EUR 850.00 For Business Accounts Only

Morningstar | TransDigm Returns to Growth, Eyeing an Early Esterline Deal Close

Wide-moat TransDigm reported a strong fiscal first-quarter 2019 that featured double-digit organic growth and a book/bill above 1.0 across the business. Margins expanded despite management fighting against 100 basis points of margin dilution from recent acquisitions as well as some mix headwinds due to fast growth out of the lower-margin commercial equipment business. Management is pushing ahead with its $4 billion Esterline deal, which could close as early as March. We moved up our 2019 projections and slightly increased our growth rates and margins in 2020 as well. As a result, our fair value estimate, which already reflects the impact of Esterline, increased to $335 from $314.

Despite the showing this quarter--adjusted EBITDA moved up 170 basis points and commercial equipment and defense revenue grew by double digits year over year--management only modestly upgraded fiscal 2019 guidance. TransDigm is calling for $4.19 billion of revenue at the midpoint (up $20 million from the previous outlook) coupled with $16.76 of adjusted EPS (up $0.50 from the previous midpoint). If this quarter's strong performance continues, we think management will upgrade guidance again. Excluding Esterline, which we include in our model for half of TransDigm’s fiscal 2019, we forecast adjusted EPS of $17.15, revenue of $4.25 billion, and operating cash flow of just over $1 billion for TransDigm alone.

Although Esterline needs to be cleaned up, we believe the deal will be value-accretive given the 12 times EBITDA multiple TransDigm paid and the upside we think TransDigm can unlock. Incorporating the deal into our model previously boosted our TransDigm fair value by 5%. However, we continue to posit that even if TransDigm executes the integration smoothly, the company’s investors (who are used to quick tuck-in deals that can have their pricing and operations optimized in six to nine months) may be surprised when fixing Esterline requires something closer to 18-24 months.

TransDigm will probably divest some nonaerospace Esterline assets once it begins digesting the company. We’re not modeling in any of these divestments and therefore implicitly assume that TransDigm will fetch a fair price for these assets should it execute a sale. TransDigm hasn’t identified what it plans to sell, but we think up to 15% to 20% of Esterline revenue could be divested after the deal closes.

Management addressed the ongoing inspector general’s investigation, which is looking into TransDigm's sales practices with the U.S. Department of Defense, focusing primarily on the Defense Logistics Agency, a major defense customer for the company (although we think it's less than 5% of total revenue). The report will be made public in the next few months, but management said the investigation has found that TransDigm should voluntarily refund the U.S. government $16 million. We think the report will likely mirror a previous inspector general report, which found that the Defense Logistics Agency should ask TransDigm for a voluntary $2.6 million refund related to the company’s pricing practices around aircraft parts. Management didn't pay the refund, and although the company hasn't made any decisions yet, we don't think it will pay this one either. In any event, we believe this relatively small fine would most likely be a one-time event--as opposed to a structural shift in contractual practices between TransDigm and the Department of Defense--and therefore isn’t material to our valuation.