TransDigm Group Incorporated (TDG) Earnings Call Transcript & Summary

All right. Welcome to the UBS Industrials and Transportation Conference. I'm Myles Walton, I am the aerospace and defense and airlines analyst here at UBS. It's a pleasure to continue the conference with the management team of TransDigm, including the CEO, Kevin Stein; and the CFO, Mike Lisman. I'm going to go ahead and kick it right off into Q&A, but welcome Kevin, welcome Mike.

Thanks. So Mike is here. We're ready to go.

All right. All right. Full team. So maybe we can just start up. Others in the supply chain and airlines in particular have pointed out that April, May, they felt it couldn't get much worse and it doesn't look like it's getting much worse. And so we're kind of -- here we are bouncing off at the bottom. Is that kind of a perspective that you'd echo given what you're seeing in your business? And maybe just give us an overview.

I can't comment on what necessarily I'm seeing in my business. But from what I see in terms of airlines and flight activity, activity in general, I would say we've bottomed in all regions, and we're starting to gradually build our way out of it. I have family members even flying now for the first time in a few months. So it's gradually going to start happening. This is what we have to watch really closely because this will dictate the shape of the recovery curve as how are people flying? And is it still significant restrictions or not and how comfortable are people feeling?

Okay. And I imagine there are some piece of your business that on the commercial aftermarket side and the OE side that have been further hit than others, more defended than others. Maybe just give us a quick view of the lens, through the lens of products and kind of what the differences you've seen there in resiliency or vulnerability?

So I can only comment on what we've seen through our earnings call. And I did give some guidance on our first month of the quarter that it was looking a lot like our sizing model, which assumed 75% off in the aftermarket, 25% to 40% off in OEM and defense growing a little bit. And I think that is what we saw through April without getting into where things are at right now. But I do feel like we have seen the bottom and now we're going to start building our way out of it. From a product point of view, those products that are maybe a little bit more discretionary in nature, maybe seat belt, some bathroom fixtures, flooring and wall materials, bin latches, things like that, that are a little more discretionary and you can fly them without being in perfect condition, we've seen some of those businesses, that subset of products, they've been impacted slightly more than the rest of the business. But generally speaking, I think we're holding in pretty well. And our POS data indicates that things are hanging in okay. I mean off, of course, as expected, but we're not seeing cratering anywhere. We're not seeing businesses fall off the map. There still is activity. And again, we look for green shoots across the world, aviation. We see China is back to off 30%, 40% now only. A lot of their domestic has come back pretty quickly. International is still not there. I mean that's the piece we're going to have to watch pretty closely is the international side of the equation because that, generally speaking, is more RPMs are tied up with international travel. So it remains to be seen how this plays out. But we're looking for green shoots across the industry, and we're starting to see some.

Just from an engine versus non-engine perspective, if you look at your business through the lens of that, is there a way to size the proportionality of your business?

Yes. I think our team pulled together some data that something like 35% of aftermarket is engine-related, maybe something along those lines, just short of 50%. I would say we're probably less weighted than that. We probably don't have as much engine exposure. We don't make bearings, rings, seals, compressor cases and the like. We do have some actuation and thermal blankets and the like on there, valving, maybe some wiring, sensors, igniters, but it's not as big a piece as a percentage as others in the industry that have more engine exposure. So we're probably underrepresented to the industry from an engine versus airframe perspective in the aftermarket.

Got it. Okay. And one of the questions that you get asked all the time, but this affords you the opportunity to answer it again is around recycled parts and used serviceable material.

USM.

Yes. And you've had a comment about the price points that make it worthwhile and your price points being lower, but maybe any data you have to support that and any impact you'd anticipate even on the margin?

Well, we continue to look at this. We look at PMA and we look at USM all the time. And we want to see if there's a leak in our market share, in our direction, in our strategy. And we really don't find anything there. USM, I studied this a couple of years ago. We continue to look at it across the business. Along with PMA, it's probably a couple of percent. It lends itself to some products that are of the right price points from the work we've done. If you can't sell a part off of a plane for $5,000 to $10,000, they're probably not as interested in taking it off. We sell very few LRUs, line replaceable units. Those are the whole unit. What you sell is subparts that allows someone to repair the unit, to bring it back up to a certain performance envelope. We look at that and say, we're not overly exposed on the USM side. We're not overly exposed on PMA. Certainly, it bears close watching as there is a significant amount of the fleet that is parked. It usually takes a year or so after a plane's been parked before it's parted out. So there's probably a bit of a wait and see out of this to see if that really happens. It depends on how quickly the demand comes back on the RPMs on flying on how quickly this comes back. We would argue that we are very nicely distributed. We're market weighted in the platforms, the planes that we're on. So the disappearance of any one platform won't serve as an outsized issue for us. Older products, a little bit more profitable, but not dramatically so. So legacy platforms matter to us. You do make a little bit more money. But let's not forget, you lose all your economies of scale when the product goes out of production from the OEM. You only make a few products a year as replacements and so you lose economies of scale. It's not clear that older planes and older parts are all that much more profitable. They're a little bit directionally, but it's not a monumental amount. We watch the USM carefully to see if there is leakage here. We don't see a lot. We will continue to focus on it as there will be more parked planes in the short term than there are in the long term to see if this becomes a problem for us. But again, our average sale price is around $1,000. And when you sell parts in the USM, you sell them for a significant discount to brand-new OEM. So if you can't sell parts for a few thousand dollars apiece, you're not going to have any activity in the USM market and the lion's share of our parts fall into that category. So we don't see it as an outsized problem for us, but one that we will continue to watch closely. And I guess I answered that question a little longer because I think that, that is a major concern area for many as they look at our business, and they look at where can the story get disrupted. Well, if there's a ton of planes parked and they're cobbling stuff off and selling them, that will have an impact on their aftermarket, but not in reality. Parts don't easily transfer from one platform to the next. They still, as they come off, frequently have to be repaired and overhauled themselves, and that gives us access to those parts as well. And we're always looking for used parts on the USM side as an opportunity. We've done our own studies where we've tried to buy up some of these parts and see if we could perturb the market pricing, and we don't see much of an impact. We haven't been able to find much of an impact. We just, again, believe strongly that USM is not a main problem for us as we go forward, but we'll continue to watch it closely.

Okay. Okay. It sounds like you've probed the market on the USM side. Did you actually have a brokerage internal business? And then I think you have smaller PMA businesses. I'm just curious how those are doing.

They're doing fine. Yes, we do a little bit of where we PMA products. Of course, to sell your products in the aftermarket, you have to PMA them yourself. So we have hundreds of thousands of PMAs that are licensed to us. But in the normal PMA part manufacturer assist process where you have a company like HEICO coming up with a -- or others coming up with a similar product that they can sell versus yours, we don't do a lot of that. But yes, we do follow this closely.

Okay. Good. And I guess one other one is from a regional perspective and regional concentration. Are you of the mindset that, you talked about your balance across the fleet, are you also balanced geographically with probably some skewing based on ages of the regions or is there any other regional?

Yes. I would say we are. We are pretty evenly weighted between Airbus and Boeing, and that accomplishes a lot of it right there. Wherever Boeing and Airbus are, we are. They're both equally important, equally weighted to us, more or less. So I think we're as geographic and platform distributed as you can be.

Okay. One of the bigger questions is around the recovery. And let's say that capacity ASMs get back to where they were. And obviously, the big question back to me is usually, well, when they get back there, the fleet will be substantially younger. And therefore, TransDigm will have a harder time getting back to run rate sales or unit volume. Is that something that you think is the case or do you have a kind of a different viewpoint?

Yes. And Mike, you can jump in on this one, too. I think there are lots of opinions out there, and we're not sure. It remains to be seen how this plays out. I don't want to start tilting at windmills and worrying about what may be coming. I'm focused on what is happening right now. Whether the business is different after COVID, whether the demand is different, if it takes us a couple of years to get there, we'll have to see. These are possibilities. I just don't know. We're reacting to the order book as we see it, ensuring that we're staffing to the correct level, that we're not wasting resources and money as we're doing it, and then react to the demand that's there. I'm not sure how this will look, we will look like afterwards. Mike, you had any?

I think that's right. And I think it's hard to say and forecast with precision exactly what a commercial aftermarket growth rate could look on the other side as you come out of this. Obviously, a slightly younger fleet on balance you'd rather not have it for us when you're selling into the aftermarket. But that said, we don't think it's a massive headwind, right? If you guys look back a couple of years ago during the '15 to '17 time frame when the fleet was slightly younger because there were a lot of aircraft within the 5-year initial warranty period that were rolling off production lines, there was a lot of talk in the industry just about the drag that was creating on commercial aftermarket growth. And it was something that I think people quantified it maybe low single-digit percentage of impact. It's not something that we think will be a massive drag. We'll see. Just like USM, we'll continue to watch it. Could have an impact, but I don't think it's something that would like stop us from growing on the other side of this thing as we come out of it.

And I think it's important, Myles, to understand, we have a very small market share. In our serviceable market, we're a single-digit market share, kind of very small organization. There's lots of room to grow, whether it's through acquisitions or continued good work that we do on capturing new business opportunities ahead of where we were before to expand our market share. There is so much room to grow here. There's so much opportunity for our business model and for our disciplined approach with only about 4% share in the serviceable market. There's a lot of room for us to continue to grow and expand.

We'll come back to that in a second. That's an interesting point around the potential to scale through share. I wanted to focus next, though, on profitability. You've kind of set out a pretty audacious goal for maintaining or holding the line around the 40% EBITDA margins. And to the outside, that would seem like a pretty impossible task with volume and mix working against you so fast. You obviously were early in cost actions and then did another secondary cost action. But what's the level of confidence around holding that low to mid-40% EBITDA margin through the downturn here?

Well, it's aspirational, of course. I don't want to tell you it's a slam dunk. It takes a lot of work to do that. We got out ahead of the cost reductions. That tends to be what we do. Sometimes we're not right about that, but we always choose to be lean and mean. And so we try to get out ahead of that. We, in the end, probably through salary reductions, through headcount reductions and furloughs, we'll probably cut 25, plus or minus, percent of our labor. It's a significant headcount cut to that. I believe it was warranted. That's what we're seeing in the business, but continuing to look at productivity opportunities, pricing opportunities even in this kind of a market. There's a number of products that we're seeing decent demand on as we commented on last quarter. Those give you opportunities to still price. So yes, 40% is aspirational, but we wouldn't say it if we didn't believe we have a pathway, a track record, a strategy that gets us there through our value drivers that we use all the time. That's the nice thing about our strategy is it's simple and we continue to refer back to it in times of growth or in times of contraction like this. We can use the same value driver model to look for opportunities. And that's what we will do and that's what we are doing. So we'll see. I'm confident that we have a robust strategy that gets us there. Whether at the end we can get all the way there and execute, we'll see. But that is our goal. It's aspirational, and I think we've got a strategy that gets us there. And we tend to be pretty good about execution.

Yes. And the company has demonstrated that. And you alluded to it there on the pricing side. Just how should the market or how should investors think about your ability to price through a downturn? All the moat is still there. You're still sole source, proprietary. And so why would the pricing power be any less? Obviously, the volumes have come down, but would the pricing absolutely change in any way?

There is apparent pricing power versus actual. So there's still the apparent pricing power that's always there. But of course, there's going to be inventory in the channel so it takes a little while for you to feel that impact. So again, you've got to follow your order book and what people are demanding from you. And that will tell you where the opportunities are to continue to practice your value-based pricing. Again, no one's talking about raising prices, doubling the price of a product here. We're talking about doing the same things that we always do. In times of decline and contraction, some leaders and managers believe that is the wrong time to try and issue any kind of price increases. We don't look at it that way. We see that our costs have been impacted quite significantly and use that as justification to explain to the field that this is what we have to do. And that's what our teams do. And they stick and they are successful. But again, we're not lunatics in this. We're not greedy. We look for justification. And clearly, our costs have gone up quite significantly during this time, and that's what we're managing our way through. So it's a good justification.

Makes sense. Makes sense. And so maybe to come back to the share question and M&A in general. On Esterline, obviously, a large deal done roughly a year ago and seem to be getting integrated quite well. Are you getting more comfortable or are you now comfortable with large deals that may, on the surface, not look like they 100% fit into the mold. But once you get them in-house, you realize that maybe you can make them fit and/or just your general impression of the pipeline?

I'll let Mike comment on pipeline and activity and the like. But the integration process is never done. I mean it's done because they're now in and part of the team. But there's continuous improvements. There's continual look at rationalizing businesses and what can we invest in to grow and where are the opportunities. So we will always and continue to invest and look for those. And I think that we will find those opportunities as we go forward. There's still growth. There's still opportunity here. I'll let Mike comment on the pipeline and the like, but we're open for business.

Yes. On the pipeline, I'd say we're active at kind of the small to midsize range. We're always looking at stuff. We don't ever shut it down because the one thing we realized on something like Esterline, frankly, we looked at that for years before we made...

Many years.

Yes. I mean it was like a running joke in the M&A department. We, every quarter, would dust off the analysis. So we're always active and looking for stuff and positioning ourselves now to hopefully be in a good spot to go and deploy some of the $4 billion, $4.5 billion of cash we have sitting on the balance sheet once there's more certainty in the world and we feel good about putting a bet down. It's hard to forecast exactly when that might be, but we're always looking at stuff, as you guys know, and we're doing so right now.

But I think comfortable with big acquisitions.

Yes. I think the big ones, frankly, is, I think, as we've referenced on the last earnings call, doing a big one right now from a financial standpoint, where we are with the end markets, it's probably unlikely, right, because the more conservative thing to do and appropriate approach given the uncertainty in the world is to probably sit on a bit more cash than you need. But with regard to when that changes, it's hard to say, when it does, I mean, I think Esterline was kind of proof that we could go and do some larger things.

And that our model works, our strategy works, and that we were right.

Yes. At the end of the day with an Esterline, you're really just biting off a bunch of small business units that are typical acquisition sizes for us, right? If you look at that business, they probably chunked it up into maybe 20 different business units. We divide it down to something more like 15 or 16 today because we sold off a couple of pieces of it. But even when it was Esterline, those business units pretty much functioned, in a lot of ways, independent from corporate. There was some involvement from corporate sales teams or lean initiative teams, but all the units at Esterline, for the most part, still had their own legacy names. And now the way we run the business units today, it's probably just taking them back more towards that, being a bit closer to like a private equity portfolio company than they were under Esterline. But they've still got their sense of individuality, if you will. And Esterline, we really just bid off a bunch of a couple of hundred million dollar businesses all at once.

And you mentioned, Mike, you're getting the $4 billion, $4.5 billion in cash on hand, which is, I think, the largest balance you've had as a company. And what made you go to pretty much take whatever was being offered or was there a sizing algorithm that went behind that in any way?

It was an insurance policy. There was no great sizing algorithm or Excel model that said, you should go raise $4 billion, $4.5 billion. I think, frankly, we just looked at it and said, oh, c***, there's a lot of uncertainty. What better insurance policy than to have a ton of cash sitting on the balance sheet. The last thing we want to do is kind of run out of cash with this business. And if at the end of the day when you think about that debt raise, if TransDigm at its peak was $35 billion, $36 billion, $37 billion of equity value, we think we're going to get back to being $35 billion, $36 billion, $37 billion of equity value someday. And when you look at the after-tax cost of the debt raise we did given the type of notes we raised in the shorter-term duration with the takeout costs, to pay $100 million or $120 million of insurance expense, if you think about it that way, to protect your $35 billion or so of equity value doesn't sound like a lot of costs, right, it's dollars per share. So who cares if you're just protecting the egg.

Makes sense. Makes sense. And then maybe just transition over to defense for a second. Can you give us some color on what you're seeing from any impact you alluded to on the call from any DoD proposals? And I know that actually the industry organizations have come out in defense of TransDigm effectively saying that some of the policy recommendations being circulated would be detrimental to the entire industry. Kind of any perspective or update you have on that front?

So we've been working really closely, as has Mike, with our government outreach, DoD, DLA, IG, and this is going to be an ongoing noise for us. I don't know we've become big enough that we will always be on the radar. The key is to stick to our disciplined approach and process and make sure we do a better job of reaching out to the government, whether it's the DLA, the buying agency, the DoD as a whole or congressmen and senators. We have done a lot more of that. We've formed a sort of a multi-stage, multi-tiered strategy of how we will communicate. We formed PACs. We're utilizing lobbying groups. We've put together a D.C. office, small just like everything we do, very focused, very lean, but it will have the desired effect, I believe. So we're taking this very seriously. We're working closely with the government on all of these fronts. I think in general, I can't comment on the order book today. But we did comment on it last quarter, and I think we said we were surprised. Is that right, Jaimie, is that what I -- yes, robust. We were a little surprised by how strong the order book was last quarter on the defense side. And I think that's a continuation of just a relatively robust defense sector for us. We continue to see opportunities there, new products, acquisitions. We'll see how that all plays out. But the defense business is doing okay today. As we communicated last quarter, our communication with DOD, DLA has dramatically improved. We have working groups together. I think it's a very different relationship. And you commented on how a number of industry buying groups have come out against some of the regulations. They're not necessary, so on and so forth. That supports us. It supports the industry as a whole. I think that you're right in that. But our efforts, I think, have had some positive impact on the relationship we have. Anything, Mike, what do you think?

No, I think that's -- I agree with what Kevin said. It's unfortunate that some people, just based on what publications you read, TransDigm is still a little bit getting a bad labeling as kind of a poster child or our face is still on the bull's eye, however you want to characterize it, just based on what happened in kind of 2019. Given all the things Kevin mentioned, we're looking to obviously just change that, right? I don't think it was appropriately cast that way.

Yes. It's not something you can change overnight. It takes a while.

It'll take a little bit of time, but we're doing the right things to hopefully see that change occur at some point.

Okay. Okay. Good. And maybe on the, back to the cost side for a second, the changes you made pre-COVID back in January were anticipation, I think, more on the OEM side. And obviously, COVID, you've correspondingly moved with further cost reductions and reductions. Are you sizing your cost structure on the OEM side to the current stated manufacturing rates of the OEMS or are you taking a more conservative view on their build rate picture?

We used the sizing assumption of 25% to 40%. I think if you look at the OEMs, Airbus OEMs, Airbus hasn't disclosed a ton of information, but they're expected to -- between the 2 of them basically be -- if you set the MAX to the side, they're expected to see rate reductions of something on the order of 30% to 35%. So we feel like our sizing assumption was pretty appropriate. With regard to where they go, I think beyond the kind of 2021 time frame, which is what the 30%, 35% addresses, I think we'll have to see. We don't have a really good long-term forecast with regard to what might happen at Boeing and Airbus for '22 through '24, but we'll see. And then, I think, take further action, if anything is required.

Yes. I think the inventory overhang is unknown there, and that will complicate. I was always amazed in my prior career as we interfaced with Boeing on supply side items that the amount of inventory that they could find always was, it was daunting at times. I don't think given the price of our parts and the like that there is quite the same amount of inventory, and we don't have visibility to it. You have a very little distribution on inventory, but really nothing at airlines or OEMs do you have any visibility. So we've tried to take an appropriate conservative look at this to incorporate some of the inventory issues that we expect to see as we build our way out of this, but it remains to be seen. Again, we have to follow the order book very closely and react quickly as we see things change. But yes, we tried to take a conservative look at it. We've always tried to do this. We always try to get out ahead on the headcount side. We want to run our organization lean. And we did that this last time. I would say that some of our January headcount reduction that we announced or right around the time of our earnings call, February 6 or somewhere around there, we did talk about wanting to get out ahead of the MAX issues, but also we were seeing slowdowns in the Asia traffic so wanted to get out ahead of it. I think all together, somewhere around 25%, as we've commented, will be the headcount reduction on the labor side. And that ought to help you back into what the actual number, dollars for your model, as you know, we told you what our labor rate as a percentage of our cost, material overhead. So it ought to help you lock in on what that savings will get us.

Yes. Okay. That makes sense. And then just 4, 5 minutes left, maybe, Mike, on the working capital side, what kind of opportunity given the reduction in volumes should we anticipate and any headwinds there? I imagine you guys aren't in a position of long lead commitments for materials like some others who might be tied to your old employer, Kevin. But just give us a picture of what your inventory or working capital source of cash might look like?

Yes. In time, you should get a benefit, right? The hard part is forecasting exactly when it will come through. We're conservative internally in terms of how we just model getting that cash. Ideally, it's almost impossible to do this. But ideally, you'd be able to hold your net working capital as a percentage of revenue. Practically, you can't shut off what's coming in from suppliers immediately. So it's going to end up, obviously, ends up spiking a little bit just too as the denominator gets smaller as well due to revenue. In time, though, over the span of a quarter or 2, the cash should come out and get more closely in line with the percentage of revenue that we've been at historically. So hopefully, that's helpful. We don't expect there to be any kind of immediate near-term surge of a couple of hundred million dollars due to net working capital. But in time, as the revenue base goes down, you'd expect it to come back out and you hold the percentage as a percentage of revenue. Is that helpful?

Yes, yes, totally. And so when you talk about being cash flow positive, even on these volume declines in the near-term quarter-to-quarter, there's not really much of anything built in there from a working capital liquidation certainly to the near end, I guess.

Yes. Correct. We don't need a working capital inflow to hit the kind of positive levels that we referenced on the earnings call. We're actually slightly conservative in how we model that to get to the kind of cash flow range we discussed.

But I would say it is something we've been grinding on our folks about. As Mike has worked on AR, AP, inventory coming in, we've been grinding across the board on this. I think there will be some headwinds in the short term here, but our teams are very disciplined.

Great. Maybe one last one which is, any color outside of the pure passenger aftermarket relative to cargo or biz jets that you think is maybe functioning differently or similar? Is there any...

Biz jet seems better than I would have thought. It seems like there's maybe a faster recovery on the biz jet side. So maybe that's a positive. Cargo, with the collapse of belly cargo capacity, we've seen total cargo fall. I think the numbers this morning were 27% in total cargo metrics, but an increase in utilization of the larger capacity cargo planes. This could have some interesting opportunities for us as they're using their cargo space. The cargo planes tend to consume a lot of spare parts. This could be positive mix for us in an otherwise difficult mix scenario. But I don't know what else to comment yet. I haven't seen any long enough summary numbers yet, and I won't until we report, but we commented in the last quarter about discretionary. We would anticipate the discretionary aftermarket materials might be a little bit harder impacted and I guess that more or less is what we saw last quarter. The cargo space, maybe we'll see some improvement, maybe it won't be as bad. We'll have to see how that plays out. But I'm looking at business jet takeoff and landings a little bit better and some interesting cargo trends that we'll have to see how those impact us as they go to more less belly utilization, which doesn't use a lot of spare parts, is more manual with the person going in and pulling things out it tends to be. And to a more automated, yes, we'll see it could be an interesting opportunity for us.

Okay. Great. We're at the end of the conversation. So I really appreciate Kevin, Mike, you joining, and thanks for listening to those in the call, and thanks for being on the call with us, Kevin and Mike.

Thanks.

Thanks.

Appreciate it.

Take care.

Bye-bye.

Bye-bye.