SATS Ltd Investors Should Know This Important Investing Formula

The return on equity (ROE) metric is an important measure of a company’s ability to generate a profit with the shareholders’ capital it has. Generally speaking, a high ROE is preferred over a low one, all things being equal.

The following chart illustrates how SATS Ltd’s (SGX: S58) ROE has changed over its last five fiscal years:

SATS's ROE chart - Wilson
Source: SATS’s annual reports

SATS has two major business segments, namely, Food Solutions and Gateway Services. Under the first segment, SATS provides services such as airline catering, food distribution, industrial catering, and more. With the Gateway Services segment, some of SATS’s activities include the handling of cargo and passengers at airports.

As you can see from the chart above, SATS’s ROE has been steadily rising over its last five fiscal years, from 10.5% in FY2012 (financial year ended 31 March 2012) to 13.9% in FY2016. This rising ROE has coincided with a big 112% jump in SATS’s share price from S$2.23 at the start of 2012 to S$4.72 today.

What has driven SATS’s ROE performance these past few years? We can gain some insight by breaking down the ROE according to the following formula:

ROE = Profit Margin x Asset Turnover x Equity Multiplier

Some of you may find the formula familiar. It is actually the DuPont formula created by the DuPont Corporation nearly a century ago in the 1920s to measure its own internal efficiency.

So what can the DuPont analysis tell us about the changes in SATS’s ROE from FY2012 to FY2016? Let’s start with the first component of the breakdown, the profit margin:

SATS's profit margin chart - Wilson
Source: SATS’ annual reports

SATS’s profit margin was stable between FY2012 and FY2014 but started climbing in FY2015. As of FY2016, SATS’s profit margin stands at 12.8%. A considerable amount flows to SATS’s bottom-line for each dollar of revenue it brings in.

The improvement in SATS’s profit margin is mostly attributable to good cost management. Even though the company’s revenue stayed flat over the years, inching up from S$1.69 billion in FY2012 to just S$1.70 billion in FY2016, net income increased from S$171 million to S$218 million.

SATS's asset turnover and equity multiplier chart - Wilson
Source: SATS’ annual reports

The second component of the DuPont breakdown, the asset turnover, is a measure of how good SATS is at utilizing its assets to generate revenue. It is calculated by dividing the company’s revenue with its assets. Generally, a higher asset turnover translates to a better performance.

As you can see from the chart, the metric did improve slightly from 0.8 in FY2012 to 0.9 in FY2013, but then drifted back to where it started in FY2016.

Given what I mentioned earlier about SATS’s stagnant revenue, it should not be a surprise to learn that the company’s assets have remained flat as well. The slight improvement in the asset turnover in FY2013 was due to higher revenue generated, something SATS did not manage to sustain.

The last component of the DuPont formula is the equity multiplier and it is found by dividing a company’s assets with its equity. It is a gauge for how much leverage – and thus financial risk – SATS is taking on. Generally, higher leverage results in a better return on equity, but it also comes at the expense of a weaker balance sheet.

You can see that SATS’s equity multiplier has pretty much been the same over the past few years.

A Fool’s take

To sum up, SATS’s rising ROE is mostly the result of its higher profit margins. However, it is worth noting that the company has actually shown little revenue growth over the past five years. The better profit margin comes from tighter cost controls, but it’s worth keeping in mind the idea that there is a limit to how much costs can be cut.

At this juncture, I should highlight that more work needs to be done beyond the DuPont analysis efore any firm investing conclusion can be made on SATS. This look at the company’s ROE should only be seen as a useful starting point for further research.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Wilson Ong doesn’t own shares in any companies mentioned.