Topicus, Transdigm and Value-Based Pricing

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 they 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.