• ST Engineering's 2Q19 net profit of S$138.2 in line with expectations.
• Orderbook is at all-time high of S$15.6bn, due to addition from MRAS and solid order wins in 1H19.
• Interim dividend of 5 Scts per share declared.
• Maintain BUY with revised Target Price of S$4.64.

High Visibility of Earnings Growth

• ST ENGINEERING LTD (SGX:S63) ended 2Q19 with a record-high orderbook of S$15.6bn, underpinning healthy growth prospects in the near-to-medium term. 2Q19 net earnings of S$138.2m were in line with expectations, and the acquisition and integration of MRAS in the Aerospace division is tracking well.
• We continue to like ST Engineering for:
  1. strong inorganic growth potential from recent acquisitions in the Aerospace and Electronics division plus
  2. near-term organic growth to be driven by workload increase at engine MRO shops, ramp-up of Airbus Passenger-to-Freighter programmes and margin improvement in Marine division; and
  3. medium-to long-term growth from leveraging to Smart City and IOT-related products and contracts, as well as robotics and automation solutions in transport, logistics, healthcare and hospitality domains.
• Dividend yield is at a decent 3.5% at current prices and we expect ST Engineering to be favoured by investors amid the current uncertain market environment owing to its defensive nature.

Where We Differ

• Demand for ST Engineering’s business divisions should not be affected too much by ongoing trade war tensions, and higher input costs are generally provided for in contracts.
• Valuation looks elevated at first glance but is reflective of record-high orderbook levels and leaves room for re-rating.

Potential Catalyst

• Significant order wins, earnings delivery from new acquisitions, and progress with Smart City initiatives.

What's New - En Route to Solid Growth in FY19

Headline 2Q19 net profit in line with our expectations.

• 2Q19 headline net profit of S$138.2m (+17.6% y-o-y, +5.4% q-o-q) met our expectations, with 1H19 net profits of S$269.3m forming 47.2% of our existing full-year projection for FY19. Excluding one-offs recorded in 2Q18, net profit growth was more measured though.
• To recap, ST Engineering had booked a one-time medium-term note redemption expense of S$20m and a divestment gain of S$9m in 2Q18. Excluding these items, ST Engineering’s core earnings in 2Q18 would have been S$128.6m (against headline profit of S$117.5m), implying 2Q19 net profit growth of 7.4%. Growth in the period was primarily driven by the boost from acquisition of MRA Systems (MRAS), though offset to an extent by the lack of contribution from a now insolvent Jet Airways.

Group revenue of S$1,780m was up 7.8% y-o-y and 2.8% q-o-q

• Group revenue of S$1,780m was up 7.8% y-o-y and 2.8% q-o-q, mainly boosted by the Aerospace division, which recorded a marked 16.7% y-o-y increase on the back of new revenues from MRAS, which contributed for around two and a half months in 2Q19 after the acquisition was completed in April 2019.
• The Land System segment also achieved commendable revenue growth of 22.6% y-o-y, underpinned by the delivery of “Hunter” Armoured Fighting Vehicles for the Singapore Armed Forces.
• Meanwhile, the Electronics segment recorded a modest revenue decline of 2.9% y-o-y due to certain project timing issues, while the Marine segment saw a 6.1% revenue decrease due to lower shipbuilding revenue.

Overall PBT margin widened slightly to 9.5%, in line with our expectation (vs 2Q18 – 9.1%, 1Q19 – 9.2%).

• This was primarily underpinned by the absence of the negative impact of the early redemption of the medium-term notes (under the ‘Others’ segment).
• Division wise, the Aerospace segment saw the steepest decline in its PBT margin to 9.8% (vs 11.6% in 2Q18), due to the lack of a one-off divestment gain which was recorded in 2Q18, higher depreciation expenses and costs associated with climbing the learning curve for its A321 passenger-to-freighter (P2F) conversion programme and the relocation of a pilot training school. However, this was tempered by the Marine segment, which saw its PBT margin expand to 12.2% (vs 6.8% in 2Q18), supported by a more favourable sales mix (higher ship repair revenues) and improved US shipbuilding performance.
• Meanwhile, margins in the Electronics and Land Systems divisions both diminished modestly, due to higher expenses on broadening international market reach, and more extensive R&D in robotics and autonomous solutions. The adoption of SFRS (I) 16 accounting standard related to operating leases also saw an increase in depreciation expenses overall due to the additional depreciation booked on “right-of-use” assets on the balance sheet.

Balance sheet remains sound despite sharp increase in debt.

• Although ST Engineering’s net debt increased to S$1.3bn as at end-2Q19 (vs S$0.1m as at end-4Q18), owing to the addition of hitherto off-balance sheet operating leases and borrowings to fund the acquisition of MRAS, its net gearing and net debt-to-EBITDA are still manageable at 0.5x and 1.8x respectively.
• While the company’s net gearing is anticipated to increase modestly to around 0.6x from the current 0.5x after the acquisition of Newtec, we believe ST Engineering still has significant headroom for additional organic and inorganic initiatives, given its stellar AAA credit rating and strong ability to generate robust free cash flows.

Strong earnings visibility underpinned by record-high order backlog

• Strong earnings visibility underpinned by record-high order backlog, which stood at S$15.6bn as at end-2Q19, up from S$14.1bn as at end-1Q19. ST Engineering has already announced new order wins of S$4.6bn in FY19, compared to S$5.2bn for full-year FY18, and hence is tracking for a bumper year of new order wins.
• In addition, its orderbook now includes MRAS’s order backlog, while management clarified that the additional contracts clinched from Jet Airways was never included.
• ST Engineering expects to deliver S$3.8bn (24% of orderbook) in the remaining two quarters of FY19. Thus, 2H19 revenues should comfortably surpass 2H18 (S$3.4bn) and 1H19 (S$3.5bn) numbers and result in healthy earnings growth momentum.

Aerospace division will continue to benefit from integration of MRAS which is proceeding as planned.

• Management indicated that the integration of MRAS was moving along smoothly, and that ST Engineering was on track to ramp up MRAS’s LEAP-1A engine nacelle capacity to 60 per month by end- FY19 from the current 55 per month. Beyond FY19, we believe MRAS could eventually grow its capacity to 75 per month in the medium term, given the robust A320neo family order backlog (6,683 aircraft as at end-July 2019), though it would require substantial capital investment.
• While we expect MRAS to incur integration costs to the tune of S$8m in 2H19 and S$10m in FY20, and incur some impact to operating margins from costs related to production automation and supply chain optimisation, it will still be materially accretive to the Aerospace division’s earnings.

Other divisions are tracking well against our estimates; growth story intact.

• Tailwinds in the form of a gradual upturn in the offshore cycle, and burgeoning demand for autonomous, robotics and smart city solutions will promote growth in ST Engineering’s other segments. The acquisition of Newtec, which is slated to be completed in 4Q19, should provide a boost to earnings in FY21/22.

Interim dividend of 5.0 Scts per share (flat y-o-y), but we are now more conservative on FY19/FY20 dividend estimates.

• ST Engineering's 1H19 interim dividend of 5.0 Scts is at par y-o-y and we believe ST Engineering will probably look to match FY18’s dividend of 15 Scts per share in FY19, which implies a dividend yield of around 3.6% at the current share price. See ST Engineering's dividend history; ST Engineering’s share price.
• Given the higher gearing already on balance sheet and further acquisition-fuelled growth ambitions, an increase in dividends in the near term appears less likely in our view. Thus, we have trimmed our dividend expectations for FY19/FY20 down to 15 Scts/16 Scts per share, down from 16 Scts/17 Scts per share respectively.

Maintain BUY With a Higher Target Price of S$4.64

• As we roll over our valuations to blended FY19/20 estimates, our Target Price is revised upwards to S$4.64, reflecting the healthy earnings growth expected in FY19/20.
• As trade tensions and emerging market weakness take a toll on equity market sentiments worldwide, we expect ST Engineering’s share price to remain supported by the flight to safe havens, as ST Engineering remains a high-quality defensive stock amid current uncertainties.

Source: DBS Research - 15 Aug 2019