We recently wrote a results preview note for SATS, with the conclusion that its 2QFY20 results will remain lackluster due to margins pressure from cargo weakness. True enough, the company’s 2QFY20 results were below market expectations, with across-board downward earnings revision from the street.
SATS: Long-term fundamentals in-tact
Don’t get me wrong. I am positive that SATS’ long term prospects remain a bright one. The tourism industry is one of the few remaining bright spots in the world still expected to register stable growth over the next decade or two.
The upcoming 2020 Olympics to be held in Japan will also give a nice boost to SATS’ Japanese subsidiary, TFK, where revenue improved 6% YoY in the recent quarter.
SATS’ core business of providing gateway services and inflight meals to airlines will undoubtedly grow alongside a rising global aircraft fleet. The company’s recent initiatives to diversify into the non-aviation food solutions market in China, if successful, will be a major long-term earnings growth driver.
However, its various expansion initiatives will likely incur start-up/integration expenses that will negatively impact its earnings over the next 6-12 months, in our view.
Last but not least, the recent unrest in HK has significantly impacted the financial performance of Hong Kong Airlines, a key and significant owner/client of Asia Airfreight Terminal (AAT).
SATS: 3 near-term headwinds
Despite our positive stance on SATS’ long-term fundamental outlook, we believe that it’s operating performance will be negatively impacted by these 3 factors.
1. Margins pressure from consolidation
SATS recently consolidated Ground Team Red Holdings Sdn Bhd (GTR), a JV with Air Asia and Country Foods Pte Ltd (CFPL) which was previously a 49% associate. The latter is now 100%-owned by SATS, effective 5 Sep 2019.
The consolidation of these two entities had a positive impact on revenue growth but negatively impacted margins due to the businesses’ lower-margin nature (mid-high single-digit operating margins) vs. SATS’ core Food Solutions margins (low-teens operating margins).
Management has previously guided that the rapid expansion of GTR will result in higher costs incurred for manpower etc and this will result in relatively benign margins from this entity during its high-growth phase.
2. Persistent cargo weakness
We believe that SATS’s cargo business, which encompasses approx 11-12% of Group’s revenue, continues to be under pressure, in terms of both volumes and pricing.
Cargo volumes were down 3.2% YoY in 2QFY20 due mainly to Sino-US trade tensions. It’s Singapore revenue declined by 7% while Hong Kong’s revenue decline was even more severe due to the unrest.
This is a segment that has high operating leverage, hence any decline in business volume or pricing will have a significantly large impact on margins.
Consequently, weakness on the cargo front was a huge contributing factor towards the Group’s overall EBIT margins decline of 1.5ppt to 13.1%. Despite an imminent “phase 1” trade deal being concluded between the US and China by mid-Dec, the overall global cargo outlook remains weak.
“Air cargo’s peak season is off to a disappointing start, with demand down 3.5% in October. Demand is set to decline in 2019 overall – the weakest annual outcome since the global financial crisis. It has been a very tough year for the air cargo industry”.
Alexandre de Juniac, director general and chief executive of IATA
3. Disruption in Hong Kong
Hong Kong is a key market for SATS, particularly on the cargo front.
The prolonged unrest in Hong Kong might have claimed its first major victim. Hong Kong Airlines, Hong Kong’s third-largest airline was on Monday (2 Dec) given five days to find a substantial amount of new capital to keep the business afloat, as its cash on hand fell to a level that put its license in jeopardy, according to the Air Transport Licencing Authority.
The company on Wednesday announced that it had drawn up an “initial cash injection plan” that would allow it to pay the remaining staff their overdue salaries by Thursday.
Recall that Hong Kong Airlines, in March 2017, took a 51% stake in SATS HK and a 35% stake in AAT. Hong Kong Airlines subsequently chose AAT for cargo services and SATS HK for ramp services for its operations at Hong Kong International Airport.
The potential “demise” of Hong Kong Airlines, if their license is to be suspended, will negatively impact AAT’s cargo operations and could result in further profits decline/losses for SATS in the upcoming quarters. Receivables accruing to SATS (Hong Kong Airlines is a major client) might have to be written off as well.
AAT is SATS’ third-largest associate revenue contributor, after SATS BRF and PT Cardig Aero Services, based on its FY19 results. We believe that a significant decline in AAT’s operating performance will have a significantly large impact on its overall associates/JVs’ performances.
Conclusion
SATS is an ideal low-CAPEX play to ride on the “evolution” of air travel in the coming 2 decades.
The company consistently generates strong operating cash flow that helps support a growing dividend trend and is one of the most consistent SG blue-chip companies when it comes to dividend payment growth.
However, with the company trading at a forward PER multiple in excess of 20x, with limited to no near term earnings growth visibility, as illustrated by our analysis on the company, we see its valuation as demanding.
A decline of its share price closer to the SGD$4.50 level might be a more ideal entry-level for long-term investors looking to ride the structural growth cycle of the air travel industry.
With a potential yield of 4.4% at our ideal entry-level, investors are paid to wait as the company execute on its long-term vision to be the company that “feed and connect Asia“.
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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.
2 thoughts on “SATS: A solid long-term stock but we see 3 near-term headwinds”
Do you still think SATS is a good buy now after dropping to 4.46?
Taking into consideration the virus impact, I believe the short-term earnings impact will be much more significant than i originally envisioned when this article was first written. I would say depending on how fast air travel is resumed in Singapore, particularly for Chinese tourists, might there be a better assessment of the counter.
I don’t think the dividend payment would be cut but the growth trend might be halted in FY20. Nonetheless, it is still a decent 4%.
I still like the long-term outlook of the company. However, short term is going to be very choppy. I will look to incrementally add to the position.