9 - 720 - 422 RE V: J U LY 10, 2020 BENJ A M I N C . ES T Y D A NI EL F I S H ER TransDigm in 2017: The Beginning of the End or the End of the Beginning? If you are not working on getting the pricing up, the cost down or developing new products, you might as well go home…because otherwise you are probably getting in someone else’s way who is focusing on these things. — TransDigm CEO Nick Howley, 11/1/14 1 TransDigm is a strong sell until further notice. — Seeking Alpha, investment blog, 3/13/17 2 On January 20, 2017, the day Donald Trump was inaugurated as President of the United States, noted activist short-seller Andrew Left of Citron Research published a report alleging that TransDigm Group was gouging customers with price increases which caused its stock price to fall by 10% that day (see Exhibit 1A). TransDigm was a manufacturer of highly engineered aerospace components with a unique business model focused exclusively on value creation. Since its founding in 1993, TransDigm’s revenue and non-GAAP EBITDA had grown at compound annual growth rates of 20% and 24%, respectively (see Exhibits 2A and 2B). And since its IPO in March 2006, its stock price had increased more than 10 times (see Exhibit 1B). Given that the United States Department of Defense (DoD) was one of TransDigm’s largest customers, Left argued that Trump’s stated desire to reduce wasteful spending in defense procurement left TransDigm in a precarious position: The ugly underbelly of TransDigm’s business is that aggressive year-over-year price increases are the only thing shielding TransDigm from revealing negative organic growth of close to -10%. Any combination of U.S. government pressure and/or OEM’s pressing on their own supply chains will expose their business to actual gross revenue contraction and a devastating cut in EPS, followed by multiple contraction. 3 Two months later, on March 20, U.S. Representative Ro Khanna (California Democrat) sent a letter to the Acting Inspector General of the Department of Defense (DoD) which read: 720-422 TransDigm in 2017: The Beginning of the End or the End of the Beginning? I write to request that your office open an investigation into TransDigm Group for potential waste, fraud, and abuse…[Recent] reports suggest that that TransDigm Group has been operating as a hidden monopolist by…disguising its cost structure [and] unreasonably hiking prices to benefit shareholders and executives.4 With both investors and politicians now questioning TransDigm’s business model, TransDigm CEO Nick Howley (HBS ’79) had to decide what to do. Did the call for an investigation portend the end of TransDigm’s impressive 24-year run, or would the company continue to prosper using what one analyst called “one of the most unique and valuable business models in the aerospace sector”?5 Industry Background The aerospace industry could be divided into two broad segments: commercial aviation and defense aviation. Within each segment, there were two key markets: the original equipment manufacturer (OEM) market (i.e., companies that built new airplanes) and the maintenance, repair, and overhaul (MRO) market (i.e., companies that serviced existing airplanes). Whereas commercial customers—the ones who bought civilian airplanes and maintenance services—included airlines, businesses, and individuals, defense customers—the ones who bought military aircraft and maintenance services— included governments and defense departments as well as contractors to government agencies (see Table A). In all four markets, there was a need for parts: new parts for OEM production and spare parts for maintenance. Frequently, the same companies that supplied new parts to OEMs also supplied spare parts to MRO firms and other customers in what was known as the “aftermarket.” Table A Typical Customers for Aerospace Parts and Components by Market Segment Commercial Aviation Original Equipment Manufacturers (OEM) Market Maintenance, Repair, & Overhaul (MRO) Market Source: Boeing (Commercial Jets) Embraer (Regional Jets) Cessna (Private Jets) Airlines (Comm. & Reg. Jets) Businesses (Private Jets) MRO Firms (for airlines & businesses) Defense Aviation U.S. Dept. of Defense (DoD) Contractors (Lockheed, Boeing, etc.) U.S. Dept. of Defense (DoD) Defense Logistics Agency (DLA) Contractors (Lockheed, Boeing, etc.) Casewriter analysis and summary. Commercial Aviation The commercial aviation segment included large commercial jets, smaller regional jets, and business jets. The two major OEMs for large commercial jets were Boeing and Airbus (100% combined share); the two major OEMs for regional jets were Bombardier and Embraer (90% combined share); and the three leading OEMs for business jets were Gulfstream, Bombardier, and Cessna (79% combined share).6 OEMs manufactured a particular aircraft model for at least 20 years. Once built, the planes remained in service for 20 to 30 years, which meant parts were needed for up to 50 years (i.e., for 20 years of production plus 30 years of maintenance for the last planes built).7 Demand for air travel had grown by 5% annually in recent years and was expected to continue growing at that rate for the next 20 years.8 To keep up with growing demand for air travel, airlines had ordered 10,000 commercial jets over the past four years, and both Boeing and Airbus each had backlogs of more than 6,000 planes, equivalent to roughly a decade of production for each company.9 2 TransDigm in 2017: The Beginning of the End or the End of the Beginning? 720-422 Airplanes were incredibly complex products to design, build, and maintain. The Boeing 737, for example, had approximately 370,000 parts while the Boeing 747 had approximately 6 million parts. 10 Because it was extremely challenging to build these highly integrated systems and to get them to operate flawlessly, and because equipment failure could have such devastating consequences, airlines were extremely reluctant to change designs as long as planes were flying without problems. Aircraft parts fell into three categories: engines; components (including individual parts and sub-systems such as navigation systems and landing gear); and aerostructures (e.g., wings, fuselage, and tail). Individual suppliers typically specialized in one category or another. For example, Pratt & Whitney made engines while TransDigm made components and parts such as fans and fuel hoses. Components were by far the least expensive parts with prices ranging from a few dollars for a small hose to tens of thousands of dollars for a high-end generator. Thousands of companies made parts and hundreds of them made high-precision parts. Most manufacturers of high-precision parts specialized in a specific set of components or a relatively narrow range of parts.11 Depending on the size, commercial jets had list prices ranging from $100 million for a narrow-body Boeing 737 to $400 million for a wide-body Airbus A380.12 Assuming a cost of $150 million (e.g., the discounted price for a Boeing 787 Dreamliner13) and an estimated cost of capital for an airline of 8%, the capital cost for a large jet would be $12 million per year or $33,000 per day. 14 According to MIT’s Airline Data Project, an average-sized aircraft with 175 seats made approximately $90,000 of revenue and $11,000 of operating profit per day.15 Most of the operating costs—approximately two-thirds by one estimate—were fixed costs at least in the short term.16 In contrast to the highly concentrated commercial OEM market, the commercial MRO market was much more fragmented with more than 100 independent firms and a number of affiliated firms (i.e., firms affiliated with airlines).17 These companies typically specialized in one of five categories: engines (40% of MRO spending), components (22%), maintenance services (17%), airframes (15%), and modifications (6%).18 While many companies manufactured spare parts, only one or two firms typically supplied any particular part. OEM manufacturers selected only one supplier for each part because it was not economic or administratively efficient to have multiple suppliers for inexpensive parts given the arduous certification process mandated by the Federal Aviation Administration (FAA), the federal agency responsible for regulating commercial aviation. 19 Once approved by the FAA and chosen by the OEM for an aircraft, that part commanded most of the aftermarket sales. According to one estimate, the $75 billion MRO market was expected to grow by 4% annually over the next decade.20 Defense Aviation The defense aviation segment was smaller and operated slightly differently from the commercial segment. The majority of global defense spending occurred in the US and Europe. 21 In early 2017, President Trump announced his desire to increase defense spending to more than $600 billion per year,22 a figure that was expected to grow by 1% to 2% per year for the foreseeable future.23 The U.S. DoD spent $46 billion on military aircraft in 2016.24 Unlike commercial jets, neither military aircraft nor specific parts required FAA approval. Nevertheless, aircraft were subject to rigorous airworthiness tests and components were subject to precise technological reviews before they could be installed on new aircraft or used to repair existing ones.25 Whereas the OEM market for military aircraft was concentrated—with the DoD as the ultimate customer and Lockheed Martin and Boeing as the two largest contractors 26—the defense MRO market was much more fragmented with a combination of local and global competitors. The largest defense MRO’s were BAE Systems, Lockheed Martin, and Pratt & Whitney, and they provided services to the DoD as contractors.27 Although military personnel typically repaired defense equipment, it was quite 3 720-422 TransDigm in 2017: The Beginning of the End or the End of the Beginning? common for defense MROs to perform maintenance and repair services.28 Like the commercial aviation segment, the same companies that supplied the defense OEM’s with new parts as subcontractors supplied the defense MRO’s with spare parts for as long as a particular aircraft was in use. Becoming a Parts Supplier for OEMs Because OEM suppliers dominated the MRO market, it was critical to be selected as an OEM supplier.29 The intense competition to become an OEM supplier plus the large, upfront investments in R&D needed to design parts and equipment needed to produce them resulted in low margins and negative cash flows in the OEM business at least initially. The real profits, however, were made in the aftermarket. From day 1, spare parts generated higher margins and higher cash flows. The catch, however, was that to become a supplier of spare parts, you had to be the supplier of OEM parts. In essence, it meant selling the razor (OEM parts) at a loss to be able to sell the blades (aftermarket spare parts) at a profit.30 The combination of a rigorous certification process by the FAA and strict enforcement of intellectual property (IP) rights on highly engineered aerospace parts made it difficult for companies to enter the aftermarket and compete with existing parts suppliers. The FAA had to certify a commercial jet’s design, production, and airworthiness before it could begin carrying passengers. To get certified, OEM’s had to show that each system, subsystem, and part met specific quality and performance standards. Depending on factors such as the complexity of the components and the similarity to previously approved components, the certification process could take anywhere from a few months up to several years, and could cost hundreds of thousands of dollars if not considerably more. 31 The instructions alone for getting an airworthiness certificate (see FAA Advisory Circular #21-12C) were 51 pages long.32 Once approved, the FAA certified the OEM and the parts used on an aircraft. The certificate holder could either produce the part itself or sign licensing agreements with other companies to manufacture the part as long as the subcontractors had gotten a “parts manufacturer approval” (PMA) from the FAA.33 As a result, the part, the manufacturing process, and the resulting product (i.e., the aircraft) all required FAA approval. Like the OEM certification process, the PMA approval process was lengthy and entailed multiple steps and considerable cost. Companies could try to obtain a PMA for a part or component without having a licensing agreement with an OEM, but they had to prove that their component was either identical to the certificated part which could raise IP issues, or they had to prove it satisfied airworthiness requirements through extensive testing.34 Defense procurement worked somewhat differently. Government agencies solicited bids and then awarded contracts for production. For example, the DoD recently awarded a $35 billion contract to Boeing to manufacture 179 fuel tankers (the KC-46).35 As soon as OEM contractors won DoD contracts, they would start signing contracts with sub-contractors to produce specific parts. 36 Whereas the DoD was responsible for negotiating OEM contracts for new planes and weapon systems, the Defense Logistics Agency (DLA), an agency within the DoD, was responsible for negotiating contracts for spare parts.37 Procurement of all kinds was governed by extensive regulations known as the Federal Acquisition Regulation (FAR). To win a contract, companies had to negotiate with DoD or DLA contracting officers to determine a “fair and reasonable” price.a Depending on the size of the order, suppliers were required to provide a The term “fair and reasonable” did not have a precise meaning. Regulations stated that adequate price competition normally established a fair and reasonable price. For parts with a single supplier, contracting officers considered commercial prices to determine whether a proposed price was, indeed, fair and reasonable. (See: 48 CFR § 215.371-3.) 4 TransDigm in 2017: The Beginning of the End or the End of the Beginning? 720-422 different kinds of information and follow different procedures to help contracting officers determine whether a price was, indeed, fair and reasonable. If, for example, a contract exceeded $750,000 and there was only one bidder, the Truth in Negotiation Act (TINA) required the company to provide certified cost or pricing data (i.e., the manufacturing cost or prices charged to other customers). For smaller contracts, those under the “simplified acquisition threshold” (SAT) of $150,000, the DLA officer could award the contract using a more streamlined process to increase efficiency and reduce administrative costs. In these instances, contracting officers were not required to seek public bids or collect price or cost information.38 Finally, if a part were sold or offered to commercial customers, contracting officers could use either the listed price or actual transaction prices to determine if the prices offered to the government were fair and reasonable rather than requesting certified cost data. To qualify, however, suppliers had to verify that a part was, in fact, a “commercial item” or very similar to one (known as a “commercial-of-a-type” part). Company Overview Nick Howley and Douglas Peacock founded TransDigm in 1993 through a management buyout. They bought four small aerospace companies with total revenues of $60 million from a single corporate parent.39 Peacock created the name TransDigm by combining “Trans” which sounded like something related to the aerospace industry and “Digm” which connoted a change in paradigm. 40 Over the next ten years, a series of private equity firms owned TransDigm before it went public in 2006.41 At that time, it had revenues of $374 million.42 From the beginning, TransDigm focused on manufacturing a wide variety of highly engineered, aerospace components including ignition systems, engine pumps, and valves (see Exhibit 3). By 2016, it sold more than 75,000 parts prompting Howley to say, “If it’s flying, we have parts on it.”43 Approximately 90% of sales were from proprietary parts meaning their designs were protected by patents or other intellectual property44; 80% of sales came from parts where TransDigm was the sole source provider45; and approximately 90% of parts generated sales of less than $2 million per year. 46 According to Howley, a large airline spent “maybe $65,000 a year” on a particular TransDigm part, which meant the company was “rarely very high on anyone’s screen.”47 TransDigm’s sales in 2016 were split fairly evenly across three segments: 37% in the commercial aviation aftermarket, 30% in the defense market,b and 29% in the commercial OEM market (nonaviation sales accounted for the remaining 4%, see Exhibit 4).48 To secure aftermarket sales, TransDigm competed for OEM contracts and acquired companies that already had OEM contracts in place. The vast majority of TransDigm’s profits came from the aftermarket, “probably 80% to 90%” according to Howley (see Exhibit 5).49 He told investors: “It's this long tail, the long tail of the aftermarket at a very high margin…[that] gives the business its stability…[We] like the predictability of demand, we like the margins and, frankly, we like the pricing power in the aftermarket.” 50 Although the same principles applied to the defense market, TransDigm had lower margins on defense sales.51 Across the various markets, TransDigm had a total installed base of approximately 95,000 aircraft including Boeing’s 737, 747, and 777 jets; Airbus’s A318, A330, and A380 jets; private jets from Cessna and Learjet; and military aircraft such as the AH-64 Apache attack helicopter, the F-18 fighter jet, and b Of the sales in the defense market (30% of the total): 12% went to various domestic OEMs, 6% to foreign OEMs, 5% to foreign governments, and 7% to various agencies or departments of the U.S. Government. (See: CQ FD Disclosure, “Q1 2017 TransDigm Group Inc. Earnings Call — Final,” 2/7/17, via Factiva.) 5 720-422 TransDigm in 2017: The Beginning of the End or the End of the Beginning? the Predator drone missile.52 Its top ten customers accounted for 45% of total sales in 2016; its two largest customers, Airbus and Boeing, accounted for 13% and 12% of sales, respectively. 53 As of early 2017, TransDigm had 32 operating units and more than 80 business units. 54 Exhibit 6 shows TransDigm’s income statement with sales of $3.2 billion and net income of $586 million in the fiscal year ending September 31, 2016. Exhibit 7 shows its balance sheet with assets totaling $10.7 billion including $1.6 billion of cash. On the liability side, it had $10.3 billion of debt, negative shareholder’s equity due to special dividends and share repurchases, and a sub-investment grade debt rating of B+ from Standard & Poor’s. Over the past ten years, a period that included the global financial crisis, TransDigm’s leverage ratio (net debt divided by “EBITDA as defined”, the firm’s non-GAAP cash flow measure) had ranged from a low of 3.0X in 2009 to a high of 6.8X in 2014, and had averaged 4.7X.55 TransDigm generated gross margins of 55% and operating margins of 42% in fiscal 2016. Exhibit 8 shows TransDigm’s profit margins, investment levels, and productivity measures for calendar year 2016 relative to other aerospace parts manufacturers, MRO’s, aircraft OEM’s, and commercial airlines. None of the other aerospace parts manufactures had gross margins above 40% or operating margins above 20%. TransDigm’s profits were used to pay dividends, acquire firms, and service debt obligations. Exhibit 9 shows cumulative cash flows from 2012 to 2016. These figures do not include a special dividend of $24 per share which TransDigm declared in October 2016 after the fiscal year had ended. 56 Since 2009, it had paid four special dividends totaling $67.50 per share.57 Finally, in terms of leadership, Howley was the CEO and Chairman, while Kevin Stein was the COO and President. Howley’s base salary was $1.15 million in 2016 which was paid almost entirely in performance-vesting options rather than cash.58 His total annual compensation had averaged $21 million per year from 2014 to 2016.59 Stein’s compensation had averaged $8.6 million over the past two years and had increased significantly when he became COO and President in 2016.60 TransDigm’s “Value-Focused Strategy” in Theory61 TransDigm’s stated goal was to give “shareholders private equity-like returns with the liquidity of a public market.”62 It used a set of clearly defined operating principles to achieve this goal: 1) Products: “We own and operate proprietary aerospace businesses with significant aftermarket content…[W]e compete on the basis of engineering, manufacturing and marketing high quality products, which we believe meet or exceed the performance and maintenance requirements of our customers, consistent and timely delivery, and superior customer service and support…We believe the availability, dependability and safety of our products are reasons for our customers to continue long-term supplier relationships”63 2) Operations: “We have a simple, well-proven operating methodology based on our three value driver concepts: profitable new business, improvements to our cost structure, and value-based pricing.”64 3) Acquisitions: “We execute a focused and disciplined acquisition process, buying proprietary aerospace business where we see a clear path to value creation.”65 4) Finance: “We view our capital structure and the efficient allocation of capital as a key part of creating shareholder value…[We] return money to our shareholders when and if that seems an appropriate way to create value.66 The company supplemented these operating principles with several business practices: 6 TransDigm in 2017: The Beginning of the End or the End of the Beginning? 720-422 • Decentralization: “We maintain a decentralized organization structure that keeps us close to the customer and a compensation system that is closely aligned with shareholders. This enables us to attract and retain entrepreneurial managers who think and act like owners.”67 “[W]e pass up on some economies of scale because we believe 200 to 300 employees…is the best way to run a niche business. We believe you can focus a small team on creating value…And that’s almost a religious belief.”68 • Intellectual Property: “We have various trade secrets, proprietary information, trademarks, trade names, patents, copyrights, and other intellectual property rights, which we believe, in the aggregate but not individually, are important to our business.”69 • Supplier Relationships: “Most of our raw materials and component parts are generally available from multiple suppliers at competitive prices…At times, we concentrate our orders among a few suppliers in order to strengthen our supplier relationships.” 70 For a small subset of their inputs, the firm recognized that “The lengthy and expensive FAA and OEM certification processes associated with aerospace produces could prevent efficient replacement of a supplier, raw material, or component part.”71 This combination of operating principles and business practices, as Howley noted, resembled a private equity firm. Like a PE firm, TransDigm grew through acquisitions, but targeted companies that were too small to be “exciting for the bigger PE firms.” 72, c He warned potential competitors, “If you are a PE firm that is looking at a proprietary aerospace business and you’re outbidding us, you’ve got to be pretty worried…because the only way you’re going to do that is to be making a higher bet on the margin improvement.”73 Doing so would be difficult, he said, because, “We know how to run these businesses better than anyone else in the world...” 74 Consistent with that claim, TransDigm typically paid three times sales (total enterprise value to sales) to buy smaller companies yet it traded at approximately eight times sales.75 Unlike a PE firm, TransDigm did not sell its portfolio companies. The “Value-Focused Strategy” in Practice Since its founding in 1993, TransDigm had completed 58 acquisitions.76 Bernie Iversen, TransDigm’s executive vice president (EVP) of business development, described the acquisition process this way: “We are not emotional…we don't do deals for…soft topics like we want to add to our market share,…we want to diversify, or…we want to get our name in the paper…The only reason [we buy companies is]…if we can create value, and [the] value is quantifiable.”77 The first step in the acquisition process was to identify a set of acquisition targets. Iversen said: We’ve got about 1,200 businesses that we know of. Typically, when we look at these businesses, the EBITDA range comes in around 11% to 20%...[and about 85% of them have sales of less than $100 million.78]...The base that we see is pretty fragmented [which means there is a]…lot of opportunity to buy and improve these businesses. You know, the challenge is finding someone that wants to sell their business… [F]or the last 12 months…[w]e looked at 337 businesses and of those, we really dug in deep in about 21 of them...[T]hat’s where we spent some time and modelling it out to see if we c Financial buyers had become increasingly interested in this sector in recent years. For example, Warren Buffett’s Berkshire Hathaway acquired Precision Castparts, an aerospace components manufacturer, for $37 billion in 2015. It was Berkshire’s largest acquisition to date. (See: Jonathan Stempel, “Buffett pays high price for Precision Castparts,” Reuters, August 10, 2016.) 7 720-422 TransDigm in 2017: The Beginning of the End or the End of the Beginning? can make it work. And of those 21, we submitted seven letters of intent to buy the business, and of those seven, we end[ed] up acquiring five of them.79 EVP Jorge Valladares described the modelling process used to estimate a target’s potential value: We tend to be very analytical in nature. Facts and data. We'll look at OEM production rates and we'll make our own realistic assumptions…[W]e try to be realistic as we model the new business. Generally, the model will consist of lower OEM margins. We're looking for the high aftermarket revenue streams and margin streams in the future.80 Once TransDigm acquired a company, they implemented a disciplined integration process which Bob Henderson, COO of the firm’s Airframe segment, described this way: [We] review the OEM and the aftermarket contracts, if they have them…Where are they not really pricing based upon the value that they provide to the customers? And we'll start moving those price points up…Next, we are looking at implementing a productivity plan…We've made some estimates of…what we think we are going to be able to do relative to headcount reduction [and start to make those cuts]….We try to get that done as quickly as possible; typically, that's done in 45 to 60 days. At the same time…we are working with the supply chain. We are sending letters out looking for cost reductions...[Then we] organize the company into business units…[to] provide a customer focus...[Finally] we review the new business projects [product development]…We are really getting into it full scale after about 15 days, and within the first 90 days, we've made a significant chunk of the value that we are planning on making in that business.81 Iverson noted his group (business development) was involved with both identifying potential acquisition targets and integrating them once they had been acquired: [With new acquisitions, we]…typically are looking at the aftermarket piece and resetting the pricing. Here is where we take the model and drive down to the part number level and assigning categories on if it's current or out of production, sole source, not sole source and come up with a pricing that will meet or exceed what we have in our model…[W]e take that information and roll up a pricing forecast and come up with a revenue forecast…On the productivity, we jump in pretty quickly on this too…[T]here's no secret to productivity. Less headcounts, more productivity.82 As described in its operating principles and as noted by Henderson above, TransDigm used three value drivers to improve businesses: value-based pricing, productivity enhancements (i.e., cost reduction) and incremental volume (i.e., new product development). Management tracked all three drivers closely. For example, tracking new business was particularly important as OEM sales generated aftermarket sales. Toward that end, management tracked and reported the change in “shipset content” over time (i.e., the value of parts installed on a new aircraft—say the Boeing 777X—relative to a prior version—the Boeing 777).83 Exhibit 10 shows how these three value drivers increased EBITDA in three recently completed acquisitions. Exhibit 11 shows a numerical example TransDigm used to explain its value creation strategy to analysts and other investors. Commenting on the firm’s value creation strategy, the analyst at BB&T said: TransDigm would never say this, but they are really in the monopoly-building business. By aggregating like-type, lower-priced products in a decentralized corporate structure, TransDigm manages to stay off everyone's radar screen. But let's be clear: TransDigm is 8 TransDigm in 2017: The Beginning of the End or the End of the Beginning? 720-422 not doing anything wrong, they are just taking a more aggressive approach to pricing that other suppliers with only one or two products might not take.84 A paradigmatic example of TransDigm’s value-driven acquisition strategy was its $286 million acquisition of Arkwin Industries in 2013.85 Arkwin manufactured hydraulic systems and had sales of $95 million and EBIT of $20 million at the time.86 Howley explained the rationale for the acquisition: Arkwin is a long standing manufacturer of proprietary products with established positions on high use platforms, strong aftermarket content and an outstanding reputation. The highly engineered products will allow us to expand our content on a number of substantial platforms and engine applications. Arkwin fits well with our consistent product and acquisition strategy. As with all TransDigm acquisitions, we see opportunities for significant value creation.87 Reflecting TransDigm’s “autonomous, decentralized structure,” Arkwin sold parts directly to customers under its own brand name and its website did not mention its affiliation with TransDigm. 88 Exhibit 12A shows statistics on orders for Arkwin parts made by the U.S. Government from 2006 to 2015. Exhibit 12B shows the distribution of these orders by total order amount. Not all acquisitions worked out as smoothly as the Arkwin acquisition did. For example, TransDigm got sued following the acquisition of Dukes Aerospace in 2009.89 Dukes’ CEO Chet Huffman claimed that TransDigm had misrepresented how it would run the company after TransDigm fired 20% of the staff almost immediately and implemented “drastic price increases,” neither of which was expected. 90 Transdigm’s lawyer disagreed saying that TransDigm missed the seller’s “overly optimistic” projections because of a dramatic downturn in the corporate jet market due to the global financial crisis not because of TransDigm’s operating policies.91 Layoffs in acquired companies, however, were not uncommon. According to Bob Henderson, TransDigm cut the combined workforce at the four companies it acquired in 2015 by 22% within a year.92 Challenges in Early 2017 The start of 2017 was a particularly volatile and quite negative period for TransDigm’s stock price. The volatility began with a 10% drop after Left published his first report on January 20 showing several examples of parts whose prices had increased dramatically—in one case by 736%—after TransDigm had acquired the companies (see Exhibit 13).93 Left cited a few particularly egregious examples of price increases from a report written by The Capitol Forum (a Washington-based investigative news service) three days earlier.94 Although TransDigm did not respond to Left’s report, several analysts did. In a report titled “Don’t Hate the Player, Hate the Game,” the Jeffries analyst claimed that TransDigm’s high margins were due to acquisitions of companies that already had high margins rather than pricegouging.95 The analyst at RBC acknowledged “an incremental risk,” but noted that TransDigm had “…successfully navigated periods of enhanced defense pricing scrutiny in the past with no discernible impact on its sales or profitability.”96 Two weeks later, on February 7, TransDigm’s stock price jumped 6% after the company released better than expected financial results.97 Between these two events, The Capitol Forum, released additional reports criticizing TransDigm. On February 3, it released analysis showing that prices rose sharply after TransDigm acquired companies. Analysis of more than 2,000 parts made by 20 companies that TransDigm had acquired from 2001 to 2015 showed that prices increased 5.8% annually before the acquisition and 11.0% after it (see Exhibit 14).98 Then on February 13, The Capitol Forum reported that Boeing was moving a tie rod (a part used to connect two components) manufactured by TransDigm to another supplier because it 9 720-422 TransDigm in 2017: The Beginning of the End or the End of the Beginning? had become “increasingly frustrated” with TransDigm’s price increases.99 Interestingly, this story did not appear in the business press. In fact, public reports of disagreements between TransDigm and its major customers, including Airbus and Boeing, were virtually non-existent. A month later, on March 9, Left released a second report alleging that TransDigm was purposefully (and illegally) obscuring its ownership of subsidiaries to deter the DoD from requesting volume discounts. “When [a company] starts being evasive, covering up instead of coming clean, and smoke starts appearing…GET THE F*** OUT!!!,” he said.100 TransDigm’s stock price fell 4% the next day. Following this barrage of criticism, U.S. Representative Ro Khanna, a member of the House Armed Services Committee, sent a letter to the DoD Acting Inspector General requesting an investigation into TransDigm’s business practices.101 “Given that the Trump administration is proposing budget increases for the military, it is incumbent upon Congress to ensure that these increases provide for the common defense, rather than enrich a few individual financiers who stand to benefit at the expense of our troops and weapons systems,” he wrote.102 Specifically, Khanna accused TransDigm of price- gouging and using distributors to “mimic the aesthetics of a competitive market.” 103 When Khanna’s letter became public, TransDigm’s stock price fell 10% to $210. It was now down more than $80 off a six-month high of $290 in September 2016, while the market was up more than 7% (see Exhibit 1A). Calls for DoD audits in general and calls for audits of TransDigm’s business practices in particular were not new. For example, the DoD concluded its procurement agency (the DLA) had not obtained fair and reasonable prices from Meggitt Aircraft Braking Systems in 2015, and had overpaid by $8.5 million on orders totaling $17 million.104 Conducting a similar audit of TransDigm in 2006, the DoD concluded that the DLA) had overpaid by $5.3 million for 77 parts, which TransDigm refused to refund. 105 The DoD’s explanation for why the DLA had overpaid was that its contracting officers were unable to get critical cost data from TransDigm.106 In the report, the Inspector General made clear why overpayment was such a problem: [This report]…concerns the rapidly increasing cost of spare parts and its adverse impact on the DoD challenge to maintain a superior level of combat readiness and force structure as well as improve equipment quality and responsiveness…The procurement of spare parts is essential in assisting war fighters with carrying out their missions.107 Two years later, in 2008, a distributor of TransDigm parts called Dutch Valley Supply was the subject of another DoD audit. That report concluded that Dutch Valley had overcharged the DoD by $3.0 million for parts costing $6.9 million.108 Although the Dutch Valley audit did not mention TransDigm explicitly, it concluded that sales through distributors could be used to increase prices because the manufacturer controlled both the prices at which parts were sold to distributors as well the prices at which parts were offered to customers including the DoD. Conclusion Despite dramatically underperforming the S&P 500 index over the last six months, most analysts did not appear overly concerned about the recent decline or TransDigm’s prospects more generally. In fact, several considered the price decline to be a buying opportunity. 109 For example, an analyst from Deutsche Bank observed that the DoD frequently did audits of this kind, and, despite finding evidence of overpayment, the outcomes were usually benign.110 The analyst at Canaccord added: “We do not assume that where there is some smoke…there is necessarily fire. We continue to believe improving fundamentals, coupled with upside from recent acquisitions, will provide upside to estimates, and we are maintaining our BUY rating.”111 For the time being, TransDigm appeared to have analyst support. 10 TransDigm in 2017: The Beginning of the End or the End of the Beginning? 720-422 Nevertheless, it remained to be seen whether increasing political oversight, growing short-seller pressure, and heightened OEM frustration would affect the firm. In its defense, TransDigm executives could point to the firm’s stated commitment to “honesty, integrity and… ethical behavior”112 and its Code of Business Conduct and Ethics which was adopted in 2006. According to the Code: It is the Company’s policy to comply with all applicable local, national and international laws, rules and regulations…We hope that you share the Company’s belief that a dedicated commitment to ethical behavior is the right thing to do, is good business, and is the surest way for the Company to remain a highly successful company.113 When employees encountered difficult or complex situations, the Code suggested they ask themselves four questions before deciding how to act:114 1. Will my actions be ethical, fully comply with the law, and fully comply with the Company’s policies? 2. Will my actions have the appearance of impropriety? 3. Am I trying to fool anyone, including myself, as to the propriety of my actions? 4. If my activities were reported in the press, would I be embarrassing myself or colleagues? With the exception of Left, no one was accusing TransDigm of breaking the law, but it was possible that Khanna’s letter was a harbinger of stricter procurement regulations, increased oversight, and additional requests for reimbursement. In the short term, Howley had to decide whether to respond to this growing chorus of criticism and, if so, how? As part of his response, and because Representative Khanna might well ask him at a Congressional hearing, Howley had to decide how he would answer the four questions raised in the company’s Code of Business Conduct and Ethics. Was he ready to do that? Over the longer term, he had to decide whether TransDigm should proceed with its proven value creation strategy or consider changing certain aspects of it. If he were going to change the strategy, which aspects should he change, and why? And how would he explain the changes to analysts and his many loyal shareholders?
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