SATS Ltd - Margins threat from inflation, challenging aviation sector (CIMB)

UNDERPERFORM Maintained

S$2.61 @18/07/11

Target: S$2.60

• Turbulence ahead. We expect SATS to be swept into some turbulence ahead with headwinds arising from 1) margin squeeze from food inflation and inability to pass through costs in an environment of struggling profitability for main airline clients, and 2) the emergence of a third ground handler in Changi Airport, which could stiffen competition and further erode pricing power. At 13.7x CY12 P/E, SATS is trading slightly above its average forward P/E. A slowing aviation industry and margin pressure could spark a de-rating of its share price. We resume coverage with new forecasts, an unchanged UNDERPERFORM rating and S$2.60 target price, based on 13.1x CY12 P/E, its historical mean since 2004.

• Knock-on effects of a fragile aviation industry. With 59% of revenue derived from the aviation industry, SATS’s profitability is tied to the airline industry’s performance. We have an Underweight rating on this sector as our regional transport analyst anticipates margin pressure from falling utilisation and high fuel costs. Belt-tightening among airlines could have negative knock-on effects on service providers such as SATS, which may end up being squeezed between cost-conscious customers and high food costs.

Two negatives ahead. SATS’s operating environment looks increasingly challenging ahead. We identify headwinds from 1) margin squeeze from food inflation and inability to pass on high food costs to its airline customers, who have an even murkier profitability outlook, and 2) the emergence of a third ground handler in Changi Airport, potentially stiffer competition and erosion of pricing power.

Food inflation + weaker airline profitability = margin pressure for SATS

Harder to pass on food inflation as airlines themselves are headed for turbulence. We expect airlines’ profit margins to be squeezed by high fuel prices, low utilisation and limited pricing power. Margin compression among airlines is likely to filter down to service providers such as SATS, which may find it increasingly difficult to pass on higher food costs due to growing cost-consciousness among its customers. This comes at a time when global food prices are reaching new highs and could result in a squeeze in SATS’s profit margins.

Impact of food inflation could be worse this time around. Food prices last peaked in 2008, lifting food costs to 10.7% of revenue (from 8.5% before inflation set in) and eroding the net profit margin from 20.3% in FY08 to 13.8% in FY09. Margins were decimated despite the relatively high profits enjoyed by airlines then. The situation this time around is worse. Our in-house projections point to falling aviation industry profits and margins in FY12. This suggests belt-tightening measures among airlines, which could translate to caps on SATS’s charges and an even tighter squeeze on the group’s profit margins.

Moderating aviation growth provides little catalysts for SATS given that the aviation industry is its key revenue contributor at 59.2% of group revenue. The International Air Transport Association (IATA) has been growing increasingly bearish about the airline industry, recently slashing its 2011 airline industry profit forecast to just US$4bn vs. the US$18bn net profit recorded in 2010. Global passenger demand growth is expected to slow from 7.3% in 2010 to 4.4% in 2011 while cargo demand growth is projected to ease from 18.3% in 2010 to just 5.5% in 2011.

Casualties among full-service carriers will cut deeper. Lingering fears over a global economic slowdown could weigh on air travel demand. Already, the number of leisure travellers recorded between Jan and May 2011 has fallen 3-4% as higher costs (driven in part by high fuel prices) deterred travel demand. Amid a generally cautious climate, we expect full-service carriers to be harder hit than low-cost carriers due to the price sensitivity of travellers.

Unfortunately for SATS, full-service carriers represent the more lucrative segment as they are able to provide a more complete suite of services and command higher margins. While resilience among low-cost carriers will support demand for SATS’s basic services such as ground handling, demand for other services, such as meal catering, might decline. Profit margins may also fall as low-cost carriers tend to be pricesensitive.

SATS missing out on Singapore’s tourism growth as LCCs bring smaller profit pools. Buoyant tourism growth remains one of the bright spots for Singapore’s economy with 1H11 passenger volumes up 10.7% yoy. However, much of this growth has been led by low-cost carriers, which witnessed a 25.2% jump in volume vs. full-service carriers’ growth of just 6.6% yoy. Low-cost carriers now occupy 25% of market share in Changi and could increase their penetration amid growing price-sensitivity among travellers. SATS does not stand to fully benefit from this trend as low-cost carriers typically require fewer services (for instance, meals are not included) and are more price-sensitive.

Additional cost pressure from wages. Higher wages could add further pressure on SATS’s operating expenditure given that staff costs form a major cost component at 37% of revenue. We anticipate wage pressure arising from 1) CPF hike announced in Singapore Budget 2011, which we estimate could raise staff costs by 0.15% in FY11 and 0.3% from FY12 onwards, 2) larger workforce upon full consolidation of TFK and more potential acquisitions, and 3) the emergence of a third ground handler in Changi Airport, which would intensify hiring competition.

New third ground handler reins in pricing power

Retaining market share at the expense of price competition? Adding to headwinds from inflation and a fragile aviation industry outlook is stiffening competition at Changi Airport. US-based Aircraft Service International Group (ASIG) was recently awarded the third ground handling licence, allowing it to compete head-on with SATS, which dominates 80% of market share, and CIAS. While we expect SATS to retain majority market share, we fear that stiffening competition could lead to erosion of pricing power if ground handlers resort to price competition as a means of differentiation. We think this is highly likely given limited avenues for differentiation in an industry which offers relatively uniform products and services. Our projections have factored an 11% decline in unit prices in FY12, similar to the decline seen in FY06 when Swissport entered the market.

SATS likely to retain dominant share. We do not expect ASIG’s emergence to cause a big dent in SATS’s market share as SATS enjoys customer stickiness as the dominant player in Changi Airport. Recall that Swissport attempted to gain a foothold in the market in FY06-09 but eventually bowed out after it suffered over S$50m of losses over its four years here and was unable to capture meaningful market share. Going by precedence, ASIG could face an uphill task trying to capture market share at Changi Airport.

But may suffer from weaker revenue growth. Our analysis of SATS’s financial performance during Swissport’s presence in FY06-09 found that revenue growth during this period lagged behind Changi Airport’s traffic growth. This could be attributed to 1) lower unit prices as a result of price competition, and 2) slight loss of market share. In FY06-09, SATS’s revenue CAGR was recorded at 2.1%, below Changi Airport’s 5.2% growth in the number of flights handled. Swissport’s presence did not appear to have a significant impact on SATS’s profit margins, which held up reasonably well. Instead, macro factors such as the opening of Terminal 3 and food inflation dragged margins in FY09.

Valuation and recommendation

Resume coverage with UNDERPERFORM rating and S$2.60 target price. SATS currently trades at 13.7x CY12 P/E, slightly above its historical average. We see little room for share price outperformance as valuations appear fair. Instead, we fear that a slowing aviation industry and margin erosion could spark a de-rating of its shares. During the 2009 downturn, SATS traded as low as two standard deviations below its mean or 6.7x forward P/E. We resume coverage with new earnings forecasts, an unchanged UNDERPERFORM rating and a S$2.60 target price, based on 13.1x CY12 P/E, its historical mean since 2004. De-rating catalysts could stem from margin compression and deteriorating aviation industry prospects.