The Best Play in the Aerospace Sector?
Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Every investor has one of these stocks. You know the type. The one where you find something you really like about the stock and then spend years waiting for its evaluation to get into range, or some other part of the company to perform, or some macro clouds to clear or whatever. The upshot is, you never get round to owning the stock. In my case it’s Heico (NYSE: HEI), and despite the good results, I am still going to exercise caution here.
Commercial aerospace is certainly a hot sector this year, and any investor only has to look at the full order books for Boeing (NYSE: BA) and EADS and conclude that it is an industry worth following. In fact, a closer look at Boeing’s order book reveals the usual suspects of emerging market and budget airlines placing heavy orders. This is a good sign of current growth, but of course, stocks are priced on future growth. That said, it's time to turn back to Heico.
What is Heico, and why is it attractive?
Heico is a small company selling aerospace products and services in niche markets. It reports in two divisions, the Flight Support Group (FSG) and the Electronic Technologies Group (ETG).
The FSG makes up 64.2% of revenues and 66.7% of income. Within this division there are three subsets of Parts, Repair, and Distribution. I think there is a strong long term case for all of them.
The Parts Group is the largest independent supplier of Federal Aviation Administration (FAA) approved engine and component parts. I like this because airlines are always looking for ways to cut costs but cannot compromise on quality. Heico offers them this solution with its own FAA approved parts, and there must be a good long term opportunity for Heico to increase penetration rates. Moreover, airplane parts are standardized and they tend to have low depreciation rates, so it is no surprise to see how good Heico is at cash flow conversion.
The Distribution group also has favourable demand trends, because airlines are increasingly trying to ape the car industry and shift to ‘just-in-time’ methods of managing inventory. In other words, airlines should drive increased demand for distribution services, as they look to outsource procurement rather than hold loads of inventory on their books. It is a similar argument with the Repair group, where airlines are keen to cut their own cost by having repair and maintenance outsourced.
The ETG makes up 35.8% of revenues and 33.3% of income. It has been the star performer recently and a mix of acquisitions plus organic growth (6%) saw revenue rise 51% in the last quarter. This division manufactures a range of electrical and electro-optical devices principally to the aerospace industry. Again, this is a nice industry to be in as the portion of airplane value in electrical and electronic systems is increasing with ever more complex aircraft.
All sounds good, so where is the downside?
I think there are a couple of issues here.
First, while the company is exposed to strong secular trends within aerospace, we have to bear in mind that it still operates in a highly cyclical industry. The key driver of aftermarket demand and repair and overhaul activity is miles flown and capacity utilization. These metrics are very highly correlated with global economic growth, so while Heico has the capability to do better than the industry -- due to the trends outlined above -- it will also suffer when the economy slows, just as it did in 2009. Indeed, in the last set of results, Heico pointed out that repair work declined. It doesn’t take long for a bit of a slowdown in the economy to feed through into its numbers.
The second issue is that traditionally, defense makes up around 20% of sales for the company. With the Pentagon announcing plans to cut back spending by $487 billion over the next 10 years, it’s hard to be too optimistic about the outlook. This makes things a bit tricky for Heico, because defense spending is usually what supports aerospace stocks in any cyclical downturn. Therefore, I would argue that the relative evaluation that the market holds them at should be reduced to factor in the extra risk. In a sense, this has already happened, because I note that a comparable company, AAR (NYSE: AIR), has been weak -- despite reporting very strong commercial aviation numbers -- due to fears over its defence spending exposure.
Where next for Heico and the sector?
Heico is not alone in offering growth through structural trends in the industry. I like something like BE Aerospace (NASDAQ: BEAV) with its focus on cabin infrastructure within commercial aviation. Its interesting new product is a modular lavatory system which allows for extra seating on a plane, so there should be good retrofit opportunities here. Another interesting stock is Hexcel (NYSE: HXL), which provides carbon based lightweight composites for aeroplanes. If fuel costs are going up, then airlines will have to find ways to reduce costs, and weight is usually the answer. In addition, composites have many engineering properties which make them structurally superior and increasingly used on next generation planes.
In conclusion, while I think Heico is a great company, and alongside BE Aerospace is probably the pick of the sector, now might not be the best time to seek exposure if you are concerned about global growth. This is frustrating because the underlying secular trends for this company are very strong and long term I think it will do very well. However, if you are more positive on the macro environment and/or looking for some cyclical exposure, then Heico is well worth a look. Alas, I am going to have to stay out yet again.
SaintGermain has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend HEICO. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.