Investment case: Heico

Limited Competition

New entrants have made various attempts to enter the aviation spare part aftermarket, but no company other than HEICO has succeeded in gaining critical mass. Taking the time to accurately analyse and reverse engineer a part down to the molecular level is surprisingly the easy part. The market for aftermarket parts is highly regulated with FAA approval required for each part given the significant consequences of a part failure. There is a lengthy processes involved in having a part approved by the FAA and it takes substantial expertise. Another hurdle after receiving FAA approval is to convince airlines to buy these parts. It takes years to build this trust with the airlines as their reputation for safety is everything. It is virtually impossible for a new entrant to replicate HEICO's business. If a new entrant was able to reverse engineer parts at the same rate as HEICO at 300-500 parts a year, it would still take them more than 20 years to get to the level that HEICO is at today.

Why HEICO parts?

HEICO has a highly recurring revenue stream due to its focus on producing parts that require periodic non-discretionary replacement. Airlines can either purchase these replacement parts directly from OEM’s such as General Electric, Rolls Royce and Pratt & Whitney or save 20-50% by using parts produced by independent manufacturers such as HEICO.

Studies show no differences in the safety record of OEM aftermarket parts versus those produced by independent players and after FAA investigations, OEMs can no longer use arguments based on safety to win back aftermarket business from independent players. HEICO parts are considered the gold standard of non-OEM replacement parts. There is limited competition for HEICO from other independent aftermarket parts suppliers and they essentially operate as a monopoly with very strong pricing power. OEMs typically increase prices by 7-10% per annum so given the strong focus on cost savings by airlines, HEICO parts provide an attractive high quality alternative.

Management

SilverCross values management teams with skin in the game and HEICO is a good example of where a management team is truly aligned with its shareholders. Management views HEICO as a partnership where shareholders are not only investors but also partners. Laurans Mendelson has been the CEO and Chairman since 1990. He owns 4.2% of the company and his sons Eric and Victor each own 2.8%.

The total ownership by directors, executive officers the HEICO Savings & Investment Plan (for staff) and the Mendelson Family is 13.7% of the company.

We have had meetings with the CEO, his son Larry and the CFO, Carlos Macau. We were inspired following our tour of their largest manufacturing facility in Hollywood, Florida where approximately 100 different types of parts are developed each year.

Onwards and upwards

With approximately 1400-1600 new aircraft coming to the market and only a few hundred being retired each year, the fleet of commercial aircrafts is constantly growing. Global capacity in the commercial aviation space is expected to grow at 4-6% over the next 20 years. Despite HEICO’s dominance as an independent aftermarket parts supplier, they still only have 2-4% market share.

HEICO has significant opportunity to reverse engineer and develop new parts. The number of parts per airplane vary from 400,000 for a Boeing 737 to six million for a Boeing 747-8. HEICO’s portfolio currently consists of 10,000 FAA approved parts and by developing 300-500 new parts per annum they have decades of potential growth ahead.

Growth in the ETG division is driven primarily through a prudent allocation of free cash flow to acquire smaller niche, high margin companies. They target companies with low production runs that are typically ignored by the marketplace and generate high margins, high return on invested capital and, importantly, have a strong management team. HEICO’s management follow a Warren Buffett-style approach, giving managers of acquired companies autonomy and normally acquiring a maximum of 80% of the equity, leaving the management team with a 20% stake to ensure alignment.

Management expects the ETG topline to grow in the mid to upper single digit range. The two divisions combined have a targeted group topline growth of 8-10% per annum. We believe that by continuing its proven strategy, HEICO can sustain its historical earnings compound annual growth rate for many years to come.

Dual-class share structure

HEICO has a dual-class share structure. Some companies have this in place, so that the common stock remains with insiders on a preferential basis. This is not the case for HEICO. The A-shares were created in 1997 through a 3-for-2 stock split to finance an acquisition that did not materialise. The A-shares have 1/10th of the voting rights of the common shares and are also less liquid. The liquidity of the A-shares is more than sufficient for the SilverCross fund.

Risk analysis

A key risk for HEICO is part failure, which could seriously damage its reputation. We regard this risk as small given that HEICO has supplied over 65m parts with zero failures so far. Another risk is the age of the CEO as he will have to retire at some point. His two sons have been with the company for decades and no strategic decisions are made without them so we would be comfortable if one of them was to take over the leadership role. In terms of cyclicality, HEICO’s revenues have historically declined in periods where airlines significantly cut capacity. In the last 20 years this occurred only in the 2008/2009 recession and the period following the 9/11 terrorist attacks. HEICO is somewhat insulated from the severity of any capacity cuts as airlines typically increase their focus on cost saving during these times and consequently increase their sourcing of parts from the likes of HEICO versus OEM’s.

We have been invested in HEICO since March 2016.