ST Engineering - DBS Research 2018-09-14: Acquisition Boosts Growth Trajectory

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SINGAPORE TECH ENGINEERING LTD SGX:S63

ST Engineering - Acquisition Boosts Growth Trajectory 

• Buys engine nacelle OEM business from General Electric at enterprise value of US$630m.
• Significant transaction boosting earnings growth and climbing the value chain.
• Acquisition PE at 12x (FY18) looks reasonable vs peers’ at 19x. Robust outlook backed by firm order book.
• Maintain BUY with revised Target Price of S$4.30.

Earnings growth gets inorganic push.

• ST Engineering announced a significant acquisition in the Aerospace division, buying 100% of General Electric’s engine nacelle (engine casing) manufacturing business for an enterprise value of US$630m. This deal will help the Aerospace division move up the value chain further into component OEM businesses, and helps ST Engineering to acquire significant intellectual property in advanced composites and other technologies and brings complimentary spare parts and component MRO opportunities.
• We believe the pricing of the deal is fair at around 12x forward (FY18) PE, compared to peers’ 19x PE, especially given strong growth potential, driven by A320neo engine nacelle system program, with 40-50% ramp up potential for that program in the near term. The transaction is expected to be completed by 1Q-2019 and will be earnings accretive immediately.
• We raised our FY19/20F earnings by around 5%/ 9% to factor in the acquisition, and now expect strong double digit earnings growth in FY19.

Where we differ:

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• Demand in ST Engineering’s business divisions should not be affected much by the ongoing trade war tensions, and higher input costs are generally provided for in contracts.  ~SGinvestors.io ~SGinvestors.io ~ Where SG investors share
• Overall, we believe ST Engineering is at the cusp of a ‘next leg up’ in its growth story while trading at reasonable valuations (FY18F PE of 19x is just below mean historical level).

Potential catalyst:

• Significant order wins, M&A activity, and progress with smart city initiatives. 

Valuation: 

• We lift our Target Price to S$4.30 in the light of earnings revisions and is based on a blended valuation framework, which factors in both earnings growth and long-term cash-generative nature of ST Engineering’s businesses. 

Key Risks to Our View: 

• ST Engineering needs to make new acquisitions work in line with expectations. Execution hiccups at new business segments could also derail earnings.

Strategic acquisition to move up the value chain for growth

Big acquisition after a long time.

• ST Engineering (STE) announced that it entered into a conditional share purchase agreement to acquire 100% ownership in MRA Systems, LLC (MRAS) from General Electric Company (GE) at a base aggregate purchase consideration (enterprise value) of US$630m (approximately S$868m). The transaction is expected to be completed by the end of 1Q-2019. This is a significant inorganic growth opportunity for ST Engineering and represents one of its biggest acquisitions to date.
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Moving up into OEM business.

• MRAS is a leading original equipment manufacturer (OEM) specialising in the production of engine nacelle systems, replacement parts and other complex aerostructures for both narrow-body and wide-body aircraft, using advanced composite materials. An engine nacelle is the casing that houses an aircraft engine, providing efficient aerodynamics during flight and thrust reversal capabilities.
• MRAS has a staff strength of around 800 employees and has been operating in a facility in Chesapeake Bay, Baltimore, Maryland, USA for nearly 90 years. MRAS also has an impressive portfolio of IPs and patents covering key technologies for nacelle systems. Additionally, MRAS’s expertise in sophisticated composite structures will further enhance ST Engineering’s future endeavours into other composite OEM products.
• To date, ST Engineering already has composite manufacturing capabilities through its European JV with Airbus, EfW, which produces floor panels for Airbus aircraft.

Ideal target to expand ST Engineering’s OEM and MRO capabilities.

• We believe the addition of MRAS to ST Engineering’s global network will greatly augment ST Engineering’s OEM capacity and compliment ST Engineering’s MRO capabilities.
• MRAS is the sole supplier of a diverse set of mature and next-generation nacelle systems. Of particular significance is its JV with Safran Nacelles, which is the single-source nacelles provider for Airbus A320neos using CFM LEAP-1A engines. MRAS has delivered over 500 LEAP-1A units so far. Other notable single-source programmes include nacelles for COMAC’s C919 LEAP-1C turbofan engine and ARJ21 GE CF34 engine. Mature programs include nacelles for GE engines on B747-8, A330, B767 and Embraer ERJ-190 aircraft types.
• The separation from GE is not expected to affect MRAS’s current relationship with suppliers and joint venture with Safran Nacelles, and GE should continue to work closely with ST Engineering in the future. The nacelles market also opens up component MRO opportunities for ST Engineering, with nacelle systems making up 11% of the component MRO market overall.
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Huge growth potential driven by A320neo order backlog.

• We believe the acquisition will propel ST Engineering’s top-line and earnings. Given the favourable market dynamics and its position as a single-source nacelles provider for A320neo using LEAP-1A engines, we expect significant ramp up in MRAS’s nacelle unit deliveries in the coming years.
• Airbus aims to increase its monthly production of the A320neo to 63 by mid-2019 from the current 55 to accommodate the strong demand for aircraft, driven by the growth in global air traffic and airlines replacing existing fleets with more fuel-efficient models. Of the existing 6,068 orders for the A320neo (57% of all narrowbody aircraft orders), 38% or 2,295 aircraft will be equipped with the CFM LEAP-1A engine, which indicates a massive orderbook of 4,590 nacelles (2 per plane) for MRAS. Airline customers have not decided on engine type for another 35% of A320neo orders or 2,150 aircraft, which represents further growth potential, if a portion of these opt for the CFM engine type.
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• Management expressed their confidence in ramping up capacity for LEAP-1A engine nacelles by ~40-50% post the acquisition. No significant capex is required for this ramp up as sufficient capacity exists at its existing facilities. In addition, a considerable amount of orders to date for the COMAC C919 and ARJ21 aircraft will also underpin healthy demand for MRAS’s nacelles.

An attractive price to pay for a highly synergistic acquisition.

• The base aggregate purchase price translates to multiples of 10x LTM EV/EBITDA and 1.2x LTM EV/ sales. After adjusting for closing adjustments such as underfunded pension obligations, other debt-like items, transaction expenses, net working capital, and other contingent adjustments, net consideration payable to the seller will be roughly US$440m (S$606m).
• The price implies a FY18 P/E multiple of around 12x (derived by annualising 1H18 PBT of US$24.1m and assuming a corporate tax rate of 21%), and thus, the acquisition is expected to be earnings and value-accretive as it is much lower than ST Engineering’s current P/E multiple of around 19x for FY18. The price also implies a P/NAV of around 1.33x and P/NTA of 6.76x, based on NAV of the MRAS assets of US$331.5m and NTA of US$65.1m as of 30th June 2018.
• The only metric where the transaction looks expensive is P/NTA, as a majority of the target’s book value is derived from intellectual property, patents and customer relationships. FY17 PE of around 27x (based on FY17 net profit of MRAS of S$22.4m) also looks a tad expensive, but factors in strong growth in FY18 and beyond, driven by A320neo engine nacelle ramp up.
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• We have identified several OEM peers in the table below that manufacture critical aircraft components. Based on the multiples that peers are trading at, we believe that the deal represents a good bargain for ST Engineering. The acquisition multiples are lower than the average multiples across all measures, especially on the forward P/E basis where the implied acquisition multiple of 12x is significantly lower than the forward P/E ratio of comps of around 19x.

Earnings accretive from FY19 onwards, maintain BUY.

• The acquisition is expected to be closed in 1Q-2019, hence, there will no contribution in FY18, and around 9M of contribution in FY19, with full year contribution from FY20 onwards.
• Given the hefty purchase price, we believe majority of the transaction will be funded by debt as ST Engineering’s funds on hand and operating cash flows is unlikely to be sufficient to finance its capital expenditure, dividend plans and near-term debt obligations. However, given ST Engineering’s excellent AAA credit rating and low cost of debt financing of around 4%, we expect ST Engineering to still achieve solid earnings accretion even after factoring in acquisition financing-related interest expenses.
• We revise up our earnings forecasts for FY19/20F by around 5% and 9% respectively to factor in the acquisition, and we now expect double digit earnings growth in FY19, compared to a flattish trajectory in FY15-17, as ST Engineering returns firmly to positive growth territory, driven by both organic and inorganic growth. Net gearing is expected to climb to around 20-21% post the acquisition, and we believe there is room to gear up further and utilise balance sheet more efficiently.
• Maintain BUY with revised Target Price of S$4.30.

Suvro Sarkar DBS Group Research | https://www.dbsvickers.com/ 2018-09-14

SGX Stock Analyst Report BUY Maintain BUY 4.30 Up 4.100