SIA Engineering – Analysis of Purchase Part 5

For this Part 5 and final part of my analysis of purchase, I take a look at the outlook for the global MRO industry based on some industry reports and comments, while at the same time commenting on the prospects and plans for growth for SIAEC. I will also a pros and cons analysis and finally, conclude about SIAEC.

Global MRO Industry Outlook

First of all, I have to say that it’s pretty disappointing that SIAEC had stopped their coverage of the global MRO market since FY 2009; wherein the annual reports for FY 2009 and FY 2010 do NOT contain any commentary on the global MRO industry or market outlook. If a reader traces back through ten years of Annual Reports, he would find that every year before FY 2008 (inclusive) had a pretty detailed commentary on the global MRO market, to the extent that it helped a reader to understand a lot about the industry without the need to do much more independent research.

In terms of air traffic and the airline industry, a recent news report on Channel News Asia on June 28, 2010 stated that Changi Airport registered highest passenger growth in May 2010. The airport handled 3.39 million passengers for May 2010, a 22.6% increase year on year. Globally, increases were also registered for air traffic and this bodes well for the airline industry; translating into more business for MRO providers and SIAEC as well. Importantly, the article stated that aircraft movements for the 5-months ended May 31, 2010 rose 9.6% to 106,177; increased aircraft movements will mean more maintenance and upkeep work to be performed and seems to indicate that the industry will bounce back to pre-crisis levels, though of course this would be gradual rather than a sudden spike.

I shall attempt to use the SIAEC FY 2008 Annual Report on the global MRO market and draw inferences from it (where relevant) to project to the future of the market. In the article on Page 24 of the Annual Report, it was mentioned that the Middle East is another centre of aviation buzz, and that Dubai (in 2008) serves 35 million passengers annually. According to the website, Middle East MRO will see steady growth of 4.4% annually to reach US$3.4 billion by 2018, compared to US$2.8 billion in 2008, while the Middle Eastern fleet has doubled since 2007. The long-term outlook for the MRO industry remains positive as global growth is expected to be maintained at 4.3% CAGR through 2018. This bodes well for the long-term growth of SIAEC.

Note: Information for this brief summary was taken from here and here.

Prospects and Future Plans

I shall use this section to discuss some of the plans and prospects for SIAEC, which are part of their strategy to ensure long-term growth and increased cash flows for the Group; and hopefully will translate into higher dividends for shareholders!

1. Tie-up with Vietnam’s Tan Son Nhat Airport to provide line maintenance services – On February 24, 2009, SIAEC announced that they had signed an agreement with Saigon Ground Services to form a line maintenance JV at Tan Son Nhat International Airport in Ho Chi Minh, Vietnam. SIAEC is supposed to hold a 49% equity shareholding in the JV, but to date this has not been reflected in the Annual Report under Joint Ventures or Associated Companies. Strangely though, it was mentioned in the FY 2010 on Page 4 but the exact details of the contribution and the scale of operations were only touched on nearly 1.5 years ago; and since then there was no announcement or press release on this. However, I am optimistic that SIAEC will be able to tie the details down soon and hopefully in FY 2011 there will be a more definitive announcement on this, and also whether the service offerings will be extended to include maintenance checks and component overhaul services.

2. Establishment of a facility in Bahrain (MOU with Gulf Technics) to service the Middle Eastern market, with potential inroads into Africa and Europe – On January 21, 2010, SIAEC announced the signing of an MOU with Gulf Technics to set up and operate a facility in Bahrain for the maintenance, repair and overhaul (MRO) of aircraft. As of this writing, 7 months later, SIAEC and Gulf Technics should still be hammering out details and working towards a definitive agreement to set up an MRO maintenance facility in Bahrain. Note that MOU signing phase is simply an expression of interest and does not constitute any contractual obligation; thus this is still a WIP and thus was not reflected in SIAEC’s FY 2010 Annual Report. Based on the MRO Industry review in my previous section, assuming SIAEC is able to successfully penetrate the Middle Eastern market, it will hold lots of potential for SIAEC to grow their earnings and cash flows.

3. Investment in Engine Developments with Pratt & Whitney – This is something which is relatively new for SIAEC, investing in aircraft engine technology through their long-time partner Pratt & Whitney (P&W). On January 18, 2010, SIAEC announced that they will co-share and participate in P&W’s Risk-Revenue Sharing Program (RRSP); with a 3% stake in the C-Series aircraft engine program and a 1% stake in the MRJ aircraft engine program. Two special purpose vehicles Nexgen I and II have been incorporated for this purpose and are wholly-owned by SIAEC; and it remains to be seen how lucrative this venture is as it is still pretty “virgin” to SIAEC and the benefits are neither obvious nor clear. Eagle Services Asia, a JV between SIAEC and P&W, will be used as the first engine centre in the global RRSP MRO network for the PW1500G engine, and it was mentioned that Eagle Services is poised to benefit from this arrangement as this was cutting-edge new technology which P&W was investing in. The press release goes on to say that “SIAEC is investing in the future of aviation technology”, which seems to imply that SIAEC is trying to get in at the front door when it comes to new technologies and capabilities. Whether this translates into tangible results such as increased customer base, higher revenues or more share or profits/dividends remains to be seen, but it will be interesting to keep up with this development in the next few quarters to note its contribution.

4. Leveraging on SIA for business (see later section for pros and cons of SIA as “anchor” customer) – With SIAEC leveraging on SIA for business, this means that there will be a steady inflow of revenue and orders for MRO from their biggest client. In fact, just six months back in March 2010, SIAEC renewed its comprehensive Services Agreement with SIA worth S$2.2 billion over 5 years; and which covers a broad spectrum of MRO and fleet management support services. The existing services agreement expires in 2010.

5. More Joint Ventures in the offering – SIAEC has a long history of aggressively pursuing and concluding joint venture arrangements with internationally renowned partners; with Safran Group being the latest addition, as well as Gulf Technics of Bahrain. It will be fair to assume that Management will continue to focus on developing and extending their reach through such lucrative arrangements into the mid-term, as it allows them to grow and expand without high capex requirements. In the near-term, I guess I can reasonably expect their marketing and business development efforts to pay off with at least 1 joint venture/associated company being formed every 2 years (this was the average over the last ten years, with some years having none and other years seeing two to three such arrangements). These will all add to their earnings base and ensure more cash flows in for them to increase dividends over the long-term.

6. More innovative investments into complementary businesses – With the recently concluded P&W Engine RRSP agreement, it is fair to say that SIAEC could be coming up with other innovative ideas on how to use their spare cash (a lot of their cash is free cash which is being churned out) to invest in complementary businesses or service offerings which are tied to their main line of business. Though there is a risk of “diworsifiction” as mentioned by Peter Lynch, SIAEC’s Management has thus far shown a tendency to be able to grow the business through astute investments; and the P&W investment may be a test for them to see if they can think “out of the box”. I concur that it remains to be seen if they can successfully invest in other complementary businesses as time is too short to evaluate the most recent P&W one, but my belief is that the quality of Management is an important factor which I am willing to bet my dollar on.

Other Salient Aspects of SIAEC (Worthy of Mention)

• Comprehensive training facilities and to impart knowledge of Kaizen (continuous improvement) costing to staff.
• Adoption of NTUC’s motto of “Cheaper, Better, Faster” to improve operating efficiencies and cut costs. Recently announced that the Group had given out S$600,000 in rewards to employees relating to this scheme; and eventually SIAEC plans to save up to S$10 million in productivity gains for Phase I initiatives (there was no mention of Phase 2).
• Investment in good IT systems  SAP as ERP software to integrate all divisions and departments together for streamlined process flows.

Pros and Cons Analysis for SIAEC

Pros

1. Very strong operating and free cash flows - As can be seen in the analysis in Part 1, SIAEC has very consistent and strong operating cash inflows for the last ten years; and in recent years there was also positive inflows coming from investing activities as its myriad of joint ventures and associated companies boosted its returns and cash. After subtracting capex for new machinery and for upgrades of fixed assets, there was free cash flow generated every year; hence the Group’s cash balance would continue to grow.

2. Growing list of JV and associated companies, with increasing dividends flowing in every financial year - SIAEC has continued to expand its list of JV and associated companies and has been increasing its dividends steadily over the years as a result of FCF generated; Part 3 has also shown how much cash has been flowing in from these alliances into SIAEC’s coffers, and there is thus a very high probability of dividends being sustained or even increased in the medium-term; and this provides a cushion of support for owning shares in the company in case growth tapers off. UPDATE: SIAEC just signed its 25th JV Agreement with Panasonic Avionics on November 4, 2010.
3. Symbiotic relationship with SIA which is a world-renowned brand and a leader in the airline industry - SIAEC has the backing of Singapore Airlines (SIA), which is a world-renowned airline and which is very profitable. Most of their MRO jobs come from SIA, but they are increasingly being less reliant on SIA for business as they diversify their revenue streams away from SIA and into other airlines.

4. Consistently high ROE with low capex requirements and an unleveraged Balance Sheet - SIAEC is able to generate consistently high ROE above 20% on average without debt at all in its Balance Sheet, which is very impressive considering the track record stretches all the way across ten years; and through recessions and busts as well. This demonstrates that Management is able to allocate capital efficiently to generate high returns on equity for its shareholders and the business model is able to sustain high returns without relying on either debt or equity issuance.

5. High barriers to entry industry - Although the MRO industry is admittedly fragmented and there are many players each servicing specific large airlines, the barriers to entry are high in terms of equipment needed and expertise required (of technicians and engineers). SIAEC has built up a proven track record over the years in terms of high quality service to international clients and this reputation and branding also helps to create a moat which competitors will find difficult to assail.

6. Clear and Successful growth strategy with proven track record - SIAEC’s growth strategy had been clearly articulated right from the start (in FY 2001’s IPO year); and Management has consistently followed this strategy to grow the Group’s business and cash flows over the last ten years. As a shareholder, I have the confidence that this business model is a proven one (with a decade of history and track record as evidence), and will guide the Group forward to better results and performance over the medium-term. This is much better than other companies which are constantly seeking new (and unproven) avenues for tapping growth and expansion, all with a high risk of failure which will result in shareholders’ monies being burnt away.

Cons
1. High valuations and high price to book ratio - Valuations are not exactly cheap, coming in at 15x historical PER and about 14x ex-cash historical PER. Price to book is about 3x and is pretty demanding as well; so one can argue that SIAEC is fairly valued rather than under-valued, based on historical results of course. Still, I must add that I am investing for the future, and I am expecting profits and cash flows to improve as the years go by, through the measures undertaken as mentioned in the previous analyses. Also, do note that SIAEC is a “blue chip”; hence valuations are expected to be higher than companies such as Kingsmen which are much smaller. Valuations for SIAEC are comparable against its close competitors and are currently hovering at its 5-year average; so its days of being severely undervalued during the Global Financial Crisis (actually, almost every company was under-valued then, some trading way below book value) are most likely over. Its yield and consistent FCF can be used as a margin of safety in case the business falters. Interestingly, Teh Hooi Ling wrote an article dated August 15, 2010 in the Business Times titled “In Search of Super Returns in Stocks”; where she mentions that investors would be willing to pay a high premium over book value if the Company can generate earnings above its cost of capital. She argues that if a company can earn substantially above its cost of capital (by measuring ROE) over an extended period of time, then the stock should trade above book value. Price to book ratio will be higher as long as the Company is having “abnormal earnings”, which is defined as ROE minus the cost of capital, for an extended and sustained period of time. Please check out her article here.

2. SIAEC’s business is dependent upon the aviation and air travel industry (hence not so resilient in the face of recessions and busts) - Air travel is pretty cyclical and is affected by downturns and recessions, and since SIAEC is intricately linked to SIA in terms of business volume, one can expect industry doldrums to impact SIAEC’s earnings and cash flows as well. Thus far, the effects are not that obvious due to the diversified nature of SIAEC’s JVs and business alliances, but there have been years in which they paid less dividends and earnings took a dip. Hence, this is a minus point for SIAEC even though its cash flows are fairly resilient so far.

3. Major customer SIA can also be a bane if SIA’s fortunes suffer - Despite the obvious advantages of having SIA as their major and “anchor” customer, this can also backfire badly if SIA themselves get stuck in a rut, or are experiencing problems with their top and bottom lines.

4. Core revenue did not increase by much as compared to competitors - This should be viewed in the light of SIAEC’s strategy compared with other MRO players, as SIAEC focused more on joint ventures and alliances as compared with their competitors. As a result, one should note that core revenues did not increases as much on a CAGR basis as compared to its competitors. On the flip side, SIAEC does make up for it with higher share of profits from associated companies and joint ventures as well as higher cash dividends from these investing activities.

5. There is a need to continually invest in technical skills and human knowledge base in order to remain competitive - SIAEC is in the service industry, which means its main costs will be concentrated in staff costs. Even though capex is low as a proportion of revenues, one should note that skills upgrading is a constant requirement for this industry and nature of work; and funds have to be continually invested to train technicians to handle new technologies and aircraft. Sometimes, this training can be very costly as it entails sending engineers and technicians to Europe to learn from the companies domiciled there. This is therefore a minus as the high fixed staff costs structure (including training and development) would imply that SIAEC cannot easily cut costs during a severe recession/downturn (if not they may lose out to their competition).

6. Majority-held by SIA (80% or 870 million shares), hence SIAEC is effectively still controlled by SIA - Being an 80% major shareholder, SIA is effectively controlling SIAEC and thus minority shareholders may not have much say in terms of voting on resolutions and/or other such matters pertaining to divestments or investments which require shareholder approval. There is an inherent risk of being “overrun” by the majority shareholders when it comes to voting on critical matters relating to SIAEC.

Conclusion

After evaluating the risks and rewards, I proceeded to invest an amount of about S$49K into SIAEC, at an average price of S$4.087 per share. The pros are a lot stronger than the cons, in the sense that many of the point raised as cons had already been mitigated (for example, costs did increase during the downturn as per point 5 but not to the extent of wiping out too much cash flows, which is the lifeblood of a Company). As for Point 6, though the risk exists; thus far there have been no boardroom “brawls” with regards to unpopular policies being unilaterally passed by parent SIA. The justification for the high valuation and PTB is that SIAEC is able to maintain very high ROE>20% for the last ten years, while generating loads of FCF; hence it is accorded a high valuation due to the quality of the business (which, incidentally, is still growing). The high PTB was already explained earlier.

Furthermore, the yield for SIAEC at my purchase price stands at about 4.38% historical; and this yield based on healthy FCF should act as a buffer in case the earnings of SIAEC suffer or there is some impairment in the strong fundamentals of the Group. In other words, my margin of safety exists using the yield as a “cushion” and the track record and blue-chip status of SIAEC as my support basis.