50x, Nick Howley, and Value Creation

A simple model for driving value creation

Intro

In every business there tends to be only a couple metrics that determine success. 2 or 3 KPI’s that (hopefully) management and investors can agree upon to act as a North Star for strategy and decision-making. The KPI’s change from industry to industry but the core idea remains the same - at the end of the day only a couple of things actually matter.

It’s obvious then to say that selecting the right KPI’s to measure is incredibly important to building a great business. What’s just as important, less discussed, and arguably more difficult, is the extreme focus required.

It’s incredibly hard and thus rare to rally an entire company around just a couple metrics, it’s 100 times harder to do so over months, years, decades. Those in charge will face distractions, ugly truths, and constant market pressures, but maintaining 100% focus and commitment to your key drivers is necessary to building an enduring business. If you find yourself in the presence of a person or a business that does have that singular focus, keep them close by. This article is centered around a man with that singular focus and the few levers he honed in on while building a wildly successful business.

Nick Howley

Nick Howley, Founder and former CEO of Aerospace Parts Manufacturer, Transdigm, is a rare example of a human who is maniacally focused on the few items that matter, and consistently avoids those that don’t. He recently went on the 50x podcast and gave a masterclass in business management. This is an absolute gem of a podcast and if you haven’t listened I highly encourage you to do so. (Link)

Nick founded Transdigm in 1993 with $25mm of initial equity & today the company is worth ~$32 billion. A $100k investment in ‘93 would be worth ~$175 million today. Not bad at all, right? When Nick speaks, the entire business world should listen.

Equity Value Creation: Price, Cost, New Business

The podcast discusses many topics ranging from capital structure, to people, to decentralized organizations, but what I want to focus on here is what Nick calls his 3 key value drivers: Price, Cost, and New Business.

Only about 10 minutes into his interview, Nick makes very clear his focus on “equity value creation” through his 3 key levers:

“I was immediately and completely focused on what I’d call equity value creation. It was pretty obvious to me, and had been previously, that much of what you do in many large organizations has little to do with value creation. My question was how can you find a simple way to explain that to people and get them all focused around that? Between Doug and I, we were able to distill that down to what I think is the essence, the only thing that you can do to change the intrinsic value in one of these businesses, and this is true in most industrial businesses. You can get the price up, you can get the cost down and you can generate new business. Almost anything else is tertiary at best. I know some things have to be done.

To Nick, it was that simple. He focused on 3 key things - Price, Cost, and New Business - and found a simple way to get his whole team focused around them. Nick lived by these drivers and it shows in this podcast. Between his two podcasts combined, the word “cost” is mentioned 70 times, and “price” is mentioned 51 times (to be fair, a lot of M&A is discussed). That level of focus and intensity on only a couple of items is how you achieve the other-worldly returns Transdigm has.

Price, Cost, and New Business all sound great but everyone has different perspectives on how to manage these levers, and these perspectives can drive a wide range of outcomes. You can be focused on the right things and still fail by lousy execution. Nick provides some detail into how he approaches all 3 of his levers, I want to just focus on price & cost below (lots of quotes incoming).

Price:

It’s very clear Nick and Transdigm are focused on pricing to the value they create, not the cost that it takes to produce:

In pricing, our goal was to price the product not to the cost, but to price it to what we thought the value we provided to the customer, which is a mix of what do you provide and what’s the switching cost. Sometimes you can calculate that pretty closely, but frequently it’s a little bit of trial-and-error to get there. I found in this business, and I subsequently found it in almost every business we bought, that most niche engineered product type of businesses underpriced their product.

Businesses often lose out on incremental revenue when anchoring price to costs. Your price should be reflective of the value your client receives. If your product or service is providing value well above the price, your cost to produce should be irrelevant to your client.

How to test pricing in the market:

“We expect somebody that’s running a business of ours, a president to be intimately involved in the pricing. We don’t think that’s something he can delegate down. He has to have pretty clear rules that elevate the thing quickly right to the top. We don’t want there to be any confusion. If we’re not getting the price, who’s not getting the price? We want to clearly understand why we’re not getting the price…

One of the things we would say over and over again: rather than worry forever about what you’re going to try, pick a subset that you can afford to either lose and figure out how you’re going to back off if it doesn’t work rather than ring your hands before you try it. It generally has been workable.”

Cost:

Nick has a unique view on company cost structure by ignoring fixed & variable costs and flipping the income equation. Instead of viewing his business as “Revenue - Costs = Income”, he views it as “Revenue - Income = Costs”, implying that he sets a margin target and then backs into what his costs need to be. This is a simple but powerful mindset shift that forces more focus on cost management:

In cost, our goal in cost control has always been, and I say this over and over again, we don’t understand fixed from variable. We’re not going to try and get into that argument. We’re just going to say our cost base is your revenue minus your EBITDA. Our goal there is to at least offset inflation every year with savings. A simple way to think about that is if you want to give everybody a 3% raise and your business is flat, you got to take 3% of the people out. Now, when the business grows, you got to do other adjustments for that, but the simple goal is offset inflation. It’s easy to do for a year or two. It’s very hard to do over time. The other trick is you have to count all your cost. Otherwise, what happens is it just becomes a gaming exercise of what can I call fixed and what can I exclude and what is really not addressable. So that we’re pretty rough on that.

Visualizing Value Creation

The below image is from Michael Mauboussin’s article, The Economics of Customer Businesses, and is a similar sentiment to the gospel Nick is preaching throughout the Podcast. Mauboussin comments on the value creation levers that exist between a consumer’s Willingness-to-Pay (highest price a consumer is willing to pay) and a business’s Willingness-to-Sell (lowest price a supplier is willing to take). In any viable business, actual prices and costs exist in between WTP and WTS, providing a surplus to both the consumer and the business.

Using the image above, Businesses can drive value-creation in 2 obvious ways:

1. Increasing the price closer to the consumer’s WTP

2. Reducing costs and thus lowering your WTS

The first option, raising prices, runs the risk of upsetting customers and really should only be advised when there is an obvious gap between the consumer’s WTP and the market price they are paying.

The second option, reducing costs, typically can be controlled by the business without any impact on the end-consumer (unless you are sacrificing quality). Increasing productivity, scale, and reducing or reallocating inefficient spend should be at the forefront of every manager’s mind every single day.

Closing:

Going back to my main point; Nick’s 3 levers - Price, Cost, and New Business - are incredibly simple. It is literally business 101. It is his almost-exhaustive intensity to focus on what truly matters that drives his desired outcome of creating value (and making a lot of money).

I would challenge readers to consider their own business, and their own work, and look for areas they can drive value creation. The process begins with ruthlessly cutting out and saying no to things that do not drive value.