In Q2, Warren Buffett’s Berkshire Hathaway increased its existing stake in aerospace and electronic technology firm Heico (NYSE:HEI.A) by 11.4 percent, bringing its total holdings to 1.3 million shares.
Heico is something of an unusual choice for Berkshire, as the stock doesn’t appear to be trading at a deep discount to its intrinsic value and doesn’t have the kind of brand-driven moat Buffett often looks for in his investments. Why did Buffett buy Heico, and could the stock still be worth buying today?
Heico’s Unique Market Position
While it isn’t a giant name like Boeing or Lockheed, Heico has a strong position in the aerospace and defense industry that could allow it to take advantage of both increasing flight volumes and growing geopolitical uncertainty.
Heico manufactures replacement parts and avionics components for aircraft, creating parts that are functionally the same as OEM parts at a significant discount to what OEM manufacturers charge.
Though brand-new aircraft often come with OEM service contracts, Heico’s approved replacement parts play a key role in maintaining older aircraft and systems at an attractive discount for the entities that own them.
This places Heico in a unique position within its market and allows it to have something of a niche moat despite not having anywhere near the scale of the large OEMs.
Current secular trends, most notably geopolitical tensions that are driving investment in defense, support ongoing growth in demand for Heico’s parts. Last year, defense budgets globally rose by 9 percent, and commercial aviation demand remains strong. In this environment, a business like Heico that can deliver replacement parts that are approved for use in place of OEM parts at a lower price could see substantial growth.
Heico’s Been On a Serious Run
Heico has been on an impressive run for the last few years, delivering 17 consecutive quarters of revenue growth and 16 consecutive quarters of earnings growth. These trends remained strong in its fiscal Q3, which saw Heico’s net sales increase 16 percent on a year-over-year basis to $1.15 billion.
Net income, meanwhile, climbed by 30 percent to reach $177.3 million. Both net income and revenues in fiscal Q3 represented all-time record highs for Heico. For the first nine months of the fiscal year, revenue and net income were up by 15 percent and 34 percent, respectively.
Heico’s overall profitability has been quite respectable over the last year, with the business’s net margin totaling 16.2 percent. This was closely tracked by a return on equity of 16.3 percent, though return on invested capital came in lower at 10.5 percent. Both Heico’s ROE and ROIC, however, are more than double the sector averages, pointing to how successfully management has run the business at a time when many firms are facing pressures on their margins.
Is Heico Undervalued?
At a glance, HEI.A may seem like an unusual choice for the Berkshire Hathaway portfolio. Today, shares trade at 52.5 times trailing 12-month earnings and 7.9 times sales.
While Buffett’s cost basis is a good bit lower than what the shares are trading for today, the shares owned by Berkshire were still purchased at something of a premium valuation . Heico is even fairly expensive on a price-to-operating-cash-flow basis with a multiple of 43.0.
Berkshire’s interest, therefore, would seem to be in Heico’s value relative to its long-term potential for earnings growth. As we’ve already seen, Heico is well-positioned for ongoing expansion as defense and commercial air spending keep trending upward.
Analysts expect these growth trends to allow Heico to grow its earnings per share at a rate of about 17 percent annually over the next 3-5 years.
Starting from the current 12-month EPS of $4.56, this growth rate would see Heico earning around $10 per share five years from now. Given current global circumstances, it’s far from unlikely that this strong growth could also continue beyond the 5-year mark.
Keeping this growth potential in mind, Heico may be trading at a fair valuation, though the chances that it’s sharply undervalued seem slim. The one standing analyst price target for HEI.A is $280, representing a 17 percent increase from the most recent price of $239.35. Considering the high current valuation when weighed against the long-term growth potential, this is likely a fair representation of Heico’s value.
Why Did Buffett Buy Heico?
One of the first things to consider when looking at Berkshire’s position in Heico is that Buffett likely didn’t make the investment personally. The Oracle of Omaha is already preparing to step back from his responsibilities as CEO at the end of the year, and he typically focuses on investments that allow him to deploy large sums of Berkshire’s capital.
At $233 million and representing less than 0.1 percent of the Berkshire portfolio, it’s more likely that another member of Buffett’s team decided to initiate the Heico position. With that said, the principles used to make the investment decision would have been the same ones that Buffett and his late business partner Charlie Munger have been using to invest successfully at Berkshire for decades.
Heico appears to have been a case in which, rather than looking for a deeply discounted business, Berkshire decided to pay a fair price to invest in a very attractive business with strong long-term growth potential. Heico is benefiting from positive secular trends and occupies a fairly unique market niche, both of which could contribute to sustained earnings growth ahead. The business is also financially stable and already respectably profitable.
As to whether Heico could still be a buy, it’s important to note that the stock’s price is a good bit above what Buffett and his team paid for it when Berkshire first started buying it last year. Even so, the growth that Heico is delivering and the runway it could have in front of it could still put the stock in a fair valuation range today.
While HEI.A is unlikely to deliver the gigantic returns that investors are coming to expect in higher-risk areas like AI, next-generation power and quantum computing, Heico still looks like it could be worth considering for its long-term compounding potential.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.