SIA Engineering - DBS Research 2022-11-03: Skies Continue To Clear Up

• SIA Engineering (SGX:S59)'s 2QFY23 (Jul to Sep 2022) net profit came in at S$19.7m (+53.9% q-o-q, +87.6% y-o-y), with 1HFY23 net profit of S$32.5m accounting for 44% of the consensus’ full-year estimate and 46% of our full-year estimates, thus largely in line with expectations, given our expectation of a back-loaded recovery. 2QFY23 revenue amounted to S$190.7m (+11.2% q-o-q, +38.0% y-o-y), driven by a recovery in work volumes across line maintenance and hangars. See SIA Engineering's announcement dated 01 Nov 2022.
• At the core operating level (excluding JV/associate contributions), SIA Engineering continued to book operating losses in 2QFY23/1HFY23, as higher work volumes have been offset by a lower quantum of government grants and wage and general inflationary pressures, as SIA Engineering ramped up hiring ahead of the expected demand recovery in coming quarters.
• Government grant support was just over S$2m in 2QFY23, according to our estimates, and core net profit (excluding government support) of S$17.3m in 2QFY23 represents a significant improvement from the previous quarter (S$4.1m), largely driven by strong performance in the JV/associate line.

Line maintenance volumes picked up to around 65% of pre-pandemic levels by the end of 1HFY23

• Line maintenance volumes picked up to around 65% of pre-pandemic levels by the end of 1HFY23, further improvement in store. Management reported that the number of flights handled in Changi Airport by SIA Engineering’s line maintenance unit in 1HFY23 doubled y-o-y and reached 63% of the pre-pandemic workload, compared to 38% six months back at the end of FY22.
• Flight activities have picked up strongly over the last few months as Singapore has progressively opened up its borders and relaxed travel restrictions. There should be further improvement in flight movements in Changi Airport, and expectations are for flight movements in Singapore to reach around 80% of pre-pandemic levels by the end of FY23. That should be a key inflection point for SIA Engineering’s line maintenance operations and herald its return to profitability at the core operating level.
• The base maintenance division also saw improvements and completed more checks this quarter (140 light checks compared to 118 in 1QFY23), driven by demand recovery and additional capacity created by the adoption of Lean practices to improve turnaround times at hangars.

Engine shop performance shows significant improvement.

• Share of SIA Engineering's associate/JV contributions came in strong at S$25.0m in 2QFY23 (S$41.4m in 1HFY23, up 54% y-o-y), and confirms our view that JV/associate contributions should recover faster than core operations, given a more global exposure.
• The convincing turnaround in associates and JVs was driven by a broad-based recovery led by engine centres and supported by component centres and airframe and line maintenance JVs, on the back of more widebody aircraft returning to service in the skies.

Margins should improve as SIA Engineering has ramped up headcount ahead of demand.

• While margins in 1HFY23 were hit by higher manpower costs, SIA Engineering's management indicated that the current headcount levels should support line maintenance recovery to at least 80% of pre-COVID levels. This should help margins in 2HFY23 as revenues catch up with the higher staff costs.
• Manpower though will still be lower than what it was pre-pandemic, even when SIA Engineering hits full recovery in terms of flights handled and maintenance checks owing to efficiency increases.

Activity levels for MRO operators will rise as airlines return more aircraft into service.

• Overall supply-demand dynamics for the MRO sector remains fairly positive at this juncture, given recovering flight activity, and airlines are scrambling to reactivate stored jets in anticipation of a strong rebound in passenger traffic. The protracted supply chain disruptions worldwide in the aftermath of COVID-19 and the Ukraine crisis mean that production constraints faced by Airbus and Boeing are unlikely to be alleviated soon, and thus airlines will need to keep flying older aircraft or bring back parked aircraft into service, which is beneficial for MRO operators. Thus, we believe work volumes will continue to improve, and we should see a turnaround at the core operating levels in 2HFY23 and beyond.
• The key overhang for SIA Engineering remains China’s COVID-19 policy and reopening trajectory, given that 40% of intra- APAC travel involves the country in some form, so if and when China decides to open up, that would be a further key catalyst for the airline and aviation services.

New facilities and capabilities will help in the medium term.

• Earlier this year, SIA Engineering announced some growth initiatives, chief among which was the acquisition of a 75% stake in SR Technics Malaysia (remaining will be held by SR Technics) to form a component MRO JV. The JV broadens the range of component repair capabilities and has helped the group secure a 10-year MRO licensing of repair capabilities with Honeywell for 737NG, 737MAX, and 787 Air Data Inertial Reference Unit components.
• In April 2022, SIA Engineering announced the expansion of its regional base maintenance network with the potential lease of two hangars in Subang, Malaysia, as SIA Engineering aims to complement its Singapore hub operations with additional capacity and capabilities in neighbouring Malaysia.
• Earlier in 2022, SIA Engineering also announced the start up of the Engine Services Division in Singapore to provide a Quick Turn facility for CFM LEAP-1A and CFM LEAP-1B engines, which has completed its first quick turn and is currently ramping up capacity.

Upgrade to BUY, as SIA Engineering's share price weakness provides better entry point to earnings improvement story.

• Since our downgrade in May, SIA Engineering's share price is down around 15%, underperforming the broad STI by around 10%. We believe this provides a more attractive entry point for investors to play the earnings recovery story for SIA Engineering, which should exhibit a return to core profitabilty in 2H23 and beyond.
• We are projecting a 32% CAGR in core recuring net profit over FY22-25 on the back of the recovery in international air traffic. In case China opens up, the recovery trends could be faster.
• No dividends were declared by SIA Engineering in 1HFY23 as a conservative measure, but we expect dividends could be restored at the end of FY23, given the rebound in the earnings trajectory that we are expecting.
• As we roll over valuations to blended FY23/24 numbers, our target price for SIA Engineering is revised up to S$2.80, despite an upwards revision in risk-free rate assumptions.
• Note that with a strong balance sheet, SIA Engineering remains immune to interest rate hike cycle. SIA Engineering continues to remain at a robust net cash position of more than S$600m, and its net cash balance actually grew over the course of the pandemic period, with prudent capital management, which is commendable. SIA Engineering has been cautious and has only undertaken bolt-on acquisitions and partnerships, as mentioned earlier, but we could potentially see its earnings recovery accelerate if attractive M&A opportunities arise in new growth areas.
• Moreover, SIA Engineering stands to benefit rather than lose in the current interest rate hike cycle, so there is no downside risk to SIA Engineering’s prospects on this front.