ST Engineering - Maybank Kim Eng 2018-09-17: A Big LEAP


ST Engineering - A Big LEAP

Making the biggest acquisition in its history

  • ST Engineering’s proposed acquisition of 100% of Middle River Aircraft Systems (MRAS) from General Electric (GE US; USD12.68; NR) for USD630m on a cash-free, debt-free basis holds multiple positives in our view. The purchase will be earnings accretive immediately when closed in 1Q FQ2019.
  • We raise FY19E/FY20E PATMI by 10%/9% to factor in the event and our DCF-based Target Price by 5% to SGD4.35 from SGD4.15 (WACC 8.1%; TGR 2% unchanged).

Key positives: strategic fit, growth, synergy

  • From roots in airframe, components and engine MRO, ST Engineering’s aerospace business has been moving up the value chain with subsequent expansion to aircraft conversion and floor panel manufacturing (JV with Airbus [AIR FP; EUR106.20 NR]). This acquisition will enable ST Engineering to become more firmly embedded in the aircraft manufacturing chain with OEM capability and IP in nacelles and complex composites design.
  • MRAS should be a meaningful growth contributor from the onset as its balanced portfolio of next-gen and mature nacelle programmes includes the LEAP-1A engine that powers the new A320neo and is Airbus' new engine option for its A320 aircraft family. MRAS is the single-source contractor for these programmes.
  • We also expect medium-term synergies with ST Engineering’s existing global MRO business as MRAS could open doors for the LEAP family and other MRAS- nacelle-related engine aftermarket work with airlines currently not ST Engineering MRO customers.

Valuation moderate; funding not an issue

  • The USD630m debt-free, cash-free purchase price translates to a trailing 10x EBITDA and 1.2x revenue for the 12 months ending June-2018, and on a pro-forma basis MRAS would have contributed to an 11% profit uplift for 1H18 for ST Engineering (ignoring any funding costs). In comparison, pre-MRAS announcement, ST Engineering traded at a trailing 12.7x EBITDA and 1.5x revenue for the same period.
  • Despite the size of the acquisition, ST Engineering should be able to comfortably fund the net consideration of cUSD440m (difference from USD630m base price due to under-funded pension liabilities and debt, etc.) through internally generated cashflow and borrowings.
  • We forecast FY19E net gearing to increase from our earlier 15% estimate to a revised very manageable 38% level post this acquisition.

About Middle River Aircraft Systems (MRAS)

Profile: Long history in the aviation industry

  • MRAS is an established Baltimore, US-based OEM of engine nacelle systems (i.e. housing/cowlings/jackets typically for engines or even SatCom equipment and weaponry, etc. that is separate from the aircraft fuselage) with a c90 year history in the aviation industry.
  • MRAS has a balanced nacelle portfolio of customers using mature/legacy engines as well as next-gen engines, all of which are single-source contracts.

Current portfolio: Balanced next-gen and mature programmes

  • In our view MRAS' key next-gen nacelle programme with growth potential for the next 8-8 years is for the CFM’s LEAP-8A engine that powers the A888neo and is Airbus' new engine option for its A888 aircraft family. CFM is a JV between General Electric and French aerospace company Safran (SAF FP; EUR888.88; NR).
  • MRAS' nacelle programmes for other engines that power commercial jets are:
    • LEAP-8C (powers the COMAC C888 jetliner)
    • CF88 (powers regional aircraft build by Embraer (ERJ US; USD88.88; NR) and COMAC).
    • Passport (powers Bombardier's 8888 business aircraft),
    • GEnx (used in Boeing 888-8) and,
    • CF8 (broad-based used in many wide-body aircraft).

Growth: LEAP-1A programme has best growth outlook for 3-5 years

  • From MRAS’ current portfolio, we believe the LEAP-8A nacelle for the Airbus A888neo has the highest growth potential over the coming 8-8 years.
  • According to industry data as of June-8888, the total orders for A888neo stand at slightly over 8,888 aircraft, of which c8,888 have chosen the LEAP-8A engine and 8,888 are still unannounced (the rest have chosen a competitor's engine, i.e. Pratt & Whitney GTF).
  • Separately, Airbus is reportedly ramping up production given its record order backlog. According to ST Engineering, Airbus plans to scale up A888neo production from 88 to 88 units a month by mid-8888.
  • Meanwhile, for MRAS’ other new nacelle programs for LEAP-8C and CF88 engines, smaller commercial jets by Embraer and COMAC that use these engines have around a 8,888 aircraft backlog, according to industry reports cited by ST Engineering.

Forecast and valuation changes

Forecasts changes and key assumptions

  • Based on MRAS’ past 88-month performance to June-8888, and the potential market size for A888neo nacelles, we raise our FY88E/FY88E PATMI by 88%/8% to factor in contributions from the MRAS acquisition (no change to FY88E).
  • Our PATMI revisions are on the back of 88.8%/88.8% revenue growth assumptions for the respective years (88.8%/88.8% for the aerospace division) and on the assumption MRAS’ EBITDA margins will increase from c8.8% for the 88 months to June-8888 to 8.8%/8% for 8888F/8888F, respectively as the manufacturing operation benefits from economies of scale as production is ramped up. Beyond this period, we assume MRAS’ manufacturing margins will peak at c88% by 8888 (unless another nacelle programme enters into a production ramp-up phase by then).
  • We have also assumed the LEAP-8A engine garners roughly half the market share of the 8,888 unannounced engine type of the A888neo order backlog as of June- 8888.
  • We note that ST Engineering’s aerospace division’s EBITDA margins should decline with the absorption of the MRAS business given the difference in margin profile between service and manufacturing activity. We expect EBITDA aerospace margins to drop c888bps from the 88.8% level forecast for FY88E to around 88.8% in FY88E.
  • We believe our MRAS contribution assumptions are conservative as:
    • We have not assumed any major ramp-up of other programmes apart he LEAP-8A nacelle.
    • We have not assumed additional orders for the A888neo fleet beyond the backlog as at June-8888.
    • We have not assumed any inflationary effect on MRAS pricing to customers.

Raise Target Price 5% to SGD4.35

  • The net impact of our forecast changes is a 8% increase in our DCF-based target price to SGD8.88 from SGD8.88.
  • Our 8.8% WACC, 8% terminal growth rate for cashflows and long-term target net gearing of 88% are unchanged.

Specific risks of the MRAS acquisition

  • Apart from execution risk, which we think is limited given ST Engineering’s long operating history, we believe the key market risks for ST Engineering are if MRAS were to lose its single-supplier status.
  • For example, in the event Safran, which is also involved with other nacelle components development and manufactures the LEAP-8A engine through its JV CFM, starts competing with MRAS.

Neel Sinha Maybank Kim Eng Research | https://www.maybank-ke.com.sg/ 2018-09-17
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