Opportunities and Risks
High on the agenda:
a forward-looking risk management
The aviation industry and the global engine business are highly competitive. For MTU, therefore, a forward-looking risk management is a central element in securing and shaping its future. The company does not merely limit itself to complying with the statutory requirements stipulated in the German law on the control and transparency of business operations. Rather, MTU has implemented a comprehensive risk management system in all business segments. This system, which serves to identify, assess and minimize risks, is overseen by the Board of Management, allowing it to recognize and head off potential risks on an on-going basis. Standardized guidelines for all companies of the Group ensure that all risk managers are in a position to adequately identify risks in their respective areas and provide information regarding potential preventive measures. The following section outlines the key risk areas that have a sustained influence on MTU’s business operations, assets, finances, and earnings.
Diversification reduces risks
The commercial engine business has an oligopolistic structure. MTU predominantly markets its products under risk-and-revenuesharing arrangements. Here, the lead partners in the consortium determine the prices, conditions, and concessions. MTU, as a consortium partner, is bound to these conditions to the extent of its program share. The customers in this segment, and in the commercial MRO business, are the airlines. Some of them have been hard hit financially by the global turbulences the industry has experienced in the wake of the terrorist attacks of September 11, 2001. The drastic rise in fuel prices further exacerbated this situation in 2005, causing the major US carriers Northwest Airlines and Delta Airlines, among others, to seek protection under Chapter 11.
And yet, the young engine fleet and MTU’s diversification are decisive factors in reducing these risks. Airlines tend to favor new engines because these require less maintenance. Comparisons in the industry show the MTU engine fleet to be among the youngest. This young engine fleet is developed and produced by MTU in cooperative ventures with various consortium partners, which significantly reduces dependence on any of these consortia. The growth of global air traffic allows airlines, even when under Chapter 11 bankruptcy protection, to utilize the majority of their capacities, generating a corresponding demand for spare parts and maintenance.
In the military engine business, MTU in firmly embedded in international cooperations. The customers are national and multinational government agencies whose budget varies with the level of public spending. However, MTU’s diversity in the military business eliminates the dependence on a particular contractor. Past experience has also shown that under the individual procurement programs a reduced demand in one country is offset by higher procurement levels in another country. Recent examples are Austria’s decision to buy the Eurofighter and the export contracts received for the Tiger helicopter.
In the spare parts business, new competition has emerged from companies which manufacture parts under the FAA’s system of Parts Manufacturer Approval (PMA) and sell them at cheaper prices than the engine consortia. In the commercial MRO business, Designated Engineering Representatives (DER) are vying for a piece of the cake. DERs are independent experts approved by the FAA who develop repair methods for engine parts. MTU expects DER repairs to play only a minor role in the market. In the spare parts business, MTU maintains its competitive edge over the PMAs first and foremost by developing advanced technologies.
MTU minimizes its risks throughout all business segments through its existing installed engine base, which is on a growth path. The market cycles for aircraft, and hence for engines, on the one hand, and for maintenance services and spare parts on the other, are typically not the same, thus balancing the risks. Furthermore, MTU spreads its risks by offering a wide range of products in virtually all aircraft engine performance categories.
Safety is a high priority
MTU’s products are subject to the most stringent safety standards. For this reason, the company requires various approvals, in particular from the Federal Office of Civil Aeronautics (LBA) in Germany and the FAA in the US. These approvals are valid for a specific time period and are renewed only after repeat qualification. Detailed and accurate descriptions of all production and repair processes ensure consistent compliance with all relevant regulations.
MTU also requires official approvals for the operation of certain production facilities, such as test stands and electroplating equipment. These approvals are maintained through strict adherence to the regulations and appropriate documentation. MTU holds certification to DIN EN ISO 14 001, adding another level of risk prevention through sound environmental practices.
Partnerships reduce development risks
In the commercial and military engine business, MTU undertakes to perform development work which may be plagued by unexpected delays. The company ensures strict adherence to time schedules by employing a highly qualified workforce that receives regular training. Furthermore, through its involvement in collaborative efforts, it works in partnerships beyond corporate boundaries, which makes balancing of risks easier.
Long-term contracts ensure supplies
In some areas of raw materials, parts, components and third-party services provisioning, MTU strives to reduce its reliance on outside suppliers by securing the services of multiple vendors. On the other hand, MTU has longterm agreements in place with single-source providers as a hedge against short-term fluctuations in supplies. This two-pronged strategy also reduces the risk of short-term price hikes.
A long product life cycle protects revenues
In the commercial engine business, multiple forms of concessions to customers are common practice in marketing series engines. Through risk-and-revenue-sharing contracts, MTU shares in these concessions to the extent of its program share. The fact that the cooperation partners have a common interest to a large degree helps prevent excessive concessions during contract negotiations. Furthermore, risks are spread across the programs. More generous concessions to major customers during the launch phase of a program are largely offset by a decline in the marketing costs for older programs. In the commercial spare parts business, catalog-based pricing is used. These prices are subject to annual adjustment. Revenue risks emanate from the OEM’s activities to bolster sales through replacement campaigns or special conditions. In this case, although lower prices are accepted, the increased volume has a positive effect on revenues. The military engine business is mostly subject to long-term contracts where the risk of short-term price changes is eliminated. In the commercial MRO business, more than half of the revenues are based on mid- and long-term maintenance agreements. Therefore, the risk of price drops is limited here as well.
Forward-looking accounts receivable management
In the commercial engine and commercial MRO businesses, airlines are direct and indirect customers of MTU. A large number of the carriers are facing financial difficulties, are planning or carrying out restructuring measures or mergers or are under bankruptcy protection. This affects the value of the accounts receivable, both MTU’s and its cooperation partners’.
The consortium lead partners in the commercial engine and spare parts businesses have an extensive accounts receivable system in place. In the commercial MRO business, MTU tracks its open accounts receivable in short cycles in cooperation with the sales department. In addition, potential risks are assessed and precautions taken as necessary before contracts are concluded. Where available, the company protects itself against political credit risks by means of export credit guarantees.
Top priorities: employee recruiting and employee retainment
MTU’s businesses are characterized by intense competition for the highly skilled employees needed to develop and manufacture world-class high-tech products. As a result, MTU’s human resources team has made the recruiting and retainment of key employees a top priority of its activities. To this end, it utilizes a flexible compensation system, attractive fringe benefits, a comprehensive internal and external training and education program and a well-balanced healthcare plan.
Insurance against catastrophic risks
In the aviation industry, accidents can never be ruled out completely despite strict compliance with manufacturing quality standards and utmost diligence in performing maintenance work. In the military engine business (excluding exports), MTU is largely exempt from product risk liability through government agency indemnification. The remaining liabilities, first and foremost aviation product liability, especially in the commercial engine business, are covered by comprehensive insurance. Other risks that could threaten the continued existence of the company, such as fire and interruption of business operations, are covered as well. No insurance cover has been taken out for the risk of terrorist attacks because of the excessively high premiums. Management liability is covered by D&O insurance with appropriate deductibles. Furthermore, there is coverage against risks which do not threaten the existence of the company.
Strongly reduced debts cuts interest charges
MTU’s financial debt carries interest rate risks. For the high yield bond, the interest rate is fixed for the entire maturity period. Lease liability interest rates are also fixed for their respective maturity periods. For the revolving credit facility, which currently amounts to €17 million and is otherwise burdened only by guarantees, the company has to pay interest at a variable rate that reflects current market rates. Moreover, certain factors, such as a deteriorating financial situation within the company, could cause further increases in the interest rate.
In the year ending December 31, 2005, MTU cut its financial debt by 72% and hence significantly reduced the interest-rate risk. In addition, a portion of the company’s US Dollar surpluses were used to pay interest on the remaining liabilities, concluding interest rate swaps for the purpose.
High priority on dollar hedging
The US dollar is the common transaction currency in the commercial engine and commercial MRO businesses. The largest share of labor costs and a portion of purchased materials and services, however, accrue in euros. Although MTU settles these purchases in US Dollars to the extent possible, a permanent surplus in US Dollars remains, for which an exchange risks exists. A sustained rise in the exchange rate of the euro against the dollar in particular can have a negative impact on the company’s assets, finances, and earnings.
To minimize this exposure, MTU typically conducts forward exchange contract transactions in US Dollars. These hedging transactions are based on a strategy that looks at the current US Dollar exchange rate and, depending on the expected trend, provides a hedging scenario that may be negative, neutral, or positive with regard to the anticipated rate. Based on the action options available, forward sales contracts may follow. The valuation of these hedging transactions is explained in the Notes section.
In 2005, MTU’s hedging transactions extended across a period of two years, with the volume decreasing year by year. At the end of 2005, MTU had sold $560 million at an average exchange rate of $1.27 to €1.
Every move must be exactly right: Assembly work on a V2500 engine fan at MTU Maintenance Hannover, the world’s leading provider of maintenance services for this engine.
Visual inspections are key to quality assurance at the highest level.