ST Engineering - DBS Research 2019-03-29: M&A Driving Smart City Ambitions

SGinvestors.io

SINGAPORE TECH ENGINEERING LTD (SGX:S63)

ST Engineering - M&A Driving Smart City Ambitions

• Announces proposed acquisition in satcom space, complementary to existing offerings.
• Will be earnings accretive from FY20 onwards.
• Deal enables better positioning in Smart Cities market and should help management achieve revenue targets
• Maintain BUY with Target Price of S$4.15.

Another inorganic kicker in place.

• SINGAPORE TECH ENGINEERING LTD (ST Engineering, SGX:S63) continues to deliver on its inorganic growth strategy, this time in the Electronics division in the satellite communications (satcom) space, with a proposed €250m (S$383m) debt-funded acquisition of Belgium-based Newtec Group NV (Newtec).
• The deal will help ST Engineering secure a firmer footing in Smart City and IoT solutions market by providing a digital connectivity platform. While not immediately material owing to integration costs, the deal is expected to yield significant revenue synergies for ST Engineering over the next few years and should be accretive from FY20 onwards, adding to the double-digit earnings growth trajectory already in place through the expected completion of the acquisition of nacelle systems provider MRA Systems in 1H19.
• We continue to like ST Engineering for:
  1. strong inorganic growth potential from the abovementioned acquisitions, including growing Smart City revenues, and
  2. recovery in engine MRO demand and ramp up of Airbus P2F programmes in Aerospace division.

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 ~20x is just at mean historical level).

Potential catalyst:

• Significant order wins, earnings delivery from new acquisitions, 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 the long-term cash-generative nature of ST Engineering’s businesses.
• Dividend yield of around 4.3% should continue to provide support to the ST Engineering's share price.

Key Risks to Our View:

• Execution hiccups at new business segments and newly acquired entities could derail earnings. Also, higher gearing owing to debt-funded M&A deals could increase finance costs.

WHAT’S NEW - Proposed acquisition of European satcom company

Inorganic boost to satcom ambitions.

• ST Engineering plans to acquire a 100% stake in Newtec, an established Belgium-based company in the European satcom industry, at a base aggregate purchase consideration of €250m (S$383m).
• Subject to regulatory approvals, completion of the deal is anticipated in 2H19. ST Engineering expects to fully finance the acquisition with cash on hand and external borrowings.

Who is the target company?

• Newtec is an established OEM in the field of satcom equipment – it designs, manufactures and sells satcom equipment, and provides critical satcom technologies. The acquisition is complementary to ST Engineering’s existing presence in the ground equipment segment of the satcom industry value chain, where it operates through its US- based subsidiary iDirect, which ST Engineering had acquired back in 2005.
• Newtec manufacturers ground equipment like modulators, modems, satellite terminals, hubs, switches etc. and more importantly, owns IP and patents for critical satcom technologies.

Advantage from LEO satellites.

• Newtec is one of the first incumbents to innovate satcom technology suitable for Low Earth Orbit (LEO) satellites, where a surge in launches are expected in coming years.
• With 5,000 LEO satellites scheduled to be launched in the next five years, future demand for Newtec’s LEO satellite technology solutions should be buoyant. The surge of LEO constellations will also increase bandwidth capacity and reduce operating cost, thereby creating new satcom demand.

Rationale for acquisition.

• We believe the key reasons for ST Engineering pursuing this acquisition are :
  • The acquisition would broaden ST Engineering’s satcom products and services portfolio in a good growth industry, with demand for satcom expected to grow at a CAGR of 10-15% in the next few years.
  • While ST Engineering currently serves needs of satcom platforms in the maritime, aeronautical, land transport and enterprise domains, Newtec will add to expertise in cellular backhaul, consumer and broadcasting domains. Newtec provides two-way, high throughput terminals, and is a key player in broadcast segment.
  • ST Engineering will position Newtec as the group’s European satcom centre, and the geographical diversification will help add new markets and cross-sell products.
• In particular, the acquisition is anticipated to bolster ST Engineering’s arsenal of Smart City solutions, and empower the group to:
  1. accelerate the deployment of satcom-enabled 5G telco networks, enabling connectivity to and within remote regions, and
  2. meet increasing demand for IoT and M2M connectivity, to link millions of devices and sensor points for data gathering, surveillance, and big data analytics.

Earnings growth prospects are decent in the medium term.

• We believe the acquisition of Newtec is a step in the right direction in meeting its target of achieving S$2billion revenue from smart city business by 2022, as earlier enumerated by management. We reckon Newtec recorded FY18 (September FYE) revenue of around €92.6m and FY18 EBITDA of around €17.1m which is about 2% of ST Engineering’s FY18 revenue and 3% of FY18 EBITDA, respectively, just for scale comparison.
• ST Engineering expects to realise around S$200m from future cost and revenue synergies, with majority coming from incremental revenue opportunities, though there will be some cost savings, especially from shared R&D infrastructure.
• Taking into account industry growth rates and potential revenue synergies, we believe 15%+ revenue growth rates are possible for Newtec in the next 2-3 years.
• Earnings in Year 1 and 2 post acquisition will be affected by transaction costs and integration costs, with the majority in Year 1, and hence we are looking at slight negative contribution from the transaction in FY19. In FY20, we expect the deal to be earnings accretive but earnings contribution will be more material from FY21 onwards ( > S$10m), adding another 2-3% growth over existing projections, in our opinion.

Acquisition pricing does not look cheap though.

• The base aggregate purchase consideration is €250m (S$383m), which when compared against Newtec’s NTA and NAV of €5.1m and €28.4m respectively as of 30 Sep 2018, implies P/NAV of around 8.8x and P/NTA of about 49.0x. A significant portion of the purchase consideration will thus, consist of goodwill, which will lead to material decline in ST Engineering’s NTA (net tangible assets) per share post acquisition.
• The acquisition price also implies multiples of 14.6x EV/ EBITDA and 2.7x EV/Sales for the financial year ended 30 Sep 2018, according to management estimates. On a standalone basis, this looks expensive at first glance compared to traditional engineering space and even against ST Engineering’s own valuation of around 13.0x EV/EBITDA on FY18 numbers.
• If we compare against peers in the satcom and IoT equipment space (see details in attached PDF report), median FY18 EV/EBITDA multiple is close to 21.0x and EV/ Sales multiple is close to 2.0x, so the acquisition multiples for Newtec are not out of sync for the industry, though not cheap.
• Valuations would look attractive only if we factor in the synergy value, but that is subject to execution risk.

Near term neutral on the deal.

• While the transaction is earnings accretive, especially from FY21 onwards, and positions ST Engineering well to offer digital connectivity platform for Smart City solutions in future, it is at best an incremental step and not a transformative one, in our opinion.
• Smart City revenues is a key focus area for management and the deal will give a big push towards realising the S$2bn Smart City related revenue target by 2022. In the near term, however, impact on earnings is not material, while balance sheet is impacted, both by NTA dilution (higher intangibles) and higher net gearing levels.
• With the acquisition of MRA Systems in the Aerospace division also likely to be completed in 2Q19, we estimate net debt/ equity for ST Engineering will reach around 0.4x, compared to almost zero net gearing in previous years. More efficient use of the balance sheet to generate shareholder returns is commendable, but that needs to be balanced against funding costs, credit ratings, and dividend sustainability. Thus, we believe further debt-financed acquisitions may become tougher to execute, though ST Engineering may consider equity fund raising option as well in future if M&A opportunities arise.

Suvro Sarkar DBS Group Research | Singapore Research Team DBS Research | https://www.dbsvickers.com/ 2019-03-29

SGX Stock Analyst Report BUY MAINTAIN BUY 4.150 SAME 4.150