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Morningstar | Raising Our ST Engineering FVE to SGD 4.36 on Improved Capital Efficiency

After fine-tuning our earnings and capital efficiency assumptions for narrow-moat Singapore Technologies Engineering, and to reflect contributions from the proposed purchase of Belgian satcom company Newtec, we raise our fair value estimate to SGD 4.36 per share from SGD 3.76. We like the acquisition of Newtec and expect its contribution to raise revenue growth for STE’s electronics arm to 10% from 9% over our explicit five-year forecast period. Coupled with the acquisition of MRA Systems, which we assume will contribute a full six months' profit, we expect STE’s earnings to jump 13% in 2019 excluding one-off items. We forecast a five-year EPS compound annual growth rate of 13%. While the two acquisitions will lift estimated net gearing to 0.7 times, we expect free cash flow growth to resume in 2020 and maintain our DPS forecast of SGD 0.15 through 2023. We think STE is attractive at current levels and believe a current dividend yield of 4% supports the share price.

STE’s capital structure is expected to be more efficient, leading to a reduction in our weighted average cost of capital to 8.4% from 8.6%, which adds SGD 0.30 to our fair value estimate. For 2019, we see capex staying stable while the acquisitions of MRAS and Newtec cost SGD 989 million. We expect the two companies to contribute SGD 145 million to STE’s 2019 gross profit, accounting for almost 10% year-on-year growth. We believe STE’s EBITDA margin may dip to 12% in 2019 and 2020 before recovering to 2018's level of 12.6% in 2021. This reflects potential integration costs and our belief that MRAS’ profit margin is lower than STE’s existing aerospace segment, given that it hasn’t scaled up yet.

STE’s sale of its construction equipment business over the past few years and an improved product mix for its marine segment has helped reduce working capital needs. We noticed a sharp improvement in 2018 but factor in some slowing in 2019 due to the acquisitions and the risk of global growth headwinds.

Newtec, for which STE is paying EUR 250 million in entirety, provides STE’s existing satcom business with synergies as it is an OEM of satcom equipment and specializes in media- related services while STE is currently strong in transportation-related services. Industry growth is anticipated to be 10%-15% annually so strong demand and synergies from a combined European sales team is expected to drive SGD 200 million in both revenue and cost efficiency over the next five to seven years, based on management guidance. We believe this is achievable given our forecast revenue of around EUR 100 million in 2019 and high teens EBITDA margin and industry growth. There is a significant SGD 345 million in goodwill and intangibles that will eat into STE’s net tangible asset value, or NTA. We forecast NTA per share to decline to SGD 0.28 in 2019 from SGD 0.44 in 2018. While we have not raised our 2019 profit forecast for STE due to acquisition costs, our 2020 bottom line is lifted by 11% with a full-year contribution from Newtec to help lift group profitability from 2020. As such, we expect STE’s EPS to grow 12.6% in 2019 and 22.7% in 2020.

As expected, the completion of the MRAS acquisition has been delayed by around one quarter as the U.S. government shutdown slowed some approval processes. We have adjusted our earnings to reflect a six-month contribution in 2019. As MRAS produces nacelles for the A320neo, if ongoing problems with the 737 MAX improve demand for the A320neo, this could be positive over the longer run for STE. But there is little that Airbus has in spare capacity to meet new demand, so we don’t see a significant impact.

A recovery in its U.S. operations and an improved product mix has lifted marine segment profit margins. We have raised our assumed gross profit margin to 16%, which is short of 2018's level at 19%. We believe the completion of the ConRo deliveries has helped with the segment’s margin in 2018, and while we expect future margins to be better than in the past few years, it may not be sustained at 19%.

Regardless, an improved outlook and operating leverage for its land systems and marine divisions as well as the sale of its construction equipment business in India, which follows the similar sale in China previously, is expected to improve working capital management. STE saw a nice reduction in working capital needs in 2018 with inventory days falling to 82 from 124 and receivables to 62 from 92. We believe some of this could be marine segment delivery related and due to the sales of noncore assets and so, in our base-case assumption, we think this may rise slightly again in 2019 with the two acquisitions and in line with our lower gross profit margin assumption for the marine segment. Historical average is closer to 78 days for receivables and 111 days for inventory. We have assumed 73 and 95 days, respectively.