• Signing of bilateral flight resumption agreements by Singapore raises hopes of more flight movements at Changi airport from 3Q20 onwards.
• Enhanced Jobs Support Scheme grants from the Singapore government for aviation MRO sector prompts us to raise SIA Engineering's FY21F earnings by around 28%.
• 1QFY21 (2QCY20) will be the darkest quarter for SIA Engineering (SGX:S59). Should be past the worst soon, upgrade to HOLD.

Hopes of Improvement in Operating Environment

Good signs for local aviation sector as Singapore government moves to gradually restore flights on a bilateral negotiation basis.

• With infection spreads largely under control in their respective countries, Singapore and China have gone on to pioneer arrangements to resume international flights between the countries, by launching a "fast lane" arrangement to facilitate essential travel for business and official purposes. Currently, China is allowing each Singapore carrier to fly only to one city in China once a week. Singapore Airlines now flies to Shanghai, Scoot to Guangzhou and SilkAir to Chongqing.
• Under the Singapore-China “fast lane” agreement, which starts today, 8 June, travellers on both sides will be exempt from rules to serve quarantine periods of up to 14 days. But they will need to be tested and bear the costs of testing and hospitalisation, if needed. For a start, the new scheme will apply only to business and official travel, and for flights between Singapore and six provinces in China: Shanghai, Tianjin, Chongqing, Guangdong, Jiangsu and Zhejiang. This arrangement will be gradually expanded to the other Chinese provinces and municipalities.
• Passengers coming into Singapore will need to fulfill a long list of conditions prior to travel, with COVID-19 swab tests before and after arrival, pre-approval from authorities and adherence to a pre-approved itinerary. Similar rules will apply to Singapore travellers going to China. These strict conditions should enable more travellers to have trust in the system.
• Singapore’s Trade and Industry Minister Chan Chun Sing said last week that similar travel discussions were ongoing with other countries including South Korea, New Zealand and Malaysia. These are part of Singapore's gradual reopening of borders post circuit breaker for Singaporeans and residents to conduct essential activities overseas and to allow foreigners entering Singapore in limited numbers, with the necessary safeguards in place to ensure public health considerations are addressed. Recreational travel will still continue to be discouraged, however.

Aircraft movements at Changi Airport, which drives line maintenance demand, should improve materially from 3Q20.

• Apart from Singapore, we see gradual opening up of skies in various parts of the world including Europe and other ASEAN countries. Thus, we believe July-August will be critical months for restoration of confidence of travellers and governments in air travel. This should set the stage for quasi normalisation of flight numbers by early next year, though we do not believe aircraft movements will reach pre-COVID levels even by the end of 2021.
• Overall, we expect around 86% y-o-y decline in aircraft movements in Changi in 2QCY20 (cargo offsetting passenger flights decline to an extent), 50% decline in 3QCY20, 20% decline in 4QCY20, before seeing the y-o-y growth trend reversing to positive territory in 2021, owing to lower base effect of 2020 numbers.
• For SIA Engineering, we expect 40% decline in line maintenance revenues in FY21 compared to FY20, before recovering in FY22.

SIA Engineering’s 4QFY20 net profit came in above the street’s expectations at S$51.4m (+20.4% y-o-y, flat q-o-q)

• SIA Engineering’s 4QFY20 net profit came in above the street’s expectations at S$51.4m (+20.4% y-o-y, flat q-o-q), bringing FY20 net earnings to S$193.8m, which was 12.8% above consensus’ estimate of S$171.8m.
• Key highlights of the results:
  • SIA Engineering's 4Q20 revenue of S$229.3m was down 10.4% y-o-y and 9.0% q-o-q, with FY20 revenue of S$994m slightly above consensus’ projection of S$978m.
  • COVID-19’s impact on 4Q20 was more prominent in March, with line maintenance volume at Changi down 52% to 6,740 flights handled in March from 13,945 flights handled in January; base maintenance volumes at SIA Engineering’s Singapore base in 4Q20 was hardly affected by COVID-19 situation.
  • EBIT during the quarter was dragged by higher provision for doubtful debts, and asset impairments of S$11.2m, but boosted by around S$18.1m of subsidies from the Jobs Support Scheme. Excluding these items, 4Q20 core EBIT would have amounted to around S$7.4m (-62% y-o-y, -54% q-o-q), with SIA Engineering’s core EBIT margin at 3.2% in 4Q20 (vs 6.4% in 3Q20, 7.6% in 4Q19).
  • Associate and JV earnings came in at S$34.9m (+8.0% y-o-y, -11.9% q-o-q), with minimal impact from COVID-19 during 4Q20.
  • Strong operating cash flow of S$91.1m in FY20 (up from S$75.4m in 1H19), but dividends received from SIA Engineering's associates and JVs sank by 22.3% y-o-y to S$84.0m amid the challenging operating environment; capex (including intangible assets) during the period was relatively flat at S$43.6m.
  • Balance sheet remained robust, with SIA Engineering ending the year in a S$505.8m net cash position. However, keeping in mind requirements for future, dividends were cut. Final DPS was 5.0Scts (down from 8.0Scts last year), bringing total DPS for FY20 to 8.0Scts, down from 11.0Scts last year.

Core Operating Outlook for FY21 Challenging

• SIA Engineering's 4Q20 was better than expectations owing to timing of grants, but it hardly reflects the full blow of COVID-19 on the aviation sector in the next few quarters.
• The key operating challenges are highlighted below:
  • With vast numbers of aircraft grounded globally, markedly lower air traffic will translate into lower flying hours and naturally prolong maintenance intervals, with an almost immediate impact on line maintenance (flights handled at various airports. Line maintenance accounts for close to 60% of SIA Engineering’s revenues and almost all of core operating profits. This segment should improve from 3QCY20 onwards.
  • SIA Engineering’s fleet management segment revenue will also come under significant near-term pressure, as revenue in the division is largely correlated to flying hours. Fleet management is around 10% of revenues.
  • On the heavy/base maintenance front, SIA Engineering has been encouraging airlines to capitalise on the lull period to bring forth mandatory aircraft checks and is currently focused on preservation work for Singapore Airlines’s grounded fleet in Changi, which will help to mitigate the blow to its top line somewhat.
  • Additionally, we see the following structural headwinds slowing down the pace of SIA Engineering’s turnaround:
    • Airlines will ground older aircraft – which require more regular maintenance – for an extended period.
    • Expect considerable margin erosion, despite strong government support and SIA Engineering’s cost-cutting measures, as airlines will negotiate aggressively for service pricing concessions and discounts, and competition in MRO sector will increase with lower pricing power. SIA Engineering had delivered well on productivity measures to boost margins over the last few quarters, but these efforts may not be visible in the near future as other factors dominate.
    • Potential stress in the aviation sector (airlines going insolvent) will also reduce demand for MRO work, and could lead to write-downs of receivables.
    • Income from its engine and components OEMs JVs will also be negatively affected by sluggish aircraft production/deliveries.

Nonetheless, SIA Engineering’s resilient balance sheet and support from government schemes places it in reasonable position to weather the storm.

• The management also shared that the company is reviewing its existing portfolio of investments and is open to M&A opportunities and could potentially look for synergistic companies to include in its portfolio. Singapore government’s support for the local aviation sector will provide another big boost in FY21.
• We had previously estimated that Jobs Support Scheme grants to SIA Engineering’s local workforce would be in the region of S$52m, but with the enhancements in the scheme to cover aviation MRO sector as one of the most stressed sectors in Singapore requiring the highest tier of wage support, we believe the grants could now be close to S$150m, and significantly alter SIA Engineering’s earnings profile in FY21.
• Hence, despite cutting core earnings (before grants) for FY21 further to factor in bleak 1Q-FY21 prospects, our net profit forecast for FY21 is actually boosted by 28%, underpinned by grant income.

Upgrade SIA Engineering to HOLD, Target Price Revised to S$2.30

• The lower impact on expected earnings in FY21 should also enable SIA Engineering to maintain dividends at 8Scts in FY21, and not cut further from FY20 levels, thus improving investor sentiment for the stock. Hence, we upgrade our call to HOLD with a higher Target Price of S$2.30.
• Our revised Target Price of S$2.30 is based on a blended valuation framework (P/E, EV/EBITDA, dividend yield and DCF), and is largely pegged to mean valuation levels. We re-introduce a 15% M&A/ privatisation premium in the Target Price.

Source: DBS Research - 8 Jun 2020