TransDigm: Esterline Technologies Acquisition

Mark, could you provide some context to the platform and product segment that you worked with, in Esterline?

You can think of it as a division; we called them platforms. Most of what we did was handle what we would classify as the man-machine interface, between a system input, on board an aircraft and the pilot themselves. This division made things like displays that pilots could touch. They made rotary controls that the pilots could use. They made control panels that the pilots would be able to input into. Our division or our platform also did software associated with all of that. We also did some communication development or communication equipment for ground vehicles. In other words, a customer for us would also be the US Army or any other army around the world. So those types of things. Basically, information coming out of the pilot, into the system and then the system goes off and manipulates it, one way or the other.

Which products were you dealing with, mostly?

A little part of our division was called Korry Electronics, even though it was part of Esterline. Korry itself dealt with, generally, the control panels. Let’s say, you go on board a 787 or a 767, you look to the left and into the cockpit, there will be a number of control panels and we would generate those. We would create those and sell them to different OEMs and different airlines, all over the world.

As you said, you were in the Esterline control and communication systems platform, what was the split, roughly, between OEM business and aftermarket business?

Aftermarket, if I include all the spare parts and everything, would probably run at about $45 to $50 million. The OEM business itself, when I left the company, was running around $75 to $80 million, but that was growing, because many of the platforms that we were supplying to directly, were still in a development phase or still on a smaller number of production runs.

In terms of the structure of Esterline and the team, what’s the FTE structure or what did the team look like?

A classic team for development or just in general?

For example, take the Esterline control and communication segment, what would that org structure look like?

The platform would have a vice president or director or general manager. There were a number of those people that would report into group VPs at the corporate headquarters, in Bellevue, Washington. The platform itself, would have individual units as part of it. Our platform had six individual units, I believe, when I left. Each individual unit had its own vice president or president of that particular company. The units could run anywhere from 25 million a year, up to 180, depending on what it is that they were doing. Most of the time, some of the larger ones would have a president who would run that. He would have his own senior staff. Some of the smaller ones would also have their own person running that group and their own senior staff, but it would just be at a smaller level.

How would you explain the core organic unit growth of the control products that you were selling to the OEMs? What was the underlying growth rate, without pricing increase, just the pure unit growth?

The unit growth, year over year, was heavily dependent on the rates of what the OEMs were doing. We would win a contract from an OEM and an OEM could be anywhere from Sikorsky to Boeing to Airbus; it could be Embraer, Gulfstream. We would end up signing a contract with these OEMs for a number of different years. As long as our pricing worked out well and we didn’t raise our prices too much, then they would stay with us. That’s how the business was set up.

Can we walk through winning a contract. How does it work? Let’s say, I’m an OEM, I’m building a new platform, what is the typical process of winning a negotiation and winning a new platform?

This is a long answer. Originally, what we would do is, we would be working with OEMs, like Boeing or Airbus or Embraer or Gulfstream or Bombardier, trying to understand what it was that they would like to see from our part of the aircraft. Like I said, many times, when you get on an airplane and you can look to the left in the flight deck and you can see a number of different control panels, in the overhead, they call it and buttons and switches and knobs and everything else. We would work with the OEMs, to see if the system was still going to be the same and how many different things we would have change with our system, in order to actually be in a position where we could even bid on the business.

In other words, as with Gulfstream, if they didn’t want push-button switches and they didn’t want rotary devices and they didn’t want it in the overhead, they wanted something that looked much cleaner, like touchscreen displays, then we would have to work on that, in order to support where it is they were going. We would work with them, early on, in order to help set the development requirements. Then, from that standpoint, we would know what the OEM wanted out of us and, as long as the business case worked, we would bid on a program and if we won, we would sign a contract and we would be the supplier for those particular things, for that OEM, for a number of years.

Does the OEM share what they are looking for with many different suppliers?

They do, but if you are very early on, in terms of conceptual phases, and you’ve got a piece of technology that they want, when it comes to a point of being able to put a bid out on the street, they will send it to a number of suppliers, but realistically, there’s only one supplier that is probably going to give them exactly what they want. That’s the supplier that’s been working with the technology early on and going, with them, all the way up to the point where they are writing the requirements.

So yes and no. But we spend a considerable amount of time, with all the OEMs, going down that path. Do you want touchscreens? Do you want the old push-button switches? How do you want us to certify this? We would flush all of that out, very early. Literally, Gulfstream has one OEM. You wouldn’t want to physically, really, build one system for just one. You would want to build a system that would work for both Gulfstream and Bombardier and Airbus and Sikorsky and everybody else.

Typically, the OEM would only work with one supplier, very early on in that concept phase?

Yes, normally. If there was another supplier that had something interesting, then they would keep us both at arm’s length, until we zeroed in on what it was that they really wanted. The way it works is, very early, if you can show them that your technology roadmap is going in the same direction that they want it, then they will spend time with you. They will help you figure out, from their standpoint, what it is that they’d like to see you do, versus us just guessing.

So early on in the development phase, you’re working with the OEM, they’re telling you exactly the specification of the products. How does the pricing work?

The pricing is, literally, based around a number of different things. We will have a number of different revenues streams associated with one program like this and one system. We’ll have the initial sale of the hardware to them, that goes into the aircraft, as it goes down the line. We will probably set spares, if the OEM wants spares and we’ll set that pricing, at that point. We, internally, would also look at their customers and see what the revenue streams would be for those customers, as well.

Business jet companies, like Gulfstream or Bombardier, they basically control the entire revenue stream, from the time that we deliver hardware, all the way up to the point where the product is ready for disposal. But for Boeing and Airbus and some parts of Embraer, the airline is the entity that will buy the spare parts for that particular revenue stream. We would take that into consideration when we came up with pricing. It all comes back to whether we’re getting the proper return on our investment. Normally, if we’re supplying to Boeing, then we will give Boeing a good price because Boeing knows that we’re going to sell spares, in the aftermarket, to airlines and Boeing expects that. In many cases, a company like Boeing will, basically, buy the hardware from you, at cost, is what they’re going to try to get to. They know that you are going to be making up some of it in the aftermarket.

If it’s a business jet company, it’s a little bit different because that company, like Gulfstream, will control the entire lifecycle of that aircraft.

So Boeing would say, we’ve been developing this control panel for the last X amount of years. I’ll buy this from you, at cost and you also sign a contract with Boeing for the spares, that then get sold. You sell at a margin and then Boeing sells at an even higher margin, in the aftermarket, to airlines?

Interestingly enough, today, Boeing would like to do that. The way it’s set up, companies like Esterline/Korry can still sell directly to the airlines. Boeing would love to be able to have control over that; they just never have, so they try to get the suppliers to sign up to programs that, such as Power by the Hour, which is one we have all heard of. In other words, if Boeing is trying to sell a system or trying to sell a service to the airlines, like Delta or British Airways or Lufthansa or whatever and part of that service could be staging spares, wherever the airline needs them. For bigger pieces of equipment, like engines and avionics and all that kind of thing, that’s pretty much the way it’s done.

Piece parts, components, those types of things, aren’t necessarily part of those packages. But Boeing will also try to squeeze the supplier into a position where they can only set a price at a certain point to airlines. The airlines could possibly come back to Boeing and say, Korry is charging five times what I know it costs to make and you need to get your suppliers in line. Boeing would come back and try to push us in certain directions.

Why would a supplier ever sell the spare parts to Boeing, when they can sell them to airlines at a much higher margin?

You wouldn’t, unless you had to. Big companies, like Boeing and Airbus, will try to put things like this into the contract, to say, you have to sell me certain spares at a certain point. If we’re talking components, Boeing won’t turn around and resell those to the airlines, because of the way the contracts were written, years ago. The supplier of components will still be able to sell those directly to the airlines or the final user, whether it’s a leasing company or airline or whatever.

But Boeing shares in the profit on that?

They don’t but they do limit how much we can raise the prices on those spare components. I’ll put it this way, they don’t actively share part of the profit associated with that. What they’re getting, and they know it, is a much lower price on the front end, because of it, on the initial hardware sale.

They’re pretty much saying, I’m going to buy this from you, at cost. This is the price you can sell at, to all of my customers?

Yes.

That’s interesting because the TransDigm model and argument is that they claw back that ownership of the aftermarket and they maybe sell at the same price, at cost, to Boeing or Airbus, for the hardware OE sale. But then they really ramp up and earn the margins on the aftermarket, to airlines. What’s your view around that?

As far as Korry and Boeing were concerned, Korry actually made a push-button switch and Korry was the only supplier of that switch, in the world. You could not buy it anywhere else. The barriers to entry for making that switch are very high. It takes a lot of tooling; it takes a lot of engineering. It sounds strange, but it does. It takes a lot of that type of stuff, in order to get that switch certified, in a flight deck. If they want, Boeing can come in and say, okay, you can only have certain customers in the aftermarket, to buy your switches and we’re only going to let you raise it up to three times the normal cost. TransDigm could turn around and say, no; we’re not going to do that and we’re the only people on the face of the earth that actually make these things and we’re going to charge whatever we want. So they are probably doing that. I’m not privy to what it is that they are actually doing but they could possibly do that and, maybe get away with it, at least in the short term.

Why didn’t Korry and Esterline do this before?

Because we wanted to have a position with Boeing, that allowed us to get bigger pieces of aircraft. In other words, if I were TransDigm and I’m not trying to sell complete systems to Boeing or Airbus or these other OEMs, then I don’t care. I can raise it as much as I want and you have to pay the price and that’s it.

Korry and Esterline, on the other hand, didn’t want to do that. We wanted to get a fair price, we wanted to stay in business, of course; we wanted to be able to sell into the aftermarket. But we also wanted to work with Boeing and Airbus and these other companies, in order to make bigger systems on board the aircraft. I’ll put it this way, a 737 aircraft has switches in the overhead and that’s what we sell to Boeing and we sell spare switches to airlines. For the 787 and 777X, Esterline/Korry sells the entire overhead, with all of the control panels and all of the certification aspects associated with that. I’m not just selling switches; I’m selling a complete system to Boeing. That’s the position that we want to be in.

So you’re working with Boeing, to upsell the bigger systems of the platform?

That’s exactly right.

You think that if TransDigm or Korry were previously to take that position of actually, no, I’m going to charge whatever I want in the aftermarket, Boeing would backlash against that and not be willing to work with you to sell the larger systems?

That’s right. That would be the case, for sure. They would not want to work with us and they would cut us out of some much larger business.

But Korry is the only company on the face of the earth, to supply those.

Yes, but it still goes back to the same thing. Yes, we could raise our prices as high as we wanted, some of the bigger airlines would have to pay the price. They would come back, they would complain to Boeing about it. Boeing would try to apply pressure, to drive our spare prices down and we could say, no, it doesn’t matter; we’re going to charge whatever we want. But that’s a short-term strategy and it’s not one, in my mind, that puts you in good standing with your customer, as you go forward.

Let’s face it, as far as Korry and Esterline were concerned, at that level, you had to have Boeing. They were probably the largest customer inside of the four walls; they weren’t the only ones, but you had to have Boeing. You had to have a decent relationship with them. It wasn’t always great but we worked with them on a daily basis and they were a large customer. If I’m trying to look at this from a short-term standpoint, sure, I can just raise my prices all I want and if that’s really what I’m trying to do, fine, because it will take one to two years, maybe longer, to get somebody else out there who could develop and sell the switches themselves; it would be very difficult.

That’s only if your strategy is to upsell to bigger systems?

Yes. Like I said, if you wanted to be TransDigm and you could do this and you could just raise the price to wherever you want, go ahead. Short-term system. We even pressed Boeing to the point of them threatening to get rid of us, because we wanted to get as much out of our spares as we possibly could. We wanted the initial sale of the hardware to be as high as we could make it and there were other parts of Esterline, not necessarily Korry, that were doing the same thing and they got replaced. If the barrier to entry is low enough, it will happen. If it’s high enough, they’ll take a little longer but they can possibly pull it off. We just never wanted to go down that road.

How did Boeing replace the part?

There would be another company that would be willing to build a switch to the Boeing part number. We’re talking components here. Making a push-button switch sounds easy; if I’m just looking at my computer or I’m looking at my car, it seems as if it’s pretty simple. But if you’re trying to put one into an aircraft, it’s incredibly difficult and takes a very long time, in order to develop it. Again, it could take two to three years, to get it to the point where I’ve designed, developed and certified a push-button switch that goes into the overhead of an aircraft. The barrier to entry is pretty high.

As you said, if you pushed Boeing too far, even if you have a monopoly, it might take them time, but they would still look to find a partner to replace the part?

Yes, they would. If their customers, their airlines, were complaining too much about spare pricing, yes, they would do it. Eventually, they would do it. I guess my point is, with TransDigm, if they want to continue to raise the prices, then there will be OEMs out there that will replace them.

I guess their argument would be, we’re the only company on the face of the earth that supplies this. Therefore, we can ramp the prices somewhat and, actually, I don’t care about selling bigger systems to you; I’m just going to keep on going acquiring, 10, 20, 30 more Korrys, over the next 10 years, for example?

Yes. That’s a position; that’s very definitely a position.

What’s the attractiveness of bigger systems?

You have a bigger say in the aircraft design. If your competitors are also looking at doing that, then you almost have to go into that position. You almost have to take on bigger systems because the OEM themselves, whether it’s Boeing or Airbus or Embraer or Mitsubishi, they are all pushing you into that direction, in the first place. We talked about technology roadmaps before and what it is that the OEMs want. If they have a supplier that they like, they want to control what that supplier is doing, more and more, and they would like that supplier to have a bigger and a larger system. By the way, if you make a bigger and a larger system, that larger system still has push-button switches in it, so you can still some spare parts in the aftermarket, if you want to.

But really, it comes down to the OEM, once they find a supplier that they can work with and they can deal with then, yes, they would like to give them more business, so they can keep their supply base numbers down, as much as possible. They don’t want 5,000 suppliers; they would rather have 500.

The situation with Korry, for example, if they were to ramp up the prices, you mentioned that the airline customers in the aftermarket, would then complain to Boeing, who would then be onto Korry or Esterline’s back? Would the customer airline really complain, for a part that’s, frankly irrelevant, to the total cost?

For a component, not really. They would have to be buying many of them, in order for them really to go back to Boeing and have Boeing put the pressure on Esterline. If it’s a larger system, if it’s the entire overhead that goes into a 787, that spares price, for those particular panels that are a lot more expensive, is set. Once I have a larger system, I’ve got a number of different control panels, in the overhead of a 787. As part of the initial contract with Boeing, Boeing would also set how many times we can multiply the hardware price buy, to sell to an airline.

Once I get into bigger and bigger systems, there’s reliability that comes into play. Boeing will say, to an airline, which is their customer, that we’re going to guarantee that you can have a certain particular piece of hardware, ready to go, at a certain point and that would include something that we would end up having to sell to Boeing, so they would try to set the price for that. In other words, if the initial hardware price to Boeing was X, then we’re only going to allow you to sell this particular part, directly to an airline, for 2X, or 3X, maybe. But since it was a much bigger piece of equipment and there was a lot more money involved, Boeing took a much heavier hand.

How much are those systems? Take the whole of the system in the cockpit, for example, in the aftermarket; how much would that be, as a system?

It really depends. It could be anywhere as low as $50,000 per ship set, all the way up to $125,000, $130,000.

And the small components and parts?

Again, it depends. If you’re selling it to Delta or British Airways or something like that, they get a special price and it would probably be $250, $300. If you’re selling it to an operator that runs three aircraft in Africa, then the switches themselves would be somewhere between $3,000 and $4,000 apiece.

Why?

Because the operator that only has two or three aircraft will bear the price. It’s not the biggest part of the business, but when we start talking about component spares, it really depends who you are. If it’s a larger airline, you’re going to get a good price. If it’s a medium-sized airline, maybe, maybe not, you will end up with a different price. If it’s a much smaller airline or operator, then they are going to have to bear the full weight of it.

Did they moan?

Well, sure. For components, a major airline would go back to Boeing and complain, then Boeing would come to us and they would say, no, you can’t really do this to these guys. If I was a small operator, of five or six aircraft, that would never happen. That small operator can complain all they want to Boeing and it’s not going to make any difference. They don’t have the weight, like a Boeing or a British Airways, so they’re kind of stuck with what it is.

So you kind of do to the small operators what TransDigm would do to everyone?

Honestly, yes.

So for these parts, typically, at Esterline, what would be the distribution of the price of parts? For example, would there be 60% or 70% that is below $10,000? How many parts are really below $5,000, for example?

The bulk of them. The bulk of the switches that would be sold or the components that would be sold, the margins are high, but the bulk of what we would be selling wouldn’t be that $4,000 or $5,000 switch. It would be somewhere between $500 to $1,000. Honestly, this is an area I don’t know that much about, but I do know that the pricing was flexible, depending upon who the customer was.

Back to the corporate strategy then. Esterline clearly had this pricing power over the parts. They have an effective monopoly on certain switches, for example. Relying on the strategy to upsell to bigger systems is a big call and also quite risky, in that you become more reliant on platform and aircraft sales and production?

Yes. So, why? The odds are that if a competitor of Esterline gave Boeing or Airbus or Embraer what they wanted and was supplying a complete overhead system to the OEM – in this case, I’ll use Airbus, as Esterline/Korry have sold many switches to Airbus too – the odds that they would be buying our switches would be almost non-existent. They would buy their own. They would go to another party and they would buy the switches. If our customer is saying, we need you to think about building bigger systems and even if we didn’t particularly want to, we realize that if we didn’t, somebody else would move in, do what Airbus wanted them to do and that supplier would not be buying switches from Korry.

So you worried that you were going in at the component level and someone would come in at the system level and completely displace you?

Right. If you wanted any of the business, you had to go do that. Boeing is the only OEM out there where our part was a monopoly. We competed with other switch manufacturers, worldwide, for all these other OEMs that I’ve been talking about.

I’m just curious about the growth rate. Let’s say, in the aftermarket, you don’t increase the pricing, what would be the unit growth rate that you would get, on these small switches, these $500 switches?

The growth rate, itself, probably wouldn’t be that much, year over year.

It would be the aircraft production?

Yes; it would be, how many aircraft are out there and how many spares am I going to sell into that aircraft market. As long as that aircraft market doesn’t really shift, then I’m not really going to see it grow that much, unless I’m messing around with the pricing that we’ve already talked about. On the other hand, there was an interesting shift that actually happened. We were starting to build overhead systems, to sell directly to companies like Bombardier, Airbus, Embraer, Mitsubishi, Sikorsky, Boeing, all of these companies. One of the larger users of the push-button switches was Korry itself. The growth rate was based around how many aircraft all of these OEMs were going to end up manufacturing. It was quite a bit.

So the growth rate itself was initially based around how many G500s and G600s is Gulfstream going to make, in one year. Let’s say, it was probably 60 or 70 aircraft a year. How many 787s was Boeing going to make a year? It’s about 12 a month, I think. So 144 a year. How many 777s are they going to make? You just add up all of that and say, okay, that’s where we can see where we’re going.

When I left the company, there were quite a few of those aircraft that still hadn’t hit rate production. Mitsubishi was making a regional jet and had not made it into rate production yet. The parts that we were selling to them, the price made sense and when we got into rate production, that particular program would pan out.

The reason why I asked that is, there’s an argument out there around TransDigm that a large part of, if not all, of the organic growth that they report, is from pricing and not from actual unit growth. I’m just trying to understand, in a steady state environment, do we just expect the unit growth rate to be GDP plus the growth of the platform that they are on or supplying? For example, in today’s environment, for TransDigm, where you see production being cut, the organic growth rate, is it going to be driven just by pricing?

You’re right. Their organic growth rate would be based around pricing. Mostly based around pricing. The types of systems that we are talking about are utility control systems, which are controlled by all of those panels that are in the overhead of an aircraft. That doesn’t mean that all of the aircraft that are flying will never be upgraded into a better system. They are still flying B52s and they’ve been flying them since the 1950s and they continue to upgrade those aircraft. The US Air Force continues to upgrade C130s. There is growth in those areas, to put a new system on board the aircraft. You can still go at it that way.

But for the most part, while you’re off trying to develop a system that can go into a C130, you’re going to be messing around with your price, to try to get as much out of it, year over year, as you can.

Let’s just get into detail then, on the actual pricing and the process of buying components in the aftermarket. I’m an airline, I want to replace some controls and switches in the cockpit. If I’m buying from the supplier, what is the process?

It depends. They can buy it straight from the supplier, they can buy it straight from Esterline, straight from Korry. If you are a smaller operator, you could do it that way too. You could also buy from distribution, if you wanted to.

So it depends on the internal airline MRO, versus a third-party MRO?

Yes.

As a supplier, you would be approached by the MRO shop, whether it’s internally at the airline or third party and they would say, I’ve got an order for parts for this system?

Yes. Normally, the distributors that we worked with, there was also a business arrangement with them, that they would buy certain numbers of our part numbers, on an annual basis and they would keep them in inventory, which would allow us not to have to do that. They would have their price and we would have their price to them. Again, it’s all dependent on who your customer is and what level they’re at.

If I’m a major airline, you’re going to be able to buy something directly from Korry and you’re going to get a better price. If you’re a smaller operator, you probably are going to be buying from distribution and then it depends on how many components you’re going to end up buying.

What’s the deal with distributions, that suppliers have?

I don’t remember.

I believe that Boeing and Airbus have captive distributors, as well?

I don’t remember, or they may have their own distribution network.

So you would work with them, to supply the airlines?

Yes.

If I’m an airline, when do I, typically, replace those parts, those small switches at Korry, for example?

When they break. There’s a warranty associated with them. But some of the older aircraft that have push-button switches, like a 757 or a 767 and some of the other older aircraft, many times, especially for 757s or 767s and some of the older 777s, the mechanics tend to break the parts. It’s hard to explain how the switch works but some of the older switches have incandescent lamps in them, in order to light up the switch when it’s pressed. The incandescent lamps only last so long so they have to switch them out, from time to time. Many times, if you don’t put the switch back in the socket the way it’s supposed to be, you could break it. Once you break it, there’s no repair and you have to buy another one.

It wasn’t set up to be that way, but that’s kind of the way it works. In certain cases, you have to have that switch. You can’t push back. You have to be able to have the system up and running, which includes the switch. So in many cases, you have to have switches sitting at different locations, wherever the airline flies, so it can be ready to go on board.So yes, they break and they have to be replaced.

Do the lessors approach parts and spares differently from airlines?

I don’t particularly remember. I believe the way it works is, the lessor will lease the aircraft to the airline and the airline is going to have to be responsible for buying the parts. It’s not like Delta, if they had leased a number of different aircraft from one of the lessors, it’s not like they go back to the lessor to get a part. They’ll come to distribution or come to us and it’s the airline’s responsibility for that.

If I’m an airline, I assume I’m not only going to replace one switch, for $300 or $400. I assume there’s going to be more stuff I’m going to purchase from distribution, from the MRO shop, whatever it is. I assume that I also receive a big invoice, an itemized invoice, as an airline, of what I’m actually buying. I’m just trying to get a grip on the pricing power of players like TransDigm and these parts that have supposed monopolies. Does the airline really care about the price of a $500 switch, with the cost base they have?

It depends. I think one of the questions was, what’s the biggest risk of selling to airframers? Like we are now, the first thing they will look at is their inventory numbers. Many times, people will buy components in such a way that they just buy them, because the piece part price is such that they don’t have to spend a lot of time worrying about it that much.

But if we get into an area like we are now, yes, they’ll even start going down to that level and worrying about how much a $500 switch costs. They’ll stop buying them and if they think the pricing is still too high, they’ll go out to some of their parked aircraft and pull switches out of parked aircraft, just so they can have them in the aircraft that they are using.

You mean the airlines?

Yes; airlines will do that. Again, if you even press them too hard, some of the bigger ones, who have the capability of going off and doing this, they will figure out ways to get a lower price. But if we’re in the mode of how we were, let’s say six months ago, they buy them, they want to make sure they’ve got spare parts where they need them, because the worst possible thing that can happen is that you miss a push back.

Do you think there is a significant risk for TransDigm, in their strategy?

I don’t know if I’d call it a risk. I’ll put it this way, if you want to talk about sustainability as risk, or not – and this is only my opinion – I think that their business model is unsustainable. Shareholders are going to want margins to increase, year over year and you can only raise the pricing so much, before the airlines will figure out a way to get around it and they will go off and do that. For the short term, yes, you can pull that off. But for the longer term, I just don’t think that it’s sustainable.

Is it the airlines or the OEM that really drives the change?

I think it’s both.

So the airlines will complain to Boeing, TransDigm’s company has ramped the prices up; I can’t afford this, it’s ridiculous. Then Boeing would say, right, let’s do something about it?

Yes. They would get the pressure that way. Again, we’re talking about a component that there is a monopoly position on. It is a big part of the business, but it’s not the part of the business. There were switches that Korry made that were different sizes, that there were competitors for, out in the marketplace. It was easy for an OEM to say, okay, I’m just not going to buy these switches anymore; I’m going to buy these. TransDigm, from what I understand, likes to have monopoly positions, where they can just raise the pricing. Generally, that happens on the military side, once you’re designed into something. I think the push-button switches with Boeing is unusual. But again, I do not think that it is sustainable.

As long as you are looking at it from a short-term standpoint, fine.

The other argument in that is, they can keep ramping the prices on certain components, if they can keep on finding more components to buy, more companies to buy?

Yes, you’re right. I think they do that.

Also if the service is great. If you’re Boeing and TransDigm delivers on time, delivers on quality, has an efficient supply chain etc., I’m sure there’s worse suppliers to go after?

I’ll leave that to them; I don’t know. But the scenario that you laid out, it could be sustainable for them.

What’s your sense of how the customer’s look at TransDigm? The airlines?

I don’t know how the airlines look at TransDigm, specifically. I’m assuming, if they’re still getting a price that they can stomach and, as you said, everything else is working well, supply chain works well and they’re getting switches when they need them, then to a point, they’ll be okay with that. It’s some of the other OEMs and manufacturers that, I know, once they found out that TransDigm had bought Esterline, they immediately stopped doing business with Esterline, even though the sale wasn’t final. There are other manufacturers out there that just won’t deal with them.

So one of the smaller OEMs was like, I know what TransDigm’s playbook is here; I’m not getting involved?

Yes. Or, I’m going to work right now, to find a way to replace you.

Why is that? Is that because the OEM is no longer capturing some of the margin, because they could limit the aftermarket prices and now they’ve realized that they can’t have ownership over that?

My opinion is, they would just look at the overall, initial hardware price and they didn’t want to be put in a position where they would have pricing that would go up, year over year, regardless. The OEMs want to be able to count on, this is what the cost structure of this is going to look like, from a supply chain standpoint, as long as they can. But if it’s fluctuating all over the place, then they can’t rely on that. They don’t know what to expect and they can’t weather all these things like pandemics or volcanoes going off in Iceland.

How much did you used to raise the aftermarket prices by, year on year?

I don’t remember. It obviously wasn’t enough to get rid of Korry, that’s for sure. But I don’t remember exactly what it was.

But it’s still inflation, plus a couple of percentage points, to get that margin?

Yes.

How is the pricing different for military and the DoD?

With the military, the military will have the ability – and it’s in the contract; in other words, if you want to sell to the military, you have to do this – they reserve the right to come in and look at your books and they can, basically, tell you how much they’re willing to pay, in terms of profit. Unless you can show that the hardware was commercially competitive, then you have to pay whatever the military says. You just have to pay it. That’s the way it is. They could come in, look at your books and they could say, we don’t agree with this. You are making too much money on these particular parts and, in extreme cases, they would say, you owe us back pay or we’re not going to issue another contract to you, until you get that straightened out.

It’s different from in the commercial world. The government can just come in and say, this is how much we think that these should be sold for and that’s the price. Honestly, they don’t want to squeeze you to the point where you can’t make money. They know that too. They want you to make money. They just don’t want you to make as much money as you think you should make. They can come in and they’ll look at the books and they’ll go through a complete audit and say, okay, it’s fine or no, you need to make some adjustments.

Have they told you to reduce the price before?

Yes, they have. In certain cases, we’ve told them that the price was too low and they allowed us to raise it. The military is just different. It’s just something that everybody deals with. You know you have to deal with it and, like I said, they’re not going to try to put you out of business. They just want to get the best price for the taxpayer they can.

I think TransDigm’s pricing, in the defense, for the military, has also been audited, multiple times and the results have come back saying it was fine and they were within the standards required and the pricing was fair. Somewhat fair; I think they had to pay back a portion, voluntarily. That would suggest, potentially, that most of the price increases, or all of the price increases, actually come from the commercial space then?

Most of it, yes. I don’t know, for sure, because I was not there when they were going through this. But I don’t know that I could argue your point.

Just finishing off, Mark, and looking at TransDigm’s model, I know you mentioned that it’s just not sustainable. What do you think could be the breaking point?

I don’t know. You’re also correct in that, if I plan on having a pricing model that is sustainable for three years, let’s say, and I continue to buy companies and I continue to sell off companies, inside of that window, it could work. I just have to be very good at buying and selling companies. They tend to do that. It’s a strategy. It’s just not one that Esterline wanted to go off and pursue.

I assume that the customers realize, the OEMs realize, when TransDigm buys a business, the prices are going to change. The aftermarket prices do change but if it’s a one-time change, which then grows at inflation, you capture that margin and own the aftermarket then. But you just have to keep replenishing the portfolio of new components?

Yes.

I assume that once you get to bigger systems, as you said, it’s much more difficult to capture margin, because they are bigger ticket prices for the airline and the OEM will want to be more involved?

Absolutely. But the point is, you had to go down that path because if you weren’t the person to build that bigger system, you would be the person who was not selling the components. That’s the strategy.

Nothing?

Right. You can get nothing.

Maybe finishing off, Mark, how do you look at the position of the OEMs, today? I think there’s been a lot of discussion around Boeing, Airbus, squeezing the supply chain or capturing more of the IP, however you want to look at it. How do you look at their strategy?

I think we mentioned it before, people are going to travel as much as the GDP grows. That’s not going to stop. We’ve seen, over the years, and for years and years thought about this, airlines and OEMs, specifically the airlines, they’re quick to react when there is a downfall and they’re not quick to react coming back up. But they tend to weather it, one way or the other. Do I think that Boeing is going to be selling 50 737 MAXs a month, no. They’re not going to be there. But at some point, they will be back at that level. It’s just inevitable. It’s just going to happen.I think, longer term, they’ll be back to where they have been and it’s just going to take some time to get there.

Mark, it’s been a pleasure.