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While improving air connectivity and rising global wealth are driving growth in air travel worldwide, it is the lucrative after-sales service market that may be an even more attractive sector for investors to be in.

The increasing demand for air travel has driven up the demand for new aircrafts to support this huge influx of passengers. With every aircraft requiring maintenance and repair services, we see immense potential in the MRO market as global fleet increases.
As Singapore holds a global market share of 10% and accounts for a quarter of Asia’s MRO business, our local players are in a very good position to benefit from the growing after-sales market, especially in the Asia Pacific region, which is expected to generate the biggest growth.
As the industry leader, we believe ST Engineering (SGX.S63) will be the prime beneficiary in this booming after-sales service market. Its growth outlook remains positive given its strong order book and potential new revenue streams through recent acquisitions.
Using the Discounted Cash Flow (DCF) model, we arrive at our target price of SGD 4.2 with a total potential return of 17.5%.

The world wants to fly, as evident by the growing number of air passengers each year.

Improving air connectivity and rising global wealth is driving growth in air travel worldwide. The outlook for air travel demand is expected to remain strong with consumers spending more on travel and tourism.

When there is an exponential growth in demand for air travel, this inevitably drives up the demand for new aircrafts and airports to support this huge influx of volume. According to Oliver Wyman’s projections, global fleet will need to grow roughly 41% from its current fleet to meet the air travel demand in the next decade. The Asia Pacific region will be contributing to the bulk of growth, accounting for approximately 40% of the global fleet .

Chart 1: Global fleet is growing, with Asia Pacific contributing to the bulk of growth

While many may jump straight into airline-related stocks, thinking that they will be the main beneficiaries, we believe that the after-sales service markets of aircrafts may be the more attractive sector to be in right now. With every aircraft requiring maintenance and repair services, this industry will be steered upwards as global fleet increases.

The aircraft after-sales service market covers a wide spectrum of activities such as engine overhaul, cabin modification services, fleet management and etc. Singapore is currently one of Asia’s largest ecosystem for aerospace engineering activities, with over 130 companies providing a whole range of services. Therefore, boosted by the tailwinds of increased aircraft demand, we believe Singapore aerospace players are very well-positioned to reap the benefits.

Strong growth in the MRO industry

Similar to automobiles, all commercial/civil aircrafts are subjected to periodic maintenance checks under a highly regulated environment. According to Oliver Wyman, global Maintenance, Repair and Overhaul (MRO) market is expected to grow by 40% in the next decade. The biggest growth region will be the Asia Pacific, where it is expected to almost double from USD 24.5 billion to USD 42.6 billion in the next 10 years, with China and India being the main growth drivers (Chart 2).

Chart 2: Asia Pacific will be the fastest growing MRO market

Currently, Singapore has a global market share of 10% and accounts for a quarter of Asia’s MRO business. Therefore, as the MRO sector grows, the earnings growth of local MRO players should follow suit as well.

Aerospace segment the biggest growth driver for ST Engineering

Many of us may know that the two leading home-grown industry players in the aerospace sector are ST Engineering (SGX.S63) and SIA Engineering Company (SGX.S59). However, we believe ST Engineering will stand to gain the most in this booming aerospace MRO market. As the industry leader, ST Engineering is more exposed to new opportunities for potential partnerships with industry-related companies, which may provide new revenue streams for the company.

With 50 years of experience and a strong presence in over 100 countries all around the world, ST Engineering is well-known to be capable of providing a wide range of nose-to-tail aerospace engineering solutions. While the company also has other businesses in Electronics, Land Systems and Marine, its Aerospace segment brings in the lion’s share of total revenue at about 40%, and we believe that this segment will continue to be the main growth driver given the flourishing aerospace industry.

In fact, ST Engineering has secured several new contracts over the past few quarters, including a 14-year maintenance contract with Vietnam Airlines, with the new joint venture headquartered at the Noi Bai International Airport in Hanoi . We believe this is a strategic move for ST Engineering to ride on the robust development of the Vietnam economy and their double-digit growth in the air travel sector.

Furthermore, ST Engineering is also expanding its MRO business in the US, with the development of a new 655,000 sq ft hangar in Florida allowing ST Engineering to further strengthen its foothold in this market that is worth USD 20 billion. On top of that, business has been brisk for ST Engineering. Not only did it renew its 10-year MRO contract with an existing North American operator in 1Q19, it has also bagged a new contract with a major North American airline for the first time.

SIA Engineering, on the other hand, is heavily reliant on its parent airline for new contracts. This paints a gloomy outlook for SIA Engineering in the next few years, and therefore, we believe ST Engineering will stand to benefit more between the two main MRO players in Singapore.

Tapping on new and existing areas for growth through acquisitions

Even though parts-and-repair is the less glamourous side of the aviation sector, its lucrativeness has attracted original equipment manufacturers (OEM) to expand their presence in this after-sales service industry. While this can pose as a threat to the MRO players, ST Engineering has responded well by not only upgrading their engineering capabilities, but also establishing strategic partnerships with OEMs and other industry-related companies. This has allowed them to expand into manufacturing to tap on new areas of growth.

In fact, the recent acquisition of MRA Systems (MRAS) will support ST Engineering in the OEM business of manufacturing engine nacelle systems (exterior casing that holds aircraft engines). MRAS’ strong portfolio of intellectual properties and programmes that support next generation aircrafts, such as the fast-growing A320neo series, will also scale up ST Engineering’s MRO capabilities.

With every aircraft engine requiring a nacelle system, the nacelle manufacturing business will grow, without question, as the global aircraft fleet expands. Also, as the single-source nacelles provider for the A320neo using LEAP-1A engines, ST Engineering is in a very strong position to reap the benefits of the growing A320neo fleet (Chart 3).

Chart 3: A320neo as the fastest growing next-generation aircrafts

Therefore by venturing into the OEM business, ST Engineering is able to benefit directly from the robust growth of global aircraft through new revenue streams. Besides, this will likely enhance and scale its capabilities given how vertical integration may lead to potential synergies.

In the Electronics segment, ST Engineering has also recently announced another full acquisition in Newtec Group to position itself for future growth in the satellite communication (satcom) industry. Satcom is a fast-growing industry and is expected to grow at a CAGR of 8.8% in the next 7 years, supported by the increasing use of the Internet of Things (IoT) and the demand for better connectivity, such as the 5G technology. The acquisition allows ST Engineering to better position itself in Europe’s satellite telecommunications business, and the management has guided for potential acceleration in their growth trajectory.

Earnings visibility in the near term

Besides looking at future earnings growth, ST Engineering has also clocked in strong order wins in 2018 in its other segments, posting a strong order book of SGD 13.2 billion as of Dec 2018. This comprises of new order wins of SGD 2.19 billion from its Electronics arms, and new contracts worth SGD 991 million from its Marine arm. Its fourth arm – Land Systems has also won several contracts from LTA. The strong emphasis on defence and building a smart nation from the recent 2019 Singapore Budget also paints a positive outlook for ST Engineering given its key role in Singapore’s defence sector.

Out of the SGD 13.2 billion order book, Management has stated that SGD 4.9 billion of the order book is expected to be delivered in 2019 during their Q4 earnings call, providing certain revenue visibility for ST Engineering in the near term. As shown in Chart 4, ST Engineering’s share price has reacted positively to its order book historically, and given that we expect the growth in order wins to continue, we should observe a similar trend in ST Engineering’s share price.

Chart 4: Share price of ST Engineering has a strong correlation to its order book

Key investment risks

While ST Engineering has a strong lead over its competitors in the aviation race, their rivals are certainly not resting on their laurels. In recent years, OEMs like Airbus and Boeing have started expanding their presence in the after-sales service market to further dominate the industry. Low-cost rivals in Southeast Asia have also targeted Singapore’s aviation maintenance sector to take a slice of the pie.

While this is a concern to ST Engineering, we believe the threat is not imminent given that its MRO capabilities are way ahead of their competitors. One competitive advantage our local player has over their low-cost rivals is the full suite of services they can provide. Beyond just convenience, we believe the efficiency and quality of ST Engineering can also make up for the cost premium.

That said, ST Engineering still has to closely monitor the developments of their competitors, and continue to reinvent themselves to stay ahead of the game.

Besides aerospace, ST Engineering also specialises in other areas, such as electronics, land systems and marine. While having diversified revenue streams will allow ST Engineering to navigate through the volatile global business environment, a slowdown in any of these other segments could hamper its overall performance. However, to reiterate, ST Engineering has a strong SGD 13.2 billion order book, of which SGD 4.9 billion will be delivered in 2019, providing clear earnings visibility.

Share price has potential for re-rating

Given the favourable long-term investment prospects for the MRO market, we believe ST Engineering (SGX.S63) share price has the potential for further re-rating. As ST Engineering generates consistent cash flows, we applied the discounted cash flow model on the company using the following assumptions in Table 1. Our assumptions yielded an estimated intrinsic value of SGD 4.2, representing an upside potential of about 13.2% based on its last traded price. Its estimated dividend yield of 4.3% is also fairly high, and will certainly appeal to income investors looking for dividend plays in the stock market. Table 1: Valuations of ST Engineering

2019E2020E2021E2022ETerminal Value
Net Income546.9615.3673.7731.4
Depreciation and Amoritzation269.2292.9318.7346.7
Change in non-cash working capital(65.5)90.067.061.1
After-tax interest expense45.043.041.040.0
Capital Expenditure479.0493.0507.5522.4
Free Cash Flow316.6548.3592.9656.913,423.1
Assumptions
Discount Rate7.0%
Equity Value13,452.1
Shares outstanding (millions)3,119.5
Target Price (SGD)4.2
Share price as of 29 Mar 2019 (SGD)3.7
Potential Upside13.2%
Source: Bloomberg, iFAST Compilations
Data as of 29 Mar 2019

Going forward, we believe the sales growth and earnings of ST Engineering (SGX.S63) should track the booming aviation sector (Chart 5). Coupled with an increasing emphasis on defence expenditure and “smart city” initiatives by Singapore and many other countries, we see good potential in ST Engineering given its strong foothold in this industry.

Chart 5: STE share price should track its EPS moving forward

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.

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