The mission-critical aerospace supplier you’ve never heard of.
Most people have never heard of TransDigm (ticker: TDG). Yet this mission-critical supplier of niche aerospace parts has what we believe to be one of the widest economic moats in the world.
And hence the makings of a punch-card business.
Buffett: “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches — representing all the investments that you got to make in a lifetime.
And once you’d punched through the card, you couldn’t make any more investments at all.”
Elevator Summary
We think TransDigm is a wonderful business for a variety of reasons.
In a steadily growing air travel industry with a dominant market position, TransDigm sells hard-to-replicate niche products like tiny valves and motors with thousands of different sizes.
Due to the mission-critical nature of each part to the overall safety of an aircraft, there are stringent regulatory approvals required to compete against TransDigm. These regulations create immense switching costs for TransDigm’s customers to leave for a cheaper (and possibly riskier) alternative.
They also provide really high barriers to entry for new competitors. The upfront investment of time and capital required to pass these regulations simply isn’t worth it for most smaller scale, less experienced suppliers. Hence, existing customers have a lack of substitutes and must use TDG.
TransDigm’s crown jewel is its aftermarket business — this is when you’re an existing customer of TDG and they sell you replacement parts or perform maintenance. This business drives sticky, recurring revenues and profits due to the consistent refurbishment and replacement associated with keeping an aircraft safe and updated after years of wear and tear. As a result, TDG has visibility into many years of future unit sales growth (huge).
What does this all add up to? The holy grail — Pricing Power.
TransDigm is able to increase prices and generate prodigious amounts of free cash flow, which it has historically deployed into accretive add-on acquisitions and special dividends to shareholders. We believe this cycle will continue.
And of course, not only do you have a good horse, but you have a great jockey.
With an experienced and highly aligned management team at the helm, with a demonstrated track record of shareholder value creation (~30% annual stock price return over the past 15 years), we believe TDG represents an excellent business.
Simply put: the company makes something really important for its customers where they have no real alternative; these customers will need a lot more of this in the future; this business is really hard to replicate; and you have great leadership.
We believe the company can grow its sales by double-digits and earnings at 20%+ for years to come.
Business Overview:
We’ve all ridden in airplanes before. There are thousands of components needed for a plane to get off the ground and stay off the ground. TransDigm plays a critical role in your trip from NYC to LA.
The company makes small parts that wear out and need to be replaced several times over the 25-year life of an airplane. These niche products include valves, pumps, sensors, motors, batteries, and other pieces for commercial and military aircrafts.
The co-founder and CEO Nick Howley has been the leader since the company’s founding in 1993.
Investment Thesis
TDG has a number of competitive advantages that we believe create a formidable moat for the business.
Advantage #1: High barriers to entry and hard-to-replicate products
The company’s product line-up is proprietary, vast (tens of 1,000s of SKUs), and diverse (50+ product lines). They’re installed on almost all of the major commercial aircraft platforms globally, with an estimated base of >70,000 aircrafts having TransDigm parts installed.
It’s a huge advantage that TransDigm focuses on small, niche products: for ~80% of their products they are the sole-source supplier (i.e., they are the only one!), and ~90% of their revenue comes from proprietary products. T
his means that most of the company’s sales come from products where no current substitute exists, making the business very difficult for competitors to disrupt.
Furthermore, the aerospace parts industry has stringent regulatory certifications and approvals required by the Federal Aviation Administration (FAA) in order to do business. These high barriers to entry help shield TransDigm from new competitive entrants, thereby strengthening its economic moat.
Advantage #2: Sticky business with high switching costs
Once an aircraft platform is approved by the FAA, the original suppliers generally have a strong-hold on the “aftermarket” and therefore good pricing power. Aftermarket refers to sales made after the initial aircraft is manufactured and placed into operation — these sales are made “after” the plane is in the market.
This is particularly true in TransDigm’s case. TDG’s aftermarket business generates about 60% of company sales and 90% of company profits.
What Amazon Web Services is to Amazon, this segment is to TDG.
Their parts tend not to be high-ticket items, so customers have less pressure to look for cheaper competing products and potential competitors have less incentive to enter their markets. As a result, TDG’s product line-up produces a stable, recurring revenue and profit stream.
Advantage #3: Industry tailwinds
The popularity of air travel continues to grow. Revenue passenger miles (RPMs) are an industry measure of traffic that adjusts for changes in the size and/or distance traveled per flight segment. RPMs has historically been the best predictor of commercial aftermarket demand, which together with the defense aftermarket drives ~80% of TransDigm’s profits.
Growth in RPMs over the last 40 years has been very consistent (5–6% annually). Each year, Boeing publishes a long-term forecast of industry growth based upon its order flow, global traffic patterns, and economic conditions. Boeing has called for 5% annual passenger and cargo traffic growth over the next 20 years.
We believe there will continue to be a steady, upward trajectory in passenger traffic going forward, and TransDigm should be a leading participant in that trend, growing its unit sales by at least low single digits per year on average.
Advantage #4: Pricing power
A pillar of TransDigm’s business has been its ability to consistently raise prices at rates exceeding inflation.
On average over the last 20 years, TDG has realized a ~5% annual price increase for its components. Importantly, pricing gains have been pretty uniform across its product line-up. The company’s best-selling product is less than 1% of total sales, so no single product is responsible for its price increases.
We think TDG’s demonstrated ability to increase prices will continue. The combination of rising traffic growth and price growth in its core commercial aftermarket business will continue to generate attractive organic growth and profits well into the future.
Advantage #5: Wonderful unit economics
Given these dynamics, TransDigm’s EBITDA margins are high, around 45% — an exceptional level for a manufacturing company. The business also has very low capital intensity — the ratio of capital spending to sales is about 2%.
Returns on tangible invested capital, pre-tax, are around 90%. This is incredible for a non-software company.
Advantage #6: Experienced management and operating strategy
Many people believe that eventually all business models can be copied — it’s up to leadership to make sure the company can stay alive.
TransDigm’s management team and corporate culture is highly performance oriented, which is manifested in an effective and aligned incentive plan. Co-Founder and CEO Nick Howley has instilled an ownership culture and executed a disciplined acquisition strategy that has created significant wealth for shareholders. This type of management — hyper-focused on shareholder value creation and return of capital — is exactly the type we hunt for at Titan.
As an organization, TransDigm is structured with a kind of Berkshire Hathaway-like localization. Each business unit operates fairly autonomously, with a focus on “thinking like an owner.”
Compensation is heavily performance-based, which keeps all managers and employees ruthlessly driven to hit KPIs for EBITDA and free cash flow growth — the ultimate drivers of the stock price in the long run.
The CEO is a very disciplined buyer and strong operator with a private equity mindset. However, unlike traditional PE firms, he’s collecting companies to own for the long term, rather than selling them a few years later like most private equity players. He’s buying companies that are typically sole suppliers of aftermarket airplane parts. Then once he buys them, he and his team squeeze the costs out year after year, driving margin improvements and heaps of free cash flow.
This acquisition strategy has become a huge competitive advantage for TransDigm. The portfolio of 60 companies it has acquired since 1993 produce specialized proprietary products that other companies are limited to competing with due to FAA certification and approval processes. As a result, each acquisition reinforces the moat of high barriers to entry, switching costs, and pricing power that makes TransDigm such a powerful compounder of cash flow.
What are the Risks?
Taking pricing power too far
Some investors are concerned that the company has begun to focus on shorter-term profitability at the expense of long-term resilience. They believe the culture has been getting more fragile in the sense that TransDigm’s management team is being more vocal around their leverage and their pricing power. This creates additional fragility that was not present a few years ago.
Leverage
Given its consistent free cash flow generation, TransDigm can take on leverage. It does so substantially (~6x net debt / EBITDA ratio) to operate its business and acquire other subsidiaries.
Some of this leverage is “floating rate” debt, which means it is subject to more expensive interest payments if/when interest rates rise. This would hurt the company’s net earnings, at least in the near term.
Attention from short-sellers and/or regulators
Citron Research, a famous short-selling research firm, has accused TransDigm of becoming the “Valeant of the Aerospace Industry” due to claims of price gouging and abnormally high profit margins at the expense of customers.
TDG’s stock plunged 12% in early 2017 when this report was published, but rebounded only 13 trading days later. Wall Street analysts covering TDG have called the report biased and over-speculative, but regardless, TDG’s intellectual property allows it to a structurally wide moat against competitors, resulting in higher prices and margins. This seems unlikely to change for the foreseeable future.
Book recommendation: The Outsiders
If you’d like to learn more about TransDigm-like businesses and their leadership stories, we highly recommend the book “The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success” by William Thorndike. The author mentions TransDigm as a “contemporary analog for Capital Cities,” one of the eight companies/leaders profiled in the book.
Disclaimer: This is a part of our Titan Deep Dive series. Each quarter, we spotlight a company that just entered the Titan portfolio. This is a business overview, not an investment recommendation.
As of this writing, TransDigm (TDG) was a portfolio holding of Titan Invest (“Titan”), an SEC registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. TDG may cease to be a portfolio holding at some point in the future. The Titan Deep Dive series determines spotlight companies based on objective, non-performance criteria. It should not be considered an offer, solicitation of an offer, or advice to buy or sell any mentioned securities or a solicitation to become a Titan client. Any forecasted metrics may not reflect actual future results. The research is based on current public information that Titan Invest considers reliable, but Titan Invest does not represent that the Company’s research here is accurate or complete, and it should not be relied on as such. The views and opinions expressed in this post are Titan’s own, current as of the date of this article, and are subject to change. Financial metrics are subject to future adjustment and revision. The securities identified do not represent all of the securities purchased, sold, or recommended for clients in the Titan portfolio.
