Brand-X Airplane Parts Maker: Cleared for Take Off

By Michael Brush
Exclusively for InvestorIdeas.com
October 26, 2006

If you look out the window next time you are on a plane and see a simple white engine with unadorned black lettering – sort of like a box of off-brand macaroni – don’t be too surprised.

The age of generic replacement parts for airplanes is upon us.

Of course, you probably won’t ever fly on a plane that has an entirely “generic” engine. They’ll still be made by the three trusty, dominant jet-engine builders: General Electric (including CFM International); Pratt & Whitney which is a division of United Technologies; and Rolls Royce.

But the replacement part business is another matter. For years it has been a lucrative playground for these big-three plane engine makers. Using the power that comes with oligopoly, they’ve force regular price hikes of 5%-12% a year for parts on the airlines, air cargo companies and the military.

They’ve made good use of the old “razor and blade model” so idolized by Warren Buffet. They’ve sold the engines cheap and made their money on the replacement parts.

But now, a small Hollywood, FL-based company called HEICO (HEI) hopes to change all that. HEICO makes generic replacement parts that are cheaper than those produced by the big engine makers.

In partnership with Lufthansa Technik, which has a stake in HEICO and is one of the biggest companies in the world doing aircraft overhauls, HEICO wants to break open the replacement parts business and get a bigger foothold.

Putting up resistance

That’s been hard to do because the big engine makers want to protect their lucrative aftermarket for replacement parts. So naturally they have raised questions about the quality of generic engine and airplane parts, known in the industry as “PMA parts.” PMA stands for “parts manufacturer approval,” or the regulations under which these parts are given the green light.

But in early 2006 Pratt & Whitney announced it was moving into the generic plane parts business itself. It’s developing parts for the CFM56-3 engine, one of the most popular engines. Made by CFM International, the engine is used in the Boeing 737 and the Airbus A320 planes.

With one of the big three jet engine makers going into the generic parts business, it has a newfound respect.

Wind at its back

In other ways, HEICO now has the wind at its back. Right now, generic parts only account for 2% of the $14 billion parts market. So there is plenty of room to grow. Consider these trends that may help.

• Around the globe, the aircraft fleet is aging. And it is being used a lot more, as air travel has bounced back. That means more wear and tear. So maintenance is growing.


• As most travelers know, airlines are looking everywhere to cut costs including under your pillow -- that is back when they used to give you a pillow. So it stands to reason that airlines welcome generic parts – parts that represent 60% or more of the cost of an overhaul. HEICO has over 5,000 parts approved – including things like combustion chambers, compressor blades and seals. It hopes to have 350 new parts in 2006. But there is much more room to grow here, too. There are anywhere from 10,000 to 20,000 parts in jet engine platforms.


• HEICO struck a deal with the China Aviation Import and Export Group Corporation (CASGC) last February. Owned by the Chinese government, CASGC purchases the aircraft and engines for Chinese government airlines. The agreement allows HEICO parts to be sold in China – giving it exposure to robust economic growth in China. HEICO also has partnerships with American Airlines, United Airlines, Delta Air Lines, Air Canada and Japan Airlines. These partnerships help it get a better handle on what parts to make.

Besides trying to build the market for generic airplane parts, HEICO should continue to grow through acquisitions. It has purchased 27 small businesses in aerospace, defense, and electronics since 1996. Growth through acquisitions should continue.

The insider buying

All of these factors help explain why four directors and chief executive Laurans Mendelson bought about a quarter million dollars worth of HEICO stock at $35.39 on October 20, according to Thomson Financial.

Chief executive Mendelson’s purchase was a particularly bullish signal, and not only because it was the largest. Besides that, Mendelson already owned about 1.4 million shares, and he has around 212,000 unexercised options. Whenever you see a chief executive topping off big exposure to a stock like this, it’s an even better buy signal. Mendelson has also cashed in over 200,000 options in the past few years. But he hasn’t sold any of the stock.

Five analysts project HEICO will turn in 20% annual earnings growth over the next several years, according to Thomson Financial.

An options overhang

One sour note is that HEICO issues a lot of options, which isn’t unusual for a defense and aerospace company. However, it creates a dilutive overhang. Company documents show there are 2.8 million options outstanding with an average exercise price of around $10. That’s over 10% of the total shares outstanding of 25.3 million. Those options will either dilute the shareholder base as they are cashed in, or the company will have to spend cash to buy back stock to offset the dilution.

Besides designing and selling parts through its Flight Support Group which brings in about 70% of revenue, HEICO also has an Electronic Technologies Group. This division provides sophisticated electrical and optical systems used in aerospace, defense and communications – things like infrared simulation and test equipment, power supplies, electromagnetic interference shielding, and amplifiers. These products have higher margins. The division accounts for about 30% of revenue.

An unanswered question

But getting back to the generic parts business, one burning question probably remains unanswered in your mind. Are generic parts safe? The answer: Generic parts are certified by the Federal Aviation Administration as being equal or superior to the original manufacturer parts they are replacing. There. That should make you feel better.

The bottom line: This looks like one of those situations where a company will continue to gain market share because of a simple, but powerful force in capitalism, the desire in private industry to drive costs down. One brokerage recently initiated coverage and a big part of HEICO’s strategy is to grow through acquisition – so I wouldn’t be surprised to see some kind of financing around the corner. That can temporarily bring shares down. Otherwise, HEICO looks like a buy right here.

Disclaimer

At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.

For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

Insiders Go for Ghanese Gold Play Called Golden Star; Plus Updates on Three Energy Stocks

By Michael Brush
Exclusively for InvestorIdeas.com
October 05, 2006

If you are a gold bug why should you be praying for rain in Ghana? Because water reservoirs are low in this West African country, and that’s cut electrical power which has forced gold mining companies to reduce production.

That’s one reason investors who hold Golden Star Resources (GSS) have been in pain of late. Tiny Golden Star holds large chunks of land it what’s known as the Ashanti Trend in Ghana, a region long known for its abundant gold resources. From recent highs above $3.75 in May, Golden Star has tanked to below $2.50 – a 33% decline.

Down here the stock looks cheap. It has a price to book ratio of 1.2, compared to levels twice that or more at many mining companies.

That’s probably one reason insiders recently picked up $275,000 worth of the stock. Buyers included chief executive Peter Bradford, who spends most of his time with feet on the ground in Ghana – better to manage progress. (Golden Star is based in Colorado.) Bradford alone plowed $225,000 into the stock. Insiders bought at prices between $2.24 and $2.74 in late September.

Over the next several months or so, Golden Star will likely expand its processing capabilities to handle different types of ore. This plus some other changes could more than double 2005 production of 200,000 ounces to over 500,000 ounces in 2007.

That’s the game plan. The problem is Golden Star has had problems keeping promises on matters like earnings and costs, not to mention the quality of mines.

So this stock is now the proverbial “show me” story.

Normally “show me” stories are risky. But when insiders plow a substantial amount of money into a stock, it tips the balance in favor of success.

That’s what we have here. Gun-shy analysts and investors are cautious, while insiders put money into the stock on a significant dip. Typically, these kinds of situations work out on favor of investors who are long.

Golden Star’s main operating mines in Ghana are called Bogoso, Prestea, Wassa and the Prestea Underground. They are all in southern Ghana. Golden Star has proven and probable gold reserves of 3.8 million ounces and “indicated” gold resources of 3.62 million ounces.

Show Me

Despite its potential, Golden Star has several strikes against it. These are all pretty well known, so I’d guess they are priced in to the stock. But it’s always good to know what you’re up against when you are long a stock. Here’s a look.

• Poor track record. Golden Star has a record of missing expectations because of disappointing operating results and development delays. Its Wassa mine has operated below expectations since its start-up in April 2005.


• Illegal mining. Illegal miners in Ghana go so far as to carry out their own blasting operations which, of course, disrupt Golden Stars’ own efforts, delaying projects. Unlike Venezuela, where the government has aggressively moved out illegal miners, Ghana doesn’t seem to be doing as much.


• Funding needs. Expansion projects are costly and Golden Star may need to raise more money. This could be dilutive to existing shareholders.


• Power shortages. They’ve disrupted mining operations and exploration, as well as progress on the development of a new processing plant which would help Golden Star a lot. A nearby hydroelectric station in Ghana is operating at below capacity because of low reservoir levels. It’s recently rained a lot in Ghana, and utility officials are supposed to be meeting now to decide if they can up power production. Golden Star has diesel-powered generators but these cost about five times as much.

Lukewarm rating

Because of challenges like these, CIBC World Markets analyst Brad Humphrey recently cut his price target on this stock to $4.05 from $4.85, maintaining a lukewarm “sector perform” rating.

He says investors now have a "wait and see" attitude, and it will take several quarters of meeting expectations before this changes. “In the meantime, we do not expect Golden Star's shares to outperform its peers,” writes Humphrey in a recent research report.

Potential Catalysts

Insiders clearly disagree, given their purchases. Here’s a look at some of the potential catalysts on the horizon, besides a return to normal power generation.

• 
  Bogoso sulfide expansion. If you want to skip the science, it’s enough to know that Golden Star’s plant at its Bogoso site can’t process more than half the ore that comes up. They are putting in a new plant that can help get the job done, which could increase overall gold production to 500,000 ounces next year.

Now for a more technical description. Gold ore reserves at Golden Star’s Bogoso and Prestea mines come in two types. One kind contains no sulfides, or it has sulfides that have been naturally oxidized. These are called “oxide” or “non-refractory” ores. These ores can be extracted by what’s called “carbon-in-leach” processing. In this process, cyanide is used to leach out gold which is then absorbed by carbon.

In contrast, "refractory" ores contain un-oxidized sulfide which traps gold. These ores cannot be processed by “carbon-in-leach” plants, like the plants Golden Star has at Bogoso. So Golden Star is adding a bio-oxidation plant to help get the job done. Bio-oxidation is a process that uses bacteria to oxidize refractory sulfide ore so it can go through carbon-in-leach processing. See? That wasn’t so hard.

• Feasibility studies. Other catalysts include two feasibility studies for the Prestea Underground and the Hwini-Butre and Benso projects. These are expected before the end of the year. Initial tests have shown decent potential.


• Wassa mine improvements. This mine has been one of the disappointments that has investors concerned. But higher grade ores may be coming up from other pits near this mine.


• Takeover bait. Down at these levels, big, resource-hungry players in gold may be eyeing Golden Star as a takeover candidate.

Gold prices

Small swings in the price of gold can have a dramatic impact on earnings at mining companies. Fortunately for Golden Star, the outlook for gold is bullish.

As a metal, gold seems like a mere commodity. But sophisticated observers know gold has held a power psychological grip on investors and non-investors alike for centuries – as a source of beauty as well as a store of value in uncertain times.

Historically, gold has been the default currency when economic systems and fiat currencies go haywire. Rightly or wrongly, that hasn’t changed. So with all of the geopolitical uncertainty in the world, demand for gold should stay strong from “gold bugs” who seek comfort and security in bullion.

These forces should support demand as well:

• A rising middle class in India, where people, like elsewhere in the world, have a fascination for gold jewelry. Wedding season is around the corner in India which -- believe it or not -- has some gold analyst bullish on demand for bullion.


• A weakening dollar which will continue to fall. This helps gold because it’s priced in dollars. So as the dollar drops, it looks cheaper to many buyers who operate in non-dollar currencies. So they buy more gold.


• Signs of inflation, which makes wealthy investors worry that their money will lose value. Gold has acted as a classic hedge against inflation in the past.
  Declining gold sales by central banks around the world, which will reduce supply according to some analysts.


• Where does all this leave Golden Star? “It’s one of the cheapest gold stocks out there,” says Thomas Winmill who manages the Midas Fund (MIDSX), one of the top-performing precious metals funds. He thinks Golden Star is among gold stocks with the least downside and the biggest potential upside. He has long exposure to the stock.

Follow up

Insiders were recently adding to positions at the following stocks featured at Insiders Corner. They have been buying at:

Abraxas Petroleum (ABP) click here
Oil field services company Weatherford International (WFT) click here
Goodrich Petroleum (GDP) click here

Finally, we have to award an honorary badge of courage to insiders at homebuilder Tarragon (TARR). With greater exposure to urban real estate markets, Tarragon supposedly has protection against the dramatic weakness in housing markets across the country.

Insiders sure think so. Since the middle of May, they have stubbornly continued to buy as the stock steadily eroded from $16.75 to recent levels of $9.73. With most of their purchases under water, insiders kept up their buying in late September. Most of their purchases have been poor buy signals, but you have to admire their persistence. Who knows – the most recent purchases at $9.73 may have marked the bottom for the stock.

The bottom line: Gold has pulled back dramatically since highs in May. But the bull run is not over -- for all the reasons listed above and more. Buying bullion is the safest bet on higher gold prices since you don’t have to worry about managers mucking up, says commodities expert and adventure capitalist Jim Rogers, author of Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market. Despite Jim’s admonition, I think you’re likely to get more upside – albeit with additional risk – in a beaten-down gold company where insiders are buying, like Golden Star. I’d buy right here below $2.50.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.