SATS Ltd - It gets bitter before it turns sweeter (OCBC)

Downgrade to HOLD

Previous Rating: BUY

Current Price: S$2.27

Fair Value: S$2.36

The TFK earnings drag. SATS Ltd reiterated that the recently acquired TFK Corporation is not expected to have a material impact on FY12 earnings, but we are unconvinced. TFK's output volumes have trended lower since early 2010 due to Japan Airlines International's (JAL) restructuring efforts. In addition, the earthquake that hit Japan in Mar 2011 has further depressed TFK's output volumes. In 1QFY12, excluding one-off accounting gain of S$10.1m arising from its pension obligations, TFK reported pre-tax loss of S$7m. Consensus numbers do not seem to have factored in the impact of loss-making TFK on the group. We have lowered our FY12 earnings forecast by 14.2% to reflect the drag of TFK on the group's earnings. Our new FY12 net profit of S$171.3m is the second lowest on the street and 13.2% lower than consensus.

TFK restructuring and turnaround. Post-earthquake, management maintained its original target of turning TFK profitable by FY13. Management's optimism comes from the end of JAL's restructuring and route cuts and Japan's new focus to increase air travel in Tokyo's two main airports. Given SATS' good execution track record, there is a good chance of management coming good on their target. We have correspondingly increased our FY13 earnings forecast by 1.4% to S$212.6m.

Challenging outlook. Management has warned of challenging times in the coming months as a result of the Eurozone debt crisis and the downgrading of USA's credit rating. While Asia's economies are comparatively better, SATS continues to face the pressure on rising wages and food costs. With more than 60% of its revenue being aviation-related, SATS' earnings and share price will take a beating if the global economy and air travel suffer.

Downgrade to HOLD. SATS' share price has fallen 23% from a recent high in Jan 2011. As a result, SAT's implied forward P/E has fallen below one standard deviation lower than the average of the last two years. While consensus FY12 earnings of S$197m do not seem to have factored in the negative impact of loss-making subsidiary TFK in the near term, the market seems to be pricing in the expectation. With the headwinds facing the aviation sector and global economy, the street's implied P/E of 15.3x on FY12 earnings also seems a little too optimistic. Instead, we assigned a 14.5x P/E, or one standard deviation below its two-year historical average, on our earnings forecast over the next four quarters to arrive at a fair value of $2.36 (versus $3.02 previously). Given an upside of 3.6%, we downgrade SATS to HOLD.