Friday, September 23, 2016

SIA Engineering - Part 1

SIA Engineering (SIAEC) is one of the strong blue chips name in Singapore to buy and hold for dividends. It has also made regular appearance in the annual dividend stock list posted on this site in almost every year since 2009. The long term stock chart below shows that it has compounded its intrinsic value, albeit with some cyclicality while paying annual dividends for the past 14 years (based on Yahoo! Finance, the "D"s representing when dividends were paid). An investor who bought the stock at $1.5 in 2002 would have almost tripled his money including dividends.

SIAEC's long term share price

SIA Engineering's business deals with the maintenance of aircraft when they land in Singapore as well as in the other airports in Asia where the firm has presence. 40-50% of its revenue is ultimately tied to its parent: Singapore Airlines but the other businesses are also growing. SIAEC also operates line maintenance in Australia, US, HK, Indonesia, Philippines and Vietnam via joint ventures and subsidiaries.

The investment thesis for this stock quite straightforward.

SIAEC is a play on the rise of global tourism alongside the influx of Low Cost Carriers or LCCs operating in Asia. It also benefits from more full fledge airlines outsourcing maintenance to established third parties like itself. As a leader in the industry, it enjoys a strong track record, economies of scale, an accumulation of knowhow and efficient processes and a strong branding via its relationship with Singapore being an aerospace hub and its parent SIA. It has generated strong free cashflow in the past and is likely to grow its earnings with the opening of T4 and T5.

Aircraft maintenance is a flow business that thrives on more air travel, more aircrafts in the skies and more efficient safety checks. SIAEC is one of the few key players in Asia in the space alongside ST Engineering and HAECO, the maintenance arm for Cathay Pacific and has benefitted from this trend. The maintenance, repair and overhaul (MRO) business as it is formally called has high barriers to entry as it requires a certification process for each and every airline as well as a steady track record in order to win customers. In fact, some airlines view this as fundamental that it doesn't outsource this entirely but conduct some MRO operations in-house. Hence SIAEC had benefited mainly from LCCs in recent years since LCCs do not have the capacity to have full fledge MRO operations in-house.

However more national carriers are also choosing to outsource maintenance to players like SIA Engineering as they can they reduce their asset footprint, sell hangars and facilities. It is also expensive for airlines to maintain a competent MRO workforce. Hence established players like SIAEC that have know-how and once they get economies of scale, can do MROs much cheaper than established airlines.

With Changi Airport embarking on an ever-expansion to Terminal Four or T4 in 2017 and ten years later to T5, SIAEC will also stand to gain more business simply by being the dominant player in Singapore. Airlines would definitely love to stopover in Singapore, do a quick overhaul and move on. This has always been our advantage. We are efficient, can turn around fast, has the reputation to get the job done well and all these in turn help to suck in more traffic and strengthen our brand name.

The Singapore Girl, helping SIA builds its brand name over decades

In fact, branding is one of the key business moat for any companies. SIA started building its brand name since the inception of the company. The Singapore Girl is iconic. To this day, most people when ask what they know about Singapore Airlines would answer, "Singapore Girl." For SIA Engineering, it is imperative that they strengthen on their own brand name as a reputable MRO operator capable of delivering the best maintenance with high efficiency.

For SIAEC, the parent SIA business is doing well too. The SIA Group has built a sizeable fleet over time across its four brands: Singapore Airlines, Silk Air, Tiger and Scoot and this MRO business is captive for SIAEC. It generates the base earnings which allows the firm to re-invest in JVs in Singapore and in the region. SIA owns almost 80% of SIAEC and hence is happy that its subsidiary does well.

However while the story sounds good, SIAEC's earnings had stagnated for a few years. Part of the reason was cyclical as the global maintenance schedule has a cycle with major checks done only periodically. There was also an influx of new airplanes in the last 2-3 years which require less maintenance at the initial stage which led to a decrease in workload for the industry. But we should expect maintenance to come back as these airplanes mature. Also, the total installed base of airplanes globally had continued to increase, so logically, maintenance work over the cycle shouldn't decrease. In fact, maintenance would only increase over time with a larger installed base.

The other key risk for SIAEC was the increase in labour cost in Singapore. With the government restricting immigration, SIAEC, as with many labour intensive businesses with our other listed entities (Sembmarine and Keppel), had suffered from an increase in labour cost as they were unable to hire cheap foreign workers for the more menial work. The mitigating factor here would be its strategy to diversify into lower cost regions such as the Philippines and Vietnam.

So that's the investment thesis as well as the risks.

Next we look at the free cash flow (FCF) generation of the firm. The table below shows a quick and dirty analysis of SIAEC's FCF and also a simple Discounted Cashflow (DCF) model for the firm. Most analytical work that real investors do really don't need 20 tabs excel spreadsheet with each tab running into thousands of lines. We just need to know the key drivers and try to model it as simple as possible. So that's what the following table tries to achieve.

SIAEC's FCF analysis

On the left we have SIAEC's FCF for the past few years. As stated, it had stagnated. It only made S$168m in FCF in the last year which was less than half of its peak at S$353m made in 2011. However the average FCF is a much more decent S$233m over the past seven years which translates to a FCF of c.6% (shown in the far right as FCF Yield). In the projections, in the middle, we try to forecast the future FCF. As with all predictions, it's almost 100% that we won't get this right. The whole purpose of doing the projection is to have a sense of how the stock price is trading vs its intrinsic value.

So as simple as it can be, we project its Dec 2016 FCF to be slightly higher than average of S$233m at S$245m. This is also what the company might be able to achieve in 2016-2017 after a weak 2014-2015 esp with the opening of T4. For the next few years though, we are projecting a 10% increase in FCF per year for three years as we expect T4 to be up and running full speed by the end of 2017. Then in 2019 the growth tapers off at around 3% per year. With this scenario, we get to an intrinsic value per share (IVPS) of $5.2 with an upside of 36% (beside FCF yield). Incidentally, the stock hit its high in 2013 at $5.29! Often times, we see such convergence between technical and fundamental analysis.

In the next post, we will dive into the full DCF calculation and analysis. But for now, it suffice to say that SIA Engineering looks like a good investment giving 36% upside. Its moat had allowed it to generate both a good ROE (at 16%) as well as a 6% FCF yield. It has consistently paid dividends and continues to pay c.4% today. This is one of the true blue chips in the Singapore stock market.

The author owns SIA Engineering since 2013.