Business and Market Analysis
The 4 main sectors that ST Engineering (“ST”) operates in are
Aerospace, Electronics, Land Systems and Marine. ST Aerospace services include military and commercial maintenance, repair and overhaul and cabin interior
reconfiguration. For ST Electronics, they provide smart cities
solution, satellite communications and intelligent transportation solutions. ST Land Systems provides mainly defence and homeland
security systems while ST Marine provides shipbuilding and engineering services
for both defence and commercial ships.
In 2017, ST Aerospace represents 38% of ST overall revenue, followed by ST Electronics of 32% with $1b coming from its smart city business. This represents 15% of its total revenue and management expect to double it by 2022 through organic growth and future acquisition. ST Land Systems contribute 19% of overall revenue and due to the sluggish oil
and shipping industry, ST Marine represents only 10%,
less than half of what it used to be in 2014.
In terms of geography, ST main operation is in Asia which include Singapore, Middle East and Asia Pacific region where 61% of its revenue comes from. USA is its 2nd biggest market followed by Europe. ST management expects 66%
of future revenue growth to be from global markets with USA and Middle East
remaining to be key for its defence exports. This is due to USA being the largest defence market in the world while Middle East is expected to grow at 9% p.a.
Aerospace Industry
According to Deloitte 2017 Aerospace and Defence Outlook Report, the aerospace industry is forecast to grow strongly. This is due to the strong demand for newer and more advanced aircraft and growing passenger
traffic especially in Asia-Pacific and Middle East region. Due to growing middle class and as air tickets become relatively cheaper, travel demand has been increasing at a CAGR of 4.7% for the last 10 years. Passenger and airfreight are expected to continue growing at 4.8% and 4.2% respectively. This has resulted in increased aircraft production which is expected to reach 1,550 units in 2021, a 14% increase as compared to 2016, and by year 2035, to 2,206 units. Airbus and Boeing had already indicated ramp up in
production rate and more aircraft means greater demand for
ST Aerospace services.
Defence Industry
With rising global tensions, global defence spending is set
to rise. HIS Markit’s Jane’s Defence Budgets Report had forecasted global
defence spending to reach $1.67t in 2018, the highest level since the
end of cold war. This is a 3.3% increase as compared to 2017 and was partly
fueled by the Trump administration where he has recently approved a $700b
military budget, the largest in US history. The USA is one of ST core market
and this will create ample opportunities for them. Furthermore, with the
reduction of USA corporate tax rate from 35% to 21%, this will further benefit
ST as their US subsidiaries contribute 18.5% of their overall revenue (based on
country of incorporation).
Singapore Defence and Home Affairs Security spending has continued to increase significantly due to the security threat that we are
facing being one of the highest in recent years. Singapore Military and Home Affairs Security budget in 2018 is estimated to be S$14.8b and S$6.5b respectively.
This is an increase of 25.6% for military and 66% for home affairs security as
compared to 5 years ago. As a core supplier for Singapore military and security
needs, this will also provide ample opportunities for ST across its sectors.
Shipping Industry
The marine and shipping industry is more exposed to oil
prices as many of the firms are operationally related to offshore drilling. As
such, due to the downturn in the oil and gas industry, ST marine sector was impacted.
Furthermore, overcapacity in the shipping industry has continued to weigh down
its own recovery. The low charter rates lead to reduce maintenance and CAPEX
budgets which increase the competitive landscape of the marine industry. And
with the recent surge in global trade protectionism, it can adversely impact
the shipping industry as 80% of world trade in goods is carried by
international shipping industry. All these factors may continue to weigh down
ST marine sector profitability. However the recent recovery in oil prices might restart its growth.
Smart Cities
The smart cities market size is currently valued at USD$563b
in 2016. With the current digital revolution, Frost & Sullivan is expecting
the market to grow to $1.57t by 2020, which is nearly triple of what it is today and this provide ample opportunities for ST to offer its smart cities solution. ST
management has targeted to double its smart cities revenue by 2022 and this seems achievable due to the strong market growth.
Order Book
As at end of 2017, ST order book stood at $13.2b which is
near an all-time high. In 1Q18, ST Electronics and Aerospace announced that they had won $635m and $510m worth
of contract respectively.
Profitability
Looking at ST revenue growth for the past 10 years, it has been growing at a CAGR of 2.16%. Though this might seems low, ST
provides the stability that may be sought by dividend play investor. ST
Engineering has consistently pay out dividend of $0.15 a share per year for the past 5 years. Based on
current share price of $3.47, this represents a respectable dividend yield of 4.3%. However, ST generally pay out dividend at around 90% of profits. This means that it only retains 10% for internal use such as working capital purposes or for future investment. A detailed look at the company cash flow has shown that its strong balance sheet
has allowed them the ability to maintain its high dividend pay-out ratio (refer to
cash flow and stability section).
As mentioned, the two star performer of ST are its Aerospace and Electronics sectors.
Since 2014, ST Aerospace and ST Electronics revenue have been growing at a CAGR of
5.3% and 7.4% respectively. ST Land Systems has stagnant while ST Marine has negative growth of -17% due to the impact from the shipping and oil and gas industry. Furthermore, ST Aerospace and ST Electronics has decent profit margin of more than 8%. As compared to its peer, ST Aerospace operation margin is usually around 20%, 4%
point higher than SIA engineering.
In 2016, there was a sharp drop in profitability in
ST Land Systems because of the impairment cost for the closure of
JHK, their land road construction equipment business in China which has been
loss making since 2014 due to the lacklustre construction sector. This has
impacted ST Land Systems margin which had since recovered. Just today, ST has announced that JHK has filed for bankruptcy after failing to dispose its assets due to the weak demand for industrial properties in China Zhenjiang area. The investment was fully written down in 2016 and management expect no material impact on its net tangible assets and earnings per share for the current financial year.
Growth opportunities from the Aerospace and Smart Cities
industry should support ST future growth. With the delivery of SAF next generation
armoured fighting vehicle in 2019, this should boost its revenue in its Land Systems sector. As for ST Marine, hopefully the recovery in the oil and gas sector can sustain so that upstream investment will return and support
the market.
Management Efficiency
ST ROE, which shows the return for every $1 of equity
invested, is currently at 22.85%. This is good as compared to its peer such as
SIA Engineering which generally has an ROE lower than 20%. However, as compared
to past years, ST ROE has been trending down. This might be due to investment made by ST for the past few years not fully bearing fruits yet.
Cash flows and
Stability
Free cash flow (FCF) is the amount of cash the company is
able to generate after deducting the cash required for investment for the growth of the company. ST has been able to generate positive free cash
flow for most of the year except in 2015 where they invested heavily in the
bond market. As mentioned previously, the high dividend pay-out ratio is a
concern to me as I am wondering why ST does not need to retain cash for its business. This seems not to be an issue as the
company free cash flow is sufficient to cover its dividend pay-out and they even have additional cash to invest in the bond market. The high cash withdrawal in 2014 and 2015 was due to repayment of
bank loans and investment in bond market respectively.
With interest coverage of 12x, ST has strong ability to pay off its debt interest. Debt has been on a downtrend with current debt to equity at 0.5x. If required, ST has ample room to borrow more from banks or issue bond for investment or refinance its existing loan. Furthermore, ST tangible assets are able to fully cover its debt with a ratio of only 0.15x (every $0.15 debt is backed by $1 of tangible asset). Out of ST
total debt, only 27% are variable rates liabilities which will be impacted by the movement of market interest rate. As such, an increase of 0.5% in market interest rate
will only reduce ST profits by $1.5m or 0.25%.
ST current ratio is at 1.21x. A figure above 1x means the company has the ability to use its current assets to pay all its current liabilities. Striping off its
inventory, the quick ratio is at 0.76x. This has been generally consistent for
the past 3 years after ST made a huge debt repayment in 2014 which resulted in
the drop in its liquidity ratios. By looking at the inventory turnover days which shows the number of days required by ST to turn its inventory into sales, it
has generally been consistent for the past 3 years with an inventory turnover days of 122 days in 2017, lower than
129 days in 2016 and 140 days in 2015. This show ST does not have the difficulty in selling off its inventory and therefore its quick ratio of
less than 1 should not be a concern currently.
Valuation
ST Price-to-Earnings (PE) ratio of 21.2x is trading at a fair level
as compared to its peers (SIA 20.6x, Honeywell International 69x, Airbus 26x,
ABB Ltd 23.5x, Boeing 25x).
ST historical share price over net tangible assets
(NTA) shows that during market exuberance, it has touched an all time high of 12.3x in 2008 before the financial crisis hits while touching a low of 5.67x in 2012. It is currently
trading at 9.38x, above its average and reaching its +1sd.
I have adjusted ST historical share price per NTA to its current NTA to see how high it can go based on current NTA. ST share price has the potential to touch a high of $4.55
during bullish market while a low of $2.10 during bearish market. If
bullish market condition persist, I would give it a target price of $3.93. If market
turn bearish, my 2 points of accumulation would be at $2.66 and $2.24
respectively.
Summary
*Profitability and stability:
Collectively, both metrics, which is fundamentally important to all businesses,
represent 40%.
*Market and environment: This measure
the current market risk or opportunity that are presented to the company which
have an impact on the direction of its share price.
*Valuation: Determine if the share price
is currently undervalued or overvalued.
