Description

Prsymian SpA (ticker PRY IM) is a high quality business that has attractive growth prospects (Global GDP + 2% - 4%), best-in-class management (proven operators with exceptional track record /strong capital allocation skills), high ROIC (25% - 30% pre-tax historically), is in the early stages of an industry-wide up-cycle (given late-cycle nature), requires minimal ongoing maintenance capex (~1% of sales) and correspondingly, a premium multiple to the "market" is justifiable, yet the street ascribes a punitive multiple given mis-perceptions around the industry's cyclicality and structure.  More notably, Prysmian recently agreed to acquire Draka Holdings for ~€1.25Bln (closed in early 2011), the 3rd largest cable manufacturer in Europe.  The Draka acquisition is an opportunistic move by Prysmian management to "double down" at the bottom of the cycle: (i) PRY is paying less than 5.5x "pro forma 2010 EBIT" inclusive of 150MM of synergies, (ii) deal is 40 - 50% accretive to earnings based on synergies alone and should add an additional 10 - 20% given Draka's more cyclical - currently operating at trough levels - end-market exposure) and (iii) deal could be a "game-changer" for the industry given Draka and Prysmian have significant overlap in end-markets that have been plagued by over-capacity which has resulted in significant earnings degradation during the downturn driven by loss of pricing (but this deal has real potential to improve this dynamic).  On a "normalized" 2013E basis, Prysmian will earn ~2.75 / share which equates to a ~5.5x multiple based on current price.  At current levels (~15 euros / share), Prysmian is an asymmetric risk / reward long opportunity, with total return potential of >60 - 100% over the next 12 months (PT of 25 - 30 euros / share based on base case below). 

Prysmian's valuation does not adequately reflect two major and imminent catalysts that will drive earnings higher:  

-          Draka acquisition is an opportunistic move by management to "double down" at the bottom of the cycle.  (i) Attractive multiple: Prysmian is paying less than ~3.6x "adjusted peak" EBIT (inclusive of synergies) and ~5.5x "adjusted trough" EBIT; (ii) Significant cost removal opportunities: Prysmian EBIT margins have historically been ~400 bps greater than Draka's (much of this gap emanates from Draka's higher fixed cost base relative to sales); as a result, Prysmian has committed to  €100MM of annual synergies and has expressed its confidence that it could ultimately reach > €150MM (given combined EBIT of ~€408MM in 2010, synergies  will add 25% - 35%+); (iii) Meaningful upside from rationalization and cycle:  significant % of Draka's sales come from construction and telecom cables, which are both lower-value-added, more commodity-like segments where excess capacity has led to meaningful price compression since 2007; Prysmian participates in both of these businesses and the combination of Prysmian and Draka creates #1 leader ; this is critical given the weakness in cyclical segments contributed >€175MM EBIT decline between 2008 - 2010    

-          Recovery of late cycle end-markets / Prysmian being valued as if its end-markets never recover: Despite a strong track record of success and enviable competitive positions in growing markets, Prysmian is being valued at ~11x trough ebit and 12 - 13x trough EPS - a valuation that implies that Prymian's cyclical markets would never recover.  The market's unwillingness to think longer-term about Prysmian's earnings power is especially puzzling given that (i) the backlog for its high value added products (representing ~75% of EBIT) increased by 83% in the past 15 months and (ii) orders for its cyclical businesses (representing ~25% of EBIT) have increased dramatically in q2 - q3 - q4 2010 and q1 2011

Prysmian equity has many favorable traits:  (i) high free cash flow yield (>18% pro forma for Draka acquisition); (ii) widening gap between how debt and equity investors view the credit (debt financing is ~4% and yet the equity trades at >18% normalized FCF yield which is too wide); (iii) un-informed / complacent sell-side that's seemingly waiting for the Prysmian management to provide additional details on Draka integration and overall shape of business trajectory; (iv) multiple catalysts (noted further below); (v) great management team with excellent capital allocation skills; (vi) strong business fundamentals (>75% of the EBIT profile is driven by high ROIC / high barriers to entry / long lead time / 2+ years of visibility); (vii) significant upside optionality (late cycle segments have significant upside to a recovery and Mr. Market is giving away these call options for "free"); (viii) sentiment in Europe is creating a low hurdle (and largely priced into the equity at current levels); and (ix) significant downside protection (given highly variable cost structure, FCF generation and management being best-in-class). 

What's most interesting about the Prysmian investment opportunity is that ~70% of the upside value (~10 / share of upside) is driven by co-specific "blocking & tackling"/ integrating Draka (no correlation to the macro nor the cycle).  My confidence in the "co-specific" aspect is driven by Prysmian management strength: CEO / Valerio Battista has a proven track record (removed >50% of the fixed costs in 2000 - 2005 period and executed on 150MM+ of operational efficiencies in recent years); industry contacts have spoken very favorably of Battista and he is widely recognized as the "machete" CEO amongst his peers in the industry given his continuous focus on cost removal (if you visit Prysmian headquarters in Italy, you'll also get a keen sense of Battista's cost-focused mind-set).  The other ~30% of the upside value (~5 / share of upside) is driven by the late cycle nature of the end-markets / the low entry multiple given Street skepticism around late cycle businesses / and the significant tailwinds that Prysmian is seeing within its utility / industrial end-markets in particular.  Finally, the company has exposure to  Construction and Telecom end-markets that offer a "free" but valuable call option given the combined entity will have a significant presence in these two end-markets and offers the most industry rationalization opportunity: (i) volumes in Construction were down >40% from peak-to-trough and pricing in both Construction and Telecom eroded 5 - 10% driven by deferral of capital expenditures and (ii) these segments are currently contributing ~0.25 / share of EPS but generated >0.75 / share at the peak and this is before taking into account "synergies" and strategic value to rationalizing excess capacity; applying a punitive 10x multiple to "normalized" post-synergized EPS of 0.75 / share equates to an additional 7.50 / share of value).  While the Construction segment has significant upside, I view this as a free call option if and when this market recovers in Europe.

BIZ OVERVIEW:

Based in Milan, Italy, Prysmian is one of the world's leading manufacturers of power and telecom cables: (i) its power cables are used in a variety of different energy applications, including for transmission and distribution of electricity, and to distribute power within homes, buildings and industrial equipment; and (ii) in telecommunications where Prysmian produces traditional copper cables as well as optical fibers used to transmit video, data and voice (the combined entity has a dominant / ~40% market share in Europe and ~28% in North America).  Established in 1879 as part of the Pirelli Group, Prysmian was purchased from Pirelli in 2005 by Goldman Sachs' private equity arm.  In 2007, Goldman IPO'd Prysmian, reportedly earning 10x on their initial investment.  Today, 100% of Prysmian's shares float freely - making it one of only two companies among the 40 most liquid stocks on the Italian exchange that has a full free float.  Prysmian is widely regarded as the most profitable, best run company in the cable industry.  Its success stems from a large-scale restructuring led by the current management team in the early 2000s (removing >€400MM of fixed cost) and its strategic focus on the fastest growing, highest value added segments of the cable industry.  As a result of its low cost structure and favorable product mix, Prysmian's ROIC has averaged ~26% since 2006 and its EBIT margins have exceeded its peers by ~400 basis points over the cycle.

The combined company operates in four end-markets: (i) Utilities, (ii) Industrial, (iii) Construction and (iv) Telecom.  Each segment has uniquely different margin profiles given variant competitive dynamics, barriers to entry, unit economics, pricing power, etc.  To simply the business model, I've grouped the (i) Utility and Industrial segments into "high quality / high margin" which represent ~50% of the combined company's revenue but closer to ~75% of EBIT and conversely, have grouped the (ii) Construction and Telecom segments are grouped into "low quality / low margin" which represent ~50% of revenue and ~25% of EBIT. 

-          Utility and Industrial Segments ("High Quality / High Margin") ~3.2Bln in organic sales / ~289MM EBIT / ~9% margin: The Utility and Industrial segments are bracketed as "high quality" given a rational competitive landscape, high barriers to entry, long lead-times, strong visibility, attractive long-term growth which has resulted in a strong margin profile.  Within the Utility segment, the combined company has >55% share of submarine cables (note that Nexans' / #2 player in submarine cables had execution issues in 2009 that should lead to further increases in Prysmian's market share moving forward), >38% share in underground high voltage cable in Europe and ~10% of the distribution cable market.  Within the Industrial segment, the combined company has dominant market share in elevator, wind cable, aerospace and renewable energy cables.  While the Utility and Industrial segments faced headwinds over the past few years (driven by the deferral of "infrastructure-related" projects due to the financial crises), there has been increased activity and lengthening of order books (i.e. for instance, the order books for submarine and high voltage transmission products have expanded by >60% in the past nine months which is a positive indicator for improved pricing / margins moving forward).  Additionally, lead times have lengthened to >2 years within the Utility segment which significantly enhances visibility and highlights a strengthening market. 

-          Construction and Telecom Segments ("Low Quality / Low Margin") ~3.3Bln in sales / ~104MM EBIT / ~3% margin: The Construction and Telecom segments are bracketed as "low quality" given the significant fall-off in end-market demand (particularly in Construction), a more fragmented industry construct (more related to Construction segment), industry over-capacity (particularly in Construction) which has resulted in a weaker margin profile.  The Prysmian / Draka combination is meaningful for both of these end-markets: (i) within the Construction segment, the combined company will have >20% market share in >50% of the markets that the company participates; in conversations with Prysmian management, they think markets that have >20% market share are typically categorized by more rational pricing and have highlighted comparable markets with these characteristics that operate with high single EBIT margins (i.e. >400 - 600 bps above current levels) and (ii) within the Telecom segment, the combined company has ~40% market share in Europe and ~28% in North America; this market share offers significant upside potential especially given telecom capex has started to pick up (note that Corning which is equivalent in size to the combined Telecom segment, noted >15% volume growth in 2011E and guided to a 4-year CAGR of >7.5% for this segment).

PEAK VS TROUGH ANALYSIS

While there are many moving parts to Prysmian + Draka, the chart below helps simplify where (i) the combined biz was at prior peak (2008) and compares this to (ii) current / trough LTM levels looking at the combined company on an apples-to-apples basis.  In particular, the graph highlights pro forma peak (2008 combined), pro forma trough (LTM September 2010), LTM actual combined and normalized EBITDA - Capex inclusive of initiatives that have been / are being implemented since 2008 peak levels.  These pro forma add-backs include synergies (~150MM - there's 25 - 50MM of upside to this figure) + cost saves opportunities / rationalization efforts at Draka (~80 - 85MM), additional capacity / new product introductions at Prysmian (~130MM).  As noted, pro forma peak EBIT peaked at approximately ~980MM in 2008 and has subsequently dropped to ~707MM as of 2010.  Not inclusive of these add-backs, 2010 EBIT was ~404MM.  On a 2 - 4 year look-forward basis, I am assuming "normalized" EBIT will be in the ~800 - 825MM range (based on the mid-point of pro forma peak / trough).  This "normalized" figure implies EPS of ~2.75 / share (or ~5.5x multiple on current share price). 

CAPITALIZATION:

Prysmian's capital structure as of March 2011 consists of ~1.46Bln of net debt (financing terms are favorable with average cost of financing in the 4 - 5% range) and >1Bln of liquidity.  Normalizing for working capital (q1 period is the peak working capital period), net debt is ~1.3Bln.  Adjusted for pension and NOLs, pro forma net debt will be ~1.25Bln.  Based on unadjusted 2010 EBITDA of 550MM (not inclusive of synergies of any of the adjustments noted above), Prysmian will be leveraged at less than 2.4x debt / EBITDA.  The combined company will have a net debt / EBITDA covenant of 3.5x moving forward (i.e. EBITDA would have to fall to ~370MM or -30% from current levels to trigger which is we believe is an adequate cushion). 

UPSIDE / DOWNSIDE:

UPSIDE (20% probability): assuming a conservative multiple of 12x to Upside Case (includes incremental pricing power) 2013E EPS of ~3.75 / share = 45 / share (vs current of 15 / share); discount this back by 1-year at 10% equals ~41 / share or >170% upside

BASE (60% probability): assuming a conservative multiple of 12x to Base Case (does NOT include pricing power / industry rationalization) 2013E EPS of ~2.50 / share = 30 / share; discount this back by 1-year at 10% equals ~27.25 / share or >80% upside

DOWNSIDE (20% probability): assuming a conservative 10x multiple to Downside Case (macro / Europe falls-off a cliff and is perpetual under-performer / i.e. Europe goes the way of Japan + mgmt is slow to execute on synergies) 2013E EPS of ~1.55 / share = 18 / share; discount this back by 1-year at 10% equals ~16.50 / share or ~10% upside

RISKS:

Antitrust investigation: There was an antitrust investigation launched by the EU Competition Commission in January 2009 into alleged competition issues in the EU market for submarine cables.  Under EU rules, Prysmian could be fined up to 10% of Group sales, which equates to a potential max liability of ~430MM or ~2/share.  I ultimately think the fine will come out below ~250MM and on an NPV basis (assuming 1 - 2 year pay-out), implies less than ~1 / share;  

Integration risk: This is a large deal - Draka has ~50 plants in 30 countries and Draka's sales are half that of Prysmian's - cannot dismiss the fact that there are material operational and cultural issues related to executing a cost-cutting program of this magnitude;

Macro risk: As with any industrial business, Prysmian's business is tied to macro-economic developments; though we think the risk on Prysmian is lower given still operating at / close to trough (i.e. late cycle nature of business)  

One consideration to mitigate "macro" risk is to short a basket of European industrial companies that are trading at rich valuations.

CATALYSTS:

Synergies clarity (3 - 6 months)

Additional project win announcements highlighting late cycle improvements (3 - 9 months)

Cycle recovery in construction and telecom end-markets + clarity on rationalizing over-capacity in these businesses (3 - 12 months)

Greater appreciation re: combined earnings power profile (9 - 18 months)

European macro risk easing (timing TBD)

Potential industry consolidation (timing TBD)

DISCLOSURE:  We and our affiliates are long Prysmian, and may buy additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of Prysmian.  This is not a recommendation to buy or sell shares.

Catalyst