Heico

Heico's fiscal third-quarter results brought 23% revenue and 34% operating profit growth year over year. Excluding businesses acquired in the last year, Heico's consolidated revenue grew organically by around 14% in the period.

Why it matters: The strong performances of the underlying businesses amplified by the 2023 acquisition of Wencor, which is yielding multiple cross-selling opportunities, are driving organic revenue and profit growth that outstripped our forecasts. Heico's electronic technologies segment, which brings in about one-third of company sales, grew 36% in the quarter, half of that organic and half from recently acquired businesses. In the flight support business, representing two-thirds of total revenue, 6 points of the segment's quarterly 18% revenue growth were due to folding in acquisitions completed within the last year.

The bottom line: We have increased our medium-term organic sales growth forecast by about 2 percentage points, which resulted in our fair value estimate increasing from $290 per share to $294.

Bears say: Some investors concerned about a potential slowdown in aircraft maintenance demand traded Heico shares down about 8% in recent weeks. We still see Heico stock as about 15% overvalued, but not because of a concern about aftermarket demand. In fact, we model Heico's organic aerospace growth at double the growth rate of our forecast for global revenue passenger miles, which is a good proxy for demand for aircraft maintenance. To approximate the stock's recent price above $330 per share, we would have to forecast organic aerospace revenue to grow at 2.5 times global RPMs in perpetuity, which is possible but not the most likely, in our view.

Our $294 fair value estimate implies a price to fiscal 2026 estimated earnings multiple of 47 times and an enterprise value of 27 times our estimated 2026 EBITDA. These multiples are meaningfully higher than those of other industrial companies, justified by robust organic growth opportunities driven by strong secular demand in the aerospace aftermarket, growth of Heico's most-profitable business lines, and ample opportunities for accretive acquired growth in a fragmented industry.

The company lists Class A shares with only one-tenth the voting rights of its regular common shares under the listing HEI.A. The company uses these shares to pay for some acquisitions and in some of its compensation plans. We think investors should only consider the regular voting shares listed as HEI for their portfolios.

We anticipate that Heico can grow significantly faster than the overall commercial aftermarket due to continued strong organic and acquired growth. We anticipate average 10.5% organic revenue growth over the next five years, reflecting the supply-constrained postpandemic demand rebound in the near term moderating somewhat to the growth of overall air traffic volume plus moderate pricing increases over the long term. With a long pipeline of acquisitions, we see the aerospace segment achieving 16.5% compound growth through 2030. In defense, we attribute our organic growth assumptions to missiles and space spending, given the company’s product exposure in these areas, a roughly 15% medium-term growth rate, including acquisitions.

We forecast that Heico will achieve healthy margin expansion, moving from a five-year trailing average of 21.7% to a midcycle operating margin of 30%. We expect operating leverage to increase as growth drives fixed costs to a smaller share of the firm's cost structure and as acquired companies become more efficient.

We expect capital expenditures to grow to about $80 million per year, but at a slower pace than sales, tapering to about 1.3% of revenue, down from historical averages above 1.5%. We apply an 8.8% weighted average cost of capital to discount our cash flow projections, reflecting an average cost of equity and very little debt in the overall capital structure. Heico tends to purchase companies with cash generated from operating activities.

We assign Heico a narrow moat rating based on intangible assets stemming from product complexity and a strict regulatory environment as well as switching costs stemming from the importance of its products operating correctly and their placement on long-cycle products. Although Heico produces very respectable midteens returns on invested capital, according to our modeling, and some aspects of its competitive advantage are quite durable, we constrain our moat rating to narrow because its commercial business model is ultimately dependent on a lack of new entry into the PMA market by marginal suppliers and rational competition with OEMs. We do not have enough confidence that both these conditions, which are outside of Heico's control (particularly rational competition with OEMs), would necessarily hold over 20 years and thus support a wide moat rating.

Heico is the largest independent (non-OEM) producer of replacement parts for aircraft and produces niche subcomponents for defense products. As its commercial aerospace and defense businesses operate distinct business models, we believe the best way to analyze the company is by end market.

Typically, original equipment manufacturers for aviation products sell the original product at a loss or very low margin and make up their massive development costs by exploiting monopolistic pricing power in subsequent maintenance and repair business—the aftermarket. Heico reverse-engineers engine and aircraft components, gets regulatory approval to sell or install them as functionally identical to the original, and then competes with OEMs for about 2%-3% share of the overall aftermarket, generally for older planes and engines. Heico’s third-party parts are known as PMA parts. Heico also runs its own maintenance, repair, and overhaul shops that allow it to effectively distribute these parts through subcontracted repairs, and the company sells directly to other MRO shops. Heico typically sells at a discount to OEMs and by our estimate controls the majority of this market. It is important to note that Heico competes with OEMs in a somewhat indirect way, as the latters' business model is focused on gaining as much content as possible on the first two maintenance cycles (roughly the first 10-15 years of an aircraft’s life), whereas Heico focuses almost exclusively on content for the final 10 years of an aircraft’s life. This works for customers because the use of PMA parts is seen as destroying the resale value of the aircraft, especially by lease operators: airlines and lessors tend to seek to maintain resale value on younger aircraft by shopping with OEMs and switching to PMAs when maintenance costs become more important and resale less so on older aircraft.

We see intangible assets in the form of product complexity, a stiff regulatory process, and a difficult-to-replicate distribution channel, all of which pose barriers to entry. Most aerospace components are manufactured to exacting standards and must be tested individually to show they meet those standards. The regulatory process, which enforces these specifications, can take years, and the FAA scrutinizes entrants more than incumbents. A new or marginal entrant would eventually need to replicate hundreds of parts to present a viable parts catalog and gain entry to the repair and maintenance marketplace; the incremental cost of integrating a new/different PMA supplier in a complex maintenance operation would initially at least offset the potential savings on a part.

Heico reverse-engineers very-small-niche components in commercial engines and aircraft. The difficulty of replicating technology can be seen in the time required to develop an engine, as it took nearly 20 years for Pratt & Whitney to develop the geared turbofan engine. It usually takes 10 years and millions of dollars of consistent research and development before Heico begins earning material revenue off an aircraft or engine platform, and the firm cites its R&D expenditure as a source of competitive advantage. We think that the time and effort required for another supplier to enter this market is a high enough barrier that most would-be competitors are not willing. Heico is dominant in the global PMA market, supplying about half of all third-party spare parts for the commercial aftermarket, which we think is tangible evidence of the barrier to entry in action.

Heico also runs the largest independent MRO shop, giving it a distribution network for its parts that would be expensive and difficult to replicate. This integrated MRO shop makes it much easier for Heico to place these parts with airlines and allows Heico to sell its products. The difficulty of generating a broad parts portfolio and a distribution network that allows Heico to consistently sell its parts reinforces its intangible asset base.

Switching costs come from a highly risk-averse customer base with complex maintenance operations. Airlines face substantial cost of failure; Heico has a 30-year record of never having a part fail in flight, which is difficult to replicate and likely makes airlines substantially more willing to use Heico parts as spares rather than those from other smaller PMA suppliers. Heico alone serves over half the PMA market in terms of parts volume, and Lufthansa holds a 20% stake in Heico's aerospace operation, which is a vote of confidence in the company from a major global airline.

We see switching costs from the requirement that airlines have properly maintained aircraft to perform the core function of their business. Airlines must maintain aircraft to type-certificate standards and must periodically disassemble and reassemble aircraft to check whether wear and tear requires new parts. Airlines cannot forgo this maintenance and must pay the required price to fly passengers on the aircraft. In many cases, the only viable alternative for Heico parts is the OEM part, which is generally much more expensive as OEMs use monopolistic pricing to cover the substantial R&D required to create the initial part.

The second switching cost is the long-cycle nature of the products Heico sells replacements for. Many commercial aircraft engines have decades of production and are used for decades after the product is out of production. For example, International Aero Engines’ V2500 engine had its first run in 1987 and is still used to power A320s because it is generally more economical for airlines to repair an engine than to purchase a new engine and fit it onto an aircraft. This long product cycle is quite common across the aviation industry for aircraft and engine products. The long life of the products that Heico provides spare parts for gives the company great revenue visibility, as it can capitalize development of spare parts over many decades.

We think the company’s exposure to defense has a wide moat, but this is not enough to apply to the overall firm. Heico produces subcomponents for a variety of defense products, which we think is protected by intangible assets stemming from product complexity. We see switching costs stemming from a lack of viable alternatives and product placement on more complex, longer-cycle products.

We think that Heico benefits from substantial, but not insurmountable, product complexity. While we think a small subset of other defense companies could replicate the laser range-finder receivers, electro-optical, microwave, and power equipment Heico produces, we think it would require time and money they could likely deploy elsewhere. We think the fact that Heico’s products must be able to withstand harsh environments, such as space and high heat, adds to product complexity, but we do not think this is an insurmountable barrier and is common in the defense and aerospace sector.

We think switching costs, particularly given the product's mission-criticality, are Heico’s primary moat sources in its defense exposure. The company’s components are well integrated into targeting systems, satellite systems, ships, and aircraft. In some cases, particularly for spacecraft, repairing a subcomponent is prohibitively difficult, which makes customers reluctant to switch to an untested supplier. In many cases, the subcomponent is tied to a critical function of the product, such as a missile targeting system, an aircraft’s power system, or a ship’s communication system, which we think reduces the probability of a customer switching to an alternative supplier.

We see switching costs stemming from the time and effort required to switch to an alternative provider, as well as product placement on longer-cycle products. While we think large defense primes can replicate the subcomponents that Heico produces, Heico produces a wide variety of small-batch subcomponents that would need to be replicated individually. While, in aggregate, this is a highly profitable business, we think the time and effort required to vertically integrate are likely not worth it for defense primes, particularly given the structure of defense contracts. Typically, defense contracts are initially awarded on a cost-plus basis and gradually transition to a fixed-price basis. At this point, the components, which may represent a small fraction of the cost of the entire system, are well integrated into complex systems that would be prohibitively difficult to reengineer with new components for tiny incremental bits of margin. While the components themselves may be easy to replicate, the complex systems they are integrated into are not, which we think constitutes a substantial switching cost for the prime contractors.

Heico independently develops replacement parts for highly complex aircraft components—the juiciest market segment in aerospace, with a fraction of the required R&D of OEMs.

Heico's components for defense products are highly integrated into complex systems, which makes their replacement or substitution difficult and unlikely.

Heico has a record of acquiring quality companies at reasonable prices.

Private equity firms have entered the defense supplier market and may push up prices for target companies, which could dent Heico's ability to generate value-accretive inorganic growth.

Heico's defense sales depend on US military funding and priorities, which are always subject to change.

As Heico grows, it may become harder over the long term to maintain peaceful relations with the OEMs whose parts it copies.