JEP Holdings Ltd - Phillip Securities 2019-10-18: Taking Off Under New Management

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JEP HOLDINGS LTD. (SGX:1J4)

JEP Holdings Ltd - Taking Off Under New Management

• Secular growth in aerospace where commercial aircraft orders have a 10-year backlog.
• Turnaround to record profits under new management. Earnings in the past 12 months rose 9-fold.
• Initiate coverage on JEP HOLDINGS LTD. (SGX:1J4) with a BUY recommendation and target price of S$0.20. Our valuation is based on 10x PE FY19e. This is a discount to global aerospace parts supply chain valuations. We believe the discount will narrow on the back of the future scale and consistent profitability.

JEP Company Background

• JEP HOLDINGS LTD. (SGX:1J4) was listed on the SGX as Alantac Technology in 2004. It initially specialised in semiconductor and hard disk drive parts. In 2007, Alantac made a major acquisition of JEP Precision Engineering (JEPS) to venture into precision parts for the aerospace and oil and gas industries. The combined entity was renamed JEP in 2010.
• In January 2018, SGX-listed UMS HOLDINGS LIMITED (SGX:558) acquired a 29.5% stake in JEP. New management was installed after Mr Andy Luong was appointed as the Executive Chairman in February 2018. 18 months later, UMS Holdings launched a mandatory conditional cash offer at S$0.15 per share. Its offer lapsed as the level of acceptances did not cross 50% of the voting shares. See JEP's announcements; UMS announcements.

Company Milestones

• Jun-07: Acquire 85% stake in JEP Precision Engineering for S$23.8mn.
• Apr-10: Rights issue to raise S$11.7mn.
• May-10: Alantac Technology Ltd changed name to JEP HOLDINGS LTD. (SGX:1J4).
• Jan-12: Acquired 100% of Dolphin Engineering Pte Ltd for S$8mn cash and 62.5mn shares at $0.04 per share. Provides large format precision engineering and equipment fabrication services.
• Aug-15: Acquired 100% of JEP Industrades Pte Ltd, involved in the trading of cutting tools used in manufacturing activities for various industries such as aerospace, mould and die, and oil and gas.
• Nov-16: New S$25mn Seletar manufacturing facility completed.
• Dec-16: Rights cum warrants issue – one rights share for every 2 existing shares @S$0.02 per share plus one free detachable warrant for every 2 rights subscribed. Each warrant exercisable at S$0.02 during the 3-year period.
• Sep-17: Moved into a new facility located in Seletar Aerospace Park.
• Jan-18: UMS Group acquired a 29.5% shareholding interest in the Company. Mr Andy Luong, who is the Chairman and CEO of UMS, became the Executive Chairman.
• Dec-18: Acquired the remaining 15% stake in JEPS and made it a wholly-owned subsidiary.
• May-19: UMS acquired 43.84mn shares (10.9% stake) of JEP at S$0.15 from Ellipsiz or total value of S$6.57mn. This raised UMS shareholding to 38.8%, triggering a mandatory conditional cash offer of S$0.15 of the remaining shares. Outstanding warrants were offered at a price of S$0.074.
• Jun-19: Close of conditional cash offer @ S$0.15 per share. Acceptance of only 8.8% and did not cross the 50% mark. The offer is considered lapsed, except for the warrants offer.

JEP's Investment Merits

• Secular growth of the aerospace industry. Aerospace accounts for 54% of revenue. JEP has been building a track-record in precision machining parts for the aerospace industry. Global backlog for aircraft deliveries has risen to around 10 years. There is a global search for capacity.
• Turnaround under new management. After UMS took over management of the company in middle 2018, JEP has turned around and booked record earnings in the past 12 months. Initiatives taken include right-sizing its workforce, transferring labour intensive work to lower-cost Malaysia and contract price renegotiations. Earnings in the past 12 months rose 9-fold.
• Attractive entry point. We believe the valuations are attractive. Sector peers trade at an average of 20x forward PE. Our target price factored in a 50% discount for JEP’s smaller scale of operations.

Revenue

• Revenue for JEP has doubled over the last five years. The major driver to earnings has been aerospace, from 60% to 70% of sales (excluding trading). Trading as a contributor to revenues surged post-acquisition of JEP Industrade. The weakest division has been oil and gas with revenue collapsing almost 90%.
• In terms of products for aerospace, the main components are engine casing (CFM), landing gear, air and management system. We are forecasting mid-single-digit revenue growth as we expect management focus to be on growing margins.
• Some of JEP customers include:
  1. Aerospace: Safran (landing gear), Collins Aerospace (air management) and Singapore Aerospace Manufacturing (engine casing).
  2. Oil and gas: Aker
  3. Large format printing: HP
  4. Semiconductor: Kulicke & Soffa (wire bonders), VAT Semiconductor

Margins

• JEP was hardly profitable in the past 4 years (2014 -2017). Gross margins of 11% or S$8mn to $10mn per annum could not cover the huge annual operating cost of S$10 to S$11mn.
• We saw the turnaround in 2H18 when gross margins surged to around 19%. The highest on record. Operating expenses also registered a S$2mn decline. There were S$1.5mn exceptional administrative expenses in FY17 from the relocation cost plus rental expenses on the old unoccupied factory premise.
• There are several reasons for the higher margins:
  1. Rightsizing of the workforce. Headcount at JEP has declined from 374 in 2017 to less than 298 currently. Employee cost is around 21% of sales.
  2. Move labour intensive work to lower-cost operations in Penang, Malaysia.
  3. Renegotiate pricing of low margin products.
  4. Moving from being a Tier 2 to Tier 1 supplier.
  5. Discard loss-making contracts.

Cash-flow

• Operating cash-flow has been positive the past five years totalling around S$13mn. The bulk of the improvement in cash-flows was 2018 positive operating cash-flows of S$10mn.
• The bulk of the cash-flow has been spent on capital expenditure in particular in 2016/17. Past five years, JEP's capex was a cumulative outflow of S$37mn. The capex has been funded 2/3 by loans and 1/3 from new issuance of shares

Balance Sheet

Assets:

• Total assets grew over the past five years by around S$40mn. The jump was from a rise in fixed assets (S$24mn) and trade debtors ($11mn). Fixed assets expanded significantly in 2016 following the acquisition of the new plant. A rise in trade debtors is in-line with the improvement of revenue, especially with the acquisition of the trading business

Liabilities:

• Bulk of the liabilities are in loans (60%) and trade payables (20%). Loans more than doubled in 2016 to S$36mn in order to fund the expansion into the new factory.

Industry

• The basic supply chain of aerospace industry can be divided into:
  • Aircraft manufacturers:
    • Boeing, Airbus, Bombardier, Embraer, Textron.
  • Engine makers:
    • Engines are the typical razor and razorblade business model where higher margins are in the engine spares and services. Manufacturers can sell engines even at a loss. Some leakages occur when non-OEM parts are used.
    • General Electric: Under GE Aviation, it is a major aircraft engine supplier. It formed a JV with Safran to create CFM International focused on mid-sized engines. CFM has produced successful series of engines such as the CFM56 and recently the CFM LEAP engine. GE Aviation is also producing the GEnx engine for widebody planes.
    • Safran: A french company, formerly known as Snecma, Safran is the JV partner of GE in CFM International. Safran other businesses include aerospace propulsion (civil, military, helicopter, space) and aircraft equipment (landing gear, brakes, nacelles, control systems).
    • Rolls-Royce: Key engine in civil aviation is the Trent series. A key product is the Trent XWB for the widebody Airbus A350. Trent 1000 for Boeing 787 has been facing delays (till 2Q20) due to issues with the turbine blades.
    • United Technologies: Owns Pratt and Whitney (PW), the OEM engine market. PW has been more focused on engines for the narrow-body planes. The latest generation of engines is the Geared Turbofan (GTF) series. The PW1100G is powering the A320/A321.
    • MTU Aero Engines: Is a german aircraft engine manufacturer. PW and MTU partnered to deliver the general turbofan (GTF) engine. GTF is used in A220 and A320. It is also a leading independent maintenance, repair, overhaul and spares provider.
  • Component makers
    • United States:
      • TransDigm: Large part of earnings is from the aftermarket. Products include actuation systems, audio systems, gear pumps, ignition systems, connectors and latches, latching and locking devices, cockpit security devices, etc.
      • Honeywell: aerospace is approximately 40% of sales. It includes avionics, auxiliary power unit, airframe assemblies, navigation and flight management
      • Parker-Hannifin: aerospace is around 20% of sales and products include fuel systems, flight and vibration controls, sensors, actuation, fuel systems, wheels and brakes
      • Spirit AeroSystems: a spin-off from Boeing. The company manufactures fuselages (50% of sales), propulsion systems and aeroplane wings.
      • Hexcel: provides advanced composite materials for the commercial aerospace industry.
    • Europe:
      • Meggitt (UK): aircraft thermal systems, sensors, engine valves, brakes.
      • Senior (UK): aircraft component manufacturer and assembler – engine parts (casing, gas turbine, latches, brackets, etc), landing gear, aircraft frames and fluid conveyance. Other parts of the business include automobile and oil and gas components.
      • Thales (France): In-flight entertainment and connectivity.
      • Cobham (UK): oxygen systems, refuelling equipment, communication systems and safety and survival mission systems
    • Taiwan:
      • Aerospace Industrial Development Corp (AIDC): Taiwan’s largest aerospace contract manufacturer. Product into military and commercial aircraft and engine components.
      • Magnate Technology: manufacture aircraft parts such as engine casing, landing gear, heat exchange, actuator, etc. A subcontractor for AIDC.
      • Aero Win Technology: Manufacture engine component for customers including Safran, Pratt & Whitney, MTU Aero.
    • Japan 3 Heavies:
      • Mitsubishi Heavy Industries: aircraft components for Boeing and Bombardier (main wings, fuselage, entry doors)
      • Fuji Heavy Industries (Subaru Corp): centre wing box, integrate the wings with the landing gear for Boeing
      • Kawasaki Heavy Industries: forward/midsection of fuselage, main landing gear well, wing trailing edge.
    • Korea:
      • Hanwha Aerospace: Aircraft and military engine; land-based weapon vehicles, security cameras and surveillance equipment and air/gas compressors.
      • There has been a spate of consolidation in the aerospace industry such as Safran acquiring Zodiac and United Tech purchasing Rockwell Collins.

Outlook

We are positive on the outlook for JEP.

• JEP’s growth is expected to stem from
  • Firstly, resilient demand for commercial aircraft. Global passenger air travel is rising the fastest in decades. According to Airbus, aircraft demand is expected to sustain at a growth rate of 4.4% CAGR from 2018 to 2037. Low penetration of air travel in emerging economies and a booming middle-class are some of the triggers of growth. Commercial aircraft deliveries currently have a 10-year backlog of orders;
  • Secondly, we expect further cost optimisation efforts from JEP’s transfer of more projects to lower-cost Malaysia.
  • Thirdly, we are expecting JEP to gain more traction with existing and new customers. JEP in improving its execution and track record which will elevate their supplier status. The current trade spat between the U.S. and China is another likely opportunity to move more aircraft components manufacturing into Southeast Asia.

Valuation

• We initiate coverage on JEP with a BUY recommendation and target price of S$0.20. See JEP's share price; JEP's dividend history.
• Our target price is based on 10x PE, a 50% discount to the industry’s 20x in view of JEP's smaller operations. We expect its discount to narrow with future scale and consistent profitability.
• Our target price exclude 12.8mn (3.1% of total shares) outstanding warrant dilution, warrants will expire 22 Dec 19.
• See attached PDF report for complete analysis.

Paul Chew Phillip Securities Research | Alvin Chia Phillip Securities | https://www.stocksbnb.com/ 2019-10-18

SGX Stock Analyst Report BUY INITIATE BUY 0.20 SAME 0.20