TransDigm (TDG) - Another Outsider
Notes from the 50x podcast on TDG and founder Nick Howley
Will Thorndike, the author of the book The Outsiders, created a podcast last year called 50x. The podcast really just seems to be an extension of The Outsiders book, where he will discuss additional “Outsiders” that have appeared in recent years. For those of you who have not read the book, it discusses eight CEOs who ran a company that dramatically outperformed during their time as CEO.
The first podcast series on 50x discusses TransDigm (NYSE: TDG 0.00%↑ ) and founder Nick Howley who has produced a 37% IRR from 1993-2021 running TDG. Incredibly TDG has done 52 acquisitions and has lost money on zero of them. Even more incredibly, Howley believes TDG has achieved a private-equity like return (20%+ IRR) on all 52 of them.
TDG primarily designs and produces parts for airplanes. Specifically, Howley created a strategy where TDG has grown by acquiring (1) companies producing low cost / high value parts where they are “sole supplier” (monopoly) of that part, (2) they own the intellectual property for making the part, and (3) the part has a significant aftermarket (allows TDG to make money on high-margin replacement parts). This is a powerful combination where TDG is selling a monopoly part that might only cost a few thousand dollars but is incredibly important to both building and maintaining the airplane. Meaning, the buyer is less price sensitive creating lots of pricing power.
The podcast interviews TDG founder Nick Howley and he comes across as a practical, no-nonsense guy with a very clear, engineering-like mindset. He has a clear view on what TDG is looking for in an acquisition target and on how to operate the acquired assets. For example, he states, what might be obvious, that the only way to create value (increasing earnings) for TDG is to (1) increase prices, (2) decreases costs, or (3) find new business. He says if a TDG employee is not working on one of the above then they should not be employed with the company. An obvious statement but he has built this simple focus into the company culture very effectively. And with this very rational view TDG operates a very light headquarters with only 25-30 employees and therefore allow the subsidiaries an extreme amount of autonomy.
The other interviewee on the podcast is Rob Small, an investor from the private-equity firm Berkshire Partners and its affiliated hedge fund Stockbridge. He reinforces many things that Howley says but provides a different perspective on the company as well as some additional insights into how Howley operates. Not surprisingly, he stresses how disciplined and hard working Howley is. He also mentions how Howley has an unusual ability to focus on the controllable variables. They discuss hard economic times for the aerospace industry (9/11, Financial Crisis, COVID) and how quickly Howley was to cut costs when he realized a downturn was occurring.
The extremely good outcome at TDG seems to be what happens when you combine a GREAT sub-industry focus, with a GREAT operator, with GREAT capital allocation abilities. It is rare that a CEO could be rated among the best operators and capital allocators, and Howley seems to be one of the rare ones. He reminds me a lot of Hunter Harrison, who completely transformed the railroad industry with his precision-scheduled railroading strategy and also showed an amazing ability to allocate capital wisely.
The entire podcast is long, running about five hours. For those of you interested in the finer details, I’d recommend listening. But if you do not have the time, my notes are below with some of the finer details.
TDG notes from 50x podcast:
28th anniversary of TDG in 2022
IRR 1993-2021 = 37% CAGR
First 13 years was owned by 3 PE investors – 37% IRR
Remainder 15 years, publicly owned – 37% IRR
Outperformed peer group by 9x
Nick Howley, for most of his life, wanted to own a niche manufacturing company
Dad owned a manufacturing company
Throughout high school and college worked a variety of jobs – from top to bottom
Went to Drexel and played football
Engineering major
Then went to Harvard Business School
Worked for Raytheon and eventually a niche manufacturing business
Also did some not so successful entrepreneurial businesses
Original transaction that effectively started TDG
EBITDA = $9-10mm on purchase price = $55mm (5-6x EBITDA multiple)
$25mm equity
Four small businesses in niche manufacturing
Commercial and defense businesses were down
Defense spending moved down due to post-Cold War era
Goals
Get costs in-line
Shut down unnecessary business lines
Wait for business to recover, then sell
Over next five years when Kelso (private equity firm) was owner
5x growth in cash flow
Capital allocation
just did debt pay down during this period
And pure organic growth
Result
Ended up selling at $450mm and 10-11x EBITDA multiple
Sold to Odyssey (private equity firm)
After Odyssey Acquisition
Started to do acquisitions – buying 8-9 businesses over next 4-5 years
In the beginning Nick Howley would act as CEO, for new acquisitions, for the first 6 months or so
Marathon acquisition
Realized they misjudged the organic growth in this business
Admits that they made the mistake of not doing enough work on it to realize this
Due to the above, they stripped a significant amount of costs from business to get the returns, which made the transaction successful
Adams-Wright acquisition
Largest manufacturer of airplane faucets
Took 20% of the costs out in a 2-month period
Mostly people costs – many doing things that did not create value
Went thru all the products on pricing structure – had done a lot of work on this as part of their due diligence pre-acquisition
Increased prices in aftermarket
Margin increased from 12% to 28%
Champion acquisitions
Large buy at the time and had to lever up to do it
9/11 hit just afterward
Replaced most of management in first 3 months
Took 20-25% costs out
Substantial adjustment in product prices
Removed half of new development costs that were unlikely to work
Corporate HQ = ~7 people during this second phase
Focused on buying:
Proprietary aerospace manufacturing businesses with significant aftermarket content
AND with clear PE-like returns likely to investors at purchase price
Sold to Warburg Pincus in 2003
After selling to Warburg Pincus
Would find acquisition targets at 15-20% EBITDA margins, and TDG would increase them to 40%
Nick Howley moved to focus on capital allocation at this time period
Approach to M&A changed
Began to have sales approach to M&A to make sure they were seeing as many deals as possible
Required, as they did before, a clear path to a >20% IRR over a 5-year period
If something got too close to a modeled 20% IRR, they got nervous
Usually was in the 25,26,27% range
As they got bigger and acquisitions got bigger, the expected IRRs trended down to be closer to 20%
Modeling assumptions that TDG used/uses
Assumed same multiple (or less) – no multiple benefit
Assumed same capital structure – no additional debt benefit
Which was usually 50% equity / 50% debt
Assumed very little credit to new business, cause “its hard from the outside looking in” to accurately assess
Important questions when they considered an acquisition
Is product proprietary?
Does product have significant aftermarket content?
The target usually underestimated their own strength in aftermarket
Can we price the product higher?
Have detailed operational plan set once they decide to buy a company
Acquisition record
Made 52 acquisitions and lost on 0
And Nick Howley thinks they actually got a PE-like return (20%+ IRR) on all of them too
Hard Economic times
9/11
Aerospace industry stopped for a few months
Took out company-wide, already lean, 20% of costs/people out of it
Picked up new business development
Developed cockpit security system – sold it across industry
Financial Crisis
Cut costs dramatically once they realized the recession was going to be probably deeper/longer
Interesting question on whether they were able to buy anything distressed
Nick Howley - “you don’t see a lot of distress in this industry. We’re buying proprietary, sole-sourced parts aerospace businesses with a lot of aftermarket. Unless you get yourself way over-levered, it’s hard to lose money [here].”
COVID
Commercial aftermarket is where all the money is so it hit you where it hurts the most
Thought volumes would go down by 1/3, so they decided to get out the same proportion of costs down to keep margins
Decentralization
Decentralization is “almost a religious belief” within TDG – if you want people to act like owners need to treat them (autonomy) and pay them like owners
Compensation
Wanted to underpay them in cash compensation but overpay in equity value when they increase IV
25-35% quartile in cash pay
But then 3-4x in equity pay
Formula
Beginning period EBITDA x multiple = EV – debt = MC / diluted SO = Intrinsic equity value per share
THEN, the held multiple the same but allowed all the other numbers to change in order to calculate the change in intrinsic equity value per share
Equity awards do not vest with <10% increase in intrinsic value per share
and 20% growth to fully vest
Dropped this to 17.5% eventually and where it is today
Did this on a company-wide basis
Almost lose no employees on once they get on the equity plan
Organic growth formula
4-5% real growth per year
total 9-10% organic growth
How to satisfy customers in the industry (ranked by Nick Howley)
(1) Product works
(2) Keep up with new tech, which mainly means extending life of product
(3) Delivery on time and be prompt on service
(4) Price
Price is not as important since “these are little things going into big things”
“Most important that you are not fouling up the big thing”
“Parts need to work and need to get them there on time”
Current M&A runway
A few big ones are still around
But he said “I don’t know” on how big the runway
Will eventually need to expand either by:
(1) Start looking at non-proprietary products / no aftermarket
(2) Start looking at proprietary products with aftermarket in other industries
Intrinsic Value Drivers – HAD EXTREME ENGINEERING FOCUS ON THIS that he spread throughout the organization/culture - focuses are:
(1) Product Price
Price not to cost but what do you think value is to customer
Value to customer based on what you are providing versus what are switching costs to customer
Usually trial and error to get to right price
Most niche manufacturers underprice their products
(2) Product Cost down
Don’t understand fixed vs. variable – too much “gaming” occurs in the planning process when you try to do this split
Simply trying to decrease costs each year (so, remove inflationary increase + get some additional cost savings)
(3) Generate new business
“Anything else is tertiary”
Focused on the controllables through the up/down markets
Have training programs on a variety of topics to reinforce culture
People overemphasize experience
Underweight people qualities of youth, and energy/drive
Viewed excess equity capital as very expensive relative to debt and therefore have done multiple special dividends
Returns
58% IRR over 10 year hold to Kelso original $25mm investment in 1993
42% IRR over 4 year – Oddysey
If held all the way thru IPO, from the start – 37% IRR
Rob Small (Berkshire Partners & Stockbridge) take on TDG
People didn’t think TDG was well-positioned cause they sell the less complex parts, not the high-tech parts - “But that was the point”
TDG was the best business he saw in private equity
Everything centered around safety in aerospace and is also an incredibly complex product (600k parts)
Boeing uses their volume to negotiate pretty good prices from suppliers
Some parts never get replaced in 30yr lifetime
Aftermarket for TDG
Very strong margins in aftermarket
“Being paid for the intellectual property and the switching costs”
2008-2009
OEM shrunk but only slightly
Aftermarket was still very strong
Berkshire Partners bought $150mm (5% position) during this time period
Berkshire Partners sold TDG a business and that is when he fully realized how good TDG is at acquisitions
TDG stripped out costs way more than Berkshire’s company could
Due to this, realized TDG should be able to pay the highest price of any rational bidder cause they run the business better than anyone else
Went SKU by SKU on pricing (in both directions) to maximize profits
TDG has always been at 15%+ IRR at least on a publicly-traded basis, according to Stockbridge’s math
Ability to focus on what is important (price/cost/new biz) is unusual
Nick Howley and the company don’t dwell on what happened – just keep moving forward
Nick Howley very intense in his work but can still crack jokes
More serious about what he does then anyone he’s met
Very focused on the controllables
Disclosure: I might hold shares in any of the companies mentioned and I might buy or sell at any time. Please do your own due diligence before making any investment. None of my writings are investment advice.