New regulations from Boeing requiring the payment of an annual fee to Boeing for providing OEM technical support to aircraft owners (who use non-Boeing or non-Boeing certified MRO parties to convert their passenger-to-freighter aircraft) could have widespread implications for the cargo PTF conversion industry and its players.

According to a recent Flight International report, the new bill from Boeing will raise the technical support cost (which has historically been free) to US$150,000 and US$250,000 for a wide-bodied aircraft, with operators of aircraft converted by non-Boeing aircraft converters (the first category) paying the full fee for every aircraft in their fleet.

In the second category, operators of aircraft converted by Boeing-licensed supplemental type certificate (STC) holders will fall under another special category and will only need to pay US$200,000 per major aircraft type per year, or US$50,000 for each aircraft for fleets of three or fewer aircraft. In the third category, operators of aircraft converted under Boeing’s own Boeing Commercial Freighter (BCF) programme will continue to receive free support. The fees thus do not apply to the Boeing Converted Freighter (BCF) programme, under which 767-300s and 747-400s are converted by Boeing partners SASCO, a Singapore- based subsidiary of ST Aero, and TAECO in Xiamen, China, respectively, using Boeing STCs.

Besides the B767-300s BCF conversion, where the group has converted two aircraft and has another 17 in the pipeline; ST Aerospace also secured a US$470mn (S$700mn), seven-year programme in 2007 to convert eighty-seven B757-200 passenger aircraft to freighters for Federal Express, under a Boeing licensed STC. The group has a long-standing MD-11 PTF conversion, which is at its tail-end with another eight aircraft, which is also a Boeing BCF conversion.

ST Electronics recently announced the award of a S$100mn contract to provide the Advanced Combat Man System (ACMS) to the Singapore Armed Forces (SAF). ST Electronics expects to commence immediately with the supply contract, which is expected to be completed by 2012F.

The ACMS is a 3G Networked Warrior system equipped with advanced C4I (Command, Control, Communications, Computers and Intelligence) and network capabilities. It is jointly developed by the Defence Science and Technology Agency, the Singapore Armed Forces (SAF) and ST Electronics with the support of ST Kinetics- in the area of weapon sub-systems. The introduction of the ACMS is a part of SAF’s 3rd Generation Transformation to progressively provide tactical units with network capabilities, and we expect more SAF contracts as the armed forces upgrade systems and processes.

STE’s confirmed orderbook as at 1Q09 stood at S$11bn, of which more than S$2.88bn will be delivered over the next three quarters. As at 1Q09, commercial sales made up 64% of group revenue, while the rest was from defence-related businesses. We expect the group to continue to build up its orderbook, given that defence spending is relatively more resilient. On the commercial aircraft MRO front, concerns remain that a fall in demand among commercial airlines may continue to impact heavy maintenance and PTF conversion work in the short term.

We have trimmed our FY09-10F earnings by an average of 1.2-2.3% and are now assuming FY09-10F aerospace EBIT margins of 12.0% from 12.5% previously, with aerospace sales growth unchanged at 2%. This would still mean that ST Aerospace would have to perform substantially better in 2H09F, which is in-line with STE management guidance.

Following the earnings adjustment, our DCF-based price target is S$2.72 (S$2.73 previously, method unchanged, based on 8% WACC and 1% terminal growth). With the recent sharp price decline of over 8% over the past five months, STE is a relative underperformer. FY10F/11F P/Es now stand at 14.4x and 13.3x, respectively, with the stock now trading at the lower end of trough levels, given its historical P/E trading range of 12-22x. We do expect the group will maintain a healthy dividend payout ratio, given that it still generates robust cash. Our forecasts show ROE staying at a commendable 27% in FY10F and FY11F, with dividend yield at a relatively attractive level of 6.5%. We note possible continued downside risk to our price target from a worse-than-expected downturn in the global aircraft maintenance, repair and overhaul business, which accounts for 36% of group EBIT (1Q09).

As at end-March 2009, STE’s cash holdings and funds under management stood at S$1.38bn, with S$1.34bn being advance payments from customers. Operating cashflow for 1Q09 totalled S$351mn, with capex at S$54mn and investments at S$4.5mn for 1Q09.