ST Engineering - DBS Research 2017-05-15: Orderbook Uplift Supports Upside

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SINGAPORE TECH ENGINEERING LTD S63.SI

ST Engineering - Orderbook Uplift Supports Upside

• Orderbook at record level of S$13.3bn.
• Singapore defence contract secured in March 2017 could be worth ~S$1bn.
• 1Q17 net profit of S$103m was seasonally weak, but guidance points to strong rebound in 2Q17.
• Bigger picture: STE is well positioned to break new valuation highs.

Maintain BUY; ST Engineering (STE) is well positioned to surpass previous valuation highs. 

• Although STE’s forward P/E is now touching 10-year highs, we believe that the greater tailwinds in STE’s favor now vs. previous peak levels justifies a valuation premium for the stock.
• In addition to the orderbook of S$13.3bn (~2x book-to-bill) being near all-time highs, and an expected turnaround at the land systems segment, we view STE’s focus on smart city solutions as having significant growth potential, which should drive the stock past previous valuation highs; the smart city market could grow at up to c.20% CAGR from US$600m in 2015 to US$1.5tn in 2020, implying a market size almost 3x as large as the global aerospace MRO market. 
• President Trump’s proposed tax cuts (beneficial because the majority of STE’s sales to the US originate from US-based facilities) and higher defence budget also provide potential macro boosts to STE.

Weak 1Q17 in line with seasonality, but guidance indicates a stronger 2Q. 

• 1Q17 net profits of S$103.4m were 18% of our FY17 profit forecast, but we believe a good portion of this was due to usual seasonality as well as a jump in provision for bad debt, mostly from the Marine segment. 
• With the bad debt write-off, the Marine segment’s exposure to oil and gas is now “insignificant”, which should result in lower provision-related losses going forward. 
• STE has indicated that 1H17 profit before tax (PBT) should be comparable to 1H16 – implying 2Q17 PBT will see a c.20% q-o-q improvement at least.

On track for renewed earnings growth. 

• Our earnings forecasts remain largely unchanged and we expect STE to record 4-5% earnings growth in FY17/18, driven by order win momentum.

Valuation

• Our TP is adjusted upwards to S$4.12 on a higher PE multiple as part of our blended valuation framework, which factors in both earnings growth and long-term cash-generative nature of STE’s businesses. 
• Our TP implies a forward PE of 23x, which we feel is justified given the tailwinds in place.

Key Risks to Our View

• A protracted slowdown in shipbuilding and execution hiccups at new business segments could detail earnings. Also, continued lack of action on the M&A front could lead to inefficient use of balance sheet and lower ROEs in the future.

1Q17 results highlights 

Weakest quarter seasonally. 

• 1Q17 net profit of S$103.4m (down 6% y-o-y) represented 18% of our full-year FY17 profit forecast, and 19% of consensus’ full-year FY17 profit forecast, slightly lower than expected. This was due to 
  1. lower-than-expected revenue recognition; 
  2. lower-than-expected pretax (PBT) margins at the Electronics, Land Systems and Marine segments, and 
  3. S$17.7m in allowance for doubtful debts & bad debt during 1Q17 (vs. S$6.1m in 4Q16 and S$0.4m in 1Q16) attributable to the Aerospace and Marine sectors. 
• 1Q17 revenue was down 5% y-o-y to S$1,539m but PBT was actually up 5% y-o-y as overall PBT margin of 8.9% for the quarter was still better than 1Q16 margin of 8.0%. Higher tax charge in 1Q17 led to lower net profit y-o-y.

But guidance points to a stronger 2Q17. 

• Despite the weaker 1Q17, STE has guided for 1H17 PBT to be ‘comparable’ (+/- 5% by their definition) with 1H16 PBT. Given that 1H16 PBT was c.S$301m, this indicates that 2Q17 should see at least c.20% q-o-q rise in PBT to around S$160m, up from S$137m PBT in 1Q17. This supports our view that the weaker-thanexpected 1Q17 numbers should not be seen as a run-rate, and the medium-term outlook remains favourable.

Orderbook at record levels, providing future growth momentum. 

• STE’s orderbook was S$13.3bn as of end-1Q17 – which is around record high levels – up from S$11.6bn at end-FY16. 
• Working backwards, we believe that the implied contract size for the construction of the Singapore Armed Forces’ Armoured Fighting Vehicles (AFVs) that was announced in March is around S$1bn – a big win for the Land Systems segment. 
• Historically, STE’s share price has reacted strongly to large order wins and substantial orderbook growth.

Land systems – lower sales flows through to PBT, but profitability has stabilized. 

• The land systems segment saw sales decline by 2.7% y-o-y and 31.5% q-o-q respectively. The absence of revenue from the Chinese specialty vehicle businesses (disposed of in 2Q16/3Q16), lower project deliveries from the Automotive segment, as well as a cyclical trough in Munitions & Weapons sales (due to timing of revenue recognition) were the reasons behind the decline.
• Despite lower sales for the quarter, PBT margins remained relatively stable q-o-q at 5.8%, as inventory obsolescence costs have declined substantially post-disposal of the loss-making Chinese specialty vehicle businesses.

Marine segment – “exposure to oil and gas now insignificant” after provision for doubtful debt. 

• The Marine segment posted a 6% q-o-q rebound in sales to S$179m, as the US shipbuilding operations saw a q-o-q improvements in sales and profitability. On a y-o-y basis, sales fell by c.16% as challenging macro conditions persists. 
• PBT of S$8.9m was down by 29% q-o-q, largely due to allowance for doubtful debts & bad debts written off amounting to almost S$13m during the quarter. However, with this write-off, management indicated that the segment’s net exposure to the oil & gas segment remains “insignificant” – which is positive in our view, as we can hopefully expect less of such one-off items.

Electronics segment’s performance was more encouraging.

• Electronics PBT was up by 5% y-o-y but down 35% q-o-q largely due to the weak PBT margins at the Communications & sensor systems group (CSG) for the quarter. This was primarily a result of cyclicality at iDirect (parked under CSG), which typically sees lower margins during the first quarter.
• Sales grew by 14.6%/1.8% y-o-y and q-o-q respectively, which is in line with our belief that Electronics segment will be the key growth driver in the near to medium term.

Aerospace segment continues to see growth in new markets.

• Aerospace revenues in 1Q17 declined by 12% y-o-y and 18% q-o-q on across-the-board weakness. We note that 1Q/3Q seem to be seasonally weak quarters for the segment revenue-wise, owing to maintenance patterns. 
• Nonetheless, PBT of S$78.1m was higher y-o-y by about 4%, as PBT margins climbed to c.14% on a more favourable sales mix during the quarter, though PBT was still down 9% on a q-o-q basis mainly due to the lower sales figure. 
• The start of operations of the second Guangzhou hangar as well as continued expansion of subsidiary EFW, which recently just broke ground on a new composite panels production facility, were key developments made during the quarter, which highlights the Aerospace segment’s continued push into new market segments to diversify revenues. 
• Aerospace order wins of S$1.1bn secured during the quarter largely comprised multi-year renewal contracts on both the commercial as well as military front.

Suvro SARKAR DBS Vickers | Glenn Ng DBS Vickers | http://www.dbsvickers.com/ 2017-05-15

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 4.12 Up 3.800