Thank you for standing by, and welcome to the Q3 2021 TransDigm Group Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your host, Director of Investor Relations, Jaimie Stemen. Please go ahead.

Thank you, and welcome to TransDigm's Fiscal 2021 Third Quarter Earnings Conference Call. Presenting on the call this morning are TransDigm's Chairman, Nick Howley; President and Chief Executive Officer, Kevin Stein; 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 reconciliation. I will now turn the call over to Nick.

Good morning, and thanks to everybody for calling in. As usual, I'll provide a quick overview of our strategy, then a few comments about the organizational change we announced. And Kevin and Mike will give color on the quarter and the performance. To reiterate, we are unique in the industry in both the consistency of our strategy in good and bad times as well as our steady focus on intrinsic shareholder value creation through all phases of the aerospace cycle. To summarize, some of the reasons we believe this are about 90% of our net sales are generated by proprietary products, and over 3/4 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 generally have significantly higher margins and over any extended period of time, have typically provided relative stability in the downturns. We follow a consistent long-term strategy. Specifically, we own and operate proprietary aerospace businesses with significant aftermarket content. Second, we utilize a simple, well-proven, value-based operating methodology. Third, we have a decentralized organization structure and a unique compensation system closely aligned with shareholders. Fourth, we acquire businesses that fit this strategy and where we see a clear path to PE-like returns. And fifth, our capital structure and capital allocation 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 have to stay focused on both the details of value creation as well as careful allocation of our capital. As you saw from our earning release, we had a good quarter, especially considering the market environment. We are still seeing some recovery in the commercial aerospace markets. We continue to generate significant…

Thanks, Nick. I would like to take this opportunity to personally thank Nick for his counsel, support and mentorship over the last 7 years. He has made the succession planning process a rewarding experience for both of us. I look forward to continuing our work together with this fantastic team as we embrace our modified rules. Now to the business of today. As I will first provide my regular review of results by key market and profitability of the business for the quarter, I'll also comment on recent acquisition and divestiture activity and outlook for the remainder of fiscal 2021. Our current Q3 results have returned to positive growth as we are now lapping the first quarter of fiscal 2020 fully impacted by the pandemic. However, our results continue to be unfavorably impacted in comparison to pre-pandemic levels due to the reduced demand for air travel. On a positive note, the commercial aerospace industry has increasingly shown signs of recovery, with vaccination rates expanding and increased air traffic, especially in certain domestic markets. In our business, we saw another quarter of sequential improvement in commercial aftermarket revenues with total commercial aftermarket revenues up 6% over Q2. Additionally, I am very pleased that we continue to sequentially expand our EBITDA as defined margin. Contributing to this increase is the continued recovery in our commercial aftermarket revenues as well as the careful management of our cost structure and focus on our operating strategy in this challenging commercial environment. 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 in 2020. That is assuming we own the same mix of businesses in both periods. This market discussion includes the acquisition of Cobham…

Good morning, everyone. I'm going to quickly hit on a few additional financial matters. Regarding organic growth, we're now done lapping the pre-COVID quarterly comps and have therefore returned to positive growth territory. Organic growth was positive 15% on the quarter. I won't rehash the results for revenue, EBITDA and adjusted EPS, as you can see all of that information in the press release for today. On taxes, our expectations for the full year have changed. We now anticipate a lower GAAP and cash tax rate in the range of 0% to 3%, revised downward from a previous range of 18% to 22%, and an adjusted tax rate in the range of 18% to 20%. The reductions in the GAAP and cash rates for the current fiscal year are onetime in nature and were driven by the release of a valuation allowance pertaining to our net interest deduction limitation and some discrete benefits from exercises of employee stock options. Regarding tax rates out beyond FY '21, we're still monitoring potential changes in the U.S. tax code under the new administration, and we'll provide some guidance on our future rate expectations once any legislation is finalized. On interest expense, we still expect the full year charge to be $1.06 billion. Moving over to cash and liquidity. We had another quarter of positive free cash flow. Free cash flow, which we traditionally define at TransDigm as EBITDA as defined less cash interest payments, CapEx and cash taxes, was roughly $305 million. For the full fiscal year, we expect to continue running free cash flow-positive. And in line with our prior guidance on free cash flow, we still expect this metric to be in the $800 million to $900 million area for our fiscal '21 and likely at the high end of this range. We ended the third quarter with $4.5 billion of cash, up from $4.1 billion at last quarter end. And finally, our Q3 net debt to LTM EBITDA ratio was 7.6x, down from 8.2x at last quarter end. In coming quarters, this ratio should at worst remain relatively stable, but more likely continue to show gradual improvement as our commercial end markets rebound. The pace of this improvement remains highly uncertain and will depend heavily on the shape of the commercial end-market recovery. From an overall cash, liquidity and balance sheet standpoint, we think we remain in good position and well prepared to withstand the currently depressed commercial environment for quite some time. With that, I'll turn it back to the operator to start the Q&A.

[Operator Instructions] Our first question comes from the line of Robert Spingarn of Credit Suisse.

Kevin, you are still looking for EBITDA as defined margins, I think, of 44% for the year, but you had this uptick in the third quarter. I guess the year-to-date is 44%. Are you expecting the margin mix to deteriorate in the last quarter? Or is this just a little bit of conservatism?

Hopefully, we're conservative. We feel comfortable given the visibility we have right now that 44% makes sense. So hopefully, it's conservative and we'll do better. We're not anticipating anything detrimental in the fourth quarter.

Okay. And then just in the past, I think you've characterized the cost structure at about 30% labor, 50% materials and 20% other. With all the moving pieces and the cost takeout over the last 1.5 years, how, if at all, have those ratios changed on a go-forward basis?

Yes. The 30% -- I think it was 35%, 50% and 15% to be more specific. And then the -- not really any material changes. Those are the kind of percentages that stuck around for a while and it's not -- the 35% is not labor.

Okay. So which is it? Just to clarify...

About 15%, rough justice, is all other, 50%'s material and some direct costs and 35%'s overhead. And there are some labor elements in there.

But it's almost all wages and benefits.

Yes. Wages and benefits.

Yes.

Our next question comes from David Strauss of Barclays.

Mike, you talked about, it sounds like, your measure for cash generation coming in towards the higher end. What has been better than you expected this year? I guess it's working capital. But specifically within working capital, what's been better? And as we think about things continuing to improve in the next year, what do you expect for working capital?

Yes. It is namely the working capital. Specifically within the working capital buckets, we're doing better on accounts receivable, most importantly. Inventory has been a little bit of improvement as well, but accounts receivable has been the main driver. Typically, our business tracks at something like 57, 58 days on DSO days, but we're down now closer to 50. Quite a bit of working capital has come out of the business, $350 million, $400 million out of AR. Over time, as we get further into the recovery, that's going to have to go back into accounts receivable so it will be a use of cash. The pace at which that happens depends on the pace of the recovery, and we have the cash to support it and fuel that increase, of course. It's kind of a good problem to have. But it will be a $350 million to $400 million headwind as we come out of this.

Okay. And the comment around getting back to capital deployment, is that really just governed by when you get back to, call it, looks like right around 6x net leverage? Is that really the biggest governing factor at this point?

On dividend and share repurchases, I think, is what you're referring to rather than M&A. I think for now, we just want to be conservative and keep the cash that we have as we come out of the current situation that our end markets are in. And then we'll assess things real-time. On average, 6x net debt to EBITDA is where the business has operated historically. We see no rationale or reason to change that going forward. Now it's obviously elevated at 7.6x. So we'll give it some time to settle down. And then we assess the repurchase and dividend alternatives quarterly.

And options.

Okay. It looks like you're going to get back to around 6x early in calendar year 2022. Is that right?

It's going to keep ticking down. I think I don't -- future leverage levels, we haven't given guidance yet. So it's hard to say. It depends on the pace of the recovery here. But it's going to -- it should keep ticking down, as I mentioned in my comments, just as the end markets improve. Couple of [tenths of a point] quarterly.

Our next question comes from Myles Walton of UBS.

Kevin, I was wondering if you could comment on the bookings trends in the quarter. I know you said the book-to-bill was greater than 1 in aftermarket, but maybe sizing it sequentially. I think last quarter, it was up sequentially 30%. I don't know where the booking is better sequentially as well this quarter.

Yes. For year-to-date, we're up considerably. For the quarter, we are -- it can be lumpy. So you're right to say that it's a little bit off, down 7%. We were up significantly last quarter. We still are booking more than we're shipping in both quarters. So I think that's also the way to look at it.

Okay. And anything with respect to the channels you're seeing? Your distribution channels, in particular, any signs of them having inventory stocks or destocks? Or is this progressing as normally as you'd expect?

I think it's progressing reasonably normally. They're placing orders. We're filling them. They're -- distribution is a smaller part of our business than it used to be. It's somewhere below 20% of our business now. The rest of it, we handle directly in the aftermarket. And their POS, their sales to the market look similar to ours, quite frankly. So the business is performing about how we would expect. We don't offer volume-based discounts for a significant percentage of our business. So it doesn't encourage overstocking in the channel.

Okay. And Nick or Kevin, any update on the DoD IG audit?

Yes. The DoD IG audit, we look to have a rough draft this fall and a publication shortly thereafter. We still have not seen that but still anticipate -- and still, quite frankly, anticipate similar conclusions to prior audits. So that's what we see right now. We have closely worked with the DoD, the IG, in regular weekly meetings to review information data and build a working group to continue to improve our relationship with the DoD and the important players on the defense side of the house. So that's what we know so far. But yes, sometime this fall.

Our next question comes from the line of Kristine Liwag of Morgan Stanley.

In aftermarket, Kevin, can you provide more color in terms of action events that are driving the strong bookings? Are these driven by general air traffic recovery demand? Or are there specific events like aircraft coming off storage that's driving this incremental growth?

I think it has to be all of the above. We're certainly seeing whatever destocking they had come to an end. But we are seeing increased takeoff and landing cycles, which we think are important to follow this industry and certainly preparing for future capacity and needs. I think all 3 are at play here. I don't have any ability to differentiate which one is the most important, but I think they're all happening.

And on divestitures, you mentioned that you're not proceeding with that one defense divestiture. Can you provide more color on what happened there? And also, overall, how do you think about the portfolio? Do you foresee future divestitures coming up?

Yes. On the first question on the divestiture, ultimately, any divestiture for us, it just comes down to a question of value and whether or not the offer's on the table or prices which you're a seller. For us, the expectation wasn't met here, so we're happy to go on owning this business. In the early innings of the Esterline integration, we divested the pieces quickly that didn't fit us most, and we're happy to go on owning the businesses for which the value expectation just wasn't met.

And for future divestitures in terms of your portfolio, are there things that you're earmarking for potential sale?

Not at this time. As Nick said in his comments, we've now pretty much done most of -- completed most of the Esterline divestitures that we anticipated doing. And this last one, we're happy to go on owning.

Our next question comes from Peter Arment of Baird.

Kevin, Nick, Mike, nice results. Kevin, you made a comment on China just being a watch item. Maybe you could just give us a little -- what are your international kind of sales mix is or just in general, if you want to break it down by region, just domestic --

We don't break down our sales by region. It's difficult for us to tell as we sell to airlines, we -- still sell 20% or so through distribution. So it's difficult for me to tell you geographic split. Obviously, we follow the takeoff and landings, flight cycles very closely. Many of you publish different reports on that. And what we've seen recently is similar to what we saw a few months ago, China domestically will have a -- will retreat and then come back. And we're in a retreat period right now. I can only assume that's because of something COVID-related, but I don't know beyond that. So hence, why I say it's a watch item. Obviously, our visibility and knowledge of what's happening on the ground there is somewhat limited.

Okay. And just as a quick follow-up, just your liquidity continues to be very good and new cash generation. Can you talk about maybe just your appetite for on the M&A front? I know you've completed all your divestitures. Just if you're seeing much or you're having confidence of looking at any commercial aerospace deals?

We just -- we're always actively looking at the aerospace businesses, and we remain active. We're not constrained at all here. We're only constrained by good ideas, but we don't -- we just don't comment on anything that's -- anything that we're working on.

Our next question comes from Sheila Kahyaoglu of Jefferies.

Nick, congrats on the move. I like how you squeezed that in there that you're going to save TransDigm some money. So my first question is on defense. The business is 1/3 of your business, and it's growing 12%. That's pretty surprising, given what we've seen from other suppliers. Kind of can you maybe parse your defense exposure, if at all, and how you kind of expect that to trend?

Yes. We have seen solid growth in defense this year. It is obviously an important segment. We continue to look for opportunities to prune that, as you've just heard. And we're happy with our defense portfolio today. As I look forward, I think continued modest growth will be the future. I think there's enough political -- geopolitical unrest in the world that will continue this. We are also not involved in the sort of the boots on the ground part of defense. So we're on the technology, the unmanned. We're in space. I think we're on the right side of defense business to continue to grow. As I looked at our growth for the quarter, I couldn't really point to one program that was leading the day. It's nice growth across the board. Our parachutes business has been doing well. The F-35 business has continued to do well for us, but it's really across the board.

Okay. Cool. And then on commercial aftermarket, it's trending at about 65% of 2019 revenue. Correct me if I'm wrong on that stat. But do you kind of expect that to improve every quarter from here? Or does it stall out as we kind of see like hiccups in China or Asia Pac air traffic?

I would expect this to be lumpy. I would expect there to be fits and starts. I don't think you're going to have a seamless perfect growth out of this. But I still expect things to be moving in the improving direction. But it doesn't mean -- much like we say defense can at times be lumpy, we've said from the beginning that we anticipate this recovery will also be lumpy in the way we ship product.

Our next question comes from Gautam Khanna of Cowen.

I was wondering if you could elaborate on the trends you saw during the quarter and through July in the aftermarket and in commercial OE. Sort of month-by-month, where things just getting better and better, kind of how it compared to the exit rate at last quarter's end?

Things have improved. They were improving monthly, much like -- if you look at the world's global takeoff and landings, it continued to improve. Europe has come back. That's certainly driving our business on the commercial aftermarket side. Does that -- maybe refine your question.

Yes. No, that's -- I guess, I'm wondering, is it sort of broad-based across the product suite? Is it -- we talked about lumpiness. I'm just curious if there's -- was any 1 month substantial? Is there any trend to discern, i.e. April better than March, May way better than June? Like is there anything…

I don't think so. I think things are gradually improving, and the bookings are gradually improving. Within the quarter, you can get lumpiness within the quarter as well. So what we look at is our -- is flight activity continuing to ramp up, and it is. And that's what gives us encouragement for the future. We also see an order book that's up significantly year-over-year and sequentially is improving.

And are there any areas in the portfolio that are -- in the aftermarket portfolio of products that are still lagging like interiors, Schneller? I'm just curious, are you seeing certain items being bought…

We've seen some improvement from Schneller business. Sorry, we've seen some improvement from Schneller business. We've also seen some of -- our higher-volume runners have been slower on some products, some of our larger aftermarket businesses is the way I mean. But in general, it's happening across the business. I don't think we're seeing any loss of business, any loss of shipset content as we go forward. We continue to monitor the PMA and used market very closely. So anything that's happening is just timing in the marketplace and airlines picking and choosing what they're working on.

Our next question comes from Hunter Keay of Wolfe Research.

I was wondering if you talk about biz jets a little bit. You obviously have been noting it's leisure-oriented. You've been saying that now for a while. I'm kind of curious, is -- are these individually owned aircraft? Are these corporate fleets that are being used for personal trips? Is it wheels up? I mean I'm trying to get a sense for sort of how demand and usage in that market is translating to what we're seeing in the aftermarket sales for you guys.

Well, we've certainly seen an uptick in biz jet cycles, I think, up quite dramatically this last quarter. We're getting back close to the pre-pandemic levels. I think the bulk of it is still leisure-oriented, it has to be. Most of travel is leisure-oriented. I think we're starting to see some business travel mix in there. But business jet has been a bright spot, but it's a very small part of our business, I think about 15%.

Got it. Okay. And then on R&D, you saw a decent uptick last year in R&D dollar spend in fiscal '20 despite COVID. Kind of curious how much of that is sort of organic growth versus maybe incremental spend that you acquired from companies that you bought. And sort of just looking forward where you're going to prioritize your R&D dollars over the next couple of quarters.

Do you mean, Hunter, a step-up on a dollar basis or a percent of revenue basis?

No, not percentage basis. Yes, that was exactly -- is it just a function of just being bigger or also just --

On a dollar basis, it's likely a function of it being bigger. Generally, when we acquire businesses, we tend to keep the R&D in place. And so that could be what's driving the step-up that you're seeing on a dollar basis.

It's -- we run R&D through our individual businesses. So it's a function of the programs and what they do at our individual. We don't have a central R&D team, as you probably know. So this is all linked to programs and projects locally for the business.

Got it. And then sort of prioritizing going forward R&D spend, any particular areas you're going to be focused on?

It varies by individual op unit. They all decide where to invest their dollars. They run their own R&D budgets.

Yes. We'll work on good stuff. Nick is telling me we only work on good stuff. And I think he's right.

Our next question comes from Michael Ciarmoli of Truist Securities.

Maybe Nick or Kevin, is there any way to parse out what the drag currently is on the aftermarket revenues in terms of like wide-body, narrow-body? I mean, obviously, the bulk of the utilization we're seeing is still narrow-body-driven. Are you guys able to kind of give any specifics to maybe what you're seeing as you're looking at product getting pulled into distribution or what the airlines are buying? Are you seeing any noticeable pickup there? Or is wide-body still a pretty big headwind?

Yes. I assume given the takeoff and landing that it's a reasonable headwind for us. But we're market-weighted. So you have to look at what's flying. Recently, we've seen more wide-bodies flying domestic routes, A350s and 787s and the like doing longer domestic routes than they did previously. So I think as we look at the business, we've been slightly surprised that wide-body doing a little better than we thought it would given what we thought was just a narrow-body -- largely narrow-body market. So we don't have it all split out, and we don't look at it that way on a quarterly-quarterly basis. But we tend to be market-weighted here, and so we follow the takeoffs and landings.

Got it. On that takeoff and landings, it looks like through August here, there's probably some flattening on that activity and down mid-20% versus '19. You're not going to give us full guidance, but I think The Street's got probably modeled for up sequentially into the fourth quarter, 8.5%, 9%. I mean based on the trends you're seeing -- obviously, APAC going a bit backwards here. I mean, anything we should be aware of going into the quarter or next couple of quarters here?

Just on the outlook and as it refers to FY '22 guidance, I think we don't want to give guidance yet. We don't want to give guidance just for the sake of giving guidance. We think we'll give it when the market stabilizes and we feel like we can accurately predict what's to come. So for now, it's hard to give too much commentary on what the next couple of quarters will look like given the lumpiness of the recovery.

[Operator Instructions] Our next question comes from Seth Seifman of JPMorgan.

Just wanted to ask about the -- a portion of the improved gross -- adjusted gross margin and EBITDA margin, it looks like it came from an uptick in loss contract amortization. It looks like it was about $20 million in the quarter, which was a tick off from Q2. What is it that drives that? And how should we think about where it's headed?

Yes. Seth, there are puts and takes every quarter on the accounting side. You get pluses from a loss contract reserve release, but there must be a couple of minuses from reserve increases on issues that arise that go against EBITDA. This quarter, we netted to a spot that's not that different from where we typically end up every quarter. But you're right, the loss contract reserve did step up a bit. It was $20 million this quarter. Last year, same quarter was about $7 million or $8 million. So it did step up. And what drives it is, from an accounting standpoint, it's a GAAP convention. It's tied to individual loss contracts and products and based on when they ship you release the reserves.

Okay. Okay. Great. And then Kevin or Nick, do you guys think at all about the new sort of aggressive Antitrust regime that the Biden administration is trying to implement and what that could mean for capital deployment going forward?

I mean I just -- this is Nick. I just don't have any way of making any judgment on that. So I just don't want to comment. I just --

Yes. It's difficult for us to get into the political sphere. So we will react as things -- but not speculate.

At this time, I'd like to turn the call back over to Jaimie Stemen for closing remarks.

Thank you all for joining us today. This concludes today's call. We appreciate your time, and have a good rest of your day. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect