FINMY - Leonardo: DRS Upside To Price In

2023-06-07 10:52:06 ET

Summary

• Since November 2022, Leonardo DRS gained 45% while its mother company was only up by 32%.
• Leonardo DRS is gaining support thanks to the Biden administration's 2024 defense budget.
• Positive news on Leonardo's core business also supports our buy rating.

Here at the Lab, we initiated Leonardo DRS ( DRS ) and RADA Electronic Industries coverage with a publication called " Together Make Sense ". Since its Nasdaq debut (November 2022-end), the company gained more than 45%. Looking at the recent company's release, it emerges that Leonardo DRS's focus has shifted to orders and is already looking beyond the 2023 guidance. Leonardo ( FINMF ), the Italian mother company, has 80.63% of DRS for an investment which accounts for $3.32 billion and is equivalent to 56% of the current market cap. In the same period (November 2022-end), Leonardo's stock price (only) gained 32%.

Leonardo DRS upside

The Biden administration's 2024 defense budget, which would amount to a good $886 billion is up about 3.5% vs the 2023 number and this is a crucial assist for the company's future plans. Already in the first quarter, Leonardo DRS CEO William J. Lynn underlined an increase in bookings to $749 million and a strong pickup in the backlog to $4.3 billion dollars (+43%). However, for the year-end, the guidance indicates revenues between $2.7 and $2.8 billion, with a limited growth of 4% compared to 2022, and an adjusted EBITDA between $315 and $330 million.

Despite that, market attention is also on potential mergers and acquisitions. In fact, Wall Street did not miss the fact that one of the competitors, Honeywell, said that this is one of the most propitious moments in memory for looking around for business. However, we believe that Leonardo DRS's situation is more cautious. Here at the Lab, M&A defense transactions present rather high selling prices. Leonardo DRS still has certain leverage to pursue M&A operations as it would strengthen its competitive advantage within the sector. This is also favored by the US government

Secondly, Leonardo DRS announced that it will be included in the Russell 2000 and 3000 indices in their 2023 annual reconstitution. The entry will be effective when the markets open on June 26th. These indices are commonly used by institutional investors for investment funds and as a benchmark for long-short equity strategies. Approximately $12.1 trillion of assets are valued on the US Russell Indices and this is very supportive for a potential stock price appreciation.

On the core business, the company is moving with greater agility on the market. Leonardo's subsidiary is a prime contractor for the supply of integrated electric propulsion components for the Navy's Columbia-class submarines for 41% of the assigned orders. This order value is approximately $1 billion. The company is also a strategic subcontractor alongside the main Pentagon suppliers.

Given the positive momentum in US defense, which is Leonardo DRS' key area, it is improbable that Leonardo will dispose of its stake. The company was acquired in 2008 and the new listing provides visibility of the embedded value. DRS is currently trading at 12x Fiscal Year 2024 EV/EBIT, and this implies a 35% discount versus its closest US-listed peers. Without taking into consideration the potential upside, since the Nasdaq relisting, DRS is currently up about 45% while Leonardo is only up by 32%.

Leonardo recent update

1. Turkish Airlines announced the existence of negotiations with Airbus and Boeing for the purchase of 400 single-aisle 737 MAX and A320neo aircraft, as well as 200 wide-body jets. This news had been circulating for some time; however, we didn't know what aircraft mix. From the latest rumors, it emerged that the smaller plan could account for 170/175 out of 200 wide-body airplanes. Assuming Turkish Airlines splits the smaller wide-body component evenly between Boeing and Airbus, the order could result in 85/87 new 787s. This could be a massive order intake for Leonardo;
2. There is a new contract worth €0.6/0.72 billion from Nigeria. The African country officially confirmed its intention to purchase 24 Leonardo M-346FA light combat aircraft;
3. Poland will likely purchase 22 AW101 helicopters . Poland is considered a domestic market. Indeed, in April 2019, the Polish government purchased 4 AW101 helicopters for its Navy (version for anti-submarine warfare) with a contract worth around €430 million, while in July 2022, 32 AW149s for the Army, for a total commission worth almost €1.7 billion. The AW101 is a medium/heavy helicopter for military and civil use. It is manufactured at Leonardo's Yeovil factory in England. Here at the Lab, we are pricing a new commission for the AW101 for a list price of at least €50 million per unit. This implies a value of €1.1 billion in the base case scenario. If we include training, spare parts, and logistical support are taken into account, this value is around €2 billion;
4. Leonardo announced a 10% equity stake acquisition in FlyingBasket, a company specializing in cargo drones. FlyingBasket was founded in 2015 and has become a leader in the field, operating in 15 different countries and partnering with Poste Italiane and Swisscom.

Conclusion and Valuation

Here at the Lab, we already provided a few comments on Leonardo's valuation. The company is also deleveraging and we expect an almost debt-free position by 2025 end and now DRS provides a material upside to price in. Leonardo's Q1 operating results were lower than anticipated but there was a solid order intake. On a SotP valuation methodology, Leonardo’s stub is currently around 4-4.5x EV/EBITA for the current year and makes the company the cheapest European defense contractor. With the positive latest news, we reaffirm our price target of €14 per share. Compared to its closest peers, the company is also trading at a PE bottom with no justification. Our downside risks include volatility in economic and geopolitical, higher competition, supply chain constraint, travel recovery (especially in commercial aviation), and the ability to perform in key contracts.

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