Singapore Airlines can unlock value by merging SIA Engineering w/ ST Aerospace to form MRO Powerhouse

11 October 2017, Global – Singapore Airlines Limited (SIA:SP) can unlock value significantly via a partial or complete divestment of SIA Engineering (SIE:SP) that would yield Singapore Airlines’ shareholders a dividend in specie of S$0.81 to S$2.34 per SIA share. While highly speculative at this juncture, we believe that a merger between SIA Engineering and ST Engineering (STE:SP)’s Aerospace division (ST Aerospace) will be highly beneficial to all parties given the complementary nature of their businesses and create a Global MRO Powerhouse.

Furthermore, SIA Engineering (SIE:SP)’s 8% share price drop in the past week, driven solely by share overhang from a block trade, is a major wake-up call to SIA Engineering’s parent company, Singapore Airlines Limited (SIA:SP) that SIA Engineering’s low free float of 22.2% is sub-optimal and needs to be addressed urgently.

TEMASEK HOLDINGS WILL WELCOME A MERGER BETWEEN SIA ENGINEERING AND ST AEROSPACE THAT WILL CREATE A SINGAPORE-OWNED GLOBAL MRO POWERHOUSE

Currently, Singapore is the top MRO hub in Asia and the Singapore government has big plans to further develop the Aerospace industry in Singapore. However, there is increasing competition from neighbouring countries which also have huge MRO ambitions and lower labour costs. Therefore, a Singapore-owned Global MRO Powerhouse will likely be welcomed and facilitated by Temasek Holdings which owns 50% of ST Engineering and 55% of Singapore Airlines Limited (Singapore Airlines in turn owns 78% of SIA Engineering).

Chart: Temasek Holdings is the major shareholder of Singapore Airlines and ST Engineering

Chart: Temasek Holdings is the major shareholder of Singapore Airlines and ST Engineering

MERGING WITH ST AEROSPACE WILL CREATE GLOBAL MRO POWERHOUSE IN A SECTOR THAT IS HIGHLY COMPETITIVE AND FACING STRUCTURAL CHANGES

ST Engineering (STE:SP)’s Aerospace division (ST Aerospace) is already the world’s largest independent MRO service provider and its MRO capabilities and network of service locations are highly complementary to SIA Engineering. This combined MRO Powerhouse is well-positioned to reap greater economies of scale and attract more third party airline customers. 

ST Aerospace also has limited synergies with the rest of the ST Engineering Group and should ideally be carved out as a separate entity to merge with SIA Engineering.Management resources are being spread too thinly given ST Engineering’s over 100 subsidiaries, associates and joint ventures in 22 countries. ST Aerospace contributed 53% of ST Engineering Group’s pre-tax profits in 2Q17. 

There are push factors that could expedite this potential ST Aerospace and SIA Engineering merger:

  • The Aircraft Maintenance, Repair & Overhaul (MRO) market has been suffering from industry overcapacity, weaker demand and rate pressure. The Aerospace industry is also undergoing structural changes as the new generation aircraft are also proving to be more reliable with extended maintenance intervals than the aircraft they replace.
  • The more extensive use of composite materials could potentially result in fewer components requiring maintenance but rather, replacement outright which benefits the OEMs but not necessarily MRO service providers like ST Engineering and SIA Engineering.
  • In addition, airlines tend to defer their non-essential MRO work in order to cut costs when they are loss-making or only marginally profitable. Some airline customers, which have grown larger in fleet size, could potentially find it more cost effective to self-handle some of their MRO work.

Depending on the deal structure, resistance may come from Singapore Airlines as the MRO business tends to have higher profit margins than the airline business and as an airline which renews its aircraft fleet more frequently than its competitors, it is important to have greater access and equity control of its MRO service provider. On the other hand, ST Aerospace has long marketed itself successfully as an independent and non-airline linked MRO service provider. 

Chart: Combining ST Aerospace and SIA Engineering will create Global MRO Powerhouse

Chart: Combining ST Aerospace and SIA Engineering will create Global MRO Powerhouse

 

*Note: ST Aerospace’s free float and P/E valuation are based on listed parent ST Engineering’s (STE:SP).

**Note: We assume ST Aerospace’s market capitalisation would amount to half of listed parent ST Engineering’s (STE:SP) as the Aerospace segment contributed 53% of ST Engineering Group’s pre-tax profits in 2Q17.

MAJORITY AIRLINE PARENTAGE IMPEDES SIA ENGINEERING’S GROWTH

Over the years, SIA Engineering has 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.

In addition, Singapore Airlines’ 77.8% stake in SIA Engineering is at times 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. 

Chart: Sizing the airline capacity share of each market in the Asia Pacific region

Chart: Sizing the airline capacity share of each market in the Asia Pacific region

SHARE OVERHANG FROM BLOCK TRADE, NOT FUNDAMENTALS, DROVE RECENT DIVE IN SIA ENGINEERING’S SHARE PRICE

SIA Engineering (SIE:SP)’s share price fell 8% to S$3.19 since 4th October 2017. This was purely driven by a substantial block trade of 38.9m shares which amounts to a hefty 3.5% of SIA Engineering’s total shares outstanding, rather than by fundamentals.

Singapore Airlines Limited (SIA:SP) did not sell any SIA Engineering shares. These shares were from an institutional investor. J.P. Morgan (JPM:US) bought this block from an institutional investor and was re-offering these shares at S$3.11 to S$3.30 per share on 4th October 2017, implying a 4.6% to 10.1% discount to the closing share price of S$3.46 of the previous day.

Due to SIA Engineering’s low free float of 22.2% and low average trading liquidity averaging only 0.3m shares per day in the past year, selling such a large block had the effect of dampening its share price. Singapore Airlines (SIA:SP) owns the remaining 77.8% stake in SIA Engineering. See our report below for more details:

SIA Engineering (SIE:SP) share price drop triggered by block trade, not fundamentals

SIA ENGINEERING HAS BEEN DOING SHARE BUYBACKS EVERY DAY SINCE 4th OCTOBER 2017

SIA Engineering has the mandate (given in July 2017) to purchase up to 22.39m shares. It has so far purchased 1.03 million shares in the open market since 4th October 2017. This is equivalent to a 0.09% of SIA Engineering’s total shares outstanding and amounts to a cash consideration of S$3.32m.

Chart: SIA Engineering’s daily share buyback

Chart: SIA Engineering’s daily share buyback

THE DE-RATING HAS SHRUNK SIA ENGINEERING’S MARKET CAP BY 8%, EQUIVALENT TO 2% OF SINGAPORE AIRLINES’ OWN SHARE PRICE SINCE 4th OCTOBER 2017

However, SIA Engineering’s share buybacks have historically been made for its employee stock options. It is not a long-term solution for supporting its share price.

In the past week, SIA Engineering’s market cap has shrunk by 8% since 4th October 2017. This implies that the value of Singapore Airlines’ stake in SIA Engineering has also fallen by S$238m, equivalent to S$0.20 per Singapore Airlines share or 2% of SIA’s own share price.

RECENT DE-RATING AND REMOVAL FROM THE STRAITS TIMES INDEX COULD EASILY HAVE BEEN AVOIDED IF SIA ENGINEERING HAD A LARGER FREE FLOAT FROM SINGAPORE AIRLINES’ DIVESTMENT

This de-rating could have been easily avoided if SIA Engineering had a larger free float. SIA Engineering’s low free float has resulted in a stock that is thinly traded. Prior to 4th October 2017, the average number of SIA Engineering shares traded was only 0.3 million per day in the past year. This also resulted in SIA Engineering being removed from the Straits Times Index benchmark on 18th September 2017 and replaced by Jardine Strategic Holdings (JS:SP).

As Singapore Airlines is currently embarking on a Transformation programme, it would be an opportune time and in the best interest of SIA Engineering (and even Singapore Airlines) for Singapore Airlines to divest part or all of its stake in SIA Engineering.

Chart: SIA Engineering shareholding structure

Chart: SIA Engineering shareholding structure

 

Chart: SIA Engineering – Daily volume of shares traded

Chart: SIA Engineering – Daily volume of shares traded

CASE STUDY: SINGAPORE AIRLINES’ DIVESTMENT OF SATS LIMITED SIGNIFICANTLY IMPROVED ITS TRADING LIQUIDITY AND INVESTOR INTEREST, RESULTING IN HIGHER MARKET VALUATIONS FOR SATS

The experience of SATS Limited (SATS:SP) is a useful case in point. Singapore Airlines’ divestment of its entire stake in SATS via a dividend-in-specie (announced in May 2009 and paid in September 2009) increased SATS’ free float substantially.

This resulted in a significant improvement in SATS’ trading liquidity with the average number of shares traded rising by 400% to nearly 2 million per day (from 0.39m previously). This has significantly boosted investor interest in SATS which in turn raised its average market P/E valuation by 46% and average market capitalisation by 75% following the divestment.

Chart: SATS Limited – Improved trading liquidity post SIA divestment significantly boosted investor interest and market valuation

Chart: SATS Limited – Improved trading liquidity post SIA divestment significantly boosted investor interest and market valuation

SINGAPORE AIRLINES CAN UNLOCK VALUE: PARTIAL OR COMPLETE DIVESTMENT OF SIA ENGINEERING WOULD YIELD SINGAPORE AIRLINES’ SHAREHOLDERS A DIVIDEND IN SPECIE OF S$0.81 to S$2.34 PER SIA SHARE

Given that Singapore Airlines is cash rich and does not need cash and SIA Engineering still 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. Combining SIA Engineering and ST Aerospace would be an ideal outcome and Singapore Airlines could own a stake in the enlarged entity in order to retain some influence over its aircraft MRO programme.

Singapore Airlines can unlock value significantly from divesting SIA Engineering. Paring down its stake in SIA Engineering from 78% to 51% would imply a dividend in specie of S$0.81 per SIA share based on SIA Engineering’s current market cap.

Singapore Airlines’ divestment of its entire stake in SIA Engineering would imply a dividend in specie of S$2.34 per SIA share. SIA Engineering’s increased free float will significantly drive a re-rating as its improved shares trading liquidity and high quality business are likely to attract more equity investors.

Related Articles:

SIA Engineering (SIE:SP) share price drop triggered by block trade, not fundamentals

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

Singapore Technologies Engineering (STE:SP) Initiation Research Report 2017 – Strong orderbook as MRO, Infrastructure & Defense spending increases

Singapore Airlines Initiation Research Report 2017: Will SIA be a “sexy” stock again?

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