Why I Averaged Down on SATS (SGX:S58)

In early February, I bought SATS at $4.49. Back then, the Covid-19 situation seemed to be largely confined within China, with just a few cases in Singapore. I think at that point of time, most of us would have expected Covid to blow over fairly quickly, and be able to get on with our lives.

How wrong were we. And how wrong was I to initiate a position in SATS in early Feb. Over the next few months, with most countries imposing travel bans, air travel and tourism were completely decimated. By March, SATS’ share price had collapsed to around $2.50, more than a 50% decline from its 52-week highs.

When I bought SATS at $4.49 in Feb, in theory, it seemed a pretty straightforward strategy – Covid would surely affect SATS, but if we don’t know exactly how serious the impact would be, thus it’d make sense to dollar cost average. My purchase at $4.49 was my first tranche, and I had the ability to average down one or two more times if necessary. After all, Warren Buffett said that if one is a net buyer of stocks, then one should be happy that stock prices are falling, right? But in practice, when the entire market sells off, when you look at the US market swinging with 5% to 10% moves in a single day, and you look at your entire portfolio declining across the board, it’s not as easy to simply stick to your plan.

Now that things have cleared up a little, I’ve spent the past week looking at SATS again. Make no mistake, fundamentals have changed drastically. Passenger flights are almost non-existent – in April 2020, at grand total of 25,200 passengers passed through Changi Airport – a 99% decrease from a year ago.

Today, it is no longer about projecting revenue growth, or expecting SATS to even turn a profit in the near term. Instead, it is about survival – analysing whether SATS would be able to survive the Covid crisis and emerge stronger.

Here are the reasons why I believe that SATS would be able to survive the Covid crisis:

1. SATS’ profit guidance released in April estimated that they would suffer a 50 to 70m loss for Q1 FY20/21.

https://links.sgx.com/1.0.0/corporate-announcements/L5NKKF5YPBP061IE/b2c8c2b43d28e4026ca6b30064127d320bf1c8ee7b7b6a2eb7597f2c1c33ff20

The estimated 50-70m loss is “after taking into consideration grants received from governments”.

Given that this is for the 3-month period from April to June 2020, where we are already in full-blown lockdown with a complete ban on all tourists and transit passengers, I believe that this is as bad as it gets. The only passengers at Changi Airport are returning Singaporeans, or foreigners leaving the country. Which make up a grand total of 25,200 passengers.

Source: Changi Airport Traffic Statistics

https://www.changiairport.com/corporate/our-expertise/air-hub/traffic-statistics.html

2. SATS started off on a strong cash position, and has the ability to raise more debt

SATS last reported their financial results on 31 Dec 2019. As at 31 Dec 2019, SATS had 212m in cash and 103.6m in short term and long term debt, with a debt to equity ratio of 18%.

Note that the increase in debt to equity ratio from a year earlier was due to recognising changes from IFRS 16. For those with some accounting background, IFRS 16 is basically a silly rule that requires companies to recognise their long-term lease liabilities as a liability, instead of recognising them in their P&L each year. For example, if SATS leases an office for 10 years, then they would have to record these 10 years worth of future lease payments as a liability, which distorts the ‘true’ financial position, because it is not exactly a ‘debt’. Excluding the impact of IFRS 16, SATS noted that their ‘actual’ debt to equity ratio still remains at 6% as at 31 Dec 2019.

Subsequently, SATS announced that they completed the acquisition of Monty’s Bakehouse, for a total consideration of S$48.4m, which includes a deferred earn out consideration of up to S$18.3m. To simplify things, I’ll just assume that a total of 48.4m was paid.

SATS also announced their intention to raise S$500m thorough their MTN programme. To date, 300m has been raised, with 200m @ 2.88% p.a. and 100m @ 2.60% p.a., which I believe are reasonable borrowing rates and reflects the financial stability of SATS. The remaining 200m of notes have not been sold yet. Even if SATS were to raise up to 500m of debt, based on their total equity of c.1.8b as at 31 Dec 2019, their debt to equity ratio would rise to 30-40%, which is still reasonable to me. Hence, I believe that SATS can still tap the debt markets if necessary. Personally, I would be comfortable with a debt to equity ratio of up to 50-60%.

Therefore, if we were to estimate SATS’ cash level as of 31 March 2020, the ballpark figure would be 212m – 48.4m + 300m, which gives us a total of $463.6m. Of course, this is assuming that the quarter from Jan to Mar had delivered at least a net cash inflow, which is likely possible, because the effects of the travel bans only started in March. Hence, if SATS’ burns cash at a rate of 60-70m per quarter, they should still be able to last for at least more than a year. If 200m more is raised, their cash runway then increases to beyond 2 years.

3. Government wage subsidies and relief for rental & license fees

SATS currently benefits from some of the measures undertaken by the govt to alleviate the impact on the aviation sector:

• 75% wage subsidy for local workers, capped at a maximum salary of $4,600
• Subsidies for retraining of workers for redeployment
• License fees relief for ground handlers
• Rental relief for ground handlers

Given that the average salary of SATS’ employees was $52,304 in 2019, it would be reasonable to assume that a sizable proportion of their workforce would be included in the JSS. The key assumption underpinning my analysis of SATS would be the continued subsidies from the govt. This is because SATS’ operating costs in an ordinary year is c.800m, hence without the various subsidies, it is likely that SATS’ losses would be far greater than the 50-70m they projected for Q1 FY2021.

In their profit guidance dated 30th April, SATS’ projection of a 50 to 70m loss for the quarter included the effects of govt subsidies, hence a major assumption of my valuation would depend on the continuation of these subsidies.

4. Food solutions and cargo flights are still operating

While c.65% of SATS’ revenue is derived from Singapore, mostly from Changi Airport, (some from Marina Bay Cruise Centre), the few bright spots for SATS would be that their food solutions segment and the handling of cargo flights are still in operation. Air freight volume has fallen by a lesser degree as compared to passenger volume, because cargo flights are still necessary for the import and export of goods.

Source: Changi Airport Traffic Statistics

Recently, there was also news that SATS has started catering meals for some of the quarantined foreign workers. This is positive for the company, although the returns from this would probably be rather insignificant, given that margins for food solutions tend to be lower.

5. Aviation remains a strategically important sector to Singapore

https://www.straitstimes.com/singapore/government-determined-to-see-sia-through-covid-19-crisis-pm-lee-hsien-loong

During PM Lee’s latest speech, he mentioned that aviation remains a strategically important sector to Singapore. “Air transport is fundamental to Singapore's role as a global and regional hub.” SIA is strategically important as our national flag carrier, and the govt has indicated their intention to ensure that SIA survives this crisis. SATS plays a crucial role in our aviation ecosystem too. Think about them as being similar to Boeing for the US or Airbus for Europe – strategically important companies that should be backed by the state during a crisis.

With Temasek being a major shareholder in SATS (39%), if things get really dire, would we see them take corporate action, similar to that for SIA? I don’t know, and I don’t wish to speculate.

Valuation

I used a simple DCF model to estimate SATS’ valuation. The assumptions are rather straightforward, and I didn’t want to dive too deep into the P&L projections because these are just ballpark figures.

The main assumptions are:

1. Covid lasts for 2 whole years – from FY2021 to FY2022

As SATS’ financial year starts from 1 Apr, that means 2 full years of losses (cash burn) from 1 Apr 2020 to 31 Mar 2022. Think of that – no overseas holidays until April 2022!

Beyond Apr 2022, hopefully, a vaccine is developed or we achieve herd immunity. Air travel returns to pre-covid levels for FY2023.

2. Cash burn of S$250m for FY21 and S$250m for FY22

I derived the cash burn based on SATS’ projected 70m loss per quarter – that implies a full year loss of 280m. However, this 280m loss would reflect the accounting losses, hence we have to add back depreciation, which is a non cash expense. For FY19, depreciation amounted to c.80m, which we will add back. Additionally, capital expenditures are assumed to be 50m for FY21 and FY22, on the assumption that capex would be scaled back due to the crisis. Hence, that gives us a cash burn of 250m per year.

Again, I want to reiterate that these assumptions are based on the expectation that SATS continues to receive govt subsidies.

3. Return to pre-Covid levels in FY23 (from April 2022 onwards)

Pre-Covid FCF was c.200m per year based on SATS’ annual report. The discrepancy between the FCF, OCF and Capex is mainly due to SATS only including ‘cash capex’ in their FCF calculations. Capex of 100m per year is assumed.

SATS Cash Flows from FY15 to FY19
Source: SATS FY19 Annual Report

4. Discount rate of 7.5% and terminal growth rate of 1.5%

To explain why I have chosen these inputs, the finance-y answer would be: Due to SATS’ historically low beta, their more efficient capital structure as a result of raising more debt, and in light of the lower interest rate environment going forward, a WACC of 7.5% is derived.

But the short answer would be: Just use any discount rate you’re comfortable with. For a comparison, DBS used a WACC of 5.7% and TGR of 3% in their SATS research dated 5 May 2020.

Conclusion

I have averaged down on SATS at $2.84, and it has become my second largest position, at an average cost of $3.41. I believe that the long term bet on aviation remains intact. 

Additionally, it was reported that Changi Airport would start to allow transit passengers from June 2, after the circuit breaker ends, subject to strict measures. Hopefully, this would be the first small step towards resuming airport operations. I await SATS’ results by 31 July 2020 for greater clarity.

Additional details not covered in my analysis:

1. Upside potential: Projection of revenue growth was based on the assumption that passenger capacity at Changi Airport remains at 85m across 4 Terminals; the impact of T5 is not included, as I don’t believe that it can be meaningfully estimated. Hence, the DCF derived value for SATS may potentially be higher, if the increase in passenger capacity upon the completion of T5 is included.

2. Downside risk: Bankruptcy of airlines resulting in default of payments. SATS had $373.9m of receivables as at 31 Dec 2019. If certain airlines go bankrupt, SATS may have to write off some of the receivables owed by these airlines. Additionally, the solvency of SATS’ individual associates were not considered. If some of their foreign associates/ subsidiaries do not receive adequate government aid, they may be at risk of bankruptcies too.

If you are keen to learn more about SATS, do check out my other articles on the company:

1. How SATS earns its Revenue

2. Estimating SATS' cash burn

Note: As of writing, I hold a long position on SATS at an average price of $3.41. 

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

If you enjoy my articles, please 'Like' my Facebook Page at: 

https://www.facebook.com/AlpacaInvestments/

Follow me on Instagram at @AlpacaInvestments