerospace stock. I started thinking about why would I say that, and TransDigm did come to mind. I'm going to own this company indefinitely. That's my plan with it.

Sciple: There you go, folks. Lou has spoken on TransDigm.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.