FINMY - Leonardo: Positive Catalysts Likely To Price In

2023-04-17 21:31:41 ET

Summary

• Agreement with Cisco for technology activities and cybersecurity.
• New contract with the Spanish Government, a higher defense budget from Italy, and Italian second-hand Typhoon jets disposal to Poland are positive catalysts for Leonardo.
• There is too much positive news that we are not accounting for. Therefore, we increase Leonardo's target price to €14 per share.
• The new CEO is positively welcomed by the Wall Street community.

Here at the Lab, we already commented on Enel's new management changes with a publication called Not The Expected CEO . In the meantime, Leonardo's stock price ([[FINMF]], [[FINMY]]) increased after the Italian Ministry of Economy and Finance (MEF) filed the list for the company's renewal of the CEO and directors board. Given the shareholders' meeting called for May 9, the MEF, with a 30.2% equity stake in Leonardo, has proposed Roberto Cingolani as the new CEO and Stefano Pontecorvo as the new company's President.

Cingolani, former Minister of Ecological Transition in the Draghi government and former Head of Technologies and Innovation at Leonardo from 2019 to 2021, will replace Alessandro Profumo. And the new company's president was the former ambassador to Russia, Pakistan, and England as well as holding important roles within NATO.

Here at the Lab, we positively view Cingolani's nomination, being a manager with a background within the group. In any case, at present it is premature to make predictions about the strategy that will be adopted; however, we believe that his predecessor strategy will most likely be confirmed with a focus on internationalization, efficiencies, and improvement of free cash flow, completing the restructuring of the Aerostructures, innovation and international alliances division. Although we believe that the market would have preferred the appointment of a manager with a more solid background in the A&D sector, Cingolani's appointment is a rational move given its focus on cybersecurity programs.

Q1 expectation and latest positive catalyst

At this point, investors' attention will focus more on the new CEO's confirmation of the €3 billion FCF cumulative target over the period 2021-2025 as well as on the group's order intake indicating new orders for €90 billion in 2022-2026. For the current year, as already mentioned , Leonardo:

expects orders for around €17 billion, revenues in the €15/€15.6 billion range, and a cash flow of 600 million. Forecasted net group debt of around €2.6 billion.

While for the first 2023 quarter, which is usually the least significant, our internal team expects a good start both in terms of order collection, which we see growing by around 15% as well as from the operating free cash flow level. In detail, for the latter figure, we forecast that the group will manage to significantly reduce its usual Q1 free cash flow absorption from €1 billion in Q1 2022 to approximately €750 million. As regards the other balance sheet data, we expect a less brilliant performance due to a more difficult comparison basis in terms of revenues and the already announced impacts of inflation on the group's EBITDA.

In the context of increasing military spending globally, the outlook remains positive for Leonardo and we expect strategic development on cyber and infrastructure protection.

1. Precisely to strengthen the civil and defense industrial sectors, Leonardo and Cisco Systems, world leaders in the networking and IT sectors, announced today a memorandum of understanding with the aim o f " strengthen reciprocal commercial relations and start a structured collaboration ”. In particular, dedicated working groups will be established to meet market demands in the fields of cyber security, secure networking, Internet-of-Things, digital workplace, and cloud edge computing. The agreement includes, among other things, the development of potential integrated solutions, as well as the possibility of joint commercial offers, through a process of analysis of products and solutions aimed at the national and international market, so as to broaden business opportunities and audience of potential customers of the two players;
2. On the traditional defense business, the Spanish government would be willing to buy another batch of 25 Eurofighter "Typhoon" fighters. According to Infodefensa, the decision could be imminent with the signing of the contract expected in the coming months. As a reminder, Leonardo holds a 20% stake in the Eurofighter consortium and supplies 60% of the onboard electronics ("avionics"). According to our estimates, a contract for 25 fighters, could be worth €2.5 billion for 100% and €500 million/€1 billion for Leonardo. Generally speaking, we underline that a fourth-generation of Eurofighter will provide strong earnings growth for Leonardo with the Italian Government interested to buy 16 new jets in the electronic warfare version. This fact is also double-checked by the fact that Italy is proposing to sell Poland second-hand Typhoon jets;
3. In addition, according to SeeNews , on 27 March the Bulgarian government signed a contract for the purchase of six Leonardo first aid helicopters whose deliveries are scheduled between 2023 and 2026 (the first in December this year, two in 2024 and 2025 and the latest in 2026). The value of the contract is approximately 58 million;
4. Still related to Italy, there are indications that the new Government could allocate a larger budget for new armaments purchase. The expenditure for extraordinary investments of the armed forces could be at least €25 billion, €8.7 billion will be allocated to the Air Force budget for new fighters. In detail, 41 additional F-35s worth €8.3 billion, and 25 Typhoons for €3.6 billion. These will enter service with the 75 F-35s planned for the Air Force and will upgrade the 94 operational Typhoons.

Conclusion and Valuation

Here at the Lab, we believe it is unlikely that the Italian Armed Forces' request will be met in full. However, we are convinced that the demand for new aircraft, in particular, the EFA "Typhoon", could represent a significant medium-term catalyst for Leonardo. Last time, we reported how Boeing ( BA ) and Airbus ( OTCPK:EADSF ) were competing for a massive order from Air India for 500 aircraft, and how NATO was also pressing Italy on a higher defense GDP budget. Boeing orders are picking up, and there are now two companies interested in the new 787s. Riyadh Air, which is expected to purchase 39 aircraft, and the state-owned company, Saudi Arabian Airlines (Saudia). According to the WSJ , these agreements between Boeing and the Saudi government are around $35 billion. Such a contract could lead Boeing to accelerate the start of 787 productions, to the benefit of Leonardo's activities in the aerostructures division.

As a reminder, Leonardo is the sole supplier of the central section of the 787 fuselages and also supplies the aircraft's horizontal stabilizers. In our current 787 estimates, we assume a production recovery that is in line with Boeing's conservative assumptions: 4 units per month in 2023, 7 units per month in 2024, and 9 units per month in 2025. There is too much positive news that we are not accounting for. Within the A&D sector, Leonardo is currently trading in the bottom Price Earnings quartile and is offering an FCF of 12.5% by 2025. Having almost reached our €12 target price, we decided to increase Leonardo's buy rating to €14 per share. Looking at the defense capitalization, the total equity value stood at €736 billion. On average, market capitalization is four times higher than equity, with Italian companies among the least valued by the Stock Exchange. Fincantieri shares implied 1.5x while Leonardo's equity is only at 0.6 times. This discount is not justified, we suggest increasing Leonardo's shares.

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