Is TransDigm's Pricing Power Sustainable?
The best businesses tend to either be low-cost producers or possess untapped pricing power. The more extreme they lean in one of these directions, the better. Costco and HEICO, which we've recently covered, are vanguards of the low-cost model. TransDigm, which I will cover today, is an example of a business with pricing power.
TransDigm makes aerospace parts. More specifically, they make proprietary aftermarket parts with a low price-to-value ratio. 90% of TransDigm's products are proprietary, meaning they own their IP. 80% of sales are from parts that it's the sole supplier of, meaning TransDigm has a monopoly.
TransDigm sells low-cost parts. Parts average $1,000 and 90% cost less than $5,000. Despite their low cost, TransDigm's parts are mission-critical. When they wear out, aircraft are grounded until replacements are installed. AOG - "aircraft on ground" - is an airline's nemesis. Every hour, minute, and second aircraft aren't in the air and generating revenue, they're burning cash. Airlines' hightest costs are fuel, labor, and food, Maintenance is fourth. As a result, TransDigm's customers are more concerned with availability and quality than price.
As the sole supplier of mission-critical parts that cost airlines a negligible amount of money, TransDigm has lots of pricing power.
Business Model
Management runs TransDigm like a private equity shop. They acquire aerospace parts companies, cut costs, raise prices, improve availability and quality, and reinvest the profits in more acquisitions. True to their private-equity mindset, they use a judicious amount of leverage. They're often levered 4-6x and cover their interest payments just twice over.
Source: 2020 Proxy
The results have been astounding. Between 2004 and 2020, operating income has compounded at 17% annually. Since Nick Howley founded TransDigm in 1993, it has made over 70 acquisitions, including one this week. If a new edition of The Outsiders is ever written, Nick Howley will surely be in it. But the sheer number of acquisitions belies the care TransDigm puts into each. Scuttleblurb writes that in 2017 TransDigm considered acquiring over 300 companies, did due diligence on 26, and closed on just 3.
TransDigm is so selective about acquisitions because they vet the employees and culture as much as they vet their products. Without a disciplined and detail-oriented management structure, a leveraged growth-by-acquisition strategy in a cyclical end-market is a recipe for disaster. TransDigm's success is as attributable to their culture as to their business model.
TransDigm's name signifies a transition from one paradigm to another. When TransDigm acquires a company, they replace its centralized bureaucracy with decentralized leadership. Like Berkshire Hathaway and HEICO, TransDigm staffs its corporate headquarters with just 25-30 employees. Reversible decisions, like pricing, inventory, or specific parts programs, are pushed to the lowest level possible. Only irreversible decisions are run up the entire chain of command, like those affecting the overall contractual relationship with a big OEM such as Boeing or Airbus or General Electric,
As a part of this paradigm shift, TransDigm eliminates middle management and empowers lower-level employees to run the business like they own it. This invigorates the business with entrepreneurial energy that's hard to quantify but nonetheless real. Stock options vest based on performance, not time, aligning incentives. There's no such thing as "vesting in peace" at TransDigm.
Eliminating middle management saves TransDigm money and pushes decision-makers closer to end customers. The company reinvests some of the savings by hiring more engineers. This increases quality and reduces design times. TransDigm can afford to throw more engineers at a problem than competitors, which OEMs appreciate.
TransDigm also tinkers with inventory when they acquire a new business. A grounded airplane costs an airline a lot more in lost revenue than the replacement part does. TransDigm keeps its customers happy by ensuring that their parts are always available, worldwide, on short notice.
It accomplishes this by carrying more inventory in a finished state rather than as raw parts. Many aerospace companies carry inventory as raw parts and try to manufacture parts as orders come in, like McDonald's. This minimizes the value of inventory on their balance sheet.
TransDigm always asks, "what's most useful for the customer?" Customers almost always want finished, qualified inventory that they can immediately use. While this inventory costs more, it also turns faster. As a result, TransDigm can increase returns on capital while simultaneously increasing delivery speeds.
Most suppliers don't do this because their centralized decision doesn't appreciate each product line's nuance. TransDigm makes inventory decisions on a product-by-product basis. For example, if customers sometimes repair rather than replace a component, TransDigm will carry inventory in an intermediate state.
Price increases are the final way TransDigm creates value from acquisitions. High-quality parts available worldwide on short notice are valuable. Customers are happy (or at least willing) to allow TransDigm high margins for this service. OEMs are likewise happy to keep the engineering and inventory costs on TransDigm's balance sheet. TransDigm is happy to earn high profits and high returns on capital. Win-win-win.
The Valeant of the Aerospace Industry?
Win-win-win might be a bit strong, as operators do pay more than strictly necessary. This has made TransDigm's business model contentious. Short sellers and competitors regularly question the sustainability of TransDigm's business model. Citron even called TransDigm "The Valeant of the Aerospace Industry." Valeant was a pharmaceutical company that eschewed in-house R&D. Instead, they spent all of their money buying proven drugs and raising their prices. They became the poster child for the country's escalating cost of health care. The business eventually imploded under dubious accounting and lots of leverage.
On the surface, the comparison seems apt. TransDigm, after all, does raise prices. It's also highly levered. But that's where the similarities end. Unlike Valeant, TransDigm doesn't raise prices arbitrarily. Price increases follow a logical and defensible process. More importantly, despite higher prices, TransDigm continues to provide value to its customers. Valeant raised prices well beyond what patients could afford. TransDigm's customers can still afford its parts because they still constitute a small portion of a plane's overall cost.
As proof, consider the case of the US Military. Defense account for a third of TransDigm's sales. The military is the sole customer for these parts and therefore has considerable bargaining power with TransDigm. The government wants TransDigm to earn a profit but doesn't want to get ripped off. The Department of Defense Inspector General has had a near-continuous stream of investigations open on TransDigm since at least 2002, and yet, nothing ever comes of them. Last year, TransDigm voluntarily refunded the DoD a trivial $16 million. If the DoD has not been able to do anything about TransDigm's prices for nearly two decades, their prices cannot be that contentious. No one likes getting ripped off, but people do like getting parts that work quickly. And no one has the energy to really put their foot down over excessive margins on a $1,000 part.
TransDigm isn't the model of stakeholder capitalism that Costco is. But it also doesn't seem to be Valeant. The US government, Valeant's largest customer, quickly squashed it when prices got out of hand. That probably would have happened by now at TransDigm if it were going to occur.
Industry Structure
To understand when and why TransDigm raises prices, it's critical to understand how the aerospace parts industry works.
The industry has four key players:
OEMs, like Boeing and Airbus;
Suppliers, like TransDigm;
Airlines and end-users, like Delta and the military; and
MRO distributors.
OEM's work with suppliers to design parts specifically for their new airframes. Parts become deeply embedded within the design, creating high switching costs.
The FAA then reviews and qualifies each part in a long, costly process. The up-front design and qualification cost is so high that there's usually just one supplier for each part. Once an OEM selects a supplier for an airframe, to grow organically, so TransDigm simply buys them. Like HEICO, some companies make "generic" PMA parts, but this is only economical if the part retails for at least $5,000. 90% of TransDigm's parts cost less than this.
Switching costs and regulations insulate TransDigm's parts from the competition. OEMs understand this and use their role as gatekeepers to extract low prices for themselves on new parts.
OEM's are happy to let suppliers make the up-front investment in engineering, tooling, and inventory, sell them parts at a modest markup and make their money back on aftermarket sales to airlines.
TransDigm is happy with this too. They earn a low double-digit margin on new parts but 70%+ margins on aftermarket parts. Aftermarket parts make up 60% of TransDigm's revenue but 90% of its EBITDA.
Operators, like airlines and the military, are the losers. They have little recourse to paying TransDigm's inflated aftermarket prices. Their only consolation is that they can afford to pay. The parts are low cost and don't really move their bottom line.
This is like Starbucks. Starbucks has 70%+ gross margins and pricing power. People know Starbucks is a rip-off. But they buy $5+ lattes anyway because A) they can afford to, and B) they're convenient. People don't care enough about getting ripped off if the price is low enough.
Pricing Power
TransDigm's strong competitive position grants its pricing power. TransDigm exercises its pricing power in two ways.
Aftermarket Leakage
If a part does not go onto a brand-new airframe, it's aftermarket, even if an OEM buys it. Aftermarket "leakage" occurs when OEMs buy parts at the new-parts rate from TransDigm and sell them at the aftermarket rate to airlines.
Leakage means that the OEM, not TransDigm, captures the higher aftermarket margins. TransDigm counts on those margins to compensate them for fronting the part's development costs and carrying readily-available inventory for airlines.
When TransDigm buys a company, leakage is one of the first things they look for. If they see that OEMs are buying 40 parts per year but only selling 10 new airframes per year, they know 30 of those parts should be subject to higher aftermarket pricing.
Many suppliers don't enforce this because they can't detect it. Remember, TransDigm deals with low-priced parts. At many companies, a few hundred bucks here or there slip through the cracks. Not at TransDigm. Their decentralized structure means that each part has a person solely responsible for its P&L.
OEMs now know that when TransDigm buys a supplier, their free run ends. They don't fight it because they know it's fair.
Low Volume Parts
TransDigm also raises prices as parts age and demand wanes. Airplane models are usually built for 20-30 years, and each plane has a 20-25 year lifespan. As planes are decommissioned, the market for their aftermarket parts shrinks. TransDigm's inventory turns slower, and their unit cost of production increases as they lose scale. TransDigm raises prices to compensate for this, with older parts receiving bigger price increases than newer parts.
Unlike Valeant, TransDigm's price increases aren't arbitrary. They follow a well-defined and logical pattern. OEMs get low-cost parts for new airframes and push engineering, manufacturing, and inventory costs off their balance sheet and onto TransDigm's. In exchange, TransDigm gets to makes its money back in the aftermarket as aircraft age.
Forward Returns
TransDigm pays executive officers almost exclusively with stock options that vest based on growth. Specifically, they measure growth in intrinsic value per share to account for earnings and capital structure changes. Payouts don't begin until there's been 10% growth and maxes out at 17.5% growth. It's not surprising then that operating income has compounded at 17% since 2004. After all, you tend to get what you incentivize for. The question is, can TransDigm continue to replicate their historical success?
Source: 2020 Proxy
TransDigm's growth is a function of organic growth, acquisitions, and leverage.
Let's begin with organic growth. Sales are correlated with revenue passenger mile (RPM) growth. Historically, they have grown 4-5% annually. TransDigm doesn't disclose how much of its organic growth is due to pricing and how much is due to volume. Most likely, they lean more heavily on pricing than volume. One way or another, organic sales tend to grow a few percent per year. At a 10% discount rate, this is worth a 17-21x earnings multiple. Today's multiple is closer to 30x.
However, future acquisitions are virtually certain. There are thousands of niche aerospace parts companies TransDigm could buy, which should fuel inorganic growth for years to come. Scuttleblurb described how they create value via acquisition:
It will buy companies for between 9x and 12x EBITDA, funding ~60% of the purchase price with debt, and implement operational changes (cost cuts, price hikes, etc.) to ~double EBITDA over the next 5 years.
The margin improvement alone drives a 15% CAGR over five years, assuming there's no change in multiple.
Today's price at around 30x implies 6.5% annual growth. This valuation demands that RPMs normalize and return to their historical growth patterns. It also requires periodic acquisitions to bump growth even higher.
Neither of these assumptions looks silly, but they don't leave much margin of safety. This year and next will be the ultimate test of TransDigm's business model. So far, it is passing with flying colors. That signals that their debt load probably is sustainable.
While TransDigm is a company I'd buy at the right price, that price is well below its current quotation. In many respects, I also prefer HEICO. HEICO’s low prices more clearly provide value to customers and have proven profitable for shareholders alike. TransDigm’s business model looks sustainable to me, certainly more sustainable than many of its detractors suggest. Still, it seems safer to avoid the question of sustainability all together, either by buying HEICO instead or by buying TransDigm with an extraordinarily large margin of safety.
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