Barron’s Profiles HEICO

From today’s Barron’s:

Heico is probably one of the best companies you’ve never heard of. That’s because it serves an obscure segment of the world’s economy: It sells replacement parts to the airline industry. The aircraft-components business has grown by 5% a year for more than 50 years, along with global passenger volumes. But because Heico has found a durable, low-cost niche in aerospace, its revenue has been growing by three times that rate since 1990, when the Mendelson family took charge.

The Mendelsons, who own 8% of the stock (ticker: HEI) and 15% voting control, have run Hollywood, Fla.–based Heico in an understated, family-style way, with minimal leverage and a high-teens return on equity. They care about long-term compounding of wealth, which requires a sustainable business advantage and a sustainable corporate culture.

Their heimische approach shouldn’t fool anyone, however. As with Berkshire Hathaway (BRK/A), Heico’s folksiness belies a rigorously managed business—one whose sales have compounded at 16% a year since 1990. Earnings have compounded at 18%, annualized, and the stock, with a current market value of $5.6 billion, at 22%. Yet, even with the A shares (HEI/A) trading at a recent $62, or 22 times my 2018 cash earnings estimate of $2.80 per share (I add back noncash goodwill-amortization charges), the stock is reasonably priced. With Heico’s competitive advantage and low-single-digit share of its core market, earnings and the stock price should continue to compound at a mid-teens rate for many years. (The A shares have fewer voting rights and are thus less expensive than the common, which fetched $72 a share last week.)

One of the best companies you’ve never heard of? Speak for yourself, pal!

Heico thrives because of Boeing (BA) and Airbus (AIR.France), which control the vast majority of the world’s commercial aircraft production. They have enormous leverage over parts suppliers, including many leading industrial companies such as General Electric (GE) and United Technologies. As a result, GE and the rest make relatively little profit selling components for new-aircraft manufacture; indeed, many are happy to sell at a loss. The average aircraft lasts 20 to 25 years, so merely getting a part on the plane ensures a stream of orders for replacements. This is where parts makers have made most of their money—and where the price umbrella for Heico opened up.

Boeing and Airbus design their planes around one or two manufacturers for each component. When parts needed replacing, airlines historically had only one or two aftermarket alternatives, until Heico came along. It still isn’t uncommon for an aerospace-parts manufacturer to make a 35% to 40% profit margin in the aftermarket. Many have taken further advantage of their position by raising prices 5% to 7% a year.

Heico has succeeded by setting prices below the dominant suppliers. What’s more, it is the only large-scale supplier of non-OEM aviation parts. Its largest PMA rival, owned by private equity firms, is a fraction of its size.

(…)

Heico is beloved by its customers and the FAA, whose lead many of the world’s other regulatory bodies follow. A new entrant could attempt to make PMA parts as Heico does, but would have to spend years, if not decades, earning the trust of the airlines and the FAA. Heico has cracked the oligopolistic nature of the aerospace industry, and is now a member of the club.

To supplement its 8% organic revenue growth, Heico uses cash flow to buy other, smaller manufacturers. Every year, dozens of 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 marginal players. Heico has bought dozens of small companies, leaving 20% of the equity with the original owners. It feeds their production into its national distribution system and FAA approval process.

Unlike some other successful industrial conglomerates, Heico doesn’t look for cost synergies. Instead it seeks good businesses—20% operating profit margins are its bogey—where management can be kept in place. Its acquired businesses have contributed 8% to annual revenue, and earnings growth has roughly tracked topline gains.

Posted by on July 1st, 2017 at 12:10 pm


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