Market discounts ST Engineering’s profit decline and disregards 5Y growth targets

ST Engineering (STE:SP) Fair Value: S$4.30
ST Engineering (STE:SP) Rating: Outperform

14 May 2018, Singapore – ST Engineering (STE)’s share price corrected 2% following its financial results release which appears counter-intuitive since its net profit actually rose 18% y/y in 1Q18. We believe the market is discounting that consensus full year profit estimates are too high and STE’s profit will decline 5%-8% y/y this year, disregarding management’s more bullish 5-year growth targets.

These negative expectations could provide a favourable entry point for long-term investors as ST Engineering’s earnings growth picks up in the next 5 years. We have conservatively forecast STE’s net profit to grow 5% CAGR in the next 5 years to discount the start-up costs and risks of expanding in new businesses, below management’s own targets.

Even with our more conservative forecasts, ST Engineering looks undervalued currently. Based on 90% payout ratio, STE can comfortably sustain annual dividend of at least S$0.15 per share. Using Dividend Discount Model valuation methodology assuming 6.5% cost of equity and 3% growth, ST Engineering’s valuation would be S$4.30 per share, in line with our fair value for the stock.

Chart: ST Engineering Earnings per share and Dividend per share (2008 to 2017)

hart: ST Engineering Earnings per share and Dividend per share (2008 to 2017)

Why did ST Engineering’s share price fall when its 1Q18 financial results and orderbook improved?

ST Engineering (SGX:S63)’s share price corrected 2% with strong volume of 9.3 million shares traded (double the average trading volume in the past month) following its results announcement Friday, 11th May 2018. This negative market reaction appears counter-intuitive since ST Engineering’s net profit actually increased 18% y/y to S$118m in 1Q18.

ST Engineering could miss consensus full year net profit forecast

ST Engineering’s 1Q18 reported net profit amounts to only 21% of the average consensus full year net profit forecast of S$550m. As such, ST Engineering will have to deliver improved profit margins or higher net profit in the upcoming quarters in order to meet market forecasts. It is highly likely that consensus forecasts will be revised down if ST Engineering fails to deliver stronger profits in the coming quarter(s).

Net profit margin has fallen below historical average level

Net profit margin fell to 7.2% in 1Q18 which, although 0.6ppt higher than 1Q17, is below its historical average level of 9.8%.

Chart: ST Engineering Historical Net Profit Margin (2000 to 2018)

Chart: ST Engineering Historical Net Profit Margin (2000 to 2018)

Market is discounting that ST Engineering’s net profit will decline this year…

The current share price of S$3.40 implies that the market is discounting that ST Engineering’s net profit will decline to S$471m, down 5%-8% y/y (depending on how 2017 financials will be restated due to adoption of the new accounting standards Singapore Financial Reporting Standards (International) (SFRS(I)) with effect from 1 January 2018) by extrapolating 1Q18 results for the full year 2018.

…disregarding Management’s 5-year growth targets

These negative expectations could provide a good entry point for long-term investors as we expect ST Engineering’s earnings growth to pick up in the next 5 years. During ST Engineering’s financial results briefing last Friday, management shared their 5-year (2018 to 2022) targets of growing the Group’s core and other businesses by 2 to 3 times global GDP growth in the next 5 years. This would imply 6%-12% growth per annum from 2018 to 2022, reversing the trend of ST Engineering’s earnings decline of 2% per annum in the past 5 years.

Management targets ST Engineering’s net profit to grow in tandem with revenue growth, implying fairly stable net profit margins in the next 5 years. ST Engineering’s exposure to global markets will also increase to two-thirds of its revenue growth. Increased Aircraft engine overhaul shop visits, Passenger-to-freighter conversion work, Rail electronics, Satcom and Smart City solutions, Digitalization contracts and Unmanned solutions will be the key growth drivers in the next 5 years.

DDM valuation methodology values ST Engineering at S$4.30

We have conservatively forecast ST Engineering’s net profit to grow only 5% CAGR in the next 5 years to discount the start-up costs and risks of expanding in new businesses. Even with our more conservative forecasts, ST Engineering looks undervalued currently. Based on 90% payout ratio, ST Engineering can comfortably sustain an annual dividend per share of S$0.15 (similar to its DPS paid in the past 5 years). Using Dividend Discount Model valuation methodology assuming 6.5% cost of equity and 3% growth, ST Engineering’s valuation would be at S$4.30 per share, in line with our fair value for the stock.

Current orderbook less than 1% shy of ST Engineering’s all-time high level of S$13.5B

Orderbook rose 1% y/y and 2% q/q to S$13.4B in 1Q18. This is less than 1% shy of its all-time high orderbook level of S$13.5B at the end of 2Q17. This will help support ST Engineering’s revenue growth going forward. ST Engineering’s share price performance has historically been positively correlated with its orderbook expansion. 

 Chart: ST Engineering’s share price versus orderbook trends (1Q05 to 1Q18)

Chart: ST Engineering’s share price versus orderbook trends (1Q05 to 1Q18)

Net profit improved across all business segments in 1Q18

All business segments reported an improvement in net profit – Land Systems +34% y/y, Electronics +23%, Marine +7%, Aerospace +6%. The 3ppts reduction in ST Engineering Group’s effective tax rate helped to boost net profit. Excluding the impact of lower tax charges, operating and pre-tax profit rose 9% y/y. ST Engineering generated positive free cash flow of S$387m in 1Q18.

Dependence on defense revenue has increased

Defense revenue grew 22% y/y in 1Q18 and accounted for 37% of ST Engineering Group’s revenue in 1Q18 from 33% a year ago. Winning (losing) the US Marine Corps Amphibious Combat Vehicle contract (results due out in late June) would be a positive (negative) catalyst for the stock.

Chart: ST Engineering – Defense revenue contribution (1Q07 to 1Q18)

ST Engineering - Defense revenue contribution (1Q07 to 1Q18)

 

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Independent Research Declaration: Crucial Perspective does not own any position in the equities featured in this report nor have we received any compensation for writing this report. 

 

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