Leading air cargo handler with a dominant foothold in North America and Europe. WFS is an international aviation services company concentrating mainly on handling air cargo (c.76% of total revenue in 2022) at airports in Europe and North America, with the two regions accounting for 92% of total revenue. Operating in 17 countries with 158 airport stations, the group is the world’s largest air cargo handler by revenue and volume. In terms of scale, WFS handled 6.8m tons of cargo in 2022, which is c.42% greater than its closest competitor, Swissport. WFS sets itself apart from its competitors by having warehouses strategically positioned at or next to major space-constrained airport hubs. Additionally, the group has a highly diversified customer base of 300 customers, consisting of airlines, integrators and freight forwarders, and boasts long-term relationships with key customers and high customer loyalty with >90% contract renewal rates, underpinning revenue visibility.

Debt-funded acquisitions fueled remarkable growth between FY14-FY22. WFS has an impressive growth track record, and a large part of this can be attributed to its success in growing the business inorganically via targeted M&As. In chronological order from 2014, the group first acquired a controlling stake in Orbital Servicos, marking its foray into the South American market. In 2016, WFS acquired 51% of Fraport’s cargo handling business in Frankfurt and broadened its presence in the US by acquiring Consolidated Aviation Services (CAS) in the US in 2016. Fast forward to 2021, WFS completed the acquisitions of Pinnacle Logistics and R.A. Hand and Mercury and Maytag Aircraft Corporation, further bolstering its market share in the United States. As a result, WFS’s revenue and adjusted EBITDA grew in tandem at an impressive 15% and 18% CAGR respectively between FY14-FY22. However, net debt also rose at a similar rate of 21% during the period as acquisitions were primarily financed through debt.

Historical operating margins have generally been better than peers; decent free cash flow generation but large portion of cash was allocated towards debt servicing. From FY14-19, WFS consistently surpassed other leading ground handling companies, achieving an average adjusted EBITDA margin of 9.3%, which was 1.6 percentage points higher than the average of its peers during the same period. It was also 4.0 percentage points higher than its nearest equivalent, John Menzies, which has the most significant exposure to air cargo. Despite a severe drop in cargo tonnage and passenger flights during the pandemic, WFS's focus on air cargo helped it fare significantly better than its peers, allowing it to sustain positive adjusted EBITDA (excluding government wage support and grants) in FY20-21. With an asset-light business model, WFS is also cash flow generative, with an average normalised free cash flow (before interest) to sales ratio of 3.8% over the past five years, which is slightly better than its competitors, though the bulk of its free cash flow was used on interest payments.

All things considered, WFS is a highly complementary and strategic fit for SATS. SATS and WFS are focused on serving different markets, with SATS predominantly centered in Asia, and WFS in Europe and North America. Together, the two groups will eclipse its competitors and form the world’s largest air cargo handler, with a global network of 201 cargo and ground stations in 23 countries, holding pole positions in major cargo hubs connecting trade lanes between Asia to Europe and North America.

Beyond expanding its network and diversifying geographically, SATS can leverage on WFS to enhance its revenue streams. Firstly, SATS will be able to offer an increased array of value-added services, including breakbulk, sortation and distribution. These services, which reduce turnaround time, are particularly valuable for time-sensitive and high-volume demands. Moreover, SATS can provide seamless visibility and traceability between cargo stations, offering comprehensive, end-to-end solutions. This would extend to multi-modal solutions, incorporating downstream cargo logistics via WFS’s trucking network in Europe and the US.

The combined group will be in a better position to capitalise on secular trends driving sustained growth in the air cargo market. Boeing predicts that global air cargo traffic will more than double over the next two decades, registering an average annual growth rate of 4.1% from 2022 to 2041. This growth will outpace the projected global economic growth rate of 2.6% during the period, as global trade grows at a faster pace of 2.8%. This encouraging trajectory is underpinned by factors like globalisation, market liberalisation, more goods becoming eligible or suited for air transport, and key growth sectors like e-commerce, integrated circuits and electronic components (ICEC) and pharmaceuticals.

SATS expects to realise >S$100m run-rate EBITDA synergies over the medium-term through several key initiatives, which include:

1. Cross-selling (near-term): A dedicated sales team will be tasked to evaluate gaps in customer coverage across the combined business and cross-sell solutions between the two customer bases.
   
   
2. Establishing e-commerce partnerships globally (near to medium term): WFS has an outstanding track-record and operational expertise in serving e-commerce players in the US and Europe, maintaining long-term partnerships with companies like Amazon. SATS will harness WFS’s strong suite of e-commerce/express cargo handling services and offer it to a broader client base in Asia Pacific, a region where e-commerce players are currently underserved.
   
   
3. Drive operational efficiencies and productivity (near to medium-term) via the exchange of best practices and automation of WFS’s operations. This includes warehouse automation, automated storage and retrieval, automated vehicles, scanner/smart gates, and live data tracking with QR codes.

SATS will also be able to reap substantial financial synergies. The notable disparity in the cost of debt between SATS and WFS suggests that SATS could achieve interest savings by optimising the combined group’s capital structure. Prior to the acquisition by SATS, WFS had a speculative single ‘B’ credit rating by S&P with a high cost of debt between 6-8% in the past five years. We estimate a 3-4% differential between the two entities’ cost of debt, though this gap has likely contracted slightly given the deterioration in SATS’s credit profile. This suggests that SATS could enjoy considerable interest savings if it were to refinance all the debt (c. EUR1.1bn as of Dec-22) on WFS’s balance sheet.

In May-23, SATS redeemed WFS’s €250m floating rate notes at 101 cents on the dollar, and subsequently issued a tender offer to redeem the €340m and US$400m fixed-rate notes. The initial tender offer was not well received as SATS only offered 101 and 101.3 cents on the dollar for the EUR and USD fixed rate notes, which was notably below the 103.2 and 103.9 cents redemption price (2024) stipulated in the bond documents. The terms of the revised tender offer, however, were much more attractive, with the consideration offered by SATS matching the bonds’ respective early redemption price in 2024. By 18 May, SATS had received sufficient consent from bondholders to trigger a clause allowing for the redemption of all fixed-rate notes, which includes those held by bondholders who did not accept the tender offer.

Taken together, SATS is on track to refinance the vast majority of WFS’s total debt in 1QFY24F. We assess SATS’s all-in cost of debt in EUR to be 200-250bps above Euribor, with the group’s current all-in cost of debt in EUR leaning towards 5.0%. Due to the premium SATS must pay for early redemption, the group will likely see limited financial savings in FY24F, given that its current cost of debt in EUR is around 2-3% below the coupon rates on WFS’s fixed rate notes. However, we project the group’s interest savings in FY25F to be far more substantial.

Apart from potential interest savings, SATS’s weighted average cost of capital could trend lower over the next few years as it pares down debt. Our estimated cost of capital for SATS remains the same at 7% despite the marked increase in debt in its capital structure. This is because SATS’s current cost of equity is adversely impacted from the group assuming higher financial risk (leading to a higher levered beta) and our higher risk-free rate assumption. Over a longer timeframe, however, improved geographic diversity and earnings stability resulting from the acquisition should translate into a lower beta, and consequently, a lower cost of capital once the group optimises its capital structure.

But the price tag for acquiring WFS is steep, and the timing less than ideal. SATS acquired WFS at an enterprise value of EUR2,250m, posting an implied valuation multiple of 9.7x EV/trailing-twelve-months pro-forma EBITDA. However, the EBITDA figure used by the group to calculate this implied valuation multiple included non-recurring items like payroll support program grants that positively impacted earnings. Stripping out these items, we estimate the true implied multiple of the acquisition was at 11.9x EV/adjusted EBITDA.
This figure is notably above the average of 9.6x of precedent transactions, such as 9.2x Cerberus paid to acquire WFS in 2018, and 10.0x (pegged to normalised EBITDA) National Aviation Services paid for John Menzies last year. It is worth noting that these past transactions largely occurred in a low interest rate environment, which was supportive for valuation multiples. Additionally, this deal was struck just before a downturn in the air cargo market, raising the question of whether SATS could have secured a better deal by waiting.

Nonetheless, the correction in SATS’s share price is overdone. To recap, SATS financed the acquisition with S$800m from a rights issue, a S$700m EUR term loan, and S$320m from its own cash reserves. The current share price of SATS is 20-25% lower on an adjusted basis (after factoring the rights issuance) from Sep-22, when rumours of the acquisition first surfaced. Considering SATS’s current share price, and assuming its standalone enterprise value is the same as before the acquisition, the market implied standalone enterprise value of WFS is just €1,178m. This suggests that the market is either only pricing WFS at a mere 6.2x EV/EBITDA or foresees the acquisition to be value-destructive for the combined group, which is overly pessimistic, in our view.

The combined entity is now only priced at c.10x EV/forward adjusted EBITDA, which is around 2.5 standard deviations below its five-year pre-COVID19 average. While we acknowledge that SATS’s business profile is now dramatically different, with a greater emphasis on the cargo and ground handling segments, we believe that it deserves a higher multiple. This perspective is supported by SATS’s yet-to-be-normalised standalone EBITDA, the combined entity’s solid free cash flow generation, and potential for the group to eventually secure a lower cost of capital.

Despite an imminent slowdown in air cargo volumes, WFS’s earnings are not expected to take a drastic hit. Airlines, freighters and integrators often find themselves at the mercy of fluctuating air freight rates, which can change abruptly based on air cargo supply and demand dynamics. Contrarily, WFS operates on multi-year contracts, averaging around three years in duration. These contracts typically include a fixed fee charged on a per metric tonne basis, with built-in inflation clauses that allow for incremental price increases over time. As such, WFS’s revenue is primarily influenced by changes in cargo volumes, leading to a more stable earnings profile for the group. In addition, even as the air freight market cools, WFS’s ground handling segment (c.24% of revenue in FY22) should continue to see healthy growth as passenger flight volumes trend higher in Europe and North America.

WFS’s reported revenue of €476.0m in 1QFY23 (4QFY23 for SATS), marking a 5.1% y-o-y increase. This growth was largely driven by a 22.8% surge in ground & ancillary revenue, while cargo revenue was stable y-o-y as price hikes compensated for lower volumes across all regions. However, EBITDA fell by 46.0% y-o-y to €20.9m, owing to a less favourable revenue mix and cost inflation. The group’s near-term outlook appears murky as a deceleration in macroeconomic growth, high inventory levels, and the easing of global supply chain bottlenecks are likely to dampen air cargo demand. Hence, we currently project the group’s EBITDA to decline by 20-25% y-o-y in 2023 (FY24F for SATS) before bouncing back in 2024.

WFS unlikely to be profitable in FY24F but should contribute meaningfully to the bottom line from FY25F onwards. Headwinds in the air cargo segment and integration costs will likely lead to WFS spilling red ink in the upcoming fiscal year. However, we foresee the group to be earnings accretive from FY25F, as its operational performance strengthens, near-term operational synergies are achieved, and interest expense decreases as most of WFS’s debt will be refinanced in FY24F. Overall, integration and execution risks should be controllable, as the majority of WFS’s management will be retained and a dedicated integration committee, led by senior executives from both groups, will oversee the process. Foreign exchange risks will arise for SATS, given that WFS’s revenue, costs, assets and liabilities are denominated in multiple currencies. However, SATS intends to implement a hedging policy and financial management strategy to effectively manage the combined entity’s overall foreign exchange exposure.

We project SATS’s (including WFS) EPS to reach 88% of FY19’s level at 19.7Scts in FY25F, a significant turnaround from -3.1Scts in FY23F. Cargo business aside, we should see a sustained improvement in SATS’s aviation food and ground handling business over the next few years as passenger flights and traffic recovers, particularly in the long-haul segment within Asia. Meanwhile, the group’s non-aviation food segment is also expected to register healthy growth as it expands its product portfolio, distribution channels and production capacity with new central kitchens in Tianjin and Bengaluru coming online, and a new food hub in Jurong. Wage inflation amid a tight labour market will continue to adversely impact the group, but lower general inflation will offer some relief. Moreover, raw material costs should drop as food costs have retreated from their peak in 2022.

Upgrade to BUY with a lower TP of S$3.40. As per the table below, our blended valuation framework now incorporates a forward EV/EBITDA component (as opposed to forward P/E before) given the change to SATS’s business profile and that EV/EBITDA is a widely used metric for ground and cargo handlers. We are taking a prudent stance by applying an EV/EBITDA peg of 11.6x as we monitor the success of the management’s integration efforts. This represents a conservative valuation, at 1.5 standard deviations below SATS’s five-year pre-pandemic average. We believe the current share price level is an attractive entry point with favourable risk-to-reward, and anticipate around 25-30% upside. Market sentiment is still predominantly bearish at this juncture, and dividends could be deprioritised, as the group focuses on repairing its balance sheet. Nonetheless, we envisage a successful integration of WFS and a sustained rebound in earnings to drive a re-rating of its share price.