Ladies and gentlemen, thank you for standing by. Welcome to the TransDigm second quarter earnings conference call. At this time, all participants' lines are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one on your telephone keypad. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to turn the conference over to your speaker today, Liza Sabol. Please go ahead.
Good morning. Thank you and welcome to TransDigm's fiscal 2020 earnings conference call. Presenting this morning are TransDigm's Executive Chairman, Nick Howley, President and Chief Executive Officer, Kevin Stein, and Chief Financial Officer, Mike Lisman. Please visit our website at transdigm.com to obtain a supplemental deck, slide deck, and call replay information. Before we begin, we'd 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 at sec.gov.
We would also like to advise you that during the course of our 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 table and related footnotes in the earnings release for a presentation of the most directly comparable GAAP measures and applicable reconciliations. With that, I will now turn the call over to Nick.
Good morning, thanks to everyone for calling in. Today I'll start off with some comments, as usual, about our consistent strategy. Quickly hit a little on the last quarter, an overview of our efforts with respect to the COVID-19 and the related market deterioration, and some short comments on capital allocation. Kevin and Mike will then expand on most of these. To reiterate, we believe we are unique in the industry in both the consistency of our strategy in good and bad times, as well as our ability to create and protect intrinsic shareholder value through all phases of the aerospace cycle.
To summarize some of the reasons why we believe this, about 90% of our net sales are generated by proprietary products, and over three-quarters of our net sales come from products for which we believe we are the sole source provider. Most of our EBITDA comes from aftermarket revenues, which typically have significantly higher margins and over any extended period of time, provide relative stability in the downturn. In the commercial aftermarket, the largest and most profitable portion of our aftermarket, demand appears likely to drop very sharply. This has happened during other severe shocks. However, in this unique circumstance, it could likely take longer to recover. Simply stated, our commercial aftermarket won't start to recover much-
I'm having trouble hearing you.
Until people start to fly again. 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. 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. In the current situation, we had to move fast to adjust our cost while maintaining the other aspects of our value creation methodology. We have a decentralized organization structure and a unique compensation system closely aligned with the shareholders. We acquire businesses that fit with our strategy and where we see a clear path to PE-like returns. Lastly, our capital structure and allocation are a key part of our value creation methodology.
As you saw from our press release, we had a solid performance in both the second quarter and the first half of fiscal year 2020. Revenues and EBITDA as defined were up substantially. We continued to generate real intrinsic value for our investors. Unfortunately, this all happened in a different environment than that which has been thrust upon us in the last 60 days. Last quarter, we expressed concerns about both the durability of the commercial aerospace production cycle and the early signs of Pacific Rim air travel slowing. As a result, we began to adjust our cost structure down in January and February of this year. In March, it became clear that the COVID-19 situation and the related government actions around the world will substantially and negatively impact the worldwide commercial aerospace business. Exactly how badly, we just can't yet know for sure.
However, we also can't wait for perfect information. We got moving fast, and we will adjust as the situation clarifies. In addition to safety, the two most important items we focused on immediately were, one, reduce our cost as quickly as possible, and two, assure substantial liquidity if things get worse than might be expected. To address these, first, the cost reduction. We have significant experience in dealing with severe downturns. Our process is pretty consistent. We make the best estimate we can for a six-month run rate. We then try our best to get our costs down enough to hold the EBITDA as defined margin at that estimated run rate. This is perhaps more difficult than usual now in this situation. In order to size the organization and our cost structure, we made certain assumptions regarding our major market segments. These are not meant as revenue guidance.
We just don't know enough, only a means to size our cost-cutting efforts. The only thing I know for sure is that we won't be exactly right, and we'll have to adjust up or down. In aggregate, I'm hopeful that we are appropriately conservative. Kevin will explain this in some more detail. We quickly reduced our cost structure in line with these assumptions. Most of these actions are in place already. To remind everyone, these costs are in addition to the cost cuts we made earlier in the second quarter. We believe we can get costs out ratably with our reduced revenue sizing estimates. We define cost as revenue minus EBITDA as defined. There will likely be a significant mix headwind if the sharp drop in the highly profitable commercial aftermarket continues for the full six months.
This will make holding the run rate EBITDA as defined margin in the mid-forties range tough. We think we can come reasonably close to this, but it'll be hard to get all the way there. With respect to liquidity, the liquidity appears to be fine. Based on any of the market forecasts we've seen, we expect to run cash positive over any extended period, including covering all required principal and interest payments. Given the substantial market uncertainty, we decided to raise additional money and borrowed $1.5 billion in April. This new debt has no maintenance covenants and no maturities until 2025. This new money is an insurance policy for these uncertain times. It's quite unlikely we need it. This is a great company with outstanding products and market positions.
The only way you get in trouble here is if the situation becomes much worse than anyone expects and you run out of fuel or cash. We're filling our tanks as full as we can at a reasonable price. Pro forma for the new debt, our cash balance is $4.2 billion as of 3/28/2020. Again, I doubt we will need this money, but better safe than sorry in this environment. We hope to come out of this with a lot of firepower. We continue to look at possible M&A opportunities and are always attentive to our capital allocation. Both the M&A world and the capital market world are always difficult to predict, especially today. As a general rule, we will tend to be fairly cautious until the smoke clears a little bit. We have withdrawn our 2020 guidance. There's just too much uncertainty.
We'll reinstitute our guidance when we feel we have a clearer picture. Our fiscal year 2020 started off strong. The first half was good, but the second half will be pretty rocky. We believe we are about as well-positioned as we can be for right now. We'll watch how the situation develops and react accordingly. Let me hand this over to Kevin to review our recent performance and expand on our assumptions and COVID-related activities.
Thanks, Nick. Today, I will first provide my regular review of results by key market and profitability of the business for the quarter, and then cover outlook and some COVID-19 related topics. We are pleased with the solid Q2 results, particularly considering the increasingly difficult global economy and commercial aerospace industry. In Q2, we saw a modest unfavorable impact to our commercial aftermarket and OEM sales for the COVID-19 pandemic as approximately the last three weeks of the quarter were negatively impacted. Despite these headwinds, our second quarter operations, specifically revenue and EBITDA as defined, expanded compared to Q2 last year, due in part to positive organic growth as well as continued acquisition integration and our announced preemptive cost reduction actions.
Q2 GAAP revenues were up approximately 24% versus prior year Q2, and EBITDA as defined was up 19% versus the prior year, with margins approaching 47% of revenue. Mike will provide more details on the financials later. 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 2019. That is, assuming we own the same mix of businesses in both periods. Please note that this market analysis discussion includes the results of the former Esterline businesses. We began to include Esterline in this market analysis discussion in the first quarter of fiscal 2020. In the commercial market, which makes up close to 65% of our revenue, we will split our discussion into OEM and aftermarket.
Our total commercial OEM market revenue declined approximately 3% in Q2 when compared with Q2 of fiscal year 2019. The decline in the quarter did reflect a minimal headwind from the impact of the ongoing 737 MAX production halt and early OEM declines related to the pandemic. It is already clear that the COVID-19 pandemic will have a significant negative impact on the commercial OEM market. We are under the assumption that the demand for our commercial OEM products will be significantly reduced during the second half of fiscal 2020 due to reductions in OEM production rates and airlines deferring or canceling new aircraft orders. Longer term, the impact of COVID-19 is fluid and continues to evolve, but we anticipate significant negative impacts on our commercial OEM market for some uncertain period of time. Now moving on to our commercial aftermarket business discussion.
Total commercial aftermarket revenues grew by approximately 1% over the prior year quarter. In the quarter, flat commercial transport aftermarket was driven by stronger growth in passenger and interior submarkets, offset by a decline in the commercial transport freight market. Our quarterly commercial aftermarket bookings were down over 10% versus prior year quarter. Most of the decline came in March of this year, but likely does not paint the correct picture for the remainder of the fiscal year, as we expect a sharper decline in the second half. There was a rapid and dramatic decline in demand for air travel during our Q2, as global restrictions on business and shelter-in-place orders went into effect in response to COVID-19. This led to a significant reduction in global flight capacity and parked aircraft across the world.
To hit a few of these points, global revenue passenger miles are at unprecedented lows as a result of the COVID-19 pandemic. IATA recently forecast a 48% decrease in revenue passenger miles in calendar year 2020 compared to 2019. For cargo demand, this was already weaker prior to the COVID-19 crisis, as FTKs have declined from reaching an all-time high in 2017. A loss of passenger belly cargo due to COVID-19 flight restrictions could provide some unexpected opportunities. Business jet utilization data was already pointing to stagnant growth before this economic downturn. Now, during this pandemic and in the aftermath, the outlook for business jets is more unpredictable and certainly weaker. As the COVID-19 situation is ongoing, the duration and severity of the pandemic are still unclear, and long-term impacts for the commercial aftermarket are hard to predict.
Now let me speak about our defense market, which is just over 35% of our total revenue. The defense market, which includes both OEM and aftermarket revenues, was about flat compared to the prior year Q2. As a reminder, we are lapping tougher prior year comparisons as our defense revenue accelerated in most of fiscal 2019. Year-to-date, defense bookings have surpassed our expectations, driven primarily by very robust defense OEM booking growth. Total defense bookings have solidly outpaced year-to-date sales. Although bookings grew across most of the businesses, APKWS and parachute-related bookings were especially strong in the quarter. With continued good order flow in defense, we anticipate any favorable trends in the immediate future will come from this segment. Now moving to profitability, I'm going to talk primarily about our operating performance for EBITDA as defined.
EBITDA as defined of about $675 million for Q2 was up 19% versus prior Q2. EBITDA as defined margin in the quarter was just under 47%. Our EBITDA as defined margin expanded both sequentially and over the prior year period as a result of our cost mitigation efforts and a consistent focus on our operating strategy. Excluding Esterline, margins in our legacy business improved both sequentially as well as over the prior year quarter. On Esterline, we are now over a year post-close. The integration continues to progress, and to date, the acquisition is exceeding our expectations for growth in this largest of TransDigm acquisitions. As we have stated in the past, we will now no longer refer to any Esterline-specific metrics as these businesses have now become part of the fabric of TransDigm. Now moving to second half 2020.
In light of the uncertainty around the ultimate impact of COVID-19 on global market and economic conditions and the highly fluid commercial aerospace industry, we still feel it is too early to provide forward-looking guidance at the current time. As Nick said, once we have a better picture, we'll reinstitute guidance. I wanted to provide a bit more detail on the end market conditions we assumed for the second half of our fiscal 2020. This is not guidance. We always have a bias to act quickly and right-size the cost structure when required. When completing the organizational right-sizing analysis that drove the reduction in force levels implemented to date, we assume the following with regard to the organization sizing needs for the second half of fiscal 2020. Again, organization sizing.
Commercial aftermarket declines of approximately 70%-80%, commercial OE declines of 25%-40%, and defense growth in the mid-single digits, which is in line with our prior guidance for the defense end market. I would like to review our COVID-19 response and expectations in more detail. As mentioned, we currently expect COVID-19 to have a significant adverse impact on our sales, EBITDA as defined in net income for the second half of fiscal 2020. Under the assumption that the COVID-19 outbreak will negatively impact our non-defense customers and their demand for our products and services during the second half of fiscal 2020, particularly in the commercial aftermarket. As Nick said earlier, we remain confident in our business model over the long term and are focused on mitigating the impact of COVID-19 to our business while supporting customers and employees.
Since the early days of the outbreak, we have been following guidance from the World Health Organization and the Centers for Disease Control and Prevention to protect employees and prevent the spread of the virus within all of our facilities globally. Some of the actions implemented include flexible work from home scheduling, alternate shift schedules, pre-shift temperature screenings where allowed by law, social distancing, appropriate PPE, facility deep cleaning, and paid quarantine time for impacted employees. Most of our facilities remain in operation, even if some are operating at reduced levels, as they are deemed essential businesses by government entities since we are the sole provider for many programs, including critical defense platforms. We are committed to preserving the health and safety of our employees while continuing to meet our customer commitments.
In an effort to assist in the fight against COVID-19, certain of our businesses have begun producing medical equipment that is critically needed during the global pandemic. Our AmSafe Restraints business is producing respirators and surgical gowns, while Mason is producing face shields. We are grateful for this ability to contribute to the fight against COVID-19. Now, before we move to specific cost-cutting measures that Nick mentioned, it is important to understand that we view a very high % of our costs as variable. Costs meaning revenue less EBITDA. Roughly half of our spending is related to materials, including production materials or subcontractor services that are production-related, including plating, painting, machining. Those costs should largely flex with volumes.
The next big bucket is people and benefits or direct items related to employment, and is more than 1/3, but less than 40% of our costs, and the remaining 10%-15% of costs include all other. We monitor these costs closely. As such, let me highlight some specific cost savings actions we have taken in response to the reduced demand and uncertainty resulting from the COVID-19 pandemic. These cost mitigation efforts were previously disclosed, but worth reviewing. An additional reduction in force to align operations with customer demand. These actions are incremental to the cost mitigation efforts previously implemented in the second quarter of fiscal 2020, mainly in response to the 737 MAX production rate changes, and brings our total workforce reduction since our last earnings call to approximately 22%-25% versus planned headcount levels. Furloughs.
We're implementing one to eight-week furloughs at many businesses over the next six months in response to specific situations. Substantially reducing cash compensation for the senior management team for the balance of fiscal 2020, and the board of directors will forego their annual retainer fees. We will continue to vigilantly monitor our operations and external events and keep the market updated on developments as appropriate. Excuse me. Let me conclude by stating, I am pleased with the speed at which TransDigm has responded to the COVID-19 pandemic, taking immediate actions to protect employees from the spread of the virus, while also dealing with the harsh reality confronting the broader commercial aerospace industry in the near term.
While the actions that the current circumstances require, ranging from broad cost reductions to furloughs and a right sizing of the employee base are difficult to implement, I have no doubt that we will better position the company to endure and emerge more strongly from the ongoing weakness in our primary commercial end markets. With that, I'll now turn it over to our Chief Financial Officer, Mike Lisman.
Morning, everyone. I'm not going to elaborate on the results for the quarter any further, as you can see the details in the press release on sales, EBITDA as defined, and Adjusted EPS growth. I just quickly wanna highlight the updates on interest expense and then tax rates included in the call slides for today. Interest expense will tick up slightly due to the new debt issuance, but it's partially mitigated by the decline in expected average LIBOR for the balance of our fiscal year. On taxes, our fiscal 2020 GAAP, cash, and Adjusted tax rates will be 3 to 8 percentage points lower than the previous guidance due to benefits included in the CARES Act, primarily the expansion in the interest deduction limitation from 30% of EBITDA to 50% of EBITDA.
Moving over to the balance sheet and liquidity, as of second quarter end, our net debt-to-EBITDA ratio stood at 5.9x . On the recent debt issuances, Nick mentioned our thinking here. The $1.5 billion of debt is basically an insurance policy. While the interest rates were slightly higher than we would like, two quick points worth mentioning. The after-tax rates look better due to the interest deduction limit expansion included in the CARES Act. Second, the terms on the debt are such that we can repay it or refinance it in two to three years without too much penalty should we decide that that's the best use of capital at that point in time.
While there's a substantial uncertainty in our commercial end markets right now, we do expect to run free cash flow positive for the back half of the fiscal year under the sizing assumptions that Kevin described in detail. From an overall cash, liquidity, and balance sheet standpoint, we think we're in good position here. We have a sizable $4.2 billion cash reserve. We don't face any big debt maturities until July of 2024, so 50 months from now. We expect that the commercial aerospace industry will find its footing before then. With that, I'll turn it back to the operator to kick off the Q&A.
Thank you. At this time, to ask an audio question, please press star one on your telephone keypad.
Again, that's star one to ask a question. Your first question comes line of Carter Copeland of Melius Research.
I can go by Copeland too. That's fine. Hey, guys. How's everybody?
Did he Carter Copeland now?
It could be anything you want. I answer to lots of things. Just couple questions for you guys. One, the mix of products and platforms, you know, on the back end of this crisis, you know, what do you foresee in terms of the impact on the business? I realize we're kind of unprecedented. We're gonna take several platforms, you know, effectively out of service at this point. You know, is there some offset there from shutting particular product lines or whatnot? Anything you can do to help us understand that would be appreciated.
This is related to, you know, a market weighting. We believe we're market weighted across our business in the platforms that we support. We're not overexposed to any one platform or other. Obviously, as planes get older, as platforms get older, they do become slightly more profitable over time as we've been able to work our value drivers on them. Since we think of ourselves as market weighted, we're not, you know, as concerned right now. We'll have to see how this plays out. Right now it's all speculation. Our plan in this, Carter, is to follow the revenue stream closely, look at the order book, and react accordingly as aggressively and quickly as possible. The speculation side of this is always hard for us to rationalize.
Again, we believe we are market weighted. We're distributed across the platforms that are sold and used today and not overexposed to any one. Certainly, there's going to be some impact in the future, but we're just gonna have to weigh that as it comes about.
Okay. That's great. Just as a quick follow-up, the comment on M&A, and Nick, you alluded towards waiting till the dust settles, but I just find myself wondering in this, in this scenario, if there are small opportunities that pop up before the dust settles, you know, how you'd be thinking about those and, you know, if you compare this to the prior downturns we've gone through, you know, what's the, you know, what's the thought process? How does this normally go? Thanks.
Yeah. I'll address that a couple ways. One, we're not out of the business, but I think we'd have to say that we're gonna be more cautious now than we would've been six months ago. You know, we're probably a little more skeptical of any valuation that someone would come up with. We're not shut down. We are definitely cautious here for a while. I would say in the past, Carter Copeland, you know, we buy, as you know, good businesses and try and make them very good. We typically don't buy fixer-uppers or, you know, bad businesses. We're looking for proprietary stuff with a fair amount of aftermarket. Generally, people don't sell that kind of stuff in depressed times.
Okay.
That's not to say if you stay alert, every now and then you might be able to pick one off, but it's unusual 'cause of the kind of things we buy.
Okay. Thanks, guys.
Your next question comes the line of Noah Poponak of Goldman Sachs.
Hey. Hey, everybody.
Hey. Good morning.
Morning.
Morning. Morning. Do you have the number on how much your commercial aerospace aftermarket revenues declined in April versus April of last year?
We did look at that. What I'll tell you is that I think it aligns with our sizing assumptions for that one-month period. Now, one month does not six months make, so we'll have to keep a close eye on it, but it aligns more or less with our sizing assumptions. The only thing I'd add to that is I think it was clear, but in Kevin's sizing of 70%-80% down in the commercial aftermarket, we're assuming that stays that way for six months, which we hope is a.
Yeah
Very conservative assumption.
Right.
That's what we're using for sort of our sizing and cost planning for right now.
That's helpful. Just, just kinda staying on Carter's question on, you know, the question we're hearing most frequently from investors is, you know, if the makeup of the fleet when the dust has settled here is going to decline in age significantly as older aircraft are retired, how, you know, what's the impact to TransDigm? Kevin, understanding that your answer there is you're market weighted, I'm assuming you're kinda market weighted on units, but I don't know if you, if you'd be willing to quantify, even if a rough order of magnitude, what percentage of your aftermarket revenues come from, you know, 20-year or older airplanes. Also, if you'd even give us some direction on how much higher the margins are in that, you know, older bracket versus your average aerospace aftermarket.
The only thing I would say about older products is, you know, they're slightly more profitable. You know, it's not like it's a wild difference. I do believe we're market weighted on this. I don't believe we're overexposed to any platform products. Certainly, you know, MD-80, we might expect will go away. You know, that is gonna have a small impact to us, of course. We think that it's weighted by the market. There's not that many of them out there. That's our answer today on this. We just need to keep watching.
The best thing you can use to analyze the market is the order stream coming in, and that's what we need to follow closely and ensure we're getting ahead of the cost side as well as where there's opportunity for additional sales, where there's opportunity both on the defense and in the commercial space, there are still opportunities that you need to capitalize on.
That's helpful. I'm just going to sneak in one last one. Nick, on the effort to hold the EBITDA as defined margin, you know, somewhere in the zone of where you had it in the first half, understanding that, you know, it's a difficult task with how quickly things are moving, but you have tried to match the cost to the revenue. In hearing you talk about that, you know, proving harder than prior downturns, do you foresee a scenario where your EBITDA margin gets a three handle on it in any of the next four quarters? Or are we talking more, you know, 200 basis points of potential deterioration?
I don't wanna speculate on that. I would hope not. I don't wanna, you know, the problem is the math is obvious. You know, if your revenue drops, you know, X% and you take X out of the cost, everything works as long as your mix stays the same. Typically, in a downturn, what has happened is you had a much sharper drop in the OEM than you did in the aftermarket, it wasn't that tough a job 'cause you got a little tailwind from the mix. Here, you got a headwind. Which makes it harder. We look at the EBITDA margins as kinda running in the mid-40s.
I would, as I say, I would hope we could come reasonably close to that, which I'm hopeful that means we could stay in the forties, and I'd hope a little more than just over the edge. That's gonna be very dependent on the duration and the depth of the aftermarket drop.
People need to start flying again.
Yeah. People gotta start flying again.
Yeah.
You know, until they start flying again.
Sounds like.
It's gonna be tough.
Sounds like you have a, you know, a process to stay there, but just with a high degree of uncertainty relative to everything going on.
That's right. That's right.
Yeah.
That's right. The problem is the math of a very sharp aftermarket drop.
Yeah. Okay, I appreciate it. Thanks so much.
Your next question comes from the line of Robert Spingarn of Credit Suisse.
Hey, good morning.
Morning.
Just wanted to ask you, Nick or Kevin, on the, just sticking with this topic, but in terms of the kind of exposure that you have to used serviceable material. I know you do some consumables or expendables, but when you think of your commercial aftermarket portfolio, what portion of that is not exposed to USM versus what is?
We analyzed this two years ago. We found it hard to see any areas where USM was, you know, a real concern, a drag on revenue or growth. Certainly there may be some spots, a part number here or there, but broadly speaking, we did not see USM as a real competitor to our aftermarket business. We've looked at USM since then regularly. We've looked at buying parts out of the used and serviceable market, and we've not seen that there's much available out there or much we can do to impact that market. You know, we've heard the same concern that as planes are retired, more of them will be put into the USM market, will be parted out. That's possible.
We haven't seen that as a large drag on our revenue historically. It's something we've talked to all of our teams about to make sure that they're looking for these opportunities or looking for inventory of their parts out there. You know, we'll have to carefully watch that. Again, historically, USM not a big concern. I don't know if it will morph into that today. Generally speaking, you know, the way we have analyzed this and what we've heard from the market, $5,000-$10,000 needs to be the average sale price. Most of our parts, the lion's share of our parts, fall well below that. I believe we've communicated prior that about $1,000 average sale price, at least a couple years ago. It just puts our parts not in the USM available market, generally speaking.
It's something we will watch closely, but right now, I'm not as concerned about the parting out of planes impacting us. That may happen, and we will have to react to it.
Just staying on this for a second, is there a way to think about your exposure or your parts with regard to A, B, C, D checks? Have you ever looked at that? You know, are you more heavy checks? Are you the more routine frequent checks that would ?
Yeah. We're really all over the place. Some of our parts, you know, get replaced by time on wing. Others, it's number of cycles. Others, it's like seat belts or passenger related, passenger volume related, not takeoff and landings. We've looked at this across the board and not really seeing any trend that we need to exploit or there's an opportunity to.
Okay. Thanks, Kevin.
Your next question comes the line of Myles Walton of UBS.
Thanks. Good morning. Maybe a clarification and then a kind of bigger level question. The clarification is that the organic growth of 5% in the pro forma end markets, kind of derive to something closer to flat. Is that more just the Esterline mix or sales dynamic, maybe a little bit lower than the legacy TransDigm activity? The bigger question is, as you're entering the downturn of the end markets, how is Esterline performing, adapting? How are those businesses performing and adapting relative to your legacy TransDigm businesses? Are they kind of fitting into the same mold, Nick or Kevin, as you kind of look to adapt to these new volume levels? Thanks.
Mike will handle the pro forma organic growth question, and then I can handle the second part.
Hey, Myles. On the organic growth, it is, it's obviously a little confusing how you could do the computation this quarter just because Esterline closed mid-quarter last year. There are different approaches you could take. You could put Esterline completely in. You could take it completely out, or you could allocate it based on the number of weeks owned. The punch line is, depending on however you do it, the organic growth comes out somewhere between 1% and 5%. We did it based on number of weeks owned, and what we'll do in the 10-Q filing, you'll see the detail. We provided enough detail so that you guys can hopefully read through it and then do the computation however you want. At the end of the day, you get something between 1% and 5% depending on the approach you take.
It's just, it's a little muddy because of the, how the acquisition date fell on Esterline.
Mike, I think it's safe to say it isn't materially different.
It's not materially different from, for other business.
Yeah.
Okay.
As far as Esterline performance goes, much like first quarter, Esterline performed very well in across the board really, but certainly on the aftermarket side, they performed well. I think they're fitting into the general performance window of our legacy businesses, as they should. They're sort of products that fit the same mold as the rest of TransDigm. They're performing very well in the market.
You know-
They're adapting from a cost structure?
Yeah. Yes.
Okay. Thank you.
Say that question again. Can you say that one more time?
I just wanna make sure they're able to adapt to the same kinda quickly moving cost structure that the legacy TransDigm is used to adapting to.
They are. We, you know, gone to them and asked for headcount reductions and furloughs and cost containment, and they've been able to respond just like the rest of our businesses. They, yeah, they're very much in tune to what needs to be done. They're seeing the same market dynamics as our legacy business.
Okay, great. Thanks.
Your next question comes the line of Gautam Khanna of Cowen.
Mr. Khanna, are you there? I think he is not.
Sorry.
Okay.
Your next question comes the line of David Strauss of Barclays.
Hey, good morning, everyone.
Morning.
Morning.
Wanted to ask about working capital. I mean, you've talked about remaining free cash flow positive in the back half of the year, but how do you, Mike, I guess this is for you. How do you think working capital moves, just thinking, receivables, payables, and inventory levels?
Yeah. Well, over a longer period of time, we do expect some cash to come out of it, but we don't count on it. When we do the downside financial modeling assumptions, we don't count on any immediate inflow, positive inflow from a downturn in working capital, whether it's accounts receivable or inventory or stretching out your payables. As this goes on for a longer period of time, maybe six months, nine months, we'd expect it to be more of a source of cash. That's not what is driving the assumption of positive free cash flow in the back half of our fiscal year.
I would just add, like our other assumptions, we think that's a conservative assumption, but we don't.
Yeah
You know, we don't wanna kid ourselves here. I would say Mike got out really early in this whole process in talking to the controllers in our businesses about watching AR and AP closely on these to ensure we didn't get overextended in debts or in basically extending credit to folks. Operationally, we're managing our inventory. We're looking at this very closely. As Mike was alluding to, it's gonna take a little while for us to impact these and start bringing them down. You need production levels to bring inventory down, and it will happen. We're working on shutting off all the incoming taps and ensuring we're not extending too much credit to airline customers or distribution partners.
Okay. a follow-up question. This, you know, 70%- 80% assumption that you use for planning purposes, I know it's not guidance. How does that compare to what your underlying assumption is for, you know, the global capacity decline? Are you assuming that, you know, this 70%-80% is in excess of the underlying global capacity decline, and then also how you're thinking about pricing for your aftermarket business in this environment.
Yeah, let me try that. I would say the 70%- 80% decline, and just 'cause I'm sure I'll keep forgetting 78%, I'll talk about 75% 'cause I can remember that 'cause it's one number. It's not 75%. I'm not sure I followed your question, but it's not 75% less than the capacity decline. I mean, we're just If you took the run rate was 100%, we think the run rate's gonna drop down to 25%. All right?
Yeah.
That's what we're using for our sizing assumption, and we're assuming that's gonna stay there for six months. Which I think is, I'm hopeful, is conservative. It wouldn't surprise me that it could be a little sharper for the first month or so, but hopefully it wouldn't last six months. We'll see. I think the market dynamics for the sort of supply and demand and switching costs and the like, I don't think they change a lot, is the way I'd address your second part of your question.
Yeah. I was just-
Yeah, I would say on price side, we will still manage our value drivers. What we need to look at are where are the green shoots in the business. You know, is Asia coming back? Are they flying? Yeah, they're starting to recover a little bit. It's still slow. As Nick said, the next few months, sharp decrease and, you know, maybe it comes back a little bit in the following months, that's the way our profile might look like. Yeah, 75%, 70%-80% downturn in the aftermarket side is what we all have.
I was just asking if you were thinking that your aftermarket business was gonna be down in excess of the decline in global capacity.
I'd have to say I don't. You know, we're using the numbers we gave you. You know, I don't quite know how to calibrate that against, you know. There's assumptions all over the place on capacity that people make. You know, we had to set our number to size to, and that's what we used.
Okay. Fair enough. Thanks.
Your next question comes the line of Robert Stallard of Vertical Research.
Thanks so much. Good morning.
Good morning.
I'm gonna try and ask David's question slightly differently. Nick or Kevin, what's the sort of risk of inventory in the chain, you know, be it at MRO shops or in distribution channels or wherever it might be, that that could end up dragging down the aftermarket more than whatever airline traffic or capacity is doing?
I'll take a shot at it, and Nick can follow up. I think there's clearly inventory in the supply chain. We do not know how much. We know distribution, but we do not know MRO shops, airlines, and the like, or for that matter, really, what OEMs have. Clearly, the inventory overhang concerns us, and it's something we'll have to watch. This is the problem with a downturn like this, is you get a little bit of a double hit. I think, given the aftermarket, I think people manage our inventory pretty closely, but I'm sure there's inventory out in the field that will need to be accounted for and will be a bit of a double hit as we manage through that, initially.
The only thing I'd add is just, I think this is right, Kevin, the distribution, where we know the inventory pretty well, is about 25% of our efforts right now.
Yeah, that's right.
The other 75% is not distribution-
Right
Which is a little harder to get your arms around.
Yeah. Then as a follow-up, as you said, you know, the declines we're talking about here are pretty much unprecedented. You have been through some previous airline downturns. Can you give us some sort of color on, you know, the pricing situation? Obviously, airlines are facing bankruptcy and other things here. How has your pricing held up in previous experience?
Reasonably well. No, no significant change.
All right. That's great. Thank you very much.
Your next question comes the line of Sheila Kahyaoglu of Jefferies.
Hi, good morning, and thank you everyone for the time. Nick, I want to maybe talk about EBITDA margins. You said, you know, holding that mid-40s level is pretty tough, but you're aligning 80% of your cost structure, so it's variable, whether it's materials and labor. Understanding you guys have very high incrementals, how do we think about that mix impact given commercial is generating 70% of your EBITDA? I know you just commented on price, but it's, you know, you're hoping to get it positive, and you've had it positive in past downturns. I guess it's all a mix impact that you're gonna see from commercial aftermarket?
Yes. Yes. Very simply, you know, that segment, that piece of our business is the highest margin business.
Yeah.
All things being equal, if that one drops off more sharply than the rest of the business, which is likely the situation here, at least for a little while, you know, that's a headwind on your margin. I think on the cost reduction, all things being equal, in other words, if you kept a constant mix and you took the revenue minus the EBITDA, or EBITDA as defined, you took that slug of cost, I think we can get that down pretty well ratably with the volume assumptions, at least within the kinda ranges we're talking about now.
Right
All things being equal, that would hold your margin. I think you got some headwind from this aftermarket being a sharper downturn, that'll just make it tougher. I think we can get close, but I don't know that we can get all the way there.
Right. instead of a 35%-
We think a steady state with this mix of business is somewhere in the mid-forties.
Okay, that makes sense. That's why you're not getting 35% margins 'cause of the mix headwind. All that cost-cutting is getting you somewhere in the low, low 40s during the downturn in terms of EBITDA margin.
I don't know what the 35% means, but I think I'm not quite sure I follow that, but anyway, I think you got the size.
Yep, that makes sense. Then just to follow up on Myles's question a little bit with Esterline, is the cost structure there any different or you guys have aligned it so it's in line with the TransDigm average?
I think it's in line with the average. I'm sure there's still opportunities for productivity there, across the board, but I think it's in line directionally.
Okay.
I think those numbers you gave are the overall company numbers.
Yes.
Yep.
Yeah.
Yep.
Okay, thanks guys.
Your next question comes from Hunter Keay, Wolfe Research.
Thank you. Good morning.
Morning.
As we think about the commercial aftermarket business, is there a way you could help us understand, sort of a breakdown of what you view as more discretionary versus directly tied to flight hours or RPMs?
I would say most of our business is tied to flight hours or RPMs, takeoff and landing cycles. I think very, very little of our business is truly discretionary. You know, you can argue that, you know, seat belts may be slightly, because they can maybe live with them a little longer than they would want to, worn, floor tiles and marked walls. You know, those are aesthetics, and those are part of our Schneller and Pexco businesses, lighting, at some of our businesses, bathroom fixtures. Some of those may be slightly more discretionary. That's what we've always said about our aftermarket, but we believe the lion's share of it is dependent on cycles or time, or hours in the air. That's what we believe the bulk of our products are.
That's why if not much of your aftermarket is discretionary, with even small amounts of flight travel, you're still going to get some aftermarket. That's what we count on.
Got it. Nick, you know, obviously every quarter you come out, you talk about the beauty of the model, sole source, proprietary, the two biggest moats, and realize the beauty is how they complement each other. Is one of those two, maybe a little bit of a deeper moat through down cycles and over the long term, if you were to sort of lean towards one or the other as having a little bit more sort of durability or moat depth, which one would you lean towards?
I don't think you mean proprietary and sole source?
Exactly.
I don't think you can separate them.
Okay.
I think they're interlocked.
Okay. Thank you.
Your next question comes the line of Seth Seifman of JP Morgan.
Oh, thanks very much. Good morning, guys.
Morning.
Morning.
Just wanted to ask about the mix shift here, you know, the defense part of the business still holding up and probably, you know, in line with what you expected. You know, you talk about over 75% of the EBITDA coming from the aftermarket, but that includes the defense aftermarket, which is, you know, decent size. I've always thought of the defense aftermarket margins being, you know, not quite at the level of commercial, but still solidly healthy and, you know, solidly above the company average, and maybe the defense OEM margins being, I don't know, in line or slightly below the company average, but better than commercial OEM. Is that a fair way to think about it?
Yeah, I think that's a fair way to think about it. In total, we make less money on our defense business than we make on our commercial business. The mix between OEM and aftermarket, a little different in defense, but directionally, what you're saying is correct.
Not Myles less.
Myles, not.
It's not Yeah, it's not a big difference.
Okay. Then just real quick follow-up. In terms of just looking at the adjustments, were there, in terms of the workforce actions you took in the quarter, were there severance costs in the quarter? If so, were those in the EBITDA as defined, or were they adjusted out?
It was de minimis this quarter in Q2. In Q3, it'll be a larger charge, something on the order of $40 million-$70 million of one-time costs, we think. What we'll do is we'll show it in the add back table next quarter, but it will be an add back since it's one-time non-recurring costs.
The EBITDA, Mike, complies with our credit agreement.
That's right.
Essentially, that's the EBITDA adjustment.
The-
'Cause as defined in our credit agreements.
That's right.
That's what we use.
Gotcha. Thanks very much.
Your next question comes the line of Peter Arment of Baird.
Thanks, Nick, Kevin, Mike. Hey, just a question or more maybe a clarification on the sizing. You mentioned on the OE, Kevin, you said 25%-40% for the, for the second half. We've got Boeing and Airbus both kind of talking about rates being down through 2022. How are you thinking about just the OE piece of sizing for the longer term?
Obviously, when this crystallizes, we will be able to issue guidance around what will happen in 2021 and 2022. We're trying to size the business for the next six-month period so that we can attack it and be ready when volumes and capacity and the like return, which Nick said we think 18-24 months, I think that's a fair way to look at it. We'll see. That's the way we're looking at it right now.
Just this is a quick follow-up. Thanks for the details on the market weight of the products. Is it also similar in terms of your narrow body versus wide body mix?
In terms of what?
In terms of your overall installed base when you think about the aftermarket. Is it similar to 70% more narrow body than wide body, or just how should we think about that?
You know, we, I don't think we've ever disclosed that, so, I don't know how to think about that. We, you know, wide bodies are important to us. They tend to have slightly higher dollar ship set content, but the volume isn't there. Again, I come back to we're market weighted in those, in the aftermarket and in the OEM side. For us, you know, to follow the business, look at the order book and react, that's what we continue to try and do. I'm not sure I'm answering your question.
I think that, guys, as you rack it up and do the math, I think your question you're trying to get at is there's some kind of overexposure to wide body production on the OE side. If we do the math, there's not.
There's not. That's right.
No, I appreciate that. Thank you.
I think the best way to look at how this business starts to recover is frankly watch the number of flights. You know, until the flights around the world start to pick up, it's going to be tough to predict anything. You're just guessing anything until that starts to happen.
Thanks very much.
Your next question comes the line of Gautam Khanna of Cowen.
Hey, can you guys hear me?
Yeah, we can hear you now.
Okay, sorry about that. Technical problems.
No problem.
Thanks for all the color. A lot of the questions I had have already been asked. The one, I guess, just to follow up on the OEM discussion, aero OEM, do you have much of a sense for the level of destocking or inventory in the channel? I mean, maybe is there a way to size how many different subcontract manufacturers you guys sell to in the Boeing and Airbus supply chain? Is it fairly concentrated or is it very diffuse in terms of just the number?
I think it depends on business. In some businesses, it's very concentrated. In others, it's very diffuse, and we sell to, you know, tier 2s and the like. It's very diffuse, and I can't give you any more clarity around that.
Okay. you know, the other thing, just I wanna make sure we understand. Is the commercial aero OE business profitable? It contributes to the 25% of company EBITDA, or is it widely skewed to the defense side, that 25%?
Are you asking if the?
You're talking about the headcount reduction?
No. No, no, sorry. The commercial OE business.
Yeah.
Commercial aero OE business. I'm just curious if you can give us a rough sense for how much of the 25% of company EBITDA we should attribute.
Yeah.
Following up on-
percentages on profitability by end market, but we can say the commercial OE business as we look at it to the best of our abilities, it's a profitable business.
Yeah.
It's less profitable than the aftermarket.
Yeah.
Sure. Yeah.
Okay. Last one. You mentioned the defense business. You talked a little bit about the parachutes and what have you. Are there any other kind of lumpy orders or drivers this year that we should be thinking about as we model out next fiscal year as perhaps non-recurring?
No, I don't know of anything that's non-recurring that. You know, the issue with defense is that it often can be non-recurring, but right now I don't know of any any pieces. Our parachutes business looks like it's well aligned. International military sales continue strong. We haven't really seen any downturn out of any countries around that yet. So we think of the military as reasonably robust for the next six months to one year.
Okay.
Then we'll see. You know, the problem with defense is it's lumpy. This quarter, we commented on APKWS, the system turning, you know, dumb bombs into smart bombs. We sell a lot of product to APKWS, the Advanced Precision Kill Weapon System from BAE, and that comes in very lumpy orders.
Got it. Okay.
That something lumpy comes all the time.
Something lumpy comes all the time.
Right.
We had lumpy orders last year just in different quarters than we're getting them this year, so it makes the year-over-year comparisons bounce all over the place.
It's much more applicable to bookings than shipments.
Yes.
The orders tend to be lumpy, the shipments don't.
The shipments are not lumpy.
Not lumpy.
Generally speaking.
Yeah.
That makes sense. Thank you very much, guys. I appreciate it.
Thank you. Your next question goes to Michael Ciarmoli of SunTrust.
Hey, good morning, guys. Thanks for sticking around to take the question. I don't know, Nick or Kevin, maybe just back on the OE, the down 25%-40%. Does that contemplate, obviously, for the next 6 months, I mean, presumably it contemplates the rate reduction, some of the facility shutdowns. Does it also contemplate inventory destocking and a realignment of the supply chain? You know, did you guys kinda put your best assumptions in there?
There's, I know that there's going to be an inventory overhang, and we tried to give you a range to hit that. We do have some in there. The amount, it's hard to speculate on because we don't know how much inventory is held at Boeing or Airbus, for instance. We're not on min-max buck, you know, bin schedules, I don't know what amount they have, generally speaking, in their different products of buckets that they buy from us. We, you know, again, looking at this 25%-40% OEM reduction in the next six months, we'll include some of the inventory overhang, we don't know how much is really there.
Got it.
I think just to recap, just to restate what I think is the obvious, we can't wait for perfect information here in these situations. What we have to do is read everything we can read, look at what we got on our incoming data-
Yeah
At some point, just stick a stake in the ground and cut our cost down to that and then watch it. As I said in the beginning, the only thing I know for sure is we'll be wrong, and we'll have to adjust one way or the other over the next 6 months, hopefully up a little. You know, I don't know, maybe up a little, maybe down a little. We'll just have to see.
Maybe just one follow-up on that, Nick. You know, the cost out there and thinking about the aftermarket and, you know, presumably one year from now we'll have more flying, do you envision that the cost actions you've taken, I mean, you know, do you view these as permanent reductions? I would think it's gonna be a couple years for aftermarket revenues to get back to pre-COVID levels.
Yeah. I would say, I mean, I don't think our costs are gonna stay down by this magnitude as the, as the costs go. In other words, it won't all be incremental fall through the profit or something. As has happened in previous downturns, we tend to come out of these things with a better cost structure than we went in because we tend to not put the cost back in at the same rate the revenue recovers.
Okay. That's what I was getting at. Thanks, guys.
Your next question is the line of Ken Herbert of Canaccord.
Hi, Kevin, Nick, and Mike. Thanks for the time.
Morning.
Morning.
I just wanted to ask, when traffic starts to stabilize for your commercial aftermarket, if I think of that business broadly in sort of 3 buckets, repair, spare parts sales, and provisioning, where do you expect to see the recovery first, and how would you expect that to potentially play out?
Yeah, I would, my guess is it would be in the repair area, is where we would see the first, you know, the first reloading as they're, you know, bringing, you know, planes that need to be serviced now to the service line. That's what my assumption is, we'll have to see. Provisioning, as we've said in the past, isn't a huge driver for us for volume. There's certainly some here and there on some programs. I think it, you know, it's repair or spare parts that we would see, and I think it's probably gonna be the repair. Nick, do you have a thought on that?
I mean, the repair and spare parts are hard to separate.
Yeah.
Okay. As you look at your aftermarket business, obviously with crises like this, as we start to come through it, I'm sure you'll find some opportunities. Are you starting to think differently about the business in terms of maybe the distribution versus direct mix? Are you maybe finding opportunities with other partners? I'd imagine, you know, an opportunity like this, you will, as things stabilize, there'll be some ways to maybe shift some areas to your advantage. Are you thinking about that, or is it too early to be thinking about those discussions?
I think it's too early.
Yeah.
I think it's too early to draw any conclusions.
I agree completely. Okay, fair enough. Then just finally for Mike, any risk moving forward at all in terms of impairments on the intangibles just with some of the dislocation in prices in the marketplace?
No, no. I think you guys probably saw the SEC requires some quarterly tests for companies like us, and we've done the analysis with our auditors at EY, and we've got pretty good cushion across the across the board here.
Great. Thank you.
There are no further questions at this time.
I think that's it. I think there's no one else in the queue. We'd just like to thank you all for calling in this morning. That concludes our call. Thank you.
Thank you.
Thank you. That does conclude today's conference call. You may now disconnect.