Subdued operations

At 22% of our FY15 numbers, 1QFY3/15 core profit of S$43m (-9% yoy) was broadly in line with our expectations and consensus. Management blamed the tragedies of MH370 and the political unrest in Thailand for the weak Changi operating data. Margin strain continued despite SATS’s efforts to reduce its headcount. Overall profits were lifted by lower-than-expected taxes. We keep Reduce as we think that valuation is stretched at 17x CY15, against muted 8% growth and downside risks from potential for further margin contraction. We maintain our target price, still based on 16x CY15 P/E (5-year mean).

Operating data nothing to shout about

TKF contribution was weaker-than-expected as revenue dropped 7% qoq and 9% yoy to S$59m. The lower revenue was mainly due to weaker utilisation in Narita kitchen slots (Yen/S$ was relatively stable from Mar 14 to Jun 14). Flights handled rose 2.5% yoy to 33,170 units in 1Q15 due to the increase in LCCs volume, but the number of passengers handled was muted at 10.7m as airlines’ load factors remained weak. Unit meals volume was stagnant at 5.1m – a sustained weakness due to Qantas flight withdrawals.

Margin pressure is here to stay

EBITDA margin shrank to 12.8% from 14% in 4Q14 and 1Q14 despite SATS’s efforts to reduce its headcount during the quarter. Actual quantum was undisclosed but SATS had 14,611 staff as of end-FY14. 1Q15 staff costs rose 2% yoy to S$204m, accounting for about 51% of its operating costs (50% in 1Q14). Margin improvement could take multiple years, according to the management. Associates’ contribution was lower-than-expected due to weaker cargo volumes in 1) greater China on slower growth and 2) Indonesia due to the elections.

Benefits from the growing Asian aviation theme? Not soon

While we believe that SATS would benefit from the growth in Asian travellers, we think that this could be a long-term (5-10 year) story. Contributions from non-aviation themes such as the Singapore Sports Hub and Marina Bay Cruise Centres are likely to be relatively immaterial in the medium term. We would look for buying opportunity if 1) the margin pressure eases or 2) the share price weakens or 3) Changi Airport reports more positive operating data.

Expensive caterers

We downgrade SATS to Reduce from Hold with a lower target price of S$2.95, still based on 16x CY15 P/E (5-year mean). Without a major breakthrough in transforming the group, we think that its near-term operations could remain challenging as both topline and margins could be under pressure. FY14 net profit missed our forecast by 11% and consensus by 6% due to weakness in food solutions (weak TFK and lesser meals served). Associates/JVs were also affected by high costs in Hong Kong and weak cargo volume. We cut our FY15-16 EPS by 12-14% and introduce FY17 forecasts. The longer-term outlook (beyond FY17) could be positive, driven by tourism in Singapore and growth in Changi Airport, but valuations (above 5-year mean) look stretched for now.

Weak topline

FY14 revenue slipped by 2% yoy to S$1.787bn, largely on a 5% drop in food solutions (62% of revenue). The key culprits were 1) an 18% drop in contribution from TFK (in line with the c.14% depreciation of ¥ vs. S$), and 2) lower meals produced (-6% yoy to 20.6m units) from the loss of Emirates’s European flights. This is mitigated by higher gateway services (+4.5% yoy) with more passengers and flights handled in Changi Airport. We now expect a 4% yoy rise in revenue in FY15, assuming TFK’s revenue has bottomed and the effects from Emirates’s flights will diminish. Note that TFK was profitable in FY14.

Can’t fight the high staff costs

Food solutions’s operating margin dropped to 12.9% from 13.6% in FY13 and that of gateway services shrank to 2% from 3% in FY13, driven by high staff costs. Overall staff costs rose 3% yoy to S$788m or 44% of total expenses. This pressure is likely to stay given its labour-intensive business model. Benefits from automation may work in its favour over the longer term but it takes time for these incentives to materialise.

Long-term story

SATS declared a final dividend of S$0.08 (total: S$0.13), lower than our expectation of S$0.15. Net cash stood strong at S$228m. SATS is a long-term stock to own but not now, as cost headwinds persist.

4QFY14 results disappoint

• 4QFY14 results below forecasts
  
• Expect weakness in aviation industry to spill over
  
• Maintain HOLD
  

4QFY14 results below expectations

SATS’s 4QFY14 results were below our expectations. Revenue declined 3.2% YoY to S$434.6m, or 7.9% below our forecast. Correspondingly, PATMI dropped 7.8% to S$42.6m, which is 5.8% below our estimate. PAT from overseas associates/JV for 4QFY14 was 46.5% lower at S$9.9m, mainly due to lower cargo volumes and higher staff costs. FY14 revenue dropped by 1.8% to S$1.8b. Food Solutions saw 5.2% revenue decline to S$1.1b, mainly due to: 1) weaker TFK performance from JPY translation losses, and 2) Quantas’ move to Dubai from Changi Airport. These were partially mitigated by a 4.5% revenue increase in Gateway Services to S$678.1m as more accounts were secured. FY14 PATMI came in 2.4% lower at S$180.4m. A final dividend of 8 S-cents was declared, bringing FY14 dividend to 13 S-cents, or 81% payout ratio. Management guided that such payout levels would be sustained.

Shifting expenses away from labour

As labour is the biggest expense item (48% of total expenditure in 4QFY14) and will only increase with wage inflation and statutory levies, management intends to invest more in technology. However, we think this proposition will likely only see success in markets where labour is relatively expensive (e.g. Singapore, Hong Kong and Japan). Hence, the impact is likely to be limited in the near future.

Caught in weak aviation industry

Management thinks PT CAS acquisition will create synergies and provide access to high-growth Indonesian market. They also plan to leverage on their existing relations with airlines and cruise operators to create connectivity for their clients, during which SATS will benefit too. However, we think the aviation industry headwinds will be the larger force in SATS’ near- to mid- term outlook. As overcapacity plagues passenger and cargo carriers, SATS’ end clients, we think the rates and volume for SATS will inevitably suffer as well, though not as cyclical as its end clients.

Based on 20x FY15F EPS, we derive a lower FV of S$3.23 (previous: S$3.35) and maintain HOLD.

Await better entry point

• 4QFY3/14 net income of SGD42.6m (-7.8% YoY) fell short of market expectations due to elevated labour costs.
  
• The other disappointment: Lower-than-expected full-year DPS of 13 SGD cts (FY3/13: 15 SGD cts).
  
• Downgrade to HOLD with lower TP of SGD3.30 in view of near-term challenges that could cap share price upside.
  

What’s New

SATS reported 4QFY3/14 net income of SGD42.6m (-7.8% YoY), which was below market expectations. Labour costs remained the key pressure point in 4QFY3/14, rising 5.3% YoY due to tight labour market in Singapore and Hong Kong. Full-year DPS was lowered to 13 SGD cts from 15 SGD cts (of which 4 SGD cts was special) translating to an 81% payout. Despite growth in workload, operating profit for the Gateway Services segment weakened to SGD13.8m in FY3/14 (-34%), while Food Solutions segment declined by a smaller quantum of 11% to SGD141.9m. The outlook appears mildly negative with management blaming it on rising costs and the overcapacity issue in the regional aviation market.

What’s Our View

While SATS remains a good exposure to the Changi Airport expansion story, we believe near-term earnings will remain weak as it struggles to contain escalating costs. While initiatives to reduce labour dependency are positive, they are unlikely to result in any material near-term benefits. The persistently weak air freight market will continue to weigh on its operations in Singapore and associates that are highly geared to the cargo business. Hence, we lower our FY3/15-16E EPS forecasts by 8%/7% and see significant downside risk to consensus estimates. Accordingly, we trim our DCF-based TP to SGD3.30 (WACC = 7.6%, tg= 1.0%) from SGD3.47 previously and downgrade our rating to HOLD. However, we see limited share price downside at 4% dividend yield, which is supported by its net cash position.

TFK at inflection point

• TFK’s contribution to SATS has been lacklustre since it was acquired in 2010, hampered by the 2011 Tohoku earthquake, rising Sino-Japanese tensions since 2012 and falling JPY.
  
• But positive developments are afoot: 1) rise in China visitation numbers to Japan, 2) steady growth in JAL’s international traffic, and 3) expanding customer base.
  
• Longer-term outlook is bright as well. Reiterate BUY on SATS with DCF-based TP of SGD3.47.
  

Lacklustre contribution since acquisition

We believe the market has been overly pessimistic about TFK Corporation’s near-term weakness and ignoring the upside potential for SATS. Granted, the Japan-based inflight catering unit has not been a significant earnings contributor since SATS acquired it in Dec 2010 (FY3/13: 18% of revenue and 6% of EBIT). But its poor performance could be traced to weak meal volumes as a result of lacklustre air traffic growth in Japan following the Tohoku earthquake in Mar 2011 and the rise in Sino-Japanese political tensions since 2012. The sharp drop in the JPY, which dented TFK’s SGD-translated contributions to the group, compounded matters.

But at an inflection point now

The dismal performance notwithstanding, we believe TFK is now at an inflection point and anticipate improving performance hereon. Our positive view is premised on three emerging trends: 1) rise in China visitation numbers to Japan, 2) steady growth in Japan Airlines’ (JAL) international traffic, and 3) expanding customer base. The longer-term outlook is bright too, with additional international slots at Haneda Airport and Japan’s continued emphasis to promote the country’s tourism industry. A potential regional air services agreement between Japan and ASEAN would give a new fillip to air traffic and hence, meal volumes at TFK. SATS is a play on the structural trend of rising air traffic in the region. Reiterate BUY with DCF-based TP of SGD3.47 (WACC = 7.6%, terminal growth rate = 1.0%).