WORLDWIDE Flight Services (WFS) chief executive Craig Smyth expects further softness in the global air freight market.

 

But if history is any indication, he said, the hit to the sector will probably last only three or four quarters. After that, the sector will likely take fewer than a couple of quarters to recover.

 

There were periods of anomaly, when the air freight market did not follow historical patterns.

 

The recent pandemic, for instance, led to a sharp contraction in capacity. And during the global financial crisis, which erupted in one quarter and lasted for four quarters with a 10 per cent reduction in volumes, it took six or seven quarters for the sector to see a full recovery.

 

Most cyclical downturns, however, tend to follow an established pattern, said Smyth, who joined air cargo handler WFS a little over six years ago.

 

With close to three decades in the aviation industry under his belt, he was also involved in an acquisition that helped transform the British bookstall owner John Menzies into a freight forwarding organisation.

 

Now, Smyth is overseeing what could be another transformative deal.

 

WFS has become a takeover target of Singapore-listed ground-handler and inflight caterer Sats : S58 -0.37%. The latter hopes to acquire Paris-based WFS for about 1.3 billion euros (S$1.86 billion), pending approval from Sats shareholders.

 

Since the deal was announced, however, shares of Sats have come under pressure.

 

Criticisms of the deal include the dilutive effect of fundraising to pay for WFS, the price tag, and the possibility that WFS&rsquo performance will weaken from here while Sats&rsquo should strengthen.

 

WFS posted a net loss of 30.9 million euros for the third quarter to September, compared with earnings of 26.8 million euros in the year-ago period, said its unaudited financial statements released last week.

 

This was even as the company&rsquo s revenue increased 44.2 per cent to 511.3 million euros.

 

Margins were hit by a 57.8 per cent rise in operating overheads and field expenses, and were mostly associated with acquisitions WFS had made in the United States last year.

 

Expenses also rose because of investments in business development and information technology, the company said.

 

Sats, too, reported a loss for the quarter to September, to the tune of S$9.9 million. This was a reversal from its year-ago profit of S$6.8 million, but was distorted by the effect of the government&rsquo s pandemic reliefs.

 

Stripping out the reliefs, Sats&rsquo net loss would have been S$19.7 million in the most recent quarter &ndash an improvement from a net loss of S$30.1 million in the year-ago period.

 

WFS also has a significant debt load. Its adjusted net total financial debt was about 1.1 billion euros as of end-September, up 54.7 per cent year on year.

 

The air cargo handler attributed the jump to its refinancing early in the year in the form of senior secured notes. These listed notes carry interest rates of 6.375 per cent, 7.875 per cent and Euribor (Euro Interbank Offered Rate) plus 6.125 per cent per annum.

 

Smyth, however, is optimistic about the cargo sector&rsquo s long-term prospects, which he believes should outperform global gross domestic product growth.

 

The current softness in the market is related to Russia&rsquo s invasion of Ukraine and the Covid-induced lockdown in China, Smyth said.

 

However, he expects cargo traffic to rebound once both these situations are resolved. Any easing of trade tensions between the United States and China would also help.

 

Meanwhile, the sector is riding a structural tailwind from e-commerce. Demand took off during the pandemic and now accounts for 20 per cent of products flown, he said.

 

Smyth is therefore confident of WFS&rsquo prospects. Until the cycle turns, he expects the company&rsquo s diverse clientele and geographical footprint &ndash spanning 160 airport stations in 17 countries &ndash will keep it steady: &ldquo The spreads, the strengths, the depth of the WFS network across the world, but particularly in Europe and North America &ndash that diversification of geography does give us a lot of resilience.&rdquo

 

According to Smyth, 25 per cent of WFS&rsquo global airline customers are Asia-based. The Middle Eastern airlines make up another 20 per cent, with Qatar Airways and Emirates among them.

 

Besides airlines, WFS also serves a myriad of players in the freight industry: &ldquo We&rsquo re the biggest partner when it comes to the handler partner of Amazon in the US. And we&rsquo re building a relationship with China now.&rdquo

 

Most of the company&rsquo s contracts also provide for the pass-through of inflation.

 

Having a presence in various nations has provided his team the experience of working in different cultures, Smyth said. He therefore does not expect any integration issues with Sats.

 

He does not believe that the acquisition would run into antitrust problems either, as he said there is an &ldquo almost zero overlap between the companies&rdquo .

 

Over the longer term, Smyth has growth on his mind. WFS aims to increase its capacity globally by 30 per cent over the next three or four years.

 

If the deal with Sats takes place, he said, retrenchment of WFS&rsquo 31,000 workers is not on the cards, as the acquisition is &ldquo all about enhancing the network&rdquo .

Sats has given better clarity on how it plans to fund what it calls the &ldquo trans­ formational opportunity&rdquo of bringing Worldwide Flight Services (WFS) un­ der its wings. At its 1HFY2023 end­ ed September results briefing on Nov 9, Sats said that the acquisition will cost $1.8 bil­ lion, and will be funded by a rights issue of not more than $800 million, term loans of about $700 million, and $320 million from internal cash resources.

 

In its Sept 28 announcement, Sats says that through cross-selling, network expan­ sion and deeper e-commerce cargo partner­ ships, the combined entity is expected to capture meaningful run-rate ebitda syner­ gies above $100 million.

 

However, investors seemed to worry that the acquisition will require a dilutive call on capital. This sent the share price plunging the following day from $3.87 to $3.07 on Sept 29.

 

The share price, barely recovered from the pandemic over the last couple of years, dipped even further to as low as $2.54 on Oct 25, lower than its previous five-year low of $2.58 on March 23, 2020, before recover­ ing somewhat to close at $2.67 on Nov 23.

 

For investors who do not yet hold Sats, is the stock now an attractive buy? Or might there be further dips to come as the compa­ ny deals with a higher debt load?

 

Analysts generally agree that the WFS ac­ quisition will benefit Sats in the long term, even though they are more careful about the near-term prospects.

 

Chu Peng of OCBC Investment Research (OIR) has kept her &ldquo buy&rdquo rating but has cut her target price by about 30% from $4.72 to $3.26. She agrees that WFS, as a global leader in cargo handling, is a complementary port­ folio for Sats to own. &ldquo Investors with a long-term investment horizon may stay invested in Sats,&rdquo she says. However, she warns that the potential rights issue remains an over­ hang and will weigh on its near-term share price performance.

 

PhillipCapital&rsquo s Terence Chua, who did not cover Sats before the WFS announce­ ment, initiated coverage on Nov 21 with a call to &ldquo accumulate&rdquo and a target price of $3.02, which is pegged to 18.5x Sats&rsquo FY2024 ending March 2024 earnings, one standard deviation below its historical average. &ldquo We believe the latest clarity on its funding struc­ ture will alleviate some of the overhangs on the stock from the uncertain funding struc­ ture,&rdquo he says.

 

He has modelled a three for 10 rights is­ sue scenario at an issue price of $2.29, which is at an estimated 15% discount to its clos­ ing price of $2.68 on Nov 18, to arrive at a theoretical ex-rights price (TERP) of $2.60.

 

Chua says Sats is now at an &ldquo inflexion point&rdquo on the back of the recovery of the aviation industry, and is projected to break even by 2HFY2023 ending March 2023. &ldquo We view Sats as best in class with a defensive business model and superior growth profile due to its overseas expansion plans and the expansion of new concepts.&rdquo

 

Sats, with its strong cash flow genera­ tion and defensive balance sheet, ticks an­ other box for Chua. With an estimated free cash flow of $150 million for FY2024, Chua says Sats can support its dividend payout and also deleverage following the acquisi­ tion. Chua estimates that the acquisition will drive up the company&rsquo s net debt to equity from 2.8% in FY2022 to 38.5% for the current FY2023, before reducing it to 29.3% for FY2024.

 

Nomura&rsquo s Global Markets Research analysts Ahmad Maghfur Usman and Divya Thomas say that the deal &ldquo elevates Sats as a global leader&rdquo . While they have kept their &ldquo neutral&rdquo view on the stock, their target price of $4.94 is the highest among all analysts with an ac­ tive, updated coverage of the stock.

 

The Nomura analysts note that the com­ pany considers this funding plan to be opti­ mal. While the company is evaluating loan proposals from the banks, Sats&rsquo management expects the terms to be not too different from its existing debt.

 

UOB Kay Hian&rsquo s Roy Chen notes that with the acquisition, his investment thesis on Sats has changed. For years, with its dividend payout at 70% to 80% of its earnings, Sats is seen as a stable yield play. With the ac­ quisition, Sats will be a stock offering a bet­ ter balance of growth and yield, says Chen, who has a &ldquo buy&rdquo call and a $3.08 target price on the stock.

PHILLIP Securities has initiated coverage on index counter Sats with an &ldquo accumulate&rdquo call and target price of S$3.02.

 

The target price is based on a price-to-equity multiple of 18.5 times for FY2024, which is one standard deviation below its historical average.

 

Analyst Terence Chua said air travel will be a key driver for Sats, estimating that recovery in the industry will push the group towards breaking even in the second half of FY2023 and profitability in FY2024.

 

For its second quarter ended Sep 30, Sats had reported a net loss of S$9.9 million.

 

Citing Sats&rsquo recent diversification efforts, including its investment in Jurong Food Hub and acquisitions in various companies, Chua expects the group to further diversify its revenue streams going forward.

 

He added that Sats&rsquo &ldquo strong&rdquo cash flow generation and &ldquo defensive&rdquo balance sheet place it &ldquo well above its peers&rdquo .

 

Chua also noted the increased clarity on the funding for Sats&rsquo acquisition of air cargo handling firm Worldwide Flight Services (WFS) as a plus point.

 

The group had in September announced that it would be acquiring WFS for a cash consideration of around 1.2 billion euros (S$1.7 billion). Without a clear funding plan accompanying the announcement, Sats shares slumped 23.5 per cent to a two-year low.

 

Sats later shared that it would finance the acquisition with a mix of internal cash resources of about S$320 million, term loans of about S$700 million, and rights issues of up to S$800 million.

 

Chua said the funding clarity would &ldquo alleviate some of the overhang on the stock&rdquo . He estimates that the term loans would incur a 5.5 per cent financing cost, payable in three to five years. On the rights issues, he expects that three rights shares could be issued for every 10 shares held by entitled shareholders.

 

While the acquisition of WFS would bring Sats&rsquo net debt up to 38.5 per cent from 2.8 per cent in FY2022, Chua believes that WFS&rsquo &ldquo strong cash flow generation capability&rdquo would lower the group&rsquo s net debt back down to 29.3 per cent in FY2024.

 

Concurring, OCBC Investment Research&rsquo s Chu Peng said the acquisition is &ldquo likely to benefit SATS over the long run&rdquo , given the synergies in their portfolios.