TransDigm Group Incorporated (NYSE:TDG) Q2 2023 Earnings Call Transcript

TransDigm Group Incorporated (NYSE:TDG) Q2 2023 Earnings Call Transcript May 9, 2023

TransDigm Group Incorporated beats earnings expectations. Reported EPS is $5.98, expectations were $5.45.

Operator: Good day! And thank you for standing by. Welcome to the Q2 2023 TransDigm Group Incorporated Earnings Conference Call. At this time all participants are in a listen-only mode. After the speaker’s presentation there will be a question-and-answer session [Operator Instructions]. Please be advised that today’s conference is being recoded. I would now like to hand the conference over to your first speaker for today, Jaimie Stemen, the Director of Investor Relations for TransDigm. Please go ahead.

Jaimie Stemen: Thank you, and welcome to TransDigm’s Fiscal 2023 Second 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 release for a presentation of the most directly comparable GAAP measures and applicable reconciliations. I will now turn the call over to Kevin.

Kevin Stein: Good morning. Thanks for calling in today. First I’ll start off with the usual quick overview of our strategy, a few comments about the quarter and discuss our fiscal ‘23 outlook. Then Jorge and Mike will give additional color on the quarter. To reiterate, we believe we are unique in the industry in both the consistency of our strategy in good times and bad, as well as our steady focus on intrinsic shareholder value creation through all phases of the aerospace cycle. To summarize, here are some of the reasons why we believe this: About 90% of our net sales are generated by unique proprietary products. Most of our EBITDA comes from aftermarket revenues, which generally have significantly higher margins and over any extended period have typically provided relative stability in the downturns.

We follow a consistent long-term strategy specifically. First, we own and operate proprietary aerospace businesses with significant aftermarket content. Second, we utilize a simple well-proven value-based operating method. Third, we have a decentralized organizational structure and unique compensation system closely aligned with shareholders. Fourth, we acquire businesses that fit this strategy where we see a clear path to PE-like returns. And lastly, our capital structure and allocations are a key part of our value creation methodology. Our long-standing goal is to give our shareholders private equity-like returns with the liquidity of a public market. To do this, we stay focused on both the details of value creation, as well as careful allocation of our capital.

As you saw from our earnings release, we had another strong quarter. Our Q2 results ran ahead of our expectations, and we once again raised our guidance for the year. We continue to see recovery in the commercial aerospace market and trends are still favorable as demand for travel remains robust. Global domestic air traffic continues to lead the recovery, but international travel is also moving forward. China’s air traffic has expanded significantly since its reopening in January, especially domestic air travel. However, there is still progress to be made for the industry as our results continue to be adversely affected in comparison to pre-pandemic levels since the demand for air travel is still slightly depressed from pre-COVID levels. In our business, we saw another quarter of substantial growth in our total commercial revenues and bookings.

Revenues sequentially improved in all three of our major market channels, commercial OEM, commercial aftermarket, and defense. Also, bookings outpaced revenues for each of these market channels. EBITDA as defined margin improved to 51.3% in the quarter. Contributing to this strong margin is our strict focus on our operating strategy and the ongoing recovery in our commercial aftermarket revenues. Additionally, we generated about $130 million of operating cash flow in Q2 and ended the quarter with over $3.4 billion of cash. We expect to steadily generate significant additional cash throughout the remainder of 2023. Next, an update on our capital allocation activities and priorities. During the quarter we agreed to acquire Calspan Corporation for approximately $725 million in cash.

The acquisition, we are happy to report, closed yesterday May 8. Calspan has established positions across a diverse range of aftermarket-focused aerospace and defense development and testing services. Calspan has a state-of-the-art transonic wind tunnel that it utilizes to perform testing for both the commercial and defense aerospace markets. Calspan’s unique service offerings exhibit the earning stability and growth potential that are consistent with our aerospace component centered businesses. We are excited about the acquisition of Calspan and expect the business to meet or exceed our long-term value objectives. We expect the Calspan acquisition to contribute just over $100 million to our fiscal year ‘23 revenue and for the Calspan EBITDA as defined margin in fiscal year ‘23 to be just less than half of the TransDigm total company margin.

Regarding the current M&A pipeline. We continue to actively look for M&A opportunities that fit our model. As we look out over the next 12 to 18 months, we have a slightly stronger than typical pipeline of potential targets. As usual, the potential targets are mostly in the small and midsize range. I cannot predict or comment on possible closings, but we remain confident that there is a long runway for acquisitions that fit our portfolio. The capital allocation priorities at TransDigm are unchanged. Our first priority is to reinvest in our businesses. Second, to do accretive M&A. And third, return capital to our shareholders via shared buybacks or dividends. A fourth option, paying down debt, seems unlikely at this time, though we do still take this into consideration.

We are currently evaluating all of our capital allocation options, but both M&A and capital markets are always difficult to predict. We continue to maintain significant liquidity and financial flexibility to meet any likely range of capital requirements or other opportunities in the readily foreseeable future. Moving to our outlook for fiscal year ‘23, as noted in our earnings release, we are increasing our full fiscal year ‘23 sales in EBITDA as defined guidance to reflect our strong second quarter results, the recent acquisition of Calspan, and our current expectations for the remainder of the year. Please note, that as the Calspan acquisition just closed on May 8, we utilized the limited information currently available to include Calspan within our guidance.

Our preliminary expectations for Calspan will be refined as necessary over the coming months. At the midpoint, sales guidance was raised $300 million and EBITDA as defined guidance was raised $150 million. The guidance assumes the continued recovery in our primary commercial end markets throughout the remainder of fiscal ‘23 and no additional acquisitions or divestitures. Our current year guidance is as follows and can be found on Slide 6 in the presentation. The midpoint of our revenue guidance is now $6.455 billion or up approximately 19%. In regards to the market channel growth rate assumptions that this revenue guidance is based on, for the commercial OEM market and commercial aftermarket, we are updating the full year growth rate assumptions as a result of our strong second quarter results and current expectations for the remainder of the year.

We now expect commercial OEM revenue growth in the range of 20% to 25%, which is an increase from our previous guidance of mid-teens percentage range and expect commercial aftermarket revenue growth in the range of 25% to 30%, which is an increase from our previous guidance of high-teens percentage range. The commercial aftermarket has been progressing well in our fiscal ‘23 and we hope that continues. However, we aim to be conservative with this guidance as the commercial aftermarket is harder to predict with many orders being book and ship, and the advanced bookings only going out a few months or so into the future. Defense revenue guidance is still based on the previously issued market channel growth rate assumptions. We are not updating the full year market channel growth rate for defense at this time as underlying market fundamentals have not meaningfully changed.

We expect defense revenue growth in the low to mid-single digit percentage range. The midpoint of our EBITDA as defined guidance is now $3.26 billion or up approximately 23% with an expected margin of around 50.5%. This guidance includes about a 50 basis point of margin dilution from the DART Aerospace acquisition and just over 50 basis points of margin dilution from the recent Calspan acquisition. The proforma margin dilution from Calspan, meaning if we had owned Calspan for all of fiscal year ‘23 is just over 100 basis points. The midpoint of our adjusted EPS is increasing primarily due to the higher EBITDA as defined guidance, and is now anticipated to be $23.75 or up approximately 39%. Mike will discuss in more detail shortly some other fiscal ‘23 financial assumptions and updates.

We believe we are well positioned for the second half of fiscal year ‘23. We will continue to closely watch how the aerospace and capital markets continue to develop and react accordingly. Let me conclude by stating that I am very pleased with the company’s performance this quarter and throughout the recovery of the commercial aerospace industry. We remain committed to driving value for our stakeholders. Now, let me hand it over to Jorge to review our recent performance and a few other items.

Jorge Valladares: 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 discussion since the third quarter of fiscal ‘22. The recent May 2023 acquisition of Calspan Corporation is excluded from this market discussion. 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 25% in Q2 compared with the prior year period.

Sequentially, total commercial OEM revenues grew by 17% and bookings improved over 15% compared to Q1. Bookings in the quarter were robust compared to the same prior year period and significantly outpaced sales. We’re encouraged by the increasing commercial OEM production rates, while risks remain towards achieving the ramp up across the broader aerospace sector. We are cautiously optimistic that our operating units are well positioned to support the higher production targets. Now, moving on to our commercial aftermarket business discussion. Total commercial aftermarket revenue increased by approximately 38% in Q2 when compared with the prior year period. Growth in commercial aftermarket revenue was primarily driven by the continued strength in our passenger sub-market, which is our largest sub-market, although all of our commercial aftermarket sub-markets were up significantly compared to prior year Q2.

Sequentially, total commercial aftermarket revenues increased by approximately 14%. Commercial aftermarket bookings were strong this quarter compared to the same prior year period, and Q2 bookings outpaced sales. Turning to broader market dynamics, global revenue passenger miles remain lower than pre-pandemic levels, but have further progressed over the past few months. IATA recently commented that despite uncertain economic signals, demand for air travel continues to be strong across the globe, particularly in the Asia-Pacific region. China air traffic specifically has seen a significant rebound after the lifting of COVID restrictions and the reopening of China to travel this past January. The recovery in domestic travel has made great strides over the past several months, primarily due to the sharp uptick in domestic air traffic in China.

In the most recently reported IATA traffic data for March, global domestic air traffic was only down 1% compared to pre-pandemic. Similarly, U.S. domestic travel in March was also only 1% below pre-pandemic levels. Domestic travel in China was down about 3% in March compared to pre-pandemic, which is a significant improvement from being down 55% only three months ago in December. International traffic also continues to improve, but at a slower pace than domestic. Approximately a year ago, international travel globally was depressed about 52%, but in the most recently reported IATA traffic data for March, international travel was only down about 18% compared to pre-pandemic levels. International traffic in North America and Europe were within 3% and 14% of pre-pandemic levels respectively.

Asia-Pacific international travel was still down about 36%, but should hopefully continue to improve as the China reopening progresses. Global air cargo volumes in the most recent March IATA data continued to be lower year-over-year and versus pre-pandemic levels. With the continued growth in passenger flying, especially the wide-body recovery, there’s more belly hold space available for cargo transport. The reopening of China has been positive for the air cargo outlook, but global trade signals continue to be mixed. It’s too early to determine where air cargo trends stabilize. Business jet utilization is below the pandemic highs in 2021 and continues to moderate. Business jet activity does remain above pre-pandemic levels, and business jet OEMs and operators forecast strong demand in the near term.

We’ll see how this normalizes over the upcoming months. Now, 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 5% in Q2 when compared with the prior year period. Sequentially, total defense revenues grew by approximately 14%. Defense bookings are up this quarter compared to the same prior year period, and Q2 bookings solidly outpaced sales, which is a positive indicator for future defense order activity. Our defense market revenues continue to be impacted by the lag in U.S. government defense spend outlays. We continue to see steady improvement, but they still remain longer than historical average levels.

Overall, our teams have made solid progress with the supply chain, with the primary focus remaining on electronic component availability. 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 expressing how pleased I am by our operational performance in the second quarter of fiscal ‘23. We remain focused on our value drivers, cost structure, and executing with operational excellence. With that, I’d like to turn it over to our Chief Financial Officer, Mike Lisman.

Mike Lisman: Good morning, everyone. I’m going to quickly hit on a few additional financial matters for the quarter and expectations for the full fiscal year. First, on organic growth and liquidity. In the second quarter, our organic growth rate was 17.6%, driven by the continued rebound in our commercial OEM and aftermarket end markets. On cash and liquidity, free cash flow, which we traditionally define at TransDigm as EBITDA, less cash interest payments, CapEx and cash taxes was roughly $350 million for the quarter. Below that free cash flow line, we saw networking capital consume just over $220 million of cash during the quarter, as we built both accounts receivable and inventory to support the ongoing and continuing sales ramp-up on both the OEM and aftermarket sides of the business.

We ended the quarter with approximately $3.4 billion of cash on the balance sheet, and our net debt to EBITDA ratio was 5.6x, down from 6x at the end of last quarter. Pro forma for the Calspan acquisition which just completed yesterday, we have $2.7 billion of cash and a net debt to EBITDA ratio of about 5.7x. On a net debt to EBITDA basis, that puts us below the five year pre-COVID average level of 6x. Additionally, our cash interest coverage ratios such as EBITDA to interest expense, are currently in line with where we’ve historically operated and been comfortable operating the business. As always, we continue to watch the rising interest rate environment and the current state of the debt markets very closely. During the second quarter, we completed refi’s of two of our nearest maturity term loans, E&F as well as the $1.1 billion Senior Secured 8% rate note that we took on at the outset of COVID out of an abundance of caution.

The net effect is that we extended these debt maturities out from 2025 into 2028. While we ended up not needing the proceeds of that $1.1 billion insurance policy note, as we called it, to withstand the COVID downturn, we felt it was prudent to have the excess cash as we headed into those tough times. We’ll continue to operate the business with that kind of conservatism when it comes to our capital structure, in good times and bad, and expect to remain proactive and prudent. Pro forma for this note refinancing and term loan extension, our nearest maturity is now 2026. As a result of these various refinancings, we had some puts and takes on interest expense, the net impact of which is that our interest expense estimate for FY’23 kicked up slightly, as you can see in today’s updated guidance.

Over 75% of our total $20 billion gross debt balance is fixed or hedged through fiscal ‘26, and this is achieved through a combination of fixed rate notes, interest rate caps, swaps, and colors. This provides us adequate cushion against any rise in rates, at least in the immediate term. Specifically on the interest rate hedging point, you’ll see some detail on the 10-Q on new hedges that we put in place during this past quarter to extend our coverage out another year through fiscal ‘26. One special note on the cash mechanics of the debt refi’s, due to the way the timing worked, we had $1.1 billion of restricted cash on our balance sheet at quarter end, but that cash was dispersed just after quarter end in the first couple days of April when we successfully completed the retirement of the 8% bond I mentioned.

So as of today, as it pertains to our balance sheet, the restricted cash balance, as well as the amount due on that 8% debt note are both zero. 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 buybacks or dividends during fiscal ‘23. With that, I’ll turn it back to the operator to kick off the Q&A.

Q&A Session

Operator: Thank you. [Operator Instructions]. Our first question comes from the line of Robert Spingarn of Melius Research. Your line is now open.

Operator: Please stand by for our next question. Our next question comes from the line of Myles Walton of Wolfe Research. Your line is now open.

Operator: Thank you. Please stand by for our next question. Our next question comes from the line of David Strauss of Barclays. Your line is now open.

Operator: Thank you. Please hold for our next question. Our next question comes from the line of Robert Stallard of Vertical Research. Your line is now open.

Operator: Thank you. Please stand by for our next question. Our next question comes from the line of Ron Epstein with Bank of America. Your line is now open.

Operator: Please stand by for our next question. Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Your line is now open.

A – Kevin Stein: Good morning.

A – Kevin Stein: That’s not exactly I think what I was referring to and I apologize if I confused. I was simply saying there’s still 10% to 15% of missing volume if you look back to the pre-COVID levels. We don’t comment on price to that extent, so I’m just looking at from a volume point of view. We still – there is still flight activity that has not returned that we anticipate will over the coming year or so, but we don’t anticipate all the volume to return in ‘23. Some of it will fall in to ’24 we fully anticipate.

A – Kevin Stein: And again Sheila, as you know we do a bottoms-up forecasting, so we don’t give our teams expectations. We allow them to tell us and I think that has proven to be more accurate than announcements from on high.

Operator: Thank you, Sheila. Please hold for our next question. Our next question comes from the line of Ken Herbert of RBCCM. Your line is now open.

A – Kevin Stein: I want Jorge to take that one.

Operator: Thank you. Please stand by for our next question. Our next question comes from the line of Gautam Khanna of TD Cowen. Your line is now open.

Operator: Thank you. Please stand by for our next question. Our next question comes from the line of Peter Arment of Baird. Your line is now open.

A – Kevin Stein: Good morning.

A – Mike Lisman: Good morning.

Operator: Thank you for your question. Please hold for our next question. Scott Deuschle with Crédit Suisse, your line is now open.

Operator: Thank you for your questions. Please hold for our next question. Our next question comes from the line of Seth Seifman of JPMorgan. Your line is now open.

Operator: Thank you for your question. Please stand by for our next question. Our next question comes from the line of Michael Ciarmoli of Truist Securities. Your line is now open.

Operator: Thank you for your questions. Please stand by for our next question. Our next question comes from the line of Kristine Liwag of Morgan Stanley. Your line is now open.

Operator: Thank you for your question. At this time, I would now like to turn it back to Jaimie Stemen for closing remarks.

Jaimie Stemen : Thank you all for joining us today. This concludes the call. We appreciate your time and have a good rest of your day.

Operator: Thank you for your participation in today’s conference. This concludes the program. You may now disconnect.