An Industry Insider's Valuation Of TransDigm - Part 1/3

| About: TransDigm Group (TDG)

Summary

TransDigm strategically acquires aerospace component OEMs that have monopolistic advantages.

These monopolistic advantages allow the company to increase pricing in both its commercial products and its military products.

The government Profit Policy risk has existing for decades.

In spit of the Profit Policy, TransDigm has thrived at close to 50% margins for over 20 years.

The Trump administration offers additional growth opportunities.

Investment Thesis:

TransDigm (NYSE:TDG) is a extremely profitable business. Its moat is extremely effective at controlling pricing and limiting product competition. Government profit policy risks have existed throughout the business' history, but have not significantly affected its profitability. I expect TransDigm to continue to have a significant monopolistic advantage in the market in both military and commercial products.

Introduction

At first glance TransDigm looks very expensive purely from an earnings perspective. However, to value the business properly you need to fully appreciate the complexities that underpin the aerospace parts business to see how wide TDG's moat really is.

This article is part one of three. Part one focuses on the key attributes that make up TDG's moat. Part two looks at more specific business fundamentals that could create cash flow risk, and part three combines these fundamental to develop a likely cash flow scenario and business valuation.

As my background is both in the military aerospace (engineering) sector and aircraft and parts procurement, I hope to provide value added detail to help clarify the likelihood of business risks.

Content

  1. Primer

  2. Growth

  3. Company Description

  4. Understanding How Aircraft Parts are Approved

  5. Summary: How TransDigm Controls Pricing

  6. Political Risks

  7. Profit Policy Risks

  8. Defence Spending Risks

  9. Commercial Forecast

  10. Summary

  11. Next Steps

1. Primer

The next time you fly, look out the window and consider that there are only three or four bolts holding each engine to the wing.

How much is a bolt worth to you? Considering this story (don't read if you already have a fear of flying), you shouldn't be surprised that aircraft engine bolts can cost several thousand dollars each. The exact same bolt could cost a buck or two from a local hardware store. In reality, you're not only paying for the bolt. You're paying for the engineer to select the right bolt, the quality control within the manufacturing system, a parts distribution system that you can trust, and the proper documentation to ensure you get the right bolt. You don't want a fake.

This is the reality of aircraft parts. Everything is expensive. But expensive keeps you alive. There is no substitute for that. Even if you don't value your life as much as the next person, the perceived reliability and safety of air travel plays a huge role in the economy. This has driven failure and fatality rates to extremely improbable levels. Air travel is only getting safer, but with increased safety comes with increased costs.

2. Unreal Growth

TDG has experience unreal performance in the aerospace industry over the past +20 years, growing revenues at 20% per year and EBITDA at over 24% per year since 1993. Its EBITDA margin has remained above 40% since 2003, hitting 50% in 2010. Currently it's steady at 48%. It is one of the best performing businesses in the aerospace industry, let alone any industry. Let's have a closer look at TDG to see how it has been able to thrive in such a challenging industry.

3. Company Description

TransDigm is a holding company that strategically buys aerospace component original equipment manufacturers (OEM) that have monopolistic advantages in those product lines. In other words, TDG is often the sole manufacturer of specific components that make up certain systems within an aircraft. Its strategy involves acquiring profitable businesses, implementing cost controls and productivity improvements, and increasing the price of each product.

Management's ability to find aerospace companies that don't price their components high enough is where this company shines. Management has played this game over and over for the past 20 years:

There remains a significant untapped market to continue to make acquisitions:

To give you some perspective, here is a sample of their product offerings from their 2017 investor presentation:

4. Understanding how Aircraft Parts are Approved

In order to really appreciate the complexities of the business, you need some insight into the process for approving aircraft parts:

When aircraft are designed, they go through a very detailed certification process to ensure the aircraft meets certain certification requirements. These certification requirements ensure the aircraft meet safety, noise, and environmental standards. Civilian aircraft use what's called a "basis of certification" to identify the collection of standards that underpin the complete aircraft type certificate (i.e. the FAA's aircraft approval). These standards are outlined in the Federal Aviation Regulations (FARs).

Based on the standards identified in the basis of certification for a particular aircraft, the main aircraft manufacturers (i.e. Airbus and Boeing) perform detailed engineering design, analysis, testing, and modeling to show compliance to these standards. Boeing and Airbus often flow subcomponent design requirements and reliability parameters to its subcontractors. Sometimes whole systems are subcontracted. The engineering data (tests, design, analysis, etc.) related to these components and/or systems is collected by the OEM and are put together like a puzzle to form the complete approval for the aircraft.

You need the appropriate experts in certain engineering specialty areas to make "findings of compliance" against each standard. You also need the right organizational approvals and relationships with the government regulator (i.e. FAA, EASA, TC) to perform and approve this type of engineering work. Moreover, you need specific approval from the regulator to manufacture parts. These are all barriers to entry.

If you want to do a design change or approve an alternative part to an existing aircraft, you need to go through the same certification process that was used during initial certification. Depending on the specific part application (i.e. criticality), there are cases where you can get smart engineers in a room to approve alternative parts with minimal engineering work. But some parts, no matter how trivial, need extensive engineering work to approve the change.

In many cases, without access to specific engineering design data, it is impossible or not cost effective to deviate from the existing OEM's approved parts list. This really hurts when you are facing obsolescent platforms or the OEM goes bankrupt. Parts generally get expensive and are hard to find in those cases.

In other cases, standard and commercial specifications are used in the approved parts list for the aircraft. For example non-critical bolts, rivets, sheet metal, etc. can be replaced by specification and not by part number. Some more complicated parts are commoditized under a technical specification order (TSO), where any manufacturer who has the right regulatory approval can design, manufacture, and sell parts that meet the specific TSO.

Here is an example of a TSO for a fuel drain valve:

Many aircraft may use this TSO to define acceptable fuel drain valves. In other cases, the aircraft or engine OEM may wish to have a customized fuel drain valve designed due to a design requirement or better performance requirements. Mandating a customized part number decommoditize the fuel drain valve for that platform. You might see this more for specific military applications, such as high performance aircraft or for systems that need higher levels of reliability.

The military process varies depending on what country you're in. Canada, the UK, Australia, or pretty much any other western country than the US, use a process very similar to the civilian certification process. Most US military aircraft are built using military specifications. Some military aircraft are based on civilian requirements. The big difference in the civil and military programs is that militaries can accept different risk profiles and in certain circumstances have more options. But not always.

5. How TransDigm Controls Pricing

TransDigm effectively controls pricing through leveraging several key competitive fundamentals in the industry (barriers to entry):

  • Data Limitations. Creating an alternative part may be expensive or difficult to do without access to the original design data.

  • Certification requirements. Alternative parts may be difficult to certify without the design data. It may also be cost prohibitive and involve flight testing, engineering analysis, and requires access to certification data owned by several sources.

  • Intellectual Property. Intellectual Property rights and patents may limit the ability of part manufacturers to create alternative parts.

  • Rising Obsolescence. Standing up a supply chain for a limited run of parts may be costs prohibitive. This limits replacement part competition for older platforms.

  • High Switching Costs. Whole systems could be modernized and replaced, however this is very complicated, expensive and time consuming. Therefore airlines don't generally change a system strictly because of parts costs unless there is a business case.

  • Product expertise. Many component designs require engineering experts with specialty backgrounds to support the design and certification of alternative parts. It may be difficult to find the right engineering or manufacturing expertise.

  • Manufacturing approval. Manufacturing replacement parts requires specific approval from the airworthiness regulator.

  • Relationships with OEMs. Often to get access to the right data and be selected as a supplier, you need to have a business relationship with the OEM.

All of these factors contribute to a small supplier base and often monopolistic effects. This is how TransDigm has been able to increase pricing after its acquisitions and maintain an extremely high profitability history.

Not all aircraft parts manufacturers benefit from all of these barriers. For example, some companies might only choose to manufacture parts under TSOs to have a larger customer base. Others may operate in areas that don't generate a lot of important IP or require very specialized engineers. Note the amount of TDG's products that are proprietary and the number of sole sourced contracts they establish:

The dominant reason you sole source is because you have only one supplier to choose from.

Let's take a simple example:

In 2011/12 TDG acquired AmSafe passenger restraints from Berkshire Partners (not to be confused with Berkshire Hathaway). They manufacture aircraft seat belts and airbags and are well known in the industry:

You would think it would be easy to approve an alternative seat belt, however a new manufacturer would have to certify the belts, latches, etc against a number of requirements, such as belt strength, wear/tear, egress, and flammability testing. You would need specific expertise in these areas. Flammability expertise is actually a very specialized skill set under cabin safety. Therefore, if you wanted to get into the seat belt business, you would need to find and hire the right people, invest in R&D, set up business development, create supply chains and manufacturing, etc. The aircraft seat belt business may not be big enough for the big players to invest in.

6. Political Risks

Here are the breakdowns between military and commercial revenues:

Note that defence represents about one third of total revenues. The risk of a political setback is limited to reducing those profits. For example, a reduction of 50% in military revenue would equate to -15% of overall revenue and theoretically profits, depending on the specific margins. This would set back the company about one year in compounding at its current rate.

There are two types of political risks that TDG faces:

  • Profit policy risks; and

  • Government Spending.

7. Profit Policy Risks

A big perceived risk factor facing TDG is its ability to control future defence pricing. The concern stems from something called the "Profit Policy". Many countries have policies that mandate procurement officers include clauses into their contracts that allow the government to audit contractors and limit profits (10-15%). Since TDG operates at an extremely high margin, this would have a dramatic effect on the overall business.

This risk has been highlighted by other analysts, suggesting to short the stock. But few truly understand how the policy works and how it's implemented. Remember, this risk has existed long before TDG was even public. This is the excerpt from the TDG annual report highlighting the risk:

"On contracts for which the price is based on cost, the U.S. Government may review our costs and performance, as well as our accounting and general business practices. Based on the results of such audits, the U.S. Government may adjust our contract-related costs and fees, including allocated indirect costs. In addition, under U.S. Government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of research and development costs, and certain marketing expenses may not be subject to reimbursement.

Furthermore, even where the price is not based on cost, the U.S. Government may seek to review our costs to determine whether our pricing is "fair and reasonable." Our subsidiaries are periodically subject to a pricing review. Such a review could be costly and time consuming for our management and could distract from our ability to effectively manage the business. As a result of such a review, we could be subject to providing a refund to the U.S. Government or we could be asked to enter into an arrangement whereby our prices would be based on cost or the DOD could seek to pursue alternative sources of supply for our parts. Any of those occurrences could lead to a reduction in our revenue from, or the profitability of certain of our supply arrangements with, certain agencies and buying organizations of the U.S. Government."

The intent of the profit policy was to avoid the perception of contractor gouging during large scale military development programs or sole source contracts. Since programs like the F35 are essentially R&D projects with unknown future costs, many of these contracts are essentially "cost plus" contracts where the government pays the contractor costs plus a set profit margin set at around 15%.

These policies have had unintended consequences. Depending on who you talk to, it has formed an us versus them attitude between government representatives and contractors. In some cases, public servants and military representatives make it their goal to destroy any contractor profit:

"there is a distrust of the traditional defense-unique industry that translates into an almost pathological desire to eliminate allegedly excessive profits, the animosity is even higher for those companies who make even greater profits in the true commercial marketplace outside of defense." (ref)

"Culturally we have evolved to a point where the system would rather pay $1 billion and 5% profit for a defense good, than $500 million and 20% profit" (ref)

I'm actually a big fan of the former Secretary of Defence who was also the former Undersecretary of Defense for Acquisition, Technology and Logistics, Ash Carter (under Obama). Ash Carter significantly moved the yardstick in terms of understanding costs in defence acquisition. He focused on incentivising productivity, increasing competition, and reducing non-productive processes and bureaucracy. For high risk acquisition programs he drove for alternative suppliers for major assemblies as an important programmatic goal for limiting monopolistic effects. Obviously Mad Dog has a different background and expertise and he may not be as focused on changing procurement.

So there is a risk that for some contracts the government could claw back profits to 10%. However, there are multiple barriers to implementing the profit policy:

  • There needs to be a direct contract with the government. The profit policy is only enforceable through contract law. Since the profit policy is a contractual obligation, if parts are provided to the government through a wholesaler or as a sub contractor, they may not be subject to profit controls, unless the wholesaler flowed down the profit policy to all of its parts suppliers (difficult to do, difficult to audit). The wholesaler would quote the market cost of the part it buys from TDG and make the appropriate markup for its cost in accordance with the profit policy.

  • The profit policy is an accounting project. If an audit occurred, you can guarantee that TDG would hire very good accountants and lawyers to decrease their accounting profits on military products. This would get tied up in courts. Since TDG sells smaller components, the overall cost analysis for each component could get really expensive and it may be very difficult to analyse the costs from a macro perspective.

  • The policy mostly applies to military unique products and not products that are commercial off the shelf or available at a competitive market rate. That definition is difficult to assess, so the DoD created a memo for clarification (here). Therefore, TDG parts that are also used in commercial applications are generally priced according to market and not based on a cost accounting approach.

  • The government may have their hands tied. Since TDG is a sole source provider for many of the parts they sell, they can place extreme pressure on the government by walking away as a prime contractor and flowing parts to the government through an independent prime contractor at market rates.

  • Part prices for sole source contracts are established upfront. The government performs their cost audit or market price assessment and uses it for price negotiations. In assuming this is done correctly, the pricing policy is met and profit clauses may not apply or included in the contract. I have attached a really good analysis by the Defence Office of Inspector General related to improper price and costing analysis performed by government costing officers on TDG contracts (from 2006).

The government already institutes its profit policy on TDG through sole source negotiations based on commercial market rates. They have been for years. It is reasonable to assume that the effects of the profit policy have been incorporated into the current margins. However, TDG is always subject to policy changes and more aggressive enforcement.

8. Defence Spending Risks

The Donald indicated that he would reduce defence spending but also indicated his military is going to start winning again. You have to take his word with a grain of salt and follow his actions. Some rumors indicate "President Trump Is Likely To Boost U.S. Military Spending By $500 Billion To $1 Trillion". My bet is on increased spending. Men with small hands tend to compensate by buying big toys.

Aircraft parts demand is generally a function of the yearly flying rates. If he cuts spending, the question is where. If he reduces capital spending for new aircraft, TDG won't see a hit to its bottom line. In fact, if he is more aggressive overseas, you will see a rise in aircraft parts demand. Often more money is spent in sustainment and parts in service, but the public only really sees the billion dollar acquisition programs (i.e. focus on F35 spending). So if he wants to start winning again, I'll bet he will continue to spend in sustainment.

9. Commercial Forecast

Overall, I am bullish on aircraft parts demand. See my article on the industry here:

10. Summary

TDG's parts business has been built on extremely solid foundations. It has been able to take advantage of industry fundamentals to create monopolistic effects. Its management has a great track record of finding acquisitions that fit the proprietary model. The total market is sufficiently sized to allow for further expansions and I expect acquisition success for the next several years. The commercial business continues to grow. Although TDG does face political risks related to the pricing policy, it can be assumed that those risks have already been applied to TDG's contract negotiations and are represented in its current margins. In addition, the military risk component of the business is limited to one third of total revenue. I also expect military spending on aircraft parts to continue at the same rate or more as a result of the current administration.

Overall, I am very confident that TDG's moat will stand the test of time for the next 10 years. Even the president seems happy flying with AmSafe restraints:

11. Part II

The next part will focus more on specific business risks at the microeconomic level. The third part will put it all together and come up with a valuation of TDG.

Cheers,

Wayne

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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