ST Engineering Ltd - RHB Invest 2017-09-06: There Is Growth Beyond 2017

ST Engineering Ltd - RHB Invest 2017-09-06: There Is Growth Beyond 2017 SINGAPORE TECH ENGINEERING LTD S63.SI

ST Engineering Ltd - There Is Growth Beyond 2017

  • We initiate coverage on ST Engineering with a BUY and SGD4.07 Target Price (13% upside). 
  • Its exposure to the commercial and defence industries across four segments creates a defensive business model that is tough to beat. It is world’s largest MRO service provider for aircraft and Asia’s leading provider of ICT solutions. Aircraft fleet size growth, rising demand for P2F conversions and more spending on Smart Nation initiatives should lead to strong 2018 growth. 
  • While a 4% yield could support the stock, strong order wins and accretive M&As may act as near-term catalysts.

Company Background 

  • The origins of Singapore Technologies Engineering or ST Engineering can be traced back to 1967 when Chartered Industries of Singapore (CIS) was formed to manufacture ammunition. 
  • CIS and a number of defence-related companies – created during the late 1960s and 1970s – were grouped under holding company Sheng-Li in 1974. The latter was renamed Singapore Technologies (ST) Holdings in 1990, and came under state investment company Temasek Holdings (Temasek) in 1994.
  • From 1990, the ST group began to list some of its companies on the SGX. ST Aero and ST Shipbuilding were the first in Aug 1990. They were followed by ST Capital, ST Electronic & Engineering, ST Auto and ST Computer Systems & Services. For defence- related firms, ST maintained management control by retaining at least 51% of the shares.
  • In Dec 1997, ST Engineering was created by amalgamating four listed companies, namely ST Aerospace, ST Electronics, ST Kinetics and ST Marine. Following the merger of the four companies on 28 Aug 1997, shares of ST Engineering made their debut on the SGX on 8 Dec 1997. Temasek remains the largest shareholder of ST Engineering with a c.51% stake.

Aerospace business division (ST Aerospace) 

  • ST Aerospace is the aerospace arm of ST Engineering. It is the world’s largest commercial airframe MRO service provider. It has a global customer base, targeting both commercial and military operators. The group provides a suite of services ranging from MRO services in airframes, components and engines to designing and technical services. It also provides trainings for pilot and technical vocations in air charter services. 
  • The ST Aerospace business division includes AMM, CERO and EMS services.

Electronics business division (ST Electronics) 

  • ST Electronics has more than 40 years of experience in providing a comprehensive range of solutions in electronics, communications, advanced electronics and ICT solutions to governments and commercial enterprises globally. 
  • Its strength lies in the ability to use cutting-edge technologies, as well as the innovating of new products to meet client needs. Some of the solutions that are implemented by ST Electronics include e-government ICT, satellite communications, rail and intelligent transportation markets, and eco-enabling ICT solutions for businesses. 
  • This division includes the following business operations, ie LSG, CSG, and SSG.

Land systems business division (ST Kinetics) 

  • ST Kinetics provides the land systems and specialty vehicles to ST Engineering. Its capabilities cover design and development, systems integration, production, after-sales support and through-life management. This wing is made up of the defence and commercial business groups. 
  • ST Kinetics business divisions comprise automotive, M&W and ST.

Marine business division (ST Marine) 

  • ST Marine is a provider of turnkey shipbuilding, repair & conversion, naval operations, and integrated logistics solution services – as well as engineering services – to a local and international customer base. Its presence in the global new build market, particularly in the Americas, is complemented by Mississippi-based Halter Marine. 
  • ST Marine has a strong track record in both commercial and naval applications. It also provides a full suite of services from concept definition, basic design, and installation & integration to integrated logistics engineering. 
  • ST Marine is mainly involved in shipbuilding, ship repair and engineering.

Other businesses 

  • Singapore Technologies Dynamics Pte Ltd (ST Dynamics) is the advanced engineering centre of ST Engineering. 
  • Meanwhile, ST Synthesis Pte Ltd (ST Synthesis) provides logistics and supply chain management to facilities engineering services.

Investment Thesis 

Strong orderbook position to support revenue growth 

  • ST Engineering’s orderbook has seen significant improvement over the last decade. The outstanding orderbook has more than doubled between 2005-2010 to SGD11.5bn. Since then, it has been ranging between SGD11.6-13.2bn. In 2Q17, the group announced its highest-ever orderbook of SGD13.5bn amidst SGD2.7bn worth of order wins in 1H17.
  • The new wins were supported by SGD1.8bn of orders landed by the aerospace segment and SGD900m in orders by the electronics division. The former’s order wins was helped by multi-year renewals from both commercial and military customers.
  • We remain confident that ST Engineering can achieve SGD5.5bn worth of new order wins in 2017. The group’s outstanding orderbook of SGD13.5bn provides strong revenue visibility for 2017 and 2018. This is as the book-to-bill ratio stands at c.2x. 
  • Driven by benefits of increased diversification by the aerospace division and Smart Nation project wins by the electronics business, we remain confident of ST Engineering delivering a PBT CAGR of 7.8% over 2016-2019.

Aerospace and electronics’ long-term growth prospects 

  • We believe the group’s move into new markets ought to support growth for its aerospace business. Singapore Technologies Aerospace Ltd (ST Aerospace) has been actively working to broaden its capabilities, which should support growth in the longer term. These include: 
    1. A partnership with Airbus for P2F conversions of the latter’s A320/A321 and A330 jets – this marks a diversification of ST Aerospace’s conversion portfolio;
    2. Continued expansion of its cabin interior service solutions business, particularly for VIP aircraft completions; 
    3. Expansion of its mid-life aircraft leasing business.
  • We believe initiatives taken by ST Engineering for its electronics division would be the key to longer-term growth for the group. It ought to be the key beneficiary of Singapore’s Smart Nation initiative.
  • In May, the Government announced that SGD2.4bn worth of technology tenders are to be called this year to invest in data analytics software and a communications backbone to link up sensors and data centres. The implementation, we believe, could take 2-3 years.
  • Among Singapore corporates, ST Engineering seems to have a foot in the door in this initiative. The group is looking to be the backbone for this network. This would be a network that connects sensors, cameras, and so forth, where data from these devices can be collected and analysed.
  • ST Engineering’s acquisition of 51% of SP Telecommunications Pte Ltd (SPTel) was completed in early May for a consideration of SGD55m. SPTel owns an extensive network of fibre optic back-haul infrastructure and facilities, similar to NetLink Trust. The combination of the electronic wing’s ICT expertise and SPTel’s assets ought to enhance the former’s capabilities in its strategy to build a comprehensive suite in smart city offerings.

Strong proxy to the rise in global defence spending 

  • ST Engineering derives 35% of its revenue from defence-related projects, with Singapore being one of its key customers. The country’s defence expenditure has grown at a healthy CAGR of 4% over the last decade to SGD13.8bn in 2016. The Government’s 2017 defence budget stands at SGD14.2bn (+1.6% YoY).
  • We have witnessed a revival of military spending in the US, which remains the second- largest geographical market for the group’s land systems business (31% of the division’s revenue in 2016).
  • US military spending was on a decline between 2011 and 2015, with annual military spending having fallen to USD596bn in 2015 from USD711bn in 2011. However, the trend reversed in 2016, as the US pushed its defence spending higher to USD611bn. On 16 Mar, US President Donald Trump submitted his request to the US Congress for USD639bn in military spending, ie USD54bn higher (c.10% increase) for FY18 as well as a USD30bn rise for FY17, which ends in September.
  • These proposals for increased military spending bode well for ST Engineering, as the US accounted for 24.4% of the group’s total revenue in 2016. We note that it has a long history of selling defence products to the US.

Consensus more optimistic of ST Engineering’s outlook beyond 2017 

  • While we have noticed material downward revisions to the group’s profit estimates for 2017 after its 2Q17 results, the reduction in 2018 estimates has not been so significant. Post recent downgrades, consensus is now looking at 9.7% profit growth next year, which seems healthy.
  • While consensus has been revising EBITDA estimates for 2017 and 2018 lower, there is still strong expectation of growth next year. This indicates greater confidence in ST Engineering’s ability to grow revenue and generate strong operating cash flows.
  • Our profit estimate for 2017 is below consensus, as we believe there may be risk of further impairments/write-offs, albeit small ones. However, we remain positive on the earnings growth outlook for 2018-2019. 
  • We expect gradual improvement in revenue growth, along with margins expansion, which should support a profit CAGR of 7.8% during the FY17-19 forecast period.

Expecting a gradual improvement in dividend payments in 2017-2019 

  • ST Engineering remains a defensive company with the ability to generate strong FCFs. With a moderation in the capex cycle, we expect the group to spend c.SGD240m in capex in FY17-19, leaving c.SGD650-810m in FCF available for dividend payments.
  • ST Engineering declared a dividend of SGD0.15 per share in 2016. This was similar to 2015’s DPS, despite reported earning dropping by 8.4% YoY. This implied that the payout ratio had increased to 97%, despite management guiding that the ratio would be at 75- 80%.
  • We view this as a good indication that management is willing to defend the absolute DPS level of SGD0.15 per share, even when the business environment is tough.
  • With rising profit, and limited capex spending requirement, we believe the group could gradually increase the dividend per share by SGD0.01 each year. We estimate DPS to gradually increase to SGD0.17 per share in 2019 from SGD0.15 in 2016.

Strong balance sheet and earnings recovery merit valuation premium 

  • ST Engineering's four key divisions bring pivotal diversification benefits – its aerospace, electronics, land systems, and marine businesses accounted for 37%, 28%, 20% and 13% of 2016’s revenue respectively. We believe such diversification allows the group to avoid reliance on any one particular unit for growth. This has engendered relatively stable revenue and profits, and allowed ST Engineering to weather even crisis periods.
  • The group’s strong net cash balance sheet and ability to generate strong FCFs support sustained dividend payments, even during weak business performance. Moreover, its outstanding orderbook of SGD13.5bn provides strong revenue visibility, as the book-to-bill ratio stands at c.2x.
  • Driven by the benefits of increased diversification by the aerospace division and Smart Nation project wins by the electronics wing, we remain confident of ST Engineering delivering a profit CAGR of 7.8% in 2016-2019.

Financial Analysis 

Resumption in revenue and earnings growth 

  • For 2017, management is guiding for revenue to be comparable to 2016, with PBT to be higher than last year’s numbers. We are forecasting for 2017 revenue to remain largely unchanged at SGD6,748m (+1% YoY). We also expect reported profit to improve to SGD495m (from SGD485m in 2016).
  • We expect recovery in the aerospace business and rapid growth in electronics segment to largely support 3-4.5% revenue growth in 2018-2019. This is because we believe the marine business would continue to remain soft during our FY17-19 forecast period.
  • We forecast for ST Engineering’s net profit margins to sequentially improve to 8.4% in 2019 from 7.2% in 2016. This would translate into the group delivering 7.8% profit CAGR during 2016-2019.
  • This strong growth in profit should also support improvement in the group’s ROEs. We forecast for ST Engineering’s ROEs to improve to 25.6% in 2019 from 22.5% in 2016. Despite the improvement, its ROEs would still be lower than the highs of more than 30% achieved during the 2010-2012 period.

Healthy balance sheet 

  • Historically, ST Engineering has maintained an under-geared balance sheet. This was largely due to strong FCF generation and timely debt repayments. The debt raised in 2009 was aggressively repaid in 2009-2014. However, due to weak operating cash flow generation in 2014-2016 – and significant investments made in 2015-2016 – the group’s balance sheet moved into a net debt position of SGD242m in 2015 from net cash previously.
  • With an improving business environment, the net debt position has been reduced to SGD175m. We believe ST Engineering could revert back to a strong net cash position in 2017, and its net cash position of SGD108m possibly almost tripling to SGD327m by 2019.

Strong FCF generation capability 

  • ST Engineering remains a defensive counter with the ability to generate strong FCFs. Capex as percentage of revenue has been fairly stable at an average of c.4% since 2011. We expect a slight moderation in the capex cycle and estimate that the group could spend c.SGD240m in capex in 2017-2019. This would imply capex as a percentage of revenue to range between 3.3-3.5% during this timeframe.
  • ST Engineering should generate an operating cash flow of SGD700-900m in 2017-2019. Based on our capex assumptions of c.SGD240m pa, FCF should range between SGD650-810m, which would be significantly higher than what was achieved by the group in the last two years.
  • Given a net cash balance sheet, we do expect much of the FCF generated by ST Engineering to be passed on to shareholders in the form of dividends.

ST Engineering could gradually increase dividend payouts 

  • ST Engineering declared dividend of SGD0.15 per share in 2016. This was similar to 2015’s DPS despite reported earning dropping by 8.4% YoY. This implied that the payout ratio increased to 97% despite management guiding that the ratio would be at 75-80%.
  • We view this as a good indication that management is willing to defend the absolute DPS level of SGD0.15 per share, even when the business environment is tough. With rising profit and limited capex spending requirements, we believe the group could gradually increase the dividend per share by SGD0.01 each year. 
  • We estimate DPS to gradually increase to SGD0.17 per share in 2019 from SGD0.15 in 2016. Our DPS estimate implies a 2018 dividend yield of 4% at ST Engineering's current share price.


Initiate coverage with a BUY recommendation and SGD4.07 TP 

  • We use a blended valuation methodology to value ST Engineering. Our SGD4.07 TP is based on the average values derived from P/E- (23x), P/BV- (5.5x), EV/EBITDA- (16x) and DCF-based valuations (WACC of 6.8% and terminal growth rate of 2%).
  • Our TP implies 23.3x 2018 P/E, which is slightly above +1SD above the group’s 1-year forward average P/E as measured since 1 Jan 2008. 
  • We would like to highlight that our DCF-based valuation ascribes a higher SGD4.14 TP, which is slightly higher than the current TP.

Key Risks 

Order inflow delays for the aerospace and electronics businesses 

  • Our earnings estimates for ST Engineering is based on the premise that rapid growth and sustained increase in Asia’s aircraft fleet sizes and average age respectively would lead to higher business opportunities for the group’s commercial aerospace business division. In addition, we assess that growth in the electronics business would be well supported by a rise in order inflows from Singapore’s Smart Nation initiatives.
  • Any delays in the growth of the Asian aviation industry or delays in the deployment of the island republic’s Smart Nation initiatives could hold-up order inflows and, hence, revenue recognition over our forecast period.

Poor diversification execution in the aerospace sector 

  • ST Engineering is looking to build a more diversified business presence in the aerospace sector through its investments in: 
    1. Elbe Flugzeugwerke GmbH (EFW) – a JV that is responsible for the Airbus P2F conversions business;
    2. ST Aerospace Aircraft Seats Pte Ltd – a JV with Japan’s Tenryu Holdings Co Ltd that is responsible for building a long-term business roadmap for the supply of economy, business, and first class seats to passenger aircraft.
  • While we see strong potential in both business opportunities, we remain cognisant that execution remains key for the group to build a credible business presence in each of these business lines.

Sustained weakness in the marine business 

  • The marine business undertook provisions for doubtful debts for an oil & gas conversion in 1Q17 and reported pre-tax losses in 2Q17. 2Q17 shipbuilding losses were due to cost overruns and 1-month downtime (due to the weather) at Singapore Technologies Marine Ltd’s (ST Marine) US-based operations. While management has highlighted that it is looking to realign its focus on ship repairs over shipbuilding, sustained weakness in the latter industry could materially drag ST Engineering’s earnings lower over the FY17-19 forecast period.
  • Amidst expectations of additional provisions to be made, we are assuming for the shipbuilding business to remain loss-making in 2017 and 2018. 
  • We note that ST Marine is part of an arbitration proceeding with Hornbeck Offshore Services Inc (Hornbeck) in the US, whereby the latter is claiming USD43.5m from the former. At the same time, ST Marine has asserted counterclaims of USD3.3m against Hornbeck. We believe there may be a case for higher-than-estimated provisions for the marine business if the arbitration case is settled in favour of the US firm.

Shekhar Jaiswal RHB Invest | http://www.rhbinvest.com.sg/ 2017-09-06
RHB Invest SGX Stock Analyst Report BUY Initiate BUY 4.07 Same 4.07