Singapore Aviation - UOB Kay Hian 2016-06-07: Positioning For 2H16

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SIA SINGAPORE AIRLINES LTD C6L.SI  SIA ENGINEERING CO LTD S59.SI  SATS LTD S58.SI  ST ENGINEERING SINGAPORE TECH ENGINEERING LTD S63.SI 

Aviation – Singapore: Positioning For 2H16

• Within the Singapore aviation sector, we are neutral on SIA while our top pick is STE among aviation support services. 
• We expect continued yield pressures for airlines but stable earnings for STE. Amid weak corporate earnings and market volatility, STE is a defensive play, with its strong balance sheet and a 2016F dividend yield of 4.2%. We expect STE to outperform other industrials, due to its enhanced capabilities in data analytics and cyber security and its leadership position in aerospace. 
• Meanwhile, the award of a trial contract by the US Marines should add to STE’s clout and open doors to other markets. Maintain MARKET WEIGHT.

WHAT’S NEW

• We review the operating dynamics of the airline and aviation support services sectors as follows:

• On airlines - 

• Yields likely to remain weak and high capex requirements likely to limit share price upside in the near term. We remain neutral on SIA as yield pressures remain intense. In 4QFY16, SIA’s pax yields fell sharply by 7% yoy, reversing from the lower rates of decline seen in the previous two quarters. Given the soft global economy and recent job attritions in the financial sector, yields could further weaken going forward and limit stock price upside. Meanwhile, SIA has substantial capex commitments of S$3.4b-5.1b per year over the next three years, which could require debt funding and lower dividend payout.
• The weakening Australian dollar could affect loads negatively as Australia is an important source market for SIA. The A$ has weakened by about 3.2% against S$ ytd. Australia is SIA’s largest market by seat capacity in km-terms, accounting for 17% of SIA’s total capacity. The sector has a relatively higher portion of premium traffic and lower loads could thus impact yields adversely. Meanwhile, recent codeshares and partnerships are likely to improve SIA’s ability to compete with other carriers, but are unlikely to be earnings accretive in the near term.

• On aviation support services - 

• We prefer ST Engineering while we are neutral on SATS but negative on SIAEC.
• STE (STE SP/BUY/Target: S$3.50) was formally awarded a US$121.5m trial contract by the US Marines in Mar 16 to build amphibious combat vehicles, Terrex 2, which should add to STE’s clout and open doors to other markets. STE could also secure a larger contract from the US Marines worth US$1.3b if selected. Meanwhile, STE has purchased a further 20% stake in EADS EFW, which holds the IP for passenger-to- freighter (P2F) conversion for Airbus A330 and A320 aircraft. This could boost earnings in the medium term. STE is also investing in cyber security, smart nation and data analytic solutions, which are likely to gain traction both domestically and overseas. In addition, the disposal of a Chinese land systems subsidiary, Guizhou Jonyang Kinetics (GJK), in May 16 will reduce the risk of further inventory obsolescence and lower its risk profile.
• SATS (SATS SP/HOLD/Target: S$4.20) faces significant wage pressures as staff costs rose 10% yoy in 4QFY16 despite a 2% decline in revenue. In 4QFY16, SATS was also adversely affected by weaker pricing for both gateway services and food solutions, resulting in lower-than-expected operating leverage.
• In addition, SATS’ FY16 dividend payout ratio, at 75.4%, was 4ppt lower than in FY15, and SATS did not guide for payout ratio to be restored to previous years’ levels. SATS’ capex is also likely to rise over the next few years as it builds kitchen facilities for its JV with Wilmar. The potential for lower dividend payout, along with rising capex, is likely to limit share price upside in the near term.
• SIA Engineering (SIE SP/SELL/Target: S$3.40). SIAEC’s airframe maintenance segment was profitable in 2HFY16, but SIAEC alluded that this is unlikely to herald a turnaround and there is still excess hangar overcapacity in the region. SIAEC also faces the problem of new generation aircraft being more reliable and thus requiring less maintenance. Profitability of the Pratt & Whitney engine JV, Eagle Services Asia, is also expected to decline as the engines are gradually phased out. Meanwhile, SIAEC indicated that recent JVs would not be accretive in the near term. Valuations remain lofty with SIAEC trading at 25x FY17F earnings, a steep 30% premium to MRO peers.

ACTION

• We prefer STE within the Singapore aviation sector, due to: 
  1. its leadership position in aerospace, 
  2. the award of a trial contract for amphibious combat vehicles (Terrex 2) by the US Marines which could pave the way for further contract wins, and 
  3. enhanced capabilities in data analytics and cyber security which should eventually drive earnings growth compared with other industrials. 
• Meanwhile, the disposal of a land systems subsidiary in China, GJK, will lower the risk of further inventory obsolescence.

ESSENTIALS

Market is likely to look out for signs of stabilising yields for SIA in 1QFY17/1HFY17 results before re-rating the stock upwards. 

• While SIA’s FY17 core earnings are still expected to rise by 29% yoy, much of the expected improvement in earnings will come from lower fuel expenses and lower fuel hedging losses rather than improved operational strength in FY17. Should SIA show improvement in pax yields, the market could re-rate the stock upwards. 
• In addition, share price is likely to react positively to increased aircraft sales and improved cash flow, which would help offset capex requirements. 
• For now, we maintain our neutral stance on SIA and prefer to be buyers below S$10.00.

Within aviation support services, our top pick is STE. 

• In an environment of weak corporate earnings and market volatility, STE is a defensive stock with strong cash flow and net cash position. STE is also AAa-rated and we expect STE to outperform other industrials due to its diversified business, enhanced capabilities in data analytics and cyber security, as well as its leadership position in aerospace. 
• At our fair value of S$3.50, STE would offer a 2016 dividend yield of 3.9%. We have conservatively assumed a lower dividend payout ratio of 83% for 2016 compared with 2012-15’s payout ratio of 88%. At S$3.19, STE currently offers a higher dividend yield of 4.2% vs MRO peer average of 3.1%. 
• While we like SATS for its regional exposure, SATS faces cost pressures and increasing capex as it ramps up operations in China via its JV with Wilmar. Thus, we would prefer to be buyers on weakness near S$3.80.

K Ajith UOB Kay Hian | Sophie Leong UOB Kay Hian | http://research.uobkayhian.com/ 2016-06-07

UOB Kay Hian SGX Stock Analyst Report HOLD Maintain HOLD 11.60 Same 11.60

SELL Maintain SELL 3.40 Same 3.40

HOLD Maintain HOLD 4.20 Same 4.20

BUY Maintain BUY 3.50 Same 3.50