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.