HEICO Is Cash Flow Focused

In today’s post, we take a look at HEICO Corporation which has two classes of common stock (HEI and HEI.a). Both classes of shares are virtually identical in all economic respects except voting rights. Each HEI share entitles the shareholder to one vote while each HEI.a share entitles the shareholder to a 1/10 vote. I use the HEI.a share price in various calculations in this post.

If you are unfamiliar with HEI and you follow ‘standard operating procedures’ when analyzing a company, your first step will likely be a review of HEI’s Investor Presentation and website. The ‘subsidiaries’ section of HEI’s website has a wealth of information about some of the companies HEI has under its umbrella.

Your next step will likely be a review of HEI’s 2023 Form 10-K for details about the company.

If you do follow ‘standard operating procedures’, you have set yourself apart from a huge segment of segment of investors who merely make investment decisions based on share price behavior.

These gamblers wouldn’t even know where to find a company’s SEC filings, investor presentations, and earnings call transcripts.

Even if they did stumble upon this material, they likely not ‘waste’ their time because the game plan is to ‘exit’ a position in relatively short order.

Gambling, however, is at odds with how a great company is managed. A great company, such as HEI, is managed to become increasingly successful over the very long-term. Naturally, management must not disregard the short- and medium term otherwise there will be no long-term.

Anybody who had the good fortune of becoming a HEI shareholder decades ago with the view of being a business owner (no matter how minor the investment)….well….read on.

Read this February 19, 2019 Forbes article and The 47,500% Return: Meet The Billionaire Family Behind The Hottest Stock Of The Past 30 Years before proceeding further.

Business Overview

HEI is the world’s largest manufacturer of Federal Aviation Administration (FAA)-approved jet engine and aircraft component replacement parts, other than the original equipment manufacturers (OEM”) and their subcontractors. It is also a leading manufacturer of various types of electronic equipment for the aviation, defense, space, medical, telecommunications and electronics industries.

The company consists of two operating segments:

1. The Flight Support Group consists of HEICO Aerospace Holdings Corp. and HEICO Flight Support Corp. and their collective subsidiaries. This segment accounted for 60%, 57% and 50% of total net sales in fiscal 2023, 2022 and 2021, respectively.
2. The Electronic Technologies Group consists of HEICO Electronic Technologies Corp. and its subsidiaries. This segment accounted for 40%, 43%, and 50% of total net sales in fiscal 2023, 2022 and 2021, respectively. In addition, this group derived roughly 49%, 56%, and 63% of its total net sales in fiscal 2023, 2022 and 2021, respectively,from the sale of products and services to U.S. and foreign military agencies, prime defense contractors and both commercial and defense satellite and spacecraft manufacturers.

Acquisitions are an essential element of HEI’s growth strategy. Since 1990, it has completed nearly 100 acquisitions complementing the niche segments of the aviation, defence, space, medical, telecommunications and electronics industries in which it operates.

It is a very disciplined buyer and looks for strong cash flow and to a lesser extent EPS. It wants to recoup its investment in 7 – 11 years. Furthermore, its strategy is controlled growth with a focus on 15% – 20% bottom line growth.

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.

Acquisitions are generally made from:

• cash from operating activities;
• proceeds from the HEI’s revolving credit facility; and/or
• the issuance of HEI Class A Common Stock.

Ownership Control

Collectively, HEI’s executive officers and entities controlled by them, the HEICO Savings and Investment Plan (401(k) Plan) and members of the Board of Directors beneficially own ~19% of the outstanding Common Stock and ~3% of the outstanding Class A Common Stock. Accordingly, they are able to substantially influence the election of the Board of Directors and control the business, policies and affairs, including HEI’s position with respect to proposed business combinations and attempted takeovers.

A high degree of ownership concentration would be of concern if the controlling parties were acting with little regard for the long-term prosperity of the company or other shareholders. Based on my analysis, however, this does not appear to be the case. I see no ‘red flags’ in how the controlling shareholders manage HEI.

Financials

Q4 and FY2023 Results

On October 18, HEI released its Q4 and FY2023 results and its FY2023 Form 10-K on December 20.

HEI’s leverage (page 58 of 150 in the Form 10-K) has increased significantly in FY2023 following the completion of the Exxelia International acquisition on January 5, 2023. In addition, it completed the acquisition of the Wencor Group, the largest acquisition in the company’s history, on August 4. As expected, this has led to a surge in HEI’s leverage.

The total debt and net debt ratios are higher than historical levels. However, HEI’s EBITDA and Net income attributed to HEICO reflect just one quarter of any income generated from the Wencor acquisition. In addition, the FY2023 results reflect the benefit of just 3 quarters of any income generated from the Exxelia acquisition. These events have the effect of distorting HEI’s FY2023 net debt calculations.

Management has articulated that both highly synergistic acquisitions are expected to be accretive to earnings within the year following closing. In addition, HEI anticipates that it will continue to achieve its often articulated growth objective in the years after the closing.

One of management’s priorities is to restore the total debt to net income attributable to HEI ratio to historically low levels within the next two fiscal years. Investors should, therefore, expect no major acquisitions in the foreseeable future. HEI, however, will continue to actively pursue smaller bolt-on acquisitions from its robust pipeline of acquisition opportunities.

FY2024 Outlook

HEI typically does not provide net sales and earnings guidance. However, management continually states that the company will continue to invest in research and development and execute its successful acquisition program.

Inflationary pressures may lead to higher costs, however, Wencor has yet to be fully integrated. Once fully integrated, some expenses will be lowered.

Encouraging areas of the business are commercial aviation where air travel is recovering. Headwinds, however, are in the high end non aerospace business areas such as high end electronics.

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

HEI’s FY2023 – FY2011 OCF (in millions of $) is $449, $468, $444, $409, $437, $328, $288, $260, $173, $191, $132, $139, and $126.

Its FY2023 – FY2011 CAPEX (in millions of $) is $50, $32, $36, $23, $29, $42, $26, $31, $18, $16, $18, $15, and $9.

The difference between OCF and CAPEX in FY2023 – FY2011 gives us FCF (in millions of $) of $399, $436, $408, $386, $408, $286, $262, $229, $155, $185, $114, $124, and $117.

Credit Ratings

HEI’s domestic senior unsecured long-term debt ratings are:

• Moody’s: Baa2 (newly rated as of June 20, 2023)
• Fitch: BBB (newly rated as of June 14, 2023)

Both ratings are in the middle tier of the lower medium-grade investment-grade category. These ratings define HEI as having an adequate capacity to meet its financial commitments. Adverse economic conditions or changing circumstances, however, are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

*S&P Global does not rate HEI’s debt.*

Dividends and Share Repurchases

Dividend and Dividend Yield

On December 18, 2023, HEI declared its 91st consecutive semi-annual cash dividend since 1979; the dividend history is accessible here. An HEI investment, however, should be made primarily for its capital gains potential.

HEI typically leaves its dividend unchanged for 3 consecutive semi-annual periods. The recent dividend declaration marks the 3rd consecutive semi-annual dividend at the $0.10 level. I expect the declaration of a $0.01 dividend increase in the second half of June 2024 for distribution in mid July.

Stock Splits and Share Repurchases

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

The weighted average number of common shares outstanding in the FY2023 – FY2016 time frame is 138.905, 138.037, 137.854, 137.302, 137.350, 136.696, 135.588, and 133.145 (millions of shares).

Details of HEI’s share repurchases commence on page 106 of 150 in the FY2023 10-K.

We see from HEI’s FY2023 Condensed Consolidated Statements of Cash Flows (page 63 of 150), that share repurchases are negligible and are related to the redemption of common stock related to stock option exercises as opposed to share repurchases on the open market.

Looking at the FY2023 Condensed Consolidated Statements of Cash Flows, we see that HEI issues shares as part of its employee compensation structure. Furthermore, it also issues HEI.a shares to the sellers of many of the companies it acquires thus permitting the sellers to participate in HEI’s wealth creation model.

Valuation

HEI’s diluted EPS for the FY2023 – FY2016 time frame is $2.91, $2.55, $2.21, $2.29, $2.39, $1.90, $1.37, and $1.17. The diluted PE ratio for HEI.a shares during the same time frame is 64, 47, 58.15, 51.12, 37.46, 33.16, 29.55, and 29.65. The valuation is higher for the HEI shares.

On January 8, a young investor I am helping on the journey to financial freedom acquired HEI.a shares at just under $135. Using this share price and the current broker-adjusted diluted EPS guidance, the forward adjusted diluted PE levels are:

• FY2024 – 15 brokers – mean of $3.44 and low/high of $3.23 – $3.76. Using the mean, the forward adjusted diluted PE is ~39.2.
• FY2025 – 14 brokers – mean of $4.06 and low/high of $3.83 – $4.45. Using the mean, the forward adjusted diluted PE is ~33.3.
• FY2026 – 6 brokers – mean of $4.49 and low/high of $4.25 – $4.80. Using the mean, the forward adjusted diluted PE is ~30.1.

I place any reliance on the FY2026 estimates in assessing HEI’s valuation because:

• Only 6 brokers provide their FY2026 estimates; and
• Much can change in 2 years. I do not believe anybody can reasonably predict how a company is going to perform this far into the future.

Executive management repeatedly stresses that cash flow is of greater importance than EPS. The focus of all key personnel in the companies that fall under the HEI umbrella is to make the correct economic decisions to drive cash flow and long term value; the creation of short term earnings is not a priority.

Since cash flow is of greater importance to HEI’s leadership, it only makes sense that investors should try to assess HEI’s valuation based on cash flow.

Looking at several years of Consolidated Statement of Cash Flows, we see that HEI’s earnings are distorted by non-cash Depreciation and Amortization. In FY2018 – FY2023, for example, HEI’s annual depreciation and amortization were ~$130, ~$96, ~$93, ~$89, ~$85, and ~$77 million in FY2023 – FY2018. These figures are typically in the range of 25% – 30% of HEI’s annual Net income from consolidated operations.

Looking at HEI’s valuation using Price/OCF, we see that Net cash provided by operating activities (in millions) in FY2023 – FY2018 was ~$449, ~$468, ~$444, ~$409, ~$437, and $328.

The weighted average number of common shares outstanding (in millions) in FY2023 – FY2018 was ~139, ~138, ~138, ~138, ~137, ~137, and ~137.

Using these figures, we get OCF/share values of ~$3.23, ~$3.39, ~$3.24, ~$3, ~$3.20, and ~$2.40 for FY2023 – FY2018.

Using the current ~$135 share price and ~$3.23 in FY2023 OCF, the Price/OCF level is ~41.8.

HEI’s OCF is generally higher than its EPS. If we conservatively estimate that HEI’s FY2024 OCF will be 117% of its $3.44 FY2024 forward adjusted diluted EPS, we should expect HEI’s FY2024 OCF to be ~$4.02 (117% x $3.44). Using the recent purchase price of just under $135, the forward Price/OCF level is ~33.6.

If we estimate that HEI’s FY2025 OCF will be also be 117% of its $4.06 FY2025 forward adjusted diluted EPS, we should expect HEI’s FY2025 OCF to be ~$4.75 (117% x $4.06). Using the recent purchase price of just under $135, the forward Price/OCF level is ~28.4.

HEICO Is Cash Flow Focused – Final Thoughts

HEI’s track record of a high level of discipline leads me to think it will continue to create wealth for long term shareholders.

If dividend metrics are key in your decision making process, HEI may not appeal to you. Dividend metrics, however, are of little importance to me. I focus on quality, risk, and a company’s total potential long term investment return.

One of the young investors I am helping on their journey to financial freedom acquired HEI.a shares on January 8 in a Tax Free Savings Account (TFSA). While this investor will incur a 15% dividend withholding tax on all dividends distributed, the dividend component of the HEI.a investment is immaterial.

HEI.a’s Average Annual Total Return (AATR) over the past 10 years slightly exceeds 20%. I know historical performance does not predict future performance but I am reasonably confident this HEI.a investment should be able to generate at least a 15% AATR; the company’s strategy is controlled growth with a focus on 15% – 20% bottom line growth.

Applying the Rule of 72, this HEI.a investment should be able to double in value in just under 5 years.

NOTE: The Rule of 72 is a quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. Alternatively, it can compute the annual rate of compounded return from an investment, given how many years it will take to double the investment.

Should the AATR fall short of the company’s minimum 15% bottom line growth and come in a 10%, the investment should theoretically double in value in ~7.2 years.

This young investor should not need to access any investment within their TFSA during their lifetime. If we err on the side of caution, however, and assume this young investor will access this investment in ~50 years, this investment should have had enough time to significantly appreciate in value.

Keeping in mind the disclaimer reflected below, you might want to take a closer look at HEI.a if you are a young investor with a very long investment time horizon. Even though I am DEFINITELY not going to live another ~50 years, I think enough of HEI.a to have made it my 25th largest holding when I completed my 2023 Year End FFJ Portfolio Review.

I own HEI.a shares as opposed to HEI shares primarily from a valuation perspective; the HEI shares are currently ~$36/share more expensive. Although I only receive one vote for each share owned as opposed to 10 votes for each HEI share, I only own 400 shares in a ‘Core’ account and 400 shares in a ‘Side’ account in the FFJ Portfolio. My votes, therefore, are irrelevant.

Author Disclosure: I am long HEI.a. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author 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.

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