{"id":34606,"date":"2018-11-13T19:12:04","date_gmt":"2018-11-14T00:12:04","guid":{"rendered":"https:\/\/digital.hbs.edu\/platform-rctom\/submission\/kevin-stein-at-transdigm-group\/"},"modified":"2018-11-13T19:12:04","modified_gmt":"2018-11-14T00:12:04","slug":"kevin-stein-at-transdigm-group","status":"publish","type":"hck-submission","link":"https:\/\/d3.harvard.edu\/platform-rctom\/submission\/kevin-stein-at-transdigm-group\/","title":{"rendered":"Kevin Stein at TransDigm Group"},"content":{"rendered":"

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.<\/em><\/span><\/p>\n

Kevin Stein, CEO of TransDigm Group (\u201cTDG\u201d), a leading \u201cdesigner, producer and supplier of highly engineered aircraft components,\u201d gazed out his office window, playing back his conversation with CFO Michael Lisman from November 8, 2018.[1]<\/p>\n

Stein<\/span>: General Electric\u2019s Aviation & Aerospace (\u201cGE\u201d) segment is using Additive Manufacturing (\u201cAM\u201d) 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 \u2013 saving the supplier and customer time and money.[2]<\/p>\n

Lisman<\/span>: Right. I wrote a memo showing how GE is using AM as a product development tool in three primary ways (Exhibit 1<\/strong>):<\/p>\n

1. Develop and design products using more effective prototyping
\n2. Produce products with more complexity and fewer parts
\n3. Repair broken parts and produce spare parts<\/p>\n

Stein<\/span>: Thanks, helpful. I also read that in 2015, GE received Federal Aviation Administration (\u201cFAA\u201d) approval to use its 3D-printed temperature sensor in commercial jet engines\u2026Boeing will use the part in more than 400 of its 777 passenger jets.[3]<\/p>\n

Our customer promise is to \u201cdevelop highly customized products to solve specific needs for aircraft operators and manufacturers\u201d for the Commercial OEM, Commercial Aftermarket, and Defense end-markets.[4][5]<\/p>\n

Our high barriers to entry are underpinned by the \u201cniche nature of [end] markets\u201d and \u201cthe industry\u2019s stringent regulatory and certification requirements.\u201d[6]<\/p>\n

Does GE\u2019s innovation in AM worry you?<\/p>\n

Lisman<\/span>: I think we\u2019re meeting that customer promise today\u2026without 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\u2019 (Exhibit 2<\/strong> and Exhibit 3<\/strong>).[8]<\/p>\n

Stein<\/span>: I agree with you that today<\/strong><\/span>, 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?<\/p>\n

Lisman<\/span>: We just bought two businesses, Extant in April 2018 to add \u201crepair and overhaul services\u201d[9] and Esterline last week to strengthen our aftermarket offering.[10] Interestingly, Esterline has significant prototyping capabilities, including 3D Printing.[11]<\/p>\n

Stein<\/span>: Those few resources don\u2019t put us on par with GE. There are two other reasons why I think we should strongly consider additional investment in AM.<\/p>\n

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.<\/p>\n

Second, the Inspector General for the Department of Defense (\u201cDoD\u201d) published a memorandum last summer, stating that the department will conduct an audit to \u201cdetermine whether the DoD is purchasing spare parts at fair and reasonable prices from TransDigm.\u201d[13] We haven\u2019t faced this type of scrutiny since 2006 when the DoD agreed with a whistleblower that TDG was charging the government \u201cexcessive prices\u201d and that the government was \u201cunable to effectively negotiate prices for spare parts.\u201d[14] The US Government can \u201cunilaterally\u2026terminate\u201d or \u201creduce the value of existing contracts.\u201d[15] We\u2019ve often cited the highly-customized nature of our products as a defense against this occurring \u2013 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.<\/p>\n

The bottom-line is that we have a uniquely attractive business model in a niche market, but GE\u2019s advances in AM are a potential threat to our continued dominance.<\/p>\n

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

A few questions for you:
\n1. How else would you value our potential investment in AM?
\n2. Of the following options, how would you invest in AM?<\/p>\n