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Morningstar | TransDigm Lands a Big One: Esterline to Be Acquired for $4 Billion

TransDigm, manufacturer of aerospace components and spare parts, announced on Oct. 10 plans to acquire Esterline for $4 billion, including the assumption of $400 million of debt, in an all-cash transaction that will see TransDigm raise significant funding via new term loans. TransDigm shares are off about 3% and Esterline's have soared 30%. According to our estimates, the deal price represents 12.5 times Esterline's 2019 consensus EBITDA, whereas peers are trading at an average enterprise value/EBITDA of 14.5 times. We think TransDigm saw a beaten-up stock price at Esterline (up only 13% since 2013), got familiar with the company when it purchased a small Esterline unit earlier this year, and believes it can optimize Esterline's core aerospace and defense business, which represents about 70% of the company’s revenue.

We've incorporated Esterline into our model and assume management boosts Esterline's operating margins roughly 450 basis points to 13% by 2021-22 and achieves nearly 4.5% average annual growth from 2019 to 2022. This results in a new fair value estimate for TransDigm of $307, up from $303. We are retaining our wide moat rating, but we’ll be watching for improvements to Esterline's business.

TransDigm is anticipating a close in the second half of 2019, and we think there is risk that the close could slip to the right and preclose divestments are also possible due to the increased Department of Justice scrutiny of recent aerospace deals. This is a transformative deal and represents the largest acquisition that TransDigm, a prodigious acquirer, has ever carried out. It's also not the typical niche acquisition that enjoys excellent aftermarket penetration ripe for near-term pricing optimization. Instead, it will take years to realize synergies and efficiencies. We like that Esterline enhances TransDigm's exposure to growing defense budgets but Esterline’s lower aftermarket penetration is less attractive; TransDigm should be able to grow this business.

Data Device, which TransDigm acquired for $1 billion in 2016, is a fraction of the size of this deal and in terms of employees, Esterline's is about 40% larger than TransDigm (around 13,000 employees versus 9,200 for TransDigm) but revenue comes in below TransDigm at a 2018 consensus estimate of $2 billion compared with $3.8 billion for TransDigm. Revenue per employee for Esterline stands at around $150,000 compared with $350,000 TransDigm, underscoring a potential opportunity for TransDigm to optimize the business. Similarly, Esterline registered 15.9% average reported EBITDA margins over the past five years versus the incredible 42.3% reported EBITDA margins for TransDigm.

Esterline has faced multiple operational challenges, with sales and EPS basically stagnating over the past several years despite a strong aerospace upcycle. As a result, shares have risen only 13% since 2013. TransDigm got an excellent view into Esterline's operations when it purchased the struggling Kirkhill Elastomer business from the company earlier this year, so we think management knows what it is getting into here but there will still be considerable challenges extracting efficiencies and synergies out of Esterline, and the process will likely take several years, in our view. Bob Henderson, TransDigm's vice chairman, will oversee the integration and operations of Esterline. TransDigm's management team expects the deal to be “modestly accretive” within the first year of ownership.

The aerospace supply chain continues to consolidate--witness the recent United Technologies-Rockwell Collins deal as well as the Safran-Zodiac tie-up--and we wouldn’t be surprised if there is a preclose settlement between the Department of Justice and TransDigm that includes divestments of certain Esterline businesses. Separate from any Department of Justice deal, TransDigm management may divest Esterline's nonaerospace businesses like nuclear power and rail, which represent about 30% of Esterline's sales; this will likely occur after closing.

Looking solely at aerospace and defense sales at Esterline, the company is slightly more exposed than TransDigm to the defense market, with just over 40% of aerospace-related sales linked to defense applications versus 35% of TransDigm's business. We like this increased defense exposure because of our bullish view on near- to midterm defense spending, particularly in the Department of Defense operations and maintenance account, which is where Esterline's higher-margin spare parts are funded. In terms of aftermarket versus equipment sales, Esterline derives about 30% of its consolidated revenue from services (spares as well as retrofits and upgrades), which is much lower than TransDigm's exposure (over 50% of sales) to higher-margin aftermarket work. Examining just the aerospace businesses at Esterline, TransDigm management indicated that the aftermarket sales are north of 25%. Esterline has been working to increase its aftermarket exposure; we think TransDigm’s management team is likely to be more successful.