FINMY - Leonardo DRS: Order Backlog Already Priced In

2023-04-18 12:25:43 ET

Summary

• 2023 guidance was below expectations.
• Leonardo DRS will supply integrated electric propulsion components for the next generation of US Navy submarines.
• Here at the Lab, we believe that the main value is on DRS's main shareholder. We confirm our equal-weight view.

Here at the Lab, we have a good grip on Leonardo S.p.a. ( OTCPK:FINMF ) and since our initiation of coverage called Now a Buy , the company is up by more than 46% (Fig 1). In the meantime, we also published a review of RADA Electronic Industries and Leonardo DRS ( DRS ), confirming our positive view of the transaction, and today, we are back to comment on the latest DRS developments.

Fig 1

The DRS stock price, after providing lower 2023 guidance at the end of March, had corrected from about $13 to 11 dollars per share, but last week, DRS shares closed the session above $14.5. As a reminder, Leonardo held 210 million DRS shares with a market value of almost $3 billion and now represents around 44% of its market capitalization and 30% of the total enterprise value. As Leonardo is the company's main shareholder with 80.77% of DRS's equity stake, the Italian company decided to merge all of Leonardo's US assets into one company. This reorganization, which will be completed in the coming months, has already led to a recovery in the value of previous write-downs of almost €1.3 billion attributed to Leonardo Us Holding. This asset concentration process will, directly and indirectly, hold all the American subsidiaries with the exclusion of Leonardo Us Electronics, which for the moment will remain directly owned by Leonardo UK. The major maneuvers were already launched in 2022 and will be a positive catalyst for DRS providing a more agile company within its core operation and will significantly decrease admin costs.

Latest DRS results

With the latest results, Leonardo DRS delivered top-line sales of $2.7 billion, an adjusted EBITDA of $318 million, and an EPS of $1.88 per share (Fig 2). DRS revenue line was down by 6.5% on a yearly basis, but the company recorded a record net profit which more than doubled to over $400 million signing a plus of 163% compared to the previous year. However, during the analyst call, DRS management highlighted some supply chain critical issues in electronic components which are slowing down revenue growth in the current year (the 2023 target implies organic growth of +2/6%) with an ongoing impact of cost inflation on margins estimated by our team at 50-60 basis points on a yearly basis. The company's 2023 outlook sees DRS with a revenue line at $2.7 billion, an adjusted EBITDA of $315/330 million, and an adjusted EPS in the area of $0.64-0.69 per share (well below 2022 results) - Fig 3. Summing up, the 2023 EBITDA targets are 9% below the Factset mid-point consensus. Despite that, even if the outlook is not great, the defense sector remains very favorable, and the company will achieve a record order backlog, here at the Lab, we are assuming a 10% growth in the US defense budget. In detail, the company has new orders of $3.2 billion (book-to-bill ratio of 1.2), which took the portfolio to a record $4.3 billion signing a plus 49% on a yearly basis. However, looking at the numbers, it seems that DRS has also been hit by labor cost constraints and that 2024 could see a greater acceleration.

Source: Leonardo DRS 2022 results (Fig 2)

Fig 3

Last week, DRS announced that it has been awarded contracts worth more than $1 billion, when fully operational, to supply integrated electric propulsion components for the United States Navy's next generation of submarines. The new Columbia-class submarine is a priority for the United States Navy and will take over the Ohio-class ballistic missile fleet. Leonardo DRS is a leading provider of next-generation propulsion and electric power conversion technologies to the US Navy, with systems important to next-generation submarines and surface vessels. DRS solutions lead the way in providing energy flexibility to support the increased power requirements of current and future naval platforms.

Conclusion

On the publication results, Leonardo DRS already announced its order book value, and here at the Lab, we believe that the US next generation of submarines are already been counted in the company's backlog. We consider the news positive but already priced in. On the other hand, this only represents 5% of the main shareholder's annual orders and we believe that Wall Street is not currently pricing correctly Leonardo S.p.a. In our latest release , we explained how Leonardo S.p.a. is trading at the bottom P/E compared to the A&D sector and is still offering a free cash flow yield of 12.5%. For this reason, it makes strategic sense to be neutral on DRS and overweight its main shareholder Leonardo S.p.a.

For further details see: