Transdigm Group Incorporated (TDG) — Q2 2019 Earnings Call Transcript

Thank you, and welcome to TransDigm's Fiscal 2019 Second Quarter Earnings Conference Call. Presenting this morning are TransDigm's Executive Chairman, Nick Howley; President and Chief Executive Officer, Kevin Stein; and Chief Financial Officer, Mike Lisman. Before we begin, we would like to remind you that statements made during this call, which are not historical in fact, are forward-looking statements. For further information about important factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements, please refer to the company's latest filings with the SEC. We'd also like to advise you that during the course of the call, we will be referring to EBITDA, specifically EBITDA As Defined, adjusted net income, and adjusted earnings per share, all of which are non-GAAP financial measures. Please see the tables and related footnotes in the earnings release for a presentation of the most directly comparable GAAP measures and a reconciliation of EBITDA, EBITDA As Defined, adjusted net income and adjusted earnings per share to those measures. I will now turn the call over to Nick.

Good morning and thanks for calling in. Today, as usual, I'll start off with some summary comments on our strategy – our consistent strategy. A few comments on the second quarter and year-to-date, fiscal 2019, a quick update on the Esterline deal and a few other items. Kevin and Mike will then review the business performance and the outlook for fiscal year 2019. To reiterate, we believe our business model is unique in the industry, both in its consistency and its ability to create intrinsic shareholder value through all phases of the aerospace cycle. To summarize, some of the reasons why we believe this. About 90% of our sales are generated by proprietary products and over three-quarters of our net sales come from products for which we believe we are the sole source provider. Most of our EBITDA comes from aftermarket revenues, which typically have higher margins and provide relative stability in downturns. Our longstanding goal is to give our shareholders private equity-like returns with the liquidity of a public market. To do this, we have to stay focused on both the details of value creation as well as careful allocation of our capital. We follow consistent long-term strategies. Specifically, we own and operate aerospace businesses with significant aftermarket content. Second, we utilize a simple, well-proven, value-based operating methodology. Third, we have a very decentralized organizational structure and a unique compensation system that is very closely aligned with shareholders. Fourth, we acquire businesses that fit with our strategy and where we see a clear path to PE-like returns. Lastly, our capital structure and allocation of our capital are key parts of our value creation methodology. Fiscal year 2019 performance continues strongly with another good quarter, quarter and year-to-date revenues, our EBITDA As Adjusted dollars, and TransDigm based EBITDA margins were up significantly over the prior year. Incoming orders remain strong, especially in the commercial aftermarket and well ahead of shipments across all major market segments, all boding well for the balance of the year. As you can see, we have increased our base business guidance for the year with an anticipated increase in all major markets. The revised guidance now includes 28 weeks of contribution from the completed Esterline acquisition as well as an increase in base TransDigm revenue and EBITDA guidance. EPS for fiscal year 2019 is impacted by our capital market decision to raise $4 billion of senior secured notes in order to maintain substantial near-term financial flexibility. Kevin will expand on the quarter and full-year outlook. Our liquidity is strong, assuming no additional acquisitions or capital market activity we expect to have about $3 billion of cash at the end of the fiscal year. We also expect to have over 7 million of unused revolver and some additional room under our credit agreement. We continue to actively evaluate and seek M&A opportunities. We have a decent pipeline of mostly small and midsize possibilities. Again, I cannot predict or comment on possible closings but as I said before, we are still working steadily at M&A and we're still open for business. A few comments about the Esterline transaction, we closed this transaction in mid-March. As I think you know, we paid about $4 billion for roughly $2 billion in revenue, based on the public consensus information that existed at the time, about 330 million of fiscal year 2019 EBITDA was anticipated. We estimate this at about a 12 times EBITDA purchase multiple of the consensus fiscal year 2019 EBITDA. As we said before, we think Esterline has been a misunderstood company; its core aerospace and defense businesses makeup around three-quarters or more of the revenue. Its core business has proprietary content and sole source positions, generally similar as a percent of revenue to TransDigm. The core aftermarket also appears significant. We estimate somewhere in excess of 30% of the revenues of the core business. As you know, and as we discussed with the Esterline acquisition, we use an LBO model to value businesses that generally assumes we finance about half debt and about half equity. We then assume we sell the business in five years and look to get a return on our equity of 20% or more without any significant multiple arbitrage. As you know, as a practical matter, we rarely, if ever, sell them after five years. If you do the math on Esterline, this solves to a target EBITDA margin in the low-to-mid 20 range or about an 8% margin expansion. We are still working out the timing on this but it likely won't all happen in the first year. We have owned these businesses for about 55 days now, and we see no reason to think that we cannot meet our purchase expectation over time. We see some indications that we may well do better. In summary, so far it appears the opportunity at Esterline is at least as good and perhaps better than we originally thought. Kevin will discuss the integration in a little more detail. We are currently actively exploring the sale of certain Esterline assets that don't fit us well with our focus. These could recover something around $1 billion of our purchase price on a pretax basis. We'll decide whether to proceed when we get a better view of the actual prices. We have the flexibility to consider the full range of capital allocation alternatives. We will defer any other 2019 decisions on capital allocation until either late in the third quarter or the fourth quarter of fiscal 2019 and assess the overall business and capital market environment at that time. Lastly, with respect to the IG report that I mentioned in last quarter, it was publicly posted in substantially the same form as we discussed in our last earnings call. I want to reiterate that there are no assertions of any wrongdoing and a request for a $16 million approximate voluntary refund. As a follow-up to this, Kevin and I, along with some other DoD individuals, have been asked to testify at the House Committee on Oversight and Reform in mid-May. The purpose is to discuss the report pricing and possible legislative or regulatory changes. Now let me hand this over to Kevin, who will discuss both Q2 and year-to-date 2019 performance as well as the full-year guidance.

Thanks, Nick. Today I will review our results by key markets, then discuss the profitability of the business for the quarter, provide revised fiscal year guidance, briefly update our org structure, and finally give an update on the integration of Esterline. As you've seen, we had a strong quarter in the first half of the year, including above-average organic growth. Mike will provide more details on the financials for our second-quarter operations, specifically revenue and EBITDA As Defined were up nicely over the prior quarter. Q2 GAAP revenues were up 28% versus prior year Q2 and EBITDA As Defined was up 24% over the prior year with margins at 48% of revenue. Now we will review our revenues by market category. For the remainder of the call, I will provide color commentary on a pro forma basis compared to the prior year period of 2018, that is assuming we own the same mix of businesses in both periods. Please note this market analysis excludes Esterline. We will begin to include the Esterline acquisition in our market analysis once we have validated the data as we have a different market segmentation process. In the commercial market, which makes up close to 70% of our revenue, we will split our discussion into OEM and aftermarket. In our commercial OEM market, Q2 revenues increased approximately 10% when compared with Q2 of fiscal year 2018. Due to our year-to-date revenue growth of 11% and continued booking strength, we are increasing our commercial OEM full-year revenue guidance to mid-single-digit growth from our previous guidance of low-to-mid single-digit growth. Please note this increased OEM guidance includes our expected impact from 737 Max groundings and shipping delays. We have done an analysis on the potential impact and conclude the Max issues should not have a material impact on our financials this year and may possibly provide upside to our commercial aftermarket in the future. A nice segue to our commercial aftermarket business discussion. Total commercial aftermarket revenues grew by just over 6% in the quarter and year-to-date; continued global revenue passenger mile growth and slower retirements of older aircraft continue to provide a backdrop of improved market dynamics. In the quarter, commercial transport passenger growth of 9% was offset by a slowdown in the commercial transport freight submarket. Bookings coupled with our year-to-date revenue performance versus tough comps in the prior year and strong underlying fundamentals provide us confidence in the second half of the fiscal year. We are increasing our commercial aftermarket guidance to grow high single-digits from our previous guidance of mid-to-high single-digit growth. Now let me speak about our defense market, which is just over 30% of our total revenue. The defense market, which includes both OEM and aftermarket revenues, was up approximately 18% over the prior year quarter. Last year, we reported strong defense bookings that we are now seeing materialize into sales. However, we are expecting defense sales growth to temper in the second half of our fiscal year, following this exceptionally high first-half revenue growth and gradually slowing bookings. Due to the higher-than-expected year-to-date sales growth, we are increasing our defense full-year revenue guidance to grow high single-digits from our previous guidance of mid-to-high single-digit growth. Moving to profitability, I'm going to talk primarily about our operating performance or EBITDA As Defined. EBITDA As Defined of about $572 million for Q2 was up 24% versus prior Q2, and this includes about $27 million for Esterline contribution for the 17 days of ownership in the quarter. EBITDA As Defined margin in the quarter was just under 48% of revenues, this includes over 3.5 margin points of acquisition dilution from Esterline and the fiscal year 2018 acquisitions of Kirkhill, Extant, and Skandia. This core margin of 51.5% excluding Esterline and other fiscal year 2018 acquisitions improved approximately 2 points in the quarter over Q2 2018. Margin improvement progress is always important to us; it indicates that our base businesses continue to find opportunities to drive improvement within our value drivers. We continue our relentless pursuit of value generation. Turning now to 2019 guidance. We are increasing our sales and EBITDA guidance to reflect the strong first half results of our base business and to incorporate Esterline for about 6.5 months of ownership for the balance of the fiscal year. The midpoint of our fiscal year 2019 revenue guidance is now $5.44 billion, an increase of $1.25 billion. This revenue guidance is based on the revised market channel growth rate assumptions we just discussed for TransDigm’s base business, plus the inclusion of Esterline revenue, which reflects 6.5 months of ownership. The midpoint of fiscal year 2019 EBITDA As Defined guidance is now $2.35 billion, an increase of $255 million with an expected margin of around 43%. About 20% of this increase is related to performance at our base business with the remainder attributed to Esterline, excluding Esterline the full-year margin is expected to be around 50%. We are slightly increasing the midpoint of our adjusted EPS guidance by $0.05 to $16.81 per share. Mike will discuss in more detail shortly. Now before I speak about the Esterline acquisition integration, I wanted to briefly update you on our organization structure. Jorge Valladares, who has been with TransDigm for over 20 years, has been promoted to TransDigm’s Chief Operating Officer and he’s now responsible for all operations of the base TransDigm business. Jorge most recently served as our COO of our Power and Control segment. Now moving on to Esterline integration and expectations, the Esterline integration has been progressing to plan over the first 55 days of TransDigm ownership. To date, we have seen no material differences from the opportunity identified in our acquisition model. As you know, we have an experienced team of TransDigm executives, both EVPs and group controllers, engaged full-time in this integration. They have been carved out so they have little or no day-to-day TransDigm responsibilities. The former corporate office in Bellevue, Washington has been closed. This should complete by calendar year-end. We are phasing the workforce reductions in Bellevue to minimize disruptions and risks. In general, the platform organization structure has been eliminated and aligned with our TransDigm. Each of the former Esterline operating units have been assigned to a TransDigm EVP, and we have TransDigm group controllers assigned to these operating units to provide financial reporting support. We are now going through the process of reviewing the operating units and determining where value generation opportunities may exist. Again, no surprises have been seen in these early days. Culturally, we continue to press the concept of thinking and acting like an owner with the President and senior staff of the operating units. This supports the execution of our value generation concepts. So far, so good for the integration. Although, we did include Esterline in our fiscal year 2019 guidance, we are not providing guidance beyond this fiscal year at this time, due to uncertainty around what businesses we may keep or sell. As Nick mentioned, we are exploring the sale of certain assets that do not fit our strategic focus, but guidance for fiscal year 2019 assumes no asset sales. In summary, we are excited to have acquired Esterline and look forward to reporting our integration process to you in the future. We are also enthusiastic about the second half of our fiscal year as underlying fundamentals remain strong.

Thanks, Kevin. I'll give a quick review of the financial results and the updated guidance in more detail. First for the TransDigm base business and then second for the TransDigm plus Esterline entity. The following sales, EBITDA, and EPS comparisons exclude the impact of both the 17 days of Esterline ownership that fell into the quarter and then also the new debt financing. Second-quarter net sales were up 15% versus the prior year and above average organic growth of 11% drove the majority of that increase. EBITDA As Defined increased 18% from the prior year second quarter. Our adjusted EPS for the second quarter would have been $4.63 per share, which would have been an increase of 22%. Again, the $4.63 is what adjusted EPS would have been had we not purchased Esterline, so it's a theoretical number. Now switching gears and including Esterline. Esterline contributed about $121 million of revenue and $27 million of EBITDA to our Q2. This implies an EBITDA margin of 22%, which is higher than average, due to the elevated shipment levels that happen at quarter-end. The Esterline EBITDA margin over the last six months of our fiscal 2019 is not expected to be quite this high. On cash and liquidity, we ended the quarter with just over $2.4 billion of unrestricted cash on the balance sheet. Our forecasted cash balance at year-end is just under $3 billion and that excludes any more acquisition activities, sales of Esterline assets, dividends, or share repurchases. During the quarter, we completed the raising and funding of the $4 billion of senior secured notes. We raised more debt than we needed to in order to fund the deal, as we had a relatively high cash balance already. We opted to do this because the debt came at an attractive rate, and it also permitted us to keep significant cash available. With the new debt raise, our net debt leverage ratio increased from what would have been 5.2 times for the base TransDigm business at second quarter end to 6.1 times for the new pro forma entity. This change to our debt and leverage levels muddies and confuses the year-over-year EPS comparisons. The punchline is that you don't see as much EPS growth as you do EBITDA growth because of this higher debt ratio. Had we not elected to do the higher debt raise and increase our net leverage, the inclusion of Esterline would have had a larger positive impact on adjusted EPS growth for the year. For example, had we taken on only $2 billion of incremental debt and financed the remaining $2 billion with cash, adjusted EPS for fiscal 2019 would have been more than one full dollar higher than the midpoint of the new guidance. Now on changes to our expected tax rates for the year. These rates have increased from the prior guidance of 21% to 23%, and the increase is driven by the fact that we are over the interest deduction limitations that's part of the new U.S. federal tax law. We're now estimating our full-year GAAP and cash tax rates to be about 24% to 25% and adjusted rates to be about 26%. As Kevin mentioned, we estimate the midpoint of our adjusted earnings per share to be $16.81, and this revised guidance for the year doesn't assume any sales of Esterline business units or Esterline EBITDA during the rest of the year. With that, I'll hand it back over to Liza to kick off the Q&A.

Thanks, Mike. Operator, we are now ready to open the lines. But first, I just want to remind all of our investors to keep your questions to two and then please re-enter yourself back into the queue to allow an opportunity for all to ask a question. Thank you.

Hey, good morning everyone.

Good morning.

Good morning.

Esterline as a standalone had something in the zone of $70 million of corporate, give or take. How much of that hangs around with you?

Let me try it, you mean – I guess we'd try that a couple of ways, Noah. How much hangs around with us? If you look out a year or so, very little. When it goes away is sort of a phasing, as Kevin talked about, because we don't want to disrupt things until we feel comfortable we're all backfilled. But I think almost everyone in the corporate office there – almost everyone now has a scheduled out termination date.

Yes, that’s right.

Okay. And it looks like the margin implied for the Esterline business in the back half of 2019 in your new guidance. If I strip out what you said was organic and then consistent with your comments, Nick, on the percentage points of improvement, it's something in the zone of 17%. It looks like that might actually be down year-over-year based on how you're defining it. Is it? Are you assuming that, that is kind of flat to down year-over-year?

No. I don't think it's down. I think your math is directionally accurate, but I think that that's actually up from the prior year.

Okay. Yes. I guess where I'm going at that is I'm looking at the 3.19 of EBITDA that you disclosed, which would be a 15.7% margin. And I know it was a pretty backend-loaded margin, so that's why I was assuming that maybe that was down or, I guess, in the zone of flat. I appreciate that a lot of the actions you will implement here will take time, and integration takes time. I was just wondering if there's something different about this that makes some of those initial upfront actions slower?

I think not any different than other acquisitions. It always takes time for the contracts to play out before you can address any pricing or cost reduction initiatives. It does take time. And that's what we're trying to communicate here.

And I guess I might also add, Noah, that we could be – we will tend to lean on the conservative side here until we get more comfortable with the forecasting ability of all the individual operating units.

Yes. Makes sense given its size. Just one other question on it, and then I'll leave it, which is you've mentioned that the opportunity set is no different than you thought initially. How does the opportunity set compare to Kirkhill? Does total Esterline have as much margin opportunity as you found in Kirkhill?

Let me – Kirkhill started negative. So surely, the – I mean just to be facetious, surely the rate of change can't be as high.

Yes. Forget rate of change, but just the absolute level you took it to.

I don't want to cut out one individual operating unit. I think I gave you about what our thoughts are on Esterline. And I think, hopefully, Noah, we gave you some sense that we – as we're into it a little bit, we think it's more likely a little better than a little worse than we thought.

Hey, good morning, team.

Good morning.

Just a couple of quick ones. One, with respect to the percent aftermarket that you had talked about for Esterline in the past, I think it was – you pinned that around 30%. Now that you've maybe gotten a bit of a better look, does that number change at all? And then within that number, how should we envision the split there between A and D?

What’s A and B?

What’s A and B?

Between civil and military. Sorry.

Yes. I don't know the aftermarket split, and we haven't finalized our number. I think a 30% or a little more is probably a good number. And remember, that's the core business ex after we have either dispositioned or separated out the ones that we don't think fit as well. I would say in the split there between commercial and defense, I just don't know. But it's just – not that I'm avoiding it. I just don't know what the exact split is. But I would say, in total, the defense content is a little less than TransDigm's. Not a lot less but a little less.

Okay. That’s helpful. And then with respect to the cost structure, if you exclude out Sorio or whatever those assets are, how much of that cost structure that remains is European? Is that a significant number?

Do you mean how much of the businesses are European?

Yes. How much of Esterline, excluding those assets that we're talking about, when you look at how much of that cost structure is still based in Europe since that's clearly a…

A fair slot. There's still – I don’t want to opine on who we are and aren't going to sell. But there's still – there's a fair number of businesses, and taking one out of it won't make it go away. There's still some decent-sized businesses that are in Europe that we'd, in all likelihood, hang on to.

Hey, good morning.

Good morning.

Nick, just on that last question. Can you give us anything about the targeted divestitures' magnitude, not necessarily separate businesses?

Well, I think I did give you – I gave you a rough dollar value of – the dollar value we think we might get back. And that was about $1 billion, pretax, if we go ahead with everything we have in the queue. Now I don't know whether we'll go ahead with that until we see the prices. But you can figure – if it works and we like the prices and if we get somewhere around what we think, we may sell up to about $1 billion.

That’s pretax.

Okay. And then this might be for Mike, I don't know, but with regard to Esterline EBITDA trending over time, I think you said earlier, you talked about the mid-20s. You mentioned that the latest quarter was a bit higher than it has been for shipment reasons, shipment timing. How do we think about the cadence of margin improvement at Esterline, how long it takes and what the rate of change is there? You've said in the past, you probably don't get to TransDigm heritage margins, but how do we think about this on a two, three-year basis?

I think Nick gave kind of the margin ramp at the outset, and we're pretty conservative on the internal modeling assumptions we've used. So we didn't have it going up to the levels that Nick outlined in year one; as he said, it was more over several years.

Okay. Can you put any more color around that, Mike, just to refresh us and now that you've been in the business for a couple of months?

Yes. We’ve got a lot of moving parts with potential divestitures, and I don't want to commit to anything now, going out a couple of years.

And Rob, we’ll give the – next year we’ll give the guidance, when we give it, it'll be much more specific then.

Okay. And then just to clarify. You’ve been running at 52 per month on the MAX. You haven't slowed down at all?

We have not slowed down.

Okay. Thank you.

Thanks so much. Good morning.

Good morning.

A couple of questions on the core business. First of all, defense. You had a very strong first half, and you're expecting that to slow down in the second. What do you think has caused this outsized growth in the second half? And what's changing – sorry, the first half. And what's changing in the second half of the year?

Yes. We saw strong order growth in both the OEM and aftermarket last year. And I think that's coming out now in our shipments. We are just seeing the order book slowdown in both OEM and defense. Maybe it's inventory timing. We don't know of any programs or any other slowdown. So we would normally say inventory adjustments in the supply chain for that. But the slowdown is in both OEM and aftermarket as we look at that going forward from an order book point of view.

Okay. And then moving on to the aftermarket. I think the oil price is up about 40% or 45% year-over-year. Have you seen any of your airline customers adjusting their utilization patterns or their spares buying or anything like that based on the high oil price?

We are not seeing that we have noticed any adjustments in buying activity or patterns because of high fuel or not. We haven't seen any pattern change.

So you're still seeing the older aircraft heavily utilized, right?

Absolutely. The reports on the NG are that they've definitely ramped up usage.

Thanks for taking the question. So I think going back to Rob's question on this, Nick, the low to mid-20% EBITDA margins that you outlined. Were you saying that that's kind of the target that you need to get to, to hit your entire rate of return? Or that's what you think is achievable over the next couple of years?

Yes. That's what we use. That's what we use sort of the value of the business. It was running – and you can easily, as I'm sure you have, you can back into that easily enough. You know the assumptions we use. And the business was running somewhere around 15% EBITDA. If you solved back through our math, you'd get to 23-ish or 22% to 24%. And that's all we're saying. If we look at this, as I said, today, we see no reason to think that's not doable, and if anything, we feel a little better. That's what we're saying.

Yes. Okay. And then the – you talked about selling potentially assets that could bring in $1 billion. How do you think about dilution there and using the cash proceeds to potentially offset the dilution from selling these assets?

We really haven't decided yet. We'll sort of cross that bridge when we come to it. We have a fair amount of cash now, and this would just make even more. We'll decide that when we get there. I don't want to start counting the chickens before they're hatched.

Thanks, good morning. First one, in terms of the Esterline versus the core business, how are you seeing bookings trending there? And if you'd look organically just at Esterline as if you had owned it in both periods, what kind of growth are you implying in the new guidance that's inclusive?

I don't have any comment on the organic growth part of the guidance. I think the order book looks strong. It looks as good as TransDigm does right now as a base. So we're seeing strong bookings growth on the Esterline side as well.

I think in the segments, Kevin, you don't feel comfortable yet, breaking them out yet, until we get a better analysis of that.

Because they used a different methodology to calculate aftermarket, and those differences are important to us to understand. We're going through that process right now.

Okay. But from a standpoint of mid-single-digit, it sounds like it's growing organically about the same as TransDigm right now. Probably on the units it doesn't have the benefit yet of price, is that fair?

I think, guys, until we start reporting their metrics the same way that we do ours at TransDigm, we don't want to get crossed up on this until we get it right. There is no reason to think – There's no reason to think there's nothing we see that concerns us. That the…

I'm sorry, I'm not sure I'm understanding you. Can you repeat your question?

I guess what I'm wondering is, you've had three quarters in a row here of a double-digit growth rate organically in the defense business, the orders were outpacing that, they've slowed, but the end market is still a pretty supportive, and looks like multiple pieces of the end market that are more specific to your business are growing faster than the total end-market. So I'm trying to triangulate all of that into thoughts on sustainability of growing that business, high-single-digits annually beyond 2019.

I think given the order book slowdown, I would think that, that would be difficult to think that that's going to continue to grow at that pace into next year. It might, but I haven't formulated next year's guidance thoughts yet. We still have some time to see how the rest of the year comes in. The defense bookings tend to be longer-term than other business segments that we have. We've talked about that in the past, that bookings can take a very long time to come out. We saw that over the last couple of years that our bookings took longer than folks anticipated to come out. But, as I look forward, I think carrying a high-single-digit percentage growth in defense probably will be difficult going forward. But that's, I think a standard observation for the defense business. It tends to go through cycles.

I think I would just add on the bookings. I don't think you can draw much from a quarterly booking number in the defense world. They tend to bounce all over the place, on a year-to-date basis which might be a little longer-term and might be a little more indicative. We continue to book ahead of the shipments.

Okay. Yes.

Yes, I think last quarter you mentioned some softness in the discretionary interiors market. I'm wondering if you saw the growth rebound in that market and just discuss the condition there.

Yeah, we did a little bit. Still, I would say in general the interior side is just doing okay. It's just not a glowing bright light for us, but it's doing okay. In the quarter, our transport, commercial transport submarket was – did well. I think I said 9%. Interiors, okay. Freight was the low one, though. That's what brought the composite down to 6% for the whole. And that was somewhat anticipated. We've seen the slowdown in the freight market for a little while. So it was somewhat anticipated that we would start to see things back off there.

And is it possible to provide an estimate or a range for what you think the intangible amortization expense may be for fiscal 2019?

I think we've put a chart of our best guess in the slide deck for today. I think it's Page 17. And that’s subject to change due to purchase price accounting.

That concludes our call for today. We'd like to thank you all for calling in this morning.