The aerospace industry is a notoriously difficult place to build a great business. Cyclical demand, high capital intensity, and constant regulatory scrutiny make it a graveyard for compounding returns. But not for everyone. Hidden inside this complex ecosystem is one of the most remarkable compounders in market history — TransDigm.

TransDigm is a programmatic acquirer with a highly unique capital allocation approach that has delivered returns well over 30% for more than three decades.

Few companies have been as reliable in driving returns. And few companies have been able to build such a reliable and high-quality business.

And I truly believe there are good reasons that TransDigm can keep delivering outstanding results.

With that backdrop, let’s figure out whether TransDigm could be a good addition to our Intrinsic Value Portfolio!

— Daniel

TransDigm: Reaching New Highs

From McKinsey to Dominating Aerospace

TransDigm was founded in the early 1990s by two former McKinsey consultants, Nick Howley and Doug Peacock. The idea was to take a private-equity approach to aerospace. Before TransDigm, the big manufacturers in the aerospace industry were focused on the volume-and-pricing game.

Howley’s and Peacock’s idea was something new. They didn’t want to build a huge, bureaucratic conglomerate. Instead, they had the vision for a decentralized conglomerate of dozens, even hundreds, of small monopolies. They started buying small, highly profitable niche businesses, companies that dominate a specific component of an aircraft, think seatbelts.

Every single time I set foot on an airplane this year, the seatbelts were made by a company called AmSafe. It won’t come as a surprise to you that AmSafe is owned by TransDigm. If you look through an airplane part by part, you would find dozens of parts delivered by a TransDigm subsidiary.

But TransDigm is not your typical serial acquirer. It’s what investors call a programmatic acquirer. Programmatic acquirers have a disciplined, repeatable process for acquiring and improving businesses. A sort of playbook they use every time.

A vital part of TransDigm’s playbook is the “value creation model.” Get proprietary content, drive productivity, and then price for value. This is how Howley explains pricing for value:

Turns out that when you buy monopolies, you have quite a lot of pricing power. Even more so when you do it in an industry where your customers are very price-insensitive.

TransDigm produces hundreds of different parts for every part of an airplane. From the seatbelts mentioned above to cabin doors or motor parts. On average, a TransDigm product costs about $ 1,000. That’s an important detail because $1000 is immaterial to OEMs (original equipment manufacturers) like Boeing, Airbus, or the Defense Department. A Boeing 737 or the Airbus equivalent A320 can cost up to $100 million.

That’s why TransDigm can raise prices by an absurd amount each year. We are talking about price increases of up to 40% a year. These price increases and TransDigm's leverage as the sole producer of 75% of the goods it sells lead to margins that can exceed 1000%.

But when those price increases were noticed, TransDigm faced severe public backlash. It wasn’t the OEMs that revolted, but the Defense Department. Defense contracts are usually capped on the prices contractors are allowed to charge. That cap is based on what is seen as a “fair and reasonable margin.” That margin is 15%. A 2019 investigation, though, found that 112 of TransDigm’s 113 contracts with the DoD exceed that margin.

And we are not talking about a couple of percentage points. TransDigm sold parts at margins in the thousands of percent. They were able to circumvent the reporting standards and, therefore, the fair and reasonable margin, by breaking large DoD contracts into smaller, more numerous contracts. As a result, TransDigm no longer had to report its costs and margins.

When this was made public, it triggered an immediate political and public uproar. Lawmakers accused the company of exploiting taxpayers, and several congressional hearings were held to question its executives. Headlines labeled TransDigm the “poster child of Pentagon price gouging,” and the outrage was amplified by the small size of the parts involved. Simple screws, pins, and valves were sold to the government at many times their production cost.

Facing mounting pressure, TransDigm agreed to refund roughly $40 million in what the DoD called “excess profits.” The company maintained that its pricing was fully compliant with federal acquisition rules and that none of its actions were illegal. Still, the episode cemented its reputation as one of the most aggressive and unapologetic operators in the defense supply chain — a company willing to test every boundary of what regulators define as “fair and reasonable.”

Charlie Munger was once asked about the pricing of TransDigm and answered the following:

It’s hard to disagree with him on the defense contracts. If my tax dollars went to screws sold at a 1000% markup, it would feel sickening. However, it’s important to understand that TransDigm’s monopolies are not entirely built on government regulation.

Moat and Competitive Advantages

And that’s a crucial point. There’s an important distinction between government-granted monopolies and natural monopolies, and it helps explain why TransDigm’s dominance has lasted so long. A government-granted monopoly exists when regulation explicitly limits competition. Think of a utility company that’s awarded an exclusive license to serve a city. In those cases, the barrier is legal rather than economic, and regulators can usually intervene to cap prices or dictate returns once profits rise too high.

TransDigm’s monopoly power, by contrast, is largely natural, despite substantial regulatory benefits. One of the biggest benefits is the FAA regulation on aircraft designs and the aftermarket. Once an aircraft is designed by an OEM and the FAA accepts the design, no part can be changed later on.

So when TransDigm sells the seatbelts, cabin doors, and parts of the motor for that aircraft design, the OEM has to go back to TransDigm every time one of those parts needs to be replaced. That’s where TransDigm makes its margin, and that’s what makes the business so predictable and durable. It’s almost like a subscription business.

The aftermarket accounts for about 1/3 of TransDigm’s revenue but 75% of its adjusted EBITDA (TransDigm calls it EBITDA as Defined; we talked about it more in the podcast). Most manufacturers actually sell the parts at a loss initially and turn profitable through the aftermarket sales.

TransDigm does not sell at a loss initially, but it also makes most of its margin later on. The aftermarket potential is one of the most important things for TransDigm when considering what companies to acquire. Besides that, acquisition targets should manufacture proprietary products and be the sole producer.

Those characteristics are the root of TransDigm’s natural monopoly. Again, regulations help, but most of the power is in the market dynamics. The niche businesses that TransDigm acquires operate in parts of the market that are highly attractive to first movers but unattractive for new entrants.

An entrant would need to spend hundreds of thousands or even millions of dollars in R&D to design a competing product, go into production without the scale advantages of the first mover, and then try to convince customers to buy from them.

Most companies don’t even try because of the first hurdles, but the last one is an underappreciated barrier to entry as well. Entrants would encounter a problem we also know from the asset management industry. The keyword is career risk. A fund manager won’t be fired for owning Apple stock, even if it ends up underperforming. Everyone owns it, and everyone agrees it’s a fantastic company. You only get fired for taking risks with unknown or unpopular stocks that end up underperforming.

It’s similar to the relationship between the people responsible for purchasing products for OEMs or the DoD and TransDigm. No one gets fired for buying TransDigm products. They are well-known, high-quality, and reliable.

Potential entrants couldn’t even play the pricing game to convince customers to switch. If they were to undercut TransDigm, TransDigm would simply flex its muscle and lower prices until the competitor bleeds out, as they lose money selling the product.

That’s the natural moat capital-intensive, niche businesses offer to first-movers.

The M&A Playbook

But all of this is based on the premise that TransDigm continues to acquire only the highest-quality companies. Since its founding, TransDigm has completed about 100 acquisitions. Each one of them must offer a clear path to private-equity-style returns. TransDigm aims for an internal rate of return of at least 20%.

As Nick Howley put it in an interview, “If we can’t see a way to double our money in five years, we won’t do it.” That discipline has kept the company from chasing deals for the sake of growth and instead focused on high-quality, niche businesses that can compound steadily within the group.

There’s actually a list of terms that Howley never wants to hear as a justification or reason for an acquisition. On that list are terms like “synergy,” “market share,” or “diversification.”

One of the first things TransDigm does when it enters a company is to improve efficiency. Unprofitable or low-margin businesses get sold or shut down, and pricing for the core product gets renegotiated (remember: value pricing model).

Then they begin applying the same management incentive structure that every TransDigm business, including the parent company, uses. Howley is obsessed with turning employees into owners through their compensation structure.

Roughly 80-90% of the executive and manager compensation is performance-based. The fixed base salary makes up a small fraction of the package, a little more than a million dollars per year for top executives, including former CEO Kevin Stein and Executive Chairman Nick Howley.

The cash bonus ranges from 75% to 125% of base salary, adding an additional 10–15% to total potential compensation. The bonus is tied primarily to adjusted EBITDA and free cash flow. Revenue is irrelevant for the compensation, which is something I like to see.

If you look at a company involved in a lot of M&A, you don’t want management to be rewarded based on revenue growth. This could encourage them to buy mediocre businesses with poor unit economics and margins just to boost overall top-line growth.

The remaining 70–80% of compensation comes from multi-year stock option grants that only vest if two conditions are met. The first is simply time-bound. Options typically vest over five to six years, with 20% vesting annually after the first year.

Beyond that, they require that the company’s stock price increase by a specific compound annual rate or CAGR — to be precise, the options only vest if the stock compounds at a minimum of 10% a year. The full number of options vests if the stock compounds at 17.5%. I love this compensation structure. The management team makes money when you, as a shareholder, make money.

After all of this is done — improving efficiency, focusing on core products, renegotiating pricing, and implementing a new incentive structure — TransDigm’s headquarters pulls back and avoids interfering in the day-to-day business.

TransDigm is highly decentralized, so its subsidiaries are highly self-sufficient. Similar to Berkshire Hathaway. The idea behind that is to reduce bureaucracy as much as possible.

In terms of size, TransDigm focuses on small and mid-cap acquisitions. The largest acquisition to date was Esterline Technologies in 2019, at a price tag of $4 billion. Esterline was a solid-performing aerospace supplier with mid-teens margins. When TransDigm came in, they simplified the business by selling eight operating units for $1.3 billion and renegotiated pricing on the core products.

Five years after the acquisition, EBITDA margins went from 15% to almost 40%. And as you can imagine, looking at TransDigm’s stock chart, the Ester example was not cherry-picking. Of the close to 100 acquisitions TransDigm has made, not a single one was a loser, and as far as I know, every one reached the 20% threshold. At least that’s what Nick Howley claims. But looking at the returns, I believe him.

Capital Structure and Allocation

Speaking of returns, Howley also had a very unique perspective on leverage. In fact, for a PE company, that perspective might not be so unusual after all. However, for a public company, it is. Howley’s view is that there are only three factors that can increase a business's intrinsic value: you can raise the price, lower costs, or generate new business.

Now, the capital structure is where he sees the potential to amplify the intrinsic value that you generate through those drivers. The math works because of the nature of TransDigm’s cash flows. About three-quarters of its revenue comes from the highly reliable aftermarket, where margins and cash conversion are much higher than on the initial sale.

Airlines might delay new aircraft orders during a crisis, but they cannot skip maintenance on aircraft they already operate. This consistency allows TransDigm to maintain leverage levels that would be risky for most manufacturers. TransDigm targets a 6x Net Debt to adjusted EBITDA ratio, and its debt maturities are spread out over many years.

Currently, it’s right in line with that target ratio, sitting at 5.7x. And that’s after accounting for the latest $5 billion debt issuance for the new special dividend.

Yes, that’s correct. TransDigm issues billions in debt to finance special dividends for shareholders. As shown in the chart above, there have been several billion-dollar dividends over the years.

I must admit, TransDigm was the first company I ever analyzed with such a unique capital-allocation policy, but there is no arguing that it worked phenomenally well. And it’s really not like the strategy hasn’t been tested under the most severe bear cases for TransDigm. Just take the pandemic, for example. COVID has, without a doubt, been the worst possible thing to happen to the aerospace industry.

When global travel collapsed in 2020, TransDigm faced the sharpest commercial downturn in its history. Air traffic fell by more than half, major OEMs slashed production, and airlines grounded their entire fleets.

And despite all that, net sales and adjusted EBITDA only dropped by a bit more than 10% during the entire pandemic. That’s where TransDigm’s diversification also paid off. While commercial aftermarket sales plunged by more than 40% over two years, the defense business remained comparatively stable, growing its share of total sales as military procurement continued even during lockdowns.

It’s definitely an unconventional capital allocation strategy, but as long as that cash comes at a lower cost of capital than TransDigm’s retained earnings, which can be plowed back into acquisitions, then you can justify these special dividends.

Having said all that, we are no longer in the post-2008 era of zero interest rates. When older debt matures and must be refinanced, Transdigm's average interest rate will rise. You can see the impact in the rise in interest expense as a percentage of revenue. Currently, it stands at 17.5% and despite volatility here and there, the long-term trend is definitely going up.

Again, I have full confidence in TransDigm to manage this, and both the track record and the chart below show that TransDigm is far from being in a position where total debt or interest expense could get them into trouble. Currently, TransDigm earns two to three times as much as it spends on interest.

Future Growth Prospects

We love researching companies that have a track record of outperforming the market because, as you know, “turnarounds seldom turn.” Great companies tend to stay great, and bad companies, well, they tend to stay that way.

However, we are also aware of the law of large numbers. A company worth $75 billion will have a much harder time generating a 35% IRR than a company worth $75 million.

So it’s even more impressive that TransDigm was able to do just that. TransDigm has achieved an IRR of 36% for over three decades. The first 20+ years, from 1993 to 2006, were the private era in which the return was 36.5%. Then TransDigm IPOed and… well, continued to return 35% a year.

But the question is, how will the next 20 years look? One clear tailwind for TransDigm is the outlook for air travel overall. The long-term chart for global air travel has essentially moved in one direction for decades, and with the growing middle class in emerging markets, it’s hard to imagine that trend reversing anytime soon.

Last year, the pandemic's impact on air travel was finally overcome, and this year, more kilometers will be traveled by plane than ever before.

Another tailwind for TransDigm is that the fleet age, so the average age of active aircraft has risen significantly in the last five years, since airlines have been slower to retire older planes because of supply-chain bottlenecks at Boeing and Airbus, delayed deliveries of new aircraft, and the need to maintain capacity as passenger traffic rebounds.

And a higher average age means thousands of aircraft are flying well beyond their original maintenance schedules, requiring more frequent component replacements across exactly the kind of subsystems where TransDigm dominates. In short, more aftermarket potential for TransDigm.

The most important thing for TransDigm, though, is to keep finding attractive businesses to acquire. Intuitively, you might think that there’s a limit to how many attractive opportunities there can be. Ultimately, there’s a finite number of parts in an airplane, and not all of them have attractive unit economics.

But I believe I can ease those fears. Global airline operating expenses are about $850 to $900 billion per year. About 15% of that is maintenance expenses. And from those maintenance expenses, TransDigm is active in 47% of the market. That leaves TransDigm with an addressable market of about $60 billion. Within that $60 billion pool, TransDigm currently captures only about 3%, or roughly $1.7 billion in annual commercial aftermarket revenue. 

So the market is still highly fragmented, with thousands of small, specialized manufacturers that are potential targets for TransDigm.

Valuation and Investment Decision

TransDigm is obviously far from cheaply valued, but that has been the case since its IPO. The company is simply much better than the average company in the S&P 500. I haven't seen any other company yet that consistently outperforms and maintains a premium valuation.

In my model, I assume revenue growth of 10-11% per year, with defense sales outpacing commercial sales. That’s slightly below top-line growth in the past 5 and 10 years, but mostly in line with the current outlook in the aerospace market and analyst expectations.

In terms of adjusted EBITDA margin expansion and the conversion of adjusted EBITDA to Free Cash Flow, I keep it with the company's goals and historic averages. So, an adjusted EBIDTA margin expansion of 1% per year and a 50% conversion to FCF. Both have been consistently achieved in the past, and the conversion tends to be even slightly higher than the targeted 50%.

What makes TransDigm difficult to model is the significant but inconsistent dividend payouts. In my model, I used a simplified approach, focusing solely on the historical dividend-to-adjusted EBITDA ratio. So, when a dividend of $1 billion was paid, how did that compare to the adjusted EBITDA in that year? I calculated the average and assumed TransDigm would pay out that dividend each year.

It’s not perfect, especially since these dividend payments are financed through debt anyway, but it’s a decent proxy. You could also model it using target leverage ratios, the Net debt to EBITDA metrics, and certain triggers that activate when the Net Debt to EBITDA ratio drops below a specific threshold. Ultimately, though, it’s a guessing game. We might see three more special dividends by 2030, or none at all if they find enough acquisition targets.

When thinking about investing in TransDigm, it’s less about the modelling exercise and more about trusting management, their capital allocation strategy, and the runway.

I was initially skeptical of TransDigm’s heavy use of debt, but after looking at how the company has weathered every kind of crisis without issue, it’s hard to argue against their approach — they’ve proven that it works.

And it’s one of the few companies where I believe they could maintain similar compounding rates despite its current size. I’m not saying I expect a 30% IRR, but I think TransDigm could continue to deliver mid-teen returns for quite some time, especially given its unique approach to paying shareholders.

It’s not a no-brainer, though, and the business is complex, so we decided to establish a starter position of roughly 2% at an average price of $1,306. Over time, we will learn more about the company and decide whether we double down or stay at 2% for now. We will also host a call in our Intrinsic Value Community about the stock soon. Perhaps the insights we get from that call can help with that decision.

For more on TransDigm, you can listen to our podcast here.

More updates on our Intrinsic Value Portfolio below 👇

Weekly Update: The Intrinsic Value Portfolio

Notes

• New Addition to the Intrinsic Value Portfolio:

  • A couple of weeks ago, I covered Copart for the show — and I have to admit, I kind of fell in love with the company’s quality. But at prices in the mid-$40s, it still felt too expensive. Fortunately, Mr. Market gave us an opportunity this week.

  • My price alert went off at $39.80, and we decided to start a 2% position. Copart is the kind of company that could eventually grow into a 5% holding for us. That said, sentiment isn’t great right now, and I’d love to add more in the mid-$30s — I know, that sounds a bit greedy, but that’s where the setup looks especially attractive. At that level, I wouldn’t be surprised to see Copart itself step in with buybacks, which would be a strong signal given how selective management tends to be with buybacks.

• Nubank has reported Q3 earnings on Thursday, and they delivered again! After successfully growing to one of Brazil’s biggest banks, the expansion to Mexico has been similarly successful. One quarter of the banked population of Mexico is now a Nubank customer!

  • Customers in Brazil are still growing at a CAGR of 38%, and the average revenue per active customer (ARPAC) is increasing at a CAGR of 20%. As you might remember from our pitch, one of Nubank’s competitive advantages has been the low cost to serve a customer. This advantage is expanding as the cost to serve continues to decline by double-digit rates.

  • The situation in Mexico is similar, only with considerably higher growth rates. The number of customers increased at a CAGR of 105% since 2021. And customer quality is high. ARPAC reached $12.5. For comparison, when the business in Brazil was at the same age, the ARPAC stood at $6.5. The increase is also due to Nubank’s improvements in customer monetization generally.

• Last week, Shawn and I were invited to speak at an investing conference in Lisbon. Of course, we had to do some sightseeing as well. So this is us exploring the history of Lisbon:

  

Quote of the Day

"One perhaps self-serving observation. I’m happy to say I feel better about the second half of my life than the first. My advice: Don’t beat yourself up over past mistakes – learn at least a little from them and move on. It is never too late to improve. Get the right heroes and copy them. You can start with Tom Murphy; he was the best.”

— Warren Buffett (from his last Shareholder Letter)

What Else We’re Into

📺 WATCH: Clay Finck pitching Interactive Brokers on We Study Billionaires

🎧 LISTEN: Stig Brodersen pitches Remitly to Tobias Carlisle and Hari Ramachandra

📖 READ: Warren Buffett’s Last Ever Shareholder Letter

You can also read our archive of past Intrinsic Value breakdowns, in case you’ve missed any, here — we’ve covered companies ranging from Alphabet to Airbnb, AutoZone, Nintendo, John Deere, Coupang, and more!

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