KEEPING AN EYE ON ST ENGINEERING



ST Engineering (STE) has performed poorly for the past few months, and I have added it to my watchlist. STE is an integrated engineering group with 4 main business segments - Aerospace, Electronics, Marine and Land Systems. For FY 2016, the group generated $6.68 billion in revenue and $484.5 million in net profit, representing a net profit margin of 7.2%. The revenue breakdown was 65% from commercial sales and 35% from defence sales. Earnings per share was 15.6 cents, and the group distributed 15.0 cents of dividends to shareholders.

STE Annual Report 2016

This year, 9M 2017 earnings per share stands at 11.03 cents, up from 10.12 cents last year. Profits were higher mainly because of a one-off charge of $61.1 million incurred in 2016, when its specialty vehicle business in China was written off.

STE Annual Report 2016

For an overview, STE's Aerospace segment was the largest in terms of revenue (37%) and net profit (48%), followed by the electronics sector. Its Land Systems segment, while posting a higher revenue than the Marine segment, reported a lower net profit because profit margins for this segment has been extremely low.

I read through STE's Annual Report and I was pleased to see that they had reported detailed breakdowns of the financial statements for each segment. I have included my calculations of the net profit margins for each segment, to give us a more complete picture of the relative performance of each segment.

Aerospace Segment


STE Annual Report 2016

Being STE's largest business segment, and with the highest net profit margins, the Aerospace Segment is facing headwinds from structural changes in the aerospace maintenance and repair industry. Newer aircraft such as the Boeing 787 require less maintenance hours, which affects STE's maintenance, repair and overhaul (MRO) business. Furthermore, there is also increased competition from MRO companies in China and our neighbouring countries, such as Garuda Maintenance Facility AeroAsia, an Indonesian company that recently went public. Consequently, STE's net profit margins have declined over the years, which probably reflects the stiff competition in the MRO industry. STE's passenger to freighter conversion segment provides some support to earnings, as they are one of the leading companies providing P2F services, and receives support from Airbus.

STE has also ventured into the aircraft leasing business, where it aims to build up a fleet of mid-life aircraft to be leased out. When its aircraft leasing business attains sufficient scale, it would complement STE's core MRO segment.

For some comparison, SIA Engineering, a similar company in the aerospace MRO segment, currently trades at a P/E ratio of around 20.

Electronics Segment


STE Annual Report 2016

STE's Electronics Segment is by far their best performing segment during the past few years. Revenue and net profit from this segment has been increasing over the years. For the past year, manufacturers of electronic components have experienced a strong rally, with many companies seeing their share prices rising by more than 100%. I believe this reflects the growing demand for more electronic components required for 'smart' devices.

STE's Electronics Segment includes the Intelligent Rail Transport solutions which has projects in Saudi Arabia, Thailand, Malaysia and Singapore; cyber security and satellite communications. In my opinion, this segment has the greatest potential upside, with the demand for electronics set to rise alongside various 'Smart City' initiatives. For example, in 2016, STE partnered SUTD and invested $44.3 million to set up a Cyber Security Laboratory. As more companies go digital, cyber security would be a top priority for businesses, and STE's cyber security business can benefit from this trend.

Marine Segment


STE Annual Report 2016

The Marine Segment has been a drag on earnings, with the persistent low oil prices affecting the entire offshore and marine sector. The weak earnings from this segment is one of the main reasons for STE's declining net profit. For 9M 2017, net profit from the Marine segment deteriorated again, down by 51.5% from a year earlier. 

STE aims to mitigate the impact of the oil downturn by switching to service more vessels in other sectors such as livestock shipping

Land Systems Segment


STE Annual Report 2016

STE is a leading supplier of equipment and munitions to the Singapore Armed Forces, and most of us would be familiar with products such as the SAR-21 rifle or the Terrex IFV, which are manufactured by STE for the SAF. While this segment provides rather stable earnings, because STE is a major contractor for the SAF, what surprised me was that the profit margins were extremely low. However, we should also note that the unusually low earnings for FY 2016 was because of a one off loss from the closure of its Specialty Vehicle unit in China, resulting in a loss of $61 million.

A potential growth catalyst for this segment would be the development of autonomous vehicles. STE recently acquired Aethon for $50 million, which is a leading supplier of autonomous robots for the healthcare, industrial and logistics sector. With its wide scale of operations, STE would be able to penetrate the Asia Pacific market for autonomous robots. Aethon also aims to expand into the European market.


STE has also partnered LTA to develop autonomous buses. STE has expertise in this area, having developed two autonomous vehicles which are currently operating at Gardens by the Bay. Perhaps sometime in the future, STE might become a leading public transport operator here.


Ideally, STE's investments in the autonomous vehicles industry should put the company in a prime position to match the future demand from this sector, and boost its returns from this segment. 

Potential Risks


STE's dividend payout ratio has been consistently on the high side, as seen from the table above. STE distributed 98% of its earnings to shareholders in FY2016. Personally, I am not in favour of such a high payout ratio, as I believe that STE should retain a higher percentage of its net income to fund its capital expenditures, or to reduce debt. Should earnings continue to decline, I believe that a reduction of dividends is possible. Investors seeking dividend income should watch out for this.

Conclusion


STE's share price is still on a downtrend since its peak of $3.86 in, and is currently at $3.21, near its a 52-week low of $3.16. At this price, STE is trading at a P/E ratio of around 20x and offers a dividend yield of 4.7%. However, although STE's management has stated that it expects full year earnings for FY 2017 to be comparable to that of 2016, there is no certainty that the 15 cent dividend would be maintained.

My investment strategy is to identify companies with a good track record of stable earnings. When these companies are sold down due to negative market sentiment, rather than a deterioration of fundamentals, it would present an opportunity to accumulate their share at a lower valuation. Although STE's Aerospace and Marine sectors continue to face challenges, I believe that STE's current situation seems to fit this criteria. STE's fundamentals haven't worsened much compared to a year before, but its share price has been falling. While STE has seen its earnings decline for the past few years, I hope that with potential growth catalysts in the Electronics and Land Systems segments, we would be able to see their earnings bottoming out soon.

With Temasek Holdings owing a 49% stake in STE, I believe that STE is a rather safe bet and would continue to be one of Singapore's leading companies. I would be looking to accumulate if STE's share price falls further.

Note: As of writing, I do not have a position in ST Engineering

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