SIA Engineering - DBS Research 2020-03-20: Brace For Tough Times Ahead; Downgrade To FULLY VALUED


SIA Engineering - Brace For Tough Times Ahead; Downgrade To FULLY VALUED

  • Expect flight movements at Changi to be materially impacted by COVID-19 at least till end-2020.
  • SIA Engineering (SGX:S59)'s FY21 earnings could decline by around 43% y-o-y on a 20% y-o-y decline in line maintenance revenues.
  • Lower profits likely to imply lower dividends as well.

Airlines’ capacity cuts to be a drag on SIA Engineering’s earnings

MRO demand will be materially affected in the near term.

  • The global aviation maintenance, repair and overhaul (MRO) industry is usually more resilient than the airline industry during economic downturns and recession scenarios. During the last major downturn for the airline industry in 2009 post-global financial crisis (GFC) period, when airlines had lost around US$5bn globally, global aviation MRO spending had dipped less than 10%.
  • However, the impact to airline capacity and airline profitability in 2020 owing to the fallout of COVID-19 outbreak will likely be much greater as we are seeing capacity cuts of more than 50% in the offing for some airlines in the near term, including Singapore Airlines (SGX:C6L).

Parent SIA will cut capacity sharply in 1H-FY21.

  • SIA announced recently that it is suspending additional services as more countries impose border controls to tackle the spread of COVID-19. These latest suspensions mean that Singapore Airlines will only operate 50% of the capacity that had originally been scheduled up to end-April. The company expects to make further cuts to its capacity as more border controls are potentially imposed.
  • Singapore Airlines is also taking urgent measures to cut costs. Around 60-70% of SIA Engineering’s top line is derived from parent Singapore Airlines. News of SIA cutting capacity is not good news for SIA Engineering as it will not only lead to lower line maintenance revenues but also less heavy maintenance requirements as Singapore Airlines may ground a portion of its fleet to reduce operating expenses while the downturn persists.
  • As seen in the table in attached PDF report (click on view full report button below), we expect Singapore Airlines to see reduced passenger capacity of around 20% in FY21, which will have a direct cascading effect on SIA Engineering’s fortunes.

SIA Engineering’s dependence on line maintenance will render it vulnerable.

  • SIA Engineering currently does not disclose the break-up of revenues by line maintenance and heavy maintenance as it did previously. Instead, it now groups everything under the airframe overhaul and line maintenance segment. However, we believe the line maintenance division, which accounts for roughly half of SIA Engineering’s top line, contributes the bulk of SIA Engineering’s operating profits, as the heavy maintenance division, fleet management and engine and component segments are loss-making or only break even at best.
  • For the last three financial years for which we have data for breakdown of line maintenance profitability vs. heavy maintenance, it is clear that line maintenance is increasingly important for SIA Engineering from an operating profit point of view vis a vis the heavy maintenance (repair & overhaul) segment.

Line maintenance will be affected by slowdown in aircraft movement at Changi Airport.

  • SIA Engineering has roughly 80% market share in the line maintenance business at Changi Airport, which contributes most of the revenues for its line maintenance division. A steep fall in visitor arrivals into Singapore is expected as a result of strict quarantine requirements imposed over the past month. Advisories to avoid non-essential travel from Singapore limits outbound demand as well, forcing airlines to withdraw capacity from Changi Airport.
  • We believe the trend of aircraft movements at Changi Airport, which drives line maintenance demand, will closely mirror the trend of capacity cuts by Singapore Airlines. We expect around 13% decline in aircraft movements in Changi in 1QCY20 and declines of around 50%, 30%, 10% in 2Q/3Q/4QCY20 respectively, before seeing a 15% revival in 1QCY21.
  • For SIA Engineering, we expect 15% decline in line maintenance revenues in 4QFY20 (March FYE) and around 20% decline in line maintenance revenue for FY21 compared to FY20.

Lowering revenue and earnings forecasts.

  • Taking the above impact to line maintenance revenues into consideration, we are cutting our FY21 revenue forecast for SIA Engineering by 18% to S$864.5m and FY21 net profit forecast by 48% to S$100.5m. The sharper cut in net profit is due to high operating leverage in SIA Engineering’s business model (high staff costs owing to specialised technical staff and engineers), as well as lower joint venture (JV)/ associate contributions to the bottom line. For FY20, the cut to earnings is only around 3%, as only 2 months are affected.
  • In FY22, we expect recovery in flight numbers but we still cut revenue estimates by around 11% and net profit estimates by around 29% as travel trends and airline spending on maintenance will likely not reach pre-COVID-19 levels that soon.
  • After the revision in earnings estimates, we are looking at a 2% decline in core earnings for FY20 and a steep 43% decline in net profit for FY21, before a recovery in FY22.

Expect bigger impact on bottom line than SARS.

  • If we take a look at SIA Engineering’s FY04 financials which were affected by the SARS outbreak (around 9 months of impact in 2003 before air travel recovered fully), revenue had declined by around 23% and net profit had declined by around 32% on the back of a 25% decline in line maintenance revenues.
  • The reason we are looking at a larger impact to the bottom line this time around is the structural decline in core operating margins that SIA Engineering has faced over the years. Even in FY04, SIA Engineering’s operating margins were around 12% after a steep decline, while FY19 operating margin stood at less than 6% in an otherwise normal year.
  • Over the last three quarters, SIA Engineering’s productivity improvements had resulted in some margin recovery momentum but expect that to be halted by the current COVID-19 situation.

Downgrade to FULLY VALUED with lower Target Price of S$1.35.

  • We downgrade our recommendation to FULLY VALUED, as we expect weak results in upcoming quarters and lower dividend expectations will lead to underperformance. Weakness in the airline space will also likely persist for some time and bankruptcies for third party airline customers cannot be ruled out as the travel restrictions drag on.
  • Based on the aforementioned cut in earnings and lower valuation pegs of around -1SD valuations, our blended valuation framework yields a Target Price of S$1.35.
  • See SIA Engineering Share Price; SIA Engineering Target Price; SIA Engineering Analyst Reports; SIA Engineering Dividend History; SIA Engineering Announcements; SIA Engineering Latest News.
  • If we were to just use PE valuations to evaluate bear case valuation scenarios, -1SD valuation of 12x FY21 earnings gives us a valuation of S$1.10 and -1.5SD valuation of 10x FY21 earnings gives us a valuation of S$0.90.

Suvro Sarkar DBS Group Research | Jason SUM DBS Research | 2020-03-20
SGX Stock Analyst Report FULLY VALUED DOWNGRADE BUY 1.35 DOWN 3.300