14 February 2018

Leonardo – Teal Group Analysis

Author: Philip Finnegan, Drawn From: Defense & Aerospace Companies Briefing

Strategy: Leonardo's management is continuing to work to change the corporate culture and improve the company's performance to reach levels achieved by European competitors. Its new industrial plan unveiled in February 2018 seeks to restart growth, improve financial performance and cut debt.


The business already has been restructured. Cost-cutting and divestitures of non-core businesses have improved profitability.


To turn around the company, management has undergone repeated shakeups replacing many long-time managers


The focus now is entirely on defense and aerospace. Leonardo sees the potential for the company to act as a prime contractor in helicopters, military trainers and torpedoes. Leonardo has been working to divest non-core holdings, with energy divested at the end of 2013 and transportation sold in November 2015.


 The company has already created the international presence it long sought.


 It has aggressively expanded beyond Italy. Its purchase of DRS Technologies has given it a long-coveted stake in the US defense market (although the company purchased the business at a high price).


 Leonardo's acquisition of its partner’s stake in AgustaWestland made it the second largest defense contractor in the U.K. Leonardo has already consolidated the Italian industry within it, including Aermacchi, Marconi Mobile Holding SpA and Telespazio SpA.


 For several years, Leonardo has been embroiled in serious crisis management. It is burdened by corruption charges that have forced management changes at the top. The company has been hit by Italy's austerity program, which is cutting key defense programs.


 Strengths: Leonardo’s management now appears to have a much sharper strategic outlook. It is willing to cut the cord on unprofitable investments and shake up the company.

 Leonardo is a leader in sectors that include civil helicopters, trainers, radar and sensors and naval guns.


 Leonardo also has developed a strong position on the Boeing 787 wide body air liner.


 Leonardo’s management is showing a new flexibility in pursuing its strategic options. It recognizes its limitations and as such is focusing heavily on developing relations with other European aerospace firms and with leading US defense program contractors, including Northrop Grumman Corp and General Dynamics Corp.


 Leonardo has a strong international presence, well above major international US defense firms.


 Weaknesses: Leonardo suffers from poor performance. It has experienced cost overruns on a number of contracts and has great difficulty meeting its financial targets.


 The industrial structure is inefficient. It suffers from an inefficient supply chain, low engineering productivity, poor return on investments, inefficient management of working capital and poor cash generation.


 Leonardo's corporate culture has serious problems. The company has been embroiled in several different bribery probes.


 There has been turmoil in senior management. In May 2017, the fifth CEO in six years was installed.


 Leonardo suffers from excessive reliance on Italy. It relies heavily on the Italian defense budget, which is quite troubled due to the European debt crisis. The large Italian fiscal deficit will put serious pressure on the Italian defense budget for years to come. It is now flat despite being well below the 2% NATO target.


 Beyond reliance on the Italian defense budget, Leonardo suffers from its vulnerability to government political pressure. With its reliance on the Italian government, Leonardo at times must take steps to satisfy the government that may not fit in the company’s overall strategy.


 Leonardo does have limited exposure to the strong U.K. defense budget through AgustaWestland, but the U.K.’s tough procurement policy that has been a severe limitation to industry profits is of concern.


 The company’s focus on the use of joint ventures also raises issues about profitability. Tradition ally joint ventures lack both the profitability and operational control of fully-owned units of a company.


 The company is too diversified in its product portfolio. Many of Leonardo’s defense business are still below the critical mass needed for long-term survival, including its aeronautics and defense electronics businesses.


Leonardo has a high level of indebtedness that has led major debt rating agencies to classify its debt as non-investment grade or "junk."


Opportunities: Leonardo is seeking to revamp the company's tradition ally decentralized structure by making each of the individual companies into divisions. The goal is to eliminate overlap and better allocate investment between helicopters, aerospace, defense electronics and space based on potential return.


Leonardo is under taking a restructuring plan to improve profitability. The plan involves cutting operating costs, rationalizing the supply chain and renegotiating commercial agreements.


Aircraft growth promises to be led by Eurofighter (following sale to Kuwait) and training aircraft. Defense electronics should benefit from avionics, naval, cyber and DRS.
Aeronautics offers good potential for growth in its civil business due to increased production rates on the Boeing 787.


In helicopters, customer support, with its higher profit margins, has been increasing as a portion of sales. The company also sees prospects to improve its position in military helicopters by focusing on key large campaigns.


In space, the merger of Leonardo’s space operations with Alcatel should improve the long-term viability of the business.


Threats: Leonardo's debt rating is below that of competitors in international markets. While it appears to be making progress in reducing its debt, its rating will take time to improve.


The company's home market in Italy is under pressure due to the country's fiscal problems.
The company has never proved its ability to earn profit margins comparable to competitors.


The heavy military research and development spending in the United States that benefits US companies promises to have an impact on businesses such as Defense Electronics over the long-term.


Several corruption probes created turmoil in the company's management and in its customer base. They have damaged the company's reputation.


About the Author

Philip Finnegan

Philip Finnegan

Phil is Director of Corporate Analysis at Teal Group. He has provided strategic and market analysis for clients in commercial aerospace and defense, including major U.S. and European prime contractors, since joining Teal fifteen years ago.

He also writes and edits Teal's Defense and Aerospace Companies Briefing, which analyzes the performance, outlook and strategies of 50 aerospace and defense companies in the United States, Europe, Asia and South America. He is a co-author of the annual World Unmanned Aerial Vehicle Systems with responsibility for UAV companies.

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