ST Engineering @ 3.04 ( Defence / Singapore ) 2 comments
Final Poll Results: 5:10
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1.High valuation vs peers given low medium-term growth outlook
Rather surprising, my last choice Sun East--- it has actually garnered a 7-0 vote in favour, a rare occurence. No dissent is good, no dissent is good. Makes things easier for me, no need to spend additional efforts to convince the opposition.
Now, to one of the stalwarts of Singapore --- Singapore Technologies Engineering, that bastion of Singapore defence engineering and STI behemoth -- what could be safer than it?
How much premium does one build into a stock that is considered strategic to Singapore and would probably never be divested by Temasek Holdings? There are cases where this would be considered an advantage --- no potential overhang of shares on the market --- but in the case of ST Engineering, I would see value in separate components (what they call SBAs --- strategic business areas), but too bad value can't be unlocked.
Let's examine each of their four SBAs (strategic business areas) where I shall attempt to compare their valuation to a peer on the SGX. ST Aerospace has probably the strongest business of the four --- it also contributes the biggest share of revenue and profit for the group, ~35% and ~50% respectively. ST Marine is involved in naval shipbuilding as well as commercial ship repair. ST Electronics has three arms: large-scale systems (transport systems, combat systems), communication and sensor systems, and software systems. ST Land Systems is involved in munitions, land weapons and land vehicle systems --- it is also the one that has been a drag on the bottomline over the last 2-3 years. I shall draw on local examples, and where local peers are lacking, to international peers where I feel comparison will be flattering to the SBA in question. All PEs are historical.
Local listed peer comparison
ST Aerospace <--> SIA Engineering (21X PE)
ST Marine <--> Pan-United Marine (11X PE) [Note that Sembcorp Marine is not suitable because its valuation is tied more to oil rigs now]
ST Electronics <--> Nera Telecom (10X PE) [rather a stretch I know, so refer to the comparison to US peer below]
ST Land Systems <--> no local peer
Foreign listed peer comparison
ST Aerospace <--> no need lah, you think it is comparable to Boeing or Airbus?
ST Marine <--> Todd Shipyards, a US naval/commercial shipyard of comparable revenue base and margins (14X PE) [not many of these pure play shipyards]
ST Electronics <--> Honeywell (23X PE) or Raytheon (21X PE) [I am being REALLY generous here in the comparison]
ST Land Systems <--> General Dynamics (19X PE) [Again, I am being REALLY generous here in the comparison]
It is rather revealing that ST Engineering, the sum of the total, is trading at 22.5X PE which is at the high end. Note that some of the above US peers may be considered diversified defence conglomerates like ST Engineering (General Dynamics, for example), but with much larger operations, much larger markets and most importantly, much more advanced proprietary technologies. On a segment-by-segment comparison and on a holistic comparison, ST Engineering looks at best fairly-valued (indeed, in some valuation analyses, conglomerate discounts are applied which suggests the whole is less than the sum-of-parts).
I am of course suggesting that higher operational scale --> higher PEs, a thoroughly justifiable assumption, ceteris paribus (ie. all things being equal). The other important factor that might justify higher valuation is growth potential. Revenue and net profit has been growing at about 10% from FY03 to FY05, and recent 1Q06 profit has stagnated. What this means is that long-term performance suggests the group deserves a 15X PE at best (in accordance with Peter Lynch's PEG valuation), while near-term performance does not suggest accelerating earnings growth potential.
The third factor that might justify higher valuation is that business risk is minimal for the group. This is because of its close strategic relationship with the Singapore Ministry of Defence which ensures that its products and services will always have a ready local market. A geographical segmental analysis of its revenue shows that 2/3 of total revenue is drawn from "Asia" --- I wouldn't be far off to say that at least 80% of this 2/3 portion derives from the Singapore market, and from one strategic customer alone. But Mindef's spending is pegged to the national GDP (5-6% of GDP, if I'm not mistaken) and assuming GDP grows at 10% every year (another generous assumption by me), I would not expect revenue contribution to ST Engineering from their patronage to exceed that growth rate (indeed, some quarters are expecting that budget to direct towards new purchases rather than maintenance of existing equipment, in which case ST Engineering's share might drop). In other words, earnings volatility (interpreted as risk) is low, but growth potential is also rather conservative. It might in some cases suffer from the "curse of Temasek" (curse of the state-linked companies in attempting to buy overseas strategic assets) in efforts to expand overseas.
One has to decide whether to accept the rather high valuations (given the above perspectives) in exchange for assured earnings base, low financial risk (strong balance sheet and cash flow), and good dividend payout (~15 cents, or 5% yield). Fund managers buy the stock for the above attributes, hence driving up its price; depending on one's risk appetite, the individual investor might consider buying it as well. However, I am of the view that near to medium-term capital gains for this stock is unlikely, and hence for my style of investing it is a hot-stock-not for me.
(1) Valuation figures on Todd Shipyards, Honeywell, Raytheon, General Dynamics
(2) Mar 2005 speech: Statement by Minister Teo Chee Hean at the Committee of Supply Debate 2005