SATS - DBS Research 2017-09-25: Passenger Traffic To Drive Growth

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SATS LTD. S58.SI

SATS - Passenger Traffic To Drive Growth

• Positive on SATS as a key beneficiary of Changi’s air traffic growth and Qantas’ move to Singapore. 
• SATS' Share price correction should have priced in weak 4Q17-1Q18 EBIT earnings.
• Expect margin expansion with better leverage on staff productivity going forward. 
• Maintain BUY with higher TP of S$5.02.

Maintain BUY, TP revised to S$5.02. 

• We remain positive on SATS and maintain our BUY recommendation with a higher TP of S$5.02, giving a total potential upside of 12% including dividends. We see long-term potential growth drivers from
  1. more landing slots at Changi Terminal 4 leading to higher passenger traffic;
  2. Qantas diverting its European sector hub from Dubai to Changi;
  3. automation and staff productivity coming through, limiting cost increase at a modest pace in the next few years; and
  4. opening of Terminal 5 which will support growth over the longer term. Valuations are compelling with SATS trading attractively at 19.3x forward PE vs 21x peer average.

Where we differ. 

• While consensus sees pricing pressure dampening earnings growth, our differentiated view believes that passenger growth at Changi will be a key driver for the share price based on our critical factor analysis. 
• We also see better staff productivity and cost controls will eventually come through to lift margins going forward. Recovery in aviation volumes should offset the impact of pricing pressure eventually.

Potential catalyst. 

• Rising passenger capacity for Changi will act as a long-term growth catalyst. Winning Qantas contract will also help lift customer and revenue base going forward.

Key Risks to Our View

• We have raised our earnings and TP in view of a recovering aviation outlook and better cost structure. Slower recovery of air traffic and failure to keep operating costs in check are key risks to our earnings and TP.

Growth to be led by higher passenger traffic. Changi Terminal 4 to help boost traffic. 

Changi Terminal 4 to operate first flight on 31 October.

• Changi Airport will officially open on 31 October 2017 when it welcomes Cathay Pacific CX659 from Hong Kong at 540am. Nine airlines comprising four AirAsia Group’s airlines, Cathay Pacific, Korean Air, Cebu Pacific, Spring Airlines, Vietnam Airlines, are due to operate out of Terminal 4 from 7 November. Terminal 4 will provide links to more than 20 destinations operating close to 800 flights a week and has an initial capacity of 8m passengers per annum and an eventual passenger capacity of up to 16m.

Potential for to handle more flights and passengers. 

• With a ground handling market share of 80% at Changi, we see SATS as a key beneficiary of more flights should airlines decide to increase flights to Singapore. Terminal 4 could potentially add another 16m passengers per annum at operating capacity and with additional aircraft landing slots available, there is scope for airlines to scale up the number of flights into and out of Changi which will drive growth for SATS.

Automated system improves productivity. 

• Changi Airport has implemented Fast and Seamless Travel (FAST) at Terminal 4.
• There are automated bagdrop machines and self-service check-in kiosks (where passengers can print their boarding passes and bag tags).

Share price strongly correlates to Airport Services revenue, which is in turn driven by passenger traffic at Changi. 

• Based on our stock critical factor analysis, SATS’ share price strongly correlates to Gateway/Airport Services revenue at 0.81.
• Revenue includes ground handling, airport cargo delivery, management services, aviation security service and cruise terminal services. There is a strong correlation of 0.9 between Gateway/Airport services revenue and passenger traffic at Changi. This translates into a correlation of 0.7 between SATS’ share price and passenger traffic at Changi. We therefore see SATS as a key beneficiary as Changi prepares to grow double its passenger capacity to 135m by 2025. 
• While consensus sees pricing and cost pressure dampening earnings growth at SATS, our differentiated view believes air traffic at Changi will drive both share price and earnings growth on a long-term basis.

Qantas more positive for traffic 

Qantas to make Changi its largest hub outside of Australia.

• Qantas has announced that it will divert its European bound flights via Singapore from Dubai from 25 March 2018.
• Qantas will operate its daily Sydney-London service (QF1/QF2) via Singapore using an A380 and increase services to Melbourne from 10 to 14 times weekly in a move to increase its presence in the fast-growing Asian market. The Australia Dubai flights will be served by Emirates through their codeshare arrangement. This is expected to increase Changi’s throughput by 3,806 Singapore-Australia one-way seats (+5.5%) and 3,388 Singapore-UK one-way seats (+18.3%) weekly. Its current 38 weekly services by Qantas out of Singapore to Brisbane, Melbourne, Perth and Sydney will increase to 49 services (including the daily service to London) from March 2018. 
• Qantas has announced plans to offer nonstop flights to London and New York from Melbourne, Sydney and Brisbane by 2022, which would reduce stopover flights in Singapore or elsewhere from Australia.

Positive for SATS. 

• We believe this is a net positive development for Changi’s air traffic as Qantas’ long-term plan is to capture the Asian market and the opening of Terminal 5 will position Singapore to be a key aviation hub in Asia over the long term. 
• SATS already serves Qantas for its existing flights into and out of Singapore. It also previously served Qantas before it announced relocating its hub away from Singapore in 2012.

Australian visitors are among top 5 most frequent visitors to Singapore. 

• From January to June 2017, the number of arrivals by Australian visitors through air amounted to 453,455, growing by 6.1% y-o-y and accounting for close to 7% of 6.6m visitor arrivals. Australians are ranked 4th in terms of visitor arrivals, on par with Malaysia but behind visitors from China (1.1m), Indonesia (0.9m) and India (0.5m) this year.

More flights available for travel between Singapore and Australia. 

• Changi has connection to nine destination airports in Australia (Adelaide, Brisbane, Cairns, Canberra, Darwin, Gold Coast, Melbourne, Perth, Sydney) through nine airlines (Asiana Airlines, British Airways, Emirates, Jetstar Airways, Jetstar Asia, Qantas, SilkAir, Singapore Airlines, Tigerair/Scoot) which collectively operate over 240 flights a week.

Changi traffic is recovering 

Changi continues to grow. 

• Total passenger throughput at Changi has grown at a CAGR of 5.7% over the past five years. Air traffic at Changi continues to be positive since the beginning of this year. Cargo throughput has grown 7.5% yo-y, driven by more international trade and e-commerce.
• Passenger traffic has also grown, particularly for transit passengers which grew 19% y-o-y over the same period.
• Increased flights into Singapore have led to more aircraft landings this year.

Operating margins less of a critical factor to share price 

Track record in improving margins. 

• Our critical analysis also finds that operating margins are less correlated to share price, at only 0.68. Nonetheless, SATS has a track record and discipline in controlling cost and margins. Its initiative to improve productivity has improved EBIT margins from 9.6% in FY14 to 13.3% in FY17. In particular, the discipline to restructure low-margin businesses such as the disposal of Urangan Fisheries into SATS BRF has help to lift operating profit growth as well. We expect productivity to limit staff cost increase to come through and the impact from higher licensing fees to be minimal as their contribution to total cost is not big.

Expect productivity to limit increase in staff costs: 

• SATS key cost component has historically been staff cost which makes up 57% of total operating expenses and 50% of sales.
• Improving productivity has been part of SATS’ efforts to minimise staff cost increases while growing revenue. This is done via more automation, which will improve productivity in the long run. Investment has been evident in higher capex and depreciation expenses, as staff cost increases remained modest. SATS has since been using more automated check-in kiosks at the terminals, while machines which clean and sort cutlery inflight meals at the flight kitchens for example will improve productivity. 
• The use of augmented reality (AR) smart glasses in its ramp handling operations could potentially increase productivity and shorten loading time at the apron area by as much as 15 minutes. We therefore believe rolling out automated systems on a larger scale will lead to stronger margin improvement over time.

Higher licensing fees small proportion of total opex. 

• Changi Airport Group had been giving ground handlers including SATS a 20% rebate discount on flight catering franchise and ground-handling fees since May 2015. That ended in March 2017. We therefore expect higher licensing fees on a year-on-year basis going forward. Licensing fees are however not a big cost component as they only make up 5-6% of total opex and revenue.

Valuation

Share price decline in 2013 to 2014 was led by lower EBIT, recent correction likely to reflect 4Q17 and 1Q18 EBIT performance. 

• SATS share price has corrected by 12% from a YTD high of S$5.32 in January. The last time SATS share price de-rated was from September 2013 to November 2014, due to consecutive quarters of y-o-y decline in EBIT earnings of between 2% to 25% each. It is also noteworthy that aviation food revenues declined by 3-10% y-o-y in each of these quarters which also led to headline revenue decline. The recent share price correction could also be due to two quarters of y-o-y EBIT decline seen in 4Q17 and 1Q18.

Share price correction is likely priced in, as aviation food and headline revenue did not disappoint as much. 

• While share price has corrected recently likely due to EBIT, headline revenue in 4Q17 and 1Q18 grew 1.2% y-o-y (vs -1.6% between September 2013 and March 2014 ended quarters).
• Aviation food revenue declined only by only 2% (vs 3-10% between September 2013 and March 2014 ended quarters).
• EBIT decline at 8% and 2% y-o-y in the last two quarters is at a much lower magnitude (vs EBIT decline of 10-25% y-o-y between September 2013 and March 2014 ended quarters).
• For these reasons, we believe downside to the share price after a 12% correction should be limited at this stage, and with air traffic growth with potentially more flights to be added to Changi going forward, margins should improve eventually.

Maintain BUY with higher TP of S$5.02. 

• Our earnings estimates are largely unchanged as we forecast modest earnings growth which is slightly above consensus, led by better traffic at Changi and improving margins on better staff productivity. As airlines increase flights into Changi, SATS’ plans to service its customers with technology while maintaining similar headcount, driving further staff productivity and margins. The stock is currently priced at a PE valuation of 19.9x FY18F earnings, below peers and near +1SD of its historical range. The stock currently yields 3.6%.
• We continue to like the stock as a key beneficiary and strong proxy to Changi Airport’s future air traffic growth. 
• We derive our TP based on the average of 22x FY18F PE and DCF at S$5.02. Our PE component of 22x target is within the peer average of 21-25x, while our DCF component assumes a WACC of 7.6% and terminal growth of 3%

Alfie YEO DBS Vickers | Andy SIM CFA DBS Vickers | http://www.dbsvickers.com/ 2017-09-25

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