Heico (HEI) Earnings Review

Heico  (NYSE: HEI  )  this week delivered solid fourth‐quarter earnings, and guided toward 8%‐10% growth in net sales and net income for 2015. Moreover, management served notice of its intent to "aggressively pursue" acquisition opportunities to generate growth.



Heico's stock is slightly down on the year, even as the commercial aerospace sector has continued to grow strongly. However, given good growth in its commercial aviation end market and its increased cash flow generation, Heico has good growth opportunities going forward. Let's look into the details.


READ THE FULL EQUITY RESEARCH ARTICLE LINKED

More Key Takeaways From GE's Report

Whenever General Electric  $GE gives results, the market tends to listen very closely. Its recent earnings report was broadly positive with orders up 8% and guidance of double-digit industrial earnings growth for 2014. However, a company of this size will never have all its industry sectors working well at any one time. In a previous article, its power and water, oil and gas, and lighting and appliances segments were looked at. Now it's time to look at its aviation, health care, and transportation units.

GE's profit split
In order to see the importance of its relative segments, here is a breakout GE's segments profits in 2013:

Source: Company presentations.

Of the four most important sectors, aviation and oil and gas put in the best performances in 2013. Power and water disappointed -- particularly in the first half -- but orders and revenue came back strongly in the second half. In the fourth quarter alone, power and water equipment orders were up 81%, and segment profits rose 9%. Meanwhile, its health care performance was relatively mundane with just 4.4% profit growth in the year.

Source: Company presentations.

GE's health care segment and Covidien
Despite its relatively mundane performance, GE's health care results are interesting because they highlight a bifurcation in global health care spending on capital machinery. Austerity measures and cash pressures are putting pressure on hospitals in developed markets, while emerging markets are more willing and able to spend. For example, in its fourth quarter, GE's health care orders were flat in the U.S., with Europe only up 2%. Meanwhile, Latin American orders were up 15%, with China up 8%.

These trends play to the strengths of a company like medical device company Covidien  $COV . The company's is characterized by having relatively low-ticket medical devices; something very attractive to emerging markets. Indeed, its growth prospects and investment plans are weighted toward emerging markets. Covidien grew sales to the BRICs by 25% in its last quarter, and it plans to generate at least 20% of its total sales from emerging markets by the end of 2014.  All told, Covidien has the potential to outgrow its markets.

GE's aviation segment
Aviation has been the star performer in GE's industrial segment, and for a host of reasons the commercial aerospace market has bright prospects in 2014. On the conference call, GE's management predicted that its jet engines "will be up to 2,500 units, versus about 2,378 in 2013", but the most interesting commentary was concerning its 16% rise commercial spares demand. In answering an analyst question on the subject, Immelt replied that flying hours were "improving dramatically", and airlines were restocking as they had cut back on inventory levels in 2012. Meanwhile airline fleets are growing and aging as well.

All told, this is great news for a company like Heico  $HEI . Heico generates two-thirds of its sales from its flight support group whose services include parts, repair and distribution for airlines. The segment put in a stellar performance in 2013 with sales and net income rising 17% for the full year. Moreover, it estimates overall sales growth of 12%-14% for 2014. If passenger demand remains strong and airline profitability continues to increase, then Heico is likely to have another strong year.

Mining still not globally joyful
In general, it was a positive report, however there were some notes of caution. Transportation segment orders were 2% lower, with mining being the main culprit. Mining orders declined 60% with demand for mining parts described as weak. All of which is not good news for mining equipment company Joy Global $JOY .

The mining industry has suffered this year as commodity prices have fallen, and in the words of Joy Global's executive vice president, Edward Doheny,  "[Years] of investment in additional production capacity finally caught up with demand. This resulted in most major commodities currently in a significant supply surplus".  The outlook doesn't look great. Growth is slowing in China and the government taking steps to reduce coal capacity; the outlook is still murky. Moreover, prices for a commodity like copper -- traditionally seen as the most cyclical of all metals -- continue to decline.

Copper LME Settlement Price data by YCharts

The bottom line
In conclusion, it was a broadly positive report from GE. Aviation and emerging market health care look strong in 2014, but developed market spending on health care capital equipment looks moderate at best. Meanwhile mining looks headed for another difficult year unless China can reaccelerate its growth rate.

Ametek Offers Aerospace Upside

It’s been a mixed earnings season for industrial-based stocks and Ametek’s (NYSE: AME) last set of results provided a pretty good microcosm of what has been going on. In short, companies with heavy exposure to industries like automotive and aerospace have done well, while almost everything else has found things difficult. So what makes Ametek interesting and what can we read across for other companies?

Ametek generates growth across the cycle

The company is attractive for a few reasons. Firstly although it is not a pure-play aerospace company, it has heavy exposure and as the industry is looking set for good long-cycle growth, it has good prospects. Secondly, Ametek has long been a company categorized by its management’s ability to make earnings-enhancing acquisitions without damaging its return on invested capital (ROIC).

As the chart indicates, Ametek has done a pretty good job of consistently generating ROIC even when market conditions are not great. An acquisition-led growth strategy does have its advantages and disadvantages. On the plus side, the company can carry on generating growth by getting companies cheaper in the downswing (and benefiting from the hopeful upswing in the economy); but on the downside its management will be under pressure to make the right acquisitions. And making the wrong decision can occur irrespective of where the economy is positioned.

Recent results

The good news is that Ametek’s management has a strong track record in this regard and acquisitions are a key part of the focus for 2013 as well. Even in the latest Q1 results we saw organic sales decline 2% but acquisitions contribute 9% and –even in a weaker environment for aerospace- its sales were up 7%.

As ever with this type of company, cost management and lean manufacturing will be a strong focus. Indeed cost reductions were made in the quarter, without which, EPS would have been up 18%. There was good news on the cost-cutting front with estimates for total full-year savings rising to $95 million from $85 million previously. Operating cash flow rose 11% and full-year EPS guidance was raised at the low end to imply 11% to 13% growth. Moreover the commentary on linearity was positive with April cited as looking ‘good’. Like many in the industrial sector it saw some weakness in March.

Industry background

As usual with earnings season, Alcoa (NYSE: AA) tends to set the tone for the industrials. A brief look at the conclusions from its earnings reveals that areas like aerospace and automotive remain relatively positive. Europe remains weak on the whole and the heavy truck and trailer market is experiencing a sharp slowdown. Moreover much of Alcoa’s growth is predicated on stronger conditions in China. The surprising thing was that Alcoa did not alter its full-year end-demand outlook by much even though the consensus is that Q1 did get weaker overall for industrials.

Alcoa’s trends were confirmed by Ametek when it discussed some softness in its power and industrial business created by the North American heavy truck market, so no surprises there. Furthermore within its process business segment the strongest performer was oil and gas while metals analysis revenue was relatively weaker.

The key strength in the business was from aerospace. Its electronic instruments group (EIG) saw aerospace (commercial, business and regional jets) revenue rise by low double digits and growth is expected to remain solid for the rest of the year inline with build-out rates at Boeing and Airbus. Overall EIG sales were up 3%.

It was a similar story in the other segment. The electromechanical group (EMG) saw its differentiated business sales up in the mid-teens with particular strength cited in its aerospace maintenance, repair and overhaul (MRO) operations.  However, overall sales for EMG only rose 3% thanks to a 14% contribution from acquisitions.

Which stocks read across well?

Frankly I think investors should try and stick to the themes that are working well and try and find value in them. If aerospace and automotives are doing well and companies like Alcoa and Ametek are confirming this, then why not stick to the idea? Three names that I like are Heico (NYSE: HEI), Precision Castparts (NYSE: PCP) and PPG Industries (NYSE: PPG).

Heico recently reported strong results and the business clearly has good long term prospects from helping airlines to try and reduce costs by outsourcing flight support activities. Even though Heico argued that its success in the quarter (its flight support group saw sales and income rise 10% and 14%, respectively) was largely a consequence of internal execution rather than industry growth, I think that there are enough positive signs within its performance to suggest further growth this year.

Its space-related sales may well be variable and its defense sales will be subject to sequestration effects so now may not be the best time to buy into the stock. But if you can tolerate these fears, the stock is attractive.

Precision Castparts is attractive because of its heavy exposure to commercial aerospace (75% of its market) and its opportunities to generate synergies from its acquisitions. In addition, it is ramping up production in order to meet demand from Boeing on the 737 and 787.

My one concern with this company is the cyclicality of its cash flows. The aerospace industry is cyclical but there is evidence to suggest that it is likely to experience better conditions in this cycle. However companies like Precision Castparts always need to make significant capital expenditures in order to service demand.

This is great when demand is good but it leaves them exposed should demand start to weaken. You can make the argument for making an evaluation based on assessing its long-term earnings or cash flow performance but in reality I think the market just trades these stocks based on momentum.

My favored play on this theme would be PPG Industries. The company has good exposure to aerospace and automotive and its purchase of Akzo Nobel’s US household paints operation is timely. Costs appear to be moderating and it has some cost synergies coming from the acquisition. Margins are expanding thanks to its restructuring efforts (such as selling some of its commodity-based businesses) and its cash flow generation remains very strong.

Meanwhile the recent court order over the Pittsburgh Corning (a joint venture with Corning) has somewhat de-risked the stock from uncertainty over future asbestos claims. Earnings growth is being held back this year thanks to some of the issues discussed above but, this is a business which has generated an average $1.1 billion in free cash flow over the last three years and trades on an EV/Ebitda multiple of 9.5x. Looks like good value to me.

Where next for Ametek?

This is an impressive company and a real ‘go to’ option for a pick in the industrial sector. Unfortunately its trailing PE of around 22x plus its EV/Ebitda multiple of 13.1x suggest it is largely pricing in the good news. It’s well worth monitoring and hoping for a dip because $42 looks like a fair price for the stock. Given any kind of market retraction it's worth a close look. 
 

Heico Flying High

The aerospace industry is faced with some unusual end market prospects for the next few years. In previous cycles, commercial aviation was characterized by extreme cyclicality and ongoing profitability issues as government sponsorship of national airlines tended to encourage over capacity. By way of comparison, military spending was always more stable and tended to provide a useful counterweight in difficult economic times. How times have changed!

The current situation is different. Commercial airline profitability is coming in better than expected and I think we can expect more upswing in this recovery. For the sake of brevity, I can’t go into the reasons why, but there is a more in-depth discussion on the issue linked here. On the other hand, horrendous sovereign debt issues in many countries are creating the necessity for pro-long term growth measures like cutting public spending (sic), and cutting defense spending (particularly on hardware) is a key component of this.

Which stocks could benefit?

With these kind of industry dynamics, investors should be favoring stocks exposed to commercial aviation and one useful idea is cabin interior manufacturer B/E Aerospace . The company benefits from new and retrofit of cabin interiors. My point is that if airlines are seeing more stable long-term financial conditions, then they should be more inclined to retrofit their older aircraft. As a consequence, analysts have B/E Aerospace on 20%+ earnings growth rates for the next few years. All of that can disappear in a flash should the global economy falter, but for now the stock looks attractive.

Another stock worth looking at for its secular growth prospects is Hexcel (NYSE: HXL). Hexcel’s attraction is that it is the global leader in lightweight advanced composites. With the trend towards wide bodied aircraft firmly in place, the pressure to increase the usage of lightweight components will only increase. Similarly, if we are in a world of $100+ oil prices, then airplane manufacturers will have to try and reduce aircraft weight (the most effective way to reduce fuel costs). Indeed, I note that Hexcel reported revenue from Airbus and Boeing programs being up 20% in the last quarter with the 787 Dreamliner being a particularly composite heavy airplane.

What about Heico?

Another stock that I think could be a beneficiary is Heico . Its operations are split into the Flight Support Group (FSG) and Electronic Technologies Group (ETG).

The FSG is involved with offering parts, repair, and distribution to airlines. It tends to be cyclical, as airplanes will require more servicing as they rack up more air miles. Moreover, it has some interesting secular drivers because airlines are increasingly looking to cut costs and outsourcing this activity offers them the option to do this. The ETG offers various aerospace components to a mix of commercial and government customers. Traditionally, military-based spending makes up around 20% of Heico’s revenue.

Given the changed dynamics of the aerospace industry, I think its long-term prospects are excellent. Provided global growth is good, it can benefit from the increased profitability and financial stability of the airlines.

Heico lifts off

The recent results pretty much confirmed this view, and the stock has taken off since they were released, but is now the time to be chasing the stock price? Before I get into the details, readers should note that I have a primer on the company linked here.

Here are the key takeaways from the latest results

• FSG reported record results and exceeded expectations as sales and income grew 10% and 14%, respectively. However, Heico argued that this was largely a consequence of its group leaders execution rather than any ‘rising tide’ in the industry.

•  Sequestration affects have already been felt in its short cycle business and Heico is expecting more of an effect in a ‘6-9 timeframe’ and ‘continued deterioration’ in its domestic defense related revenue.

•  ETG saw sales rise 10% and income up 32% as operating margins rose 400 basis points, helped by increased space based sales which tend to be higher margin. This is a positive, but space revenues tend to be variable and contingent upon program funding.

• The Reinhold acquisition is expected to be earnings accretive this year.

• The full year revenue guidance was raised to 8% to 10% growth from its earlier estimate of 6% to 8%, and net income growth was raised to 11%-13% from the previous 9%-11%. My interpolation from company statements is that free cash flow could come in at $120 million for the full year.

In a sense, I think that the full year guidance hike was partly predictable from the company’s statements in the last report. As noted in my link above, management did remark that they tend to be conservative in their guidance.

Where next for Heico?

Putting all of these things together would paint a picture of a company firing on all cylinders amid some favorable market conditions. On the other hand, investing is about finding the best value proposition rather than buying a stock when all the good news is already in the price.

As discussed in the bullet points above, Heico is going to have to deal with sequestration issues which will affect defense-related revenues. The space industry is somewhat variable and the FSG will have to keep executing at the current high level to drive future upside. So, there is some risk here. On a forward free cash flow yield of 4.5% (according to my calculations), I think it is fairly valued and better to wait for a dip before buying into this high quality company.