ST Engineering’s Operating Outlook Is Improving, but High Debt Damps Earnings

We lower our fair value estimate on narrow-moat ST Engineering S63, or STE, to SGD 4.60 from SGD 4.74 following its full-year 2022 results that revealed higher capital expenditures, debt, and amortization costs than we anticipated. We remain upbeat on the coming few years for its operating and free cash flow outlook on the airline industry recovery and particularly as loss-making projects and entities are divested or closed. STE trades on 4.5% dividend yield presently, and we think it may benefit from a pick up in investor interest once the federal-funds rate shows signs of peaking.

EBITDA margin of 15.4% was around 40 basis points shy of our estimate, but we believe that this is due in large part to operating losses at its U.S. marine businesses, which it sold in late 2022. We expect EBITDA margin to improve to 16.4% in 2023 with lower costs from the TransCore integration and the absence of the U.S. marine losses. Overall, we made little material change to our key assumptions, but we do factor in higher debt at SGD 6.5 billion and interest expense as well as amortization and depreciation. Average cost of debt of just over 3% guided by management is also slightly above our original assumption. All in, our earnings forecast is lowered by 16% in 2023 and 2024. While the jump in debt is 8% more than we expected, raising net gearing to a somewhat uncomfortable 2.5 times, we see STE’s free cash flow improving and debt servicing remaining comfortable.

There was no surprise in its revenue, which grew 17.4% in 2022 and looks set to average growth of 11% through 2024, led by its commercial aerospace segment on a recovery in airframe maintenance demands as international travel continues to rebound and with STE’s strong order book for passenger-to-freighter conversions. We also expect a full-year contribution from tolling operator TransCore to lift its urban solutions contribution. The defense and public security segment is expected to see stable mid-single-digit growth.