Sats’ WFS purchase represents short-term pain for long-term gain

SHARES of airline caterer and ground handler Sats : S58 0% have recovered slightly in recent weeks, raising a question of whether the market is slowly beginning to recognise the merits of its deal to buy air cargo handler Worldwide Flight Services (WFS). If that is the case, should shareholders who attend the extraordinary general meeting later this week to vote on the WFS acquisition give their approval?

On Sep 28 last year, Sats announced its intention to buy WFS for 1.3 billion euros (S$1.9 billion). The deal was to be at least partially funded by a large rights issue, with a presentation indicating a “base funding plan” of S$1.7 billion in equity fundraising.

The day after the announcement, Sats’ shares fell as much as S$0.91 or 23.5 per cent to close the day at $3.07. By the end of the week, the shares had fallen 22.2 per cent or S$0.86 to S$3.01. The slide has continued, and Sats closed on Friday (Jan 13) at S$2.91.

In November 2022 and January 2023, the Securities Investors Association (Singapore), or Sias, organised two hybrid dialogues between Sats shareholders and senior management to clear the air over the WFS purchase and to assist shareholders in making an informed decision when voting. Below is an encapsulated version of these sessions, at which Sats presented a scenario that can best be summarised as “short-term pain but long-term gain”.

What if another pandemic were to strike?

Among the questions at hand: Is it good enough for a Singapore-based company with a very small domestic market to be just another player in the Asian cargo market, or should it have loftier ambitions and aim for a global footprint?

In answering this question, Sats’ management has taken into account a factor that three years ago was not on anyone’s mind: the possibility of another pandemic that, if it results in yet another shutdown of all countries, would once again drag Sats into a loss-making position, as Covid-19 did, given its heavy reliance on airline catering and ground handling.

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As the pandemic raged, and passenger numbers dropped to zero, air cargo was a bright spot, continuing to generate revenue. Many airlines converted passenger aircraft to take on more cargo by removing seats to make space. Singapore Airlines : C6L 0% was reported to have strapped parcels on passenger seats in a bid to maximise cargo uplift.

Buying WFS has expanded Sats’ reach in cargo handling to Europe and America, trebling its revenue. If another pandemic were to strike, the combined entity would stand to benefit significantly by virtue of its significant presence in major airports across the Americas, Europe and Asia-Pacific.

To justify a major acquisition on the possibility of another pandemic happening may be tenuous, but the reasoning appears fundamentally sound.

Does the acquisition make sense in this environment?

This issue was raised at the November dialogue session, and the reply from Sats’ chief executive Kerry Mok was that the uncertain economic outlook enabled the company to secure a lower price for WFS than that which was originally asked.

“We are not paying top valuation, neither are we paying the lowest,” he said. “The price is within range.”

Shareholders have raised questions about WFS’ profitability, which was significantly boosted during the pandemic.

A report by proxy adviser Glass Lewis, which recommends shareholders approve the deal, noted that the transaction is priced at 12 times WFS’ last 12 months’ (LTM) earnings before interest, taxes, depreciation and amortisation (Ebitda) and an adjusted Ebitda multiple of 11.1.

Its own assessment of 14 completed transactions announced since 2018 in the airport services or air freight industries found that the deal’s LTM Ebitda and adjusted Ebitda multiples ranked in the 55th and 52nd percentile, respectively.

Will there be managerial continuity to ensure integration of WFS into Sats?

This was asked multiple times at the November 2022 and January 2023 sessions, and the answer given was that the key members of WFS’ management team have indicated their commitment to continue working with WFS after the acquisition. Appropriate retention plans will be put in place to support their retention. Sats plans to give the integration process 12 to 18 months, which the company believes is sufficient time for both companies to learn about each other.

As stated in the original release, “WFS will become a wholly owned subsidiary of Sats after the proposed acquisition and will continue to be led by chief executive officer Craig Smyth, alongside other key members of the senior WFS management team”.

It was also revealed at the sessions that WFS approached Sats four years ago about possible collaborations, which management said suggests WFS had already identified Sats as a strategic fit.

Does the deal make financial sense?

In its Sep 28, 2022 announcement, Sats said the deal is expected to be “immediately financially accretive”. If completed at the start of the financial year, the deal would have raised its earnings per share (EPS) for FY2022 ended Mar 31 by 78 per cent – from S$0.018 to S$0.032 cents. Its net profit on a pro forma basis would have risen from S$20 million to S$56 million.

In its Jan 3, 2023 circular, however, Sats revised its figures. Now, EPS rises only to S$0.019 while net profit only goes up to S$28 million.

Sats has clarified that the downward revision is because the deal will now be partially funded by S$700 million in borrowings, which therefore increases the interest expense and reduces the pro forma net profit.

The increased debt load will, however, reduce the cash burden on shareholders, as the rights issue will not have to exceed S$800 million. The remaining S$320 million to fund the acquisition will come from its cash holdings.

Sats has also disclosed that WFS incurred net losses for the first three quarters of 2022, largely due to unrealised foreign exchange losses against its senior secured notes as well as one-off items.

Management believes that initiatives such as cross-selling, network expansion and deeper eCommerce cargo partnerships might allow the combined entity “to capture meaningful run-rate Ebitda synergies in excess of S$100 million”.

Shareholders must now weigh the positives of the WFS purchase against the negatives created by a major deal, including the dilution from the rights issue.

The writer is founder, president and CEO of Sias