TransDigm (NYSE:TDG) is a global leader in the design, production and supply of proprietary aircraft components and systems, many of which have significant aftermarket content, within commercial and defense aerospace end markets. TransDigm focuses on market niches where it obtains majority market share of proprietary and sole-source products that require intensive customization and proprietary engineering at the product level. As a result, the Company generates impressive profit margins through value-based pricing power bolstered by significant intellectual property, a decentralized management structure focused on operational excellence and improvement as well as new product development frameworks that centers on solving customer’s technical issues via innovation and collaboration.
Pricing Power Driven by Barriers to Entry
TransDigm’s products are concentrated in areas protected by intellectual property and other barriers to entry. 90% of the Company’s revenue is from proprietary products and 75% revenue is from sole-source contracts. The Company designs parts (protected by intellectual property rights) for new aircraft models and generates revenue from aftermarket consumption of those parts over the life of aircraft models, generally estimated to be 25 to 30 years. A typical aircraft platform can be produced for 20 to 30 years, giving TransDigm an estimated product life cycle in excess of 50 years. In addition, other barriers to entry exist to protect the Company’s market position. Given the mission-critical nature of many of its products, the Federal Aviation Administration must certify their use on each aircraft model prior to installation. Few competitors to date have taken on the time-intensive process of creating products to compete with TransDigm’s given the niche nature of many offerings as well as the fact that many of TransDigm’s parts have been designed in concert with the original manufacturer (e.g., Boeing or Airbus) and so replicating the part’s functionality without assistance from the OEM or infringement on the Company’s patent is difficult. These protected market positions allow the Company to price based on value delivered to the customer and increase prices over time, leading to greater profitability and value creation for its shareholders.
Decentralized Management Structure
The Company operates with 27 operating units and over 60 product lines. While such decentralization leads to losses of economies of scale, it enables front-line managers to act quickly to adjust production processes and create more efficient operations as the production lines they oversee are typically small operating units. The Company operates production line processes at most facilities and its managers are held accountable annually for improving these operations to drive efficiencies. Critically, the ideas that form the basis of these productivity target lists are generated by the front-line managers, not corporate, which allows for those individuals closest to production to identify and act on potential areas for cost savings. Such operating strategies are critical for the Company as a key growth avenue for the business has historically focused on acquiring niche product lines and improving their operations to drive value creation for shareholders.
New Product Development Focused on Customers’ Technical Issues
TransDigm focuses its research and development budget on issues identified by its customers (either OEMs or airlines) through close engagement at an engineer-to-engineer level. Given the customized and highly engineered products it produces, TransDigm attempts to be top-of-mind when customers have difficult issues to solve. These customer engineers become product sponsors once they agree to work with the Company and give TransDigm comfort that its research spend will lead to future revenue and profit down the line. The Company will not proceed with full-scale development and design until it has received a written contract award or other similar level of formality from the customer committing to order the product once it is produced. This level of certainty allows TransDigm to spend with greater confidence that its return on investment will be realized and that the new product will prove to be a reliable source of future revenue and profitability.
TransDigm’s operating model has provided the critical underpinning to its successful business model. The Company has been able to successful build highly profitable niche businesses through effective use of intellectual property and other barriers to entry, it has utilized a decentralized yet delayered operating structure to focus local management on their production lines to drive operational efficiencies and has implemented an R&D structure that requires close customer collaboration to create new product offerings.
Sources: TransDigm SEC filings, investor presentations & transcripts and publicly available news articles.