This “Picks and Shovels” Stock is a Buy

Sunnier days are returning to the global travel industry, especially air travel.

Passenger traffic recovered dramatically in 2022, after collapsing in the first years of the coronavirus pandemic. While global air travel is still down about 20% from 2019, here in the U.S. it is pretty much back to pre-pandemic levels. Nearly 76 million people flew in the U.S. in October—just 3% fewer passengers than in the same month in 2019, according to the latest available government data.

And there is more good news on the way for the global travel industry: China is reopening after three years of a strict zero-COVID restrictions.

China has the world’s largest population of tourists. In 2019, before the pandemic, 155 million Chinese tourists traveled abroad, spending $255 billion. This is according to analysts at Citi, who have projected a solid recovery in the first quarter of 2023 and mass return of Chinese tourism in the second quarter.

So how can investors profit from this travel and tourism renaissance?

The “Picks and Shovels” of Tourism

During the California gold rush, it was not the miners who became rich but rather the suppliers who sold them their picks and shovels. Similarly, today’s picks-and-shovels sellers are the companies that maintain the planes and supply the spare parts.

In addition to the return of air travelers after the pandemic, there is another tailwind for companies in this business. The two major aircraft manufacturers—Boeing (BA) and Airbus SE (EADSY)—have struggled to fulfill new plane orders for the airlines. The end result is that the air carriers have to hold on to their older jets for longer and pay more for replacement parts and service.

And then we have the pandemic effect, with airlines grounding their planes. With little money coming in, the airlines put off maintenance. Instead of expensive engine overhauls, they opted to swap out their oldest engines for so-called “green-time” engines that have racked up fewer flying hours. But now, that pool of green-time engines is nearly gone.

So, airlines “…have to continue flying older, out-of-warranty aircraft that consume parts and need repairs,” Melius Research analyst Robert Spingarn explained to the Financial Times. “Commercial after-market companies [the businesses that sell spare parts and accessories] are benefiting.”

Analyst Ken Herbert at RBC Capital Markets told the Financial Times that repair facilities reported a 19% increase in sales in the fourth quarter of 2022 compared with a year earlier, while revenue for parts sellers grew by 15%: “Airlines are scrambling to keep up, which means they have to spend more on the airplanes [in their fleets]. “That’s been a big tailwind.”

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The Financial Times also reported that United Airlines Holdings (UAL) spent $2.2 billion on parts and repairs in 2022, a 20% rise compared with 2019 and a 64% increase from 2021. Delta Air Lines (DAL) reported a 13% increase in parts and repair costs over 2019.

Heico Is Flying High

One aerospace picks and shovels play is aircraft replacement part manufacturer Heico (HEI), a company with a market capitalization of roughly $20 billion. Heico’s products are virtually the same as the ones made by the original equipment manufacturers (OEMs), but less expensive. In a way, their products are like generic pharmaceuticals, but for airplanes.

The company operates through two divisions: Flight Support Group (FSG) and Electronic Technologies Group (ETG). The FSG division uses technology to design and manufacture jet engine and aircraft component replacement parts. In addition, the FSG segment repairs, overhauls, and distributes jet engine and aircraft components, avionics and instruments for domestic and foreign commercial air carriers and aircraft repair companies, as well as military and business aircraft operators.

The ETG division designs, manufactures, and sells various types of electronic, data and microwave, and electro-optical products, including infrared simulation and test equipment, laser rangefinder receivers, and electrical power supplies.

For the fiscal year that ended October 31, 2022, Heico revenues increased 18%, to $2.21 billion. Net income increased 16%, to $351.7 million. Revenues reflect FSG division increase of 35%, to $1.26 billion; the ETG division had an increase of just 1%, to $972.5 million. Geographically, U.S. revenues rose 21%, to $1.44 billion; the rest-of-world showed an increase of 14%, to $764.7 million. Heico’s most recent quarterly sales of $610 million and operating income of $147 million were both records, topping levels from before the pandemic in 2019.

I believe Heico has a robust long-term growth runway, due to its aircraft replacement parts being priced below competition from the OEMs that dominate the commercial aftermarket.

Before the pandemic struck, Heico’s clear cost advantage in serving the price sensitive airline industry with generic parts drove a 26% annual earnings per share growth during the 2017 to 2019 period. And now, with air travelers returning in droves (especially from China), the company’s growth trajectory will resume its upward flight path. Its estimated 2% current market share in aircraft replacement parts could grow substantially.

Heico should also benefit from governments ramping up spending on air and space defense, thanks to the Ukraine war. It will likely get a bigger piece of a growing pie over the long term.

That makes Heico a buy anywhere in the $160 to $180 range.

— Tony Daltorio

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Source: Investors Alley

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