HEICO Has A Great 'Business Moat,' But Not A Great Stock Valuation

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Many investors love companies with business moats but finding one that works as an investment isn’t easy.The key isn’t really having a moat… it’s about the process of building and enhancing the moat....

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I really wish I could be bullish, but sadly, I can’t even be neutral toward the stock.   EXTREME-PHOTOGRAPHER/E+ via Getty ImagesSurely, you’ve heard of moats. It’s a metaphor that signifies a business that is protected from outside threats… mainly from competitors. Think of it like a moat that surrounds a castle. It keeps invaders at bay. A gurufocus.com article reproduced (for free on Yahoo Finance) detailed Warren Buffett’s idea of a business moat. (He’s the one who popularized this idea.) He wants “a business with a wide and long-lasting moat around it, surround -- protecting a terrific economic castle with an honest lord in charge of the castle.” Rather than surround corporate headquarters with water, Buffett suggests as follows: What we're trying to find is a business that, for one reason or another -- it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it. On paper, that sounds irresistible. Many analysts on Seeking Alpha discuss moats. And Morningstar (MORN) built its equity research protocols around it. Check some of that firm’s reports. (You can probably find them for free in the Research portions of your online broker’s website.) Most of the analysis centers on how narrow or wide a moat the company has, or if it has any moat at all. But do moats really work for investors? If they do, you’d think the VanEck Morningstar Wide Moat ETF (MOAT) would have consistently beat the SPDR S&P 500 ETF (SPY) after it debuted April 25, 2012. As of today, MOAT is ahead 416% to 386%... and that’s over more than 10 years. StockCharts.comMaybe the moat metaphor is flawed. I won’t even say MOAT is less volatile. And until the super growth stock gyrations (surges and corrections) that started just before the pandemic, trends for MOAT and SPY are barely distinguishable. This falls far short of what the exalted rhetoric around moats should lead us to expect. Maybe the standard moat metaphor is flawed. Let’s face it… Buffett never claimed poetry as a skill set. (At a Berkshire annual meeting I attended in the '90s he admitted to having only skill. He cited his talent for allocating capital. He admitted that had he applied that skill at a different point in time, he’d probably have wound up as “lunch for some animal.”) Or, maybe, the concept is being misapplied and Buffett is a tolerable poet after all. Here are some additional Buffett remarks that don’t seem to get much attention. But we are trying to figure out what is keeping -- why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle? (Emphasis supplied by me.) That’s what makes moats work. Having one means nothing. (None of the moat-protected Medieval castles survived. All fell prey to siege, catapults, etc.) What counts is the process of building and strengthening a moat. (I won’t get carried away by permanence. Nothing is. In 2018, Bezos acknowledged that Amazon.com (AMZN) will eventually go bankrupt. Let’s just worry about a reasonable investment horizon.) Perhaps that’s why I’m so impressed with HEICO Corporation (NYSE:HEI). Morningstar says this aircraft parts maker has a narrow moat. (Schwab link.) Take a look at what HEI’s (shown in red) narrow moat has been sparking, in the market, compared to SPY and MOAT. StockCharts.comI suppose if that’s what narrow does, I don’t want to be wide! (Feel free to sing that to the tune of If Loving You Is Wrong I Don’t Want to be Right.) Actually, as I’ll show below, I think HEICO’s moat is wide. But first… The Basics of HEICO – Pretty Good The company has two segments. One is the Flight Support Group (FSG). The other is Electronic Technologies Group (ETG). FSG designs, makes and distributes replacement parts for jet engines and planes. HEI IRThink of this as analogous to independently made auto parts your mechanic may have bought and installed in your car. The more you use your car and the longer you keep it, the more replacement parts you’ll need. It’s that way, too, for jet engines and planes. You know how inconvenient it can be if you aren’t diligent in maintaining your car and diligently addressing worn down parts. For aircrafts, messing up here is not merely inconvenient. It can be catastrophic. It can be lethal. Have you ever watched the Canadian documentary television series, Mayday (airs in the U.S. on the Smithsonian Channel as Air Disasters)? If so, I’m sure you’ve seen how devastating an issue even in a tiny part can be. So as planes leave the ground, so too does this critical need to maintain. Ditto the need to ditch and replace any part, no matter how tiny, that’s no longer just right. We know, though, that plane usage ebbs and flows. The 2020 pandemic year, with air travel disrupted, and many planes grounded, was a business nightmare for the industry. It took some time to get up and running as Covid receded. As in many industries, rebuilding the supply chain took longer than rebuilding demand. But things are humming along now. Actually, humming along is putting it mildly. FSG today is, quite literally, a powerhouse. Some pockets of demand are stronger than others. As new planes come into service, that limits the overall need for replacement parts. But there’s enough demand from older planes to keep FSG’s results on a strong uptrend. Acquisitions also add to the bottom line. These come at hard to predict times and in hard to advance guess sizes. So, we could see year-to-year comparisons moderate in 2025 when compared to this year’s numbers. Even so, FSG’s progress remains excellent overall. ETG designs, makes and distributes “electronic, data and microwave, and electro-optical products” (according to the 10-K description). HEI IRThese are highly engineered, mission-critical items use in aircraft, rotorcraft, satellites, ships, spacecraft, land vehicles, handheld devices, etc. The 10-K tells us their uses. Include “targeting, tracking, identification, simulation, testing, communications, lighting, surgical, medical imaging, baggage scanning, telecom and computer systems.” They have to function in sometimes-very harsh environments. These involve smaller niche markets. ETG items are every bit as important to the respective platforms into which they’re installed as are those sold by FSG. But the nature of the activates is not as persistent and routine. At the moment, the ETG as a whole isn’t hot like FSG. Demand stemming from ETG’s Aerospace and Defense customers has been and still is strong. That’s been less so lately from other kinds of customers. But inventory de-stocking among the latter looks to have run its course. Management expects strong results in 2025 from these other sources. Anyway, thanks to FSG’s strength, the company as a whole is powering ahead. Here are the segment breakdowns. They show how well FSG is doing now. Analyst Compilation and Calculations based on data from page 114 of latest 10-K and pages 27 of latest 10-QAnalyst Compilation and Calculations based on data from page 114 of latest 10-K and pages 27 of latest 10-QAnalyst Compilation and Calculations based on data from page 114 of latest 10-K and pages 27 of latest 10-QHere’s a look at recent and projected quarterly trends. Analyst Compilation based on Data from Seeking Alpha Earnings and Financials PresentationsAnalyst Compilation based on Data from Seeking Alpha Earnings and Financials PresentationsTrend fluctuations aside, HEI’s growth has been and is significantly outpacing Industry (Aerospace) and SPY medians. (I prefer medians since these aren’t impacted by wild distortions often caused by unusual data items, even in big companies that can dominate weighted averages.) Analyst's computations and summary from data displayed in Seeking Alpha PortfoliosAnalyst's computations and summary from data displayed in Seeking Alpha PortfoliosThis growth track record owes much to… The Moat HEICO Has Been and Still Is Building Here’s where the replacement auto parts analogy ends. HEICO can’t just make parts and sell them. It can only sell PMA (Parts Manufacturer Approval) parts. The approval comes only from the Federal Aviation Administration (FAA). The FAA issues two kinds of PMA approvals. One is a Design Approval. To get this, HEI must show “that a replacement or modification article complies with the airworthiness standards of eligible products (aircraft, engine, or propeller)….through tests and computations.” The other is Production Approval. HEI has to convince the FAA that it should be allowed to produce and sell FAA approved aircraft articles that are eligible for installation on FAA type certificated products. The regulatory scheme for this is demanding. HEI isn’t the only company that makes PMA parts. But it makes a heck of a lot of them. The company’s latest 10-K tells us it had already developed about 19,500 such parts. And its adding about 350-500 per year. Most importantly, according to Morningstar’s August 27, 2024 report, “HEICO has a 30-year record of never having a part fail in flight, which is difficult to replicate and likely makes airlines substantially more willing to use HEICO parts as spares rather than those from other, smaller PMA suppliers.” Aircraft original equipment manufacturers (OEMs) also sell parts. But PMA parts tend to be 20% to 80% cheaper. So you might think HEI has a bigger market share. Interestingly, that’s not so. OEMs dominate the market for replacement parts. And there’s logic to this. Buyers of new planes tend to also take OEM service contracts through which OEMs use their own parts. Doing otherwise and putting non-OEM parts into the plane could hurt resale value. That means HEI sells mainly for planes in the latter stages of their useful lives. That’s when the airline is more likely to be thinking use-and-then-scrap rather than use-and-then-sell. Now, the incentive to use cheaper (but equally high quality) PMA parts is strongest. In theory, OEMs could go after this business, too. But they’re not fools. They have bigger fish to fry… like manufacturing newer, more sophisticated and more expensive equipment. And this is hard. Boeing’s (BA) safety problems have been hogging headlines. But even Airbus can’t rest easy. (Source) Meanwhile, if I say, “Rolls-Royce,” the words luxury and quality may reflexively pop into your mind. Besides cars, they make jet engines. And even these have been experiencing problems. I can’t imagine the FAA looking favorably on efforts by OEMs to pull resources away from their demanding new equipment needs in order to compete with HEI in selling parts for the oldest planes! But even given that, HEI isn’t pushing its luck. It won’t develop, produce and sell just any part. It says, in its 10-K, that it goes through “a selection process which analyzes industry information to determine which replacement parts are suitable candidates.” Much of this is done based via internal development. But that’s not all. HEICO is a consistent acquirer. Since 1990, it made 98 purchases. Many have been small additions. One, the August 4, 2023 $1.9 billion purchase of Wencor, has been big. All however, have to fit into HEI’s quality standards. Working under the PMA regulatory umbrella is mandatory. From 1990 through 2023, HEICO achieved annual sales and net income growth rates of about 15% and 18%, respectively. Acquisitions are included in those growth rates. It would, of course, be sexier to say all that growth has been organic. But let’s respect those numbers anyway. The easiest way to differentiate between a skilled strategic acquirer versus an unskilled empire-builder acquirer is a sales growth rate well in excess of growth in net income. That would mean the acquirer is overpaying just so it could say the company is big. HEICO’s growth rates suggest its acquisitions haven’t just been making it bigger. It’s been getting better, too. That’s confirmed by a look at the basic fundamentals. Analyst's computations and summary from data displayed in Seeking Alpha PortfoliosDebt to FCF is a bit high, but not troubling. Considering the company just recently made the big Wencor purchase, I understand it. Debt ratios and interest coverage are fine. Returns on equity and assets are also pretty good. They’re way above industry medians. And they’re in line with the SPY medians. Those numbers wouldn’t look the way they do unless HEI is getting a lot of things right. Actually, it’s what we would expect from a company that has and continues to build on a strong business moat. Risk Every business has risk, even those with moats. For HEI, a product failure leading to catastrophe is an ever-present risk. So, too, is the potential for another event, like COVID, that would ground planes en masse. So, too, is the risk of a big future acquisition that turns into a mess. These are the kinds of risks lawyers make companies recite in their 10-K filings. I can’t point to anything that tells me something like that really may be on the horizon. But events like this might happen. I should remind you here that Morningstar assigns HEICO only a “narrow” moat. It’s not wide because, according to the Morningstar report, “[w]e do not have enough confidence that (lack of competition from smaller players and OEMs) would necessarily hold over 20 years.” Moats are creatures of opinion, not fact. Morningstar (apparently following Buffett) seems to aim for permanence. As mentioned above, I’m looking for a reasonable investment horizon. So, I’m of the opinion that competitive risk is no more than a formal 10-K type thing. I therefore say HEICO has a wide moat. To me, the mega risk right now is stock valuation… What to do About HEI Stock I would love to buy a Lamborghini. But it’s too darn expensive. I would love to buy HEI stock. But it’s too darn expensive Analyst's computations and summary from data displayed in Seeking Alpha PortfoliosIf you’ve seen my September 6, 2024 Tesla article, you might wonder why I don’t do for HEI what I did for TSLA. For TSLA, I said “Buy” despite valuation ratios higher than what we see for HEI. I did so by breaking TSLA into a commercial component (the everyday business) and aspirational venture component. That doesn’t work for HEI. Its commercial activities are terrific. As discussed, it’s doing a wonderful job building and enhancing a wide moat. But as great as that is, it’s still limited to the existing business; what we see today. There’s nothing new on the horizon, analogous to TSLA’s full automation goals. If I thought the Street’s future growth expectations were meaningfully understated, I could, perhaps, argue for a venture-like label for un-forecasted growth. But the 17.93% PROJ 3-5Y EPS Gr is in line with what HEI has achieved since 1990. I have no basis for saying it’s too conservative. Suppose I set the PEG FWD to, say, 2.75. That would put the P/E FWD at about 50. That would give us a $177 stock price. And the EV/Sales would be at about 6. So, I can’t find a way to say “Buy” right now. My first glance at the price chart suggests I can get away with saying “Hold.” StockCharts.comThe still-rising 10-day exponential moving average (EMA) is and for a while has been above the price. It’s also above the rising the 50-day EMA and that too kept on rising. That’s favorable. But look at the Chaikin Money Flow (CMF) indicator and the Chaikin Oscillator (CO). Both measure which party to trades is more motivated. CMF does it for institutional investors. CO does it for the market in general. The CO is now moving below neutral. I could live with that considering how bouncy this line has been. But I’m bothered by the CMF. The stock’s strongest rallies over the past 12 months have been accompanied by very strong CMF. That indicates a lot of support from institutional investors. That’s not so for the latest rally. CMF has been above neutral. But it’s been uncharacteristically anemic. Institutions seem to be finding it hard to keep buying. That, plus the high valuation, equals “ouch.” As I’ve said before, my investment stance depends mainly on whether I think a stock will be better than, in line with, or worse than the market. Here’s how I apply that to the Seeking Alpha rating system:  “Strong Buy” means I see the stock as being better than the market, and I’m bullish about the direction of the market. “Buy” means I see the stock as being better than the market, but am not confident about the market’s near-term direction. “Hold” means I see the stock as moving in line with the market. “Sell” means I see the stock as being worse than the market, but am not confident about the market’s near-term direction. “Strong Sell” means I see the stock as being worse than the market, and I’m bearish about the direction of the market.   Based on this scale, I’m sadly rating HEI as a “Sell.” Opinions on companies and stocks can differ. That’s so here. I love the company. But I can’t condone this stock price. 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