FINMF - Leonardo: Supportive News

Summary

• Leonardo won a contract in Canada worth almost €700 million to modernize and expand (to 16) the country's helicopter fleet.
• With Boeing's latest business plan, Leonardo's aerostructures division will be back to growth.
• Leonardo is still very much discounted compared to its A&D peers. Our buy rating is then confirmed.

Here at the Lab, in 2022, we initiated Leonardo's coverage ( FINMF ) with a neutral rating with a publication titled Back To Profitable Growth . Over the year, we decided to increase the Italian defense player to an overweight target thanks to macro and micro reasons. Our investment buy rating was supported by 1) a higher-order backlog with positive development in Nigeria and a rapprochement of Germany and the UK towards Saudi Arabia, 2) the higher European Union defense budget, 3) OTO Melara potential transaction, and 4) an ongoing debt repayment. We also reported how Leonardo was heavily impacted by the aerostructures division, this was due to the COVID-19 pandemic outbreak. While Airbus fully recovered its 2019 numbers, Boeing, which is Leonardo's number one client, is still behind. However, in our conclusive paragraph, we emphasized how we:

...estimated a free cash flow yield of around 9% for the whole of 2022 with an expected increase to around 13% in 2025. While we understand that high net debt may be a cause for concern, the latest debt development might soften the Investor community sentiment.

Going back to key Leonardo takeaways, it is important to report the latest news which fully supports Mare Evidence Lab's thesis. In detail:

1. Leonardo won a contract in Canada worth almost €700 million (C$ 1 billion). Indeed, the Canadian Department of National Defense has awarded the Italian company, through Leonardo UK-Yeovil, a contract for the modernization and expansion of the AW101/CH- helicopter fleet 149 SAR (Search and Rescue) Cormorant. The 13 Cormorants already in service will undergo a full modernization and three units will further join the fleet. A contract that will 1) enhance the operational performance both in new systems and technologies, 2) ensure compliance with the latest and future airspace regulations, and 3) extend fleet operations to 2042 and beyond. No details have been disclosed on the timing of these upgrade interventions. However, according to our estimates, contract value represents about 14% of Leonardo's estimated annual revenues from the group's helicopter division (about 27% of the total company's turnover). This is very material, considering also that the contract weight which is equal to 4.3% of Leonardo's target new order acquisition for 2023;
2. As already anticipated, Leonardo's aerostructures division was impacted by a pause in deliveries in the 2021-2022 period. In numbers, approximately 50% of revenues were fuselage sections for the 787. Having checked Boeing's business plan, now 787 productions have resumed and the Aerostructures division is turning around thanks to 787 new deliveries. Boeing's platform has predicted that will reach a rate of about seven B/Cs assembled per month by 2025, up from the current rate of a single aircraft per month. If we follow the Boeing industrial plan forecast, Leonardo will grow by mid-single digits at the revenue level with a €3 billion cumulative free cash flow until 2025;
3. Leonardo reached an agreement with a trade union for the early retirement of around 400 group resources on a national basis. This should be very supportive of the company's total salary compensation. However, we estimated a negative one-off charge of €4 million in 2023.

Conclusion and Valuation

Leonardo's stock was up by just 28% in 2022 versus a plus 63% compared to the European defense peers. This was mainly due to consensus 2022-2023 earnings per share estimates amid group supply chain concerns, high inflation, and slower order growth relative to rivals. However, Leonardo is back to growth and we expect that the execution of the medium-term plan will further support the reduction of the ongoing deleveraging and which will lead to a significant increase in the share price. According to our estimates, Leonardo's stock is undervalued and is one of the least expensive stocks in the European A&D and multi-industry sectors, with the company that is currently offering a free cash flow yield of 13% by 2025, but with a PEG (price/earnings to growth) ratio that is in the bottom quartile. Leonardo will publish its 2022 results on 8 March 2023. There are some downside risks: execution risks, inflation uncertainty, the recovery of the Aerostructures division, and a worse-than-expected cash flow performance. Since our upgrade called Leonardo is a buy , the company is already up by 18% and despite the latest positive news that is material to our investment thesis, we decided to maintain our target price at €10.5 per share versus the current €8.9 per share.

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