ST Engineering - DBS Research 2019-02-22: Growth Outlook Remains Positive

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SINGAPORE TECH ENGINEERING LTD (SGX:S63)

ST Engineering - Growth Outlook Remains Positive

• ST Engineering’s 4Q18 core net profit of around S$154m slightly below, but FY18 core net profit still up 5% y-o-y. 
• More non-core assets weeded out, enables management to focus on growth areas. 
• Acquisition of MRAS on track for 1H19, should support close to double digit earnings growth in FY19/20. 
• Maintain BUY with Target Price of S$4.15. 

BUY on multiple re-rating drivers ahead.

• ST Engineering’s share price has done well YTD in 2019 and still remains a good investment opportunity for the long term.
• 4Q18 results did not look good on a headline basis owing to one-off restructuring costs related to the group’s portfolio rationalisation efforts, but adjusted FY18 net profit was up 5% y-o-y and re-starts the group’s growth trajectory. Faster growth is expected in FY19/20 with the expected completion of the acquisition of nacelle systems provider MRA Systems in 1H19.
• We like SINGAPORE TECH ENGINEERING LTD (SGX:S63, ST Engineering) for a combination of factors:
  1. strong inorganic growth potential from the abovementioned acquisition,
  2. growing smart city revenues,
  3. recovery in engine MRO demand and in the longer-term, sizeable contribution from Airbus P2F programmes currently in ramp-up phase; and
  4. good progress in the fields of logistics automation and systems integration for electric and autonomous vehicles.

Where We Differ:

• Demand for ST Engineering’s business divisions should not be affected much by ongoing trade war tensions, and higher input costs are generally provided for in contracts.
• Overall, we believe ST Engineering is at the cusp of a ‘next leg up’ in its growth story while trading at reasonable valuations (forward PE of 18.4x is below mean historical levels).

Potential catalyst:

• Significant order wins, turnaround at US shipbuilding operations, and progress with Smart City initiatives.

Valuation:

• Our Target Price of S$4.15 is based on a blended valuation framework, which factors in both earnings growth and long-term cash-generative nature of ST Engineering’s businesses. Dividend yield of around 4.5% should continue to provide support to the stock price.

Key Risks to Our View:

• A protracted slowdown in shipbuilding and execution hiccups at new business segments could derail earnings. Also, lack of action on the M&A front could lead to inefficient use of balance sheet and lower ROEs in the future.

WHAT’S NEW - 4Q18 margin performance encouraging, growth prospects intact

Reported net profit below expectations on one-off charges.

• ST Engineering’s 4Q18 reported net profit of S$124.5m (-24.4% y-o-y, -7.5% q-o-q) was significantly below expectations, largely due to the impact of the following events during the quarter:
  • Aerospace segment: Transaction costs related to the acquisition of MRAS and divestment losses related to a pilot training school in US totalling around S$15m.
  • Land Systems segment: Impairment and divestment losses of around S$15m relating to the divestment of Leeboy India (road construction business), and full impairment charges for Leeboy Brazil and Technicae (automotive MRO business in Brazil).
• Barring the impact of this restructuring costs arising from ST Engineering's ongoing portfolio rationalisation efforts and the acquisition of MRAS, adjusted net profit for 4Q18 would be at S$154m (up 4% y-o-y after excluding the favourable tax gains of S$20.3m recorded in 4Q17). This would have been only slightly below our expectations.

Weaker aerospace segment revenues offset by robust top-line growth across all other operating segments.

• ST Engineering’s Group revenue of S$1,774m (+6.5% y-o-y, +9.1% q-o-q) in 4Q18 exceeded our expectations. Unlike the previous three quarters, the aerospace segment recorded a 13% y-o-y decline during the quarter, owing to timing issues in contract execution and revenue recognition.
• On the contrary, the Land systems and Electronics segments recorded solid quarterly results, boosting revenue growth by 29% and 16% from a year ago respectively, driven by resilient demand for Smart City projects, and robotics and autonomous solutions.

Underlying PBT margins improved, margins should grow despite MRAS integration and residual acquisition costs.

• ST Engineering’s Core PBT margin widened to 10.7% (9.1% including one-off charges) in 4Q18, compared to 10.1% in 4Q17 and 10.2% in 3Q18, owing to better headline margins in Aerospace, Land Systems and Marine segments, which tempered thinner margins in the Electronics segment.
• PBT Margin for the Aerospace segment climbed to 12.7% in 4Q18 (estimated at around 15.0% barring divestment losses and acquisition related transaction costs), up from 10.7% in 3Q18 and back to the typical 12-13% range.
• Though ST Engineering will still have to incur some integration costs in FY19 associated with manufacturing automation, centralising operations and software/data systems for MRAS, these expenses will not be immediately expensed, but amortised uniformly over the next few years. Furthermore, the group has already paid off majority of acquisition-related expenses, and should incur minimal additional costs on that front in FY19. MRAS margins should also improve over time, owing to economies of scale as production ramps up in response to higher production of A320neo aircraft at Airbus.
• The turnaround in the Marine segment is looking increasingly credible, as ST Engineering’s Marine segment ends the financial year with its fourth profitable quarter. PBT margin in the segment rose to 12.2% in 4Q18, its fourth consecutive quarterly increase. With a solid order backlog for FY19, margins should sustain as ST Engineering realises greater operating efficiency on the back of increased work volumes.
• A temporary unfavourable revenue mix drove margin deterioration in the Electronics segment to 9.5% in 4Q18 (down from 13.5% in 4Q17). Meanwhile, one-time impairment/divestment losses narrowed PBT margins in the
• Land Systems segment to 0.7% (estimated at around 5.1% excluding one-off charges) in the quarter, considerably lower than 7.1% (would have been 1.2% excluding the favourable tax adjustment) a year ago. Going forward, margins should normalise in the absence of non-recurring items.

Outlook for revenue growth remains robust as drivers in place:

• Singapore Budget 2019: The Singapore Government plans to spend about S$22.7bn on defence, security and diplomacy in 2019, of which, defence spending is expected to hit S$15.5bn, up from S$14.8bn in 2018. As the primary defence contractor to the government, ST Engineering will likely benefit from more military-related contracts in their Land systems and Marine segments. Additionally, the government’s ambitious plans on furthering Smart City initiatives and emphasis on cybersecurity will provide greater opportunities for ST Engineering’s Electronics segment.
• Aerospace segment: On the flip side, there could be a slight delay in the completion of the acquisition of MRAS to early 2Q19 (from end-1Q19) due to the protracted government shutdown in the US earlier. There could also be some integration costs involved in the earlier stages of MRAS contribution to group earnings. However, the acquisition will definitely be earnings accretive and key inorganic kicker for group earnings in FY19/20. The group is also making sound progress in its P2F programs, having delivered 3 A330 aircraft and recently inducting its first A321 in FY18, with 18 more firm orders to be delivered in FY19 and beyond. Additionally, increased engine repair workloads will help temper softness in the demand for components and modifications.
• Electronics segment: Demand for Smart City solutions will likely remain buoyant, as cities continuously strive for modernisation. In particular, we are optimistic on the outlook of ST Engineering’s mobility business, as growing city populations proliferate road and traffic congestions.
• Marine segment: We expect ST Engineering to achieve increased vessel orders as the offshore sector treads the path to recovery. In particular, demand for LNG-related vessels should be strong given greater adoption of the fuel. And with IMO2020 fast approaching, the increased need for scrubber retrofitting on vessels should help drive marine engineering revenue.
• Land Systems segment: As mentioned in earlier reports, the group has made remarkable strides in smart logistic robots and electric & autonomous vehicles. Starting in 2019, the group will begin selling its recently developed suite of adaptable, scalable autonomous material handling equipment for the warehouse, airport, seaport and manufacturing facilities to capitalise on the trend of logistics automation.
• Exciting business area under Land Systems – Healthcare: ST Engineering is positioning itself to capture burgeoning demand for preventive and smart healthcare solutions. The group is focused on developing solutions to maximise hospital efficiency for patients and foster the use of real time data to facilitate swifter decision making for healthcare operators. As of today, ST Engineering has smart robots deployed across 160 hospitals in the US, and they are looking to gain traction in the Singapore market as they establish their track record.

Orderbook near all-time high, expect faster drawdown in FY19.

• Orderbook remained flat y-o-y and q-o-q at S$13.2bn which is near historical peak levels. In an encouraging sign, the group announced new order wins of around S$5.24bn in FY18, which included S$991m (inclusive of around S$245m of options) in new orders for the Marine segment.
• Of the existing orderbook, the group expects to deliver S$4.9bn (37% of orderbook – higher than usual run rate) in FY19 as it accelerates project and contract execution.

Final dividend of S$0.10 declared, stable y-o-y despite MRAS acquisition.

• This brings the full-year dividend to S$0.15/share, with an implied 4.4% dividend yield.
• ST Engineering’s balance sheet continues to be robust with minor net debt level. While we expect net gearing to increase to around 20- 25% post acquisition, the management indicated that the VTS unit and MRAS should generate sufficient operating cash flows to service the debt.
• The group has a solid track record in maintaining dividends amid challenging times, and we do not foresee any changes to ST Engineering’s dividend policy, given the overall group’s strong ability to generate operating cash flows and additional headroom for debt.

Suvro Sarkar DBS Group Research | Singapore Research Team DBS Research | https://www.dbsvickers.com/ 2019-02-22

SGX Stock Analyst Report BUY MAINTAIN BUY 4.150 SAME 4.150