Thesis

• Pirelli is leveraging its brand and technology through high return-on-capital investments that are driving a structural change in its manufacturing footprint, profitability, growth and return profile, which is not currently being discounted by the market. 
• Specifically, through secular growth in premium tire volumes and increased premium market share, I expect Pirelli to earn e1.20 per share in 2013 and e1.41 per share in 2014 on an expected 2011-2014 EPS CAGR of 29% and long-term low teen growth.
  • My model is 15% and 17% higher than the street in 2013 and 2014, respectively.  I expect 16.6% margins in 2014 vs. management’s plan of 15-16% and consensus at 14.5%.  The variance relates to the mix benefits from premium growth.
• Pirelli offers 71% total return over the next 12-18 months based on a target 10x 2014 EPS and E0.36 per share dividend. 
  • Significant scope for valuation re-rating given increased leverage to premium secular growth, higher profitability and higher return on capital.

Industry Highlights

• The tire industry is secularly moving up the value chain; premium tires (160mm units in 1.3bn unit industry) have grown at a 10% CAGR from 2007-11 despite the recession and is expected to grow at that rate over the next five years driven by:
  • Regulations and tire labeling legislation based on fuel efficiency and safety including the use of winter tires
  • Growth of the luxury and SUV segments
  • Greater use of higher diameter tires on mass market models
  • Increasing use of run-flat tires
  • Amplification of these trends through 2x frequency of replacement for premium tires vs. standard tires
• Due to capacity reductions in the last recession and the growth of the global car park, the tire industry is expected to remain in balance.  On a shorter term basis, growth comparables become significantly easier starting in 4Q12.   
• The tire industry has historically exhibited modest cyclicality due to 80% exposure to aftermarket demand. 
• As a result of the secular growth in premium tires, participants with large exposure to that segment are becoming less cyclical. 
  • For example, Pirelli grew its EBIT margin 220bps in 9Mo12 despite volumes down 7.0%, 150bps in 4Q11 with volumes down 4% and 250bps in 2009 with volumes down 6%.
• The premium segment has an oligopolistic global industry structure, featuring competition based on technology and branding rather than price.
• The industry has demonstrated consistent pricing power.  In 2011, despite significant raw material headwinds that amounted to almost 10% of sales, the industry was successful in maintaining margins.  The industry was also able to maintain pricing despite volume weakness in 2009. 

Company and Investment Highlights

• Based on a three year industrial plan, management is focused on increasing Pirelli’s premium tire capacity through retrofits of existing plants as well as new plants located in low cost countries.  Pirelli is increasing its group margins from 10.3% in 2011 to 16.6% by 2014.  The company will generate significant free cash flow by 2014 based on higher profitability and lower capital investment. 
  • The company will increase production of premium tires from 20mm in 2011 to 32mm in 2014 while production of standard tires will decrease from 39mm to 31mm during that period.  Truck production will likely marginally grow. 
  • Premium passenger car tire EBIT currently accounted for 52% of EBIT in 2011 and will grow to 65% in 2014, while industrial Tires will decline from 23% to 13%.  
• Pirelli has ample room to take market share within the premium segment.  Currently, Pirelli’s market share for OE in the premium segment is 20% while the company’s overall market share in premium is just 13.4%.  My model assumes that by 2014, Pirelli will take 150bps of premium market share and achieve 14.9% share. 
• Pirelli is also driving efficiency gains through an e250mm (~4% of sales) improvement plan.  There are hard examples of savings including e80mm through supplying the NAFTA market through a new Mexican plant vs. exporting from higher cost Brazil. 
• After a JV agreement with Russian Technologies, Pirelli has gained a foothold within the Russian market, which benefits from a strong winter tire mix and an increasing car park.  Through investment leveraging its brand and technology, Pirelli expects to grow Russian sales from e250mm to e500mm and margins from mid-single digit to 14-15%.    
• Despite a track record of beating street estimates and management’s own aggressive plan, the market remains skeptical.  However, Pirelli is following the same strategy over the next 3 years as it has executed since 2009.  I continue to see upside relative to street estimates based on the earnings leverage from mix improvement as well as greater acceptance of management’s efficiency plan. 
• Valuation remains compelling at 8.1x 2013 consensus earnings and 4.9x EBITDA in line with peers despite a better growth and return outlook.  The market is valuing Pirelli based on a cyclical peak in earnings while I believe Pirelli is a secular growth company.  In fact, 15% of shares outstanding are short based on a view that margins have peaked. 
• Pirelli is focused on shareholder return.  Management has long-term incentives based on not only beating its aggressive 2012-2014 plan, but also on an improving stock price.  Conversely, management is penalized if they miss the plan.  Pirelli pays out 40% of its net income in dividends.  The Chairman/CEO owns 11% of the company. 
• Pirelli will also continue to benefit from simplifying its corporate structure.  There is potential for divesting the more cyclical, lower return industrial tire segment after a reorganization of the corporate structure this year and the elimination of the COO position. 
• Near term cyclical conditions are supportive and Pirelli will benefit from a ramp up of its Chinese facility that will drive premium volume growth to 25% in 4Q vs. 13.5% in the first nine months. 
  • Over the last 8 quarters starting from 4Q10, volume growth was 3.4%, 6.1%, 1.2%, -3.9%, -7.4% (1Q12), -7.6% (2Q12) and -6.2% (3Q12).  Pirelli is guiding to 0% in 4Q and will have easy comps throughout 2012.  While there has been weak end market demand, Pirelli will be lapping an industry wide inventory reduction that occurred this year.  
    • Destocking in Europe YTD amounted to 2% of total volumes in the first nine months with sell-in down 12% but sell-out down 10%. 
    • Because of the mild winter in 2011/2012, dealers had excess winter tire inventory entering this season and so winter tire sales have been depressed in 2012, setting up an easy comp in 2013. 
• Pirelli will benefit from decreased raw materials (pricing already locked in for 1Q13 and management has guided to a 300bp tailwind (e50mm) in the first quarter.   

Risks

• Italian sovereign and related market risk.  Europe accounts for 35% of sales. 
  • Pirelli’s 2012 guidance already discounts a 20-25% decline in European standard passenger tires
  • Southern Europe accounts for just 9% of sales. 
• There may be a potential supply/demand imbalance, since the industry is adding significant capacity in emerging markets to meet expected demand growth. 
  • In prior imbalances, industry has maintained pricing discipline and reduced capacity.
• Due to very weak demand in 2012, Pirelli has excess inventory.  Management is expecting to cut e83mm of inventory in the fourth quarter and expects e70mm reduction in 1Q14.  Pirelli has incorporated this cut into their earnings guidance.
• Premium pricing and profitability can become pressured if large players become aggressive in the segment.
• Latin American accounts for 34% of sales and ~35% of EBIT.  There are significant capacity additions over the next few years (18mm units over 4 years in a 96mm unit industry). 
  • 30% of Brazilian market is supplied through imports, which will be displaced.  Michelin’s capacity increase will displace their imports from Europe. 
  • Pirelli is converting 4mm units of Brazil capacity used for exports to NAFTA for premium production.
  • Pirelli controls its distribution (over 600 mostly exclusive dealers with over 100 directly-owned) in Brazil, which represents an effective barrier to entry.  Low-end players use the supermarket channel. 
• Despite proven ability to price, raw material price escalations can cause volatility in earnings. 
• An oil price spike related to Middle East tension can cause reduced miles driven and aftermarket demand.
• European replacement truck tire market may remain depressed due to economic difficulties.
• European winter tire market faces difficult 2012 second half comparison and inventory may be higher than normal, which may affect 4Q earnings.  Pirelli’s guidance assumes a 10% decline in winter tire sales. 
• As of September 30, 2012, net debt amounted to almost e1.9bn (or 2.4x net debt/EBITDA), but Pirelli expects YE net debt of around e1.2bn. 
  • Management expects a significant seasonal working capital benefit of almost e550mm in addition to the benefit from e82mm of inventory reduction in the fourth quarter.
    • In my valuation, I use the seasonal peak for working capital in order to calculate net debt. 
• Pirelli has an e160mm loan to Prelios (Pirelli’s historic real estate company), which will be restructured to 0-50c on the dollar.  A missed interest payment has already occurred and a negative provision in the amount of 2-4% of Pirelli’s market cap will be booked likely in 4Q. 
• Bears point out this loan as bad corporate governance; however, this loan was necessary in order to separate Prelios (Pirelli’s old Real Estate business) from the core business