Transdigm Group Incorporated (TDG) — Q1 2023 Earnings Call Transcript

Thank you, and welcome to TransDigm's Fiscal 2023 First Quarter Earnings Conference Call. Presenting on the call this morning are TransDigm's President and Chief Executive Officer, Kevin Stein; Chief Operating Officer, Jorge Valladares; and Chief Financial Officer, Mike Lisman. Please visit our website at transdigm.com to obtain a supplemental slide deck and call replay information. Before we begin, the company 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 available through the Investors section of our website or at sec.gov. The company would 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 call for a presentation of the most directly comparable GAAP measures and applicable reconciliations. I will now turn the call over to Kevin.

Good morning. Thank you for joining us today. I'll begin by providing a brief overview of our strategy, some comments about the recent quarter, and discuss our fiscal 2023 outlook. Following that, Jorge and Mike will share more insights on the quarter. We stand out in the industry due to our consistent strategy during both favorable and challenging times, along with our unwavering commitment to creating intrinsic shareholder value throughout all phases of the aerospace cycle. Here are a few key reasons for our confidence in this approach: approximately 90% of our net sales come from unique proprietary products, and most of our EBITDA is generated from aftermarket revenues, which usually have significantly higher margins and offer relative stability during downturns. Our long-term strategy is clear: we own and operate proprietary aerospace businesses with substantial aftermarket content. We employ a straightforward, established, value-based operating model. Our organizational structure is decentralized, and we have a unique compensation system closely aligned with our shareholders. We pursue acquisitions that align with this strategy and where we can foresee private equity-like returns. Additionally, our capital structure and allocation are essential components of our value creation strategy. Our enduring goal is to offer our shareholders returns similar to private equity while maintaining the liquidity of a public market. To achieve this, we concentrate on value creation details as well as prudent capital allocation. As highlighted in our earnings release, we experienced a strong start to fiscal 2023 and have raised our guidance for the year. We are observing a recovery in the commercial aerospace market. Our Q1 results indicate positive growth compared to the same period last year. We are optimistic about the ongoing recovery in the commercial aerospace sector, as demand for travel remains strong. International air traffic is nearing recovery levels seen in domestic travel, and China resumed air travel in January after lifting pandemic restrictions. However, the industry still has progress to make, as our results are negatively impacted when compared to pre-pandemic levels due to ongoing depressed air travel demand. For our business, we saw another quarter of robust growth in total commercial revenues and bookings. Bookings exceeded revenues across all three major market channels: commercial OEM, commercial aftermarket, and defense. We also achieved an EBITDA margin of 50% in the quarter, driven by the recovery in commercial aftermarket revenues and our disciplined operational strategy. Furthermore, we generated strong operating cash flow of nearly $380 million in Q1 and ended the quarter with about $3.3 billion in cash. We anticipate generating significant additional cash throughout the remainder of 2023. Now, regarding our capital allocation activities and priorities, they remain unchanged. Our top priority is to reinvest in our businesses, followed by pursuing accretive M&A, and then returning capital to shareholders through share buybacks or dividends. While paying down debt is a consideration, it seems unlikely at this time. We continuously assess all our capital allocation options. As previously mentioned, we concluded the quarter with a substantial cash balance of about $3.3 billion, providing us with ample liquidity and financial flexibility to address a range of potential capital needs or opportunities in the foreseeable future. In terms of M&A, we are actively seeking opportunities that align with our model. Acquisition activities are ongoing, and we have a solid pipeline of prospects, primarily in the small and midsize segment. While I can't predict specific closings, we are confident that we have ample opportunities for acquisitions that fit our portfolio. The M&A and capital markets are inherently unpredictable, especially in the current environment. Now, moving to our outlook for fiscal 2023. As noted in our earnings release, we are increasing our full fiscal year 2023 sales and EBITDA guidance by $65 million, reflecting our strong first quarter and expectations for the rest of the year. Our forecast assumes continued recovery in our primary commercial end markets for fiscal 2023 with no new acquisitions or divestitures. Our updated revenue guidance midpoint is $6.155 billion, representating an approximate 13% increase. Regarding growth rate assumptions for our market channels, we are adjusting the full-year growth rate for the commercial aftermarket to the high teens percentage range due to our strong first quarter results. This is an increase from our previous guidance of mid-teens. We are not updating the market channel growth rate assumptions for commercial OEM and defense as the underlying market fundamentals remain unchanged. We continue to anticipate commercial OEM revenue growth in the mid-teens percentage range and defense revenue growth in the low to mid-single-digit percentage range. The midpoint of our EBITDA guidance has now risen to $3.11 billion, representing an approximate 18% increase, with an expected margin of around 50.5%. This includes about 50 basis points of margin dilution attributed to our recent DART Aerospace acquisition. We expect EBITDA margins to increase as the year progresses. The midpoint of our adjusted EPS is now projected at $22.17, up about 29% primarily due to the higher EBITDA guidance. Mike will delve into more fiscal 2023 financial assumptions and updates shortly. As the year unfolds, should the positive trends in the commercial aerospace recovery, including the increase in flight activity in China, continue, we may revise our guidance upward. We believe we are well-positioned as we move further into fiscal 2023. We will closely monitor the developments in aerospace and capital markets and respond as necessary. On the organizational front, I want to announce the retirement of Halle Martin, our General Counsel, Chief Compliance Officer, and Secretary. Halle has been an integral part of our team since 2012, having previously served as outside counsel. Jes Warren has been promoted from her role as Associate General Counsel to take on this important position as part of our succession planning. Thank you, Halle, for your invaluable guidance and dedication to TransDigm. In conclusion, I am very pleased with the company’s performance this quarter and during the overall recovery of the commercial aerospace sector. We are committed to our value drivers, cost structure, and operational excellence. Now, I will turn it over to Jorge to discuss our recent performance and other relevant matters.

Thanks, Kevin, and good morning, everyone. I'll start with our typical review of results by key market category. For the balance of the call, I'll provide commentary on a pro forma basis compared to the prior year period in 2022. That is, assuming we own the same mix of businesses in both periods. The market discussion includes the May 2022 acquisition of DART Aerospace in both periods. DART has been included in this market analysis discussion since the third quarter of fiscal '22. In the commercial market, which typically makes up close to 65% of our revenue, we'll split our discussion into OEM and aftermarket. Our total commercial OEM revenue increased approximately 20% in Q1 compared with the prior year period. Bookings in the quarter were strong compared to the same prior year period and solidly outpaced sales. Sequentially, the bookings improved almost 15% compared to Q4. We continue to be encouraged by build rates steadily progressing at the commercial OEMs and the strong demand for new aircraft. However, ongoing labor instability and supply chain challenges across the broader aerospace sector present risks to achieving OEM production rates. Now moving on to our commercial aftermarket business discussion. Total commercial aftermarket revenue increased by approximately 31% in Q1 when compared with the prior year period. Growth in commercial aftermarket revenue was primarily driven by continued strength in our passenger submarket, which is our largest submarket, although all of our commercial aftermarket submarkets were up significantly compared to prior year Q1. Sequentially, total commercial aftermarket revenues grew by approximately 7% and bookings grew more than 25%. Commercial aftermarket bookings were robust this quarter compared to the same prior year period and Q1 bookings significantly outpaced sales. Turning to broader market dynamics. Global revenue passenger miles remained lower than pre-pandemic levels, but have continued to steadily trend upwards over the past few months. Airline passenger demand remained strong throughout the fall and holiday season. IATA currently forecast calendar year '23 air traffic will be within about 15% of pre-pandemic. The recovery in domestic travel continues to be stronger than international travel, although international traffic is catching up. In the most recently reported IATA traffic data for December, global domestic air traffic was only down 20% compared to pre-pandemic. For the U.S., domestic travel in December was within 10% of pre-pandemic levels. Domestic travel in China continued to lag other major air traffic regions and was down about 55% compared to pre-pandemic. However, the lifting of COVID restrictions and the reopening of China to international travelers bodes well for air traffic growth. Roughly a year ago, international travel globally was depressed about 60%, but in the most recently reported IATA traffic data for December, international travel was only down about 25% compared to pre-pandemic levels. International traffic in North America and Europe were within 5% and 15% of pre-pandemic, respectively. Asia Pacific International travel was still down about 50%, but should improve subsequent to the January reopening of China. Global air cargo demand has continued to pull back over the past few months. As of IATA's most recent data, December was another month in which air cargo volumes showed year-over-year decline and were below pre-pandemic levels. The recent easing of pandemic-related restrictions in China could be favorable for air cargo in '23, but it's too early to determine. Business jet utilization has come down from pandemic highs and has continued to temper over the past handful of months. However, activity is still above pre-pandemic levels and business jet OEMs and operators forecast strong demand in the near term. Time will tell how this plays out as there is softening optimism for the business jet market due to the uncertainty within the current macro and financial environment. Shifting to our defense market, which traditionally is at or below 35% of our total revenue, the defense market revenue, which includes both OEM and aftermarket revenues, grew by approximately 3% in Q1 when compared with the prior year period. Defense bookings are up significantly this quarter compared to the same prior year period and Q1 bookings strongly outpaced sales, which bodes well for future defense order activity. Impacting our defense market revenues are the ongoing delays in the U.S. government defense spend outlays. While these delays appear to be slowly improving, they do remain longer than historical average levels. Our teams are steadily making progress with the supply chain, but continue to face challenges. The lack of electronic component availability continues to be the primary focus for our teams. As Kevin mentioned earlier, we continue to expect low to mid-single-digit percent range growth this year for our defense market revenues. Lastly, I'd like to wrap up by stating how pleased I am by our operational performance in this first quarter of fiscal '23. We remain focused on our value drivers in meeting increased customer demand for our products. With that, I'd like to turn it over to our Chief Financial Officer, Mike Lisman.

Good morning, everyone. I'm going to quickly hit on a few additional financial matters for the quarter and then expectations for the full fiscal year. First, on organic growth and liquidity. In the first quarter, our organic growth rate was 15%, driven by the continued rebound in our commercial OEM and aftermarket end markets. On cash and liquidity, free cash flow which we traditionally define as EBITDA, less cash interest payments, CapEx and cash taxes was roughly $400 million for the quarter. We ended the quarter with approximately $3.3 billion of cash on the balance sheet, and our net debt-to-EBITDA ratio was exactly 6x, down from 6.4x at the end of last quarter. On a net debt-to-EBITDA basis, this puts us right at the 5-year pre-COVID average level. Additionally, our cash interest coverage ratios, such as EBITDA to interest expense are currently in line with where we've historically operated the business. We feel comfortable here given the benefit of our interest rate hedges and fixed rate debt instruments that were entered into in a lower interest rate environment. As always, we continue to watch the rising interest rate environment in the current state of the debt markets very closely. During the first quarter, we completed an extension of our nearest maturity term loan pushing the maturity date from mid-2024 out into 2027. Pro forma for this refinancing, our nearest term maturity is now 2025. As a result of this refi, our interest expense estimate for FY '23 ticked up very slightly, as you can see in today's updated interest expense guidance. Over 75% of our total $20 billion gross debt balance is at a fixed rate through a combination of fixed rate notes and interest rate caps and swaps through 2025. This provides us adequate cushion against any rise in rates at least in the immediate term. Going forward, we expect to continue both proactively and prudently managing our debt maturity stacks. Practically for us, this means pushing out any near-term maturities well in advance of the final maturity date and then also utilizing hedging instruments where we can in order to lock in the cash interest costs. As we sit here today from an overall cash liquidity and balance sheet standpoint, we think we remain in good position with adequate flexibility to pursue M&A or return cash to our shareholders via share buybacks or dividends during fiscal '23. With that, I'll turn it back to the operator to kick off the Q&A.

How are you anticipating the commercial aerospace aftermarket revenue to progress sequentially through the year compared to the first quarter?

I would expect much like flight activity that it should keep trending upwards. That's our expectation. We'll see if that plays out.

Okay. And you mentioned bookings ahead of shipments across the board. Do you have any quantification of that?

We've historically not given book-to-bills across the end markets, Noah, but I think it's pretty healthy growth that supports the revised guidance on revenue for today. So we feel good about hitting that healthy growth and healthy outperformance and really positive book-to-bill ratios across the end markets.

Okay. And just last one. The EBITDA guidance revision is the same as revenue at the midpoint. So it implies a 100% incremental on the additional revenue. I know it's not that simple. But can you just walk me through how the EBITDA is able to be the same as the revenue in the guidance revision?

Yes. I think, Noah, what you're seeing there is just the upsides mainly in the commercial aftermarket space, which is our most profitable end market of the 3. And then separately, some better cost performance, right? You're not typically getting 100% drop to your point, but we are doing slightly better on the cost than we expected, but that's what you're seeing there.

Kevin, you mentioned that the M&A pipeline is still looking pretty active. I was wondering if you're seeing any sign of these higher interest rates starting to impact the appetite of financial buyers?

Yes. I think we've seen some impact over the last 6 months or so. I think you see that in a general lack of activity, although we've been busy evaluating different targets. I think we see that changing, though, as there seems to be some important properties coming to market in the next 6 months or so, I think this should change. So we remain relatively optimistic as always. But I think that gives you some indication of what we're looking at in the future.

And one for Mike in related topic actually. You mentioned there's some debt due in 2025. If you were to refinance that today, what sort of interest rate would you expect to pay on that?

It's hard to say, something like what we got on the December refi, we just did a month or 2 ago. The interest rate ticked up by about 1.0% from LIBOR plus 225 to SOFR plus 325, and debt markets are a little bit better given what's come out on inflation and the Fed rate move since that December rate. So maybe you do a little bit better than that, but it's hard to say that's just a guess.

Kevin, I wanted to get your thoughts on M&A outside of A&D. Is that something you'd ever do? And if you were to do something outside of A&D, should we expect you to start small? Or could we see you start with something bigger?

Well, we don't like to speculate on that. We have studied what it would look like to acquire something outside of A&D, but we think it's best to stay focused on aerospace. There are still so many great opportunities and a number of them coming up. Like I said, in the next 6 months that keep us very focused on the pure-play aerospace and defense. For intellectual reasons and also because we may have to do one day in the distant future, we do look at other areas, but none of them have appeared interesting enough to overshadow our desire to keep growing in aerospace and defense.

Great. That's really helpful. And then for Mike, you showed some really good leverage on SG&A this quarter. I think your sales were up 17%, but SG&A was actually down. So curious if you could outline a bit what the cost mitigation efforts are that you're running there and then how SG&A might trend as we move throughout the year?

Yes. We really look at the EBITDA line historically. We've not gone back and looked and commented specifically on gross profit versus SG&A trends just because of the accounting puts and takes there. And as we think about forecasting for the year, we really look at EBITDA as defined ratio and feel good about hitting the 50.5% or maybe slightly better than we gave the guidance for today. And it's hard to comment specifically where SG&A could go for the balance of the year on a quarterly basis.

Yes. I would just add, I think, in general, as we've had and we've performed in past downturns in the uptick. We did a lot of heavy lifting with restructuring as a result of the COVID pandemic and the teams have done a nice job managing to the lower cost structure and supporting the additional demand. And I think we'll continue to do so throughout the year.

This is Josh Corn on for David. Working capital was fairly neutral in Q1. Do you still see the $150 million drag for the year?

We do. I mean, as we come back to pre-COVID levels, that's going to go in over the course of the year. It's kind of lumpy in how it happens and the progression and forecasting is tough, but we do expect that amount to go back in.

And it looks like overall aftermarket revenues were back pretty much to pre-pandemic levels. Can you give us a sense of where volumes are?

I think we're still 20% to maybe 30% off in volumes. There is still a lot of regions, as Jorge reviewed, that have not fully come back.

Nice results, and I'm sorry if you missed your opening remarks, but just on China, just kind of assumptions around what you expect there just as we get the reopening traffic picking up pretty materially, hopefully, wide-body activity comes back. Just remind us kind of the mix that we should be thinking about with China and just how you kind of incorporated that in your forecast?

Sure. I'll take that one. From our perspective, we're still in the early innings of China opening up, obviously, this past month. Our teams, as they always do, do a bottoms-up analysis and planning process as we enter any fiscal year. And there was some recovery expected baked into our forecast and our plan. We'll see how it plays out. Generally, we don't have and we don't track specific regions. We think we're fleet weighted. And obviously, it's a big market. So hopefully, that will be helpful as we progress throughout the year.

I guess just a follow-up quickly. On just the wide-body activity, could you make a comment, Jorge, just on what you're seeing regarding some of the airlines behavior on the wide-body?

Yes. I don't think we've seen much shift. Again, the opening for China international travel is pretty new. You would logically expect the wide-body usage to improve given those types of routes. But we're still, again, in the early innings of this.

In the past, you've sometimes given color on discretionary versus nondiscretionary aftermarket demand. Any color there or by channel distribution versus direct?

Yes. I think most of our revenues are on direct sales. In general, we're seeing good strength and good recovery across all of the individual submarkets.

And on the discretionary versus nondiscretionary point, we think consistent with what we've said in the past, we're mostly nondiscretionary when it comes to the commercial aftermarket bucket.

And that's where you're seeing kind of the incremental strength is in the nondiscretionary. I'm just curious like...

It's like hard to break it out...

I think we're seeing strength across the board in all of the submarkets.

Could you clarify your comment about the potential for further upward revisions in guidance as the year progresses? How much of the uncertainty is related to China compared to original equipment build rates? Can you quantify what the main sources of that uncertainty might be?

I think it's probably a big piece from China. But clearly, OEM is not performing where it was prior to the COVID outbreak. So there is room really in all of the market segments for improvement.

Yes. We have more capital than we have historically. We feel optimistic about the M&A opportunities ahead, as Kevin mentioned, and we have more than enough to operate the business effectively. However, we continuously consider our capital allocation priorities and want to ensure we have sufficient resources for possible M&A in the current market.

This is Rocco Barbara on for Seth. Now that leverage is in the 6x range that has been stated in the past to be the general ballpark range for the company, how do you think about new acquisitions and/or capital deployment moving forward? Also where would you consider returning cash again?

It's difficult to pinpoint an exact answer. As I mentioned earlier, we are continuously evaluating our capital deployment options, which we do regularly, often on a monthly basis. We aim to be strategic with our capital, ensuring we always have enough available for potential M&A opportunities. Additionally, it's important to us to be efficient with shareholders' capital, and if no suitable uses are found, we would consider returning it. Currently, our leverage ratio is approximately 6x, which aligns with historical levels seen in lower interest rate conditions. We feel comfortable at this 6x level, especially given the advantages from hedging. While it's hard to predict if we will increase leverage for a promising acquisition opportunity, it is always a possibility if it would contribute to our EBITDA. Therefore, it's reasonable to expect that, with our hedges in place and stable interest rates, we will likely remain close to the 6x range, experiencing minor fluctuations consistent with our history over the past five years. However, we do not anticipate any significant changes in our approach to leverage.

Great. Then as a quick follow-up. You had mentioned earlier that you expect EBITDA as defined margin to kind of expand as we go through this year. Should we be expecting that expansion to continue in the out years? Or are we approaching a range where the margin will begin to plateau?

We are still navigating 2023. We'll give guidance on '24 and beyond when it's appropriate. But obviously, our model is to keep expanding, keep improving our business.

I kind of wanted to take a look back at the supply chain. Obviously, there's a lot of financial stress in the lower tiers. Do you guys see that as a room for opportunity when it comes to M&A? Just kind of wanted to gauge your outlook on that.

Not really. We don't look to vertically integrate. We look to acquire phenomenal aerospace and defense businesses that we can further improve. Buying parts of the supply chain vertically integrating usually doesn't meet our criteria for highly engineered, unique aerospace components with aftermarket content, and we like to stay very disciplined in that approach. That's been the secret to our success, I think, in our M&A culture.

Just wanted to ask, how are you managing through the current labor market environment? Has attrition been manageable? Do you need additional hires to meet the growth you're anticipating this year? Or have there been any challenges related to productivity?

Yes, I'll take that. I think generally, the teams have done a really nice job. We continue to focus on CapEx and productivity. Over the last couple of years, we've been able to invest in the business, and find different automation opportunities to take labor out of the process here and there. I think in general, the labor market conditions have been improving over the last couple of months. Most teams have plans in place to support potential OE production rate increases as we're all hoping will occur. So I don't see any significant issues. And I'd say, in general terms, it's probably improved a little bit the last couple of months.

Thank you all for joining us today. This concludes today's call. We appreciate your time and have a good rest of your day.