Transdigm M&A Playbook Running Out Of Fuel

Transdigm: M&A Playbook Running Out
Of Fuel
|Must Read Nov. 24, 2015 3:20 PM ET1 comment
by: Lester Goh
Summary
• At ~30x P/E Transdigm trades at a premium relative to industry peers (~18x
P/E). This premium is unwarranted given that Transdigm is unlikely to repeat
history.
• While the bull case appears highly compelling prima facie, it has many holes
- TDG is unlikely to sustain 20%-25% CAGR in revenues/EBITDA going
forward.
• The roll-up's high leverage, huge size, and management discipline with
respect to price paid for acquisitions are the main hindrances to inorganic
growth.
Transdigm: M&A Playbook Running Out Of Fuel - TransDigm Group Incorporated (N… Page 1 of 20
http://seekingalpha.com/article/3711056-transdigm-m-playbook-running-fuel 1/8/2016

• Organic growth is unlikely to achieve such high rates due to the niche
markets that TDG specialize in - it appears that its specialization is working
against the company.
• With unsustainable historic growth rates, shares should re-rate lower.
Shares should trade at $146 - $193, assuming 10.5x EBITDA or 23x P/E.
Risk/reward appears compelling for a short.
In general, roll-ups have been hit particularly hard by the August market sell-off.
Market participants appear to be flinching at the massive absolute leverage that
these companies hold. Since these companies typically grow through acquisitions,
high leverage and low acquirer stock prices are certainly not synonymous with
opportunity. Roll-ups such as Valeant (NYSE:VRX) and Platform Specialty Products
(NYSE:PAH) are shining examples of the above narrative. These names are forced
to lower their leverage by aggressively paying down debt in order to reverse market
perception.
Amongst leveraged roll-ups however, there appears to be an outlier - Transdigm
(NYSE:TDG) - whose stock price has not reflected its high leverage and severe
growth headwinds. I note that I have been bullish on TDG in the past, but I am
changing my stance upon closer examination of the company's growth opportunities
- they are not as rosy as they seem. In essence, it is likely that most of the money to
be made in this stock has already been made.
Thesis
Shares of Transdigm are unattractive for longs at current trading prices. In my view,
shares are a compelling short due to the following reasons:
• At ~30x P/E, Transdigm trades at a premium relative to industry comps (~18x
P/E). This premium would be warranted if TDG is able to achieve 20%+ CAGR
in revenues and EBITDA going forward, but as we will find out later, this is highly
unlikely.
• In order for its premium multiple to be warranted, TDG needs to sustain its
double-digit CAGR for revenues and EBITDA. Based on current fundamentals,
this would be a Herculean feat.

• In order to sustain historical growth rates, TDG would need to acquire larger and
larger companies. Considering its high leverage, size, and management's
discipline with respect to the price paid for acquisitions, inorganic growth
opportunities are likely to be few and far between.
• While one may argue that TDG can grow organically instead, given its apparent
long runway, this is highly unlikely due to the dynamics of the niche markets that
it serves.
• Although TDG has been superb in right-sizing operations through a cost-
conscious culture, opportunities for EBITDA margin expansion are growing thin.
Ultimately, my thesis is predicated on the following - despite TDG's history of
growth, it is irrational to expect such levels of growth to continue. As such, TDG
does not deserve to trade at such a premium multiple.
It is my view that a 10.5x EBITDA multiple or 23x P/E is more appropriate, giving
credit to management's capital allocation expertise, the firm's lean operations, and
its niche specialty. If my thesis materializes, shares would see ~23%-38%
downside from current levels - based on the aforementioned EBITDA and P/E
multiples. It is worth noting that the actual potential for share price decline could be
far greater as it hinges on a change in market perception (which tends to be
extreme).
While I concur that TDG is indeed a rare and wonderful business (I will explain why
in a later section), in my opinion, investors have fallen in love with its history of
success, and seem to be assuming that the future would be equally bright.
Reasons for the mispricing
In my view, shares are mispriced for the following reasons:
• TDG has had an absolutely superb growth history. The aerospace industry is
poised to benefit from multi-decade secular growth trends going forward, making
nearly any long bet on an aerospace company (with the exception of airlines, of
course) a compelling one.

• TDG is unique in terms of its capital allocation decisions. Management is
extremely focused on increasing per-share value, which is unsurprising given
that the firm has its roots in private equity. As a result of its capital allocation
prowess, shares of TDG have seen two decades of 30%+ compounding.
• The firm is a so-called "hedge fund hotel", with numerous reputable funds (e.g.
Lone Pine) owning the stock. Having such renowned names invested in the
stock is essentially a vote of confidence for the company.
I believe that a combination of the above factors has led to overconfidence in
Transdigm and thus its high market valuation. While some confidence might be
warranted given TDG's long-term growth prospects, it seems that investors have
placed too much faith in the stock.
Company Description
Considering that there is considerable sell-side coverage and otherwise publicly-
available research on the company, my description will be kept brief.
Transdigm is an aerospace roll-up specializing in niche markets - revenues are
~90% proprietary (i.e. patent-protected) and ~75% sole-source (no discernable
competition).
Its products comprise a small portion of its customers' costs (~3%, global airline
operating expenses = ~$686b, maintenance spend = ~$60.7b, TDG's niche markets
are ~$23b or ~3% of $686b) and yet are essential to the operation of an aircraft,
giving the company a high degree of pricing power. While the company operates in
a currently weak defense market (due to budget cuts and other factors that are well-
known), its greatest asset is really its commercial aerospace division, which
comprises ~70% of revenues.
Customers are essentially locked with Transdigm as a supplier of spare parts
following the OEM production stage and are not concerned with switching suppliers
(as the costs of TDG's products are de minimis relative to that of an aircraft). The
company focuses on proprietary aerospace products with significant aftermarket
content (~50%+), thus giving it a highly resilient income stream throughout

economic cycles. Operations are highly concentrated within the North American and
European region; the firm's presence within Asia is small (5 locations, compared to
10+ in Europe and 20+ in North America).
Due to the requirement of FAA certification for every part on an aircraft and the fact
that most of markets for Transdigm's individual products are minuscule, new
entrants are unlikely; recertification would take years and the market is too small
anyway (thus limiting profit opportunities for new players).
This is also the reason why a majority of aerospace manufacturers that specializes
in the niche markets that Transdigm serves tend to be family-owned businesses and
small private companies. As a result, Transdigm has been able to roll-up the
industry and consolidate these businesses for much of the past two decades.
The apparent bull case
The crux of the bull argument is as follows:
1. Due to the fact that Transdigm offers products that are essential to the operation
of the majority of aircraft in use today (as well as a large portion of next-gen aircraft
such as the A350), it is virtually assured to be a beneficiary of secular growth trends
in air travel / new aircraft deliveries.
a. RPK grew by ~6% in 2014 and is expected to grow by mid single-digits for the
foreseeable future according to Boeing (report, pg 12). Airbus research (report, pg
9) indicate similar expectations.
b. Boeing expects new aircraft deliveries to amount to ~38,000 (pg 8 of Boeing
report) over the next two decades (2015-2034) while Airbus' expectations are not as
sanguine, coming in at ~32,000 deliveries (pg 10 of Airbus report). Regardless, this
doubles (or nearly doubles, if we use Airbus' forecasts) the number of aircraft in
service by the end of the next two decades.
2. Transdigm controls only ~5% of its addressable market, and thus it seems that
the company has a very long runway for growth.
3. Management has nailed M&A down to a science and has a two-decade track
record of acquiring and integrating new businesses.

a. Since its incorporation, revenues and EBITDA have grown at ~20% CAGR over
20+ years, mainly through acquisitions. However, Transdigm is no Tyco; the firm
has seen continued organic growth throughout its history as well.
b. At inception, TDG possessed ~20% EBITDA margins. 50+ acquisitions and 20+
years later, EBITDA margins have more than doubled to ~45% as management
focused on consolidating facilities, eliminating excess overhead, and streamlining
operations.
While the points listed above do have merit, I do not believe that it is blue-skies
ahead for Transdigm, especially in the near-to-medium term. As an aside, I note that
the Transdigm narrative is highly compelling - I would wager a significant sum that
most readers would already be opening their checkbooks at this point - which is
another reason why I think that shares might be incorporating stratospheric
expectations.
The bull case is misguided - new aircraft deliveries are being pushed out to
later years and a majority are being sold to Asia
Although it is undeniable that TDG will be a beneficiary of secular growth trends in
air travel / new aircraft deliveries, this growth is being delayed by a few years,
largely due to the decline in oil prices.
As oil prices continue to remain at their depressed levels, airlines around the world
appear to not be in a hurry to upgrade to more fuel-efficient models as the current
commodity environment continues to render older aircraft models economically
viable.
This lack of urgency is illustrated in the following reports (2Q report, 1Q report)
which details commercial aircraft orders & deliveries:
• In calendar 2Q this year, total aircraft orders fell from 1,167 units to 828 units,
reflecting a ~29% decline y/y.
• In calendar 1Q this year, total aircraft orders fell from 509 units to 266 units,
reflecting a ~48% decline y/y.

While I note that deliveries seem to be ticking upwards (which may suggest resilient
demand), this is likely due to aircrafts being ordered in the prior years being
delivered; canceling orders is likely to carry monetary penalties, hence discouraging
the practice.
The bottom line here is rather simple - if oil prices continue to languish at current
levels, growth in TDG's revenues stemming from new aircraft deliveries would be
pushed out to later years. The delay in deliveries pushes high-margin revenue for
Transdigm even further out given that the OEM production stage (3-5 years) is
generally low-margin (~20%) and the spare parts production stage that follows it is
high-margin (~60%).
Moreover, per Boeing and Airbus estimates, the majority (~37% per Boeing, 39%
per Airbus) of new aircraft to be delivered over the next two decades will be
delivered to Asia (pg 8 of Boeing report, pg 10 of Airbus report) where Transdigm
has a much smaller presence, as noted in an earlier section.
While one might argue that low oil prices would theoretically lead to higher RPMs
(low oil prices frees up a significant portion of the consumer's budget, which could
be spent on leisure such as air travel), this thesis does not appear to be playing out
- growth in RPMs continue to remain at their historic averages (5%-6% a year).
Organic growth from its current installed base, while highly likely, will be
unable to sustain the market's high expectations
In the prior section, I established that near-term organic growth is unlikely to stem
from increases in TDG's installed base (i.e. new aircraft deliveries). The next logical
question would then be - how about organic growth from its current installed base?
Growth from this area is virtually assured - RPM continues to grow at mid single-
digits and the metric has historically been a decent proxy for TDG's organic growth
rates:
• Organic sales grew by ~8% in 2014, while RPM grew ~12%

Note that RPM data is sourced from the U.S. Department of Transportation. The
differential in growth rates from period to period is likely due to an inherent time lag;
spare parts (i.e. TDG's products) tend to be ordered months later. In short, I am not
questioning TDG's ability to grow organically. Instead, I argue that the market is
expecting more than just organic growth.
This assertion is supported by the fact that the majority of TDG's revenues were
obtained through acquisitions during the 2010-present period - from 2010 to 2015,
revenues grew at a ~26% CAGR compared to a ~20% CAGR since inception.
At the beginning of that period, TDG traded at a low-to-mid teens P/E multiple. As
the company continued making acquisitions, its multiple expanded at a rapid pace,
eventually reaching its current multiple (~30x P/E). Suffice to say, the market
appears to be pricing TDG at a premium multiple as it expects the company to
continue growing at 20%-25%+ CAGR. In other words, if organic growth equals total
growth over the next few years, the market's expectations would likely be lowered
substantially, causing shares of TDG to re-rate lower.
The next bone of contention the reader would probably have is as follows - can't
TDG take share from competitors and thus increase its organic growth rates? After
all, it only owns ~5% of its addressable market, suggesting a long runway for
growth.
This is where TDG's specialization in niche markets works against the company. As
noted above, suppliers that participate in the same markets as TDG enjoy a highly
captive customer base. Switching suppliers for these highly engineered products
would almost certainly result in operational disruption.
In addition, if the supplier had been with the customer for years and presumably
supplied spare parts that continue to be of high quality, switching suppliers would be
risky to a customer as they would be unable to assess whether the spare parts
supplied by the new supplier would be similarly high quality.
Moreover, the need for FAA recertification is perhaps the largest barrier to
switching. Anyone familiar with the aerospace industry would be aware that FAA
certification takes years, and for good reason (after all, safety is the regulatory
body's highest priority).

In brief, the odds of TDG increasing its organic growth rates by taking share from
competitors are very low. The fact that organic growth rates for the company has
more or less tracked RPM growth in the past suggests that this growth is sourced
largely from its current installed base (i.e. no new customers as a result of stealing
market share). Additionally, considering that the TDG playbook has been to acquire
its competitors also further cements my confidence in the above assertion (if you
can't steal market share, the only choice you are left with would be obtaining it
through acquiring of your competitors).
What about growth from M&A?
Without a doubt, the next point bulls would raise would be something along the lines
of inorganic growth; I believe I have established that organic growth is unlikely to
provide 20%-25%+ CAGR and thus the only way the company can achieve these
rates is through acquisitions. Furthermore, considering management's track record
and the company's history, growth stemming from M&A seems to be highly
plausible.
However, the story of growing through M&A has a few holes in it.
First of all, Transdigm is levered to the hilt per management's comments (emphasis
mine):
Now, switching gears to cash and liquidity; the company
generated $521 million of cash from operating activities
and we closed the year with $714 million of cash on the
balance sheet. The company's gross debt leverage
ratio at September 30, 2015, was approximately 6.4
times pro forma EBITDA and 5.9 times pro forma
EBITDA on a net basis."
Source: 4Q FY15 Earnings Call Transcript

With leverage being astronomically high, it is likely that management would be
focused on paying down debt instead of pursuing acquisitions funded by debt. After
all, additional leverage would cost incrementally more in terms of interest expense.
Although I have faith in Transdigm being able to pay down its debt and reduce
leverage (its business model is highly resilient, with revenues growing every year
and even throughout the 2008 crisis - moreover, the company is relatively immune
to rate hikes due to ~75% of its debt being fixed rate and the remainder floating), the
point I am trying to make is that paying down debt would mean drastically lesser
acquisitions going forward.
Source: Transdigm 2014 Analyst Day
Notably, as seen above, the company is currently at the high-end of its historical
leverage profile. It appears that management wishes to keep net leverage (net
debt/EBITDA) at around 4.5x. It is also interesting to note that TDG's rapid growth
from 2010-2015 was likely a function of it having relatively low starting leverage
(~3.7x net debt/EBITDA during 2010). In a nutshell, the pace of acquisitions from
here on out is unlikely to be a repeat of 2010-2015.
Transdigm: M&A Playbook Running Out Of Fuel - TransDigm Group Incorporated (… Page 10 of 20

Leverage is not the only limiting factor
While some may raise the argument that TDG could take 2-3 years to deleverage
and resume M&A, leverage is not the only limiting factor here. Apart from leverage,
there are other factors that would hinder Transdigm in its M&A ventures. One of
these factors is its size. With TDG being an approximately $2.7b revenue business,
it would need to acquire incrementally larger companies in order to sustain its
historical rate of growth.
The question really comes down to this: are there larger acquisition candidates
available? The company provides some helpful information to aid us in answering
this particular question, as seen above.

Amongst a population of 1,600 businesses, the majority (~960 per my rough math -
60% * 1,600) of acquisition candidates have <$25m in revenues while ~480 (30% *
1,600) businesses possess $25-$100m in revenues and the remaining 160 has
>$100m in revenues. It goes without saying that the majority of acquisition
candidates would barely move the needle for TDG given its current size.
This point is further corroborated by the fact that the company is highly selective
when it comes to acquiring other businesses. While such discipline is rare and
deserves applause, the fact remains that suitable acquisition candidates are in short
supply.

As seen above, management's "closure-rate" for acquisitions is approximately
~1.5% (5 / 337 = ~1.5%). If we apply this rate to the 160 "large" (>$100m in
revenues) businesses that are potential candidates for TDG, only a few would be
suitable candidates (suitable to move the needle for the company, that is), which
goes to show how limited the universe of future bolt-ons is for the company.
The above slide also raises yet another impediment to Transdigm's acquisition
strategy - price. Management looks to acquire businesses at 9x - 12x EBITDA.
However, given its current size, opportunities to acquire businesses that would
move the needle for the company at such valuations are unlikely to be widespread.
Many of TDG's prior acquisitions have been of small companies which are almost
certainly family-owned. Due to their small size, they are unlikely to have
sophisticated financial advisors providing them advice (i.e. bargaining for higher
prices) and thus they can be bought at low multiples.
This is not mere speculation - TDG has actually managed to purchase small private
businesses at multiples that would make public investors blush with envy - in 2014,
it acquired EME Holding GmbH for ~$48m. At that time, EME had revenues of
~$40m. Assuming a 20% EBITDA margin (I realise that I can assume higher
margins, but it would only serve to highlight the surprisingly low valuation that TDG
managed to purchase the business at), TDG managed to purchase the business at
~6x EBITDA (48 / (40 * 20%)).
Public investors might be shocked at how low private businesses go for and will
definitely raise the question: "Is it really possible to pay mid single-digit EBITDA
multiples for businesses set to benefit from secular growth trends?"
Although such an endeavor would require an immense amount of patience, the
answer is a resounding yes. Based on my experience (albeit anecdotal), small
private businesses (petrol stations, fast food franchises, legal practices, etc) could
be bought at low-to-mid single-digit multiples of earnings, oft with seller financing.
In many instances, the seller simply says that they intend to retire with $x amount,
or want to make 10x their investment, or other similar things along that line. My best
guess as to why such pronounced price inefficiencies exist is that these businesses
are often too small to be brought public and thus sellers are glad to sell at bargain

multiples in exchange for liquidity. The fact of the matter is that selling prices of
small private businesses are often driven by personal factors, rather than Wall
Street comps.
If one digs through TDG's acquisition history, it is clear that they have benefited from
this inefficiency during its early years. From inception (1993) to 2010 (just before the
huge ramp in revenues and EBITDA through a small number of large acquisitions),
TDG acquired 20+ businesses and grew revenues from $48m in 1993 to $828m in
2010. Given the relatively small increase in revenues (relative to the 2010-2015
growth numbers, that is), it is safe to say most of the early acquisitions were of small
private businesses (it is difficult to confirm this statement as TDG only IPO'd in
2006).
However, TDG does not enjoy the benefit of such low multiples anymore (at least
not to the extent that it had during its early years) due to its current size. Although it
can still acquire small privately-owned businesses, these acquisitions would barely
move the needle. TDG's only choice would be to move towards larger acquisitions.
Recalling my earlier commentary on the small number of "large" businesses
(>$100m in revenues) in existence, the "growing at 20%-25% CAGR through M&A"
story is beginning to fall apart.
The M&A thesis is really tested when one looks at the multiples TDG has to pay to
acquire larger businesses. Earlier this year in March, the company acquired Telair
Cargo Group for ~$725m. Telair had revenues of ~$300m and EBITDA margins
approaching 20% (let us assume they're 20%), implying a 12x EBITDA multiple -
near the maximum that management is willing to pay. The reason why such
businesses are being sold for far greater multiples than their smaller counterparts
(which often can be bought at low valuations per my above commentary) is likely
due to the fact that larger businesses tend to have significant sell-side
representation helping them to bargain for a higher and arguably, fairer valuation.
TDG has also noted that a majority of its past acquisitions have been from private
equity or strategics, who without a doubt would have numerous investment bankers
advising them on the deal.
My point regarding M&A opportunities essentially boils down to this: TDG has to
acquire larger and larger businesses to sustain 20%-25%+ CAGR which the market
is expecting. But such large businesses are in short supply, and given

management's disciplined acquisition criteria (9x - 12x EBITDA), larger acquisitions
will be limited going forward - not to mention that TDG's high leverage also limits
maneuverability.
If EBITDA cannot grow through incremental revenue, can it grow organically?
I am confident that I have fleshed out the reasons why revenue is unlikely to grow at
historic rates (whether through organic or inorganic growth) and therefore 20%+
EBITDA growth going forward is unlikely to be achieved solely through top-line
growth. Well, can EBITDA grow organically?
The answer to that question is no. EBITDA margins have historically expanded from
20% (in the 90s) to its current 45% through a mixture of revenue growth (which will
be lower than historical rates as we have established in earlier sections) and cost-
cutting / profit enhancement initiatives / operations streamlining / etc.
However, margin expansion through lean operations is unlikely to be sustainable
going forward - for the past half-decade, gross margins have been steady at
45%-46% while SG&A has been at 11%-13%. These numbers suggest that
operations are as lean / efficient as can be and that further slashing of costs is
highly unlikely.
Management has historically done a great job at wringing efficiencies out of its
supply chain and right-sizing its workforce, but it appears that such initiatives are
already at their limit. In short, growth in EBITDA will not stem from supply chain
improvements / workforce reduction.
Relative valuation
Given TDG's niche focus, it is hard to anchor its valuation to any peer - I actually do
not think that there is a suitable publicly-traded comp for TDG. There are no
aerospace companies with 40%+ EBITDA margins for example. Hence, what we're
left with is industry comps. TDG currently trades at a ~30x P/E, while industry peers
trade at ~18x.
If we give credit to management's capital allocation expertise and the firm's niche
specialty - say, a 5 turn premium to industry peers, shares should trade at 23x P/E
or ~$181/share.

Given that its industry peers are poised to benefit from the same secular growth
trends in air travel / new aircraft deliveries going forward, it is hard to justify a
premium based on these growth prospects. Furthermore, many of its industry peers
have much larger presences in emerging markets (where TDG is weak), which is
where the majority of future growth will stem from. Moreover, a cursory look at
industry peers reveals that most industry players are not as highly levered as TDG.
Considering that I am assigning zero discount to the firm's valuation to account for
its high leverage suggests that my numbers are likely to be conservative - I am only
assigning TDG a premium to peers (due to strong capital allocation / cost-conscious
operations / niche focus) and no discounts.
Perhaps the closest peer to TDG would be Precision Castparts (NYSE:PCP), which
is in the process of being acquired by Berkshire Hathaway. Precision bears many
similarities to Transdigm - both are capital-light businesses (low-capex), both
produce products that comprise of a small portion of customers' cost but are
essential to the performance of their end-products, both possess high EBITDA
margins (Precision has EBITDA margins in the high-20s, and could surely push it
into the thirties if the company levered itself to TDG multiples), and finally both have
huge aerospace divisions set to benefit from the secular growth trends mentioned
earlier.
At a $37.2b purchase price and ~$2.6b in EBITDA, this implies a take-out multiple of
~14x EBITDA. For reference, TDG currently trades at ~17x EBITDA. Acquisitions
usually carry a "control premium", and if we assume that said premium is 25% (this
number checks out if we look at studies of M&A over the years), a fair valuation for a
business like TDG would be ~10.5x EBITDA - or ~$146/sh (~38% decline from
current prices). I do not assign a premium for TDG's "fair" EBITDA multiple given
that Precision's management is similar to Transdigm in terms of capital allocation
expertise and having a cost-conscious culture.
Catalysts
The bulk of my bear thesis on Transdigm is centered around the company being
unable to achieve historic growth rates in revenues and EBITDA going forward.
Therefore the most likely catalyst for share price depreciation would be a decline in
growth rates for these metrics or a lack of acquisitions announcements going
forward.

However, there are other potential catalysts as well. Management has historically
(they seem to mention it on every earnings call) cited their capital allocation process
as follows (emphasis mine):
As you know, we regularly look closely at our choices for
capital allocation. To remind you again, we basically have
four choices and our priorities are typically as follows.
First, invest in our existing businesses; second,
make accretive acquisitions, consistent with our
strategy, these two are almost always our first choices.
Third, give extra capital or funds back to the
shareholders, either through special dividends or from
times occasionally stock buybacks. Fourth, pay off debt;
however given the low cost of debt, especially after tax,
this is still likely our last choice in the current capital
market conditions."
Source: 4Q FY15 Earnings Call Transcript
To close off 2014, the firm had ~6.3x net leverage. In the 4Q call, management
noted that net leverage had been reduced to ~5.9x, suggesting that the firm is
turning its attention towards its last resort (with respect to capital allocation, i.e.
paying off debt), essentially implying that making accretive acquisitions will be taking
the back-seat for now. If management continues deleveraging going into 2016, I
expect the market to take the hint and adjust its expectations accordingly.

Finally, if shares begin to sell off aggressively, we could see a situation similar to
what happened with Valeant in recent months - as shares sold off, hedge funds
begin exiting their position, exacerbating the drop in the stock price. As noted
above, Transdigm is owned by many hedge funds.
Risks to the thesis
1. Transdigm could surprise and make huge acquisitions going forward. Partial
mitigant: High leverage, its current size, and management's discipline with
respect to purchase prices - all explained above.
2. Transdigm could grow EBITDA through cost-cutting. Partial mitigant: Cost-
cutting appears to be at its limits (given steady gross margins and SG&A
expenses), if the firm continues slashing costs, it could lead to a gradual
impairment of their competitive position.
3. Transdigm could be acquired, similar to how Precision was acquired by
Berkshire. Partial mitigant: This scenario is unlikely given the company's
premium valuation relative to peers. Private equity is unlikely to show up as
well, as their playbook (streamline operations, levering to the hilt, etc) is
already being used by current management.
Conclusion
TDG has had a highly successful history of compounding revenues, EBITDA, and its
share price at double-digit rates. While secular growth trends in air travel / new
aircraft deliveries, the company's small market share in its addressable market, and
management's time-tested track record in making accretive acquisitions and
integrating / improving operations suggest that the story could be as rosy as it was
going forward, this is unlikely to be the case.
High leverage, the firm's huge size, and management's disciplined price criteria with
respect to acquisitions are major headwinds that would prevent TDG from growing
revenues and EBITDA at 20%-25%+ growth rates in the future. Growing EBITDA
through further cost-cutting would be unwise as well.

As TDG continued making acquisitions coming out of the financial crisis, its P/E
expanded from the low-teens to its current number at ~30x P/E, implying that the
market clearly expects historic double-digit growth rates to continue for the
foreseeable future. Clearly, this is highly implausible.
A fair valuation for TDG seems to be in the range of $146-$181 (or a 23% - 38%
decline from current trading prices), although I note that based on my experience, a
complete 180 in market sentiment (from bullish to bearish) could result in a far lower
valuation for the company (see Valeant's / Platform Specialty Products' share price
performance in recent months).
Risk to the upside seems limited as well, given that the company is trading at the
absolute highest of its historic valuation multiples. With limited downside (for a
short), and the potential for modest upside, the risk/reward proposition with respect
to shorting TDG at current levels appears highly compelling.
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.
Additional disclosure: The author's reports contain factual statements and
opinions. The author derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are
accurate or complete. Opinions are those of the the author and are subject to
change without notice. The author's reports are for informational purposes only and
do not offer securities or solicit the offer of securities of any company. The author
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. The author advises readers to
conduct their own due diligence before investing in any companies covered by him.
The author does not know of each individual's investment objectives, risk appetite,
and time horizon. His reports do not constitute as investment advice and are meant
for general public consumption. Past performance is not indicative of future
performance.

Transdigm M&A Playbook Running Out Of Fuel

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