HEICO: Flying under the radar
At Constantia, we look to own businesses that can sustainably compound our investors’ capital through economic cycles. Our investment process seeks to identify cash flow compounders that are run by management teams with the ability and skill to allocate the surplus capital the business produces into new opportunities which accelerate the organic growth profile or widen the moat of the business. A recent addition to the fund that possesses many of the qualities we look for is HEICO Corporation, an aerospace and electronics company that provides mission critical parts for aircraft.
In our opinion, HEICO is one of the best companies most people would never have heard of.
A Sky-High Barrier to Entry Business
A typical airline can have as many as four hundred thousand parts that they require on an ongoing basis to service their fleet, and without which they would not be able to safely transport passengers and goods around the world. HEICO is a core provider of many of these highly specialised parts, ranging from wheels, brakes, engine and power generation components, through to airplane interior solutions (such as tray tables, electric seats, etc.), all of which are essential to the safe and reliable operation of an aircraft.
In the US, the Federal Aviation Administration (FAA) regulates who can provide parts to airlines under their Parts Manufacturer Approval (PMA) program, creating a significant barrier to entry into this market. However, these barriers to entry are not sufficient to guarantee long term success; what keeps the competitive advantages intact in any business is how management responds to the ever-evolving demands of their customer. HEICO approaches this challenge by ensuring that their parts are on average 50% cheaper than the equivalent OEM parts, while delivering a similar (or better) level of quality. For customers with a long-standing relationship with the group, this discount can widen to as much as 80%. HEICO management makes a point of sharing value with the customer and offering a high-quality product at a very fair price. Any would-be competitor thinking about entering the market would find it almost impossible to compete on the basis of undercutting HEICO on price.
We like investing in businesses that provide mission critical products with high switching costs to their customers, which is exactly what HEICO does. As aircraft manufacturers (who had new aircraft orders cancelled hand over fist over the past 12 months) look to make up for the lost year of 2020, one way would be to increase replacement part pricing. Should this happen, we would not be surprised to see HEICO benefit as cash-strapped airlines look to keep their own costs under control.
A Capital Allocation Machine
Over an extended period of time, the Mendelson family (who acquired a controlling stake in the business in the early 1990s and have successfully steered the business since) has collectively proven their ability to prudently allocate shareholder capital to accelerate the growth of the group while also enhancing the competitive advantage and rewarding shareholders.
HEICO has compounded revenues at 15% per annum for 30 years – more than 3x the rate of the broader aircraft components industry. Despite this incredible track record, HEICO today still only has 2% market share of their core replacement parts market, indicating the many years of growth ahead of the group.
One of HEICO’s most successful capital allocation avenues has been the repeated redeployment of the group’s cash generation into small acquisitions that continually expand the product set. The Mendelson’s have notched up more than 80 acquisitions over a three-decade innings, paid for by internally generated cash flow. Especially noteworthy is the fact that returns on invested capital have remained solidly above any reasonable estimate of the cost of capital for decades, suggesting a strong valuation discipline underpinning the capital allocation capability.
At the same time, the business has rewarded shareholders along the way with more than 40 years of uninterrupted dividends (paid even in the annus horribilis of 2020).
HEICO makes sure that the management team of the businesses they acquire continue to run them; in turn, HEICO expands the addressable customer base for their products and accelerates their research and development pipelines. Adding niche products to HEICO’s existing product basket simplifies the purchasing decisions of their customers who can buy a wider product set from one supplier, further widening their moat and supporting their operating margins.
One of the core principles of our investment process is to focus on the cash flow that a business can repeatedly generate through time, and not on accounting earnings. HEICO is one example of a business that has managed to maximise its cash generating potential, not its accounting earnings (a fact that the CEO frequently and rightly points out to investors). This is evidenced by its consistent delivery of free cashflow per share greater than earnings per share as illustrated below:
The airline industry has a history of deep cyclicality: think back to the attacks on the World Trade Centre in 2001, or the Global Financial Crisis of 2008/2009 – not to mention the extraordinary circumstances introduced by the COVID-19 pandemic since last year. Viewed in isolation, any one of these events would be more than enough to dissuade a short-term investor from owning HEICO. However, when viewed over a longer time frame, each recession has provided HEICO a once-in-a-decade opportunity to deploy their extremely conservatively managed balance sheet to accelerate the acquisitive growth engine. We anticipate a repeat of this pattern as air travel returns in a post-COVID world.
Winston Churchill reputedly said, “never let a good crisis go to waste”. We would be hard pressed to find a better-suited company to capitalise on the pandemic-induced recession in the aerospace industry, where financially constrained competitors look to partner as a function of their own survival, and similarly constrained customers look to cut costs by switching to cheaper replacement part providers.
We believe those who may have read William Thorndike’s exceptional book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success would find parallels between the select group of well-known CEOs studied by Thorndike, and the Mendelson’s excellent track record of capital allocation. (In fact, were Mr. Thorndike looking to write a sequel, we would suggest that the Mendelson’s should be a contender for the headline act!)
HEICO is an exceptional business in our view. Operating in an obscure segment of the airline industry, it is unlikely to come up on the radar of many investors. Being a boutique manager with a focused approach for investing in businesses that compound their cash flow through cycles, we own HEICO for the quality, diversification and differentiation it brings to the Fund. In doing so, we partner with an aligned management team that has a demonstrable track record of creating value for staff, customers and shareholders over decades.