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 the speaker's presentation, there will be a question-and-answer session. 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 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 private equity-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 a 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 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's 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 progresses, 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 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 with 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 in 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 the 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.

The first question will be from Myles Walton of Wolfe Research. Please go ahead.

Sure. Thanks. Good morning, everyone. Mike, I’d like to follow up on free cash flow. You’ve had a significant use of working capital as you prepare for future growth. Should we expect a similar level of working capital build in fiscal '23? Additionally, I want to clarify your thoughts on reducing net leverage or net debt to EBITDA. Would you also consider lowering gross leverage, or is that not part of your current plans? 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 accounts receivable 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 to $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 benefits 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.

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 address?

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, 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 about 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. 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.

I have a few more questions regarding our capital structure and capital deployment. Mike, you mentioned that there might be an opportunity to maintain slightly lower leverage if the interest rate environment remains stable. Can you specify or quantify what that would look like in terms of net debt to EBITDA? Additionally, you talked about the interest coverage ratio. Can you clarify what you're aiming to sustain there? Furthermore, considering the ongoing bid-ask spread challenges in the M&A market, are you considering share repurchases at the start of the year?

Sure. Regarding the interest coverage ratios and leverage, let me explain our perspective. First, concerning the cost of capital, we prefer to use debt over equity since it is currently cheaper. Our debt costs are around 8% to 9%, and with a debt cost of 5.75% this year, it remains significantly lower than the targeted equity return of 17.5%. Second, we need to consider our cash interest coverage, especially in a rising rate environment, focusing on how much debt we can prudently take on without risking equity value. We look at ratios like EBITDA to interest expense, which has fluctuated between 2x to 3x, averaging around 2.5. We are comfortable operating within this range moving forward. In fiscal '23, thanks to our hedges, we are positioned well within these limits, and we expect similar benefits in fiscal '24 and '25. However, if we did not have these advantages, we might need to lower our leverage a bit to maintain the desired coverage ratios. But for the next few years, thanks to our hedges and the debt taken on during a lower interest rate environment, we are in a strong position. As for the share repurchase question, we will continue to consider all our options, which include reinvesting in our business, pursuing mergers and acquisitions, and returning capital to shareholders through buybacks or dividends. We may opt for both strategies, although not necessarily to the same extent as last year. Additionally, we will prioritize paying down our 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, that we are a bottoms-up forecasting company, not a top-down one. This means the forecasts from all our various businesses inform us. Over time, this approach tends to be more accurate than making guesses about RPM growth from the top down. I believe this is the most precise method to forecast the business, and we have had great success 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 from 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 will be 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, are there 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 the 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. 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, we don't break these things down very precisely. Our aim is to account for inflation. Currently, our teams are projecting mid-teens growth year-over-year. There is significant uncertainty, especially regarding Asia, making it challenging to predict larger figures. Naturally, inflation is reflected in the year-over-year numbers, but we don't provide a specific breakdown because it varies by product and business. The key is to consider what inflation has been, and we are attempting to reflect that in our pricing. We are certainly experiencing 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 believe it's somewhat higher. You're correct, it's around 2.7% to 2.8% of sales compared to 2.5% in previous years. We're making these investments because we anticipate strong returns from our operating unit teams, typically within two years. This is contributing to our productivity, which is one of our three key value drivers, and the EBITDA margin expansion you're observing. We're making solid capital expenditures and supporting them financially. Additionally, we have a few one-time solar projects that are financially sound and benefit from tax incentives, especially in California where costs are a bit higher due to that. Overall, we're focusing our investments on effective projects that enhance productivity and improve margins.

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. 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.

Good morning. I have a question about the EBITDA margin, which remained flat year-over-year and sequentially, even though revenue increased. While I believe you will meet or exceed your forecasts for 2023, were there any elevated costs that influenced the incrementals, keeping them in line with the current margin of 50%?

I think we had about 0.5 points 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 believe there is always some level of uncertainty, but currently, there is a significant need along with challenges in supplying OEM aircraft. It may take some time before production rates align with actual demand, so I'm not particularly concerned in the next five years. Beyond that, we'll need to assess market conditions and any new technologies. Generally, the aerospace industry evolves slowly, and we don't expect many new platforms to emerge soon. Many existing planes will likely move into the aftermarket as they age. I don't foresee a major increase in retirements or significant changes from historical trends. However, as we look ahead over the next few years, we are quite optimistic that this will present favorable conditions for the company, both in the commercial sector and similarly on the defense side.

That's very helpful, I appreciate it. If I could ask one more quick question. Last year, you mentioned expecting 20% to 30% aftermarket growth. Instead, you achieved 43%, and I assume the situation in China was worse than expected back in November 2022. Looking back at this year, do you have any idea how much the situation in China affected the business, if at all? Or is that not how you view it?

We don't view it that way. Our focus is on the opportunities ahead. However, China represents about 20% of aerospace travel, give or take, and it's a major market that has hardly participated. So yes, that was factored into our numbers and acted as a hindrance to even better results and a recovery to pre-COVID levels. The primary issue lies within the Asia region, as most other regions have nearly recovered 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, regarding the guidance, you've mentioned your bottoms-up approach, but it seems that besides China, your guidance also considers various economic risks, inflation, and possible recessionary conditions. It appears that this mid-teens forecast includes many risks. I'm curious if this situation reflects a scenario where you've accounted for significant potential challenges. As we progress through the year, while I recognize you have some dark contribution, on a comparable basis, will we be close to reaching pre-COVID aftermarket revenue peaks by the year's end?

I think we're getting close to achieving aftermarket levels comparable to those before COVID by sometime in 2023. We will have to see how everything unfolds, especially with developments in Asia influencing this. Overall, I believe this positions us well for both our commercial and defense sectors.

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 challenge with aftermarket is that much of it isn’t booked; it’s booked and shipped within the quarter. So you are forecasting things that are uncertain. However, they have closer relationships with their customers than we do at the corporate level, which is why we tend to trust their numbers. We hope that it’s conservative. We hope that all these factors do not result in any significant impact on the aerospace market; we will 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. Please hold on while we move to the next question. Our next question comes from David Strauss of Barclays. Please proceed.

Thanks. Good morning. Following up on the previous comment about new visibility into airline inventories, can you share your insights on the distribution side? Specifically, how much of your aftermarket is currently running through distribution?

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 mentioned working capital. I'd like to ask about your inventory levels. They have now returned to where they were before the pandemic. Are you holding any excess inventory due to concerns about the supply chain, or are these inventory levels aligned with your projected sales?

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 shipment 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 frequently evaluate the situation, which becomes current in August 2023, so we need to address it by August 2024. We have sufficient cash to cover that. Currently, even in the worst-case scenario, we anticipate having ample cash by that time, considering the revenue we expect to generate from our operations. The market has shown signs of improvement in the past two weeks with various debt transactions that extend maturities, and we are reviewing these options. Our goal is to manage our financial structure effectively, maximizing our available resources as depicted in the slides, and extending timelines as needed. We prioritize this every day.

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 while we prepare for our next question. We have a follow-up question from Noah Poponak of Goldman Sachs.

Kevin, you were recently asked about your aerospace original equipment forecast and the business units that contribute to it. You've indicated that the expected outcomes are not aligning with the production rates discussed by the large commercial original equipment manufacturers. Additionally, there is significant supply chain disruption. Can you provide us with an update on your perspective? Is the situation improving? Is the demand you're observing from Boeing and Airbus aligning more closely with the production rates they've mentioned, or has there been no change?

Yes. I'll address that, Noah. Overall, the demand from Airbus has been aligning reasonably well with the stated production rates. Boeing, however, is currently facing various supply chain challenges and labor shortages, which can cause some discrepancies from one operating unit to another. It appears that there has been a slight improvement over the last quarter. We are all optimistic that Boeing will continue to address its issues and achieve the production rates.

Okay. In your defense business, the entire market has faced supply chain labor challenges, and we've observed that spending has been lagging behind the rate of authorizations. However, in the last few months, that gap has narrowed and we are beginning to see an improvement in your defense revenue. Is that trend continuing? Is your order rate improving? How do you anticipate this situation developing in the future?

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 FY '23.

Okay. If we exclude our price estimates, the low to mid-single forecast does not suggest much for unit sales. Can we interpret this forecast as reflecting the midpoint between market conditions from 18 months ago and the recent quarter? However, since it's only one quarter, we shouldn't assume full recovery just yet. If the trend continues to improve towards authorization, there could be some potential upside.

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. One moment while we prepare for the next question. And the last question will be coming 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?

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

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