Table of Contents

Aggregators in the Public Markets (Part 1): TransDigm Group.

• What is TransDigm
• TransDigm is a supplier and designer of proprietary aircraft parts to the aftermarket
• If you had invested in 1993, you would have achieved an annual IRR of 35% over the past 25 years
• One of the most successful industrial/manufacturing businesses that has compounded over many years
• Founded by Nick Howley + Douglas Peacock + PE Firm (Kelso->Odyssey->Warburg->IPO)
• Nick Howley's Background
• Started in "on the ground" businesses, family had a machine shop
• Early one learned the reality of cash flow and productivity in a tangible way
• Real blocking and tackling, learned as much there as he did in formal education
• The machine shop is a tough business, not a good business
• Engineering background
• Value Creation Strategy
• Follow a simple, straightforward strategy
• Essentially, we are in the business of owning and operating proprietary (strong moat) aircraft parts (essential) businesses that cater to the aftermarket (pricing power + better margins)
• Have a compensation system aligned with shareholders
• Underpay managers and over-equitize them
• Decentralized Operations
• Have ~65 business units
• Essentially operate like a PE portfolio where each unit is a PortCo and TransDigm is the HoldCo
• Follow a disciplined acquisition strategy
• Only buy proprietary aircraft businesses with significant aftermarket
• Use a lot more leverage than typical public companies, so need high cash flow/moat/etc.
• Goal is to match or exceed the returns of the private market in a publicly traded HoldCo
• Three P's: Price, Profitability/Productivity, and Profitable New Business
• Price Goal = Price > Inflation
• Profitability/Productivity = Cost Out + Increase Productivity
• Profitable New Business = Organic / Acquisitions
• This approach works for the industrial/manufacturing/niche engineering businesses (Nick can't talk to software businesses or industries where there are high rates of change)
• Use when have 100 employees and still using with 100k employees
• We focus everything on these three things
• They can be opposed to each other, i.e. the price too high, can sell or generate new business etc.
• Need to balance all three
• Price
• The goal is to never price to cost, but price to value added to customers
• I would say in the area of pricing, most businesses don't really track / or know what their pricing trends are
• If you can't specifically say it you probably don’t know it
• Most acquisitions we work on… part of the analysis is what the prices and the trends are
• If you can't move prices close to inflation, you need to focus on cost
• How high can you get the price before you get cut?
• Need to be in tune with the market to figure out which complaints about price increases are "normal" grumbles or if you raised prices to high
• Close enough to hear the objections, bc no one will ever say "thanks for raising prices"
• Need to know what is normal complaining and what is too much complaining
• Where you are in the value chain also plays a major role in pricing power
• If your product requires repeat buys, you should know how much the switching costs are
• If you are unsure about where to raise prices, pick a small subset of a business and try it
• Usually get more than you think you can, assuming you have value to the customer
• Anyone can figure out what the factors driving switching costs and back into something reasonable
• What is the role of the CEO in pricing?
• Intimately involved
• The CEO needs to grow equity value, and prices are a key part of LT equity value growth
• When you buy a business, the CEO has to be intimately involved
• Also, when CEO is involved there should be no surprises and no confusion
• In industrial markets, usually grow like GDP and hard to make market changes
• Easiest levers to pull are usually price (price) and cost (profitability), not new business (profitable new business)
• Profitability
• We focus on productivity and reducing costs
• Ignore fixed and variable cost, view it all as costs that we need to reduce
• Cost = Rev. - EBITDA
• If you have 100mm business and 20mm EBITDA, 80mm cost base
• 4% inflation = 3.25mm increase/year
• Likely need to cut costs more than you want
• Always count all the costs, if there is productivity increase and no margin increase, usually the productivity increase comes only from cutting pricing
• Usually people only use a subset of costs, so the margins aren't growing bc there are costs that are not being accounted for intentionally
• Profitable New Business
• Look at everything from an investor's perspective, i.e. using a discount rate (IRR) and probabilities
• Look at it like an investment justification
• For acquisitions we form an investment thesis, understand the overhead (certain number of engineering hours, freebies to the company, testing costs, etc.) Then ask what is the return?
• If put 3mm in project get 200k profit very hard to justify the acquisitions or expansion
• Be realistic about markup and market penetration, do not overestimate yourself
• If you get it someone else is losing it
• Many things don’t work, i.e. even if you win you did not win
• 3mm and a 5% chance of winning, why are you bothering to do it
• Don’t invest in things you find cool but are unprofitable from a mathematic standpoint
• Which of the three P's is the most impactful for shareholder value?
• You have to focus on all of them, not just one
• Acquisitions can be a driver of the three P's but remember that results from them are hard to measure
• How to measure customer satisfaction as you drive on pricing and productivity?
• On time deliveries and how much of the backlog is past the shipping date
• Never 0
• If the pass through backlog is less than day or two of average shipments you are doing pretty well
• An engineered niche product that works, is high quality, and on time delivery is important if you are a small part in a big process of product 
• Late deliveries and defects are a huge detractor
• If you are getting new business from an existing account, how pissed off can they really be?
• What is your M&A track record?
• M&A: 0 loss ratio and never impaired capital, compared to 50%-70% M&A overall being value destroying
• One of the key things is that we learn the market: aerospace
• The main way to destroy value is if you don’t understand the market or the market position of your business
• For M&A, TransDigm likes to own 100% of all proprietary IP, can accept some impairment i.e., less than 100% ownership
• Everyone says their product is proprietary but most are not
• Is there significant aftermarket? = more stable and profitable
• How much is really aftermarket? Some people are clueless, they say 0% which can't be true or they start calling everything aftermarket which also is impossible
• If you can't make the math work, move on
• Case Study (Acquisition)
• All of our products can be tied to a platform, a plane etc.
• Once you understand the platform, you can reasonably predict revenue over the next 5-6 years
• If EBITDA is 18mm, go through 3 layers
• What can we do on pricing, cost takeout (usually headcount in the first couple years), new business (could be plus or minus bc of overhead and investment)
• Helps set a EBITDA goal/target
• We assume 50% debt and 50% equity, debt multiple is off of EBITDA 
• Look at it as a standalone PE investment, assume exit EBITDA multiple as unchanged since entry
• Buy at the multiple and focus on EBITDA growth
• If equity value is not growing at 20% we don’t buy it
• Don't buy for synergies, must stand alone
• We never sell, bc they are almost always more profitable as part of the whole than stand alone
• Most ppl don’t realize this, most acq. do not work, but you will never hear someone say "this failed". Why is that, bad buy? integration? culture?
• Putting aside economic cycles, ppl bought for all kinds of reason other than value creation
• Nobody looked into value creation deep enough
• But to grow multiple, sell upmarket, etc.
• We are fairly prescriptive in the beginning, make the business look like how we want it to look like, very trackable
• Most of the time we have to change out the senior management
• Put in our own ppl to any business that has substance
• Cannot change culture unless you change the top
• Take a business and put it into a unit, each product line will have an income statement and a product line manager
• We set up the income statement and set the targets, price target, cost targets, new business targets
• It is not perfect but brings clarity
• Why is headcount the first thing taken out?
• In these businesses, costs (sales-EBITDA) is usually 60% ppl related and 40% other
• The other 40% is other stuff, always hard to tell
• If you are buying a commodity you have to pay the price
• Not unusual that the commodity prices have gone unnegotiated for a long time
• Also, most do not check for other suppliers
• Quickest way to increase profitability is reduce employment numbers
• Usually not the direct labor, all overhead
• Not that people aren't working, it is that people are doing things that do not matter
• Usually you can cut 10-15% employment out of it with no problem
• How do you identify the amount of labor that can be taken out?
• No formula for it
• If there are 10 ppl in accounting, we look at other similar businesses and vet over the first 30 days
• Do not overanalyze, you will never get there
• Consultants will be there for a year lol
• How to think about compensation strategy as part of the philosophy?
• We have 68 standalone business units
• Each unit has a president and 4 direct reports

1. Head of Sales, Finance, Ops., and Engineering

• 7-10 business units have a group office
• CEO, COO, CFO
• These key value creators are in the equity plan
• If you aren't in that group, they will pay market
• Those in the value creation group will pay them at the 35th percentile vs the market and give them options that vest on performance
• EBITDA growth and cash flow targets
• We assume the stock is going to grow at 15% a year, double every 5 years
• Highly lucrative for ppl bc the stock has gone up
• If you can create a value, you can make way more here than an operating unit at Honeywell etc.
• What do I do if I acquired a business with high salaries, no equity plan, and want to change this?
• Always tricky, we don’t want to buy a business and decrease salaries
• If you have people overpaid, lay off others rather than reduce salaries
• This comes up less than I expect
• On the decentralized model, are you giving options of the business unit or the TransDigm level?
• We do it at the TransDigm level bc that is where you can sell
• We have made a couple exceptions
• I've gone back and forth on synthetic equity for each structure
• Complicated as hell
• We move people around, get too complicated
• That being said, we have done two times, we have bought companies from private equity firms with founders that wanted to roll
• We give them synthetic equity structure for them, buy them back in 5 years
• EBITDA*multiple-debt=equity
• How to deal with free rider issue?
• Do quarterly business reviews, product line by product line
• Look at PnL, price target, productivity target, new product target
• Cross fertilize all the units, becomes self-checking
• Let's say you both sell into biz. jets one biz. growing at 6% and the other is 3%, other managers get grousing
• Problems become obvious and some ppl are just overly optimistic and get better over time
• Peel back the businesses, the fast answer is product mix, but almost never the answer
• Better answers are the market is not buying as much, or not buying as much and price dropped, or just have more costs than expected
• What profile do you think are the most important in ppl?
• Like to promote from within, different culture
• Culture is closer to a big PE business on the public market
• Internal promotes that understands the value creation process
• Look for smart enough, energetic, honest
• Most overvalue experience and undervalue smart, honest, and hardworking
• Have a bunch of specifics, smart enough, work hard, open and honest communicator, pass the no asshole rule
• Can train specifics but cannot train honest, energetic, and smart
• If they are willing to listen, you can get there
• Does this work in other businesses that aren't in a good market like TransDigm?
• Its math, sales-cost=profit how can I improve, sell more stuff, remove costs, or increase price
• If your goal is to grow equity value, just need to sell more stuff and get the cost down
• You can make the argument that if you can grow faster the multiple can increase
• Tough road to take bc not fundamentally improving the business (putting aside capital structure issues)
• Have you made any big mistakes?
• As a general rule, I have never replaced anyone too soon, I have waited too long
• If you lose confidence in somebody you will never recover it