SIA Engineering - DBS Research 2018-11-12: Margin Pressures Expected To Sustain


SIA Engineering - Margin Pressures Expected To Sustain

  • SIA Engineering's 2QFY19 net profit of S$38m below estimates.
  • Better contribution from JV/associates as engine shop upswing continues.
  • But core operating margin of 4.5% seems to indicate new normal for margins, much below historical levels.
  • Cut FY19/20F earnings by 8-9%, downgrade to HOLD with lower Target Price of S$2.94. 

Downgrade to HOLD as core operating margins falter again.

  • While JV/associate contributions have recovered well over the past few quarters owing to an upswing in the engine MRO cycle and higher workload from the problematic Trent 1000 engines, core operating margins declined to the 4-4.5% range in 1H19 from 7.0% in FY18, led by a decline in core airframe maintenance revenues amid high competition and structural headwinds.
  • Higher than expected JV/associate profits continued to offset low core operating margins in 2Q19 but overall results in 2Q19 were still slightly below expectations. JV/associate profits made up almost 80% of 1H19 earnings, compared to historical range of 55-60% of group earnings.
  • We revise our revenue and core operating margin assumptions for FY19/20 downwards and lower our net profit forecasts for FY19/20F by 8-9%. Factoring in the earnings cuts, lower dividend assumptions and removing the M&A premium, we arrive at a lower Target Price of S$2.94 for SIA Engineering and downgrade our rating to HOLD.

Where We Differ:

  • SIA Engineering's cash flow generation has been weak YTD in FY19 owing to negative working capital movements. This follows a similar pattern in FY18, and we believe could lead to lower than expected growth in dividends going forward.
  • SIA Engineering has cut interim dividend to 3Scts in 1H19 from 4Scts previously, which caps dividend expectations for FY19 at 13Scts (flat y-o-y).

Potential Catalyst:

  • If lower dividends translate to using cash reserves for M&A activity in the MRO space, that would be positive for the stock. Privatisation by parent Singapore Airlines (SGX:C6L), though unlikely, can’t be entirely ruled out either, after HK-based peer HEACO’s privatisation by Swire Group earlier in 2018.


  • Our Target Price of S$2.94 is based on a blended valuation framework (PE, EV/EBITDA, dividend yield and DCF) to reflect both growth and cash flow metrics.

Key Risks to Our View:

  • Upside risk exists in the form of potential privatisation/M&A.

WHAT’S NEW - JV/associates upswing offsets weak core operating performance

Diminishing core EBIT margin remains a drag.

  • SIA Engineering's 2Q19 net profit was slightly lower than our expectations at S$38.0m (at par y-o-y, -6% q-o-q). This brings 1H19 net profit to S$78.5m, forming 44.8% of our full-year net profit forecasts.
  • Solid performance of associates and JVs in 2Q19 partly mitigated the core operating margin deterioration, otherwise the bottomline would have been farther from estimates.

Top line under pressure amid challenging operating environment.

  • SIA Engineering's revenue decreased to S$251m (-9% y-o-y, -6% q-o-q) in 2Q19 due to challenges in the heavy maintenance and fleet management segments, owing to reduced work volumes and keen competition.
  • 1H19 airframe and line maintenance revenue fell to S$442.6m (-6.4% y-o-y), due to lower high-value heavy maintenance activity, with the number of ‘C’ checks at Singapore hangars dipping sharply to 31 (-31% y-o-y) because of the extended maintenance intervals of newer aircraft. The ‘C’ checks at Clark hangar remained stable y-o-y though.
  • Meanwhile, fleet management revenue also declined to S$50.8m in 1H19 (-17.5% y-o-y), in spite of more aircraft under management (88 as at 1H19 vs 84 aircraft as at 1H18), due to a different aircraft mix and less beneficial contract rates from the same period a year ago.
  • The only silver lining remained the line maintenance division, which benefited from the increase in the number of flights handled at Changi Airport to 75,783 (+4.1% y-o-y) and there was also a marginal increase in light ‘A’ checks to 223 (+1.8% y-o-y) at the Singapore base to partially check the revenue decline.

Lower utilisation and pricing pressure to erode core EBIT margin.

  • Core EBIT margin contracted to 4.5% in 2Q19 (against 7.0% in 2Q18), due to lower hangar utilisation and elevated pricing pressure. A larger proportion of ‘light’ checks and disputes between aircraft lessors and airlines which resulted in some aircraft remaining idle in hangars negatively affected work volume in the period.
  • Simultaneously, airlines continued to negotiate aggressively for cheaper contract rates amid the unfavorable oil price environment.
  • Going forward, we expect core EBIT margins to remain range-bound within 4-5%, as accelerated aircraft deliveries in the region counterbalance longer maintenance intervals of new aircraft.

New focus on cabin interiors.

  • In order to overcome the secular trend of reduced MRO work content on new aircraft, SIA Engineering intends to emphasize its efforts on cabin maintenance services.
  • While airframes and engines may have better reliability, aircraft cabins are still subject to high wear and tear, and as airlines have different cabin maintenance requirements owing to unique seat specifications/ configurations, this segment can be better served by MROs. However, it is still early days for the group as far as third party cabin maintenance services are concerned.

Another healthy quarter for associates and JVs; engine shops continue performing well.

  • 2Q19 associate and JV profits of S$32.4m (+31% y-o-y, -7.4% q-o-q), were significantly better than expected, underpinned by greater contribution from engine centers. This substantiates our belief that we are seeing the engine MRO cycle upswing.
  • Overall, the engine shops should continue doing well with an upswing in the engine MRO cycle – SIA Engineering and competitors have mentioned engine shops operating at high utilisation rates – as well as some support from workload on the problematic Trent 1000 engines, which should persist for the next 1-2 years (providing higher work volumes to its JV SAESL with Rolls Royce).
  • Eagles Service Asia, the JV between SIA Engineering and Pratt & Whitney will likely start servicing PW1100G-JM PurePower Geared Turbofan engines by 4Q19, and further boost engine shop profits. This will be only the second shop in Asia capable of servicing the Turbofan engines, which are used in narrowbody aircraft including the A320neo family.
  • The long-term prospects are also boosted as SIA Engineering anticipates the GE state-of-the-art engine facility in Singapore to be operational by mid-late 2022. We expect the group to continue expanding its portfolio of JVs and associates through strategic partnerships with OEMs.

Conserving cash for M&A, productivity improvements or more technological capabilities.

  • Operating cash flow was negative in 2Q19, owing to adverse working capital movements, and 1H19 operating cash flow of S$34.5m is tracking below our full-year forecasts.
  • Additionally, the company reduced interim dividends to S$0.03 per share (from S$0.04 per share in the same period ago), which may imply that FY19 total dividend may at best match FY18’s S$0.13 per share. However, the group’s balance sheet overall still remains in a strong net cash position of around S$434m.
  • Management indicated that they are looking to deploy the capital to augment productivity and embrace modern technological capabilities like additive manufacturing and data analytics, or could alternatively utilise the capital for M&A within the MRO sector.

Lower earnings estimates, downgrade rating to HOLD.

  • Due to reasons described in the above sections, we revise our revenue and core operating margin assumptions for FY19/20 downwards and lower our net profit forecasts for FY19/20 by 8-9% each.
  • Factoring in the earnings cuts, lower dividend assumptions and removing M&A premium, we arrive at a lower Target Price of S$2.94 for SIA Engineering and downgrade our rating to HOLD.
  • With likely y-o-y fall in earnings in FY19 and flat dividends at best, we reckon SIA Engineering would not be seen as a safe haven stock in current volatile market conditions, and recommend looking at ST Engineering (SGX:S63) instead for better growth-cum-yield story.

Suvro Sarkar DBS Group Research | https://www.dbsvickers.com/ 2018-11-12
SGX Stock Analyst Report HOLD DOWNGRADE BUY 2.94 DOWN 3.920