ST Eng - Improved showing in 2Q09

Sequential revenue growth across all segments. Topline grew 7% q-o-q and 8% y-o-y to S$1,409m – with the Electronics and Marine segments continuing to outperform. Group PBT, while weaker 8% y-o-y, was up 25% sequentially as well. Profitability wise, Aerospace was the star performer as margin recovered from 8.7% in 1Q09 to 12.2%in 2Q09. There could be further upside in 2H09, given that the PTF programme has turned around and will be increasingly accretive, with 7 more deliveries scheduled for the rest of the year. Land Systems PBT slipped 35% q-o-q, as weapons exports slowed.

Orderbook slips slightly to S$10.7b. YTD, STE has announced S$463m of new orders, compared to S$2.67bn new orders in FY08. While there is no near term pressure on revenues – as STE is poised to recognise about S$2.1bn of its existing orderbook in 2H09 – we believe long-term growth can be only be fuelled by M&A or investing in new capacity.

Defensive, at best. Despite a US$500m bond offering, concrete forward-looking steps are yet to be visualised. So, while earnings look secure – with management guiding for comparable revenue and PBT in FY09 vis-à-vis FY08, re-rating possibilities at 18x FY09 P/E are limited by concerns over growth. Maintain HOLD, in light of the 5.4% dividend yield – TP revised up to S$2.60 in line with a slight revision in EPS numbers.

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ST Engineering - Margins rebound after 1Q09 weakness

ST Engineering’s 2Q09 results were in line with expectations, with net profit at S$108.7m improving 28% versus a weak 1Q09. Turnover was up 7% sequentially to S$1.4bn, boosted by Aerospace and Land Systems. STE also declared an interim dividend of 3 cts per share, equal to 1H08.

Following some margin pressure in 1Q, all divisions showed an improvement in margins from a more favourable sales mix with the exception of Land Systems. PBT margins for the group improved to 10% versus 8% in 1Q09. Most significantly, Aerospace EBIT margins rebounded to 12% from 9%, particularly as its 757 PTF programme exits the gestation phase.

STE maintained its orderbook at S$10.74bn from S$10.6bn at end-FY08, indicating robustness in demand. STE will deliver about S$2.06bn of this in the next 2 quarters. This puts it on track to deliver our full year turnover estimate of S$5.4bn, with a strong likelihood of exceeding this. Earnings also have the potential to outperform if the group is able to sustain the margins that were achieved in 2Q09.

Management has maintained guidance for the full year, and expects FY09 to show comparable turnover and PBT to FY08. This implies a higher turnover and PBT in the second half versus the first half. Our forecasts are in line with this projection, and we are leaving them intact. While net profit forecast at S$436.1m indicates a YoY decline of 8%, FY08 included a tax write-back of around S$50m. We expect a recovery in earnings for FY10 by 14%, as global economies are showing signs of recovering.

STE still expects to pay out 100% of earnings as dividends. As our forecasts remains unchanged, and we also maintain our FY09 projected dividends at 14.5 cts per share. FY09 dividend yield is at 5.5%. We are maintaining our recommendation at Hold, in view of the limited upside to our target price of S$2.70.

ST Engineering - Better results as margins improve at aerospace division

1H09 net profit fell 20%, buffering 1Q09's 31% decline. Still, 1H09 net profit of S$193.9m was below full-year annualised consensus estimates and our forecast of S$412.9m. The lower net profit was due to the following: a) higher research & development expenses, b) acquisition costs at the land systems segment, c) higher doubtful debts, and d) lower interest income. A higher tax provision likewise led to a lower net profit.

Operating margins at the aerospace division improved from 8.9% in 1Q09 to 11.6% to 2Q09. This came on the back of profits from passenger to freighter (PTF) conversion work and the absence of interest rate swap expenses. One of the primary concerns was a slowdown at the aerospace segment and continued losses on FedEx's B757 PTF conversion work. With the improvement in PTF conversion work, we expect margins to improve slightly at the division, but this would be contingent on a stable US dollar.

Maintenance, repair and overhaul (MRO) rates are in US dollar. STE expects a better 2H09 and has guided higher pre-tax contributions from the aerospace and electronics segments; and flat contributions from the land systems and marine segments. The electronics division is expected to recognise contributions from the LTA Circle Line and Taiwan MRT projects, as well as the integrated resort project.

We have raised our net profit forecast slightly by 1.0% for 2009 and lowered net profit for 2010 by 0.5% after factoring in higher turnover, slightly better aeropace margins and higher interest expenses from a recent US$500m notes issue. At the current price of S$2.63, the stock is trading at 18.1x 2009 and 2010 average earnings and close to mid-cycle valuations. A stronger topline growth and improvement in the PTF conversion work warrant an upgrade. We now peg the stock at a slightly higher PE band multiple of 16.5x on twoyear forward earnings. We upgrade our recommendation from SELL to HOLD. Our new fair price is revised to S$2.40.

ST Engineering - Levering up

US$500million MTN issue: ST Engineering announced a US$1.2billion multi-currency Medium Term Note (MTN) program on 6 July. This was swiftly followed by the sale of US$500million (~S$730million) 10-year notes at a coupon of 4.8% (150bps above 10-year U.S. Treasuries) 3 days later. As of 1Q09, the company has a net cash position of S$467million, with S$249million of borrowings repayable in 1 year.

Improving balance efficiency or arresting working capital squeeze?: We estimate net gearing to rise to 1-2%. The move could improve balance sheet efficiency given the historical net cash position. However, drawing down 42% of the MTN program raises concern that a significant part of the proceeds could be used to address near-term working capital needs. We estimate that cash conversion cycle increased from 50 days (1Q08) to 69 days (1Q09), translating to an additional ~S$280million annual working capital needs. Channel checks also suggest that MRO rates remain under pressure. The upcoming 1H09 results (early August) should provide greater clarity on the working capital situation and key rationale for the notes issue.

Gearing up for M&A: Management signals potential M&A in the pipeline. Assuming the proceeds are deployed to repay current borrowings and fund incremental working capital, there should still be at least S$200million for M&A. Likely candidates may include the in-house MRO units of distressed airlines looking to spin off and outsource their MRO work to manage costs. Historical share price performance post announcement of M&A deals have been mixed (Table 1), although there was greater visibility of synergies and earnings accretion at Aerospace and Marine, in our view, in the cases of the Panama MRO facilities (PAE) in Feb-06 and Halter Marine in July-02.

Dividend risk reduced, but “cash-rich premium” no more: The bond issue alleviates concerns over dividend risk but we note that the potential move into a net gearing position should remove the “cash-rich premium” that the market has traditionally placed on the stock.

Current valuation looks rich: Recent share price performance puts the stock at 16.4x/16.0x JPM/consensus P/E, which we see as unattractive versus the peer average of 9x. Maintain UW.

ST Engineering: Another LTA deal

ST Engineering’s wholly-owned subsidiary ST Synthesis sealed a five-year contract worth S$26.5m by Land Transport Authority (LTA), the second deal from the agency in three weeks.

The contract kicks off immediately, and involves the provision of comprehensive maintenance services on the electrical and mechanical systems of Kallang Paya Lebar Expressway (KPE), South-east Asia’s longest underground tunnel. ST Synthesis will also provide facilities management services for the KPE, a first for the Group.

ST Engineering has been active snagging contracts, winning over S$200m worth of deals in the past two months alone. The Group has record orders of over S$11b. We estimate earnings will contract 1.8% to S$465.2m in FY09 before growing 10.9% to S$516m in FY10. At S$2.41, it trades at 15.5x FY09 and 14x FY10 P/E, while yields remain attractive at over 6.4%. Our target price of S$2.83 is based on DDM.

ST Engineering on bad hiring practices that compromise safety requirements

Some of you might have heard about news flow from the US that implicates ST Engineering on bad hiring practices that compromise safety requirements in the highly regulated MRO industry.

You can see the news article link here:
http://www.wfaa.com/sharedcontent/dws/wfaa/latestnews/stories/wfaa090630_mo_harris.23327cea.html

We have obtained written clarification that the allegations by STE that the news article are "inaccurate and groundless". They will be responding officially to the newswire soon. Their official response to us below:

"With regard to the recent news report, we clarify that the allegations of ST Aerospace's hiring of foreign workers to replace local employees and thereby keeping an unsafe working environment at our facilities at San Antonio and Mobile (Alabama) are inaccurate and groundless.

All workers at both facilities are carefully screened prior to hiring to ensure that they fully meet our stringent requirements and those of the regulatory authorities concerned.

Our companies operate in a highly regulated industry, and are subject to multiple audits by customers and regulatory agencies each year. We regularly interact with regulatory bodies to maintain our highest safety standards to continue to produce a safe product for the industry. It is practically not possible for such allegations of having a major flaw in our hiring practice through use of unqualified personnel to have gone undetected by these external parties, as well as by our internal audit system. Our quality system is tested and robust, and our excellent safety record bears testimony to this.

Both ST Aerospace's facilities ? San Antonio Aerospace (SAA) and ST Mobile Aerospace Engineering (MAE) ? have a well documented process of maintaining a safe and qualified workforce, and they work closely with various regulatory organizations to ensure that they are in full compliance with all applicable regulations. Contrary to the news articles, SAA and MAE do not compromise safety."

We are retaining our HOLD rating on STE with a fair value of S$2.46. Yields are about 5.8% for FY09F. We are not able to get much clarity on their recently announced Medium Term Note program and will update you when we get more details. They will be announcing their 2Q09 results on 4 Aug 09.

ST Engineering - Order book: more than meets the eye

STE routinely secures orders which it does not announce, due to client sensitivities. We estimate these ‘secret’, mostly defence-driven contracts amount to about S$485m in a typical quarter, but have recently risen to a multi-year high. On our estimates, the value of unannounced contracts exceeded S$1bn on 3 occasions in the last 5 quarters. Q109 order book was at a record S$11bn. Rising customer advances support our case: though only S$7m of contracts were announced in Q109, total customer advances increased by S$250m to a record S$1.34bn.

Our findings suggest ‘windfall’ orders of over S$2.1bn, which translates into additional S$267m net profits STE could book in over the coming years. The size of the non-commercial orders secured lately suggests the market might be overlyworried about the aerospace business and underestimating the quality of STE’s future earnings stream.

STE trades at 16.4x on 1-year forward earnings, and close to its minus-one standard deviation of 15.8x (Jan 2000-present). Moreover, based on our recent interactions with management, we believe that the company remains committed topaying 100% of earnings in dividends.

We continue to derive our PT using DCF-based methodology, but now explicitly forecast long-term valuation drivers using UBS’s VCAM tool.

Singapore Technologies Engineering - Buy: Strength Amid Adversity

Maintain Buy – Share price outperformance has reversed (-20% vs. STI) post 1Q09 results and buying opportunities exist; earnings look poised to improve, with concerns, particularly MRO biz and margins, appearing overdone. ~6% dividend yield, record high orderbook and new orders in the pipeline – despite uncertain macro environment – strengthen the investment merits. We reiterate our confidence in mgmt execution and see >10% upside from current levels.

Key highlights – Chat with mgmt suggests infrastructure projects in the region have picked up; therefore Electronics (~20% of EPS) has potential to surprise. We also remain confident in the PTF conversion programs; delay risks should abate with recent cargo yields stabilizing. In the longer term, executing pipeline of MRO initiatives (e.g. GE and CFM engines; new capabilities) will be a key focus. ST Eng needs to translate outsourcing potential to stable revenue baseload and margins. We believe earnings from 2010 should reflect this.

M&A strategy – Recent acquisition of Precision Products, a casting and tooling manufacturer, suggest ongoing efforts to selectively use M&A to plug technical capabilities gaps and enlarge scope of services. We think more M&A deals may follow as valuations are now at more reasonable levels.

Encouraging new orders profile – The >S$200mn new orders secured in 2Q09 to date reflects: 1) diversification – greater proportion of orders from public sector, 2) repeat contracts, e.g. Guangzhou Metro for systems work, 3) secure new customers, e.g. Chittagong Port Authority contract for MIS system and Swedish Defense order for 40mm ammunition.

Singapore Technologies Engineering: Slow start to the year.

Outlier quarter. Singapore Technologies Engineering's (STE) 1Q09 topline was flat at S$1.32b while PATMI shrunk by 30% YoY to S$85.2m. The quarter was primarily marred by STE's Aerospace division as it did not deliver any MD-11 conversions. STE grew its order book to S$11b where S$2.88b (52% of our FY09F revenue) will be delivered over the next three quarters. Management has indicated that the next three quarters should see improvements in margins and better spaced out deliveries that will provide comparable annual performance vs. FY08.

Sticking to its guidance. STE continues to iterate its guidance for a "comparable" PBT for this year while turnover has been downgraded from "higher" to "comparable". For 1Q09, "nil" deliveries of the very mature and profitable MD-11 Passenger-to-Freighter (PTF) conversion created the gap between our forecasts and actual earnings. While Aerospace has contributed to significant drag in the previous quarters, the 757 PTF conversions are expected to be accretive in FY09F after its loss-making year in FY08. This should kick in during 2H09. We have adjusted our estimates to factor in a weaker 1H09 and are giving STE a chance to perform for its 2H09.

Still vague with order book. With the exception of Land division, management maintained its enigmatic view of the division that has driven the order book to its record highs. The remainder of the 48% of our topline can be fulfilled from recurrent businesses that are not reflected in the order book.

Defensive but not growth. STE's share price initially saw its share price trade in a tight range (S$2.00-S$2.50) without large contract wins or accretive acquisitions that typically served as share price catalysts. While its S$1.38b of cash equivalents puts STE in good stead to make acquisitions, we doubt that significant ones that will give major earnings accretion to the group will occur this year. We have rolled our valuation forward to a blended 16x FY09/10F PER (prev. 15x FY09F PER) and our fair value is bumped up to S$2.46 (prev. S$2.31). However, the recent 30% surge with the market rally since our upgrade on the 13 Feb seems to have factored in a growth story vs. our estimates which show a decline for FY09F. In view of the limited upside, we are downgrading our rating to a HOLD. Sustained improvements in margins and accretive contract wins will incentivise us to re-peg our valuation.

ST Engineering: Losing steam

Core numbers weaker sequentially as well. While revenue of S$1.3b was within expectations and flat y-o-y, PBT was down 29% y-o-y to S$111.3m. While it looks better than 4Q08 PBT of S$88.9m at first glance, it should be noted that the 4Q08 number includes S$54m of charges related to impairment and allowances.

Strong showing by Electronics and Marine but... Aerospace PBT was down 52% y-o-y to S$40m, as the B757 PTF conversions continue to be loss making. In contrast, the MD-11 conversion program was already profitable and accretive in 1Q08. The Land Systems arm saw revenues dip 32% in 1Q09 as auto sales in US declined sharply. We expect both these sectors to be weak in FY09 – the Bronco deliveries to UK have already been pushed to 2010 and aircraft maintenance/ conversion schedules may be susceptible to deferments.

Time to look beyond defensive. Management expects to achieve results in FY09 comparable to FY08. Orderbook did indeed climb to a record S$11b and balance sheet looks stronger with higher net cash of S$480m. However, given the weakness in Q1, unfavourable timing of programs in Aerospace and lower margin projects across segments, we lower our FY09 and FY10 EPS estimates by 6-8%. Downgrade to HOLD, in the absence of any near-term catalysts – the stock is ex-dividend now – and we believe high beta stocks are more likely to perform in a recovery scenario than defensive stocks. Our TP is maintained at S$2.50 –pegged at 17.5x FY09F. At current price, the stock is trading close to its normalized PE of 18x to 21x.

ST Engineering: Approaching target

Recording higher earnings QoQ. ST Engineering (STE) saw flat 1Q09 revenue while net profit dropped 30.4% YoY as mainly attributed to lower contributions from the Aerospace division. However, on a QoQ basis, profit before tax (PBT) had actually increased 25% to 1Q09. Stripping out the S$34.4m tax write-back seen in the previous quarter, net profit would have improved 25.5% sequentially, below our expectations.

Generating strong cash flows. STE continued to see robust operating cash in 1Q09 where FCF per share translated to 9.9 S¢, notably higher than its EPS at 2.8 S¢. Management also assured that worries over its cash flows being "artificially" boosted by advance payments from customers were unfounded. As STE continues to secure new contract wins, cash flows from these clients would thus not be lumpy.

Outlook seen to be improving. Management highlighted that its 1Q09 results are not reflective of the entire year as they believe that the next nine months would see better margins which in our view is mainly due to its Aerospace business. STE also added that based on historical trends, its 2H has usually been better than its 1H ? we therefore expect its current record order book at S$11.0b (from S$10.6b in FY08) to increase even more going forward.

Maintaining earnings estimates, but downgrading call. We forecast earnings to contract 1.8% to S$465.2m in FY09, before growing 10.8% to S$516.0m in FY10. At S$2.63, it trades at 17.0x FY09 and 15.3x FY10 P/E. Over the past five years, it has been trading at an average of 19x P/E. Its dividend yield of 5.9%, while above that of the STI's 3.8%, is not particularly palatable for a high yielding counter. Based on our DDM, we derive a target price of S$2.83. Given the limited 7.7% upside, we are downgrading the stock to NEUTRAL.

ST Engineering - Majority of orderbook still very secure

We are turning more cautious on STE’s earnings outlook, in the face of the most challenging economic conditions seen in over two decades. We are therefore tempering our earnings growth forecasts, due to a higher assumption of provisioning for bad debts on some of its contracts.

We have assumed higher risk mainly on contracts with 1) non-sovereign customers, 2) riskier country profiles and 3) non-defence related contracts. We are also factoring in lower earnings from non-orderbook business in the aerospace division, where conditions are still challenging.

We see increased risk is to geographies such as Greater China and the Middle East. Shakier business segments include low-cost airlines and aviation in general. However, these contracts still represent less than 5% of STE’s overall orderbook, and are tempered by STE’s own risk controls.

FY09 earnings are therefore trimmed by 7% to S$480.7m, which implies modest 1.5% growth YoY. FY10 earnings are similarly cut by 7% to S$508.0m. STE’s orderbook stands at S$10.6bn, of which it expects to deliver S$3.6bn for FY09, or about 66% of our turnover projection.

STE continues to trade at some of the highest valuations in the Singapore market. Price to book ratio stands at 4.6x versus the STI’s 2.4x, and FY09 PER stands at 14.0x versus 7.3x for the index. While we believe that premium valuations are justified due to STE’s outstanding track record, any disappointment or underperformance from the company will negatively impact the share price more severely.

STE has re-affirmed it will still pay out 100% of earnings as dividends. However, along with our earnings cut, we are raising our risk-reward threshold by pegging a minimum 6% yield from FY09 projected dividends. This generates a target price of S$2.70, from $3.60 previously. With an upside of 20% and dividend yield of 7.7%, we maintain our Buy call.

ST Engineering - A gentleman will walk but never run

Following ST Engineering’s FY08 results, we lower our target price from S$3.00 to S$2.60 and retain our Outperform rating.

FY08 results lacklustre: Net profit of S$474m (-5.9% YoY) was below consensus (S$496m) and above our forecast (S$462m). Operating income was down 7.5% YoY, as was the margin (9.5% vs 10.9% in FY07). Aerospace contributed less than 50% of profit for the first time since 2002 (post 9/11).

Net cash or net debt? The discussion on the company’s net cash/debt position hinges on the treatment of customer advances, which are sizeable. In a ‘growth organically only’ scenario, we believe that customer advances should be treated as part of the cash balance, placing the company in a net cash position (10% net cash/equity).

Assuming acquisitions, which we believe to be a strong likelihood over the next 12 months, we prefer to back out customer advances from the cash balance in analysing the balance sheet. In this scenario, the company enters a net gearing position (21%). We believe a reduction in the dividend payout is therefore highly likely in 2009.

In either scenario, it is worth noting that the company has been whittling down its cash balance to pay out 100% of earnings in dividends since 2002.

Guidance for lower earnings? Prima facie, the guidance for comparable earnings in 2009 is upbeat. However, we estimate this implies a 5.7% shrinkage in core earnings after backing out ~S$20m in benefits from the Budget announcements as a 5% strengthening in the US$/S$ rate. We also believe provisions will feature again in the FY09 results, given the challenging operating environment for airlines.

We have lowered FY09 and FY10 EPS forecasts by 9.6% and 10.7%, respectively.

12-month price target: S$2.60 based on a DCF methodology. Catalyst: Contract wins will be positive, offsetting negative newsflow on the airline industry.

We expect STE will outperform the index owing to its ‘safe haven’ status, due to its large exposure to defence sales. On an absolute basis, we expect the share price to track sideways for most of 2009, perhaps rallying late in the year. We maintain our Outperform rating.