HEICO: A Compounding Beast
HEICO is a cash flow compounding machine. From 1990, when present management took over, to the end of 2019, the company grew operating cash flow at 22% per year and the stock compounded at 23% annually – staggering results over such a long time period.
What has allowed a small specialty aerospace manufacturer transform into one of the best performing stocks over the last three decades? While much has gone right for HEICO over the years, the common threads for their success are:
o HEICO’s status as a low-cost producer insulated from competitors as a result of the business model they’ve adopted;
o The specialty and niche solutions they provide are protected by formidable barriers to entry due to FAA regulations, and;
o An Outsider management team with skin in the game has fostered a long-term and owner-minded culture throughout all levels of the organization.
This has been a winning combination for the business and its shareholders. $10,000 invested in HEICO in 1990 would have been over $4 million at the end of 2019. The same $10,000 would have been $170,000 if invested in the S&P 500.
Background
Originally organized in 1957 and under present management since 1990, HEICO is a specialty aerospace and defense manufacturer. The company operates in two segments, Flight Support Group (FSG) and Electronic Technologies Group (ETG).
The flight support group (58% of revenue, 49% of operating income) is the world’s largest manufacturer of FAA-approved jet engine and aircraft component replacement parts other than the original equipment manufacturers (OEMs), namely Rolls-Royce, GE, and Pratt & Whitney. HEICO develops, manufacturers, repairs, and distributes aircraft components for large U.S. air carriers like Delta, Southwest, and American Airlines. Despite occupying a leading position in the replacement part industry HEICO believes they have just 2% market share.
The Electronic Technologies Group (42% of revenue, 51% of operating income) designs and manufactures highly-engineered, mission-critical subcomponents that need to operate in harsh environments. They focus on niche applications that are used in larger systems. Examples of products include laser-targeting systems, high-tech range finders, emergency backup batteries, electromagnetic shielding, underwater beacon locators, and many more. These products are primarily used in defense applications but also in the commercial aerospace, space, medical, and telecom industries.
Source: 2019 Investor Presentation
In 1990 HEICO generated $26M in sales and $2M of net income. Through expanded product offerings, a widened customer base, and a disciplined acquisitions strategy (77 acquisitions since 1990) HEICO ended 2019 with nearly $2.1B in revenue and $330M of net income.
Competitive Position
Rolls-Royce, General Electric, and Pratt & Whitney are the primary manufacturers of jet engines and aircraft component replacement parts. Collectively these OEMs follow a razor/razor-blade model whereby they spend billions on R&D to develop and build complex aerospace parts which lose money upon sale to their customers. The OEMs make money from in-service support (like replacement parts and service) once their programs have launched, slowly recouping their up-front investment. It’s not uncommon for a program to take a full 15 years to reach breakeven. Below is an illustration of what an OEM’s cash flow generally looks like over the life of a program.
This razor/razor blade model necessitates that OEMs charge a premium for replacement parts and services in order to earn a respectable profit. Therein lies the opportunity for HEICO.
Instead of spending gobs of money to design and build new aerospace components, HEICO piggybacks off of the OEMs design and reverse-engineers their parts once they are in use. These components are referred to as PMA parts (parts manufactured approval) and must receive FAA approval which certifies they are interchangeable with the OEM parts. It’s not as if customers sacrifice quality by going with PMA parts either. Per the company’s Q4 2019 earnings call, they have shipped 75 million parts with zero worthiness directives or in-flight shutdowns (aka quality issues). So, customers basically receive the same quality at a much lower cost.
Because HEICO is not designing intricate parts from scratch, they spend a fraction of what OEMs spend on R&D. In 2019 HEICOs Flight Support Group spent roughly 2% of revenue on R&D whereas Rolls-Royce spends 5-10% of sales on R&D annually in its widebody engine division (per 2019 annual report). Unsurprisingly, with substantially lower operating costs HEICO charges 25-50% less than an OEM for their replacement parts, giving them a significant competitive advantage as a low cost producer and a chance to continue penetrating their customer base. Even if the OEMs wanted to price-match HEICO, it would be suicide given the only profit they generate comes from the higher priced aftermarket products and services, a fact that further entrenches HEICOs position.
To be sure, OEMs still sell by far the most replacement parts to customers, as evidenced by HEICOs 2% market share. OEMs engage in things like bundling replacement parts with new engines, requiring OEM replacement parts for valid warranties, among other tactics, to lock-in replacement part volume. However, their lead appears to be shrinking as HEICO offered around 5,000 PMAs in 2010 compared to over 11,000 today as more customers gravitate towards low-cost PMAs for a portion of their parts.
The value proposition HEICO offers strikes me as an inevitable “black hole” that will continue attracting more and more volume over time. This is especially true during downturns, when costs matter more than ever to the high fixed-cost airlines. As discussed in last weeks’ post on Costco, there is gravitational pull towards lower prices in nearly every industry, and value typically accrues to the low cost providers and end customers.
I wonder if pandemic-struck carriers start to lean more heavily on PMAs and suppliers like HEICO in the years coming out of this downturn. At any rate, HEICO doesn’t need some seismic shift in customer behavior to justify their existence. They simply need to continue chipping away at the OEMs to grow for years at a similar rate.
In addition to an enduring cost-advantage over the OEMs, HEICO also enjoys a sizeable barriers to entry moat protecting it from other competitors.
Regulatory Barriers to Entry
Getting components FAA approved and on the PMA list is the key to growth in HEICOs markets. The more parts for which HEICO receives approval and the faster the parts are approved, the faster the company can grow. But, as with any regulatory process, receiving FAA approval is no small task and approvals can be lengthy. As discussed in the company’s annual report, HEICO believes that PMA part turnaround time from the FAA is a function of:
o The agency’s confidence in the applicant;
o The complexity of the part;
o The volume of PMA’s being filed;
o The resources available to the FAA.
HEICOs favorable and extensive track record with the FAA along with its demonstrated technical expertise in designing and manufacturing PMA parts leads to faster and more reliable approval of its parts compared to competitors. The PMA process creates a significant barrier to entry for competitors because of a) the technical expertise required to reverse-engineer these parts and b) limits to the rate at which parts can be brought to market by competitors due to the FAAs own resource constraints. This amounts to a sizeable lead in the PMA market that HEICO is unlikely to relinquish.
Owner-Operator Culture
In 1990 Laurans Mendelson took control of HEICO and has been at the helm ever since. Mendelson embodies the owner-minded culture we so often look for in investments because he is an owner and still controls over 20% of stock in the company. Mendelson’s two sons, Eric and Victor, serve in key leadership positions and lead the FSG and ETG divisions, respectively.
Despite making 77 acquisitions since 1990 HEICO can be thought of as an “anti-conglomerate” as they embrace an extremely decentralized structure. We’ve written about how this was one of the common themes among the world’s most successful “Outsider CEOs” and HEICO is no exception.
Upon acquiring a new niche aerospace business HEICO seeks to maintain the scrappy entrepreneurial spirit that made the business great in the first place. Operating segments maintain extreme autonomy with limited interference from corporate headquarters. It’s typical for HEICO to acquire 80% of a business and leave the remaining 20% with the owners, who usually continue to run the business and maintain substantial skin in the game. I think of HEICO much like Berkshire in that they attract business owners who love running their business, and want to continue doing so even after monetizing some of their ownership stake.
Rather than go on about the culture they’ve created that I greatly admire, I’ll steal a few snippets from the company’s material.
A great example of the way management thinks is embodied in how Eric Mendelson answered a question from an analyst trying to nail down the short-term impact of the 737 Max grounding last year:
“I think HEICO is probably one of the companies in the industry with the least impact as a result of the 737 MAX. We do have some new content that goes on it, and that will be impacted, but I believe that's going to be mitigated by the increase in our aftermarket part sales. So I don't see this as a major item to HEICO. HEICO has always got various speed bumps along the way. We take care of those. We don't call out special excuses for special events. So I'm very confident that there's not going to be much of an impact to HEICO.”
The management team doesn’t make excuses, tout “adjusted” results, or think in one-year increments, all signs of real business owners.
Another example of their practical thought process comes from the 2019 proxy discussing the executive’s compensation plan:
Source: 2019 Proxy
You just don’t see language emphasizing common sense over academic concepts in many proxies, and it speaks to the rationality of the executive team and board of directors.
One more example, later in the proxy, discussing key executives loyalty:
Source: 2019 Proxy
When executives intentionally suggest harming their short-term personal interests in the name of long-term sustained success, you’ve got something lasting and investors should pay attention.
Finally, it isn’t just the executive team with skin in the game. Roughly half of HEICOs company 401K plan is held in HEICO stock, allowing for an ownership mindset (not to mention significant wealth creation) for “rank and file” employees.
It’s not shocking that a management team with major skin in the game and whose mantra is “compound cash flow” exemplifies the many characteristics of historically great Outsider CEOs, and the result has been outstanding performance for decades.
Fundamentals and Returns
Predictably, HEICO earns solid returns on capital at attractive reinvestment rates. From 2010 to 2019 HEICO generated roughly a 20% return on incremental capital employed (change in operating cash flow vs. change in debt and equity). This is particularly impressive considering over that time period they retained more than 100% of net income (roughly 115%) implying around 22% compounding of intrinsic value – right in line with how the stock has compounded since 1990. The last decade has been an especially good period for air travel (until COVID), but HEICOs performance is not unique to the last ten years and the value proposition strengthens during recessions. All signs point to the last decade being the rule, not the exception.
As highlighted in the proxy, the management team maintains a pristine balance sheet with leverage around 1x 2019 EBITDA, allowing the business to survive virtually any COVID or otherwise adverse scenario. This also gives the management team plenty of financial flexibility to continue rolling up niche aerospace acquisitions as they uncover them for reasonable prices, which they believe they will continue to do.
Source: Author, company filings
Growth
In any given year growth rates in each segment are hard to predict with great accuracy, as much of the revenue is based on timing of maintenance and overhaul requirements from customers along with defense budget spending. Over long periods each segment should continue growing organically at mid-to-high single digits with similar revenue growth coming from acquisitions in a somewhat more lumpy manner. Taken together total revenue seems poised to continue growing near its historical 15% pace.
With 2% share in their core market, a value proposition in no danger of eroding, and second generation management equipped to run the business in the same manner for decades, HEICO should have adequate room to reinvest a majority of their cash at similar incremental returns yielding 15-20% compounding for the foreseeable future.
Valuation
A long term investment in HEICO (the only way to think about it in my view) requires less precision on a yearly basis and instead a conviction that the value proposition will continue to generate solid returns on capital and that the carefully crafted ownership culture will continue to provide an attractive home for acquisitions. I’d bet both turn out to be true well into the future.
The business currently trades for ~33x 2019’s free cash flow, which may be tough for value investors to swallow. Using a 10% discount rate the valuation implies around 7% terminal growth, which is quite reasonable and doesn’t bake in any inorganic growth. I wouldn’t say HEICO is a bargain with a wide margin of safety, but the valuation isn’t too stretched considering the quality and growth runway of the business.
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