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Morningstar | TransDigm Beats Consensus for Fiscal 4Q; Esterline Close in Focus for 2019

Wide-moat TransDigm reported fiscal 2018 results that beat consensus EPS and revenue expectations. Fiscal 2019 guidance came in almost right on top of consensus expectations for revenue and EBITDA as defined (management's preferred profit metric). Combined, these developments sent shares up. Despite the good news this quarter, our DCF model indicates that shares are a bit overvalued trading at a price to fair value estimate of about 1.15. That said, we did move up our fair value estimate to $314 from $307 because of the time value of money since our last update combined with management's slightly better-than-expected fiscal 2019 guidance.

Fiscal fourth-quarter revenue increased 13.6% versus the year-ago quarter, landing at just over a billion dollars. Organic growth came in better than we anticipated at a 7.7% increase year over year versus expectations for 6%-7% thanks to a strong quarter from the defense business, which increased sales 12%. EBITDA as defined measure came in at $524.8 million, representing a 50% margin and a 20-basis-point year-over-year expansion. Adjusted EPS in the quarter increased roughly 28% to $4.44.

TransDigm closes fiscal 2018 with a 9% full-year increase in revenue coupled with 40 basis points of EBITDA as defined margin expansion thanks to higher gross margins driven by productivity improvements, which we were happy to see, and which headwinds from acquisitions partially offset. Management and investors are looking ahead to closing the $4 billion Esterline acquisition in 2019. We think TransDigm will lift operating margins at Esterline by around 450 basis points by 2021-22 and push the business to achieve 4.5% revenue growth over the next several years, which is an improvement over Esterline’s historically stagnant top line. Still, we think investors used to TransDigm acquiring companies, quickly optimizing pricing, and turning around operations may be disappointed when they realize the slog they're in for with Esterline.

Based on management guidance, we've moved up our estimates slightly for the 2019 fiscal year. Excluding any impact from Esterline closing, TransDigm targets a fiscal 2019 revenue midpoint of $4.17 billion and an EBITDA as defined of $2.07 billion, implying about 40 basis points of margin expansion compared with last fiscal year. We include Esterline in our 2019 forecast (assuming deal close at half year) already but backing this out shows management guidance came in a bit better than our initial fiscal 2019 organic revenue and EBITDA as defined forecast of $4 billion and $1.95 billion, respectively. Fiscal 2019 GAAP EPS is expected to decline this coming fiscal year because of the $2.63 tax benefit recorded in fiscal 2018. Excluding this tax benefit, the midpoint for fiscal 2019 EPS guidance of $14.90 represents 9.2% year-over-year growth.

Drilling down a bit more on management comments, the team at TransDigm anticipates commercial hardware (referred as commercial OEM) revenue to increase revenue by low to mid-single-digit percentages coupled with mid- to high-single-digit percentage growth out of the commercial aftermarket and defense activities. We think there is upside to the commercial hardware growth forecast from management and for the defense activities, which we continue to remain bullish on given the translation of rising defense budget authority into outlays over the next six to 12 months.

As an aside, we'd note that the U.S. Department of Defense investigation into TransDigm pricing practices has dropped off the radar for investors and while we think an adverse ruling might put a dent in shares, we believe the risk overhang created by short sellers in early calendar 2017 has largely passed. Moreover, as we have previously noted, direct sales to the Department of Defense stand at less than 10% of sales, and our modeling shows that even Draconian price cuts enacted by the Department of Defense would affect TransDigm by only around $10 per share, or about a 3% drop from where shares are currently trading. Barring TransDigm from competing on future programs would be a much bigger blow, but we think this is highly unlikely given the routine nature of defense pricing audits like this one.