FINMY - Leonardo: A New Strategic Plan May Add Value

2023-08-25 04:32:44 ET

Summary

• Solid Q2 with a strong commercial momentum. Leonardo achieved the highest order intake in its history.
• The company is on target to deleverage and increase cash flow trajectory.
• The guidance was confirmed, and so was our valuation.

Here at the Lab, we positively report Leonardo's stock price performance (FINMF) (FINMY). Since our buy rating called " Now A Buy ," we recorded a total return of almost 70%, and we believe the company is still discounted. Our investment was backed by 1) a recovery in the Aerostructures division supported by Boeing, 2) an ongoing deleveraging story, 3) " DRS Upside To Price In ," and 4) a " Supportive Order Pipeline . " In addition, within the A&D sector, Leonardo is currently trading in the bottom P/E range quartile and is still offering a free cash flow yield projection of 12.5% by 2025.

Q2 Comment

Very briefly, in H1, Leonardo delivered sales up by 6.4% year-on-year to €6.9 billion with a core operating profit of €430 million (+5.7%). The company reported a slowdown in net income, which fell to €208 million; however, Leonardo confirmed its 2023 full-year guidance. In detail, considering H1 results, the Defence Italian Group confirmed orders intake for €17 billion and revenue generation at around €15.5 billion with EBITA at approximately €1.3 billion. On a positive note and in line with our supportive buy rating, the company's cash flow shows a solid improvement. They remained negative by €517 million but marked an increase of 46.3% compared to the -€962 million achieved last year. Leonardo increased its order by approximately €8.7 billion with a plus 21.4% compared to Q2 2022 and brought a record €40 billion backlog to the portfolio. This implies a book-to-bill at 1.3x. The group's net debt fell by 24% to €3.6 billion, with a target to achieve a year-end deficit of €2.6 billion thanks to lower cash absorption and better operating cash flow (plus a reverse trend in tax payment and no dividend cash-out).

New positive catalyst

Following our article called " Positive Catalysts Likely To Price In ," today we are back to update the latest Leonardo key highlights:

1. The company closed new commercial contracts in LATAM, strengthening its leadership position in the private helicopter transport market. This was announced during the Labace 2023 trade show;
2. More importantly, Leonardo DRS CEO announced that the group is exploring the possibility of having a role in creating the future infantry fighting vehicle for the US Army called " XM30 ", which will replace the " Bradley " infantry fighting vehicle. This new US program could be worth $45 billion. We are following up with an article on DRS; however, according to our initial estimates, Leonardo DRS might sell parts for $0.5 million per unit, about 5% of the cost of each vehicle. Therefore, this contract would imply a value for Leonardo's subsidiary of $2.25 billion;
3. In this period , Leonardo has been awarded 18 R&D projects under the European Defense Fund and the Work Program 2022. EDF is the flagship tool of the EU Commission to promote cooperation among the State members. The European Defense Fund will contribute to the strategic defense autonomy and create a more integrated European defense industrial and technological base. The funds allocated a total of €832 million, and Leonardo will receive 74% of the amount;
4. The French newspaper La Tribune reported an interview with the CEO of Airbus Helicopters (one of Leonardo's main competitors), and he explained how they are targeting 10% plus deliveries in 2023 thanks to dynamism in both the civil and military sectors. For 2024, the forecast is to deliver 400 helicopters (+6% approximately year on year), while we are implying a 5% plus in Leonardo Helicopters deliveries. However, we see no reason why Leonardo's deliveries should grow at a lower rate than Airbus. To support our view are the rumors of 40 new helicopters for the German Bundespolizei. This award is expected by 2023 end, and we anticipate a total of around €2 billion in new orders;
5. During the call, the new CEO indicated a review of R&D expenses with priorities in cybersecurity and space. We positively view this development. In addition, he also suggested reshaping the many JVs in which Leonardo has a stake. Leoanrdo's business model simplification is a current upside not priced in and will likely create long-term shareholder value. Here at the Lab, we already commented on OTO Melara. Leonardo owns a 25.1% stake in Hensoldt , 25% in MBDA , and 29% in Avio .

Conclusion and Valuation

Thanks to the solid H1 results, we are now implying revenue of €15.2 billion in 2023 with a core operating profit margin of 8.2%. We are ahead of consensus in debt deleveraging, and we estimate a financial obligation of €2.6 billion by year-end. The new CEO brings a new ambition, and we expect a new strategic plan update in 2024. He confirmed room for improvement in earnings and cash conversion. In our estimates, Leonardo is trading at a P/E of 9.6x in 2024 with an EV/EBITA of 7x. This is much better than the company's past 4-4.5x EV/EBITA valuation. However, Leonardo is still the cheapest defense contractor. As a reminder, without even considering the US defense company in the EU area, cross-checking Dassault Aviation and BAE System valuation, their P/E multiple are double-digit (P/E at 16x average and EV/EBITDA of 10x). Therefore, we confirmed our price target of €14 per share. Leonardo's downside risks include lower funds from the EU union, wage inflation, higher competition, supply chain constraints, and execution risk to perform in critical contracts (and transforming order backlog announcements in revenue generation).

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