Description

Thesis
- High quality business with supportive secular tailwind and good earnings growth
- Trading at 40% discount to peers
- Embedded call options that can increase the size of business by 60%

Company Overview

MTU Aero Engines is a German aerospace company with 2 main businesses:

1. Aerospace engine manufacturing and aftermarket (“OEM”) – 35% of revenue, 60% of profits, 70% of valuation

- MTU is a key partner in many aircraft engine programs across narrowbody and widebody planes. Most notably, they are a 16% and 18% partner in Pratt and Whitney’s V2500 and GTF engines, respectively. These are engines on Airbus’s A320/321 ceo and neo planes. They are also a 5-10% partner in GE and P&W's engines on B747, B777, B787, A330, A380 planes.
- Aircraft engine uses the razor-razor blade business model where companies sell new engines at low prices with thin profit margin or at a loss. But then, these engines are in service for 20y+ and come in for regular aftermarket services / replacement parts that are highly profitable (50%+ EBIT margins)
- MTU also manufactures engines for military use cases - it is a profitable smaller segment levered to EU defense (which benefits from geopolitical uncertainty in Europe post Russia-Ukraine war).

2. Aerospace engine maintenance repair and operations (“MRO”) – 65% of revenue, 40% of profits, 30% of valuation

- MTU is one of the world’s largest providers of engine repair shops for both MTU engines and third-party engines i.e. MTU’s MRO division will fix engines regardless of whether MTU’s OEM division manufacture those engines
- This is a lower margin business than OEM where the value proposition is the skilled labor to fix the engines. MRO shops need to acquire licenses from engine manufacturers to operate, skilled labor who can fix engines, and tooling/capital to set up shops.
- There are several margin expansion opportunities in this segment including the ongoing shift to lower cost sites, expansion into more profitable business lines e.g. engine leasing, etc.

Thesis
Thesis 1: MTU is a high-quality business

A. Consolidated / duopolistic market: there are only a few companies in the world that can make aerospace engines. MTU’s engines are typically one of the two engine choices on any given aircraft i.e. they tend to operate in a duopoly. They are the only choice on some aircrafts.

B. High barriers to entry: aerospace engine manufacturing is highly technical, requires billions of dollars in development costs, and involves strict regulatory certification.

C. High pricing power and sticky customer base: Once an airline buys an engine, they become captive customers for the life of the engine giving engine manufacturers high pricing power. Airlines must go buy replacement parts from engine manufacturers after flying that engine for a certain number of hours per regulatory and safety requirements. Given it’s a must purchase item that only they make, engine manufacturers have strong pricing power on these aftermarket parts. MTU sees M-HSD% price increase on their replacement part per year. Pricing power supports a 50%+ EBIT margin in their aftermarket business. Additionally, airlines highly value fleet uniformity. Once they pick an engine for a certain type of plane, they are unlikely to switch to a different engine for other planes of that same type to avoid operating complexity, additional pilot training, and maintenance resources.

D. Supportive secular tailwinds: Air travel demand is secularly growing. As people around the world become richer, they fly more, needing to buy more planes/engines and service those engines.

Algorithm

Over the long-term, this is a business that grows revenue at HSD% (MSD%+ price + above GDP volume due to secular tailwind) and earnings and FCF at DD. Over the past few years, growth has been faster than this long-term algorithm (revenue 20%+ y/y) due to air travel recovery from Covid and HSD% pricing to pass through inflation. I expect higher growth to continue over the next few years but normalize over time.

Thesis 2: Trading at 40% discount to peers.

MTU’s closest comp is Safran (SAF.FP), a French aerospace engine manufacturer. Historically, MTU and SAF trade at the same multiple. Currently, MTU is trading at a 40% discount to SAF.FP.

On a forward EV/EBIT basis, SAF.FP is currently trading at 21x EV/EBIT vs. MTX.GR at 13x. On a P/E basis, SAF.FP is currently trading at 28x P/E vs. MTX.GR at 18x.

What happened?

MTU has exposure to an engine called the Geared Turbofan or “GTF,” which is currently undergoing an engine recall program.

I estimate that the GTF represents ~50% of MTU’s valuation reflecting low earnings contribution today (5-10% of overall business) but higher multiple due to high future growth (will grow to 15-20% of earnings by 2030 and 35-40% by 2040 on my estimate). As a reminder, MTU sells a variety of other engines and has a large independent MRO business and a military business that represent the other 50% of the company.

In 2023, which is when the valuation between SAF.FP and MTX.GR really diverge, Pratt & Whitney (part of RTX), MTU’s partner on the GTF engine announced that they needed to recall the vast majority of the GTF fleet due to a manufacturing issue where they discovered that a small percentage of the powdered metal that go into the GTF engine has been contaminated. Having this contamination does not immediately cause the engine to fail or shutdown midflight and certainly not a plane crash, but it significantly reduces the number of years the engine can fly. Thus, they need to recall the GTF fleet into the shops to inspect and replace contaminated parts in a staggered manner from 2024-26. When engines are in the shop, the airlines are not flying those engines and will get compensated for the disruption.

Although MTU did not at all cause this issue i.e. P&W is the only powder manufacturer and was solely responsible for this quality escape, MTU is an 18% partner in the GTF program and is contractually responsible for 18% of the costs. This results in €700M+ of cash costs ($1B pre-tax) to MTU primarily to compensate airlines for parking planes when the engines are being recalled. The reason the number is so high is because of supply chain and capacity shortage in the shops leading to an estimated turnaround time of 250-300 days which include 150 days of waiting around for a slot to open up.

MTU lost 30% of market cap after this news despite the issue being equal to ~5% of market cap though has recovered a lot of that over time.

Besides the ongoing recall, the GTF also faces durability issue where time on wing is shorter than expected. This is more of a normal teething issue for a new engine that its competitor also faces (though to a lesser degree) and its predecessor V2500 engine also faced when it first launched. Durability has been gradually improving with a new major upgrade, GTFAdvantage, to launch in 2025, which should significantly address durability. Progress on this, however, is overshadowed by the powder issue.

GTF issue vs. valuation

Certainly, the powder recall is a serious issue that is understandably an overhang on the stock. However, a 40% discount to peer seems excessive and creates a buying opportunity. You don't need to believe MTX trade anywhere near SAF multiple for this to be a buy. 

A. MTU is currently trading at a 40% discount to SAF.FP vs. same multiple historically. MTU is a multiple engine, multiple business line company. The GTF is certainly important to the company but with my estimate that the GTF is ~50% of valuation, a 40% discount on the valuation of the whole company is like saying we are putting an 80% discount on this one engine since there are no issues with other engines/business lines. 80% discount is like saying the GTF engine is gonna be a failure. In reality, while the GTF engine certainly has issues, but it works, does not need re-designing, is technologically advanced, has been flying on thousands of planes, and has the best fuel savings in the market. The valuation discount is disconnected from the scale of the issue.

B. On the true cost of the powder, that is ~€700M or €13/share which is like a 5% discount not a 40% discount.

C. If you assume P&W has grossly underestimated the issue or they discover something else and the issue is actually 3x what they expected, we still cannot explain the massive discount to SAF. In fact, it’s possible that the impact to MTU is less than this ~€700M. MTU is doing various things to reduce turnaround time which would reduce airline compensation (80% of this bill). They are adding capacity, optimizing the network, and management said they are optimistic they can reduce this payment. MTU is also trying to get compensation from P&W since MTU didn’t cause this issue. I conservatively assume they won’t get any though another GTF partner MRO.LN said they expected some compensation from P&W.

D. So, clearly the market is pricing is more than just this one-time issue - it’s a question of the future such as market share, reputational/credibility risk, etc.

E. Market share: the GTF currently has a 40% market share of the A320neo backlog and SAF.FP’s LEAP has 60% market share. This has been roughly consistent / maybe GTF trended down LSD% i.e. we have not seen significant market share impact. So, why don’t airlines see this issue and all switch to LEAP?

First, fleet uniformity benefit. Airlines strongly prefer one type of engine for one type of plane for e.g. all GTF or all LEAP for the A320neo planes. This significantly reduces operational complexity, maintenance costs, pilot training time, etc. <10% of airlines operate two engine types for the A320neo planes, and these are the airlines posing the highest market share risk i.e. airlines that can more easily switch around GTF and LEAP orders. For e.g. Indigo shifted from GTF to LEAP and Frontier shifted from LEAP to GTF but these were both before the current powder issue. The other 90%+ of airlines that historically use solely LEAP or solely GTF for their A320neo engine will likely stick with that for future A320neo orders. Monthly shifts in market share often reflect which airlines place orders and whether those are LEAP or GTF airlines rather than an airline orders some GTF and then some LEAP for their A320neo.

Second, competing engine has capacity constraints and cannot meet demand easily even if a customer wants to switch.

Third, engine orders for delivery in 2024-2027 are largely locked in and firm. There’s contractual limitation to switch and there hasn’t been any announced switch as far as I know for deliveries over the next few years. Planes are designed differently for the engine type so you can’t plug one engine out and put in another without modifying the plane. Airlines also already train pilots and set up maintenance for an engine type which is not easily switched.

Engine orders for delivery in 2028 and beyond are still largely undecided. Airlines typically select engines a few years before delivery. To be fair, for the minority that have already committed to an engine early (i.e. those willing to commit to say a 2028 delivery in 2024), the majority (70%) is LEAP. These are less so switches from GTF to LEAP but more an existing LEAP customer who confirms more LEAP in the future. But since these early commitments represent only a small % of the backlog, the backlog remains 60-40 similar to pre-powder. GTF customers are waiting for this issue to be resolved before placing more GTF orders (don’t need to place orders until a few years before delivery so might not commit until 2026) so there is some risk here if issue worsens considerably over the next few years to 2026 and is bad enough that existing GTF airlines are willing to forgo uniformity benefit above and switch to LEAP, but this has not played out post powder issue.

Fourth, the significant discount above (80% discount on this engine) has more than priced in substantial share loss

F. Reputation/credibility: MTU and its management have good reputation and track record, but this powder recall exposes the risk that they are liable for P&W’s mistakes. While P&W/RTX management is not viewed most favorably by the Street or investors, they do know how to make engines and have developed many successful commercial and military engines. This is a rare quality escape, arguably the worst issue at P&W over the past 10 years. It just happens to cost a lot of money given how big the GTF fleet is and how tight supply chain is (cannot fix quickly). To be clear, there is some tail risk and uncertainty and that warrants a multiple discount to SAF.FP’s clean story but it should be far less than a 40% discount on the whole company / 80% discount on this one engine.

G. Even when compared with other companies also exposed to the GTF e.g. RTX and MRO.LN, MTU multiple cut is more significant (I have not dived into a multiple breakdown at RTX or MRO.LN in detail but tried to do a quick analysis normalizing for things like defense re-rating at RTX, MRO.LN’s other engines, etc.).

Thesis 3: Longer term call options

I’m not sure these long-term factors move the stock near term but are worth discussing given the significant potential of these call options.

A. New Boeing narrowbody plane
- Currently, Boeing exclusively uses CFM (SAF.FP and GE JV) for their 737 planes. MTU is not on any Boeing 737 or 737max. The market has been shifting towards a dual engine model and MTU thinks they will get on Boeing’s new narrowbody plane (Max replacement, which will likely be announced in 2027-2030 and launch in 2030+). Our expert calls suggest a similar shift to a dual engine model, especially since the next Boeing plane would most likely not be a 737 variant (which has exclusivity agreement with CFM). This would essentially ~double sales of the key engine which for the whole company could mean an additional 50% increase in value. We won’t know for sure if this will play out for a few years, but we get a free call option on this huge upside.
- MTU currently has exclusivity on A220 which by the same market trend towards dual engine, they will probably lose exclusivity on, but this is a much smaller fleet relatively to the BA upside opportunity, say ~10% loss of sales on the key engine or 4-5% decrease in value for the company.

B. 18% to 25% program share
- Currently, MTU has an 18% program share on the GTF. For the new NB engine program, MTU said they have a contractual agreement to increase their share to 25% so that’s a ~40% increase on the key engine or an additional 20% increase in value. We won’t know the final detail again for a few years, but MTU sounds confident that this has been contractually agreed on. This is not in our base case but again, a free call option with significant upside.
- With the new engine, they also expect a new clause that will limit liabilities from issues that they do not cause i.e. avoid powder 2.0 where they are financially responsible for P&W’s issues.

C. Combining the two optionality above and subtracting out the lost exclusivity on the A220, you get an embedded free call option that can increase the value of the business by 60%. This is in addition to regular stock appreciation from compounding earnings.

Right now, sentiment is understandably negative around the ongoing GTF powder issue but once we move past this, I think the narrative will focus back to the high quality of the business, longer-term opportunities, and attractive valuation.

Numbers

I have 50%+ upside in Base Case and -15% in downside case, which seems like an attractive skew. 

My numbers are in line with St for 24 and above for 2025-26 due to a few key drivers

1. Given issues with the GTF, existing customers are flying the V2500 more and pushing out retirement of that fleet. The V2500 is a very profitable engine with strong pricing power and flying more of them will generate more revenue that is margin accretive.
2.  On new engines, they are achieving scale on GTF production and expect breakeven in the next few years i.e. new engines will switch from a loss line item to a zero to profit line item. I conservatively did not assume a breakeven but less losses.
3.  On MRO, the company has been expanding to lower cost higher margin sites and growing a highly profitable engine leasing business which should be accretive to margins that St is not assuming.
4. Less R&D spend once GTF Advantage enter into service
5. The company is currently under-levered and said they will conservatively manage dividend over the next few years given the cash outflow from the powder issue. But by 2026-27, when issue is behind us, management should be able to flex the balance sheet towards their target leverage and buyback stock.

Base case
- Powder issue in line with what they have announced. Modeled in powder recall by adjusting for the cash outflow from 2024-2026 to compensate airlines and reduce long-term profitability on the GTF engine.
- Multiple at 20% discount to SAF.FP (vs. same multiple historically) to reflect uncertainty/risk of market share loss/more GTF issues, etc. i.e. conservatively imply 40% discount to key engine.

- Multiple discount to SAF.FP also reflect a worse FCF conversion than SAF.FP (although historically market didn’t discount this as they traded at the same earnings/EBIT multiples). This FCF difference was mostly due to WC which is a bigger drag at MTX. Ex-WC, FCF conversion (normalized for powder) is more comparable.

- I'm comfortable with a 22x P/E on a standalone/absolute basis given the above normalized algo (LDD earnings growth) i.e. if one wants to argue SAF's multiple is rich and a relative value is not appropriate.  

- I focus on 2026 for valuation (and discount it back) since this is a more normal year where the powder issue is more in the rearview and the company has a more normal FCF conversion

- No multiple upside/value given to any of the call options listed above.

Bear case
- Powder issue 2x what was announced
- Multiple de-rates further

- Margins of all business lines worse than base case

Bull case
- Fundamentals same as base
- Assumes SAF.FP’s multiple to reflect GTF uncertainty offset by call options listed above.

Street
- Street’s EBIT for 2026 is €1.17B i.e. our base case is 10% above St

Risks
- Turnaround time on powder recall increases and more costs
- Market share - large number of GTF customers switch to LEAP (stock more than priced in small market share shift - see above)
- Another major engine issue (this is somewhat unknowable and the risk you take owning any aerospace company)

Catalyst

- No news is good news so for every earnings release where they said issue is not getting worse, the stock should trade up. This has been the case for the past three earnings.
- MTU/RTX announcing a reduction in turnaround time and final powder recall bill based on ongoing initiatives and capacity adds - this might be in 2H24. MTU is doing various things to reduce turnaround time although constraint now is RTX’s ability to ramp up powder production

- Existing GTF customer adds another large GTF order after this issue giving market more confidence around market share.
- GTF Advantage, to launch in 2025, performs well and get good customer feedback
- Earnings beat