Su Fuoco: Italy, Finmeccanica, Piaggio And CIR by GreenWood Investors
Speed Read:
- The Italian economy is recovering quickly and leading economic indicators are accelerating
- Yet, it has been the second-worst performing index in the world so far this year, opening up tremendous opportunities for global investors
- Finmeccanica has been thrown out with the bathwater, yet is outperforming its restructuring targets by a mile. Valuation remains @ crisis levels and ignores future restructuring opportunities
- Scooter and motorbike sales are on fire (su fuoco) and Piaggio is launching important new products for the segment that needs to quadruple just to get back to pre-crisis levels
- CIR Group is buying back stock at a discount of greater than 50% of NAV while all of its key investments are going to have a transformational 2016 rich with catalysts
While Italy has lagged the European and global recovery up until 2014, the last twelve months have started a definitive reversal of this trend. Trailing economic growth has picked up, growing 1% in the fourth quarter, but leading indicators are suggesting much more robust growth ahead.
Consumer confidence recently hit a record high, and has typically led auto sales and other durables by 2-3 quarters (not just in Italy but all over the world). Unemployment, typically a concurrent indicator, has also shown progress in retreating. Both consumer confidence levels and unemployment levels suggest an auto sales environment of >2.5 million vehicles, levels not seen since 2009 when the country had scrappage incentives in place to counteract the economic decline. While auto sales haven’t yet hit such levels, they’ve still strongly recovered to a recent annualized selling rate of 1.7-1.8 million (up from 1.3 million in 2014). In most recovering economies, auto sales recover well before the rest of the economy does.
Exhibit 1: Consumer Confidence & Auto Sales
Sources: ANFIA, Factset
Automobile and other durable manufacturing has led the industrial production of Italy higher, and capacity utilization is only 2% shy of the pre-Great Recession highs.
Exhibit 2: Italian Industrial Production Components
Source: Factset
Auto sales haven’t been the only early indicator of a material improvement in Italy’s consumer, as sales of scooters and motorbikes have also significantly improved in the last year, and have a much longer way to go to recover than do auto sales – roughly quadruple current selling levels.
Exhibit 3: Recent Sales of Two-Wheelers in Italy
Source: ANCMA
Why are we bringing up this recurrent theme we’ve been harping on over the last 14 months? Because somewhat paradoxically, the Italian index is the second-worst performing index in the world, trailing every single index except the Shanghai stock index.
Exhibit 4: Global Index Performance
Source: WSJ
Part of the contraction was spurred by renewed worries that banks have yet to resolve long-standing non-performing loans (we agree with this concern). Yet, the performance of the banks has dragged down a couple of our favorite positions, all of which have little exposure to the Italian banking sector. Although lending surveys have been largely positive through February of 2016, even if they were to deteriorate, credit has never played a large role in generating growth for Italy.
Exhibit 5: FTSE MIB Constituents Performance YTD (Banks in Red)
Performance as of March 10, 2016
Although the government has had difficulty paying for a generous welfare state and an aging population, corporate and consumer debt has never fueled Italy’s economy. Household debt has been quite a bit lower than developed peers. For example, as Italy is coming out of recession now, Italy’s household debt to GDP is still only 56%, or nearly half the levels where the US was coming out of recession in 2009 (98%). Despite the more severe economic recession Italy has endured, household debt levels as a percentage of GDP are in line with France and Germany and half that of the United Kingdom. Corporate debt levels are also relatively conservative compared with the US, France and the rest of the EU.
We would note that clearly the government’s debt balance is one of the worst in the world, and has been for a while – largely due to a stagnant economy since joining the Eurozone. We talked about this years ago, when many traders thought Germany would proactively leave the eurozone.
The eurozone common currency has left a lot to be desired – mostly for peripheral European countries. Because countries that would routinely de-value their currency as a result of perennially higher wage inflation (Italy, Spain, Greece, Portugal) became locked into a common currency with wage-stagnant Germany, workers in peripheral countries lost competitiveness to Germany. Germany went from being the “sick man of Europe” prior to the start of the euro to the best-in-class economic performer. This was all on the backs of unemployed peripheral workers – these statistics have a 91% correlation. We’d challenge anyone to find higher cross-country correlations of economic variables. Most of the economic correlations we run are lucky to get a correlation above 50%.
Exhibit 6: Italian “Excess” (Subtracting Germany) Economic Variables in Eurozone
We’re 91% sure that we’re right: as Italian employers kept increasing wages in line with historical standards, the competitiveness of the workforce vs. Germany was severely damaged. Because Germany wages have started to finally rise, and Italy has had prolonged labor deflation over the past several years, Italian unemployment has begun improving, particularly compared to Germany’s unemployment rate. The key to all of this ending well for all parties involved will be continued wage inflation in Germany and other parts of “strong” Europe. Because there is a lag to the unemployment rate catching up with the labor competitiveness, this bodes well for a continued decline in Italian unemployment, which would in turn, add fuel to the auto and scooter sales that are on fire (su fuoco).
It also reinforces our view that Germany will be the last member to leave the eurozone. A significantly higher Deutsche mark would lead to an immediate loss of competitiveness for Germany, particularly in the manufacturing sector. Unemployment would double in a matter of a couple of years, and would significantly benefit the rest of Europe. German businessman know this. German moderate politicians know this. Apparently the population never got the memo. Leave it to the madness of crowds to demand the very thing that would lead to significant hardship (even still, the US primary voter is making German voters look particularly intelligent on a relative basis).
All of this macro aside, we think the negative performance of the Italian index that is largely driven by fears in the banking sector (which will largely improve with the new measures announced today by the ECB), has left some pretty enticing opportunities in the country.
Perhaps the most interesting opportunity that’s opened up in the beginning of 2016 has been in shares of EXOR SpA, whose discount to NAV has blown out from under 20% to over 40% in recent weeks. Click here to read the research we published on EXOR, FCA and RACE a couple weeks ago. Jonathan Buck wrote about the opportunity in his recent Barron’s piece and quoted our analysis. Jonathan was also very early among the journalist community in advising people to buy what was then Fiat SpA, while most traders and journalists were still thinking the company was a short. It has never paid to bet against John Elkann and Sergio Marchionne.
While EXOR, FCA, and RACE remain highly attractive investment opportunities, there are three other Italian stallions we excluded in the last research piece, largely to keep it to under 30 pages.
Finmeccanica (FNC IM) has declined precipitously while its main European competitors have stayed roughly flat. Our contacts inside the company are optimistic about the company’s prospects, particularly in the electronics unit – the one unit we flagged in December of 2014 that had the biggest opportunity for improvement. Much of the progress on profitability has come from old restructuring plans, and so Mauro Moretti’s restructuring has yet to bear financial fruit. Even still, using trailing twelve month figures ending 9/30/15 (the fourth quarter is the most important quarter for the company), the company has already beat its 2016 goals for operating income. Yet, shares are the cheapest they’ve been since the company was rocked by multiple high-profile scandals.
The market has lamented the delay in finalizing the ~€8 billion Kuwait order for Eurofighter Typhoons, yet even without the contract (which we believe is still on track to be finalized soon), the company has enough momentum in the aviation and electronics units that it doesn’t need any “jumbo,” deals in order to show significant progress in financials. We still think the Kuwait deal is on track, as the Kuwait parliament has approved a downpayment on the Typhoons and increased total funding for the purchasing of aircraft in the last couple of weeks. FNC is bidding on a very large number of “jumbo,” deals as it has partnered with Raytheon to offer its own modern trainer (the most modern in the world) to bid for the TX trainer program in the US. That’s estimated to be an $8B program and the company has already won important customers in Italy, Poland, Israel, Singapore, with incremental large customer interest coming from UAE, Taiwan and the Philippines among others.
The weakest segment of the aerospace & defense industry has been large helicopters, thanks to the evaporation of the oil & gas offshore customer. Finmeccanica’s Agusta Westland unit has taken a significant amount of market share away from Sikorsky and other large helicopter manufacturers in the last year, yet still has felt some effects from the weaker oil & gas industry. Yet, the company is forging ahead with the AW609, partnering with ERA Group (one of the the largest helicopter operators in the world) and some Middle Eastern countries on this important tiltrotor – it will be the first tiltrotor to enter the market for a few decades and the first commercially-sold tiltrotor in the world. As we’ve said in the past, we expect VIP / corporate customers to be very interested in the ability to take-off from a London rooftop and end up in Moscow, Frankfurt, or Milan only hours after. Still, while sell-side expectations are low for the overall company, the helicopter division is the one in which we think consensus is a bit too high. Just like Moretti, we’d prefer a more constructive consensus in order to significantly outperform these estimates.
Aside from all of these headlines, Finmeccanica remains the cheapest aerospace & defense company in the world, yet has a significant amount of restructuring opportunities ahead of it to improve the underlying profitability of the company. Shares of Finmeccanica are trading at the same valuation levels they did as the company recovered from multiple high-profile scandals in the middle of the financial crisis. It’s notable that while we would argue for a larger share repurchase authorization, the company has bought back some of its stock at these low valuations.
Piaggio (PIA IM) initially sold off in the late summer of 2015 on concerns that the Indian three-wheeler segment (in which it is a leader) was weakening. The market has totally ignored the fact that European two-wheeler sales, led by strength in Italy, have significantly improved. This is a more important factor for Piaggio’s profitability, and the Italian sales gains have accelerated in the beginning of 2016, as shown above in exhibit 3. Sales of 3-wheel trucks in India stabilized later in 2015, with December recovering to a flat result from previously negative performance.
Because Piaggio’s contribution margins on its Vespa and Piaggio scooters are well north of 30%, and its trailing operating profit margins are just under 6%, the company has significant financial and operating leverage to a better scooter sales environment. Even with a bottom definitively established on its European sales, we’re paying well the below average valuation for a company that is coming out of a “trough” earnings environment – typically a cyclical stock will have an expensive valuation at its trough, yet with Piaggio we get a discount to historical norms, all with gathering evidence its core European market and Italian market are on fire.
Exhibit 7: Piaggio’s Margin Structure
Piaggio’s Margin Structure
Needless to say, the company has reactivated its share repurchase program and has been buying back healthy doses of stock in the recent weeks. It reports fourth quarter results tomorrow.
Last but not least, CIR Group (CIR IM) has also enjoyed the recent correction in the markets, through an active share repurchase program while it trades at a discount to NAV of over 50%. Each incremental share repurchase is substantially accretive to NAV per share. All of the company’s underlying holdings have important years ahead of them. Sogefi will continue to round out its geographical component offering by taking its European products and expanding its product offering in each part of the world. Also important to the group is the converged platforms of Renault-Nissan and Fiat-Chrysler in which it has had important wins in recent years. Much of the growth at both companies are coming on these converged platforms. Sogefi finally has a capable management and an operating plan after a year of having its plans on hold as it searched for a new CEO.
The company’s privately-owned KOS Group, is required by its agreement with AXA to seek a liquidity event in 2016 for the private-equity group’s ownership in the company. KOS has been performing well, fueled by cheap purchases of new rehabilitation and nursing home facilities and the operational synergies they provide. French peers Korian and Orpea are eager to enter the Italian market and trade at very rich valuations (11-18x EBITDA). We don’t think CIR will sell its interest in KOS, but it’ll be interesting to see what valuation the investment receives this year during the liquidity event.
Gruppo Espresso has recently entered into an agreement with Fiat-Chrysler to merge its business with two of FCA’s owned newspapers. The management of L’Espresso have done an exceptional job in raising profit margins through the prolonged downturn of the Italian advertising market. The merger will only accelerate the cost-savings initiatives as the two companies have significantly duplicative costs. Thus, even prior the advertising market in Italy improving, the group will be able to build significant value through synergy extraction after the deal with FCA closes. Espresso has also been buying back stock this year.
While all of these companies have recently been buyers of their own stocks – the nature of these buybacks are decidedly different than the programs of most of their US peers – who are almost all buying back their own stock at historically high prices and higher-than-average valuations, with margins potentially peaking. Italy is literally in the polar opposite position of the US right now: the economy is in a nascent recovery with significant room to expand before mid-cycle levels are reached, the European Central bank has quickly become the most accommodative central bank on the planet, helping the Italian banks restore their earnings power and balance sheets, and the stocks are all trading at historically low valuations. Its stable reform-minded government has also recently looked like a model for America to emulate as the “American Berlusconi” has gathered voting momentum. It’s hard to think of a better backdrop for meaningful stock outperformance going forward.
