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HEICO: Mayday! Mayday! Mayday! | Must Read Mar. 22, 2016 10:00 AM ET19 comments by: Lester Goh Summary Valuation multiples for aerospace-related companies have soared in recent years, and for good reason. However, there are some that do not actually deserve said multiple expansion. HEICO is exhibit A. Bulls point towards the Company's stellar growth history, partly driven by the roll-up story, as well as the apparent growth tailwinds that should drive results going forward. Upon closer examination, there are many prominent negatives. Intensifying pressures from OEMs and lessors, coupled with the unprecedented multi- year aircraft production ramp, will act as hindrances to organic growth. Inorganic growth opportunities appear few and far between, given the Company's size, dividend commitments and elevated leverage. HEICO: Mayday! Mayday! Mayday! - HEICO Corporation (NYSE:HEI) | Seeking Alpha Page 1 of 17 http://seekingalpha.com/article/3959965-heico-mayday-mayday-mayday 1/8/2016

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HEICO: Mayday! Mayday! Mayday!|Must Read Mar. 22, 2016 10:00 AM ET19 comments

by: Lester Goh

Summary• Valuation multiples for aerospace-related companies have soared in recent

years, and for good reason. However, there are some that do not actually deserve said multiple expansion. HEICO is exhibit A.

• Bulls point towards the Company's stellar growth history, partly driven by the roll-up story, as well as the apparent growth tailwinds that should drive results going forward.

• Upon closer examination, there are many prominent negatives. Intensifying pressures from OEMs and lessors, coupled with the unprecedented multi-year aircraft production ramp, will act as hindrances to organic growth.

• Inorganic growth opportunities appear few and far between, given the Company's size, dividend commitments and elevated leverage.

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• Shares should re-rate to mid-teens free cash flow - implying ~45% downside from current levels - given HEI's poor growth profile going forward, in my view.

ThesisThe aerospace industry at large has tailwinds that should drive growth going forward for many years to go. This is largely due to the unprecedented production backlogs at major OEMs - Boeing (NYSE:BA) and Airbus (OTCPK:EADSY) in particular -driven mainly by worldwide fleet growth and replacement demand. Against such a backdrop, it should come as no surprise that the aerospace-related companies are trading at very high valuations relative to current earnings, implying that investors expect bottom lines to inflect significantly as production ramps. For many players, this should hold true, but there are a select few where these tailwinds are actually headwinds. In my view, HEICO (NYSE:HEI) ("HEICO", "HEI", or the "Company") is a perfect example.

Reasons for the opportunity: stellar growth history, secular industry tailwinds, roll-up euphoria.Bulls are overly focused on the roll-up story as well as the secular industry tailwinds, but are apparently neglecting subdued organic growth (which recently turned negative), whether said industry tailwinds are really a positive, as well as intensifying pressures from OEMs and lessors. The roll-up story is also starting to fall apart, given the Company's dividend commitments and elevated leverage levels. At the current valuation, longs pretty much need everything to go right, something which I am highly skeptical of. Cracks in the story are already surfacing - and judging by the current valuation - have gone unnoticed.After digging deep into the fundamentals, HEICO's future - with respect to its growth profile - appears cloudy. In my view, shares deserve no more than a mid-teens multiple at best on ~$160m in free cash flow, implying ~45% downside from

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current levels. Notably, considering that I am of the belief that the market is misinterpreting the Company's supposed growth tailwinds, downside risk could be far greater than estimated - if my thesis plays out, it would involve a major shift in investor sentiment.Short interest also supports the assertion that this is a very non-consensus bet, given the progressive declines in short days to cover, per NASDAQ, since the release of fiscal 2015 results.Quick BackgroundHEICO has been an exceptional grower for many decades. When current management - the Mendelson trio: father and two sons - took over in 1990, growth has been nothing but stellar. Over the past 25 years, shareholders have seen the Company's top line and bottom line expand at ~16% and ~18% CAGRs, with the stock following a similar trajectory. Management has achieved this through broadening its product line, expanding its customer base, and rolling up competitors.HEI's primary business is in selling aftermarket parts and repair services to airlines, specifically for jet engines. In other words, its main end-market is aerospace. Demand for its products and services within the aerospace market are driven mainly by the growth in global air travel, which manifests as the rise of RPMs.Although the Company has a segment that sells largely to the defense (~55% of said segment's sales, or ~32% of overall sales), space, and other industrial end-markets, these areas are either subject to volatile budgets (defense) or are typical GDP-growers and hence will not be the focus of this report; the main driver for HEICO going forward will likely be the aerospace segment.Longs are essentially betting that the future will look like the past. Prima facie, this seems plausible, given the unprecedented aircraft production ramp that has been occurring in recent years. Upon closer examination, the future is not so bright, given the many negatives that I will explore in this note.Aerospace companies are often grouped together, making it likely that market participants view them as one group instead of a diverse set of businesses. In my view, this is the main reason why HEICO has traded higher alongside its "peers", leading its shares to decouple from reality in recent years.

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Continued product line expansion does not seem to be bearing fruitLongs tend to emphasize the Company's track record of getting Parts Manufacturer Approval ("PMA") products approved by the FAA. Per the 2015 10-K, HEICO has been adding 300-500 new PMAs per annum off a base of ~10,000, not only suggesting ~3-5% annual growth is probable off of new product introduction, but also indicating continued R&D productivity.Yet, organic growth has been lacking - 2015 in particular was worrying. The aerospace segment grew ~6% overall, but this growth was driven solely by acquisitions. Excluding acquisitions, organic growth turned negative (acquisitions added ~$55m in sales, but segment sales increased ~$47m).However, when compared to RPM growth, the above performance was a disaster. RPMs grew ~6% in 2014 (note: 2014 numbers are used to evaluate 2015 as RPM is a leading indicator of aftmkt demand - analysts may disagree, so the reader can feel free to use the 2015 number of ~6.7%, which strengthens my case). One would expect sales to keep pace with RPM growth at the very least. Moreover, considering that the Company added an incremental ~3-5% of products to its existing line, one would expect sales to increase in excess of the RPM growth rate, driven by deeper customer penetration. Both scenarios did not materialize.Management offers some detail. Per the 10-K, sales from new product introductions were ~$11.4m. This piece of information essentially confirms that the Company's legacy products are losing market share, given the above comments on organic growth. This situation seems unlikely to reverse purely from heightened rates of new product introduction, given that products can only come to market when it has obtained regulatory approval; the FAA is the bottleneck in this equation.In my view, the negative inflection of organic growth is just the early innings of what is in store for the Company - given the current valuation, it appears to me that the market has yet to catch on; bulls appear to have missed (or dismissed) the organic growth number turning negative, given the strong share price performance off the back of 2015.In subsequent sections, I detail extensively why it is my belief that the future is not as bright for HEICO as longs believe, and why the organic decline is not an anomaly.

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Record aircraft backlogs unlikely to positively affect HEI; in fact it is a huge negativeBulls look at the current unparalleled backlog in aircraft. Boeing and Airbus have a 7-9 year backlog of aircraft deliveries at current production rates, and that backlog is current; it does not account for future demand, which is well supported. Boeing estimates that ~38,000 new aircraft would be needed over the next two decades. Airbus's estimates are in a similar ballpark.This demand is driven by megatrends - which by their nature are inherently hard to derail - such as an expanding middle class, global air travel demand, rising population, etc. Investors reason that the Company should benefit from this massive tailwind going forward. In my view, this conclusion is erroneous.Reason being - new aircraft are sold initially with OEM parts (i.e. not with HEICO's PMAs). These parts do not require maintenance right away, but instead require repairs/replacements about a decade after the aircraft is in use (long-term OEM service contracts - see infra - could drastically lengthen this time horizon). Transdigm (NYSE:TDG) offers a graph that illustrates this dynamic, as seen below.

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Source: Transdigm February 2016 Investor PresentationEssentially, even if one assumes that HEICO would be able to convince customers to use PMA parts, the Company is unlikely to benefit in the near term. Moreover, I am unsure (see next section) as to whether the aforementioned assumption is a valid one going forward.To make matters worse, the majority of new aircraft deliveries are bound for non-U.S. countries. The value share for North America is projected to be a mere 21%, or $940b, according to Boeing. This is certainly not good news for HEICO, given that it has significant scale only within the U.S. (~65% of sales are to the U.S.), and thus would be selling into a smaller (relative) market going forward.

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The bulk of new aircraft deliveries will be sent to places such as Asia, Europe, and the Middle East, where the Company has limited scale; ~35% of its sales are to non-U.S., the non-U.S. market is estimated to be $4,630b, with Asia taking $2,200b. This makes it all the more difficult for HEICO to grow, given its relatively small presence in the largest markets. To be fair, HEICO is trying to build up its non-U.S. presence, evident from the incremental ~$10m in PP&E assigned to long-lived non-U.S. assets. However, non-U.S. revenues are growing at a snail's pace. Jet engine OEMs, thanks to their huge size, are already operating at global scale.Now, HEICO may still have some breathing room if new aircraft deliveries slow down. This is due to the fact that deliveries usually follow retirements, and thus if deliveries are delayed, older planes (HEICO's core market) would be in use for much longer. However, new aircraft deliveries are unlikely to slow down.The continued oil price depression has led bulls to make the argument that airlines would delay purchasing new aircraft as the current commodity environment makes old aircraft economically viable. Unfortunately, this (delayed purchases) is not the case. Growth in backlog for aircraft OEMs have actually accelerated, as mentioned above.This acceleration is unlikely to lose steam because passenger load factors are far higher than they were a decade ago - the metric is now approaching 80%, suggesting continued strong demand for air travel. These consumer trends would spur airlines to grow their fleet to satisfy increasing demand - the rise of lessors (see infra) have also greased this fleet growth (for additional background, please see Jeremy Raper's wonderful AerCap (NYSE:AER) article). A recession is unlikely to derail passenger load factors - the metric fell ~2% in 2008 and rebounded strongly in 2009 and subsequent years. Global air travel tells a similar story, as seen below.

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Source: AerCap 2015 Investor DayFinally, it appears that HEICO is really fighting an uphill battle. Boeing projects that the ~38,000 new aircraft to be delivered over the next two decades would be ~42% for replacement and the remaining ~58% for growth, implying that ~16,000 new aircraft will be for fleet replacement. Boeing also estimates that the 2014 fleet is numbered at ~21,600. In essence, ~74% of the current fleet will be replaced over the next two decades, drastically reducing HEICO's addressable market.Increasing OEM attach rates for service contracts will hinder HEI from benefiting from record aircraft backlogsBulls enjoy pointing out that HEICO currently commands a very small share of the overall market. Per the 10-K, this amount was less than 2%. Couple this with the unprecedented aircraft backlog and the most common takeaway from these pieces of information is that HEICO still has an extremely long runway to grow as it takes

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share when aftermarket opportunities open up a decade after the initial jet engine sale. Many investors are likening HEICO to a "mini-Transdigm", which is an incorrect assessment, in my view.Transdigm competes in a highly fragmented market supplying OEM and aftermarket parts. Crucially, it does not compete with jet engine OEMs - OEMs are its customers. Most competitors are family-owned businesses, supplying a small amount of content on each aircraft. Market power in these markets is hard to come by, thanks to the industry structure.In stark contrast, HEICO supplies only the aftermarket parts/service. As a result, the Company competes with the OEMs in duopoly markets - Rolls Royce (OTCPK:RYCEY) and GE (NYSE:GE) owns the wide-body while GE and Pratt & Whitney own the narrow-body and other smaller segments. By virtue of their dominant market positions, taking share from OEMs is really a David-versus-Goliath situation, one where I am unsure whether David would prevail.Longs highlight that the Company offers aftermarket parts at a discount to OEMs. Further, given that the parts are FAA-certified - basically validating that they are the functionally-equivalent to the OEM-supplied parts - longs argue that this should allow the Company to take share. After all, airlines are always looking to cut expenses, right?However, market share data suggests that this has not occurred. In the 2015 10-K, HEICO mentions that it has less than 2% market share. Interestingly, in its 2005 10-K (10 years prior), the Company also cites its "less than 2%" market share.The fact that HEI uses the phrase "less than" suggests two things. At best, HEI has maintained market share. At worst, it has lost market share. Regardless of which scenario is the truth, the data underscores the enormous difficulty of taking share from OEMs. In my view, this trend will continue going forward. To understand my reasoning, it is vital to understand the competitive landscape for jet engine development and manufacturing.Jet engines cost billions to develop (Rolls Royce spends ~$800m in annual R&D, engines take years to develop) and are typically sold at a loss (or break-even, at best). The jet engine manufacturers (Rolls, GE, and Pratt) make their money

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primarily on huge out-year maintenance streams. These margins are very fat - in the area of ~20% if one looks at GE's aerospace numbers. Put simply, the aftermarket is the OEMs' crown jewel, and they protect it accordingly.These duopolies (in each of body sub-segments) are nearly impossible to break:

• Not only would a new entrant need to spend billions to develop a new engine,• but it would also need to convince OEMs to use their engine (a stretch, given

their no-name brand and non-existent track record by definition),• and suffer billions in losses (due to high R&D and marketing expenses) till the

maintenance streams come online; and• moreover, if the new entrant attaches its engine to an unsuccessful plane (say,

the A340 or A380), the limited production would render the entrant unable to gain scale. Likely end result: decades and billions wasted.

This was the process that the incumbents went through, and once you gain scale in maintenance, you can repeat the process indefinitely and there is almost nothing potential entrants can do (for more detail: please refer to my prior article covering Rolls Royce).How do OEMs protect this crown jewel? Basically, they persuade their customers to enter into long-term service contracts for the aftermarket maintenance of jet engines (i.e. HEICO's core market). These contracts are known as TotalCare, OnPoint, and PureSolution for Rolls Royce, GE, and Pratt & Whitney respectively and are put in place for 10-20 years. Low attach rates were likely one of the driving forces allowing HEI to prosper in the past, but this is unlikely to be true going forward. In ValueAct's November 2015 letter to investors (ValueAct has a large position in Rolls), TotalCare is attached to nearly 100% of the jet engines sold today, compared to half a decade ago - GE and Pratt likely followed the same path.The rise of lessors is also a problem

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In recent years, aircraft leasing has grown significantly, evident by the rapid rise of companies such as AerCap. Leasing is really a thorn in HEICO's side and the rise of lessors is not good news for the Company.Every lessor has the horror story of not being able to allocate an aircraft when its lease expires. This is a dire situation for lessors as it would result in the lessor being stuck with the aircraft with zero revenue generation. They would likely take losses as the aircraft would need to be maintained and stored even if they are not in use. The use of PMA parts can effectively block an aircraft transfer because not all regulatory bodies and airlines accept PMA replacement parts.Given the huge losses that lessors can sustain when it is not able to re-allocate the aircraft, it is unlikely for lessors to want to take that risk, even if it means achieving some cost savings through lower-priced parts, in my view; the losses through maintenance/storage could far exceed the savings. Bulls think that this is becoming a smaller problem after each year, but market share data for HEICO (see supra), by far one of the largest PMA parts manufacturer, suggests otherwise and highlights that adoption is still a problem.Now, this would be less of a problem if lessors were a small part of the aircraft market, but this is unfortunately not the case, as seen below.

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Source: AerCap 2015 Investor DayWith continued low interest rates due to the Fed continuing to stand pat, as well as the numerous benefits provided to airlines by lessors (de-capitalizing the balance sheet, better bargaining power, wider aircraft selection, etc.), the growth in aircraft leasing is likely to be secular in nature, meaning that these competitive pressures are anything but transient.Inorganic growth seems ripe to slow given balance sheet constraintsLongs then turn to inorganic growth to prop up the growth story of HEICO, which seems a fair assumption given the Company's history. Digging deeper suggests otherwise.

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HEICO has consistently raised its dividend payouts every year - dividends grew five-fold from $0.03 per share to $0.15 per share in the last decade, likely drawing the interest of dividend growth investors. This level of consistency suggests that management is committed to growing or at least maintaining the dividend going forward.At ~68m in shares outstanding, this obligation is a ~$10m cash drain every year, growing by ~6% per annum (if future increases are in line with historicals). Considering the Company's ~$30m cash balance (per the most recent 10-Q), the dividend is a significant amount. Couple the dividend obligation with working capital needs (historically in the range of ~$20-30m), it is hard to see cash on hand being used for acquisitions - it seems likely that HEICO might even need to periodically increase borrowings to fund working capital.The Company has funded its acquisitions primarily through issuing long-term debt. At ~$600m, debt/equity is elevated (~61%) compared to where management has kept it historically (<20%). Management strikes me as conservative, and given that the business is largely family-owned, this is unsurprising. Importantly, this suggests that the Company is unlikely to lever up further for the sake of growth (as an aside, share repurchases are also unlikely for similar reasons). A scenario involving free cash flow growth driven by debt paydown is a non-starter, given only ~$5m in interest expense.In addition, management is likely very busy with integration (it made six acquisitions in 2015 compared to one in 2014), further making it unlikely that growth will stem inorganically going forward. Size is also a limiting factor, given the historically small magnitude of acquisitions which would make it difficult to move the needle going forward.Only source of growth seems to be from cost-controls/non-aerospace segments; earnings growth profile suggests a mid-teens free cash flow multiple at bestGiven the above discussion on inorganic growth, and the commentary on organic growth in prior sections, the only significant source of growth in earnings going forward seems to be through cost management/non-aerospace segments.

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It is difficult to buy the gross margin expansion story, given that it has remained fairly stagnant at ~35-36% in the past decade - unsurprising if one accepts my contention that legacy products are losing share (see supra), making it difficult to gain scale in manufacturing (facilities need to be re-tooled, new equipment need to be brought in to produce incremental product introductions).Opex seems to be coming down, but at a very slow pace. If we assume that it would be coming down like it has, and give the Company credit for 1-2% organic growth (unlikely to come from aerospace, given that organic growth has recently turned negative - this growth will likely stem from non-aerospace segments, with risks to the downside given pronounced defense exposure and volatile government budgets), earnings could grow ~3-5% at best. Share repurchases are also unlikely, as discussed above.Such a growth profile would warrant no more than a mid-teens free cash flow multiple, in my view. A 15x multiple on ~$160m in free cash flow (expensing ~$6m in stock-based comp, assumes ~7% growth from 2015 - aggressive given prior discussions as well as management's apparent ramp in capital spending to build its non-U.S. presence), shares of HEICO see ~45% downside to the mid-$30s from its current ~27x multiple.Catalysts

• Overall decline in revenues - organic growth has already turned negative (something that is likely to continue, in my view), and given my comments regarding the implausibility of inorganic growth, it is likely that an overall decline in revenues is incoming. This would shift investor sentiment in a major way, given that the market seems enamored with the growth story that HEICO has been touting for many years. Given that OEMs are aggressively bundling their aftermarket services (i.e. TotalCare, et. al), HEICO might try to compete through lowering prices. The Company might not have a choice if its customers push for even better pricing, leveraging on the OEM situation.

• Margin contraction - could occur either due to a decline in revenues (see supra) or an increase in opex. Increase in opex seems likely given the heightened integration activities going on currently due to the Company's six acquisitions in fiscal 2015 (as compared to one in 2014).

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• Leverage issues or lack of access to the credit markets - notably, management has never operated at such levered levels before - in 2008/2009, debt/equity was a comfortable ~12%. The Company has not been stress tested as a levered entity in a credit downturn.

• Opex might also see an increase, deflating the positive operating leverage story, as the Company tries to increase spending to regain market share.

• Economic downturn - while this is really a macro call (note: I do not like to make macro calls) which is hard to predict, it is important to keep in mind that this could also act as a catalyst and amplify the prior catalysts as airlines delay maintenance (other than required by FAA regulation), resulting in a "maintenance holiday" to conserve cash.

Risks

• Continued low oil. Mitigant: even if low oil results in older aircraft being in use for longer, the Company does not appear to be able to take advantage of this given its market share losses (negative organic growth vs. mid-single-digit RPM growth). Moreover, consensus expectations for oil are for black gold to recover to the $60s in the next few years, suggesting that the low oil environment is rather temporary.

• Increase in PMA parts acceptance reinvigorating organic growth. Mitigant: While a good story (lower prices help airlines save costs), the story does not appear to be playing out, given HEICO's market share numbers in the past decade.

• An equity raise to delever or continue to inorganic growth story. Mitigant: Management seems to jealously guard its ownership, evident from shares outstanding remaining rather stagnant (at ~66-68m shares) for the past decade. Further, selling equity would mean diluting the Mendelson's family ownership. These two factors make an equity raise quite unlikely, in my view.

Conclusion

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HEICO exhibits a few features that make it a compelling short: 1) irrational valuation relative to its growth profile, 2) a weakening competitive position, 3) numerous catalysts to accelerate risks to the downside, 4) a levered balance sheet untested in a harsh economic environment, and 5) a growth story that already has cracks given the negative inflection in organic growth, as well as inorganic growth concerns.The main reason for my belief as to why the current opportunity exists is due to the market's apparent lack of understanding of the game-changing dynamics that are occurring within the competitive landscape, instead preferring to tout the Company's growth history.In my view, the Company is an attractive short candidate offering ~45% downside from current levels. Risks to the upside is limited by HEICO's already-stretched valuation, and the fact that its multiple is already within range of historical highs.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.

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