Liza Sabol - TransDigm Group, Inc. Nick Howley - TransDigm Group, Inc. Kevin M. Stein - TransDigm Group, Inc. Terrance M. Paradie - TransDigm Group, Inc..

Carter Copeland - Barclays Capital, Inc. Ken Herbert - Canaccord Genuity, Inc. Bill Ledley - Cowen & Co. LLC Matthew C. Akers - UBS Securities LLC Myles Alexander Walton - Deutsche Bank Securities, Inc. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Seth M. Seifman - JPMorgan Securities LLC Michael F.

Ciarmoli - KeyBanc Capital Markets, Inc. Hunter K. Keay - Wolfe Research LLC.

Good day, ladies and gentlemen, and welcome to the TransDigm Group Incorporated Q2 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, this call is being recorded.

I would now like to turn the call over to Liza Sabol. You may begin..

Thank you. Welcome to TransDigm's fiscal 2016 second quarter earnings conference call. With me on the call this morning are TransDigm's Chairman and Chief Executive Officer, Nick Howley; Chief Operating Officer of our Power Group, Kevin Stein; and Chief Financial Officer, Terry Paradie.

A replay of today's broadcast will be available for the next two weeks. Details are contained in this morning's press release in our website at transdigm.com. 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 a reconciliation of EBITDA, and EBITDA As Defined, adjusted net income and adjusted earnings per share to those measures. With that, now let me turn the call over to Nick..

commercial aftermarket growth in the mid to high single-digits. We're still somewhat cautious, but obviously, feel better than we did 90 days ago. In the defense military revenue, growth in the low single-digit percent or slightly down year-to-date, but the strong year-to-date bookings and the strong Q2 bookings give us some confidence here.

Commercial OEM revenues, we see growth in the low to mid single-digit percent range. We're still assuming commercial transport shipments will be slightly up, but we're concerned that the biz jet shipments for the year could be flat to modestly down.

We also expect to see a modest decrease in freighter revenue for the year, based on the announced 747 rate decrease.

Without any additional acquisitions or capital structure activity, we expect to have around $1.1 billion in cash and over $400 million in undrawn revolver at year-end 2016 – excuse me, $500 million, we also have additional capacity under our credit agreement.

Assuming no acquisitions or other capital market activity, our net leverage is anticipated to be about 4.9 times EBITDA at the end of 2016 or down about one full turn. In summary, Q2 was a good quarter, as we look to the balance of the year, the market conditions are still a little unclear and that makes us cautious.

However, we think we still may have some modest margin upside to help offset any market variations. In any event, I'm confident with our consistent, value-focused strategy and a strong mix of businesses, we can continue to create long-term intrinsic value for our shareholders. And with that, let me turn this over to Kevin..

Thanks, Nick. Good morning, everyone. As Nick mentioned, in total, we had a good second quarter. As we've stated previously, we believe our planning processes, unique application of the TransDigm value drivers and our organizational focus on accretive acquisitions that meet our strategic vision are the keys to delivering shareholder value.

And as you will see, we have made appreciable progress on each of these this past year. For an update on our acquisition-related value driver, let me give you an update on the last acquisitions we accomplished. To this point, let me once again provide some color to our acquisition strategy.

As we do with each acquisition, we follow a detailed and scripted integration plan.

This includes an implementation of our value creation process and metrics, restructuring the company into our business unit focus groups, focusing the engineering and business development efforts on winnable and profitable new business and finally, we tighten up the cost structure.

For Telair, this was a significant acquisition in early 2015 for TransDigm and focuses on the defense and commercial cargo markets. Today, the acquisition is on track, on its integration path and has delivered sales and EBITDA in excess of our model.

In general, the defense market has performed well for us in this business, but the freight market may be beginning to soften. We remain confident that this is a fine business for TransDigm.

Additionally, we closed on Pexco in May of 2015, a custom plastics extrusion company located in Yakima, Washington, which specializes in proprietary commercial aerospace interior products used in the galleys, lavatories, floors, ceilings, and stowage bins of aircraft.

Today Pexco Aerospace is performing at our expectations across all key financial and growth metrics, with a strong focus on our value generation strategy. The team successfully closed and completed the consolidation of the manufacturing facility in Huntington Beach with minimal customer disruption.

While implementing a largely new management team at Pexco, we have realized better than expected productivity results with all of our manufacturing activities now under one roof. With performance on our value drivers ahead of plan, we currently are finding sales and EBITDA are additionally running ahead of plan.

We are pleased with the overall performance of the team and have confidence that the acquisition will continue to run at expectations. In August of 2015, we finalized the acquisition PneuDraulics into the TransDigm family. PneuDraulics is located in Rancho Cucamonga, California, about 60 miles east of Los Angeles.

PneuDraulics' highly engineered and proprietary products primarily are valves, actuators and subsystem components used in hydraulic and pneumatic applications. PneuDraulics serves all of the major markets in aerospace, including commercial, regional, business jet and defense markets.

We were confident when we acquired PneuDraulics that it was a solid business with an excellent management team. This has proven to be the case, as the management team has proven to be fast adopters of the TransDigm value drivers culture. The integration of PneuDraulics is going according to the plan.

The company's performance has met or beat expectations for the three value drivers of new business, productivity and value-based pricing. Although we have experienced some softness in the business jet market, the commercial aerospace market is currently holding up well and our EBITDA, driven by our value driver concept, has exceeded our expectations.

In general, we are pleased with the results and expect this business to be a solid acquisition and a good company for TransDigm in the future. Lastly, Breeze-Eastern was acquired by TransDigm on January 4, 2016. Breeze, which is located in Whippany, New Jersey, designs and manufactures mission critical electromechanical systems.

The main products consist of rescue hoists, cargo hooks and winches, primarily for rescue helicopters and cargo aircraft. Approximately 75% of Breeze revenue comes from the defense sector and approximately 70% of it comes from the aftermarket.

In the first 90 days since the acquisition, we have established a new leadership team, comprised of both existing Breeze-Eastern employees as well as experienced TransDigm personnel.

We have also taken productivity actions to better align the size of the organization with the level of business activity, which will increase overall value, including the announcement of the consolidation of the Virginia facility into the main campus by late calendar year 2016.

We are also realigning the business into our usual customer-focused business unit teams to enhance operational performance and responsiveness. These changes will be completed during the second half of our fiscal year as we align the financial reports with these two business units and we physically colocate the team personnel within the facility.

These changes will support and accelerate new product development activities as the teams are beginning to focus on rapidly bringing advanced hoist and winch technologies to market. To date, the Breeze-Eastern acquisition has delivered value as expected for TransDigm shareholders, with revenue and EBITDA as expected.

To update on the recent progress of our new business value driver, let me bring your attention to three recent wins we have received in the aerospace market. AvtechTyee recently was awarded significant bookings across multiple configurations of a recently upgraded sealed audio control panel used on the Boeing 737 Next Generation.

The bulk of these orders were primarily to satisfy initial provisioning of spares by airlines with upcoming deliveries from Boeing. The bookings also included upgraded sealed audio control panels with satellite communication functionality.

This functionality enables the flight crew to directly dial and connect to any phone number around the world through existing satellite communication networks in areas where HF and VHF radio function can be unreliable.

Next at PneuDraulics, we were awarded components in four major hydraulic system areas by Textron Aviation for the Cessna Longitude program. PneuDraulics was awarded hydraulic components for spoiler actuation, brake systems, landing gear and central hydraulic systems.

Additionally, this represents the largest total shipset award for PneuDraulics to date. 24 discrete components were awarded per aircraft, with a forecasted build rate of 36 aircraft per year at peak and a production launch in the next couple of years. Lastly, Aero Fluid Products has won an exciting new program for the A320neo.

The Painesville, Ohio-based team was awarded the oil control manifold for this new program. The OCM is an aluminum block mounted on the main engine gearbox that contains multiple valves, openings and sensors that control the temperatures and pressures of the engine oil.

This is a growth award as the team did not enjoy this business on the A320 legacy platform. Finally, I wanted to bring your attention to one of our key business planning processes. Last time, I updated all of you on our succession planning process.

Given the time in the fiscal year, I now wanted to update on our fiscal year 2017 planning process, which we have just kicked off. This process gives us an excellent glimpse of the aerospace market for commercial and defense applications.

This process is a bottoms-up forecast done by each of our individual product lines, rolling up to business units then the entire company, with a focused emphasis on our TransDigm value drivers of productivity, value-based pricing and new business.

This process, which is the foundation of our fiscal year guidance that we provide to the market each year, begins with a lot of hard work by each individual business unit and culminates with focused reviews of each of our 31-plus operating companies and about 80 business unit teams throughout the back end of our fourth quarter.

We believe this granular bottoms-up data-based review is the best way we know of to compile market intelligence and provide guidance to our shareholders. It has served us well and allowed us to generally be quite accurate in our annual guidance and internal planning.

With that, now let me hand it over to our CFO, Terry Paradie, who will review our financial results in more detail.

Terry?.

$0.05 from dividend equivalent payments, $0.57 from non-cash stock option expense and $0.53 of acquisition-related expenses. Now, I'll hand it back to Liza to kick off the Q&A..

Thanks, Terry. Operator, we are now ready to open the lines for questions..

Our first question comes from Carter Copeland of Barclays. Your line is open..

Hey, good morning, guys..

Hey, Carter..

Good morning, Carter..

Just a quick clarification, Nick, on the OEM revision, should we just assume that it's just a inventory destock associated with the rate cuts on 777, 747 the publicly announced ones and maybe some of the business jets, is that really what you're really seeing there, it's the sort of transitory effect of inventory?.

Yeah. There's a little bit inventory movement, and I would say we're a little – and the other is the freighter rate cut but everyone knows about that, but the – and we're probably – we're less bullish – maybe more bearish is the better way to put it on the business biz jet market..

So when you say you're less – or bearish, does that mean you're looking to the end of the year and keeping some cushion for potential summer lower production activity?.

Yeah, you're talking about the biz jet now, Carter?.

Yeah, on biz jet. Yeah..

I think what you're probably seeing – what you're seeing is the numbers have been less exciting than we hoped. We had sort of anticipated the year that was flat to slightly up in business jet. As we see our numbers part-way through the year in our bookings, that's starting to look a little less likely to us.

Could there be a little upside to that? Possibly there could..

Okay. Great. Thanks. I'll let somebody else ask..

Yeah..

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

Hi, good morning..

Morning..

Hey, Nick. (32:43) the commercial aftermarket..

Hey, Ken, I can barely hear you. You're breaking up..

Okay, sorry about that.

Is that any better?.

Yes..

Sorry. So, I just wanted to follow up on the commercial aftermarket, great numbers in the quarter.

Was there anything – I know obviously you were flat last quarter, do you get a sense that there was anything that may be pushed from the first quarter to the second quarter or anything unusual or one-time in nature in the up 13%, or really just sort of a culmination of what we started to hear about in terms of increased spending by the airlines on some of the older aircraft?.

I think you're starting to see – you have a situation where it ran low too long. I don't think you can count on 13% growth quarter-over-quarter in perpetuity by any means. I'd probably look at it more like the first half of the year, it's up 7% to 8%, maybe it was a little too light in the first quarter and a little heated in the second quarter.

But I think the best way to look at it sort of on a year-to-date basis..

Okay. Now, that's reasonable. And obviously, you've maintained the full year guidance....

Right..

...even though your comparisons now start to anniversary with certainly the weaker back half of fiscal 2015.

Is that really, like you talked about, just reflecting, obviously this recovery could be lumpy and visibility is probably a little more challenged now, or is there anything else that is maybe holding you back a little bit on this – on the outlook?.

No. I think we had a judgment in the beginning of the year and we're about the same place still..

Okay. Perfect. Well, thank you very much and nice quarter..

Thanks..

Our next question comes from Gautam Khanna of Cowen. Your line is open..

Hi. Thanks. This is Bill Ledley on for Gautam as he's traveling to Boeing.

I have a question for you on if any of your proprietary products have been sole source -the sole source products, have they been awarded to any competitors or second source from the OEMs?.

Well, I presume you mean recently, not in the history of our whole life?.

Yeah. Recently..

Not that we know of. Not that we know of. And I don't mean to be evasive there, but I think we'd know of them but we don't know of any..

Okay. Thanks.

And then on the M&A pipeline, you mentioned some better strength at least relative to what you saw at the end of Q1, can you talk about if there's any strength in any one particular area?.

I don't – we clearly see more activity. I don't know that I can say it's one more than another and as you know, we don't – as we've said, it's very difficult to predict closings. It was last quarter, I said it didn't look very good, and this quarter things are getting active again. For some reason, we see more.

I'd like to – I wish I knew a good reason for it, but I'm not sure I do..

Okay. Thanks very much..

Our next question comes from David Strauss of UBS. Your line is open..

Hey, good morning. It's actually Matt on for David..

Yeah. We're feeling bad about everybody heading out to the Boeing..

(36:01).

Quick one on your guidance, it looks like you're expecting margins about the same in the back half as the first half, is there any reason why that shouldn't sort of grow a little bit just on higher volumes?.

Yeah..

I think on the back half (36:19).

I thought we moved the margins up (36:20)..

It will be up probably in the second half than they were year-to-date..

Yeah. I'm sort of disconnecting on that. I thought the second half was up a little, not a lot, but a little..

Okay..

(36:28) high second quarter aftermarket mix..

Let me just look into the numbers..

Yeah. Right there..

Yeah. It's not up a lot, but it's up maybe 0.5 point in the second half..

If you back into it..

And as I said, we could have a little room there..

Yeah. Okay. And then I guess one other one going back to your acquisition pipeline, it sounds like things are accelerating a little bit there.

I guess, as you get bigger, is it getting more difficult to find deals that are big enough to move the needle there or is that not an issue?.

Well, we think there's still plenty of stuff. I mean, obviously, just mathematically, the bigger you get, the average size acquisition doesn't move the needle as much, you got to buy more of them to move the needle as much.

But I think at least so far, we still see adequate number of businesses, the question is getting them to sell or not, not are there enough. And then – and we feel better about the, as I've said, the rate of activity right now..

Okay. Thanks..

Our next question comes from Myles Walton of Deutsche Bank. Your line is open..

Thanks. Good morning. It's actually Myles on for Myles..

Is this Myles?.

It is, Myles on for Myles..

It is Myles? Myles for Myles..

Myles on for Myles..

I'm already in Seattle..

Okay..

I came in early just to be in your call, Nick..

This actually is Harry speaking for Nick..

So, the first one is on the EBITDA margin increase. So I think, Kevin, you said it was from the acquisitions, or maybe it was Nick who said it was from the acquisitions and the core was still running at 49%. That's a pretty high increase for the acquired margins in terms of versus what you were otherwise planning.

I think if you back into it, it's maybe a 500 basis point plus increase to your underlying acquired margins in the kind of planning period.

So was that cost, is it price, is it volume, can you just elaborate a little bit?.

Yeah. The answer is in total, I don't know the answer. I know it business by business but I don't know the answer in total. But they are – I'm going to give you a guesstimate here to some degree..

Sure..

I don't think – the volumes are not – in net-net, the volumes are not way up, which means it's primarily the other pieces of margin, which is cost and price..

Price and cost..

Yeah. I know in total, their revenues aren't way up..

Okay, okay.

And the only clarification on the 13%, so when you give the organic, which would exclude the acquisitions for both periods, would the aftermarket growth be materially different than that 13% we saw reported on a pro forma basis?.

It's not materially different. It's not materially different..

Okay. Great. And the last one, Nick, so you talked about the normalization in the debt markets.

Yeah..

Is there any inclination to tap when the well is running healthy and maybe take advantage of open markets and healthy markets, if they're giving you the same rates you currently have, and just be more proactive than not?.

As you know, we're always looking at that. We're always looking at that in conjunction with the acquisition pipeline. And that's one we'll sort of decide as things clarify for us..

Okay. But you don't feel like the trends are kind of a cloud break before more clouds return, you think it's kind of just become more of what it was and it was anomalous earlier in the year..

Myles, I think it's, as I've said before, I kind of feel like it's a loser's game to speculate on the capital markets..

Yeah..

To some degree we have our sort of view of what we like and what we don't like, and....

Yeah..

...we kind of make a decision when the time comes. As I've said for the last five years, we've consistently lost money on interest rate hedges. That hasn't changed our view, we'll just keep pouring the money down a rat hole..

Yeah. You make more than enough money in other places, Nick..

Yeah. Right..

All right. Thanks. Good quarter..

Our next question comes from Robert Spingarn of Credit Suisse. Your line is open..

Hey, guys..

Hey, Rob..

Good morning.

Can you hear me all right?.

Yeah..

Yeah..

Here in Seattle as well, they do have phones here. So given that, I just want to go back to where Myles was going. The 13% aftermarket in fiscal second quarter versus this flat performance in fiscal first quarter.

I want to make sure I understood, were you alluding to that being more pricing-driven rather than volume, or is it equal?.

No. All I meant to say is that I'd probably look at it as a year-to-date number, rather than get too hung up on what the first quarter and second quarter were. If I implied it was mostly price – if I implied it was 13% was price was the big driver, I didn't mean to say that. If I did, that was a mistake..

No. No. Okay. I just wanted to make sure – I want to get a sense from a destocking or activity perspective, what's really creating this volatility and then how we can get comfortable – if we can get comfortable – with what the second half looks like.

And which begs a follow-on question, which is what is the embedded organic growth in the full year guidance? So we've had minus – let's say, we've had 1.7% for six months organic growth, what is in the guidance?.

I think we gave you the guidance, it's mid to high single-digits..

I'm talking about....

That's the guidance for the year, which happens to be about where we are halfway through the year..

Hold on, I'm talking about your organic growth, 4.4% in the quarter, minus 1.1% in the first quarter. So, 1.7% positive for the first half of the year, okay, organic growth..

Oh, total company, I thought you were talking about commercial..

No, no, no. I'm sorry. I switched gears there..

Yeah. I lost you, I thought you were talking about the commercial aftermarket..

So I know that you've divided it by segment in the slides, so I'm talking about the overall company (43:23).

Got you, got you, got you. I want to – I'm not looking at the number here, but I want to say it's about 4%. It's about 4% is the organic growth year-over-year in our guidance..

So the second half should be marginally better than the first half..

Yes. Yes..

Okay. Okay. And then from an employment perspective, you obviously raised your margins, you've streamlined – Kevin talked about this but, again, I know you're looking at the volumes from a six-month perspective.

If you're going to have a little bit better growth here in the backend of the year, how do you – do you have the capacity as is, do you have to add some people?.

We have capacity. Whether we'd have to add a few here and there, I don't know the exact number Rob, but there's no problem with capacity..

Okay. Well, that's it for me. Thanks, Nick..

It'd be within a reasonable range, within the reasonable range of variation. You could see in six months..

Our next question comes from Seth Seifman of JPMorgan. Your line is open..

Thanks very much. Good morning and good quarter. In the aftermarket, there's been a disconnect recently in the level of organic growth for the power and control pieces versus the airframe.

Wonder if you could talk about what that was in the quarter and maybe a little bit about why do you think that disconnect emerged?.

I don't think there's any particular reason for that. It's primarily just a mix of the businesses. I would say that one probably has a little more defense business in it than the other and that may have it down a little lower. There's no systematic difference between them..

And you'll see the numbers in the 10-Q when we file that tomorrow..

Yeah..

Okay. Okay. And then....

Any difference in the results are primarily just the difference between what the aftermarket content is from one versus the other, what the defense versus commercial content is and one versus the other, it'll make them move around..

Okay. Okay.

And then I guess of the, let's say, 7% to 8% year-to-date pro forma aftermarket growth that we've seen, of the 30 or so business units that you referenced, about how many of those would you say were above average, how many were below average?.

I don't know the exact number, but it was a good quarter, and it was not – everyone's not up, but generally – as a general rule, it was a good quarter for most businesses..

Great. Okay. Thank you very much..

Our next question comes from Michael Ciarmoli of KeyBanc. Your line is open..

Hey, good morning, guys. Thanks for taking my question..

How are you doing?.

Nick, can you talk – I mean there's certainly been a lot of structural change in the aftermarket, I mean you've got the battle tested business model with -pricing may be coming under pressure, more OEMs getting involved, pooling, used parts, do you guys have to do anything differently or can the model continue to sustain without any change?.

We think the model is fine. We'll keep watching, I don't quite know that we're as bought in to these structural changes, but – how much of it's just the normal cycle, but we keep watching them. We don't see any reason that our fundamental model doesn't continue to work, at least in the foreseeable future.

I can't tell what 20 years from now does, but in the foreseeable future, I don't see anything that structurally changes the fundamentals here..

Okay. Is there – can you walk me – I mean we keep hearing some suppliers talk about going after product lines that are maybe at a premium. And maybe just educate me on this, there is sole source proprietary product, can it actually be recompeted, can it be certified? It seems like there's some mix messaging out there.

I mean do you guys still feel like those product lines that are our sole source proprietary that you own the IP, are those still bulletproof or can they be recertified, redesigned or dual sourced?.

Well, anything – I mean, ultimately, as I like to say, if TransDigm went bankrupt and died and all the plants caught on fire, ultimately, the airline industry would find a way to survive. So, it's not that there's no other way to get around it. It is a – there's a significant entry barrier, there's significant cost, there's significant qualification.

There's also the issue that we own the IP, so you've got to find a way around that. It's a substantive barrier that we frankly have not seen any material change in. Now, is it impossible? If you don't care about the costs, you can always find a way around most anything..

Got it..

But I don't see any fundamental change in the switching cost characteristics here..

Okay. Just the last one for me, defense. Looks like it got a little worse sequentially, still guiding for the up low single-digit for the year. How good do you feel about that, how good is your visibility? I know you talked about the bookings running ahead of (48:38).

It's not good through the whole year, but it's good – it's getting good through more of the year, obviously, each month. And we have – the bookings have been strong..

Okay..

So, we feel reasonably good about our guidance. So, I would say we feel quite good about our guidance in total. I don't – we could be off a point here and there on a segment and we think we've given you our best judgment..

Okay. Fair. I'll jump back in the queue. Nice quarter, guys..

Our next question comes from Hunter Keay of Wolfe Research. Your line is open..

Hi, thank you.

Sorry for the cell phone, can you hear me, okay?.

Yeah..

Great, thanks. So a little more on commercial aftermarket.

So when everything was melting down earlier in the year and with the benefit of hindsight, Nick, can you – are your customers maybe a little more fragile than you thought they were? And if so, which areas of the business might be a little bit more soft or discretionary that maybe you didn't anticipate? And conversely, which areas might be a little bit less discretionary and maybe hung in a little bit better relevant to some of the other parts, as things were really, really hairy there earlier in the year?.

Well, first let me pack up the word fragile. The vast majority of our aftermarket is sole source proprietary stuff. So it's not that it's going somewhere else, it's that the customer either has decided to defer something or draw down their inventory, so I mean ultimately over time. And that's a very customer by customer situation.

So, it's hard to make any generic comment on that. As far as our outlook for the year, I guess the way I would answer that is we started off the year saying that our outlook was for mid to high single-digits growth and we're still the same place. So I would say if I look at this half way through the year, we're about where we thought we'd be..

Great. Okay. Maybe let me ask the question in a different way as a follow up.

Again, when things were really, really dicey there a few months ago, I know you guys were worried you thought you were going to be all-in, but does it change the way you maybe think about certain segments of the aftermarket in terms of how you'd pursue M&A? Or do you look at just those prior couple months there sort of a one-off anomaly, and not so much sort of like a thesis-altering type of approach in how you think about pursuing acquisitions going forward?.

Certainly doesn't change the way we pursue acquisitions. We're looking for proprietary aerospace businesses with significant aftermarket content. And I would say we don't find a quarter or a couple of quarters' – that would be nothing that would change our fundamental strategy nor has it..

Thank you very much..

There are no further questions at this time. I'd turn the call back over to Liza Sabol for any closing remarks..

Thank you all for participating on our call this morning and please look for our 10-Q, which we expect to file sometime tomorrow..

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