TDG - Transdigm

[cmlber]

Perhaps USG could squeeze TDG contracts to cost+ based on "monopolist provider" rule.

 

Can you clarify what you mean by the "monopolist provider" rule?

[Guest Schwab711]

Perhaps USG could squeeze TDG contracts to cost+ based on "monopolist provider" rule.

 

Can you clarify what you mean by the "monopolist provider" rule?

 

According to DoD policy, all sole source contracts should be cost+ (same as 'reasonable profit' I've been saying). If there are multiple suppliers then the former does not necessarily apply (though it could). I think this is what Jurgis was referring to.

[Jurgis]

What Schwab711 said.  8)

[cmlber]

Perhaps USG could squeeze TDG contracts to cost+ based on "monopolist provider" rule.

 

Can you clarify what you mean by the "monopolist provider" rule?

 

According to DoD policy, all sole source contracts should be cost+ (same as 'reasonable profit' I've been saying). If there are multiple suppliers then the former does not necessarily apply (though it could). I think this is what Jurgis was referring to.

 

Can you link to a source on this?  I'm not aware that this is a policy.  I believe the policy is sole source contracts above a certain cost require the disclosure of cost information so that the DoD can negotiate cost+ deals effectively.  I haven't seen anywhere that would prevent a supplier from refusing to do a cost+ deal though. 

[writser]

Just jumping in here. I dont know why we are talking so much about their defence business, some shorts are even speculating that this would sink the company. Last time I checked commercial aftermarket still makes almost 40% of their revenue and I bet it's much higher % of their EBITDA. That segment has always been the most important reason for me to be invested in Transdigm and I haven't seen any reason this story would have changed somehow.

 

Well, as a counterargument, think about second-level effects. If it turns out that they are ripping off the DoD you can be sure that other customers will start monitoring their bills more closely, at the very least (and it makes it more likely they are cheating other customers too - seldom one cockroach bla bla). Philidor was only a small part of Valeant but the ensuing scrutiny brought down the entire company. Transdigm also has to pay ~500m cash to their lenders annually. A small drop in EBITDA will affect equity holders disproportionally.

 

Just stating the obvious here .. Not too hard to envision a bad scenario.

[Jurgis]

I haven't seen anywhere that would prevent a supplier from refusing to do a cost+ deal though.

 

Nobody is saying that TDG cannot refuse to do a cost+ deal. Sure they could. But would they really say "FU" to a big customer who actually might look for alternative source if they are told to "FU" and then that source could sell to other TDG customers.

 

I'd bet TDG won't say "FU". They will go for cost+, but will also dance to get the biggest + possible.

 

I believe there was info in Citron report that TDG itself suggested adjusting contract to cost+ for some contract where government got cost info.

[cmlber]

I haven't seen anywhere that would prevent a supplier from refusing to do a cost+ deal though.

Nobody is saying that TDG cannot refuse to do a cost+ deal. Sure they could. But would they really say "FU" to a big customer who actually might look for alternative source if they are told to "FU" and then that source could sell to other TDG customers.

 

I'd bet TDG won't say "FU". They will go for cost+, but will also dance to get the biggest + possible.

 

I don't think you appreciate the pricing power of a monopoly provider of hundreds of thousands of mission-critical parts.  It's not like there are ten parts and TDG is concerned the DoD could find an alternate supplier with enough time.  There are literally hundreds of thousands of parts, many of which have proprietary technology.  The biggest PMA supplier, Heico, which controls more than 50% of the market for generic parts (i.e. OEM knock offs) tells investors that they have the capacity to produce 300-500 parts per year. 

 

In 2006 the DoD made an inquiry into Transdigm's pricing and concluded:

 

Given the constraints of a sole-source contracting environment, Defense

Logistics Agency contracting officers were unable to effectively negotiate prices for

spare parts procured from TransDigm subsidiaries.

 

Another option is for DLA to reengineer or develop a Government-owned

technical data package and qualify new sources to establish a competitive market

for high dollar sole-source parts. For example, DLA and the Air Force are

attempting to address TransDigm’s unreasonable prices by funding a

reengineering project to develop a fully competitive technical data package for

the oil pump assembly housing (NSN 2990-01-259-0589). That technical data

package could be solicited to other vendors to obtain reasonable prices. However,

this process is lengthy and can be expensive.

 

I suspect this is how negotiations went in 2006 when this investigation happened:

 

DoD:  This part only costs you $20 and you've been selling it to us for $100.

 

TDG:  Ya, and?

 

DoD:  We want it for $40.

 

TDG:  No.

 

DoD:  Then we're going to find another supplier.

 

TDG:  Ok, good luck.

 

10 years later TDG has compounded at 30%+/year.

[Liberty]

The real danger is the debt. If margins were to contract severely because of action by the government, they'd still have to service a pretty large debt. If the debt is, say, 6-6.5x at current EBITDA, what is it at 30% EBITDA margins? At 20% EBITDA margins? What if the aero cycle rolls over during that time? Manufacturing these airplane parts will always be a viable business, but there could be some serious pain if they had to transition to a different model.

 

I'm not anything will happen, but the high debt and some unanswered questions about pricing and how much EBITDA comes from which part of the business were part of my reasons for selling a little while ago around $250. Maybe I'm being overly cautious...

[Spekulatius]

The real danger is the debt. If margins were to contract severely because of action by the government, they'd still have to service a pretty large debt. If the debt is, say, 6-6.5x at current EBITDA, what is it at 30% EBITDA margins? At 20% EBITDA margins? What if the aero cycle rolls over during that time? Manufacturing these airplane parts will always be a viable business, but there could be some serious pain if they had to transition to a different model.

 

I'm not anything will happen, but the high debt and some unanswered questions about pricing and how much EBITDA comes from which part of the business were part of my reasons for selling a little while ago around $250. Maybe I'm being overly cautious...

 

The real danger is that something is fraudulent about TDG business model, the debt will just provide to gravity to have the equity slide against zero, in the case of serious issues, just like it did with VRX.

 

The thing that I don't get is how they do make all these "highly proprietary" parts with only 4 % R&D. You would usually expect a huge development cost to make all these "highly proprietary" parts, but in fact the R&D cost suggest that this is not the case. How can this be?

[undervalued]

Perhaps USG could squeeze TDG contracts to cost+ based on "monopolist provider" rule.

 

Can you clarify what you mean by the "monopolist provider" rule?

 

According to DoD policy, all sole source contracts should be cost+ (same as 'reasonable profit' I've been saying). If there are multiple suppliers then the former does not necessarily apply (though it could). I think this is what Jurgis was referring to.

 

Can you link to a source on this?  I'm not aware that this is a policy.  I believe the policy is sole source contracts above a certain cost require the disclosure of cost information so that the DoD can negotiate cost+ deals effectively.  I haven't seen anywhere that would prevent a supplier from refusing to do a cost+ deal though.

 

I think Wayne mentioned it in his article http://seekingalpha.com/article/4054392-industry-insiders-valuation-transdigm-part-1-3

[Guest Schwab711]

Perhaps USG could squeeze TDG contracts to cost+ based on "monopolist provider" rule.

 

Can you clarify what you mean by the "monopolist provider" rule?

 

According to DoD policy, all sole source contracts should be cost+ (same as 'reasonable profit' I've been saying). If there are multiple suppliers then the former does not necessarily apply (though it could). I think this is what Jurgis was referring to.

 

Can you link to a source on this?  I'm not aware that this is a policy.  I believe the policy is sole source contracts above a certain cost require the disclosure of cost information so that the DoD can negotiate cost+ deals effectively.  I haven't seen anywhere that would prevent a supplier from refusing to do a cost+ deal though.

 

Here's one of the manuals I was referencing:

http://www.ruffinpc.com/pdfs/dcaap7641_90.pdf

 

I know there is a more recent version but I haven't had time to read through the differences yet. I originally started with the earlier manual because I was interested in early M&A. For our purposes, it's probably better to use the current manual:

http://www.dcaa.mil/DCAAM_7641.90.pdf

 

Either way, this journal references the 'recommendation':

http://aaajournals.org/doi/pdf/10.2308/ogna-50558?code=aaan-site (p.2, 1st paragraph)

 

Information on "Pricing Considerations":

http://www.acq.osd.mil/dpap/dars/pgi/pgi_htm/PGI215_4.htm

>  See PGI 215.404-3(a)(vi)

 

FAR 15.404-4©(4) [referenced above]:

https://www.law.cornell.edu/cfr/text/48/15.404-4

 

There's also new legislation that I don't fully understand yet but I believe the above is current.

[hooplaer23]

The debt levels at 30% EBITDA margins instead of 47% margins would obviously be very problematic for the company, but for that to happen, you have to believe there will be a significant change in the company's business model beyond its sales to the U.S. government (i.e. to other governments and more importantly to its commercial customers).  As I described in a previous post, the company indicated that approximately $210 million of its sales were to the U.S. government (both direct and through distributors).  In 2016 the company had 3.2 billion in revenue and $1.5 billion in EBITDA as defined.  Even if the U.S. government sales were 100% EBITDA margin (which seems implausible), and that entire $210 million in EBITDA went away, the company would still be earning $3 billion in revenue and $1.3 billion in EBITDA, or 43% margins. 

 

You could argue that sales to domestic defense OEMs like Boeing and Lockheed, which account for 12% of revenue ($380 million) could also face margin pressure, but these sales likely had lower EBITDA margins to be begin with.  Using the same scenario where these revenues are 100% EBITDA margin (again they aren't in reality), if you cut revenue and EBITDA by another $400 million you would get $2.6 billion in revenue and $0.9 billion in EBITDA, or about 35% EBITDA margins. 

 

I am not saying that it is impossible that this scrutiny could flow over into its commercial aftermarket business, although I believe that is unlikely.  But my point is to highlight the draconian assumptions you have to make on the defense side to even get to 35% EBITDA margins if you assume no change to the commercial business. 

[cmlber]

Here's one of the manuals I was referencing:

http://www.ruffinpc.com/pdfs/dcaap7641_90.pdf

 

I know there is a more recent version but I haven't had time to read through the differences yet. I originally started with the earlier manual because I was interested in early M&A. For our purposes, it's probably better to use the current manual:

http://www.dcaa.mil/DCAAM_7641.90.pdf

 

Either way, this journal references the 'recommendation':

http://aaajournals.org/doi/pdf/10.2308/ogna-50558?code=aaan-site (p.2, 1st paragraph)

 

Information on "Pricing Considerations":

http://www.acq.osd.mil/dpap/dars/pgi/pgi_htm/PGI215_4.htm

>  See PGI 215.404-3(a)(vi)

 

FAR 15.404-4©(4) [referenced above]:

https://www.law.cornell.edu/cfr/text/48/15.404-4

 

There's also new legislation that I don't fully understand yet but I believe the above is current.

 

Those links discuss the thresholds where a company is required to disclose cost data.  There is no requirement that TDG supply the government with products under cost+ contracts.  There is only a requirement to share cost information, under the theory that this will make it easier to negotiate, for products with sales above a certain threshold. 

 

[thefatbaboon]

My mind keeps going back to the slide from the last investor day (page 21). 

 

90% of total commercial aftermarket revenues are made from the sale of parts that sell less than $2m per year.  Across all the various major airlines like BA or AA that ends up being maximum $135,000 per year per part per airline.

 

 

[HopeIsNotAStrategy]

 

There are literally hundreds of thousands of parts, many of which have proprietary technology.  The biggest PMA supplier, Heico, which controls more than 50% of the market for generic parts (i.e. OEM knock offs) tells investors that they have the capacity to produce 300-500 parts per year. 

 

Been following HEI for awhile, newer on TDG. Thanks everyone for all of the very helpful info in this thread. Agree cmlber with your 2/9/2016 comment that the combination of "sole-source aftermarket in niche, low dollar categories" is crucial and a durable moat, but just a note on the barrier to PMA knockoffs. HEI has said that they can only do 300-500 new PMA parts per year not because they could not get more parts through the approval process, but because they cannot sell the new parts; they are maxing out on what airlines are willing to incrementally adopt from a new supplier. Customer adoption is the barrier, not the number of parts TDG has vs HEI's ability to penetrate them.

[cmlber]

 

There are literally hundreds of thousands of parts, many of which have proprietary technology.  The biggest PMA supplier, Heico, which controls more than 50% of the market for generic parts (i.e. OEM knock offs) tells investors that they have the capacity to produce 300-500 parts per year. 

 

Been following HEI for awhile, newer on TDG. Thanks everyone for all of the very helpful info in this thread. Agree cmlber with your 2/9/2016 comment that the combination of "sole-source aftermarket in niche, low dollar categories" is crucial and a durable moat, but just a note on the barrier to PMA knockoffs. HEI has said that they can only do 300-500 new PMA parts per year not because they could not get more parts through the approval process, but because they cannot sell the new parts; they are maxing out on what airlines are willing to incrementally adopt from a new supplier. Customer adoption is the barrier, not the number of parts TDG has vs HEI's ability to penetrate them.

 

That's correct, they say they can probably double capacity if the airlines were more accepting.  The point remains though, that even if they could do 2,000 parts/year, TDG has hundreds of thousands of parts.  It would take many years to PMA all of their parts. 

[Spekulatius]

The  Hurdle to replace a part with a part from a different supplier, or even the same supplier made differently is quite high in Aerospace. some parts required requalifcations, engineering reviews etc. when engineers would even think twice if it were a consumer product.

 

Think one of the risk that had not been discussed much that TDG is facing is if an customer find substantial deficiencies in TDG quality system. It may not even be an actual defect part, even though those often abuse those deficiencies come to light. From a quality system POV, aerospace is quite unforgiving and the norm for AS9100 (aerospace quality manual) is much tougher and specific than the standard ISO norms.

For example  aerospace typically requires full tracablilty of all the produced parts/lots as well as raw materials. If something were found significantly deficient, because TDG cuts corners, it would potentially be very expensive to cure and in this case, I think the airlines willingness to look for alternative suppliers would go way up.

 

I think with all the acquisitions that TDG is performing and the associated cost cutting, this risk is way higher than it would be with a company that has a lower growth rate or growth organically.

 

I don't work in Aerospace, but I have worked with a company that supplier parts for aerospace customers as well, so I am sort of familiar with the quality system as they compare with standard industrial products for example.

[Guest Schwab711]

There are literally hundreds of thousands of parts, many of which have proprietary technology.  The biggest PMA supplier, Heico, which controls more than 50% of the market for generic parts (i.e. OEM knock offs) tells investors that they have the capacity to produce 300-500 parts per year. 

 

Do you know how many parts represent 10%, 25%, and 50% of total revenue? I'm thinking Heico probably wouldn't need to get a PMA for a large number of parts to compete against a high % of TDG's revenue.

 

I know any comparison to VRX has a ton of implications and I am not trying to imply anything like that with TDG. However, VRX had 1000s of drugs (and also said that no specific drug was a material portion of their revenue) but the top-30 drugs represented roughly 50% of total revenue. They were a lot more concentrated than most people expected once they went from reporting top-10 to top-30. Given TDG's business, I think it would be useful to know the revenue of their top-25 parts and/or how many parts represent 10%, 25%, and 50% of revenue. I imagine Heico would focus on the highest grossing parts and has no interest in getting a PMA for a part that has $10k/yr in sales.

[cmlber]

There are literally hundreds of thousands of parts, many of which have proprietary technology.  The biggest PMA supplier, Heico, which controls more than 50% of the market for generic parts (i.e. OEM knock offs) tells investors that they have the capacity to produce 300-500 parts per year. 

 

Do you know how many parts represent 10%, 25%, and 50% of total revenue? I'm thinking Heico probably wouldn't need to get a PMA for a large number of parts to compete against a high % of TDG's revenue.

 

I know any comparison to VRX has a ton of implications and I am not trying to imply anything like that with TDG. However, VRX had 1000s of drugs (and also said that no specific drug was a material portion of their revenue) but the top-30 drugs represented roughly 50% of total revenue. They were a lot more concentrated than most people expected once they went from reporting top-10 to top-30. Given TDG's business, I think it would be useful to know the revenue of their top-25 parts and/or how many parts represent 10%, 25%, and 50% of revenue. I imagine Heico would focus on the highest grossing parts and has no interest in getting a PMA for a part that has $10k/yr in sales.

 

TDG discloses that 90% of their revenue comes from parts with $2mm of revenue or less, that's on a $3.5bn revenue base.  PMAs are 2-3% of the market, and Heico says TDG parts are probably less penetrated then average because they aren't high enough volume to target.  They specifically say they tend to avoid TDG parts.  A $1-2mm part is worthy of being PMA'd, so it's safe to say the 90% of revenue is not 1500-3000 $1-2mm parts.  Many parts are also highly proprietary and can't be reverse engineered. 

[Spekulatius]

.  Many parts are also highly proprietary and can't be reverse engineered

 

That  does not rhyme with the fact that their R&D spending is 4% of revenues. Based  in what they are stating and diversity of the product line, I would expect their R@D content to be much higher. Either it is simply not true whet they are stating or they are just harvesting profits from the companies they acquiring from existing products, which would be similar to VRX business model.

 

Decent article in gurufocus:

http://www.gurufocus.com/news/493786/transdigm-looks-cheap--but-no-thanks

[thefatbaboon]

.  Many parts are also highly proprietary and can't be reverse engineered

 

That  does not rhyme with the fact that their R&D spending is 4% of revenues. Based  in what they are stating and diversity of the product line, I would expect their R@D content to be much higher. Either it is simply not true whet they are stating or they are just harvesting profits from the companies they acquiring from existing products, which would be similar to VRX business model.

 

Decent article in gurufocus:

http://www.gurufocus.com/news/493786/transdigm-looks-cheap--but-no-thanks

 

Spekulatius, I don't how much one can infer from the apparently low % of total revenues spent on R&D.  If one assumes this business is very bifurcated between (1) First decade of design, test, initial oem production, initial spare stocking on the one hand and (2.) Subsequent decades of very high margin, zero R&D, zero compliance, staff reduction, production refinements, oem tail off,  starting spare volume decline (negative LSD to negative MSD depending), and above inflation pricing. 

 

Bucket 1 is likely a very R&D intensive, low margin, engineered business and it probably extends over quite a few years.  It takes a large portfolio of old,  tail products (likely in volume decline) to get an average EBITDA margin like TDG but for anyone looking to compete in the first decade they have got to stand up a highly engineered, regulated, low margin business that designs and sells really low ticket-price items and wait and see what might happen to margins in subsequent decades. It is very likely if you split off the first decade and prepared a Revenue Statement of all TDG's 1st decade businesses it would look totally different to overall TDG.

[Spekulatius]

^ The above explanation for the low R&D implies that TDG is just harvesting existing products from the companies they rolled up and not replacing them, in agggregate.

As we speak, the engineers at Boeing, Airbus, Lockheed etc. are designing the next generation Aircraft and TDG's engineers should be designing parts for those, unless they don't care about the business in. 10 years. That's the VRX model again. It's either that, or TDG's products are really build to print from their customers, which imo, creates a lower hurdle to replace TDG as a supplier long term.

 

I also ask myself what engineer would want to work for a company with such abysmal Glassdoor reviews. Admittedly, the Glassdoor reviews may be biased, due to TDG merger activities, but still - this is one of the lowest ratings I have ever seen. I probably would pass on a job offer from such a company. You will be the judge whether that matters or not for an TDG's investment thesis.

 

For me, the red flags with this one are quite obvious and very evident. I think this will be another case where the Rollup story ends up in tears.

[cmlber]

As we speak, the engineers at Boeing, Airbus, Lockheed etc. are designing the next generation Aircraft and TDG's engineers should be designing parts for those, unless they don't care about the business in. 10 years. That's the VRX model again. It's either that, or TDG's products are really build to print from their customers, which imo, creates a lower hurdle to replace TDG as a supplier long term.

 

TDG discloses that they have more content on the next generation of the major platforms than they had on the previous generations.

 

This is a direct quote from a former Airbus buyer, "I don’t want to find out later that because you didn’t have enough resources to actually perform my whole production line is stopped. You get crucified if you hold up the production line. Huge reluctance to switch, that’s why they like to roll the contracts over. If you find out the new guy cant do the job, then the head of programs says how come I’ve got a latch problem we’ve been doing this for 20 years and never had a latch problem, what idiot did this?"

 

The buyers at Airbus and Boeing are very hesitant to switch.  Their incentives are to try to get a little bit of savings each contract and just roll it over with the same supplier, even if there are cheaper alternatives.  They will be fired if a new supplier has performance issues.

 

They also have to worry at the corporate level about what TDG could do if they tried to get very aggressive at the corporate level.  The only thing preventing TDG from raising prices 10x across the entire portfolio tomorrow is the desire to keep the pricing increases reasonable so Boeing/Airbus don't kick them off future platforms. 

[thefatbaboon]

Spekulatius,

 

Perhaps you are not giving enough credit for the length of time TDG sells its products and the effects this has on its margins.

 

What do you think would happen to the R&D margins of normal r&d spending big pharma companies if you took the patent exclusivity that protects their successful drugs and instead of it giving effective exclusivity for 15 years, you tripled it and made it 45 years and left absolute r&d spend the same.

 

The r&d margin on the overall business would collapse.

 

Try playing around with the arithmetic of a 30- 50 year high margin tail. 

[Spekulatius]

^ The above explanation for the low R&D implies that TDG is just harvesting existing products from the companies they rolled up and not replacing them, in agggregate.

As we speak, the engineers at Boeing, Airbus, Lockheed etc. are designing the next generation Aircraft and TDG's engineers should be designing parts for those, unless they don't care about the business in. 10 years. That's the VRX model again. It's either that, or TDG's products are really build to print from their customers, which imo, creates a lower hurdle to replace TDG as a supplier long term.

 

I also ask myself what engineer would want to work for a company with such abysmal Glassdoor reviews. Admittedly, the Glassdoor reviews may be biased, due to TDG merger activities, but still - this is one of the lowest ratings I have ever seen. I probably would pass on a job offer from such a company. You will be the judge whether that matters or not for an TDG's investment thesis.

 

For me, the red flags with this one are quite obvious and very evident. I think this will be another case where the Rollup story ends up in tears.

 

Looking at this a bit more, I found that peer company Heico's R&D is even lower than TDG's, at around 3% of the revenues. So the argument that TDG's R&D is not compatible with their business model based in comparables in the industry is not valid. Just wanted to point this out there for the sake of disclosure. Doesn't make me a long, but facts are facts.