ST Engineering (STE SP) - UOB Kay Hian 2016-10-19: Cessation Of A Chinese Land System Unit Expected To Lead To A S$61m Charge

ST Engineering (STE SP) - UOB Kay Hian 2016-10-19: Cessation Of A Chinese Land System Unit Expected To Lead To A S$61m Charge SINGAPORE TECH ENGINEERING LTD S63.SI

ST Engineering (STE SP) - Cessation Of A Chinese Land System Unit Expected To Lead To A S$61m Charge

  • STE intends to cease operations at its Chinese land systems unit JHK and this is expected to result in a one-off S$61m in impairment losses and closure costs. 
  • While we had previously alluded to the possibility of a divestment of JHK, the quantum of losses nonetheless surprised us. 
  • We lower our 2016 net profit estimate by 11% and our target price by 6% to S$3.40. 
  • Maintain BUY.


WHAT’S NEW

  • STE exits the Chinese automotive business; provides for S$61m in impairment losses. 
  • The unit, Jiangsu Huatong Kinetics (JHK), produces road and construction machinery in China and has been operating in the red. The JHK management has formally proposed to its board to cease operations in view that the business will not be able to operate on an ongoing basis due to a lack of working capital. A decision will be finalised in 15 days. ST Engineering (STE) deems the board will likely approve the cessation, thus it will record a S$61m one-off impairment losses and closure costs in its upcoming 3Q16 results. 
  • In 2Q16, STE also disposed of its excavator manufacturing business, Guizhou Jonyang Kinetics (GJK), but recorded S$10m in divestment gains.


STOCK IMPACT


We had highlighted that STE could dispose of the Chinese land systems unit, but the quantum of losses come as a surprise. 

  • In our previous note, we indicated that STE was likely to dispose of JHK and that could be one of the reasons for its lowered 2016 profit guidance. Even so, the steep S$61m impairment charge exceeded expectations. The charge will lower our 2016 net profit estimate by 11%.
  • The exit of the automotive business in China removes a key uncertainty, but highlights the risk of venturing into new markets. The Chinese unit has long been a drag on earnings with the inventory oversupply and challenging environment in China.

Inventory obsolescence alone amounted to S$45.5m and S$19.4m for land systems in 2014 and 2015 respectively 

  • (2Q16’s write-back of allowance for inventory obsolescence was likely due to the divestment of GJK). 
  • Upon the cessation of both Chinese land system units, we expect the land systems division is unlikely to recognise further inventory obsolescence charges in the coming quarters and this will no longer be a drag on group earnings.

Separately, we believe STE is also no longer in the running to secure a GBP3b contract from the Royal British Navy. 

  • STE had showcased a variant of the Terrex, the armoured personnel carrier. Bloomberg had reported that a German consortium has secured a GBP3b contract to supply 800 Boxer infantry armoured personnel carriers. 
  • While we believe the street has not factored in incremental earnings from the contract for the next two years, the loss of the contract could still have a negative impact on stock price in the near term.


EARNINGS REVISION/RISK

  • We lower our 2016 net profit estimate by 11% as we factor in the S$61m one-off charge for the cessation of its Chinese land systems unit.


VALUATION/RECOMMENDATION

  • Maintain BUY but we lower our target price by 6% to S$3.40 (previously S$3.60).
  • We continue to value STE using DDM with a risk-free rate of 2.5% and terminal growth rate of 3.0%. 
  • Our target price implies 2016F dividend yield of 3.7% and PE of 23x and offers a 10.5% total return.


SHARE PRICE CATALYST

  • More contract wins.




K Ajith UOB Kay Hian | Sophie Leong UOB Kay Hian | http://research.uobkayhian.com/ 2016-10-19
UOB Kay Hian SGX Stock Analyst Report BUY Maintain BUY 3.40 Down 3.600



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