• SIA contract, cargo outlook, associates’ returns and M&A pipeline were the main subjects of questions by investors in HK during our NDR with SATS LTD. (SGX:S58).
• We like SATS as a proxy for secular growth in air travel but its investments and gestation may require investor patience in the short term.
• We trim our FY20-22F EPS by 2.0-5.5% to reflect higher costs and gestation from investments.
• Maintain ADD with lower Target Price of S$5.40 (previously S$5.46).

Gateway: Steady Growth From Stronger Volume in Flights & Pax

• It is business as usual for SATS’s flights handled segment although Changi’s data showed 1.7% y-o-y decline in number of flights in Apr 2019. We believe the drop in volume was unlikely to be structural but due to the grounding of B737 Max and suspension of Jet Airways (JET IN).
• For SATS, the aircraft-grounding effect is cushioned by the resumption of Qantas contract and new contracts won in 2H18. However, SATS was not spared the weaker freight volume.
• Changi’s data showed six consecutive months of y-o-y drop in freight volume with the sharpest drop (12.8%) in Apr 2019. Cargo made up 25% of gateway revenue. We still forecast 4-5% y-o-y gateway revenue growth for FY20-22F.

Volume Increase Needed to Maintain EBIT Margin

• SATS expanded its EBIT margin from 10.2% in FY15 to 13.5% in FY19, thanks to deconsolidation of SATS BRF Food and better operating leverage from higher gateway revenue. Investors were concerned over repricing margin from airlines, especially the recently-renewed 5+5 year contract from SIA.
• With SATS commanding 85-90% of the market share in Singapore currently, a price cut is not imminent; however, we suspect there is pressure on pricing for catering services. We believe compromises have been made by the two parties, whereby higher volume is expected vs. lower pricing.
• Cost optimisation is key. Some of the initiatives that have been rolled out to ensure efficiency include:
  1. SATS having full control of the economy meals,
  2. shrinking menus form 1,000 to 100 with lesser mix, and
  3. reducing gateway staff headcount due to the increase in automated ground handling (self check-in).
• We tone down our food solutions EBIT margin by 4bp to 15% for FY20-21F (FY19: 15.4%) to reflect this.

Rising Earnings Trajectory From M&As to Start in FY22F

• On SATS’s 3-year investment target of S$1bn, we estimate S$700m will be M&A related. Management is comfortable with an investment size of S$80m-150m each. We think SATS has improved in its M&A execution over the past two years, with earnings-accretive M&As such as Ground Team Red (GTR) and Mumbai Cargo that yielded higher ROICs than its long-term ROIC of 8%.
• Given the expected heightened investment mode over the next three years, we believe SATS’s M&A-related costs, including staff and business development costs, would also rise.
• We also factor in gestation for new M&As and defer our earnings growth expectations for associates from FY20F to FY22F. Accordingly, our EPS is trimmed.
• Maintain ADD but lower Target Price to S$5.40, based on 21.9x CY20F P/E (historical 3-year average).
• Catalysts are sizeable earnings-accretive M&As and margin expansion. Sudden plunge in global economy is key risk.

What’s the Business Growth Driver?

• Secular demand for travel is key. Case in point: SATS has grown its capacity handled by five times, from 22m passengers p.a. in FY00 to 128m p.a. in FY19. Number of meals served also grew from 21m to 167m over the same period. SATS now operates in 30 countries with 60 locations. Secondly, inorganic growth is inevitable as SATS’s Singapore revenue growth is limited to 3-4% p.a., as SATS’s market share is already 85-90% there.

What If More Airlines Operate on LCC Model in the Long Term?

• This is a big picture and long-term question that SATS needs to address. The structural change in travelling patterns to become more economy and fuss-free means Asian full-service carriers may follow the path of some European and American airlines to opt for the low-cost carrier (LCC) model of pre-ordered meals.
• We think the cultural difference in travellers’ style and the importance of branding among Asian airlines (notably Singapore Airlines (SGX:C6L) may keep meals on board as a ‘must-have’, but the critical question is whether they are pre-ordered or ordered on board

What Is SATS’s Investment Pipeline in the Near Term?

• India and China are key focus markets for SATS. Buying out competitors in familiar markets to gain market share is a viable option with low business risks, in our view.
• Other low-hanging fruits that we think SATS would pick include:-
  1. increase stakes in existing associates,
  2. expand/build new kitchen facilities, and
  3. build new cargo terminals

Dividend Not Compromised Even With S$1bn Investment

• We believe the aggressive investment plan is unlikely to compromise SATS’s dividend payout, thanks to its strong cash hoard and operations. See SATS's dividend history.
• SATS has been generating firm operating EBITDA of above S$300m since FY17 with S$332m in FY19. As at end-FY19, it had S$254m net cash after S$210m dividend payment. Dividend payout/EBITDA ranged from 59-63% in FY17-19.
• We keep our DPS for FY20F similar to FY19F’s S$0.19, representing 60% of our EBITDA forecast, before gradually stepping up to S$0.20 by FY20F.

Source: CGS-CIMB Research - 14 Jun 2019