The intellectual property in TransDigm’s products creates a competitive advantage
The majority of aerospace products that TransDigm designs and manufactures are either the only part that can be used in an application (sole-source) or their own design of a solution for which there are competitor parts (proprietary). The large share of revenue from sole-source (80%) and propriety products (90%) gives TransDigm pricing power. As a consequence, their margins are more than double the industry average as evidenced in Chart 10 below.
Chart 10: TransDigm EBITDA margin vs peer group average
Source: Capital IQ; Peer Group: HEI, HON, MGGT, TGI & SAF (FY2019)
Several barriers to entry deter potential competitors
The highly regulated nature of the aerospace industry results in stringent regulatory and certification requirements. Each part requires a Parts Manufacturer Approval (PMA) from the US Federal Aviation Administration. This certification takes up to 18 months and costs anywhere from US$20 000 to US$1 000 000 per part, with an average cost between US$75 000 and US$100 000. TransDigm has more than 300 000 active PMAs and conservative estimates suggest that it would cost at least to US$22.5 billion to replicate its current portfolio. On top of that, the company introduces thousands of additional PMAs each year. Competitors would have to make a significant investment over many years before they could start to earn a return on investment. As a result, PMAs introduced by competitors represent less than 2% of TransDigm’s annual sales.
In addition, their portfolio is extremely diverse, with no single part individually making up a large portion of their revenue. Approximately 90% of aftermarket revenue is generated from PMAs selling less than US$2 million a year. TransDigm’s products are also relatively inexpensive, with average selling prices of US$1 000. At that price level the most critical considerations for customers are reliability, quality and timeous delivery. The low price and critical nature of the products reinforces the high cost of switching, creating another significant hurdle for competitors.
Aftermarket revenues strengthen the business model
TransDigm products are used by aerospace original equipment manufacturers (OEMs) when building new aircraft and the company also designs and manufactures aftermarket parts that are used to service and support the global fleet of aircraft to meet regulatory requirements and maintain aircraft warranties. The typical lifespan of an aircraft is around 25 to 30 years and a single aircraft platform can last 20 to 30 years, resulting in more than 50 years of potential stable and recurring aftermarket revenues from parts used in each platform. Aftermarket parts generate 52% of TransDigm’s revenue and are very profitable, comprising the majority of the company’s EBITDA. This helps to smooth out the volatility in revenue from OEM customers and mitigates the company’s leveraged balance sheet and acquisitive mergers and acquisitions (M&A) strategy.
Capital allocation expertise and private equity-like structure
The aerospace industry is fragmented, with many small private businesses and non-core operations of larger businesses. TransDigm maintains a highly-geared balance sheet to acquire profitable proprietary businesses with significant aftermarket content where they believe they can unlock value. The company has a unique private equity-like structure and the stated objective of delivering “private equity-like growth in value with the liquidity of a public market”.
A geared balance sheet and frequent M&A are commonly a cause for concern, particularly in an inherently cyclical industry such as aerospace and defence. But the company’s management team has significant experience in managing earnings variability, executing acquisitions and integrating acquired businesses into their company and culture. Since their IPO in 2006 they have acquired more than 49 businesses without a single impairment or asset write down, demonstrating just how robust their M&A process is.
Good management and a stellar business model
TransDigm’s proprietary and sole-source revenue base and significant aftermarket content affords them strong market positions, pricing power and a stable, recurring revenue stream that is protected by effective barriers to entry. Management has an excellent track record of capital allocation and the business model has proven durable through the economic cycle, resulting in consistently good returns on invested capital as evidenced in Chart 11 on the following page.
Chart 11: Returns on tangible invested capital
Source: Capital IQ , Northstar Calculations (FY2019)
Northstar has followed Transdigm for a number of years, but the company’s stock traded at levels that did not include a sufficient margin of safety for us to be comfortable buying the share. With the selloff in late March, the margin of safety opened up and we were able to make a meaningful investment at a very attractive valuation level. The share price has recovered significantly since then and currently trades at our base case intrinsic value estimate. We see significant upside to a bull case and remain a long-term holder of TransDigm.