Good day, and thank you for standing by. Welcome to the Q4 2022 TransDigm Group, Inc. Earnings Conference Call. At this time all participants are in a listen-only mode. After speakers presentation, there will be question-and-answer session. [Operator Instructions] Please be advised that today's conference call is being recorded.

I would now like to turn the call over to Jaimie Stemen, Director of Investor Relations. Please go ahead..

Thank you, and welcome to TransDigm's Fiscal 2022 Fourth Quarter Earnings Conference Call. Presenting on the call this morning are TransDigm's President and Chief Executive Officer, Kevin Stein; Chief Operating Officer, Jorge Valladares; and Chief Financial Officer, Mike Lisman.

Please visit our website at transdigm.com to obtain a supplemental slide deck and call replay information. Before we begin, the company would like to remind you that statements made during this call, which are not historical in fact are forward-looking statements.

For further information about important factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements, please refer to the company's latest filings with the SEC available through the Investors section of our website or at sec.gov.

The company would also like to advise you that during the course of the call, we will be referring to EBITDA, specifically EBITDA as defined, adjusted net income and adjusted earnings per share, all of which are non-GAAP financial measures.

Please see the tables and related footnotes in the earnings release for a presentation of the most directly comparable GAAP measures and applicable reconciliations. I will now turn the call over to Kevin..

Good morning. Thanks for calling in today. First, I'll start off with the usual quick overview of our strategy, a few comments about the quarter and discuss our fiscal 2023 outlook. Then Jorge and Mike will give additional color on the quarter.

To reiterate, we are unique in the industry in both the consistency of our strategy in good times and bad as well as our steady focus on intrinsic shareholder value creation through all phases of the aerospace cycle. To summarize, here are some of the reasons why we believe this. About 90% of our net sales are generated by unique proprietary products.

Most of our EBITDA comes from aftermarket revenues, which generally have significantly higher margins and over any extended period have typically provided relative stability in the downturns. We follow a consistent long-term strategy, specifically, we own and operate proprietary aerospace businesses with significant aftermarket content.

We utilize a simple, well-proven value-based operating methodology. We have a decentralized organizational structure and a unique compensation system closely aligned with shareholders. We acquire businesses that fit this strategy and where we see a clear path to PE-like returns.

Our capital structure and allocations are a key part of our value creation methodology. Our long standing goal is to give our shareholders private equity-like returns with the liquidity of a public market. To do this, we stay focused on both the details of value creation as well as careful allocation of our capital.

As you saw from our earnings release, we closed out the year with another good quarter considering the market environment. We continue to see recovery in the commercial aerospace market and remain encouraged by the favorable trends in air traffic.

Our Q4 results show positive growth in comparison to the same prior year period as we are lapping the fourth fiscal quarter of '21, which was more heavily impacted by the pandemic.

Although our results have improved over the prior year quarter, they continue to be adversely affected in the comparison to pre-pandemic levels as the demand for air travel remains depressed.

We are happy to see the continuation of the favorable trends in global air traffic recovery with domestic air travel still leading and international air traffic catching up. The majority of countries have fully reopened to international travelers. However, China air traffic lags the recovery seen in other countries.

Domestic air travel in China continues to experience strict COVID policies that limit travel. China's international air traffic remains very depressed and has only made modest improvement from COVID lows. In our bookings, we saw another quarter of robust growth in our commercial revenues and bookings.

I am very pleased that despite this challenging environment, our EBITDA as defined margin was 49.8% in the quarter. Contributing to the strong margin is the continued recovery in our commercial aftermarket revenues, along with our strict operational focus and disciplined approach to cost structure management.

Additionally, we had good operating cash flow generation in Q4 of almost $275 million and closed the quarter with approximately $3 billion of cash. We expect to steadily generate significant additional cash through 2023. Next, an update on our capital allocation activities and priorities.

During fiscal '22, we are pleased to have allocated about $2.4 billion of capital in the aggregate across M&A and return of capital to our shareholders. Specifically, these activities included the acquisition of DART Aerospace, a special dividend of $18.50 per share and share buybacks.

As mentioned earlier, we are exiting fiscal 2022 with a sizable cash balance of approximately $3 billion, which leaves us with significant liquidity and financial flexibility to meet any likely range of capital requirements or other opportunities in the readily foreseeable future.

Regarding the current M&A pipeline, we are actively looking for M&A opportunities that fit our model. Acquisition opportunity activity continues, and we have a decent pipeline of possibilities as usual, mostly in the small to midsize range.

I cannot predict or comment on possible closings, but we remain confident that there is a long runway for acquisitions that fit our portfolio. Both the M&A and capital markets are always difficult to predict, but specifically so in these times. Now moving to our outlook for fiscal 2023.

As you saw in the earnings release, we initiated full fiscal year 2023 guidance. The guidance assumes no additional acquisitions or divestitures and is based on current expectations for a continued recovery in our primary commercial end markets through fiscal 2023.

Guidance was previously suspended as a result of the significant disruption in our primary commercial end markets related to the COVID-19 pandemic. Throughout fiscal '22, we were encouraged by the recovery seen in our commercial revenues and strong booking trends.

Total commercial bookings in fiscal '22 exceeded sales by a healthy double-digit percentage that supports the fiscal '23 commercial end market revenue guidance, which I will comment on shortly. We are cautiously optimistic that the prevailing conditions will continue to evolve favorably.

However, as our fiscal '23 progress, we will continue to monitor the ongoing uncertainty and risks and market conditions closely and will react as necessary. Changes in market conditions and the impact to our primary end markets could lead to revisions in our guidance for 2023.

Our initial guidance for fiscal 2023 continuing operations is as follows and can also be found on Slide 7 in the presentation. The midpoint of our fiscal year 2023 revenue guidance is $6.09 billion or up approximately 12%.

As a reminder and consistent with past years, with roughly 10% less working days than subsequent quarters, fiscal '23 Q1 revenues, EBITDA and EBITDA margins are anticipated to be lower than the other three quarters of '23. This revenue guidance is based on the following market channel growth rate assumptions.

We expect commercial aftermarket revenue growth in the mid-teens percentage range, commercial OEM revenue growth also in the mid-teens percentage range, and finally, defense revenue growth in the low to mid single-digit percentage range.

The midpoint of fiscal 2023 EBITDA as defined guidance is $3.045 billion or up approximately 15% with an expected margin of around 50%. This guidance includes about 50 basis points of margin dilution from our recent DART Aerospace acquisition.

We anticipate EBITDA margin will move up throughout the year, with Q1 being the lowest and sequentially lower than Q4 of our fiscal 2022. The midpoint of adjusted EPS is anticipated to be $21.38 or up approximately 25%.

Mike will discuss in more detail shortly the factors impacting EPS along with some other fiscal 2023 financial assumptions and updates. We believe we are well positioned as we enter fiscal '23. As usual, we'll closely watch how the aerospace and capital markets continue to develop and react accordingly.

Let me conclude by stating that I'm very pleased with the company's performance in this period of recovery for the commercial aerospace industry. We remain sharply focused on our value drivers, cost structure and operational excellence.

We look forward to fiscal 2023 and the opportunity to continue to create value for our stakeholders through our consistent strategy. Now let me hand it over to Jorge to review our recent performance and a few other items..

Thanks, Kevin, and good morning, everyone. I'll start with our typical review of results by key market category. For the remainder of the call, I'll provide color commentary on a pro forma basis compared to the prior year period in 2021. That is assuming we own the same mix of businesses in both periods.

The market discussion includes the recent acquisition of DART Aerospace in both periods and the impact of any divestitures completed in fiscal 2021 are removed in both periods. We also included DART in this market analysis discussion in the third quarter of fiscal 2022.

In the commercial market, which typically makes up close to 65% of our revenue, we'll split our discussion into OEM and aftermarket. Our total commercial OEM revenue increased approximately 29% in Q4 and approximately 24% for full-year fiscal 2022 compared with prior year periods.

Bookings in the quarter were strong compared to the same prior year period and again outpaced sales. Sequentially, total commercial OEM sales improved roughly 8% compared to Q3.

We're encouraged by build rates steadily progressing at the commercial OEMs, but risks remain with regard to the achievement of certain OEM production rate targets due to ongoing labor shortages and supply chain issues across the broader aerospace sector. Now moving on to our commercial aftermarket business discussion.

Total commercial aftermarket revenue increased by approximately 36% in Q4 and 43% for full-year fiscal 2022 when compared with prior year periods.

Growth in commercial aftermarket revenue was primarily driven by the continued robust demand in our passenger submarket, which is our largest submarket, although all of our commercial aftermarket submarkets were up significantly compared to prior year Q3. Sequentially, total commercial aftermarket revenues grew by approximately 6%.

Commercial aftermarket bookings were strong this quarter compared to the same prior year period and Q4 bookings once again outpaced sales. A few key points to consider. Global revenue passenger miles remained lower than pre-pandemic levels.

Revenue passenger miles have generally continued to trend upwards over the past few months, although there was a slight pullback in August RPMs and September has remained relatively flat compared to August. This is primarily a result of softer domestic China traffic due to ongoing zero-COVID policies.

Commentary from airlines in recent months regarding passenger demand continues to be positive. Despite the increase in airline ticket prices, passenger demand has remained strong as the summer travel season came to a close and we entered the fall season. The recovery in domestic travel continues to be stronger than international travel.

In the most recently reported IATA traffic data for September, domestic air traffic was only down 19% compared to pre-pandemic. The U.S. and Europe continue to lead, showing strong demand for domestic travel. U.S. domestic travel in September was back to pre-pandemic levels.

However, China's domestic travel had another steep drop off in September due to strict COVID policies and was down about 60% compared to pre-pandemic. The international air traffic recovery has continued to make progress throughout 2022. Many countries have fully reopened international travelers, and there is pent-up demand for long-haul travel.

Approximately six months ago, international travel was still down about 50%, but in the most recently reported IATA traffic data for September international travel was only down about 30% compared to pre-pandemic levels. International traffic in North America is within about 10% of pre pandemic.

In Europe, international traffic is within 20% or so of pre pandemic. Asia Pacific international travel has made good progress over the past months, but RPMs are still down about 60%. Global air cargo demand has pulled back over the past months.

As of IATA's most recent data, September was another month in which air cargo volume showed year-over-year decline and were below pre-pandemic levels.

Further easing of pandemic-related restrictions and factory re-openings in China could support near-term improvement in air cargo, though uncertainty remains regarding China's timeline for full reopening. Business jet utilization has come down from pandemic highs, but is still well above pre-pandemic levels.

Business jet OEMs and operators continue to forecast strong demand in the near-term. There is growing optimism that the pandemic brought a favorable structural change to the business jet industry, time will tell. Moving on to our defense market, which traditionally is at or below 35% of our total revenue.

The defense market revenue, which includes both OEM and aftermarket revenues, grew by approximately 2% in Q4 and declined by approximately 3% for full-year fiscal 2022 when compared with prior year periods. This year followed a typical pattern of irregular and lumpy defense sales and bookings.

The lag in defense outlays and supply chain shortages were the main contributors to our softer-than-expected defense performance for 2022. Negatively impacting our defense market revenues were the delays in the U.S. government defense spend outlays. There's often a lag between U.S.

government defense fed on federalization and outlays and the lag is hard to predict. While these delays have been longer than typical, we did see some improvement in bookings this quarter, which bodes well for future defense order activity.

On the supply chain, our teams continued to experience delays due to part shortages surrounding electronic components. Our operating units are proactively engaged with the supply chain and continue to implement mitigating actions to overcome these challenging issues.

We do expect our defense business to expand in fiscal 2023 due to the strength of our current order book. As Kevin mentioned earlier, we expect low to mid single-digit percent range growth in fiscal 2023 for our defense market revenues.

I'd like to finish by recognizing the strong efforts and accomplishments of our teams during this challenging fiscal year. I'm very pleased by our operational performance and our team's ability to overcome the negative impacts of the pandemic and supply chain disruptions we experienced throughout the year.

As we enter our new fiscal year, our management and their teams remain focused on our consistent operating strategy and meeting the demand for our products. With that, I'd like to turn it over to our Chief Financial Officer, Mike Lisman..

Good morning, everyone. I'm going to quickly hit on a few additional financial matters for fiscal '22 and then also our expectations for fiscal '23. First, a few fiscal '22 data points on organic growth, taxes and liquidity.

In the fourth quarter, our organic growth rate was 16%, driven by the continued rebound and our commercial OEM and aftermarket end markets. On taxes, our GAAP and adjusted tax rates finished the year within their expected ranges. Our FY '22 GAAP tax rate was 23% and the adjusted rate was just under 25%.

On cash and liquidity, free cash flow, which we traditionally define as EBITDA less cash interest payments, CapEx and cash taxes was just over $1.2 billion for the year, a bit higher than the $1.0 billion we had originally expected, driven primarily by the good operating performance that Kevin and Jorge mentioned.

We ended the year with approximately $3 billion of cash on the balance sheet. And at quarter end, our net debt-to-EBITDA ratio was 6.4x, down from the 6.7x level where we finished last quarter when you pro forma in the $18.50 per share dividend that we paid in August. We continue to watch the rising interest rate environment closely.

We remain 85% hedged on our total $20 billion gross debt balance through a combination of interest rate caps and swaps through 2025. This provides us adequate cushion against any rise in rates at least in the immediate term.

With regard to any potential changes to our long-term approach to using debt to boost our equity returns, we'll see how the interest rate environment develops over the next three years, but do not anticipate any big changes in our approach at this time.

Though one could envision a scenario where we slightly dial back the leverage on a net debt-to-EBITDA basis to achieve the type of cash interest coverage ratios where we've historically operated and been comfortable operating the business. Next, on the FY '23 expectations.

I'm going to really quickly give some more details on the financial assumptions around interest expense, taxes and share count. Net interest expense is expected to be about $1.14 billion in fiscal '23, and this equates to a weighted average cash interest rate of approximately 5.75%.

This estimate assumes an average LIBOR rate of 4.9% for the full fiscal year, which is simply the average based on the current forward consensus LIBOR curve. On taxes, our fiscal '23 GAAP cash and adjusted rates are all anticipated to be in the range of 24% to 26%.

The slight increase in our tax rate versus the prior year is due mainly to the manner in which the net interest deduction limitation is calculated under existing tax legislation for fiscal '23 versus how it was computed in prior years.

On the share count, we expect our weighted average shares to be $57.1 million during fiscal '23, and this figure takes into account the 1.5 million shares we repurchased during the '22 fiscal year but assumes no additional buybacks occurred during the '23 fiscal year.

With regard to liquidity and leverage for fiscal '23, we expect to continue running free cash flow positive throughout the year. As we traditionally define our free cash flow, which again is EBITDA as defined less cash interest, CapEx and cash taxes, we estimate this metric to be in the $1.4 billion area, maybe a little better in fiscal '23.

Assuming no additional acquisitions or capital markets transactions, we'll end the year with well north of $4 billion of cash on the balance sheet and estimate that our net leverage will be in the area of 5x EBITDA as defined at September 30, 2023.

From an overall cash, liquidity and balance sheet standpoint, we think we remain in good position with adequate flexibility to pursue M&A or return cash to our shareholders via share buybacks or dividends during fiscal '23. With that, I'll turn it back to the operator to start the Q&A..

[Operator Instructions] First question that we have will be coming from Myles Walton of Wolfe Research. Please go ahead..

Sure. Thanks. Good morning guys. Mike, maybe to pick up on free cash flow where you just were -- obviously, you had a pretty healthy consumption of working capital as you build into the growth ahead. Is a similar amount of builds anticipated in fiscal '23? And just a clarification.

You talked about maybe bringing down the net leverage or net debt to EBITDA leverage. Would you consider bringing down the gross leverage as well? Or is that something that is not what you're thinking about? Thanks..

Sure. So first, on the net working capital point. From peak to trough during COVID, about $410 million came out of net working capital. That's if you define it as just AR plus inventory less payables, which is primarily how we look at it. About 260 went back in during fiscal '22. So we've got about $140 million, $150 million more to go.

We expect the bulk of that to happen during the coming fiscal year, so fiscal '23. That's generally how we think about it and getting back to where we were pre-COVID.

And then on the leverage point, we'll see at this time, we don't anticipate going and paying down any of the gross debt balance because we have the benefit of the hedges and also the benefit of having taken out the bulk of that $20 billion of debt and a far better interest rate environment when rates were a lot lower.

We have the next three years where we have the benefit of the hedges. We're really just not subject to the current market interest rates given that they're now 4 percentage points higher than they were about 12 months ago. But we do look at it if we think about it often.

And as you know, historically, we've been comfortable operating the business with a higher leverage level on a net debt-to-EBITDA basis. We tend to think we'll have a similar approach going forward, and the methodology there hasn't changed. But no, in response to your question, we don't, at this time, envision paying down any gross debt..

All right. Thank you..

The next question is coming from Robert Spingarn of Melius Research. Your line is open..

Hey good morning..

Good morning..

Good morning.

Kevin, on the commercial aftermarket growth rate in the guidance, if China opens up, how might that number addressed?.

Well, I think you know there's not much flight activity happening. And as a percentage of the fleet, it is a significant percentage of flight activity prior to COVID. So it could be a real tailwind to us as that opens back up.

Given the uncertainty in the market with global conflicts, China and their zero COVID inflation, potential recession it was hard to forecast more growth than what we put in the mid-teens right now. There's just enough uncertainty out there..

Is it as simple as just saying maybe it's 20% of the market and it's half recovered and so it's a 10% number.

Does that math make any sense?.

It could make sense. We don't like to get baked around those numbers. We don't look at things regionally like that. However, it's probably directionally accurate..

Okay. And then just on M&A again. We've seen valuations come down in the public markets, today notwithstanding, but they've also come down in the private markets for quality assets with significant amounts of commercial aftermarket content.

Have you seen that?.

I wouldn't say that we've seen that. There's a lot of activity. Unfortunately, we haven't had anything across the finish line since DART's a couple of quarters ago. We're very busy, generally speaking, in small to middle-sized businesses.

We just haven't been able to get any of them across the finish line due to an unfavorable market sentiment around how do I get financing for a business, not us, but it's certainly restricting deals that are available in the marketplace. So I think altogether, it's been a little bit disappointing.

There are some headwinds in M&A for the general market, and we stay aggressive..

Okay, great. Thank you, Kevin..

Yes..

Thank you for your question. And one moment while we get ready for the next question. The next question I have is from Robert Stallard of Vertical Research. Your line is open..

Thanks so much. Good morning. .

Good morning..

Kevin, just following up on the other Rob's question about the capital deployment situation.

Are you seeing any change in sentiment or maybe direction or activity from financial buyers? Are these guys getting squeezed by the higher interest rates? Are they not bidding for things aggressively as they were in the past or perhaps even having to sell assets?.

I don't think we've seen anybody selling assets, but we believe there is squeezing happening. It's certainly limiting the number of people that can bid on businesses today, and I think that is slowing the number of businesses that can come to market..

Okay. And then maybe a follow-up on this area as well. Given the strength in the U.S.

dollar at the moment, are you more interested in perhaps buying more European aerospace and defense assets going forward?.

We don't factor that into really the way we look at returns on a business. We evaluate them all based on really what they can do. So we're not looking for businesses in Europe any more than usual. We look at all geographies, regions. So we're encouraged and looking everywhere.

We have a team of M&A folks that are looking for opportunities in Europe, certainly as we speak. But there's no additional focus on it..

Yes. That's great. Thanks Kevin..

Thank you for your question. One moment while we get ready for the next question. And the next question that I have will be coming from Noah Poponak of Goldman Sachs. Your line is open..

Hi, good morning everyone..

Good morning, Noah..

Good morning..

Just a few more to make sure I have it all on capital structure and capital deployment. Mike, you alluded to the potential to hold slightly lower leverage if the rate environment stays here. Can you define what -- or quantify what that would mean in terms of net debt to EBITDA? And you mentioned the interest coverage ratio.

Can you define what quantify what you're looking to maintain there? And then to the extent that you keep this bid-ask spread challenge in the M&A environment, will you look to maybe repurchase shares to start off the year here?.

Sure. So a couple of things on the interest coverage ratios and leverage point, and I'll come around to the repurchase shares point. I can tell you how we think about it. So two things. First, the first part is just the cost of capital question, right, with regard to the approach with leverage, and that piece is pretty easy.

To the extent debt remains cheaper than equity, which is true today with our debt costs trading in the 8% to 9% area based on implied yields, we still have a preference to use debt as much as we can, simply because it's cheaper, right? The debt cost of 5.75% this coming year with the benefit of the hedges and that's well below the targeted equity return of 17.5% that we've had for a long time now here at TransDigm.

So that piece is pretty easy. But then second, and this gets to the cash interest coverage point, and that's of equal or more important in this kind of rising rate environment.

And that's practically how much debt and prudently can we take on without being stupid and jeopardizing the value of the equity, right? And on the cash interest coverage question, we look at EBITDA to interest coverage ratios.

So we frequently in the past have talked about net debt to EBITDA, as you guys have heard on this call many times, and that ratio has sort of been in the 6x ballpark for TransDigm. That's if you take the last five years and average it when you strip out the COVID period.

And if you look at that same time period, but instead focused on a cash interest coverage ratio, like EBITDA to interest expense, you'd see that one bounce around 2x to 3x and that 2x to 3x ballpark with an average of just about 2.5. So we look at that ratio a lot now more than we have in the past, along with the net debt-to-EBITDA ratio.

And we feel comfortable running TransDigm in that kind of two to three ballpark for EBITDA to interest coverage ratio going forward. And if you think about fiscal '23 specifically, because of the hedges, we're nicely in the middle of those brackets, right? And we've got that benefit in fiscal '24 and 2025 as well.

But again, that's only because of the hedges and because we took out that debt and those lower interest rate environments, and that's not lost on us as a management team. So we think about it quite often. And we know that we have those benefits for the next three, four years.

And you could envision a time where if we didn't have -- or today, we didn't have those benefits, we might have to dial back the leverage a bit to sort of hit the EBITDA to interest coverage ratios that I mentioned of sort of the 2x to 3x ballpark.

That's not the case and won't be for three years because we got the benefit of the hedges and haven't taken out the debt in the prior lower interest rate environment.

So that's a long-winded way of hopefully giving you some insight at least into how we think about it and putting some bands around the coverage ratios that we're comfortable running the business at.

And then coming around to your second question, Noah, on the share repurchase point, I think, as Kevin has said many times before, we'll continue to evaluate all three options. The priorities at TransDigm are unchanged. First, reinvest in our own businesses. Second, go and do M&A.

And then third, return capital to our shareholders via buybacks or dividends. We'll look at both -- could do both, maybe not as we did this prior year. And then last, pay down gross debt balance..

Okay. Super helpful. I appreciate all that detail, Mike. Thank you..

Sure..

Thank you for your question. And now for the next question a moment. Our next question will come from Sheila Kahyaoglu from Jefferies. Your line is open..

Great. Thank you so much. Good morning guys..

Good morning..

Good morning.

Thanks. When we think about fiscal '23 adjusted EBITDA margins, the guidance implies up 130 basis points above your target of 100 despite 50 basis points of dilution from acquisitions. I guess you have commercial OE and aftermarket up 15%.

How do we think about the puts and takes to margin expansion?.

I think generally, we went through a fair amount of restructuring due to the COVID pandemic. And historically, we've been able to restructure the business during these types of crises and get some gains as the business returns. And I think we're seeing that.

We saw that throughout this year, and we would expect that to flow through next year as well with some of the reduction and the real heavy focus on productivity that we've got going on at the operating units.

I think we've given the general guidance that we're comfortable with in terms of the particular market segments and the OEM assumptions and the aftermarket assumptions and that's where we feel comfortable guiding to in this environment..

Yes, that makes a lot of sense..

I would also say, Sheila, in this world, we're -- as we've said many times, we're a bottoms-up, not a top-down forecasting company. So this is the work of all of our many businesses that roll up their forecast to us. And I think over time, they can be more accurate than a top-down approach of guessing what RPM growth is going to be.

I think this is the most accurate way to forecast the business, and we've been very successful with it..

And just a follow-up on that. You mentioned supply chain a few times in your script.

How are you preparing for that? And do you expect any impact to your profitability than that?.

Yes. I think the teams have been active really going back 12, 18 months when we started to see early signs of trouble with the supply chain. So we've been engaged with the suppliers. We're putting inventory back into the system to support the recovery, as Mike noted in his remarks.

And we continue to stay on top of the details and that's really what we have found to help us through this situation. So I don't think we're anticipating any unusual pressures. Obviously, we're seeing inflation like the rest of the world is seeing.

And we're trying to do our best to battle that inflationary pressure, but the teams continue to stay engaged at the detailed level..

Great. Thank you..

Thank you for your question. One moment while we prepare for the next question. And the next question is coming from Gautam Khanna of Cowen. Your line is open..

Hey, good morning guys..

Good morning..

Good morning/.

I had just a couple of questions.

First, I was wondering, just can you quantify the impact of supply chain shortfalls on defense sales or whatever, all-in sales and what if there's any carryover you expect to recover next year?.

Yes, I'll handle that. I think it's been minimal in nature. You run into a supply chain issue that might impact a handful of orders and you work with the existing backlog to offset that with other orders where you've got the supply.

So we're not seeing a material impact in any shape or form in terms of FY '22 results, and we're not anticipating a significant carryover that would influence the FY '23 guidance..

Okay. That's helpful.

And on the aerospace aftermarket, commercial aero, is any trends that you're seeing that you can discern between kind of discretionary aftermarket versus nondiscretionary and maybe anything in '22 that was amplified by reactivation of parked aircraft or anything? Anything that sort of you can parse out within the results you've already reported?.

Yes. I mean, I think at a high level, the overall industry enjoyed the benefit of the recovery. Certainly, the last three quarters as travel returned and some of the restrictions opened up.

I think as we noted, we've seen the strength in our largest submarket, which is the passenger submarket, and that includes interiors, spare parts, structural type parts, components, avionics, across the full portfolio of products. I don't think there's been any unique trend in terms of one product type versus the other.

We've just enjoyed participating in the return to air travel..

Thank you guys..

Thanks..

Thank you for your question. And one moment while we get ready for the next question. And the next question will be coming from Matt Akers of Wells Fargo. Your line is open..

Yes, thanks. Good morning.

I wonder if you could talk about the OEM forecast and what sort of build rates you're assuming in there, just given some of the delays you've seen at Boeing, do they need to get back to kind of their target rate call it early next year or something like that for you to hit that mid-teens? And also, is there any risk that you may have delivered ahead just given some of the delays kind of from the edge and stuff that we've seen?.

Yes. I mean, again, as Kevin noted, we've got a well-established bottoms-up forecasting and planning process at each individual operating unit. So they are closest to the customers, they're close to Boeing and Airbus and the other airframers.

And we utilize the information that they provide, they being the OEs in Boeing and Airbus and each unit looks at what it thinks it's at in terms of the deliveries to date and what that means in terms of the future deliveries. So we use their information as best guidance.

But again, we do a bottoms-up process and each operating unit looks at its specific scenario..

Okay. Thank you..

Thank you for your question. One moment while we get ready for the next question. Our next question will be coming from Scott Deuschle of Credit Suisse. Your line is open..

Hey, good morning. Thank you for taking my question.

Kevin, can you address the timing and scope of aftermarket price increases contemplated in the guidance? Or to ask it another way, can you help me desegregate the mid-teens as market guide between volume and price?.

Yes. It's -- well, we don't split out these things so carefully. Our goal is always to pass along inflation. Right now, the forecast from our teams that we have bottoms up is mid-teens of a forecast for growth year-over-year. There's so much uncertainty in that with what's going to happen in Asia that it's hard to forecast larger numbers than that.

Obviously, there's always some price in these numbers year-over-year as we've all seen inflation. But we don't split it out to put such a specific number on it because it differs by product, business. I think the way to look at it is what has inflation been and we're trying to pass that along.

We see definitely inflationary pressures across our business..

Okay. And then Mike, the CapEx guide for next year, I think, implies around 3% of sales at the high end. Obviously, the returns on capital in this business are amazing. So I think that's great to see. But just curious if you can talk a bit about what the spend is for? Thank you..

Yes. I think It's slightly elevated. I think you're right, 2.7%, 2.8% of sales versus 2.5% in some prior years. We're investing that money because we see good paybacks and good projects from our op unit teams of two years or less. And that's what's driving the productivity.

One of our three value drivers and the EBITDA margin expansion that you guys see in here. We're seeing good CapEx investments, and we're putting money behind it.

And then we've got a couple of onetime projects on -- some solar projects that make good sense and have good paybacks because of tax incentives, particularly in the state of California, where it's elevated a bit, because of that. But generally, we're investing behind good projects here that are driving the productivity and the margin improvement..

Okay, great. Thank you guys..

Thank you for the question. One moment while we prepare for the next question. And the next question will be coming from Kristine Liwag of Morgan Stanley. Your line is open. Hello your line….

He is on mute. I think we lost Kristine..

Hey guys, can you hear me?.

There she is..

Okay. Sorry about that..

No problem..

Maybe following up on some margins, some of Sheila's questions earlier. 50% adjusted EBITDA margins will be record high for you. I mean, at some point, OE comes back, a headwind to margin.

Could you talk about other levers you can pull to keep growing margins beyond '23 outside of pricing? And also on that pricing portion, is there a level where pricing is too good and the portfolio becomes more attractive for PMAs to revisit your parts?.

Yes, I'll handle that. So in terms of productivity and margin expansion, it's something that we have always focused on. That has historically been one of our three value drivers, as most of you know. It's maybe one that we don't promote or talk about as much as we need to, but the teams have really done just a great job absorbing the restructuring.

As they go through their process and the planning process, they understand what the OE impact is going to be and the mix of the products. And as Mike mentioned, we continue to look for good opportunities to invest in CapEx in the form of automation of processes, automation of testing, trying to take some of that labor generally out of the process.

So I think the teams have really done a fantastic job, and you're seeing that benefit the margins as you go through. In terms of pricing, ultimately, our goal has always been to get incremental price slightly above inflation. Inflation is running hot. We're seeing the inflationary pressures at our op units in terms of our cost structures.

If the market priced strategy that we've always employed. And obviously, we're continually aware of what's going on in the market and trying to understand what the competitive threats are in the marketplace. And I don't think that has changed today. That's always been an active focus for us..

Great.

And the PMA question?.

Yes.

Can you repeat the specific PMA question for me?.

Yes, is there a point when your pricing is so good that the PMA providers could revisit your portfolio and find it attractive to PMA some of your parts?.

Yes. I think in general, as I mentioned, this is part of the competitive analysis that our teams go through and understanding what the market prices are for a particular product. Generally, we have low value component-type products.

So there's some limit in terms of the overall PMA targets to our portfolio, but it's something that the teams actively are aware of and trying to protect against..

Great. Thank you..

Sure..

Thank you for your question. One moment while we prepare for the next question. And the next question will be coming from Seth Siefman of Morgan Stanley. Your line is open..

Hello, Seth are you there?.

Yes, sorry, it's Seth -- sorry from JPMorgan. Yes. Okay. Good morning. So just curious, I don't want to nitpick, it was a very solid quarter, but the EBITDA margin flat year-on-year-ish and flat sequentially despite higher revenue. I don't -- I'm sure you guys will be comfortably in line or above the -- what you forecast for 2023.

But were there some elevated costs that led to the incrementals being only kind of just about in line with the current margin of 50%?.

I think we had about 0.5 point of drag from the DART acquisition..

And the other element is commercial OEM was up about 29% year-over-year, quarter-over-quarter, right? So there's some mix impact there as well..

Great. Okay. Okay. And then I guess, stepping back and looking longer-term, I thought one of the interesting slides at the Boeing Investor Meeting last week was they had a slide with their backlog where they showed it being 70% for replacement and 30% for growth, which I think is a much lower growth component than in the past.

When you think about all that replacement that at least they're anticipating.

Do you guys think about a coming wave of retirements over the next several years? And maybe what that might mean for your business?.

I think there's always the risk of [indiscernible], but I think there's a lot of need right now and a difficulty to supply OEM aircraft, I think it's going to be a while before build rates catch up to actual demand. So I'm less worried in the next five-year horizon.

After that, we'll have to evaluate what the market conditions look like, are there new technologies. Generally speaking, the aerospace industry changes very slowly. There's not a lot of new platforms coming out in the future. A lot of these planes are going to go into aftermarket demand arena as they come -- as they get older.

I don't really think that we're setting ourselves up for a lot more retirements or something different than in the past. But we'll have to see.

I think as we look forward, again, over the next several years, we're pretty comfortable that this is going to set up favorably for the company, both on the commercial side and it should be also true on the defense side..

That's very helpful. I appreciate it. If I could sneak in one more really quick. You guys -- when we were on this call a year ago, you guys talked about 20% to 30% aftermarket growth. You did 43% and I would imagine that the situation in China was much worse than anybody would have anticipated in November of 2022.

Do you -- not looking forward and thinking about the impact to 2023, but looking backward to this year? Do you have any sense of how much the situation in China hurt the business, if at all? Or is that just not the way that you guys look at it at all?.

I don't think that's the way we look at it. We look at what is the opportunity out in front of us. But certainly, China is 20% of aerospace travel, maybe a little more, plus or minus. It's a significant market that didn't participate almost whatsoever.

So yes, that was in our numbers and was a headwind to better -- even better results and a recovery to pre-COVID levels. It's really down to just the Asia region. Most of the other regions have come back pretty close already..

Great. Thank you very much..

Thank you for your question. One moment while we prepare for the next question. And the next question will be coming from Michael Ciarmoli from Truist. Please go ahead. Your line is open..

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

Good morning..

Good morning..

Kevin, maybe just on the guidance. I mean you kind of said the way you do the bottoms-up approach, but it also sounds like in addition to China, contemplated in that guidance are the range of economic risk, inflation, potential recessionary life conditions. And I mean, it would seem like this mid-teens incorporates a lot of risks.

And I'm just wondering, is this sort of -- I hate to say a worst-case scenario, but it sounds like you've really baked in a lot of potential headwinds there.

And I guess just thinking about as we go through the year, I know you've got some dark contribution, but on an apples-to-apples, do we get pretty close as we exit the year to back to pre-COVID aftermarket revenue peak?.

I think we're approaching that -- yes, I think that's a comfortable way to look at it, that sometime in '23 across the board, we will achieve aftermarket parity with prior to COVID levels. We'll have to see how that all unpacks. There's still a lot that has to happen in Asia for that to happen.

But again, it's -- I think it sets up favorably for us on commercial and on the defense side..

Got it. Got it.

Any color on that guidance? I mean just thinking about it? I mean, if you guys came up in the range? It would seem like this would be more on the low end of the range with a lot of risk factors already?.

It could be. This is a bottoms-up approach from our teams, and they go out and look at what they think is going to happen. The problem with aftermarket is that a lot of it's not booked, it's book and ship within the quarter. So you are forecasting things that are unknown. But they're closer to their customers than we are up here at corporate.

So this is why we tend to trust their numbers. We hope that it's conservative. We hope that -- all of these things don't come out as any significant impact to the aerospace market, we'll have to see..

And I would just add, at the practical matter, we don't have any visibility to the inventory levels at our airline customers. So the teams are using all the communication that they can directly with the customer to try and build up their plans and forecasts..

Got it. Perfect. That's helpful. Thanks guys. Appreciate it..

Sure..

Thank you for your question. One moment while we take our next question. And we have -- our next question will be coming from David Strauss of Barclays. Please go ahead..

Thanks. Good morning.

So following up on that last comment about new visibility into airline inventories, but what about on the distribution side, what do you see in terms of that channel? And at this point, how much of your aftermarket is -- maybe update us how much is running through distribution these days?.

Yes. I think roughly 20% to 25% runs through distribution, exclusive distribution-type agreements. The point of sales are improving in each future quarter. And each of the teams work with their distribution partners to kind of forecast what the right inventory levels are to support that growth.

And we think we're in the reasonable range based on the assumptions that all the teams have been making..

Okay. Mike, you talked a bit about working capital. I want to specifically about -- ask about your inventory levels. They are now back to basically where they were pre pandemic.

Are you carrying any sort of extra inventory yourselves just in and around concerns around the supply chain? Or are these inventory levels about right for -- right from where your projected sales levels are?.

We're carrying a little bit of extra just the op units are, just frankly, given the supply chain risks. And that's done off-unit by off-unit based on the specifics of what they're purchasing. We do that, obviously, to mitigate shipments risk and supply chain risk. So there's a little bit of extra in there.

I can't put an exact dollar amount to it, but we're also just ramping up and taking product in for the growth that we see ahead going into '23 and the elevated revenue level..

Okay.

And last one, Mike, when would you expect to deal with this 2024 term loan? How far out would you look at that?.

We look at it often. It goes current, obviously, in August of '23 later this year. So we'd have to take it out by August of '24. We have enough cash to do that. I think at the present moment, if worst came to worst, and we'll have plenty of cash come at that point in time given what we'll generate from operations.

But we look at it, the market seems to be open up a bit -- opening up a bit in the last two weeks or so with different types of debt transactions to push maturities out and we look at all that stuff and we want to manage the stacks, maximize the white space upfront, as you guys see in the slides and push things out into the right.

And we focus on that every day now..

Yes. That's an important point to stress. This is looking at debt refinancing, capital allocation, it's something this team spends a lot of time on daily..

Thanks very much..

Thank you. One moment for our next question. We have a follow-up question from Noah Poponak of Goldman Sachs..

Kevin, you just were asked about building your aerospace original equipment forecast and you spoke to the business units feeding up to you.

But you've been speaking -- you sort of -- I guess, have been a little bit ahead of the curve and saying this stuff is not coming through to the production rates that the large commercial OEs have been talking about. And obviously, there's a lot of supply chain disruption out there. I just wondered if you could update us on how you're seeing that.

Is it getting better? Is the demand pool you're feeling now from Boeing and Airbus linking up closer to the production rates they're talking about? Or has it not changed?.

Yes. I'll take that one, Noah. I think generally, the Airbus demand pool has been tracking within a reasonable tolerance band of the stated production rates. Boeing obviously has noted they're working through a variety of supply chain issues as well as labor shortages. So from operating units to operating unit, it varies a little bit.

I think we've seen -- it's probably fair to say a little bit of improvement over the last quarter. And we're all hopeful that Boeing continues to resolve some of its issues and hits the rates..

Okay. And then similarly, in your defense business, that entire end market has had supply chain labor headwinds, and we've seen this -- the outlay pace strangely behind the authorization pace. But that is -- the last few months, that's caught up and we see a little bit of an inflection in your defense top line.

Is that getting better? Is your order rate getting better there? How do you see that dynamic playing out moving forward?.

Yes, I think generally, across the defense market, both at the OEM level and aftermarket, we did see improvement in terms of the order rate this last quarter in Q4 of FY '22, which is what's supporting the growth forecast that we've provided in 2023 -- FY '23..

Okay. I mean low to mid-single, if we strip out what we estimate price to be, doesn't imply much for units.

Is it safe to interpret that forecast as maybe splitting the difference of what's going on in this end market starting 18 months ago with what you've seen in the last quarter, but it only being a quarter, so you don't want to assume that it's fully recovered quite yet.

But if it -- if that outlay trend keeps recovering back to authorization, there maybe be some upside there?.

Well, I think, Noah, this is Kevin, I think we were surprised in '22 at the defense business not being stronger and that the defense industry was hit harder it seems like by supply chain issues and outlays. And I think we're just being a little conservative as we look forward to what the defense industry could become in '23.

We had a good bookings quarter in Q4 but it's been lumpy and difficult to predict through '22. So we're taking a little bit more conservative approach here, I think..

Make sense. Okay. Thanks again..

Sure. Yes..

Thank you for your question. And our last question is coming as a follow-up from Scott Deuschle of Credit Suisse. Your line is open..

Hey, Thank you for taking the quick follow-up.

Mike, is the stock and deferred compensation expense for next year, is that a good run rate to use beyond 2023?.

Sorry, is it a good what?.

Run rate to use beyond 2023?.

I think so with some moderate uptick obviously for headcount, but I think it's a fair gauge, yes..

Okay. Thanks..

That concludes the Q&A session. I would like to turn the call back over to Jaimie Stemen, Director of Investor Relations for closing remark. Go ahead, please..

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