HEICO: Expensive, But A Perennial Performer
Originally published 10/21/2018 on seekingalpha.com
Shares command a rich valuation, which is more than justified by their performance and growth potential
Favorable business mix and durable industry trends allow this firm to continue firing on all cylinders.
Shares have recently pulled back following strong earnings, and represent an attractive entry point.
HEICO (Heico) (HEI) thrives in an overlooked industry, selling replacement parts to airlines. The recent pullback in shares presents a prime opportunity to start a position in a premier aerospace firm.
The Mendelson family has rigorously managed Heico, while controlling 8% of the stock and 15% of its voting power. It has taken a long-term approach by focusing on low-cost niches and refraining from excess use of leverage, leading to a strong financial performance of the company during its tenure. The aircraft-components industry has grown by mid-single digits for several decades, closely following passenger volumes. Heico has managed to grow revenue at three times that rate since the Mendelson family took control in 1990.
The company operates with two divisions: Flight Support Group (FSG) and the Electronic Technologies Group (ETG). The revenue mix is currently about 60% FSG and 40% ETG, though the profit contribution is closer to a 50/50 split.
Flight Support Group
The Flight Support Group designs and manufactures non-OEM replacement parts to repair jet engines and aircraft. This line of business has been growing since 1974 when Heico began to pursue FAA certification of its non-OEM replacement parts, a space traditionally dominated by OEM service agreements.
The FAA certification process can be a long and tedious process, constantly fraught with push-back from OEMs. As Heico was able to accumulate certifications for increasingly complex parts, they began to develop a moat against competing companies that also tried to break into the replacement parts business.
This business has proved to be lucrative for Heico, as the company could often produce quality parts at a significant discount to the OEMs. As a testament to its high standards, Heico has sold almost one hundred million replacement parts without any of its parts being found to be the cause of an adverse event. Thus, Heico has managed to break into the highly lucrative replacement parts business, while ensuring a deep moat around its business model to fend off any potential competitors.
One of the enablers of Heico’s replacement part business is the streamlined manufacturing processes of the large aircraft makers. Boeing (BA) and Airbus (OTCPK:EADSF), for example, typically select only a few suppliers for each component. Becoming a qualified supplier for a component ensures a steady stream of replacement parts far into the future, often at significant profit margins. In addition, many manufacturers take advantage of their position by raising prices by mid-single digits every year.
Airlines have historically only had one or two manufacturers they could buy replacement parts from, creating a sizable opportunity for Heico. Heico’s replacement part business currently commands a low single digit market share, a number that is still multiples larger than its next largest competitor, but also one that still offers significant opportunity for continued growth. The pace of growth thus far is largely due to the conservatism of the aviation industry restrained by the consideration that any adverse effect can bring significant financial and reputational consequences to not only the airline, but also the part manufacturer found to be at fault.
This initially worked against Heico, as airlines avoided taking a risk with non-OEM parts. However, that tide has begun to shift as Heico’s operational excellence has persuaded many airlines that they can order parts of the same quality at a significant cost savings. This has led to increasing growth for Heico, while still maintaining a significant barrier to entry.
To supplement its growth, Heico uses its free cash flow to acquire smaller aerospace manufacturers. These are often smaller producers which supply niche, high-value products, but lack the scale to operate efficiently. Heico will acquire these companies, while leaving the owners with a small equity stake, and integrate their products into its distribution system. This has allowed Heico’s Flight Support Group to continue to grow earnings well above revenue growth.
The future remains bright for FSG. On its latest earnings call, Larry Mendelson, Chairman and CEO of Heico, said there were still plenty of possible accretive acquisitions in the marketplace despite increasing valuations. In addition to that, a recent ruling by IATA and CFM International, a joint venture of General Electric (GE), to reduce barriers to competition in the replacement parts business, will help Heico to potentially accelerate its 9-10% FSG revenue growth.
Electronic Technologies Group
The other portion of the business that contributes about 40% of revenue but almost half of its profits is the Electronic Technologies Group. The ETG focuses primarily on highly specialized components that are needed to perform in often extreme environments such as the Arctic or in space. These components will typically be requested by the customer and are produced in small batches, reducing any potential threat from competitors. This has led to Heico often being the supplier of choice, creating lucrative opportunities and sticky relationships.
The future remains bright within ETG, as the company is aggressively expanding into new opportunities and partners, while increasing margins as scale becomes beneficial. The segment will be able to continue to grow with top-line growth at 30%+, and operating income at 40%+.
Strong Culture Promotes Higher Valuation
A critical underpinning to Heico’s success has been its culture. The Mendelson family has focused on executing on its long-term strategy while creating an opportunity for Heico’s employees to participate in its success. One of the early moves by the Mendelson family was to place a large block of stock into a trust that could only be purchased by Heico employees, a commitment to the employees that helps to enable the company’s success. In addition, the previous owners of acquired companies can keep 20% of the equity in their company while still being able to manage day-to-day operations.
As an investor, it is often important to take a step back and think about what a company is on a broader scale. It is the integration of the vision, hopes and efforts of the people who have a vested interest in seeing the company succeed day in and day out, and because of that, the company provides for all its stakeholders, not just shareholders. Heico passes this mark with flying colors.
Something said by Heico’s CEO Larry Mendelson during the Q3 2018 earnings call reinforces this point:
"Heico is a big team with--I can’t tell you, we probably have, how many, 50 different operating--say, 50 different? I would say 90% of those 50 groups have incredibly outstanding management. That is what makes Heico grow. It’s not me and it’s not Victor and it’s not Eric, it’s not Carlos. I’m giving all the credit, 95% of the credit goes to those team members, some of which make more money than I do, or Eric or Victor or Carlos, and God bless them because they’re so outstanding…..
Now, what has happened is that we now have a good majority of those 4,000 people think of Heico as their company. It’s no longer we’re working for some rich guys on Wall Street and mutual funds and the CEO, he’s getting all this money, we’re getting nothing, when I retire I have Social Security, I can’t even make ends meet and so forth. The last thing I want to tell you is about six months ago when I sent out the quarterly reports, I received an email back from one of our secretaries, and the comment - I’ll paraphrase, dear Larry, thank you so much for sending the report. We are doing so well. We meant she - it wasn’t Heico. She didn’t write Heico is doing so well, we are doing so well, and she further went on to say, and it’s wonderful to know that someday when I retire, I will retire as a millionaire. This is a secretary."
Heico embodies some of the best aspects a shareholder can hope for: A dedicated and invested management team, proven integration between employees of all levels, and a sustainable and growing business. Heico has a winning formula on its hands, and I look forward to its future.
Risks to the Thesis
Heico's premium valuation opens the firm up to an earnings multiple re-rating if the growth story fails to meet expectations. With the firm recently raising guidance and guiding towards beneficial tailwinds in the coming years, any future commentary that jeopardizes that guidance could hurt the firm's potential return. This could include industry-specific trends that may not have a direct impact on Heico, such as a slowing of new commercial aircraft orders or a rise in valuation of firms that Heico acquires.
The biggest long-term risk is in regard to the management team. Larry Mendelson and his sons have done a tremendous job managing Heico. However, if anything were to happen to the leadership team, there could be significant doubts regarding whether Heico will be able to perform at the same level that it has been so far.
Heico’s shares have recently pulled back after hitting all-time highs following their Q3 earnings report, but still trades at a rich 40x 2019 earnings estimates. Despite that, the company’s strong operational focus, culture, and history of shareholder friendliness set Heico on a path for future success. Heico has grown earnings by 18% annually since the Mendelsons took over, and with growth rates forecasted to remain in the mid-teens, the valuation looks to be reasonable.
Disclosure: I am/we are long HEI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.