SIA Engineering (SIE:SP) Initiation Research Report 2017: Well-positioned to leverage on potential MRO upturn

18 May 2017, Singapore – We initiate coverage on SIA Engineering (SIE:SP, SIAEC) with a fair value of S$4.50 and Outperform rating.  The global MRO market demand is expected to remain soft near term for the fifth consecutive year; mainly driven by the structural change of longer intervals between maintenance checks, newer generation aircraft and components proving to be more reliable than the planes they replace and competition from lower cost MRO service providers which is likely to result in continued pressure on SIAEC’s repair & overhaul business and limited earnings growth this year FY18 (year to March).

Meanwhile, SIA Engineering’s line maintenance business segment remains lucrative with 20% EBIT margin, largely driven by its 78% line maintenance market share at Singapore Changi International Airport as well as stations in 36 airports in 7 countries in total. SIA Group is also expected to step up its fleet growth from FY19 based on its aircraft deliveries which should provide a secure and growing baseload of work for SIA Engineering as well as rising de-lease aircraft MRO work for the aircraft that SIA Group plans to phase out.

SIA Engineering’s earnings growth should pick up in the longer term as its continued upgrade of its MRO capabilities to service the new generation aircraft, engines and components and expanding network of partnerships with global Original Equipment Manufacturers (OEMs) as well as Airbus and Boeing will bear fruit as more of these aircraft are delivered in the coming years.

Fair value: S$4.50

Rating: Outperform

SIA Engineering’s net cash position and continued free cash flow generation will support stable long-term dividends with an average yield of 4% with the possibility of special dividends around every 5 years. In addition, SIA Engineering’s low free float of 22% needs to be addressed and a potential partial divestment of SIAEC by SIA will be positive for the stock.

The key risks are further extension in aircraft and engine maintenance intervals and higher than expected wage cost pressure. For long-term investors, the MRO business is a more attractive investment than the airline business – it is relatively more asset-light, has higher barriers to entry and more attractive profit margins.

Background

I started covering SIA Engineering (SIAEC) 16 years ago, not too long after the company’s IPO. Since then, SIAEC’s total revenue has risen 70% but its operating profit margin has halved to 8% (excluding the staff cost impact of its HAESL divestment) so its core business’ EBIT in FY17 turned out to be 18% lower than its EBIT back in FY01, mainly driven by losses in its Repair & Overhaul business. The company structure and earnings drivers of SIAEC have also changed. Following its strategy to form more partnerships with global OEMs which are seeking a greater share of the after-market business, 45% of SIAEC’s pre-tax profits are now driven by profit contributions from its associates and joint ventures compared to only 4% back in FY01.

Chart: SIA Engineering Company Limited – Crucial Perspective Scorecard (Full marks = 100 points)

Chart: SIA Engineering Company Limited - Crucial Perspective Scorecard (Full marks = 100 points)

Chart: SIA Engineering Company Limited – Financial Summary

Chart: SIA Engineering Company Limited - Financial Summary

KEY POSITIVE DRIVERS

Dominant line maintenance market share at Singapore Changi International Airport where the number of scheduled flights is picking up

SIA Engineering is the dominant line maintenance service provider at Singapore Changi International Airport where it has a 78% market share based on our estimates. Line maintenance profit margins tend to be higher and more defensive compared to heavy maintenance. Competition tends to be global for the larger maintenance checks and overhaul work and continues to face intense competition due to excess industry capacity globally. In FY17, SIA Engineering’s Line Maintenance business’ operating profit margin (excluding the effect of the HAESL divestment) was 20%. In contrast, its Repair & Overhaul business incurred an operating loss of S$10m (excluding the effect of the HAESL divestment), amounting to 1.7% of revenue.

With more aircraft maintenance, repair & overhaul (MRO) work broken up into smaller modules and shifting to the line maintenance side in the longer term, SIA Engineering has a competitive advantage in capturing this business as it continues to expand its footprint in Singapore and overseas. 

Chart: Planned flights growth in Singapore

Chart: Planned flights growth in Singapore

Line maintenance presence in overseas markets help gain access to MRO demand from airlines at 36 airports in 7 countries

In addition, through its historical acquisitions and organic growth, SIA Engineering also has line maintenance presence at 36 airports in 7 countries, including Australia, China (Hong Kong only), Indonesia, Philippines and Vietnam in addition to Singapore, enabling it to gain access to MRO demand from airlines based in these markets, and to provide its major airline customers, particularly SIA Group, international MRO support in the key countries they operate in.

Profitability ranks ahead of its closest sector peers

SIA Engineering’s profitability ranks ahead of its closest sector peers HAECO and Lufthansa Technik which are also major airline-linked commercial MRO service providers. SIAEC’s profitability is, however, weaker than ST Aerospace which is the largest independent third-party airframe MRO service provider in the world. This could be partly due to the more stable nature of ST Aerospace’s defense aerospace business which constitutes around 40% of the segment.

Chart: EBITDA margin comparison of major MRO players in 2016 (Jan-Dec)

Chart: EBITDA margin comparison of major MRO players in 2016 (Jan-Dec)

Chart: EBIT margin comparison of major MRO players in 2016 (Jan-Dec)

Chart: EBIT margin comparison of major MRO players in 2016 (Jan-Dec)

Secure and large baseload of maintenance contracts from parent SIA Group which is accelerating its fleet growth

SIA Group contributes 63% of SIA Engineering’s total revenue at the core business level and 33% if we take into account the combined revenue of SIA Engineering’s associates and joint ventures as well (below SIAEC’s operating line). This provides a secure baseload of maintenance work for SIA Engineering, without any risk of customer payment defaults given SIA Group’s own strong balance sheet.      

Based on SIA Group’s existing aircraft orders, its aircraft fleet is expected to grow 9% y/y in calendar year 2017, 13% in 2018, 14% in 2019 and even after taking into account aircraft retirement, the future fleet growth rate is likely to be higher than SIA Group’s historical average aircraft fleet growth of 4% in the past 5 years. This should help boost the growth in SIA Engineering’s MRO workload in the longer term. In addition, as SIA Group takes delivery of the newer aircraft, we expect the Group to progressively phase out its older planes and returning the leased Airbus A330s. There are still 23 A330 aircraft in SIA’s fleet and more MRO work is likely to be needed when de-leasing these aircraft

Chart: SIA Group Gross Aircraft Fleet Growth (2016 to 2025)

Chart: SIA Group Gross Aircraft Fleet Growth (2016 to 2025)

Advanced MRO service provider with the capability of servicing new aircraft types well ahead of global sector peers; new generation aircraft fleet size is expected to increase 10 times in the Asia Pacific region in the coming years 

The key advantage of being airline-linked is that SIA Group’s frequent fleet renewal programme provides SIA Engineering access to acquiring the technical knowhow to maintain new generation aircraft, engines and components. SIA Engineering tends to be one of the earlier adopters of new technologies and has the certifications to maintain new generation aircraft, engines and components well ahead of many of its global sector peers. For instance, SIA Engineering was the first MRO service provider to have the capability to service the Airbus A380. It is also one of the first few MRO service providers globally to have the capability to service the A350 and B787 aircraft.

There are 272 new generation aircraft (including the Airbus A320neo, A350, Boeing B737 MAX, B787) in operation in the Asia Pacific region. Based on the existing aircraft orders, this market is going to grow at least 10 times in the coming years given that there are another 2795 new generation aircraft on order in the Asia Pacific region which will provide opportunities for SIA Engineering’s MRO business to grow. 

Chart: New generation aircraft fleet growth in the Asia Pacific region (2016 to 2026)

Chart: New generation aircraft fleet growth in the Asia Pacific region (2016 to 2026)

In addition, SIA Engineering, through its partnerships with Rolls Royce and Safran, has the capability of servicing the majority of the engine types (including the Trent, LEAP engines) that have been ordered to power these new generation aircraft types.

Chart: Distribution of engines (both in service and on order) powering the new generation aircraft types in the Asia Pacific region

Chart: Distribution of engines (both in service and on order) powering the new generation aircraft types in the Asia Pacific region

Potential earnings upside from supplying on-demand 3D printed parts to airline customers as part of their aircraft’s repair & overhaul work

SIA Engineering has signed a Memorandum of Understanding with Stratasys to explore the establishment of a joint venture to accelerate the adoption of 3D printed production parts for commercial aviation. The two companies plan to establish a Singapore-based Additive Manufacturing Service Centre, offering design, engineering, certification support and part production to SIAEC’s partners and customers.

One-stop shop providing a wide spectrum of MRO services to airline customers which reduces their aircraft downtime given SIA Engineering’s 24 subsidiaries and joint ventures formed mostly with global OEMs and more recently with Airbus and Boeing

SIA Engineering has the capability of providing airframe maintenance and overhaul services for 8 major aircraft types and 13 engine types. For line maintenance & technical handling, SIA Engineering’s services cover 11 aircraft types and 13 engine types. In addition, SIAEC can provide fleet management services for 7 aircraft types.

Chart: Service capability by aircraft type

Chart: Service capability by aircraft type

Chart: Service capability by engine type

Chart: Service capability by engine type

SIA Engineering has 24 joint ventures and subsidiaries, mostly partnering major OEMs, providing (often captive) access to third-party airline customers in the Asia Pacific region. In addition, SIA Engineering (49% stake) also signed a joint venture agreement with Moog (51% stake) in December 2016 to provide MRO services for Moog’s products which include components on the new generation aircraft (including Boeing B787, Airbus A350)’s flight control systems, subject to regulatory approval.

More recently in April 2017, SIA Engineering has signed a Memorandum of Understanding with Stratasys to explore the establishment of a joint venture to accelerate the adoption of 3D printed production parts for commercial aviation. The two companies plan to establish a Singapore-based Additive Manufacturing Service Centre, offering design, engineering, certification support and part production to SIAEC’s partners and customers.

Chart: Spectrum of services provided by SIAEC’s 24 subsidiaries and joint venture partners in 8 countries

Chart: Spectrum of services provided by SIAEC’s 24 subsidiaries and joint venture partners in 8 countries

One of the largest MRO service providers globally with efficient and high quality services

The lost revenue opportunity due to leaving aircraft grounded for maintenance tends to be much greater than the cost of aircraft maintenance for an airline or aircraft lessor. As such, SIA Engineering’s high level of productivity and superior service quality is a differentiating competitive advantage compared to its sector peers. A more efficient aircraft maintenance program would help improve the aircraft utilization and profitability of airlines. SIA Engineering may not be the cheapest MRO service provider but its superior labour productivity which reduces the number of hours needed to complete the service overhaul may help to offset this. Singapore’s large and growing Aerospace industry cluster (which houses many major global OEMs in the Aerospace supply chain) as well as efficient logistics infrastructure also enables the swift transportation of components and spare parts, helping to significantly improve the turnaround time of servicing an aircraft in Singapore.

Low jet fuel prices is likely to drive airlines to keep their aircraft for longer globally which should help lift MRO demand

Part of the reason behind the downturn in the global MRO industry in recent years is that the historical high jet fuel prices as well as industry oversupply in Asia have driven the airline industry to accelerate the retirement of older planes. This significantly reduced the demand for MRO services as newer planes generally require less maintenance work compared to the older ones. The newer generation aircraft and engines are also proving to be more reliable and have longer maintenance intervals than the aircraft they replace. The sharp drop in the jet fuel prices has improved the demand for older aircraft which could revive maintenance demand for these planes, engines and components to some extent.

Strong balance sheet with consistent net cash position; continued free cash flow generation should support stable long-term dividends

SIA Engineering is consistently in a net cash position with little debt on balance sheet. We expect its financial position to remain strong and continue to be free cash flow positive notwithstanding its plans to increase its investments in R&D, upgrade its capabilities (3D printing technologies) and establish the infrastructure for its new business ventures with Airbus, Boeing and MOOG and growing its line maintenance presence in more overseas markets both organically and via acquisitions.

Potential opportunity to secure work for the CFM Leap-1C engine that powers China’s Comac C919 which already has 570 aircraft on order

SIA Engineering should develop the capabilities to service the Comac C919 aircraft as well, in our view. Through its partnership with Safran, SIA Engineering has been appointed as the On-site support provider for the CFM LEAP-1A engine which powers the A320neo and the LEAP-1B which powers the B737 MAX. We believe SIA Engineering is therefore well-positioned to seek the potential opportunity to develop the capability of becoming the on-site support provider for the CFM LEAP-1C which powers the Comac’s C919 in the longer term, as well as service the other components in the Comac C919 aircraft.

SAESL’s workload will gradually increase by inferring from Rolls Royce’s recent guidance

Rolls Royce management recently commented that its large engines after-market revenue outlook is expected to be stable y/y in 2017 and start to become more favourable y/y in 2018, 2019, 2020 and 2021. We therefore expect Singapore Aero Engine Services’ (SAESL) revenue outlook to follow the same trend.

MRO business volume growth outlook is favourable in the longer term, supported by the global and Asian airlines’ fleet expansion plans

Based on the scheduled aircraft deliveries after taking into account capacity reduction from aircraft retirement and seat reconfiguration, we forecast the global airline industry’s capacity to grow around 7% y/y in 2017, moderating to 6% per annum from 2018 to 2020 and 5% in 2021.

Asia is the biggest buyer of aircraft globally and based on the existing aircraft orders, we expect the Asia Pacific airlines fleet capacity to grow 6% per annum from 2017 to 2021. This will support MRO demand growth at 5% per annum based on our forecasts and SIA Engineering is fairly well-positioned to leverage on this growth given its geographical location in this region.

Chart: Global airline sector capacity growth (2016 to 2021)

Chart: Global airline sector capacity growth (2016 to 2021)

KEY DOWNSIDE RISKS

New generation aircraft are proving to be more reliable with extended maintenance intervals

The newer generation aircraft and engines are proving to be more reliable and have longer maintenance intervals than the aircraft they replace. The more extensive use of composite materials may potentially result in fewer components requiring maintenance but rather, replacement outright which benefits the OEMs but not necessarily MRO service providers like SIA Engineering.

Airlines tend to defer their non-essential MRO work in order to cut costs when they are loss-making or only marginally profitable

The Asian airline sector’s profit margins remain thin on average as intense competition due to industry oversupply is likely to persist this year. This coupled, with higher jet fuel prices y/y, is likely to put pressure on the Asian airline sector’s profit margins this year, driving them to cut costs and continue to defer their non-essential MRO work. However, we expect the Asian and global airline industry demand-supply balance to improve in the coming years which should drive a recovery in MRO demand in the longer term.

Gradual phasing out of the PW4000 engine is likely to continue to dampen the earnings outlook of four of SIA Engineering’s associates, particularly Eagle Services Asia

SIA Engineering’s 49%-owned associate Eagle Services Asia (ESA)’s primary business is servicing the PW4000 engine which is gradually being phased out globally and it will take time to upgrade and expand its capabilities. Apart from ESA, SIA Engineering’s other associates Asian Surface Technologies, Component Aerospace Singapore and Turbine Coating Services are also negatively impacted by this trend.

Airline parentage could pose challenges in acquiring some third-party airline customers due to SIA Engineering’s perceived lack of independence from SIA Group

Singapore Airlines’ 78% stake in SIA Engineering could be negatively perceived by potential third-party airline customers that compete directly with SIA Group (Singapore Airlines, SilkAir, Scoot, Tigerair, SIA Cargo), resulting in their reluctance to award maintenance contracts to SIA Engineering, thus limiting its growth opportunities to some extent.

Competition from neighbouring countries which also have huge MRO ambitions and lower labour costs

Singapore’s neighbouring countries, especially Indonesia, Malaysia and Thailand, have also been developing their MRO hubs. They have the advantage of lower labour costs as well as home carriers with faster-growing aircraft fleets and airport flight movements. SIA Engineering has established two joint ventures (both line and heavy maintenance) in the Philippines as well as line maintenance presence in Indonesia and Vietnam.

However, SIA Engineering has still not been able to break into China (apart from Hong Kong) and India which are the key major aviation markets so far. This could continue to limit its growth opportunities. The following is a breakdown of the airline capacity contributed by each major aviation market in the Asia Pacific region compared with SIA Engineering’s revenue breakdown by the geographical location of its customers. SIA Engineering needs to broaden its overseas MRO network more aggressively in order to capture more business from higher growth markets, particularly in China, India and the rest of ASEAN.

Chart: Distribution of the airline capacity share in the Asia Pacific region

Chart: Distribution of the airline capacity share in the Asia Pacific region

Chart: Revenue breakdown of customers by geographical location

Chart: Revenue breakdown of customers by geographical location

Staff cost is SIA Engineering’s largest cost component, accounting for 48% of its total operating cost. Every 1% rise in staff cost cuts SIA Engineering’s FY18 net profit by 2% all other things being equal.

Some of the airline customers decide to self-handle some of MRO work when their aircraft fleet size grows bigger

Some airline customers, which have grown larger in fleet size, could potentially self-handle some of their MRO work. One example is VietJet which has a large aircraft fleet on order and is building its own basic MRO capabilities.

EARNINGS OUTLOOK

We expect SIA Engineering to report full year FY18 net profit of S$156m, down 53% y/y but up 4% y/y on a recurring basis (as FY17 net profit was boosted by the gains from its HAESL divestment), delivering an ROE of 10%. Going forward, we expect SIA Engineering’s revenue to grow 7% per annum, reaching S$1.3B and achieving a net profit of S$203m (+20% y/y) by FY20. We expect SIA Engineering to continue to generate positive free cash flows averaging S$163m per annum in FY18-FY20 and maintain its net cash position, thus sustaining a healthy level of stable and long-term dividends averaging S$0.16 per share per annum, with the potential for special dividends around every five years.

VALUATIONS

We value SIA Engineering at S$4.50 which is based on our discounted cash flow valuation model, assuming long-term free cash flow of S$226m and WACC of 5%. This is well supported by the S$4.70 fair value implied by the Gordon growth valuation model assuming 11% ROE, 5% cost of equity and 3% growth.

Chart: SIA Engineering – Discounted cash flow valuation model

Chart: SIA Engineering – Discounted cash flow valuation model

Chart: SIA Engineering – Gordon growth valuation model

Chart: SIA Engineering – Gordon growth valuation model

 

STOCK CATALYSTS

Upside from the potential partial divestment of SIA Engineering by Singapore Airlines in the longer term

SIA Engineering’s low free float of 22% and low daily trading volume need to be addressed in our view. SIA Engineering has also become a more well-diversified MRO service provider and less dependent on SIA Group which contributed only 33% of SIAEC Group’s combined revenue (if we were to consolidate the revenue of all its associates and joint ventures) versus 44% eleven years ago when data was first made available. It is therefore sub-optimal for Singapore Airlines to own such a large stake in SIA Engineering in our view.

More importantly, reducing SIA’s substantial 78% stake in SIA Engineering could boost SIA Engineering’s third party airline customer base. Given that Singapore Airlines is cash rich and does not need cash and SIA Engineering contributes to SIA Group’s earnings, it is understandable why SIA management would not be keen to consider this corporate action. We believe Temasek Holdings will need to drive this strategically important corporate restructuring.

Alternatively, paring down its stake in SIA Engineering from 78% to 51% and retain majority control as aircraft maintenance is still regarded as a core business to Singapore Airlines as it renews its aircraft fleet more frequently than its global peers and needs an engineering service provider that continues to upgrade its technological knowhow to service the new generation aircraft. SIA Engineering’s increased free float is likely to drive a re-rating as its improved trading liquidity and high quality business are likely to attract more equity investors.

CRUCIAL PERSPECTIVE FORECASTS

Chart: SIA Engineering Company Limited – Profit & Loss Statement

Chart: SIA Engineering Company Limited - Profit & Loss Statement

Chart: SIA Engineering Company Limited – Balance Sheet

Chart: SIA Engineering Company Limited - Balance Sheet

Chart: SIA Engineering Company Limited – Cash Flow Statement

Chart: SIA Engineering Company Limited - Cash Flow Statement

Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

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