Description

I want to offer the Transdigm and Heico crowd another way to play a recovery in the aerospace industry: MTU Aero Engines. During WWII, MTU made jet engines on all Nazi airplanes. Now they manufacture jet engines in collaboration with GE and Pratt & Whitney, predominantly for commercial aviation.

Executive summary / TL;DR

• While jet engine OEMs don’t earn high IRRs and are risky, MTU is at a point where commercial and technical viability of its key engines is proven. The next 20 years should see growth in profitable after-market sales.
• They have the balance sheet to get through a Covid-related slowdown.
• >20% IRR on 6 year horizon. Growth runway until 2040.

Business Description

Manufacturing jet engines is not as good of a business as being a provider of aircraft components. R&D costs are much higher and development can take many years. Jet engines are subsequently sold at a loss. Only years later, when the installed base is large enough and engines will come in for their 1st shop visit, the OEM will start to make money on after-market sales. IRRs are therefore much lower. The trick to investing in engine OEMs is to find the point where commercial and technical viability of an engine has been proven and profitable after-market sales are guaranteed.

In addition to being costly, the R&D process in risky. Other than the technological complexity, a jet engine gets developed with only a few air frames in mind. If the air frame does not sell as well as assumed, or has technological problems itself (think Boeing 737 Max) this could lead to huge multi-billion dollar losses for OEMs. To share the risk, many jet engines are developed as part of a larger consortium. The large OEMs (GE, P&W, Rolls Royce) will partner with smaller companies such as MTU (Germany), Safran (France), GKN Aerospace (they acquired Volvo Aero), Avio Aero (Italian, now owned by GE) or the Japanese Aero Engines Corporation (JAEC). In such a partnership, each partner takes responsibility of a key components (low pressure turbine, high pressure compressor, center frames, brush seals and whatever else goes in an engine… I’m no rocket scientist). More importantly, they share the after-market business proportionately to their stake in the partnership.

Jet engines have a typical life span of <25 years. In its lifetime it goes in for a shop visit 3 or 4 times. The first shop visit in year 4 or 5 costs the airline 2-3m EUR. The second shop visit costs 4-5m EUR because of the need to replace life limited parts. Shop visits 3 and 4 are somewhere in the middle of visit 1 and 2 in terms of costs. If you’ve been flying in humid and dirty air (think: India), you’ll need more maintenance. If your plane is parked in the desert waiting for Corona to pass, you need very little maintenance. If an airline is financially stretched, they could postpone a 1st shop visit by max 2 years. Maintenance spend is predominantly a function of # of hours flown.

After-market should be split in MRO (maintenance, repair and overhaul) and spare parts. MRO has margins of ~20%*, but spare parts come at 65% margin.

MTU

MTU is involved in a lot of different engine programs. However, only 2 engines drives most of the value for MTU shareholders, so that’s what I’ll focus on. That’s the V2500, used on the old A320ceo, and the PW1000G, used on the new A320neo.**

Because the A320ceo has now been replaced by the A320neo, the V2500 is pretty much done selling. There is an installed base of 6000 engines in the world with an average age of 9 years. Because of the aftermarket dynamics explained above, after market sales should peak somewhere in the mid 2020’s. The V2500 currently makes up 40-50% of after-market sales.

The A320neo uses the PW1100G (also called Geared Turbo Fan, or GTF).*** As with any engine improvement, it’s more energy efficient and makes less noise than its predecessor. The engine is in the early phase of its life and does not yet contribute to after-market sales. In fact, losses on the engine probably peaked in 2018 or 2019. However, the engine promises to become more profitable than the V2500 because:

• air transport is a larger industry today than 1-2 decades ago.
• a larger share of this travel goes to narrow body.
• 60% of this is expected to go to Airbus A320 (backlog 6.2k) and 40% to Boeing 737 MAX (backlog 4.4k), versus a 50/50 split in the time of the V2500.
• 78-80% of the PW1100G sales is expected to be converted to MRO contracts, versus 60% for the V2500.
• MTU owns 18% in the PW1100G partnership versus 16% in the V2500.
• There’s a bunch of regional jets using the GTF: The A220, E-Jet E1, etc.

MTU expects the GTF installed base to increase to 15,000 by 2030.

Math Scribbles

Valuing MTU is not much easier than understanding how a geared turbo fan engine works. I have to warn you that the below is going to be imprecise. Almost to the point that it’s embarrassing. In my defense, their disclosure is a bit limited. Anyway, here we go.

The difficult part is that for every hour an engine is operational, MTU accrues earnings. However, they only book them as revenue at the time the engine comes in for maintenance.**** So for the GTF, I can calculate ‘accrued earnings’, which won’t show up in the P&L and in most cases CF statement for another couple of years. The same goes for the V2500: Accrued earnings are at a peak (maximum installed base), but income on the P&L will take another couple of years to reach its maximum.

Let’s start with the easy part: At 122 EUR / share, the market cap is 6.5b EUR. Net Debt is 1b EUR and there is another 1b EUR in unfunded pension liabilities. 2019 Adj EBIT was 756m EUR. Historically this is a 15x EV/EBIT business. P/E 2019 is 12x versus a 20-30 range in the last few years. That’s the discount you get for assuming the Covid uncertainty.

But that’s half of the story. The most valuable engine has been accumulating losses for the last few years. If I fast forward to 2030, there will be an installed base of 15,000 engines (as per MTU targets. Don’t forget half of this is already in the Airbus backlog). An engine operates 4,500 hours per year and as you can calculate will cost 115 EUR per hour in maintenance today*****, so say 150 EUR in 2030. At 65% margins (as most of this will be spare parts) and an 18% program share, this translates to about 1.2b EUR in EBIT. Mind you, earnings will only peak on the P&L in 2040. Let’s just say there is a very long growth runway to earnings that are almost twice the total of the entire company today. In 2019, the GTF still subtracted from earnings (probably in the 30-50m EUR EBIT range).

Figure: EBIT estimate for the GTF

That’s about as precise as I can get. I could put some numbers in a spreadsheet for the V2500, which would tell me the V2500 is about 300-400 EUR of EBIT today. But to be honest, those are very rough numbers. All I know is that after-market revenue for the V2500 will grow for another 5 years and will not drop off a cliff immediately after.

As for the other sources of after-market revenue, there will be some decline in business in the PW2000 (Boeing 757) engine and the CF6 (A330, Boeing 747). This is probably 150m EUR in EBIT today which will slowly come down in the next decade.

In short, I think we can double EBIT until 2025 and have lots of growth runway after that. Given that not all those accrued earnings will show in the P&L (I model 320m of reported GTF EBIT versus 674m accrued), let’s conservatively say 1.2b EUR in EBIT by 2025, at 15x EV/EBIT (as we’d be like ‘Covid-what!?’ by then), an 18b EUR EV. Add 2-3b in FCF that you will earn until then and you get to a little more than a triple in 6 years or a >20% IRR.

Some final thoughts:

I almost forgot, Covid-19. With all planes grounded, very little maintenance is currently needed. The IATA estimates a 35-40% drop in flights activity in 2020. Sell-side models a 25% drop in after-market sales. GE is seeing a 60% drop in shop visits in April. But really, who knows. All I know is that MTU has the balance sheet to make it through some tough times, has a lot of value (i.e., the installed base) against which to borrow and is of strategic importance to the Germans who would always provide liquidity.

As for the impact on the newbuild market, Airbus is dropping its production rate for the A320 from 60 to 40 per month.

MTU also acts as an independent MRO service provider, on top of its MRO responsibilities as a partner in an engine program. This business seems to be growing quite nicely.

With most sales being USD denominated, MTU is long the USD. Most of this exposure is hedged on a rolling 4 year basis.

Notes:

* The headline margin for MRO is 9-10%, but that’s because of a lot of pass-through revenue of spare parts at 0 margin.

** To keep things simple (for myself), I focus the writeup on the V2500 and the PW1100G. Technically, the PW2000 (Boeing 757) and CF6 (Boeing DC-10-10) contribute ~25% to after-market revenues and are relevant too. The GEnx (Boeing 787) and GE9X (Boeing 777) are important engines in the wide body market.

*** In the narrow body market the 2 main planes are the Airbus A320 and Boeing 737 Max. GE is the sole supplier to the B737 Max. The A320ceo was split between the V2500 (P&W, MTU, JAEC) and CFM56 (GE, Safran). The A320neo is split between the PW1100G (P&W, MTU, JAEC, GKN, ~43% market share) and the LEAP-1A (GE, Safran)

**** About half of all engines have some sort of ‘flight by the hour’ contract. Every contract here is different, but in broad lines, they pay the OEM for every hour flown. Some of them pay a monthly or quarterly fee which shows on the B/S as 706m EUR of contract liabilities. Others only pay at the time of a shop visit. Airlines can be assured that their engine is always operational (they receive a lease engine during shop visits) and MTU can manage its shop capacity by being allowed to choose when a shop visit happens. There also won’t be any deferred maintenance when an airline is in financial hardship.

***** To calculate the maintenance costs, assume 14m of maintenance expenses (4 shop visits of resp. 2.5, 4.5, 3.5, 3.5m USD) and divide by 25 years with 4500 operating hours per year. Then convert to EUR.

Catalyst

People will fly again.

Continued growth in V2500 after-market revenue.

PW1100G (GTF) will start to generate after-market revenue.