Singapore Aviation

Singapore Industrials 1 August 2017

Singapore Aviation

Initiation: leveraging on global aircraft additions

 We highlight the aircraft maintenance, repair and overhaul (MRO) segment as a bright spot within the Asian aviation industry

 Valuations might look stretched, but we see consolidation among the players in Singapore as a key catalyst for further rerating Royston Tan  Initiating on STE (Buy [1]) and SIAEC (Outperform [2]); maintaining (65) 6321 3086 Hold (3) on SATS and Underperform (4) on Singapore Airlines [email protected]

Investment case: We initiate on the Singapore Aviation sector with a Key stock calls Positive view, and favour the maintenance, repair and overhaul (MRO) New Prev. players over Singapore Airlines (SIA). With Airbus forecasting the global Singapore Airlines (SIA SP) Rating Underperform Underperform aircraft fleet to almost double over the next 20 years, we expect aviation Target 9.060 9.060 service providers to benefit from increased air/ground traffic and higher Downside q 12.8% volumes of after-market MRO work. Hence, we believe the time is ripe for a SATS (SATS SP) consolidation of Singapore’s MROs, which we flag as a possible catalyst for a Rating Hold Hold further rerating of the MRO segment. Target 5.050 5.050 Upside p 4.6% Catalysts: aircraft growth to drive demand for aviation services. Singapore Technologies Engineering (STE SP) Rating Buy Airbus’ forecast for the global aircraft fleet suggests a supportive Target 4.460 environment for aviation service providers, with services such as ground Upside p 18.3% handling and inflight catering seeing demand rise in step with regional air SIA Engineering (SIE SP) travel. In our view, existing operators that are quick to adapt to new Rating Outperform technologies and recognise the need for production automation should be Target 4.100 Upside p 12.6% in a position to expand their market shares. Source: Daiwa forecasts Income erosion concerns look overplayed. We consider the MRO providers to be long-term beneficiaries of expansion in the global aircraft fleet. Concerns over a possible erosion of maintenance income amid a transition towards new-generation aircraft look overplayed to us, as we think higher spending on advanced-engine MRO would more than offset any decline from traditional heavy airframe MRO.

Time is ripe for consolidation. SIA, parent of SIA Engineering (SIAEC; SIE SP, SGD3.64), has announced a strategic review. We think one possible course of action could be the divestment of its 77% stake in SIAEC to STE’s aerospace division. Now could be an opportune time for a merger, given the need to realise cost synergies amid an increasingly competitive MRO landscape, which is weighing on incumbents’ margins. We would expect a merger of Singapore’s MRO heavyweights to capture economies of scale and boost consolidated profits by 41% by 2019.

Valuation: We initiate on Singapore Technologies Engineering (STE SP, SGD3.77) with a Buy [1]) and SIAEC an Outperform [2]), with DCF-based TPs of SGD4.46 and SGD4.10, respectively. While both stocks’ valuations look stretched, at more than 1SD above their past-2-year average 12- month forward PERs, we see scope for higher multiples upon a corporate merger. Separately, we maintain our Hold (3) and Underperform (4) ratings on SATS (SATS SP, SGD4.83) and SIA (SIA SP, SGD10.39), respectively.

Risks: A key risk to our Positive sector call would be weaker-than-expected MRO demand if airlines were to delay non-essential MRO work.

See important disclosures, including any required research certifications, beginning on page 65

Singapore Aviation: 1 August 2017

How do we justify our view? Growth outlook Valuation Earnings revisions

Growth outlook Global air transport fleet: 20-year growth

Airbus forecasts the global aircraft fleet to expand by 45,000 c.36% over the next decade. In turn, we forecast demand 40,000 for aircraft after-market services will see a CAGR of 3.8% 35,000 22,030 Growth over the next 10 years. Moreover, we believe independent 30,000 MRO providers such as STE and SIAEC which can forge 25,000 strategic partnership with OEMs will be the key 20,000 beneficiaries in an environment of rising demand for air 15,000 travel. While the industry’s bright prospects have attracted 12,870 Replacement 20,500 new entrants and depressed incumbents’ margins, we see 10,000 5,000 the time as ripe for the 2 Singapore MRO heavyweights to 7,630 Stay consolidate their businesses and realise better margins. 0 Beginning 2017 2036E Source: Airbus

Valuation Singapore Aviation: EPS CAGR vs. forward PER Valuations do not seem cheap, with all stocks trading Forward PER (x ) 25.5 above their past-2-year average PER multiples. We believe SIA SIAEC has the most earnings potential over the next 3 25.0 SIAEC years, albeit from a low FY17 base. We see STE as having 24.5 the best mix of earnings growth vs. PER, while SIA is likely 24.0 the most over-valued among the 4 stocks on this matrix. 23.5 While valuations might seem stretched relative to the past- 23.0 SATS 2-year average PERs, we believe dividend-paying blue 22.5 chips warrant a premium in today’s yield-compressed 22.0 environment. Besides, there is the possibility of a corporate 21.5 STE merger of STE and SIAEC to form a global third-party 21.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 MRO heavyweight. 3-years earnings CAGR (% )

Source: Boeing

Earnings revisions Singapore Aviation: Bloomberg EPS revisions The market has revised down its 3-year forward earnings 5% forecasts for the Singapore Aviation Sector in the YTD. We 0% have all along been more bearish than the street on SIA’s earnings outlook, and broadly in line with the consensus on (5%)

SATS’ earnings potential. Meanwhile, YTD the street has (10%) marginally tapered its earnings outlook for both STE and SIAEC. Compared with the consensus, our FY1-3 EPS (15%) forecasts are 0-17% higher, due likely to our more positive (20%) view on the companies’ aerospace divisions. (25%) SIA STE SIAEC SATS

FY 1 FY 2 FY 3

Source: Bloomberg

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Sector stocks: key indicators

EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg SATS SATS SP 4.830 Hold Hold 5.050 5.050 0.0% 0.216 0.216 0.0% 0.235 0.235 0.0% SIA Engineering SIE SP 3.640 Outperform 4.100 0.155 0.183 Singapore Airlines SIA SP 10.390 Underperform Underperform 9.060 9.060 0.0% 0.336 0.393 (14.6%) 0.280 0.291 (3.5%) Singapore Technologies Engineering STE SP 3.770 Buy 4.460 0.174 0.190 Source: Bloomberg, Daiwa forecasts

20-year global air passenger growth 20-year global air transport fleet growth 8,000,000,000 45,000 7,000,000,000 40,000 6,000,000,000 35,000 22,030 Growth 5,000,000,000 30,000 4,000,000,000 25,000

3,000,000,000 20,000 15,000 2,000,000,000 12,870 Replacement 10,000 20,500 1,000,000,000 5,000 0 7,630 Stay

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2006 2009 2015 2035 2003 2012 1970 Beginning 2017 2036 Source: ICAO, IATA Source: Airbus GMF 2017 Note: Passenger aircraft above 100 seats, freighter aircraft above 10 tonnes

10-year global commercial air transport MRO demand growth 10-year global MRO incremental spending by key geographical (USDbn) regions (USDbn) 120 104 Asia-Pacific (ex-china) 100 China

80 68 Middle East 60 North America Latin America 40 Eastern Europe 20 Africa 0 2016 2026 Western Europe Engine Component Line Airframe Modifications 0 1 2 3 4 5 6 7 8 9 Source: Aviation Week Source: Bloomberg, ICF

Singapore aviation: Key operational data and ratios FY 1 FY 1 FY 2 FY 1 FY 1 Net WACC LT-growth FY 1 BBG Share Mkt Cap OPM PER PER Div Yield gearing assumption assumption ROE Company Code price (USD m) (%) (x) (x) (%) (%) (%) (%) (%) SIA SIA SP 10.38 9,180 4.7 30.9 37.1 1.9 Net cash N.A. N.A. 3.0 ST Engineering STE SP 3.77 8,640 8.5 21.6 19.8 4.1 Net cash 7.3 1.0 24.5 SIA Engineering SIE SP 3.64 3,000 8.1 23.5 19.9 3.8 Net cash 7.3 1.0 11.1 SATS SATS SP 4.82 3,970 13.6 22.4 20.5 3.7 Net cash 7.3 1.0 14.9

Source: Bloomberg, Daiwa forecasts Note: ST Engineering OPM is based on its Aerospace division

Singapore Aviation: 1 August 2017

Table of contents

Singapore Aviation: a tale of two stories ...... 5 Airlines still flying under a cloud of uncertainty; positive on service providers’ underlying fundamentals ...... 5 Singapore aviation: service providers likely to outperform; possible M&A driving valuation premiums ...... 5 MRO: both an opportunity and a threat ...... 8 Opportunity from larger aircraft fleet size ...... 8 Threat from shift toward new-generation planes ...... 9 Increasing OEM after-market participation ...... 11 Growing the Singapore MRO pie through consolidation ...... 12 Initiating on STE with Buy (1), SIAEC with Outperform (2); maintaining Hold (3) for SATS, Underperform (4) for SIA ...... 14 Key risks to our Positive sector view ...... 16 Demand for air travel weaker than expected ...... 16 New-generation aircraft more resilient ...... 16 Failure to adopt new technology ...... 16 Continued pressure on margins ...... 16

Company Section Singapore Technologies Engineering ...... 17 SIA Engineering ...... 40 Singapore Airlines ...... 57 SATS ...... 60

Singapore Aviation: 1 August 2017

Singapore Aviation: a tale of two stories Airlines still flying under a cloud of uncertainty; positive on service providers’ underlying fundamentals Airlines Legacy airlines like SIA The driver for air travel demand has shifted in recent years from developed economies to and Cathay Pacific will developing nations, and the increasing wealth effect of the latter will likely see a surge in likely continue to face the middle-class population with access to affordable air travel. We expect this margin pressure due to development to benefit the no-frills air-travel business model championed by the low cost elevated competition carriers (LCCs), while legacy airlines, particularly in the Asia Pacific region where competition is most intense, will continue to face pressure in terms of yield and margins.

Aviation-linked service providers Key aviation-linked service providers include the likes of: 1) airport operators, 2) ground- handling & inflight catering service players, as well as 3) aircraft maintenance, repair and overhaul (MRO) players.

Airport operators. Growth in global air travel has been a major tailwind for airport operators around the world, particularly within the Asia Pacific region where passenger traffic growth has been consistently above the global average. This generally translates into higher operating cash flow for these operators.

Ground handlers and inflight-caterers. Ground-handling and inflight-catering service providers such as SATS Ltd have relatively low capex commitment compared with airport operators and benefit from terminal expansion initiatives taken by the latter which ultimately lead to growth in passenger traffic. However, manpower shortages remain a critical issue that is forcing service providers to turn to automation.

Margin pressure from MRO players. Similar to fleet growth, we believe the MRO market in Asia will likely new entrants likely to experience the bulk of the increase in MRO demand, and will be challenged to build the result in lower necessary infrastructure as well as workforce to cater to this demand. The up-gauging of profitability for 3rd-party aircraft (increasing seat capacity by reconfiguring the seat structure of the aircraft), coupled MRO players with the introduction of new-generation aircraft, will require existing MRO players to reinvent their service offerings so as to better compete against the original equipment manufacturers (OEMs). Rising demand for MRO services has, however, attracted new entrants, resulting in a more competitive landscape.

Singapore aviation: service providers likely to outperform; possible M&A driving valuation premiums Overweight service providers vs. airline We remain cautious on the prospects of SIA, the national carrier of Singapore. Its full service carrier (FSC) segment remains under intense competitive pressure from North Asia and Gulf carriers, and we expect the trend to persist over the coming 1-2 years, resulting in further yield compression for the parent airline in FY18, on our forecast. Its LCC segment has shown a stronger operational performance over the past 2 years, but in our view remains susceptible to heightened competition from regional LCC operators, where fleet growth is expected to double over the next 20 years per data from Boeing. We reiterate our Underperform (4) rating on the stock, with a 12-month PBR-based 12-month target price of SGD9.06.

While we remain positive on SATS’ medium- to long-term fundamentals, we see its short- term earnings-growth prospects (FY18E EPS growth of c.2%) as unexciting relative to the stock’s prevailing FY18 PER of 22x. However, the company remains a strong free cash

Singapore Aviation: 1 August 2017

flow generator despite likely higher capex commitments ahead, with its dividend per share (DPS) likely to show continued growth in the coming years, on our forecasts. We maintain our Hold (3) call on SATS with a 12-month DCF-based target price of SGD5.05.

We believe STE has the We initiate coverage of Singapore Technology Engineering (STE) and SIA Engineering best mix of earnings (SIE SP) with Buy (1) and Outperform (2) ratings and 12-month target prices of SGD4.46 growth relative to and SGD4.10, respectively, given our positive view of the MRO landscape. We prefer STE valuation over SIAEC on fundamental grounds, as we see STE’s diversified business structure and the strong growth outlook for its electronics division as an added advantage over SIAEC’s pure exposure to the MRO market. In our view, STE has the best mix of earnings growth relative to valuation — while on our forecasts its 3-year net profit CAGR trails that of SIAEC (c.8% vs. c.15%), STE is trading at a lower forward PER multiple of 22x vs. SIAEC at 24x and yields a higher dividend. We think SIAEC’s most recent results (1Q FY18) still indicate possible margin weakness, which we believe would stand as a downside risk if the trend were to continue.

Overall, we see both companies as ideal candidates for consolidation, with STE (acquirer) potentially realising substantial earnings accretion through cost synergies and SIAEC’s stakeholders benefiting from an acquisition premium.

Hence, our pecking order within the Singapore Aviation sector is as follows:

1) ST Engineering 2) SIA Engineering 3) SATS Ltd 4) SIA

Singapore aviation: Key operational data and ratios FY 1 FY 1 FY 2 FY 1 Div FY 1 Net WACC LT-growth FY 1 BBG Share Mkt Cap OPM PER PER Yield gearing assumption assumption ROE Company Code price (USD m) (%) (x) (x) (%) (%) (%) (%) (%) SIA SIA SP 10.38 9,180 4.7 30.9 37.1 1.9 Net cash N.A. N.A. 3.0 ST Engineering STE SP 3.77 8,640 8.5 21.6 19.8 4.1 Net cash 7.3 1.0 24.5 SIA Engineering SIE SP 3.64 3,000 8.1 23.5 19.9 3.8 Net cash 7.3 1.0 11.1 SATS SATS SP 4.82 3,970 13.6 22.4 20.5 3.7 Net cash 7.3 1.0 14.9

Source: Bloomberg, Daiwa forecasts Note: ST Engineering OPM is based on its Aerospace division

Time is ripe for a consolidation Market concerns over stretched valuations seem justified on the face of it, with both STE and SIAEC currently trading in excess of 1SD to their historical 12-month forward PER multiples. However, we contend that the likelihood of a consolidation between the 2 companies in the near future is more than even, which could be a catalyst to drive valuations further upward, in our view.

SIAEC’s 1Q FY18 We see the time as ripe for STE and SIAEC to consolidate their MRO businesses in order operating margin of 6.6% to compete more effectively with global MRO heavyweights such as Lufthansa Technic and shows that margin AFI KLM, amid margin pressure as the after-service market gets increasingly crowded. pressure remains a Both STE and SIAEC have faced margin compression over the years as a result of new pertinent issue for 3rd entrants’ competition, as well as reduced volumes of relatively high-margin heavy party MROs maintenance work. Integration would help stem the margin-decline trend, in our view, with the enlarged entity potentially benefiting from significant cost synergies given the similarity in the 2 companies’ businesses.

Singapore Aviation: 1 August 2017

STE: aerospace division operating-margin trend SIAEC: operating-margin trend 12% 15% 11.2% 14.0% 14% 13.5% 11% 12.6% 9.8% 13% 10% 9.4%

12% 9% 11% 10.6% 8% 7.5% 9.6% 10% 7% 6.5% 9% 6% 8% 7% 5% 6% 4% 2012 2013 2014 2015 2016 FY2013 FY2014 FY2015 FY2016 FY2017 Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

We believe the Recent comments by SIA’s CEO, Goh Choon Phong, indicating that the group is competitive landscape undertaking a strategic review of its portfolio of businesses, which includes the company’s sets the stage for 77% stake in SIAEC, have ignited the possibility of a consolidation between STE’s consolidation between aerospace division and SIAEC to form one of the world’s largest MRO entities. We see Singapore’s 2 MRO such a scenario as a win-win for all parties and potentially a key catalyst driving a rerating heavyweights of the sector.

We provide further details on the synergies potentially on offer from such a business combination in the following sections of this report. The table below provides a quick snapshot of how we think the numbers for this combined entity might stack up.

Forecast profits for STE and SIAEC upon potential merger (SGDm) Combination (1) 2017E 2018E 2019E Notes Revenue 3,757 3,962 4,136 Staff costs 1,699 1,789 1,867 Material costs 640 690 722 Depreciation & amortisation costs 156 156 157 Others 885 927 952 Operating profit 377 400 439 Operating margin 10.0% 10.1% 10.6% JV/Associates profit 145 158 171 Operating profits after associates 522 558 610

Combination + cost savings (2) 2017E 2018E 2019E Notes Revenue 3,757 3,962 4,136 Staff costs 1,529 1,610 1,680 Assume 10% cost savings Material costs 608 656 685 Assume 5% cost savings Depreciation & amortisation costs 156 156 157 Others 858 899 924 Assume 3% cost savings Operating profit 606 641 690 Operating margin 16.1% 16.2% 16.7% JV/Associates profit 145 158 171 Operating profits after associates 751 799 861

Cost savings increment ((2)- (1))/(1) 44% 43% 41%

Source: Daiwa forecasts

Singapore Aviation: 1 August 2017

MRO: both an opportunity and a threat Opportunity from larger aircraft fleet size Global aircraft fleet size to double in the next 2 decades

Total global air passenger growth Global fleet growth forecast 8,000,000,000 Start Fleet End Fleet 20-year new Region 2017 2036 deliveries Converted Remaining 7,000,000,000 Africa 640 1,592 1,065 46 481 6,000,000,000 Asia-Pacific 6,456 17,749 14,484 463 2,802 CIS 831 1,702 1,224 55 423 5,000,000,000 Europe 4,697 7,997 6,888 137 972 4,000,000,000 Latin America 1,411 2,882 2,677 59 146 Middle East 1,249 3,322 2,588 30 704 3,000,000,000 North America 5,216 7,286 5,973 434 879 2,000,000,000 World 20,500 42,530 34,899 1,224 6,407

1,000,000,000

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2006 2009 2015 2035 2003 2012 1970 Source: ICAO, IATA Source: Airbus Note: Includes only 100+ seaters (passenger aircraft) and 10t+ (freighter aircraft)

MRO providers in the According to forecasts by Airbus, the global aircraft fleet is set to double in size in the next region which has the 2 decades, driven by greater demand for air travel. In turn, demand for global MRO capacity to address MRO spending will grow by 4.1% pa from USD67.6bn in 2016 to USD104.6bn by 2026, demands ahead will be according to Aviation Week. On Airbus’ forecasts, the Asia Pacific region will see the key beneficiaries fastest growth in fleet size, with a near tripling over the next 20 years (see table above). In our view, this outlook bodes well for MRO vendors such as STE and SIAEC operating in the region, as they should have first-mover advantage and the regional capacity to capitalise on burgeoning MRO demand, unlike their counterparts in Europe and North America where the rate of fleet growth is slower.

MRO likely to be driven by net increase in global feet (particularly LCCs) and robust demand for engine MRO We believe that the main drivers of increased MRO spending over the coming decade will be: 1) net additions to the global fleet from c.20,500 aircraft in 2017 to c.42,530 aircraft in 2036 (Airbus data), and 2) strong demand for engine MRO. While engines are increasingly fuel-efficient, they are operating at ever higher temperatures and pressures, resulting in more expensive shop visits to restore and replace parts and materials.

20-year global air transport fleet growth 10-year global commercial air transport MRO demand growth (USDbn) 45,000 120 104 40,000 100 35,000 22,030 Growth 80 30,000 68 25,000 60

20,000 40 15,000 12,870 Replacement 20 10,000 20,500 5,000 0 7,630 Stay 2016 2026 0 Engine Component Line Airframe Modifications Beginning 2017 2036 Source: Airbus GMF 2017 Source: Aviation Week Note: Passenger aircraft above 100 seats, freighter aircraft above 10 tonnes

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2015-35E new airplane delivery forecast 2015 vs. 2035E fleet composition forecast 30,000 50,000

25,000 40,000

20,000 30,000

15,000 20,000

10,000 10,000

5,000 0 2015 2035 0 Narrow-body Wide-body Regional Jet Narrow-body Widebody Regional Jet Source: Boeing Source: Boeing

Boeing forecasts that the increase in global aircraft fleet size over the coming decades will centre on single-aisle or narrowbody aircraft, in line with the proliferation of LCCs. LCCs generally do not have their own in-house maintenance units and tend to outsource MRO work to 3rd-party MRO vendors such as STE and SIAEC. Hence, MRO providers that can provide total service packages or develop the capability to offer such packages should be well placed to gain maintenance contracts from the booming LCC sector, in our view.

Singapore should benefit from China’s MRO demand In line with the forecast fleet additions in the region, Asia is widely expected to drive the growth of the global MRO market. However, while China will almost certainly spearhead MRO spending growth in Asia over the next 1-2 decades, supported by the significant new order deliveries forecast by Boeing, rising labour costs and temporary infrastructure and capacity constraints are likely to force the country’s operators to look to countries south and east to fulfil their maintenance requirements. We believe that Singapore, the region’s MRO hub of choice today, should be the natural beneficiary of the capacity/infrastructure constraints facing the China players.

China: new airplane deliveries through 2035E China’s airlines are set Airplane type Seats Total deliveries Dollar value to expand their fleets Regional jets 90 and below 140 10B Single-aisle 90-230 5,110 535B aggressively, according Small wide-body 200-300 870 240B to Boeing Medium-side body 300-400 630 220B Large wide-body 400 and above 60 20B Total 6,810 1.025T

Source: Boeing

New revenue stream through transport modifications According to Airbus’ industry outlook statement, there is potential to convert about 1,224 aircraft into freighters over the next 20 years as operators seek cargo fleet renewal and expansion. Earlier this year, in a move that will bring together 2 of France’s biggest aerospace groups, Safran SA, an aircraft-engine maker, announced a deal to purchase plane-seat supplier Zodic Aerospace SA for almost USD10.5bn. Closer to home, STE has been actively growing its cabin interior business as well as its passenger-to-freight conversion business.

Threat from shift toward new-generation planes Reducing light/heavy maintenance checks with improved turnaround times At first glance, it might seem the introduction of new-generation planes such as the Boeing 787, which requires fewer maintenance checks than, say, the 767, will be detrimental to MRO providers. Boeing estimates that, compared with the 767, the 787 should bring a 65% reduction in the time needed for a c-check (a maintenance check performed every 20- 24 months, after a specific number of actual flight hours, or as defined by the

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manufacturer). Such a reduction would imply lower maintenance costs and increased airplane availability (and thus revenue potential) for airline operators. Boeing also guarantees its customers that the 787 will see an overall 30% reduction in airframe and systems maintenance costs relative to the 767.

Airbus and Boeing: new aircraft maintenance schedule comparison The new-generation 787 A330 A350 target will see man hours for Line maintenance 8 days None below 10 days Line visit 800 FH Only technical servicing below 1,200 FH scheduled maintenance Base visit 24 months 36 months decline from 95,000 to Structures visit 6 and 12 years 12 years 33,000 over a 12-year horizon 767 787 Line 750 FH 1,000 FH Base 6,000 FH/18 months 6,000 FH/12,000 FH/36 months External structure 6,000 FC/3 years 12,000 FC/6 years Internal structure 12,000 FC/6 years 24,000 FC/12 years Landing gear 18,000 FC/10 years 24,000 FC/12 years

Source: Airbus and Boeing

However, according to data from Aviation Week, MRO demand for the Boeing 787 is set to balloon from USD1.1bn in 2016 to USD8.4bn in 2025 as more 787s enter service (Boeing had delivered 329 787s as of end-September 2016, and Aviation Week projects another 1,743 aircraft will be delivered through to 2025). Hence, it appears that the opportunities reside in the higher-value component and engine MRO segment, while MRO providers whose business focus is on airframe maintenance solutions could see slower growth potential.

Boeing 787: MRO demand breakdown by segment Boeing 787: MRO demand (USDbn)

9 8.4 Airframe 7.9 Modifications 3% 8 9% 7 6.3 6 5.4 4.7 5 Component Engine 3.9 35% 4 22% 2.9 3 2.4 1.6 2 1.1 Line 31% 1 0 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Source: Aviation Week, MRO-network Source: Aviation Week, MRO-network

Direct maintenance cost per aircraft and flight hours still on the rise

Direct maintenance cost per flight hour (USD) Direct maintenance cost per aircraft (USD m)

1,100 3.7 1,087 3.60 1,090 3.6 1,079 3.55 1,080 1,067 3.6 3.52 1,070 3.5 1,060 1,049 1,050 3.5 3.39 1,040 1,032 3.4 3.37 1,030 3.4 1,020 1,010 3.3 1,000 3.3 2010 2011 2012 2013 2014 2010 2011 2012 2013 2014 Source: IATA Source: IATA Note: Based on data from 51 airlines Note: Based on data from 51 airlines

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According to data from IATA, based on operational statistics accumulated from 51 airlines, the maintenance cost/aircraft actually increased from USD3.4m in 2010 to USD3.6m in 2014. Similarly, the maintenance cost/flight hour rose from USD1,032 in 2010 to USD1,087 in 2014. In the absence of a major change in fleet composition, we do not foresee a dramatic decline in the direct maintenance spend per aircraft.

Indeed, we note that SIA’s maintenance cost increased by 39% from SGD647m in FY15 to SGD898m in FY17, during which time its overall group ASK capacity expanded by only 4%.

SIA: maintenance cost vs. maintenance cost per ASK Direct maintenance cost by aircraft family (USD m/aircraft) 950 0.60 8 900 7 6 850 0.55 800 5 750 4 0.50 700 3 650 2 600 0.45 1

550 0

757 767 777

A330 A340

500 0.40 Q400 ATR72

FY2015 FY2016 FY2017 747-400

737classic

A320family 737NG/MAX

Maintenance cost (SGDm) (LHS) Cost per ASK (cents) (RHS) EMB190/195

Source: SIA Source: IATA

For every mega aircraft such as the Boeing 747 (515 aircraft in operation as at end-2016) and A330 (1,154 aircraft in operation as at end-2016) that is retired, we forecast there will be an addition of 6 new narrowbody aircraft (A320 and Boeing 737), based on the existing Boeing/Airbus backlog of >10,000 aircraft. Assuming that global airlines as a whole are increasing their fleet size, we think that maintenance spend by airlines will continue to trend higher.

Increasing OEM after-market participation Despite OEMs becoming a force to be reckoned with in the aftermarket category, particularly in areas such as engines and components overhaul, we believe that 3rd-party independent MROs will remain relevant over our forecast horizon due to their: 1) dominance in airframe MRO, and 2) infrastructure presence in key MRO hubs that OEMs might not be able to replicate due to financial constraints.

3rd-party MRO providers We think that a win-win situation would be to establish JVs between both groups, where can co-exist with OEMs the OEMs can tap the independent MROs’ infrastructure networks and the latter can obtain through strategic the support and backing of the OEMs to bring genuine components in order to better serve partnerships customers. Hence, we expect JVs to provide cost savings and risk sharing in terms of scale economies, new market shares and regional presence.

Engine OEMs Wide-body. GE, Rolls Royce and Pratt & Whitney are the acknowledged aftermarket leaders in this category, together accounting for c.92% of widebody engine sales globally. By extension, an independent MRO that has forged strategic partnerships with these 3 players will have captured the bulk of the widebody engine MRO market. SIAEC’s recent JV with GE for the aftermarket maintenance of GE90 and GE9x engines completes its JV tie-ups with all 3 engine OEMs in the widebody category (it already has partnerships with Pratt &Whitney under Eagle Services Asia and with Rolls Royce under Singapore Aero Engine Services).

Narrow-body. The GE-Snecma JV, CFM International, accounts for c.69% of the world’s narrowbody engine market. Its CFM56 is the most successful engine in commercial aviation history, with more than 24,000 iterations of the engine still in service. Its next-

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generation engine model, “LEAP”, will be used to power the A320neo, 737 MAX and COMAC C919 aircraft models. STE, which signed a 10-year engine and material support agreement with CFM back in 2008 for MRO services to the CFM56-3, CFM56-5B and CFM56-7B engines, has benefited significantly from this collaboration.

Component OEMs Both Airbus and Boeing Both Airbus and Boeing, which have duopoly status in the construction of wide and haven taken bigger narrowbody aircraft, are aggressively expanding their aftermarket footprint, which is a stakes in the MRO concern in terms of licensed parts manufacturer approval (PMA) and could see aircraft market in recent years component parts’ prices rising in the future. An independent MRO such as SIAEC would need to set up various JVs with PMAs, as well as Airbus/Boeing, to provide comprehensive solutions for airlines and aftermarket fleet management solution providers. We believe that SIAEC’s recent collaboration with Boeing for a comprehensive suite of fleet management services for Boeing aircraft is a prime example of a strategic partnership decision that should see the former benefiting from an increasing fleet of Boeing aircraft in the Asia Pacific region.

Competition to encourage consolidation As the market expands, competition among the trio of commercial aviation MRO operators – airline-in house, independent MROs and OEMs – looks set to intensify. We believe this development will ultimately lead to lower profit margins. As we see it, the market is now at a stage where M&A and consolidation activities among MRO players will accelerate in the coming years, spurred by the need to address margin pressures.

We see a need for a MRO players can look at horizontal integration through globalisation or vertical integration more cost-efficient entity through expansion of service offerings at all levels of the supply chain. We believe that an in Singapore to compete enlarged entity through the business combination of STE’s aerospace division and SIAEC against global MRO makes sense in the current competitive climate. In terms of geographical presence, STE’s leaders key networks in Europe, the US and China, in addition to its base in Singapore, complement SIAEC’s strong presence in the Asia Pacific region. In terms of service offerings, we believe the combination of STE’s leading position in airframe maintenance (No.1 player globally) and SIAEC’s comprehensive partnerships in engines/ component MROs, as well as strong line maintenance business due to its affiliation to SIA, would create an enlarged entity with market-leading capabilities in all segments of the MRO industry.

Growing the Singapore MRO pie through consolidation With 10% of the global MRO market currently, Singapore has strengthened its nose-to-tail MRO capabilities for fixed and rotary-wing aircraft on the back of Asia-Pacific growth, which is forecast to be the fastest-growing region in terms of aircraft addition, in step with air travel demand. While the global MRO landscape is forecast to grow by 4.3% over the coming decade, according to data from Aviation Week, strong demand for these aftermarket services has drawn new entrants, resulting in lower margins for the incumbents.

STE: aerospace division operating-margin trend SIAEC: operating-margin trend 15% 12% 14.0% 11.2% 14% 13.5% 11% 13% 12.6% 9.8% 9.8% 12% 10% 11.0% 9.4% 9.2% 11% 10.6% 10.5% 10.5% 9.6% 9% 10% 8.1% 9% 8% 7.5% 8% 7% 6.5% 7% 6% 6% 2012 2013 2014 2015 2016 2017E 2018E 2019E FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

Singapore Aviation: 1 August 2017

Both STE and SIAEC have seen their MRO margins narrow over the past 4-5 years as incremental costs outstrip revenue growth. While our expectations call for a bottoming of margins in FY17 for SIAEC (one-off higher bonus staff costs in FY17 due to sale of HAESL) and 2016 for STE, margin pressure could well persist in today’s competitive landscape.

STE and SIAEC: forecast profits on standalone basis (SGDm) STE 2017E 2018E 2019E Notes Revenue 2,568 2,658 2,766 Staff costs 1,188 1,228 1,278 Assume that 50% of COGS is staff cost Material costs 426 441 459 Assume that 20% of COGS is material cost Depreciation & amortisation costs 113 113 113 Assume constant Others 571 596 612 Operating profit 270 279 304 Operating margin 10.5% 10.5% 11.0% JV/Associates profit/Others 45 48 51 Operating profits after associates 315 327 355 SIAEC’s operating margin will likely remain SIAEC FY18E FY19E FY20E Notes under pressure, at 8.1% Revenue 1,190 1,304 1,370 Staff costs 535 561 589 for FY2018E Material costs 214 249 262 Depreciation & amortisation costs 43 43 44 Others 301 331 340 Operating profit 96 121 134 Operating margin 8.1% 9.2% 9.8% JV/Associates profit/Others 103 113 123 Operating profits after associates 198 233 257

Source: Daiwa forecasts

The time could be ripe for a consolidation between both STE’s aerospace division and SIAEC in a bid to stay competitive, in our view. Indeed, the corporate review announced by SIAEC’s parent, SIA, has stirred the possibility of a business combination between the 2 MRO heavyweights, where the combined entity would be a major force in the global MRO industry. On a standalone basis, our forecast calls for STE to grow its operating profit after JV/associates to c.SGD355m in 2019. Similarly for SIAEC, we forecast that figure to be c.SGD257m for FY20.

STE and SIAEC: forecasted profits upon potential merger (SGDm) Combination (1) 2017E 2018E 2019E Notes Revenue 3,757 3,962 4,136 Staff costs 1,723 1,789 1,867 Material costs 640 690 722 Depreciation & amortisation costs 156 156 157 Others 873 927 952 Operating profit 365 400 439 Operating margin 9.7% 10.1% 10.6% JV/Associates profit/Others 148 161 174 Operating profits after associates 513 560 612

We see a 10% savings in Combination + cost savings (2) 2017E 2018E 2019E Notes staff-related costs as Revenue 3,757 3,962 4,136 reasonable and critical to Staff costs 1,529 1,610 1,680 Assume 10% cost savings realise synergies and Material costs 608 656 685 Assume 5% cost savings Depreciation & amortisation costs 156 156 157 economies of scale with Others 858 899 924 Assume 3% cost savings relation to a larger entity Operating profit 606 641 690 Operating margin 16.1% 16.2% 16.7% JV/Associates profit/Others 148 161 174 Operating profits after associates 751 799 861

Cost savings increment ((2)- (1))/(1) 45% 43% 41%

Source: Daiwa forecasts

A potential merger between the 2 companies would result in a larger entity with a combined operating profit after associates of c.SGD612m in 2019 on a simple consolidation basis. However, given the similarity between the businesses (both provide airframe maintenance, engines/components MRO), we believe that cost synergies could

Singapore Aviation: 1 August 2017

be achieved upon combination. Assuming: 1) a 10% decline in staff costs, 2) a 5% decline in material costs, and 3) a 3% decline in other miscellaneous operating costs, we derive a combined operating profit after associates of c.SGD861m in 2019, which marks a c.41% increment in profitability once cost synergies are realised.

STE to acquire SIAEC from SIA? We believe SIA divesting We would view a potential acquisition of SIAEC by STE as a win-win situation for all its stake in SIAEC would parties. For SIA, SIAEC’s parent, the company could monetise its 77% stake in SIAEC, generate the cashflow which would be timely given its huge capex commitment (c.SGD6bn per annum over the required for its capex next 5 years) to renew its existing fleet of aircraft over the coming decade. While such a needs move would relieve pressure on its balance sheet and reduce financial commitments, it would have no bearing on our negative stance on the company’s operational outlook, which remains under severe passenger yield pressure in a rising-cost environment.

STE would stand to gain a critical high-margin MRO segment, ie, the line maintenance business from SIAEC, an area it is currently lacking as it does not have any airline affiliation. We believe the enlarged entity could realise significant cost synergies, with operating margins increasing from c.9-10% to c.16% in 2019E on our forecasts in the event of a successful business combination. This would in turn allow the larger entity to compete more effectively against global peers.

For SIAEC’s shareholders, the acquisition could be realised at a decent premium from current levels, in our opinion. On the surface, STE buying SIAEC’s shares at current market levels would not seem to be earnings accretive, given that SIAEC is trading at a higher 1-year forward PER multiple (STE: 22x, SIAEC: 24x). However, if cost synergies can be realised, we estimate that profit levels could increase by c.41% in 2019 due to the combination. Based on our forecasts, the incremental earnings for STE would be c.SGD506m in 2019 (SGD861m – SGD355m) for a cost of SGD4bn (SIAEC’s current market value), translating to an acquisition cost of 8x 2019E earnings. Assuming a 20% acquisition premium for SIAEC (SGD4.8bn or SGD4.37/share), the acquisition cost to STE would increase marginally to 10x 2019E earnings — still an earnings-accretive move for the latter.

Initiating on STE with Buy (1), SIAEC with Outperform (2); maintaining Hold (3) for SATS, Underperform (4) for SIA The table below highlights the key operating statistics for the 4 stocks within the Singapore Aviation space. Our pecking order is as follows:

1) ST Engineering 2) SIA Engineering 3) SATS Ltd 4) SIA

Key operational data and ratios FY 1 FY 1 FY 2 FY 1 Div FY 1 Net WACC LT-growth FY 1 BBG Share Mkt Cap OPM PER PER Yield gearing assumption assumption ROE Company Code price (USD m) (%) (x) (x) (%) (%) (%) (%) (%) SIA SIA SP 10.38 9,180 4.7 30.9 37.1 1.9 Net cash N.A. N.A. 3.0 ST Engineering STE SP 3.77 8,640 8.5 21.6 19.8 4.1 Net cash 7.3 1.0 24.5 SIA Engineering SIE SP 3.64 3,000 8.1 23.5 19.9 3.8 Net cash 7.3 1.0 11.1 SATS SATS SP 4.82 3,970 13.6 22.4 20.5 3.7 Net cash 7.3 1.0 14.9

Source: Bloomberg, Daiwa forecasts Note: ST Engineering OPM is based on its Aerospace division; share prices as of 31 July 2017

As highlighted, we prefer companies within the aviation services segment vs. airlines, given our bearish view on the earnings outlook for airlines in the coming 2-3 years as a result of intense competition pressuring passenger yields in the Asia-Pacific region. SIA is

Singapore Aviation: 1 August 2017

set to incur huge capex costs to renew its fleet, which could prove to be a double-edged sword in a low fuel-price environment where fuel-consumption efficiency holds less weight. We reiterate our Underperform (4) rating and SGD9.06 target price, which implies 12% potential downside from its current share price.

Aviation services companies, on the other hand, operate in a low capex environment, with the exception of airport operators. Within the Singapore context, the 3 aviation services companies (STE, SIAEC and SATS) generate significant amounts of free cash flow annually as a result of their low capex requirement relative to their ability to generate substantial operating cash flow. This allows them to return excess capital to shareholders in the form of dividend payments (the dividend yields for these 3 companies range from 3- 4%, on our forecasts).

We standardise our key While we are positive on SATS’s business outlook over the medium term, the company DCF assumptions for looks to be fairly valued on a shorter-term horizon vs. both STE and SIAEC. Given that we STE, SIAEC and SATS: are employing a DCF methodology in valuing all 3 entities, we look to standardise key WACC at 7.3% and LT assumptions such as WACC and long-term growth so as to compare the companies based growth rate at 1% solely on their earnings and cash-generating profiles. Our analysis calls for the greatest share-price upside for STE, at 18%, followed by SIAEC, at 13%, and SATS, at 5%.

We initiate coverage of STE with a Buy (1) call and 12-month DCF-based TP of SGD4.46 and SIAEC with an Outperform (2) rating and 12-month DCF-based TP of SGD 4.10. We maintain our Hold (3) call on SATS with a 12-month DCF-based TP of SGD5.05.

Over the following pages, our initiation reports on STE and SIAEC provide a more in-depth analysis of the companies’ business and financial outlooks, and address key concerns such as those pertaining to stretched-looking valuations.

Singapore Aviation: 1 August 2017

Key risks to our Positive sector view Demand for air travel weaker than expected Primary risk: weaker- Our Positive view of the Singapore Aviation sector is predominantly premised on its than-expected air travel position as a play on strong demand for air travel in the coming decade, which should in turn drive aircraft demand. As the global aircraft fleet size expands, ancillary services such as airport gateway services, in-flight meals, aircraft/engines/components maintenance should rise in tandem. However, if demand for air travel is weaker than industry expectations, resulting in an oversupply of aircraft, this would have a significant negative impact on both airlines and aviation services providers — more so for the former given their leveraged position due to high capex requirements. This stands as the primary risk to our sector view.

New-generation aircraft more resilient We are generally more positive on aviation service providers leveraging on the increase in global aircraft fleet. We believe the big increase in fleet size will translate to a greater volume of work in the coming years for MRO service providers such as STE and SIAEC. However, the overriding trend is that the new-generation aircraft are generally more resilient than their predecessors and hence require less maintenance on areas such as airframe. While we believe that the strong volume increase will help offset the decline in unit maintenance cost, weaker-than-expected volume due to airlines deferring non- essential MRO work could result in slower growth prospects for Singapore’s MRO players.

Failure to adopt new technology The demand for more MRO work has attracted new entrants in recent years, leading to a more competitive environment that has driven down the profit margins of the incumbents. While we acknowledge that margins in the traditional airframe heavy maintenance will likely remain under pressure in the coming years, we think MRO providers can still generate higher margins by targeting value-added jobs such as aircraft conversions and cabin reconfigurations, as in the case of STE. The transition towards Big Data and greater use of automation should reduce manpower costs (largest component of operating expense) and boost the margins of incumbents willing to adopt new technologies to improve their operational work flow. Conversely, failure to respond to new technological developments would likely result in business erosion and a further deterioration in these companies’ operating margins.

Continued pressure on margins The heightened competitive landscape has negatively impacted the margins of 3rd party MROs such as STE and SIAEC, as was evident in their most recent financial results. While we see a gradual improvement in margins over the course of the next 2-3 years on the back of increasing cost cutting efforts, failure to mitigate certain key operational expense items such as manpower cost would likely result in operating margins coming in lower than our expectations. This is also a key reason why we believe that the time is ripe for existing incumbents such as STE and SIAEC to consolidate their businesses and realise cost synergies from economies of scale through integration.

Singapore Industrials 1 August 2017

Singapore Technologies Engineering (STE SP)

Singapore T echnol ogies Engi neering

Target price: SGD4.460 Share price (31 Jul): SGD3.770 | Up/downside: +18.3%

Initiation: a diversified juggernaut

 Aerospace and Electronics divisions likely to spearhead growth Royston Tan (65) 6321 3086  Attractive forward dividend yield of 4.1% [email protected]  Initiating with a Buy (1) and 12-month target price of SGD4.460

Investment case: We initiate our coverage of Singapore Technologies Share price performance

Engineering (STE) with a Buy (1) call. The company is a diversified (SGD) (%) industrial conglomerate that we see as well placed to leverage key macro 3.9 110 trends, such as growth in global aircraft fleet size and the shift towards the 3.6 106 Internet of Things (IoT) and global smart cities. With its forward dividend 3.4 101 3.2 97 yield of 4.1%, we see the stock as among the few strong dividend-paying 3.0 92 blue-chip counters on SGX with good long-term business growth prospects. Aug-16 Nov-16 Feb-17 May-17 STE (LHS) Relative to FSSTI (RHS)

Catalysts: Strong order wins likely to drive Aerospace contribution. STE’s order backlog as of end-1Q17 reached a record-high SGD13.3bn, 12-month range 3.050-3.850 from SGD11.6bn as at end-2016, due to strong order momentum from its Market cap (USDbn) 8.64 Aerospace division. On our forecasts, the record backlog sets the stage for 3m avg daily turnover (USDm) 7.83 Shares outstanding (m) 3,109 this division to register revenue and operating profit CAGRs of 3.5% and Major shareholder Temasek Holdings (50.0%) 8.2%, respectively, over 2016-19. With new hangar investments in China and the US, the Aerospace division should have the infrastructure capacity Financial summary (SGD) to capture burgeoning demand for MRO services, as the global aircraft fleet Year to 31 Dec 17E 18E 19E doubles over the coming 2 decades (source: Airbus). Revenue (m) 6,727 6,978 7,265 Operating profit (m) 615 666 703 Net profit (m) 542 591 620 IoT, Smart City and Autonomous vehicles (AV) demand set to Core EPS (fully-diluted) 0.174 0.190 0.199 accelerate. STE is a leading InfoComm Technology (ICT) provider in the EPS change (%) 11.9 9.0 4.9 region with a portfolio of product solutions to capitalise on the demand for Daiwa vs Cons. EPS (%) 1.4 5.0 2.2 PER (x) 21.6 19.8 18.9 IoT and Smart City solutions. As part of the Singapore AV consortium, STE Dividend yield (%) 4.1 4.2 4.4 will look to spearhead the nation’s move towards a driverless society, in our DPS 0.155 0.160 0.165 view. Also, we think the ongoing revolution in urban living should bode well PBR (x) 5.2 5.0 4.8 for STE’s Electronics and Kinetics divisions, where we forecast an EV/EBITDA (x) 14.4 13.5 13.0 ROE (%) 24.5 25.8 25.9 operating-profit improvement of c.77% over 2016-19. Source: FactSet, Daiwa forecasts

Integration with SIAEC? We believe the benefits of consolidation between the 2 local MRO heavyweights under our coverage would go beyond cost synergies, as the enlarged entity should be better placed to capitalise on growing MRO demand. We would see such an acquisition as a win-win, with STE being a long-term beneficiary of this earnings-accretive acquisition.

Valuation: STE is trading at 21.6x 2017E PER, a premium to its past-2- year average PER multiple of 18x but a substantial discount to peers’ average forward PER multiple of 25x. Our DCF-based 12-month TP of SGD4.460 implies a forward PER of 25.6x. Given its 2017E dividend yield of 4.1%, investors are effectively being paid to wait for STE to capitalise and execute on macro themes that are riding on strong tailwinds.

Risks: Possible new entrants within its Aerospace division could result in elevated competition and weaker-than-expected operating margins.

See important disclosures, including any required research certifications, beginning on page 65

Singapore Technologies Engineering (STE SP): 1 August 2017

How do we justify our view? Growth outlook Valuation Earnings revisions

Growth outlook STE: segmental operating profits (SGDm) The Aerospace and Electronics divisions look set to 800 spearhead earnings growth for the group, which will more 700 than offset earnings weakness from its Land systems and 600 Marine divisions, on our forecasts. Both its Aerospace and 500 Electronics divisions are sitting on near-record order-book 400 levels, which should provide revenue visibility over the 300 coming 2-3 years. While Aerospace will likely be the major 200 revenue and earnings contributor for the group over the 100 next 3 years, we see the Electronics division registering the 0 strongest operating profit CAGR of 10% from 2016-19E, (100) 2015 2016 2017E 2018E 2019E bolstered by strong demand for its ICT solutions. Aerospace Electronics Land System Marine

Source: Company, Daiwa forecast

Valuation STE: 1-year-forward PER multiple (x) STE is trading at a 21.6x PER on 2018E EPS. While its 22 current valuation is 1SD above its past-2-year average 21 forward PER multiple of c.18x, we deem this valuation as 20 justified, considering the following factors: 1) our 2016-19E 19 net profit CAGR of 8.5%, 2) peers’ 1-year forward earnings 18 multiple of 25x, and 3) the currently low interest-rate 17 environment, which favours strong dividend paying 16 counters. We believe STE’s diversified business model,

with positive exposure to rapidly growing industries such as 15

Jul-16

Oct-16 Apr-17

aircraft maintenance, IoT, and Smart Cities, should support Apr-16

Jun-16 Jan-17 Jun-17

Feb-16 Mar-16 Feb-17 Mar-17

Aug-16 Dec-16 Sep-16 Nov-16

May-16 May-17 the company’s long-term earnings growth potential and Forward PER Ave +1SD -1SD hence justify its valuation premium over its historical Source: Bloomberg, Daiwa forecasts average.

Earnings revisions STE: consensus earnings revisions (SGD) We have yet to see many positive earnings revisions from 4.1 0.22 the street as analysts remain generally cautious on 3.9 0.21 structural changes within the MRO sector that could have a 3.7 0.20 3.5 negative impact on STE’s heavy maintenance income. We 0.19 see concerns of a long-term decline in STE’s heavy 3.3 0.18 maintenance income as overplayed and believe that a 3.1 0.17 strong volume increase over the coming years will more 2.9 than offset any decline in unit maintenance spending. In 2.7 0.16 turn, this development could be accompanied by more 2.5 0.15

positive earnings revisions by the market, in our view.

Apr-15 Oct-15 Apr-16 Oct-16 Apr-17

Jun-15 Jun-16 Jun-17

Feb-15 Feb-16 Feb-17

Dec-15 Dec-16

Aug-15 Aug-16 Price (LHS) 2017 EPS 2018 EPS 2019 EPS

Source: Bloomberg

Singapore Technologies Engineering (STE SP): 1 August 2017

Financial summary Key assumptions Year to 31 Dec 2012 2013 2014 2015 2016 2017E 2018E 2019E Aerospace revenue growth (% YoY) 5.2 3.0 (0.9) 1.4 18.9 3.0 3.5 4.1 Electronics revenue growth (% YoY) 6.5 4.6 (4.1) 7.9 10.3 9.0 7.5 6.0 Land Systems revenue growth (% YoY) 2.2 (2.5) (5.3) (0.1) (6.5) (7.0) 2.0 2.0 Marine revenue growth (% YoY) 15.3 22.5 8.3 (28.6) (12.3) (15.0) (5.0) 0.0 Operating margin (%) 10.3 10.1 8.5 8.1 7.0 8.5 8.9 9.0

Profit and loss (SGDm) Year to 31 Dec 2012 2013 2014 2015 2016 2017E 2018E 2019E Aerospace 2,019 2,079 2,061 2,090 2,484 2,559 2,648 2,757 Electronics 1,578 1,650 1,583 1,709 1,885 2,054 2,208 2,341 Other Revenue 2,783 2,904 2,895 2,536 2,315 2,114 2,121 2,167 Total Revenue 6,380 6,633 6,539 6,335 6,684 6,727 6,978 7,265 Other income 43 34 40 55 68 46 46 46 COGS (4,924) (5,201) (5,221) (5,053) (5,378) (5,301) (5,478) (5,703) SG&A (541) (500) (477) (478) (463) (496) (499) (518) Other op.expenses (257) (258) (286) (294) (371) (362) (381) (386) Operating profit 701 707 595 566 539 615 666 703 Net-interest inc./(exp.) (23) (21) (14) 6 (12) (11) (3) (6) Assoc/forex/extraord./others 38 43 70 58 64 69 70 72 Pre-tax profit 715 730 651 630 591 673 733 769 Tax (131) (138) (114) (99) (98) (121) (132) (138) Min. int./pref. div./others (8) (11) (5) (3) (8) (9) (10) (11) Net profit (reported) 576 581 532 529 485 542 591 620 Net profit (adjusted) 576 581 532 529 485 542 591 620 EPS (reported)(SGD) 0.188 0.187 0.171 0.171 0.156 0.174 0.190 0.199 EPS (adjusted)(SGD) 0.188 0.187 0.171 0.171 0.156 0.174 0.190 0.199 EPS (adjusted fully-diluted)(SGD) 0.187 0.187 0.170 0.171 0.156 0.174 0.190 0.199 DPS (SGD) 0.168 0.150 0.150 0.150 0.150 0.155 0.160 0.165 EBIT 701 707 595 566 539 615 666 703 EBITDA 838 849 766 736 735 798 858 904

Cash flow (SGDm) Year to 31 Dec 2012 2013 2014 2015 2016 2017E 2018E 2019E Profit before tax 715 730 651 630 591 673 733 769 Depreciation and amortisation 137 142 171 170 196 184 192 201 Tax paid (85) (110) (133) (111) (77) (121) (132) (138) Change in working capital 240 154 (72) (227) (13) 230 3 4 Other operational CF items 34 14 8 (19) 60 (74) (83) (84) Cash flow from operations 1,041 930 624 443 756 892 714 751 Capex (241) (349) (255) (296) (328) (261) (271) (282) Net (acquisitions)/disposals 28 54 47 (261) (24) 0 0 0 Other investing CF items 41 38 50 79 84 0 0 0 Cash flow from investing (173) (258) (157) (477) (267) (261) (271) (282) Change in debt (8) 28 (393) 101 (24) 0 0 0 Net share issues/(repurchases) 42 52 17 5 0 0 0 0 Dividends paid (490) (534) (517) (508) (477) (493) (507) (525) Other financing CF items (53) (16) (32) (117) (35) (43) (34) (34) Cash flow from financing (509) (470) (925) (519) (535) (536) (541) (559) Forex effect/others (18) 18 (0) 13 3 0 0 0 Change in cash 342 220 (458) (541) (44) 94 (98) (90) Free cash flow 799 581 370 147 428 631 443 469 Source: FactSet, Daiwa forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

Financial summary continued … Balance sheet (SGDm) As at 31 Dec 2012 2013 2014 2015 2016 2017E 2018E 2019E Cash & short-term investment 1,738 2,065 1,590 1,134 1,094 1,188 1,090 1,000 Inventory 1,922 1,808 1,802 1,943 1,898 1,830 1,898 1,976 Accounts receivable 1,171 1,234 1,330 1,320 1,458 1,238 1,284 1,337 Other current assets 605 655 604 394 363 428 443 460 Total current assets 5,435 5,761 5,326 4,791 4,813 4,684 4,715 4,773 Fixed assets 1,202 1,520 1,578 1,709 1,670 1,747 1,827 1,908 Goodwill & intangibles 553 638 671 737 1,020 1,020 1,020 1,020 Other non-current assets 841 786 745 932 862 915 862 1,001 Total assets 8,032 8,707 8,319 8,169 8,365 8,366 8,424 8,702 Short-term debt 211 434 75 175 87 87 87 87 Accounts payable 1,694 1,605 1,667 1,703 1,722 1,682 1,745 1,816 Other current liabilities 1,985 2,055 1,974 1,843 1,991 2,039 2,109 2,188 Total current liabilities 3,890 4,094 3,716 3,720 3,801 3,808 3,941 4,092 Long-term debt 1,069 939 944 1,019 993 993 993 993 Other non-current liabilities 1,060 1,414 1,395 1,170 1,127 1,042 851 851 Total liabilities 6,019 6,447 6,055 5,908 5,921 5,843 5,784 5,936 Share capital 782 853 883 829 852 852 852 852 Reserves/R.E./others 1,113 1,264 1,249 1,303 1,330 1,390 1,485 1,590 Shareholders' equity 1,895 2,116 2,132 2,132 2,182 2,242 2,336 2,442 Minority interests 118 144 132 129 262 282 303 324 Total equity & liabilities 8,032 8,707 8,319 8,169 8,365 8,366 8,424 8,702 EV 11,073 10,710 10,802 11,446 11,562 11,488 11,607 11,718 Net debt/(cash) (458) (692) (571) 59 (14) (108) (10) 80 BVPS (SGD) 0.624 0.692 0.692 0.684 0.704 0.721 0.752 0.785

Key ratios (%) Year to 31 Dec 2012 2013 2014 2015 2016 2017E 2018E 2019E Sales (YoY) 6.5 4.0 (1.4) (3.1) 5.5 0.7 3.7 4.1 EBITDA (YoY) 8.2 1.3 (9.9) (3.9) (0.2) 8.7 7.5 5.3 Operating profit (YoY) 9.6 0.9 (15.9) (4.9) (4.7) 14.1 8.4 5.6 Net profit (YoY) 9.2 0.8 (8.4) (0.5) (8.4) 11.9 9.0 4.9 Core EPS (fully-diluted) (YoY) 8.5 (0.2) (8.7) 0.1 (8.6) 11.9 9.0 4.9 Gross-profit margin 22.8 21.6 20.2 20.2 19.5 21.2 21.5 21.5 EBITDA margin 13.1 12.8 11.7 11.6 11.0 11.9 12.3 12.4 Operating-profit margin 11.0 10.7 9.1 8.9 8.1 9.1 9.5 9.7 Net profit margin 9.0 8.8 8.1 8.4 7.2 8.1 8.5 8.5 ROAE 31.5 29.0 25.0 24.8 22.5 24.5 25.8 25.9 ROAA 7.5 6.9 6.2 6.4 5.9 6.5 7.0 7.2 ROCE 21.5 20.4 17.2 16.8 15.4 17.2 18.2 18.6 ROIC 37.9 36.7 30.1 23.8 18.9 20.8 21.7 21.1 Net debt to equity n.a. n.a. n.a. 2.8 n.a. n.a. n.a. 3.3 Effective tax rate 18.3 18.9 17.5 15.7 16.6 18.0 18.0 18.0 Accounts receivable (days) 67.8 66.2 71.6 76.3 75.8 73.1 66.0 65.8 Current ratio (x) 1.4 1.4 1.4 1.3 1.3 1.2 1.2 1.2 Net interest cover (x) 30.0 33.8 41.8 n.a. 44.8 55.5 198.7 113.5 Net dividend payout 89.6 80.1 87.9 87.9 96.2 89.0 84.0 83.0 Free cash flow yield 6.8 5.0 3.2 1.3 3.7 5.4 3.8 4.0 Source: FactSet, Daiwa forecasts

Company profile

ST Engineering is an integrated engineering services provider for both government and commercial markets, and is also the world's largest independent MRO provider (by commercial airframe man- hours). In 2016, commercial sales accounted for c.60% of overall revenue. The company provides a broad range of services and products across four key divisions - Aerospace, Electronics, Land systems and Marine.

Singapore Technologies Engineering (STE SP): 1 August 2017

STE: a defensive juggernaut Operating a diversified business model We believe STE’s ST Engineering is an integrated engineering services provider for both the commercial and diversified business government markets; it is also the world’s largest third-party aerospace MRO model will ensure (maintenance, repair and overhaul) provider (in terms of man-hours). The company derives greater earnings stability around 65% of its revenue (2016) from the commercial sector across four key divisions: 1) relative to SIAEC aerospace, 2) electronics, 3) land systems and 4) marine.

Our positive thesis on the company is underpinned by the following investment merits:

1) Strong order backlog: STE’s ending order book has more than doubled over the past decade (1Q17 ending order book of SGD13.3bn vs. SGD5.4bn in 2005). In our view, the company’s strong order backlog will provide support for continued revenue growth over the short to medium, particularly within its Aerospace and Electronics divisions, where we forecast 3-year revenue CAGR of 3.5% and 7.0%, respectively. Despite its order backlog being at record levels, we believe the company can achieve further backlog additions due to our positive outlook on its Aerospace and Electronics divisions.

STE: ending order book STE: dividends/share (SGD cents) (SGDbn) 17.0 14 16.5 12 Ending order book 2004: SGD5.3bn 10 1Q17: SGD13.3n 16.0

8 15.5 6 15.0 4 14.5 2

0 14.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1Q17 2013 2014 2015 2016 2017E 2018E 2019E Source: Company Source: Company, Daiwa forecasts

We see STE increasing 2) Cash-generating businesses to support payment of dividend: We expect STE’s its DPS by c.SGD0.01 in financial position to remain strong – the company was in a net cash position (includes 2017E on the back of investments) of SGD710m as at end-1Q17, driven by strong positive operating cash flow better core earnings generation. In addition, we find the stock offers a 2017E dividend yield of 4.1%, which performance should be an attractive proposition given the currently yield-compressed environment. We see management rewarding shareholders through a higher DPS over the coming 3 years on the back of core earnings growth. We assume a payout ratio of 83-89% over 2017-19E, which does not seem excessive given a past-5-year payout ratio of c.88%.

STE: 1-year-forward PER multiple (x) STE: profitability trend 22 (SGDm) 21 650 12%

20 600 11% 19 10% 550 18 9% 500 17 8%

16 450 7% 15

400 6%

Jul-16

2008 2009 2010 2012 2013 2014 2015 2016 2011

Apr-16 Oct-16 Apr-17

Jun-16 Jan-17 Jun-17

Feb-16 Mar-16 Mar-17 Feb-17

Aug-16 Sep-16 Nov-16 Dec-16

May-16 May-17

2017E 2019E 2018E Forward PER Ave +1SD -1SD Net profit (LHS) Operating margin (RHS)

Source: Bloomberg, Daiwa forecasts Source: Company, Daiwa forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

Merger would yield 3) Possibility of value-accretive integration with SIAEC: While investors might be wary significant cost savings of STE’s hefty-looking 21.6x 2017E PER vs. its past-2-year average of 18.0x, we see and be earnings scope for a further rerating on the back of possible integration of STE’s Aerospace division accretive by 2019 – with SIAEC. We think the enlarged entity would be a powerhouse third-party MRO that potentially a major short- could offer a complete suite of aircraft aftermarket services and would be among the term catalyst, in our view biggest beneficiaries of global aircraft fleet growth trend over the next 1-2 decades.

4) 3-year net profit CAGR of 8.5%: Our forecast calls for a 2016-19E bottom-line CAGR of 8.5% vs. a past-3-year CAGR of -5.9%. STE’s earnings likely bottomed in 2016, a year hampered by operational losses in its Land systems division due to a SGD61m one-off charge for Jiangsu Huatong Kinetics. If not for these one-off losses, 3 of its 4 divisions would have been able to generate high-single-digit operating profit growth YoY in 2016. While we think the outlook for its Marine division remains challenging, it should remain profitable over the coming 2-3 years by virtue of its focus on the construction of niche maritime assets, unlike O&M counters which are now mostly loss-making.

Initiating on STE with a Buy (1) call and TP of SGD4.46 While valuations don’t We initiate coverage of ST Engineering (STE) with a Buy (1) rating and DCF-based 12- look cheap, we see STE month target price of SGD4.460. While potential investors might be wary of the stock’s appreciating further prevailing 2017E PER multiple of 21.6x (vs. a past-2-year average forward PER of 18x) should results beat and our fair value-implied multiple of 25.6x, we believe that today’s yield-compressed consensus this coming environment argues for a premium on dividend-paying blue chip counters. Moreover, we 2Q17 see scope for further share-price upside if STE’s 2Q17 earnings were to beat the market’s expectations. We note that STE is trading significantly below peers’ forward average PER multiple of 25x, and we think this valuation gap would close upon the resumption of earnings growth over the coming 2-3 years.

Finally, we believe that a possible integration between STE’s Aerospace business and SIAEC could generate cost synergies (see accompanying sector report) that would see the enlarged entity realise a c.41% increment in profitability compared with both entities on a stand-alone basis. We see a more-than-even chance of an integration scenario happening within the coming 2-3 years as incumbents seek to reduce margin pressure amid a highly competitive landscape.

Singapore Technologies Engineering (STE SP): 1 August 2017

Divisional performance Aerospace ST Aerospace is the ST Aerospace (Singapore Technologies Aerospace Ltd) is the aerospace arm of STE largest airframe MRO and the world’s largest third-party commercial airframe MRO (maintenance, repair and provider in the world, overhaul) provider, with a global customer base that includes leading airlines, and airfreight with 12.5m airframe man and military operators. The division is also the biggest contributor to the group’s business, hours completed in 2016 accounting for 36% and 57% of its overall 1Q17 revenue and PBT, respectively.

The Aerospace division has a staff of around 8,200 employees (end-2016) providing the following key services: 1) aircraft maintenance and modification (AMM) (which include freighter conversion and cabin interior modification), 2) component/engine repair and overhaul (CERO), and 3) engineering and material services (EMS) (which include asset management and pilot training).

STE: Aerospace revenue breakdown by geography (1Q17) STE: Aerospace revenue breakdown by service (1Q17) Others 8% Engineering & material Europe services 21% 35% Aircraft maintenance & Asia modification 46% 43%

Component / Engine repair & USA 25% overhaul 22% Source: Company Source: Company

STE’s hangars are more Geographically, Asia (46% of 1Q17 revenue), the US (25%) and Europe (21%) contribute geographically diverse to the majority of the division’s top line. According to the company, it has 2 hangar facilities than SIAEC’s, with the located in the US, 2 in Guangzhou, China, 2 in Shanghai, China, 1 in Dresden, Germany former’s hangars mostly and 3 in Singapore. These facilities enable the company to accommodate 40 widebody, 27 in Singapore and the narrowbody and 24 general aviation aircrafts simultaneously. Another hangar in Pensacola, Philippines Florida, accommodating two widebodies, is slated to start operation in 2018.

ST Aerospace is the market leader in airframe MRO category

Top 10 airframe MROs Company Airframe man-hours Total MRO man-hours Total revenue (USD) 1 ST Aerospace 12.5 million not disclosed 1.2 billion 2 HAECO Group 10.3 million 12.8 million 1.8 billion 3 AAR 5.3 million not disclosed not disclosed 4 MRO Holdings 4.3 million 4.7 million not disclosed 5 Lufthansa Technik 4.2 million 8 million 5.6 billion 6 AFI KLM E&M 3.7 million not disclosed 4.6 billion 7 Ameco Beijing 3.1 million 4.8 million 230 million for third-party only 8 Turkish Technic 3.0 million 6.0 million 1 billion 9 Gameco 2.8 million 5.2 million not disclosed 10 Aviation Technical Services 2.6 million 3.0 million not disclosed Source: Aviation Week network. Based on 2016 reported man-hours and revenue

Based on its last disclosed annual commercial airframe man-hours, ST Aerospace (12.5m man-hours) is the market leader in this category, followed by HAECO (10.3m) and AAR Corp (5.3m), according to Aviation Week (2016). While we foresee ST Aerospace maintaining its leadership position in airframe maintenance in the years ahead, as we have previously highlighted this segment of MRO maintenance will likely play a less crucial role due to the advancement of new-generation aircraft that require less maintenance intensity

Singapore Technologies Engineering (STE SP): 1 August 2017

in terms of man-hours (the Boeing 767, over a 12-year period, requires 95,000 man-hours of maintenance, while the new-generation 787 requires only 33,000 man-hours).

However, fewer man-hours per aircraft will likely be partly compensated by the increase in overall global fleet size, particularly for narrow-body aircraft such as the A320CEO/NEO in which we believe ST Aerospace has the edge vs. SIAEC in the Asia Pacific region. A key strategy that ST Aerospace can further adopt is to enhance its capabilities on component/engine support, the segment with the largest MRO market growth potential over the coming decade as highlighted in the accompanying sector report.

Large potential for CFM56-5B,-7B overhauls but competition is intense While demand for MRO According to the forecasts by Airbus and Boeing, the A320CEO/NEO and 737NG/MAX of both CFM engines are aircraft will remain the largest contributors to MRO spending in 2026, accounting for c.46% expected to remain high, of the total annual MRO spend of c.USD105bn. These aircraft belong to the narrowbody competition in this category featured by most low-cost carriers (LCCs). The A320CEO/NEO uses the CFM56- category is also 5B engine, belonging to the CFM56 family, which is the world’s most popular jet engine extremely intense model, with some 36,000 engines in service globally. The 737NG/MAX uses the CFM56- 7B engine. Both engine models will require more than double the number of overhauls per annum in 2025 vs. 2016, as shown in the table (on the right) below, according to data from Aviation Week.

Growth of top-4 aircraft models CFM56-5,-7 Engine MROs 12,000 Engine family 2016 2025 2016-2025 Total CFM56-5A 256 36 1,362 10,000 CFM56-5B 528 1,058 7,864 CFM56-5C 240 16 1,200 8,000 CFM56-7B 936 2,230 16,292 Total 1,960 3,340 26,718 6,000

4,000

2,000

0 Current 2026

A320neo Boeing 737 MAX Boeing 787 Boeing 777

Source: Airbus, Boeing Source: Aviation Week Fleet & MRO forecast Note: Commercial operators only

ST Aerospace is one of the key partners of CFM International (the OEM of the CFM56 engine family) to provide an extensive suite of MRO support for the CFM56-3,-5B,-7B engine family in the Asia Pacific region. The company was also the first independent MRO provider to be declared a TRUEngineTM service provider in 2011, a status that was renewed in 2014. Any CFM56 engines overhauled by ST Aerospace are eligible for TRUEngine status, allowing the engine serial numbers to be included in the TRUEngine database made available to industry appraisers and potential buyers. The TRUEngine designation provides assurance to owners, operators and engine buyers that engines under the TRUEngine programme have been maintained to CFM’s recommended configuration.

We should expect the However, while we believe the number of CFM56 engine overhauls will increase number of CFM56 significantly over the coming decade, this segment is highly competitive, with overhaul facilities to approximately 60 other airlines or independent MRO shops competing to win overhaul jobs increase in Asia Pacific for these engines. In the Asia Pacific region, there are currently around 5 CFM56 overhaul over the next decade, facilities: GMF AeroAsia in Indonesia, ST Aerospace in Singapore, GE Engine Services in further intensifying Malaysia, MTU in China and Evergreen Aviation Technologies in Taiwan. Indonesia’s Lion competition among Group also plans to enter the fray, with subsidiary Batam Aero Technic announcing plans engine MROs to become a CFM56 MRO organisation. As part of Lion Air’s CFM International Leap 1A engine order announced in February, CFM is providing guidance on designing, construction and commissioning of Lion Group’s engine test facility in Batam, Indonesia.

Singapore Technologies Engineering (STE SP): 1 August 2017

The CFM56-5B and CFM56-7B engines have increased markedly in durability compared with their predecessors and typically operate 8-9 years before the first overhaul vs. 3 years for the CFM56-3. This competitive nature is well reflected in ST Aerospace’s Component/Engine Repair and Overhaul (CERO) segment.

STE: Aerospace PBT for 1Q17 (SGDm) CERO: 5-year historical PBT trend (SGDm) 100 90 76.5 80 80 70 17.2 59.8 60 30.9 60 13.2 46.8 50 45.3 40 7.7 40 20 44.8 39.5 30 20 0 5.7 1Q16 1Q17 10 Aircraft maintenance & modification Component / Engine repair & overhaul 0 2012 2013 2014 2015 2016 Engineering & material services Source: Company Source: Company

Despite the engine/component MRO market likely registering the highest growth potential, we think ST Aerospace’s CERO segment will remain under constant margin pressure in the coming years due to elevated competition from new entrants attracted by the high growth profile of the region.

We believe that for ST Aerospace to outperform its peers, the company will have to: 1) set up an effective partnership with OEMs, where both parties can collaborate and contribute to shaping new products and services, as well as share the risk and know-how of their product/service offerings, and 2) move up the value chain and expand its range of service offerings such as passenger-to-freighter conversion business.

Establishing partnerships with OEMs As the MRO industry has grown over the years, it has also become more attractive to OEMs, which have entered the market aggressively and are competing by combining after- sales MRO services with new aircraft models. As older aircraft such as the A330, B747-B, B767, and B777 are increasingly replaced by newer, fuel-efficient models like the A350WXB, B777X and B787, it is likely that OEMs will secure a bigger slice of the pie for themselves.

OEMs already dominate the market share for engine MRO services (GE, Pratt & Whitney and Rolls-Royce), and industry experts expects them to grow further over the next decade. Third-party MRO providers compete mainly in the air-frame and line maintenance space, where commercial airline operators outsource such work to focus on their main operations.

While STE might have To mitigate this, ST Aerospace has established partnerships with OEMs; it has more OEM partnerships partnerships with over 30 OEMs to date, according to the company. Some of the key vs. SIAEC, STE’s partnerships include Boeing and Airbus, GE for On-Wing Support of GEnx-1B and -2B contributions from JVs/ engines, CFM for CFM56 support, P&W on hi-tech component repairs, and UTC associates have lagged Aerospace for 787 nacelle systems. that of SIAEC Expanding its range of services The division has also turned its focus toward diversifying its service capabilities into other areas:

1) Focusing on passenger to freighter conversion (P2F) and developing as a turnkey cabin reconfiguration provider. According to Boeing, global trade is expected to drive freight traffic growth over the next 20 years. It forecasts a global freight traffic CAGR of 4.2% over the 2015-35 period. Airbus expects the number of

Singapore Technologies Engineering (STE SP): 1 August 2017

freighter aircraft deliveries to exceed 2,370 aircraft over the next 20 years, of which more than 60% would be converted aircraft (ie, converted from passenger aircraft to freighter aircraft). Around 88% of these deliveries are expected to be standard body aircraft, where ST Aerospace has focused on building its expertise.

Global freighter deliveries forecast (2015-2035) STE’s focus on freighter 3,500 3,010 conversion distinguishes 3,000 it from peers 2,500

2,000 1,770

1,500

1,000

500

0 2015 2035 Standard body Medium widebody Large production

Source: Boeing

Elbe Flugzeugwerke GmbH (EFW), a manufacturing facility in Germany whose capabilities include passenger-to-freighter conversions and aircraft maintenance and repair, in which ST Aerospace recently increased its stake to 55% from 35% (remainder held by Airbus), will be the company’s centre for P2F conversions, aircraft MRO and engineering services in Europe, according to management.

Another high-value area which the company hopes to expand into is the business aviation sector, particularly maintenance and VIP configurations. This has been undertaken by ST Aerospace’s affiliate, Aeria Luxury Interiors.

2) Grow its aircraft/engine leasing business — ST Aerospace, under its jointly controlled company, Total Engines Asset Management Pte Ltd (TEAM), has a leasing portfolio of engines which includes the International Aero Engines’ V2500 engine as well as the top-selling CFM56 series engines. The company also has a joint venture with Sojitz Corporation (Sojitz) to collaborate in the aircraft leasing business. The JV aims to grow its aircraft leasing business by acquiring more mid-life narrowbody aircraft that are currently on lease to airlines.

3) Expanding its commercial pilot training business by injecting SGD6.2m into ST Aerospace Academy Pte Ltd (STAA) and setting up a new aviation centre in Seletar (Singapore) for air charter, ground training and flight training. It has also acquired a 100% stake in the Aviation Academy of America to grow the pilot training business there.

Divisional forecasts We are forecast a revenue CAGR of 3.3% for the Aerospace division over 2016-19E, and for its operating margin to improve by 1.4pp over the same period. We expect this improvement to be driven mainly by healthy demand for line and airframe MRO, as well as contracts for its P2F conversion and cabin interior work. Further, we believe revenue growth in its CERO segment will remain relatively muted as OEMs continue to dominate the engine MRO market.

Singapore Technologies Engineering (STE SP): 1 August 2017

STE: Aerospace division key forecasts and assumptions STE: Aerospace division revenue and operating margin forecasts AEROSPACE (SGDm) SGD m 2015 2016 2017E 2018E 2019E 3,000 15% Unconsolidated divisional forecasts 2,800 14% Aircraft maintenance & modification (AMM) 1,045 1,090 1,122 1,156 1,202 13% 2,600 Component / Engine repair & overhaul (CERO) 653 606 612 630 649 12% Engineering & material services (EMS) 398 797 834 871 914 2,400 11% Total Aerospace revenue 2,096 2,493 2,568 2,658 2,766 2,200 10% Operating profit 222 240 270 279 304 9% 2,000 Operating margin (%) 10.6% 9.6% 10.5% 10.5% 11.0% 8%

1,800 7% Assumptions 1,600 6%

YoY growth (%)

2008 2009 2010 2011 2013 2014 2015 2016

Aircraft maintenance & modification (AMM) -5.7% 4.3% 3.0% 3.0% 4.0% 2012

2018E 2019E Component / Engine repair & overhaul (CERO) 7.0% -7.2% 1.0% 3.0% 3.0% 2017E Revenue (LHS) Operating margin (RHS) Engineering & material services (EMS) 12.5% 100.3% 4.6% 4.5% 4.9% Total Aerospace revenue 1.2% 19.0% 3.0% 3.5% 4.1%

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

The Aerospace division has recorded strong growth in order wins since 2009. We expect the trend to continue, driven by our expectation of demand for MRO services to remain strong, and as the company focuses on expanding its services in other business areas – freighter conversion, cabin interior configuration, pilot training and engine leasing.

Electronics ST Electronics (Singapore Technologies Electronics Limited) provides a range of services which encompass: 1) rail electronics and intelligence transportation, 2) satellite and broadband communications (satcom), and 3) advanced electronics and information communication technologies (ICT) solutions.

STE: Electronics revenue breakdown by service (1Q17) STE: Electronics PBT breakdown by service (1Q17)

Software Large-scale systems group Large-scale systems group Software 25% systems group 27% systems group 37% 44%

Communication Communication & sensor & sensor systems group systems group 48% 19% Source: Company Source: Company

We foresee the The Electronics division represents the second-largest segment of the company’s overall electronics division business, accounting for 34% and 30% of its 1Q17 revenue and PBT, respectively. The being the fastest- majority of this division’s revenue is derived from Asia (1Q17: 85%). growing segment in STE’s portfolio of According to the company, around a third of its contracts are defence related, a third are businesses, driven by non-defence but government related, and the remaining third are commercial contracts. increasing demand for ICT solutions In 2016, ST Electronics secured a record SGD2.33bn worth of contract orders, and has grown strongly over the past several years, bolstered by its expertise in providing intelligent transportation systems in rail and traffic management, and by focusing on growth areas such as its satcom services, as well as broadening its offering of advanced ICT solutions.

Singapore Technologies Engineering (STE SP): 1 August 2017

STE: Electronics annual new order wins trend (SGDbn) The division’s strong 2.5 order backlog sets the stage for further revenue 2.0 growth in the coming 2-3 years, on our forecasts 1.5 Past 10-year average order wins 1.0

0.5

0.0 2009 2010 2011 2012 2013 2014 2015 2016 Source: Company

Since playing a pivotal role in the development of Singapore’s Mass Rapid Transit (MRT) and Light Rail Transit (LRT) systems from 1984, the division has garnered over 60 turnkey projects overseas, most recently for the platform screen doors for Riyadh’s Metro Lines 4, 5 and 6 as well as a contract to supply the passenger information system (PIS) to CRRC Qingdao Sifang Ltd for Hong Kong’s MTR by 2023.

In satcom and advanced electronics and ICT services, the company’s TeLEOS-1 Earth Observation satellite has successfully completed its in-orbit test and launch of commercial imagery service. In the e-Government and e-Enterprise space, ST Electronics has been active in delivering security solutions for governments such as its radar surveillance systems, as well as under its DigiSAFE brand of cyber-security products.

Industry demand for ICT services expected to remain strong We are most upbeat on the prospects for STE’s Electronics division. Given the scope and depth of services it is able to provide – from the provision of satcom services to the installation of security solutions (CCTV surveillance, physical access systems) – the Electronics division is poised to capture the anticipated growth in demand for ICT services over the coming decade, in our opinion.

Smart City, IoT and a The emergence of themes centred around ‘Big Data’ and ‘Internet of Things (IoT)’ signals driverless society are that the demand for related services could accelerate in the coming years, driven by an exciting technological increase in internet penetration and adoption of mobile computing devices globally. evolution that will According to various industrial sources, the global Cloud IT market is expected to grow benefit STE’s Electronics from USD180bn in 2015 up to USD390bn in 2020, attaining a CAGR of 17%. In Singapore, division over the next the government has already launched a series of initiatives as part of its Intelligent Nation decade and out Masterplan (iN2015) to improve the country’s infocomm infrastructure over the next 10 years.

A corollary to the increase in data services would be an increased need for cyber security and information protection services, an area where ST Electronics also has an established presence. According to figures cited by the IDA, the global cyber security market is expected to grow from around USD64bn in 2011 to USD120bn in 2017, with Asia-Pacific expected to grow at a faster pace of around 13.4% per year to reach USD26bn by 2017.

In response, the Singapore government launched the National Cyber Security Masterplan 2018 to enhance the cybersecurity of Singapore’s public, private and people sectors. In addition to government and Critical Infocomm Infrastructure (CII), the plan’s scope has been broadened to take into consideration businesses and individuals. ST Electronics has been an integral part of this initiative – the division opened the DigiSAFE Cyber Security Centre in June 2014 to provide training programmes and develop capabilities in this segment, given its expertise in developing military defence and software systems.

Singapore Technologies Engineering (STE SP): 1 August 2017

Divisional forecasts We forecast a revenue CAGR of 7.9% for the Electronics division over the 2016-19E period, driven by its high order backlog and our expectations for order win momentum to remain strong, and for operating margins to be largely stable over the period.

STE: Electronics division key forecasts and assumptions STE: Electronics revenue and operating margin trend ELECTRONICS (SGDm) (% ) SGD m 2015 2016 2017E 2018E 2019E 3,000 12 Unconsolidated divisional forecasts 2,800 11 Large-scale systems group 397 431 468 509 541 2,600 Communication & sensor systems group 815 926 1,010 1,099 1,181 10 Software systems group 532 554 576 600 618 2,400 Total Electronics revenue 1,743 1,911 2,054 2,208 2,341 2,200 9 Operating profit 179 192 208 242 256 2,000 8 Operating margin (%) 10.3% 10.0% 10.1% 10.9% 10.9% 1,800 7 1,600 Assumptions YoY growth (%) 1,400 6 Large-scale systems group 4.2% 8.6% 8.7% 8.6% 6.4% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E 7.3% 13.6% 9.1% 8.8% 7.5% Communication & sensor systems group Revenue Operating margin Software systems group 12.2% 4.2% 4.0% 4.2% 3.0% Total Electronics revenue 8.0% 9.6% 7.5% 7.5% 6.0%

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

Land systems In April 2017, ST Kinetics Singapore Technologies Kinetics Ltd (ST Kinetics) is the land systems and specialty signed a partnership vehicles arm of STE. The division has its origins in Chartered Industries of Singapore Pte agreement with Ltd (CIS), established in 1967 as a defence contractor for the Singapore Armed Forces Singapore’s Land (SAF). In 2000, STE acquired CIS through its automotive division at the time (ST Transport Authority to Automotive) to form ST Kinetics. Today, the division delivers products and services to both develop driverless buses the defence and commercial sectors in three segments: 1) automotive, 2) munitions and weapons, and 3) services, trading and others. According to the company, the breakdown between defence and commercial contracts is roughly even.

STE: Land systems revenue breakdown by service (1Q17) STE: Land systems PBT breakdown by service (1Q17)

Services, trading & others 17% Automotive 30%

Munitions & weapons 10% Services, trading & others Munitions & 69% weapons Automotive 1% 73%

Source: Company Source: Company

In 1Q17, the Land systems division contributed 18% and 12% of the company’s overall revenue and net profit, respectively.

The Kinetics division built its expertise developing military munition and vehicles. It designs and manufactures the BRONCO family of armoured all-terrain vehicles, used primarily by the Singapore Army but which has also seen export orders by the British Army for use in Afghanistan. Of late, the Terrex family of infantry fighting vehicles (IFVs) has been the focus as the Land systems sector has strengthened its presence in the wheeled armoured and the IFV segments of the global defence market.

To branch into the commercial vehicle space, the Kinetics division acquired Specialised Vehicles Corp through its US subsidiary VT Systems in 2005 – the former is a vehicle manufacturer specialising in beverage, emergency rescue, special application and multi-

Singapore Technologies Engineering (STE SP): 1 August 2017

temperature refrigerated truck bodies and trailers through its two brands – Hackney and Kidron. In 2006, it acquired LeeBoy, a US manufacturer of road construction and maintenance equipment.

Expanding its research overseas According to the company, it will focus on expanding its international sales in the markets of Africa, Latin America and Asia through its LeeBoy brand. ST Kinetics has established overseas joint ventures and subsidiaries (Guizhou Jonyang Kinetics in China [2005]; LeeBoy India [2010]); LeeBoy Brazil [2013]) to expand its global presence in the specialty vehicles and road construction and equipment market.

We expect the defence segment of the business to be largely stable over the near term, as the Singapore government remains a key customer for the business. While export orders for its military vehicles are typically less recurrent due to political sensitivity as well as strong competition from defence heavyweights such as BAE Systems, its expertise should allow it to continue to secure contracts overseas.

Divisional forecasts Revenue and adjusted We forecast a revenue CAGR of -2.3% for the Land systems division over 2016-19E, but operating profit growth expect operating margins to improve to 5% in 2019 vs. -0.9% in 2016. Management will likely remain expects this division to tap on global defence opportunities with customised solutions, with subdued due to the lack defence budgets in Asia Pacific seen as likely to grow due to the modernisation needs of of large defence orders countries in the region and ongoing geopolitical tensions. It is reasonable to assume the global defence landscape will continue to evolve, with an increased demand for counter- terrorism solutions, systems for cyber security and intelligence fathering as well as unmanned security.

STE: Land systems division key forecasts and assumptions STE: Land systems revenue and operating margin trend LAND SYSTEMS (SGDm) (% ) SGDm 2015 2016 2017E 2018E 2019E 1,600 8 Unconsolidated divisional forecasts 1,500 7 Automotive 1,136 1,011 907 925 944 1,400 6 Munitions & weapons 199 222 227 231 236 Services, trading & others 66 79 79 81 84 1,300 5 Total Land systems revenue 1,401 1,312 1,213 1,238 1,263 1,200 4 Operating profit 47 (11) 49 62 63 1,100 3 Operating margin (%) 3.4% -0.9% 4.0% 5.0% 5.0% 1,000 2 Assumptions YoY growth (%) 900 1 Automotive 6.6% -11.0% -10.3% 2.0% 2.0% 800 0 Munitions & weapons -21.5% 11.6% 2.0% 2.0% 2.0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E Services, trading & others -23.5% 19.7% 0.5% 3.0% 3.0% Revenue Operating margin Total Land systems revenue -0.3% -6.4% -7.5% 2.0% 2.0%

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

Marine Singapore Technologies Marine Ltd (ST Marine) provides shipbuilding, ship conversion and ship repair services in both the naval defence and commercial markets. It currently has 2 yards in Singapore (Benoi and Tuas) and 3 in the US (all in the state of Mississippi under subsidiary VT Halter Marine) which can accommodate vessels up to 70,000dwt in total.

Singapore Technologies Engineering (STE SP): 1 August 2017

STE: Marine revenue breakdown by service (1Q17) STE: Marine PBT breakdown by service (1Q17) Engineering Engineering 6% 12%

Shiprepair 34%

Shipbuilding Shiprepair Shipbuilding 60% 32% 56%

Source: Company Source: Company

The Marine division is the smallest contributor to the overall group, accounting for 11% and 7% of 1Q17 revenue and net profit, respectively.

Shipbuilding likely to remain challenging in the near term Shipbuilding division’s Shipbuilding services accounted for 60% of the marine division’s 1Q17 revenue. Due to focus on niche projects weaker shipbuilding performance, the overall marine division saw revenue decline from has allowed it to stay in SGD958m in 2015 to SGD841m in 2016, with a corresponding decline in PBT to the black SGD75.1m.

In our view, the outlook for shipbuilding remains challenging and is not expected to recover in 2017. The company intends to focus on niche projects such as the LNG ferries that are operating in Sulphur Emission Control Areas. Internationally, we think the naval and paramilitary shipbuilding market has a positive outlook, though some navies are postponing their acquisition programmes due to budget cuts.

Divisional forecasts We forecast revenue CAGR of -8.2% for the Marine division over the 2016-19E period, driven by an anticipated slowdown in newbuild orders. However, we expect operating margins to recover moderately by 0.4pp over the same period due to the company’s focus on higher-margin projects.

STE: Marine division key forecasts and assumptions STE: Marine revenue and operating margin trend MARINE (SGDm) (% ) SGD m 2015 2016 2017E 2018E 2019E 1,400 14 Unconsolidated divisional forecasts Shipbuilding 614 486 399 375 375 1,200 12 Ship repair 262 299 270 261 261 1,000 10 Engineering 83 56 45 43 43 Total Marine revenue 958 841 714 679 679 800 8 Operating profit 72 64 57 54 54 Operating margin (%) 7.5% 7.6% 8.0% 8.0% 8.0% 600 6

Assumptions 400 4

YoY growth (%)

2009 2010 2011 2013 2014 2015 2016 2008 2012

2018E 2019E Shipbuilding -38.9% -20.9% -17.8% -6.0% 0.0% 2017E 0.6% 14.2% -10.0% -3.0% 0.0% Revenue Operating margin Ship repair Engineering 7.9% -32.0% -20.0% -5.0% 0.0% Total Marine revenue -28.6% -12.2% -15.1% -5.0% 0.0%

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

Financial analysis and valuations

Stable growth, high ROAE and ROIC levels We forecast revenue to increase at a 2.8% CAGR over 2016-19E, driven by revenue growth at its Electronics and Aerospace divisions at CAGRs of 7.0% and 3.5%, respectively, over the same period. Meanwhile, we expect the Land systems division (revenue CAGR of -1.1%) to show a moderate decline, while the Marine division is likely to see persistent headwinds as a result of the weak macro outlook in the O&G industry (revenue CAGR of -6.9%). For 2017, management is guiding for overall revenue to be stable relative to 2016 levels (our 2017 forecast: up 0.7% YoY).

STE: revenue growth forecasts (%YoY) STE: operating margin and net profit forecasts 10% (SGDm) Revenue growth to be supported by record 650 12% 8% order backlog 600 11% 6% 10% 550 4% 9% 500 2% 8% 450 0% 7% 400 6%

(2%)

2008 2011 2012 2013 2014 2015 2016 2009 2010

2017E 2018E (4%) 2019E Net profit (LHS) Operating margin (RHS) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

We forecast STE’s operating margin to improve by 2.0pp over the 2016-19E period, and for adjusted net profit to see a 8.5% CAGR over the same period. Recall that in 2016, the Land Systems division was impacted by doubtful debts/bad debts written off for JHK amounting to SGD20.4m, as well as impairment losses on PPE for this division of SGD30.8m. Excluding these items would have resulted in 2016 net profit increasing from the reported SGD484.5m to c.SGD536m for marginal growth of 1.3% over the 2015 figure. We forecast its 2017 net profit to increase to SGD542m, a 1.1% YoY rise relative to adjusted earnings for 2016. We look for 2018 net profit to accelerate at a faster clip of 9% due to a combination of higher revenue growth of 3.7% YoY and a 0.4pp operating-margin improvement, driven mainly by the strong order backlog in its Electronics division where average new order wins of SGD2bn in the past 3 years are significantly higher than the 10- year average of SGD1bn. Our expectation here would result in the group’s profitability eclipsing the record figure of SGD581m generated in 2013.

STE: ROAE and ROIC forecasts While ROAE and ROIC 50% are likely to decline from 45% the 2013 peak, they will still exceed 20% on our 40% forecasts 35%

30%

25%

20% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E

ROAE ROIC

Source: Company, Daiwa forecasts

STE’s return on average equity (ROAE) and return on invested capital (ROIC) have averaged 28% and 36% over the past ten years, which we consider to be impressive considering the company’s lowly-geared balance sheet (net gearing of 0.2x as at end- 2016). However, these high ratios are unlikely to be repeated in the coming years due to

Singapore Technologies Engineering (STE SP): 1 August 2017

elevated competition in the industry resulting in lower margins and a need to reinvest larger amount of capital into capex vs. paying out in dividends to ensure that STE remains at the forefront of product advancements. We expect both ROAE and ROIC over our forecast horizon to average approximately 25% and 27%, respectively — still respectable ratios by any industry standard.

Free cash flow generation to remain strong STE’s business is strongly free cash flow generative, while its capex as a percentage of revenue (excluding M&A activity) has averaged 4% over the past ten years. We expect capex as a percentage of revenue to remain relatively low at 4% for 2017-19E, translating to figures of SGD256-266m during this period.

STE: capex forecasts STE: free cash flow and operating cash flow forecasts (SGDm) (%) (SGDm) (% ) 350 6 1,200 6

5 1,000 5 300 4 800 4

250 3 600 3

2 400 2 200 1 200 1

150 0 0 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E Capex % of revenue OCF FCF Capex as a % of revenue (RHS)

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

We expect STE to still generate robust operating cash flow in the range of SGD700-900m in 2017-19E. Based on our capex assumptions, free cash flow generation should average comfortably above SGD400m per annum, in line with its past 10-year average of c.SGD430m. We expect most of the free cash flow to be returned to shareholders in the form of dividend payments.

Strong balance sheet and potential for higher dividend STE remains a net cash STE’s balance sheet has been relatively under-geared over the past several years, driven counter if we take into by strong free cash flow generation and debt repayment over 2009-14 (gross debt/equity consideration declined from 0.86x in 2009 to 0.6x in 2014). However, as a result of significant purchase investment-related of investment-related assets such as bonds in 2015, the company turned marginally net assets such as bonds as debt (not inclusive of short and long-term investments) in 2015. We are in favour of the cash equivalents company deploying excess liquidity into interest generating assets that can be easily redeployed for M&A activity as and when the opportunity arises.

STE: net debt/EBITDA ratio forecasts (x) STE: dividend and FCFE trend 0.4 (SGDcents) 0.3 26 110% 0.2 24 100% 0.1 22 0.0 20 90% (0.1) 18 (0.2) 16 80% (0.3) 14 70% (0.4) 12 (0.5) 10 60%

(0.6)

2008 2009 2010 2011 2012 2013 2014 2015 2016

2018E 2019E (0.7) 2017E 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E DPS (LHS) FCFE/share Payout ratio (RHS)

Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

Although management’s stated policy for dividend payout is for 75-80% of its ‘sustainable’ net profit, the company’s dividend payout ratio has averaged around 89% since 2009. We assume a dividend payout of 89% for 2017 (2017E DPS of SGD15.5 cents) as we expect the company to increase the absolute dividend amount from the past-4-years level of SGD15.0 cents per annum on the back of the stronger earnings outlook. Thereafter, we assume 83-84% payouts for 2018-19E, which translate to DPU growth of SGD0.5 cents per annum for the next 2 years. Our 2017 forecast implies a forward dividend yield of 4.1% at the current price.

Consensus revisions trend Over the past year, the Bloomberg 2017-19E EPS have seen relatively modest revisions as compared to the Bloomberg 2017-19 EBITDA revisions. At the EBITDA level, we expect a marginal revision in 2017E numbers vs. 2018E numbers as consensus could still be factoring in further inventory obsolescence in 2017 (2015: SGD53.4m, 2016: SGD54.9m) for the Aerospace sector division as the result of a change in provisioning policy for rotable stocks (aircraft components which need to be rotated at frequent intervals), which began in 2016.

STE: Bloomberg EPS consensus revisions STE: Bloomberg EBITDA consensus revisions 4.1 0.22 950 4.1 3.9 0.21 3.9 900 3.7 0.20 3.7 3.5 3.5 0.19 850 3.3 3.3 0.18 3.1 800 3.1 0.17 2.9 2.9 750 2.7 0.16 2.7

2.5 0.15 700 2.5

Apr-15 Apr-16 Oct-16 Apr-17 Oct-15

Jun-15 Jun-16 Jun-17

Feb-15 Feb-16 Feb-17

Dec-16 Dec-15

Aug-15 Aug-16

Oct-15 Apr-16 Oct-16 Apr-17 Apr-15

Jun-15 Jun-16 Jun-17

Feb-15 Feb-16 Feb-17

Dec-15 Dec-16

Aug-15 Aug-16 Price (LHS) 2017 EPS 2018 EPS 2019 EPS 2017 EBITDA 2018 EBITDA 2019 EBITDA Price

Source: Bloomberg Source: Bloomberg

Our 2017-19 EPS forecasts are 1-5% above those of the Bloomberg consensus. Meanwhile, our operating profit forecasts are 5% higher, possibly as we do not incorporate potential forex or derivative gains or losses into our forecasts. We attribute our higher operating profit forecasts to our expectations for a higher operating margin recovery from the 2016 level, driven by the Aerospace division (we assume no major inventory obsolescence).

Valuations Methodology We value STE using a DCF model with the following inputs: a weighted average cost of capital of 7.3%, and a terminal FCF growth rate of 1% — similar to the assumptions used in the valuation for both STE and SATS.

STE: DCF valuation inputs STE: sensitivity of DCF analysis (2017-25E) Terminal assumptions WACC Long-term FCF growth 1.0% WACC Base WACC 7.3% FCF NPV - FCFF 2017-24 5,052.6 Growth 5.3% 5.8% 6.3% 6.8% 7.3% 7.8% 8.3% 8.8% 9.3% NPV Terminal FCFF 9,258.4 0.0% 5.59 5.10 4.69 4.33 4.03 3.76 3.53 3.33 3.14 Total Enterprise Value 14,311.1 0.5% 6.03 5.45 4.97 4.57 4.23 3.93 3.68 3.45 3.25 1.0% 6.57 5.88 5.32 4.85 4.46 4.13 3.84 3.59 3.37 Less: Net debt (end-2016) 175.4 1.5% 7.25 6.40 5.73 5.19 4.74 4.36 4.03 3.75 3.51 Less: Minority interest (end-2016) 261.9 2.0% 8.14 7.07 6.24 5.59 5.06 4.62 4.25 3.94 3.67

Value of equity 13,873.7 No. of shares (2016 m) 3,108.6 DCF per share value SGD 4.46

Source: Daiwa forecasts Source: Daiwa estimates and forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

We use a DCF approach to valuation as we believe it best captures our view of STE as an integrated engineering services business, as well as our expectations that the company should continue to generate strong, stable free cash flow growth over the longer term. Moreover, as some contract orders secured by the company are executed over a period of several years, whereas others are fulfilled within the same year, a long-term view better reflects the potential trajectory of STE’s earnings and cash flow recognition.

STE: 12-month forward PER (x) STE: 12-month forward EV/EBITDA (x) 22 16

21 15 20 14 19 13 18 12 17 16 11

15 10

Jul-16

Apr-16 Oct-16 Apr-17

Oct-16 Apr-17 Apr-16

Jan-16 Jun-16 Jan-17 Jun-17

Jun-16 Jan-17 Jun-17

Feb-16 Mar-16 Feb-17 Mar-17

Aug-16 Nov-16 Sep-16 Dec-16

Aug-16 Dec-16 Sep-16 Nov-16

May-16 May-17

May-16 May-17 Forward PER Ave +1SD -1SD Forward EV/EBITDA Ave +1SD -1SD

Source: Bloomberg, Daiwa forecasts Source: Bloomberg, Daiwa forecasts

We find STE is currently trading at a 12-month forward PER of 21.6x, which is above its past-2-year mean of 18x. Similarly, on a forward EV/EBITDA basis, the counter is trading near 1SD above its past-2-year mean, at 14.4x.

Share price performance STE’s share price has appreciated by some 22%, slightly underperforming the FTSE Straits Times Index which rose by 26% but significantly better than its peer SIAEC, which saw share price depreciation of c.1% over a 1-year horizon. We believe its strong share- price performance is attributable to investors piling into strong-dividend paying blue-chip counters such as STE amid the yield-compressed climate.

STE: share price performance vs. SIE vs. FSSTI (1-year) STE: share price performance since 2007 30% 5.00 25% 20% 4.50 15% 10% 4.00 5% 0% 3.50 (5%) (10%) 3.00 (15%) 2.50

2.00

28/06/2016 19/07/2016 09/08/2016 30/08/2016 20/09/2016 11/10/2016 01/11/2016 22/11/2016 13/12/2016 03/01/2017 24/01/2017 14/02/2017 07/03/2017 28/03/2017 18/04/2017 09/05/2017 30/05/2017 20/06/2017 11/07/2017 01/08/2017

Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16

Dec-07 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-09 Dec-10 Dec-11 STE SIAEC FSSTI Dec-08

Source: Bloomberg Source: Bloomberg

Given the c.18% upside potential from the current share price of SGD3.77 to our target price of SGD4.46 for STE, we initiate coverage of the stock with a Buy (1) rating. We believe STE’s attractive dividend yield of 4.1% for 2017E makes for a compelling proposition in today’s yield-depressed environment.

Our target price of SGD4.46 translates to a 1-year forward PER multiple of 25.6x, generally in-line to peers’ 1-year forward average PER multiple of 25x. In addition, STE is trading at a significant discount to its peers on forward EV/EBITDA and trailing P/FCF multiples. Moreover, on our forecast, the stock pays a much higher dividend yield (2017E: 4.1%) than the peer average of 2%.

Singapore Technologies Engineering (STE SP): 1 August 2017

Peer comparison STE: peer comparison Bloomberg Share Price Market cap EV/EBITDA (X) PER (X) P/FCF Div Yield Net D/E Company name Code (Local) (USD m) FY 1 FY 2 FY 1 FY 2 (X) (%) (%) Aerospace peers HONG KONG AIRCRAFT ENGINEERG 44 HK 54.75 1,166 N.A. N.A. N.A. N.A. 6.2 7.1 31.5 AAR CORP AIR US 37.40 1,286 8.9 7.5 21.0 17.8 N.A. 0.8 16.1 THALES SA HO FP 93.59 23,530 9.2 8.4 19.5 17.2 19.0 1.7 -45.5 SAFRAN SA SAF FP 79.93 39,423 10.2 9.0 20.2 18.0 16.9 1.9 -10.8 HEICO CORP HEI US 80.37 6,306 19.0 17.5 38.6 34.2 31.4 0.2 33.6 AVIC AIRCRAFT CO LTD-A 000768 CH 18.22 7,507 40.0 31.5 72.6 54.7 40.7 0.3 -0.1 SPIRIT AEROSYSTEMS HOLD-CL A SPR US 60.43 7,289 7.1 6.9 12.6 11.8 15.3 0.5 21.2 Average 15.7 13.5 30.7 25.6 21.6 1.8 6.5 Electronics peers SIEMENS AG-REG SIE GR 114.55 115,157 10.2 9.6 14.4 13.7 15.5 3.1 56.0 HITACHI LTD 6501 JP 740.60 32,486 4.8 4.5 11.5 10.3 10.0 1.8 1.6 CISCO SYSTEMS INC CSCO US 31.45 157,252 7.0 7.1 13.2 12.9 12.5 3.5 -54.3 Average 7.3 7.1 13.0 12.3 12.6 2.8 1.1 Kinetics peers ZOOMLION HEAVY INDUSTRY S-A 000157 CH 4.83 5,205 26.4 22.4 24.2 29.1 27.0 3.1 80.5 CATERPILLAR INC CAT US 113.95 67,134 10.4 8.9 22.7 18.1 15.6 2.7 -0.7 KOMATSU LTD 6301 JP 2,986.00 26,339 11.7 9.6 23.1 16.6 30.6 1.9 41.7 Average 16.1 13.6 23.3 21.3 24.4 2.6 40.5 Marine peers SEMBCORP MARINE LTD SMM SP 1.71 2,628 19.1 16.8 40.6 29.9 N.A. 1.5 130.5 YANGZIJIANG SHIPBUILDING YZJSGD SP 1.45 4,084 6.6 6.9 13.4 14.0 N.A. 2.8 -30.9 Average 12.8 11.9 27.0 22.0 N.A. 2.1 49.8

Total Average 13.6 11.9 24.8 21.3 20.1 2.2 18.0

SINGAPORE TECH ENGINEERING* STE SP 3.77 8,640 14.4 13.5 21.6 19.8 14.8 4.1 -9.6 Source: Bloomberg, *Daiwa forecasts

Singapore Technologies Engineering (STE SP): 1 August 2017

Key risks Project management risk A significant portion of STE’s business is dependent on securing contracts for projects, some of which can last for several years. The company then has to execute the project as efficiently as possible within the specified contract amount in order to maximise its operating margin without compromising on project quality. Thus, poor project management and the potential for cost overruns represent a key downside risk to our earnings forecasts.

Availability of skilled labour STE has over 20,000 employees across its 4 key divisions. Ensuring the availability of skilled staff and retaining talent is imperative in the engineering services industry. Over 2010-16, STE’s total headcount across the 4 divisions grew by around 6% to 21,974 (2016 average), while staff costs as a percentage of revenue remained stable at an average of 24.6% over the past seven years. An inability to manage its staff base could mean the company will have to expend resources to train and hire new staff, implying downside risks to our net profit forecasts.

STE: staff headcount trend STE has been turning 23,000 1,600 towards automation to 22,500 reduce its reliance on 1,550 22,000 manpower, particularly 1,500 with the Aerospace 21,500 division 21,000 1,450 20,500 1,400 20,000

19,500 1,350 2010 2011 2012 2013 2014 2015 2016 Staff headcount Staff costs (SGD m)

Source: Company

Obsolescence risk STE’s business is impacted by changes in technology and industry requirements, and it has to constantly invest in research and development to remain at the forefront of providing engineering services and solutions. An inability to keep pace with these developments could lead to impairment of its assets or inventory obsolescence charges, which would have a negative bearing on our earnings forecasts.

Foreign exchange risk As STE has numerous subsidiaries operating in various countries, its operating transactions are exposed to forex risk – primarily from the USD and Euro. According to the company, its policy is to hedge at least 50% of its transactions. It employs a variety of methods to achieve this, from forward currency contracts to embedded derivatives in its sales contracts to the customer – especially in the case of projects that are delivered over a period of several years; STE typically seeks to minimise its currency exposure upfront. A significant depreciation of the USD/Euro therefor represents a downside risk to our earnings forecasts.

Singapore Technologies Engineering (STE SP): 1 August 2017

Appendix Diversified operations with high barriers to entry STE has its origins as a defence contractor for the Singapore Armed Forces (SAF) with the establishment of Chartered Industries of Singapore in 1967. Following the public listings of ST Aerospace and ST Marine in 1990, as well as ST Electronics and ST Automotive (renamed later as ST Kinetics) in 1991, the four entities were merged and listed under ST Engineering in 1997. Temasek Holdings remains the largest shareholder of the company with a c.50% stake as at end-2016.

Singapore defence spending (SGDm) vs. % of total spending (2011-2017E) Uptrend in Singapore 16,000 13,839 14,207 13,103 29% defence spending is 14,000 12,295 11,276 11,524 11,751 27% likely to increase its 12,000 25% momentum over the 10,000 23% coming decade amid the 8,000 backdrop of increased 6,000 21% terrorism globally 4,000 19% 2,000 17% 0 15% 2011 2012 2013 2014 2015 2016 2017E Defence spending (LHS) % of total spending (RHS)

Source: CEIC, Singapore Departments of Statistics

The Singapore government remains a key customer to STE, and provides stability to the company’s earnings base during economic downturns, in our view. Singapore’s defence expenditure has grown at a c.4% CAGR over 2011-16 and accounts for around 3.4% of GDP (2016). We expect this trend to continue – according to the Ministry of Finance, Singapore’s defence budget will increase by 1.6% in FY2017 to SGD14.2bn.

Over the years, STE has also focused on expanding its business reach in the commercial sector – commercial sales accounted for 68% of overall revenue as at end-1Q17, compared to 41% in 2000. The company currently operates across several geographic locations – in Asia (62% of 1Q17 revenue), the US (22%), and Europe (10%).

In our view, one of the key strengths of STE is its diversified business with 4 distinct business segments – aerospace, electronics, land systems and marine. The Aerospace division is the largest contributor to the business, accounting for 36% of consolidated 1Q17 revenue, followed by Electronics (34%), Land systems (18%) and Marine (11%).

STE’s key competitive advantage, in our view, is the scope and depth of its service offerings – from providing MRO services (Aerospace) to the installation of rail and traffic management systems (Electronics), as well as the building of military and commercial vessels (Marine) and sale of commercial specialty vehicles (Land systems) – the company is constantly evolving and developing this scope through research and development.

Further, the various divisions do not operate in isolation but are integral in securing contracts through the offer of comprehensive engineering solutions to customers. For example, in the design and construction of Fearless-class Patrol Vessels for the Singapore Navy, both the Marine and Electronics divisions were involved, with the latter division supplying combat systems integration solutions.

Singapore Technologies Engineering (STE SP): 1 August 2017

STE: overview of operations

STE

Aerospace Electronics Land systems Marine Others (37% of consolidated (28% of consolidated (19% of consolidated (13% of consolidated (3% of consolidated revenue) revenue) revenue) revenue) revenue)

Aircraft maintenance Large-scale systems Automotive Shipbuilding - VT Miltope (rugged & modification group (81% of Kinetics revenue) (64% of Marine revenue) equipment) - ST Sy nthesis (logistics (54% of Aerospace revenue) (23% of Electronics revenue) - Defence v ehicles - Nav al and commercial management services) - Heav y maintenance, - Railw ay systems - Commercial specialty v essels with a focus on structural repair and - Traffic management v ehicles (transport buses, customisation and high- modification w ork on a wide sy stems refrigerated trucks etc.) specifiication v essels range of aircraft - e-Gov ernment/e-Enterprise - Construction v ehicles

Component/Engine Communication & Munitions & weapons Shiprepair repair & overhaul sensor systems group (14% of Kinetics revenue) (27% of Marine revenue) (27% of Aerospace revenue) (47% of Electronics revenue) - Large/Medium/Small Calibre - Repairs for a w ide spectrum - Repair and ov erhaul - Satellite broadband & w eapons and ammunition- of v essels (seismic, dredgers, serv ices for a w ide range of communications chemical tankers, FPSO, aircraft components and - Sensor and surv eillance OSVs) engines sy stems - Ship conv ersion and modification

Engineering & Software systems Services, trading & Engineering material services group others (9% of Marine revenue) (19% of Aerospace revenue) (30% of Electronics revenue) (5% of Kinetics revenue) - Env ironmental engineering - Aircraft cabin interiors - Modelling, Training - Vehicle inspection services and w aste management - Pilot training Simulation, Interactiv e Digital (STA Inspection) serv ices Media & eLearning - Tax i services (CityCab)

Source: Company, compiled by Daiwa Note: based on 2016 figures

Singapore Industrials 1 August 2017

SIA Engineering (SIE SP)

SIA Engineeri ng

Target price: SGD4.100 Share price (31 Jul): SGD3.640 | Up/downside: +12.6%

Initiation: prime beneficiary of increase in MRO demand

 Leveraging on SIA’s expansion plans Royston Tan (65) 6321 3086  Strategic partnerships with OEMs to stay relevant [email protected]  Initiating with Outperform (2) rating and target price of SGD4.10

Investment case: We initiate coverage on SIA Engineering (SIAEC) with Share price performance an Outperform (2) rating. The company looks set to be a long-term (SGD) (%) beneficiary of 3 main trends: 1) our forecast for SIA’s fleet to grow by c.50% 4.3 110 over the coming decade, which will provide a base load of fleet 4.0 103 maintenance work for SIAEC, 2) an expanding network of partnerships with 3.8 95 3.5 88 established OEMs, and 3) leveraging on the opening of Terminal 4 in 2H17 3.3 80 to grow its line-maintenance division. We also see the possibility of a Aug-16 Nov-16 Feb-17 May-17 consolidation with STE’s (STE SP, SGD3.77, Buy [1]) aerospace division. SIA (LHS) Relative to FSSTI (RHS)

Catalysts: SIA and JVs to boost maintenance, repair and operations 12-month range 3.350-4.210 (MRO) demand. Given that SIA Group accounts for c.60-70% of SIAEC’s Market cap (USDbn) 3.00 consolidated revenue, the 50% forecast growth in SIA’s fleet over the 3m avg daily turnover (USDm) 1.17 coming decade should bode well for SIAEC’s MRO workload in the future. Shares outstanding (m) 1,120 Major shareholder Singapore Airlines Limited (77.7%)

SIAEC has also been a beneficiary of SIA’s aggressive fleet renewal Financial summary (SGD) process, with the former securing partnerships with Boeing for fleet Year to 31 Mar 18E 19E 20E management services as well as Airbus for airframe maintenance contracts Revenue (m) 1,190 1,304 1,370 in the Asia Pacific region. The recent JV with GE Aviation to provide a full Operating profit (m) 96 121 134 Net profit (m) 174 205 227 range of engine MRO services for the GE90 and GE9x will also contribute Core EPS (fully-diluted) 0.155 0.183 0.202 to JVs/associates growing by 20% over the next 3 years, on our forecast. EPS change (%) 15.0 17.9 10.4 These collaborations with OEM heavyweights are a recent phenomenon Daiwa vs Cons. EPS (%) (0.8) 10.0 16.5 and their financial contributions may not yet be evident, in our view. PER (x) 23.5 19.9 18.1 Dividend yield (%) 3.8 4.4 4.9 DPS 0.140 0.160 0.180 Turnaround in repair and overhaul division. We believe that this division PBR (x) 2.6 2.6 2.5 could spring a positive surprise and turn profitable in the coming 1-2 years EV/EBITDA (x) 20.9 17.6 16.1 ROE (%) 11.1 12.9 14.1 on the back of increased heavy-maintenance check volume. The Source: FactSet, Daiwa forecasts acceleration in delivered aircraft from 2012 onwards could trigger stronger demand for SIAEC’s heavy checks from FY18 and beyond where we forecast a mid-teens percentage increase in “C” and “D” checks each year.

Merger with STE’s aerospace division. We have highlighted in our sector report the possibility of a merger with STE’s aerospace division that would realise cost synergies for both entities and stem the current pressure on operating margins.

Valuation: We derive a 12-month DCF-based TP of SGD4.10, which implies a 1-year forward PER multiple of 26.5x. This valuation is supported by an FY17-20E earnings CAGR of 14.8% and forecast yield of 3.8% in FY18. We believe that SIAEC can continue to trade at a valuation premium amid a low interest rate environment and a more-than-even chance of integrating with STE’s aerospace division.

Risks: Slower-than-expected demand for heavy maintenance checks.

See important disclosures, including any required research certifications, beginning on page 65

SIA Engineering (SIE SP): 1 August 2017

How do we justify our view? Growth outlook Valuation Earnings revisions

Growth outlook SIAEC: adjusted profit trend (SGD m)

We see SIAEC generating an earnings CAGR of 14.8% 280 over FY17-20E, bolstered by a turnaround in its repair and 260 overhaul division due to greater volume of heavy 240 maintenance work. Strategic collaborations with 220 heavyweight OEMs such as Boeing, Airbus and GE in 200 recent years could take shape and drive associate/JV 180 contributions by c.20% over FY18-20E on our forecasts. 160 Last but not least, SIAEC’s current key earnings contributor, its line maintenance division should be a key 140 beneficiary of greater air traffic growth in the Asia-Pacific 120 region where demand for air travel is forecast to be among 100 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E the most robust in the world over the coming decade. Source: Company, Daiwa forecasts

Valuation SIAEC: 12-month forward PER (x)

SIAEC is trading at 24x FY18E PER which is close to 2SD 27 above its 2-year historical forward PER multiple of 21x. 25 This valuation rerating is likely a combination of strong demand for high-paying dividend stocks amid a 23 compressed yield environment as well as expectations for 21 a potential divestment action by its parent, SIA that could 19 trigger an acquisition premium, in our view. Our fair value of SGD4.10, based on DCF-methodology using a WACC of 17

7.3% and long-term growth rate of 1%, implies a forward

2/10/2017 6/10/2016 7/10/2016 8/10/2016 9/10/2016 1/10/2017 3/10/2017 4/10/2017 5/10/2017 6/10/2017

PER multiple of 26.5x, a 9% discount over its MRO peer 5/10/2016

10/10/2016 11/10/2016 12/10/2016 average multiple of 29x. Forward PER +1SD -1SD Average

Source: Bloomberg, Daiwa forecasts

Earnings revisions SIAEC: Bloomberg EPS consensus revisions According to data from Bloomberg, consensus earnings 4.40 0.22 revisions for SIAEC have been on a downtrend for the past 4.20 0.21 2 years and the strong share price performance since the 4.00 0.2 0.19 beginning of 2017 has not been driven by strong 3.80 0.18 3.60 expectations of EPS improvement for FY18-19, but instead 0.17 by the possibility of corporate action, in our view. We 3.40 0.16 expect SIAEC’s FY18 adjusted earnings to register a 15% 3.20 0.15

increment over the previous year. 3.00 0.14

12/05/2015 12/07/2015 12/09/2015 12/11/2015 12/01/2016 12/03/2016 12/05/2016 12/07/2016 12/09/2016 12/11/2016 12/01/2017 12/03/2017 12/05/2017 12/07/2017 Price FY2018 EPS FY2019 EPS

Source: Bloomberg

SIA Engineering (SIE SP): 1 August 2017

Financial summary Key assumptions Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Airframe maintenance and overhaul n.a. 5.0 (15.3) (8.0) (1.6) 12.2 16.3 5.4 revenue growth (%) Fleet management program rev growth n.a. (5.2) 14.3 7.2 (26.9) 4.0 4.0 4.0 (%) Line maintenance rev growth (%) n.a. 3.1 1.7 4.0 11.5 5.0 5.0 5.0 Operating margin (%) n.a. 9.8 7.5 9.4 6.5 8.1 9.2 9.8

Profit and loss (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Airframe maintenance and component 552 579 490 451 444 498 579 610 overhaul services Fleet management program 174 165 188 202 147 153 160 166 Other Revenue 421 435 442 460 513 539 566 594 Total Revenue 1,147 1,178 1,121 1,113 1,104 1,190 1,304 1,370 Other income 0 0 0 0 0 0 0 0 COGS (214) (223) (177) (189) (188) (214) (249) (262) SG&A (683) (705) (708) (674) (701) (742) (782) (819) Other op.expenses (121) (135) (152) (146) (144) (138) (152) (154) Operating profit 128 116 84 104 72 96 121 134 Net-interest inc./(exp.) 1 1 1 2 3 3 3 3 Assoc/forex/extraord./others n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Pre-tax profit 306 294 205 202 355 198 233 257 Tax (32) (23) (20) (21) (18) (20) (23) (26) Min. int./pref. div./others (4) (5) (2) (5) (5) (5) (5) (5) Net profit (reported) 270 266 183 177 332 174 205 227 Net profit (adjusted) 270 266 183 177 151 174 205 227 EPS (reported)(SGD) 0.243 0.237 0.163 0.157 0.296 0.155 0.183 0.202 EPS (adjusted)(SGD) 0.243 0.237 0.163 0.157 0.135 0.155 0.183 0.202 EPS (adjusted fully-diluted)(SGD) 0.243 0.237 0.163 0.157 0.135 0.155 0.183 0.202 DPS (SGD) 0.000 0.000 0.000 0.140 0.180 0.140 0.160 0.180 EBIT 128 116 84 104 72 96 121 134 EBITDA 163 153 127 148 125 142 167 181

Cash flow (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 306 294 205 202 355 198 233 257 Depreciation and amortisation 35 37 43 44 53 46 46 47 Tax paid (27) (24) (23) (19) (20) (20) (23) (26) Change in working capital 16 (36) (19) (24) 19 14 11 2 Other operational CF items (196) (159) (109) (126) (275) (103) (113) (123) Cash flow from operations 134 113 96 77 132 136 154 158 Capex (32) (68) (49) (41) (38) (45) (47) (50) Net (acquisitions)/disposals 138 157 112 79 62 88 96 106 Other investing CF items 5 12 15 (16) 200 (5) (5) (5) Cash flow from investing 110 101 78 22 224 38 44 51 Change in debt 3 16 9 1 (9) 0 0 0 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (245) (248) (273) (167) (141) (157) (187) (207) Other financing CF items 23 30 14 (1) (1) (1) (1) (1) Cash flow from financing (219) (202) (251) (168) (150) (158) (187) (208) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 25 13 (77) (69) 205 16 11 2 Free cash flow 102 45 47 36 94 91 107 108 Source: FactSet, Daiwa forecasts

SIA Engineering (SIE SP): 1 August 2017

Financial summary continued … Balance sheet (SGDm) As at 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 523 536 464 394 602 618 629 630 Inventory 108 107 125 155 148 164 191 201 Accounts receivable 87 117 96 91 102 103 111 116 Other current assets 119 106 89 286 128 130 132 134 Total current assets 837 865 773 926 979 1,014 1,063 1,081 Fixed assets 305 337 344 341 332 333 337 343 Goodwill & intangibles 49 54 62 63 65 67 69 71 Other non-current assets 442 450 478 491 542 555 568 583 Total assets 1,633 1,707 1,657 1,822 1,918 1,970 2,038 2,078 Short-term debt 6 8 9 9 4 4 4 4 Accounts payable 246 242 227 228 250 281 327 345 Other current liabilities 26 26 20 20 25 25 25 25 Total current liabilities 278 276 256 256 279 310 356 374 Long-term debt 0 14 24 24 22 22 22 22 Other non-current liabilities 25 27 27 30 29 29 29 29 Total liabilities 304 317 307 310 330 361 407 425 Share capital 348 387 411 417 420 420 420 420 Reserves/R.E./others 954 974 914 1,069 1,134 1,155 1,177 1,201 Shareholders' equity 1,302 1,361 1,325 1,486 1,554 1,575 1,597 1,621 Minority interests 27 30 25 26 34 33 33 32 Total equity & liabilities 1,633 1,707 1,657 1,822 1,918 1,970 2,038 2,078 EV 3,160 3,156 3,207 3,251 2,993 2,963 2,938 2,922 Net debt/(cash) (517) (514) (431) (361) (576) (592) (603) (604) BVPS (SGD) 1.171 1.214 1.178 1.320 1.383 1.401 1.421 1.442

Key ratios (%) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) n.a. 2.7 (4.9) (0.7) (0.8) 7.7 9.6 5.0 EBITDA (YoY) n.a. (6.4) (16.9) 16.9 (15.8) 13.8 17.6 8.6 Operating profit (YoY) n.a. (9.8) (27.3) 24.3 (31.0) 33.1 25.7 11.4 Net profit (YoY) n.a. (1.6) (31.0) (3.6) (14.3) 15.0 17.9 10.4 Core EPS (fully-diluted) (YoY) n.a. (2.5) (31.2) (3.7) (14.2) 15.0 17.9 10.4 Gross-profit margin 81.3 81.1 84.2 83.0 83.0 82.0 80.9 80.9 EBITDA margin 14.2 13.0 11.3 13.3 11.3 11.9 12.8 13.2 Operating-profit margin 11.2 9.8 7.5 9.4 6.5 8.1 9.2 9.8 Net profit margin 23.6 22.5 16.4 15.9 13.7 14.6 15.7 16.5 ROAE n.a. 20.0 13.6 12.6 10.0 11.1 12.9 14.1 ROAA n.a. 15.9 10.9 10.2 8.1 9.0 10.2 11.0 ROCE n.a. 8.4 6.0 7.1 4.6 5.9 7.3 8.1 ROIC n.a. 12.6 8.4 9.0 6.3 8.5 10.6 11.6 Net debt to equity net cash n.a. n.a. n.a. n.a. n.a. n.a. n.a. Effective tax rate 10.4 7.8 9.8 10.3 5.0 10.0 10.0 10.0 Accounts receivable (days) n.a. 31.5 34.5 30.6 31.9 31.4 29.9 30.3 Current ratio (x) 3.0 3.1 3.0 3.6 3.5 3.3 3.0 2.9 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 0.0 0.0 0.0 89.2 60.9 90.4 87.6 89.3 Free cash flow yield 2.5 1.1 1.1 0.9 2.3 2.2 2.6 2.7 Source: FactSet, Daiwa forecasts

Company profile

SIA Engineering is engaged in the provision of airframe maintenance and component overhaul services, line maintenance and technical ground handling services, fleet management programmes and investment holdings.

SIA Engineering (SIE SP): 1 August 2017

SIA Engineering

We initiate coverage on SIA Engineering (SIAEC) with an Outperform (2) rating and 12- month target price of SGD4.10. We view SIAEC as a key long-term beneficiary of 3 main trends: 1) SIA’s aggressive fleet expansion plan that could see the airline increase its fleet size by c.50% over the coming decade, which would provide a growing base load of fleet maintenance work for SIAEC due to the company’s affiliation with SIA, 2) an expanding network of partnerships with OEMs that will benefit SIAEC with more aircraft being delivered over the coming 1-2 decades, and 3) leveraging on the Terminal 4 expansion in 2H17 to grow its line maintenance division in Singapore.

Beneficiary of SIA’s fleet growth

SIA Group fleet size (as of May 2017) SIA’s fleet of aircraft is SIA one of the youngest Aircraft In Service Orders Notes Airbus A330-300 24 0 All to be replaced by Airbus A350 from 2017-19 among global airlines; Airbus A350-900 14 53 Replacing Airbus A330-300, Boeing 777-200 and 777-200ER this strategy, while Airbus A380-800 19 5 One to be retired in 2017, 5 to be delivered in 2018-19 capex intensive, is Boeing 777-200 11 0 Replaced by Airbus A350-900 Boeing 777-200ER 12 0 Replaced by Airbus A350-900 required to maintain its Boeing 777-300 5 0 premium brand image, Boeing 777-300ER 27 0 Refitted with new cabin products in our view Boeing 787-10 0 30 Launch customer. Estimated delivery in 2018-19 Total 112 88

Silk Air Aircraft In Service Orders Notes Airbus A319-100 3 0 Replacement aircraft: Boeing 737-800 and Boeing 737 MAX 8 Airbus A320-200 10 0 Boeing 737-800 17 6 Deliveries until 2017 Boeing 737 MAX 8 0 31 Total 30 37

Scoot Aircraft In Service Orders Notes Boeing 787-8 4 3 Boeing 787-9 2 4 Total 6 7

Tigerair Aircraft In Service Orders Notes Airbus A319-100 2 0 Airbus A320-200 21 0 Airbus A320neo 0 37 Estimated first delivery in 2018 Boeing 787-8 4 0 Operated for Scoot Boeing 787-9 4 0 Operated for Scoot Total 31 37

Group Total 179 169

Source: CAAS Note: Does not include USD13.8bn worth of orders for 20 777-9s and 19 787-10s Boeing planes

Based on our estimates, SIA Group’s fleet could increase by approximately 50% over the coming decade. The group’s fleet stood at 179 planes as of May 2017 with an order backlog of 169 aircraft to be progressively delivered over the coming decade. This backlog excludes a letter of intent (LOI) signed with Boeing for an additional 39 aircraft (20 777-9s and 19 787-10s) worth c.USD13.8bn announced in early February 2017. Based on our estimates, taking into consideration replacement aircraft, SIA’s fleet size should grow by at least 50% over the coming decade, in line with its historical 10-year fleet growth rate of 4% per annum.

Given that SIA currently accounts for c.60-70% of SIAEC’s total revenue, the growth in SIA’s fleet size should bode well for SIAEC’s MRO workload in the years ahead. In the short-term, SIAEC may be a minor beneficiary of additional MRO work for the de-leasing of certain aircraft models such as the 24 on-lease A330s (leased by SIA from Airbus as

SIA Engineering (SIE SP): 1 August 2017

temporary capacity before the A350s are delivered). However, according to SIA’s management, this de-leasing MRO work is usually done with SIA’s OEM partner, in this case, Airbus rather than through SIAEC. Nonetheless, we see SIAEC as a strong contender for the increasing MRO work required by SIA over the coming decade.

Partnerships with OEMs We believe the financial SIAEC has many years of JV experience, mostly with engine and component parts makers impact from the such as Rolls Royce, Pratt & Whitney and Safran, to name a few. Recent JVs with collaboration with airframers such as Boeing and Airbus are a relatively new phenomenon, a sign that airframers has yet to be airframers are now seeking a greater role in aftermarket service by collaborating with felt and could be evident independent MROs. Due to the company’s affiliation with parent SIA, which has placed in the coming 2-3 years large orders with both Boeing and Airbus for new-generation aircraft, SIAEC has been able upon achieving business to participate in various JVs with Boeing for fleet management services for B737, 747, 777 stability and 787 aircraft as well as a recent JV announced in February 2016 with Airbus for airframe maintenance and cabin upgrade and modification services for the A380, A350 and A330 aircraft to airlines in Asia Pacific and beyond.

SIAEC: subsidiaries and JV partners S/N Company Partner/s Location Engine 1 Asian Compressor Technology Services Pratt & Whitney (51%), China Airlines (24.5%), SIAEC (24.5%) Taiwan 2 Asian Surface Technologies SIAEC (29%), PAS Technologies (51%), United Technologies International Corporation (20%) Singapore 3 Component Aerospace Singapore SIAEC (46.425%), Pratt & Whitney (53.575%) Singapore 4 Eagle Services ASIA SIAEC (49%), Pratt & Whitney (51%) Singapore 5 Singapore Aero Engine Services SIAEC (50%), Rolls-Royce (50%) Singapore 6 Turbine Coating Services SIAEC (24.5%), Pratt & Whitney (51%), ST Aerospace (24.5%) Singapore 7 SIAEC and GE* SIAEC (49%), GE (51%) Singapore Components 8 Aerospace Component Engineering Services SIAEC (51%), Parker Hannifin Corporation (49%) Singapore 9 Fuel Accessory Service Technologies SIAEC (49%), United Technologies International Corporation (51%) Singapore 10 Goodrich Aerostructure Service Center- Asia SIAEC (40%), UTAS Aerostructure Group (60%) Singapore 11 JAMCO Aero Design & Engineering SIAEC (45%), JAMCO America (5%), JAMCO Corporation (50%) Singapore 12 JAMCO Singapore SIAEC (20%), JAMCO Corporation (75%), Itochu Singapore (5%) Singapore 13 Panasonic Avionics Services Singapore SIAEC (42.5%), Panasonics Avionics Corporation (57.5%) Singapore 14 Safran Electronics & Defence Services Asia SIAEC (40%), Safran Electronics & Defence (60%) Singapore 15 SIAEC and Moog SIAEC (49%), Moog (51%) Singapore 16 Safran Landing Systems Services Singapore SIAEC (40%), Messier Services (60%) Singapore Fleet management 17 Boeing Asia Pacific Aviation Services SIAEC (49%), Boeing Singapore (51%) Singapore Line maintenance 18 Aircraft Maintenance Services Australia SIAEC (100%) Australia 19 Aviation Partnership SIAEC (51%), Cebu (49%) Philippines 20 Pan Asia Pacific Aviation Services SIAEC (47.06%), Malaysian Airline System (23.53%), PT Garuda Indonesia (17.65%), Royal Brunei Airlines (11.76%) China 21 PT Jas Aero-Engineering Services SIAEC (49%), P.T. Cardig Aero Services (51%) Indonesia 22 SIA Engineering (USA) SIAEC (100%) USA 23 Singapore JAMCO Services SIAEC (80%), JAMCO Corporation (20%) Singapore 24 Southern Airports Aircraft Maintenance Services SIAEC (49%), Airports Corporation of Vietnam (51%) Vietnam 25 SIA Engineering (Japan) SIAEC (100%) Japan Airframe maintenance 26 SIA Engineering (Philippines) Corporation SIAEC (65%), Cebu Air (35%) Philippines 27 Heavy Maintenance Singapore Services SIAEC (65%), Airbus Services Asia pacific (35%) Singapore Source: Company Note: * Formation of JV subject to finalisation of definitive agreements and receipt of required regulatory approvals

JV with GE to complete engine MRO dominance SIAEC announced on 20 June 2017 that the company will establish a new engine overhaul joint venture with GE Aviation (GE) based in Singapore. This is SIAEC’s first major collaboration with GE and is made possible as a result of SIA’s LOI for 39 Boeing widebody aircraft. The JV will provide a full range of engine maintenance, repair and overhaul services for GE90 and GE9X engines. The GE90 engine exclusively powers the Boeing 777-300ER and 777-200LR and the GE9X is the sole engine selected for the Boeing 777X aircraft.

SIAEC has been appointed by Safran as CFM’s (a JV between GE Aviation and Safran) authorised on-site support service provider for the LEAP-1A and LEAP-1B engines in Asia Pacific. The LEAP-1A is one of two engine options for the Airbus A320neo, the other option

SIA Engineering (SIE SP): 1 August 2017

being the Pratt & Whitney Geared Turbofan (GTF) engine, where SIAEC’s 49%-owned associate Eagle Services Asia (ESA) was also recently selected as a MRO facility for this engine type in Singapore, while the LEAP-1B is the exclusive power plant for the Boeing 737 MAX.

The top 4 aircraft that require the greatest amount of MRO work (according to Boeing and Airbus) are the: 1) A320CEO/NEO, 2) 737NG/MAX, 3) 787 and 4) 777 plane models. With these JVs in place, SIAEC now has the ability to service all 4 aircraft models and their engines:

1) A320neo: LEAP-1A and GTF engines 2) Boeing 737 MAX: LEAP-1B engine 3) Boeing 787: Rolls Royce Trent 1000 engine 4) Boeing 777: GE90 and GE9X engine

Top 4 most used aircraft model growth Growth in new 12,000 generation single aisle 10,000 aircraft will be evident over the coming decade 8,000 6,000

4,000

2,000

0 Current 2026 A320neo Boeing 737 MAX Boeing 787 Boeing 777

Source: Boeing, Airbus

According to data from Boeing and Airbus, the number of A320neo, Boeing 737 MAX, 787 and 777 will increase by almost 5-fold from current levels over the coming decade based on existing orders placed. This will likely drive demand for various MRO services for these aircraft models, particularly for engine MRO maintenance, which is likely to be the key MRO service driver over the coming decade, as we have previously highlighted in the sector portion of this report. In our view, SIAEC will be a key beneficiary of this macro growth trend over the long term due to its full suite of engine JVs with respective OEMs. However, the transition to newer generation engines is unlikely to be the key earnings driver for SIAEC over the short term.

Still dependent on line maintenance to drive profitability in the short term While SIAEC looks to be securing future growth in its engine MRO business through various JVs with OEMs, short-term profitability will continue to be spearheaded by its line maintenance segment, in our view. SIAEC is the dominant line maintenance service provider at Changi Airport where it has a c.70% market share. This segment generates an operating margin of 18% based on its latest FY17 results vs. the repair and overhaul segment which incurred an operating loss of SGD22m.

SIA Engineering (SIE SP): 1 August 2017

SIAEC: line maintenance revenue and profitability (SGDm) SIAEC: repair & overhaul revenue and profitability (SGDm) 600 900 800 500 700 600 400 500 300 400 300 200 200 100 100 0 0 (100) 2011 2012 2013 2014 2015 2016 2017 2011 2012 2013 2014 2015 2016 2017 Revenue Operating profit Share of profits of associates and JV Revenue Operating profit Share of profits of associates and JV

Source: Company Source: Company

With the opening of Terminal 4 in 2H17, and Terminal 5 and the 3rd runway sometime in the next decade, we expect the number of flights at Changi Airport to increase steadily over the coming 1-2 decades, bolstered by strong air travel demand in the region, a macro trend we have highlighted previously.

Commercial aircraft movement at Changi (‘000s) We expect Changi Airport 400 360.5 10.0% 343.8 341.4 346.3 350 324.7 to see record traffic in 301.7 8.0% 2017 driven by the 300 6.0% opening of Terminal 4 250 200 4.0% 150 121.1 2.0% 100 0.0% 50 0 -2.0% 2011 2012 2013 2014 2015 2016 Jan-Apr 2017 No of aircraft YoY growth

Source: CAG

SIAEC also provides line maintenance services at airports across the region, including Australia, Hong Kong, Indonesia, Japan, the Philippines, Vietnam and the US through its JVs in these countries. We believe that SIAEC’s line maintenance strategy entails forming more JVs with partners around the world, especially in high air traffic growth areas such as China, India and Korea.

SIA Engineering (SIE SP): 1 August 2017

Financial analysis and valuations

SIAEC’s financial performance has been disappointing of late, with operating profit declining from SGD128m in FY13 to SGD72m in FY17. The weak results were a combination of declining revenue and operating margins. The company operates 2 divisions: 1) repair and overhaul, and 2) line maintenance. Looking ahead, we expect both divisions to generate revenue growth, with a turnaround coming from the repair and overhaul division while the line maintenance division continues on a steady growth trajectory. Our FY19-20E EPS are 10-17% above those of the consensus, due to our more bullish outlook for its repair and overhaul division.

SIAEC vs. STE vs. FSSTI index 1-year price performance SIAEC’s share price has 30% 25% declined by c.13.5% from 20% its high of SGD4.21 since 15% going ex-dividend, and 10% post its dismal 1Q FY18 5% 0% results (5%) (10%)

(15%)

28/06/2016 10/07/2016 22/07/2016 03/08/2016 15/08/2016 27/08/2016 08/09/2016 20/09/2016 02/10/2016 14/10/2016 26/10/2016 07/11/2016 19/11/2016 01/12/2016 13/12/2016 25/12/2016 06/01/2017 18/01/2017 30/01/2017 11/02/2017 23/02/2017 07/03/2017 19/03/2017 31/03/2017 12/04/2017 24/04/2017 06/05/2017 18/05/2017 30/05/2017 11/06/2017 23/06/2017 05/07/2017 17/07/2017 29/07/2017 STE SIAEC FSSTI

Source: Bloomberg

The stock has rallied by c.8% YTD and is trading at 24x FY18E PER, a 14% premium to its 2-year historical average forward PER ratio of 21x, but still a 17% discount to peers’ mean 1-year forward PER ratio of 29x. We look to provide an explanation pertaining to the stock’s share price performance of late in our valuation segment. Our DCF-based valuation suggests a fair value of SGD4.10, a 13% upside from its current share price. Hence, we initiate on SIAEC with an Outperform (2) rating.

Revenue growth from acceleration in higher valued maintenance checks Repair and overhaul Repair and overhaul The repair and overhaul division consists of: 1) airframe maintenance and component division has been loss overhaul services, and 2) a fleet management programme. The division’s revenue has making for the past 2-3 declined over the past 4 years due to a lower quantity of high-valued maintenance “D” years, partly due to a checks being carried out for airlines, based on our observations. Compared to the more lower volume of “C” and frequent “A” checks which require only approximately 60 man-hours, a complete aircraft “D” checks overhaul on a “D” check basis can entail up to 50,000 man-hours and require a couple of months to complete. Each of these detailed maintenance checks can generate millions in maintenance revenue for the company.

As can be seen from the below chart, SIAEC’s total “D” check projects declined drastically from 60+ per year in FY13/14 to the mid-teens in each year from FY15 onwards. This could be a combination of: 1) airlines deferring heavy maintenance checks, 2) loss of market share to peers and 3) a longer maintenance cycle, with newer generation aircraft now requiring less heavy maintenance checks during their product lifecycle.

SIA Engineering (SIE SP): 1 August 2017

SIAEC: repair and overhaul division operating performance SIAEC: number of maintenance checks carried out 1,000 6.0% FY13 FY14 FY15 FY16 FY17 FY18E FY19E FY20E A checks 435 414 385 397 427 450 475 500 800 4.0% B checks 0 0 0 0 0 0 0 0 600 2.0% C checks 99 117 86 99 110 120 125 130 D checks 61 69 17 16 14 15 20 25

400 0.0%

200 -2.0%

0 -4.0%

(200) -6.0% FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E Revenue (SGD m) Operating profit (SGD m) Operating margins (RHS) Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts Note: Inclusive of Clark base hangars

However, the acceleration in aircraft deliveries, based on data from Airbus and Boeing from 2012 onwards, could spell higher demand for heavy maintenance checks (generally scheduled every 6 years after operation) for SIAEC from FY18/19 onwards, notwithstanding a further loss in market share by the company. Deliveries by the two major aircraft OEMs have averaged at approximately 900-1000 units per annum over 2007-11. From 2012 onwards, deliveries have increased on average by 100 units per year, peaking at 1,436 units in 2016. The acceleration in delivered units should bode well for future MRO demand on a medium-term horizon, in our view.

Airbus and Boeing fleet deliveries

We see both Boeing and 1,600 Acceleration phase Airbus deliveries 1,400 Stable phase increasing over the 1,200 coming years, based on 1,000 their strong order 800 backlog that stretches 600 for the next c.10 years 400 200 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Boeing Fleet delivery Airbus fleet deliveries

Source: Boeing, Airbus

Our assumption calls for an acceleration in both “C” and “D” checks from FY18 to FY19 with the more frequent “A” checks increasing in line with overall global fleet growth in the region at c.5-6%/annum.

Line maintenance The line maintenance Line maintenance generally refers to minor, unscheduled/scheduled maintenance carried division will likely grow out on aircraft which usually occurs at or near the gate or terminal, launch area, ready at a steady low-mid area, hardstand or alert area. Routine in-service inspections and day-to-day check actions single digit growth rate in accordance with pre-determined schedules form a significant part of line maintenance over the coming 2-3 activity. years, on our forecast The division has been the major earnings contributor to SIAEC, with revenue growing steadily from SGD421m in FY13 to SGD513m in FY17. SIAEC has had various JVs with different partners to provide line maintenance services in different parts of the world such as Australia, Hong Kong, Indonesia, Japan, China, Vietnam, the US and the Philippines. While Singapore is likely to remain the dominant geographical revenue contributor for this division due to its affiliation with SIA and the subsequent opening of Terminal 4 at Changi in 2H17, we believe the company is likely to source partnerships in high growth markets such as India and Korea.

SIA Engineering (SIE SP): 1 August 2017

SIAEC: line maintenance division operating performance Top 10 Airports by aircraft movements 700 25.0% Rank Airport Total Movements YoY Change (%) 600 1 Hartsfield-Jackson Atlanta International Airport 882,497 1.60% 23.0% 2 O'Hare International Airport 875,136 -0.80% 500 3 Dallas/Fort Worth International Airport 681,244 0.20% 400 21.0% 4 Los Angeles International Airport 655,564 3.00% 5 Beijing Capital International Airport 590,169 1.40% 300 19.0% 6 Denver International Airport 541,213 -4.30% 7 Charlotte Douglas International Airport 540,944 -0.80% 200 17.0% 8 McCarran International Airport 522,399 0.30% 100 9 George Bush Intercontinental Airport 502,844 -1.20% 10 Charles de Gaulle Airport 475,776 0.90% 0 15.0% FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E Revenue (SGD m) Operating profit (SGD m) Operating margins (RHS) Source: Company, Daiwa forecasts Source: Airports Council International

Given our positive outlook on air travel demand with a corresponding increase in aircraft handled at various airports around the world, the division should continue to perform well over the coming years, in our view.

Key operating expenses to trend in line with top line SIAEC’s top-3 operating expense items are: 1) staff costs, 2) material costs and 3) subcontracting costs. Staff costs saw a major increase in FY17 due predominantly to higher remuneration to staff after the gain on sale of HAESL. We expect a comparable staff expense figure in FY18E vs. FY17 despite FY18E revenue increasing by 8% YoY on our forecast.

SIAEC: operating cost breakdown (FY13) SIAEC: operating cost breakdown (FY17)

Subcontracting Others Subcontracting Others costs 9% costs 9% 13% 13% Company Company Staff costs Staff costs accommodation accommodation 5% 49% 5% 50% Amortisation of Amortisation of Material costs intangibles intangibles Material costs 21% 0% 0% 18% Depreciation Depreciation 3% 5%

Source: Company Source: Company

We expect both material costs and subcontracting costs to trend in line with the increase in airframe maintenance and component overhaul services, as well as line maintenance work.

Operating margins to moderate at c.10% by FY20 SIAEC’s operating While FY17 operating margin was negatively impacted by higher-than-normal staff costs margins of 6.6% in 1Q resulting in Group operating margins of 6.5%, we expect operating margins to show FY18 remained gradual improvement to c.10% by FY20. We expect the repair and overhaul division to disappointing due to achieve marginal operating losses in FY18 (-1% OPM) on a higher revenue base and high staff costs generate marginal profitability from FY19-20 (operating margins of 1-2%). We believe that SIAEC will benefit from a greater number of higher valued maintenance checks over the coming 2-3 years, partially offset by increased competition in the engine MRO segment as well as the gradual loss of the PW4000 engine business (one of four engine models that powers the Boeing 747 family of aircraft).

SIA Engineering (SIE SP): 1 August 2017

SIAEC: divisional operational margins (%) SIAEC: divisional operating profit (SGDm) vs. Group operating margin (%) 140 12.0% 25% 22.2% 23.4% 120 20% 21.0% 20.0% 20.0% 10.0% 19.1% 18.4% 19.0% 100 15% 80 8.0% 10% 60 6.0% 40 5% 5.5% 4.4% 20 4.0% 1.0% 2.0% 0% -0.5% -2.1% -1.0% 0 -3.8% 2.0% (5%) (20) (10%) (40) 0.0% FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E Line maintenance repair and overhaul Line maintenance Repair and overhaul Operating margin (RHS) Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

The line maintenance division should witness a moderate improvement in margin from 18.4% in FY17 to 20%, on our forecast for FY18-20.

JVs and associates to grow on engine/component MRO demand We believe that SIAEC’s SIAEC’s JVs and associates mainly operate within the engine and component MRO engine MRO JVs are categories. With engines getting bigger and more sophisticated, the MRO spend per visit critical in growing the should generally be higher than older engine models. SIAEC has formed critical Group’s bottom line. partnerships/JVs with engine and component OEMs over the years that will help the company participate in MRO growth in these 2 segments.

The slow phase out of the 4-engine Boeing 747 could see lower engine MRO opportunities for SIAEC, particularly on the Pratt & Whitney PW4000 engines (one of four engine models that powers the Boeing 747 family of aircraft), where SIAEC’s 49% owned associate Eagle Services Asia (ESA) primary business is in the repair and overhaul of PW4000 engines.

However, we are confident that SIAEC’s established partnerships with various engine MROs will help mitigate earnings weakness due to the subsequent phase out of the Boeing 747. In our view, a crucial partnership would be with Safran, announced in April 2016 that recognises SIAEC as on-site support provider for the CFM LEAP-1A and -1B engines in the Asia-Pacific region. Both of these CFM engine models are the next generation engines that will power the top-selling A320neo and Boeing 737 MAX aircraft models. While the MRO potential is yet to be evident, given that the A320neo was introduced only in December 2010 and only has 116 units in operation as of May 2017, the potential for substantial engine MRO work is significant over the coming decade with 5,035 firm orders as of May 2017. Similarly, although Boeing has only delivered 2 Boeing 737 MAX aircraft thus far, we believe there is strong future engine MRO potential (LEAP-1B) with 3,699 firm orders as of May 2017.

SIAEC: JV and associate contributions (SGDm)

We expect JV/associate 4,500 4.50% margins to bottom in 4,000 FY18 and increase 3,500 4.00% gradually to 3% by FY20E 3,000 3.50% 2,500 2,000 3.00% 1,500 1,000 2.50% 500 0 2.00% FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E JV and associate Revenue JV and associate profits Net margins (%) - RHS

Source: Company, Daiwa forecasts

SIA Engineering (SIE SP): 1 August 2017

We expect SIAEC’s JV/associate contributions to be relatively flat at SGD100m in FY18E vs. SGD96.4m in FY17, accelerating by c.9-10% over FY19-20E with marginal improvement in net margin in FY19-20E after bottoming out in FY2018.

Net profit CAGR of 14.8% over FY17-20E

SIAEC: divisional operating profit and JV/associate net SIAEC: adjusted profit trend (SGDm) contributions (SGDm) 350 280 300 260 250 240 200 220 150 200 100 180 50 160 0 140 (50) 120 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E 100 Repair and overhaul Line maintenance JV and associates FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2020E Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts

A key risk to forward Based on the above financial assumptions, we expect SIAEC’s to register a net profit earnings missing our CAGR of 14.8% over FY17-20E, driven mainly by an improvement in business prospects estimate lies in the for its repair and overhaul division. While concerns continue to linger over structural inability of the Group to challenges within the MRO industry due to the introduction of new generation aircraft that manage operating require less maintenance man-hours per aircraft, we believe that the strong increase in expenses and improve global aircraft fleet over the coming decade will help partially mitigate the decline in MRO its margins spending per aircraft. MRO companies with sufficient capacity will likely be a key beneficiary of this new MRO trend of greater volume but lower unit spend on airframe maintenance. Locally, SIAEC has a total of 6 hangars with 9 aircraft bays which comprise a total of 56,000 square metres. It has further access to 3 hangars in Philippines through SIA Engineering (Philippines) Corporation. Given that the company used to service a larger number of maintenance checks with longer duration in the past, SIAEC will likely have sufficient hangar capacity to deal with the larger volume of maintenance work in the coming decade, without having to spend significantly on facility capex, in our view.

We have also highlighted that due to the increasing sophistication of various aircraft components and engines, the unit spend for MRO maintenance on these engines and spare part components will likely be more expensive than the older models.

Valuations The recent weakness in Given the weak earnings profile of SIAEC over the past 3 years coupled with the street’s share price due to 1Q neutral to slightly bearish consensus call on the stock, SIAEC’s share price performance FY18 earnings has likely outperformed expectations since the start of 2017 where the stock has disappointment provides appreciated by c.26% from a low of SGD3.35 to a high of SGD4.21, before correcting to longer term investors an the current level of SGD3.64 due to weaker-than-expected 1Q FY18 results. Despite opportunity to bottom persistent earnings weakness of late, due mainly to margin pressure, we believe SIAEC fish at lower price levels still presents upside potential over the coming 12-months based on the following factors: 1) YoY earnings improvement for FY18 on our estimates, driving a consensus re-rating, 2) market preference for blue-chip dividend paying companies in the current yield- compressed environment driving down SIAEC’s cost of equity, and 3) potential corporate action which could involve a privatisation or stake divestment action by its parent company, SIA.

SIA Engineering (SIE SP): 1 August 2017

Consensus revisions have not been significant According to data from Bloomberg, consensus earnings revisions for SIAEC have been on a downtrend over the last couple of years, while the strong share price performance since the beginning of 2017 has not been driven by strong expectations of EPS/EBITDA improvement for FY18-19E. Share price has seen corrected by 14% from its peak post the 1QFY18 results.

SIAEC: Bloomberg EPS consensus revisions (SGD) SIAEC: Bloomberg EBITDA consensus revisions (SGDm) 4.40 0.22 4.40 220 4.20 0.21 4.20 200 4.00 0.2 4.00 0.19 3.80 3.80 180 0.18 3.60 3.60 0.17 160 3.40 0.16 3.40 140 3.20 0.15 3.20

3.00 0.14 3.00 120

12/05/2015 12/07/2015 12/09/2015 12/11/2015 12/01/2016 12/03/2016 12/05/2016 12/07/2016 12/09/2016 12/11/2016 12/01/2017 12/03/2017 12/05/2017 12/07/2017

12/05/2015 12/07/2015 12/09/2015 12/11/2015 12/01/2016 12/03/2016 12/05/2016 12/07/2016 12/09/2016 12/11/2016 12/01/2017 12/03/2017 12/05/2017 12/07/2017 Price FY2018 EPS FY2019 EPS Price FY2018 EBITDA FY2019 EBITDA

Source: Bloomberg Source: Bloomberg

While we do expect SIAEC’s FY18 adjusted earnings to register a 15% increment over the previous year, this is partly attributable to a low base effect, with FY17 earnings being the lowest in the last 4 years. Based on our forecast FY18 numbers, SIAEC is trading at a forward PER of 24x, close to 2SD above its 2-year historical forward PER range. The valuation rerating, in our opinion, is likely driven by the current yield-compressed environment, more so than strong expectations for earnings improvement.

SIAEC: 12-month forward PER (x) SIAEC: 12-month forward EV/EBITDA (x) 27 32 30 25 28 23 26 24 21 22 19 20 18

6/25/2017 4/25/2016 5/25/2016 6/25/2016 7/25/2016 8/25/2016 9/25/2016 1/25/2017 2/25/2017 3/25/2017 4/25/2017 5/25/2017

10/25/2016 11/25/2016 12/25/2016

6/10/2017 5/10/2016 6/10/2016 7/10/2016 8/10/2016 9/10/2016 1/10/2017 2/10/2017 3/10/2017 4/10/2017 5/10/2017

11/10/2016 12/10/2016 10/10/2016 Forward EV/EBITDA +1SD Forward PER +1SD -1SD Average -1SD Average

Source: Bloomberg, Daiwa forecasts Source: Bloomberg, Daiwa forecasts

Chase for dividend-paying blue-chip stocks Yield-plays such as Singapore REITs have outperformed the STI index in 2017 as the market continues to value high-paying yield stocks in the current depressed yield environment. The 10-year Singapore bond yield has declined by c.40-50bps since the beginning of the year, indirectly driving demand for high-yielding stocks.

SIA Engineering (SIE SP): 1 August 2017

Singapore 10-year bond yield (%) SIAEC: cost of equity (%) 12.0 3.0 11.0 2.8 10.0 2.6 9.0 2.4 8.0 2.2 2.0 7.0 1.8 6.0 1.6 5.0

1.4

9/1/2011 9/1/2012 3/1/2008 9/1/2008 3/1/2009 9/1/2009 3/1/2010 9/1/2010 3/1/2011 3/1/2012 3/1/2013 9/1/2013 3/1/2014 9/1/2014 3/1/2015 9/1/2015 3/1/2016 9/1/2016 3/1/2017 1.2 9/1/2007 7/6/2012 7/6/2013 7/6/2014 7/6/2015 7/6/2016 WACC Average

Source: Bloomberg Source: Bloomberg

Coupled with the decline in SIAEC’s cost of equity since 2H15, currently near the lower- band of 6.6%, the resulting impact is a positive valuation rerating that could possibly surprise the consensus.

Corporate action by parent company A merger between STE SIAEC’s parent company, SIA currently holds c.77% stake in the company and this has and SIAEC could drive been a limiting factor in attracting more institutional investors due to the low free float, in the latter’s share price to our view. After a weak set of 4Q FY17 results released in May 2017, SIA announced that it SGD4.50-5.00 levels, on would be undertaking a comprehensive review of the entire Group’s operations and this our estimates has led to market rumours of possible privatisation of its majority stake in SIAEC. While we see the chance of a privatisation of SIAEC by SIA as low, given the latter’s limited financial resources and possible synergies achieved through a business combination with STE, a divestment by SIA to monetise its passive stake in SIAEC could be a win-win for both parties, in our view.

The market may be anticipating major corporate action with regard to SIAEC over the coming months, which may partly explain the valuation premium (in terms of forward PER) attached to SIAEC.

Methodology We value SIAEC using a DCF model with the following input assumptions, similar for what we have used for STE: a WACC of 7.3% and long-term growth rate of 1%. According to data from Bloomberg, SIAEC’s current WACC is only 6.6%. We attribute a higher WACC figure of 7.3% for SIAEC vs. current Bloomberg value of 6.6% due to our expectations for a rising interest rate environment.

STE: DCF valuation inputs STE: sensitivity of DCF analysis (FY18-28E) Terminal assumptions WACC Target gearing 0% Base WACC 7.30% FCF Long-term FCF growth 1.0% Growth 5.8% 6.3% 6.8% 7.3% 7.8% 8.3% 8.8% 9.3% NPV - FCFF 2018-25 1,411.4 0.0% 4.60 4.28 4.00 3.76 3.55 3.36 3.20 3.05 NPV Terminal FCFF 2,654.2 0.5% 4.88 4.50 4.19 3.91 3.68 3.48 3.30 3.14 Total Enterprise Value 4,065.6 1.0% 5.22 4.78 4.41 4.10 3.84 3.61 3.41 3.24 1.5% 5.64 5.10 4.67 4.32 4.02 3.76 3.54 3.35 2.0% 6.16 5.51 4.99 4.57 4.23 3.93 3.69 3.47

Less: Net debt/(cash) (end-FY17) (575.8) Less: Minority interest (end-FY17) 34.0 Value of equity 4,607.4 No. of shares (FY17 m) 1,124.0 DCF per share value (SGD) 4.10

Source: Daiwa forecasts Source: Daiwa estimates and forecasts

Based on these assumptions, we derive a fair value of SGD4.10 for SIAEC. Given the potential upside of c.13% from the current share price, we initiate coverage with an Outperform (2) rating. If the current compression in yields were to persist, we would not be surprised to see SIAEC’s share price appreciate to SGD4.41 as illustrated by our sensitivity table analysis, based on a discount rate of 6.8%.

SIA Engineering (SIE SP): 1 August 2017

Comparison to peers Our fair value of SGD4.10 values SIAEC at 26.5x 12-month forward PER which is still a 9% discount over its peer 1-year forward average PER multiple of 29x. The company is in a strong net cash position versus most of its competitors, which are generally in a net debt position and it pays a higher dividend yield of c.3-4% compared to its peer average of 2%.

SIAEC: peer comparison table Bloomberg Share Price Market cap EV/EBITDA (X) PER (X) P/FCF Div Yield Net D/E Company name Code (Local) (USD m) FY 1 FY 2 FY 1 FY 2 (X) (%) (%) SIA ENGINEERING CO LTD* SIE SP 3.64 3,000 20.9 17.6 23.5 19.9 46 3.8 -36.3 SINGAPORE TECH ENGINEERING* STE SP 3.77 8,692 14.4 13.5 21.6 19.8 14.8 4.1 -9.6 HONG KONG AIRCRAFT ENGINEERG 44 HK 54.75 1,166 N.A. N.A. N.A. N.A. 6.2 7.1 31.5 AAR CORP AIR US 37.40 1,286 8.9 7.5 21.0 17.8 N.A. 0.8 16.1 THALES SA HO FP 93.59 23,530 9.2 8.4 19.5 17.2 19.0 1.7 -45.5 SAFRAN SA SAF FP 79.93 39,423 10.2 9.0 20.2 18.0 16.9 1.9 -10.8 HEICO CORP HEI US 80.37 6,306 19.0 17.5 38.6 34.2 31.4 0.2 33.6 AVIC AIRCRAFT CO LTD-A 000768 CH 18.22 7,507 40.0 31.5 72.6 54.7 40.7 0.3 -0.1 SPIRIT AEROSYSTEMS HOLD-CL A SPR US 60.43 7,289 7.1 6.9 12.6 11.8 15.3 0.5 21.2 Average (exclude SIAEC) 10911.0 16.2 14.0 28.7 24.3 23.8 2.3 0.0 Source: Bloomberg, *Daiwa forecasts; based on prices as of close on 31 July 2017

SIA Engineering (SIE SP): 1 August 2017

Key risks Lower-than-expected demand for heavy maintenance checks One of our key thesis calls for a turnaround in SIAEC’s repair and overhaul division, which has been a serial underperformer in recent years due to a drastic drop in overall “D” maintenance checks. While our analysis calls for a strong increase in the number of “D” maintenance checks from FY19 onwards, due to our observation of accelerating aircraft deliveries from 2012 onwards, any delays by airlines to send their aircraft for these maintenance checks could result in lower-than-expected revenue generation from this business segment and prolong its loss-making outlook.

Collapse in line maintenance margins The line maintenance division has been the key earnings driver for SIAEC in recent years and we are generally positive on further revenue/earnings growth in the coming 2-3 years, in line with an increase in aircraft traffic in the region. However, operating margins in this segment have declined from 20-23% in FY13-16 to 18.4% in FY17. This could be due to more work shifting from hangars to aprons, where the former generally commands a higher margin. Our assumption calls for an operating margin improvement in this business to 20% in FY2018-20E. Persistent margin weakness could result in SIAEC’s earnings missing our estimates.

Disappointing JV/associate contributions SIAEC’s JVs and associates contribute significantly to SIA Group’s overall bottom line. JV/associate contribution is mainly derived from engine/component MRO. One key associate for SIAEC is ESA, its subsidiary which has a close to monopoly control in servicing PW4000 engines in Asia Pacific. Recall that PW4000 engines are one of four engines used to power the 4-engine Boeing 747 aircraft, and that demand for such aircraft has diminished in recent years. A collapse in PW4000 engine MRO could result in a worse- than-expected associates’ contribution.

Singapore Industrials 1 August 2017

Singapore Airlines (SIA SP) Singapore Airlines

Target price: SGD9.060 (from SGD9.060) Share price (31 Jul): SGD10.390 | Up/downside: -12.8%

Dark clouds persist

 Load factor improvement offset by yield decline Royston Tan (65) 6321 3086  Increase in key operating expenses a cause for concern [email protected]  Reiterating Underperform (4) and TP of SGD9.060

What's new: SIA’s 1Q FY18 results were a mixed bag, with a strong rise in Forecast revisions (%) the parent airline load factor (+4.2pp YoY) to 80.0% offset by a decline in Year to 31 Mar 18E 19E 20E passenger yields (-1.9% YoY). The breakeven load factor increased by Revenue change 1.8 0.5 0.5 Net profit change (12.9) (1.6) (8.3) 4.5pp YoY to 82.2% due to higher operating expenses, such as Core EPS (FD) change (14.6) (3.5) (10.1) maintenance and ground handling expenses. While regional airlines’ Source: Daiwa forecasts outlook seems to have improved moderately over the past couple of quarters due to reduced competition from the Gulf carriers, management Share price performance remains cautious on competition from the North Asian airlines, which have (SGD) (%) negatively impacted its transpacific routes. 11.5 100 11.0 94 What's the impact: Strong demand for air travel has clearly benefited SIA 10.5 88 through higher passenger load factors of late. While SIA’s parent airline 9.9 81 9.4 75 load factor improvement has been stronger than we expected, the Aug-16 Nov-16 Feb-17 May-17 passenger yield remains depressed and is likely to stay weak over the SIA (LHS) Relative to FSSTI (RHS) coming quarters, in our view. Moreover, operating costs remain on an uptrend, with the increase in key expense items such as maintenance and 12-month range 9.600-11.050 overhaul charges showing no sign of abatement. Parking/handling charges Market cap (USDbn) 9.18 rose by c.10% YoY due to the removal of rebates from Changi Airport 3m avg daily turnover (USDm) 9.35 Group (CAG). Also, depreciation cost is forecast to trend higher as the Shares outstanding (m) 1,199 Major shareholder Temasek Holding Pte. (55.0%) group fleet size increases, though we now foresee a slower rate of growth due to the longer useful life of the A350 aircraft (depreciated at the higher Financial summary (SGD) end of its useful life band of 15-20 years for passenger aircraft). Year to 31 Mar 18E 19E 20E Revenue (m) 15,291 15,151 15,463 While we see SilkAir and Budget Aviation Holdings benefiting from strong Operating profit (m) 716 466 580 Net profit (m) 403 336 397 regional air travel demand, there are challenges, such as elevated Core EPS (fully-diluted) 0.336 0.280 0.331 competition from regional low-cost carriers, as well as higher operating EPS change (%) (7.7) (16.6) 18.2 expenses. This was evident in SIA’s 1Q FY18 results, where the breakeven Daiwa vs Cons. EPS (%) (22.6) (26.6) (21.1) PER (x) 30.9 37.1 31.4 load factor for both carriers increased at a faster rate vs. the passenger Dividend yield (%) 1.9 1.9 1.9 load factor. Management guided that passenger load factors on key DPS 0.200 0.200 0.200 regional routes such as India/China, operated by SilkAir and Budget PBR (x) 0.9 0.9 0.9 EV/EBITDA (x) 4.7 5.7 4.8 Aviation, remain depressed (low-70s) and the situation is unlikely to change ROE (%) 3.0 2.5 2.9 much over the coming quarters. Source: FactSet, Daiwa forecasts

We lower FY18-20E net earnings by 4-15% due to our higher assumptions for certain key expense items, such as parking/handling charges, which are partly offset by our lower depreciation-charge assumptions.

What we recommend: We reaffirm our Underperform (4) rating and 12- month PBR-based (0.8x FY18E PBR) target price of SGD9.060. The key upside risk: strong improvement in passenger yield.

How we differ: Our FY18-20E EPS are 21-27% below the consensus, due likely to our lower operating- margin assumptions.

See important disclosures, including any required research certifications, beginning on page 65

Singapore Airlines (SIA SP): 1 August 2017

Financial summary Key assumptions Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Overall RPK growth (%) 6.8 1.4 (0.9) 0.1 1.0 1.0 1.0 1.0 Overall RFTK growth (%) (6.0) (5.1) (1.1) 2.6 1.0 1.0 1.0 1.0 Overall ASK growth (%) 4.3 1.9 (0.4) (1.4) (0.2) 0.2 0.5 2.0 Overall AFTK growth (%) (5.5) (3.6) (2.4) 4.9 0.0 0.0 0.0 0.0 Overall PLF (%) 79.3 78.9 78.5 79.6 79.0 80.0 80.0 80.0 Overall CLF (%) 63.4 62.5 63.3 61.9 62.5 63.2 63.8 64.4 Overall passenger yield growth (%) (3.4) (2.6) 0.9 (5.4) (4.0) (2.0) (2.0) 0.0 Cargo Yield growth (%) (4.3) (2.1) 0.3 (11.6) 0.0 0.0 0.0 0.0 Int'l jet-fuel price (USD/bbl) 126.0 120.0 105.6 62.4 65.0 65.0 62.0 65.0

Profit and loss (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Passenger revenue 10,689 12,445 12,856 12,775 12,304 12,482 12,420 12,737 Cargo revenue 2,259 2,248 2,235 2,037 2,144 2,187 2,231 2,276 Other Revenue 2,150 551 475 416 420 622 500 450 Total Revenue 15,098 15,244 15,566 15,229 14,869 15,291 15,151 15,463 Other income 0 0 0 0 0 0 0 0 COGS (12,663) (12,759) (12,956) (12,307) (11,963) (12,193) (12,146) (12,116) SG&A (565) (604) (634) (654) (691) (673) (680) (689) Other op.expenses (1,612) (1,621) (1,566) (1,586) (1,592) (1,709) (1,859) (2,077) Operating profit 258 259 409 681 622 716 466 580 Net-interest inc./(exp.) 20 25 25 20 28 (40) (76) (113) Assoc/forex/extraord./others 204 83 8 271 (132) 254 58 55 Pre-tax profit 482 368 443 972 519 758 448 522 Tax (40) 57 (36) (121) (77) (129) (76) (89) Min. int./pref. div./others (63) (65) (39) (47) (82) (54) (35) (36) Net profit (reported) 379 360 368 804 360 575 336 397 Net profit (adjusted) 307 398 334 804 429 403 336 397 EPS (reported)(SGD) 0.322 0.300 0.307 0.670 0.305 0.479 0.280 0.331 EPS (adjusted)(SGD) 0.261 0.332 0.278 0.670 0.364 0.336 0.280 0.331 EPS (adjusted fully-diluted)(SGD) 0.261 0.332 0.278 0.670 0.364 0.336 0.280 0.331 DPS (SGD) 0.230 0.460 0.220 0.450 0.200 0.200 0.200 0.200 EBIT 258 259 409 681 622 716 466 580 EBITDA 2,424 2,720 2,815 3,192 2,214 2,425 2,325 2,657

Cash flow (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 482 368 443 972 519 758 448 522 Depreciation and amortisation 1,612 1,601 1,565 1,576 1,592 1,709 1,859 2,077 Tax paid (193) (65) (116) (41) (51) (129) (76) (89) Change in working capital 16 138 (157) 346 33 (230) (40) 1 Other operational CF items (63) 56 281 153 440 (0) 0 0 Cash flow from operations 1,854 2,098 2,015 3,006 2,533 2,108 2,191 2,512 Capex (1,875) (2,575) (2,600) (2,909) (3,945) (3,500) (4,000) (2,000) Net (acquisitions)/disposals 569 1,253 1,002 583 2 460 460 460 Other investing CF items 161 (501) (215) (374) 999 (200) (200) 0 Cash flow from investing (1,146) (1,823) (1,813) (2,700) (2,944) (3,240) (3,740) (1,540) Change in debt (61) (52) (82) (91) 217 910 910 910 Net share issues/(repurchases) (38) (16) (107) (84) (91) 0 0 0 Dividends paid (244) (375) (553) (359) (559) (290) (290) (290) Other financing CF items 4 7 601 (788) 209 (110) (146) (182) Cash flow from financing (339) (436) (141) (1,321) (225) 510 474 439 Forex effect/others (13) (15) 45 (55) 43 0 0 0 Change in cash 357 (176) 107 (1,070) (592) (621) (1,075) 1,410 Free cash flow (21) (477) (585) 97 (1,412) (1,392) (1,809) 512 Source: FactSet, Daiwa forecasts

Singapore Airlines (SIA SP): 1 August 2017

Financial summary continued … Balance sheet (SGDm) As at 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 5,409 5,171 5,282 5,039 3,920 3,299 2,224 3,634 Inventory 275 243 202 182 178 200 200 200 Accounts receivable 1,737 1,896 1,769 1,494 1,601 1,508 1,494 1,494 Other current assets 79 0 0 62 0 0 0 0 Total current assets 7,500 7,311 7,253 6,776 5,700 5,007 3,918 5,328 Fixed assets 13,098 13,027 13,523 14,144 16,433 18,224 20,365 20,288 Goodwill & intangibles 219 223 498 516 424 464 504 544 Other non-current assets 1,612 2,082 2,648 2,334 2,163 2,363 2,209 2,209 Total assets 22,428 22,643 23,922 23,770 24,720 26,058 26,996 28,369 Short-term debt 74 61 447 212 42 42 42 42 Accounts payable 5,240 5,130 6,031 6,036 6,166 5,865 5,811 5,811 Other current liabilities 233 201 162 192 80 80 80 80 Total current liabilities 5,547 5,391 6,640 6,440 6,289 5,987 5,934 5,934 Long-term debt 945 1,074 1,651 1,413 1,926 2,835 3,745 4,655 Other non-current liabilities 2,519 2,603 2,700 2,784 3,035 3,427 3,427 3,746 Total liabilities 9,011 9,068 10,992 10,637 11,250 12,248 13,105 14,334 Share capital 1,856 1,856 1,856 1,856 1,856 1,856 1,856 1,856 Reserves/R.E./others 11,249 11,381 10,608 10,899 11,227 11,562 11,658 11,816 Shareholders' equity 13,105 13,237 12,464 12,755 13,083 13,418 13,514 13,672 Minority interests 313 337 467 378 387 392 377 363 Total equity & liabilities 22,428 22,643 23,922 23,770 24,720 26,058 26,996 28,369 EV 7,704 7,902 8,650 8,364 9,835 11,370 13,341 12,827 Net debt/(cash) (4,391) (4,037) (3,184) (3,414) (1,953) (422) 1,563 1,063 BVPS (SGD) 11.148 11.032 10.388 10.630 11.087 11.191 11.271 11.403

Key ratios (%) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) 1.6 1.0 2.1 (2.2) (2.4) 2.8 (0.9) 2.1 EBITDA (YoY) (5.2) 12.2 3.5 13.4 (30.6) 9.5 (4.1) 14.3 Operating profit (YoY) (30.3) 0.4 57.9 66.4 (8.6) 15.0 (34.9) 24.5 Net profit (YoY) (16.6) 29.7 (16.2) 141.2 (46.6) (6.2) (16.6) 18.2 Core EPS (fully-diluted) (YoY) (15.7) 27.1 (16.2) 141.2 (45.7) (7.7) (16.6) 18.2 Gross-profit margin 16.1 16.3 16.8 19.2 19.5 20.3 19.8 21.6 EBITDA margin 16.1 17.8 18.1 21.0 14.9 15.9 15.3 17.2 Operating-profit margin 1.7 1.7 2.6 4.5 4.2 4.7 3.1 3.8 Net profit margin 2.0 2.6 2.1 5.3 2.9 2.6 2.2 2.6 ROAE 2.4 3.0 2.6 6.4 3.3 3.0 2.5 2.9 ROAA 1.4 1.8 1.4 3.4 1.8 1.6 1.3 1.4 ROCE 1.8 1.8 2.8 4.6 4.1 4.5 2.7 3.2 ROIC 2.6 2.8 3.9 6.1 5.0 4.8 2.7 3.2 Net debt to equity n.a. n.a. n.a. n.a. n.a. n.a. 11.6 7.8 Effective tax rate 8.4 n.a. 8.2 12.4 14.8 17.0 17.0 17.0 Accounts receivable (days) 39.1 43.5 43.0 39.1 38.0 37.1 36.2 35.3 Current ratio (x) 1.4 1.4 1.1 1.1 0.9 0.8 0.7 0.9 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. 18.0 6.1 5.1 Net dividend payout 71.4 153.5 71.7 67.1 65.5 41.7 71.3 60.4 Free cash flow yield n.a. n.a. n.a. 0.8 n.a. n.a. n.a. 4.1 Source: FactSet, Daiwa forecasts

Company profile

Singapore Airlines (SIA) is an international airline based in Singapore. The company is also engaged in engineering services, training of pilots, air charters and tour wholesaling and related activities. The Company's segments include airline operations, engineering services, cargo operations and others.

Singapore Industrials 1 August 2017

(SATS SP) SATS SAT S

Target price: SGD5.050 (from SGD5.050) Share price (31 Jul): SGD4.830 | Up/downside: +4.6%

Long-term beneficiary of strong air travel demand

 Leveraged to regional airport expansion plans Royston Tan (65) 6321 3086  Automation initiatives to reduce manpower reliance [email protected]  Maintaining Hold (3) and TP of SGD5.050

What's new: We believe that aviation service providers such as SATS, Forecast revisions (%) which is one of the world’s top-10 ground handlers and inflight meals Year to 31 Mar 18E 19E 20E caterers, are likely to be major beneficiaries of the sizable airport expansion Revenue change - - - Net profit change - - - plans in Asia Pacific. Besides leveraging on the soon-to-be opened Core EPS (FD) change - - - Terminal 4 in Singapore, SATS’s stakes in various ground handling and Source: Daiwa forecasts inflight catering entities around the region should allow it to effectively participate in the region’s strong growth for air travel demand, in our view. Share price performance

(SGD) (%) What's the impact: SATS recent partnership with Jetstar to provide the 5.5 120 latter with a suite of inflight meals options is a step in the right direction for 5.2 114 5.0 108 the company, in our view. Given the proliferation of the low cost carrier 4.7 101

(LCC) model, particularly in the Asia Pacific region, LCCs are set to 4.4 95 account for a larger proportion of the market for inflight meals over the Aug-16 Nov-16 Feb-17 May-17 Aug-17 coming decade, in our view. By actively seeking partnership with LCCs, we SATS (LHS) Relative to FSSTI (RHS) see SATS as having the first-mover advantage to capitalise on LCCs’ rapid growth in the inflight meals business. 12-month range 4.400-5.320 Market cap (USDbn) 3.97 Moreover, most LCCs lack the resources to carry out their own in-house 3m avg daily turnover (USDm) 10.54 Shares outstanding (m) 1,115 ground handling work. According to IATA, more than 60% of ground Major shareholder Temasek Holdings (43.2%) rd handling work is currently outsourced to 3 party ground handlers such as SATS. With the advent of LCCs as well as full service carriers introducing Financial summary (SGD) rd larger and more sophisticated aircraft, the need for 3 party specialists with Year to 31 Mar 18E 19E 20E the expertise to handle an array of complex ground handling operations Revenue (m) 1,745 1,815 1,875 becomes critical in ensuring airlines’ cost efficiency. Hence, we do not Operating profit (m) 237 260 274 Net profit (m) 242 265 276 expect the outsourcing trend to abate. Core EPS (fully-diluted) 0.216 0.235 0.245 EPS change (%) 3.1 9.1 4.2 Growth in air traffic is creating its own set of challenges. Due to elevated Daiwa vs Cons. EPS (%) (2.8) 0.2 (1.5) PER (x) 22.4 20.5 19.7 competition, pricing pressure has impacted aviation service providers’ Dividend yield (%) 3.7 3.9 4.1 margins. Skilled labour scarcity and rising manpower costs are other DPS 0.180 0.190 0.200 headwinds that aviation service providers have faced in recent years. To PBR (x) 3.2 3.1 3.0 deal with rising manpower-related costs, SATS has been investing in EV/EBITDA (x) 14.1 12.9 12.0 ROE (%) 14.9 15.7 15.8 automation initiatives to enhance productivity and improve its margins. Source: FactSet, Daiwa forecasts

What we recommend: While we like SATS on a medium- to long-term horizon given our view of the company as a natural beneficiary of rising global air travel demand as well as airport expansions around the world, its current valuation likely fully prices in its short-term earnings growth potential. Hence, we maintain our Hold (3) rating and DCF-based 12-month TP of SGD5.050. The key upside/downside risks: stronger-than-expected margin improvement/ underperformance in its associates.

How we differ: Our FY18E EPS is 3% below the consensus, which we attribute to our lower revenue and associates’ contribution assumptions.

See important disclosures, including any required research certifications, beginning on page 65

SATS (SATS SP): 1 August 2017

Financial summary Key assumptions Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Gross meals produced - Airlines (m) 28 26 26 28 27 28 29 30 Cargo/mail processed (m tonnes) 1 2 2 2 2 2 2 2 Passengers handled (m) 41 43 42 45 52 54 57 60

Profit and loss (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Food solutions 1,165 1,104 1,052 967 973 972 1,001 1,033 Gateway services 649 678 697 726 751 774 814 842 Other Revenue 6 5 5 5 6 0 0 0 Total Revenue 1,819 1,787 1,753 1,698 1,729 1,745 1,815 1,875 Other income 0 0 0 0 0 0 0 0 COGS (393) (380) (349) (283) (258) (262) (270) (331) SG&A (766) (788) (801) (826) (857) (874) (891) (909) Other op.expenses (468) (448) (425) (375) (384) (372) (393) (362) Operating profit 192 171 178 215 231 237 260 274 Net-interest inc./(exp.) (2) (2) 0 2 3 0 0 0 Assoc/forex/extraord./others 51 46 46 48 76 68 58 59 Pre-tax profit 241 216 225 265 310 306 318 333 Tax (40) (33) (34) (47) (48) (49) (51) (53) Min. int./pref. div./others 0 (2) 5 2 (3) (2) (2) (4) Net profit (reported) 202 180 196 221 259 254 265 276 Net profit (adjusted) 185 180 196 221 235 242 265 276 EPS (reported)(SGD) 0.179 0.160 0.174 0.196 0.230 0.226 0.235 0.245 EPS (adjusted)(SGD) 0.164 0.160 0.174 0.196 0.209 0.216 0.235 0.245 EPS (adjusted fully-diluted)(SGD) 0.164 0.160 0.174 0.196 0.209 0.216 0.235 0.245 DPS (SGD) 0.150 0.130 0.140 0.150 0.170 0.180 0.190 0.200 EBIT 192 171 178 215 231 237 260 274 EBITDA 285 248 246 285 304 313 338 352

Cash flow (SGDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 241 216 225 265 310 306 318 333 Depreciation and amortisation 93 77 68 70 74 75 77 79 Tax paid (29) (39) (35) (36) (41) (49) (51) (53) Change in working capital (11) 35 21 17 38 (61) (4) 56 Other operational CF items (48) (42) (43) (43) (71) (45) (45) (45) Cash flow from operations 246 247 236 273 309 226 296 369 Capex (38) (57) (61) (51) (88) (90) (85) (80) Net (acquisitions)/disposals (5) (118) 28 (41) (98) (20) (20) (20) Other investing CF items 26 29 92 35 46 40 40 41 Cash flow from investing (17) (146) 58 (56) (140) (70) (65) (59) Change in debt (5) (5) (1) 0 (7) 0 0 0 Net share issues/(repurchases) 8 6 (49) (2) 4 0 0 0 Dividends paid (289) (169) (147) (156) (179) (202) (213) (224) Other financing CF items 0 6 (4) 1 9 0 0 0 Cash flow from financing (286) (163) (200) (157) (173) (202) (213) (224) Forex effect/others (3) (5) 1 2 0 0 0 0 Change in cash (60) (66) 96 62 (4) (46) 18 86 Free cash flow 208 190 175 222 221 136 211 289 Source: FactSet, Daiwa forecasts

SATS (SATS SP): 1 August 2017

Financial summary continued … Balance sheet (SGDm) As at 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 406 341 411 490 506 462 481 567 Inventory 53 46 19 22 22 24 25 26 Accounts receivable 301 288 283 277 271 287 298 308 Other current assets 21 50 81 40 58 49 51 44 Total current assets 780 725 793 830 857 822 856 945 Fixed assets 592 568 552 517 539 553 561 562 Goodwill & intangibles 193 185 166 164 158 158 158 158 Other non-current assets 438 542 510 596 726 763 791 829 Total assets 2,003 2,020 2,020 2,106 2,279 2,297 2,365 2,494 Short-term debt 23 18 16 110 10 10 10 10 Accounts payable 237 267 287 309 331 287 296 362 Other current liabilities 51 45 43 51 69 69 69 69 Total current liabilities 310 330 346 470 410 366 375 441 Long-term debt 109 97 90 1 98 98 98 98 Other non-current liabilities 84 79 67 70 80 82 85 87 Total liabilities 503 505 502 541 588 547 558 626 Share capital 338 368 368 368 368 368 368 368 Reserves/R.E./others 1,065 1,049 1,073 1,123 1,236 1,292 1,347 1,404 Shareholders' equity 1,403 1,417 1,441 1,491 1,604 1,660 1,715 1,772 Minority interests 97 98 77 74 88 90 93 97 Total equity & liabilities 2,003 2,020 2,020 2,106 2,279 2,297 2,365 2,494 EV 4,816 4,759 4,689 4,532 4,403 4,412 4,358 4,238 Net debt/(cash) (274) (227) (306) (379) (397) (354) (373) (459) BVPS (SGD) 1.253 1.265 1.291 1.344 1.439 1.489 1.539 1.590

Key ratios (%) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) 7.9 (1.8) (1.9) (3.1) 1.8 0.9 4.0 3.3 EBITDA (YoY) 7.1 (13.0) (0.8) 15.8 6.7 2.9 7.9 4.3 Operating profit (YoY) 13.8 (11.1) 4.1 20.6 7.5 2.9 9.6 5.2 Net profit (YoY) 8.1 (2.4) 8.5 12.7 6.6 3.1 9.1 4.2 Core EPS (fully-diluted) (YoY) 8.1 (2.4) 8.8 12.8 6.6 3.1 9.1 4.2 Gross-profit margin 78.4 78.8 80.1 83.4 85.1 85.0 85.1 82.4 EBITDA margin 15.7 13.9 14.0 16.8 17.6 17.9 18.6 18.8 Operating-profit margin 10.6 9.6 10.2 12.6 13.3 13.6 14.3 14.6 Net profit margin 10.2 10.1 11.2 13.0 13.6 13.9 14.6 14.7 ROAE 12.7 12.8 13.7 15.0 15.2 14.9 15.7 15.8 ROAA 9.0 9.0 9.7 10.7 10.7 10.6 11.4 11.3 ROCE 11.3 10.5 10.9 13.0 13.3 13.0 13.8 14.1 ROIC 12.7 11.5 12.1 14.7 15.7 14.8 15.4 16.2 Net debt to equity n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Effective tax rate 16.5 15.5 15.2 17.6 15.6 16.0 16.0 16.0 Accounts receivable (days) 59.6 60.1 59.3 60.2 57.9 58.4 58.9 59.0 Current ratio (x) 2.5 2.2 2.3 1.8 2.1 2.2 2.3 2.1 Net interest cover (x) 128.2 95.0 n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 83.9 81.3 80.4 76.4 73.9 79.5 80.7 81.6 Free cash flow yield 3.9 3.5 3.3 4.1 4.1 2.5 3.9 5.4 Source: FactSet, Daiwa forecasts

Company profile

SATS Ltd is a food solutions and gateway services company. The Company's operating segments include food solutions, gateway services and corporate. The food solutions segment provides inflight and institutional catering, food processing, distribution services and airline laundry services. The gateway services segment provides both airport and cruise terminal services.

Singapore Aviation: 1 August 2017

Daiwa’s Asia Pacific Research Directory

HONG KONG SOUTH KOREA Takashi FUJIKURA (852) 2848 4051 [email protected] Sung Yop CHUNG (82) 2 787 9157 [email protected] Regional Research Head Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Jiro IOKIBE (852) 2773 8702 [email protected] Shipbuilding; Steel Co-head of Asia Pacific Research Mike OH (82) 2 787 9179 [email protected] John HETHERINGTON (852) 2773 8787 [email protected] Banking; Capital Goods (Construction and Machinery) Co-head of Asia Pacific Research Iris PARK (82) 2 787 9165 [email protected] Kevin LAI (852) 2848 4926 [email protected] Consumer/Retail Chief Economist for Asia ex-Japan; Macro Economics (Regional) SK KIM (82) 2 787 9173 [email protected] Olivia XIA (852) 2773 8736 [email protected] IT/Electronics – Semiconductor/Display and Tech Hardware Macro Economics (Hong Kong/China) Thomas Y KWON (82) 2 787 9181 [email protected] Kelvin LAU (852) 2848 4467 [email protected] Pan-Asia Head of Internet & Telecommunications; Software – Internet/On-line Games Head of Automobiles; Transportation and Industrial (Hong Kong/China) Leon QI (852) 2532 4381 [email protected] TAIWAN Regional Head of Financials; Banking; Diversified financials; Insurance Rick HSU (886) 2 8758 6261 [email protected] (Hong Kong/China) Head of Regional Technology; Head of Taiwan Research; Semiconductor/IC Design (Regional) Yan LI (852) 2773 8822 [email protected] Nora HOU (886) 2 8758 6249 [email protected] Banking (China) Banking; Diversified financials; Insurance Anson CHAN (852) 2532 4350 [email protected] Steven TSENG (886) 2 8758 6252 [email protected] Consumer (Hong Kong/China) IT/Technology Hardware (PC Hardware) Adrian CHAN (852) 2848 4427 [email protected] Kylie HUANG (886) 2 8758 6248 [email protected] Consumer (Hong Kong/China) IT/Technology Hardware (Handsets and Components) Jamie SOO (852) 2773 8529 [email protected] Helen CHIEN (886) 2 8758 6254 [email protected] Gaming and Leisure (Hong Kong/China) Small/Mid Cap John CHOI (852) 2773 8730 [email protected]

Head of Hong Kong and China Internet; Regional Head of Small/Mid Cap INDIA Alex LIU (852) 2848 4976 [email protected] Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Internet (Hong Kong/China) Head of India Research; Strategy; Banking/Finance Carlton LAI (852) 2532 4349 [email protected] Saurabh MEHTA (91) 22 6622 1009 [email protected] Small/Mid Cap (Hong Kong/China) Capital Goods; Utilities Dennis IP (852) 2848 4068 [email protected]

Power; Utilities; Renewables and Environment (Hong Kong/China) SINGAPORE Jonas KAN (852) 2848 4439 [email protected] Ramakrishna MARUVADA (65) 6499 6543 [email protected] Head of Hong Kong and China Property Head of Singapore Research; Telecommunications (China/ASEAN/India) Cynthia CHAN (852) 2773 8243 [email protected] David LUM (65) 6329 2102 [email protected] Property (China) Banking; Property and REITs Thomas HO (852) 2773 8716 [email protected] Royston TAN (65) 6321 3086 [email protected] Custom Products Group Oil and Gas; Capital Goods

Shane GOH (65) 64996546 [email protected] PHILIPPINES Property and REITs; Small/Mid Cap (Singapore) Micaela ABAQUITA (63) 2 737 3021 [email protected] Jame OSMAN (65) 6321 3092 [email protected] Property Transportation – Road and Rail; Pharmaceuticals and Healthcare; Consumer (Singapore)

Singapore Aviation: 1 August 2017

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Singapore Aviation: 1 August 2017

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Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions.

Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analyst is named on the report); and no part of the compensation of such analyst (or no part of the compensation of the firm if no individual analyst is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report.

The following explains the rating system in the report as compared to relevant local indices, unless otherwise stated, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next 12 months. "2": the security is expected to outperform the local index by 5-15% over the next 12 months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next 12 months. "4": the security is expected to underperform the local index by 5-15% over the next 12 months. "5": the security could underperform the local index by more than 15% over the next 12 months.

Disclosure of investment ratings Rating Percentage of total Buy* 66.1% Hold** 21.6% Sell*** 12.3% Source: Daiwa Notes: data is for single-branded Daiwa research in Asia (ex Japan) and correct as of 30 June 2017. * comprised of Daiwa’s Buy and Outperform ratings. ** comprised of Daiwa’s Hold ratings. *** comprised of Daiwa’s Underperform and Sell ratings.

Additional information may be available upon request.

Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.)

If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items.  In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.  In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.  For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.  There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.  There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.  Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us.

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