MTU Aero Engines paints a picture of booming growth and robust profitability. Their Q2 2018 earnings call overflows with optimism, fueled by a strong aftermarket, soaring passenger traffic, and the much-anticipated ramp-up of GTF engine production. But beneath this sunny facade, a potentially devastating problem lurks: the long tail of GTF warranty claims. While analysts buzz about supply chain constraints and the A220's bright future, a careful reading of the transcript reveals a hidden truth – MTU might be underestimating the financial burden of keeping those troublesome GTF engines in the air.

MTU, a key partner in the Pratt & Whitney-led GTF engine program, readily acknowledges the ongoing challenges with their flagship product. Technical issues, including problems with the bearing seal and combustion chamber, have plagued the GTF since its introduction, forcing a costly and time-consuming retrofit program. While MTU assures investors that they're on track to meet delivery targets and implement fixes, the elephant in the room remains: the looming financial impact of these early technical removals (ETRs) and the potential for a sustained wave of warranty claims.

During the call, CFO Peter Kameritsch confirmed that GTF retrofit shop visits accounted for "about one-third" of the year-to-date growth in Commercial MRO revenues. He further stated that the "bulk" of these retrofit visits would occur in 2018 and 2019. This back-end loaded wave of ETRs implies a significant backlog of problematic engines requiring attention, and potentially, substantial compensation to airlines for operational disruptions.

"Analyst Harry Breach astutely questioned the potential for "settlements" with airlines beyond the provision for warranty shop visits. He specifically highlighted the possibility of airlines demanding compensation for loss of profit due to high levels of unscheduled engine removals (UERs) and AOGs (aircraft on ground). This critical line of inquiry, however, was met with vague reassurance. Reiner Winkler simply stated that such negotiations are ongoing, and while "a little bit of some payment" is expected, it's "already... similar as it was last year.""

This dismissal raises several red flags. Firstly, the continued need for "settlements" beyond standard warranty shop visits points to persistent operational issues with the GTF fleet. Despite the implementation of fixes, airlines are still experiencing significant disruptions, forcing them to seek compensation beyond the basic engine repairs. This suggests that the GTF's reliability might not be improving as rapidly as MTU portrays, leading to ongoing financial liabilities.

Secondly, MTU's assertion that the provision for compensation hasn't changed from last year is concerning, given the growing number of GTF engines in operation. A static provision in the face of a growing fleet and persistent reliability issues suggests a potential underestimation of future claims. As the number of operational GTF engines increases, even if the UER rate remains constant, the absolute number of claims will rise, potentially outstripping the existing provision.

This potential discrepancy becomes even more alarming when considering the sheer volume of GTF engines entering the market. MTU proudly announced securing orders for over 600 GTF engines at the Farnborough Airshow, further bolstering their already impressive order backlog of 10,000 engines. This aggressive production ramp-up, while positive for long-term revenue, could exacerbate the warranty claim problem. More engines in operation, coupled with ongoing technical challenges, translates to a higher probability of warranty claims, potentially impacting future profitability.

Projected GTF Engine Deliveries and Potential Warranty Claims

The following chart illustrates the projected growth in GTF engine deliveries, highlighting the potential increase in warranty claims as the operational fleet expands. The data on deliveries is based on MTU's statements during the Q2 2018 earnings call, while the warranty claim projection is hypothetical, assuming a constant claim rate per engine.

MTU's bullish outlook might be neglecting this ticking warranty time bomb. A static provision, coupled with vague assurances about ongoing "settlements," raises concerns about the accuracy of their financial projections. As the GTF fleet grows, the financial burden of ensuring its reliability could weigh heavily on MTU's profitability, a hidden risk that investors should closely scrutinize.

"Fun Fact: MTU Aero Engines is a descendant of the engine division of Rapp Motorenwerke, a company founded in 1913 by Karl Rapp, who also founded BMW. MTU's roots lie in the very dawn of aviation, a legacy that now faces a critical test with the GTF engine program."