Vol. 5 No. 12 - January 17, 2017 - Click here to access our library.

Conclusion

History of price increases. Transdigm operates as a private-equity-like business that has historically focused on acquiring companies that make high-margin, but relatively low-priced proprietary aerospace products with significant aftermarket sales.  This strategy has allowed Transdigm to raise prices and also stay under the radar by not affecting the overall price of an airplane so much that it would attract scrutiny. 

Transdigm has increased prices on its customers in both commercial aerospace and the military sectors, and in 2017, we expect an increase in political risk from Trump administration personnel looking to reduce military costs, and business risk from commercial customers who are facing a profit squeeze from the increased political attention to the sector.

Customers push back. Recently, commercial customers have begun to push back against Transdigm’s price increases; however, there has been little to no political attention devoted to Transdigm’s often significant price increases on parts sold to the government during the Obama administration. In the Q4 2016 Earning’s Call, Transdigm’s CEO, Nick Howley, stated that the defense markets make up approximately 30% of Transdigm’s revenue.  We estimate domestic defense accounts for approximately 18-23% of revenue.  A recent RBC Capital Markets report put that number at 22%.

Enter Trump, negotiator in chief. Under a Trump administration, however, things are likely to change, perhaps dramatically.  To start, President-Elect Trump has already applied pressure to defense contractors, and efforts to cut prices on government contracts are likely to accelerate once Trump formally takes office.  Trump has focused thus far on Boeing and Lockheed Martin products, to which Transdigm contributes.  Additional and continuing pressure will likely result in increased pressure on subcontractors and parts suppliers as contractors try to maintain profitability by reducing supply costs.

Political risk from layoff-driven strategy? Further, political risk is not limited to increased prices on customers. The Transdigm model—which is focused on acquisitions, sharp price increases, and layoffs—leaves the company vulnerable to political risk under a Trump administration focused on increasing jobs.  While Transdigm is not a household name, it is not hard to imagine Trump tweeting about creating more competition or lowering costs if he were to find out that Transdigm is a supplier to high-cost military contracts. 

Low margin for error. Finally, Transdigm’s significant leverage, caused by a business model focused on debt-fueled acquisitions and price increases, leaves little room for error or political risk.

For this article, we interviewed numerous industry sources, some of whom previously worked at companies that were acquired by Transdigm.  Some of those sources were asked to stay on by Transdigm and others were terminated in connection with the acquisition. We also spoke with a government contracting officer, individuals who are involved in the procurement process, and various lawyers that represent companies in the procurement process.  Furthermore, the article includes difficult-to-locate pricing data.

A Closer Look at Government Contract Business and Trickle-down Effect

Trump pressure on defense contractors likely to result in increased pressure on subcontractors.  Boeing and Lockheed are already under scrutiny and pressure from Trump.  Specifically, Trump raised concerns about the costs associated with Lockheed’s F-35 program and Boeing’s 747 Air Force One program—both of which are programs to which Transdigm contributes parts.

Scrutiny of defense contractors and cost overruns will likely accelerate in a Trump administration.  Indeed, during his first press conference as President-Elect on January 11, 2017, Trump discussed how he had been quite active “in an economic way for the country . . .” After discussing the pharmaceutical industry and his desire to create new bidding procedures for the drug industry, Trump continued, “we’re going to do that with a lot of other industries.”  Again, Trump called out the F-35 program stating “And it’s way, way behind schedule and many, many billions of dollars over budget.  I don’t like that.”  Finally, Trump stated “And we are going to do some big things on the F35 program, and perhaps the F18 program. And we’re going to get those costs way down and we’re going to get the plane to be even better. And we’re going to have some competition and it’s going to be a beautiful thing.”

Previously, Trump reportedly asked Boeing to price out a comparable F-18 Super Hornet due to cost overruns and cost concerns with Lockheed’s F-35. Some observers have noted, however, that the F-18 cannot actually replace the F-35 because of the F-35’s stealth capabilities.  As such, some observers believe that defense contractors may be asked to take a look under the hood of the F-35 airplane and ascertain whether there are ways to reduce the costs of various component parts that comprise the F-35. Transdigm’s most recent 10-K discloses that it contribute parts to a number of military programs, including the F-18 and F-35 programs.  In addition, Transdigm’s June 23, 2016 analyst day presentation states that the “A400M and F-35 are Major Military Growth Platforms.”

To the extent the F-35 program continues to face scrutiny and defense contractors face new scrutiny in a Trump administration, it could have negative implications for Transdigm’s revenues. Additionally, it is likely that as defense contractors and airplane manufacturers face increased scrutiny in a Trump administration regarding the cost of certain military projects, those contractors are likely to try to and squeeze their subcontractors to ensure that the entire project remains profitable for the manufacturer.  The effort by manufacturers to lock down suppliers will likely occur in both commercial and defense contract business lines, with corporate negotiating tactics mattering most on the commercial side and political pressure mattering more on the defense contractor side. 

Available pricing data shows steep price increase for military customers after Transdigm acquisition. Our review of pricing data provided by the Defense Logistics Agency (DLA), and a review publicly available data on the DLA Internet Bid Board System (DIBBS), reveals a clear pattern of steep price increases immediately after Transdigm completes an acquisition. In our investigation, we reviewed Requests for Quotes (RFQs) issued by the DLA when it conducts procurement for parts. 

The RFQs contain the procurement price history for that specific part. Due to restrictions in the DIBBS database, we are only able to view actual RFQ documents issued within the last year, meaning that pricing information from DIBBS is available to us only for current or very recently closed procurements. Outside of DIBBS, however, we have reviewed information on Haystack Gold, a defense parts and logistics management system used by contractors, which contains more historical pricing. Although there were many examples of significant price increases after Transdigm completed an acquisition from the Haystack Gold Data, we have only provided examples from the DIBBS database here, as they are direct from the DLA’s own procurement processes.

While some parts are bought at irregular intervals and in differing quantities (making price comparison more difficult), all parts produced by Transdigm companies generally double in price after a Transdigm acquisition, with some parts increasing by well over 100%. To show this pattern across the range of companies Transdigm has purchased, The Capitol Forum reviewed acquisitions of five sole-sourced parts produced by five different companies both before and after Transdigm acquired the company

Stakeholders should note that the cage code of suppliers differs on some RFQs, which is a result of the company using different distributors to sell the part, a topic that we will discuss in future reports. All parts are produced by the same company before and after the Transdigm acquisition. Additionally, most companies generally used distributors both before and after acquisition, leaving Transdigm becoming the parent company the only variable that has changed. The Capitol Forum has collected the RFQs for each of the above contracts (click here to view) and below is a table comparing the pre-acquisition and post-acquisition prices of each part:

The above companies are listed as the only “Approved Source Data” for prices on these parts, meaning that DLA relies solely on Transdigm or the manufacturer as a source for pricing information, according to a government contracting officer. When other companies are listed in conjunction with Transdigm subsidiaries to provide approved source data, such that there is competition, the post-acquisition price of these parts remains generally consistent with the pre-acquisition price. The dichotomy between sole-source and multiple-source contracts reveals the strategy of Transdigm’s business model: acquire proprietary parts manufacturers and use the lack of competition to increase the price per unit.

Transdigm has previously relied on lower-dollar contracts to minimize pricing oversight. There are a number of ways that Transdigm is able to increase the price of parts without incurring pushback from the DLA, but perhaps the most important of these is that the contracts do not rise above the $150,000 Simplified Acquisition Threshold. 

Any contract that falls below $150,000 follows the Simplified Acquisition Program requirements, which, according to a government contracting officer, require less levels of review to determine fair and reasonable pricing.  Additionally, according to Marvin Heymann who runs Marvin Heymann and Associates, a company focused on helping design and build businesses find, win, and successfully perform US Federal Government Contracts, and other sources familiar with the procurement process, procurement officers currently do not thoroughly review pricing information for any number of reasons, including, staffing issues, time constraints, and sheer laziness. 

According to Scott Arnold, a partner at Blank Rome with a concentration on government contracts law, most sole-source contracts that are above the $750,000 Truth in Negotiations Act threshold require the contracting party to submit certified cost and pricing data to the government.  This threshold, and the required certified cost and pricing data, is significant, as there are numerous legal risks including civil penalties and the potential for criminal penalties if a company submits incorrect or false certified cost and pricing data.  While there is no indication that Transdigm has skirted any of these legal requirements, Transdigm seems to be aware of the TINA requirement as an impediment to dramatically increasing the price on certain parts.  Specifically, this issue was discussed on Transdigm’s Q4 earning’s call regarding the Breeze-Eastern acquisition: “With some existing LTAs and a few government TINA-covered contracts, this business probably doesn't quite get up to our average EBITDA margins.”

For contracts that are under the TINA threshold of $750,000, but still above the Simplified Acquisition Threshold of $150,000, according to Mr. Arnold, the government contracting officer should still make an assessment as to the reasonableness of the contract price.  Even though the more stringent certified cost and pricing data that is applicable for contracts in excess of $750,000 does not apply, contracting officers can still obtain other forms of cost and pricing data outside of certified cost and pricing data to establish reasonableness. 

In subsequent articles, we will explore how Transdigm may have, in the past, used distributors to create the illusion of competition and establish reasonable prices even though it was the sole source manufacturer of a particular product for contracts above the Simplified Acquisition Threshold, the complexities of the distributor network, and how the use of the sole source designation and commercial exemptions to providing cost and pricing data may have caused the DLA to overpay for parts.

Price increase strategy translates to significant Trump social media risk. Trump has made renegotiating deals that, in his estimation, “rip-off” the American taxpayer a cornerstone of his presidency, and has pledged to bring down prices across a number of products, from prescription drugs to military planes. Trump has used social media to highlight government overspending for programs and platforms operated by Boeing and Lockheed Martin. Transdigm’s steep increases of prices for needed parts for military planes represent a relatively straightforward case for Trump to make to highlight government waste and bad deal-making. Were Trump to be made aware of Transdigm’s business model, Transdigm could face the same business risk as Boeing and Lockheed, which resulted in pledges by both companies to cut costs.

Layoffs also increase Trump risk.  According to sources as well as publicly available information, in addition to increasing the per unit price of particular parts, Transdigm looks to continually increase revenue per head to make acquired companies more profitable. According to a source from a company acquired by Transdigm, “Well, the first year or two, that's not too hard to be able to meet their [financial] requirements because you’re raising your prices. And so your revenue starts to go up and your bottom line starts to go up very strongly because every dollar increase of revenue goes right to the bottom line… But then once you've done that, then there’s a lot more attention on revenue per head.  And so you are expected to continuously find ways to reduce costs in the business by letting go of people.”

Based on a review of LinkedIn profiles, Glassdoor, conversations with employees at companies that were acquired by Transdigm, and news sources discussing layoffs at Transdigm-acquired companies, there is high turnover at companies acquired by Transdigm after acquisitions, which supports our sources estimation that employees are laid-off to increase the profitability of acquired companies.

According to the top-rated review of Transdigm on Glassdoor, “[the company] Was great before we were acquired several years ago... the company is hemorrhaging good talent and senior management is so focused on making the annual sales target, that they simply do not care. It's not uncommon for people to either leave or be laid off and the job not be filled... in many cases, the work is shifted onto the remaining employees already trying to manage a difficult workload. Employees are not appreciated at all and it is obvious with the lay-offs which have come to be expected virtually every year since the acquisition. This is true for all companies acquired by Transdigm... every company experiences the same thing... mass layoffs at time of acquisition, no appreciation of employees and it just goes downhill from there.” A review of Harco Laboratories, a company acquired by Transdigm in late 2011 states “The company was privately owned until December 2011. Transdygm Corp bought the company out and promised no changes. In Jan 11, 2012 31 out of a work force of 150 were laid off without a chance of rehire.”

Trump has stressed repeatedly that he will be a champion of the working class, particularly in the manufacturing industry. Trump often uses his social media platforms to highlight factory closings and layoffs, as well as to take credit when these decisions are reversed. The companies and workers acquired by Transdigm constitute the very segment of the economy Trump has most stridently positioned himself to defend. As a result, Transdigm’s practice of reducing workforces in order to increase revenue could constitute a second, compounding risk to additional scrutiny from Trump.

Business model that focuses on debt-fueled acquisition and price increases leaves little room for error, political risk.  In order to fund acquisitions, Transdigm issues debt and is a highly-leveraged company. Transdigm recently indicated that is contemplating taking steps to ease some of its debt burden, as it recently announced the potential refinancing of a portion of its senior secured term loans to reduce its interest expense and extend maturities. Risk factors in Transdigm’s 10-K include, Transdigm’s indebtedness and the need to generate a significant amount of cash to service its indebtedness. The need to generate significant cash to service its debt requires acquisitions to perform and leaves little room for political risk due to increased pressure to rein in costs from Trump.

According to a source who previously worked at Aerosonic, which was acquired by Transdigm in 2013, Transdigm’s business model is largely predicated on a one-two punch.  First, Transdigm identifies and acquires companies that manufacture smaller component parts of an airplane at low price points with a lot of aftermarket content.  The companies with high-aftermarket sales are those that make parts for older aircraft.  There is unlikely to be significant competition in that space because the airplanes are on the downward slope of their existing life and initial startup manufacturing costs are high. It seeks companies that have proprietary designs, preferably with a lot of aftermarket content, and then make it a point to out-bid any potential competition. 

The second step of the one-two punch, according to our source, is for Transdigm to increase their product prices as much as it can. Since Transdigm is often in a position where it the only manufacturer for a part that a company needs, it can charge prices that result in gross margins of 80-95%, according to our source who worked at Aerosonic, and price increases are one of Transdigm’s most important internal key metrics. Finally, once the opportunity for significant price increases begins to fade, it moves to the next phase of profit enhancement, which is to aggressively reduce costs. In an effort to increase revenue per head, according to industry sources, Transdigm also generally lays off workers at acquired companies.

Because the business model is predicated on the one-two punch of finding companies and increasing the price, the inability to execute the one-two punch successfully in light of the massive debt load could pose problems for Transdigm. According to the former Aerosonic employee, “if it gets to the point that they’re unable for some reason to acquire additional companies, say due to debt covenant violations or inability to borrow, and get that one-two punch in place, acquire and then push the prices up or aggressively cut costs, then their model starts to collapse.” 

While our source did not want to speculate as to the potential consequences of Transdigm being unable to continue with its existing business model, our source did comment that Transdigm’s business model is akin to a treadmill “and unless they can really keep going on their treadmill, at some point it just doesn’t work. Customers are often hesitant to purchase new products from Transdigm companies, severely limiting organic growth opportunities.”  With little wiggle room, increased political risk from intense scrutiny of defense contracts, substantial customer pushback, or even the chance of a poorly executed acquisition that does not provide expected returns, there are significant risk areas that could cause problems for Transdigm.

Key questions and items we will explore in subsequent reports:

1. Who are the key Trump appointments, including appointees for undersecretary of defense positions, that stakeholders should be monitoring?

2. The use of captive distributors to sell products to the military, submit competing bids and other issues surrounding the complex distributor network.

3. Key-man or succession risk.  Many sources we spoke with identify current CEO Nick Howley as a driving force behind Transdigm’s business and long-term success.  Both sell-side analysts and industry participants think that that Transdigm’s business may not be as aggressive or successful if Mr. Howley departs.

4. Methods that the commercial sector has employed to push-back against Transdigm’s price increases.