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Morningstar | ST Engineering Interims Clouded by One-Off Items; Longer-Term Viewpoint Lifts Our FVE to SGD 3.60

We raise our fair value estimate for Singapore Technologies Engineering, or STE, to SGD 3.60 from SGD 3.40 as we reflect on strategies from the firm that should begin to materially drive earnings growth over the next five to 10 years. Some of this upside is already reflected in the company’s current share price, so a larger buffer is preferred versus risk, but the company’s 4% dividend yield remains attractive. Our narrow moat and stable moat trend ratings are intact. STE’s second-quarter performance was largely within our expectations, although we make slight changes to our forecast to reflect one-off gains and costs. Our 2018 net profit forecast is lowered by 3% but is lifted by a similar quantum in 2019 as lower finance costs filter through.

We are comfortable with the sharp rise in STE's fair value estimate, as at our terminal value, STE would trade on 16 times price/earnings, well below the company’s current 19 times. The increase in our fair value estimate is largely driven by our view that STE can maintain average revenue growth of 6.7% through 2027, underpinned by aerospace segment growth of 5%, as we expect STE to maintain its market share in MRO activities, in line with our narrow moat rating, while seeing rising OEM revenue. Our growth assumption is stronger than global MRO average growth of 4% to factor in STE’s larger exposure to emerging Asia, which is expected to grow at 6% based on reports from Oliver Wyman and ICF International, with China looking at almost 11% growth.

We also factor in success in its strategy to boost defense exports, which increases land systems and marine activity, although we are not as optimistic for revenue in marine to rebound to its 2013 high as management intends. We still assume that electronics segment growth, at 9%, will be a key driver, with global Smart City spending expected to average 10% growth. Coupled with margin expansion, we are looking for STE to increase net earnings at an average 9% pace through 2027.

This would be a marked improvement over the zero growth over the past three years, but we believe its ongoing restructuring to focus on core areas should begin to bear fruit in the next five years. STE has continued to sell off or shut down noncore assets and has been investing in companies with products that it thinks will fill a gap in its provision of Smart City solutions. Some of these one-off items have affected its second-quarter earnings, with the sale of a stake in Airbus Helicopters leading to a one-off gain of SGD 9 million. The quarter also saw a one-off finance charge of SGD 15 million from the early redemption of its medium-term notes. However, this will lead to interest savings of around SGD 14 million-SGD 16 million from 2019 onwards.

The loss of the bid to supply the U.S. Marine Corps with a deviation of its Terrex 2 combat vehicle is a disappointment, but STE is still looking at bids to supply the U.S. Army with new-generation combat vehicles. Given a lack of transparency, it’s difficult to accurately assess the market that STE is targeting, but management has indicated that it sees defense exports augmenting revenue, so that growth in overall group revenue growth of around 6% would be achievable.