ST Engg unit in JV to set up aircraft facility

ST Aerospace and its partner will invest US$99m in China

SINGAPORE Technologies Engineering (ST Engg) said yesterday its ST Aerospace arm will partner Guangdong Airport Management Corporation (GAMC) to set up a commercial aircraft heavy maintenance facility in Guangzhou, China.

They will invest US$99 million in a joint venture company called ST Aerospace (Guangzhou) Aviation Services, which will be operated and managed by ST Aerospace.

ST Aerospace will own a 49 per cent stake, and GAMC the other 51 per cent.

Located at Guangzhou Baiyun International Airport, the facility will have two hangars – each able to accommodate two widebody aircraft simultaneously. Construction is expected to take about two years, after which the facility will provide maintenance and modification services for Boeing and Airbus aircraft.

ST Engineering said the JV company is expected to start operating two years after incorporation. The venture, which is pending approval by the Chinese government, has already been endorsed by the Civil Aviation Administration of China.

ST Aerospace president Chang Cheow Teck said: ‘Guangzhou is a major aviation hub in Asia. We hope to build a strong capability to provide high-quality and reliable services for our global customers who operate in and fly into China.’

The JV brings the number of ST Aerospace’s China establishments to four. Its three other JVs in China are an aircraft maintenance, repair and overhaul (MRO) company in Shanghai; an engine MRO company in Xiamen and an import-export facility in Guangzhou.

ST Aerospace’s most recent deals include a US$105 million contract with Shanghai-based Spring Airlines in April and a US$750 million engine maintenance contract with India’s Jet Airways at end-March.

ST Engineering said the latest JV is not expected to have a material impact on its consolidated net tangible assets per share and earnings per share this financial year.

ST Engineering’s share price fell two cents yesterday, closing at $3.22.

Growing with resilience

Singapore Technologies Engineering Ltd (STE) is an established integrated engineering company with a strong position in defence and aerospace business. While maintaining a strong base in Asia, STE increased its exposure to global markets through organic growth and acquisitions over the years.

Strong dividend record. As the stock has a strong track record of high dividend payout, the dividend grew in line with the company growth at CAGR of 6.1% over the past 10 years. STE paid out all of its earnings for the year from 2003-2008. However, we believe that on the long run, maintaining a 100% payout ratio is not sustainable as the company needs to retain cash for further expansions.

Strategic partner of Singapore’s defence. STE has strong roots in Singapore’s defence ecosystem and its dominant position in the local defence industry enabled the company to anchor a base load of business.

Resilience of earnings. The four business segments of Aerospace, Marine, Electronics and Land systems provided diversity that enabled the company to stay profitable during the recent economic downturn.

Sustainable Growth. The top line of the company grew at a CAGR of 10.5%, while bottom line grew at a CAGR of 4.3% over the past 10 years. With the order book at an all time high of S$11.8bn (as of 31 March 10), we expect growth for the company to be sustainable.

Key drivers of growth:

• Being one of the largest MRO players in the world, recovery in aviation traffic would increase the flight hours clocked by aircrafts. With the increase in utilization, the demand for MRO services could rebound strongly.

• Increase in automation and networking requirement of infrastructures, such as railways, traffic, buildings and military systems would propel the growth of the electronics segment of the business.

• The Marine business in US has exhibited strong growth in recent years and we expect their growth to continue with the significant contracts won.

• Growth for the Land system segment would be fueled by contract wins with foreign militaries and commercial sales of specialty vehicles in emerging markets.

Key risks:

• Due to concerns over sovereign debt in Europe and US, scale back of Defence and Government expenditure could hinder global growth in the medium term, although we expect this to be mitigated by growth in Asia, to which revenues are skewed.

Valuation:

• We used a Free Cash Flow to Equity (FCFE) model (COE: 8.4%, Terminal growth rate: 3.5%) to arrive at a 12-monthly target price of S$3.64. After considering our projected dividend payout, total returns for the stock over the next 12 months would be 15.0%. We initiate with a BUY call.

Record passenger bumping suggest US airline recovery

According to a recent Bloomberg article, U.S. airlines may bump the most passengers in nine years as business travelers resume flying following the deepest cuts in seats since World War II. U.S. Transportation Dept data indicate that almost 220,000 passengers were not able to board flights in 1Q 2010 even though they bought tickets, which is 25% higher yoy. At that pace, denied boardings in 2010 would surpass 2009’s 762,400 and reach the highest total since 2001. The increase in passenger bumping stems from traffic revival at carriers such as Delta and American Airlines, which have yet to restore reductions in capacity made during the recession. Continental and Southwest Airlines indicated their planes flew fuller than ever in May 2010. US Airways indicated that the industry is seeing a dramatic recovery in business travel. Airlines routinely sell more coach tickets than they have available on the assumption that not all passengers will show up.

This news is positive in our view and may prompt the eventual return of aircraft to active service for those which have been placed in storage during the crisis. ST Aerospace is well positioned to benefit with it being amongst the top two MRO providers in the US. The group currently handles about 70% of FedEx’s global fleet in MRO activities and about a third of UPS’s global fleet. In addition, its key US customers include United, US Airways, Delta, Northwest, Continental, Southwest and American Airways. The recovery of business travel is in line with IATA’s more positive view of global airline industry. IATA indicated recently that the industry will post US$2.5b profit in 2010, reversing two years of losses. It had been predicting US $2.8b loss as recently as March but has now removed that estimate as the economy rebounds.

Turnaround year

• Maintain Outperform, results in line. 1Q09 net profit of S$92.8m (+9% yoy) was below our initial expectation of S$112m and consensus (S$121m), forming 19% of our FY10 forecast. The star segments were Marine and Electronics, offsetting Aerospace weakness. However, we expect stronger subsequent quarters to make up for the shortfall as management guides for better turnover and PBT in FY10 vs. FY09. Our earnings estimates are unchanged with our target price still at S$3.62, based on blended valuations. We see catalysts from more sizeable order wins and a stronger pick-up in all divisions.

• Aerospace seasonally weak; aviation industry bottomed out. 1Q10 Aerospace PBT of S$42.7m (+7% yoy) was below our expectation mainly due to a slower-than expected pick-up in the components division and fewer milestone completions. Sales in the US remained strong on the back of long-term contracts with airlines. Aerospace delivered three PTF projects in 1Q10. We believe there is room for improvement in its PTF margins as another 12 deliveries are expected in subsequent quarters. We expect 2Q10 earnings to be stronger (above S$58m) as management guides for a better 1H10 vs. 1H09 (S$101m). Management also sees the aviation industry bottoming out and expects MRO spending to resume in 6-9 months’ time.

• Stronger outlook for Marine and Electronics. Marine’s order book has been ‘healthy’ with brisk shipbuilding at VT Halter Marine US and Singapore yards. Management also sees more enquiries on specialised vessels in Singapore which could offset weaker rates in ship repair. Electronics is expected to be positive from more milestone completions for LTA’s Circle Line, the Taiwanese MRT, satellite communications and software system projects.

• Land Systems hit by forex loss. 1Q10 PBT of S$22.8m (-14% yoy) was affected by lower sales in the Munitions & Weapons division. The group also booked a S$6m forex translation loss as a result of euro weakness.

• Record-high order book. Group order book reached S$11.8bn with YTD announced wins of about S$1.9bn mainly from Aerospace. About S$3.2bn will be recognised in the coming quarters. Operational cash flows improved 18% yoy to S$457m in 1Q10.

Currency issues derail earnings slightly

At a Glance

• Net profit of S$93m (including forex losses) was slightly below our estimates as Aerospace earnings disappointed

• Earnings should, however, gather momentum in 2H10 as new projects in Aerospace, Land Systems contribute

• Management more upbeat on prospects for rest of year, expects FY10 Group PBT to be “higher” than FY09

• Maintain BUY with reduced TP of S$3.55 as we trim our FY10 EPS estimates by 3.6% on account of weaker US$

Comment on Results

Weak margins and forex losses. Owing to a slowdown in the components business, Aerospace division margins weakened to 9.6% in 1Q10 vs. 12.9% in 4Q09 and PBT declined 26% q-o-q. As a result, the Group’s reported net profit of S$92.8m (up 9% y-o-y, down 28% q-o-q), on the back of S$1.36bn in revenues, came in slightly below our estimates, even after adjusting for a forex loss of S$8.3m. Being more heavily exposed to the heavy maintenance business, the ongoing recovery in air travel has had a more lagged effect on STE’s MRO business than earlier anticipated. Land Systems PBT was also down 13% y-o-y, partly due to a weak Euro.

Recommendation

Management seemed more upbeat about the Group’s prospects for the rest of the year, as they now expect FY10 PBT to be “higher” than FY09 PBT, rather than “comparable” as guided at end-FY09. This comes on the back of a robust orderbook of S$11.8bn, up significantly from the S$10.3bn as of end-FY09. The new contract from Jet Airways (India) should commence in 2Q10, and a majority of the Warthog deliveries to the UK MOD are also scheduled for 2H10. On the PTF conversion front, 3 aircraft were redelivered in 1Q10 and another 14 aircraft are scheduled for redelivery in FY10, thus adding to Aerospace division profitability. Key risk is currency. Every 1 % change in USD/SGD rate affects topline by S$13m and bottomline by about S$1.3m. Thus, given the prospects of a weaker US$ –our economist recently revised his end-FY10 USD/SGD target to 1.34 from 1.38 – we trim our FY10-11 EPS estimates by 3-4% and adjust our TP to S$3.55. Maintain BUY; given the largely stable earnings base and decent dividend yield of 4.5%.