Fitch Ratings has revised German-based aerospace and defence group MTU Aero Engines AG's (MTU) Outlook to Stable from Negative, while affirming the group's Long-Term Issuer Default Rating (IDR) at 'BBB'.
The revision of the Outlook reflects Fitch's view that MTU's core funds from operations (FFO) margin will recover in 2021 and gradually increase in subsequent years as demand for aerospace equipment and maintenance, repair and overhaul (MRO) services recovers to pre-pandemic levels. This should lead to consistent free cash flow (FCF) generation and the increased likelihood of deleveraging in the short term to levels that are commensurate with the rating.
The ratings reflect MTU's stable aftermarket-driven earnings performance, alongside improvements to its profitability and capital structure. Fitch believes that its substantial investment phase will peak in 2022, which along with the continued ramp-up of its new geared turbo-fan engines, should lead to a material improvement in FCF generation in the medium term.
Fitch believes that MTU is well-positioned to benefit from the faster recovery in single-aisle aircraft production (as opposed to twin-aisle widebodies) and maintenance needs, and believes that its revenue will exceed pre-pandemic 2019 levels in 2022. Fitch expects double-digit revenue growth in its MRO division in 2021 and again in 2022, as global aircraft fleets continue to increase their flight hours, while its OEM commercial division, where revenue fell over 30% in 2020, should return to 2019 levels by 2024 as production of engines ramps up again.
Although MTU's FFO margin declined materially in 2020 to 10.5%, from 15% in 2019, it remained robust through the pandemic and is strong for the rating. For the LTM to June 2021, it increased to 12.3% on the back of higher activity levels and improved cost containment, and Fitch expects it to gradually rise to pre-pandemic levels by 2025.
FCF also remained resilient over the past two years, remaining positive in 2020 through capex discipline, a cut to dividends as well as prudent working-capital management. Fitch expects FCF generation through the short-to-medium term, although it is likely to be weak in 2021 and 2022 as MTU catches up on deferred capex and reinstates its dividend, albeit at a moderate level. From 2023, Fitch expects the FCF margin to rise to over 3% on a sustained basis as capex returns to around 5%- 6% of revenue and underlying FFO continues to improve.
Fitch expects gross leverage to return to historical levels in 2022 as FFO improves and MTU repays some of its debt, as it has in 1H21. By end-2022, we expect gross leverage to return to under our 2x negative sensitivity and to continue to improve gradually to around 1x by 2025. Net leverage is expected to remain between 0x and 1x over the medium term. MTU raised EUR600 million in 2020 to shore up its liquidity in the face of the uncertainty over the sector. Coupled with the decline in FFO, this led to gross leverage deteriorating to 3x at end-2020, a level higher than the historical range of 1x - 2x.
The stability of MTU's cash deployment strategy is key to its rating. Fitch believes that the group is likely to continue to balance the needs of its business and shareholders while maintaining a conservative capital structure in the short-to0medium term. As we expect FCF generation to continue to improve in line with higher operating cash flows, MTU may increase the amount of distributions to its shareholders. However, Fitch believes that such a policy is likely to be pursued prudently.
The ratings are constrained by limited business diversification, restrained pricing power due to MTU's position in the production chain, and exposure to the cyclical commercial aerospace sector. MTU's main aircraft manufacturer customer is Airbus, which accounts for roughly 60% of its OEM engine series sales.
MTU benefits from its position as a key component manufacturer for aircraft engines, exposure to a diverse range of aircraft platforms in both the commercial and defence aerospace sectors, and long-term relationships with the world's largest engine manufacturers. Fitch believes that MTU is positively exposed to aircrafts for which production rates are on the rise, including the A320neo, A220, Embraer E2, B777X, and new business jets.