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

11th March 2017, Singapore – We believe the worst is over for Singapore Airlines but the stock could remain range-bound near term given our expectations of lacklustre earnings in 4QFY17 and continued pressure on passenger yields in FY18. However, the longer-term drivers lean on the positive side and given SIA’s strong balance sheet and attractively high break-up value, we expect Singapore Airlines’ share price to re-rate in the longer term, driven by its stronger growth.

Fair value: S$11

Rating: Outperform

Chart: Singapore Airlines – Crucial Perspective Scorecard (Full marks = 100 points)

Chart: Singapore Airlines - Crucial Perspective Scorecard

Chart: Singapore Airlines – Financial Summary

Chart: Singapore Airlines - Financial Summary

KEY POSITIVE DRIVERS

+ Wide and well-diversified global route network

Singapore Airlines (SIA) has a wide and global route network, with 35% of its SIA mainline carrier’s passenger revenue derived from North and Southeast Asia routes, 23% from Europe, 17% from South West Pacific, 16% from the Americas and 9% from West Asia and Africa routes. This well-diversified global network enables SIA to tap on air traffic from a large catchment area and reduces its earnings impact from travel demand disruptions on any particular route. We expect the global air travel demand to grow 5%-6% per annum in the next 5 years which will provide the base line of SIA’s traffic growth trajectory going forward.

Chart: SIA passenger airline revenue by route region (FY16)

Chart: SIA passenger airline revenue by route region (FY16)

+ Growth will pick up, following 4 years of rationalization

We expect Scoot to play a bigger role in driving the overall growth of SIA Group as its competitive cost structure positions it well to access previously unviable routes for the SIA mainline carrier.

Around 45% of SIA’s passenger business is driven by the first and business class segments. While SIA’s premium product and superior service level positions it well to capture and retain this premium market on routes to key business cities and other high density routes, SIA’s premium cost structure makes it challenging for the airline to operate services and compete effectively on routes with a larger and more leisure-driven traffic mix.

With Scoot taking delivery of more and more B787 aircraft and building scale, its cost structure has become highly competitive, with 9MFY17 unit cost c48% below SIA’s passenger airline’s unit cost even though it operates only 12 aircraft at present. We believe this positions Scoot well to grow in untapped markets and help lift the SIA Group’s earnings growth in the longer term. Scoot’s merger with Tigerair (which has turned profitable), with a single operating license and full integration under a single Scoot brand by the second half of calendar year 2017, will also help drive synergies, especially in the areas of network optimization and traffic feed.

+ Rising leverage to the growing Asian outbound travel market

The North and South East Asia route region is becoming an increasingly more important contributor of SIA’s passenger revenue, rising from 27% in FY10 to nearly 35% in FY16. In fact, the Asian markets drive 62.5% of ticket sales for SIA Group of passenger airlines. SIA’s mainline carrier’s existing product is superior but its cost structure is high relative to the Asian airline competitors. Scoot’s much lower cost structure will help the Group to compete and capture more traffic as per capita incomes continue to rise in this region. We expect Scoot to operate some of SIA’s B787-1000 aircraft and possibly the A350-900s when they are delivered, in addition to Scoot’s existing plans to grow its aircraft fleet to 20 by the end of calendar year 2018.

Chart: SIA – North and South East Asia route region passenger revenue contribution (FY05 to FY16)

Chart: SIA – North and South East Asia route region passenger revenue contribution (FY05 to FY16)

Chart: SIA Group – Revenue breakdown by origin of sale (FY16)

Chart: SIA Group – Revenue breakdown by origin of sale (FY16)

+ Regaining Transpacific market share will help boost revenue

Singapore Airlines lost market share and revenue on the Asia-US routes when it suspended non-stop direct flights between Singapore and Los Angeles and Singapore and New York following the decommissioning of its five A340-500s which were economically unviable during the high fuel price period.

The carrier’s recent launch of direct flights from Singapore to San Francisco following the delivery of the A350-900 aircraft as well as the Singapore-New York non-stop direct flights on the A350-900 ultra-long range aircraft when they are delivered from 2018 should enable Singapore Airlines to regain market share in the Asia-US route region, especially premium traffic. If Singapore Airlines regains the same level of revenue contribution from the Americas route region as it had back in FY05 (when fuel prices were at similar levels to the current fuel prices), we estimate there could be a S$300m potential revenue upside and these direct flights are likely to command a higher average profit margin compared to Singapore Airlines’ existing connecting flights to the US.

Chart: SIA – Americas route region passenger revenue contribution (FY05 to FY16)

Chart: SIA – Americas route region passenger revenue contribution (FY05 to FY16)

+ Bigger beneficiary of falling fuel prices going forward; well-hedged against sharp spike in fuel prices in the next 5 years

Singapore Airlines’ average hedged fuel price level has fallen to around US$68/bbl (jet kerosene) since 2HFY17 from around US$84/bbl (jet) in 1HFY17 and US$106/bbl (jet) back in FY16. This would enable SIA to benefit more from falling fuel prices. In addition, it is also well-protected against any sharp spike in fuel prices in the next 5 years given that it has hedged 33%-39% of its annual fuel consumption from FY18 to 2022 at US$53/bbl-US$59/bbl (Brent crude oil). In fact, should fuel prices surge in the next 5 years, SIA’s low average fuel price paid, plus its young and more fuel efficient aircraft fleet, will increase its unit cost advantage versus its competitors.

SIA is also future-proofing with its new generation aircraft orders. SIA and Scoot have already started operating new generation aircraft – 8 A350s and 12 B787s by end March FY17 and have another 59 A350s and 38 B787s scheduled for delivery from 2017 to 2023. Apart from their new cabins which should boost customer appeal. These planes are also more fuel efficient than the aircraft they replace and will help mitigate the earnings impact from a sudden surge in fuel prices. Similarly, for short-haul operations, SilkAir and Tigerair have 37 B737 MAX and 39 A320neo aircraft on order to be delivered from 2018 to 2025 which will also improve their fuel and operating efficiency.

+ EBIT margins have improved but are still low and a long way from FY11 levels

Singapore Airlines’ profitability has improved but its margins are still well below the levels achieved in FY11 when the airline industry recovered from the global financial crisis. Part of the reason is that SIA had fairly expensive fuel hedges so it did not fully benefit from the lower spot fuel prices. However, we expect this to change from 2HFY17 as the expensive fuel hedges have rolled over and its average hedged fuel price is meaningfully lower going forward.

Chart: Singapore Airlines – EBIT margin (FY11 to 9MFY17)

Chart: Singapore Airlines – EBIT margin (FY11 to 9MFY17)

+ One of the best premium and long-haul carriers in the region

Around 45% of Singapore Airlines’ passenger revenue is driven by the front end of the cabin. Premium class passenger yields have generally held up better than economy class yields. SIA still has one of the best first and business class products in the market notwithstanding its competitors’ product upgrades in recent years and is well-positioned to continue to capture the growing well-heeled travelers market. Moreover, SIA is based in one of the busiest and most efficiently run air hubs globally. Its catchment area in Southeast Asia, Australia and New Zealand is home to a population of around 630 million people. International travel penetration is still low in many of these markets and Singapore is strategically located to provide these underserved markets with good global connectivity. Their own national carriers tend to have more limited network and flight frequencies while their local low cost carriers’ network reach is mainly regional short-haul.

KEY DOWNSIDE RISKS

+ Yields could remain under pressure due to SIA Group’s accelerating aircraft deliveries from FY18/19 to FY21/22

SIA’s main passenger airline business’ passenger yield has fallen slightly more than its passenger unit cost in the past 5 years. This is mainly due to industry oversupply and intense competition. We are concerned that SIA’s passenger yields could remain under pressure when the number of aircraft deliveries pick up from FY18/19.

SIA Group has historically taken delivery of 17 new aircraft per year in the past 5 years. This number is expected to accelerate to around 32 new aircraft per annum from FY18/19 to FY21/22 based on scheduled aircraft deliveries. As such, SIA Group will need to accelerate the retirement of its old aircraft and to continue with its premium economy class cabin configuration to keep its annual net capacity growth to a more moderate level or risk greater than expected yield pressure to fill up the seats. SIA Group’s average fleet age was 7 years 5 months as at end March 2016, older than it average fleet age of 5-6 years old historically but still younger than the global industry average of 12 years.

Chart: SIA’s passenger yield has fallen slightly more quickly than its unit cost in the past 5 years (FY12 to 9MFY17)

Chart: SIA’s passenger yield has fallen slightly more quickly than its unit cost in the past 5 years (FY12 to 9MFY17)

+ Continued stiff competition from Middle Eastern airlines with Qatar Airways expanding aggressively to capture connecting traffic

Given its homebase Singapore’s small population, Singapore Airlines is highly dependent on connecting traffic from/to the region and has traditionally been the gateway airline for the Southeast Asia and to some extent, the South West Pacific region. SIA’s future success therefore depends on how attractive it is for travelers to opt to connect via Singapore, rather than flying direct or transit via another air hub. The Middle Eastern airlines have been investing in state-of-the-art aircraft and cabin in recent years. Their fleet capacity is expected to grow 12%-13% per annum in 2017 and 2018 before decelerating to 9% per year in 2019 and 2020 and 7% in 2021. The Gulf carriers’ expansion, particularly Qatar Airways, could therefore continue to put competitive pressure on Singapore Airlines, especially in the economy class cabin where their product and service differential is limited, as they offer more attractive fares for passengers.

+ Strengthening US dollar against the Singapore dollar

SIA has more US dollar-denominated operating costs than US dollar-denominated revenue as well as US dollar-denominated aircraft and related equipment capital expenditure. Therefore, a stronger US dollar tends to negatively impact Singapore Airlines’ earnings.

+ Overseas airline investments could remain a drag on SIA Group’s earnings and could require further capital injection to fund their future expansion

SIA Group’s overseas airline investments, 49%-owned Vistara in India and 20%-owned Virgin Australia are expected to remain loss-making and marginally profitable respectively. They could potentially require further capital injection to fund their future expansion.

EARNINGS OUTLOOK

We expect Singapore Airlines to report full year FY17 net profit of S$524m, down 35% y/y and ROE of 4%. Going forward, we expect Singapore Airlines’ revenue to grow 5% per annum, reaching by S$16.5B by FY19. We forecast Singapore Airlines’ net profit to grow 16% per annum to S$707m by FY19.

VALUATIONS

We value Singapore Airlines at S$11 which is based on 1.0x P/B, assuming ROE of 5% and 0% long-term growth. This represents a 20% discount to our estimated “liquidation” value assessment of SIA Group. Our S$11 fair value implies 6x Adjusted EV/EBITDAR, in line with Singapore Airlines’ historical average Adjusted EV/EBITDAR valuation.

Chart: Singapore Airlines – Gordon growth valuation model

Chart: Singapore Airlines – Gordon growth valuation model

Chart: Singapore Airlines – Estimated “liquidation” value

Chart: Singapore Airlines – Estimated “liquidation” value

STOCK CATALYSTS

Singapore Airlines’ share price corrected 13% and underperformed the FSSTI by 24% in the past 12 months. This was mainly driven by investors’ concerns about continued pressure on passenger yields.

+ Share price could trade range-bound near term

We believe the worst is over for Singapore Airlines but the stock could remain range-bound near term given our expectations of lackluster earnings in 4QFY17 and continued pressure on passenger yields in FY18. However, the longer-term drivers lean on the positive side and given SIA’s strong balance sheet and attractively high break-up value, we expect Singapore Airlines’ share price to re-rate in the longer term, driven by its stronger growth.

+ Upside from the potential partial divestment of SIA Engineering longer term

SIA Engineering (SIE SP)’s low free float of 22% and low daily trading volume need to be addressed in our view. More importantly, reducing SIA’s substantial 78% stake in SIA Engineering could boost SIE’s third party airline customer base. Potential synergies can also be realized should SIA Engineering consider merging with ST Aerospace (which is owned by ST Engineering) given their largely complementary businesses. 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. Combining SIA Engineering and ST Aerospace would be an ideal outcome and SIA could own a stake in the enlarged entity.

Alternatively, paring down its stake in SIA Engineering from 78% to 51% would imply a dividend in specie of S$0.92 per SIA share based on SIA Engineering’s current market cap. 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: Singapore Airlines – Balance Sheet

Chart: Singapore Airlines - Balance Sheet

Chart: Singapore Airlines – Balance Sheet

Chart: Singapore Airlines - Balance Sheet

Chart: Singapore Airlines – Cash Flow Statement

Chart: Singapore Airlines - 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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