Wednesday, October 23, 2013

TransDigm Group (TDG)

So this is sort of a footnote to the previous post about a really great book
  (The Outsiders:  Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. )

In chapter one (page 34), Thorndike mentions the TransDigm Group (TDG) as a contemporary analog for Capital Cities.  TDG has grown  cash flow at 25%/year since 1993 through internal growth and acquisitions (which Thorndike calls an "exceptionally effective acquisition program").   The approach is similar to Capital Cities in that they focus on businesses with exceptional economic characteristics.

The CEO responsible for this nice record, Nick Howley, is still the Chairman and CEO and is 60 years old (as of the 2013 proxy) so the story may still be intact; maybe it's worth a look.

TDG Performance versus S&P 500 Index Since IPO

That's a 33%/year performance since 2006.  Pretty nice and consistent with the performance of other outsider CEOs.  The book says TDG grew free cash flow +25/year since 1993. 

Here are some figures for the last five years:

                                             2007             2012        CAGR
Sales   ($mn):                       593               1,700       +23.5%              
Operating income ($mn):     234                  700       +24.5%
Adjusted EPS:                     $2.01               $6.67     +27.1%
EBITDA:                            $275                $809       +24.1%

These are pretty decent growth rates and the period includes the great recession.

What would one pay for a business that grew adjusted EPS at +27%/year in the past five years?  The midpoint of the company guidance for 2013 is $6.80.  With the current stock price trading at $143/share, that's a P/E ratio of 21x.  This may not be Graham and Dodd cheap, but with historical EPS growth of +27%/year and a company goal of growing 15-20%/year (in equity value), 21x may not be expensive at all, not to mention that free cash flow is much higher than adjusted earnings.  If we use 55% of current year expected EBITDA as free cash flow (see later slide), we would get $8.93/share in free cash flow per share and a multiple of 16x free cash; not bad for a company growing so quickly.

Some of the components included (or excluded) in the "adjusted" earnings and EBITDA may be debatable, but I'm not trying to pinpoint an exact valuation here; just getting a general sense of the company.

Unlike the many outsider companies, TDG has a great investor relations website with some interesting slides (see here).

By the way, one thing we have to look at later is that current year adjusted EPS guidance is $6.80 (at midpoint) versus $6.67 in 2012. I haven't dug into this to see if the growth period for TDG is over, or if it's a short term thing (EPS was also flat in 2010, so this may be lumpier than your typical 'growth' stock).

Ownership
Management/directors own just over 10% of the shares, but Howley doesn't own much except for what he gets from options (which only vest with performance).  Howley owned just under 5% at the time of the IPO but hasn't owned much since except for the options.

Berkshire Fund VII (Private equity, not the Buffett entity!) owns 7.6%,  and Lone Pine Capital owns 6.7% (as of the 2013 proxy).  It looks like they sold some shares but still own 2.6 million shares as of the August 13F.   Lone Pine Capital is run by the highly successful Stephen Mandel, a Tiger cub (ex-Tiger Management).  Tiger cubs are known to do a lot of work (analysis) on their holdings.

Also, I noticed that Tiger Global, also a high performing Tiger cub bought some shares this year which indicates that TDG might still represent some value.  Tiger Global owned a large stake for a while but didn't own any shares (according to the 13F) earlier this year until some shares showed up on the 13F in August.  It's only 530,000 shares or so compared to their 4.5 million shares they owned back in 2008.  TDG didn't show up in the 13F as far back as late 2011, so maybe this is seller's remorse.  In any case, it's a datapoint for whatever it's worth.  Tiger cubs are generally very fundamentally based investors who focus a lot on management so it's a good sign that they are shareholders.


Anyway, let's take a look at some slides.

First I'll snip some stuff out of the 2012 Analyst Day presentation:


TDG makes and sells aftermarket products for the aerospace industry.  It is apparently a high-moat business since not just anyone can make stuff and sell it to people who put them in planes.  They are highly engineered and government approved (for safety etc...), which usually takes time and money to do.

The private equity-like business model is their dependence on acquisitions for part of their growth.  They typically pay 9-11x EBITDA and through efficiencies,  get the effective EBITDA multiple down by more than 50%.


Here's a very long term view of their results, going back to their founding in 1993 (actually, the following two charts are from the September 2013 investor presentation as they have updated figures):

 

It's good to know that TDG continued to grow even after EBITDA margins got into the 40s in the early-to-mid 2000s.   So EBITDA margin improvement from 20% in 1993 to 47% in 2013 is not the whole story; TDG has grown substantially even since 2004 when margins hit 46%.



They operate in a growing industry, so this is not rolling up local yellow pages or anything like that:


I think there is no doubt that the aviation industry is growing over the long term:


High moat businesses:

Big Market:


Sole source means they are the only ones that can replace a part.

Kind of Berkshire-like (or outsider-like) localization:


Performance based pay:


Clearly defined objective:

...and way to achieve it:


Plenty of room for more acquisitions:


As Munger says, what you don't do is just as important (or more important) than what you do:


And of course, what's the point without free cash?

Conclusion
Well, this is just a quick first look but it is certainly pretty interesting.  It's trading at 21x current adjusted P/E and 16x free cash flow (assuming free cash is 55% of EBITDA this year), which is not a bad valuation if they continue to grow in their target range of 15-20%.

I have yet to dig into the filings, conference call transcripts and annual reports going back, but there is plenty of interesting things here to make this worth at least a closer look.  I haven't followed this company at all so I don't have a comfort level with this as much as the other companies I post about, but the fact that it came out of the outsider book and has Tiger cub shareholders (even though one of them may be on their way out) gives me more comfort than a random idea I read about on the internet.

The immediate concern, I suppose, would be to get a sense of why things are slowing so much in 2013; a year that doesn't look so bad. 

Earnings for the FY 2013 (which ended in September) should be out soon and maybe we can get some more clarity on the outlook for next year.

Other concerns are obviously how long Howley will stay on, how size may become a problem going forward etc.

As usual, if I find anything interesting to add, I will make a followup post to this.

 

27 comments:

  1. What's the best formula that relates an earning multiple (P/E or EV) with ROIC?

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    1. Hi,
      That's a good question. I don't know, really. In the past I've seen X-Y plots plotting ROE on one axis and PE on the other, but that kind of thing shifts over time. The same with EPS growth rates and PE ratios have been done too, and they shift around.

      So the answer is, I don't know.

      The closest thing I hear all the time is growth rates versus P/E ratio (since EPS growth is retention rate x ROE, it ties back to ROE too). I'm sure you've heard of the PEG ratio (P/E-to-growth ratio).

      A PEG of 1.0 would mean a 15% growing company trading at 15x P/E. A 20% grower trading at 20x etc... I've heard even Julian Robertson say that such and such growing at X should trade at X time P/E. I've never really understood that, but it is a metric that has been used forever.

      In bull markets, people tend to push that up to 1.5x or 2.0x (PEG) or whatever.

      Thanks for reading.

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    2. Thanks for the candor and maintaining this blog. As you could imagine I've been searching for an easy, back-of-envelope type of way to relate the ROIC and earnings yield, and haven't had any luck.

      Greenblatt in his class notes for the security analysis class he taught at CBS compares a risk-free bond yield of 6% to a stock trading at a 5% (a stock trading at 20x P/E). He states the stock if it has a 20% ROIC, then it is a better place to put your money than the risk free yield, but the notes don't he goes through this calculation.

      Anyways, this post reminded me of that note from his class, as lot most of these companies mentioned trade a fair valuation in terms of an earnings yield. But this doesn't give credit to the businesses or their executive's ability to continue to post strong returns on capital and generate FCF.

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    3. The business with 20% ROIC at 5% would be good because a 20% ROIC implies growth. A risk free bond yield of 6% will not grow over time while the 5% 'coupon' of a good business will grow over time.

      Going back to ROE and P/E for a second, the reason you won't find a good formula to relate those is because any company can lever up and goose their ROE. In a cyclical business, this can really hurt their credit rating. So they may end up trading at a very low P/E multiple.

      I guess this can be dealt with by using EBIT/EV and EBIT/(NCA+PPE). The Magic Formula website used to post the EBIT/(NCA+PPE) along with the screened stocks and those figures used to be all over the place; some had 50% and others more than 100%... So it's hard to say how you would translate that back to a fair EBIT/EV.

      It is an interesting question, but I would think time is better spent thinking of other things...

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    4. In theory, P/E = (1 - g / ROIC) / (WACC - g) where g = long-term growth

      You can find a nice derivation of this formula in the McKinsey book Valuation.

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  2. The story reminds me of Teledyne - a lot. If you read Distant Force, it sounds like a damn similar analogue..

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  3. I am a big fan of your blog and the aforementioned book. I like TDG a lot and it's one of those unicorns that never quite gets cheap enough for me to buy. I may capitulate soon... A few more names that fit the mold of "The Outsiders" include Precision Castparts and Danaher. In fact, I believe you could make a case that DHR deserves its own chapter in The Outsiders. If you like what the Rales brothers have done at DHR, a nice analog is what they are doing at Colfax. Funnily enough, Colfax's largest institutional investor was (is?) BDT Capital, otherwise known as Byron D. Trott Capital. I'd love to know if you have looked at any of these names.

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    1. Hi,

      Thanks for the nice comment! I am aware of Precision Castparts and Danahar and looked at them in the past but not that hard. I should look at it again with my 'outsider' spectacles on. I know that Danahar is regarded as good, rational capital allocators.

      Unbelievable, I've never even looked at TDG before and had no idea it was doing so well recently. I just spent some time going through the stuff on their website and I was kind of surprised. It's surprising that with all the talk about Singleton, I've never really heard anyone talk about TDG as it is today. I may not be the only one so I will make a quick post about that.

      I've never heard of Colfax but it looks interesting. BDT Capital as an owner is good news, obviously, and I noticed that Tiger Global owns some too. Those are two good reasons to dig into it. I may post something about it.

      Anyway, thanks for posting a comment. I will look at all of these names and hopefully it will be material for interesting future posts!

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  4. Hey, great blog. Don't know if I've ever formally commented, but have linked to numerous posts of yours in our weekly linkfests at marketfolly.com

    Re: CFX, it's actually filled with Tiger Cubs (and grandcubs too) at least as of Q2. Blue Ridge Capital (John Griffin was Julian Robertson's right-hand man at Tiger before going out on his own). Slate Path Capital was recently started by an ex-Blue Ridge guy. Hound Partners is a Robertson-seeded fund and shares the same office address. Maverick Capital, another cub. Then there's Marble Arch, a fund started by ex-Hound guys. While many smart guys have been involved in TDG in the past (and currently), the CFX positions have been more recently started (past year or so). You'll obviously see a lot of overlap among these funds because some share ideas and have similar research processes/criterion for investments.

    Keep up the good work.

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    Replies
    1. Thanks for the compliment! That's very interesting that the Tiger Cubs are all over this thing and it's a relatively fresh position. I guess I better put this one at the front of the queue in terms of looking at. Tiger is very deeply fundamental-based and they do tend to hold positions for a long time so Tiger holdings are a great place to find long term ideas, particularly situations with really good managements (as Robertson really wants good management).

      Thanks again for dropping by!

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  5. Thanks for sharing your thoughts. Your posts about the outsiders open up many interesting ideas for me.

    What do you think about this company's debt load? The debt to equity ratio seems awfully high.

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    1. Yes, the debt/equity is high here. They, like Malone, use a lot of debt. But keep in mind that this is what they do. Capital management is their specialty. The debt would scare away most conservative value investors, I guess (like they avoid Malone), so it's not for everyone.

      For me, I would take comfort by going back and looking at operating earnings versus interest expense over time and it seems they covered it fine throughout the great recession. A lot of levered companies lost tons of money as operating earnings tanked and couldn't cover interest expense; that's usually been the way most cyclical companies went deep into the red if not bust in the past.

      So for me, that would be the more important question. Also, net debt to EBITDA is a more common leverage indicator than debt-to-equity.

      Thanks for reading.

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    2. It seems that the management wants to keep the leverage high. It paid special dividends of $12.85 per share on Oct 23, 2012 and $22 on July 11 this year. And from various presentations, the management sounds confident about consistent future cash flow from its aftermarket business.

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    3. I suppose I need to dig a bit deeper to learn about the nature of this business and understand how much cyclicality there is in a downturn. My highest debt/equity holdings is VRX, which I'm comfortable with because the predictability of its cash flow. The same can be argued about Malone's cable biz. (BTW, I would put VRX's CEO as a potential "outsider". )

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    4. Well, there was quite a harsh stress test recently in 2008-2009. You can see how they did during that downturn, which I expect would be something that is not your typical cyclical downturn; that is much worse than you would expect in a normal downturn, and not one that would happen very often (hopefully).

      I think one of the keys to their stability is their emphasis on the aftermarket business; the aftermarket business is busy as long as planes are flying; parts need to be replaced etc...

      The OEM business is tied to new plane deliveries and things like that, so this may be cyclical, but the aftermarket business correlates to flight hours, or in the industry they use RPM (revenue passenger miles). As long as planes are flying and more of them are flying, then the aftermarket business will keep growing or will at least sustain revenue levels even in a downturn (you can't delay repairs/parts replacement, although there is some movement as inventory levels can go up and down. I think inventory adjustment (at the customer) is hurting their revenues this year, for example).

      VRX is a big Sequoia stock so I've read a lot about them. Valueact now owns a bunch of it too. I should look at it closer....

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    5. As per their 2012 Analyst day, management view the capital structure as part of the value creation process. "...we think that when you take margins & the stability of the cash flow that.....if you don't have some significant amount of leverage, you frankly have an inefficient capital structure" (Nick Howley) The was the commentary around slide 30 above.

      Also interesting (Howley again) is "One of the things that I continually get asked is what are our goals for revenue growth, EPS growth, EBITDA growth, things like that. I have to tell you honestly we don't have any. And I – at least under my watch, I think it's unlikely we will have any. Our goal is pretty simple. We want to give our investors private equity-like returns on their equity. What we mean by that is somewhere in the 15% to 20% a year return on equity over the long period of time. We'll do that
      every year, but we've been able to pretty consistently do that year-in year-out through a long time, and I don't see any
      reason why we can't continue to do that."

      On the ROIC/ PE reference Greenwald above...the thinking/ formula is:

      1) take your stock trading at a 20x PE, 5% earnings yield.
      2) identify the cash distribution part of earnings return ie say they pay out 1% in dividends/buybacks,
      3) they reinvest 4% into the business via retained earnings.
      4) you need to figure out the reinvestment return on those retained earnings over & above your require return (cost of capital) say 20%

      Total return = Cash return + Reinvestment return (ROIIC/R) + Organic Growth (GDP+/-)

      1% + 4% (20%/10%) + 3% = 12% Total return versus your 6% risk free bond yield.

      Obviously this framework is successful only to the extent you are right about the existence & sustainability of a competitive advantage. In other words, clearly the extent to which ROIIC exceeds and continues to exceed R is a major driver for total return.

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  6. Hi, something to note for TDG, they have given out special divdends recently Beside as a growing company shouldnt they be compounding the capital rather den distributing it back to shareholder. And if they choose to return. why give dividends rather than repurchasing shares which is a more effective way of returning value. (unless management view the company as not cheap)

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    Replies
    1. Hi,
      Good point. They said that they have enough capital to keep acquiring and growing plus they have plenty of cash flow. They are very shareholder friendly (unlike, say, Apple), so they decided to return capital as soon as they have what they think is more than enough.

      As for repurchases versus dividends, repurchase is usually better. But in this case, I think TDG was able to get the tax treatment as return of capital (or 90% of it) so was tax efficient, and for the size of the capital, it was faster to pay out as dividend than to repurchase that amount of stock in the market which would have taken time due to liquidity etc.

      Thanks for reading.

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    2. Hey thanks for replying.sorry. i dont get this point "I think TDG was able to get the tax treatment as return of capital (or 90% of it) so was tax efficient". Your blog is really insightful and you can get new ideas from it . It worth the read:). anyway have u an opinion on verisk analytic (vrsk) versign, davita

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    3. Hi, in the last conference call they said that the $22 special dividend will be treated (90% of it) as return of capital. Return of capital is not taxed as a dividend, but a reduction in the cost basis of the stock so it will turn into a capital gain when you sell the shares. With current taxes, it is beneficial. I don't know the details on what kind of dividend qualifies as return of capital, but I assume it is applicable here as they raised debt to pay the dividend (and they are not distributing earned profits). But I don't know much about these tax things... They did say in the othe conference call that they did a dividend because it was a big one and there was execution risk if they tried to buy back stock in the market (stock price may rise).

      I am familiar with the two names you mention but don't have anything to say about it now.

      Thanks for reading.

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    4. Any thought about Esterline, a manfacturer of engineered products for Ariline and Defense industry and its new CEO Curtis Reusser? Thanks.

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    5. Hi, I noticed that it sounds a little like Transdigm when I read it as a Barron's round table pick (Witmer) but I'm not too familiar with it. I looked through some annual reports (they have reports going back at the website) and it looks pretty interesting. There must be a lot of these industrial companies that grow through good capital allocation that just falls through the cracks because aren't run by famous capital allocators.

      I will be looking at this closer and if I have enough to say, I may make a post about it.

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    6. Thanks for so generously sharing your knwledge. I have learnt a lot reading your posts.

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  7. I have read your reports on dva and tdg and i think you do a great job. Thank you . I would like subscribe to your blog but dont see any subscribe button etc

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    1. Thanks. I know there is an email subscription available, but that hasn't been working as emails have not been going out. This is a blogger function so I don't really have any control; I have no idea what's wrong. I've googled around for a solution but I couldn't find anything.

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  8. Hi,

    Any updated thoughts on this? Trading at < 14x 2018E FCF given the over hang on a potential gov't investigation on a small part of the business.

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    1. Sorry for the late response. No, no new thoughts. The allegation that TDG is another VRX is also interesting. I look forward to the next conference call to see how they respond to it. I think their view is that TDG's parts are a very small part of overall budgets so isn't really an issue like a pharma company jacking up drug prices, often to the ruin of people who need it. Healthcare spending is just a lightening rod, but small specialized aircraft parts are not so much.

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