HEICO - A Defense and Aerospace Gem

HEICO (HEI) is a Defense and Aerospace gem with which many investors might be unfamiliar. Other investors might have encountered HEI. Because they fixate on dividend yield and consecutive years of dividend increases, however, they cast aside this potential investment.

Before we go further, feast your eyes on HEI's 31-year cumulative total return relative to a couple of indexes.

Investors who had the foresight to invest $100 in HEI in 1990 and had the discipline to remain an investor over 3 decades would have had an investment valued at ~$60,000 as of October 31, 2021 (HEI's fiscal year end).

Hopefully, I have piqued your interest!

I last reviewed HEI in my June 12, 2021 post. With the May 23 release of Q2 2022 results, this is an opportune time to revisit it.

Business Overview

The company's history dates back to 1957.

Part 1 of the FY2021 10-K has a good overview of HEI's industry, customers, business strategy, solutions and risks.

Two Classes of Common Stock

HEI has (HEI.a) and (HEI) listed shares. Both classes of shares are virtually identical in all economic respects except voting rights. The difference is that each HEI share is entitled to one vote per share while each HEI.a share is entitled to a 1/10 vote per share.

Growth Through Acquisitions

Acquisitions have been an important element of HEI's growth strategy. Since 1990, it has completed ~88 acquisitions complementing the niche segments of the aviation, defense, space, medical, telecommunications and electronics industries in which it operates.

HEI serves as a unique opportunity for entrepreneurs looking for additional partners to bring into their company. Because of its history, HEI has become an acquirer of choice because management understands what it is to be an entrepreneur and knows what it is like to operate a small business. It is not a private equity firm looking to sell the business nor is it a large corporate acquirer that will eliminate the essential nature of what made the company successful. HEI strives to maintain the uniqueness and individuality of its businesses to ensure it has passionate people who want to listen to their customers and deliver exactly what the customer needs.

HEI typically targets acquisition opportunities that allow it to broaden its product offerings, services and technologies while expanding its customer base and geographic presence. Even though HEI has pursued an active acquisition policy, its disciplined acquisition strategy involves limiting acquisition candidates to businesses that management believes will continue to grow, offer strong
cash flow and earnings potential, and are available at fair prices.

Historically, HEI quickly integrates its acquisitions. This results in them being accretive to earnings in the year following the purchase.

Pioneer Industries Acquisition

In February 2022, HEI announced it had entered into an agreement to acquire 74% of Pioneer Industries, LLC for cash at closing, plus potential additional cash consideration to be paid if certain post-closing earnings levels are attained. Additional financial details were not disclosed.

With this acquisition, Pioneer's owners and leaders (brothers whose family founded Pioneer in 1945) will retain 26% of Pioneer's equity and continue in their current roles with the company.

HEI often employs this method of acquisition when the owners of the company being acquired express an interest in staying involved and HEI considers this to be an optimal means by which to acquire the target company.

In acquisitions where the sellers retain Redeemable Noncontrolling Interests, they hold equity interests and have 'Put Rights' that require HEI to provide cash consideration for their equity interests at fair value or at a formula that management intended to reasonably approximate fair value based solely on a multiple of future earnings over a measurement period. The Put Rights are
embedded in the shares owned by the noncontrolling interest holders and are not freestanding.

The total value of these Redeemable Noncontrolling Interests as of April 30, 2022 amounted to ~$0.304B. At FYE2021 (October 31, 2021), the total was ~$0.253B.

A summary of the Put Rights associated with the redeemable noncontrolling interests in certain of HEI's subsidiaries as of FYE2021 is found on page 97 of 124 in the FY2021 Form 10-K.

Flight Microwave Acquisition

In March 2022, HEI announced that its Lucix subsidiary acquired 100% of the stock of Flight Microwave Corporation in an all cash transaction. Further financial terms and details were not disclosed.

Unlike the Pioneer Industries acquisition, the shareholders of Flight Microwave are selling the company outright.

In this acquisition, Flight Microwave will operate as part of HEI's Lucix subsidiary and will eventually relocate to Lucix's Camarillo, California headquarters, engineering and production center.

Flight Microwave and Lucix are located ~57 miles from each other. By consolidating Flight Microwave's operations under Lucix's roof, HEI reduces overhead. Other efficiencies will also be realized even though nearly all of Flight Microwave's team will remain with the business post-closing.

Financials

Q2 and YTD2022 Results

HEI's Q2 and YTD2022 results are accessible in Form 8-K; the Form 10-Q has yet to be released.

HEICO - Non-GAAP Financial Measures Q2 2021 and Q2 2022

FY2022 Outlook

HEI is not immune to cost inflation and potential supply chain disruptions stemming from the pandemic. It has experienced increases in costs of labour, materials and services consistent with overall rates of inflation. The impact of such increases on net income attributable to HEI has been generally minimized by efforts to lower costs through manufacturing efficiencies and cost reductions as well as selective price increases.

Even though the COVID pandemic will likely continue to adversely impact the commercial aerospace industry, management expects the commercial air travel recovery to continue, particularly in certain domestic travel markets, while less so in international markets. While management remains confident in the recovery of its target markets and the potential for sales increases, the timing is uncertain.

The pace of recovery in global travel remains difficult to predict. HEI, therefore, is not providing guidance other than to estimate an FY2022 CAPEX of ~$45 million.

Operating Cash Flow (OCF) Free Cash Flow (FCF)

HEI's FY2021 - FY2011 OCF (in millions of $) is $444, $409, $437, $328, $288, $260, $173, $191, $132, $139, and $126.

Its FY2021 - FY2011 CAPEX (in millions of $) is $36, $23, $29, $42, $26, $31, $18, $16, $18, $15, and $9.

The difference between OCF and CAPEX in FY2021 - FY2011 gives us FCF (in millions of $) of $408, $386, $408, $286, $262, $229, $155, $185, $114, $124, and $117.

In the first half of 2022, HEI's OCF is ~$175 million (~$78 million in Q1 and ~$97 million in Q2). Back out ~$16 million in CAPEX and YTD FCF is ~$159 million.

If HEI generates ~$95 million of OCF in each of Q3 and Q4, then FY2022 OCF should end up at ~$365 million. Back out management's FY2022 ~$45 million CAPEX projection and FCF should be ~$320 million.

HEI has demonstrated over many years that it has a sound formula to generate OCF and FCF to finance its growth and reward shareholders.

Credit Ratings

HEI's debt is not rated.

The Company's borrowings under its revolving credit facility mature in FY2024 and the weighted average interest rate on borrowings under the Company's revolving credit facility is 1.1%. This facility contains both financial and non-financial covenants for which HEI is in compliance.

HEI has no significant debt maturities until FY2025 and plans are to use the company's financial strength and flexibility to aggressively pursue high-quality acquisitions of various sizes to accelerate growth and maximize shareholder returns.

Dividends and Share Repurchases

Dividend and Dividend Yield

On December 20, 2021, HEI declared its 87th consecutive semi-annual cash dividend since 1979. This dividend was distributed on January 20, 2022 and marked the 2nd consecutive dividend at the $0.09/share level. HEI will likely declare a semi-annual dividend at the end of June for distribution in mid-July. I expect the dividend to be increased to $0.10/share.

With the HEI.a shares trading at ~$109, the new dividend yield will be sub 0.2%. Please refer to the graph and chart at the beginning of this post if you are disappointed.

Stock Splits and Share Repurchases

HEI has had six 5 for 4 stock splits over the years.

A stock split increases the number of outstanding shares and reduces the share price; the value of the company does not change.

The weighted average number of common shares outstanding in the FY2021 - FY2016 timeframe is 137,854, 137,302, 137,350, 136,696, 135,588, and 133,145 (millions of shares). The Q2 2022 financials reflect 137,916 million outstanding shares.

Details of HEI's share repurchases commence on page 89 of 142 in the FY2021 10-K.

Valuation

HEI's diluted EPS for the FY2021 - FY2016 timeframe is $2.21, $2.29, $2.39, $1.90, $1.37, and $1.17. The diluted PE for HEI.a shares during the same timeframe is 58.15, 51.12, 37.46, 33.16, 29.55, and 29.65. In contrast, the diluted PE for the HEI shares is 65.26, 57.82, 47.76, 40.78, 35.37 and 33.69.

HEI's valuation is rich if we rely on EPS and diluted PE to determine valuation. HEI's acquisition strategy, however, results in sizable depreciation and amortization expenses on the Consolidated Statement of Cash Flows (~$46.7 million in the first half of FY2022 and ~$93, ~$89, ~$85, and ~$77 million in FY2021 - FY2018). These are expenses that reduce EPS but they do not negatively impact cash flow.

Rather than rely on EPS, I use net cash provided by operating activities divided by the weighted average number of common shares outstanding.

Net cash provided by operating activities (in millions) in the first half of FY2022 and FY2021 - FY2018 was ~$175, ~$444, ~$409, ~$437, and $328.

The weighted average number of common shares outstanding (in millions) in the first half of 2022 and FY2021 - FY2018 was ~138, ~138, ~137, ~137, and ~137.

Using these figures we get OCF/share values of ~$3.24, ~$3, ~$3.20, and ~$2.4 for FY2021 - FY2018. I envision the number of outstanding shares for FY2022 will remain at ~138 million. As estimated earlier in this post, OCF will come in at ~$365 million. If my estimates pan out, we are looking at ~$2.65 in OCF/share.

HEI.a is trading at ~$109. Divide this by ~$2.65 and we get a Price/OCF of ~41.

HEI is trading at ~$135. Divide this by ~$2.65 and we get a Price/OCF of ~51.

If we look at HEI using adjusted diluted earnings, the valuation based on FY2022 estimates is somewhat similar to my Price/OCF estimate.

Using the ~$109 HEI.a share price and current broker guidance, the forward adjusted diluted PE levels are:

  • FY2022 - 15 brokers - mean of $2.61 and low/high of $2.40 - $2.78. Using the mean, the forward adjusted diluted PE is ~42.
  • FY2023 - 13 brokers - mean of $3.00 and low/high of $2.75 - $3.26. Using the mean, the forward adjusted diluted PE was ~36.

Using the ~$134.50 HEI share price and current broker guidance, the forward adjusted diluted PE levels are:

  • FY2022 - 15 brokers - mean of $2.61 and low/high of $2.40 - $2.78. Using the mean, the forward adjusted diluted PE is ~52.
  • FY2023 - 13 brokers - mean of $3.00 and low/high of $2.75 - $3.26. Using the mean, the forward adjusted diluted PE was ~45.

At the time of my June 12, 2021 post, FY2021 adjusted diluted earnings estimates from 13 brokers were a mean of $2.18 and a low/high range of $2.08 - $2.25. Based on the ~$130.50 HEI.a share price, the forward adjusted diluted PE was ~60 based on the mean estimate and ~58 based on the high end of the range.

Final Thoughts

I initiated a position in the HEI.a shares on September 16, 2019 within one of the 'Side' accounts within the FFJ Portfolio and added to my exposure in June 2021.

On March 18, 2022, I transferred 400 shares from one account to another for tax planning purposes. This has led to the new adjusted cost base reflected on my monthly FFJ Portfolio reports.

I chose to invest in the Class A shares because HEI.a's share price is generally much lower than that of HEI so the valuation is somewhat more favourable.

HEI's total investment return following my September 2019 purchase is somewhat abysmal considering the title of this post is HEICO - A Defense and Aerospace Gem. Within a few months of initiating my position, the aerospace sector was hard hit as a result of COVID. Many global economies came to a grinding halt and air travel fell off the map. The fact that HEI has still been able to post reasonably decent results over the past couple of years demonstrates this company's resiliency.

I can understand why you might be reluctant to invest in HEI but before you rule it out as an investment, I encourage you to read the following Forbes articles.

Despite recent challenges and ongoing headwinds, I have complete confidence that HEI will generate attractive returns over the long term. I intend to continue to periodically increase my exposure.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long HEI.a.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.