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Heico Corporation (HEI) is a successful and growing technology-driven aerospace, industrial, defense and electronics company. Business is comprised of two operating segments: Flight Support Group (FSG) and Electronic Technologies Group (ETG).
HEI's performance has been negatively impacted in recent quarters because of the challenges its FSG customer base is experiencing due to the the COVID-19 pandemic. The company, however, has a very manageable debt level, remains profitable, and generates very strong Free Cash Flow.
Summary
- Heico Corporation’s (HEI) recent results have been weak given that its Flight Support Group’s commercial aerospace customer base has been negatively impacted by COVID-19.
- Despite the challenging business environment, HEI continues to generate profits and strong Free Cash Flow.
- The company employs a very conservative degree of leverage.
- The company has a proven acquisition strategy and growth shall continue to come via organic growth and through further acquisitions that meet HEI strict acquisition standards.
- The dividend yield is negligible as management is of the opinion that retaining funds in the company can yield far superior long-term investor returns.
- The current valuation is such that I am not prepared to increase my exposure at this point in time.
NOTE: HEI has two classes of common stock that are virtually identical in all economic respects except voting rights. Each share of Common Stock is entitled to one vote per share. Each share of Class A Common Stock is entitled to a 1/10 vote per share. Holders of the Company’s common stock are entitled to receive dividends and other distributions payable in cash, property, stock or otherwise, when and if declared by the Board of Directors.
HEI prefers to pay cash for its acqusitions but the Class A shares were created in 1999 for the purpose of being able to use HEI shares as a medium of exchange for large transformational deals.
I own Class A shares and am using the price of these shares in my analysis.
Introduction
In September 2019 I initiated a position in HEICO Corporation (HEI-a and HEI) immediately after disclosing in this article that I would be acquiring HEI’s non-voting Class A shares through one of the ‘Side Accounts’ within the FFJ Portfolio.
Business Overview
HEI is a successful and growing technology-driven aerospace, industrial, defense and electronics company. Business is comprised of two operating segments: Flight Support Group (FSG) and Electronic Technologies Group (ETG).
A comprehensive overview of HEI’s business, competition, and risk factors can be found commencing on page 4 of 143 in the 2020 10-K and in HEI’s Investor Presentation.
FSG’s commercial aerospace products and services continue to be negatively impacted mainly due to the continued suppressed demand in global commercial air travel as a result of COVID-19.
The products and services designed and manufactured by ETG, however, have not experienced the same impact from the pandemic. This operating segment produces mission-critical subcomponents that must successfully operate in the harshest environments which are utilized in larger systems power, targeting, tracking, identification, simulation, testing, communications, lighting, surgical, medical imaging, baggage scanning, telecom and computer systems and are often located on aircraft, rotorcraft, satellites, ships, spacecraft, land vehicles, handheld devices and other platforms.
HEI has grown organically and also through multiple acquisitions over the years. Its culture drives the bottom line and success of the company and appeals to entrepreneurs who watch every dollar and work 24x7 - an asset that does not appear on the balance sheet.
Senior management spends a fair amount of time studying the market and is keenly aware of its peers so if an acquisition opportunity presents itself, HEI is ready to act upon it given its very strong balance sheet. Management, however, has indicated that it in the past it has looked at some very large transactions but it has been priced out of the market. Senior management has indicated it will not pay ~12 - 14 times EBITDA since that is not part of the company's strategy.
Q1 2021 Results
On February 23, 2021 HEI released Q1 2021 results.
HEI reported that demand for its commercial aerospace products and services were negatively impacted in Q1 2021 mainly due to the continued suppressed demand in global commercial air travel.
Details of the gross and operating margins for the two operating segments can be found in the Press Release. We see that the headwinds experienced by the FSG segment resulted in a Q1 Operating Margin of ~19.2% versus ~22% in Q1 2020.
Cash flow provided by operating activities increased ~32% to $107.2 million in Q1 versus $81.1 million in Q1 2020.
Free Cash Flow in Q1 amounted to $91.7 million versus $74.3 million in Q1 2020 (Net cash provided by operating activities minus capital expenditures). This more than adequately covered the semi-annual dividend of ~$10.8 million and enabled HEI to make a $70 million reduction on its borrowings on the revolving credit facility.
HEI’s current ratio (current assets/current liabilities) improved to 4.89 times in Q1 2021 versus 4.83 times in Q1 2020 and 4.83 times in Q4 2020.
FY2021 Guidance
In the February 23, 2021 Earnings Release, management stated:
‘As we look ahead to the remainder of fiscal 2021, the Pandemic will likely continue to negatively impact the commercial aerospace industry and HEI. Given this uncertainty, HEI cannot provide fiscal 2021 net sales and earnings guidance at this time. However, we believe our ongoing fiscal conservative policies, healthy balance sheet, and increased liquidity will permit us to invest in new research and development and gain market share as the industry recovers.’
Credit Ratings
None of the ratings agencies cover HEI as HEI does not require credit ratings to raise financing. Funding is derived from Free Cash Flow generated from normal business operations and from a $1.5B credit facility which may be increased to $1.85B under certain circumstances (see Press Release).
HEI’s ‘Net debt to shareholders' equity ratio’ as at January 31, 2021 amounted to 13.0%. By comparison, HEI reported 29.8% as at October 31, 2019. 27.9% as at January 31, 2020, 20.8% as at April 30, 2020, 17.7% as at July 31, 2020, and 16.6% as at FYE October 31, 2020. The very conservative use of leverage is ideal for my risk averse nature.
Furthermore, HEI’s net debt to EBITDA ratio improved to .62x as of January 31, 2021 from .71x as of October 31, 2020 and there are no significant debt maturities until fiscal 2024.
Details about HEI’s long-term debt and revolving credit facility can be found on pages 84 and 85 of 143 in the 2020 10-K.
HEI is unlikely to appeal to dividend income seeking investors as its dividend yield is well below 0.5%.
The company has no ‘dividend’ page on its website, and therefore, I direct you here to view HEI’s dividend history; a dividend is distributed at the beginning and middle of each calendar year. The January 21, 2021 semi-annual dividend was the company’s 85th consecutive semi-annual cash dividend (see here).
HEI has initiated stock splits on several occasions with details of the most recent stock splits being available here.
In 1990, HEI’s Board of Directors authorized a share repurchase program, which allows the repurchase of HEI common stock in the open market or in privately negotiated transactions at HEI’s discretion, subject to certain restrictions included in HEI’s revolving credit agreement. Details of HEI’s share repurchase program can be found on page 97 of 143 in the 2020 10-K.
Valuation
When I wrote my September 15, 2019 article HEI had generated $1.76 in YTD diluted EPS as at the end of Q3 2019 versus $1.40 for the first 3 quarters of FY2018; on an adjusted basis HEI had generated YTD EPS of $1.77. At the time, adjusted EPS guidance for FY2019 was $2.33 and $2.59 for FY2020 from 11 and 12 brokers, respectively. Using the $98.02 share price for the Class A shares as at September 13, 2019, I arrived at a forward adjusted PE of 42.06.
HEI generated $2.29 in diluted EPS in FY2020. When these results were released December 21, 2020, HEI Class A shares were trading at ~$118 giving us a PE of ~51.5.
Management has not provided FY2021 guidance and my sources of information reflect 11 brokers as having provided a low/high and mean FY2021 adjusted diluted EPS estimates of $2.06, $2.33, and $2.23. Using the current ~$123 share price we get a forward adjusted PE range of ~52.7 - ~59.7 and ~55.2.
We also see from the February 23, 2021 Press Release that HEI has generated Q1 diluted EPS of $0.51. Let’s give HEI the benefit of the doubt that it will generate $2.20 in FY2021 diluted EPS. The Class A shares are currently trading at ~$123 so on the basis of $2.20 in diluted FY2021 EPS we get a forward PE of ~56!
Looking at HEI’s valuation from a Price/Free Cash Flow perspective in FY2011 – 2020, HEI generated FCF/share of ~$0.892, ~$0.946, ~$0.87, ~$1.326, ~$1.462, ~$1.722, ~$1.926, ~$2.095, ~$2.978, and ~$2.818. Using the average share price for each year during this timeframe and dividing same by the FCF/share figures above we arrive at Price/FCF valuations of ~12.26, ~12.42, ~19.06, ~16.17, ~16.12, ~16.39, ~22.18, ~30.04, ~31.35, and ~31.37.
We can see that on the basis of the P/E and Price/FCF metrics, HEI is currently richly valued.
Final Thoughts
Even if HEI were to suddenly experience a significant resurgence in its FSG segment and were to generate a remarkable improvement in earnings and FCF in the remaining 3 quarters of the current fiscal year leading to $3.25 in FY2021 EPS and FCF per share, we would be looking at a ~37.8 forward PE and forward Price/FCF based on the current ~$123 share price.
An argument can be made that I should sell my HEI shares given that I am of the opinion shares are grossly overvalued. As a long-term investor, however, I take the position that I am a part business owner versus a ‘trader’ and I do not sell shares unless I think there has been a material permanent deterioration in the business in which I have invested. Such is not the case with HEI. In fact, HEI is an extremely well managed company which I think will be far more valuable in the future.
Since a return on an investment in HEI will be predominantly in the form of capital gain, it is imperative I not overpay for HEI shares. I am of the opinion HEI’s share price is vulnerable to a pullback in the short-term and do not intend to acquire additional shares at this time.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long HEI-a.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
