Valuation premium hinges on dividend payout: We assume coverage of ST Engineering with Underweight and a new DDM-based PT of S$1.80. It has outperformed the market by 25% in the past 12 months and trades at 16.1x 12-month forward P/E and 4x trailing P/B. The stock has outperformed and is able to command its current valuation premium, as the company has been paying out at least 100% of its earnings since FY02. Any dip in the payout ratio could result in significant de-rating with potential downside of 47% as it reverts to trade in line with its aerospace and defense peers.

Cash rich no more: The company’s net cash (cash and cash equivalents - total debt) has deteriorated over the past four years to a low of S$58MM in 9M08. Taking into account the customer advances portion, ST Engineering is in a negative cash position of -S$955MM as of 9M08. The risk to its dividend payout might be increasingly acute.

Is the defense business still defensive? While we expect the Singapore Armed Forces to continue providing ST Engineering with a good baseload of defense work, defense contracts from the US government might slow, driven by a diminishing US presence in Iraq. Defense work accounts for below 40% of group revenue.

Aerospace and Marine fundamentals could stay weak: With global capacity reduction still in place, MRO work for ST Aerospace could decline on lower flight frequency. Marine’s earnings should restart from a lower base in FY09 with completion of the Frigate Program. Shipbuilding work should slow with ship repair remaining stagnant at best.

Beware of potential bad debt: While 9M08 group revenue was up a mere 6.5% Y/Y, accounts receivable increased by 24% Y/Y. ST Aerospace might have extended credit to some customers facing financial difficulties, resulting in potential bad debt provisions going forward.

Key upside risks to our PT: (1) Faster-than-expected recovery in the Aerospace and Marine segments; and (2) increase in contract wins, especially defense-related ones. We include two bearish options strategies from our Equity Derivatives Strategy team, which can provide downside protection against the potential earnings/dividend shocks and deterioration in the fundamental outlook.