A TransDigm Collar Position To Protect Your Investment

| About: TransDigm Group (TDG)

When your car needs a new alternator, you can just go down to Autozone (NYSE:AZO), Advance Auto Parts (NYSE:AAP), O’Reilly Automotive (NASDAQ:ORLY) or Pep Boys (NYSE:PBY), get a new alternator and replace it. But, if the alternator on your airplane needs replacing this strategy will not work, as the FAA has regulations for replacing aircraft parts.

One company you might consider for purchasing replacement aircraft parts is TransDigm Group (NYSE:TDG). TransDigm is in the aerospace parts business. The company recently announced plans to acquire Harco Labratories. Harco Labratories makes components for commercial aircraft such as thermocouples, sensors, engine cable assemblies and other related aircraft parts. TransDigm has been on an acquisition spree of late with its recent acquisitions of McKechnie and Talley Actuation. TransDigm seeks to acquire companies in the aerospace industry with proprietary products and significant aftermarket content.

With the aging commercial and defense industry aircraft, the company benefits from providing replacement parts for older aircraft. And, with the FAA continuing to increase regulations for maintaining older aircraft, the demand for TransDigm’s product will only increase.

The company has been noted as having the highest operating margins in the aerospace and defense industry at 42.8%.

In comparison, the company’s competitors Goodrich (NYSE:GR), Honeywell (NYSE:HON) and United Technologies (NYSE:UTX) have operating margins of 15.8%, 10.4% and 15.02%. TransDigm is blowing the competition out of the water in terms of performance. The company realizes 90% of its sales from proprietary aerospace products and most of its products are sole source, explaining, at least partially, why the company has high profit margins. When you don’t have any competitors, and your customer HAS to have your product, you can pretty much charge ANY price you want – and get a way with it.

TransDigm’s business is less about high volume and more about customized products, and TransDigm is one of the few companies that design and supply highly engineered laminates for commercial aircraft.

In its most recent conference call, the company indicated it is seeing improvement in the commercial aerospace market. The company’s stock price reflects the improving commercial aerospace market with a stock price up around 45% for the year and a continued upward trajectory over the last two years, as shown by the stock price chart provided below:

(Click chart to expand)

To go with its highflying stock price TransDigm also has the pricey P/E and P/S ratios of 34 and 4.5, respectively.

TransDigm will not be able to maintain its lofty growth rate or operating margins indefinitely. At some point, the company will reach the point of diminishing returns, as its competitors will get into the company’s back pocket, and the TransDigm’s profit margins will take a hit. Additionally, the company will eventually exhaust the pool of available companies to acquire and its growth rate will slow down. Faced with eroding profit margins and slower growth, the company’s stock price will take a hit. I don’t have a view for the timeframe for this scenario happening, could be tomorrow, or could be ten years from now, but an investor in the company sitting on a nice return might want to consider protecting the position.

As an example, an investor might consider a collar position for the TransDigm. A collar position may be entered by selling a call option against the stock with some of the proceeds from selling the call option used to purchase a put option for protection.

Using PowerOptions search capabilities, a collar position was found for TransDigm with a potential return of 2.1% and a maximum potential risk of 8.6%. The timeframe for realizing the potential return is 37 days. The call option to sell is the 2011 December 95 with a price of $4.60 and the put option to purchase is the 2011 December 85 with a price of $1.45. If the price of TDG is greater than or equal to the price of the $95 strike price of the call option at expiration, the position will return 2.1%. And, if the stock dives in price, the maximum potential loss is 8.6%. The profit/loss diagram for the collar position is shown below:

Entering the collar position can give an investor in TransDigm some peace of mind, especially with the company’s earnings report coming up on the horizon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Tagged: , , Aerospace/Defense Products & Services, Options
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