Price Dictates Questions

It’s been an interesting couple months in the market. While the blog has been quiet, the market certainly hasn’t. Thankfully, the portfolio emerged unscathed. In fact, it’s arguably the best it’s ever been.

We added TransDigm as a core holding. Most of the position was added between 3/16/20 and 3/20/20. We initiated a position and quickly took it to 10% of the portfolio at cost. In retrospect, 10% may have been too small but it would take a truly exceptional opportunity to purchase more than 10% at cost.

TransDigm, at that time, was one of the easier additions to the portfolio I’ve ever made. Investors appeared worried TransDigm might have covenant problems, which brought the possibility of bankruptcy into play. Those fears were misplaced as TransDigm’s covenants only “sprung” when TransDigm drew more than 35% of it’s revolving credit facility. As of 3/16/20, it was pretty clear that TransDigm could survive for at least 1.5 years without tapping at least 35% of the credit facility.

Investor fear wasn’t completely unwarranted (though it did lack nuance) as TransDigm runs a highly leveraged strategy supplying parts to the aerospace industry. Aerospace was one of the hardest hit industries from COVID-19. While many were, and some remain, concerned that travel would be permanently altered by COVID-19 that concern is misplaced. At worst, a recession would potentially impair the long term growth rates in travel. But the desire to travel is highly unlikely to disappear. Just look at history.

At a ~$15.5Bn valuation the free cash flow yield to equity, on a normalized basis, appeared to be ~6-7%. Not screamingly cheap in absolute terms, but pretty solid considering:

  • near 0% interest rates,
  • potential upside from additional efficiencies from the Esterline acquisition
  • future acquisitions
  • the quality of the company.

People will push back on business quality. The most common criticism involves TransDigm’s “aggressive” pricing. That criticism has an element of truth to it but seems far closer to convenient criticism than reality. Yes, TransDigm increases the prices of some parts when they acquire companies. Yes, those parts generate absurd margins when viewed in isolation. However, people need parts and low volume parts need to cost a lot in order to justify production. That’s true in every industry. For instance, there are businesses that warehouse odd bolts, screws, and springs in order to sell them to refineries for thousands of dollars per bolt, screw, and/or spring.

While that may seem crazy to some, it’s also how business works. I’d rather partner with the people smart enough to find those opportunities than complain about them existing. After all, we live in the world that exists not the one we think “should” exist.

The most difficult question to answer was whether TransDigm would be able to refinance its debt maturities. A large portion of the company’s debt is due in 2026. The company’s ability to refinance that debt will be a function of whether (a) travel returns by 2023/2024 and (b) (1) the rate environment and (2) why rates are where they are.

It’s important for travel to return, or begin to trend in that direction, by 2023/2024 because lenders are going to want to see solid trends to refinance into. As stated, it’s highly likely that travel substantially returns. Thus, we are comfortable accepting the refinancing risk despite it introducing a potential total loss to the equation.

As of this writing, TransDigm’s stock increased ~70% from our cost basis. To be sure, today’s price might be insanity. In fact, we trimmed a bit of the exposure on 6/5/20 as Transdigm became 13% of the portfolio and the quoted price gives your manager indigestion. That said, TransDigm will remain in the portfolio regardless of quoted prices. It will leave the portfolio only if travel doesn’t return. Consequently, we look forward to a long partnership with TransDigm.

In conclusion, today’s buyers need to have much more nuanced views of when travel will return, how many acquisitions TransDigm can accomplish, and whether the company can increase pricing. Those are much tougher questions to answer. Thankfully the panic sellers helped us avoid those hard questions. Price dictates due diligence and the market rewards patience. Try to avoid the difficult questions by swinging big when you see the easy ones.

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