Kevin Stein at TransDigm Group

Kevin Stein, CEO of TransDigm Group (“TDG”), a leading “designer, producer and supplier of highly engineered aircraft components,” gazed out his office window, playing back his conversation with CFO Michael Lisman from November 8, 2018. The debate du jour: does General Electric's innovation in Additive Manufacturing pose a threat to TDG's dominance of their end-market?

Disclosure: The following hypothetical conversation takes publicly available facts and makes logical conclusions. While these facts and conclusions are structured as a conversation between two business leaders, they are in no way meant to reflect the views of Kevin Stein or Michael Lisman.

Kevin Stein, CEO of TransDigm Group (“TDG”), a leading “designer, producer and supplier of highly engineered aircraft components,” gazed out his office window, playing back his conversation with CFO Michael Lisman from November 8, 2018.[1]

Stein: General Electric’s Aviation & Aerospace (“GE”) segment is using Additive Manufacturing (“AM”) to design more complex structures that concurrently reduce the number of parts in a given structure, resulting in a simpler supply chain and faster assembly – saving the supplier and customer time and money.[2]

Lisman: Right. I wrote a memo showing how GE is using AM as a product development tool in three primary ways (Exhibit 1):

1. Develop and design products using more effective prototyping
2. Produce products with more complexity and fewer parts
3. Repair broken parts and produce spare parts

Stein: Thanks, helpful. I also read that in 2015, GE received Federal Aviation Administration (“FAA”) approval to use its 3D-printed temperature sensor in commercial jet engines…Boeing will use the part in more than 400 of its 777 passenger jets.[3]

Our customer promise is to “develop highly customized products to solve specific needs for aircraft operators and manufacturers” for the Commercial OEM, Commercial Aftermarket, and Defense end-markets.[4][5]

Our high barriers to entry are underpinned by the “niche nature of [end] markets” and “the industry’s stringent regulatory and certification requirements.”[6]

Does GE’s innovation in AM worry you?

Lisman: I think we’re meeting that customer promise today…without AM. 90% of revenue is related to proprietary products and ~75% of EBITDA contribution is related to high-margin aftermarket sales.[7] This is why, in FYE 2018, we produced an EBITDA margin of 49.2%, ~3x our competitors’ (Exhibit 2 and Exhibit 3).[8]

Stein: I agree with you that today, GE is not a threat to TDG. However, I worry that as GE scales and recognizes the attractive margins and recurring revenue of our end market, they will enter our space. Besides, the customers in this memorandum are our biggest customers. What if Avio Aero scaled and displaced our dominance in aftermarket spare parts and repair?

Lisman: We just bought two businesses, Extant in April 2018 to add “repair and overhaul services”[9] and Esterline last week to strengthen our aftermarket offering.[10] Interestingly, Esterline has significant prototyping capabilities, including 3D Printing.[11]

Stein: Those few resources don’t put us on par with GE. There are two other reasons why I think we should strongly consider additional investment in AM.

First, we hold spare inventory as replacement parts over the ~25-year life of an aircraft.[12] This yields increased inventory carrying cost. AM could solve this problem as it is conducive to one-off production of custom products.

Second, the Inspector General for the Department of Defense (“DoD”) published a memorandum last summer, stating that the department will conduct an audit to “determine whether the DoD is purchasing spare parts at fair and reasonable prices from TransDigm.”[13] We haven’t faced this type of scrutiny since 2006 when the DoD agreed with a whistleblower that TDG was charging the government “excessive prices” and that the government was “unable to effectively negotiate prices for spare parts.”[14] The US Government can “unilaterally…terminate” or “reduce the value of existing contracts.”[15] We’ve often cited the highly-customized nature of our products as a defense against this occurring – but with a Commander in Chief who loves to negotiate and a company like GE developing technology to design and repair complex products, I worry about our moat.

The bottom-line is that we have a uniquely attractive business model in a niche market, but GE’s advances in AM are a potential threat to our continued dominance.

My intuition says that we should invest in AM for the long-term viability of our business. I saw your analysis (Exhibit 3) assessing the impact on market capitalization based on two variables:
A. % Defense Sales Lost
B. % EBITDA Margin Lost
This suggests that we would invest ~$2 billion to prevent GE from entering as a competing critical vendor to the Defense Aftermarket.

A few questions for you:
1. How else would you value our potential investment in AM?
2. Of the following options, how would you invest in AM?

  • Reinvest internally generated Cash Flow from Operations
  • Acquire an AM company. GE’s stock price is plummeting and there are whispers that they are looking to divest assets – should we bid for their AM business?
  • Form a Joint-Venture with a company that is also looking to build their AM capabilities

(793 words)

EXHBIT 1

TDG_Exhibit 1

 

EXHBIT 2

TDG_Exhibit 2

 

EXHBIT 3

TDG_Exhibit 3

 

Endnotes

  1. TransDigm, 2017 Annual Report, p. 11, [https://www.transdigm.com/investor-relations/annual-reports], accessed November 2018.
  2. General Electric, “Additive Manufacturing,” https://www.ge.com/additive/additive-manufacturing, accessed November 2018.
  3. General Electric, “Additive Manufacturing: Aviation & Aerospace,” https://www.ge.com/additive/additive-manufacturing/industries/aviation-aerospace, accessed November 2018.
  4. TransDigm, 2017 Annual Report, p. 12, [https://www.transdigm.com/investor-relations/annual-reports], accessed November 2018.
  5. “Q4 2018 Transdigm Group Inc Earnings Presentation,” press release, November 6, 2018, on TransDigm website, [https://www.transdigm.com/investor-relations/presentations], accessed November 2018.
  6. TransDigm, 2017 Annual Report, p. 40, [https://www.transdigm.com/investor-relations/annual-reports], accessed November 2018.
  7. “Q4 2018 Transdigm Group Inc Earnings Presentation,” press release, November 6, 2018, on TransDigm website, [https://www.transdigm.com/investor-relations/presentations], accessed November 2018.
  8. Source: Comparable Companies, Capital IQ, Inc., a division of Standard & Poor’s.
  9. “TransDigm Completes Acquisition of Extant Aerospace,” press release, April 24, 2018, PR Newswire, https://www.prnewswire.com, accessed November 2018.
  10. “TransDigm Acquisition of Esterline Conference Call,” press release, October 10, 2018, on TransDigm website, [https://www.transdigm.com/investor-relations/presentations], accessed November 2018.
  11. Esterline, “Product Development: Prototyping,” htttp://www.esterline.com/lremedical/ProductDevelopment/Prototyping.aspx, accessed November 2018.
  12. TransDigm, 2017 Annual Report, p. 42, [https://www.transdigm.com/investor-relations/annual-reports], accessed November 2018.
  13. U.S. Department of Defense, Inspector General, “Audit of Spare Parts Procurement from TransDigm, Inc., by Troy M. Meyer, Open-file report 2017-0627 (Alexandria, VA, 2017), https://media.defense.gov/2017/Dec/21/2001860092/-1/-1/1/D2017-D000AH-0162.000.PDF.
  14. U.S. Department of Defense, Inspector General, “Report on Spare Parts Procurement from TransDigm, Inc., by Richard B. Jolliffe, Open-file report 2006-0223 (Arlington, VA, 2006), https://media.defense.gov/2006/Feb/23/2001712361/-1/-1/1/06-055.pdf.
  15. TransDigm, 2017 Annual Report, p. 20, [https://www.transdigm.com/investor-relations/annual-reports], accessed November 2018.
  16. General Electric, “Additive Manufacturing: Aviation & Aerospace,” https://www.ge.com/additive/additive-manufacturing/industries/aviation-aerospace, accessed November 2018.
  17. General Electric, “Additive Manufacturing: Aviation & Aerospace,” https://www.ge.com/additive/additive-manufacturing/industries/aviation-aerospace, accessed November 2018.
  18. General Electric, “Scan and fix: GE Aviation uses additive technology to fast track engine component repairs,” https://www.ge.com/additive/case-studies/scan-and-fix-ge-aviation-uses-additive-technology-fast-track-engine-component, accessed November 2018.
  19. Source: Comparable Companies, Capital IQ, Inc., a division of Standard & Poor’s.
  20. Source: TransDigm Financials, Capital IQ, Inc., a division of Standard & Poor’s.

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6 thoughts on “Kevin Stein at TransDigm Group

  1. As a potential shareholder, the market cap erosion analysis is an interesting way to consider investments in AM and I do believe that TDG should invest in some AM capabilities (either through further M&A or organic expansion); however, I believe it should do so incrementally and does not need to make a $2 billion leap without a clear timeline or strategy as to what in the TDG supply chain and in what product categories AM will be focused. I also don’t necessarily agree with the causal logic: if the DoD sales are reduced by 10 or 15%, is that a reason to marginally increase the $2 billion investment proportionally? In a world with AM, things might change, including the economic model of TDG.

    AM is still a nascent technology and despite serious potential in the aerospace supply chain, it has not yet economically viable against most known aircraft parts, produced at volume. GE has received FAA approval for select, geometrically complex pieces, but AM pieces have not replaced most (if any) core load-bearing structures to-date and the integrity of parts overtime is uncertain. TDG’s core competency is high performance proprietary parts, particularly in the aftermarket, and it should explore the potential to use AM to complement current methods and ensure product defensibility, but there is no reason to believe that AM will simply change everything and do so immediately, warranting a significant blank check investment.

  2. I agree broadly that TPG should consider using AM to compete with GE but the one concern I have is the safety issue and reliability of AM versus traditional machined part. My intuition is that parts made between the two processes could have different internal load characteristics even though the specifications on the outside may be the same. For example, two engine blades may both fit size, material, and finish criteria but one may be able to take stronger stresses because one was machined as one solid piece versus the other was made by adding layer and layer of material on top of another.

    Especially in industries such as aerospace and defense, one part failure is catastrophic and I would be concerned of the risk of any one piece failing. Perhaps peace of mind may be worth holding 25 years of inventory…

  3. I agree with the previous comment regarding the risks associated with a large bet on AM. Given the nascent nature of AM, it would likely be extremely difficult to ascertain fundamental value for any acquisition targets. Also, given how fast AM technology is evolving, there is significant risk of technology and equipment obsolescence, and TDG risks overpaying for an target that could become worthless. It also seems likely that acquisitions of AM companies (esp. those that have IP, but limited cash flow) would be dilutive to near-term earnings/cash flow at TDG, which might lead to an adverse share price reaction (at least until the market is willing to give TDG credit for the longer term value of the combination).

    Instead, TDG should consider forming a JV with another company who has AM capabilities, rather than spending $2Bn on an acquisition. JV’s can help mitigate the valuation problem because both partners will be invested in the future of the JV; unlike an outright sale, there is less incentive for the seller to “fleece” the buyer. In addition, if TDG can form a JV with a company that has AM R&D capabilities, TDG might gain ongoing access to evolving AM technologies, thereby also reducing obsolescence risk.

  4. Hi CPM. First of all: I loved your writing style, absolutely memorable.

    Second, I think this is a fantastic take on the AM technology. It is clear that AM will be a perfect fit for TDG *at some point in time*: they carry very rare pieces and have to hold inventory for years. To your question, I don’t see the threat as imminent, so my intuition is that TDG has time to develop this technology in house, which is probably the cheapest option given that there doesn’t seem to be an immediate competitor taking business away from them today. It is likely that in the long term TDG will have to shift their business from supplying the parts that the airlines need to providing the 3D printers that airlines will have at their warehouses where they just print the parts they need. That’s why I see their business unit as a strategic in-house department.

    The only alternative I see is that they can find an AM focused company to buy that meets some very specific criteria. My guess is that it will have to be a AM startup that specializes in really high quality / reliability printing, with very special materials (used for aerospace) and huge printers.

  5. It seems like TDG has the early mover advantage over GE in additive manufacturing. I’d be curious to learn how GE plans to build out its AM operations. Since they are a legacy business, they will be afraid to displace existing processes. They will likely move cautiously into full-scale AM manufacturing, leaving TDG a long runway to innovate and leap ahead. TDG should move fast and try to replicate or enhance GE’s core products and yet-to-be-created AM-only products to built their “moat.” With the advantage of time, more experimentation and the talent/resources to back AM, TDG will likely beat them to realize the potential of this technology.

  6. Interesting conversation. I think an interesting piece that could also be considered is TDG’s relationship with GE as a supplier. While not totally familiar with TDG’s full product suite, my assumption is that many of the parts that they supply are on GE engines, rather than the broader airframe (fuselage, wings, etc.). If that is the case, could TDG actually partner with GE to accelerate AM in future engine designs by integrating into TDG parts in GE engines?

    Alternatively, if more of TDG’s services business is actually driven by parts on the broader airframe, is AM at GE even a risk at all?

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