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TransDigm Group, Inc. (NYSE:TDG)

F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

August 5, 2008 11:00 am ET

Executives

Sean Maroney – Director of Corporate Accounting and IR

Nick Howley – Chairman and CEO

Ray Laubenthal – President and COO

Greg Rufus – EVP, CFO and Secretary

Analysts

Carter Copeland – Lehman Brothers

Robert Spingarn – Credit Suisse

Fred Buonocore – CJS Securities

David Strauss – UBS

Matt Vitros [ph] – Barclays

Jason Howard [ph] – News, Inc. [ph]

Operator

Good day, ladies and gentlemen, and welcome to the third quarter TransDigm Group Incorporated earnings conference call. My name is Sue, and I will be your coordinator for today. (Operator instructions) I would like now to turn the presentation over to your host for today's call, Mr. Sean Maroney, Director of Corporate Accounting and Investor Relations. Please proceed.

Sean Maroney

Thank you, Sue. I'd like to thank all of you that have called in today and welcome you to TransDigm's fiscal 2008 third quarter earnings conference call. With me on the line this morning are TransDigm's Chairman and Chief Executive Officer, Nick Howley; our President and Chief Operating Officer, Ray Laubenthal; and our Executive Vice President and Chief Financial Officer, Greg Rufus. A replay of today's broadcast will be available for the next two weeks. Replay information is contained in this morning's press release and on our website at www.transdigm.com.

Before we begin, the company would like to remind you that statements made during its call which are not historical in fact are forward-looking statements. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied in the forward-looking statements. For further information about important factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements, please refer to the information regarding forward-looking statements and risk factors included in the company's latest filings with the SEC. These filings are available through the Investors section of our website or through the SEC's website at www.sec.gov.

The company would also like to advice you that during the course of the call, we will be referring to EBITDA, specifically EBITDA as defined and adjusted net income, both of which are non-GAAP financial measures. Please see the tables and related footnotes in the earnings release for a presentation of the most directly comparable GAAP measure and a reconciliation of EBITDA as defined and adjusted net income to that measure.

Now having taken care of the necessary disclosures, I’ll turn the call over to Nick.

Nick Howley

Good morning, everyone, and our thanks again for calling in to hear about our company this quarter. As I did last quarter, I'd like to start off with some comments about both our stock price, our strategy and performance, the company's consistent ability to create, what I’ll call, intrinsic equity value, and our current sense of the aerospace market as applies at least to our business.

Our stock price has dropped about 20% since the start of our fiscal year, that’s October 1. We don’t believe this to be reflective of the underlying value of our business, but we understand this is directionally consistent with the decrease in valuations among other aerospace companies and I suspect driven significantly by fuel cost concerns and the related airline activities. However, I still believe our business model is unique in both the stability and diversity of our products and market segments.

To summarize some of the reasons that we believe this, to remind everyone, about 95% of our sales are generated by proprietary products; about 80% of our sales come from products for which we are the sole source provider; about 60% of our revenue and a much higher percent of our EBITDA comes from the aftermarket sales. Aftermarket revenues have historically produced a higher gross margin and provided significant stability in the downturn.

The equity market reaction and the discounted values seem inconsistent with the relative stability of aftermarket demand to me. In fact, most analyses that I have seen tend to indicate some modest growth in worldwide traffic in the next year in spite of the currently difficult fuel price and economic situation, though with a low rate in recent years.

With our uniquely high EBITDA margins, which run 46% or higher, and a relatively low capital requirements that’s in the 2% to 3% revenue range, TransDigm has year-in and year-out generated very strong free cash flow. This has given us the flexibility to pursue acquisitions, optimize our capital structure, or take whatever actions that we feel are necessary to maximize our value through all phases of the market.

We have a well proven, value-based operating strategy focused around what we refer to as our three value drivers. That’s new business development, continual cost improvement, and value-based pricing. We stick to these concepts as the core of our operating management methodology. This consistent approach has worked for us to up and down markets and allowed us to continually improve and increase the intrinsic value of our businesses.

We've been successful in regularly acquiring and integrating businesses. We acquire proprietary aerospace product component businesses with significant aftermarket content. We have in total acquired 22 such businesses and we've been able to acquire and improve aerospace component businesses right through the cycles.

Through a consistent focus on, one, our operating value drivers; two, our clear acquisition strategy; and three, close attention to our capital structure. We've been able to create intrinsic equity value for our shareholders for many years right through the cycles. The performance after 9/11 for the EBITDA grew and margins expanded right through the downturn was the most recent example. This consistency does not seem to us to be fully recognized and valued at this time.

Our revenues continued strong in Q3 and we expect them to remain so in Q4. At this time, we expect 2009 revenues to be above the 2008 levels. However, as I said earlier, it appears increasingly possible that fiscal year 2009 could see low, if any, growth in worldwide air traffic. At this time it appears the demand for commercial OEM production remains strong and should do so in the next year. I suspect this may well be due to our newness in the public equity market.

Our past practice, consistent with our value focused management methodology, has been to reduce our cost structure ahead of any potentially softening market conditions. Over the past cycle, this has proven to be an effective means of protecting long-term shareholder value. We have begun this process and expect to have made significant cost reductions by the end of our fiscal year Q4. We will closely monitor our cost structure in the market conditions as we move into the next year.

Our philosophy has always been to get out ahead of any potential market condition and adjust our cost structure quickly. As I said, we will monitor this closely as we move into 2009 and we can adjust up or down as the market environment clarifies.

As you can see from our press release, in spite of a softening in both economic outlook and the aerospace market, and excluding any additional acquisitions, we feel comfortable again increasing our guidance from the previous EPS midpoint of $2.72 a share to an adjusted guidance of $2.77 a share at the midpoint, all on an adjusted basis. This improvement comes primarily from two areas; one, a modest increase in the base operating performance; and two, the contribution from the recent CEF acquisition. Greg will give a little more detail on this guidance in his section.

We continue to beat the bushes for more businesses to buy. We maintain our consistent focus on proprietary aerospace components with significant aftermarket content. I'm confident we'll find more, but the timing is always tough to predict. With respect to our underlying markets for the balance of the year, in the commercial OEM area, build-out works appear stable for the balance of the year and with the exception of the 787 delays about as we anticipated.

In the commercial aftermarket, we are beginning to see some signs of a slowdown in growth, especially in North America, as the fuel prices and economic conditions seem to be beginning to take a toll. The quarterly numbers can bounce around. I remind you over a longer period of time, our real aftermarket volume has generally been able to track at or a bit ahead of overall worldwide traffic trends. Also just to remind everyone again, the DC9/MD80s, Classic 737s and the 727 platforms, most at risk of retirement, make up only about 3% of our last year’s revenues. The defense business continues better than we anticipated. We are cautious regarding the market outlook, the confidence and the strength of our unique business model to continue to create value.

Now let me turn to our specific financial performance for this quarter. I'll remind you this is the third quarter review for fiscal year 2008. Our fiscal year started October 1. We are three-quarters of the way through the year. Also as I’ve said in the past, quarterly comparisons can be significantly impacted by differences in OEM aftermarket mix, large orders, transient inventory fluctuations in the system, modest seasonality and some other factors. In spite of some timing issues, we had a good year-to-date and third quarter.

Revenues are up about 24% on a year-to-date basis and 18% on a quarter versus prior quarter basis. Pro forma growth, that is assuming we own the same mix of businesses in both periods, is up about 10% on a year-to-date basis and about 12% on a quarter three versus quarter three basis. That’s in spite of a down drag from certain one-time items impacting the comparisons.

Revenues by market segment, again, on a pro forma basis versus the prior year, that is assuming again we own the same mix of businesses. In the commercial segment, which makes up about three-quarters of our volume, first in the commercial OEM area, it’s up about 12% on a quarter-over-quarter basis and about 8% on a year-to-date basis. Though both sectors grew on both the quarterly and year-to-date basis, our commercial transport sector OEM grew faster than the regional biz jet sector. We still expect our pro forma commercial OEM revenues to be up about 10% for the year.

The commercial aftermarket revenue was up about 6% on a year-to-date basis and about 3% on a quarter-to-quarter basis. This year-to-date growth is impacted by two significant one-time items, which we mentioned earlier. First is some one-time activities in shipment timings in comparison to the prior year. The other was the extended maintenance cycle for certain cockpit security components. Additionally, we’ve now seen some modest inventory adjustment with some of our distributors. If you remove the impact of these three items, our core aftermarket was up almost 10% on a year-to-date basis. Q3 was also impacted but to a lesser degree by some of these items.

Given the fuel price situation, the economic outlook, and the airlines financial position, we are now less optimistic regarding the balance of the year in the commercial aftermarket. With no adjustments for one-time items, we now anticipate pro forma commercial aftermarket revenues to be up in the 6% to 8% range for this year versus the prior year. That’s below our previous fiscal year estimate of about 10% growth.

In the defense segment, which makes up about a quarter of our revenue, revenues were up over 25% on a quarter versus quarter basis and 20% on a full year basis. Though we saw strength across almost all our product lines, the activity in the aftermarket was particularly strong in the area of helicopter upgrades, both for increased power requirements and to add counter measures. We also saw a lot of activity across a broad range of air-based and ground-based gun positioning products.

The defense business is always tough to predict, especially in the political season, always subject to political wins and budget uncertainties. Absent any significant changes, however, we now expect pro forma defense revenues to be up in the mid-teen percentage range versus prior year. This is up from our previous fiscal year estimate.

In summary, for the full year we expect our businesses to perform a bit above our initial expectations with a modest shift in aftermarket mix between commercial and defense revenues. Excluding any acquisitions, we expect our overall pro forma revenue growth to be up about 10%, very close to our previous guidance.

Moving on now to profitability and on a reported basis now, I’m going to talk primarily about our operating performance or EBITDA as defined. The total adjustments to EBITDA are lower in the current year due to both less acquisition related expenses and we didn’t have any secondary offering cost as we did in ’07.

On a Q3 versus comparable quarter basis, our EBITDA of about $87 million is up about 18% versus the prior year – the prior Q3. The EBITDA margin is 46.6% for Q3 and 46.4% on a year-to-date basis. This is almost the same as the prior year, in spite of the diluted impact of the acquisitions and the ongoing 787 development expenses. These two factors still have a margin impact of about 1.5% to 2.0% – to two points on a year-to-date basis. We still expect to see some margin expansion in Q4. Greg also will give you a little color on that.

With respect to the acquisition pipeline, we continue actively looking at opportunities. There is a pipeline of possibilities that are more small than larger opportunities as is typical. They are still slow to close. We remain disciplined and focused on value creation opportunities. Predicting the timing is always difficult. And as I’ve said in the past, as a general rule, we're not going to discuss any specifics on acquisitions until they’re closed or unless they're closed.

And with that, let me ask Ray Laubenthal just to give you a short bit of color on the Q3 operations.

Ray Laubenthal

Thanks, Nick. As Nick mentioned, in total third quarter results were as we expected. Our acquisition integration and productivity improvements continue to add solid value. Our new business order activity was strong and the new product development activity made good progress. We continue to price our products to reflect the value we provide to our customers and we also acquired another operating unit, CEF Industries.

Let me explain each of these areas in a little more detail. We acquired CEF on May 7. Located in Chicago, CEF designs and manufactures specialized and highly engineered mechanical and electro-mechanical actuators, compressors, pumps and related components. The majority of the company's revenues are military related with the C-130 production program and the large aftermarket supporting the worldwide C-130 installed base being the single biggest platform.

Other platforms include the V22, Joint Strike Fighter, the A380, A320, A330 and 340, the F-15, the C-17, as well as certain regional jets and business jets. At CEF, we quickly went to work on transitioning this business to be focused on our three value drivers. We are revising their pricing, we reduced the cost structure by 16% through a work force reduction, and we have focused our new business efforts to target profitable programs. We are in the midst of modifying their go-to-market process. And lastly, to ensure these transition efforts continue, we promoted Pete Palmer, one of our veteran managers, to be the President of this operating unit.

At our operating units, productivity projects continue to progress favorably. In addition to the normal blocking and tackling productivity projects, we’ve started to reduce our cost structure in preparation for possible near-term softness in demand. As Nick mentioned, this initial reduction will be completed by the end of Q4 and then we’ll closely watch the activity level. We continue to be very active finalizing our Boeing 787 designs and manufacturing processes. The development activity and spending continues to be particularly high on our new digital flight audio systems at Avtech. Conversely, the work on our composite fuel and hydraulic isolator products at Adel Wiggins is nearing completion.

We expect the development and expense on these projects to come down in Q4, so we anticipate some modest spending to push into our fiscal 2009 year due to the Boeing driven schedule push-outs and design revision. In addition to these new programs, pricing at our operating units is improving consistent with our past actions, hence progressing well.

Now let me hand it over to Greg Rufus who will review our third quarter financial results in more detail.

Greg Rufus

Thanks, Ray. Good morning, everyone. Again, thanks for calling in. As you have just heard Nick's comment centered on current market conditions, pro forma revenues and EBITDA as the fine comparable results, and Ray gave a brief summary of our value drivers and the integration of CEF this quarter.

For those of you who have listened to prior calls, you are aware of the various accounting charges associated with our acquisition activity. As you know, for an acquisitive company like TransDigm, these charges come into play when looking at GAAP financial results compared to prior year comps throughout the year. Consistent with our past practice, all adjustments used to arrive at EBITDA as defined and adjusted EPS are reconciled in this morning’s press release.

With the CEF acquisition, we will continue to be impacted by purchase price accounting activity through FY ’09 and this will activity will continue to be a factor in quarterly comparisons. Today, my comments will focus around third quarter GAAP reported results. I’m pleased to report to you that we had another very successful quarter. In a nutshell, the third quarter sales were what we expected, the base margins were strong, the acquisition margins although dilutive continue to improve, and the cash flow was very strong.

Let me explain this in detail. Quarter three sales were $186 million, up $28 million or 18% from the prior year. Organic sales were up $18 million or about 12% increase over the prior year. Similar to last quarter, organic sales growth came from strong defense sales, primarily the defense aftermarket and to a lesser extent defense OEM sales across all product lines, an increase in commercial OEM, and an increase in commercial aftermarket sales. In other words, organic sales growth came from all markets. Our recent acquisitions, CEF and Bruce, contributed to the balance of the growth.

Reported gross profit was $100 million or 54% of sales. This is an $18 million increase and is 22% greater than the prior year, and it is also greater than our sales growth of 18%. The reported gross profit margin increased approximately 180 basis points versus the prior year. The biggest factor for the improved margin was due to the decrease in purchase price accounting charges between periods. Excluding purchase price accounting charges, gross profit margins improved 60 basis points, including the dilutive impact of the CEF and Bruce acquisitions. The strength of our proprietary product and productivity improvements at our base businesses continued to enable us to expand our margins.

Selling and administrative expense was 10.4% of sales for the quarter compared to prior year expense of 11% of sales. Included in the prior year was $1.7 million or about 1% sales of non-recurring expenses associated with the May ’07 secondary offering. R&D spending increased from the prior year and was high by historical standards, but consistent with the prior year as a percent of sales for the quarter.

Net interest expense was $22 million, a decrease of $4 million, almost 16% versus the prior year third quarter. The decrease in interest expense was due to a lower interest rate. Average interest rate decreased to approximately 6.4% this quarter compared to 7.6% last year. The weighted average debt balance was $1.4 billion for both periods.

Regarding our tax provision, our effective tax rate was 36.4% for the quarter compared to a prior year effective tax rate of 37.5%. This current quarter tax rate reflects the favorable impact of our legal entity restructuring, which took place in the fourth quarter of last year and an increase in the domestic manufacturing deductions which was both partially offset by the lower research and development tax credit. We expect our fiscal year ’08 effective tax rate to be 36% and our FY '08 cash tax payments to be approximately $40 million.

Quarter three net income was $36 million or 19.3% of net sales compared to $22 million, or 14% of net sales in the prior year. This is a 63% improvement versus the prior quarter. The combination of strong EBITDA as defined growth of 18%, a decrease in non-recurring and acquisitions costs, a decrease in interest expense of almost 16%, and a lower effective tax rate, all contributed to this significant increase in net income over the comparable prior quarter.

With the net income improvement on a GAAP basis, quarter three diluted earnings per share were $0.72 per share compared to $0.45 per share a year ago, a 60% improvement in this quarterly comparison. Our adjusted diluted earning per share was $0.75 in the third quarter, which was a 39% improvement versus a year ago.

Cash generation continues to remain strong. We ended the quarter with $189 million of cash on the balance sheet. We expect our year-end cash on the balance sheet to be around $215 million. As a reminder, we will make our semi-annual payment on our subordinated notes of approximately $22 million and tax payments of approximately $20 million in the fourth quarter. Excluding the purchase of CEF, the company will generate approximately $185 million of cash for the fiscal year 2008, which is over 55% of EBITDA as defined for the full year or 140% of our net income. At the end of the third quarter, our net debt leverage ratio to EBITDA as defined was 3.6 times, a significant improvement from 4.3 times this past September.

I’d now like to switch subjects. As announced in our pres release this morning, along with Nick mentioning it earlier, we are increasing our guidance for the remainder of the year. We give full year guidance on five items; revenues, GAAP net income, EBITDA as defined, GAAP EPS, and adjusted EPS. All five line items have been increased. Our press release gives all five comparisons.

To keep things simple, I will focus on the adjusted earnings per share. Our prior guidance for adjusted EPS was a range of $2.69 to $2.75, or a midpoint of $2.72 per share. Our current guidance for adjusted EPS is in a range of $2.75 to $2.79, or a midpoint of $2.77 per share. The increase in the adjusted EPS midpoint is $0.05 per share, $2.77 less the $2.72. With one quarter remaining this fiscal year, the $0.05 per share increase comes from two areas. $0.02 results from stronger operating performance, including expenses associated with our cost reduction programs that Nick mentioned earlier. $0.03 results from our ownership of CEF, which we acquired in mid-May.

This current year estimate of adjusted EPS of $2.77 is 32% greater than our FY ’07 EPS of $2.10. On an unadjusted GAAP basis, the 2008 EPS midpoint of $2.61 is 43% greater than the FY ’07 earnings per share of $1.83. As I said earlier, we had a very successful third quarter and nine months for fiscal 2008. And with one quarter remaining, it’s turning out to be one heck of a year.

This concludes our prepared remarks, and we will now open the phone lines for questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Carter Copeland from Lehman Brothers. Please proceed.

Carter Copeland – Lehman Brothers

Good morning guys.

Nick Howley

Good morning, Carter.

Carter Copeland – Lehman Brothers

Quick question just to clarify something here on the aftermarket. You said the aftermarket revenues year-to-date were up 6%, and you are expecting 6% to 8% for the year, but they were 3% on a quarter-over-quarter basis. So that would seem to imply an acceleration sequentially for next quarter. Do some of these headwinds go away in terms of these extensions in cockpit security retrofits or the inventory adjustment, just trying to square what’s going on in the quarterly pattern if it’s lumpiness or what’s really going on there?

Nick Howley

Carter, I wouldn’t draw a whole hell of a lie on the quarterly pattern. I mean, there is enough kind of moving around and little bits of shipments can adjust it from quarter-to-quarter. We feel pretty good with that 6% to 8%, which obviously means we think – we surely don’t expect to see any decline or maybe a little move up in the fourth quarter, but I wouldn’t – I don’t mean to suggest that that’s any fundamental change in the market, just more kind of a timing.

Carter Copeland – Lehman Brothers

You said that you are beginning to see the weakness presumably in the order rates in North America. Can you provide any more color about other regions around the world? Is there any differentiation in the US versus Europe versus Asia, any color there would be much appreciated?

Nick Howley

I don’t know that I can give you a lot of specifics on that, Carter, and I say that – and the reason I say that is because we settle a fair amount through distribution and sometimes the numbers lag a little on that. You know, you’re not right up to date on where everything went. But generally my general sense is it’s the same as most people are talking about. North America is the toughest hit. As best I can tell, Pacific RIM is doing okay and Europe is kind of in the middle.

Carter Copeland – Lehman Brothers

And then with respect to margins and profitability as you look beyond ’08, it sounds like there are several pieces here whether it’s 1.5 to 2.0 points from 787 development expenses in those items, and the drag on the mix, meaning OE growing faster than aftermarket. As you think about going into ’09, how does that change? What are your expectations to some of those 787 development expenses in those items? Do they roll off and do we get a reversal of some of these drags in terms of inventory adjustments to distributors and the cockpit security retrofits? Just what are your expectations at least broadly or directionally in terms of margins for next year?

Nick Howley

I don’t think in the company – for the company, Carter, we’ll give that when we give out our guidance for the year. And I don’t want to start to kind of peck at it a piece at a time. The one thing I will say on the 787 is, as Ray mentioned, we do expect – or we hope a goodly part of that will be run off by the end of this year.

Ray Laubenthal

The spending.

Nick Howley

The spending, as Ray talked to you about that. On the cost reductions, Carter, in the past what we’ve done – and that’s what we are doing again here. When we are in a time of uncertainty, our view has been get out ahead of it quickly, adjust to cost structure as quickly as down as you prudently think you can, and then watch what happens. And that’s sort of where we are. We frankly feel little uncertain about next year.

Carter Copeland – Lehman Brothers

Fair enough. Thanks a lot guys.

Nick Howley

Okay.

Operator

And your next question comes from the line of Robert Spingarn from Credit Suisse. Please proceed.

Robert Spingarn – Credit Suisse

Hi guys.

Nick Howley

Hi, good morning, Rob.

Ray Laubenthal

Hi, Rob.

Robert Spingarn – Credit Suisse

Good morning. Just to talk I think about the same issues that Carter brought up. The aftermarket, can you talk a little bit about the inventory adjustments you’ve seen with the distributors and perhaps help us to understand how this connects the capacity cuts that we are all anticipating I guess starting after Labor Day? Are we already seeing those? How – what is the flow that we should be thinking about that you consider from these capacity cuts?

Nick Howley

Let me answer that kind of generically first and then maybe a little specifically, Rob. I would say it’s tough to tie them directly. My general experience is, when the market starts to soften a little bit, people start to get nervous and you start to see a little bit of inventory adjustment all through the system. It’s always tough to tell what the airlines have. The distributors, we can get a better look at. And I don’t want to overplay that. That’s not a big number, but it’s a slight down drag. Most of the distributors or most of our largest distributors have agreements that require them to hold X months in inventory. And the months is different depending on the product line. So to the extent that they start to see or perceive any softening, they start to pull their inventories in a little bit. Now again we haven’t seen a lot of it. We’ve just seen a little bit of the start of it here recently. And we’ll see how it goes forward. I mean, it ultimately is a function of what happens to the end demand.

Robert Spingarn – Credit Suisse

So we should be thinking – from that answer, Nick, it sounds like some distributors have been above, I don’t know, how significantly above that minimum inventory level, you know, simply allowing themselves less cushion.

Nick Howley

Yes – not much. Most of them are pretty darn close to their contracted levels, but if their outflow moves off a little or they start to think it’s a little, they will start to stretch the deliveries a little bit.

Robert Spingarn – Credit Suisse

Okay. So there’s not that much downside from an inventory perspective since they are close to those–?

Nick Howley

Yes. I would say not – you know, it’s almost you make your judgment on what you think the end result is going to drop off, which it hasn’t a lot yet. You get a little bit of a ripple, just like you will in the airlines. The airline numbers are tougher to see, but to some degree you see the same thing. They overreact a little at the beginning of a downturn.

Robert Spingarn – Credit Suisse

And going back to – Carter touched on this with the 6% rising perhaps to a 6% to 8% level by the end of the year, and considering your answer to that in terms of the specifics are tough to nail down, let me try it out at a different way. Sequentially, quarter-to-quarter. So I’m talking about June to September, September to December, on an absolute basis, absolute dollars in aftermarket. Okay? Organic aftermarket. Are we going to see an increase off this June quarter as we get into September and December, or is this the area that you really do think we are going to start to flatten out on?

Nick Howley

Well, we gave you – let me answer that first by saying, it is – this is the area that we are most uncertain about, Rob. I mean, it’s pretty easy. As you know, it’s pretty easy, you take a pretty good shot at the commercial OEM rates. If you miss that 90 days out, you are in trouble. The aftermarket is where we feel the most uncertainty going into next year. I would say – you know, you see our guidance for the fourth – and you see our annual guidance for the aftermarket, which just by the math tells you we don’t expect next quarter to be down. I know it couldn’t be 6% on the year – 6% year-to-date and 6% to 8% on the year if the next quarter drops.

Robert Spingarn – Credit Suisse

But that also has to do with the comps and what’s in last year’s quarter and so on. That’s why I asked about it on an absolute basis.

Nick Howley

You mean on the fourth quarter against the prior year fourth quarter?

Robert Spingarn – Credit Suisse

Yes.

Nick Howley

I don’t – let me just – the truth of the matter is, I am not sure I know that number. Let’s see if I can quickly see it.

Robert Spingarn – Credit Suisse

I don’t recall what was in last year’s fourth quarter, but if it was a weak-ish quarter, you could have a great growth rate, but it’s misleading on an absolute basis.

Greg Rufus

No, last year’s last quarter was a pretty good quarter.

Nick Howley

Yes. No, we expect it to be up over the fourth quarter of last year – I just want to – on a pro forma basis again, assuming we own the same mix of businesses.

Robert Spingarn – Credit Suisse

Okay. And the whole point to this, and you guys knew you are going to be asked about the aftermarket –

Greg Rufus

Yes, sure.

Robert Spingarn – Credit Suisse

Very clear that it’s a focus area for you. For the obvious reasons, we’re all interested in it. I just go back to – you’ve talked about 3% revenue exposure to the aircraft debt [ph] issue, the older airplanes that are up for consideration for grounding, and I try to think about if it’s only 3% exposure and you’ve got the kind of commercial aftermarket growth rate you’ve got, I’m trying to see if I – what would justify a flattish aftermarket number next year or if that’s conservative? Or are we starting to see pressure trickle into some of the introduction platforms?

Nick Howley

Rob, I can’t – I don’t know that I have that much specificity on our view yet for next year. We are primarily looking at our internal information and sort of taking data on what other people seem to be forecasting for world traffic miles. And you’ve probably seen them, most of what I see bantered around. Our numbers like North America down 0% to 5%; Pacific RIM up maybe 5%, 6%, 7%; and Europe flattish. When you weight those out, you get a relatively modest growth next year. We are picking up on that and saying, I don’t know that I have any reason at this point to disagree with that. And I’d add to that my other experience has been when the market starts to slow, people tend to overreact for a quarter or two in the industry. So –

Robert Spingarn – Credit Suisse

What I’m hearing from you, Nick, not to belabor the point –

Nick Howley

Yes.

Robert Spingarn – Credit Suisse

But is that maybe you think the overreaction will be on the A320s or the 777s, because there I think the growth rates will be higher and that’s what I think you’ve attempted to tell us is where your greater exposure is, 737NG et cetera.

Nick Howley

Carter, you are drawing more out of this than I’m saying.

Robert Spingarn – Credit Suisse

Okay.

Nick Howley

What I’m saying is, we look at the data we have, we look at the economic situation, we look at the forecast that the different analysts are making for revenue passenger miles, and we look at that and say, ’09 is something we have some concern about.

Robert Spingarn – Credit Suisse

All right.

Nick Howley

As I told you before, generally we are able over any extended period track the worldwide traffic miles. I also say in the beginning of a softening, people tend to overreact some and it’s not always logical and it’s not always by platform, it’s just nervousness.

Robert Spingarn – Credit Suisse

I think that’s a fair point.

Nick Howley

So that’s why we are, I would say, cautious. That’s why we, as we have in the past, while we tend to – as soon as we get any snip of kind of some market softening, we tend to twine and tweak in our cost structure as fast as we can and then see what happens. And that’s sort of where we stand. We feel uncertain.

Robert Spingarn – Credit Suisse

Okay. Okay, thanks very much, Nick.

Nick Howley

Okay, Rob. Sorry, did I call you Carter, Rob? I apologize.

Operator

And your next call comes from the line of Fred Buonocore from CJS Securities. Please proceed.

Fred Buonocore – CJS Securities

Yes, good morning. Very nice quarter, gentlemen.

Ray Laubenthal

Thank you.

Fred Buonocore – CJS Securities

So, I guess after all that we’ve established that you have got some concern and uncertainty over the aftermarket for FY ’09 and there is a scenario where commercial air travel could be flat for 2009. And I think that’s not a surprise to anybody. Can you help us then understanding that you’re not planning on giving any FY ‘09 guidance until your Q4 announcement? Nick, can you help us kind of build up maybe a way to think about potential revenue growth in a zero RPM growth scenario for next year?

Nick Howley

Well, I’m not going to back in to giving guidance yet for 2009.

Fred Buonocore – CJS Securities

No – of course.

Nick Howley

(inaudible) God forbid, you would hate me to do that, right?

Fred Buonocore – CJS Securities

No, definitely not.

Nick Howley

By the way, let me start off by saying, Rob, I’m sorry, I called you Carter at the end there. I think in a flat RPM environment, I would expect we would still get our pricing. With that – and if I take history, after 9/11, that was not an issue and I don’t expect this to be anywhere near that kind of a disruption. So you’d still see that. I would expect I think in 2009 – as we said, we still expect the OEM business to be bullish in 2009. The defense business I think is kind of a judgment call.

Fred Buonocore – CJS Securities

So, aside from kind of the vagaries as a government budget process, is there anything transpiring on the defense side of things that would give you any reason to believe that anything should change dramatically in the next six months on–?

Nick Howley

Other than what I will tell is defense business is historically difficult to predict in the short-term, particularly in the political season.

Fred Buonocore – CJS Securities

Got it. And then just on the acquisition environment, you talked about deals still continuing to be slow to close, but have you seen continued trend in maybe multiple potential sellers are expecting or prices – potential prices coming out?

Nick Howley

I would say we still see – we’re still seeing a reasonable amount of activity. In other words, we are seeing transactions – and we’re seeing potential transactions. Things are closing slower, moving slower. Some of that I think is just uncertainty in an uncertain market, in an uncertain aerospace market and economy. Some of it I think is a sort of bid ask spread. Everyone remembers that their buddy [ph] got 12 times EBITDA two years ago and why can’t I. And then that market – those are sort of the things we see. What we know is things are moving little slower.

Fred Buonocore – CJS Securities

And then it sounds like really your priorities for cash haven’t changed one bit in the face of what could be a tough 2009. Is that a fair assessment?

Nick Howley

Our priorities are the same as they always are. Our first priority with our cash is to make accretive acquisitions of proprietary aerospace component businesses with significant aftermarket content. That’s our first priority. As long as we think there is a reasonable possibility that we can utilize the money that way and maintain our flexibility, that’s what we’ll do.

Fred Buonocore – CJS Securities

Got it. And then financially in addition to cost-cutting that you’ve talked about in your ongoing productivity initiatives, are there any other actions that you can talk about, that you can take to continue the strong performance we’ve come to expect from the company in the face of what could be a tough year? Or the other costs?

Nick Howley

I think what I’ve told you before the cost side, we’re making a pretty decent adjustment here in the fourth quarter and that what we’ll do there is we’ll just we’ll watch and see what happens. I will tell you historically I expect we could do it in the past, if the market gets tougher, then we might have thought, you will see us adjust some more. If we overshot a little, we’ll fine with tweaking that back in.

Fred Buonocore – CJS Securities

Right. And anything you can do to make up what somewhat might be a slowdown on the top line?

Nick Howley

Yes. We will do what we can. Historically what we do is our three value drivers; our price, productivity or cost, and new business. We’ll work the most hard as we can. Usually we’ve been able to – not usually, almost always we’ve been able to find a way to see ourselves through softening markets.

Operator

And your next question comes from the line of David Strauss from UBS. Please proceed.

David Strauss – UBS

Thanks. Nick, have you spoken specifically on the call? I didn’t hear what you’re doing on the cost side at this point, is this headcount or is this SG&A or what exactly are you doing at this point?

Nick Howley

First, it’s – primarily what we have done so far is headcount. The largest chunk of our cost, if you take out materials, is people cost by a very significant amount. That basically is what you have to work with. And that’s what we’ve been – we are in the process now of adjusting headcount at least for this present effort, most of which will be concluded by the end of September.

David Strauss – UBS

How much are you looking to take out with this move as a percent of total?

Nick Howley

Close to 10%.

David Strauss – UBS

Okay. And how does that compare to–?

Nick Howley

And other related and other – close to10% in the headcount and then there is other related expenses that go with that.

David Strauss – UBS

And that 10% will be out by the beginning of next fiscal year?

Nick Howley

Yes.

David Strauss – UBS

Okay. And is that about inline with what you did post 9/11?

Nick Howley

No, you took out little more post 9/11. We don’t feel quite that nervous.

David Strauss – UBS

And I guess in relation to that in terms of your cost structure, it looks like last cycle you were able to hold your gross margins and your SG&A as a percent of sales went down pretty nicely and I know you’ve got R&D baked into that. Your SG&A looks like got down to about 8.5% of sales. Is that a level that you think you could get to again this time? Is that kind of a objective that kind of hold gross margins and bring down the SG&A?

Nick Howley

Well, we don’t look at it that way. We look at it on EBITDA margin. And our hope with this – I don’t want to get into forecasting next year’s margins.

Greg Rufus

And I would just like to point out that going back to 9/11 versus now, our composition of the company has changed with our acquisitions too. So we don’t want to reference a prior target like that. It’s just every cost between sales and EBITDA is what we look for, David.

Nick Howley

Yes, that’s right. I mean, we just don’t think of it that way. We think of the whole cost basis we have to adjust. But I would say we would surely hope that we could keep our margins, our EBITDA margins consistent. We hope we might be able to do a little better.

David Strauss – UBS

Okay. And then looking back kind of 2001 through 2003, what do you think your organic revenue growth was during that period? If you – obviously you adjust for acquisitions. I think you bough Champion during that period. And if you also exclude the Airbus cockpit door mandate, it looks like your revenues were relatively on that kind of basis were relatively flat over that period. Does that look about right?

Ray Laubenthal

Going back history, what we’ve looked at was our commercial aftermarket for the first six to nine months did drop, but it was offset mostly by a big pickup in defense. So when you total them all up, it was pretty close to flat. And pricing, but he has – I think he asked for a two-year stretch.

David Strauss – UBS

Yes, just kind of looking –

Ray Laubenthal

And specifically not the two years but in that time frame, that’s what happened. In the year after –

Nick Howley

In the year after. I just don't remember with the two years. I don’t need –

David Strauss – UBS

So your aftermarket was down a little bit including price?

Ray Laubenthal

No, no.

Nick Howley

No, no, we are just talking on the organic market – the market itself.

David Strauss – UBS

Okay. And then Greg, interest expense this quarter was down a couple million bucks and your debt level has been changed. What’s going on there? I know you have some –

Greg Rufus

Well, we entered into a couple of hedging contracts during the course of this year. It had proven out to be paying off right now.

David Strauss – UBS

Okay. All right guys thanks.

Greg Rufus

The LIBOR is down too, David. You’re right.

David Strauss – UBS

Yes, I know some of it’s variable. Okay, thanks guys.

Operator

(Operator instructions) And your next question comes from the line of Carter Copeland from Lehman Brothers. Please proceed.

Carter Copeland – Lehman Brothers

Yes, just one sort of housekeeping thing. Greg, could you tell us what the sales contribution from CEF was in the quarter?

Greg Rufus

We haven’t disclosed the top line. I gave the EPS impact of over about – we bought it in the middle of May?

Nick Howley

Yes.

Greg Rufus

And we typically, Carter, don't break out the location top lines and give – disclose it publicly.

Carter Copeland – Lehman Brothers

Okay.

Operator

And your next question comes from the line of Matt Vitros [ph] from Barclays. Please proceed.

Matt Vitros – Barclays

Good morning, guys. Not so hard on it, but I just want to be a little bit more clear, I mean we always talk about the proprietary products in the aftermarket and how that gives you absolute pricing power, and not to get into too much of a what-if, but say RPMs here domestically were a little bit lower than you expected. Can you just talk about your absolute level of pricing power, do you get a lot of pushback, or is the fact that their sole source in selling proprietary products that powerful and give you the ability to really push price?

Nick Howley

Well, we don’t disclose our absolute level of pricing. So I can answer that one easily. I can tell you that we generally get our pricing through all phases of the market cycle. The best measurement is, after 9/11, during that period of time we were able to get our pricing and our pricing stuck, and I’d expect it to stick next year and this year.

Matt Vitros – Barclays

Okay. And then just a quick clarification, in your presentation for your Analyst Day, there was a small pie-chart that showed I think 24%, 25% of your sales come from overseas or foreign sources and 75% I guess is here domestically. So if we expect air traffic to be slower here domestically, wouldn’t you be more awaited to that 0% to 5% decline or is there a different way we should be thinking about that?

Nick Howley

Greg, I don’t know whether his number is complete.

Greg Rufus

I know. What that –

Matt Vitros – Barclays

Am I looking at the wrong thing?

Nick Howley

No, there were two pie charts. The one on the left was how we report sales for GAAP basis, if you are looking at that specific schedule.

Matt Vitros – Barclays

Yes, that’s what I’m looking at, yes.

Nick Howley

And when we report our sales, it appears that more of our sales are US related and then – but they are really not. And how you have to think of that is there is a pie chart right next to it.

Matt Vitros – Barclays

The installed base?

Nick Howley

The installed base. And you have to think of our sales being consumed where the installed base was. So that was a point of clarification when you read the 10-K. For example, you sell to Aviall, that’s all domestic sale, but they sell all over the world. You sell to Boeing. That’s a domestic sale, but they export all over the world. So that was a clarification point of what is in the 10-K versus our business is really impacted by what goes on in the world and where the installed base is.

Matt Vitros – Barclays

Understood. So it really is a global traffic number that would impact your–?

Nick Howley

Absolutely.

Matt Vitros – Barclays

Okay, perfect. Thank you very much guys.

Operator

And your next question comes from the line of Jason Howard [ph] from News, Inc. [ph]. Please proceed.

Jason Howard – News, Inc.

Hi guys. First a couple of clarifications from earlier questions. The question that was asked earlier about your revenues, organic revenues after 9/11, did I hear you right? You said the aftermarket overall for the industry was down a little bit. You guys were down I think you said a little bit. But then that was offset by pricing? Can you just go back to that and just explain what happened to the industry itself and to you guys aftermarket revenues, say, like for the next six to 12 months after 9/11?

Nick Howley

I don’t remember the exact numbers. But I will say the best indication of our aftermarket is revenue passenger miles. And if you take the year after 9/11, I want to say the worldwide traffic over that 12-month period came down, I would say, something in the mid-single digits kind of range as a percent.

Jason Howard – News, Inc.

Okay.

Nick Howley

And generally our pricing was able to offset that. In addition , the defense aftermarket grew quite rapidly over that period. Now this is just core, core sort of over the TransDigm stuff. Additionally we were able to get a very large cockpit security retrofit order that significantly pushed up the aftermarket volume. So those are sort of the pieces of it after 9/11.

Jason Howard – News, Inc.

Okay. So would you say that – I know you don’t have the numbers handy, but is it fair to say that excluding the cockpit door mandate that you think that your aftermarket revenues after 9/11 were essentially flat because volume was down but pricing was up.

Nick Howley

I think I do not remember the absolute numbers, but I – you got the general concept.

Greg Rufus

And we are starting to blend the couple fiscal years here because the shipments for cockpit security took place in ’03.

Nick Howley

Yes, right.

Greg Rufus

So, you can’t – I mean, you can only look at a portion of that.

Nick Howley

But I think conceptually – I mean, those are the pieces and you’re in the right direction.

Jason Howard – News, Inc.

Okay. So that mandate actually wouldn’t have really helped revenues in 2002 anyway, fiscal ’02, if you were really shipping–?

Ray Laubenthal

Which subject?

Nick Howley

(inaudible) you lost me.

Jason Howard – News, Inc.

Well, the cockpit shipment.

Ray Laubenthal

Yes, we only started shipping that in the fourth quarter of ’02. It’s like maybe 7 million or 8 million.

Nick Howley

Yes, and those are disclosed numbers, by the way. If you look in the 10-Ks, I don’t remember them, but we – I think we supplied the numbers for cockpit security because it’s still large.

Jason Howard – News, Inc.

Okay. So, is it fair to say that you got about fiscal ’09 just in general, if RPM – worldwide RPMs are flat, which would be quite soft relative to historical levels, if RPMs are flat, then you guys would think that your business model, just the aftermarket itself, revenues would still be up because volume would be flat because you generally track the aftermarket, but you’ll still get pricing of, say, 2% to 3%. And then that would slow down actually to even the fast rate EBITDA growth because you would also trade volume for pricing, right, because that’s just more profitable, because that flows through bottom line. Is that fair for the business model in general? And I’m not asking for specific ’09 guidance. I’m just asking is that how you think about your aftermarket business.

Nick Howley

Let me make a couple of comments to be sure I understand you. Yes, directionally that’s the way we think about it. Now I would tell you for ’09, all that would be true assuming everybody operated in steady state. But what can happen in the downturn is you can get a couple of quarters of people overreacting. So you can get X percent revenue passenger miles and for a couple of quarters you can get X minus parts sales because people start to draw inventories down or they just get nervous and don’t order. That can’t last very long, but it can last for a quarter or so at the beginning of a downturn. So you have that working against you. But you have the model correct. The other thing I would add is, I don’t know if you are implying that there are some trade-off between our price and our volume. In other words, if we put the price up, we lose volume. If you are, I don’t agree with that.

Jason Howard – News, Inc.

Yes – no, no, I was just saying that all else being equal, EBITDA will grow faster on a 3% price increase versus a 3% volume increase.

Nick Howley

And by the way, I’m not confirming 3% and I’m not saying the 3% is in the right range even

Jason Howard – News, Inc.

No, no, I understand. What was your pricing after 9/11, like in fiscal ’02? I thought it was like 2% or 3%.

Nick Howley

That – when we talk, that’s low.

Jason Howard – News, Inc.

That’s low, okay. And the last question is, historically what has been the volatility in that overreaction? I mean, when you say X minus, again I’m not–?

Nick Howley

Very difficult to predict. Very difficult to predict. All I can say there’s typically some overreaction. I don’t have a good sense and I don’t know that there has been any consistency to it.

Jason Howard – News, Inc.

Okay. Is it ever like as high as 10% or anything like that?

Nick Howley

I told you I don’t feel comfortable in the number. 10% sounds high to me though.

Jason Howard – News, Inc.

Okay. Just trying to get some order of magnitude of how – obviously just hitting the downside.

Nick Howley

I mean, there’s not tons of inventory out in the system.

Jason Howard – News, Inc.

Okay. It’s unlikely you would see that level. Okay, thanks very much.

Operator

And you have a follow-up question from Robert Spingarn from Credit Suisse. Please proceed.

Robert Spingarn – Credit Suisse

Nick, Ray, Greg, I’m thinking about you’ve all talked about the expenses that you can reduce next year. And I think you all have a very good track record on this sort of thing and our margins in general. And so I want to delve into that a little bit. If I just take my own model and look at the costs about the EBITDA as defined line, I think one of you mentioned that’s the way to think about this?

Nick Howley

Right.

Robert Spingarn – Credit Suisse

Everything about that number. So if we have roughly, I don’t know, let’s call it 380 million in cost between revenue and EBITDA in ’08, that’s a rough number because we don’t have the fourth quarter yet, how should we think about the labor component of that number?

Nick Howley

Rob, you’re just taking the revenues and subtracting the EBITDA, right, saying everything else is cost?

Robert Spingarn – Credit Suisse

Correct.

Nick Howley

Is that basically what you’re doing? Okay.

Robert Spingarn – Credit Suisse

Well, only because you phrased it that way and I just figured it was the easiest way to attack this here.

Nick Howley

That’s the way we look at it.

Robert Spingarn – Credit Suisse

And so when we talk about a 10% reduction, what piece of that are we reducing?

Nick Howley

We are reducing – yes, the 10%, by the way, just to be sure, that’s headcount reduction. I said a little less than 10%.

Robert Spingarn – Credit Suisse

And you said there were associated costs. So maybe the right way to ask the question is, what headcount – or what percentage of that figure is headcount that’s addressable here?

Nick Howley

Yes, fair point. Rob, I would say if you take our cost structure, and I’ve said this many times in the past. If you take that cost, that lump of cost that you came up with, what I guess it was 380 million, this isn’t exactly right, but it’s something like half material or outside buys and half inside costs.

Robert Spingarn – Credit Suisse

Okay. The inside cost, and divvy that up a little bit?

Nick Howley

Yes, and if you take the inside cost, you might have – the big chunk of that is wages in some way, shape, or form, and benefits. It’s not – I don’t know this number exactly. It’s not 90% of it, but it’s surely well above 50%.

Robert Spingarn – Credit Suisse

Okay. So about some number above a quarter?

Nick Howley

You’re going – you’re going to try and get a cutback number out of me. And I’m not willing to –

Robert Spingarn – Credit Suisse

No, I understand. I’m not trying to get you to give us ’09 here, but I’m trying to come out with a decent construct for figuring out how you’re cost initiatives can affect margin next year and can they actually more than offset what we might see in terms of weakness on the top line of all this commercial aerospace stuff end up happening?

Nick Howley

Rob, what we are reacting to is the fact that if the OEM continues to rise and the aftermarket growth slows down, you get a mix in the wrong direction.

Robert Spingarn – Credit Suisse

Absolutely. And it’s more acute for you than it is for almost anybody else?

Nick Howley

Pardon?

Robert Spingarn – Credit Suisse

In your particular business mix, it’s more noticeable.

Nick Howley

That’s right.

Robert Spingarn – Credit Suisse

And it is for other guys who are less reliant on the aftermarket, less profitable on the aftermarket.

Nick Howley

That’s right. So one of the things we are trying to do is we are – we don’t know exactly what that mix swing going to look like. As I told you, we’re uncertain going forward to next year. We’re trying to get enough cost out up ahead of the problem that we feel that we are close enough that we won’t get our sales and margin squeeze here.

Robert Spingarn – Credit Suisse

Okay. Fair enough. I think we can back in. Thank you.

Operator

Sir, at this time you have no more questions.

Sean Maroney

Okay. I’d like to thank everybody for calling in today and I’d like to let you know that we will be filing our 10-Q in the next couple of days. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: TransDigm Group, Inc. F3Q08 (Qtr End 06/30/08) Earnings Call Transcript
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