Businesses as Ecosystem Organisms

A couple of months ago we published a case on TransDigm — the king of the aerospace aftermarket. We wrote that TransDigm, in many ways, was an instance of Charlie Munger’s dictum to “take a simple idea, and take it seriously”: private equity operators Nick Howley and Doug Peacock took a close look at the aftermarket parts corner of the aerospace industry, and then realised you could exploit it in a very particular, very profitable way.

Before diving into TransDigm’s business, it’s important to understand the unique market in which the company functions. TransDigm operates in the aerospace aftermarket — a secondary market for spare parts, accessories, and non-core airplane equipment.

Airplanes are incredibly complex machines made up of many small parts. What makes the aerospace aftermarket interesting from a supplier’s perspective is the nature of the demand. Some airplane parts do not need to be replaced for decades. Other parts are replaced more often — if infrequently. But even the volumes for the parts that are replaced often tend to be low. 

Why, then, is the market attractive? The answer is regulation. Even the smallest, most insignificant airplane part is subject to certification: once a part is approved for an aircraft, it cannot be swapped out for another part without a new regulatory application. Such applications may take years. This implies that for as long as an airplane model is in service — which is typically decades — demand for parts will continue to exist. And it means absolute pricing power for the aftermarket parts supplier: if an airplane is not cleared to fly, carriers face impressively large sums of lost revenue — far larger than whatever they have to pay for an overpriced part. Predictably, these dynamics mean that parts manufacturers have jacked up prices for their product with little-to-no repercussions. 

Here’s Rob Small again:

“So the combination of low volumes, large barriers to entry, the need to be responsive on a very diverse set of products, and the intellectual property that was built up from the original design allow for very strong margins in the aftermarket. So that’s just the business and almost everyone who plays in the aftermarket makes pretty solid margins on those aftermarket businesses.” 

TransDigm, it seems, has “precisely and perfectly” picked a strategic position in this industry. Nick Howley, founder, ex-CFO, and now executive chairman of TransDigm, likes to talk of how the company has been optimized to function in this specific position:

“Our experience in this industry is what matters is the product works, you keep up with the technology mostly, which is make the life longer. You deliver them on-time, service the heck out of it. And pricing is a distant third or fourth in the value creation because, once again, these are little things going into big things. What matters is they don’t foul the big thing up. They work and you get them there on time. And if something goes wrong with that, you fix it fast.”

All of this wasn’t obvious from the get-go, of course. Howley and Peacock uncovered the elements of TransDigm’s strategy over a number of years. But it’s not too much of a stretch to say that they looked at this peculiar market setup, and then proceeded to exploit it like so:

• TransDigm became very good at identifying businesses that make differentiated parts (meaning there are no alternatives for those parts, giving the manufacturer unparalleled pricing power).
• It uses debt to buy up aforementioned parts manufacturers.
• Within 180 days it gets the cost down, cuts out useless jobs, sells off businesses that make undifferentiated parts, and starts increasing prices.
• Which then allows them to harvest cash to pay down debt and make more acquisitions, and finally —
• They deliver their parts on time, professionally, and at a high level of quality, so that their customers don’t hate them too much (you may have to overpay, but at least you get good service as you’re paying through your nose).

As a result, TransDigm has grown at a tremendous rate: a dollar invested in 1993 would have been worth $1,750 in 2022, with a patently ridiculous 36% IRR across some 30 years. TransDigm continues to be the dominant force in the aerospace aftermarket — beating copycat competitors who simply can’t match its disciplined operation.

Which, well, cool — one way of looking at this is to say that TransDigm is a particularly well-adapted organism, perfectly evolved to exploit this very specific niche in the industrial universe.

Enter HEICO.

HEICO is a family-owned conglomerate that operates a large collection of Part Manufacturer Approval (PMA) businesses. PMA is a fancy term for ‘copycat parts’ — unlike TransDigm, who buys the original manufacturer of aerospace parts, HEICO looks at the same market setup, and then goes “hmm, I wonder how hard is it to copy existing parts and then apply for that supposedly painful recertification process? That would be cheaper, wouldn’t it? What if we do that, eat the pain, and then undercut the price gougers?”

The answer to those questions, is that: a) yes, it turns out that this is possible but very painful; it took them a number of years to get their first new part certified, but b) you can absolutely build a valuable business doing just this, for decades, compounding capital as you do so.

From this week’s Commoncog case on HEICO:

Laurans Mendelson, who goes by “Larry,” helped his sons fund the acquisition. The Mendelsons had bought 15% of HEICO’s stock for $3 million, but hard cash wasn’t enough to take control. The family failed to oust the incumbent management team because of irregularities in a proxy vote held for this purpose. The Mendelsons took the matter to court and emerged victorious in 1990. 

Outside courts of law, the Mendelsons got to work making their investment more profitable. They cultivated a relationship with the management of Lufthansa Airlines, making the argument that PMA had the potential to save them huge costs. The airline was impressed, and in 1997, Lufthansa acquired a 20% stake in HEICO’s PMA business. This partnership gave HEICO invaluable insight into Lufthansa’s technical data, allowing them to align their focus towards high-volume, high-value parts. Further, HEICO weathered the rigours of obtaining FAA approval knowing that there was guaranteed demand once it was secured. Having Lufthansa as a customer also significantly increased HEICO's credibility as a PMA manufacturer. 

The Mendelsons acquired HEICO in 1990. Since the acquisition, sales have compounded annually at 15%; net income at 18%, driving an annual return of 21%. And so the story of HEICO is really the story of a family turning an underperforming parts manufacturer into a meteoric success.

I should note that HEICO fell into this strategy not through premeditated analysis, but instead through luck (or effectuation — if you wish), they are not wedded to the idea of playing exclusively in the aerospace aftermarket:

HEICO’s present business activities fall within two broad categories, the Flight Support Group (FSG) and the Electronic Technologies Group (ETG). However, according to Ruden, the Mendelsons wouldn’t describe HEICO as “an aerospace or electronic technologies company,” but a “very strong, well-managed vehicle for generating cash flow.” Indeed, Victor Mendelson said in an interview: “We couldn't become wedded to any single strategy or dogma other than producing excellent products, investing in the products and people, and emphasising cash flow. So we always had a very open mindset as to how we were going to do that. We knew our general direction, but we knew that along the way, we would have to adjust course, and that's essentially what's allowed us and allowed our people to succeed.”

But here’s the bit about HEICO’s story that I want to draw your attention to. The Mendelsons saw this market setup, saw the way that TransDigm and its competitors were playing in that market, and deliberately set out to play second-fiddle to the original equipment manufacturers: