Constellation Software and Transdigm have many similarities from the outside looking in: decentralised org structure, fragmented end markets, a core M&A roll up strategy, great capital allocators at the helm, etc. After spending some time researching both companies, one key strategy that both follow religiously is value-based pricing.
Value-based pricing is as it sounds: price products based on the value you provide, not the cost of the product. The first insight from our interview with a Former Managing Director at TSS was how VMS founders perpetually underprice their products:
A lot of software companies, in their contract, in small print, say okay, we can change the price at the indexation rate. Indexation is maybe 1% or 2%. But they are building newer software, with more added value and that added value is actually worth money to the customer. If you do not charge them for that added value, for the new functionality into the ERP system, then you are actually giving them a present. I truly believe that most of the VMS companies are underpriced.
If a VMS company is adding new features annually that adds value to customers, the subscription price shouldn’t be increasing at inflation-like 2-3% per year. If it's truly adding value to customers, the price should be increasing 10%+ per year. The low marginal cost of adding new software features can psychologically make it difficult to increase the price relative to the value being added. This is one reason why the likes of Constellation and Topicus see such growth in EBITDA post-acquisition.
The same happens in the aftermarket for aerospace parts. This is a quote from our interview with a Transdigm VP last year:
Recently, in aerospace terms, 2008 to 2012, Airbus and Boeing went on a very rigid campaign, to change their contracts, to remove two-tier aftermarket pricing from a lot of their OEM contracts. But prior to 2008, the language didn’t even exist, in many of the contracts that said, regardless of the in-market use, you will sell all products to me at a fixed price. That didn’t even exist in some of the contracts but yet, people allowed them to procure spare components at production OEM prices. That put a big strain on a lot of the supply chain and that’s why some of the businesses were available for Transdigm to acquire.
Transdigm realised that many suppliers were allowing the airframer to capture the aftermarket profitability. Suppliers sell OEM parts for new aircraft and replacement parts for the aftermarket. Historically, airframers demanded that suppliers sell them parts at a fixed price so they could resell the parts into the aftermarket and capture the margin. For in-production aircrafts, the supplier may have enough volume in OEM parts to make their economics work. However, when the aircraft rolls out-of-production, the OEM volume declines and leaves the supplier with the fixed-price aftermarket business. It's very difficult for the parts supplier to be profitable with no OEM business and a fixed-price aftermarket business. This partly explains historically why Transdigm could pick up so many good deals.
Given the high qualification costs, engineering R&D and upfront capex for parts, an aerospace parts supplier needs the aftermarket profitability to earn a return on the capital invested. Like a small VMS company typically doesn’t capture the value of incremental features or modules, part suppliers were not capturing the value of the aftermarket. This means both VMS companies and aero suppliers for out-of-production platforms can be perpetually underpriced.
Transdigm’s value-based pricing strategy is merely making the distribution of aftermarket profits more equitable between the airframer and the parts supplier. Constellation and Topicus’ pricing strategy is capturing the value of the added modules and features to existing SaaS products.
Transdigm’s core insight was the near-monopolistic position of a supplier that owns the intellectual property for parts on an out-of-production aircraft. It was the first to cut the fixed pricing agreement with the airframers and take back ownership of the aftermarket. Transdigm understood the cost, complexity, and risk for OEM’s to find a new part supplier for out-of-production platforms that customers would rather pay the asking price to get the aircraft back in operation. This is true pricing power.
Imagine, on the systems that TransDigm participates in, Boeing having to go and requalify. The qualification cost, the development of a new supplier. All of that cost and the bigger issue that people, sometimes, overlook, the risk of failing qualification. Those barriers make it very difficult for the OEMs to walk away.
Transdigm also benefits from the fact the parts cost is so small relative to the total MRO bill that the customer barely notices the change in price. Transdigm’s intellectual property, zero competitors, high regulatory barriers to entry, and low-cost to high-benefit all accumulate to explain the incredible performance of the company.
The competitive positioning of CSU or TOI operating companies isn’t quite as strong. Software evolves far quicker than aerospace parts. This increases the risk of obsolescence relative to an approved aerospace part. However, the European VMS competitive landscape is still favourable. Since 2014, TOI has acquired 60 companies with an average purchase price of 6m EUR. These are small companies in small markets. This naturally deters entrants and leaves CSU and TOI with mini-oligopolies across different verticals.
The majority of TOI revenue is also within public markets. Small markets and long sales cycles deters entrants or in the worse case produces small, poorly capitalised competitors. Even when PharmaPartners was facing a lot of pressure, there was no better alternative for customers to switch:
A lot of customers were very, very unhappy and, when I started in 2015, that had already been going on for some time. A lot of them said that they were going to leave but they also knew that the other competitors did not have the software that they were looking for. Out of three others, with less good software, the question is, who are you going to choose and is it worth moving to a different software. That’s what actually bought us some time to improve our services, our customer relationship and our software to bring it up to speed to the needs that our customers had.
Be design, Transdigm's IP ownership secures a long runway of parts demand. An aircraft's life is ~25 years and given airframers manufacture platforms for many years, it’s not uncommon for certain aircraft models to be running for 40+ years. As long as the plane is operating, parts demand exists. By definition, Transdigm’s exclusive ownership of the IP secures demand for the life of the platform. On the other hand, VMS businesses have to actively extend the contract duration to lock in demand for the long run. ‘Building blocks of contracts’ is an interesting strategy to increase customer stickiness:
We made building blocks of the contracts. If you are a customer with a five-year contract, in two years, I would make a new contract with you, for a new part of the software, but that would not have the same end date as your original one; it would be either a shorter period of time, so for one or one and a half years, or it would be for another five years. If we have two or three contracts and those contracts all have a different end date, then I know, as a company, that if you are not going say goodbye to the first small contract, I know you will also be there for the big one, and vice versa. My risk of losing you is much lower because it is costing you, as a customer, more money to step out of one contract but still have to pay for two. If you put on more layers then you have an endless customer, because they can never leave because the cost of leaving is so high, it is no longer interesting for them to leave.
Value-based pricing is a way of life for both Transdigm and Constellation. It’s ingrained in the culture of both companies. A focus on the value rather than the cost of the product encourages teams to add increasing value to customers which drives organic growth. We believe the ability of both companies to price according to value not cost is the single most important factor to sustain long term growth. We also have no doubt Howley and Leonard have spent years studying Buffett:
"the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business" - Warren Buffett