Description

MTU Aero Engines AG (MTX GR)

Thesis

• High quality compounder that has been indiscriminately penalized in part due to European listing and unfair associated read-across for macro concerns; low risk way to play post-COVID air travel recovery; meaningful built-in earnings tailwinds from depreciation of €
• Business model locks in long-term attractive economics
  • Company is an integral part of the global aircraft engine value chain
  • Due to high aircraft engine development costs, engine manufacturers (GE, Pratt & Whitney, Rolls-Royce) typically subcontract out development and manufacturing of various engine subcomponents (MTU is one of these subcontractors); in exchange, the subcontractors retains a revenue share in the engine platform(s) in perpetuity through an equity stake
  • Business model generally generates modest losses (inclusive of R&D) on sale of initial engine component(s), but then locks in high margin spare parts sales for the duration of the given aircraft engine platform’s lifecycle
    • Aircraft engines undergo regular, recurring overhauls based primarily on hours in service; overhaul frequency averages about once every five years
    • Regulatory requirement for use of certified parts during overhaul so certified parts producer has monopoly on spare parts sales
    • Strong pricing power; annual spare parts price increases of mid-to-high SD are typical
  • Spare parts sales represent ~2/3 of the company’s consolidated EBITA
• Shares have likely been penalized by German listing given high level of concern over European economy
  • Company is headquartered in Germany and ~85% of employees are located in Germany, hence the German listing
  • However, business is global and global air travel is the primary driver of the company’s level of business activity
  • Aerospace contracts (aircraft, engines, parts, service) all priced in US$
• Solid growth prospects for the company’s existing engine platforms
  • Airlines have increasingly been migrating from hub-and-spoke model to point-to-point mode
  • This favors single-aisle aircraft vs widebodies
  • Company’s engine platforms are heavily biased towards single-aisle aircraft (Airbus A220 and A321)
• Global passenger air travel tailwinds
  • Engine overhaul frequency is primarily a function of hours of use; as such, overhaul frequency has decreased post-pandemic due to decline in global passenger air travel
  • Mid-year 2022, global air travel had returned to ~70% of pre-pandemic levels; MTU should see meaningful demand tailwinds as demand levels continue to normalize/improve
  • Thus far in 2022, airlines have generally telegraphed solid demand in excess of expectations
• Freighter headwinds likely overstated
  • While passenger air traffic shrank during COVID, air freight volumes grew as supply chain snarls drove a migration from ocean freight to air freight
  • Air freight volumes have been indexing 10-15% above pre-COVID levels
  • Multiple sell-side firms have been calling out risk to MTU of air freight reversion to mean
  • However, to-date air freight volumes have been holding up well and the company’s engine program ownership profile implies that concerns may be overstated
• € tailwinds
  • Global aerospace sales are priced in US$ but MTU’s expenses are largely denominated in €
  • As a result, the company currently has ~$1.5bn of net US$ exposure
  • This exposure is fully-hedged for 2022, 60% hedged for 2023, 50% hedged for 2024, and largely unhedged thereafter
  • At current US$/€ exchange rates, this implies theoretical potential EPS tailwinds of €1.20 in 2023, €1.70 in 2024, and €3.40 in 2025 (on a current base of €8.00/shr 2022E)
• Manageable energy exposure
  • Company has some exposure to natural gas, which is used for primarily for heating, and to a smaller extent production or test runs for industrial gas turbines
  • Rely on a mix of renewable and non-renewable energy
  • Have invested in geothermal facility that is slated to go online in 2025
  • Energy expenses were ~€20mm in 2021, fully-hedged for 2022, partially hedged for 2023
  • So assuming longer-term pricing roughly double 2021 (pre-Ukraine), would represent 50bp of headwind; tripling of prices vs 2021 would represent ~100bp of headwind
• Solid quality business: ROICs HSD, ROEs mid-teens to mid-20%s, very consistent FCF generation
• MTX held its Capital Markets Day in mid-November
  • Targets were comfortably ahead of consensus; mgmt typically guides conservatively and has a solid history of outperformance
    • 2023 revenue ~5% ahead of consensus
    • 2025 revenue ~14% ahead of consensus
    • Adj EBIT targets modestly ahead of consensus
• Valuation/growth
  • Between continued reversion of global passenger traffic to pre-COVID levels, margin expansion back towards historical pre-COVID levels, and free cash flow we see value accreting at ~20% annually
  • Multiple expansion back to in-line with the S&P 500 provides an additional 15% upside

 Business

• OEM (36% 2021 revs, 74% EBITA)
  • Segment designs and manufactures aircraft engine components, primarily low pressure turbine blades and compressors
  • Typical EBITA margins of 20-25%
  • Subsegments
    • Military (11% revs, 17% EBITA)
    • New Engines (13% revs, (10%) EBITA)
      • Low pressure turbine blades, compressors
  • Spare Parts (12% revs, 67% EBITA)
• MRO (64% 2021 revs, 26% EBITA)
  • Segment operates a network of engine repair shops across the world
  • Typical EBITA margins of 5-10%; labor cost + fixed markup
  • Steady, predictable business; grows in-line with overall air traffic
• Primary engine platforms
  • V2500
    • Powers Airbus A320CEO
    • 16% ownership
  • Geared Turbo Fan
    • Powers Airbus A220, Embraer EJ2, A320NEO/321
    • 18% ownership
  • GEnx
    • Powers Boeing 787
    • 7% ownership
  • Military
    • EJ200, powers Eurofighter Typhoon, 33% ownership
    • TP400, powers Airbus A400M transport, 22% ownership
• Geography
  • 72% North America
  • 15% Germany
  • 6% Other Europe
  • 4% Asia
  • 3% Other

Upside/Downside

• Base case assumptions
  • Multiple in-line with S&P 500
  • 3-year compounded rev growth in-line with management target of ~€8bn revs by 2025
  • Margin expansion ~100bp ahead of consensus, in part driven by favorable US$/€ tailwinds

Risks

• Global recession impact on passenger air traffic; mitigating factor…tailwinds as passenger traffic ramps from COVID-depressed levels
• Continued supply chain challenges in global aircraft production could limit growth

Catalyst

Continue ramp of global passenger traffic; announced participation in additional engine platforms