TransDigm's Product Innovation, Howley, & TDG 10-year equity returns | In Practise

TransDigm's Product Innovation, Howley, & TDG 10-year equity returns

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In 1993, Nick Howley purchased four small aero component suppliers: Adel Fasteners, Wiggins Connectors, Aero Products, and Controlex. He then integrated the companies into two separate groups: AdelWiggins and AeroControlex. Both are operating companies of the TransDigm Group today. We interviewed a Former President of AdelWiggins to share insight into what it’s like working at a TransDigm operating company.

Adel Fasteners are ~$40 small shock absorbers which hold the wiring and pneumatic line in the fuselage. There are literally thousands of small Adel clamps in a single aircraft. Wiggins Connectors are ~$400 small fluid connectors for waste, water, and hydraulics throughout the aircraft. Both companies have long histories: Adel was founded in 1938 and Wiggins in 1925.

The durability of AdelWiggins is driven by two main factors: the aftermarket structure and product innovation. Over 90% of TransDigm’s revenue is from proprietary products and 80% from products as the sole-source provider. Given the component unit price is typically below $2,000, the products usually fly under the radar of competition. This combination of an oligopolistic market structure, proprietary, sole-sourced components, and decades of an aftermarket to service drives the durability of TransDigm opcos:

There were three competitors for each of those type of products. One or two main ones then, as TransDigm acquired Esterline, they gobbled up a competitor on the wire bundle clamps. It is now down to one in the States and one in Europe, so competition shrunk through acquisition. This is not a sexy product and it was not a big system integration so it was not on anybody's radar where there is a product needed in every aircraft on a critical system. As you know, with less competition, pricing becomes slightly easier to move upward.

The attractiveness of proprietary aero components is fairly well known; however, the innovation of operating companies is a crucial and often overlooked aspect TransDigm. Innovation is key to retain OE business and is one of TransDigm's three core strategic pillars:

The architecture of aircraft systems has not changed much and both Wiggins Connectors and Adel had a reputation in the industry with very innovative products. They continue to innovate, mostly to reduce touch labor at the OEMs. Many times, the old threaded fluid connectors took several minutes to join a certain pipe fitting and then there was also an electrical jumper for moving any static electricity from one section of the pipe to another. They made a clam shell quick connection which included grounding in the body. They kept innovating and leveraged their brand name in the industry. They had close relationships with both the OEMs and engineers. When Boeing designed a new aircraft, our engineers were always there helping develop new fluid and hydraulic subsystems.

Some argue that TransDigm merely buys proprietary IP and then just increases the price of the components. However, this underestimates TransDigm's innovative capability to retain and win new business. After all, there is no aftermarket business without winning the OE business to get on the aircraft platform in the first place. TransDigm focuses on growing dollars per shipset on new and existing platforms. This metric can be seen as a proxy for ‘same-store sales’. Growing dollars per shipset requires a deep relationship with Boeing and Airbus engineers so when new aircrafts are designed, TransDigm has a seat at the table. The closer you are to the OE, the more you can tailor the specification to your products to retain business as a supplier:

We always looked to expand our shipset value on current and new platforms. When I was at AdelWiggins, they had a composite product line in development with Boeing. This was probably one of the neatest new business stories out of the group. This composite product was called a lightning isolator… At almost $300,000 per 787, which ramped up to 14 per month, that was a significant product line which grew from less than $1 million to almost $40 million a year. We were also able to leverage that into the military platform on the A400M and work with Airbus on the A350. That was one of the great innovative stories of a new product line introduction.

This adaptability is ingrained in TransDigm’s culture. The group is structured in small teams with maximum accountability at the front line. Each opco has multiple Business Unit Managers all reporting to a President. The Business Unit Managers are effectively product line managers with full P&L control of their individual line:

AdelWiggins had five different product lines and we had three product line managers who were responsible for P&L, their own business plan, new business growth and pricing... They were responsible for their own pricing, which led to their own compensation if they were able to do better than what was budgeted for. The president was responsible for racking each of the product line P&Ls together to develop a site level one, set the budget and ensure it was cascaded through the product line groups. We let the product line managers develop their own budgets including pricing and new business growth plans and we would challenge them to ensure they were getting maximum value out where they could. We made sure it was their plan so that they had their own skin in the game. In that way they had that owner operator mentality.

This owner-operator culture stems from the top. To this day, every quarter, Howley and the senior management team meet with each product line manager of their ~50 opcos. Howley reviews the three strategic pillars for each individual product line at TransDigm. As a shareholder, this is how you want your management team to act:

The president, controller and product line manager would go to Cleveland and report on the business, which was powerful because everyone took it seriously. They knew Nick and Bob were shrewd businessmen and would question their decisions, so they learned a lot from that type of exposure to those guys. It was a good growth vehicle for those product line managers that would eventually move up into presidents at one of the companies down the road, if they were good enough.

Although TransDigm may have a unique culture and lead product innovation, the company still materially increases aftermarket pricing for components post-acquisition. Historically, for proprietary components, there has been no limit on such aftermarket price increases. However, this is potentially about to change. Aftermarket contracts for each platform beyond the 787 seem to include a limit on pricing increases:

"there was a set point where they would say, for any of these aftermarket products from this aircraft, it has to be controlled and negotiated. They would try to control it to between 300% and 400% of OE pricing, compared to unlimited, so pricing is a bit more controlled. They could also ask for a royalty by saying, you would not have the IP if you did not participate in our aircraft which is all our IP, so it would stronghold suppliers into giving royalties in the aftermarket. They look to try to route aftermarket products through Boeing, BDS or KLX and they would get a piece of the pie on the aftermarket sales as well."

The challenge for shareholders is that it's not clear exactly how much TransDigm does increase pricing post-acquisition. This makes its difficult to understand whether a 300% or 400% price increase cap is material. If it is, how could this impact the terminal value of assets on new platforms? And could you really finance these assets with a capital structure with 7x leverage?

The encouraging point for TransDigm is that the new aftermarket contracts are only drawn for platforms launched after and including the 787. As far as we understand, it doesn't seem to impact assets on older platforms. One could therefore argue that the terminal value of proprietary component assets on newer platforms are worth significantly less than over the previous decade. This doesn’t mean TransDigm's equity cannot perform well. If the EBITDA accretion from the potential Meggitt deal is anywhere near Esterline’s performance, Group EBITDA could increase 40-50%. If the deal does go through, this could drive outperformance of the equity for the next 3-4 years. However, if the bargaining power is indeed moving back towards the OE's, structurally lower M&A returns and lower leverage could lead to very different returns for the equity over the next decade.

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