[TDG – TransDigm] Niches get riches - part 1

In the Spring 2019 issue of Graham and Doddsville, John Hempton was quoted as saying:

“In my case, [I usually want to own] a company that makes a widget that is a small yet important part of a bigger thing, has high switching costs, and has incrementally improved over time. I call this the trifecta. There´s an old saying for this: ´There are riches in niches.´”

TransDigm reflects at least two parts of this trifecta.  Over its 26 year history, this company has spun riches out of essential but nondescript aircraft components: valves, pumps, audio systems, latches, hinges, locking devices, engine sensors, bathroom faucets, passenger seat belts, and of other parts that help power aircraft, secure passengers, lock cabin doors, and reinforce airframes.  It sells lots and lots of these low-dollar value parts at low/mid-teens EBITDA margins to aircraft manufacturers like Boeing and Airbus and realizes hefty ~70% margins charging airline operators and governments for spare parts over the 30 year life of an aircraft (60% of TDG’s total revenue is commercial; 35% defense). 

Around 90% of TransDigm’s revenue comes from parts for which it owns the IP, which means that in most cases it is awarded the aftermarket revenue streams, and around 80% is derived from parts for which it is the only manufacturer in the world.  As a manufacturer of proprietary, sole-sourced parts, TransDigm has also been largely insulated from the onerous cost containment measures of OEMs, who over the last 5 years have been insourcing components, claiming more aftermarket revenue, and pressuring their supply chains (Boeing’s “Partnering for Success” initiative has been dubbed “Pilfering from Suppliers” by cynical vendors).  They have extracted concessions from “make-to-print” manufacturers with non-proprietary products like Spirit Aerosystems¹ – which builds according to Boeing’s IP and whose pricing negotiations with Boeing have been in part responsible for its escalating forward loss reserves – but have left proprietary manufacturers alone for now. 

TransDigm commits engineering and R&D resources upfront for several years, developing new products before revenue has been committed, but these investments typically go towards continuously improving reliability, weight, and features rather than conjuring ground-breaking innovations with uncertain payoffs.  Moreover, new product development is typically catalyzed by inbound requests from OEM customers, each of whom has an internal sponsor advocating on behalf of TransDigm to ensure product acceptance.  Once an OEM selects a parts supplier for an airframe program and the FAA has approved the plane and the bill of material suppliers, then absent some major screw up, the supplier’s part is deeply embedded in the airframe’s design and can only be extracted at great cost.  And, unlike an engine manufacturer like Rolls Royce, who loses money upfront on every engine it sells, TransDigm generates profits on parts sales to OEMs, who will use the same airframe design for ~30 years. 

After the OEM has sold the aircraft to an airline, TransDigm enjoys yet another, juicier stream of profits.  TransDigm gets away with what seem like extortionary aftermarket margins because its parts are critical to a plane’s operation yet comprise a small enough portion of maintenance costs that it avoids scrutiny.  According to management, the global airline industry incurs operating expenses of around $700bn.  $70bn of that is maintenance, of which $30bn is spare parts and components.  TransDigm’s ~$2bn in commercial aftermarket revenue amounts to less than 10% of that. 

No single component is centrally important to TransDigm nor costly enough to matter to an airline.  Only 10% of TDG’s aftermarket revenue comes from parts that generate more than $2mn in revenue, so across the top 20 carriers that make up half the airline market, each spends, on average, maybe $50k/year ($2mn/2 divided into 20) on TransDigm’s highest volume sellers compared to $1bn to $2bn of annual maintenance outlays.  The ~thousand bucks that an airline operator spends on an average TransDigm part is just not material enough to worry about.  Of far greater concern is having to ground an airplane for an extra day and forgoing revenue on a large fixed cost base because, I dunno, the valve on a fuel system pump is defective or in short supply.  So long as these critical components always work and are delivered on time, there is little reason for an airline to swap suppliers.         

The lifetime returns that TransDigm realizes on an airframe program are pretty stunning.  TransDigm invests upfront in engineering and manufacturing for 3-7 years, but then realizes profits for up to 60 years: an OEM uses the same airframe design for ~30 years and each plane manufactured according to that design has useful life of ~30 years.  TransDigm generates profits on the parts sold to the OEM to make those planes and then realizes even fatter profits when that plane gets put into service by the airline, who will need to purchase replacement parts and spares over that plane’s ~30-year life.

The profit profile looks something like this:

While aftermarket accounts for ~60% of revenue, it is closer to 85%-90% of TransDigm’s EBITDA.

The cumulative research, design, and development investments borne in the first 5 years are negligible relative to the cash flows that follow.  The sum of the cash flows in just the initial 5-year period starting in year five, right when OE production starts but before aftermarket revenue streams are anywhere near maturity, already exceeds the upfront investment by nearly 7x.

Compare that to the cash flow profile of a jet engine manufacturer.  Below is an exhibit from Rolls Royce’s 2018 Investor Day, which profiles the lifetime cash flows of a 2,000-widebody engine program.

Not only does Rolls face substantial one-time up-front development costs, but unlike TransDigm, it loses money on every engine it ships to the OE (or breaks even at best).  Even baking in the savings that Rolls has yet to realize on its OE engines, aftermarket cash flows over the subsequent 25 years that an engine is in service amount to just 4x the cumulative upfront investment.  Moreover, for Rolls Royce to maintain relevance in a highly competitive duopoly, those cash flows must be reinvested in risky, cutting edge projects.  Finally, the baroque complexity of engine manufacturing, with all its suppliers and component parts and steps, exposes the engine manufacturer to cost overruns.  In other words, compared to TransDigm, engine manufacturers take on far more risk for lower returns.