The Short Seller Who Crushed Valeant Has Picked His Next Targetby , , and
The short seller who took down Valeant bets against TransDigm
TransDigm’s Howley is among the best-paid CEOs in America
Andrew Left sure knows how to pick a fight.
A little more than a year after his improbable takedown of Wall Street darling Valeant Pharmaceuticals, the blustery short seller is at it again. And the head of Citron Research is using the same blueprint as he sets his sights on TransDigm and its founder and Chief Executive Officer Nicholas Howley.
To hear Left tell it, TransDigm is another Valeant waiting to happen. He alleges the same price-gouging and debt-fueled financial engineering to explain how the aircraft-parts supplier delivered Valeant-like stock returns exceeding 1,500 percent in the past decade -- and made Howley one of America’s best-paid executives. In the past five years alone, he took home $278 million. At Boeing, a company 30 times the size, CEO pay was less than half that.
“There’s a thin line between brilliant and being crazy,” Left told Bloomberg. “While it works, you’re brilliant, but when it fails, you’re irresponsible.”
The accusations rankled long-time investors and were met by howls on Wall Street for being inflammatory, flawed or inaccurate. Greg Rufus, who was TransDigm’s CFO for 15 years and was one of the chief architects of its growth, also strongly disputed Left’s assertions. Both Howley and the Cleveland-based company declined repeated requests for comment.
“If the guy was here, I’d read him the riot act,” said Rufus, who retired in September. “This company is nothing like Valeant.”
Still, some aren’t taking any chances. Since Citron published its report on Jan. 20, shares of TransDigm have slumped 13 percent, prompting it to delay a loan refinancing deal. And as President Donald Trump squeezes defense contractors like Lockheed Martin and Boeing, Left foresees an even bigger comedown.
TransDigm hasn’t been accused of wrongdoing by regulators and few on Wall Street agree with Left. (He sees TransDigm, which last traded at $219.68 a share on Wednesday, falling to $166 and possibly lower. Analysts say the stock should be closer to $300 in the next 12 months.)
But if nothing else, Left’s public campaign has raised thorny questions about the aggressive business and pay practices of a company that even its media-shy CEO said was one of the biggest that “no one ever heard of.”
By almost any measure, TransDigm has been a big success since the 64-year-old Howley, a mechanical engineer and Harvard Business School grad, started the company with a former colleague two decades ago.
Since going public in 2006, Howley has completed roughly 30 deals, most of them debt-financed, and turned his initial $50 million investment into a company with $11.6 billion in market capitalization.
His business model, which reflects a private-equity ethos of its former owner Warburg Pincus, relies on repeatedly acquiring key, hard-to-manufacture aerospace parts and then raising their prices -- much like Valeant did with drugs. For example, after TransDigm bought Aerosonic in 2013, it quadrupled the price of its vibration panels to $271 from $67.33, according to trade publication Capitol Forum, which provides analysis on government contracts.
That kind of pricing power has pushed TransDigm’s gross margins above 50 percent in every quarter since becoming a publicly traded company, data compiled by Bloomberg show. It’s also helped shareholders reap returns averaging almost 30 percent a year.
“Their margin structure is the best in the industry and has been since the beginning,” said Ted Scalise, a money manager at TIAA Investments, which is among TransDigm’s top 20 shareholders. “If you write down a list of everything you’d use to evaluate management, it’s all been strong.”
Left sees that as a red flag and says the price increases mask a lack of growth and a burgeoning debt load, which now exceeds $10 billion.
“The stock has done well but it has not grown based on organic growth, it’s based on acquisitions,” he said. The risk is that “one day, like everything else, you run out of things to buy and prices to raise.”
TransDigm’s aggressive expansion can be directly explained by an equally aggressive, if uncommon, pay structure. Howley and his lieutenants receive the bulk of their pay in stock options that vest only if the company succeeds in increasing its intrinsic share price -- an internal measure derived from pro-forma earnings before interest, taxes, depreciation and amortization, minus net debt -- by at least 10 percent a year.
It differs from most other public companies, which have largely scaled back options and tend to use a variety of financial metrics.
And in some ways, it echoes the pay program of former Valeant CEO Michael Pearson, who was mainly compensated with restricted stock tied to ambitious shareholder return targets. Pearson oversaw Valeant’s meteoric rise before probes into its business practices, accounting and drug pricing caused its stock to plummet more than 90 percent.
Valeant says it has been fully cooperating with authorities throughout the investigation and “intends to uphold the highest standards of ethical conduct.”
TransDigm’s compensation also resembles the rewards packages granted by consumer-brands company Jarden Corp. In 2014, it promised executives big restricted-share payouts if per-share earnings rose above levels so ambitious that even the company called them “improbable.” The awards paid out in full when Jarden was acquired by Newell Brands in 2016.
“It’s a great story to tell shareholders that basically all of your compensation is performance-driven,” said Steven Hall Jr., an executive-compensation consultant at Steven Hall & Partners. Still, “how do you balance an aggressive growth strategy with not incentivizing either excessive risk-taking or actions that are detrimental to the company? There’s no easy answer.”
TransDigm itself says its metrics are consistent with those of high-performing private equity firms. From the start of its 2013 fiscal year, the company has heaped $4.6 billion of dividends to shareholders, including top executives.
About $83 million of Howley’s windfall came from such payouts. The remainder consisted of salary and bonuses, proceeds from option exercises and share sales, and the value of perks. In all, Howley took home almost twice as much as the nearest top-earning CEO among TransDigm’s compensation peers who have served at least five years, data compiled by Bloomberg show.
That might seem outlandish for any CEO, especially for one who is, by all accounts, frugal in just about every other way. Other than an occasional scotch and cigar, colleagues say Howley has few indulgences. Most days, he brings in a packed lunch from home.
For most shareholders, Howley’s been worth it. Even after the recent tumble, the stock has more than tripled in the past five years, including dividends.
“Who cares if he’s paid a lot,” said Umberto Fedeli, chairman of the Fedeli Group, an insurance company based in Independence, Ohio, and a long-time associate of Howley’s. “We do live in a capitalistic society and if you perform well and do well, you get paid.”
TransDigm’s debt burden still means Howley doesn’t have much room for missteps. In its fiscal year ended September, leverage reached the highest since 2004, suggesting its Ebitda growth didn’t keep pace with its debt. Some of its obligations are now rated as low as CCC+ by S&P -- a level that reflects a company’s vulnerability to default. Rising interest rates will only make things more difficult, according to hedge fund Riposte Capital, which exited its TransDigm position, according to a Jan. 26 investor letter.
Left, for his part, offers naysayers a cautionary note.
“You’re playing a dangerous game,” Left said. Right now, “Howley is the most respected name in the aerospace industry. At one point, Michael Pearson was the smartest man in the pharmaceutical industry.”