At the time of writing, Heico’s stock has fallen roughly 60% since the beginning of the market drop on February 20th. The company adds great value to its customers and is led by a stellar management team. The investment thesis will however become impaired over the next two years because of the exposure of Heico to the airline industry. This write-up will aim to poke as many holes in the thesis for Heico and determine if the stock's current market price is low enough to compensate for the various risks Heico’s business has.
In this write-up, I will start with a description of what the company does, then a deep dive of the economics of the business, and end with how the coronavirus situation has impaired these economics.
Description of the company
Heico is a global aerospace, defense and electronics company focused on niche markets and cost-saving solutions for its customers. Their products are found in the most demanding applications requiring high-reliability parts and components such as aircraft, spacecraft, defense, medical equipment and telecommunications systems.
Their Flight Support Group (60% of revenues) is a provider of commercial, FAA-approved aircraft replacement parts; a significant provider of aircraft accessories, component repair and overhaul services for avionic applications. They are a leader in niche aircraft parts distribution and a manufacturer of other critical aircraft parts.
The breakdown:
-aftermarket repair parts, which includes the PMA business (50%)
-MRO (maintenance repair and overhaul) parts and services (30%)
-Specialty products (20%)
The Electronic Technologies Group (40% of revenues) designs and manufactures mission-critical, niche electronic components found in aviation, broadcast, defense, medical, space, scientific and other complex equipment.
The breakdown:
-space, defense and aero (70%)
-other electronics (30%)
Heico’s customers are most of the world’s airlines, satellite manufacturers, commercial and defense equipment producers, medical equipment manufacturers, government agencies, telecommunications equipment suppliers and others.
Explanation of Parts Manufacturer Approval (PMA) process
Their Flight Support Group supplies more than 11,200 FAA-approved PMA parts for all major commercial aircraft in production. Original Equipment Manufacturers (OEMs) often provide replacement part for aircraft components. However, non-OEM manufacturers (like Heico) can sell replacement parts, but they must obtain PMA designation from the FAA for each of their parts sold. The FAA confirms the quality of both the design and the manufacturing process for the part. Heico reverse-engineers the part to show that their replacement part is of equal or better quality than the original. The entire process can take a year or more from start to finish. I compare this lengthy, regulatory-heavy process to the process pharmaceutical firms must go through to get their drugs approved.
The alternative to the PMA process is for OEMs to supply the parts, not companies like Heico. Airplane manufacturers like Boeing and Airbus design their planes around one or two manufacturers for each component, and these manufacturers sell to the airframe assemblers at breakeven or lower. These OEMs then take advantage of their dominant position in the aftermarket by raising prices each year, and airlines are thus often subject to these mounting costs.
Value-add to customers
Enter Heico. They have succeeded by pricing PMA parts at a great discount compared to the dominant suppliers (OEM’s like Pratt & Whitney, General Electric, Honeywell). Indeed, Heico’s value add is to sell the same quality replacement parts at 30-50% discounts to OEM pricings, which is why Heico is beloved by airlines. Airlines have also become comfortable with Heico’s safety record - not once in its entire history have Heico’s parts malfunctioned and caused adverse incidents.
Heico considers long-lasting relationships with customers to be among their most valuable assets. Their customers save a lot of money and time by working with Heico, and the company anticipates that their parts and repair operations will save customers over 1.3B$ in the aggregate over the next 3 to 5 years (pre-virus number). Heico further increases their product diversity every year, since their team develops between 300-500 new PMA parts. Many of Heico’s solutions are tailored to unique customer needs, which allows Heico to develop strong relationships that last beyond the life of a single program. For example, airline customers are often directly suggesting additional parts that Heico could reverse engineer as part of the PMA process. This means Heico invests heavily in R&D, which allows them to perfect their ability to manufacture mission-critical components for cannot fail environements.
Obviously, engine OEM’s aren’t thrilled with Heico under-cutting them and so they are using strategies against PMA adoption, like the usage of long term agreements which lock customers into the OEM system for 10 or more years, thus shutting out PMA providers. This is one risk which I believe will diminish after the current pandemic situation ends.
PMA adoption continues to have a long runway for growth. Despite being the leading independent provider of PMA parts, Heico estimates it has less than 2% market share of the market. Heico’s net margins are around 15% and they do not want their margins to go over 20% since the company does not want to be perceived as gouging or excessively profiting from their customers. Compare this focus on the customer’s financial well-being with Transdigm. The latter also sells aircraft parts but arguably posseses better economics than Heico, since Transdigm is the sole supplier for airlines for about 75% of the parts they sell, whereas Heico has competition for many of the parts it sells. However, Transdigm knows this and has a reputation for price gouging their customers, and their margins hover in the low 40%. Transdigm has been using this model successfully since 1993 but now the chickens have come home to roost. I doubt airlines will look at Transdigm very favorably coming out of this debacle.
Thus, Heico is beloved by its customers and the FAA, whose lead many of the world’s other regulatory bodies follow. Heico has sold 70 million PMA parts with zero adverse incidents. A new entrant could make PMA parts as Heico does, but would have to spend decades earning a good reputation with the airlines and the FAA.
Capital allocation strategy
Heico devotes a significant portion of its free cash flow to acquire mission-critical, high-reliability and highly-specialized niche products. Every year, engineers leave Boeing, United Technologies and other large aerospace companies to start their own businesses but lack the national scale and the FAA’s trust to be anything more than very small players. Heico buys these companies and feeds their production into its national distribution system and FAA approval process. Sellers and managers of businesses often retain an interest in the company when they sell the majority to Heico, which is why 80% of Heico’s acquired companies continue to be run by the sellers and management team that owned and ran the business before Heico purchased it. Heico also runs a decentralized organization as they encourage business unit leaders to invest in growth. Unit leaders invest in new machinery, R&D, inventory positions and facility expansion when necessary, and as long as IRR’s are attractive, the parent organization trusts units to make investments.
Heico benefited significantly from the strength in commercial air traffic and fleet growth right up until January 2020. Heico continued to gain share with airlines because of its reputation for delivering high quality replacements parts which are priced at meaningful discounts to the Original Equipment suppliers.
Change in the situation
The current situation for airlines is quite precarious. The downturn for airlines is brutal, and the extent of it on airlines is far worse than the post 9/11 period. Airlines have shut down entire operations. Flying has come grinding down a complete halt. Heico has benefited from greater Revenue Passenger Mile in the past and so the part of the investment thesis relying on increased flying is significantly impaired. Negative impact on airline traffic also slows down maintenance cycles.
Heico has long been optimistic that the type of long-term and expensive contracts OEMs are forcing upon airlines are not economical, and OEMs will ultimately be rejected by the airlines since they realize long-term, expensive contracts are not worth it for them. These difficult times when the chances of bailout for airlines due to the coronavirus seem increasingly likely might be a positive catalyst for Heico and other PMA providers. Letting the planes go down would put nearly a million people out of work and deprive countries of nearly all their long-distance travel infrastructure. However, the bailouts are likely to attract significant scrutiny from government officials and the public alike. Therefore, airlines are likely to enter into a period of financial conservatism. PMA part adoption is likely to enjoy greater growth because of its cost advantages. I also doubt that many airlines will be purchasing new planes. New planes require less maintenance and so sticking with existing planes benefits Heico.
Heico’s earnings call in February 2020 provides me with some reassurance that there will be greater PMA part adoption in the next 18-24 months. February 2020 was roughly a month after the virus had hit Wuhan in China, and the airline industry was starting to be affected due to decreased amounts of passengers. Heico mentioned during the call that their customers had become a lot more focused on cost-saving opportunities, and that there had been an increased an interest in PMA parts. The Mendelsons mentioned they were helping their customers with low-cost solutions during this crisis. As they have been doing for their entire history, they are obsessed with the well-being of their customers. This is a good sign, because businesses (like people) remember who helps them in times of duress.
Heico also said on the call the effect on airlines would be a short-term effect. I do not think that is true anymore however. We don’t need to be very pessimistic to forecast a drag in RPM lasting at least another 18 months, if not more. But after this 18 month period ends, Heico is likely to emerge from this dilemma a much stronger company. Heico has been building 30 years of goodwill with the airlines, and the company stands ready to help now more than ever.
I do not see the upcoming bankruptcies of airlines as a permanent risk. Airlines have long been a capital-intensive, low-margin business. They have been going bankrupt not long after the Orville brothers invented the first airplane and Heico has weathered these bankruptcies well, being around since 1990. Obviously, the risk is more widespread in the airline industry this time around and it is likely that Heico will suffer rapid order declines over short periods of time. There is a risk however that not all European airlines will receive a bailout, unlike American airlines. In fact, the investment pitch of several European airlines until recently was that the European market was oversaturated and that weaker players will eventually be eliminated, releasing untapped earnings potential. This means a few European airlines might just go bankrupt, especially the most levered ones. Heico will suffer until the market consolidates and the surviving airlines pick up the market share left by the strongest airlines.
The bigger bear case is not that some airlines go bankrupt, but that air traffic never comes back to current levels. The value-add of low-cost part providers like Heico can not be denied, but we can debate for a long time whether consumers’ behavior will be altered forever even after this pandemic end. That’s the extreme bear case.
However, I may be a tad too pessimistic since the Aviation Week has indicated that as the coronavirus spreads and airlines ground more aircraft, many will use the opportunity to conduct maintenance and refurbishment work.
Opportunistic M&A
As mentioned above, Heico does a lot of M&A to acquire more parts manufacturing companies. With the current trying times for Small and Medium Businesses, it is likely that a lot of them will be financially distressed. Heico and its balance sheet stand ready to make plenty of opportunistic acquisitions. Their net debt to EBITDA stands at 0.9x, but management has indicated in the past they are ready to lever up to 6-7x EBITDA, provided these levels come down to 2-3x eventually. I compare Heico’s stance on M&A to Berkshire Hathaway. Warren Buffett is likely to use his war chest of cash to make purchases of distressed firms in these times, and I have no doubt the Mendelsons will do the same. The Mendelsons have operated in the M&A space with extreme discipline in the past, paying low single-digit multiples of EBITDA for purchases. M&A optionality was alive before the virus hit, but now more than ever.
Companies also like to be acquired by Heico. For example, in July 2019, Heico acquired Bernier, a French designer and manufacturer of interconnect products used in defense, aerospace and industrial application for communications related purposes. The team members at Bernier petitioned the approval process in France to select Heico as the purchaser because they felt strongly that Heico would be the best acquirer, treat the team members in the best possible way and grow Bernier sustainably. This goodwill with acquired companies will help Heico pay cheaper multiples during their upcoming acquisitions, similar to how Berkshire Hathaway’s reputation for focusing on long-term, sustainable returns has allowed them to pay lower multiples for acquisitions.
Another risk that has not changed in this situation is the fact that Larry Mendelson is 80 years old. It can be a risk of the business due to a potential loss of his expertise and relationships in the industry. Larry does have two sons, Eric, who manages the business with the commercial airlines, whereas Victor handles the parts for defense aircraft.
Valuation
This part is quite tricky. To predict how Heico does, we have to predict how airlines do, for which we have to predict how long the virus’ effects last. And the derivative of the last point is predicting how long passengers do not want to travel. These are difficult elements to estimate, with many different variables to consider. Let us be pessimistic and say the drag lasts 18 months. A report from Jefferies from March 2020 says they expected a 20% drop in commercial aircraft aftermarket revenue. Heico’s revenues are 58% derived from the commercial aftermarket. FCF estimates for 2020 was of 475M$. Heico is known for sandbagging guidance but in hindsight I think even they may have overestimated 2020 numbers. Even though Heico’s entire revenue stream will not be affected, I chose to be conservative and apply a 20% cut to the entire projected 2020 cash flow. That gives cash flow of 380M$. Applying a 18x FCF multiple, which is roughly where Heico traded before valuation exploded into the stratosphere between December 2018 and February 2020, gives a valuation of 6.84B$. This means roughly another 15% down from current levels and I would start buying more shares. I’m not willing to project past 2020.
In conclusion, I don’t believe the market has priced Heico according to the worst-case bear scenario yet. A 15% drop from current levels at least is warranted. I believe with a reasonable degree of certainty that Heico’s value-add in terms of cost savings will see PMA part adoption increase dramatically once the pandemic ends. There is also optionality from M&A possibilities for Heico. I am confident that if air traffic comes back to normal, even if it takes 18-24 months, that Heico will be a much stronger company and that a 6.84B$ valuation will appear cheap looking back.
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