Some companies just fly under the radar, doing their thing, and pretty soon you look around and they are a market leader. And no one has ever heard of them. That’s the story of aircraft parts maker Transdigm (NYSE:TDG). It’s up 6% this month, or almost triple what the market has done.
The Cleveland-based company is in a high-margin, low volatility business that generates consistent cash flow through long-term contracts with customers. With a $3.9 billion market cap and $828 million in annual sales, Transdigm first went public in 2006 and is now classified as a mid-cap growth stock.
Transdigm, pronounced Trans-dime, generates 70% of revenue from commercial customers, and 30% from military and space. Key customers include jet and rocket manufacturers Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT) and Airbus, and airlines such Delta (NYSE:DAL), United Continental (NYSE:UAL), and Luftansa. The top ten customers account for less than half of sales, which is nicely diverse.
Since 2007, TDG (in black) has more than doubled returns of larger aerospace suppliers Goodrich (NYSE:GR) and Honeywell (NYSE:HON) by selling higher margin components. As you can see in the chart below, the shares are up 240% over those four years, barely stopping for a pause during the recent bear market and recession.
This is incredible, considering that airplane parts are normally considered a commoditized business. Transdigm is successful because it does not compete directly with the giants on big parts. Instead, the smaller firm focuses on niche components on which it can add value, such as ignition systems, cockpit-security devices, gear pumps, and mechanical/ electromechanical actuators and controls. More than three-quarters of its sales are in products for which it is the sole supplier. (See all units at its website.)
Transdigm generates roughly 60% of its revenue after its components have been purchased for a new aircraft, as the company is paid by airlines and military customers to maintain and update components for the life of their planes. These service contracts, which typically persist for 30 years per plane, are typically high-margin and provide a more consistent revenue stream than the component sales themselves.
U.S. and European regulatory and certification requirements make it difficult for competitors to enter the industry, which is ideal for maintaining a broad moat around a business. Trust in air safety is critical, and once a component has developed a reputation for reliability it is hard for rivals to poach in that territory.
As a result, Transdigm is able to maintain uniquely high margins. In the past fiscal year, TDG boasted a 44.8% operating margin, compared to the 14% and 9.7% margins of competitors Goodrich and Honeywell.
Both business and leisure air travel have begun to rebound. U.S. airlines carried 57.3 million passengers in September, up 4.9 % year over year, according to the Department of Transportation. International premium travel in first and business class was up 12.1% in September, and 24% of travelers plan to take more business trips in 2011, according to Deloitte’s Business Traveler Survey.
Airlines also are adding capacity. Delta is increasing its domestic and international capacity by up to 5% and 12%, respectively. Domestic capacity is expected to rise 3.2% in the first three months of 2011.
Plane orders, and thus demand for demand for Transdigm’s parts, are also rebounding in response to the economic recovery. Indian carrier IndiGo purchased 180 A320 airliners worth $15.6 billion. Airbus revised its 2009 forecast up 900 planes and said it expects global demand for passenger jets to be around 25,000 aircraft through 2029.
Transdigm’s revenue reflects the rebound. Fourth-quarter sales were up 13% compared to last year while earnings jumped 29%. Management expects revenue to rise 44% in 2011 to $1.2 billion with the acquisition of McKechnie Aerospace, a manufacturer of commercial aerospace parts.
Transdigm’s defense business may face some headwinds. Congress recently proposed $78 billion in defense cuts after already committing to reduce the Pentagon’s budget by $100 billon. Most of the budget reductions target poorly performing weapons programs such as a Marine Corps landing craft and a ground launched missile, but Lockheed also expects to lose 124 planes over five years.
On the plus side of the ledger, the latest spending bill also includes a $2 billion plus order to Boeing for 41 more F/A-18 fighters so the news is not all bad Transdigm.
Transdigm CEO W. Nicholas Howley has been at the helm of Transdigm since 2005 and has grown the company 20% annually during his tenure. Management owns 13% of outstanding stock, which should align their interests closely with ours.
The firm’s balance sheet is debt-heavy, with $3 billion in debt and $234 million in cash. Analysts expect the firm to earn $547 million in 2011, putting the firm’s leverage at 6x earnings.
At first glance this might seem high, but bond investors remain very attracted to TDG’s excellent operating margins and ability to generate consistent cash. Even as other junk issues were pulled from the market in early November, the company doubled its debt issuance to $1.55 billion on Dec. 1 because of strong investor demand.
In summary, this is a great business: Very high profit margins, consistent cash flows, a wide moat and 30-year guaranteed contracts. Analysts expect Transdigm to earn $4.37 a share in 2012, pricing the stock at 17.5x forward earnings. Historically, TDG has traded at 23.5x forward earnings. This valuation suggests the stock should trade at $102, giving us 34% upside from the current quote. It looks like a keeper
For more insights like this, check out Jon Markman’s daily trading newsletter, Trader’s Advantage, and long-term investment letter, Strategic Advantage.
