TransDigm Group Incorporated (TDG) Q2 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 TransDigm Group Inc. Earnings Call. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today’s conference Liza Sabol, Ma'am, you may begin.

Thank you, and welcome to TransDigm's Fiscal 2019 Second Quarter Earnings Conference Call. Presenting this morning are TransDigm's Executive Chairman, Nick Howley; President and Chief Executive Officer, Kevin Stein; and Chief Financial Officer, Mike Lisman. Before we begin, we 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. We'd 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 a reconciliation of EBITDA, EBITDA As Defined, adjusted net income and adjusted earnings per share to those measures. I will now turn the call over to Nick.

Good morning and thanks for calling in. Today, as usual, I'll start off with some summary comments on our strategy – our consistent strategy. A few comments on the second quarter and year-to-date, fiscal 2019, a quick update on the Esterline deal and few other items. Kevin and Mike will then review the business performance and the outlook for fiscal year 2019. To reiterate, we believe our business model is unique in the industry, both in its consistency and its ability to create intrinsic shareholder value through all phases of the aerospace cycle. To summarize, some of the reasons why we believe this. About 90% of our sales are generated by proprietary products and over three quarters of our net sales come from products for which we believe we are the sole source provider. Most of our EBITDA comes from aftermarket revenues, which typically have higher margins and provide relative stability in the downturns. Our longstanding goal is to give our shareholders private equity like returns with the liquidity of a public market. To do this we have to stay focused on both the details of value creation as well as careful allocation of our capital. We follow consistent long-term strategies specifically we own and operate aerospace businesses with significant aftermarket content. Second, we utilize a simple well-proven value based operating methodology. Third, we have very decentralized organization structure and a unique compensation system that is very closely aligned with shareholders. Fourth, we acquire businesses that fit with our strategy and where we see a clear path to PE like return and lastly, our capital structure and allocation of our capital are key part of our value creation methodology. Fiscal year 2019 performance continues strong with another good quarter, quarter and year-to-date revenues, our EBITDA As Adjusted dollars and TransDigm based EBITDA margins were up nicely over the prior year. Incoming orders continue strong, especially in the commercial aftermarket and well ahead of shipments across all major market segments, all boding well for the balance of the year. As you can see, we have increased our base business guidance for the year with an anticipated increase in all major markets. The revised guidance now includes 28 weeks of contribution from the completed Esterline acquisition as well as an increase in base TransDigm revenue and EBITDA guidance. EPS for fiscal year 2019 is impacted by our capital market decision to raise $4 billion of senior secured notes in order to maintain substantial near-term financial flexibility. Kevin will expand on the quarter and full-year outlook. Our liquidity is strong assuming no additional acquisitions or capital market activity we expect to have about $3 billion of cash at the end of the fiscal year. We also expect to have over 7 million of unused revolver and some additional room under our credit agreement. We continue to actively evaluate and seek M&A opportunities. We have a decent pipeline of mostly small and midsize possibilities. Again, I cannot predict or comment on possible closings but as I said before, we are still working steadily at M&A and we're still open for business. A few comments about the Esterline transaction, we closed this transaction in mid-March. As I think you know, we paid about $4 billion for roughly $2 billion in revenue, based on the public consensus information that existed at the time, about 330 million of fiscal year 2019 EBITDA was anticipated. We estimate this as about 12 times EBITDA purchase multiple of the consensus fiscal year 2019 EBITDA. As we said before, we think Esterline has been a misunderstood company, its core aerospace and defense businesses make makeup around three quarters or more of the revenue. Its core business has proprietary content and sole source positions generally similar as a percent of revenue TransDigm. The core aftermarket also appears significant. We estimate somewhere in excess of 30% of the revenues of the core business. As you know and as we discussed with the Esterline acquisition, we use an LBO model to value businesses that generally assumes we finance about half debt and about half equity. We then assume we sell the business in five years and look to get a return on our equity of 20% or more without any significant multiple arbitrage. As you know it’s a practical matter, we rarely, if ever sell them after five years. If you do the math on Esterline, this solves to a target EBITDA margin in the low-to-mid-20 range or about an 8% margin expansion. We are still working out the timing on this but it likely won't all happen in the first year. We have owned these businesses for about 55 days now and we see no reason to think that we cannot meet our purchase expectation over time and we see some indications that we may well do better. In summary, so far it appears the opportunity at Esterline is at least as good. And perhaps better than we originally thought. Kevin will discuss the integration in a little more detail. We are currently actively exploring the sale of certain Esterline assets that don't fit us well with our focus. These could recover something around $1 billion of our purchase price on a pretax basis. We'll decide whether to proceed when we get a better view of the actual prices. We have the flexibility to consider the full range of capital allocation alternatives. We will defer any other 2019 decisions on capital allocation until either late in the third quarter or the fourth quarter of fiscal 2019 and assess the overall business and capital market environment at that time. And lastly with respect to the IG report that I mentioned in last quarter. It was publicly posted in substantially the same form as we discussed in our last earning call to reiterate with no assertions of any wrongdoing and request for a $16 million approximate voluntary refund. As a follow-up to this, Kevin and I along with some other DoD individuals, have been asked to testify at the House Committee on Oversight and Reform in mid-May. The purpose is to discuss the report pricing and possible legislative or regulatory changes. Now let me hand this over to Kevin who will discuss both Q2 and year-to-date 2019 performance as well as the full year guidance.

Thanks Nick. Today I will review our results by key markets, then discuss the profitability of the business for the quarter, provide revised fiscal year guidance. Briefly update our org structure and finally give an update on the integration of Esterline. As you've seen, we had a strong quarter in the first half of the year including above average organic growth, Mike will provide more details on the financials for our second quarter operations, specifically revenue and EBITDA As Defined were up nicely over last quarter. Q2 GAAP revenues were up 28% versus prior year Q2 and EBITDA As Defined was up 24% over the prior year with margins at 48% of revenue. Now we will review our revenues by market category. For the remainder of the call, I will provide color commentary on a pro forma basis compared to the prior year period of 2018. That is assuming we own the same mix of businesses in both periods. Please note this market analysis excludes Esterline. We will begin to include the Esterline acquisition in our market analysis once we have validated the data as we have a different market segmentation process. In the commercial market, which makes up close to 70% of our revenue, we will split our discussion into OEM and aftermarket. In our commercial OEM market, Q2 revenues increased approximately 10% when compared with Q2 of fiscal year 2018, due to our year-to-date revenue growth of 11% and continued booking strength we are increasing our commercial OEM full year revenue guidance to mid-single-digits growth from our previous guidance of low-to-mid single digit growth. Please note this increased OEM guidance includes our expected impact from 737 Max groundings and shipping delays. We have done an analysis on the potential impact and conclude the Max issues should not have a material impact on our financials this year and may possibly provide upside to our commercial aftermarket in the future. A nice segue to our commercial aftermarket business discussion. Total commercial aftermarket revenues grew by just over 6% in the quarter and year-to-date, continued global revenue passenger mile growth and slower retirements of older aircraft, continue to provide a backdrop of improved market dynamics. In the quarter, commercial transport passenger growth of 9% was offset by a slowdown in the commercial transport freight submarket. Bookings coupled with our year-to-date revenue performance versus tough comps in the prior year and strong underlying fundamentals, provide us confidence in the second half of the fiscal year. We are increasing our commercial aftermarket guidance to grow high single-digits from our previous guidance of mid-to-high single digit growth. Now let me speak about our defense market, which is just over 30% of our total revenue. The defense market which includes both OEM and aftermarket revenues was up approximately 18% over the prior year quarter. Last year we reported strong defense bookings that we are now seeing materialize into sales. However, we are expecting defense sales growth to temper in the second half of our fiscal year, following this exceptionally high first half revenue growth and gradually slowing bookings. Due to the higher-than-expected year-to-date sales growth, we are increasing our defense full year revenue guidance to grow high single-digits from our previous guidance of mid-to-high single-digit growth. Moving to profitability, I'm going to talk primarily about our operating performance or EBITDA As Defined. EBITDA As Defined of about $572 million for Q2 was up 24% versus prior Q2, and this includes about $27 million for Esterline, contribution for the 17 days of ownership in the quarter. EBITDA As Defined margin in the quarter was just under 48% of revenues, this includes over 3.5 margin points of acquisition dilution from Esterline and the fiscal year 2018 acquisitions of Kirkhill, Extant and Skandia. This core margin of 51.5% excluding Esterline and other fiscal year 2018 acquisitions, improved approximately 2 points in the quarter over Q2 2018. Margin improvement progress is always important to us, it indicates that our base businesses continue to find opportunities to drive improvement within our value drivers. We continue our relentless pursuit of value generation. Turning now to 2019 guidance. We are increasing our sales and EBITDA guidance to reflect the strong first half results of our base business and to incorporate Esterline for about 6.5 months of ownership for the balance of the fiscal year. The midpoint of our fiscal year 2019 revenue guidance is now $5.44 billion, an increase of $1.25 billion, this revenue guidance is based on the revised market channel growth rate assumptions we just discussed for TransDigm’s base business, plus the inclusion of Esterline revenue, which reflects 6.5 months of ownership. The midpoint of fiscal year 2019 EBITDA As Defined guidance is now $2.35 billion, an increase of $255 million with an expected margin of around 43%. About 20% of this increase is related to performance at our base business with a remainder attributed to Esterline, excluding Esterline the full year margin is expected to be around 50%. We are slightly increasing the midpoint of our adjusted EPS guidance by $0.05 to $16.81 per share. Mike will discuss in more detail shortly. Now before I speak about the Esterline acquisition integration, I wanted to briefly update you on our organization structure. Jorge Valladares, who has been with TransDigm for over 20 years has been promoted to TransDigm’s Chief Operating Officer and he’s now responsible for all operations of the base TransDigm business. Jorge most recently served as our COO of our Power and Control segment. Now moving on to Esterline integration and expectations, the Esterline integration has been progressing to plan over the first 55 days of TransDigm ownership. To date, we have seen no material differences to opportunity identified in our acquisition model. As you know, we have an experienced team of TransDigm executives, both EVPs and group controllers engaged full time in this integration. They have been carved out so they have little or no day-to-day TransDigm responsibilities. The former corporate office in Bellevue, Washington has been closed. This should complete by calendar year end. We are phasing the workforce reductions in Bellevue to minimize disruptions and risks. In general, the platform organization structure has been eliminated and aligned with our TransDigm. Each of the former Esterline operating units have been assigned to a TransDigm EVP. And we have TransDigm group controllers assigned to these operating units to provide financial reporting support. We are now going through the process of reviewing the operating units and determining where value generation opportunities may exist. Again, no surprises have been seen in these early days. Culturally, we continue to press the concept of thinking and acting like an owner with the President and senior staff of the operating units. This supports the execution of our value generation concepts. So far so good for the integration. Although, we did include Esterline in our fiscal year 2019 guidance, we are not providing guidance beyond this fiscal year at this time, due to uncertainty around what businesses we may keep or sell. As nick mentioned, we are exploring the sale of certain assets that do not fit our strategic focus, but guidance for fiscal year 2019 assumes no assets sales. In summary, we are excited to have acquired Esterline and look forward to reporting our integration process to you in the future. We were also enthusiastic about the second half of our fiscal year as underlying fundamentals remain strong. With that, I will now turn it over to our Chief Financial Officer, Mike Lisman.

Thanks, Kevin. I'll give a quick review of the financial results and the updated guidance in more detail. First for the TransDigm base business and then second for the TransDigm plus Esterline entity. And for those following along, I'm on Slide 4 in today's deck. The following sales EBITDA and EPS comparisons exclude the impact of both the 17 days of Esterline ownership that fell into the quarter and then also the new debt financing. Second quarter net sales were up 15% versus the prior year and above average organic growth of 11% drove the majority of that increase. EBITDA As Defined increased 18% from the prior year second quarter. And our adjusted EPS for the second quarter would have been $4.63 per share, which would have been an increase of 22%. Again, the $4.63 is what adjusted EPS would have been had we not purchased Esterline, so it's a theoretical number. Now switching gears and including Esterline. Esterline contributed about $121 million of revenue and $27 million of EBITDA to our Q2. This implies an EBITDA margin of 22% which is higher than average, due to the elevated shipments level that happens at quarter end. The Esterline EBITDA margin over the last six months of our fiscal 2019 is not expected to be quite this high. On cash and liquidity, we ended the quarter with just over $2.4 billion of unrestricted cash on the balance sheet. Our forecasted cash balance at year end is just under $3 billion and that excludes any more acquisition activities, sales of Esterline assets, dividends or share repurchases. During the quarter, we completed the raising and the funding of the $4 billion of senior secured notes. We raised more debt than we needed to in order to fund the deal, as we had a relatively high cash balance already. We opted to do this because the debt came at an attractive rate and it also permitted us to keep significant cash available. With the new debt raise, our net debt leverage ratio increased from what would have been 5.2 times for the base TransDigm business at second quarter end to 6.1 times for the new pro forma entity. This change to our debt and leverage levels muddies and confuses the year-over-year EPS comparisons. And the punchline is that you don't see as much EPS growth as you do EBITDA growth because of this higher debt race. How do we not elected to do the higher debt raise and increase our net leverage? The inclusion of Esterline would have had a larger positive impact on adjusted EPS growth for the year. For example, had we taken on only $2 billion of incremental debt and financed the remaining $2 billion with cash, adjusted EPS for fiscal 2019 would have been more than one full dollar higher than the midpoint of the new guidance. Now (20:22) changes to our expected tax rates for the year. These rates have increased from the prior guidance of 21% to 23% and the increase is driven by the fact that we are over the interest deduction limitation that's part of the new U.S. federal tax law. We're now estimating our full year GAAP and cash tax rates to be about 24% to 25% and adjusted rate to be about 26%. As Kevin mentioned, we estimate the midpoint of our adjusted earnings per share to be $16.81 and this revised guidance for the year doesn't assume any sales of Esterline business units or Esterline EBITDA during the rest of the year. With that, I'll hand it back over to Liza to kick off the Q&A.

Thanks Mike. Operator, we are now ready to open the lines. But first, I just want to remind all of our investors to keep your questions to two and then please re-enter yourself back into the queue to allow an opportunity for all to ask a question. Thank you.

Hey, good morning everyone.

Good morning.

Good morning.

Esterline as a standalone had something in the zone of $70 million of corporate, give or take. How much of that hangs around with you?

Let me try it, you mean – I guess we'd try that a couple of ways, Noah. How much hangs around with us if you look out a year or so, very little. When it goes away is sort of a phasing, as Kevin talked about, because we don't want to disrupt things until we feel comfortable we're all backfilled. But I think almost everyone in the corporate office there – almost everyone in the corporate office there – almost everyone now has a scheduled out termination date.

Yes, that’s right.

Okay. And the – it looks like the margin implied for the Esterline business in the back half of 2019 in your new guidance. And if I strip out what you said was organic and then consistent with your comments, Nick, on the (22:56) percentage points of improvement, it's something in the zone of 17%. It looks like that might actually be down year-over-year based on how you're defining it. Is it? Are you assuming that, that is kind of flat to down year-over-year?

No. I don't think it's down. I think your math is directionally accurate, but I think that that's actually up from prior year.

Okay. Yes. I guess where I'm going at that is I'm looking at the 3.19 of EBITDA that you disclosed, which would be a 15.7% margin. And I know it was a pretty back-end loaded margin, so that's why I was assuming that maybe that was down or, I guess, in the zone of flat. And while I very much appreciate that a lot of the actions you will implement here will take time, and integration takes time. I would have thought there'd be some pretty quick initial upfront cost actions, and I know you guys usually take some pricing actions pretty quickly. So I was just wondering if there's something different about this that makes some of those initial upfront actions slower?

I think not any different than other acquisitions. It always takes time for the contracts to play out before you can address any pricing or cost-reduction initiatives. It does take time. And that's what we're trying to communicate here.

And I guess I might also add, Noah, that we could be – we will tend to lean on the conservative side here until we get more comfortable with the forecasting ability of all the individual operating units.

Yes. Makes sense given its size. Just one other question on it and then I'll leave it, which is you've mentioned that the opportunity set is no different than you thought initially. How does the opportunity set compare to Kirkhill? Does total Esterline have as much margin opportunity as you found in Kirkhill?

Let me – Kirkhill started negative. So surely, the – I mean just to be facetious, surely the rate of change can't be as high.

Yes. Forget rate of change, but just the absolute level you took it to.

I don't want to cut out one individual operating unit. I think I gave you about what our thoughts are on Esterline. And I think, hopefully, Noah, we gave you some sense that we – as we're into it a little bit, we think it's more likely a little better than a little worse than we thought.

Okay. Fair enough. I appreciate all the details you gave us on the prepared remarks. Thanks a lot.

Thank you. Our next question comes from Carter Copeland from Melius Research. Your line is now open.

Hey, good morning, team.

Good morning.

Just a couple of quick ones. One, with respect to the percent aftermarket that you had talked about for Esterline in the past, I think it was – you pinned that around 30%. Now that you've maybe gotten a bit of a better look, does that number change at all? And then within that number, how should we envision the split there between A and D?

What’s A and B?

What’s A and B?

Between civil and military. Sorry.

Yes. I don't know the aftermarket split, and we haven't finalized our number. I think a 30% or a little more is probably a good number. And remember, that's the core business ex after we have either dispositioned or separated out the ones that we don't think fit as well. I would say in the split there between commercial and defense, I just don't know. But it's just – not that I'm avoiding it. I just don't know what the exact split is. But I would say, in total, the defense content is a little less than TransDigm's. Not a lot less but a little less.

Okay. That’s helpful. And then with respect to the cost structure, if you exclude out Sorio or whatever those assets are, what is – how much of that cost structure that remains is European? Is that a significant number?

Do you mean how much of the businesses are European?

Yes. How much of Esterline, excluding those assets that we're talking about, when you look at how much of that cost structure is still based in Europe since that's clearly a…

A fair slot. There's still – I don't want to opine on who we are and aren't going to sell. But there's still – there's a fair number of businesses, and taking one out of it won't make it go away. There's still some decent-sized businesses that are in Europe that we'd, in all likelihood, hang on to.

Okay. All right, thanks for the color guys. I’ll let somebody else ask.

Thank you. Our next question comes from Robert Spingarn from Credit Suisse. Your line is now open.

Hey, good morning.

Good morning.

Nick, just on that last question. Can you give us anything about the targeted divestitures' magnitude, not necessarily separate businesses.

Well, I think I did give you – I gave you a rough dollar value of – the dollar value we think we might get back. And that was about $1 billion, pre- tax, if we go ahead with everything we have in the queue. Now I don't know whether we'll go ahead with that until we see the prices. But you can figure – if it works and we like the prices and if we get somewhere around what we think, we may sell up to about $1 billion.

That’s pre-tax.

Pre-tax…

Okay. And then this might be for Mike, I don't know, but with regard to Esterline EBITDA trending over time, I think you said earlier, you talked about mid-20s. You talked about the fact that the latest quarter was a bit higher than it has been for shipment reasons, shipment timing. How do we think about the cadence of margin improvement at Esterline, how long it takes and what the rate of change is there? You've said in the past, you probably don't get to TransDigm heritage margins, but how do we think about this on a two, three year basis?

I think Nick gave kind of the margin ramp at the outset, and we're pretty conservative on the internal modeling assumptions we've used. So we didn't have it going up to the levels that Nick outlined in year one, as he said. It was more over several years.

Okay. Can you put any more color around that, Mike, just to refresh us and now that you've been in the business for a couple of months?

Yes. We’ve got a lot of got a lot of moving parts with potential divestitures, and I don't want to commit to anything now, going out couple of years.

And Rob, we’ll give the – next year we’ll give the guidance, When we give it, it'll be much more specific then.

Okay. And then just a clarify. You’ve been running at 52 per month on the MAX. You haven't slowed down at all?

We have not slowed down.

Okay. Thank you.

Thank you. Our next question comes from Robert Stallard from Vertical Research. Your line is now open.

Thanks so much. Good morning.

Good morning.

A couple of questions on the core business. First of all, defense. You had a very strong first half, and you're expecting that to slow down in the second. What do you think has caused this outsized growth in the second half? And what's changed – sorry, the first half. And what's changing in the second half of the year?

Yes. We saw strong order growth in both the OEM and aftermarket in – last year. And I think that's coming out now in our shipments. We are just seeing the orderbook slowdown in both OEM and defense. Maybe it's inventory timing. We don't know of any programs or any other slowdown. So we would normally say inventory adjustments in the supply chain for that. But the slowdown is in both OEM and aftermarket as we look at that going forward from an orderbook point of view.

Okay. And then moving on to the aftermarket. I think the oil price is up about 40% or 45% year-over-year. Have you seen any of your airline customers adjusting their utilization patterns or their spares buying or anything like that based on the high oil price?

We are not seeing that we have noticed any adjustments in buying activity or patterns because of high fuel or not. We haven't seen any pattern change.

So you're still seeing the older aircraft heavily utilized, right?

Absolutely. The reports on the NG are that they've definitely ramped up usage.

Great. Thanks, guys.

Thank you. Our next question comes from David Strauss from Barclays. Your line is now open, sir.

Thanks for taking the question. So I think going back to Rob's question on this, Nick, the low to mid-20% EBITDA margins that you outlined. Were you saying that that's kind of the target that you need to get to, to hit your entire rate of return? Or that's what you think is achievable over the next couple of years.

Yes. That's what we use. That's what we use sort of the value of the business. It was running – and you can easily, as I'm sure you have, you can back into that easily enough. You know the assumptions we use. And the business was running somewhere around 15% EBITDA. And if you solved back through our math, you'd get to 23-ish or 22% to 24%. And that's all we're saying. And if we look at it, as I said, today, we see no reason to think that's not doable, and if anything, we feel, a little better. That's what we're saying.

Yes. Okay. And then the – you talked about selling potentially assets that could bring in $1 billion. How do you think about dilution there and using the cash proceeds to potentially offset the dilution from selling these assets?

We really haven't decided yet. We'll sort of cross that bridge when we come to it. We have a fair amount of cash now, and this would just make even more. And we'll decide that when we get there. I don't want to start counting the chickens before they're hatched.

Okay. You think you can get to the multiple at which these assets are currently kind of embedded at your current multiple?

I think we can, depending on the businesses. Some of them may not be the most attractive. I think we can get – when you weight it all up, I think we can get close. I doubt we can get all the way there. And by that, I'm using the multiple of the 2019 public guidance.

Got it. Okay. All right. Thank you very much.

Thank you. Our next question is going to come from Myles Walton from UBS. Your line is now open.

Thanks, good morning. First one, in terms of the Esterline versus the core business, how are you seeing bookings trending there? And if you'd look organically just at Esterline as if you had owned it in both periods, what kind of growth are you implying in the new guidance that's inclusive?

I don't have any comment on the organic growth part of the guidance. I think the orderbook looks strong. It looks as good as TransDigm does right now as a base. So we're seeing strong bookings growth on the Esterline side as well.

I think in the segments, Kevin, you don't feel comfortable yet, breaking them out yet, until we get a better analysis of that.

Because they used a different methodology to calculate aftermarket, and those differences are important to us to understand. We're going through that process right now.

Okay. But from a standpoint of mid-single-digit, it sounds like it's growing organically about the same as TransDigm right now. Probably on the units it doesn't have the benefit yet of price, is that fair?

I think, guys, until we start reporting their metrics the same way that we do ours at TransDigm, we don't want to get crossed up on this until we get it right.

Okay. All right. And Mike on the…

There is no reason to think – There's on reason to think – there's nothing we see that concerns us. That the…

That’s right.

That the business is something, flawed or…

Okay. And then, Mike, on the tax rate, this 26% implied for the second half. Is that – given you've tripped the line from a deductibility perspective, is that fair to use going forward on an adjusted tax rate basis?

As we delever, it should tick down a little bit just through EBITDA growth based on how the U.S. tax law works. But if you had to have something to plug into a model, I think 25%, 26% is probably fair, but hopefully, as we delever, it comes down.

All right. Thanks.

Thank you. Our next question comes from Ken Herbert from Canaccord. Your line is now open.

Hi, good morning, everybody.

Good morning.

Kevin, I just wanted to start off on the commercial aftermarket. And I know you've talked about this in the past, but for the base TransDigm business, the strong bookings year-to-date. Can you just remind what percent of that business you would associate as sort of book-and-ship, relative to sort of the up 20 year-to-date on bookings, relative to the sales growth and how we should think about that – how much is captured in the second half of 2019 versus what spills into 2020 and beyond?

I think we – the bulk of aftermarket business is book-and-ship. There is some of it that gets booked out in advance, but the majority of it is book-and-ship even within the quarter. So – and we gave revised guidance on the market segments that we raised to the high single digits for the commercial aftermarket. So that’s what we see coming out. We have the confidence that the orderbook is in place for the second half. And possibly some of that will translate into next year, but we'll give guidance on next year when we're ready on that. It'll take a little bit of time to pull that together, especially with the complexity of Esterline. We want to make sure that we have a good handle on the data here as we're looking at it for the first time on some of the market segmentation pieces, trying to understand where it's going. Does that answer your question? Directionally at least?

Okay. That’s helpful. Yes, directionally that’s very helpful. Yes, I mean I saw you raise guidance and the bookings were a key part of that. Are you getting a sense at the airlines that they are building any inventory? Or do you get a sense that there's any change just with the profitability at the airlines, that they've sort of reversed course from what may have been some destocking or do you sort of see inventory levels there steady? I guess, what are you seeing in the marketplace in terms of the airlines and their buying patterns and inventory?

The buying patterns are always perplexing. They go up and down quarter-to-quarter. We must have seen some destocking as we're seeing orders pick up again, larger than what you might have anticipated. So there must have been some out there. But I do not get reports – regular reports on airline stocking. I do see stocking levels at distribution. That is not up. That's somewhat flat. POS is up about 16% across the ranch for the TransDigm base company. So it would appear that there's been some destocking out there that we're seeing addressed in the booking levels for the aftermarket. That's about the extent of the intelligence I can provide on it.

That’s helpful. Great, I’ll stop there. Thank you.

Sure.

Thank you. Our next question comes from Gautam Khanna from Cowen. Your line is now open.

Yes, thank you.

Good morning.

Regarding Esterline – good morning, I was curious, on Esterline, when you look at their standalone SG&A plus R&D, as a percentage of their sales, it was just over 20%, low 20s. Is there anything structurally, now that you've owned the business, that prevents that to being – that level being closer to what TransDigm's legacy SG&A plus R&D is as a percentage of sales? Like, could it actually get down to the 12%-ish level?

I think the best thing to focus on is the EBITDA percent we give you. If you start to take out the pieces of manufacturing costs versus SG&A versus R&D, the method of accounting isn't always consistent between companies. So that you can end up with getting funny answers if you start to look at them that way. I focus on EBITDA as a present of sales then you know you captured everything.

Fair enough, I appreciate it. And then just another one, if you don't mind, on the defense side, were there any large lumpy kind of – sometimes in the past you've called out just big products in the quarter or a big order and that kind of…

Yes, we have pulled out large parachute orders, missile orders. Yes, you're right. I looked for those, and I could not find any onetime, large orders on the defense side. In fact, some were – yes, they just weren't there. So it was nicely spread across the business. Not a lot of big onetimes for a certain program.

Thank you very much guys.

Thank you. Our next question comes from Sheila Kahyaoglu from Jefferies. Your line is now open.

Thank you guys. So I wanted to go back to Esterline. Nick, you've been pretty clear you target a 20% IRR, which means…

I can't hear you very well, Sheila.

Can you hear me better?

Okay. But you’re…

Okay…

It’s very faint – faint, yeah…

I promise I'm yelling. So in terms of Esterline, you guys target 20% returns, which means 22% EBITDA margins. I mean just going back to it, and I apologize I'm parsing this apart, but you strip out the corporate from Q2 2018 EBITDA and margins are still up 700 basis points to 800 basis points year-over-year. I get it you've only owned it for 17 days. So perhaps, outside of corporate, what's really changed since you've owned this asset?

Sheila, I just don’t follow the math. So I don't – I can't.

I guess you only owned it for – you only owned the asset for 17 days, and margins are still up…

I think, Sheila, the margin you're seeing in the 17 days of ownership was an elevated shipment towards quarter end. So you're getting – you're seeing it at higher EBITDA margin than you would over a longer time horizon because of the elevated…

Yes. So it's just the lumpiness of that and then you get…

Exactly…

Yeah, I wouldn't use that as a base. I would use the EBITDA that it was running when we bought it, which was somewhere around 15, 15.5-ish…

Okay. And then just on the core business with the commercial OE up pretty strongly. How do we think about transport versus business jet for the second half of the year? Thank you.

I think both seem reasonably strong on the commercial OE side. So both are seeing decent sales bookings in both business jet and commercial transport.

Is there one specific platform in biz jet that's driving the, I think, 20% growth or broad based?

I don’t have that. I can get you that. I think it’s…

No worries.

It’s indicative of the industry as a whole. I didn't call out anything on business jet as it's kind of small. But I think we've seen strength in the large platforms on business jet, really, across the board. Somewhat surprising, I guess given the dynamics of the industry takeoff and landing cycles. So remain cautious on business jet and the platforms, but the orders are coming in.

Okay, well, thank you.

Sure.

Thank you. Our next question comes from Seth Seifman from JPMorgan. Your line is now open.

Thanks very much and good morning.

Good morning.

I wanted to touch on the base business and just the EBITDA rate – quarterly EBITDA rate for the second half of the year. It doesn't really seem like it's much improved versus what you just put up in the second quarter. And given the increase, the acceleration you're looking for in commercial aftermarket. Just wondering if you could address that and whether there's potential for upside or what might be weighing on that sequential improvement.

I think we're being conservative. I think a little bit conservative there. Mike is nodding his head at me. I don't know what else to say beyond that. We raised the segment pieces. The orderbook is strong. The second half will come in. Mike, do you have anything else to add on?

Yeah, I think, Kevin hit it. It could be conservative.

And you also have bench we expect that to…

Yeah, that’s right. The defense – we have commented, Liza's correct. We have commented that we're expecting the defense business to moderate slightly so that'll have an impact, subtle. But so that's where we came up with the margin mix for the second half.

Sure. And then as a follow-up, Mike, did Esterline have long-term loss-making contracts? And if so, if those got stepped up in purchase accounting, how do you account for those earnings and adjustments?

Yes, under purchase price accounting rules, we have basically nine months to sort that outpost acquisition. So we're working through that stuff now.

Right, but do you anticipate adjusting it out?

We don’t know yet. We’re working through it.

Okay. Well, thank you.

Thank you. Our next question comes from Robert Spingarn from Credit Suisse. Your line is now open.

Hey, guys. Can you hear me?

Yes.

Okay, just wanted to go back to the defense comments that you made earlier on the investigation, et cetera. Could you just remind us of your direct and indirect exposure or channels on the military business so that we can just have an understanding of the context for this?

Yes. Our direct – our sales to the U.S. government depending on the year, run somewhere between 6% and 8% of our total revenue. And that's a combination of direct or through distributors. So let's say seven for kind of the middle ground. If you took seven, it's – I want to say it's roughly five direct and two through distributors.

Okay. Thanks for the clarification.

That's after the – it's about the same. Yes, it's pretty close to what it was when we did – when we talked about this a lot a year and a half ago.

Well, and that’s I brought it up because if there are going to be some changes to how maybe some of this business is conducted – and I don't know if you can elaborate on any of that. I just wanted to understand how much of the business it could impact?

So you have the idea. What if any changes there are, I have no ability, Rob, to speculate on that or I think those tended to be lengthy processes…

Understood...

Yes, I think that's the key. It's a lengthy process.

Right, thanks guys.

Thank you. Our next question comes from Jason Rodgers from Great Lakes Review. Your line is now open.

Yes, I think last quarter you mentioned some softness in the discretionary interiors market. I'm wondering if you saw the growth rebound in that market and just discuss the condition there.

Yeah, we did a little bit. Still, I would say in general the interior side is just doing okay. It's just not a glowing bright light for us, but it's doing okay. In the quarter, our transport, commercial transport submarket was – did well. I think I said 9%. Interiors, okay. Freight was the low one, though. That's what brought the composite down to 6% for the whole. And that was somewhat anticipated. We've seen the slowdown in the freight market for a little while. So it was somewhat anticipated that we would start to see things back off there.

And is it possible to provide an estimate or a range for what you think the intangible amortization expense may be for fiscal 2019?

I think we've put a chart of our best guess in the slide deck for today. I think its Page 17. And that’s subject to change due to purchase price accounting.

Okay, thank you, got it.

Thank you. And we have a follow-up question from Noah Poponak from Goldman Sachs. Your line is now open.

Hey, have you quantified the year-to-date bookings growth in the defense business the same way you did the over 20 in the commercial OEM, commercial aftermarket?

Yes, we haven’t – I think we haven't said that.

Do you have that number?

No, we haven’t said that. No…

The cat ate that one though, we can't find it.

I think we – in the quarter, we have seen bookings in the defense come down in the second quarter. And we're slightly better than flat year-over-year now. So bookings have definitely come down from where they were which was high-teens in the first quarter, now were just up a little bit, not flat up a little bit, but the order book has definitely cooled off on the defense side.

So the mid-teens organic and the first half you're clearly saying not sustainable in the back half, how should I think about high single for the year being sustainable or not beyond 2019?

Hi, sorry. No, high-single-digit organic growth for the whole business, you mean?

Yes, for the defense business.

No. Can you repeat your question?

Yes, I guess what I'm wondering is, you've had three quarters in a row here of a double digit growth rate organically in the defense business, the orders were outpacing that, they've slowed, but the end market is still a pretty supportive and it looks like multiple pieces of the end market that are more specific to your business are growing faster than the total end-market. So I'm trying to triangulate all of that into thoughts on sustainability of growing that business, high-single-digits annually beyond 2019.

I think given the order book slow down, I would think that, that would be difficult to think that that's going to continue to grow at that pace into next year. It might, but I haven't formulated next year's guidance thoughts yet. But we still have some time to see how the rest of the year comes in. The defense bookings tend to be longer term than other business segments that we have. We've talked about that in the past, that bookings can take a very long time to come out. We saw that over the last couple of years that our bookings took a longer than folks anticipated to come out. But, as I look forward, I think carrying a high-single-digit percentage growth in defense probably will be difficult going forward. But that's, I think a standard observation for the defense business. It tends to go through cycles.

I think, I would just add on the bookings. I don't think you can draw much from a quarterly booking number in the defense world. They tend to bounce all over the place, on a year-to-date basis which might be a little longer-term and might be a little more indicative. We continue to book ahead of the shipments.

Okay. Yes,

That's another way – another way to think about it.

I guess, I could see the thought process around how single, maybe isn't very long-term sustainable in the defense market, but we have a sense for what your pricing is in that market. So the units in high single would be low-to-mid single and looks like outlays are compounding much faster than that. So that was the genesis of the question. But on the cash flow, since you have in the past quantified an EBITDA in conversion, I think you even gave a number on free cash earlier in the year, any update there now with Esterline in the numbers?

I think it doesn't change much. You notice in this quarter was lower probably and the reason that is, because of the timing for the quarters, we had double tax payments and double interest payments.

Okay. So is the right interpretation of that, there is Esterline cash flow added to the year, but it's offset by kind of non-recurring things associated with bringing Esterline in, is that what you're saying?

You are talking about getting to the $3 billion, is that right?

I'm just talking about the updated full-year 2019 cash flow forecast.

I'm sorry, I'm not sure I'm understanding your question, it's basically – I think if you back into it, we're expecting to generate about 600 million from the combined business in the back half of the year to get to the $3 billion cash balance at year-end.

Okay.

And that's close to 50% of EBITDA for the rest of the year.

Great. It would bring that conversion sub-50 for the full year though. But it sounds like that some of the items you just mentioned in the quarter…

Yes. Yes. Esterline is not going to convert as much. It doesn't change the math very much. But I think, historically, if you rack this up and gone between 46%, 47% and 50% and we don't expect that to change much going forward.

Okay. Alright. Thanks a lot.

Thank you. Our next question comes from Hunter Keay from Wolfe Research. Your line is now open.

Hi, this is Will for Hunter. How does the deal pipeline compare relative to last quarter? You mentioned taking on more debt than needed for greater flexibility. Are you seeing more or better prospects or does this suggest some other capital deployment strategies in the back half of the year?

I'm sorry, can you repeat that question?

Sure. So how does the deal pipeline compared to last quarter, you mentioned taking on more debt to finance Esterline for great flexibility. Are you seeing better prospects or more prospects out there or does this suggest some other capital deployment strategies in second half of the year?

I don't know that it's substantially different, I mean, as I said, we're still open for business and more kind of things. We'll decide that as I said later in the year, we just haven't made a determination yet.

Okay. And then just one other one, how much the underlying TransDigm gross margins improve year-over-year if we exclude all acquisitions in the slide deck you mentioned improved by a 100 basis points excluding Esterline but that includes the other acquisitions.

I think Kevin you gave …

I gave ….

3.5%

I think you mentioned 200 basis points but that was EBITDA.

Yes, that's what we gave. It was EBITDA.

Yes, we gave EBITDA.

Okay. Do you have that for gross margins?

So you'll see when we file the Q, you can find more detail on the gross profit.

Which we'll file today, right?

Thank you. Our next question comes from David Strauss from Barclays. Your line is now open.

Thanks. Do you expect to continue to disclose Esterline separately from here?

No, no. We're going to roll it into the segmentation that we have power and control, air frame and non aerospace.

Okay. And then I don't know if you mentioned this or not, if you did, I apologize. Did you talk about what the aftermarket look like sequentially? I know your comparison was a little bit more difficult this quarter versus last quarter, but what did the aftermarket looked like sequentially?

It was up.

It was up.

And the bookings were up.

It was up and the booking were up.

Okay. Any sort of percentage basis it is up?

We don't give that.

Okay.

We don’t give that clarity.

Alright, but it was up sequentially. Okay. Thanks very much.

Thank you. And I'm showing no further questions. I would now like to turn the call back over to Liza Sabol for the remark.

That concludes our call for today. We'd like to thank you all for calling in this morning.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today’s program, you may all disconnect. Everyone, have a great day.