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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP738: Heico: The Quiet Aerospace Compounder
01:10:21
Clay dives deep into the remarkable story of Heico — a quiet compounder that’s delivered over 22% annual returns for more than three decades.
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Unknown Host
You're listening to tip.
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Clay Fink
Heico is one of those companies that does not make the headlines often, but when you look under the surface, you realize it's one of the greatest compounders. Over the past few decades, since the Mendelsohn family took control in 1990, shares have compounded at an astounding 22% per annum. A $10,000 investment back then would be worth over $9 million today. At first glance, you might assume that a company supplying aerospace replacement parts would be slow growing or unexciting, but Heiko's story flips that narrative on its head. It's an excellent case study on one of the most strongest moats I've ever studied, thoughtful capital allocation and the power of long term thinking. In this episode, I'll break down how Heico built its competitive moat, how the Mendelsohn family turned a struggling parts supplier into a $38 billion aerospace leader, and why legendary investors like Warren Buffett and Francois Rochand have taken note. With that, let's dive right into today's episode on Heico.
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Unknown Host
Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host Play Fink.
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Clay Fink
Foreign welcome to the Investors Podcast. I'm your host Clay Fink. On today's episode I'll be discussing the story of Heico. Heico is a fascinating business that has delivered exceptional returns for shareholders and impressively, Heico continues to deliver outstanding operating performance which has led to continued market beating returns. Three members of the Mendelsohn family hold executive roles at the company. Laurens or Larry is the Executive chairman and former CEO, while Victor and Eric, who are brothers, are co CEOs. Combined, the three of them own over 9 million shares in the company which today is valued at over $2.1 billion for a company that trades at a quite elevated valuation level. I was also surprised to learn that Warren Buffett and Berkshire Hathaway started purchasing shares in the company in Q2 of 2024. They have a $245 million position, which for Berkshire is really a rounding error. And Francois Version, who's a legendary investor I've interviewed here on the show earlier this year, has a core position in Heico and his fund. Much of his position was built back in 2018 and he's gradually added to his position in recent years. As of his most recent 13F, Giverny Capital owns 742,000 shares worth over $150 million. Now, if I were to tell you that Heiko designs and manufactures parts for the aerospace industry, many would probably assume that this is a really boring business that isn't that interesting from an investment perspective. But if I provided a bit more context and also mentioned that they have 75% market share and a significant competitive advantage, they recently acquired the number two player in their industry, strengthening their competitive advantage. Over the past 10 years, revenues have compounded at nearly 14% and EPS has compounded at 16%. And there is a significant Runway for the company to continue to grow. Then perhaps that will catch more people's attention. Let's kick this off by starting from the beginning. Heike was founded in 1957 and was formed under the name Heinecke Instruments. The company initially sold laboratory equipment, and they entered the aircraft industry with the acquisition of Jet avion in the 1970s and which was a player in the PMA industry. And we'll be getting into some of the terminology here. So within the aerospace industry, we have the OEMs, the PMAs, and the airlines. So the OEM is the original equipment manufacturer. So this is essentially the player that makes the aircraft. And they may also sell replacement parts for that aircraft for maintenance and whatnot. When you think about the airplane manufacturers today, there are really two major players, Boeing and Airbus. And then within the OEMs, there are over a thousand players that supply the parts to these manufacturers. The airlines, of course, purchase the airplanes from the manufacturers. And over the plane's life of 25 to 30 years, there's plenty of maintenance and the replacement of parts that is necessary for the upkeep of the airline's fleet. This is where the PMA comes in. PMA stands for Parts Manufacturer Approval. When the airlines want to buy a replacement part, they can choose to purchase from either an OEM or a pma. The PMA doesn't manufacture parts that go into the original or new airplane, but they do sell replacement parts as a potential alternative to the OEM. So Heico got into the PMA industry in the 1970s, when this was an industry that was really just getting started. In 1986, the company would be renamed to Heico corporation in the 1980s. Victor and Eric Mendelsohn were in college at Columbia University. They were exploring investment opportunities to invest their family's capital. And when they found Heico, they saw a small, publicly traded and underperforming company. In light of that, the two brothers and their father Larry, who was an accomplished accountant and real estate investor, they pooled together $3 million to acquire 15% of HEICO. And then they launched a proxy fight to gain control of the company. After some back and forth in 1990, the Mendelssohns assumed full management control of the company. Now the Mendelssohn's taking over Heiko was probably the greatest thing that ever happened to this business. Just from a frame of reference here, the company had a $25 million market capitalization when they purchased their stake and today Heico's market cap is over 38 billion. The two brothers were really leading the charge here. And Eric, he was only 24 years old at the time and Victor was 22. And all of a sudden they were managing this company at such a young age. But despite their age, they were just sharp, hardworking and really ready to make their mark on the world. Eric and Victor did a great job of knowing that they didn't have the experience to build a business on their own. So they found the right people who did have that experience to help guide them along the way and, and offer them mentorship. When the Mendelssohns gained control, Heico generated around $25 million in sales and was losing money. They set their sights on becoming the leading independent provider of FAA approved aircraft replacement parts. For those that aren't familiar, the FAA is the regulatory body in the US that oversees the aircraft industry. Any replacement part that Heico wants to sell, they'll need to get approved by the faa, which has a very strict certification process. As you can imagine, this is a highly, highly regulated industry. For a replacement part to be sold for use on an aircraft, it either has to be manufactured by the OEM or it must receive separate approval from the faa. Getting approval from the FAA is typically a very expensive and very time consuming process. One of the things the Mendelssohn saw in Heico was that the board owned zero shares in the company and they just simply weren't motivated. So they got rid of the existing management team and ran the business themselves. At the time they sold a single item, which was an engine combustion chamber. And searching for other opportunities in the aftermarket, they found that this industry was actually pretty alluring. Since everything needed to be FAA approved, nobody could easily enter the industry. Plus, replacement parts weren't patent protected. So they could reverse engineer the parts that the OEMs made and seek FAA approval to then try and sell that part at a lower price that the OEM sold them. The role of the FAA in Heico's business model is incredibly important to understand. As It's a key reason as to why new entrants are not coming in to compete with Heico today. So in a way, Heico is exploiting this opportunity in the industry where the OEMs, they spend a substantial amount of capital in developing all these parts that go into an aircraft. And Heiko is able to take those parts, reverse engineer how they were made so they can make themselves. And when they're developing these products, they're incurring a fraction of the original development costs that the OEMs incurred. This allows them to have a cost advantage and charge less than the OEMs would charge for that same part. And for Heiko to enter the aerospace aftermarket industry at the time was a really tall task because getting approval from the FAA is extremely difficult. But they thought they might have a chance at being able to figure out how to work through these strict regulations and create a viable business in the industry. Since Heico really didn't have anything to lose, I think this actually put them at an advantageous position because they were willing to try and do what most people would not even think about doing for a second. It was said that Eric Mendelsohn practically lived in the FAA's headquarters in Washington, DC. The FAA was extremely thorough in their approval process, going into the most minute details. By 1991, Hico would get the green light for its second part, a tube used in jet engines. Larry would insist that they treated their customers well, so they often sold these aftermarket parts at a 30 to 50% discount to the OEMs. Larry had shared publicly that he never wanted his customers to feel like Heico was price gouging or excessively profiting off of them. In 1997, HEICO formed a relationship with the chairman and CEO of Lufthansa Airlines, pitching him on the value that Heico's PMA business could bring to the airline. And Lufthansa would end up investing in Heico's PMA business, taking a 20% stake. This partnership with Lufthansa helped Heiko accelerate the PMA process from start to finish and and gave them insights into which parts would be best to reverse engineer and start selling. So they used these insights to figure out which parts were the highest volume and highest value for the airlines. And since they had a reputable buyer to sell to right out of the gate, this really helped them sell to other airlines as well, catapulting Heiko to be a leader in the PMA industry. The importance of this relationship with Lufthansa Airlines really can't be overstated as it gave Heico a big first mover advantage, gave them extremely valuable information in terms of what parts they should sell, helped them establish credibility as a PMA supplier and help them accelerate the development of new product lines. Additionally, they would have a customer ready to purchase the part once they got it through that approval process with the faa. So the PMA industry was still fairly nascent, even in the 1990s, and Heico really figured out a way to produce high quality parts and establish credibility when most airlines were still pretty hesitant to purchase parts from players who weren't the OEMs. You can imagine how difficult it would be for airlines to switch who they would purchase these parts from because you need to have 100% full confidence in who you're working with and who you're partnering with. Heico today has more than a 30 year track record of never having a part fail in flight, which is incredibly difficult for competitors to replicate. And it likely makes airlines substantially more willing to use Heico's parts rather than those from other smaller PMA suppliers. If we fast forward to today, Heiko is by far the world's largest provider of aircraft replacement parts. In the PMA industry. They're estimated to have an astounding 75% market share and they generate over $4 billion in revenue. And part of what's fueled that growth is acquisitions. Since the Mendelssohns took control in 1990, Heico has completed around 100 acquisitions. The Heico management team loves to buy from entrepreneurs who are like them, shrewd businessmen who are very entrepreneurial and built their companies from the ground up. They also prefer not to buy the entire firm. More often than not, they'll leave one fifth of the business in the hands of the owners and or the people running it. To ensure that incentives are aligned. They're looking for companies that they believe will continue to grow, offer strong cash flow and earnings potential, and are available at fair prices here. In a bit, I'll get more into the inner workings of the business and their acquisition strategy. But I wanted to talk more about the Mendelssohn's first since they play such a key role in the Heico story. In an interview with Eric Mendelsohn, Eric described how the Mendelssohns have used this policy where he, his brother Victor and his dad Larry would need to agree unanimously on the big strategic decisions. And I think this process has really helped them avoid the big major mistakes. So each of these 100 acquisitions they've made to date, all of them had to get approval on these to go and make the deal. And he called 98 of these 100 acquisitions as a success, which we can define as say, a single, double, triple or home run. And only two of the 100 businesses so far have not been a success that they had hoped. And but that is just an extraordinary hit rate when it comes to making acquisitions. And the reason having all three on board in decision making is because each of them thinks a little bit differently or sees things in a little bit different light. One person might be able to help spot another person's blind spots and help them highlight why they might be missing something to really get to the truth of the situation. So it's clear to me that the Mendelssohn's are exactly the type of people that I would want running my business or running a business that I'm invested in. They're just so incredibly humble, hardworking, and have this beginner's mindset where they're always open to learning something new and figuring out how to do things just a little bit better. They treat Heiko like their own family business and treat shareholders capital like they would their own capital, which has created a large quality shareholder base that have owned shares for multiple years. Their acquisition history showcases that they are excellent capital allocators. And they first ensure that they are not going to destroy shareholder value by purchasing a bad business, partnering with unethical people, or overpaying. It ties right in with Buffett's number one rule of investing, which is to not lose money. And it's no wonder that they have such an exceptional track record with acquisitions, because they figured out what really works for them. Oftentimes when they make an acquisition, the seller is getting tens of millions or even hundreds of millions of dollars and they are still going to work every day. They need to have a pretty good reason to get up and continue to work hard, because money likely isn't going to be a huge motivator for them. So the Middletons have done a really good job of giving these entrepreneurs full autonomy and doing their best to ensure that they're working with really good people and they're not being told exactly how to run their business. If you have good people and a good business, then the Mendelssohns know that they really don't need to tell them how to run their business. And that approach of giving managers full autonomy has really worked well for them. And the importance of good people should not be overlooked. Eric has said that there's no such thing as good business. With bad people. If the people running the business are people they wouldn't be happy to invite to their house for a holiday dinner, then they just aren't interested in buying their business. Larry Mendelsohn has stated, we believe that the person running his organization knows more about his team members, his labor force, his customers, his manufacturer, everything else than somebody in a corporate office 1000 or 2000 miles away. Talented people normally do not like somebody breathing down their neck and over supervising them. So I think this has worked very well. Impressively, around 80% of HICOs acquired as subsidiaries are still led by their original founders. One of the things that they like to do to keep the founders incentivized to deliver shareholder value is they leave some equity with the founder and that's typically 20% or 1/5 of the business. As with many successful serial acquirers, Heico has built a reputation as the preferred buyer in the eyes of these founders and their businesses. While private equity firms often rely on financial engineering, cost cutting, and eventually flipping the business for a profit, Heico takes a long term permanent ownership mindset. They aren't looking to extract value through layoffs or restructuring. They're looking to preserve and grow what already works by keeping founders in place, giving them autonomy and aligning incentives through partial ownership. Today, Eric and Victor are co CEOs of the company and they're in their mid to late 50s. And when I look at the third generation of the Mendelssohns within Heico, Eric's son David is just a few years out of school and he's responsible for acquisitions at Heico within the flight support group. Eric has spoken very highly of David. He got a degree in neuroscience at Columbia in just three years and he got his MBA at Columbia in just one year and he's clearly already making his mark within Heico. Today Eric has another son that's still in high school and Victor's son currently works in investment banking and may potentially join Heiko down the road as well as Another thing I'll mention as it relates to the Mendelssohns is that they have a business and finance background, so clearly they are well versed when it comes to capital allocation and generating value for shareholders. They very much think like value investors. Larry has a finance and accounting degree from Columbia and has a accounting and real estate background. And then Eric, he studied economics at Columbia and also got his MBA there. I would almost equate Heiko to a miniature Berkshire because they're doing a lot of acquisitions. They focus on where they can create the most value for shareholders. Capital allocation decisions are centralized and execution happens at the subsidiary level as they give managers full autonomy. They invest in businesses with deeply entrenched moats and they think very long term. The Mendelssohn's view acquisitions more as a way to compound cash flow rather than trying to fulfill some strategic vision. Larry Mendelsohn has made the following comments. The business of Heiko, I've often said, is not commercial aviation. It's a vehicle for generating strong cash flow and making profit. And how do you do that? You acquire or develop businesses that have unique characteristics in unique markets. Generally speaking, protected markets, niche markets where it's difficult for other people to compete because of either technology. But it's really the ability and the talent of the individual and the niche in which they're operating. So all of the businesses that we acquire have those characteristics. Lots of other people wouldn't really understand them, but they're run by entrepreneurial people in a decentralized manner and they add to Heiko's snowball of cash. But they have to have some special leg up that makes them very unique and very difficult to compete with, thereby assuring good margins and strong cash flow. That's what we really look for. End quote. Let's take a quick break and hear from today's sponsors.
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Unknown Sponsor
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Clay Fink
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It's a rare combination of flexibility, community and career growth, all backed by a brand that's trusted by millions. For a smart move with long term upside, head to intuit.com expert to apply now or learn more. That's intuit.com expert. Alright, back to the show. If a subsidiary business at Heico is making investments today that aren't going to pay off for one to two years, but they will have an impact further into the future, then Heico's totally fine with them heading in that direction. Where Heico is at today is the result of the sacrifices that were made 10, 20 and 30 years ago. The decision to partner with the airline back in the late 90s and the countless hours that Eric spent in the FAA office in the early days is still paying dividends today. Eric had stated, people ask me all the time why is it that Heico performs? If you look at the length of the economic cycle, we don't have one time write offs. We don't do things that boost earnings in the short term. And I think our culture which has been designed for the long term is very, very different than typical corporate culture or private equity which obviously drives short term results. As a result of their compensation structure and everything they're set out to be. Our people have worked hard year in, year out, the most over decades. So I think that's really what makes us unique. End quote. So the Mendelssohns were also wise to utilize a dual class share structure. So we have two tickers. You have the A shares and the B shares. The A shares is Hei A and the B shares are HEI and it's the B shares that have 10x voting rights of the A shares. This structure was implemented to allow the Mendelssohns to keep control of the business while also allowing other investors to participate in Heiko's tremendous growth and success. Now, interestingly, the two share classes trade at very different prices, despite the only difference being the voting rights. I would recommend that investors consider the A shares over the B shares. The A shares trade at a 22% discount to the B shares. It's amazing to me that the difference is that large given that the Mendelssohns have full control of the company and it will continue to stay that way for the foreseeable future. So getting additional voting rights through the B shares seems to me to be of no value. Turning to the business overview here, Heico's business comprises of two segments. We have the flight Support group or the FSG segment, which makes up around 70% of revenue, and the Electronic Technologies Group or the ETG segment which makes up the remaining 30% of revenue. The FSG segment designs, manufactures and sells PMA parts for the aftermarket of aircraft engines and airframes. These parts are approved, of course by the FAA and are the functional equivalent of parts sold by OEMs. And as I mentioned, they tend to be sold at a 30 to 50% discount relative to the OEMs, giving their customers significant cost savings. Additionally, HEICO tends to not pass along significant price increases. So while the OEMs commonly hike prices by around 5% per year, HEICO is not passing along such increases. So the cost advantages tend to increase with the passage of time and this helps widen their moat and build more trust with their customers. The FSG segment also includes MRO services which stands for Maintenance, Repair and Overhaul Services. This creates an additional recurring revenue stream for the business and Today HEICO serves 19 of the top 20 airlines globally. The ETG segment, on the other hand, designs, manufactures and sells all sorts of high tech products to US and foreign military agencies. Prime defense contractors in both commercial and defense satellite and spacecraft manufacturers. So in this segment you can think about all the parts that go on these types of aircrafts, like, you know, satellites, jets used by the military. Some of their customers include NASA, Raytheon, Lockheed Martin, SpaceX and Medtronic. This segment has not grown as fast as the FSG segment, so it's making up a lesser and lesser part of the business today. It's also primarily a segment that is acquisition driven. In researching their business segments, I discovered that the FAA actually granted HEICO what's referred to as Organizational Design Authorization or oda. And this allows for internal certification of parts. And this is really an incredibly rare privilege. And it's a testament to the trust that HEICO has built with the faa. This privilege enables faster time to market and lower regulatory costs, making the approval bottleneck easier to navigate and virtually impossible for smaller PMAs to replicate. It's a subtle but powerful competitive edge and another testament to just how good Heico's business is. They've sold over 80 million parts over the company's life. They've had zero service bulletins, issued zero airworthiness directives, and zero in flight shutdowns because of any of those parts. This underscores the unparalleled quality and reliability of Hyko's parts, especially in a highly regulated and safety critical industry like like aerospace. This is yet another aspect of Their business that is virtually impossible to replicate and further reinforces their reputation as the safest alternative to OEMs. I just really think it's interesting to look at Heico's competitive position. They have all these factors working in their favor that create this really strong barrier to entries for their business. They have the industry expertise of reverse engineering these parts in a cost effective manner. They know how to effectively and efficiently navigate the FAA approval process, which can be very strenuous, costly and time consuming. And on top of the technical know how and the relationship with the faa, you also need good relationships with the airlines. A company could go through the whole process with the FAA and come to find out that it's extremely difficult to convince an airline to switch to a new player within the industry. So I think that Heico has a really strong first mover advantage where they've built all this trust with many of these airlines and built that reputation as a good partner. Their scale also shouldn't be overlooked as Heico has the ability to offer really good prices because of that scale that they've built in working with practically every airline. It's one thing to build trust with one or two airlines, but it's a whole different thing to build that trust at scale. And there's likely a positive feedback loop too. As the airlines build more trust with Heico, they'll start to wonder why they don't do more business with them. Because the parts are good, if not better than the OEMs, they're more cost effective, and Heiko's just a great partner to work with. It's like when a customer becomes more immersed within Costco's ecosystem. They might start, you know, with a monthly visit at Costco, getting very specific things, and then they realize how much they could be saving by getting their gas at Costco, and then they come to find out that they're offering a bunch of other great deals on a new grill or a new bed. And soon enough they've gained enough of that trust that you're walking into Costco every week. Nick Sleep popularized the term scale economy shared implemented by companies like Amazon and Costco. As Costco has grown, their scale advantage increases, which allows them to pass on more savings to customers, increasing their advantage over smaller competitors. If we look at this dynamic from a slightly different angle, we can say that Heico operates in what we can refer to as diseconomies of a niche market. Heiko sells all these niche parts and dominates the small market within each of these small niches. Economically, it made A lot of sense for Heiko to enter these niches. However, if a competitor tried to enter, they likely would not make a good economic return by doing so. The first reason is that the niche is so small, they would have to be able to steal a substantial amount of share to earn a good economic return. And second, there's very little incentive to switch from using HEICO parts. So HEICO can be viewed as this conglomerate that's in thousands of different niches that they dominate. And despite the Heico conglomerate being a large business, the ponds that they're fishing in are quite small, which helps keep the competition out within the PMA industry. HEICO really doesn't have that much competition. The main competition really comes from the OEMs. They're by far the leader in the PMA space, and it would be a little bit crazy to try and compete directly with them. I'm a bit blown away by just how good their competitive position seems to be. They sell over 19,000 parts, many of which they'll continue to sell for many years into the future. There's little incentive for the airlines not to use those parts once they switch to Heico, which creates a very sticky recurring revenue stream for their business. The HEICO investment thesis hinges on the continued adoption of PMA parts and management's ability to continue to make value accretive acquisitions in the commercial aircraft parts market. It's estimated that just 2 to 4% of that belongs to PMAs and the remaining 96 to 98% is still with the OEMs. It's somewhat amazing to think that HEICO has done so well over the past 30 plus years that yet they are still a small fraction of the size of companies like Boeing and Airbus. To further put their size into perspective, HAICO today sells around 19,500 parts, and some of the Boeing aircrafts have more than 1.5 million parts in it. So there's a long Runway for PMA penetration to still run. OEMs can try to keep airlines from switching to PMAs due to warranties that are in place, leasing requirements, or embedded clauses in their contracts that discourage PMA usage. However, with the potential cost savings by switching to a pma, it can really be an attractive option given that airlines are continually facing margin pressure and are always looking for ways to limit their costs. It's worth highlighting a bit as to why the PMA market is still so small today, given that Heico has been in this space for over 330 years now. There are a number of reasons that airlines might be hesitant to use a PMA supplier, a few of which I'll list here. First, using PMA parts can affect a plane's resale value. Some regulatory agencies or airlines may not be interested in purchasing a plane with PMA parts, so as a result, an airline might be hesitant to use the PMA part for certain parts of the aircraft. Second, OEMs have threatened to be difficult to work with if PMA parts are used. For example, if an OEM's repair team is called upon to fix an engine and the engine has PMA parts in it, then they just might not be interested in working with them. This would definitely not be good for the airlines, as the OEMs will have specialized knowledge. However, it's not in the OEM's best interest to upset their customers, while HEICO is taking the opposite approach of providing significant value and cost savings to their customers. Third, there can be the perception that the PMA part is just not as good as the OEM part. Given that it's cheaper and can sometimes be seen as essentially the same product, it can create the perception that there really isn't any good reason to switch because what they're currently using already works and they've never had any issues with it. If you put yourself in the shoes of the person making the decision at the airline, there's of course potential career risk. If you push for these cost savings and and it ends up being a really painful transition or the parts just aren't as good as you initially thought. This is especially true for the most critical and important parts of an airplane, which HEICO tends to avoid because the switching costs for the airlines are much higher. And fourth, it isn't like the OEMs are just going to throw their hands up and let the airline start switching over to heico. If the airline says hey, Hico has a better part and is offering a 30% discount, then the OEM might be willing to give a bit on price in order to keep the airline from switching. And if airlines work with a supplier who's already good, then they might not really be interested in switching to a lower cost provider, especially if the cost savings don't really move the needle in the grand scheme of things. With all that said, HEICO still seems to be well positioned to benefit from the continued growth of the PMA industry. The travel industry overall can also be quite cyclical with ever changing economic conditions. And when times are tight for the airlines, they're going to be more open to cost saving initiatives such as switching to products that the PMAs offer at a conference, Victor Mendelsohn was giving a presentation and he held up a bag of parts that included pretty basic things like drain plugs and washers. He simply asked the crowd how much they thought that the OEMs would charge for that bag of parts. One person guessed $2,000, which is definitely quite expensive given the parts that we are dealing with here. It turned out that the OEM price that bag of parts at $50,000 and the new version of them was almost 100,000. And the reason the pricing was so high is very simple. It's because they were the only supplier of that part, so they could just hike the price really as high as they wanted to. Given how expensive the maintenance of airplanes can get, it's easy to see why Heiko is such a critical partner for their customers. And since oftentimes they're offering a 40% discount to the OEMs. I was recently chatting with my friend Robert Leonard here the other day, and he's a previous employee here at tip, and he made the comment to me about how airlines probably have one of the worst business models in the world. Airlines have high fixed cost, razor thin profit margins and volatile demand based on things totally outside of their control. And one of their biggest expenses, which is fuel, is very volatile. And again, they have no control over the price of fuel and they face ruthless competition. They're oftentimes competing on price, they face a ton of regulatory constraints, and they seem to almost always be facing issues with labor unions. At some of the recent Berkshire meetings, pilots from NetJets were outside protesting issues related to compensation and working conditions. So while the airline industry tends to get hammered during an economic downturn, these downturns can actually be quite positive for Heico. Because when airlines face margin pressure, they enter cost cutting mode and one of the first levers they can pull is reducing maintenance costs without compromising safety. So rather than pulling back on purchases from Heico, these environments can accelerate PMA adoption, especially for non critical parts where the risk of switching is minimal. In this way, Heico acts as a kind of countercyclical beneficiary within aerospace. The worse things get for airlines, the more attractive Heico becomes as a partner. Additionally, once a customer does eventually switch to the PMA part, there is little incentive for them to switch back to the oem. Zooming in more on the acquisition front. Heico made their largest acquisition to date in August of 2023. They acquired Wincore Group for $1.9 billion in cash and $150 million in stock at a 13 times trailing EBITDA multiple. In the words of Eric Mendelsohn, the acquisition has gone extraordinarily well, outperforming their estimates and delivering tremendous value for shareholders. OneCore was a good target for Heico because they were organized in a very similar manner since private equity saw the model that Heico put together and they emulated it, which made Wincore a good cultural fit for Heico. So it turned out that despite the high multiple they paid of 13 times, the acquisition did so well that the effective multiple they ended up paying is significantly lower than that. Over the past decade, Heiko has increased revenues every year with the exception of 2020, and that growth has accelerated with the acquisition of Wincorp. They continue to remain highly active in its acquisition strategy as they've completed four acquisitions this year in 2025. Like many other successful serial acquirers, Heiko has a decentralized operating structure allowing for subsidiaries to focus on their specialization and do what's best for their business rather than taking a top down bureaucratic approach. One thing that I like to see in most businesses is minimal share dilution. It shows that management is cognizant of the real cost of issuing shares and utilizes other methods of financing a deal. Heiko has increased their share count gradually over the years, but it's less than 1% per year and their stock based compensation is very minimal relative to the size of their business. For example, in 2023 when they made their big Wincor acquisition, it was largely financed with debt and minimal dilution was needed to finance the deal. They also keep their overall debt levels very conservative at around 1 times debt to EBITDA. After the Wincor deal, that increased closer to 2 times, but that was a very value accretive deal and that's still a very conservative level of debt for this high quality of a company. Eric Mendelsohn has said that although the company generates $4 billion in revenue, they really think of HEICO more as 100 companies generating $40 million in revenue on average. Before I looked into Heiko, I sort of assumed that since they were in the aerospace industry, there probably was not a lot of room to grow. But to my surprise, Heico may still be in the earlier stages in terms of their growth. Despite generating $4 billion in revenue, the industry overall is hundreds of billions of dollars. So they certainly have a lot of room to continue to grow and make acquisitions in these adjacent industries that are still related to their core business without needing to venture out too far. I also appreciate management's focus on the long term while Heico has the opportunity to aggressively raise prices. This would tarnish their reputation as a great partner within the PMA space, so they intentionally restrained price increases beyond cost pass throughs. This approach aims to foster customer loyalty, benefiting Heiko over the long term through increased volume and market share gains. Larry Mendelsohn has stated we could charge more, but we don't. We leave money on the table in the short term to build something permanent. This approach to pricing and this long term mindset reminds me a bit of Costco, which I've already mentioned today.
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If you value focus, creativity and a clutter free workspace, I highly recommend Trying the Remarkable Paper Pro. There's even a 100 day satisfaction guarantee so you can try it risk free. Head over to remarkable.com and see for yourself how it can change the way you work. That's remarkable dot com. Picture this. It's midnight. You're lying in bed scrolling through this new website you found and hitting the add to cart button on that item you've been looking for. Once you're ready to check out, you remember that your wallet is in your living room and you don't want to get out of bed to go get it. Just as you're getting ready to abandon your cart, that's when you see it. That purple shop button. That shop button has all of your payment and shipping info saved, saving you time while in the comfort of your own bed. That's Shopify. And there's a reason so many businesses, including mine, sell with it. Because Shopify makes everything easier from checkout to creating your own storefront. Shopify is the commerce platform behind millions of businesses all around the world and 10% of all e commerce in the US from household names like Mattel and Gymshark to brands like mine that are still getting started. And Shopify gives you access to the best converting checkout on the planet. Turn your big business idea into reality with Shopify on your side and thank me later. Sign up for your $1 per month trial and start selling today@shopify.com WSB that's shopify.com WSB all right, back to the show. Costco could have increased their prices to customers for decades, but they never do. This creates trust and a long term relationship with their customers, which ends up creating more value for shareholders over the long run. Because businesses trust working with companies like Costco and Heiko and thus want to do more and more business with them because they provide such an attractive value proposition. Heiko's also balancing the interests of the OEMs as well. So if Heiko comes in and tries to steal a substantial amount of market share for a specific product or niche, then they risk the OEM slashing their prices to retaliate. And this could really end up hurting Heiko. So they're pretty cognizant of finding the right balance of capturing enough market share to capture the cash flows they're looking to get, but also not capturing too much share and upsetting the OEMs. Heiko also benefits from the long cycle nature of the products they sell, as many commercial aircraft engines have decades of production and are used for decades after the product is out of Production. This long product cycle is common across the aviation industry and it gives Heico tremendous revenue visibility. Today, Heico offers over 19,500 different PMA parts, which includes their original catalog of around 12,000 parts in the 7,000 part suite that was added after the acquisition of Wincore. So this is a very diversified business. The next closest competitor in the industry has fewer than 2,000 parts, highlighting Heiko's dominant position in the industry. And every year, Heiko is generating around 500 to 700 new parts per year, which helps drive solid and consistent organic growth. I wanted to transition to talk a little bit more about Heico's culture. By now you've probably realized that Heico's culture is quite unique. The Mendelssohns believe in having an ownership minded culture. Since they operate in this autonomous and decentralized fashion, they want the employees to think like owners, just like they do. Today, The Mendelssohns own 8% of the company and the rest of the board owns 2.5% of the shares. And the employees themselves own 2% of the shares as they have incentives in place for employees to purchase Heico shares through their employee stock ownership plan. In their investor presentation, they note that the board of directors, management and team members beneficially own around 20% of HEICO's outstanding common stock. Now, what's interesting here in a small but telling cultural detail, is that they don't say employees, they say team members. This wasn't a PR move or some corporate fluff. It was a deliberate shift the Mendelssohns made when they took over the company in the early 1990s. Eric and Victor were fresh out of college at the age of 22 and 24, and they suddenly found themselves in charge of a company with people decades older than them, many of whom had years, if not decades of experience in engineering and manufacturing. So rather than pretending to be authoritative bosses, they leaned into humility. They didn't want to refer to others as subordinates. They wanted a culture of mutual respect. And that started with language. Everyone was a team member. When someone feels like a team member, they're not just a cog in a machine. They're more likely to feel like an owner. And Heico backs that up with actual ownership through stock incentives, their employee stock ownership program, and a sense of shared mission. Today, there are over 400 HEICO team members with more than $1 million in stock in their 401s. And that kind of alignment just does not happen by accident. Larry Mendelsohn shared. We have a very exceptional 401k plan. If employees put in 6%, we match it normally with 5% in HEICO stock. Many of our working people, I'm talking about factory workers, shipping clerks, secretarial help are millionaires. Some are multi millionaires. All are as a result of the stock that Heico has given to them. They have personal pride in being a Heico team member that brings their interest aligned with all shareholders. So we think that most of our people are focused on building Heico and being a part of a team. End quote. Heico's culture is really a cornerstone of its success and it's quite different from what you typically see in large industrial or aerospace companies. From the very beginning, the Mendelssohns understood that building a special business required building a special culture. One of the other striking things about Heico is the level of humility and trust embedded in how they operate. The Mendelssohns still operate with what you might call a family business mindset. Even though Heico is nearly a $40 billion public company, they're hands on when needed, but they favor a decentralized structure where autonomy is granted to the leaders of their many subsidiaries. Rather than dictating strategy from corporate headquarters, they empower the people closest to the customer to make these big decisions. They trust their people, and that trust breeds ownership, accountability and innovation. It's not a strategy for every company, but no doubt it's a strategy that has worked well for Heiko. On an earnings call, Larry Mendelsohn talked about some of the little things that they keep an out for in making an acquisition. If they're touring a factory of a company they're interested in purchasing, they aren't impressed by those who understand the factory and how the pieces of the puzzle all fit together to manufacture a niche part. They really like it when the founder would tour around the factory and he would know the names of the people there and he truly cared about them. He would know their family and that employee might have worked with them for over 20 years. That sort of culture goes a long way, and it's the type of culture that Heico wants to build at the foundation. Turning to the valuation here, Heico certainly trades at an elevated multiple relative to current earnings. The price to earnings ratio is 76 and the EV to EBITDA is 38. So the market is certainly pricing in significant expectations for future growth. Investors buying shares of Heiko today are like an NBA team trading for Nikola Jokic. He's unquestionably one of the best in the league. And has a track record to prove it. But the high price tag would only make sense if he keeps delivering elite performance for many years into the future. From 2015-21, you almost saw this secular trend in Heiko's multiple expanding as the EV to EBITDA reached almost 45 before settling back down. Despite the significant Multiple contraction since 2021, the stock has still managed to double since then, continuing to generate excellent earnings growth and shareholder returns. When looking back at recent history, revenue has grown in the mid teens, which has been driven both by organic growth and growth through acquisitions. Slightly more has come from the organic side, which is nice to see given that today they hold a significant market share in the PMA industry. Barclays estimates that organic growth will be around 7 to 10% over the next few years from 2025 through 2027. Part of the organic growth story is simply the growth in air travel globally. Historically, air travel has grown at around 4 to 5% per year and as I mentioned in my episode on Booking holdings, as more people enter the middle class and these emerging economies have more people having discretionary income, this helps fuel the growth in global travel benefiting companies like Kaico and Booking. They also benefit from this trend of aging fleets at these airlines due to significant delivery delays from OEMs like Boeing and Airbus. Driven by supply chain issues, labor shortages and increased demand, airlines are holding onto aircraft for much longer. The average age of airline fleets continues to creep up and as these airlines age, maintenance needs increase substantially and this fuels strong demand for replacement parts. Heiko's return on capital is quite attractive Return on capital excluding goodwill. Prior to their Wincor acquisition was in the 25 to 30% range and when making acquisitions they're pretty disciplined in meeting a hurdle rate of at least 15%. It's just so hard to pinpoint the intrinsic value for this high quality of a business. On the one hand, the company has such a durable business and strong competitive position, but on the other hand is trading near its all time high valuation. But with that said, if they can continue to grow in the double digits for at least the next decade both through organic and acquisition driven growth, and if the Mendelssohns are still running the show, then I could certainly see investors still doing well holding onto shares over the long run. Remember that even Berkshire Hathaway initiated a position in the company in 2024 in the $150 to $180 range. Based on some of the estimates I'm running, they're going to need double digit growth for well more than 10 years to justify today's valuation and take it for what it's worth. But Heico CFO stated in its Q4 2022 earnings call that they have the stated goal of growing their cash flows by 15 to 20% annualized, which is a goal they've achieved pretty consistently now for 35 years. It's also worth noting that there are other aerospace companies that trade at elevated multiples, although not as elevated as Heico's, GE trades at 39 times earnings and TransDigm trades at 51 times earnings, while Heico trades at 76 times earnings, which is partially elevated because of amortization write offs that compress reported earnings. Given that PMAs account for a small part of the overall aerospace aftermarket industry, this leaves plenty of room for Heico to grow due to their advantageous position of being a high quality provider of parts at a lower price than the OEM counterparts. However, we also don't want to adjust a financial model to our liking just because we've fallen in love with the business. There are always good opportunities available in the market, and we shouldn't be afraid to add to a company like Heico to our watch list instead and to simply wait until the market isn't quite as optimistic on a company's future prospects. When we look at the potential risks for investors in Heiko, the company currently trades at a premium valuation, and this elevated multiple implies that even strong business performance may not necessarily translate to outsized shareholder returns if market expectations are not met. If Heiko's growth slows, or if the broader market rerates high multiple stocks downward, the share price could face meaningful pressure. Since the market has high expectations for a company like Heico, any unexpected headwind could lead to a significant drawdown on a relative basis. Another risk is slowing aftermarket growth. In recent years we've seen slowing sales of new aircraft deliveries, which has been a tailwind for the aftermarket industry. Should this slowing trend turn the other way around, you could see less of a tailwind for Heico's business. And lastly, one more risk to consider is simply the FAA becoming more of a bottleneck or a pain to work with. They could potentially slow their approval process even more or potentially hand out fewer approvals. I've long wanted to do a deep dive on Heico here on the show, and my interest was reignited after chatting with Joseph Szpochnik back on episode 731 where we briefly discussed the aftermarket industry. Joseph has outperformed the market over the past decade and his newly launched etf, Rainwater Equity includes four businesses in the aerospace aftermarket industry. This includes Transdigm, which is an oem, so they supply parts to the manufacturers like Boeing and Airbus. GE Aerospace this company broke off of GE in 2024 and it trades under the ticker GE. They're a leading manufacturer of jet engines for commercial and military aircraft and have a massive aftermarket servicing business. And then third we have Lore Holdings. This is a new issue as they IPO'd in April of 2024. Their primary business is serving as an OEM, but they also do have a PMA segment as well in Heico, which of course is one we've covered today. So we had TransDigm, GE Aerospace, Lore holdings and he so Transdigm is especially well regarded in the value investing community. Since inception in 1993 through 2022, TransDigm has returned over 1750 x its primary equity and delivered a remarkable 36% IRR. And this of course makes it yet another case study worth looking into. In addition to Joseph Szpochnik, one previous guest on the show who also owns Transdigm is Brian Lawrence. According to Lawrence's most recent 13F, he has it as his second largest position with over $29 million invested. Like Heico, shares of Transdigm have compounded at high rates for multiple decades. Interestingly, Eric Middleton has sort of taken a jab at Transdigm for their approach to price increases. Additionally, one thing worth noting on Transdigm is they're much more levered than Heico. Transdigm's net debt to EBITDA is over 6, while HEIKOS is around 1. So TransDigm has more of a private equity approach to the industry as they'll buy companies with more debt and not be as hesitant to flex their pricing power. I've heard that sometimes they'll even do price increases of 100% or 200% or more, and this isn't something I think you'd see too often at Heico. Transdigm has a fairly similar business model to Heico. Just over half of their business is in the aftermarket and the remainder is the sales on the new fleets. They benefit directly from the continued growth in the industry and they generate inorganic growth through acquisitions as They've acquired over 90 companies since inception. One can think of Transdigm as the more aggressive player that will do less deals and look to generate very high returns, while Heico is a family run company that won't use high amounts of leverage and they're much more focused on durability, longevity and compounding at moderate rates for decades. Transdigm's success is rooted in its strategy of focusing on protected niches as approximately 90% of their sales come from proprietary products and about 80% from sole source products. So they're in a very similar position to HEICO since there are high barriers to entry as a result of the costly and time consuming FAA approval process for new parts. Furthermore, these components are uneconomical for new competitors to replicate due to their low volume and niche specialties. This focus on the aerospace aftermarket has provided them with predictable subscription like recurring revenue with high free cash flow margins for decades. Nick Halley is the well known genius behind Transdigm as he's the Founder and Executive Chairman and he stepped down as CEO in 2018. Cowley was on the 50X podcast with Will Thorndike, author of the Outsiders, which I'll be sure to get linked in the show notes. He was also profiled in the book Lessons from the Titans, which covers some of the most successful stories from the industrial sector. I found one funny line from Nick Halley that I thought would be worth sharing here. Oftentimes we hear that we should be invested with managers who are in it for something more than the money. Oftentimes, you know the mission of the company. Elon Musk, for example, talks about his mission of making life multi planetary or accelerating the world's transition to sustainable energy. When an investor asked howley why they should be invested in Transdigm if he's selling millions of dollars of stock, he was brutally honest in his response. He said, this may come as a surprise to you, but I'm in this for the money. I haven't had many chances to sell stock under private equity ownership and now I do. My wife wants a beach house so we're gonna get a beach house. You can believe what you want, but I'm not going anywhere. I've got more money to make and if you choose to, you can make it with me. I just love the brutal honesty there and I just sense this sort of killer attitude from Halle where he really just loves winning and wants to win at all costs. From the book I mentioned, Lessons from the Titans, the authors write the people there work harder, sleep less, and make more money than at any other company I've ever encountered. If you're a typical product line manager in an average industrial business, you likely take home 250,000 in annual compensation. That same product line manager at Transdigm can make a million dollars. All this wealth creation is a result of a compensation plan that reinforces the desired outcomes, end quote. They also give an excellent example of one of their acquisitions. Just to give a sense of how strong the moats can be within this industry, the authors write, anyone who's ever been on a commercial flight knows what an aircraft seat belt looks like and how it works. I bet you can picture the exact look and feel of the buckle and hear the flight attendant over the PA system saying, fasten your seatbelt by placing the metal fitting into the buckle and adjust the strap. Why is it that almost every aircraft seatbelt has a buckle just like the one you're imagining? That's because almost no one but the maker of the original buckle has ever certified other designs with the faa. As a result, a company named Amsafe accounts for more than 95% of the global aircraft seatbelt market. How good a business is airplane seatbelts? After all, it's only three pieces of metal in a spring. Well, you can ask transdigm. They paid $750 million for Ampsafe in 2012 and it's generated a 20% plus return on its investment. Aircraft seatbelts are a fantastic business, especially in the right hands. Look inside Transdigm's product portfolio and you'll find thousands of other widgets that don't appear complex products incorrectly deemed crappy because you literally find them in the airplane restroom, laboratory, faucets, drain assemblies and door locks. Then there are overhead bin latches and extruded plastic vents that push cold air into the cabin, along with a litany of valves, pumps, cables and connectors that all play a role in the flights of millions of people around the world every day. These businesses are phenomenally profitable, and they're all owned by Transdigm, which is fully understood and maximized the returns from each of them through 2019. Prior to the disruption caused by the COVID 19 crisis. The value created from these businesses made Transdigm the best performing stock in industrials since the company's 2006 IPO, increasing by roughly 50 times over, including dividends. A company that started with an initial equity investment of $10 million 25 years ago grew to an enterprise value that was over a thousand times larger. End quote. So now you know why so much in an airplane practically never changes. And the same seatbelts that we saw 10 years ago are the same ones we use today. Although this is not great for us as consumers because there can be no new innovations, it's excellent for investors because there's no new competition coming in to arbitrage away the high margins and returns that businesses like Heico and Transdigm are generating. Lastly, the book outlines three primary value drivers to Transdigm strategy that I'll outline here. The first is value based pricing, which to some can be perceived as leveraging their monopoly position to aggressively raise prices to unfair or excessive levels. But it's really about focusing on extracting the appropriate value commensurate with the types of parts they're producing for every part. Transdigm is maniacally focused on earning an appropriate economic return. So as older planes are retired and production runs of spare parts become less frequent and more challenging to predict, Transdigm wants to be compensated not just for the direct cost of the part, but the cost of keeping production lines going with skilled labor and good machinery. This leads to price increases at a company level at around 5% per annum. The second key value driver is productivity. Transdigm seeks to raise prices above the rate of inflation, which they see as 3%, but keep the rate of growth of costs below 3%. They have a culture of innovation and encourage each of their businesses to get more for less year after year. A simple way to see if they're effective at limiting their cost or not is to simply look at margins. Since 2015 their net profit margins have improved from 16% to 22% and the final value driver is the focus on profitable new businesses. Too often new lines of business are pursued that generate sales growth but not profitable sales growth. This is not the case at Transdigm, as a company does not entertain business development efforts unless they have a clear path to profitability. There are no exceptions to this rule. Even with these strict principles, the company has been successful in its new business generation efforts and has done so with a tightly managed R and D&CPEX budget. Anyways, I think for those interested in Heico, it's also worth studying some of these other successful companies in the industry. It's clearly a large enough industry for multiple winners. HEICO especially is a truly special business and I always enjoy studying these businesses with longtime management teams that have created a unique culture that's extremely difficult for others to replicate. I've covered similar companies in the past that are in different industries, including Copart, Costco and Hermes, and I see many parallels amongst all of them. With that, I think we'll close out the episode there. Thank you for your time and attention today. I hope you enjoyed the episode and I hope to see you again next week.
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