Excerpts from analyst's report
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The steep decline in stock price has now made STE more attractive than anytime over the past three years. We believe the decline in stock price does not reflect concern over the company’s earnings but is merely linked to index selling. Notably, the yield on STE’s bonds has not risen, and its spread over the dividend yield has risen to record levels. We believe this is not justified given STE’s record orderbook and guidance for a stronger 2H15. Upgrade STE to BUY (from HOLD) with unchanged S$3.50 target price. |
WHAT’S NEW?
• Dividend yield spread over bond yield at record levels. The recent decline in stock price has led to ST Engineering’s (STE) dividend yield over its 10-year MTN note rising to record spread of 325bp (at S$2.79), which is +2SD to long-term mean of 1.44%. The yield on the MTN has changed very little and offers a yield of 2.17%, while the stock at S$2.75 offers a dividend yield of 5.4%.
The steep risk aversion that equity holders have is not shared by bond holders, as the yield on the latter is just 10bp higher than 5-year Singapore Government bonds, reflecting its Aaa rating. We opine that the steep equity-bond yield spread is not justified and will have to narrow as operationally, very little has changed since STE reported its earnings. If the yield spread narrows to +1SD, the stock could then head towards S$3.20. On a PE basis, STE is also trading at -1SD to long-term mean.
• STE will also benefit from Ministry of Defence’s (Mindef) higher defence budget. Defence related work accounts for 33% of STE’s revenue, with the Singapore government accounting for the bulk. FY15’s defence budget has been projected to rise 4.4%yoy which in turn should lead to incremental revenue for STE.
• 1H15 earnings recap. 1H15’s earnings were slightly above our expectation and STE has guided for a stronger 2H15. The primary negative was its exposure to China and Brazil, where the land systems unit continued to make provisions. Despite that, the pace of inventory obsolescence charges has declined qoq and the unit was profitable. Thus the latest decline in stock price is seen as a reflection of market risk, rather than any company risk, in our view.
STOCK IMPACT
• Upgrade to BUY. We upgrade STE as it offers 25% upside to our target price. While STE has raised interim dividend from 4 S cents to 5 S cents, we have not assumed a higher final dividend and our 88.7% payout ratio for 2015 has not changed. Thus there is potential for upward revision in our dividend yield estimate if 3Q15 earnings are better than expected. The group has also been doing share buybacks.
EARNINGS REVISION/RISK
• No change to our earnings. Further deterioration in fuel price and slower contract wins are primary risks.
VALUATION/RECOMMENDATION
• Upgrade to BUY. We continue to value STE at 19x 2015F earnings but add net cash per share to our fair value and derive a target price of S$3.50.
SHARE PRICE CATALYST • More contract wins.
Full report here.
