2QFY15 results below expectations

• 2QFY15 PATMI plunged 40.7% YoY
  
• More aircraft checks deferred
  
• Downgrade to SELL
  

Disappointing 2QFY15 results

SIA Engineering Company’s (SIAEC) reported a 3.0% YoY decline in its 2QFY15 revenue to S$285.2m and a 40.7% drop in PATMI to S$42.1m. Its 1HFY15 results were below expectation as its revenue and PATMI formed 47.8% and 34.5% of our FY15 forecasts. SIAEC’s 1HFY15 revenue decreased 0.7% to S$579.3m, due to lower airframe and component overhaul services (ACS) revenue from fewer aircraft checks, partly offset by the higher fleet management programme (FMP) revenue. Its 1HFY15 PATMI declined 31.7% to S$95.6m, on higher subcontract costs and a 36.2% YoY drop in share of profits from associated and JV companies to S$29.1m. SIAEC’s key JV, SAESL (services Rolls-Royce engines) experienced a 30% reduction in works on engine cowls due to improvement modifications that reduced engine shop visits. Its main associate, Eagle Services Asia, also saw reduction in earnings as Pratt & Whitney engines are near the end of life-cycle.

Longer interval between checks

We think SIAEC is going through the cyclical period where customers deferring aircraft checks (i.e. increase interval between checks). The number of ‘C’ checks declined from 37 in 1HFY14 to 34 in 1HFY15 and more significantly for ‘D’ checks, the number dropped from 23 in 1HFY14 to 10 in 1HFY15. The number of ‘A’ checks remained resilient at 192 in 1HFY15 compared to 193 in 1HFY14. Note that ‘D’ checks has the most impact with an estimated revenue of S$3m-S$6m per check. With lower revenue from ACS and high staff costs, SIAEC reported an S$7.4m operating loss for its ACS segment. We expect SIAEC to face this situation for at least the next 12 months, until which, the demand for checks from customers should pick up gradually as their extended interval runs out.

Lower FV; Downgrade to SELL

With disappointing results, expected depressed earnings for the next 12 months, and change in analyst coverage, we cut our FY15 and FY16 PATMI by 28.7% and 18.1% respectively. Hence, we lower our FV from S$4.71 to S$3.80 based on 19.0x blended FY15/16F PER, and downgrade to it SELL.

A year of famine

SIE’s 2Q15 net profit of S$42m was below our expectations (S$60m) and consensus (S$68m) due to the weak contribution from JVs and associates that formed 62% of pretax profit. 1H15 net formed 40% of our FY15 forecast. Better engine reliability caused a reduction in engine visits required by its JVs and associates. The maintenance programme is likely to be delayed until CY16, when we expect it to restart with a vengeance. Airframe heavy checks plunged because of similar reasons and cancellations. The only positive is the interim DPS of 6 Scts. We cut FY15-17 EPS by 11-14% for lower contribution from JVs/associates. Accordingly, our target price is lowered to S$4.00, still based on blended P/E and DCF. Maintain Reduce. Weak qoq earnings and margin pressure could be the key de-rating catalyst.

If it ain’t broke, don’t fix it

We believe that SIE is being squeezed by struggling original equipment manufacturers (OEMs). 2Q15 JV contribution was down 30% yoy to S$18.5m, while associates’ contribution fell 52% yoy to S$10.6m. Its main JV, SAEL, which services Rolls-Royce Trent engines saw a 30% reduction in engine repairs, as the newer engines are more reliable. This translates into longer intervals between overhauls, with certain modules being delayed by up to two years. SIE’s associate, Eagle Services, was also negatively affected by lower repairs for the long-suffering Pratt & Whitney, which has been struggling to defend its engine market share.

Airframe division incurred operating loss for the first time

Airframe maintenance revenue dipped 9% yoy from S288m in 1H14 to S$262m in 1H15. Similar to the engine segment, several customers delayed their heavy check maintenance. Only 10 “D” checks were performed in 1H15 versus 24 checks in 1H14. Certain contracts were also cancelled without penalty (for goodwill). High fixed labour costs (50% of airframe costs) resulted in the division posting its first operating loss of S$7.4m in 1H15. Despite the unimpressive Changi airport data, Line Maintenance revenue was stable at S$221m in 1H15, thanks to more light checks during line maintenance.

One-year famine, at the very least

SIE is facing structural issues, with internal pressure (high labour costs) and external (customers delaying maintenance to cut costs). We believe that the stock is unlikely to outperform the market in the next 12 months.

Wings clipped; Cut to SELL

• Downgrade to SELL with a revised TP of SGD4.20, based on 20x FY3/15E P/E, as short-term outlook turns challenging.
  
• Sinister signposts: A decline in heavy maintenance workload after recent expansion in the Philippines, and a persistent weakness in shop visits for its Rolls-Royce engine shops.
  
• Management has turned bearish on its outlook.
  

Yet another disappointment

We see various challenging trends in this set of results. Revenue was little changed (+1.6% YoY) with higher fleet management sales offset by lower heavy maintenance workload. EBIT margin contracted to merely 7.0% (lowest since 1QFY3/10) as subcontract cost rose 4.5% YoY. Share of profits of associates and JVs fell 28.8% YoY to SGD30.6m due to a 37.8% fall in contribution from the engine repair and overhaul centres. Management turned bearish on its outlook, citing challenges from decline in heavy checks, reduction in engine shop visits and rising business costs.

Grounded by short-term headwinds

We see three headwinds to weigh down on FY3/15E earnings:

• New hangar facilities in the Philippines (Hangar 2: Apr 2013, Hangar 3: under construction) are coming on-stream at a time when heavy maintenance workload is slowing down.
  
• Persistent weakness in shop visits for its Rolls-Royce engine shops (FY3/14: 41% of net income).
  
• The scale-back in capacity expansion by regional airlines looks set to reduce overall maintenance workload.
  

We therefore cut our FY3/15E-17E by 15-16%. In our view, valuation looks expensive against cyclical earnings contraction. Downgrade to SELL with a revised TP of SGD4.20 (from SGD5.75), based on 20x FY3/15E P/E (from 23x), equivalent to 1SD above its historical mean; justified by its positive long-term outlook.

1QFY15 PATMI a miss

• 1QFY15 PATMI missed consensus
  
• Earnings uplift ahead from Clark base expansion
  
• Maintain HOLD
  

1QFY15 revenue in line but PATMI missed estimates

SIA Engineering Company’s (SIAEC) 1QFY15 revenue increased 1.6% YoY from S$289.4m to S$294.1m, forming 24.3% and 23.9% of our and consensus FY15 forecast respectively. Revenue growth was driven by fleet management segment, which was partially offset by reduction in airframe and component overhaul revenue as heavy checks were fewer than planned. However, lower operating margin and contributions from JV and associates resulted in 1QFY15 PATMI declining 22.3% to S$53.5m. 1QFY15 PATMI missed estimates as it only made up 18.9% and 19.0% of our and consensus FY15 forecast respectively. 1QFY15 operating profit decreased 25.3% to S$20.7m primarily due to higher subcontract costs (+33.3% to S$43.6m) though staff costs were lower (-8.6% to S$51.3m). Share of profits of JV and associates dropped 28.8% to S$30.6m, mainly due to a S$11.6m decrease in contribution from the engine repair and overhaul centers.

Moderate uplift in earnings ahead

Firstly, the commencement of operations at the third hangar of Clark base (Philippines) in Jun-14 will double the base’s capacity. We expect utilisation to be high and will start contributing to earnings for the rest of FY15 as it benefits from regional low cost carriers’ (LCC) capacity growth, whose shoestring budgets push them to opt for lower-cost sites such as Philippines. Secondly, the recently announced JV with Boeing to provide fleet management services to airlines is also expected to be a positive once it is approved and operational. By teaming up with Boeing, one of the two leading aircraft manufacturers, the JV can offer a full aftermarket menu as part of an aircraft purchase agreement, effectively locking in clients at an earlier stage.

Maintain HOLD

We think the trend of lower overhaul work will stay as regional airline capacity growth is primarily in the commoditised LCC segment. Consequently, we lower our FY15 growth forecast for contributions from JV and associates from 7% to 3%. We maintain HOLD but lower our FV from S$4.83 to S$4.71 based on 19.0x PER of 24.8 S-cents FY15F EPS (previous: 25.4 S-cents).

Losing its gem

Weak contribution from associates & JVs in 1Q15 (-33% yoy, -15% qoq) caught us by surprise. This, coupled with higher subcontractors’ costs drove 1QFY3/15 below expectations at 19% of our and consensus full-year forecast. We cut our FY15-17 EPS by 16% to reflect the poor quarter and slower associates & JV growth. Not only is SIE struggling with margin pressure from high labour costs in Singapore, the loss of earnings momentum from associates/JVs dampens the investment attractiveness of the stock. We downgrade from hold to Reduce. Switch to ST Engineering for a similar yield profile but lower cost pressure given its diversified geographical spread. Our lowered target price is still based on blended valuation of 19x P/E & DCF.

Margin pressure is not easing

Revenue was flat yoy but dropped by 6% qoq to S$294m with lower airframe and component MRO due to fewer planned heavy checks. Staff cost remained stable at S$127m in 1Q15, or 46% of total opex but subcontractors’ costs jumped 15% yoy to S$44m, possibly due to higher fleet management work. Accordingly, EBITDA margin dipped to 12.4% from 12.9% in 1Q14.

JVs & associates back to crisis level

Contribution from associates/JVs dropped to S$30.6m, of which JVs were S$16.3m (-40% yoy, -26% qoq) and associates were S$14.3m (-11% yoy, +1% qoq). We believe the plunge in JV performance was due to lesser repairs of Trent engines from its Rolls-Royce JV, Singapore Aero Engine Services. In the short term, as SIE is gearing up for Trent 900 (for A380), Trent 1,000 (for B787) and Trent XWP (for A350), it may see slower workload for maturing engines such as Trent 800 (for B777) and Trent 500 (for A340-500). Annualised contribution from JVs/associates could return to post-Global Financial Crisis level in FY10 (S$129m).

Toned down guidance

Management changed its guidance from “stable performance” in May 14 to a “more challenging outlook” with the decline in heavy checks and reduction in engine shop visits. Net cash was strong at S$581m but weakness in JVs/associates could affect dividend repatriated to SIE and dividend payout.