McKenna quoted in Forbes on TransDigm
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McKenna quoted in Forbes on TransDigm
Conglomerate TransDigm buys smaller companies — the only ones that make particular things — and jacks up prices for customers who don’t have a choice. All's fair in love and capitalism, right?
Nicholas Howley is one of those smarty-pants guys who were born on third base and go through life thinking they hit a triple. Exploiting monopoly situations is a skill handed down in his family the same as my bricklayer dad taught me how to center the bubble in a manual level.
Howley grew up in Havertown, a Philadelphia suburb, the son of the president of Lansdowne Steel & Iron, which made munitions for the U.S. military. (Like father, like son: a 1971 GAO report faulted the company for overstating costs to inflate pricing.) Howley worked there during high school and while studying mechanical engineering at Drexel University, he said last year on a podcast hosted by a business partner, private-equity investor Will Thorndike. “That was likely the best on-the-ground practical business experience I received in my life,” Howley said of Lansdowne, where he operated machine tools and got his first taste of management and finance.
That’s from Forbes’ “Meet The Billionaire Who Built A Fortune ‘Price-Gouging’ Customers Like The Pentagon,” by Jeremy Bogaisky, a Senior Editor at Forbes. He asked me a few weeks ago to work with him on this story and help sort out some accounting-related claims that whistleblowers were making. The story is much more than that and reminds me of the great work the veteran Forbes staff does on features, including detailed fact checking. ( I’ve written for Forbes in the past and two of my print magazine stories, the first ones I’d ever penned, were a finalist for the Loeb Award in 2013, thanks to a superfantastic editor, Janet Novak.)
Here’s the quote from me that made it in to the TransDigm story:
Acing The Audits
Two former finance employees at another subsidiary told Forbes that when TransDigm buys a company, it’s aggressive about setting up the so-called opening balance sheet — the basis against which future revenue and profit growth will be measured. The company books unusually high reserves for inventory losses and marginally profitable part-supply agreements that can be used as a “kitty” to boost revenue in the first few years after an acquisition, they said.
Creating high reserves reduces the book value of the acquired company, which requires TransDigm to record high amounts of what bookkeepers call goodwill to account for the difference between the company’s value and the purchase price. Goodwill essentially is a statement of confidence by TransDigm that it will make up the difference in value by improving the business.
TransDigm reported goodwill in 2022 that’s 48% of its total assets — an unusually high share, said Francine McKenna, an accounting expert and former Wharton lecturer who publishes a newsletter called The Dig. The company has only booked a hit to goodwill in its earnings once, in 2017. Both are “massive” red flags that TransDigm may be overpaying for its acquisitions and not acknowledging cases in which it hasn’t reaped the returns it expected, McKenna said.
TransDigm didn’t respond to questions about its accounting practices, but said in its statement that the company “undergoes thorough internal and external audits.”
TransDigm has been audited by Ernst & Young since 2004 and EY partner Joshua Jenkins has been the one signing the audit since 2021. Jenkins also signed the audit opinion for Sherwin Williams from 2017 to 2021 and has been the engagement partner on J.M. Smucker in the past.
Coincidentally, or not, two of Transdigm’s directors, both on the Audit Committee, have Sherwin Williams connections — Jane Cronin, who has been a director since June 30, 2021 is currently Senior Vice President and Corporate Controller of Sherwin Williams and Sean Hennessy, the Audit Committee Chair, who has served as a director since 2006. Hennessy served as Senior Vice President, Corporate Planning, Development & Administration of Sherwin Williams in 2017-2018, coinciding with the tenure of current Transdigm engagement partner EY’s Jenkins engagement partner serving as Sherwin Williams. Hennessy served as Sherwin Williams CFO from 2001 to 2016, where he obviously was heavily involved in the company’s relationship with EY , as he is now as Audit Committee Chair.
There was some accounting-related text that ended up on the cutting room floor related to another issue raised by sources that I thought Jeremy did a great job on so he said I could let you read them. There was a vague reference to them still in the story:
The company books unusually high reserves for inventory losses and marginally profitable part-supply agreements that can be used as a “kitty” to boost revenue in the first few years after an acquisition, they said.
What’s this all about?
For example, sources told Bogaisky that TransDigm allegedly books unusually high reserves in opening balances of acquisitions for losses on obsolete or slow-moving inventory. If there are real inventory losses, then there’s no hit to profit the reserve covers it, which is legitimate. This is part of the opening “fair-value” assessment companies make after acquisitions, where they have up to a year to adjust based on what they find once the new subsidiary is operating under their umbrella.
Sometime a target company has under-reserved in order to avoid hitting income, sometimes they have also over-reserved to save up for a rainy day.
What’s not kosher about adding reserves to opening balances after an acquisition is if they are simply to create a cookie jar. Say, for example, at the end of a quarter if the subsidiary or the company in general is stretching to hit earnings estimates, the company can say, “Wow! We are so efficient and clever, we got this inventory (or bad debt) issue under control and can reverse the reserve!” That allows the company to book more income.
There’s always room for management discretion, said one of the former employees. “If you want to prove fraud or something on that front, you'd have to really dig into the weeds. And it does pass an audit every year.”
Another maneuver that former employee sources described: booking large reserves for unprofitable contracts. The scheme allegedly goes like this. TransDigm establishes reserves for contracts acquired where the expected margins are lower than its standard — let’s say 10%, when TransDigm normally expects 20%. When TransDigm later records $10 in sales under that contract, it books $1 in profit, but it will pull another dollar out of the loss contract reserve and add it to the P&L statement.
“It’s super-sketchy. To the rest of the world, it's like, wow, TransDigm is amazing, they buy these companies and their profitability turns around almost immediately.”
How does the accounting on this work?
When creating high reserves on either inventory or receivables, or on low profit contracts acquired likely as deferred revenue (a liability), TransDigm books reserves that reduce the value of the assets in the acquired company, or boosts liabilities. The other side of the transaction is an increase to goodwill. Goodwill is an asset account that reflects the difference between the net fair value of assets and liabilities and the purchase price. — in other words the premium that TransDigm pays for the net assets compared to their fair value.
Goodwill is essentially is a statement of confidence, hopium, that TransDigm will realize the difference in value by improving the business via synergies, cost cutting or other genius moves.
TransDigm’s reported goodwill in 2022 is 48% of its total assets.
I said in the article that’s high. Some disagreed with me. The answer is it depends.
Here’s what Calcbench said about average goodwill as a percentage of assets in 2022.
Jeremy told me he checked some peers of TransDigm for fiscal 2022:
HEICO, 41% of assets, Howmet 39%, Raytheon 34%, Moog 24%, Honeywell 28%, Spirit 9.5%, Triumph 4.3%
Here’s what I said that ended up on the cutting room floor:
Goodwill often isn’t tightly scrutinized, McKenna said, and in a conglomerate, problems at a unit often get canceled out by the finances of others and don’t filter through to the consolidated financial statements.
For example, Berkshire Hathaway typically doesn’t disclose details about the success or failure of acquisitions that don’t materially impact overall results, she said. However, “even Berkshire Hathaway has an impairment here and there,” she points out -- whoppers like Kraft Heinz and Precision Castparts.
© Francine McKenna, The Digging Company LLC, 2023
