SIA Engineering - Maybank Kim Eng 2018-12-06: Less Icarus, More Phoenix

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SIA ENGINEERING CO LTD (SGX:S59)

SIA Engineering - Less Icarus, More Phoenix

Fallen far enough; upgrade to BUY from HOLD

• SIA Engineering’s share price, close to nine-year lows, has been on a decline for the past two and a half years due to growth concerns caused by structural changes in aviation MRO.
• On the back of a weaker-than-expected 1H19 and cautious guidance we cut FY19E/20E profit by 11%/12% and DCF-based (8% WACC; 2% TGR) Target Price (previously 5-year mean forward P/E of 21x) by 14% to SGD3.00.
• That said, share price weakness has more than adequately priced in growth risks in our view.
• Upgrade to BUY from HOLD.

Aircraft MRO intensity falling, but this is known

• About two years ago SIA Engineering’s management guided the street about medium-term growth challenges arising from various industry trends, including:
  1. lower maintenance frequency required by next-generation aircraft using more composite materials; and
  2. fleet growth at LCCs requiring MROs to innovate solutions to reduce aircraft downtime at hangars.
• SIA Engineering’s quarterly results since have largely illustrated such growth challenges with operating metrics under pressure to the new demand norms. But this adjustment process is close to its tail end we believe.
• Meanwhile, medium-term outlook for global commercial aircraft fleet and passenger traffic remains positive with LCCs driving the growth.

Franchise strengths being underappreciated

• We expect Changi Airport aircraft traffic growth to be sustained at c4-5% annually, aided by the additional capacity of Terminal 4 opened in 2017.
• Although structural changes to the MRO business have posed various challenges, note SIA Engineering’s maintenance market share at its Singapore home base has held steady at c78% over the past three years; scale advantages that we believe other operators will find hard to compete with.

Adjusting to the new-norm MRO demand

Affected by multiple factors in recent years

• SIA Engineering’s operations and financial performance have been under some duress for the past three odd years from a variety of factors, some to do with structural changes in commercial aircraft MRO services and others that are company specific.
• The key amongst them are:
  1. Lower maintenance frequency required by newer, next-generation aircraft (such as the Boeing NG family, Airbus A350 family and A320neo etc.). The longer intervals are due to various advanced technologies deployed by the OEM as well as greater use of composite materials inside the aircraft as well as the airframe.
  2. Fleet growth driven by LCCs where their business model requires minimising downtime for the aircraft. Correspondingly this requires MRO service providers to innovate solutions to limit maintenance downtime at hangars by performing a greater proportion of the tradition B Check, and even sometimes elements of the C Check in between flight cycles while the aircraft is in service (commercial aircraft MRO checks described in table in the PDF report attached.).
  3. Heightened industry competition in heavy maintenance as a number of airlines expanded MRO capacity in 2013-2015 (particularly the Middle Eastern airlines), which put SIA Engineering’s repair and overhaul (R&O) operations under pressure.
  4. The unusually high base of engine repair workload witnessed at its JV SAESL during FY12-14, driven by a specific Rolls Royce Trent900 maintenance and overhaul programme (following problems during A380 flights), which fell away in subsequent years.
  5. Rolls Royce’s restructuring of its operations in the region that saw SIA Engineering divest its investment stake in HAESL (Hong Hong), which was providing a steady investment income/dividend stream in prior years.

But outlook likely to be on the mend over 6-12 months

• The earnings pressure should ease in the next 6-12 months we believe as a number of the above factors have largely run their course.
  1. The adjustment process to the new norm of lower MRO workload appears to be in the late stages. We note that ....

Changi hub, global fleet: Growth factors not to be ignored

• The evolving nature of aircraft MRO services due to factors discussed appear to have taken centre stage for the stock price performance at the moment; But, as discussed above, we believe some of these pressure points will ease over the coming quarters.
• Furthermore there are other industry factors to consider that weigh in positively for SIA Engineering, such as global fleet growth trends and locational advantages.

Global fleet growth will remain strong

• According to IATA, the commercial aircraft fleet grew c4% y-o-y in 2017 and for the first time crossed 31,000 aircraft globally. According to various industry bodies, participants and consultants (IATA estimates, CAPA-Centre for Aviation, Oliver Wyman, Airbus, Boeing), the commercial fleet growth is expected to be sustained at c3-4% CAGR over the next 10 years driven by fleet growth at existing LCCs and new LCCs.
• Fleet growth is expected to be amongst the highest for the Asia-Pacific region where IATA expects an almost 50% increase in passengers by 2028 spurred by a growing middle-class and airport infrastructure development in secondary cities. Aircraft OEM order backlogs support this view - OEM market leaders Boeing and Airbus have record backlogs with deliveries stretching out for 10 years. They delivered a combined 1,418 aircraft (of 1,714 deliveries for the whole industry) with this set to increase c20% y-o-y to 1,705 aircraft for the two companies in 2018.

Singapore-home-base strengths

• SIA Engineering’s home base in Singapore, Changi Airport, is one of the largest airport hubs in Southeast Asia and also one of the world’s 10 busiest airports for international passenger traffic (c61.5m passengers in 2017).
• The additional of new Terminal 4 around a year ago added passenger handling capacity of 16m annually to raise total handling capacity to c85m. Terminal 5 construction is underway and when fully completed by around middle of the next decade will make Changi one of the largest airports in the world with a passenger handling capacity of 135m.
• SIA Engineering has a dominant presence in Changi Airport for line maintenance with an estimated market share of c78%. We believe the home base and scale advantages present high entry barriers for other competitors to this business and should allow SIA Engineering to benefit from medium term air traffic growth prospects at the hub.

Forecast changes

Forecasts cut due to weaker-than-expected 1H19

• While we were cautious about SIA Engineering’s performance due to the current structural headwinds, the previous two quarters were still weaker than our (and the street’s expectations). As a result of this lower base effect we are trimming our core profit estimates for FY19E/20E by 11%/12%, driven by revenue cuts of 8%/11% mainly from the R&O segment where we believe the pressure is likely to persist for a few more quarters.
• On the flipside our Associate/JV profit contribution has been modestly raised by 9%/7% from a better-than-expected performance at the engine centres, while component centre forecasts are unchanged (1H19 delivered a 90% y-o-y growth at engine centres and -10% decline at component centres).
• Our FY18E profit estimate is broadly in line with consensus estimates while our FY19E/FY20E forecasts are 3-5% higher. Excluding MKE, the consensus ratings spread of Buy/Hold/Sell on the stock is 1/5/0.

Key forecast drivers

• Below are some of the key underlying assumptions behind our SIA Engineering financial forecasts:
  • We have assumed Changi aircraft traffic growth of c5% over FY19E-21E and have also assumed SIA Engineering market share will hold steady at c78% levels;
  • We have assumed c1-2% lower ASP’s in consolidated LM revenues from incremental increases in work mix from LCCs;
  • We have assumed a further -6%/-2% erosion in consolidated R&O revenues in FY19E/FY20E before stabilising in FY21E and growing at low-single digit levels of c2-3% thereafter;
  • We have assumed aircraft under fleet management to grow marginally by just 1-2 aircraft overall, primarily from fleet growth at existing customers. We have not assumed any new customer wins;
  • We have assumed the current recovery in engine shop visits to last another 18-24 months (with the following engine overhaul up cycle another three years out commencing FY24);
  • We have revised annual dividend payout ratio downwards to 70-80% of PATMI in FY19E-21E (vs. payout ratios of 85-117% witnessed in the past five years). The small cut in 1H19 regular interim dividends to 3cts/share vs. 4cts/share in 1H18 and 1H17 coupled with a number of announcements on new JVs suggests to us that the company is likely to be in investment mode for the next couple of years.

Valuation and Risks

Target Price cut 14% to SGD3.00; upgrade to BUY

• We cut our Target Price by 14% to SGD3.00 from SGD3.50. We have changed the basis for our valuation to a discounted cash flow at 8% WACC and 2% terminal growth rate from our earlier basis of using a 5-year mean forward P/E of 21x.
• Despite the cut in our Target Price, the sharp -13% price correction in the past month alone (-17% in past three months) now provides for a potential return of c20% on modest growth forecast assumptions, in our view. This recent share price weakness has more than adequately priced in growth risks in our view.
• Upgrade to BUY from HOLD.

Risk factors

The key risk factors to our thesis, forecasts and valuation estimates are the following:

• A longer-than-expected growth recovery: Risks of new initiatives take beyond another 12-18 months to contribute, as well as the adjustment process to lower MRO workload for new aircraft drags on longer than expected.
• Parent company performance risks: SIA Engineering’s patent company Singapore Airlines (SGX:C6L) is still by far its largest customer. It typically accounts for 55-60% of SIA Engineering’s consolidated revenues and 30-35% of revenues of the associate and joint venture companies. A material downturn in the SIA group’s financial performance or fleet expansion and will very likely affect SIA Engineering adversely in terms of lower workload and/or pricing pressure.
• OEM related threats: While SIA Engineering has long-term partnerships through joint investments with key OEMs in various operating entities, many of these OEMs are also looking to strategically expand further in aftermarket services to mitigate the cyclicality of equipment sales.
• Macro-related risks: Any material slowdown in economic growth in the region is likely to slow passenger traffic growth, which in turn could delay fleet expansion plans of various airlines. This will have an impact on air traffic growth, which is a key driver of line maintenance revenues.

Neel Sinha Maybank Kim Eng Research | https://www.maybank-ke.com.sg/ 2018-12-06

SGX Stock Analyst Report BUY UPGRADE HOLD 3.00 DOWN 3.500