ST Engineering (STE SP) - Maybank Kim Eng 2018-03-12: Renaissance Revival

SGinvestors.io

SINGAPORE TECH ENGINEERING LTD S63.SI

ST Engineering (STE SP) - Renaissance Revival

Upgrade to BUY: reigniting growth 

• After three lacklustre years due to tough market conditions and restructuring costs, growth catalysts are falling in place. The aerospace landscape is improving, recent acquisitions hold growth promise, and the rationalisation at Land Systems and Marine divisions is largely completed.
• The strategy to better integrate the divisions could result in revenue and cost-synergy surprises. 
• We adjusted FY18/FY19/FY20F profit by5%/+7%/+14% and raised our DCF-based Target Price by 31% (previously based on 18x FY17 EPS) to SGD4.15 from SGD3.17. Upgrade to BUY from HOLD.

A confluence of drivers for FY18-20 

• Aerospace MRO (Maintenance, Repair & Overhaul) is witnessing green shoots from the recovery in global trade, some capacity rationalisation and growth in the global aircraft fleet. 
• We see steady demand for transport and satellite communications solutions for the Electronics division, and new drivers from smart-city and ICT solutions, both enhanced by the SP Tel (Unlisted) investment. 
• Land Systems, unshackled from the prior drag of China units, holds growth promise in the autonomous mobile robot market with its Aethon (Unlisted) acquisition.
• Prospects for Marine remain challenging in the near term but cost rationalisation has been largely completed and an oil price recovery may alleviate the situation sooner than expected.

Greater integration to leverage core strengths 

• STE’s core-value proposition is offering tailored customer solutions using its deep pool of engineering and technological expertise in multiple sectors. 
• Management’s focus on forging greater integration across what have historically been silo-like divisions is a big positive. This initiative could surprise on the upside on revenue (cross-selling) and cost synergies (central procurement, standardised systems) in coming 2-3 years.

Target Price raised 31% to SGD4.15 

• We raised our Target Price by 31% to SGD4.15 due to forecast revisions and the change in our valuation methodology to DCF (previous Target Price based on 18x FY17 EPS) at 8.1% WACC, 2% TGR and 20% ND/E assumptions. 
• The top-two risks to our forecasts are a material downturn in Aerospace and further write-offs in Marine.

REIGNITING GROWTH

• ST Engineering (STE) is Singapore’s largest integrated engineering group providing customised solutions in the aerospace, electronics, land systems and marine sectors. Roughly 65-70% of its revenues are derived from commercial contracts and the balance from defence orders.
• STE’s has characteristically been involved in a lot of M&A globally over the years. It has typically invested in or acquired entities to secure technologies that can be applied or commercialised in its engineering solutions or for various reasons of market structure, regulation, etc. that justify an on-ground presence in various geographies. Apart from the industry cycles in its operating sectors, inorganic drivers from such M&A corporate actions have also played an important role in its revenue and profit growth cycles.
• Performance in the past three years was weighed down by three of its four businesses (Aerospace, Land Systems and Marine) facing industry headwinds in specific markets (details in the section on outlook for divisions).
• We expect a resumption of growth in 2017-2020F from five factors:
  1. the aerospace landscape has been improving since mid-2017, triggered by the rebound in global trade and better-than-expected passenger traffic growth;
  2. the outlook for its electronics solutions remains robust and could hold an upside surprise with governments increasing investment in smart city infrastructure, i.e. smart street lighting, water management, metering, cyber-security etc; 
  3. rationalisation of its Land Systems and Marine business is largely done;
  4. recent acquisitions, particularly SP Tel and Aethon are important additions to capabilities for tapping high growth in enterprise ICT, cyber security solutions and the autonomous robot market; and
  5. greater integration across the business units as well as creation of new platforms to partner start-ups and fund technology gaps (initially seeded with USD150m) should enhance existing capabilities and materially speed up time-to-market for new solutions.
• One other positive wild card is some potential upside from increase in US defence spending, which the Trump administration is expected to do but has not quite panned out yet (STE derives c20-25% of revenues from the US market).

Relative share-price underperformance should reverse 

• ST Engineering (STE)’s relative share price performance has lagged the benchmark Straits Times Index over the past 12 and 24 months by around 18% and 12%, respectively. The absolute price returns of -8% and 12% over this 12- and 24-month periods has also lagged a number of the Singapore-listed industrial sector counters.
• With STE’s core PATMI growth expected to reach an inflection point this year and deliver 11% CAGR in FY17-20F, much higher than our c6.5% estimate for our coverage universe aggregate, we would correspondingly expect a reversal of fortune in its relative underperformance of recent years.

FY17 order intake strong and backlog at record levels 

• In our view, FY17 was likely one of the best new-contract-win years in STE’s history. The company does not disclose all new contracts. It does, however disclose the order-book balance at the end of each reporting period.
• Our estimates for new orders per year differ from what might be inferred from company disclosures due to two key reasons:
  1. a material number of new contracts might not be disclosed due to various reasons of limitations in information disclosure for some defence and government contracts, as well as commercial sensitivity in others; and
  2. the company does not announce firm contracts that are less than three months old or orders that might be deemed short term and somewhat recurring in nature, like ship repair, satellite and communications product sales, etc.
• Our own estimates for STE’s new orders per year are based on the assumption that the order book balance at the beginning of the year less revenues recognised plus new order intake in the year will translate into the order book balance at end of the year. On this basis, we estimate new orders in FY17 stood at cSGD8.2b, the highest level in well over a decade. 
• Also, the balance order book of SGD13.2b at end-FY17 is at an all-time high and at c2x trailing 12 month revenues.

ROE recovery to high-20s expected 

• Post the past three years of relatively lower ROEs in the c22-25% range due to restructuring and one-off charges in various operating units, we expect returns to recover to the high-20s level by FY20. These forecast ROE levels are not out of the ordinary; the company delivered 25%+ ROE for 15 of the past 20 years.
• Moreover, we believe ROE’s could trend even higher than our forecast levels from two factors: 
  1. Increasing leverage – STE has a relatively conservative balance sheet, which has historically managed to meet its organic growth needs, acquisitions and a sizeable dividend payout (80-100% of profit in the past 20 years) largely from internally generated cashflow and any divestment proceeds. We believe management is now more open to adding some debt to the balance sheet for funding acquisitions going forward.
  2. ‘Sweating’ assets further – we also note that asset turnover has been quite range bound at c0.8x for almost a decade. We believe one of the key reasons for this is because the various business divisions have largely operated in a stand-alone manner in the past thereby curtailing the level of revenue synergies that could potentially be realised from crossselling capabilities and products, as well as the avenues for cost rationalisation from integrating systems, centralised procurement, etc.
• This should change - breaking down the historical silo-like operating norm and greater cross-divisional integration of capabilities is a focus area for the management team.

Forecast revisions 

• Our profit forecasts for FY18/FY19/FY20 have been revised by -4.5%/ +7.2%/ +14.4% from a combination of adjustments to our growth expectations in the existing businesses of the various divisions, as well as imputing incremental contributions from recent acquisitions. 
• Our profit estimates for the three years are ahead of Bloomberg and Factset aggregate consensus estimates by 1-15%.

OUTLOOK FOR DIVISIONS  

1. Aerospace: poised for a conversion resurgence 

• ST Engineering (STE)’s Aerospace division is organised under three broad operating clusters: 
  • Aircraft Maintenance and Modifications (AMM), 
  • Components and Engine Repair and Overhaul (CERO), and 
  • Engineering and Materials Services (EMS).

Recent contract wins/pipeline 

• Green shoots for a rebound in STE’s passenger-to-freighter (PTF) conversion work is already in place, in our view. Its JV with Airbus in Germany secured four A330- 300 PTF conversions from DHL Express with options for 10 more, an A330 prototype PTF for Egypt Air and 10 A321 PTF conversions for Vallair Aviation Group. STE also secured various engine maintenance contracts in 2017.
• We are bullish about a growth recovery in AMM, the largest cluster, from growing demand for freighters riding on the coattails of the global trade recovery seen in 2017. The World Trade Organisation expects overall growth in goods trade to remain above trend for 2018 at c3.2% y-o-y (vs. the 3.6% estimated for 2017). This should drive acceleration in PTF work in the near term as current market conditions are favourable with ready availability of mid-life and older generation aircraft that are due to be replaced over the next three years. 
• According to CAPA-Centre for Aviation, 2017 saw aircraft OEM market leaders Boeing and Airbus deliver a combined 1,418 aircraft (of 1,714 deliveries for the industry) with this set to increase to 1,705 aircraft for 2018 based on the order backlog for the two companies. Boeing (BA US; CMP USD348.73; NR) and Airbus (AIR FP; CMP EUR97.09; NR) also forecast long-term freighter demand over the next two decades to range from 1,950 to 2,480 aircraft, of which they expect c58-60% to be met by conversions.
• We also expect CERO and EMS clusters to sustain revenue growth of c3-5% from a growing MRO market due to a larger base of aircraft in service (CAPA states that the global fleet of commercial aircraft grew 4% y-o-y over 31,000 at end-2017 with the order backlog at a record c54% of aircraft in service). Hence services related to component, engine support, training, systems and software engineering, interior retrofit and design, etc. should continue to see firm demand. Airbus estimates in global MRO services market size at cUSD60b currently and forecasts growth of around 3.5% CAGR over the next two decades with the Asia-Pacific region accounting for the highest growth rate and largest share of cumulative industry revenues over this period.
• STE management mentioned that CERO engine shop visits picked up during 2H17. This suggests to us there should be sustained momentum in this area for the next 12-18 months as a particular engine version goes through a maintenance cycle - one of the key engine families that STE has core aftermarket support expertise is the CFM56 that powers a large segment of the Airbus A320 family, A340, Boeing 737 and Boeing Next Gen, amongst others. 
• We believe the growth potential for CERO could have been greater at around high single-digit levels if not for a couple of long-term structural headwinds, like aircraft OEMs gradually encroaching in the aftermarket and new-generation aircraft having longer maintenance cycles.
• While our MRO services outlook is positive, what gives us a high degree of confidence that STE will benefit from this growth is the company’s track record of 40+ years in the business and market position. It is the world’s largest aerospace MRO service provider in terms of man-hours (and one of the three independent amongst the top ten companies) with a large footprint of facilities across Asia-Pacific, Europe and North America.
• In addition, Singapore’s drive to grow this sector over the past decade through various initiatives and the development of a 320 hectare aerospace industrial park has resulted in a large industry support services and manufacturing cluster of over 130 companies. In our view this also provides STE some comparative advantages in its home base versus most alternative MRO locations in the region. 
• The Economic Development Board of Singapore estimates that the country now accounts for around 10% of global aerospace MRO output.

2. Electronics: enabling smart cities and more 

• ST Engineering (STE)’s Electronics division is organised under three broad operating clusters: 
  • Large Scale Systems Group (LSG), 
  • Communications & Sensor Systems Group (CSG), and 
  • Software Systems Group (SSG).

Recent contract wins/pipeline 

• Recent wins include rail contracts for communication and control systems, automatic fare collection, platform screen doors, supervisory control, data acquisition and passenger information systems for various projects in Singapore, Malaysia, Thailand and the US. The company has also secured supply contracts for satellite and broadband communications products to Somalia, Mexico and Russia and supply of smart sensor network systems for smart-city management in China, Europe, India and the US. STE also signed MOUs with various partners to develop cyber security offerings and to develop intelligent aviation and maritime systems for the Southeast Asia region. STE launched a new product Black Computer L1000 as part of its cyber security related hardware offerings that physically separates internal and external network domains.
• Large Scale Systems Group (LSG) products include rail transportation systems, intelligent building management systems and electronics systems integration platforms (for military applications), amongst others. The business has a long track record in executing subway and metro rail transport projects across various countries in the AsiaPacific and the Middle-East region (STE customises almost all types of electronics modules for such projects except those required in signalling equipment and rolling stock).
• We expect steady growth in this segment to be sustained for a number of years given most countries in these regions are still increasing investments in urban transport infrastructure projects. Smart city related solutions are expected to be a key new growth area for LSG with many governments across the world increasing investments in mobility, efficient energy and utilities usage, connectivity and security in major cities light of a seemingly unstoppable urbanisation trend driving up congestion, cost of living and crime. Major cities in western counties have been early adopters of various smart-city solutions but increasingly we see China, India and various countries in the Middle East also ramping up investments in this area. Estimates on market size for smart-city investment over the next five years vary greatly depending on scope across different white papers on the subject from around USD200b at the lower end to over 5x this number.
• Communications & Sensor Systems Group (CSG) products include wireless, satellite, broadband and data communications solutions, ICT infrastructure and cyber security solutions, electo-optics & radar systems. The CSG cluster is also one of the world’s largest VSAT (very small aperture terminals) systems manufacturers for enterprise use in part due to a US acquisition in the last decade, now renamed VT iDirect. 
• We are bullish about this segment – until just a few years ago the demand for VSAT communication solutions was limited to government agencies, oil and gas firms and commercial shipping companies mainly for military use and accessibility solutions in remote locations. But the versatility of the technology in handling voice, video and data signals and cost effectiveness relative to terrestrial based alternatives has driven an acceleration in adoption across various other sectors in recent years, such as agriculture (crop monitoring), meteorology and disaster management (satellite imagery of crops, hurricanes, volcanic activity etc.), education and healthcare (government initiatives in developing countries to connect schools and hospitals), enterprises (to connect to remote operating centres across the world) and even individual end-users. Various third-party industry reports estimate the VSAT market to witness between 7-10% CAGR over the next three years.
• Software Systems Group (SSG) develops various customised training and simulation systems, enterprise and e-Government solutions and provides data centre solutions and managed services.

3. Land Systems: some gain after the pain 

• ST Engineering (STE)’s Land Systems division is organised under three broad operating clusters: 
  • Automotive (Auto), 
  • Munitions & Weapons (M&W) and 
  • Services and Trading (S&T).

Recent contract wins/pipeline 

• STE won defence and commercial contracts for 40mm munitions, next-generation armoured fighting vehicles, road construction and other speciality vehicles. It completed the delivery of 16 Terrex 2 armoured fighting vehicle prototypes to the US Marine Corps and six next-generation delivery vehicle prototypes to the US Postal Service. Also, it completed delivery of autonomous double-decker buses to Singapore’s Land Transport Authority, which is currently undergoing road trials. 
• STE signed agreements with SAIC to develop prototypes for the US Army Mobile Protected Firepower programme and also signed an MOUs with Starhub to deploy Aethon autonomous mobile robots, as well as SBS Transit (SBS SP; CMP SGD2.63; Not rated) for rail maintenance and engineering services to improve operational productivity.
• The Auto cluster suffered in 2014-2016 from very adverse market conditions for its China subsidiaries, from a slowdown in Chinese construction activity, a high level of competition from other existing players and, we believe, also a relative lack of scale in its own operations. Management decided to exit this business in 2016, taking provisions and impairment charges for the subsidiaries.
• We expect the Auto cluster revenues and profits to recover, driven by a number of projects that hold attractive growth potential. Prototypes delivered to the US Marine Corps, US Postal System and Singapore’s LTA could pave the way for larger-scale orders.
• Additionally Aethon’s TUG® autonomous mobile robots (AMR) have numerous deployment opportunities in Singapore and the region in healthcare, hospitality, logistics and manufacturing sectors. In our view, Aethon’s robots sit well with the Singapore government’s objectives of increasing labour force productivity through automation and reducing foreign labour dependency. There are a number of players in the autonomous robot marketplace but we believe the TUG® is somewhat unique in that it requires relatively little investment in infrastructure modifications in customer facilities (and hence can be deployed quickly). The robot can carry a payload of up to 635kgs, is self-charging, and does not require a dedicated access path or tracking installation on floors, utilising just a detailed programmed facility map for mobility and uses WiFi or 900Mhz channel to communicate with elevators, automatic doors and alarm systems. The TUG® robot is already in operation in over 200+ live customer sites (including 140 hospitals and a few hotels in the in the US).
• We expect M&W revenue growth to tick along at low-single-digit levels – STE’s weapons sales (a large part to Singapore’s armed forces is a fairly steady business) and its flagship 40mm munitions is a mature product, although the company does continue to innovate in variants and applications (some variants we recently saw at the 2018 Singapore Airshow event were developed for anti-drone defence). The upside wild card for M&W growth business could potentially be breakthrough to new markets outside the list of countries / governments that typically make up its customer list.

4. Marine: No panacea for the slump just yet 

• ST Engineering (STE)’s Marine division is organised under three broad operating clusters: 
  • Shipbuilding, 
  • Ship repair and 
  • Engineering.

Recent key contract wins/pipeline 

• Shipbuilding programme for the Republic of Singapore Navy (RSN) for Littoral Mission Vessels on-going construction in various stages for the fifth to eight vessel. 
• Construction for other vessels, i.e. three fire-fighting vessels of the Singapore Civil Defence Force, two LNG powered container roll-on roll-off (ConRo) vessels for Crowley Holdings (Unlisted), a vehicle and passenger ferry for a US state government department and some smaller on-going contracts, as well.
• STE did not see any major now shipbuilding contracts in 2017. It was part of a winning consortium (40% associate stake) that was awarded a 25-year Design-Build-Own-Operate concession contract for Singapore’s fifth seawater desalination plant with a 30m gallons/day capacity.

Our near-term outlook for the Marine division remains muted. 

• The RSN shipbuilding contacts should continue for a few years, in our view as the new Littoral Mission Vessels being built will progressively replace an older class of naval patrol boat in service since the 90s. The LNG powered ConRo vessels are unique in design and engineering but it is too early to say whether the product could see interest or demand from elsewhere for more units (as this was a first for STE, construction of these vessels involved additional cost provisions in FY17 due to order variations and the learning curve). The high growth years for shipbuilding in FY11-FY14 were partly fuelled by demand for oilfield services related vessels. We believe this is unlikely to repeat itself in the coming 2-3 years, despite the modest recovery in oil prices as the market is still digesting the excess capacity in oilfield services vessels that was built during the last upcycle.
• The ship repair market remains muted too as shipyards saddled with excess capacity given fewer newbuild jobs are competing aggressively for repair business. However, we do anticipate some recovery for ship repair starting around 2019 given the International Maritime Organisation’s requirement to meet more stringent ballast water and gas emission standards that kick in from 2020 (but this incremental demand will be gradual as dry-docking for heavy repairs typically takes place once every five years, and hence companies are given up to end 2024 to comply).
• The seawater desalination plant contract is a first for STE. Engineering, procurement and construction aspects of the project should be underway in 2H18. While we expect associate profit contributions in the early stages of the project will be fairly modest, there are two strategic aspects to this contact win: 
  1. it will provide a long-term recurring income stream for the division, which has been the most exposed to ‘lumpy’ contract business of the four divisions; and
  2. it will allow STE to develop capabilities in a new business that could potentially be marketed for new projects in the many other geographies that the group conducts business in.

VALUATION 

Target price and methodology 

• We value STE on a discounted cashflow (DCF) basis using explicit forecasts to FY30 and terminal value based on a 2% long-term growth rate.
• Our other key assumptions are a WACC of 8.1% and long-term capital structure with 20% net gearing (vs. FY18 forecast level of 14%). Our target price is SGD4.15. Our valuation methodology was changed from a one-year forward P/E multiple.
• Our earlier target price of SGD3.17 was based on 18x FY17 EPS (0.5SD below 5- year average to reflect the growth slowdown and declining returns expected in FY16/FY17).

Historical trading bands 

• STE is trading at a slight discount of c5% and c9% to its respective five-year forward P/E and P/BV averages of 19.2x and 4.9x. We believe the stock is likely to trade back to forward P/E levels of 20-21x, similar to the levels witnessed in the last profit-growth-recovery cycle in 2010-2014 (as well as during the pre-GFC 2005-2007 period).

Peer multiple comparisons 

• STE trades at 16.1x FY19 P/E, at a premium to the Singapore large cap industrials average of 14.1x, but it also correspondingly (and consistently) generates a much higher return on equity than all peers in this category. STE’s FY19 P/E is at a discount to its peer-basket average of international aviation services companies at 21.6x, as well as international defence and engineering companies at 18.4x.
• We also note that given the mix of sectors and number of sub-sectors STE’s operations are involved in, none of the companies in these peer baskets have a business mix that make it directly comparable to STE.

KEY INVESTMENT RISKS TO THESIS

• The key downside risks to our positive outlook for the stock and our profit forecasts are the following: 
  1. Aerospace segment: structural threat from aircraft OEMs, like Boeing and Airbus getting more aggressive in expanding in the aftermarket MRO space. Price competition in aerospace driven by smaller players struggling with excess capacity and fixed overhead. Sustained spike in oil prices that makes the economics of PTF conversions of older aircraft less attractive (versus newbuild aircraft).
  2. Electronics segment: Global macro downturn that results in cut-backs by governments for urban transport infrastructure and smart-city development projects. Emerging new technologies that have performance and deployment-cost advantages over VSAT based systems.
  3. Land Systems segment: Failure to ramp up scale in the autonomous robot sector for various reasons. Material cutback in defence spending and security budgets in Singapore and STE’s other key markets for armoured vehicles and munitions sales.
  4. Marine segment: Recovery in new shipbuilding orders slower than expected. Ship repair operations remain depressed from stiff price competition from yards with excess capacity. Further losses or write-downs required in existing contracts.
  5. Others: Currency risks arising from adverse movements of the Singapore Dollar against foreign currency denominated revenues. Interest rate risks from expectation of rates rising across most markets (we have imputed a 30bps increase in weighted average borrowing costs from FY17 levels).

Neel Sinha Maybank Kim Eng | Derrick Heng CFA Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2018-03-12

Maybank Kim Eng SGX Stock Analyst Report ADD Upgrade HOLD 4.15 Up 3.170