ST Engineering - DBS Research 2020-05-18: Upside Potential Appears Limited


ST Engineering - Upside Potential Appears Limited

  • Aerospace and Electronics segments to face heightened challenges owing to fallout of COVID-19 scenario.
  • We now expect ST Engineering's FY20 earnings to decline by 14%, still a picture of relative resilience amid the storm, in our view.
  • Lower our Target Price to S$3.40 to factor in earnings cuts, downgrade to HOLD with limited upside at current levels.
  • ST Engineering's dividends should be maintained at 15 Scts per share for the year, supporting its share price.

Earnings cut but dividends can be maintained.

  • ST Engineering (SGX:S63) ended 1Q20 with a record-high orderbook of S$16.3bn. However, with the widespread global lockdowns in place to tackle the COVID-19 crisis, and its negative impact on the global economy, new order wins could slow down, and existing order deliveries will also risk getting deferred.
  • In particular, the Aerospace and Electronics segments will face higher revenue pressure in the near term, owing to larger exposure to commercial customers. The aviation MRO space will be the biggest drag on earnings, as airlines look to defer maintenance spending, flying hours are reduced and new aircraft deliveries slow down. Taking this into consideration, we cut FY20/21 earnings by 16% and 18% respectively.
  • We now expect ST Engineering's earnings to decline around 14% in FY20, still faring relatively better than most peers. The added silver lining is that balance sheet remains strong, funding costs remain low and dividends are unlikely to be affected despite the fall in earnings. This will continue to support share price.

ST Engineering's 1Q20 Operational Update - Diverse portfolio underpins relative stability

  • ST Engineering's order backlog stood at a record-high S$16.3bn as at end- 1Q20, up sharply from S$15.3bn as at the end of 4Q19. ST Engineering announced a decent level of contract wins worth S$1.6bn during 1Q20 from the Aerospace and Electronics sectors, plus the Phase 2 contract for the production and supply of the Hunter Armoured Fighting Vehicle from the Singapore Ministry of Defence, which we estimate is worth more than S$1bn. We believe however that new order run rate could slow down in the coming quarters owing to the impact of slowdown in the wake of COVID-19 outbreak globally.
  • Management guiding for 5-15% reduction in top line for FY20, mainly dragged by softness in the aerospace and electronics divisions. The land systems and marine segments should be relatively resilient, due to their higher exposure to defense-related work. Around two-thirds of revenue impact will likely be from a reduction in demand, with the remaining split equally between supply chain and workforce issues, arising from the lockdowns in place globally.
  • ST Engineering expects to recognise S$4.5bn of the orderbook over the remaining three quarters, but non-orderbook revenue will be the concern.

Near-term issues owing to the COVID-19 situation

  • Aerospace division will face considerable pressure, arising from
    1. airlines deferring heavy maintenance due to markedly lower flying hours – activity level in its hangars is estimated to be currently at 60%, down from 80-85% in the first quarter, and could stay around the current level for an extended period,
    2. the mobilisation of newer aircraft which require less maintenance when flight activity resumes,
    3. less original equipment requirements as MRAS has reduced A320 nacelle production to 40 units/month from 60 units/month to match Airbus’s delivery schedule,
    4. issues at its Airbus A320/321 Passenger-to-freighter (P2F) business due to supply chain issues, which will take a few months to normalise.
  • Thus, aerospace division revenues and margins will be a key drag on the group’s performance in coming quarters.
  • Electronics division seeing lower project tenders and project deferrals as governments divert their attention to curb the spread of COVID-19 domestically. Additionally, its satellite communication business is suffering due to its higher exposure to the aviation and cruise sectors. Nonetheless, ST Engineering will try to catch up as much as possible in terms of contract fulfilment as lockdowns ease.
  • Delays in revenue recognition in land systems and marine segments owing to manpower and supply chain disruptions.

Mitigating factors

Most of ST Engineering's subsidiaries are classified as providers of essential services and are operating as usual.

  • The non-essential portion of ST Engineering’s workforce has successfully transitioned to work from home.
  • Aerospace division has significant exposure to countries with vast domestic aviation markets, such as the US and China.
  • Domestic flight activity is likely to normalise ahead of international flights, hence the turnaround in these countries will likely be swifter than countries that are dependent on international passengers. The group has not encountered any major MRO contract cancellations and is closely monitoring its customers to minimise its credit exposure. Aerospace division also has big cargo customers like UPS, which have not been as badly affected as passenger carriers in this lockdown.
  • ST Engineering is ramping up the first phase of Hunter AFair Value production, likely to hit peak production by mid-2020, and sustain steady production for 2-3 years. Subsequently, Phase ll of the Hunter AFair Value contract will commence.

Strict emphasis on cost control, coupled with government aid packages, should mitigate margin erosion.

  • Apart from promoting group-wide cost reduction initiatives, downsizing its international workforce in tandem with activity levels, and implementing 5-10% salary cuts for senior management and 10% reduction in director fees, the group should also benefit from government stimulus programmes in its key operating countries.
  • The Job Support Scheme in Singapore is expected to accrue in excess of S$100m in grants for the rest of the year for ST Engineering’s local workforce and defray staff costs to enable ST Engineering to tide over this near-term crisis without losing talent.

AAA credit rating recently reaffirmed by credit rating agencies; resilient balance sheet should underpin steady dividend outlook.

  • ST Engineering recently successfully issued a 5-year US$750m note at a 1.5% coupon, which is the lowest coupon ever recorded by a Singapore corporation at that tenure. The issue was more than 8x oversubscribed, which is testament to ST Engineering’s strong access to the capital markets.
  • Additionally, we believe that ST Engineering’s strong balance sheet and retained earnings buffer should enable it to sustain its dividend payout on an absolute basis (15 Scts per share) in FY20, to maximise returns to shareholders. Management also highlighted that they will judiciously look for M&A opportunities.

Earnings revision and recommendation

We are cutting our FY20/FY21 earnings estimates by 16%/18% respectively.

Downgrade to ST Engineering HOLD on limited valuation upside.

  • Our Target Price (based on FY20/21 blended valuation method, see below) is revised down to S$3.40 after factoring in the earnings cuts.
  • While we believe ST Engineering's share price will continue to be well supported by the reliability of its dividend yield (currently around 4.5%), upside potential will be capped by decline in earnings growth trajectory and slow recovery in aviation MRO space.
  • ST Engineering is also currently already trading at close to mean valuations of 20x forward PE, – which also implies a 50% premium to STI Index valuations, higher than its historical average. Hence, further re-rating and outperformance potential appears limited.

Suvro Sarkar DBS Group Research | Jason SUM DBS Research | 2020-05-18
SGX Stock Analyst Report HOLD DOWNGRADE BUY 3.40 DOWN 4.600