Description

CTT Systems:  COVID recovery compounder with exceptional unit economics, a 15-20 year runway for abnormal EBIT growth & multi-bagger potential

Business Description:

Dominant #1 (global market share >95%) for humidity control equipment in commercial aircraft.  41% of revenue from aftermarket (I estimate 68% of EBIT) and 54% of revenue from Original Equipment (I estimate 32% of EBIT). The vast majority of business value is derived from humidifiers that increase the humidity in the flight deck and crew cabin in large commercial aircraft. Growth areas for CTT: 1) humidifiers for business class have the potential to 2-4x the number of humidifiers on the planes where they are selected and 2) humidifiers for business jets.  CTT is the single-source for cabin humidifier solutions for new aircraft shipments for all the major next gen widebody programs (retrofits also possible but tiny today given the youth of the fleets): the 787 (the most important program for CTT), A350, 777x, and A380.  With the exception of the crew rest cabin humidifier on the 787 which is standard, the equipment is mainly an option that each airliner customer chooses after reviewing the parts list and discussing with Boeing/Airbus/CTT.  The cockpit/flight deck humidifiers tend to have very high attachment (est 80%+), especially on the 787 and high attachment also expected for the A350.  The crew rest humidifiers have lower attachment than flight deck (I assume 30-70% attachment) and business class humidifiers are lower attachment for now, but potentially a lucrative source of upside (I assume 25-40% attachment).

Their de-humidifier business is smaller and involves drying the area between the cabin and fuselage to prevent the build-up of condensation harm fuel efficiency via increased weight and harm equipment.  CTT is the de-humidification supplier for:  787 (but no more OE shipments as of this year, so only aftermarket), A320 family retrofits, 737 family retrofits, and optional on A350 new aircraft shipments.  The de-humidifier business is smallish now (estimated 15-20% of 2019 revenue) and a much smaller part of the future (estimated 4-5% of 2033e rev). 

Thesis

COVID will likely structurally reduce widebody travel demand below pre-COVID projections, but CTT will still compound business value due to a razor-razorblade model within an extremely attractive single source positioning on all next gen widebody aircraft.  The sunsetting of legacy aircraft normally constrains revenue growth for most aerospace suppliers, but very uniquely CTT is highly overweight new platforms, so significant growth in CTT’s humidifier installed base will continue during and beyond the current crisis because mature widebody fleets (747, 767, A340, A330, 777, A380) need to be replaced.  Installed base growth significantly above GDP should take place until the first wave of 787s are retired, or until 2037 (!) assuming 25 year life of 787 aircraft.  This will pull through a growing annuity of highly lucrative aftermarket humidifier filters (aftermarket OPM undisclosed but ABG assumes 50% OPM and it back-tests well).  The dominant position helps them achieve quite positive OPM on their OE sales, which is superior to the oligopolistic jet engine industry that often sells OE engines at negative OPM (OE OPM also undisclosed, but ABG assumes 15% OPM and it back-tests well).  CTT Systems is in the 99th percentile in demonstrating the following unit economics characteristics:  expanding CFROIC 30-45% during 2016-2019 while simultaneously growing GP at 40% CAGR.  

It is hard to overstate the importance of CTT’s super attractive next gen fleet exposure not only because of the aforementioned structural installed base growth, but also because CTT’s fleet exposure will be the first to come back on-line. Per Rolls Royce CEO on last call, “the Trent 700 is about half the utilization of the XWB at the moment...A350 and 787, these are the aircraft that are getting used the most in the widebody space at the moment.”  This is a thesis-changer because we don’t need to bet on the whole widebody fleet, we get to rely on the crutch from CTT’s super overweight exposure to the youngest parts of the widebody fleet that are coming back first.

Unique multi-bagger potential

The multi-bagger potential has multiple irons-in-the-fire.  The first scenario that could push this into multi-bagger territory is:  humidity awareness.  Hospitals and prisons have been installing humidifiers as a COVID mitigation.  This is because proper humidity allows for optimal mucus membrane functioning in the body’s natural defenses against viral infection.  The Cabins in the forward sections of large aircraft are notoriously dry (cockpit, crew area, and business class).  If airliners adopt humidification as a COVID mitigation like hospitals and prisons have, then CTT’s business could positively inflect in a material way.  Awareness may be percolating if this article is an indicator: (https://www.ainonline.com/aviation-news/business-aviation/2020-07-01/coronavirus-brings-cabin-humidity-levels-question). Also refer to Pages 32-33 in this link (https://www.aviationbusinessnews.com/wp-content/uploads/2020/10/Cabin-SepOct20-lr.pdf).  I give a modest 5% boost to the fair value to reflect this bull case.  Before I price-in more of this effect, I am awaiting the first COVID mitigation order.  For now, cash strapped airliners are not making moves on that front (27% potential upside to my fair value). 

The second scenario is: while inappropriate for a base case for a widebody aircraft supplier, there is a plausible scenario that in 4-5 years widebody pax traffic nearly recovers or fully recovers to pre-COVID forecasts – assuming widespread immunity, vaccines, and therapeutics (30% potential increase to my fair value).   Finally, if both of the above happen, I would expect prolific multiple expansion because this super high quality company has traded as high as 45x EBITDA.  

There are two real options that could surprise:  1) business class humidifier uptake on 777x (I assume 40% attachment), A350 (I assume 25% attachment), and management is even wondering publicly if Boeing will need to add a business class humidifier (I assume zero) offering to compete with 777x and A350 and 2) business jet growth as the Global 7500 package has a surprisingly high 4 humidifiers per plane and 1 dehumidifier.  The company is quite bullish about their progress in business class for commercial aircraft, so hopefully my attachment assumptions are light.  I also don’t give much credit to any business jet progress beyond the Global 7500, not because I don’t think it can happen, but because I just want a platform announcement to hang my hat on.

Risk Assessment:

Balance sheet is strong, so no worries there.  The main risk is that widebody pax traffic settles lower than my base case of 25% lower than the previous run rate projections for 2025.  There is a small risk of competitive entry theoretically, but there is no traction and the time to do it would have been during the recent widebody development programs.  No new widebody platforms expected for decade+ means entry is becoming impractical.

What’s going on with their de-humidification business?

It has suffered two major blows, but: 1) this is a small part (<10%) of my fair value estimate and 2) the bumps in the road here have no relevance to their core humidifier business, whose demand is driven by totally different factors like health/wellness/comfort for pilots, crew and business class passengers.  CTT’s zonal drying equipment got caught up in Boeing’s 2018 decision to remove their entire 787 Moisture Control system, which roped-in CTT’s de-humidifier within that larger parts list.  This was a somewhat comforting excuse until the August 2020 news that Airbus has stopped development of the Moisture Control system for the A321neo XLR, so CTT stopped its dehumidifier development. These two decisions by Boeing and Airbus are quite major in their implications for CTT’s de-humidifier business.  While we received a reminder of airline customer demand in September 2020 with a small retrofit order for A320 de-humidifiers, I still omit a recovery of the de-humidifier business from the base case.  Perhaps conservatively, I also remove it from the bull case.  CTT markets how de-humidifiers help fuel efficiency and CO2 emissions via condensation weight savings. This could cause Airbus to revisit given the high CO2 awareness in Europe – and perhaps catch Boeing’s attention on the 737max for similar reasons.  CTT hesitates to speculate on Airbus sudden A321 XLR decision because it is an important customer, but here’s my educated guess on Airbus’ decision:  after COVID hit, they launched sweeping cost reduction programs to preserve cash and CTT’s de-humidifier got caught up in those cuts.  In an environment where cash becomes more plentiful, perhaps this could re-enter my bull case and even my base case – and make no mistake, Airbus & CTT restarting de-humidifier development for the A320neo family would be huge for CTT (stock dropped -18% on the stoppage of development press release) because the narrow body installed base is far larger than widebody.

Important Assumptions and Fair Value Appraisal

The majority of business value is driven by the aftermarket stream, which relates to the next gen widebody installed base x flight hours per aircraft x humidifiers per plane.  The OE business is less important, but still meaningful, and is a function of deliveries x humidifiers per plane. 

Aircraft Deliveries – If flight hours return to 2019 levels in 2024-2025 like Rolls Royce assumes, then all else equal, the delivery profile for the widebody market should recover to levels similar to 2019.  However, I assume deliveries for the widebody market recover to a level that is 15% below 2019 deliveries and this means that CTT’s deliveries are 11% higher than 2019 because CTT has growing penetration amongst total widebody shipments as new programs like 777x ramp up.  As for the 15% haircut, I prefer conservatism because a) the delivery environment in 2019 was above trend due to pax demand strength and new program exuberance and b) a risk adjustment for uncertainties from the current crisis.

Installed Base – Starting with attrition, I estimate 6% of CTT’s installed humidifiers are on A380s and I assume 60% of that fleet retires by 2033.  The rest of CTT’s aftermarket installed base is in growth mode.  Incorporating the deliveries above with tiny A380 retirement drag leads to a humidifier installed base growth est. of 13% CAGR between 2019-2025, with growth still clipping along at 6% in 2033.  While those figures could be debated moderately up or moderately down, the directionality is not up for debate:  CTT’s lucrative aftermarket installed base will grow significantly more than real GDP for 15+ years simply due to the fact that the next gen widebody installed base needs to grow to offset aircraft retirements (CTT is again highly underweight retiring aircraft).   

Humidifiers Per Plane – For 787, I assume 2.25 average humidifiers per delivery going-forward, which is down 1 due to the zonal drying de-listing.  For A350, I assume 1.8 humidifiers on ave per delivery.  For 777x, I assume 2.4/plane.  The 777x early order entry is particularly encouraging because ANA and Emirates have already selected the business class package, which brings 2 extra humidifiers per plane.  Not only are these carriers 40% of the global 777x order book, but they are also thought-leader carriers, whose decisions tend to influence to reflect Boeing’s aggressiveness in encouraging humidifier attachment as compared to Airbus.  If humidifiers become commonplace in business class cabins, I will be far too low on these assumptions because a business class order brings 3 extra humidifiers on the A350 and 2 extra on the 777x. 

Flight Hours per Aircraft – This is the main reason why spares revs were down massively in 2020 (-74% in Q3 yoy) despite est +9-10% 2020 growth in the humidifier installed base.  Rolls Royce expects widebody flight hours to return to 2019 levels by 2024-2025 (IATA concurs with this view). Note that prior to COVID, 2024-2025 would have been projected at c. 25% higher than 2019 levels, not at 2019 levels.  Rolls’ assumption implies c. 15% lower flight hours per Rolls plane in their installed base. I assume CTT’s flight hours per plane are 10% lower in 2025 than in 2019 because CTT is exposed to a newer fleet than Rolls Royce (airliners will prefer to run the newer aircraft with lower operating costs more prolifically), but perhaps the advantage of the newer fleet will be more pronounced than this.

OPMs are very likely to drift up after the COVID snapback is complete because when deliveries reach post-COVID equilibrium, OE growth beyond that point is highly unlikely to keep pace with estimated high single digit to low teens growth in the much higher margin aftermarket rev.  I have 34% OPM in 2024 and 39% by 2033.

My risk adjusted fair value appraisal is SEK 215/sh in PV terms.  Rolling that PV forward over an expected thesis horizon of 2.5 years yields 27% expected IRR.

The base case fair value estimate (in PV terms) is SEK 205/sh and includes:

• After an assumed snapback post-COVID by 2023-2024, forecast 6.5% through-cycle EBIT CAGR out to 2033 as installed base grows with the new gen of widebodies and margins steadily expand due to mix shift toward high margin aftermarket humidifier filters

• Capitalizing the terminal EBIT at 16.0x to reflect the virtues of a high entry barriers growing annuity 

The risk adjustments applied to the base case fair value that lead to SEK 215/sh risk-adjusted FV are the following bull/bear case scenarios:

+30% impact to fair value (FV) from full pax recovery to previous run rate (33% chance)

+27% FV impact from COVID inspiring structurally higher humidification demand (20% chance)

+20% FV impact from extra multiple expansion if both of the above happen (7% chance)

-20% FV impact if industry is ex growth into perpetuity (20% chance)

-25% FV impact if competitor enters organically (5% chance)

-15% FV impact if new pax equilibrium settles 10% lower than my forecasts (30% chance)

Management/Ownership:

Alignment from Chairman owning 13.5% and CEO owning 0.5%.  The CEO is long-tenured and has built this company from nothing.  I met the CEO and he’s solid, definitely investable.  Cost control during crisis Q3 was a positive surprise.  I spoke to the CFO, who is also solid.  Recent changes to operational C-Suite driven by succession needs. 

Interestingly, Raytheon owns 9% through its Hamilton Sundstrand subsidiary due to historical reasons.  To sell business class humidifiers, CTT is having to build more relationships directly with airliners rather than relying on Hamilton Sundstrand, Airbus or Boeing to do a lot of the sales heavy lifting.  CTT is showing very encouraging success (e.g. China Southern, Emirates, ANA), but for a company with a technology heritage, adding the sales capability is an evolution.  This begs the question whether CTT is better off as a standalone given the lucrative “real option” in business class, or better off being acquired by Raytheon (via Hamilton Sundstrand) or Safran (via its Zodiac subsidiary) that already has that sales relationship with every airliner on earth.  I don’t like to write quotes directly attributable to management on topics like these, but let’s just say that this is highly likely a question that the top execs and the BoD debate internally.  There is no poison pill or other impediment to being acquired -- my educated guess is that the right deal would be considered earnestly.  

Catalyst

• Recovery in air travel
• Humidity as a COVID mitigation starts showing up in higher humidifier attachment rates
• Management is quite bullish on their progress in business class, so more contract wins here are a potential catalyst
• 787 introduces a business class humidifier to compete with the 777x and A350 passenger experience
• Business jet announcements as humidifers per plane potential is large (5)
• De-humidifier on the A321 comes back