Description

Singapore Airport Terminal Services (“SATS”) provides in-flight catering and ground handling services at Singapore Changi International Airport (“Changi”) and 39 other airports in Asia through joint ventures. SATS has a market capitalization of S$2.4 billion and an enterprise value of S$1.9 billion (based on estimated net cash balance of S$516 million in March 2008).  We project that SATS could generate fiscal 2009 (ending March 31, 2009) revenue and adjusted EBITDA of S$1 billion and S$379 million, respectively.  

We believe SATS common stock has 80% upside from its current stock price of S$2.27 because: (i) SATS may return up to 25% of its current market capitalization via a special dividend when it announces its FY 2008 results in early May 2008, (ii) the business is defensive and has limited potential downside, (iii) operations are poised for a return to growth, (iv) the significant hidden value of SATS’ pan-Asian operations implies a valuation of only 5.5x fiscal 2009 free cash flow for the core Singapore business, and (v) Temasek, SATS’ underlying anchor investor, is rational and has a track record of returning capital to shareholders.

·        Defensive, Cash-Generative Business in an Oligopoly Market:  With 80% market share, SATS is the dominant terminal services provider at Changi.  The magnitude of investment required to construct terminal services facilities and SATS’ economies of scale, create barriers to entry.  While Swissport recently won a license and launched a ground handling operation in Changi, no operator bid for the more capital-intensive in-flight catering license.  SATS generates significant free cash flow because its capex requirements are very low at only 2% of revenue (less than S$20 million).  Yet SATS benefits from the capital-intensive capacity expansion of Changi and Singapore Airlines (“SIA”), the company’s largest customer.  SATS’ cost structure is also highly variable.  Staff costs represent almost 60% of cash operating expenses, and the company has demonstrated the ability to reduce headcount to mitigate margin pressure.  Between FY 2004 and FY 2007, SATS cut staff by 20%.  In addition, the company has minimal exposure to fuel price and foreign exchange risk.  These qualities limit its exposure to cyclical downturns, without restricting its upside from the strong growth of the commercial aviation sector in Asia and of Changi as a hub.

·        Return to Growth:  Since 2004 SATS has pre-empted potential market share loss to Swissport by cutting ground handling rates and extending customer contracts for three to five years.  Because of this strategy, from FY 2004 to FY 2007 revenue grew at a 3% annual rate despite 10% growth in flights handled as rates declined at a 7% rate.  Prices are now stabilizing, while volume will continue to grow at 5% to 10% for the next few years due to the following factors:

a.   Changi Terminal 3 opened on January 9, 2008, dramatically increasing the airport’s passenger handling capacity by almost 50%.  This capacity will be filled by new airlines and low cost carriers eager to use Changi as a hub.

b.   Swissport is struggling and may shut down operations in Singapore.  On March 31, John Lilas, Swissport’s spokesman in Singapore told a local newspaper that Swissport was struggling and had recently lost 2 out of 6 ground handling customers in Singapore.  Swissport is struggling to compete with SATS and CIAS (#2 operator) because both of these larger operators are majority owned by airlines (SIA and Emirates) which have set up reciprocal ground handling deals with foreign airlines which prohibits them from using another ground handler in Singapore. We believe that Swissport is operating at a very small scale, is losing money, and may shut down in the near term.  Swissport is owned by Ferrovial, a highly levered Spanish group which owns the struggling BAA in the UK.  We believe Ferrovial has funding pressures and may be forced to shut down loss-making operations.  If Swissport shuts down, SATS and CIAS will operate in a duopoly market, and may be able to raise rates.

c.   The increasing liberalization of air services in Singapore provides an additional secular tailwind to Changi’s expansion.  By the end of 2008, Southeast Asian nations intend to implement an “open skies” agreement (“OSA”) removing restrictions on air services for all regional capital cities, and by 2015, complete open skies will be established.  This will open a 500 million passenger market to SIA and drive low cost carrier growth.  Singapore is also pursuing OSAs outside of Asia and in March 2008, an OSA between Singapore and the UK will take effect.  This will drive further traffic growth at Changi as British airlines use Changi as a pan-Asian hub.

d.      SIA has been prevented from meeting strong passenger demand because of tight aircraft capacity.  In 2006, SIA’s capacity growth was 2.7%, well below its stated target of 4% to 6%, and in the six months ending September 30, capacity fell by 1%. This situation is set to reverse.  In 2008 and 2009, SIA will receive new aircraft which will expand capacity by 7% and 8%, respectively.

e.   The Singapore government is moving aggressively to achieve a targeted 70% increase in tourism, from 10 million visitors in 2007 to 17 million by 2015.  In September 2008, Singapore will host Formula One racing, and by 2010, two massive integrated casino resorts under construction by Las Vegas Sands and Genting International will begin operations, increasing Singapore hotel rooms by 4,400, and attracting millions of new visitors.  In addition, the government has announced a long-term goal of increasing Singapore’s population by 40% to 6.5 million.

These events provide visibility into SATS’ earnings trajectory.  We incorporated these factors to develop the following financial projections:

·        History of Return of Capital:  The Company will have an estimated S$723 million cash and investments by March 2008, equal to 30% of its market capitalization.  Historically, SATS has distributed special dividends every three to five years when excess capital has accumulated, including a special dividend of S$0.37 per share for the year ended March 31, 2004, equivalent to 19% of the stock price at that time, and a S$207 million distribution in March 2000.  It has now been nearly four years since the last significant return of capital and the degree of overcapitalization today strongly suggests a special dividend may be declared in May with the completion of a financial review, which was announced in November 2007.  In addition, SATS owns real estate worth S$500 million and in January 2008 announced its first sale-leaseback of real estate. We believe there may be more to come.

·        The Temasek Factor:  Temasek Holdings (“Temasek”) controls 81% of SATS through its majority ownership of SIA.  Temasek has an extensive track record of efficient capital allocation, as demonstrated by return of capital initiatives taken at the portfolio companies listed below.  A majority of these initiatives have been announced within the last 2 years.  In May 2007, SATS’ parent company, SIA, returned S$1.5 billion to shareholders.

·   Hidden Associate Value:  SATS holds its international operations through associated companies which are not consolidated in the company’s financial statements.  These operations are located in many of Asia’s fastest-growing markets, including China, India, Vietnam, the Philippines, and Taiwan.  Historically, the company has not disclosed detailed associate operating results, leading investors to largely ignore their hidden value.  In 2007, SATS started to increase disclosure on the associates.  In FY 2009, we estimate associates will generate earnings of S$48 million.  We believe these pan-Asian operations are worth 15x earnings because they combine the high growth of the Asian commercial aviation sector with the corporate governance of a Temasek-linked company.

·        Management Inflection Point:  In November 2007, SATS appointed Clement Woon its first ever CEO from outside SIA.  Mr. Woon’s appointment is significant in that it represents the delinking of SATS from SIA and the introduction of an independent performance-oriented management team.  We believe Woon is reviewing capital structure alternatives, optimizing efficiency of the core operations, and creating a shareholder oriented culture at SATS. SATS also appointed a new CFO from SingTel, another Temasek-linked company that has delivered significant value to shareholders via capital repayments.

At SATS’ current price of S$2.27, after adjusting for the value of SATS’ pan-Asian operations, and projected cash, we are receiving the core Singapore operation for only 5.5x fiscal 2009 free cash flow, a 63% discount to the 15x multiple (or 6.7% yield) we believe it deserves.  If SATS increased its ordinary dividend payout ratio to 85% of free cash flow, we believe the market would value the dividend stream at a 5% yield, in line with ordinary dividend yields of 5% or less for high-dividend, mature Singaporean companies.  This supports our 6.7% free cash yield assumption.  The table below shows our fair valuation for SATS.  We see potential upside of 83% to our target price of S$4.15.

 DISCLAIMER:  This does not constitute a recommendation to buy or sell this stock.  We own shares of the company and we may buy or sell shares at any time.  Any projections are our estimates, and should not be relied upon.

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