HEI - HEICO Corporation: Still Flying High With Some Modest Leverage

2023-05-24 17:25:14 ET

Summary

• HEICO Corporation remains one of the great shareholder value-creating stories in the market.
• The company has recently been a bit more aggressive with M&A, in terms of deal size and leverage.
• While the long term quality is unparalleled, HEICO Corporation valuations remain too demanding for me.

Over the past summer, I believed that shares of HEICO Corporation ( HEI ) were flying too high. The diversified aerospace supplier has a great long-term track record, and traditionally has combined conservative financial practices with organic growth and bolt-on dealmaking. While there was much to like about the business, one key item made me cautious: the premium valuation being attached to the business.

A Recap

Founded in the 1950s, HEICO Corporation has delivered on very strong returns over time, with an incentivized management team holding about a fifth of total sales. Merely a $20 million business in the early 1990s, the company has grown to become a near $2 billion business at the start of the pandemic.

The company has been consistently profitable and has been organized across two largely equal segments: the flight support group and electronic technologies group, the latter of which is far more profitable. In terms of end clients, the company is quite well diversified with commercial and defense each making up about 40% of sales, complemented by a smaller space and other markets.

A $1 share in the 1990s traded at $10 in 2008, around $30 in 2016 as shares broke through the $100 mark in 2019. Ever since, shares have largely traded in a $100-$150 range, trading at $155 when I picked up coverage again in the summer.

For the year 2021, HEICO Corporation posted a modest increase in sales from $1.79 billion to $1.87 billion, with operating earnings improving by similar percentages to $393 million. Net earnings of $304 million were equal to $2.21 per share, translating into a very steep earnings multiple around 70 times. Even a low debt load could not reveal appeal on the back of this.

It was clear that HEICO Corporation was still not fully up to speed, as the company announced a few smaller bolt-on deals. Amidst an improvement in the business, the company was on track to generate over $2 billion in sales and earnings of $2.50 per share in 2022, although that still translated into a premium 60 times earnings multiple.

HEICO Corporation employed more deals over the summer, including an EUR 467 million deal for a majority stake in French-based Exxelia International, pushing up leverage to about 1 times EBITDA, as forward earnings multiples could narrow a bit. That said, even at 50 times earnings, I was very cautious.

Stagnating

Since August, HEICO Corporation shares have largely continued to command a premium valuation, trading between $140 and $180 per share, although they essentially fell overnight from $179 to $165 per share upon the release of second quarter results.

In December of last year, Heico posted a spectacular 18% increase in full year sales to $2.20 billion, and while solid operating leverage was seen, a higher effective tax rate limited the increase in earnings per share from $2.21 to $2.55 per share.

The deal to acquire a 94% stake in Exxelia closed early in January this year. By February, Heico posted a 27% increase in first quarter sales to $621 million, with revenues trending at a run rate of $2.5 billion. Again, a higher tax rate limited an uptick in earnings per share, up four cents to $0.67 per share. Net debt ticked up to $640 million, equal to about the run rate in EBITDA. With 138 million shares trading at $180, the company commanded a $28.5 billion equity valuation, for an enterprise valuation around $29 billion.

By mid-May, Heico has reached a deal to acquire Wencor Group in a $2.05 billion deal, comprised out of a $1.9 billion cash component and $150 million in Heico stock to be issued to affiliates related to Warburg.

Wencor is a commercial and military aircraft aftermarket business, offering aircraft replacement parts, value-added distribution services of aftermarket parts, and repair and overhaul services. With a $724 million revenue contribution and $153 million in EBITDA, the deal comes in just below 3 times sales and 13 times EBITDA, after factoring in $75 million in synergies from taxes. In comparison, Heico trades around 12 times sales and a far higher EBITDA multiple. So, given this premium valuation, almost any deal looks relatively synergistic.

Pro forma net debt will increase to about $2.5 billion following the deal. With its own business on track to generate about $700 million in EBITDA based on the performance in the first half of the year, the anticipated EBITDA contribution of Wencor creates a pro forma EBITDA number around $850 million, equal to about 3 times leverage.

Doing Fine, Some Concerns

Late in May, HEICO Corporation posted its fiscal second quarter results with revenues up another 27% to $688 million. Amidst a lower tax rate, earnings per share advanced more, up fourteen cents to $0.76 per share. HEICO Corporation seems firmly on track to earn about $3 per share (ahead of the Wencor deal).

Assuming a 5% depreciation expenses in relation to sales, Wencor could add about $120 million in operating earnings and given the roughly $2 billion deal tag, it is clear that interest expenses will "eat" a great deal of that added earnings power. Assuming a 5% cost of debt, the pre-tax earnings contribution is pegged at just $20 million, indicating that no great earnings contribution is expected in the near term.

Still Too Pricey

With HEICO Corporation having become a bit more aggressive in recent times in terms of M&A, that timing could perhaps be questioned, raising some concerns. The biggest issue is not that of a near term 3 times leverage ratio, but moreover the high valuation at still an earnings multiple in excess of 50 times earnings. The resulting earnings yield, of a dismal 2% or less, is not competitive at all in this environment, and not enough to be compensated by a healthy growth performance and track record.

While HEICO Corporation definitely deserves a premium valuation on the back of the great leadership of the Mendelson family, having outperformed almost all other stock over the past decades, the question is if these valuations are realistic, as the track record is aggressively priced into the stock.

While quality prevails in the long term, the question is if HEICO Corporation deserves so much of a premium here. This makes it hard to join the race based on the fundamental valuation, but a very dangerous team to bet against.

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