ST Engineering (STE:SP) Fair Value: S$4.30
ST Engineering (STE:SP) Rating: Outperform
14 August 2017, Singapore – ST Engineering (STE:SP)’s 2Q17 headline results were weaker than expected, hurt by additional provisions made by the Marine segment. This has led management to revise down its earnings guidance, expecting Group revenue and pre-tax profits to be comparable to 2016. On a more positive note, the Group orderbook continues to expand and hit a record high of S$13.5B which will support its longer term earnings growth. Its diversified conglomerate structure helps to cushion the negative earnings impact of the Marine segment. Here are our key takeaways from the results and management’s briefing:
Orderbook continues to expand, rising 16% y/y and +2% q/q to a record high of S$13.5B at the end of 2Q17. This will help support ST Engineering’s revenue and earnings growth going forward which should help lift its equity valuation higher. 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 2Q17)
Net profit fell 12% y/y to S$112m in 2Q17 notwithstanding the 8% growth in revenue. This was mainly driven by the S$8.1m loss incurred by the Marine segment owing to additional provisions that had to be made by the Marine segment relating to VT Halter Marine’s two LNG-powered Container Roll-On/Roll-Off (ConRo) newbuild vessel contracts which were signed back in November 2013. Excluding these provisions, the Marine segment would have been profitable and management does not expect further significant provisions going forward. The ship repair business remains fairly stable and management is open to acquiring attractively valued assets that complement the Marine business at the bottom of the cycle. We have revised down our earnings forecasts to factor in the additional provisions for the Marine business.
More than half of ST Engineering Group’s pre-tax profits were contributed by the Aerospace segment: Aerospace contributed 53% of Group pre-tax profits in 2Q17, much higher than its 44% contribution a year ago. Electronics segment’s pre-tax profit contribution also rose 5ppts y/y to 35%. Land Systems accounted for 19% of pre-tax profits, +1ppt y/y, while the Marine segment was loss-making in 2Q17.
Comparing ST Aerospace and SIA Engineering’s results: SIA Engineering’s recurring growth of 5% was stronger than ST Aerospace’s limited growth in April-June 2017. However, ST Aerospace still has higher profit margins – its EBIT margin was 11% versus SIA Engineering’s 7% in April-June 2017 and management expects ST Aerospace’s profit margins to remain fairly stable for the rest of this year. 52% of SIA Engineering’s pre-tax profits are contributed by its associates and joint ventures compared to only 11% for ST Aerospace. We remain positive on the Aerospace segment outlook. With the improving global air cargo outlook and low fuel price environment, we expect ST Aerospace passenger-to-freighter conversion orders to tick up.
Even before the delivery of its first Airbus A330-300 passenger-to-freighter to launch customer DHL Express, Elbe Flugzeugwerke GmbH (EFW), which is ST Aerospace’s Dresden-based 55%-owned joint venture with Airbus (which has a 45% stake), has recently won another four Airbus A330-300 passenger-to-freighter (P2F) conversion contract from DHL Express. (See our report below for more details.) There are 1238 Airbus A330-300 and Airbus A330-200 aircraft in operation with an average age of 8 years globally. Some of these could be converted into freighters when they are replaced by the new generation Airbus A350 aircraft. Similarly, we expect ST Aerospace to win the smaller Airbus A320 passenger-to-freighter conversion contracts when the Airbus A320neo aircraft deliveries pick up speed in the coming years and replace some of the older Airbus A320ceo aircraft which can be converted into freighters. There are 4031 Airbus A320ceo aircraft in operation with an average age of 11 years.
Chart: Comparing ST Aerospace and SIA Engineering’s financial results (April-June 2017)
Exposure to Asia has increased: Asia-based customers’ contribution to ST Engineering Group’s revenue has increased to 63% in 2Q17 from 57% a year ago. USA-based customers’ contribution fell 6ppts y/y to 20%. Europe’s share rose 1ppt y/y to 11% while Other region’s share fell 1ppt y/y to 6%.
Electronics segment’s less favourable sales mix resulted in only a 2% y/y growth in pre-tax profits notwithstanding the increased revenue: Revenue grew 40% y/y in 2Q17, mainly due to the modification of revenue recognition estimates for long-term contracts from milestone completion per customer acceptance to monthly work done. The completed 51% equity interest in SP Telecommunications Pte Ltd will help enhance its Electronics segment’s ICT and Smart City solutions offerings to customers. ST Electronics is also part of the consortium of 6 companies (including Clifford Capital, DBS, Sembcorp Design & Construction, SMRT International, Surbana Jurong) brought together by IE Singapore which will bid for projects related to the 350km Kuala Lumpur-Singapore High Speed Rail and we see a higher probability of success in some of these projects.
Maintaining dividends even though it turned free cash flow negative during the quarter and is ramping up its technological investments: ST Engineering generated negative free cash flow of S$148m in 2Q17 versus its positive free cash flow of S$180m in 2Q16. Management is ramping up its investment in new technologies that complement its core businesses as well as in disruptive technologies. Its US$150m Corporate Venture Capital unit and Open Innovation Lab and Scouting Offices will support its development of new capabilities and service offerings in the longer term. However, ST Engineering is maintaining its S$0.05 interim dividend per share, similar to its interim dividend payout in the past two years. We expect ST Engineering to sustain a dividend yield of 3%-4% per annum as its balance sheet remains strong with low net debt-equity levels.
Defense revenue is growing, up around 12% y/y in 2Q17: The defense business accounted for 36% of ST Engineering Group’s revenue in 2Q16. With rising security concerns around the world, we believe Land Systems is well positioned to secure more contract wins.
Chart: ST Engineering – Defense revenue contribution (1Q07 to 2Q17)
Chart: ST Engineering (STE:SP) – Crucial Perspective Scorecard (Full marks = 100 points)
Chart: ST Engineering (STE:SP) – Financial Summary
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