A long-running investigation by the U.S. government into TransDigm Group's (TDG 0.39%) pricing of spare parts concluded with a whimper and not a smoking gun. With the probe now behind it, TransDigm looks ready to take flight.
In June 2019, Congress requested the Pentagon's Inspector General (IG) launch a detailed investigation into TransDigm's pricing of aerospace parts after lawmakers grilled company officials during a hearing. TransDigm has long been an investor favorite thanks to its ability to generate software-like margins from a parts business. Allegations of pricing gouging were made by short-sellers, attracting Congressional attention and some unwanted publicity for the company.
In truth, much of TransDigm's margin success comes from the commercial side of the business and the desire of airlines to pay a premium for hard-to-find spare parts. At the time the probe was ordered, sales to the U.S. government accounted for less than 10% of total revenue.
Still, investors were eager to see what the investigation discovered, and will be glad that it is now complete.
Blame the process, not the company
The 124-page report, released Dec. 13, identifies $20.8 million in what it calls "excess profit" spread over 150 contracts awarded between January 2017 and June 2019. It recommends that Pentagon officials seek a "voluntary refund" of the funds without advising more serious action like litigation or pursuing criminal charges. For context, TransDigm generated $5.1 billion in sales in its most recent fiscal year.
There appears to be no allegations of illegal or improper behavior by the company. The IG instead focuses on the Pentagon's $2 million threshold for scrutinizing contracts. A significant percentage of TransDigm's contracting during that time fell below the $2 million threshold. The report recommends the Pentagon beef up its process for determining cost reasonableness on small contracts.
In a statement, TransDigm said, "the report makes it clear that there was no wrongdoing" by the company or the Pentagon, but still took issue with some of its findings. The company said that the IG "expressly acknowledges that it used arbitrary standards that are not applicable to the audited contracts," saying the use of those standards resulted in "flawed analysis and is misleading."
TransDigm also said it believes the report "ignores significant real costs incurred," counting those costs as profit, and failed to adequately compare costs to similar commercial contracts.
"Despite data demonstrating that the [Department of Defense] paid lower prices compared to the commercial prices for similar parts, the report did not conduct a price analysis and instead implies that the [Department of Defense] negotiated prices that were too high," TransDigm said.
What this means for investors
Investors faced two primary risks from this investigation. There was a chance TransDigm could have been found to have committed criminal acts. There was also a risk that TransDigm's relationship with the Pentagon could be soured by the probe. Either result could make it harder for TransDigm to win future business, and either could put a stain on the company that goes well beyond its government operations.
Most had expected a benign outcome, but with the probe now over, critics of the company can no longer use it as fodder. And TransDigm's relationship with the Pentagon appears to be intact. The company said in its statement that through regular engagement with Pentagon officials "there has been improvements to the procurement process, and the company has received positive feedback from [Department of Defense] customers."
TransDigm has been a market outperformer over the years thanks to its ability to acquire attractive businesses and streamline their operations. With the shadow of the investigation now behind it, the company is free to continue to pursue its M&A strategy, or return to its policy of issuing special dividends to return capital to shareholders if no targets can be found. TransDigm's last dividend, a $32.50 per share payout, was paid in January 2020.
TransDigm shares have underperformed the S&P 500 by nearly 30 percentage points over the past year, in part due to the pandemic and its impact on aviation but also because of a broader malaise surrounding the company due to the ongoing investigation and a lack of M&A. With the investigation now concluded and aviation slowly rebounding, the path is clearing for TransDigm to get back to business as usual.
If history is a guide, business as usual at TransDigm is good news for shareholders. With the investigation over, it looks like a great time for investors to climb onboard TransDigm.