• Keep BUY with lower SGD4.10 TP from SGD4.60, 20% upside and c.5% yield. As part of analyst briefings to view the commercial aerospace operations, we visited ST Engineering’s Paya Lebar and Seletar facilities. We are positive about the business outlook for MRO and passenger-to- freighter (P2F). We did note concerns on skilled labour availability, as well as labour and materials inflation. We also expect STE to see higher interest expenses from 2023 amidst rising rates. We lower 2022-2024 earnings by 3-4%, yet remain confident of its defensive business.

• Key takeaways from our recent aerospace hangar visit. Globally there are 120-140 passenger to freighter (P2F) conversions being undertaken and STE is ramping up its capacity to account for about a third of these annual global conversions. The wide body hangars at Paya Lebar were busy with B767 P2F conversions and STE can complete six wide body P2F conversions annually at its Paya Lebar facility. The narrow body hangars at Seletar were busy with A320 P2F conversions and STE can complete 12 narrow body P2F conversions annually at its Seletar facility.

• There are concerns around labour availability and inflation. Given the macroeconomic concerns, there is a likelihood of some moderation in P2F business in the near term. While the situation seems to be improving, there are still challenges on the labour, raw materials, and supply chain front. STE is experiencing labour shortage of c.10% vs what’s needed and a labour cost inflation of high-single to double digits. With respect to contract price readjustment in response to rising costs, STE noted that it has an option for price escalations in older contracts. However, historically airlines have preferred a fixed price escalation and for contracts that have variable price escalation, the escalations tend to be capped.

• Adjusting our interest rate expectations higher. We assess that as at end-1H22 about half of STE’s debt will be exposed to rising interest rates. With an additional USD700m of debt to be brought onboard to fund the Transcore acquisition, we see a likelihood of higher interest expenses for STE from 2023. We have increased the adjusted annual interest rate for STE’s debt to 2.75% from 2023, from our current estimate of 2.4%

• Outlook still solid and defensive. We expect STE’s strong orderbook to support earnings growth beyond 2022 and estimate its 2023-2024 profit growth at 13-14% given a record-high orderbook, growing defence revenue, and Urban Solutions & Satcom Security’s potentially sharp recovery. STE reported its highest order backlog of SGD22.2bn, which implies a book-to-bill ratio of 2.7 years and SGD4.6bn of this orderbook is expected to be delivered in 2H22, representing 100% of our 2H22 revenue estimates.

Source: RHB Research - 11 Oct 2022