HEI vs. HEI/A: Pair Opportunity?
Heico is an interesting, family dominated industrial with a dual class structure (Common and Class A). Heico’s best business is the manufacture of FAA certified, slightly-lower-priced replacement parts for aircraft (Flight Support, ~57% of 2012 operating income). By undercutting OEMs like GE and Pratt, HEI has built a high margin business with plenty of runway for growth. Heico also has what could broadly be described as a successful aerospace/defense electronics business (Electronic Technologies, ~43% of 2012 operating income).
For the purposes if this discussion, what Heico does is not as important as the relative characteristics of the Class A (HEI/A) and Common (HEI) shares. The spread between the two share classes appears abnormally wide at current levels, as shown in the chart above, having reached this level of divergence only a handful of times in the past dozen years. Shorting the common and buying the Class A is worth considering, if it matches the reader's style,, even though it is not a position that could be all that large (HEI trades about 40k shares a day with 42.16 close yesterday). Positions like long HEI/A vs. short HEI can be useful at extremes. Reversals can be fairly quick once started, but timing the inflection is, of course, very challenging. It is also noteworthy that HEI options have recently displayed elevated implied volatility, although we are not entirely certain as to why, and may be a point for further research.
- Key Differences: The HEI Class A shares offer 1/10th of vote while the common HEI shares offer 1 full vote. The common shares are more liquid, with about 3x more volume over the past few months. Both classes of shares have been repurchase targets, with the HEI common shares more favored in 2011.
- What a Full Vote Buys: Heico insiders exert significant influence over the company, collectively holding about 6% of Class A shares and 21% of the common. Three members of the Mendelson family sit on the Board of Directors and are in senior management. While insider may not have a lock on corporate control, it appears to us that current management exerts significant control over the company. Anti-takeover provisions may leave a would-be activist challenged to acquire meaningful influence. For most shareholders, the extra votes do not appear to add much value.
- Liquidity Better in HEI/A: Better liquidity certainly matters, in so far as it persists. The HEI common shares likely deserve a liquidity premium to the Class A shares, but the >40% magnitude appears abnormally large.
- No Arbitrage: There is no mechanism that forces these two share classes to match, except in the case of a few specific events. The Common premium could theoretically go anywhere. Historically, the current premium is at the high-end of the range - even relative to stressed equity markets. That said, positions like these can be slow to work out and can diverge further. The two securities are economically pretty close to identical, by our assessment, but do not have to trade that way.
- Events That Could Collapse Premium: Many companies have eliminated dual class structures, but that seems an unlikely short-run outcome at Heico. A sale of the company or MLBO would also likely eliminate the premium. The Chairman, CEO and elder Mendelson, Laurans, is 74, so the company may well be preparing for an eventual change at the top.
- What Insiders Prefer: Since January 2012, insiders have only made one small purchase of HEI common. On balance, insiders have sold nearly 50,000 HEI common share. At the same time, there have been many HEI/A purchases (net addition of over 4,000 shares) with Victor, Eric and Laurans Mendelson choosing the Class A shares. We assume that they know which share class offers the best value.
- Even For Longs: A long-term investor interested in HEI should look at buying the Class A instead of the common at present levels. Long-term holders also may benefit from a swap, liquidity permitting.