ST Engineering: 3Q22 operational updates in line
- Recovery in commercial aerospace segment remains encouraging, momentum should continue
- Record level of new contract wins in 3Q22, orderbook expands to S$23bn (2.6x revenue) despite disposal of US marine business
- We cut FY22/23 earnings by 5%-6% to factor in higher interest costs amid Fed rate hikes in the US
- Trading at -2SD PE valuations, maintain BUY as we still expect double-digit earnings CAGR over FY22-24F
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Recovery in commercial aerospace segment is encouraging, MRO activity levels should reach near pre-COVID-19 levels by end-2022. Commercial aerospace segment revenue grew to S$776m in 3QFY22 (+6.3% q-o-q, +27.8% y-o-y), representing 75.0% of pre-pandemic levels. Momentum in the division continues to be sound, given robust demand in STE’s OEM operations (nacelles and P2F) and sustained recovery in MRO activity levels (overall MRO utilisation is at 90%, but some hangars are fully booked out) with the reopening of borders globally, though muted air traffic in China continues to be a drag. The group is still seeing challenges in the form of a tight labour market, wage inflation, and continued supply chain bottlenecks (OEMs) in this division but still expect continued recovery going forward. P2F operations are expected to breakeven at the programme level by the year end and should see improved profitability in 2023.
Other divisions are tracking well with expectations. The Urban Solutions & Satcom (USS) division revenue came in at S$452m in 3QFY22, marginally down by 1.7% q-o-q due to global supply chain disruptions and semiconductor shortages. Meanwhile, the Defence & Public Security (DPS) segment revenue of S$1,010m was up 4.7% y-o-y but down 4.9% q-o-q, with annual growth driven by growth across all subsegments. Management shared that demand for defence solutions in the Middle East continues to be strong, while STE has been seeing heightened interest in Europe after the start of the Russia-Ukraine conflict.
Record S$4.8bn worth of new contracts secured in 3QFY22; 9MFY22 contact wins of S$10.3bn. Announced order wins during the quarter do not include the c.S$1.5bn turnkey tolling system contracts in US clinched in November 22 by TransCore. The USS segment saw contract wins of S$2.0bn in 3QFY22, including a S$1.4bn turnkey rail contract for the Kaohsiung MRT Yellow Line, tolling projects in Pennsylvania and Dubai, and smart city projects in the US and Singapore. Meanwhile, the DPS segment had S$1.8bn of contract wins, including training & simulation solutions to multiple international customers and defence contracts in the Middle East. Thus, despite the divestment of the US marine business, STE’s contract backlog (excluding US marine business) of S$23.1bn in September 22 continued to be robust, compared to S$22.2bn (S$20.3bn without US marine business) in June 22.
TransCore secures c.S$1.5bn contracts, but impact is more long term in nature. On 15 November 2022, STE announced that TransCore had been awarded turnkey tolling system contracts in the US worth about S$1.47bn (US$1.07b) comprising a S$1.25bn (US$914m) contract with the New Jersey Turnpike Authority (NJTA) and a S$218.2m (US$159.3m) contract with the South Jersey Transportation Authority (SJTA) to modernise tolling infrastructure in New Jersey. The design, installation, operation, & maintenance projects run for around 10-12 years. The projects will take a few years to commence and the revenue recognition impact will be low in the near term.
Increasing proportion of fixed-rate loans amid rising interest rate cycle; cost of debt should rise to 3.5%-4.0% in FY23-24F. STE’s current debt funding structure consists of 54% of fixed-rate and 46% of floating-rate borrowings. STE now plans to term out S$700-1,000m floating rate commercial papers through fixed coupon bonds/loans, which will increase the proportion of fixed-rate loans to 65%-70%. Additionally, the group still has US$32m in unrealised T-lock gains, which will partly offset the interest rate increase for the next bond issuance or loans. Based on STE’s recent debt-raising exercise, (US$700m 3.375% notes and US$300m 3.75% notes raised in April 22) and imminent issuance of new fixed coupon bonds/loans, we estimate the group’s cost of debt to rise to 3.5%-4.0% over the next two years, up from a low 2% base.
Disposal of US marine business will offset some of the impact. In our recent commentary, we had highlighted the disposal of the US marine business removes a key drag on future earnings, though there would be a near-term write down or disposal loss of around S$13m. Thus, the impact of higher interest rates, though felt keenly in FY23 and beyond, will be offset to an extent by the absence of losses from the US marine business.
Cut earnings estimates in view of the higher interest expenses. We have cut FY22/23 core earnings estimates by around 2.4%/5.8% (higher cut of 4.6% to FY22 headline estimates if we factor in the disposal loss from US marine business), largely to factor in higher interest expenses, and also the slightly slower revenue growth trajectory in the USS segment, owing to global growth slowdown in FY23, offset by lower losses from the marine segment as explained above.
M&As likely to take the backseat for now; integration of TransCore remains the top priority. Management indicated that while they remain open to bolt-on acquisitions that make sense for the group, should the opportunity present itself, it is highly unlikely for the group to make any further sizable acquisitions in the near future, at least until TransCore’s acquisition is well digested.
Quarterly dividend of 4.0Scts per share, as expected, was announced for 3Q22, as per change to the dividend policy to quarterly distributions from semi-annual distributions. Full-year DPS of 16.0Scts per share represents a dividend yield of around 4.7% based on current share price levels.
Share price has largely factored in negatives, maintain BUY with lower TP of S$4.10. STE’s share price has declined c.15% from its recent peaks in July, owing to the rising interest rate and recession risk scenario, and at current valuations (-2SD below historical mean despite potential double-digit earnings growth over FY22-24F), risk-reward seems attractive in our view. The cut in our TP reflects the moderation in earnings estimates, lower peer valuation pegs, and higher risk-free rate/cost of debt assumptions.
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