Kris,
I took a look at the booming aerospace & defense sector a year ago with interest in TDG and two other companies, i.e., Spirit AeroSystems Holdings, Inc. (SPR) and Triumph Group, Inc. (TGI}. I’ll take a crack at some of your concerns/questions and use this as an opportunity for me to revisit and reassess these companies. I go back beyond 5 years to 2008 to include the financial/credit crisis period.
1. Is the stock currently overvalued, PE is 65.
Donning my value investor hat, I am most interested in first looking at a company’s cash flow and determining if the company is creating value.
**TDG SPR TGI**
**MARGINS**
**Gross %**
2008 54.07 16.14 28.56
2009 56.38 12.19 29.24
2010 57.16 13.53 28.39
2011 54.82 11.34 23.18
2012 55.62 2.82 24.73
2013 54.54 -1.65 25.37
2014 53.43 16.00 22.63
2015 (ttm) 53.69 16.45 18.59
**Operating %**
2008 41.93 10.78 10.97
2009 44.04 7.44 12.25
2010 43.87 8.56 11.99
2011 40.39 7.32 10.81
2012 41.16 1.71 15.1
2013 38.94 - 6.11 14.35
2014 39.10 5.21 10.63
2015 (ttm) 39.41 5.80 10.01
**Profit %**
2008 18.65 7.04 5.84
2009 21.39 4.70 7.09
2010 19.75 5.25 5.23
2011 14.27 3.96 5.16
2012 19.11 0.64 8.24
2013 15.73 -10.42 8.03
2014 12.93 5.28 5.48
2015 (ttm) 13.01 5.68 5.29
**ROIC**
2007 9.84% 19.63% 7.25%
2008 10.74% 16.51% -23.34%
2009 11.34% 11.33% 8.89%
2010 11.49% 11.39% 8.58%
2011 11.33% 8.91% 9.92%
2012 11.70% 10.05% 11.37%
2013 10.97% -21.21% 10.89%
2014 12.79% 20.91% 7.39%
**05/01/15**
**ROIC** 13.27% 18.53% 6.59%
**WACC** 4.32% 12.95% 6.02%
**EVA** 8.95% 5.58% 0.57%
**P/E** (ttm) 64.70 20.30 15.50
**Forward P/E** 22.62 12.90 10.11
**P/B** (mrq) NA 4.00 1.30
**P/S** (ttm) 5.12 1.07 0.80
**P/FCF** 21.10 52.00 10.60
**FCF/share** $10.22 $3.78 $5.51
**Cash** (mrq) 1.01B 377.9M 34.18M
**Total Debt** 7.52B 1.15B 1.44B
**Debt/Equity** -501.0% 71.1% 63.5%
**Current ratio** 2.91 2.42 2.67
**Market Cap** 11.53B 7.13B 2.98B
52-wk high 226.21 52.94 72.31
5/1/15 PRICE 218.84 51.36 59.07
52-wk low 162.20 31.49 51.18
Notes: WACC is Weighted Average Cost of Capital; EVA is Economic Value Add (aka ROIC-WACC spread).
The table above shows that since 2008, among the three companies, TDG has the most potent combination, i.e., the most stable, strongest and highest margins (gross, operating and profit) coupled with a steady, consistently high Return of Invested Capital (ROIC).
On 5/1/15, TDG with a ROIC of 13% and a cost of capital (WACC) of 4% created 9 cents of pure economic value for every dollar invested. SPA created a nickel plus and TGI less than a penny. Notice that TDG created more value despite having a much higher P/E than SPR and TGI. Also, TDG’s Free Cash Flow per share is far above those for SPR and TGI.
For the sake of keeping my post short, take a look at this article, “Why TransDigm Group’s Earnings Are Outstanding,” that, although dated 2/26/13, still provides relevant cash flow analysis and considerations today.
http://www.fool.com/investing/general/2013/02/26/why-transdi…
Take note of these comments:
• Adding stock-based compensation expense back to cash flows is questionable when a company hands out a lot of equity to employees and uses cash in later periods to buy back those shares.
• Overall, the biggest drag on FCF also came from stock-based compensation and related tax benefits, which represented 9.6% of cash from operations.
My update: Stock-based compensation (aka “Non-cash equity compensation” in the TDG Cash Flow Statements) remains a large drag on FCF for fiscal years 2014, 2013 and 2012 at $26.3 million, $48.9 M and $22.2 M, respectively. I’ll comment more on this later in my post.
• Finally, the two most important points:
(1) Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company’s economic output. That’s because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.
Earnings’ unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.
(2) A Foolish final thought. Most investors don’t keep tabs on their companies’ cash flow. I think that’s a mistake. If you take the time to read past the headlines and crack a filing now and then, you’re in a much better position to spot potential trouble early. Better yet, you’ll improve your odds of finding the under appreciated home-run stocks that provide the market’s best returns.
As earslookin succinctly posted previously, paraphasing Warren Buffett: Growth rates, P/E, and PEG are attributes of value, not determinants of value. Here are some attributes.
**TDG % SPR % TGI %**
**Revenue $ M Change Change Change**
2008 714 3,772 1,151
2009 762 6.7% 4,079 8.1% 1,240 7.7%
2010 828 8.7% 4,172 2.3% 1,295 4.4%
2011 1,206 45.7% 4,864 16.6% 2,905 124.3%
2012 1,700 41.0% 5,398 11.0% 3,408 17.3%
2013 1,924 13.2% 5,961 10.4% 3,703 8.7%
2014 2,373 23.3% 6,799 14.1% 3,763 1.6%
2015 (ttm) 2,430 6,813 3,745
**Net Income $M**
2008 133 265 67
2009 163 22.6% 192 -27.5% 88 31.3%
2010 163 0.0% 219 14.1% 68 -22.7%
2011 172 5.5% 192 -12.3% 150 120.6%
2012 325 89.0% 35 -81.8% 281 87.3%
2013 303 -6.8% -621 297 5.7%
2014 307 1.3% 359 206 -30.6%
2015 (ttm) 316 387 198
**Diluted EPS**
2008 2.65 1.91 1.92
2009 3.10 17.0% 1.37 -28.3% 2.65 38.0%
2010 2.52 -18.7% 1.55 13.1% 2.04 -23.0%
2011 3.17 25.8% 1.35 -12.9% 3.16 54.9%
2012 5.97 88.3% 0.24 -82.2% 5.41 71.2%
2013 2.39 -60.0% -4.40 5.67 4.8%
2014 3.16 32.2% 2.53 3.91 -31.0%
2015 (ttm) 3.37 2.75 3.79
Most of TDG’s recent revenue growth can be attributed to what TDG calls “strategic” acquisitions. The purchases of Airborne Systems and Elektro-Metall were responsible for about three-quarters of TDG’s sales gains for Q1 2015. At the 1/27/15 Q1 Earnings Call, CEO Nick Howley related the following:
With respect to financial capacity, we have a little over $1 billion of cash, roughly $400 million in unrestricted undrawn revolver and additional capacity under our credit agreement. We ended the quarter with a net leverage of 5.9 times EIBTDA, well below our credit agreement limit. At 12/27/14, or the end of the quarter, based on current capital market conditions, we believe we have adequate capacity to make over $2 billion of acquisitions without issuing additional equity. This capacity grows as the year proceeds. This does not imply anything about acquisition opportunities or anticipated acquisition levels for 2015. We did not purchase any additional shares in Q1.
Subsequently, TDG pursued the following buys: Telair Cargo Group for $725 M; aerospace business of Franke Aquarotter for $75 million in cash; and the aerospace business of Pexco LLC for $496 million in cash.
2. Large Debt, is it the nature of the business?
TDG’s negative Debt/Equity ratio appears shocking when compared to SPR and TGI. Here’s what I’ve found for TDG:
LT DEBT EQUITY
2000 $ 1.77 B $ 0.59 B
2011 3.14 B 0.81 B
2012 3.62 B 1.22 B
2013 5.73 B (0.36 B)
2014 7.47 B (1.55 B)
As mentioned above, TDG with positive cash flows is on an acquisition binge, leveraging at 5.9 times EIBTDA, which is aggressive. Since I’ve only taken a quick look, I need to dig further here. I usually can find explanations for a company’s capital strategy and debt management in their quarterly and annual reports, earnings call transcripts and investor presentations, but so far nothing for TDG.
3. High stock-based compensation
Thanks for bringing up this very important issue that is not unique for TDG. It’s an ongoing growing trend across corporate America that should alarm stock investors because companies are moving away from value creation to value extraction. TDG’s allocation of corporate profits to stock buybacks and those handsome dividends paid in 2013 and 2014 diminish the amount for investments in productive capabilities and higher wages for employees. My quick look at the capital deployment of TDG, SPR and TGI shows buybacks at the top of the list, followed by dividends, and next mergers & acquisitions as opportunities.
Here’s some food for thought - an informative comprehensive article on this issue in the Harvard Business Review, Septermber 2014, Profits Without Prosperity by William Laxonick.
https://hbr.org/2014/09/profits-without-prosperity
Five years after the official end of the Great Recession, corporate profits are high, and the stock market is booming. Yet most Americans are not sharing in the recovery. While the top 0.1% of income recipients—which include most of the highest-ranking corporate executives—reap almost all the income gains, good jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is not translating into widespread economic prosperity.
The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.
The buyback wave has gotten so big, in fact, that even shareholders—the presumed beneficiaries of all this corporate largesse—are getting worried. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, wrote in an open letter to corporate America in March. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.
If the U.S. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under control. The nation’s economic health depends on it.
The author calls for reforms to the system: (a) put an end to open-market buybacks; (b) rein in stock-based pay; and (c) transform the boards that determine excecutive compensation.
The Aerospace & Defense sector is experiencing an ongoing boom. My post focuses on TDG in response to the OP. The other two companies are back on keel and deserve a closer look, especially SPR that has realized a steady price gain of 63% over the recent 52-week period.
As always, conduct your own due diligence.
Regards,
Ray