Description

The idea that I want to pitch is Thales. They are a French industrial company, mainly active in defence but with some civil exposure too. They split activities into two divisions:

Air Operations (airspace defence systems, operational command centres, radars, satnav systems), Land Defence (Missile and armaments systems, optronics sensors, protected vehicles, optronics components and systems for day and night sureillance, reconnaissance, protection and target acquisition), Defence Mission Systems (Mission systems and equipment for aircraft, helicopters, UAV, surface vessels and submarines. Also offers full range of associated maintenance services) and finally Defence & Security C4I Systems (Secure information and communication systems for armed and security forces. Present throughout the value chain, i.e. equipment, systems, support, services). 

The competitive environment is slightly different by each subsegment, but their key competitors are Raytheon, Lockheed Martin, Finmeccanica, BAE, and EADS

Aerospace & Transport

Space (Satellite and orbital infrastructure solutions - present in France, Italy, Spain, Germany and Belgium in telco, navigation, space exploration and Earth observation. Operated through a 67%-owned JV with Finmeccanica called Alenia Space; In telcos, supplies platforms for geostationary satellites, competing with Globalstar, Iridium NEXT, O3b. Prime contractor in Europe for the meteorology satellite programmes, major supplier of the International Space Station.), Avionics (Systems and equipment for aircraft navigation and handling (onboard electronics systems) for civil and military aircraft; passenger cabin systems for A380m B787, A350; flight simulators) and finally Transportation Systems (Rail signalling systems for mainline conventional and high-speed networks, metros and trams; monitoring and communication systems; revenue collection solutions).

EADS Astrium is a key competitor within Space, while there are also some local competitors in the US, Russia, China, India, Korea and Israel.

Within Avioncs Systems they compete with Honeywell and Rockwell Collins; Panasonic Avionics are the main competitor in Passenger cabins, while in Simulation they again comete with Raytheon, Lockheed Martin and BAE.

In Transportation Systems they mainly compete with Alstom, Ansaldo, STS, Bombardier, GE, Invensys and Siemens

In terms of end markets for the group, France is the single largest market at 22% of revenues, then the UK is about 12%, US 10% and Other Europe 26%. Asia Pacific and the Middle East make up the rest.

The divisional split is relatively new (2009), so it's hard to get long-terms trends at this reporting level, but broadly the trends on a trailing 12m basis (along with my forecasts) are as follows:

Probably the first thing to stand out in this table is the margin – it has been crushed and is only just starting to recover – EBIT actually fell from 752m in 2008 to -173m in 2010, recovering to 679m last year. The margin fell from 5.9% in 2008 to -1.3% in 2010, bouncing back to 5.2% in 2011.

The decline in profitability was of course partially driven by the economic downturn, but I would argue that the vast majority of the issues were of the company’s own making (as will be the resolutions to the issues – hence the opportunity). Quite a bit has been written by the sell side over the last couple of years on the topic but, briefly, the issues were to do with execution on contracts.

The way that contracts generally work in the sector is that you bid at a fixed price determined by your estimate on costs to deliver plus a margin (mid to high single digit operating in most of the European players). Thales did this as well – only they underestimated the complexity of certain projects and the associated costs. Badly. There were four or five contracts that hurt them very badly – a summary of the problem contracts and the cost overruns by year is as follows:

Source: Company, JP Morgan

A400M is a flight management system for Airbus, Meltem is a maritime patrol aircraft project for the Turkish state, while Ticketing is a ticketing system in Denmark for public transport.

All of these contracts were signed under the former CEO – since then a few things have happened:

1. The contracts have been renegotiated with amendments signed as per the table above

2. The way that they bid for contracts has been totally changed – more regular and rigorous management into the bidding process, more technical guys are involved in the bidding (before it would be a sales guy in charge of the process who would just be focused on winning the contract and not really care/understand about the technical requirements)

3. The CEO has been fired – he’s been replaced by an industry veteran from a company called Nexter – this is a defence company majority-owned by the French state. The CEO comes with a reputation for cost cutting – he was able to, remarkably, cut the workforce by 75% in his last job (I didn’t think this was possible in France – apparently it is).

Since the renegotiations there haven’t been any further cost overruns and the company has returned to profitability.

During the period of reduced profitability, the company also took the opportunity to look at their cost structure, and they concluded that it was bloated vs. their peers (peer group is defined as EADS, Safran, Finmeccanica, BAE and Raytheon. Having looked at the peer group, I come to the same conclusion:

I have looked at adjusted margins here – I add back the costs related to the problematic contracts for Thales, then for the peer group I adjust for charges around Airbus for EADS. Finmeccanica I exclude totally as it is a bit of a basket case and I’m not sure I would include it in any hedge given: a. How poorly it has already performed; b. Some renewed optimism over the last couple of weeks on their prospects.

Making these adjustments, I think that their margins are about a percent below their peers in the average year. The company agree, are focused on fixing this and have issued longer-term guidance that by 2015 the margin differential will be removed via the Probasis cost saving programme. The key elements of this are as follows:

1. Better project execution – the market understands the cost overruns on the big projects very well, but in fact only 23% of the order book is “large” contracts (defined as over 100m EUR). Over 50% of the order book is actually contracts smaller than 10m EUR and there have been too many overruns on these smaller contracts. By rolling out a similar “technocratic” process to the large contract bids on the smaller ones, they plan to save 400m EUR by 2015.

2. Better supply chain management – currently only 10% of purchasing is pooled – the company purchases over 6bn currently and have set up task groups to improve their purchasing. Specifically they have defined 30 purchasing groups, have appointed a manager for each, and it is this team’s responsibility to find 650m EUR of cost savings by 2015.

3. SG&A savings – ongoing restructuring, for example using shared service centres – they hope that this will save a further 250m EUR by 2015.

The entire savings programme would potentially be 1.3bn – it was initiated in 2009 and the company had always said that it would be back-end loaded. Most of the heavy lifting has now been done (it is slightly touchy-feely but they think that about 2/3 of the leg work has now been done) and the benefits should start to flow through. The following table gives a rough feel for the phasing of the benefits from the restructuring:

The “Competitive Pressure” line just reflects the fact that the company have always said that they need to find about 140m of cost savings per year just to stand still, so I account for this in my analysis and basically assume that by 2015 they will only be able to hold on to about 35% of the restructuring gains. I spoke to the company last week and they are comfortable with the way I am modelling this.

If they can deliver on the cost savings as I have described, and there are no further blowups in the order execution, then the 2012 multiples in the table at the top that VIC ask me to include do not really do the opportunity justice. I think that by 2013 we could be looking at a company delivering nearly 1bn EUR of EBIT at a margin of over 7%, and net income of nearly 700m of net income:

Obviously, as I model Probasis above, there would then be an incremental 160m EUR benefit in 2014 which, back of the envelope, would get me to 1.12bn of EBIT. I only see four estimates on my Bloomberg terminal but that seems to be nearly 10% above consensus, if anybody has a very long time horizon.

In terms of absolute value, very simplistically if I say that a 7% EBIT margin is worth 0.7x sales (it should actually be slightly more in the case of Thales due to the value creation profile and the tax rate) then on my 13.6bn sales estimate for 2013, the EV would be 9.5bn – the net cash and the pension liability roughly cancel each other out, so that should be the approximate equity value as well and compares to a current equity value of 5.4bn – 75% upside.

In terms of relative value, the company’s profitability is some way below the peer group but the valuation seems to more than compensate for the risk at current levels:

Also note that on consensus numbers for the peer group, the margin differential between the company and its peers does not close at all into 2013 – if one is cautious about just having naked exposure to defence in the face of the likely budget cuts, especially given the relative performance of Thales (near 3y relative lows vs. peers), a pair trade would be quite attractive.

Variant View

1. My 2014 fair value implies about 9.9x EV/EBIT – not too many European defence companies trade at that kind of multiple, and in fact even the civil names trade at about 10.5x-11.0x at the most (Rolls Royce, Zodiac) so it might be asking a bit much for such a rerating in an industry that people are so cautious on.

2. The implied margins that the company are targeting are actually a bit above the top of the historical range – the IR pointed out to me that a few of the sell side analysts are sceptical on this and think that if they hit peak margins they will have to give it back in pricing.

3. French state owns 27%, Dassault Aviation owns 26% so you are a minority  - need to apply some discount for that plus the overhang risk

4. Consensus is already someway there on the earnings so you are kind of sat there not too far above consensus on earnings unless you really lean into the case, hoping for multiple expansion.

5. Of the circa 900m EUR net cash position, approximately 715m is their proportionate share of cash and near-cash items in a company called DCNS, of which they own 35%. Though the cash is theirs, the other 65% of the company is owned by the French state so in reality Thales do not really control the company and that cash is probably not going anywhere.

6. Further budget cuts in Europe, uncertainty around French elections.

Catalyst