Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Our business is comprised of two operating segments, the Flight Support Group (“FSG”) and the Electronic Technologies Group (“ETG”).
The FSG consists of HEICO Aerospace Holdings Corp. (“HEICO Aerospace”), which is 80% owned, and HEICO Flight Support Corp., which is wholly owned, and their collective subsidiaries, which primarily:
•Designs, Manufactures, Repairs, Overhauls and Distributes Jet Engine and Aircraft Component Replacement Parts. The FSG designs and manufactures jet engine and aircraft component replacement parts, which are approved by the Federal Aviation Administration (“FAA”). In addition, the FSG 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 FSG also manufactures and sells specialty parts as a subcontractor for aerospace and industrial original equipment manufacturers and the United States ("U.S.") government. Additionally, the FSG is a leading supplier, distributor, and integrator of military aircraft parts and support services primarily to foreign military organizations allied with the U.S. and a leading manufacturer of advanced niche components and complex composite assemblies for commercial aviation, defense and space applications. Further, the FSG engineers, designs and manufactures thermal insulation blankets and parts as well as removable/reusable insulation systems for aerospace, defense, commercial and industrial applications; manufactures expanded foil mesh for lightning strike protection in fixed and rotary wing aircraft; distributes aviation electrical interconnect products and electromechanical parts; and overhauls industrial pumps, motors, and other hydraulic units with a focus on the support of legacy systems for the U.S. Navy.
The ETG consists of HEICO Electronic Technologies Corp. (“HEICO Electronic”) and its subsidiaries, which primarily:
•Designs and Manufactures Electronic, Microwave and Electro-Optical Equipment,High-Speed Interface Products, High Voltage Interconnection Devices, EMI and RFI Shielding and Filters, High Voltage Advanced Power Electronics, Power Conversion Products, Underwater Locator Beacons, Microelectronic Memory Products, Self-Sealing Auxiliary Fuel Systems, Active Antenna Systems and TSCM Equipment. The ETG collectively designs, manufactures and sells various types of electronic, data and microwave, and electro-optical products, including infrared simulation and test equipment, laser rangefinder receivers, electrical power supplies, back-up power supplies, power conversion products, underwater locator beacons, emergency locator transmission beacons, flight deck annunciators, panels and indicators, electromagnetic and radio frequency interference shielding and filters, high power capacitor charging power supplies, amplifiers, traveling
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wave tube amplifiers, photodetectors, amplifier modules, microwave power modules, flash lamp drivers, laser diode drivers, arc lamp power supplies, custom power supply designs, cable assemblies, high voltage power supplies, high voltage interconnection devices and wire, high voltage energy generators, high frequency power delivery systems, three-dimensional microelectronic and stacked memory products, harsh environment electronic connectors and other interconnect products, radio frequency ("RF") and microwave amplifiers, transmitters and receivers; RF sources, detectors and controllers, wireless cabin control systems, solid state power distribution and management systems, crashworthy and ballistically self-sealing auxiliary fuel systems, nuclear radiation detectors, communications and electronic intercept receivers and tuners, fuel level sensing systems, high-speed interface products that link devices, high performance active antenna systems for commercial aircraft, precision guided munitions, other defense applications and commercial uses; silicone material for a variety of demanding applications; precision power analog monolithic, hybrid and open frame components; high-reliability ceramic-to-metal feedthroughs and connectors, technical surveillance countermeasures (TSCM) equipment to detect devices used for espionage and information theft; and rugged small-form factor embedded computing solutions.
Our results of operations in fiscal 2020 were significantly affected by the COVID-19 global pandemic (the “Pandemic”). The effects of the Pandemic and related actions by governments around the world to mitigate its spread have impacted our employees, customers, suppliers and manufacturers. In response to the economic impact from the Pandemic, we implemented certain cost reduction efforts, including layoffs, temporary reduced work hours and temporary pay reductions within various departments of our business, including within our executive management team and our Board of Directors. Additionally, our response to the Pandemic included the implementation of varying health and safety measures at our facilities, including: supplying and requiring the use of personal protective equipment; staggering work shifts; body temperature taking; increasing work-from-home capabilities; consistent and ongoing cleaning of work spaces and high-touch areas; and establishing processes aligned with the Centers for Disease and Control guidelines to work with any individual exposed to COVID-19 on their necessary quarantine period and the process for the individual to return to work.
With respect to our results of operations, approximately 59% of our net sales in fiscal 2020 were derived from defense, space and other industrial markets including electronics, medical and telecommunications. Although demand for these products was slightly moderated in fiscal 2020, our overall results from this portion of our business were not materially impacted by the Pandemic. However, we experienced, and expect to continue experiencing, periodic operational disruptions resulting from supply chain disturbances, staffing challenges - including at some of our customers, temporary facility closures, transportation interruptions and other conditions which slow production and orders, or increase costs.
The remaining portion of our fiscal 2020 net sales was derived from commercial aviation products and services. The Pandemic has caused significant volatility and a substantial decline in value across global markets. Most notably, the commercial aerospace industry experienced an ongoing substantial decline in demand resulting from a significant number of aircraft in the
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global fleet being grounded during fiscal 2020. Our businesses that operate within the commercial aerospace industry were materially impacted by the significant decline in global commercial air travel that began in March 2020. Consolidated net sales for our businesses that operate within the commercial aerospace industry decreased by approximately 32% during fiscal 2020.
As we look ahead to fiscal 2021, the extent to which the Pandemic may have a material adverse effect on our future business, financial condition and results of operations will depend on many factors that are not within HEICO’s control, including but not limited to the duration, spread and severity of the Pandemic, government responses and other actions to mitigate the spread of and to treat the Pandemic, and when and to what extent normal business, economic and social activity and conditions resume. However, we are cautiously optimistic that the recent vaccine progress may generate increased commercial air travel and result in a gradual recovery in demand for our commercial aerospace parts and services commencing in fiscal 2021.
Additionally, our results of operations in fiscal 2020 have been affected by recent acquisitions as further detailed in Note 2, Acquisitions, of the Notes to Consolidated Financial Statements.
Presentation of Results of Operations and Liquidity and Capital Resources
The following discussion and analysis of our Results of Operations and Liquidity and Capital Resources includes a comparison of fiscal 2020 to fiscal 2019. A similar discussion and analysis that compares fiscal 2019 to fiscal 2018 may be found in Item 7, "Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Form 10-K for the fiscal year ended October 31, 2019.
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Results of Operations
The following table sets forth the results of our operations, net sales and operating income by segment and the percentage of net sales represented by the respective items in our Consolidated Statements of Operations (in thousands):
Year ended October 31,
Net sales by segment:
Operating income by segment:
Selling, general and administrative expenses 17.1 % 17.4 %
Interest expense .7 % 1.1 %
Other income .1 % .1 %
Income tax expense 1.6 % 3.8 %
Net income attributable to noncontrolling interests 1.2 % 1.5 %
Net income attributable to HEICO 17.6 % 16.0 %
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Comparison of Fiscal 2020 to Fiscal 2019
Net Sales
Our consolidated net sales in fiscal 2020 decreased by 13% to $1,787.0 million, as compared to net sales of $2,055.6 million in fiscal 2019. The decrease in consolidated net sales principally reflects a decrease of $315.4 million (a 25% decrease) to $924.8 million in net sales within the FSG partially offset by an increase of $40.5 million (a 5% increase) to a record $875.0 million in net sales within the ETG. The net sales decrease in the FSG is principally organic and reflects lower demand for the majority of our products and services resulting from the significant decline in global commercial air travel beginning in March 2020 due to the Pandemic. As a result, organic net sales of our aftermarket replacement parts, repair and overhaul parts and services, and specialty products product lines decreased by $154.0 million, $106.2 million, and $58.8 million, respectively. The net sales increase in the ETG principally reflects $52.8 million contributed by our fiscal 2020 and 2019 acquisitions and higher demand for our defense products resulting in an organic net sales increase of $13.6 million partially offset by lower demand for our commercial aerospace and medical products resulting in organic net sales decreases of $12.9 million and $5.6 million, respectively, largely attributable to the Pandemic. Sales price changes were not a significant contributing factor to the change in net sales of the FSG and ETG in the fiscal 2020.
Our net sales in fiscal 2020 and 2019 by market consisted of approximately 41% and 52% from the commercial aviation industry, respectively, 44% and 35% from the defense and space industries, respectively, and 15% and 13% from other industrial markets including electronics, medical and telecommunications, respectively.
Gross Profit and Operating Expenses
Our consolidated gross profit margin was 38.2% in fiscal 2020 as compared to 39.6% in 2019, principally reflecting a decrease of 3.6% and 1.3% in the FSG's and ETG's gross profit margin, respectively. The decrease in the FSG's gross profit margin principally reflects a 2.1% impact, or an incremental increase of $18.1 million, from an increase in inventory obsolescence expense mainly resulting from the announced retirement of certain aircraft types and engine platforms by our commercial aerospace customers due to the Pandemic's financial impact. Additionally, the FSG's lower gross profit margin reflects the impact from lower net sales within our repair and overhaul parts and services and aftermarket replacement parts product lines. The decrease in the ETG's gross profit margin principally reflects a decrease in net sales and a less favorable product mix of certain commercial aerospace and medical products, partially offset by increased net sales of certain defense products. Total new product research and development ("R&D") expenses included within our consolidated cost of sales were $65.6 million and $66.6 million in fiscal 2020 and 2019, respectively.
Our consolidated selling, general and administrative ("SG&A") expenses decreased by 14% to $305.5 million in fiscal 2020, as compared to $356.7 million in fiscal 2019. The decrease in consolidated SG&A expenses reflects a $36.5 million decrease in performance-based
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compensation expense, a $20.7 million reduction in other general and administrative expenses and a $16.5 million reduction in other selling expenses including outside sales commissions, marketing and travel. These decreases were partially offset by $13.4 million attributable to the fiscal 2019 and 2020 acquisitions and a $9.1 million increase in bad debt expense principally due to potential collection difficulties from certain commercial aviation customers that filed for bankruptcy protection during fiscal 2020 as a result of the Pandemic's financial impact.
Our consolidated SG&A expenses as a percentage of net sales decreased to 17.1% in fiscal 2020, down from 17.4% in fiscal 2019. The decrease in consolidated SG&A expenses as a percentage of net sales is due to a 1.6% impact from lower performance-based compensation expense and a .2% decrease in other selling expenses, partially offset by a 1.0% impact from higher other general and administrative expenses as a percentage of net sales and a .5% increase in bad debt expense principally due to potential collection difficulties from certain commercial aviation customers that filed for bankruptcy protection during fiscal 2020 as a result of the Pandemic's financial impact.
Operating Income
Our consolidated operating income decreased by 18% to $376.6 million in fiscal 2020, as compared to $457.1 million in fiscal 2019. The decrease in consolidated operating income principally reflects a $99.0 million decrease (a 41% decrease) to $143.1 million in operating income of the FSG partially offset by a $13.1 million increase (a 5% increase) to a record $258.8 million in operating income of the ETG. The decrease in operating income of the FSG principally reflects the previously mentioned decrease in net sales, lower gross profit margin and a $9.3 million increase in bad debt expense principally due to potential collection difficulties from certain commercial aviation customers that filed for bankruptcy protection during fiscal 2020 as a result of the Pandemic's financial impact, partially offset by a $26.1 million decrease in performance-based compensation expense. The increase in operating income of the ETG principally reflects the previously mentioned net sales growth, a $5.4 million decrease in performance-based compensation expense and a $2.5 million decrease in acquisition-related expenses, partially offset by the previously mentioned decrease in gross profit margin. Further, the decrease in consolidated operating income was partially offset by $5.4 million of lower corporate expenses mainly attributable to a decrease in performance-based compensation expense.
Our consolidated operating income as a percentage of net sales was 21.1% in fiscal 2020, as compared to 22.2% in fiscal 2019. The decrease principally reflects a decrease in the FSG’s operating income as a percentage of net sales to 15.5% in fiscal 2020, as compared to 19.5% in fiscal 2019. The decrease in the FSG’s operating income as a percentage of net sales reflects the previously mentioned lower gross profit margin and a .5% increase in SG&A expenses as a percentage of net sales mainly from the previously mentioned higher bad debt expense and fixed cost efficiencies lost resulting from the Pandemic's impact, partially offset by the previously mentioned lower performance-based compensation expense. The ETG's operating income as a percentage of net sales increased to 29.6% in fiscal 2020, up from 29.4% in fiscal 2019.
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Interest Expense
Interest expense decreased to $13.2 million in fiscal 2020, down from $21.7 million in fiscal 2019. The decrease was principally due to a lower weighted average interest rate on borrowings outstanding under our revolving credit facility.
Other Income
Other income in fiscal 2020 and 2019 was not material.
Income Tax Expense
Our effective tax rate in fiscal 2020 was 7.9%, as compared to 17.8% in fiscal 2019. The decrease in our effective tax rate in fiscal 2020 is mainly attributable to a $31.8 million larger tax benefit recognized in fiscal 2020 from stock option exercises compared to fiscal 2019 as a result of more stock options exercised and the strong appreciation in HEICO's stock price during the optionees' holding periods.
Net Income Attributable to Noncontrolling Interests
Net income attributable to noncontrolling interests relates to the 20% noncontrolling interest held by Lufthansa Technik AG ("LHT") in HEICO Aerospace Holdings Corp. and the noncontrolling interests held by others in certain subsidiaries of the FSG and ETG. Net income attributable to noncontrolling interests was $21.9 million in fiscal 2020, as compared to $31.8 million in fiscal 2019. The decrease in net income attributable to noncontrolling interests in fiscal 2020 principally reflects a decrease in operating results of certain subsidiaries of the FSG in which noncontrolling interests are held as well as the impact of a dividend paid by HEICO Aerospace in June 2019 that effectively resulted in the transfer of the 20% noncontrolling interest held by LHT in eight of our existing subsidiaries within HEICO Aerospace that are principally part of the FSG's repair and overhaul parts and services product line to HEICO Flight Support Corp., a wholly owned subsidiary of HEICO.
Net Income Attributable to HEICO
Net income attributable to HEICO was $314.0 million, or $2.29 per diluted share, in fiscal 2020 as compared to $327.9 million, or $2.39 per diluted share, in fiscal 2019, principally reflecting the previously mentioned lower operating income of the FSG, partially offset by lower income tax expense, less net income attributable to noncontrolling interests and lower interest expense.
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Outlook
As we look ahead to fiscal 2021, the Pandemic will likely continue to negatively impact the commercial aerospace industry and HEICO. Given this uncertainty, HEICO cannot provide fiscal 2021 net sales and earnings guidance at this time. However, we believe our ongoing fiscal conservative policies, healthy balance sheet, and increased liquidity will permit us to invest in new research and development and gain market share as the industry recovers. In addition, our time-tested strategy of maintaining low debt and acquiring and operating high cash generating businesses across a diverse base of industries beyond commercial aerospace, such as defense, space and other high-end markets including electronics and medical, puts us in a good financial position to weather this uncertain economic period. Further, we are cautiously optimistic that the recent vaccine progress may generate increased commercial air travel and result in a gradual recovery in demand for our commercial aerospace parts and services commencing in fiscal 2021.
Inflation
We have generally experienced increases in our costs of labor, materials and services consistent with overall rates of inflation. The impact of such increases on net income attributable to HEICO has been generally minimized by efforts to lower costs through manufacturing efficiencies and cost reductions.
Liquidity and Capital Resources
The following table summarizes our capitalization (in thousands):
As of October 31,
Total debt to total capitalization 27% 25%
Our principal uses of cash include acquisitions, capital expenditures, cash dividends, distributions to noncontrolling interests and working capital needs. Capital expenditures in fiscal 2021 are anticipated to approximate $40 million. We finance our activities primarily from our operating and financing activities, including borrowings under our revolving credit facility.
As of December 22, 2020, we had approximately $755 million of unused committed availability under the terms of our revolving credit facility. Based on our current outlook, we believe that net cash provided by operating activities and available borrowings under our revolving credit facility will be sufficient to fund our cash requirements for at least the next twelve months.
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Operating Activities
Net cash provided by operating activities was $409.1 million in fiscal 2020 and consisted primarily of net income from consolidated operations of $335.9 million, depreciation and amortization expense of $88.6 million (a non-cash item), net changes in other long-term liabilities and assets related to the HEICO Leadership Compensation Plan (“LCP”) of $14.8 million (principally participant deferrals and employer contributions), $10.1 million in share-based compensation expense (a non-cash item), and $9.6 million in employer contributions to the HEICO Savings and Investment Plan (a non-cash item), partially offset by a $48.5 million increase in working capital. The increase in working capital is inclusive of a $68.2 million decrease in accrued expenses and other current liabilities and trade accounts payable mainly reflecting lower accrued performance-based compensation as well as the timing of payments; a $28.3 million increase in inventories as a result of certain inventory purchase commitments based on pre-Pandemic net sales expectations and to support the backlog of certain of our businesses; and a $16.4 million increase in contract assets, partially offset by a $71.5 million decrease in accounts receivable resulting from lower net sales and strong cash collections. Net cash provided by operating activities decreased by $28.3 million in fiscal 2020 from $437.4 million in fiscal 2019. The decrease is principally attributable to a $23.9 million decrease in net income from consolidated operations and a $16.3 million increase in net working capital partially offset by a $5.1 million increase in depreciation and amortization expense (a non-cash item).
Net cash provided by operating activities was $437.4 million in fiscal 2019 and consisted primarily of net income from consolidated operations of $359.7 million, depreciation and amortization expense of $83.5 million (a non-cash item), net changes in other long-term liabilities and assets related to the HEICO LCP of $12.9 million (principally participant deferrals and employer contributions) and $10.3 million in share-based compensation expense (a non-cash item), partially offset by a $32.3 million increase in working capital.
Investing Activities
Net cash used in investing activities totaled $199.0 million in fiscal 2020 and related primarily to acquisitions of $163.9 million (net of cash acquired), capital expenditures of $22.9 million and investments related to the HEICO LCP of $15.9 million. Further details on acquisitions may be found in Note 2, Acquisitions, of the Notes to Consolidated Financial Statements.
Net cash used in investing activities totaled $280.6 million in fiscal 2019 and related primarily to acquisitions of $240.8 million (net of cash acquired), capital expenditures of $28.9 million and investments related to the HEICO LCP of $13.7 million. Further details on acquisitions may be found in Note 2, Acquisitions, of the Notes to Consolidated Financial Statements.
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Financing Activities
Net cash provided by financing activities in fiscal 2020 totaled $137.7 million. During fiscal 2020, we borrowed $200.0 million under our revolving credit facility to provide a cushion of liquidity during this period of economic uncertainty resulting from the Pandemic and $45.0 million to fund our fiscal 2020 acquisitions. We also received $14.3 million in capital contributions from the noncontrolling interest holders of a subsidiary of HEICO Electronic representing their share of the purchase price for a 25% interest in two acquisitions made by a subsidiary of HEICO Electronic in August 2020. (See Note 2, Acquisitions, of the Notes to Consolidated Financial Statements for further details). Additionally, we made $68.0 million in payments on our revolving credit facility, paid $21.6 million in cash dividends on our common stock, made $17.9 million of distributions to noncontrolling interests, redeemed common stock related to stock option exercises aggregating $12.1 million, paid $7.5 million to acquire certain noncontrolling interests and received $7.0 million in proceeds from stock option exercises.
Net cash used in financing activities in fiscal 2019 totaled $159.7 million. During fiscal 2019, we made $283.0 million in payments on our revolving credit facility, paid $110.9 million in distributions to noncontrolling interests, redeemed common stock related to stock option exercises aggregating $64.0 million and paid $18.7 million in cash dividends on our common stock. Additionally, we borrowed $313.0 million under our revolving credit facility to fund certain of our fiscal 2019 acquisitions and a certain distribution to a noncontrolling interest holder.
In November 2017, we entered into a $1.3 billion Revolving Credit Facility Agreement ("Credit Facility") with a bank syndicate, which matures in November 2022. Under certain circumstances, the maturity of the Credit Facility may be extended for two one-year periods. The Credit Facility also includes a feature that will allow us to increase the capacity by $350 million to become a $1.65 billion facility through increased commitments from existing lenders or the addition of new lenders. Borrowings under the Credit Facility may be used to finance acquisitions and for working capital and other general corporate purposes, including capital expenditures.
On December 11, 2020, we entered into an amendment to extend the maturity date of the Credit Facility by one year to November 2023 and to increase the capacity by $200 million to $1.5 billion. The Credit Facility continues to include a feature that will allow us to increase the capacity by $350 million to become a $1.85 billion facility through increased commitments from existing lenders or the addition of new lenders and can be extended for an additional one-year period.
Borrowings under the Credit Facility accrue interest at our election of the Base Rate or the Eurocurrency Rate, plus in each case, the Applicable Rate (based on our Total Leverage Ratio). The Base Rate for any day is a fluctuating rate per annum equal to the highest of (i) the Prime Rate; (ii) the Federal Funds Rate plus .50%; and (iii) the Eurocurrency Rate for an Interest Period of one month plus 100 basis points. The Eurocurrency Rate is the rate per annum obtained by dividing LIBOR for the applicable Interest Period by a percentage equal to 1.00
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minus the daily average Eurocurrency Reserve Rate for such Interest Period, as such capitalized terms are defined in the Credit Facility. The Applicable Rate for Eurocurrency Rate Loans ranges from 1.00% to 2.00%. The Applicable Rate for Base Rate Loans ranges from 0% to 1.00%. A fee is charged on the amount of the unused commitment ranging from .125% to .30% (depending on our Total Leverage Ratio). The Credit Facility also includes $100 million sublimits for borrowings made in foreign currencies and for swingline borrowings, and a $50 million sublimit for letters of credit. Outstanding principal, accrued and unpaid interest and other amounts payable under the Credit Facility may be accelerated upon an event of default, as such events are described in the Credit Facility. The Credit Facility is unsecured and contains covenants that require, among other things, the maintenance of a Total Leverage Ratio and an Interest Coverage Ratio, as such capitalized terms are defined in the Credit Facility. We were in compliance with all financial and nonfinancial covenants of the Credit Facility as of October 31, 2020.
Contractual Obligations
The following table summarizes our contractual obligations as of October 31, 2020
(in thousands):
Payments due by fiscal period
__________________
(1)Estimated interest payments assumes the $730.0 million outstanding balance under our revolving credit facility and related interest rate of 1.3% as of October 31, 2020, will remain constant through the credit facility's maturity date in fiscal 2024. Actual interest payments may vary significantly based on future borrowings, repayments and interest rate fluctuations. As discussed in "Liquidity and Capital Resources," we entered into an amendment to extend the maturity date of our revolving credit facility by one year to November 2023, which is reflected in the table. See Note 5, Long-Term Debt, of the Notes to Consolidated Financial Statements and "Liquidity and Capital Resources," above for additional information regarding our long-term debt obligations.
(2)Inclusive of $2.6 million of imputed interest. See Note 9, Leases, of the Notes to Consolidated Financial Statements for additional information regarding our finance lease obligations.
(3)See Note 9, Leases, of the Notes to Consolidated Financial Statements for additional information regarding our operating lease obligations.
(4)Includes contingent consideration aggregating $42.0 million related to a fiscal 2017 acquisition and certain fiscal 2020 acquisitions. See Note 8, Fair Value Measurements, of the Notes to Consolidated Financial Statements for additional information.
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(5)Also includes an aggregate $1.4 million of commitments principally for capital expenditures and inventory. All purchase obligations of inventory and supplies in the ordinary course of business (i.e., with deliveries scheduled within the next year) are excluded from the table.
(6)The holders of equity interests in certain of our subsidiaries have rights (“Put Rights”) that may be exercised on varying dates causing us to purchase their equity interests through fiscal 2030. The Put Rights provide that cash consideration be paid for their equity interests (the “Redemption Amount”). As of October 31, 2020, management’s estimate of the aggregate Redemption Amount of all Put Rights that we could be required to pay is approximately $221.2 million, which is reflected within redeemable noncontrolling interests in our Consolidated Balance Sheet. Of this amount, $2.3 million is included in the table as payable in fiscal 2021 pursuant to the past exercise of such Put Rights by the noncontrolling interest holder of one of our subsidiaries. See Note 13, Redeemable Noncontrolling Interests, of the Notes to Consolidated Financial Statements for further information.
(7)Includes $7.2 million of deferred payroll taxes related to the provisions of the Coronavirus Aid, Relief and Economic Security Act, which allows the Company to defer its portion of certain calendar year 2020 payroll taxes until fiscal 2022 and 2023. Also includes $3.5 million related to a one-time transition tax on the unremitted earnings of the Company's foreign subsidiaries which will be paid over a remaining six-year period as permitted by the Tax Cuts and Jobs Act. The amounts in the table do not include liabilities related to the HEICO LCP as they are fully supported by assets held within irrevocable trusts. See Note 3, Selected Financial Statement Information - Other Long-Term Assets and Liabilities, of the Notes to Consolidated Financial Statements for further information about this deferred compensation plan.
Off-Balance Sheet Arrangements
Guarantees
As of October 31, 2020, we have arranged for standby letters of credit aggregating $14.6 million, which are supported by our revolving credit facility and principally pertain to performance guarantees related to customer contracts entered into by certain of our subsidiaries as well as payment guarantees related to potential workers' compensation claims and a facility lease.
Critical Accounting Policies
We believe that the following are our most critical accounting policies, which require management to make judgments about matters that are inherently uncertain.
Assumptions utilized to determine fair value in connection with business combinations, contingent consideration arrangements and in goodwill and intangible assets impairment tests are highly judgmental. If there is a material change in such assumptions or if there is a material change in the conditions or circumstances influencing fair value, we could be required to recognize a material impairment charge. See Item 1A., Risk Factors, for a list of factors which may cause our actual results to differ materially from anticipated results.
Revenue Recognition
During fiscal 2019, we adopted Accounting Standard Codification ("ASC") Topic 606, "Revenue from Contracts with Customers" ("ASC 606"). Pursuant to ASC 606, HEICO
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recognizes revenue when it transfers control of a promised good or service to a customer in an amount that reflects the consideration it expects to receive in exchange for the good or service. Our performance obligations are satisfied and control is transferred either at a point-in-time or over-time. The majority of our revenue is recognized at a point-in-time when control is transferred, which is generally evidenced by the shipment or delivery of the product to the customer, a transfer of title, a transfer of the significant risks and rewards of ownership, and customer acceptance. For certain contracts under which we produce products with no alternative use and for which we have an enforceable right to recover costs incurred plus a reasonable profit margin for work completed to date and for certain other contracts under which we create or enhance a customer-owned asset while performing repair and overhaul services, control is transferred to the customer over-time. HEICO recognizes revenue using an over-time recognition model for these types of contracts.
We utilize the cost-to-cost method as a measure of progress for performance obligations that are satisfied over-time as we believe this input method best represents the transfer of control to the customer. Under this method, revenue for the current period is recorded at an amount equal to the ratio of costs incurred to date divided by total estimated contract costs multiplied by (i) the transaction price, less (ii) cumulative revenue recognized in prior periods. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs and depreciation.
Under the cost-to-cost method, the extent of progress toward completion is measured based on the proportion of costs incurred to date to the total estimated costs at completion of the performance obligation. These projections require management to make numerous assumptions and estimates relating to items such as the complexity of design and related development costs, performance of subcontractors, availability and cost of materials, labor productivity and cost, overhead, capital costs, and manufacturing efficiency. We review our cost estimates on a periodic basis, or when circumstances change and warrant a modification to a previous estimate. Cost estimates are largely based on negotiated or estimated purchase contract terms, historical performance trends and other economic projections.
For certain contracts with similar characteristics and for which revenue is recognized using an over-time model, we use a portfolio approach to estimate the amount of revenue to recognize. For each portfolio of contracts, the respective work in process and/or finished goods inventory balances are identified and the portfolio-specific margin is applied to estimate the pro rata portion of the transaction price to recognize in relation to the costs incurred. This approach is utilized only when the resulting revenue recognition is not expected to be materially different than if the accounting was applied to the individual contracts.
Certain of our contracts give rise to variable consideration when they contain items such as customer rebates, credits, volume purchase discounts, penalties and other provisions that may impact the total consideration we will receive. We include variable consideration in the transaction price generally by applying the most likely amount method of the consideration that we expect to be entitled to receive based on an assessment of all available information (i.e., historical experience, current and forecasted performance) and only to the extent it is probable
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that a significant reversal of revenue recognized will not occur when the uncertainty is resolved. We estimate variable consideration by applying the most likely amount method when there are a limited number of outcomes related to the resolution of the variable consideration.
Changes in estimates that result in adjustments to net sales and cost of sales are recognized as necessary in the period they become known on a cumulative catch-up basis. Changes in estimates did not have a material effect on net income from consolidated operations in fiscal 2020, 2019 and 2018.
Valuation of Inventory
Inventory is stated at the lower of cost or net realizable value, with cost being determined on the first-in, first-out or the average cost basis. Losses, if any, are recognized fully in the period when identified.
We periodically evaluate the carrying value of inventory, giving consideration to factors such as its physical condition, sales patterns and expected future demand in order to estimate the amount necessary to write down any slow moving, obsolete or damaged inventory. These estimates could vary significantly from actual amounts based upon future economic conditions, customer inventory levels, or competitive factors that were not foreseen or did not exist when the estimated write-downs were made.
In accordance with industry practice, all inventories are classified as a current asset including portions with long production cycles, some of which may not be realized within one year.
Business Combinations
We allocate the purchase price of acquired entities to the underlying tangible and identifiable intangible assets acquired and liabilities and any noncontrolling interests assumed based on their estimated fair values, with any excess recorded as goodwill. Determining the fair value of assets acquired and liabilities and noncontrolling interests assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, asset lives and market multiples, among other items. We determine the fair values of intangible assets acquired generally in consultation with third-party valuation advisors.
As part of the agreement to acquire certain subsidiaries, we may be obligated to pay contingent consideration should the acquired entity meet certain earnings objectives subsequent to the date of acquisition. As of the acquisition date, contingent consideration is recorded at fair value as determined through the use of a probability-based scenario analysis approach. Under this method, a set of discrete potential future subsidiary earnings is determined using internal estimates based on various revenue growth rate assumptions for each scenario. A probability of likelihood is then assigned to each discrete potential future earnings estimate and the resultant contingent consideration is calculated and discounted using a weighted average discount rate
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reflecting the credit risk of HEICO. Subsequent to the acquisition date, the fair value of such contingent consideration is measured each reporting period and any changes are recorded to SG&A expenses within our Consolidated Statements of Operations. Changes in either the revenue growth rates, related earnings or the discount rate could result in a material change to the amount of contingent consideration accrued. As of October 31, 2020, 2019 and 2018, $42.0 million, $18.3 million and $20.9 million of contingent consideration was accrued within our Consolidated Balance Sheets, respectively. During fiscal 2020, 2019 and 2018, such fair value measurement adjustments resulted in net increases (decreases) to SG&A expenses of $.5 million, $2.6 million and ($1.4) million, respectively. For further information regarding our contingent consideration arrangements, see Note 8, Fair Value Measurements, of the Notes to Consolidated Financial Statements.
Valuation of Goodwill and Other Intangible Assets
We test goodwill for impairment annually as of October 31, or more frequently if events or changes in circumstances indicate that the carrying amount of goodwill may not be fully recoverable. In evaluating the recoverability of goodwill, we compare the fair value of each of our reporting units to its carrying value to determine potential impairment. If the carrying value of a reporting unit exceeds its fair value, the implied fair value of that reporting unit’s goodwill is to be calculated and an impairment loss is recognized in the amount by which the carrying value of the reporting unit’s goodwill exceeds its implied fair value, if any. The fair values of our reporting units were determined using a weighted average of a market approach and an income approach. Under the market approach, fair values are estimated using published market multiples for comparable companies. We calculate fair values under the income approach by taking estimated future cash flows that are based on internal projections and other assumptions deemed reasonable by management and discounting them using an estimated weighted average cost of capital. Based on the annual goodwill impairment test as of October 31, 2020, 2019 and 2018, we determined there was no impairment of our goodwill. The fair value of each of our reporting units as of October 31, 2020 significantly exceeded its carrying value.
We test each non-amortizing intangible asset (principally trade names) for impairment annually as of October 31, or more frequently if events or changes in circumstances indicate that the asset might be impaired. To derive the fair value of our trade names, we utilize an income approach, which relies upon management's assumptions of royalty rates, projected revenues and discount rates. We also test each amortizing intangible asset for impairment if events or circumstances indicate that the asset might be impaired. The test consists of determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the undiscounted future cash flows is less than the carrying amount of those assets, we recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets. The determination of fair value requires us to make a number of estimates, assumptions and judgments of underlying factors such as projected revenues and related earnings as well as discount rates. Based on the intangible asset impairment tests conducted, we did not recognize any impairment losses in fiscal 2020, 2019 and 2018.
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New Accounting Pronouncements
See Note 1, Summary of Significant Accounting Policies - New Accounting Pronouncements, of the Notes to Consolidated Financial Statements for additional information.
Forward-Looking Statements
Certain statements in this report constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements contained herein that are not clearly historical in nature may be forward-looking and the words “anticipate,” “believe,” “expect,” “estimate” and similar expressions are generally intended to identify forward-looking statements. Any forward-looking statement contained herein, in press releases, written statements or other documents filed with the Securities and Exchange Commission or in communications and discussions with investors and analysts in the normal course of business through meetings, phone calls and conference calls, concerning our operations, economic performance and financial condition are subject to risks, uncertainties and contingencies. We have based these forward-looking statements on our current expectations and projections about future events. All forward-looking statements involve risks and uncertainties, many of which are beyond our control, which may cause actual results, performance or achievements to differ materially from anticipated results, performance or achievements. Also, forward-looking statements are based upon management’s estimates of fair values and of future costs, using currently available information. Therefore, actual results may differ materially from those expressed in or implied by those forward-looking statements. Factors that could cause such differences include:
•The severity, magnitude and duration of the Pandemic;
•Our liquidity and the amount and timing of cash generation;
•Lower commercial air travel caused by the Pandemic and its aftermath, airline fleet changes or airline purchasing decisions, which could cause lower demand for our goods and services;
•Product specification costs and requirements, which could cause an increase to our costs to complete contracts;
•Governmental and regulatory demands, export policies and restrictions, reductions in defense, space or homeland security spending by U.S. and/or foreign customers or competition from existing and new competitors, which could reduce our sales;
•Our ability to introduce new products and services at profitable pricing levels, which could reduce our sales or sales growth;
•Product development or manufacturing difficulties, which could increase our product development and manufacturing costs and delay sales;
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•Our ability to make acquisitions and achieve operating synergies from acquired businesses; customer credit risk; interest, foreign currency exchange and income tax rates; economic conditions within and outside of the aviation, defense, space, medical, telecommunications and electronics industries, which could negatively impact our costs and revenues; and
•Defense spending or budget cuts, which could reduce our defense-related revenue.
For further information on these and other factors that potentially could materially affect our financial results, see Item 1A, Risk Factors. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except to the extent required by applicable law.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
We have exposure to interest rate risk, mainly related to our revolving credit facility, which has variable interest rates. Interest rate risk associated with our variable rate debt is the potential increase in interest expense from an increase in interest rates. Based on our aggregate outstanding variable rate debt balance of $730.0 million as of October 31, 2020, a hypothetical 10% increase in interest rates would not have a material effect on our results of operations, financial position or cash flows. We also maintain a portion of our cash and cash equivalents in financial instruments with original maturities of three months or less. These financial instruments are subject to interest rate risk and will decline in value if interest rates increase. Due to the short duration of these financial instruments, a hypothetical 10% increase in interest rates as of October 31, 2020 would not have a material effect on our results of operations, financial position or cash flows.
Foreign Currency Risk
We have several foreign subsidiaries that utilize a functional currency other than the U.S. dollar, or principally the Euro. Accordingly, changes in exchange rates between such foreign currencies and the U.S. dollar will affect the translation of the financial results of our foreign subsidiaries into the U.S. dollar for purposes of reporting our consolidated financial results. A hypothetical 10% weakening in the exchange rate of the Euro to the U.S. dollar as of October 31, 2020 would not have a material effect on our results of operations, financial position or cash flows.
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
HEICO CORPORATION AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm 51
Consolidated Balance Sheets as of October 31, 2020 and 2019 54
Notes to Consolidated Financial Statements 60
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
HEICO Corporation
Hollywood, Florida
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of HEICO Corporation and subsidiaries (the "Company") as of October 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income, shareholders' equity, and cash flows, for each of the three years in the period ended October 31, 2020, and the related notes and the schedule listed in the Index at Item 15 (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of October 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended October 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of October 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 23, 2020, expressed an unqualified opinion on the Company's internal control over financial reporting.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the Finance/Audit Committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of
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critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Inventories, net - Refer to Notes 1 and 3 to the Financial Statements
Critical Audit Matter Description
Inventory is stated at the lower of cost or net realizable value. The Company periodically evaluates the carrying value of inventory, which requires management to make significant estimates and assumptions related to sales patterns and expected future demand in order to estimate the amount necessary to write down any slow moving or obsolete inventory. Changes in the assumptions related to future demand and sales patterns could have a significant impact on the valuation of finished goods inventory for certain of the Company’s aftermarket replacement parts and repair and overhaul parts and services business units in the Flight Support Group operating segment.
Given the magnitude of the inventory balances at these business units, coupled with the judgments necessary to project sales patterns and expected future demand within these aftermarket replacement parts and repair and overhaul parts and services business units, auditing such estimates required a high degree of auditor judgment and an increased extent of effort when performing audit procedures and evaluating the results of those procedures.
How the Critical Audit Matter Was Addressed in the Audit
Our audit procedures related to the expected future demand and sales patterns used by management to estimate the valuation reserve on inventory included the following, among others:
•We tested the effectiveness of controls, including those related to evaluating the reasonableness of expected future demand and sales patterns.
•We evaluated the reasonableness of management’s assumptions of future demand and sales patterns by performing the following:
◦Utilized historical inventory usage data to analyze the relationship between the inventory valuation reserve calculated, the inventory on hand, and the sales trends over time.
◦Compared management’s assumptions to available external market data for certain inventory items.
◦Evaluated the accuracy and completeness of the valuation reserve by selecting a sample of inventory items and obtaining supporting documentation regarding current and historical sales patterns.
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•We tested declines in the inventory valuation reserve and evaluated whether such declines were the result of the sale or write off of inventory parts or the result of changes in the significant assumptions used to develop the valuation reserve.
/s/ DELOITTE & TOUCHE LLP
Miami, Florida
December 23, 2020
We have served as the Company's auditor since 1990.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
As of October 31,
ASSETS
Current assets:
Prepaid expenses and other current assets 24,706 18,953
LIABILITIES AND EQUITY
Current liabilities:
Current maturities of long-term debt $1,045 $906
Accrued expenses and other current liabilities 162,232 178,957
Commitments and contingencies (Note 17)
Shareholders’ equity:
Deferred compensation obligation 4,886 4,232
HEICO stock held by irrevocable trust (4,886) (4,232)
Accumulated other comprehensive loss (9,149) (16,739)
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Year ended October 31,
Operating costs and expenses:
Less: Net income attributable to noncontrolling interests 21,871 31,845 26,453
Net income per share attributable to HEICO shareholders:
Weighted average number of common shares outstanding:
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
Year ended October 31,
Other comprehensive income (loss):
Foreign currency translation adjustments 8,876 (844) (5,243)
Unrealized loss on defined benefit pension plan, net of tax (1,012) (889) (97)
Total other comprehensive income (loss) 7,937 (1,708) (5,327)
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands, except per share data)
HEICO Shareholders' Equity
Cash dividends ($.16 per share) — — — — — — — (21,552) — (21,552)
Share-based compensation expense — — — 10,134 — — — — — 10,134
Proceeds from stock option exercises — — 6 6,949 — — — — — 6,955
Capital contributions from noncontrolling interests 14,329 — — — — — — — — —
Distributions to noncontrolling interests (16,176) — — — — — — — (1,732) (1,732)
Acquisitions of noncontrolling interests (7,475) — — — — — — — — —
Deferred compensation obligation — — — — 654 (654) — — — —
HEICO Shareholders' Equity
Cash dividends ($.14 per share) — — — — — — — (18,691) — (18,691)
Share-based compensation expense — — — 10,334 — — — — — 10,334
Proceeds from stock option exercises — 12 8 8,527 — — — — — 8,547
Deferred compensation obligation — — — — 304 (304) — — — —
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands, except per share data)
HEICO Shareholders' Equity
Cash dividends ($.116 per share) — — — — — — — (15,363) — (15,363)
Five-for-four common stock splits — 191 286 (477) — — — (28) — (28)
Share-based compensation expense — — — 9,283 — — — — — 9,283
Proceeds from stock option exercises — 7 2 4,022 — — — — — 4,031
Distributions to noncontrolling interests (12,005) — — — — — — — (1,054) (1,054)
Deferred compensation obligation — — — — 810 (810) — — — —
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Year ended October 31,
Operating Activities:
Employer contributions to HEICO Savings and Investment Plan 9,576 9,528 8,019
Increase (decrease) in accrued contingent consideration, net 515 2,630 (1,365)
Payment of contingent consideration (175) (3,105) —
Changes in operating assets and liabilities, net of acquisitions:
Decrease in prepaid expenses and other current assets 2,471 609 401
(Decrease) increase in income taxes payable (9,586) 1,296 (12,530)
Investing Activities:
Financing Activities:
Capital contributions from noncontrolling interests 14,329 — —
Acquisitions of noncontrolling interests (7,475) — —
Payment of contingent consideration (325) (4,073) (5,425)
Revolving credit facility issuance costs — — (4,067)
Effect of exchange rate changes on cash 2,026 390 92
Net increase (decrease) in cash and cash equivalents 349,851 (2,598) 7,533
The accompanying notes are an integral part of these consolidated financial statements.
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HEICO CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
HEICO Corporation, through its principal subsidiaries consisting of HEICO Aerospace Holdings Corp. (“HEICO Aerospace”), HEICO Flight Support Corp. and HEICO Electronic Technologies Corp. (“HEICO Electronic”) and their respective subsidiaries (collectively, the “Company”), is principally engaged in the design, manufacture and sale of aerospace, defense and electronic related products and services throughout the United States ("U.S.") and internationally. The Company’s customer base is primarily the aviation, defense, space, medical, telecommunications and electronics industries.
Basis of Presentation
The Company has two operating segments: the Flight Support Group (“FSG”), consisting of HEICO Aerospace and HEICO Flight Support Corp. and their respective subsidiaries; and the Electronic Technologies Group (“ETG”), consisting of HEICO Electronic and its subsidiaries.
The consolidated financial statements include the financial accounts of HEICO Corporation and its direct subsidiaries, all of which are wholly owned except for HEICO Aerospace, which is 20% owned by Lufthansa Technik AG ("LHT"), the technical services subsidiary of Lufthansa German Airlines. HEICO Flight Support Corp. consolidates four subsidiaries which are 70%, 84%, 85% and 86.2%, owned, respectively, and six subsidiaries that are each 80.1% owned. In addition, HEICO Aerospace consolidates a joint venture, which is 84% owned. HEICO Electronic consolidates three subsidiaries that are each 80.1% owned, two subsidiaries that are each 75% owned, and five subsidiaries which are 82.5%, 85%, 90.0%, 92.7% and 95.9% owned, respectively. Certain subsidiaries of HEICO Electronic consolidate subsidiaries that are less than wholly owned. See Note 13, Redeemable Noncontrolling Interests. All intercompany balances and transactions are eliminated.
The Company’s results of operations in fiscal 2020 were significantly affected by the COVID-19 global pandemic (the “Pandemic”). The effects of the Pandemic and related actions by governments around the world to mitigate its spread have impacted our employees, customers, suppliers and manufacturers. In response to the economic impact from the Pandemic, the Company implemented certain cost reduction efforts, including layoffs, temporary reduced work hours and temporary pay reductions within various departments of our business, including within our executive management team and our Board of Directors. Additionally, the Company’s response to the Pandemic included the implementation of varying health and safety measures at our facilities, including: supplying and requiring the use of personal protective equipment; staggering work shifts; body temperature taking; increasing work-from-home capabilities; consistent and ongoing cleaning of work spaces and high-touch areas; and
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establishing processes aligned with the Centers for Disease and Control guidelines to work with any individual exposed to COVID-19 on their necessary quarantine period and the process for the individual to return to work.
With respect to the Company’s results of operations, approximately 59% of its net sales in fiscal 2020 were derived from defense, space and other industrial markets including electronics, medical and telecommunications. Although demand for these products was slightly moderated in fiscal 2020, the Company’s overall results from this portion of its business were not materially impacted by the Pandemic. However, the Company experienced, and expects to continue experiencing, periodic operational disruptions resulting from supply chain disturbances, staffing challenges - including at some of our customers, temporary facility closures, transportation interruptions and other conditions which slow production and orders, or increase costs.
The remaining portion of the Company’s fiscal 2020 net sales was derived from commercial aviation products and services. The Pandemic has caused significant volatility and a substantial decline in value across global markets. Most notably, the commercial aerospace industry experienced an ongoing substantial decline in demand resulting from a significant number of aircraft in the global fleet being grounded during fiscal 2020. The Company’s businesses that operate within the commercial aerospace industry were materially impacted by the significant decline in global commercial air travel that began in March 2020. Consolidated net sales for its businesses that operate within the commercial aerospace industry decreased by approximately 32% during fiscal 2020.
Use of Estimates and Assumptions
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
For purposes of the consolidated financial statements, the Company considers all highly liquid investments such as U.S. Treasury bills and money market funds with an original maturity of three months or less at the time of purchase to be cash equivalents.
Accounts Receivable
Accounts receivable consist of amounts billed and currently due from customers. The valuation of accounts receivable requires that the Company set up an allowance for estimated uncollectible accounts and record a corresponding charge to bad debt expense. The Company estimates uncollectible receivables based on such factors as its prior experience, its appraisal of a
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customer’s ability to pay, age of receivables outstanding and economic conditions within and outside of the aviation, defense, space, medical, telecommunications and electronics industries.
Contract Assets
Contract assets (unbilled receivables) represent revenue recognized on contracts using an over-time recognition model in excess of amounts invoiced to the customer. See Note 6, Revenue, for additional information regarding the Company's contract assets.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade accounts receivable. The Company places its temporary cash investments with high credit quality financial institutions and limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company’s customer base and their dispersion across many different geographical regions. The Company performs ongoing credit evaluations of its customers, but does not generally require collateral to support customer receivables.
Inventory
Inventory is stated at the lower of cost or net realizable value, with cost being determined on the first-in, first-out or the average cost basis. Losses, if any, are recognized fully in the period when identified. The Company periodically evaluates the carrying value of inventory, giving consideration to factors such as its physical condition, sales patterns and expected future demand in order to estimate the amount necessary to write down any slow moving, obsolete or damaged inventory. These estimates could vary significantly from actual amounts based upon future economic conditions, customer inventory levels or competitive factors that were not foreseen or did not exist when the estimated write-downs were made. In accordance with industry practice, all inventories are classified as a current asset including portions with long production cycles, some of which may not be realized within one year.
Property, Plant and Equipment
Property, plant and equipment is recorded at cost. Depreciation and amortization is generally provided on the straight-line method over the estimated useful lives of the various assets.The Company’s property, plant and equipment is generally depreciated over the following estimated useful lives:
Buildings and improvements 10 to 40 years
Machinery and equipment 3 to 10 years
Leasehold improvements 2 to 20 years
Tooling 2 to 5 years
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The costs of major additions and improvements are capitalized. Leasehold improvements are amortized over the shorter of the leasehold improvement’s useful life or the lease term.
Repairs and maintenance costs are expensed as incurred. Upon an asset's disposition, its cost and related accumulated depreciation are removed from the financial accounts and any resulting gain or loss is reflected within earnings.
Leases
During fiscal 2020, the Company adopted Accounting Standards Update (“ASU”) 2016-02, which, as amended, was codified as Accounting Standards Codification (“ASC”) Topic 842, “Leases” (“ASC 842”). Pursuant to ASC 842, the Company classifies a lease as operating or finance using the classification criteria set forth in ASC 842. Further, the Company recognizes a lease right-of-use (“ROU”) asset and corresponding lease liability on its balance sheet as of the lease commencement date based on the present value of the lease payments over the lease term. The discount rate used to calculate the present value of the Company’s leases is based on HEICO’s incremental borrowing rate and considers credit risk, the lease term and other available information as of the commencement date since the leases do not provide a readily determinable implicit rate. The term of a lease is inclusive of any option to renew, extend, or terminate the lease when it is reasonably certain that the Company will exercise such option. For operating leases, lease expense is recognized on a straight-line basis over the lease term. For finance leases, ROU assets are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life of the leased asset. See Note 1, Summary of Significant Accounting Policies – New Accounting Pronouncements, and Note 9, Leases, for additional information regarding the Company's accounting policy for leases.
Business Combinations
The Company allocates the purchase price of acquired entities to the underlying tangible and identifiable intangible assets acquired and liabilities and any noncontrolling interests assumed based on their estimated fair values, with any excess recorded as goodwill. The operating results of acquired businesses are included in the Company’s results of operations beginning as of their effective acquisition dates. Acquisition costs are expensed as incurred and totaled $3.2 million in fiscal 2019. Acquisition costs were not material in fiscal 2020 or 2018.
For contingent consideration arrangements, a liability is recognized at fair value as of the acquisition date with subsequent fair value adjustments recorded in operations. Additional information regarding the Company's contingent consideration arrangements may be found in Note 2, Acquisitions, and Note 8, Fair Value Measurements.
Goodwill and Other Intangible Assets
The Company tests goodwill for impairment annually as of October 31, or more frequently if events or changes in circumstances indicate that the carrying amount of goodwill may not be fully recoverable. In evaluating the recoverability of goodwill, the Company compares the fair value of each of its reporting units to its carrying value to determine potential
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impairment. If the carrying value of a reporting unit exceeds its fair value, the implied fair value of that reporting unit’s goodwill is to be calculated and an impairment loss is recognized in the amount by which the carrying value of the reporting unit’s goodwill exceeds its implied fair value, if any. The fair values of the Company's reporting units are determined by using a weighted average of a market approach and an income approach. Under the market approach, fair values are estimated using published market multiples for comparable companies. The Company calculates fair values under the income approach by taking estimated future cash flows that are based on internal projections and other assumptions deemed reasonable by management and discounting them using an estimated weighted average cost of capital.
The Company’s intangible assets not subject to amortization consist principally of its trade names. The Company’s intangible assets subject to amortization are amortized on the straight-line method (except for certain customer relationships amortized on an accelerated method) over the following estimated useful lives:
Customer relationships 4 to 15 years
Intellectual property 4 to 22 years
Licenses 10 to 11 years
Patents 5 to 20 years
Trade names 8 to 15 years
Amortization expense of intellectual property, licenses and patents is recorded as a component of cost of sales, and amortization expense of customer relationships, non-compete agreements and trade names is recorded as a component of selling, general and administrative ("SG&A") expenses in the Company’s Consolidated Statements of Operations. The Company tests each non-amortizing intangible asset for impairment annually as of October 31, or more frequently if events or changes in circumstances indicate that the asset might be impaired. To derive the fair value of its trade names, the Company utilizes an income approach, which relies upon management's assumptions of royalty rates, projected revenues and discount rates. The Company also tests each amortizing intangible asset for impairment if events or circumstances indicate that the asset might be impaired. The test consists of determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the undiscounted future cash flows is less than the carrying amount of those assets, the Company recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets. The determination of fair value requires management to make a number of estimates, assumptions and judgments of such factors as projected revenues and earnings and discount rates.
Customer Rebates and Credits
The Company records accrued customer rebates and credits as a component of accrued expenses and other current liabilities in its Consolidated Balance Sheets. These amounts generally relate to discounts negotiated with customers as part of certain sales contracts that are usually tied to sales volume thresholds. The Company accrues customer rebates and credits as a reduction within net sales as the revenue is recognized based on the estimated level of discount
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rate expected to be earned by each customer over the life of the contractual rebate period (generally one year). Accrued customer rebates and credits are monitored by management and discount levels are updated at least quarterly.
Product Warranties
Product warranty liabilities are estimated at the time of shipment and recorded as a component of accrued expenses and other current liabilities in the Company’s Consolidated Balance Sheets. The amount recognized is based on historical claims experience.
Defined Benefit Pension Plan
In connection with a prior year acquisition, the Company assumed a frozen qualified defined benefit pension plan (the "Plan"). The Plan's benefits are based on employee compensation and years of service; however, the accrued benefit for Plan participants was fixed as of the date of acquisition. The Company uses an actuarial valuation to determine the projected benefit obligation of the Plan and records the difference between the fair value of the Plan's assets and the projected benefit obligation as of October 31 in other long-term liabilities in its Consolidated Balance Sheets. Additionally, any actuarial gain or loss that arises during a fiscal year that is not recognized as a component of net periodic pension income or expense is recorded as a component of other comprehensive income or (loss), net of tax. The following table presents the fair value of the Plan's assets and projected benefit obligation as of October 31, for each of the last two fiscal years (in thousands):
As of October 31,
Revenue Recognition
During fiscal 2019, the Company adopted ASC Topic 606, "Revenue from Contracts with Customers" ("ASC 606"). Pursuant to ASC 606, the Company recognizes revenue when it transfers control of a promised good or service to a customer in an amount that reflects the consideration it expects to receive in exchange for the good or service. The Company’s performance obligations are satisfied and control is transferred either at a point-in-time or over-time. The majority of the Company’s revenue is recognized at a point-in-time when control is transferred, which is generally evidenced by the shipment or delivery of the product to the customer, a transfer of title, a transfer of the significant risks and rewards of ownership, and customer acceptance. For certain contracts under which the Company produces products with no alternative use and for which it has an enforceable right to recover costs incurred plus a reasonable profit margin for work completed to date and for certain other contracts under which the Company creates or enhances a customer-owned asset while performing repair and overhaul
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services, control is transferred to the customer over-time. The Company recognizes revenue using an over-time recognition model for these types of contracts.
The Company accounts for a contract with a customer when it has approval and commitment from both parties, the rights of the parties are identified, the payment terms are identified, the contract has commercial substance, and it is probable that the Company will collect the consideration to which it is entitled to receive. Customer payment terms related to the sale of products and the rendering of services vary by Company subsidiary and product line. The time between receipt of payment and recognition of revenue for satisfaction of the related performance obligation is not significant.
A performance obligation is a promise within a contract to transfer a distinct good or service to the customer in exchange for payment and is the unit of account for recognizing revenue. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when or as the performance obligation is satisfied. The majority of the Company’s contracts have a single performance obligation to transfer goods or services. For contracts with more than one performance obligation, the Company allocates the transaction price to each performance obligation based on its estimated standalone selling price. When standalone selling prices are not available, the transaction price is allocated using an expected cost plus margin approach as pricing for such contracts is typically negotiated on the basis of cost.
The Company accounts for contract modifications prospectively when the remaining goods or services are distinct and on a cumulative catch-up basis when the remaining goods or services are not distinct.
The Company provides assurance type warranties on many of its products and services. Since customers cannot purchase such warranties independently of the products or services under contract and they are not priced separately, warranties are not separate performance obligations.
The Company utilizes the cost-to-cost method as a measure of progress for performance obligations that are satisfied over-time as it believes this input method best represents the transfer of control to the customer. Under this method, revenue for the current period is recorded at an amount equal to the ratio of costs incurred to date divided by total estimated contract costs multiplied by (i) the transaction price, less (ii) cumulative revenue recognized in prior periods. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs and depreciation.
Under the cost-to-cost method, the extent of progress toward completion is measured based on the proportion of costs incurred to date to the total estimated costs at completion of the performance obligation. These projections require the Company to make numerous assumptions and estimates relating to items such as the complexity of design and related development costs, performance of subcontractors, availability and cost of materials, labor productivity and cost, overhead, capital costs, and manufacturing efficiency. The Company reviews its cost estimates on a periodic basis, or when circumstances change and warrant a modification to a previous
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estimate. Cost estimates are largely based on negotiated or estimated purchase contract terms, historical performance trends and other economic projections.
For certain contracts with similar characteristics and for which revenue is recognized using an over-time model, the Company uses a portfolio approach to estimate the amount of revenue to recognize. For each portfolio of contracts, the respective work in process and/or finished goods inventory balances are identified and the portfolio-specific margin is applied to estimate the pro rata portion of the transaction price to recognize in relation to the costs incurred. This approach is utilized only when the resulting revenue recognition is not expected to be materially different than if the accounting was applied to the individual contracts.
Certain of the Company’s contracts give rise to variable consideration when they contain items such as customer rebates, credits, volume purchase discounts, penalties and other provisions that may impact the total consideration the Company will receive. The Company includes variable consideration in the transaction price generally by applying the most likely amount method of the consideration that it expects to be entitled to receive based on an assessment of all available information (i.e., historical experience, current and forecasted performance) and only to the extent it is probable that a significant reversal of revenue recognized will not occur when the uncertainty is resolved. The Company estimates variable consideration by applying the most likely amount method when there are a limited number of outcomes related to the resolution of the variable consideration. See Note 6, Revenue, for additional information regarding the Company’s revenue recognition policy.
Changes in estimates that result in adjustments to net sales and cost of sales are recognized as necessary in the period they become known on a cumulative catch-up basis. Changes in estimates did not have a material effect on net income from consolidated operations in fiscal 2020, 2019 and 2018.
Stock-Based Compensation
The Company records compensation expense associated with stock options in its Consolidated Statements of Operations based on the grant date fair value of those awards. The fair value of each stock option on the date of grant is estimated using the Black-Scholes pricing model based on certain valuation assumptions. Expected stock price volatility is based on the Company’s historical stock prices over the contractual term of the option grant and other factors. The risk-free interest rate used is based on the published U.S. Treasury yield curve in effect at the time of the option grant for instruments with a similar life. The dividend yield reflects the Company’s expected dividend yield at the date of grant. The expected option life represents the period of time that the stock options are expected to be outstanding, taking into consideration the contractual term of the option grant and employee historical exercise behavior. The Company’s historical rate of forfeiture is nominal and therefore not included when estimating the grant date fair value of stock option awards. As such, the Company recognizes the impact of forfeitures when they occur. The Company generally recognizes stock option compensation expense ratably over the award’s vesting period.
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Income Taxes
Income tax expense includes U.S. and foreign income taxes. Deferred income taxes are provided on elements of income that are recognized for financial reporting purposes in periods different from when recognized for income tax purposes. Deferred tax assets and liabilities are recognized for the tax effects of temporary differences between the financial reporting and income tax bases of assets and liabilities and are measured using enacted tax rates in effect for the year in which the differences are expected to reverse. Tax law and rate changes are reflected in income in the period such changes are enacted. The Company's policy is to recognize interest and penalties related to income tax matters as a component of income tax expense and to treat any tax on Global Intangible Low-Taxed Income ("GILTI") as a current period income tax expense. Further information regarding income taxes can be found in Note 7, Income Taxes.
Redeemable Noncontrolling Interests
As further detailed in Note 13, Redeemable Noncontrolling Interests, the holders of equity interests in certain of the Company’s subsidiaries have rights (“Put Rights”) that require the Company to provide cash consideration for their equity interests (the “Redemption Amount”) at fair value or at a formula that management intended to reasonably approximate fair value based solely on a multiple of future earnings over a measurement period. The Put Rights are embedded in the shares owned by the noncontrolling interest holders and are not freestanding.
The Company tracks the carrying cost of such redeemable noncontrolling interests at historical cost plus an allocation of subsidiary earnings based on ownership interest, less dividends paid to the noncontrolling interest holders. Redeemable noncontrolling interests are recorded outside of permanent equity at the higher of their carrying cost or management’s estimate of the Redemption Amount. The initial adjustment to record redeemable noncontrolling interests at the Redemption Amount results in a corresponding decrease to retained earnings. Subsequent adjustments to the Redemption Amount of redeemable noncontrolling interests may result in corresponding decreases or increases to retained earnings, provided any increases to retained earnings may only be recorded to the extent of decreases previously recorded. Adjustments to Redemption Amounts based on fair value will have no effect on net income per share attributable to HEICO shareholders whereas the portion of periodic adjustments to the carrying amount of redeemable noncontrolling interests based solely on a multiple of future earnings that reflect a redemption amount in excess of fair value will affect net income per share attributable to HEICO shareholders. Acquisitions of redeemable noncontrolling interests are treated as equity transactions.
Net Income per Share Attributable to HEICO Shareholders
Basic net income per share attributable to HEICO shareholders is computed by dividing net income attributable to HEICO by the weighted average number of common shares outstanding during the period. Diluted net income per share attributable to HEICO shareholders is computed by dividing net income attributable to HEICO by the weighted average number of common shares outstanding during the period plus potentially dilutive common shares arising
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from the assumed exercise of stock options, if dilutive. The dilutive impact of potentially dilutive common shares is determined by applying the treasury stock method.
Foreign Currency
All assets and liabilities of foreign subsidiaries that do not utilize the U.S. dollar as its functional currency are translated at period-end exchange rates, while revenue and expenses are translated using average exchange rates for the period. Unrealized translation gains or losses are reported as foreign currency translation adjustments through other comprehensive income or (loss) in shareholders’ equity. Transaction gains or losses related to monetary balances denominated in a currency other than the functional currency are recorded in the Company's Consolidated Statements of Operations.
Contingencies
Losses for contingencies such as product warranties, litigation and environmental matters are recognized in income when they are probable and can be reasonably estimated. Gain contingencies are not recognized in income until they have been realized.
New Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-02, which, as amended, was codified as ASC 842. ASC 842 requires recognition of lease assets and lease liabilities on the balance sheet of lessees. The Company adopted ASC 842 as of November 1, 2019 using a modified retrospective transition approach with the election to apply the guidance as of the adoption date instead of at the beginning of the earliest comparative period presented. The adoption of this guidance resulted in an increase in the Company's assets and liabilities due to the recognition of ROU assets and corresponding lease liabilities for leases that are currently classified as operating leases.
Upon adoption, the Company elected the package of transitional practical expedients, which allowed the Company to not reassess its prior conclusions about lease identification, lease classification, and initial direct costs. In addition, the Company elected the short-term lease practical expedient, which allows HEICO to not record an ROU asset and lease liability for any lease with a term of twelve months or less, and also elected the single component practical expedient for all asset classes, which allows the Company to include both lease and non-lease components associated with a lease as a single lease component when determining the value of the ROU asset and lease liability.
The adoption of this guidance resulted in the Company recording ROU assets and corresponding lease liabilities of $63.4 million and $64.1 million, respectively, in the Company's Consolidated Balance Sheet. The adoption of ASC 842 did not have a material impact on the Company’s Consolidated Statement of Operations or Statement of Cash Flows. See Note 9, Leases, for additional information regarding the Company's accounting policy for leases and disclosures required by ASC 842.
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In January 2017, the FASB issued ASU 2017-04, "Simplifying the Test for Goodwill Impairment," which is intended to simplify the current test for goodwill impairment by eliminating the second step in which the implied value of a reporting unit is calculated when the carrying value of the reporting unit exceeds its fair value. Under ASU 2017-04, goodwill impairment should be recognized for the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. ASU 2017-04 must be applied prospectively and is effective for any annual or interim goodwill impairment test in fiscal years beginning after December 15, 2019, or in fiscal 2021 for HEICO. Early adoption is permitted. The Company is currently evaluating the effect the adoption of this guidance will have on its consolidated results of operations, financial position and cash flows.
2. ACQUISITIONS
In August 2020, the Company, through HEICO Electronic, acquired 89.99% of the equity interests of Connect Tech Inc. ("Connect Tech"). Connect Tech designs and manufacturers rugged, small-form-factor embedded computing solutions. Connect Tech's components are designed for very harsh environments and are primarily used in rugged commercial and industrial, aerospace and defense, transportation, and smart energy applications. The remaining 10.01% interest continues to be owned by a certain member of Connect Tech's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information). The total consideration includes an accrual of $9.7 million as of the acquisition date representing the estimated fair value of contingent consideration the Company may be obligated to pay should Connect Tech meet certain earnings objectives following the acquisition. See Note 8, Fair Value Measurements, for additional information regarding the Company’s contingent consideration obligation.
In August 2020, the Company, through a newly formed subsidiary of HEICO Electronic, acquired all of the equity interests of Transformational Security, LLC and Intelligent Devices, Inc. (collectively, "TSID"). TSID develops and manufactures state-of-the-art Technical Surveillance Countermeasures ("TSCM") equipment used to protect critical spaces from exploitation via wireless transmissions, technical surveillance and listening devices. The subsidiary of HEICO Electronic that completed the acquisition is 75% owned by HEICO Electronic and 25% owned by the noncontrolling interest holders of a subsidiary of HEICO Electronic that is also a designer and manufacturer of TSCM equipment (see Note 13, Redeemable Noncontrolling Interests, for additional information). The total consideration includes an accrual of $14.0 million as of the acquisition date representing the estimated fair value of contingent consideration the Company may be obligated to pay should TSID meet certain earnings objectives following the acquisition. See Note 8, Fair Value Measurements, for additional information regarding the Company’s contingent consideration obligation.
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In June 2020, the Company, through HEICO Flight Support Corp., acquired 70% of the membership interests of Rocky Mountain Hydrostatics, LLC ("Rocky Mountain"). Rocky Mountain overhauls industrial pumps, motors, and other hydraulic units with a focus on the support of legacy systems for the U.S. Navy. The remaining 30% continues to be owned by certain members of Rocky Mountain's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
In May 2020, a subsidiary of HEICO Electronic obtained 100% ownership of the assets and liabilities of Freebird Semiconductor Corporation ("Freebird"), an entity in which the subsidiary held a controlling financial interest since November 2018. In June 2020, the HEICO Electronic subsidiary contributed the assets and liabilities of Freebird in exchange for a 49% equity interest in EPC Space LLC ("EPC”), which the Company accounts for under the equity method. As the fair value of the net assets contributed approximated the fair value of the equity interest received in EPC, no material gain or loss was recorded as a result of this transaction. EPC designs, develops, promotes, markets and sells radiation-hardened gallium nitride power solutions packaged for use in outer space and other high reliability applications.
In December 2019, the Company, through a subsidiary of HEICO Electronic, acquired 100% of the business and assets of the Human-Machine Interface ("HMI") product line of Spectralux Corporation. HMI designs, manufactures, and repairs flight deck annunciators, panels, indicators, and illuminated keyboards, as well as lighting controls, and flight deck lighting.
In December 2019, the Company, through HEICO Electronic, acquired 80.1% of the stock of Quell Corporation ("Quell"). Quell designs and manufactures electromagnetic interference (EMI)/radio-frequency interference (RFI) and transient protection solutions for a wide variety of connectors that principally serve customers within the aerospace and defense markets. The remaining 19.9% continues to be owned by certain members of Quell's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
In September 2019, the Company, through a subsidiary of HEICO Electronic, acquired all of the outstanding stock of TTT-Cubed, Inc. ("TTT"). TTT is a designer and manufacturer of Radio Frequency (RF) Sources, Detectors, and Controllers for a certain wide range of aerospace and defense applications. The purchase price of this acquisition was paid in cash using cash provided by operating activities.
In July 2019, the Company, jointly through HEICO Electronic and one of its subsidiaries, acquired substantially all of the assets and business of a France-based company and transferred the assets to a newly created subsidiary, Bernier Connect SAS ("Bernier"). The acquisition is inclusive of Bernier's 70% equity interest in Moulages Plastiques Industriels de L'essonne SARL, a plastics manufacturer.Bernier is a designer and manufacturer of interconnect products used in demanding defense, aerospace and industrial applications, primarily for communications-related purposes. The purchase price of this acquisition was paid in cash using cash provided by operating activities.
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In June 2019, the Company, through HEICO Electronic, acquired 75% of the membership interests of Research Electronics International, LLC ("REI"). REI is a designer and manufacturer of TSCM equipment to detect devices used for espionage and information theft. The remaining 25% interest continues to be owned by certain members of REI's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
In February 2019, the Company, through HEICO Flight Support Corp., acquired 80.1% of the membership interests of Decavo LLC ("Decavo"). Decavo designs and produces complex composite parts and assemblies incorporated into camera and related sensor assemblies and unmanned aerial vehicle ("UAV") airframes used in demanding defense and civilian applications. The remaining 19.9% interest continues to be owned by certain members of Decavo's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information). The total consideration includes an accrual of $2.1 million as of the acquisition date representing the estimated fair value of contingent consideration the Company may be obligated to pay should Decavo meet a certain earnings objective during the second and third years following the acquisition. See Note 8, Fair Value Measurements, for additional information regarding the Company's contingent consideration obligation. The purchase price of this acquisition was paid in cash principally using cash provided by operating activities.
In February 2019, the Company, through HEICO Electronic, acquired 85% of the stock of Solid Sealing Technology, Inc. ("SST"). SST designs and manufactures high-reliability ceramic-to-metal feedthroughs and connectors for demanding environments within the defense, industrial, life science, medical, research, semiconductor, and other markets. The remaining 15% interest continues to be owned by certain members of SST's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
In November 2018, the Company, through a subsidiary of HEICO Electronic, acquired an additional equity interest in Freebird, which increased the Company's aggregate equity interest in Freebird to greater than 50%. Accordingly, the Company began consolidating the operating results of Freebird as of the acquisition date. Prior to this transaction, the Company accounted for its investment in Freebird under the equity method. Freebird is a fabless design and manufacturing company that offers advanced high-reliability wide-band gap power switching technology. The purchase price of this acquisition was paid in cash using cash provided by operating activities.
In November 2018, the Company, through HEICO Electronic, acquired 92.7% of the stock of Apex Microtechnology, Inc. ("Apex"). Apex designs and manufactures precision power analog monolithic, hybrid and open frame components for a certain wide range of aerospace, defense, industrial, measurement, medical and test applications. The remaining 7.3% interest continues to be owned by certain members of Apex's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
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In November 2018, the Company, through HEICO Electronic, acquired all of the stock of Specialty Silicone Products, Inc. ("SSP"). SSP designs and manufactures silicone material for a variety of demanding applications used in aerospace, defense, research, oil and gas, testing, pharmaceuticals and other markets.
In September 2018, the Company, through a subsidiary of HEICO Electronic, obtained control over 53.1% of the equity interests of SST Components, Inc. (“SST Components”). SST Components manufactures discrete semiconductor components, tests electronic components, and custom assembles a wide variety of prototype and off the shelf components into desired package styles for military, space and commercial uses. The purchase price of this acquisition was paid using cash provided by operating activities.
In August 2018, the Company, through a subsidiary of HEICO Flight Support Corp., acquired all of the business and assets of Optical Display Engineering ("ODE"). ODE is a Federal Aviation Administration ("FAA")-authorized Part 145 Repair Station focusing on the repair of LCD screens and display modules for aviation displays used in civilian and military aircraft. ODE also holds FAA-Parts Manufacturer Approval authority to supply products that it repairs. The purchase price of this acquisition was paid in cash, principally using cash provided by operating activities.
In April 2018, the Company, through a subsidiary of HEICO Electronic, acquired all of the assets and business of the Emergency Locator Transmitter Beacon product line ("ELT Product Line") of Instrumar Limited. The ELT Product Line designs and manufactures Emergency Locator Transmitter Beacons for the commercial aviation and defense markets that upon activation, transmit a distress signal to alert search and rescue operations of the aircraft's location. The purchase price of this acquisition was paid using cash provided by operating activities.
In February 2018, the Company, through a subsidiary of HEICO Electronic, acquired 85% of the assets and business of Sensor Technology Engineering, Inc. ("Sensor Technology"). Sensor Technology designs and manufactures sophisticated nuclear radiation detectors for law enforcement, homeland security and military applications. The remaining 15% continues to be owned by certain members of Sensor Technology's management team (see Note 13, Redeemable Noncontrolling Interests, for additional information).
In November 2017, the Company, through a subsidiary of HEICO Electronic, acquired all of the stock of Interface Displays & Controls, Inc. ("IDC"). IDC designs and manufactures electronic products for aviation, marine, military fighting vehicles, and embedded computing markets. The purchase price of this acquisition was paid using cash provided by operating activities.
Unless otherwise noted, the purchase price of each of the above referenced acquisitions was paid in cash, principally using proceeds from the Company's revolving credit facility, and is not material or significant to the Company's consolidated financial statements.
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The following table summarizes the aggregate total consideration for the Company's acquisitions (in thousands):
Year ended October 31,
Fair value of existing equity interest — 1,417 —
Additional purchase consideration 283 — (243)
The following table summarizes the allocation of the aggregate total consideration for the Company's acquisitions to the estimated fair values of the tangible and identifiable intangible assets acquired and liabilities and noncontrolling interests assumed (in thousands):
Year ended October 31,
Assets acquired:
Other assets (including contract assets) 1,891 907 126
Liabilities assumed:
Noncontrolling interests in consolidated subsidiaries 22,204 41,247 7,518
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The following table summarizes the weighted average amortization period of the definite-lived intangible assets acquired in connection with the Company's fiscal 2020, 2019 and 2018 acquisitions (in years):
Year ended October 31,
Customer relationships 10 11 7
The allocation of the total consideration for the fiscal 2020 acquisitions to the tangible and identifiable intangible assets acquired and liabilities and noncontrolling interests assumed is preliminary until the Company obtains final information regarding their fair values. However, the Company does not expect any adjustment to such allocations to be material to the Company's consolidated financial statements. The primary items that generated the goodwill recognized were the premiums paid by the Company for the future earnings potential of the businesses acquired and the value of their assembled workforces that do not qualify for separate recognition, which, in the case of Connect Tech, Rocky Mountain, Quell, Bernier, REI, Decavo, SST, Apex, SST Components and Sensor Technology benefit both the Company and the noncontrolling interest holders. The fair value of the noncontrolling interests in Connect Tech, Rocky Mountain, Quell, Bernier, REI, Decavo, SST, Apex, SST Components and Sensor Technology was determined based on the consideration paid by the Company for its controlling ownership interest adjusted for a lack of control that a market participant would consider when estimating the fair value of the noncontrolling interest.
The operating results of the fiscal 2020 acquisitions were included in the Company’s results of operations from each of the effective acquisition dates. The amount of net sales and earnings of the fiscal 2020 acquisitions included in the Consolidated Statement of Operations for the fiscal year ended October 31, 2020 is not material. Had the fiscal 2020 acquisitions occurred as of November 1, 2018, net sales, net income from consolidated operations, net income attributable to HEICO, and basic and diluted net income per share attributable to HEICO shareholders on a pro forma basis for fiscal 2020 and 2019 would not have been materially different than the reported amounts.
The operating results of the Company's fiscal 2019 acquisitions were included in the Company’s results of operations from each of the effective acquisition dates. The amount of net sales and earnings of the fiscal 2019 acquisitions included in the Consolidated Statement of Operations for the fiscal year ended October 31, 2019 is not material. Had the fiscal 2019 acquisitions occurred as of November 1, 2017, net sales on a pro forma basis for fiscal 2019 would not have been materially different than the reported amounts and net sales on a pro forma basis for fiscal 2018 would have been $1,879.7 million. Net income from consolidated operations, net income attributable to HEICO, and basic and diluted net income per share attributable to HEICO shareholders on a pro forma basis for fiscal 2019 and 2018 would not have been materially different than the reported amounts. The pro forma financial information is presented for comparative purposes only and is not necessarily indicative of the results of
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operations that actually would have been achieved if the acquisitions had taken place as of November 1, 2017.
The operating results of the Company's fiscal 2018 acquisitions were included in the Company's results of operations from each of the effective acquisition dates. The amount of net sales and earnings of the fiscal 2018 acquisitions included in the Consolidated Statement of Operations for the fiscal year ended October 31, 2018 is not material. Had the fiscal 2018 acquisitions occurred as of November 1, 2016, net sales, net income from consolidated operations, net income attributable to HEICO, and basic and diluted net income per share attributable to HEICO shareholders on a pro forma basis for fiscal 2018 would not have been materially different than the reported amounts.
3. SELECTED FINANCIAL STATEMENT INFORMATION
Accounts Receivable
As of October 31,
Less: Allowance for doubtful accounts (12,738) (3,666)
The $9.1 million increase in the Company’s allowance for doubtful accounts is principally due to potential collection difficulties from certain commercial aviation customers that filed for bankruptcy protection in fiscal 2020 as a result of the Pandemic's financial impact.
Inventories
As of October 31,
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Property, Plant and Equipment
As of October 31,
Less: Accumulated depreciation and amortization (232,494) (211,981)
The amounts set forth above include tooling costs having a net book value of $8.3 million and $8.8 million as of October 31, 2020 and 2019, respectively. Amortization expense on capitalized tooling was $3.2 million, $3.1 million and $2.8 million in fiscal 2020, 2019 and 2018, respectively.
As of October 31, 2019, the amounts set forth above include $11.7 million of assets under capital leases and $2.1 million of accumulated depreciation associated with such assets. See Note 9, Leases, for additional information pertaining to the Company’s finance lease disclosures made in accordance with the adoption of ASC 842 in fiscal 2020.
Depreciation and amortization expense, exclusive of tooling, on property, plant and equipment was $27.1 million, $25.8 million and $23.2 million in fiscal 2020, 2019 and 2018, respectively.
Accrued Expenses and Other Current Liabilities
As of October 31,
Accrued employee compensation and related payroll taxes $83,055 $112,602
Current operating lease liabilities 14,180 —
Accrued expenses and other current liabilities $162,232 $178,957
The decrease in accrued employee compensation and related payroll taxes principally reflects a lower level of accrued performance-based compensation expense resulting from lower consolidated operating results mainly attributable to the Pandemic. The increase in current operating lease liabilities is the result of adopting ASC 842 during fiscal 2020. See Note 1, Summary of Significant Accounting Policies, and Note 9, Leases, for additional information. The total customer rebates and credits deducted within net sales in fiscal 2020, 2019 and 2018 was $4.6 million, $9.0 million and $9.9 million, respectively. The decrease in total customer
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rebates and credits deducted within net sales in fiscal 2020 principally reflects a decrease in the net sales volume of certain commercial aerospace customers eligible for rebates mainly resulting from the Pandemic's impact.
Other Long-Term Assets and Liabilities
The Company provides eligible employees, officers and directors of the Company the opportunity to voluntarily defer base salary, bonus payments, commissions, long-term incentive awards and directors fees, as applicable, on a pre-tax basis through the HEICO Corporation Leadership Compensation Plan (“LCP”), a nonqualified deferred compensation plan that conforms to Section 409A of the Internal Revenue Code. The Company matches 50% of the first 6% of base salary deferred by each participant. Director fees that would otherwise be payable in Company common stock may be deferred into the LCP, and, when distributable, are distributed in actual shares of Company common stock. The LCP does not provide for diversification of a director’s assets allocated to Company common stock. The deferred compensation obligation associated with Company common stock is recorded as a component of shareholders’ equity at cost and subsequent changes in fair value are not reflected in operations or shareholders’ equity of the Company. Further, while the Company has no obligation to do so, the LCP also provides the Company the opportunity to make discretionary contributions. The Company’s matching contributions and any discretionary contributions are subject to vesting and forfeiture provisions set forth in the LCP. Company contributions to the LCP charged to income in fiscal 2020, 2019 and 2018 totaled $4.7 million, $6.1 million and $5.9 million, respectively. The aggregate liabilities of the LCP were $178.3 million and $151.1 million as of October 31, 2020 and 2019, respectively, and are classified within other long-term liabilities and accrued expenses and other current liabilities in the Company’s Consolidated Balance Sheets. The assets of the LCP, totaling $180.1 million and $151.9 million as of October 31, 2020 and 2019, respectively, are classified within other assets in the Company's Consolidated Balance Sheets and principally represent cash surrender values of life insurance policies that are held within an irrevocable trust that may be used to satisfy the obligations of the LCP. Additional information regarding the assets of the LCP may be found in Note 8, Fair Value Measurements.
Research and Development Expenses
The amount of new product research and development ("R&D") expenses included in cost of sales is as follows (in thousands):
Year ended October 31,
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Accumulated Other Comprehensive Loss
Changes in the components of accumulated other comprehensive loss during fiscal 2020 and 2019 are as follows (in thousands):
Amortization of unrealized loss — 25 25
Amortization of unrealized loss — 73 73
4. GOODWILL AND OTHER INTANGIBLE ASSETS
Changes in the carrying amount of goodwill by operating segment during fiscal 2020 and 2019 are as follows (in thousands):
Segment Consolidated
FSG ETG Totals
Foreign currency translation adjustments (1,580) (765) (2,345)
Adjustments to goodwill 39 — 39
Deconsolidation of subsidiary — (4,249) (4,249)
Adjustments to goodwill — (285) (285)
The goodwill acquired during fiscal 2020 and 2019 pertains to the acquisitions consummated in those respective years as described in Note 2, Acquisitions, and represents the residual value after the allocation of the total consideration to the tangible and identifiable intangible assets acquired and liabilities and noncontrolling interests assumed. Foreign currency translation adjustments are included in other comprehensive income (loss) in the Company's Consolidated Statements of Comprehensive Income. Deconsolidation of subsidiary reflects the value of goodwill associated with an entity that the Company previously consolidated but subsequently contributed the net assets of the former entity to a new entity in which the Company holds a noncontrolling interest and accounts for under the equity method (See Note 2,
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Acquisitions, for additional information). The adjustments to goodwill represent immaterial measurement period adjustments to the purchase price allocation of certain fiscal 2019 and 2018 acquisitions. The Company estimates that $46 million and $92 million of the goodwill acquired in fiscal 2020 and 2019, respectively, will be deductible for income tax purposes. Based on the annual test for goodwill impairment as of October 31, 2020, the Company determined there is no impairment of its goodwill and the fair value of each of the Company’s reporting units significantly exceeded their carrying value.
Identifiable intangible assets consist of the following (in thousands):
Amortizing Assets:
Non-Amortizing Assets:
The increase in the gross carrying amount of customer relationships, intellectual property and trade names as of October 31, 2020 compared to October 31, 2019 principally relates to such intangible assets recognized in connection with the fiscal 2020 acquisitions (see Note 2, Acquisitions).
Amortization expense related to intangible assets was $57.4 million, $53.7 million and $50.1 million in fiscal 2020, 2019 and 2018, respectively. Amortization expense for each of the next five fiscal years and thereafter is estimated to be $59.7 million in fiscal 2021, $52.9 million in fiscal 2022, $47.3 million in fiscal 2023, $42.5 million in fiscal 2024, $38.0 million in fiscal 2025 and $172.3 million thereafter.
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5. LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
As of October 31,
Finance leases and note payable (1) 9,831 8,955
Less: Current maturities of long-term debt (1,045) (906)
(1)See Note 9, Leases, for additional information regarding the Company's finance leases.
The Company's borrowings under its revolving credit facility mature in fiscal 2024 as discussed further below. As of October 31, 2020 and 2019, the weighted average interest rate on borrowings under the Company's revolving credit facility was 1.3% and 3.0%, respectively. The revolving credit facility contains both financial and non-financial covenants. As of October 31, 2020, the Company was in compliance with all such covenants.
Revolving Credit Facility
In November 2017, the Company entered into a $1.3 billion Revolving Credit Facility Agreement ("Credit Facility") with a bank syndicate, which matures in November 2022. Under certain circumstances, the maturity of the Credit Facility may be extended for two one-year periods. The Credit Facility also includes a feature that will allow the Company to increase the capacity by $350 million to become a $1.65 billion facility through increased commitments from existing lenders or the addition of new lenders. Borrowings under the Credit Facility may be used to finance acquisitions and for working capital and other general corporate purposes, including capital expenditures.
On December 11, 2020, the Company entered into an amendment to extend the maturity date of the Credit Facility by one year to November 2023 and to increase the capacity by $200 million to $1.5 billion. The Credit Facility continues to include a feature that will allow the Company to increase the capacity by $350 million to become a $1.85 billion facility through increased commitments from existing lenders or the addition of new lenders and can be extended for an additional one-year period.
Borrowings under the Credit Facility accrue interest at the Company’s election of the Base Rate or the Eurocurrency Rate, plus in each case, the Applicable Rate (based on the Company’s Total Leverage Ratio). The Base Rate for any day is a fluctuating rate per annum equal to the highest of (i) the Prime Rate; (ii) the Federal Funds Rate plus .50%; and (iii) the Eurocurrency Rate for an Interest Period of one month plus 100 basis points. The Eurocurrency Rate is the rate per annum obtained by dividing LIBOR for the applicable Interest Period by a percentage equal to 1.00 minus the daily average Eurocurrency Reserve Rate for such Interest
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Period, as such capitalized terms are defined in the Credit Facility. The Applicable Rate for Eurocurrency Rate Loans ranges from 1.00% to 2.00%. The Applicable Rate for Base Rate Loans ranges from 0% to 1.00%. A fee is charged on the amount of the unused commitment ranging from .125% to .30% (depending on the Company’s Total Leverage Ratio). The Credit Facility also includes $100 million sublimits for borrowings made in foreign currencies and for swingline borrowings, and a $50 million sublimit for letters of credit. Outstanding principal, accrued and unpaid interest and other amounts payable under the Credit Facility may be accelerated upon an event of default, as such events are described in the Credit Facility. The Credit Facility is unsecured and contains covenants that require, among other things, the maintenance of a Total Leverage Ratio and an Interest Coverage Ratio, as such capitalized terms are defined in the Credit Facility.
6. REVENUE
Contract Balances
Contract assets (unbilled receivables) represent revenue recognized on contracts using an over-time recognition model in excess of amounts invoiced to the customer. Contract liabilities (deferred revenue) represent customer advances and billings in excess of revenue recognized and are included within accrued expenses and other current liabilities in the Company’s Consolidated Balance Sheet.
Changes in the Company’s contract assets and liabilities during fiscal 2020 and 2019 are as follows (in thousands):
The increase in the Company's contract assets during fiscal 2020 occurred within the ETG and principally reflects additional unbilled receivables on certain customer contracts using an over-time recognition model in excess of billings on certain customer contracts.
The amount of revenue that the Company recognized during fiscal 2020 that was included in contract liabilities as of the beginning of fiscal 2020 was $18.7 million.
Remaining Performance Obligations
As of October 31, 2020, the Company had $439.5 million of remaining performance obligations associated with contracts with an original duration of greater than one year pertaining to the majority of the products offered by the ETG as well as certain products of the FSG's specialty products and aftermarket replacement parts product lines. The Company will recognize net sales as these obligations are satisfied. The Company expects to recognize $309.1 million of
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this amount during fiscal 2021 and $130.4 million thereafter, of which the majority is expected to occur in fiscal 2022.
Disaggregation of Revenue
The following table summarizes the Company’s net sales by product line for each operating segment (in thousands):
Year Ended October 31,
Flight Support Group:
Electronic Technologies Group:
(1) Includes various jet engine and aircraft component replacement parts.
(2) Includes primarily the sale of parts consumed in various repair and overhaul services on selected jet engine and aircraft components, avionics, instruments, composites and flight surfaces of commercial and military aircraft.
(3) Includes primarily the sale of specialty components such as thermal insulation blankets, renewable/reusable insulation systems, advanced niche components, complex composite assemblies, and expanded foil mesh.
(4) Includes various component parts such as electro-optical infrared simulation and test equipment, electro-optical laser products, electro-optical, microwave and other power equipment, high-speed interface products, power conversion products, underwater locator beacons, emergency locator transmission beacons, traveling wave tube amplifiers, microwave power modules, three-dimensional microelectronic and stacked memory products, crashworthy and ballistically self-sealing auxiliary fuel systems, radio frequency (RF) and microwave amplifiers, transmitters and receivers, high performance communications and electronic intercept receivers and tuners, high performance active antenna systems and technical surveillance countermeasures (TSCM) equipment.
(5) Includes various component parts such as electromagnetic and radio frequency interference shielding, high voltage interconnection devices, high voltage advanced power electronics, harsh environment
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connectivity products, custom molded cable assemblies, silicone material for a variety of demanding applications and rugged small form-factor embedded computing solutions.
The following table summarizes the Company’s net sales by industry for each operating segment (in thousands):
Year ended October 31,
Flight Support Group:
Electronic Technologies Group:
(1) Principally industrial products.
(2) Principally other electronics and medical products.
7. INCOME TAXES
The components of income before income taxes and noncontrolling interests are as follows (in thousands):
Year ended October 31,
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The components of the provision for income taxes on income before income taxes and noncontrolling interests are as follows (in thousands):
Year ended October 31,
Current:
Deferred:
A reconciliation of the federal statutory income tax rate to the Company’s effective tax rate is as follows:
Year ended October 31,
State taxes, net of federal income tax benefit 3.7 % 3.0 % 2.9 %
Tax benefit related to stock option exercises (13.3 %) (3.8 %) (.5 %)
Discrete net tax benefit related to Tax Act — % — % (3.4 %)
Research and development tax credits (2.4 %) (1.7 %) (2.0 %)
Foreign derived intangible income deduction (1.6 %) (1.4 %) — %
Nondeductible compensation .4 % .8 % .2 %
Domestic production activities tax deduction — % — % (.8 %)
Other, net .8 % .5 % — %
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The Company's effective tax rate in fiscal 2020 was 7.9%, as compared to 17.8% in fiscal 2019. The decrease in the Company's effective tax rate in fiscal 2020 is mainly attributable to a $31.8 million larger tax benefit recognized in fiscal 2020 from stock option exercises compared to fiscal 2019 as a result of more stock options exercised and the strong appreciation in HEICO's stock price during the optionees' holding periods.
The Company’s effective tax rate in fiscal 2019 was 17.8% as compared to 19.8% in fiscal 2018. The decrease in the Company's effective tax rate in fiscal 2019 is mainly attributable to a $14.3 million larger tax benefit recognized in fiscal 2019 from stock option exercises compared to fiscal 2018 and a reduction in the federal tax rate from a blended rate of 23.3% in fiscal 2018 to 21% in fiscal 2019. These decreases were partially offset by the net impact recognized in fiscal 2018 as a result of the Tax Cuts and Jobs Act from the remeasurement of the Company's U.S. federal net deferred tax liabilities using the reduced federal tax rate resulting in a discrete tax benefit of $16.5 million and recognition of a discrete tax expense of $4.4 million related to a one-time transition tax on the unremitted earnings of the Company’s foreign subsidiaries.
The Company files income tax returns in the U.S. federal jurisdiction and in multiple state jurisdictions. The Company is also subject to income taxes in certain jurisdictions outside the U.S., none of which are individually material to the accompanying consolidated financial statements. Generally, the Company is no longer subject to U.S. federal, state or foreign examinations by tax authorities for years prior to fiscal 2016. One of the Company's foreign subsidiaries files income tax returns in The Netherlands and Thailand where the statute of limitations is open for its fiscal 2015 returns.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company believes that it is more likely than not that it will generate sufficient future taxable income to utilize all of its deferred tax assets and has therefore not recorded a valuation allowance on any such asset.
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Significant components of the Company’s deferred tax assets and liabilities are as follows (in thousands):
As of October 31,
Deferred tax assets:
Deferred compensation plan liability $41,744 $35,437
Operating lease liabilities 12,980 —
Allowance for doubtful accounts receivable 2,966 724
Performance-based compensation accrual 2,539 6,463
Deferred tax liabilities:
Operating lease right-of-use assets (12,327) —
Adoption of ASC 606 (revenue recognition) (4,733) (3,277)
As of October 31, 2020 and 2019, the Company’s liability for gross unrecognized tax benefits related to uncertain tax positions was $2.9 million and $2.7 million, respectively, of which $2.3 million and $2.1 million, respectively, would decrease the Company’s income tax expense and effective income tax rate if the tax benefits were recognized. A reconciliation of the activity related to the liability for gross unrecognized tax benefits during fiscal 2020 and 2019 is as follows (in thousands):
Year ended October 31,
Balances as of beginning of year $2,670 $2,100
Increases related to current year tax positions 489 653