Meggitt, MTU Aero Engines: Moat in The Aircraft Aftermarket

Pat Dorsey presented his in-depth investment thesis on Meggitt (UK: MGGT) and MTU Aero Engines (Germany: MTX) at Wide-Moat Investing Summit 2014.

Likes the sources of moat in the aircraft aftermarket space owing to: 1) a lengthy qualification and selection process (e.g. FAA regulations in the U.S.); 2) low levels of aftermarket competition (most parts have just one supplier); 3) low customer incentive to push on price (maintenance = 9% of airline spending; fuel and labor = 65%  which gets more scrutiny?). The end result is “insanely” high switching costs and revenue streams lasting 50+ years from airframe in-service to last plane retirement – at aftermarket margins of 30%+ (initial product sales are breakeven or negative margin). Dorsey favors the following two equities in the space:

Meggitt: Supplier of critical parts and equipment to aerospace (civil + military) and energy markets. 75% of sales from aero, 25% energy/other. 75%-90% of aero revenue is sole-source. Two key insights: 1) Reported earnings understate economic reality by about a third (due to high amortization); and 2) Meggitt has a good shot at turning operational excellence into strategic advantage through the implementation of its lean manufacturing Meggitt Production System (big buyers such as UTX, Honeywell, Airbus, are getting fed up with subpar defects-per- million and delivery rates; suppliers that drive operational excellence have a chance to win incremental business). Dorsey sees a fair value of ~£6.5 billion (before any impact from lean initiatives).

MTU Aero Engines: Supplier of turbine (jet) engine modules and largest independent engine MRO provider. 75% of EBIT from engines, 25% from MRO. Model: secure “program share” on engine platforms, sell modules at negative margin, high margin on aftermarket. Moat: long-term agreements, onerous certifications, technical capacity. Opportunity: Strong new engine deliveries and declining spares sales have led to pressure on margins and working capital. But V2500 is entering “sweet spot” for shop visits and revenue should double by 2017. Lean program reducing capital needs. MRO gaining share from non-OEMs. Long term opportunity from geared turbo fan. By 2017-2018, Dorsey estimates FCF of €300m and fair value of ~€95/share.

About the instructor:

Pat Dorsey is the founder of Dorsey Asset Management. Prior to starting Dorsey Asset, Pat was Director of Research for Sanibel Captiva Trust, an independent trust company with approximately $1 billion in assets under management serving high net worth clients. From 2000 to 2011, Pat was Director of Equity Research for Morningstar, where he led the growth of Morningstar’s equity research group from 10 to over 100 analysts. Pat developed Morningstar’s economic moat ratings, as well as the methodology behind Morningstar’s framework for analyzing competitive advantage. Pat is also the author of two books — The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth — and has been quoted in publications such as the Wall Street Journal, Fortune, the New York Times, and BusinessWeek. Pat holds a Master’s degree in Political Science from Northwestern University and a bachelor’s degree in government from Wesleyan University. He is a CFA charterholder.