Description

Executive Summary:  HEICO is a rapidly growing aerospace and defense company focused on developing products and services within niche markets that possess both high barriers to entry and attractive organic and inorganic growth opportunities. It is a capital light business, with attractive margins and returns on capital, and is well-positioned to benefit from ongoing strength in commercial air traffic, fleet growth, and improving defense and space budgets. Moreover, we think that the company can continue to gain share with airlines because of its reputation for delivering high quality replacement jet engine and aircraft parts that are priced at meaningful discounts to the OE suppliers, while we expect management to continue to deploy its healthy free cash flow in order to drive growth via its disciplined acquisition strategy. Combined, we expect that the company can continue to deliver 15-20% earnings growth over the medium-term, consistent with its performance since 1990 when the current management team took over.

At first glance, the company screens very expensively, but one must peel back the onion to gain a better understanding of the business’s true profitability. First, the company has consistently generated free cash flow well in excess of earnings due to its M&A strategy, so a focus on cash earnings is more appropriate. Second, the benefits of tax reform which have yet to be factored into forward estimates, should drive ~10% upside to estimated profits and cash flow. Third, the Street does not appear to be adequately accounting for the profitability of its most recent acquisition, which was completed with only 45 days left in the fiscal year, and we think this deal has the potential to drive 10% cash earnings growth on its own. And finally, prospective M&A is not factored into estimates despite its acquisitive history, strong free cash flow profile, and an underleveraged balance sheet that should provide the company with ~$1bn in ‘dry powder’ over the course of this fiscal year (~15% of its market cap), which is enough to deliver upwards of $0.65 of normalized cash earnings potential (vs. cash earnings of $2.09 in FY2017) without straining the balance sheet. Taken altogether, we see HEICO’s underlying 2018 cash earnings power in the range of $2.75 - $3.40 depending on the timing of prospective M&A, roughly 35-70% above where consensus earnings per share sits today. We can further take advantage of our long-term focus and limited turnover by purchasing HEICO’s A-shares, which trade at an 18% discount to the more liquid common shares, allowing us to purchase shares at something in the range of 19-25x earnings, which we feel is a bargain given its investment attributes.

Company Overview:  HEICO is a leading designer and manufacturer of Parts Manufacturer Approval (PMA) replacement parts for jet engines as well as other aircraft parts and components. The company also provides specialty products, maintenance, repair, and overhaul (MRO), and distribution services to global commercial aerospace and military customers. Additionally the company manufactures a variety of electronic equipment for use in the aviation, defense, space, industrial, medical, telecom, and electronics industries. In general, the company’s primary operations tend to be in attractive niche markets with structural barriers to entry and attractive organic and inorganic growth outlooks which have helped the company deliver consistently high sales and profit growth while maintaining strong returns on capital. Since 2001, the company has grown its sales and free cash flow at 15% and 23% CAGRs, respectively, reaching a record $1.5bn in sales and $250mn in free cash flow in its most recent fiscal year. And despite a very acquisitive model, the company has been able to maintain steady returns on both equity and invested capital, a testament to its discipline as an acquirer. Over the past decade, after-tax cash returns on equity have averaged 15%, and returns on invested capital have averaged ~13%.

The company operates through two segments: Flight Support Group (FSG) and Electronic Technologies Group (ETG), and is primarily exposed to the commercial aviation, defense, and space markets. From a revenue standpoint, the FSG segment is larger at 63% of sales (vs. 37% for ESG), though profits are more evenly distributed at 53%/47%. In general, the FSG segment has lower (but still solid) margins, but generates higher returns due to greater asset turnover, while the ETG segment enjoys extremely strong profit margins offset by slower asset turnover.  HEICO generates ~2/3 of its sales in the United States. No one customer accounts for more than 10% of revenue, and its five largest customers account for ~18% of sales.

Flight Support Group: The Flight Support Group is the leading non-OEM designer and manufacturer of PMA replacement parts for jet engines and other aircraft components. In this segment, the company works with customers (typically airlines) to develop approximately 300-500 new parts every year and currently sells ~10,000 FAA approved parts. These parts can be found in engines, wings, fuselage/interiors, cockpit, landing gear, and other major components and systems.

HEICO’s PMA business primarily competes against the engine and component OEMs who would otherwise be the airlines’ only source for parts – and would price accordingly. HEICO’s value proposition is to deliver ‘at least’ the same quality replacement part at a 30-50% discount to OEM pricing, and as result, has developed quite a favorable reputation with airlines tired of being gouged by suppliers in the aftermarket.

In addition to its PMA business, the company also provides MRO services on aircraft engines and components, covering most major systems, instruments, and structures, and its services include proprietary repairs approved by the FAA that are only allowed to be completed by designated engineering representatives (DER).  The segment also houses an aerospace distribution operation, and a specialty products group that designs and manufactures thermal insulation blankets and parts, as well as a host of other niche components for aerospace, defense, commercial, and industrial applications. The specialty product business is really the only business within FSG that focuses on original equipment; the remaining businesses are focused on the aftermarket. As such, demand tends to be correlated with airline traffic in addition to the size and age of the fleet.

The company breaks its segment into three product lines: (1) Aftermarket repair parts, which include its PMA business; (2) MRO parts and services; and (3) Specialty Products. Its aftermarket business likely generates extremely strong margins but may also embed its low-margin distribution business – it is not clear. MRO parts and services likely generate below-segment margins, and Specialty Products likely generate stronger than average margins but also exhibit the most lumpiness.

Electronic Technologies Group: The Electronic Technology Group designs and manufactures a range of mission-critical electronic, microwave, and electro-optical products for use in aviation, defense, space, industrial, medical, telecom, and electronics industries. Its products include infrared simulation, testing, and calibration equipment, laser rangefinders, receivers, transmitters, amplifiers, power suppliers, batteries, frequency shielding, and connectors. In general, the segment manufactures components that (1) are niche products designed into larger systems, (2) are found on different platforms in multiple industries to diversify its risk away from a particular program, (3) are highly-engineered, mission-critical products , and (4) typically have low production rates and thus tend to be ignored by the marketplace.

The ETG segment does not have much aftermarket exposure and thus growth tends to be correlated to aviation new builds, defense spending levels, and commercial space spending. Management believes the segment should grow in the low-to-mid-single digit range organically, while reported growth has been well in excess of organic due to a healthy dose of M&A (5 acquisitions since 2013, adding over $200mn in sales to a segment that only delivered $574mn in 2017). ETG segment EBITDA margins are extremely attractive at 33%, and we see further room for upside with the company’s late FY2017 acquisition of AeroAntenna Technology which appears to have margins >50% based on our analysis of HEICO’s filings.

Company Background: The company has been in business since 1957, but HEICO as it is known today began in 1990, when Laurans Mendelson and his two sons, Eric and Victor, ousted the prior management team, sold its legacy lab equipment business, and focused on growing its generic aviation parts business in accordance with the FAA’s Parts Manufacturer Approval (PMA) program. This was slow going in the early days as the FAA was extremely deliberate in reviewing its parts to ensure the quality was superb, and airlines tend to be cautious in general when it comes to changing out parts that could potentially impact flight safety. Over time, both customers and the FAA grew more comfortable with their replacement parts, and adoption began to pick up. In 1997, Lufthansa took a 20% stake in HEICO’s aftermarket subsidiary, which helped the company’s reputation in the marketplace and likely accelerated the adoption of PMA parts in the industry. Today, the PMA business accounts for ~1/3 of sales as HEICO’s shrewd management team has effectively deployed cash flow to diversify, first from PMA engine components to other areas of the plane, and then into the MRO and distribution businesses, and finally into OE components themselves. The Mendelson family continues to run the business, with patriarch Laurans (79) the Chairman and CEO, and sons Eric (52) and Victor (50) as co-presidents, with Eric the CEO of the Flight Support Group segment and Victor the CEO of the Electronic Technologies Segment. Combined, the family owns ~8% of outstanding shares, while HEICO’s Board, Management, and Team Members collectively own ~22% of outstanding shares.

Acquisition Strategy: To supplement the growth in its business, management has consistently used its healthy cash flow to buy other smaller businesses, first exclusively developers of PMA parts but then in other, related businesses. With the founding of its Electronic Technology Group in 1996, management pivoted away from the aftermarket into OE parts, but in typical HEICO fashion, the company continued to target niche products typically ignored by the marketplace.

Regardless of the product or end market, the Mendelson family has stayed true to their original acquisition philosophy. Management regards HEICO as a vehicle to generate very strong cash flow, and is agnostic as to which industry that acquisition targets operate in, so long as management can understand the industry and feels confident that the business benefits from a structural advantage which limits competition. The company further cream skims the market by limiting its acquisition targets to companies that have high operating margins (>20x) and low capital intensity, and thus generate strong cash flow from the get-go. Another key criteria for potential deals is that the business has strong management in place that will stay on post-deal. Since over 80% of its 66 acquisitions to date have continued on as stand-alone operations, it is essential that there is a highly capable management team in place to ensure the business continues to perform in-line with expectations.

The final – and most important – gating factor for a potential deal is valuation. Management is extremely disciplined on valuation, paying only 5x to 8x trailing EBITA (not EBITDA because depreciation is a real expense) for acquisitions. The company further de-risks deals by (a) acquiring either a majority (generally 80%) stake with an option to purchase the remaining 20% at the same acquisition multiple of future profits, or (b) structuring the deal with meaningful earn outs based on future growth in profits.

Importantly, the company believes it is the preferred buyer for the companies it acquires, as HEICO tends to be a good destination for companies (and owners) that are interested in maintaining culture, want a liquidity event but would like to continue running the company, and/or are concerned about the business’s stakeholders for the long-term. HEICO is unlikely to be an acquirer of a PE-owned company because of its valuation constraints, which suits them just fine.

Background and overview of the PMA business: In order for non-OEM manufacturers of jet engine and aircraft components to sell replacement parts, the company must receive a Parts Manufacture Approval (PMA) designation from the FAA, which confirms the quality of both the design and the manufacturing process for the part. There are two primary ways to create a PMA part: (1) the OEM of the original part can license out its design, and these partnering companies, with the original design in hand, must have their production process and quality control approved by the FAA, or (2) Manufacturers can reverse engineer the part to show that their replacement part is of equal or better quality compared to the original, and then also get their production and quality control process approved – this is HEICO’s preferred path. Depending on the track record of the company attempting to obtain the PMA and the level of complexity of the component, the process can take many months to over a year from start to finish.

The PMA program has been around since the 1950s, when the FAA began granting 3rd party manufacturers approval to make replacement parts, but was principally used by the military as a way to replace parts on obsolete aircraft. It was not until the late 1980s/early 1990s that PMA parts began to become more commercially acceptable, and it really began in the wake of a 1985 commercial airline crash that ultimately prompted regulators to mandate that engine combustors be changed at regular intervals, something that previously hadn’t been required. This resulted in so much demand that the part’s manufacturer, Pratt & Whitney, could not keep pace, which allowed HEICO, who had received FAA-approval to manufacturer Pratt’s combustor, to sell its generic replacement part. Over the next 10-15 years, PMA parts steadily gained acceptance commercially, and really began to pick up steam in the mid-to-late 2000s when the FAA reinforced the validity and effectiveness of PMAs and airlines began to recognize the quality and financial benefits.

Why the PMA business exists. In many ways, the current industry structure is responsible for the growth in PMA parts. HEICO and PMA parts in general thrive because Boeing and Airbus exert enormous influence over the industry. These companies typically design their planes around one or two manufacturers for each component, and these manufacturers are more than happy to sell to the airframe assemblers at breakeven or lower pricing in order to ensure a stream of replacement orders over the aircraft’s 20-25 year life. These suppliers then take advantage of their dominant position in the aftermarket by raising prices as much as 5-7% annually, enraging the airlines who are helpless to avoid the increased costs. Enter HEICO.

Why HEICO? Over its history, HEICO has succeeded by being an ally of the airlines and pricing its PMA parts at a significant discount vs. the dominant suppliers while still earning attractive margins/returns. Its customers have become comfortable with its impeccable safety record, and HEICO plays an instrumental role in lowering their maintenance costs (estimated at ~$25mn in annual savings for airlines who use HEICO PMA parts and services). As such, airline customers are often working with the company to suggest additional parts that HEICO could attempt to reverse engineer.

What’s more, it is the only large-scale supplier of non-OEM aviation parts, and its largest PMA rival (Wencor - owned by private equity, 0 engine PMAs) is a fraction of its size, suggesting the company is in the best position to capitalize on further PMA adoption, particularly given its impeccable 27 year safety record and know-how in navigating the PMA approval process. And even with its strong growth over the past three decades, PMA adoption continues to have a long runway. Despite being the leading independent provider of PMA parts, HEICO estimates it has less than a 2% share of the market.

Importantly, while a new competitor could conceivably replicate HEICO’s strategy, it would take decades to earn the trust of the FAA and the airlines, and the company would have to accept structurally lower margins until it reaches scale.

Hurdles to PMA adoption manageable for HEICO though risks remain:  Despite its obvious financial benefits for airlines – which have not historically been the most profitable enterprises - and long runway for future penetration, there are three key hurdles to broader PMA adoption.

1. Airline conservatism. Airlines are extremely conservative by nature, and are reluctant to do anything that could potentially affect safety, so it takes a period of decades for a PMA manufacturer to earn the airline’s trust. This absolutely was a hurdle for HEICO early on, but has turned into more of a competitive advantage for the company now that it has cracked the oligopolistic nature of the aerospace industry.

2. Perception. Despite an extremely strong safety track record, PMA part adoption continues to be sub-optimal at airlines who lease, as many leasing companies continue to believe that PMA part usage can negatively impact residual values. As HEICO has delivered over 70 million PMA parts in its history with ZERO adverse incidents, its primary challenge here is educating its customers to drive continued awareness. The company acknowledges that significant hurdles remain, but the trend continues to move in its favor.

3. OE supplier marketing efforts and contract structure. The third key hurdle to adoption has been the aggressive actions by engine OEMs to attract and retain customers for their own spare parts and service, including marketing efforts aimed at disparaging the quality of PMA parts and false claims that warranties will not be honored for products that contain PMA components.

One of the better solutions that engine OEMs have employed to combat against PMA adoption is the increased usage of Power-by-the-Hour (PBTH) contracts and other long-term agreements which lock customers into the OEM ecosystem for 10 or more years, completely shutting out PMA providers during this time period. Historically, HEICO has limited its exposure to a particular part such that HEICO and the OE supplier could both get attractive economics, but it is clear that these contracts aim to push HEICO entirely out of this market. While the engine is a less important market than it was 10-15 years ago for HEICO, it remains a key piece of business for the company. Fortunately, HEICO does not generate any aftermarket revenue until a plane is 5-10 years old, so it has several years to come up with solutions to new challenges. Moreover, this challenge has been on the company’s radar for several years already.

In response to this threat, HEICO has steadily reduced its reliance on engine parts by diversifying into other areas of the plane. And longer-term, the company is optimistic that these types of contracts will ultimately be rejected by the airlines as they realize just how poor the economics are over the life of the contract, and an ongoing investigation into the monopolistic business practices of the engine OEMs by the European Commission may just provide a needed catalyst to break the long-term agreement model.

Long-term drivers of aftermarket intact with potential for upside. Historically, commercial aviation aftermarket parts and services growth has shown a strong correlation to airline traffic growth and fleet size, and for the past 50+ years, airline traffic has increased at a 5% annual rate. More recently, airline traffic growth has been even stronger, with traffic growing ~6% over the past five years. As result, airline load factors are bumping up against long-term ceilings, and industry experts expect (1) airlines will keep older airplanes longer in the near-term and (2) more airplanes will be purchased for replacement in the long-term. This outlook supports continued growth for HEICO’s aftermarket and OE businesses, while the recent increase in defense spending coupled with higher commercial space budgets bode well for the Electronics Technology Group.

Significant room for additional M&A. Despite completing the largest acquisition late in its history this past fall, HEICO continues to have ample room for additional M&A provided targets meet its stringent requirements. At the end of FY2017, HEICO’s net debt to EBITDA ratio was 1.65x, well-below management’s comfort level of ~3x (though the company would go 6-7x levered for the right deal if they had visibility to get to 2.5-3x within a year). On our estimates, HEICO has roughly $500nn in ‘dry powder’ right now, and stands to add an additional $500mn or so over the course of 2018 without taking leverage beyond 3x. For frame of reference, if the company were to deploy an additional $1bn in capital (equal to ~15% of its market cap) even at the high end of its targeted valuation level, this would translate into ~$0.65 of cash earnings power (vs. our cash earnings estimate of ~$2.75 in 2018).

Estimates appear too conservative, even after factoring in tax reform. On HEICO’s 4Q17 conference call in 2017, the company guided for 10-12% sales and earnings growth in 2018, translating into ~$1.91 of earnings at the midpoint, but management’s guidance was based on the prevailing tax policy at the time.  Factoring in tax reform, we estimate that earnings should be ~$0.10 higher, equating to ~$2.10 (roughly 5% above stale consensus estimates).

Moreover, we believe management is being extremely conservative with its guidance for 10-12% revenue growth in both segments. In FSG, M&A should deliver 5-6% growth just based on acquisitions already on the books, and we would expect acceleration in organic growth given continued strong aftermarket trends and the delivery of specialty products sales that were slipped from FY2017 into FY2018, suggesting upside to segment growth even without any additional deals. In ETG, the Street does not appear to be adequately accounting for the profitability of its most recent acquisition, which was completed with only 45 days left in the fiscal year, and we think this deal has the potential to drive 10% cash earnings growth on its own. Not to mention that the company made a bolt-on acquisition (terms not disclosed) a couple of days after the fiscal year, suggesting there is upside to our M&A contribution estimates for the ETG segment.

Lastly, prospective M&A is not factored into estimates despite its acquisitive history, strong free cash flow profile, and an underleveraged balance sheet. We sympathize with the Street’s inability to model something that is inherently uncertain, but nonetheless think that some measure of credit must be made. If we merely assume all free cash flow after dividends is reinvested in M&A, we see ~6-8% annual cash EPS upside to our estimates.

Finally, management themselves strongly hinted that its preliminary guidance was conservative, and this team has a strong track record of raising guidance through the year.

Performance vs. Guidance:

Valuation: At ~$68, HEICO’s A-Shares, which have the exact economic interest as the common shares, are trading at ~29x our 2018E GAAP earnings and roughly 25x cash earnings. Our estimates embed no prospective M&A despite the company having as much as $1bn in ‘dry powder’ this year (~15% of market cap) and a desire to continue its aggressive acquisition strategy through 2018.

Risk factors:

1. A downturn would negatively impact airline traffic which would slow down maintenance cycles and potential impact new build production rates. We would argue that PMA penetration should accelerate in a downturn given a focus on costs, but results would be pressured.

2. A spike in oil prices could result in airlines opting to speed up retirements of older, less fuel efficient aircrafts, negatively impact aftermarket results for HEI.

3. Continued penetration of power-by-the-hour models would constrain HEICO’s ability to capture aftermarket revenues.

4. Boeing is attempting to triple the size of its services business over the next 5-10 years to ~$50bn. This has been an ongoing initiative for the company and expectations for its success vary, but we would expect HEICO’s PMA business to be relatively insulated though its MRO and distribution business’s would potentially be impacted (est’d at <15% of profits).  We do not believe Boeing has a strong incentive to compete against HEICO, whereas it absolutely is incented to use a services push to further squeeze suppliers into granting concessions on the new build components.

Catalyst

Quarterly results and guidance, continued PMA penetration