An Industry Insider’s Valuation Of TransDigm: Part 2/3


This is a continuation of my first article on TransDigm (NYSE:TDG). Also, I suggest you read Citron’s article to provide the proper context.

Part 2 focuses on the micro/specific risks that may affect the ability of TDG to generate free cash flow, including:

Financials

Estimation of Market Segment Gross Margins

Market Segment Risks

Channel Stuffing Claims

CEO’s Conflict of Interest

Debt

Next Steps

Also, I suggest readers read the following two articles:


Warren Buffett’s 1994 letter to shareholders, particularly the section about Book Value and Intrinsic Value

My interpretation of Buffett’s valuation techniques based on Buffett interviews and quotes

Let’s get into the details.

Financials

A note on my analysis: I analysed TDG inclusive of 2007, but there was one key data point missing for segment sales. To stay consistent, most of my charts start in 2008. Other than that, the re wasn’t anything inconsistent about 2007. I also ignored data before the business went public, focusing on the post IPO period. Also note that TDG’s annual year end is 30 September. Therefore, the year 2008 represents October 2007 – September 2008. So take that into consideration when aligning events such as dividends to annual data.


Here are the net sales, gross profit, and operating income:


Margin Data:


You could use EBITDA or TDG’s adjusted EBITDA margins, but I prefer to value businesses using FCF:


Here is the cumulative FCF and book value since 2008 against the dividends paid. Note, I added 2008’s cash as the starting point for the cumulative FCF:


Key takeaways:

Of course this is a wonderful business. It has great growth in net sales and in scaling gross and operating income.

The margins have slightly decreased in the past 8 years, but not significantly;

Free cash flow has tripled in the last 9-10 years. This is actually an interesting finding. Depending on when you bought, this business provided a 5-10x return over 10 years. That means that for each dollar of FCF, it was extremely undervalued early on and eventually each dollar of FCF become more valued. The growth really picked up in 2010.


The business has paid out more in dividends than it has generated in FCF over the past 8 years. Note that I didn’t include 2017 FCF or the dividend paid out in the 2017 fiscal year (October 2016 – Dividend: -$1,376M; BV: -$1,874.6M).

I think that it is obvious that the bond holders are funding growth and paying the equity holders. For that risk they received 7-12% in 2007 and just over 5 % in 2017. TDG is generating significant cash flow and could pay down debt, however it is rewarding its shareholders after the 10 year ride (note it wouldn’t make sense to pay down bonds since they are trading higher than their face value).


But consider this – imagine you own a successful small business generating $200K profit/year for the past 10 years. Go to your bank and ask them for a $1M loan. Tell them you are going to use it to pay yourself a $1M dividend. Also tell them you won’t be backing the loan personally. The business indemnifies the debt. Would they loan you the money? Something to consider if you are a TDG bond holder.

Is it bad to have negative book value?

If you go back and read Buffett’s 1994 letter, you will see that the balance sheet isn’t really a good direct measure of business valuation (unless you are valuing the business purely based on a liquidation option). I don’t think TDG is at risk of bankruptcy, therefore liquidation valuation doesn’t apply here. Furthermore, net assets includes significant intangibles that are usually placed on the balance sheet based on a discounted cash flow (DCF) analysis. I’m going to value the whole business based on a DCF analysis of FCF. Including book value somehow would double count cash flows.


As long as the business is generating significantly more cash flow than interest costs, you have a great money printing machine. However long term debt can cause a risk to the future cash flows in the form of interest rate risk, debt maturity risks, access to future lending to fund future growth, and the risk of bankruptcy if the business hits a cash flow wall (i.e. can no longer raise funds from financing and runs out of working capital)

Cash Flow Risks

In my last article (Part 1), I analysed several key macro level risks associated with the business. Let’s go into more detail with regards to the micro level business risks and assess how they could impact the future free cash flows.


Market Segment Risks

TDG is active in several key aerospace segments, each facing different risks. Here is the breakdown of TDG’s net revenues by segment. Note this graph shows layered segment revenu es. The area of each individual colour represents the revenue of that segment. For example, the top of the green line represents the total revenue, while the tiny green sliver represents the “other” revenue segment:


Here is the raw data based on the given segment revenue figures year by year:

Year

OEM

Aftermarket

Defence

Other

Net Sales

Gross

Gross Margin

2008

$206,976,190

$299,758,620

$185,564,860

$21,411,330

$713,711,000

$385,931,000

54.07%


2009

$190,388,000

$304,620,800

$243,696,640

$22,846,560

$761,552,000

$429,346,000

56.38%

2010

$190,360,420

$331,061,600

$281,402,360

$24,829,620

$827,654,000

$473,066,000

57.16%

2011

$337,685,880

$482,408,400


$349,746,090

$36,180,630

$1,206,021,000

$661,185,000

54.82%

2012

$493,060,320

$714,087,360

$391,047,840

$102,012,480

$1,700,208,000

$945,717,000

55.62%

2013

$577,320,000

$750,516,000

$481,100,000

$115,464,000

$1,924,400,000


$1,049,562,000

54.54%

2014

$664,413,680

$877,975,220

$711,871,800

$118,645,300

$2,372,906,000

$1,267,874,000

53.43%

2015

$785,063,350< /p>

$1,001,632,550

$785,063,350

$135,355,750

$2,707,115,000

$1,449,845,000

53.56%

2016


$919,709,190

$1,173,422,070

$951,423,300

$126,856,440

$3,171,411,000

$1,728,063,000

54.49%

I did a linear least square regression of the data to try to calculate the individual gross margins in each segment:

Other

Defence

Aftermarket

OEM

Estimated Margin

20.3%

45.0%


81.7%

32.9%

Standard Error

34.58%

8.86%

9.56%

16.91%

Standard Gross Margin Error

$12,749,612

R^2

0.9999

At first glance, it can appear as though we have an accurate estimation of segment margins, however note the large standard errors. If we bring some common sense into the picture, it should be obvious that we need more data to accurately estimate the margins considering the following:


This analysis assumes that the gross margins in each segment are consistent year-over-year, however I suspect that there are swings and periods of pricing pressure that change individual segment margins. Also new acquisitions can greatly affect individual margins before TDG can implement pricing changes. Therefore, it’s not really accurate to assume margins are constant.

We only have 9 data points (years) where TDG identified the breakdown between the four segments. In 2007, TDG combined OEM and aftermarket into one segment. To get an accurate estimation and to pass a statistical test, we would need several more years. Again, the above issue of consistency would get in the way as individual margins would change year-over-year.


I’m big on ignoring numbers without statistical significance and not using math that doesn’t necessarily align well with reality. So don’t start quoting these margins as gospel, I’ll state the following:

These numbers are not accurate for the reasons stated above and are based on potentially flawed logic and an insufficient sample size. They simply represent the best fit curve to the data set provided and assume a constant gross margin (not changing year-over-year).

So if we take this with a grain of salt, this process at least gets us thinking about what margins could be in each segment. Although we know that we can’t be statistically confident that these are in fact the margins, we can use some common sense to think about if they could be close or not. We can also back that analysis with some insight from the conference calls:


OEM Segment

I would imagine this is the lowest margin business. TDG wants to price competitively to become a main sup plier for the big manufacturers (i.e. Airbus/Boeing). The goal is to eventually become the proprietary provider for new fleets, so they should be willing to take an initial hit on their margins to get in the door. I suspect TDG provides parts directly to the OEMs at around 20-30% margins. Of all the segments, this one has the largest pricing risk. However, once they’re on the approved parts list, they can raise aftermarket prices.


The OEMs could pressure TDG to lower prices, but since TDG owns many subsidiaries and provides hundreds of independent parts, it would be hard to implement. TDG is providing parts that do not make up the largest manufacturing costs to Boeing/Airbus, unlike fuselage, engine, avionic, flight control systems, etc. Therefore the OEMs are more likely to spend time negotiating expensive major systems than individual system components.

Also note that most aircraft manufacturers give airlines multiple engine, avionic, etc options for each fle et. For example, you have the choice between a Rolls Royce (RR) or GE engine on the same aircraft. Each system or engine manufacturer might have different models that are approved for each aircraft type as well. The selection is usually based on what the operator wants to do with the aircraft and the airline’s existing relationship with the engine manufacturers. So GE and RR compete directly at the airline customer level. This doesn’t happen with TDG’s products. From my experience, purchasers of aircraft (airlines, military, etc.) don’t usually make acquisition decisions at the subsystem or component level. They usually think at the major system level and the overall cost-performance level of the aircraft. TDG parts are mostly below the aircraft operator waterline in terms of a strategic acquisition lens.


Aftermarket:

I wouldn’t be surprised if this is the segment where TDG makes the biggest margins. As a result of its ability to acquire businesses with proprietary products in segments with little to no competition and where regulations and engineering costs far outweigh the benefits, airlines and other users generally accept the pricing of small replacement parts. Remember what I said in Part 1, this is an industry that accepts a $1,000 bolts as the norm. I wouldn’t be surprised to see gross margins way above 50%, even in the 80% territory.


Over half our revenue and a much higher percent of our EBITDA comes from aftermarket sales. Aftermarket sales have historically produced higher margins and provided relative stability through the cycles. (Nicholas Howley Feb 2017 investor conference call)

I would expect the aftermarket industry to continue to be a very high margin business. The airlines aren’t usually equipped with the specific engineering experts to design new replacement parts. It would be too expensive for individual airlines to develop replacement options.

Other (Industrial):


This segment represents non-aerospace businesses such as industrial and mining. I suspect this segment would have smaller margins because of less regulatory hurdles. However, these products can still represent life or death in these industries and provide reliability that is important to industrial and mining profitability. Therefore, it still makes sense for TDG to sell to these clients, however not in the case where it cannibalizes aerospace sales. 20% margins seems reasonable.

This segment is small enough for TDG to absorb significant changes to profitability.


Defence:

This is the most interesting one as it relates to the “Profit Policy” identified in my first TDG article (Part 1). Considering what we know about TDG’s pricing strategy from the Citron article, the 2006 DAU report instructing Government con tracting officers to “improve” their negotiation tactics, and what I know about the industry, I wouldn’t be surprised if TDG’s defence margin business was around 40-50%.

The more I read, the less I am concerned about any major risk materializing with respect to the pricing policy. I encourage you to read Citron’s article, then my part 1 article. Consider this: the risks highlighted by Citron were already highlighted by TDG’s annual report since 2006. Furthermore, TDG specifically responded to the 2006 DAU audit in the 2007 and 2008 annual reports. Did anything change as a result? No. Like I mentioned in Part 1, it’s far to difficult to implement a full audit program on TDG since TDG often has no direct contractually binding relationship to the Government.


Here is an excerpt from the Feb 2017 investor conference call describing the relationship between TDG and the US DoD:

About 12% of our total revenues were sold to the domestic defense OEMs a relatively small portion of this was sold directly to the U.S. government About 6% of our total sales were sold to foreign defense OEMs About 5% of our total revenues are sold to friendly foreign governments either directly or through broker distributors About 5% of our total revenue or about $150 million is sold directly to the U.S. Government through various agencies About another 2% of our total revenue or somewhere around $60 million is sold to the U.S. Government through various brokers or distributors. (Nicholas Howley)


TDG does not have a significant amount of direct contracts with the DoD. In addition, the requested refund as a result of the 2006 DAU audit was “approximately $2.6 million for allegedly overpriced parts”(TDG 2008 annual report). An insignificant amount.

Here is some further amplification from the Feb 2017 conference call regarding the risks to individual cash flows and the likeliness of TDG to continue to have pricing power (summarized):

Question 1:

Why doesn’t TDG generate more competition given TDG’s returns both on the commercial side and the defense side?


Answer 1:

If you’ re not already in this business, it’s tough to get in.

It’s a long gestation period to get into.

Product per product, they are pretty small market segments.

In the M&A world TDG’s acquisitions tend to be smaller businesses.

Not as exciting for the other bigger PE firms or even the mid-size firms.

PE firms looking in a proprietary aerospace business who outbid TDG should be pretty worried. The only way you are going to win is making a higher bet on the margin improvement.


TDG bought other firms doing the same thing. Odyssey started a roll up and TDG bought it. McKechnie started a roll up and TDG bought it.

Question 2:

Have you seen changes in the marketplace in regards to your pricing?

Answer 2:

In total the pricing dynamics and the pricing numbers have not changed substantively for a number of years. Maybe one unit this year is a little better than another one, but they all tend to put and take and weight up to about the same number, which is one we track very closely.

Question 3:

Is there any difference in your pricing policy between distributors or direct to a customer?


Answer 3:

In the military, we sell to the distributors and brokers where they get the same price. There is no difference there. In the commercial I don’t think there is a material difference.

Summary: Segment Risk

I do not see any fundamental difference or change in the profitability of the industry nor do I see a risk materializing that would negatively affect the profitability of the industry in the next 5-10 years.

Alleged Channel St uffing

There have been some reports of channel stuffing, so it’s worth addressing this as a potential risk to the investor. First I’ll mention that I am not a forensic accountant, but I will try to analyse the situation as best I can.


Channel stuffing is the act of pushing unneeded inventory to distributors or other customers. Often sales teams provide incentives and rebates to lure customers to increase sales to meet quotas. Often, but not necessarily always, channel stuffing occurs in high margin businesses simply because they have the financial room to incentivise sales through discounting. When the customer has very favourable terms with the ability to get a full refund for the product or very liquid return policies, the seller should not record the sales as revenue. See the following from “Financial Statement Fraud: Strategies for Detection and Investigation”


By Gerard M. Zack:


So what financial auditors tend to look for is large sales in Q4 as a possible indicator of channel stuffing, although this is not necessarily channel stuffing. You could just have a really motivated sales team who sell more in Q4. To prove channel stuffing, you would have to audit the individual terms and conditions within the contracts and prove revenue realization on the income statement. For reference, here is the accounting policy from TDG’s 2016 annual report:

Revenue Recognition and Related Allowances: Revenue is recognized from the sale of products when title and risk of loss passes to the customer, which is generally at the time of shipment. Substantially all product sales are made pursuant to firm, fixed-price purchase orders received from customers. Collectibility of amounts recorded as revenue is reasonably assured at the time of sale. Provisions for returns, uncollectible accounts and the cost of repairs under contract warranty provisions are provided for in the same period as the related revenues are recorded and are principally based on historical results modified, as appropriate, by the most current information available. We have a history of making reasonably dependable estimates of such allowances; however, due to uncertainties inherent in the estimation process, it is possible that actual results may vary from the estimates and the differences could be material.


I compiled the quarterly revenue figures for the past 6 years:


Each annual date is not the calendar date, but rather represents the Q4 sales or year end. For example, 2012 represents the quarterly net sales from July 2012 to September 2012. Therefore, what we are looking for are either increases in sales at those dates or reductions for the subsequent Q1. If you look at the above chart, you will notice there are some reductions in Q1 almost every year. Since the business is growing, I decided to normalize the data. I used a 3 quarter rolling average of sales. Here is the formula for each normalized quarter:

=assessed quarter/(1 quarter before + assessed quarter + 1 quarter after)/3


The results:


Notice the sharp decreases in sales at each Q1 event after Q4. For example, Q4 2012 was around 102% and dropped to below 96% in Q1 2013. Although there are other decreases, it should be obvious that the biggest drops are after each Q4. Is this evidence of channel stuffing? We could stop there, but we need to also consider external effects causing variable sales. Let’s look at seasonal effects:


Notice that summer is high season for airline traffic. Since part demand is a function of airline traffic, it is reasonable to assume that sales will peak in the summer. Here is the scatter of the normalized sales by quarter, with Q4 ending at the end of September or around the beginning of month 10:


Therefore, data points at month 10 represent the cumulative revenue during most the of peak summer months. Data points at month 1 represent the culmination of months 10-12 and is indicative of the lowest peaks of air travel. Therefore, it is reasonable to assume that the drop in sales after Q4 is significantly related to the change in flying rates during the fall quarter.

Summary Channel Stuffing

Fraud detection would required access to company records. However, I don’t see significant indicators that are causing me to run away. In fact, I found the opposite. For example, there is a significant backlog of part orders (2016 annual report):


As of September 30, 2016, the Company estimated its sales order backlog at $1,554 million compared to an estimated sales order backlog of $1,428 million as of September 30, 2015. The increase in estimated sales order backlog is primarily due to acquisitions. The majority of the purchase orders outstanding as of September 30, 2016 are scheduled for delivery within the next twelve months. Purchase orders may be subject to cancellation or deferral by the customer prior to shipment. The level of unfilled purchase orders at any given date during the year will be materially affected by the timing of the Company’s receipt of purchase orders and the speed with which those orders are filled. Accordin gly, the Company’s backlog as of September 30, 2016 may not necessarily represent the actual amount of shipments or sales for any future period.


Backorders are a negative if you are in a highly competitive business with little to no switching costs. This is because customers can simply move to another supplier if they are not getting their parts on time. However it can be relatively beneficial or insignificant in a monopolistic industry since customers don’t have a choice but to wait for parts. However, I would rather the company catches up to put more money in the pockets of the shareholders.

Management Risks

Another issue that came up was regards to conflicts of interest between TDG’s CEO (Nicholas Howley) and his stake in Bratenahl Capital. Bratenahl Capital has previously owned aerospace businesses that TDG has bought. For a full background, see this article and this article that make the claims. The first article has since updated its claims of conf lict of interest based on user feedback. These articles accuse Mr. Howley of benefiting from TDG acquiring businesses from Bratenahl Capital (owned by him and his son) without disclosure. In fact, if they read the annual reports, they would have found it clearly articulated:

On February 7, 2007, TransDigm Inc. acquired all of the outstanding capital stock of Aviation Technologies, Inc. (“ATI”) for $430.1 million in cash. ATI consists of two primary operating units that service the commercial and military aerospace markets-Avtech Corporation (“Avtech”) and Transicoil LLC (which, together with Transicoil (Malaysia) Sendirian Berhad is referred to as “ADS/Transicoil”)… Mr. W. Nicholas Howley, Chairman and Chief Executive Officer of TransDigm, and Mr. Douglas Peacock, a director of TransDigm, each indirectly owned less than one-half of 1% of ATI’s outstanding equity on a fully diluted basis. In addition, prior to the acquisition, Mr. Howley and Mr. Peacock were directors of ATI commencing in 2003, and Mr. Peacock served as ATI’s Chairman from 2003 through February 2007.

I think it would be good practice for Mr. Howley to provide some amplification about his involvement in Bratenahl Capital, especially his son’s ownership and management o f Bratenahl Capital’s businesses that are potential acquisition targets of TDG. But I’m not fearful of that relationship. I think that Mr. Howley has been an excellent steward of shareholder value, but I am open to more disclosure.

Debt

As of year end 2016, TDG was generating about 2.6 times its interest expense in operating income. If TDG dedicated all available FCF to paying off debt at face value, it would take around 16 years, assuming zero growth. Another thing to consider is that although TDG has an S&P “B” credit rating, it is able to raise debt at 5.2%. You could compare debt level metrics to other businesses, but it really comes down to how confident are you in the business to continue to generate and grow FCF to service the debt. If you believe that future cash flow problems will appear, then perhaps an adjustment could be justified. However, at this point my main concerns is rising interest rates and its effect on bond rates. Therefore, in Part 3 I will make some interest rate adjustments to my future cash flow predictions.

I’m also concerned about TDG’s ability to raise further capital through debt and continue to make strategic acquisitions. I think TDG has a lot more room, but it is a consideration as a growth barrier.

Part 2 Summary

In this article, I focused on some of the mircro level risks facing TDG’s future cash flows. After carefully analysing these risks in detail, I do have some minor thoughts and concerns, however nothing that is out of the ordinary for investing in any business. Citron did raise some good points about TDG (and probably made some good money on the short). I would encourage any formal analyst to ask specific questions during the conference calls to seek amplification on points raised by this article or previous shorting articles.

Of course, there are dozens of other risks that face TDG which are highlighted in its annual report. I encourage you to read it and factor those risks into your own judgment. The risk section is one of the most impor tant parts of the annual report. It is management’s (expert) opinion of issues that could directly influence how much credit you give to future cash flows. In the case of TDG, reading management’s interpretation of risks could have clarified unanswered questions regarding the recent shorting articles.

Next Steps

In the next article, I will focus on generating a likely cash flow scenario for the future. It will be constructed considering macro factors assessed in the first part such as the market size, acquisition factors, future margins, defence spending risks, pricing risks, etc. and risk factors included in this article. I’ve tried to address the main issues on everyone’s mind, but if I’ve left out a critical consideration, please share your thoughts in the comment section. Part 3, the finally to come soon…

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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