SATS (SATS SP) - Maybank Kim Eng 2017-11-13: Some Ais Kacang And A Big Bite Of Turkish Delight

SATS (SATS SP) - Maybank Kim Eng 2017-11-13: Some Ais Kacang And A Big Bite Of Turkish Delight SATS LTD. S58.SI

SATS (SATS SP) - Some Ais Kacang And A Big Bite Of Turkish Delight

Upgrade to BUY: Confluence of growth factors 

  • We raised FY19/FY20 profits by 1%/8% and Target Price 16% to SGD5.70 (unchanged 1SD over 5y forward P/E mean) to factor in developments of the past month that may be material sweeteners to medium term growth, in our view. Accordingly, we upgrade from to BUY from HOLD.
  • The JV with AirAsia opens up new markets for gateway services while the MOA with Turkish Airlines may potentially be as big as 60-70% of Singapore’s inflight food business. 
  • 2Q18 core profit was as expected, with 1H18 accounting for c48% of FY18e forecast.

Turkish Airlines (THY) catering is potentially big 

  • While details are scant and discussions between SATS and Turkish Airlines THY (Unlisted) are in the early stages, what is known is that THY is amongst the largest airlines in the world by destinations and it carried c12% more international passengers than Singapore Airlines in 2016 (SIA SP, SGD10.83, Rating: HOLD, Target Price: SGD10.95, see report: Singapore Airlines (SIA SP) - 2Q18 Results Respectable, But Valuations Lofty). 
  • Also, Istanbul’s new airport is expected to be one of the largest in the world, with a capacity of 90m passengers in the first phase of development alone indicating that the SATS kitchen would have a lot of potential to target new airline customers as well over the medium term.

AirAsia (AIRA) opens Malaysia for gateway services 

  • SATS’ proposed JV with AirAsia (AIRA MK, MYR3.24, BUY, TP MYR3.75 will provide access to the Malaysian market for gateway services (already present in food solutions through an associate stake in Brahim’s Catering). 
  • While the street has some concerns this comes at the expense of giving up a stake in one of its jewels in the crown i.e. 40% of Singapore Changi Terminal 4; we note that AIRA carried 56.6m passengers in 2016 (26.4m were with its Malaysian operations) versus Changi Terminal 4’s capacity of 16m. Also, the real upside with this JV lies with acquiring new airline customers in the 15 odd Malaysian airports that AIRA has operations in.

Qantas coming back; non-aviation growth on track 

  • After a hiatus of five years, Qantas (QAN AU; Not-Rated) is moving its connecting hub for UK flights back to Singapore from Mar-2018, which is incrementally positive for SATS. And in key non-aviation ventures, the first large scale commercial kitchen in China is ramping up well with c18- 20 customers already on board since commencing operations mid-2017.

Forecast revisions FY19/FY20 EPS raised 1-8% 

  • We have raised our revenue forecast for FY20 by 14% and our net profit forecasts for FY19/FY20 by 1%/8%. Our FY18 forecasts are unchanged.
  • The key reasons for the changes result from factoring in the estimated impact of SATS GTRH and inflight catering at Istanbul’s new airport.
  • We have also marginally lifted our non-aviation food revenue forecasts after hearing that the first commercial kitchen in China is ramping up well after starting operations a few months ago and construction of the second one is on track.
  • Our estimates are ahead of consensus for both FY19/FY20. They are significantly higher for FY20 as we believe consensus has yet not fully captured the new ventures with AIRA and THY.

Valuation & Risks 

Raised TP by 16% to SGD5.70 

  • Following our profit forecast revisions, we raised our TP by 16% to SGD5.70 from SGD4.90 based on 21x (unchanged), equal to 1 SD over the 5y forward P/E mean for mid FY19/FY20 EPS. We believe a 1SD premium over the mean is justified by: 
    1. early stages of another earnings upswing panning out;
    2. expectation of another c200bps ROE improvement over a three-year period. 
    • Accordingly, we upgrade to BUY from HOLD.

Risk factors 

  • The key downside risk factors are as follows: A deterioration in airline industry fundamentals that will translate into pricing pressure and increasing competition amongst aviation services providers.
  • Execution and market risks exist in SATS’ various new ventures and investments. While the progress has been encouraging for a number of these ventures, payback periods are long for most and poor execution that translates to a drag on profits from its legacy businesses would be a negative. Risks specific to the new ventures with AIRA and THY are elaborated in the note.
  • More specifically, TFK Japan’s performance has been disappointing in the past couple of quarters and the market remains very competitive.
  • Any further material erosion in customers could lead to losses and erode profits from the rest of the group.
  • Confluence of growth factors We expect a number of growth factors to fall in place for SATS over the next 4-6 quarters. In our view, the one with the largest growth potential is the catering contract for THY under discussions for Istanbul’s new airport.
  • Other drivers are the JV for gateway services/ground handling with AIRA for the Malaysian market with a view to expand elsewhere in ASEAN, the resumption of Qantas’ UK flight segment through Singapore, the large scale commercial kitchens being progressively rolled out in China, the JV with DFASS and growth in the Hong Kong cargo terminal with the entry of an airline strategic shareholder.

We discuss the recent two key announcements below.

A big bite of Turkish Delight: MOA with Turkish Airlines 

What we know: 

  • SATS entered into a memorandum of agreement with THY relating to providing in-flight catering services to THY and other airlines at the Istanbul New Airport. The MOA is valid for six months unless mutually terminated during which period both parties will evaluate the opportunities leading to the execution of definitive agreements.
  • Istanbul’s new airport is currently under construction and reportedly due to be inaugurated sometime in 4Q 2018. The first phase of this airport is expected to have a passenger capacity of 90m and when fully finished in stages in around 2030 is expected to be the largest in the world with a 150m passenger capacity. To put things in perspective, Singapore’s Changi Airport Terminals 1-4 have a combined capacity of around 82m while Terminal 5, expected around 2025, will add another 50m capacity.
  • Istanbul’s Ataturk Airport will be closed down and operations moved over to the new airport once it is ready. The airport saw 60.1m passengers in 2016 (compared to 58.7m for Singapore Changi Airport).
  • Turkish Airlines is amongst the largest airline carriers in the world by number of destinations according to various aviation periodicals. As of last reported FYE Dec-2016, THY carried 35.5m international passengers, around 12% more than SIA (FYE Mar-2017). In addition, THY also has significantly large domestic operations which carried 27.3m passengers in the same year.
  • In additional to the potential market being large, Istanbul also serves a very large proportion of long haul flights between Asia and Europe by virtue of Turkey’s geographic location in Central Asia – a positive for unit meals/flight.
  • SATS’ management indicated that while discussions are on-going, the capital commitment will essentially be to fit out the kitchen and not involve building or construction.

Important variables we do not know: 

  • We do not know what structure this potential operation in Istanbul will have. It could be a JV or a wholly owned operating entity.
  • We do not know what the fee structure to the airports authority in Turkey will be i.e. whether it will be a percentage of revenues, a licence fee or a profit-sharing arrangement.
  • We do not know if there is potential for SATS to expand its offering beyond food solutions to include gateway services and cargo handling – if so, the market opportunity could be substantially bigger.
  • We do not know either the level of gross or unit meals currently consumed by THY (this would depend on the mix of long vs. short haul, international vs. domestic and full service vs. LCC flights).

Our back-of-the-envelope assumptions: 

  • We have assumed that the New Airport will commence operations in late 2018 (SATS FY19) and the kitchen will ramp up volumes over a three year period after. We have also assumed that, subject to performance clauses of course, the agreement would be quite long term in nature else SATS would not consider a significant investment in fitting out a large in-flight kitchen.
  • We have assumed an approximate unit meal ASP similar to Singapore (given that international inflight kitchens are fairly competitive with pricing) and capex levels based on the recent greenfield large scale commercial kitchen in China.
  • We have assumed an EBITDA margin much lower than Singapore at initially 7% and gradually ramping up to 12% (Singapore EBITDA margin at c19-20% levels). This is based on EBITDA margin disclosure by THY’s existing inflight caterer at Ataturk Airport, Austrian food and restaurant conglomerate DO&CO AG (DOC AV; NR). However, what we do not know if DOC’s inflight catering EBITDA margin is lower because of Turkey operations or one of many of the other numerous European airlines it services and cities it operates in.
  • To get a rough gauge of what the value of the Istanbul New Airport operation would be we have assumed a WACC of 12% (COE 15%; Cost of Debt 11%). Management suggested it would likely look to match liabilities and assets in Turkey given the currency volatility and it’s open to taking on some gearing for the project.

What could go wrong: 

  • Of course the single largest risk to our thesis is if the venture does not go through at all for whatever reason after the six-month MOU period is over. Based on the sharp share price re-rating witnessed immediately post-results, the street appears to be building in optimistic expectations about the Turkey expansion as well.
  • Greenfield execution risk in a new market. While SATS has a long track record of operating overseas, most of the entities are either associate companies or JVs with strong local partners (TFK Japan is the notable – and sizeable – exception).
  • Currency risk as the Turkish Lira has been quite volatile in recent years, exacerbated by various political events, and has seen a steady depreciation against the Singapore Dollar over the past five years.

Some Ais Kacang – JV with AirAsia 

What we know: 

  • SATS and AIRA formalised a ground handling partnership where SATS will acquire 50% interest in AIRA Ground Team Red Holdings, its gateway services arm in Malaysia, in exchange for 80% stake of its Changi Terminal 4 to be injected in the JV where both airlines will be 50:50 partners. In addition SATS will pay a cash consideration of SGD119.3m.
  • The JV will subsequently be renamed SATS Ground Team Red Holdings Sdn Bhd (SATS GTRH).
  • Prior to this deal AIRA was self-handling its gateway services requirements in its 15 airports in Malaysia.
  • AIRA carried 56.6m passengers in 2016 of which 26.4m were from its AirAsia Malaysia operations. SATS management cited that the passenger traffic at the 15 airports in Malaysia with AIRA operations stood at around 88m. This is relative to Singapore Changi Terminal 4 passenger capacity of 16m.
  • Passenger air traffic in Malaysia has been growing at high single-digit to low double-digit levels since 2011.
  • SATS’ management stated that the immediate opportunity lies in airports like KLIA, Penang, Kuching and Kota Kinabalu that have high air traffic throughput and where AIRA is amongst the leading operators in terms of flight frequency. With existing baseload volumes coming from AIRA, SATS GTRH can competitively target other airlines as potential new customers at these airports.
  • Over the longer term SATS GTRH will likely explore gateway services opportunities in Thailand, Philippines and others where SATS does not have any material presence.

Important variables we do not know: 

  • We do not know the volumes, pricing or profitability level of the existing Malaysian ground handling operations under AIRA.
  • We do not know the scale and ability of AIRA’s existing ground handling operation and whether any material investment might be required by SATS GTRH to either upgrade capabilities or expand capacity as market volumes grow.
  • We do not know how Changi Terminal 4 volumes will pan out as it has only recently commenced operations and it’s still ramping up with a handful of airlines that have moved across from the other terminals.
  • We do not know what the capital structure of SATS GTRH will be.

Our back-of-the-envelope assumptions: 

  • We have used our estimate of Singapore ground handling revenue per passenger as a starting point and used a one-thirds discount to arrive at an estimated ground handling rate for AIRA Malaysian operations. We believe that as the operations have been principally serving the parent airline, rates and margins are likely to be much lower than that seen for SATS ground handling operations in Singapore.
  • We have assumed AIRA Malaysia passenger growth of 5% per year.
  • We have assumed an initial low 4% EBITDA margin for SATS GTRS and gradually ramping up to the 7% level (in comparison SATS Gateway Services has c9-11% EBITDA margins).
  • We have assumed Singapore Changi Terminal 4 will ramp up to c10m passengers annually over the next 5 years.
  • We have assumed SATS GTRS will serve c45m new passenger customers in Malaysia over a five-year period i.e roughly half the market that exists in the 15 Malaysian airports today. We have not assumed any contributions from new overseas markets.

What could go wrong: 

  • AIRA’s ground handling operations are materially unprofitable and cannot be turned around easily (due to pricing or other factors) under SATS GTRH.
  • SATS GTRH is unsuccessful in winning new airline customers and passenger volumes at the various Malaysian airports.
  • Air passenger traffic in Malaysia stalls or significantly contracts.

SATS 2Q/1H FY2018 Results Highlights 

In-line excluding one-off: 

  • 2Q18 reported profit of SGD72.2m was up 16% YoY including a gain from the disposal of assets on de-consolidation of SATS Hong Kong. Excluding this one-off, 2Q18 core profit of SGD65.2m was up 5% YoY and in line with our expectation with 1H18 profit accounting for c48% of our earlier FY18 forecast. 
  • Given we were slightly ahead of the consensus estimates, we believe the results would have marginally beat street expectation.

Revenues flattish due to Japan: 

  • 2Q18 revenue was slightly down 0.8% (would have been slightly up 0.9% excluding the deconsolidation of SATS HK). Gateway Services grew well at 2.3% but Food Solutions declined 3.1%. TFK Japan continues to be the reason for Food Solutions’ weakness for a couple of quarters now due to the loss of a customer (Vietnam Airlines) and lower volumes from Delta Airlines as well. 
  • Management indicated a new customer came on board in Oct 2017 which, going forward, should compensate for some of the lost volumes.

Costs under control: 

  • Operating expenses dropped a minor 0.3% despite the cessation of rebates from Changi Airport Group and increases in licence fees due to control over staff, premise and other costs.

Stellar Associate/JV performance: 

  • Associate profits grew a solid 57% YoY, better than expected. While the performance was broad based, of note amongst the growth contributors were Indonesia and India plus the increased stake in Evergreen Sky Catering, Taiwan (from 15% to 25%).

Interim dividend unchanged YoY: 

  • Interim dividend of 6cts per share announced.

Neel Sinha Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-11-13
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