Description

Leonardo is an Italian A&D company. Leonardo operates through four main business divisions: 1) Defense Electronics, constituting approximately half of EBIT, 2) Helicopters, making up around 30% of EBIT, 3) Aircraft, representing roughly 20% of EBIT, and 4) Aerostructures, currently experiencing negative EBIT.

The Defense Electronics segment, delivers advanced defense technologies such as radar systems, communication networks, command and control systems, electronic warfare technologies, and cybersecurity solutions. Defense Electronics is poised for revenue growth in the MSD to HSD as Europe reinvests in its defense infrastructure, allocating a greater share of its defense budget to electronics. The Helicopters segment supplies both military and civilian rotorcraft. This segment is forecasted to experience revenue growth in the MSD due to increased defense expenditure and recovery in key civilian markets such as oil & gas transportation. The Aircraft division specializes in the design and manufacture of military aircraft, unmanned aerial systems, and drones. Leonardo plays a significant role in crucial aircraft programs like the Eurofighter and F-35. Finally, the Aerostructures segment manufactures fuselages and other structural components for both commercial and military aircraft. Aerostructures current losses presents an intriguing opportunity for turnaround.

Leonardo's earnings potential is currently overshadowed by the losses incurred by the Aerostructures division. Specifically, Leonardo's 2024 Free Cash Flow (FCF) stands at approximately €700m, but excluding Aerostructures losses, it would be close to €1b. LDO currently trades at ~16x its 2024 FCF, but excluding Aerostructures losses, it trades at only ~12x FCF.

We anticipate that the Aerostructures division will achieve FCF breakeven by 2026. The current losses in the Aerostructures segment are primarily due to its involvement in manufacturing part of the fuselage for the 787 widebody aircraft. We have two main reasons to believe that the Aerostructures division will return to breakeven or better. Firstly, the decline in 787 production from 12 to 2 per month due to Covid is now reversing, with production rates expected to climb back up to 10 per month, providing significant operating leverage. Secondly, Leonardo has already negotiated a pricing step-up with Boeing, set to take effect in late 2025. We find compelling evidence supporting the return to breakeven, especially when considering SPR's success in negotiating pricing concessions from Boeing.

Moreover, the non-Aerostructures segments are experiencing EBIT growth at a mid-single digit compound annual growth rate (CAGR). The combination of decreasing Aerostructures losses and growth in core businesses is poised to nearly double Leonardo's FCF between 2023 and 2026. Currently, LDO's peers trade at nearly 30x 2024 FCF. If LDO were to trade at 18x our ~€1.1b 2026 FCF, the stock would see a 65% increase over the next 18 months. There is substantial additional upside potential if we use a multiple more aligned with peers or if FCF surpasses our conservative estimates.

Regarding near-term catalysts, the company's Capital Markets Day is scheduled for March 12, 2024. During this event, LDO's new management team will unveil a revamped strategic plan and medium-term financial targets. The planning process of the company has been bolstered by the appointment of four new Directors by an activist investor last year, who are focused on enhancing shareholder value and improving cost efficiency. We think the stock is well positioned to outperform as investors gain confidence in the company’s capital allocation and strong growth outlook.

Another way to think about valuation is that LDO’s peers currently trade at ~16.5x 2026 FCF. Historically, LDO has traded at a ~20% discount to peers. Therefore, perhaps LDO should today be trading at ~15x 2026 FCF based on applying the historical discount to peer 2026 multiples. You could argue that a bull case investor day outcome could cause LDO to trade up to 15x 2026 FCF which is +40% in near-term if mgmt. guides 2026 FCF to say 1050m or better. (this is our FCF base case). Or, if LDO only guides 2026 FCF to 900m which is the street #, LDO could still trade up ~15-20% near-term if investors have more confidence in that street forecast and apply a similar multiple. We don’t think that there is much LDO specific downside into the event given the achievable street numbers and discounted multiple. That said, general enthusiasm for Euro defense stocks could decline particularly if there is stabilization in the various ongoing global conflicts.

Catalyst

Investor day

Aerostructures segment returning to profitabilty (operating leverage + Boeing negotiation)