UPDATE: THE SECRET PM

Near term support to earnings; less exposed to industry’s pricing pressure.

Throughout ’14, Pirelli has demonstrated strong execution skills in a more difficult environment by improving further its premium mix contribution and gaining market share. In addition, thanks to its premium niche model, Pirelli   is less at risk than peers to the industry’s pricing pressure.

Near term, several factors will provide support to earnings:

FX: Pirelli used conservative estimates and we see €40m upside to FY 14 guidance.
Oil price: Pirelli’s raw mat guidance is based on flat oil price.

Recent trend should provide €25m support to EBIT spread between ’14 and ’15.

Latam and Russia concerns largely priced in Latam: We expect profitability to stay broadly stable as premium is under represented (c6% of consumer sales in Latam vs 56% of group’s global consumer sales).

Our stress test shows that even in case of a single digit decline in standard/medium volume, Pirelli should be able to maintain profitability if premium organic growth stands above 10%.

The latter seems achievable since new premium car sales annual growth of 20% in ’08- 12 should support replacement demand and Pirelli is well positioned to gain market share thanks to its established distribution network.

Russia is a concern given limited visibility but Pirelli’s exposure remain small (<5% of sales) and we estimate the overall downside risk on EBIT at c€50m (5% of group’s) if mid-term targets are not met.

So far, delivery in Russia has been very strong with 50+% organic growth in 9M 14.

One of the last deleveraging stories left in Autos: ’15 consensus 9% too low. Two drivers:

1) Debt refi: Pirelli recently announced a bond issue and renegotiated its  credit line, both at a much lower cost. We estimate up to 9% positive impact to consensus ’15 EPS and a cost of debt reduction from 5.75% in Q3 to as low as 3.3%

2) asset disposal: steel cord business should reduce net debt by c€255m, or c€0.5/share

We expect a DPS of €0.4/share (3.5% yield and 14% above consensus.

Valuation: Upgrade to Buy (from Neutral), €14 (from €12) (DCF-based).

Pirelli trades on EV/Sales of 99/90%, EV/EBITDA of 5.1/4.7x, adj.

PE of 10.1/9.1x, vs EBIT margin: c14%/ROIC: c17% (‘15/16E).

Our upside/downside yield €16/9.

GS UPGRADES TO BUY

Friday • 11 November 2014 • 09:47

Goldman upgrade Pirelli to Buy on the back of its resilient earnings growth in the context of a challenging market environment.

We believe the successful execution of Pirelli’s premium strategy, and thus continued delivery of solid  earnings growth, should drive a re-rating.

12-month share PT EUR13.5

Friday • 07 November 2014 • 09:47

At a high level Pirelli numbers are a little disappointing: high margin premium tyre sales are booming (+17% yoy in Q3) yet total company operating margins are slightly down year over year. Within that consumer tyre margins are up 40bps to 14.2% while industrial (truck) tyre margins are down 350bps to 12.3%.

So there are two stories to tell.

The good one is that despite a slowing overall consumer tyre market the premium segment continues to boom, with volumes up 17% year on year in Q3, allowing Pirelli’s consumer business to deliver 5% sales growth and 8% operating profit growth despite a 4% headwind from weaker currencies. The premium growth is strong across all geographies. Over the first 9 months premium currency neutral sales were up 10% in Europe, 12% in the US, 20% in Latin America, 30% in Asia. With 14.9% operating margins delivered over the first 9 months of 2014 the consumer business is well on its way to achieving its target of 16% margins by 2017.

The bad story is that slowing global economic growth is having a big impact on the industrial (truck) tyre business. The industrial business has two main markets: Europe and Latin America.  Pirelli estimates the new sales market contracted by 5% in Europe and by a big 29% in Latin America. Owing to high (30%) market share, the Latin America industrial business enjoys margins are in the high teens versus high single digits in Europe. Thus the big decline in Latin American sales has a disproportionate impact on margins for the industrial business., hence the 350bps contraction in margins. Pirelli’s group margin expansion strategy recognises that the Latin American industrial business already enjoys best-in-class margins. All the plan aims to do is keep margins for the industrial business in the 13-14% range. For the first 9 months of 2014 industrial margins are at 13.4%. The 12.3% margin delivered during Q3 has got to be seen in the context of sales down 30%. Once the market stabilises margins should revert to the 13-14% range.

Despite the “macro event” in Latin America, which has caused Pirelli to lower its forecast for industrial business volumes from -2% to -5%, Pirelli continues to stand by its 2014 group targets of pre-structuring operating margins around 14.5% thanks to continued strength in its consumer business. Pirelli is therefore on course to deliver net profit of around EUR 400mln this year, on its way to a target of over EUR 500mln. Today’s market cap of EUR 5.2bn is not a fair reflection of that profit potential.

BUY PIRELLI: 50% UPSIDE

Tuesday • 14 October 2014 • 11:47

The US market’s PE rerating is probably complete. The relentless march lower in credit default premiums is waning. Long duration US corporate bonds yields peaked at around 9% in 2009 – equivalent to an equity PE ratio of 11. They then began a very steady decline to around 4.5% by 2013 – equivalent to a PE ratio of 22.

Corporate bond yields have not been able to move decisively lower than 4.5% for two years. In fact there is no historical precedent for long duration corporate bonds sustaining yields below 4.5%, outside of a period of directly controlled interest rates in the 1940s. Today in Europe, where risk-free interest rates are below 1% in Germany, credit default premiums have widened, preventing corporate discount rates moving lower.

If the boost from lower discount rates is over then equity investors can no longer count on a rising PE multiple to deliver returns. Without the aid of lower discount rates stock market returns become hyper sensitive to changes in growth expectations. The late 1960s – a similar period of low discount rates and high PE ratios – serves as a guide to how the market can move in tight unison with economic expectations.

The ISM index peaked in February 1966 at 62 and dropped to 46 by November, during that period the market fell 17%. Not long after that the ISM index troughed, at 46 in January 1967, rising to 55 by August. Over that time the market rose 12%. Again in November 1968 the ISM index peaked at 61, falling to 45 by June 1970, over that period the market fell 28%.

The key strategic insight from the 1960s, and other “sideways” markets, is that mean reversion trumps trend extension. When stocks rally hard on expectations of rising economic growth, risk exposures should be pared back. Conversely, when stocks fall sharply on expectations of recession, risk exposures should be increased.

The rationale for this strategy stems from the lack of excess in the “supply side” of the economy, and, the unwillingness of the supply side of the economy to invest in new capacity. Today, with the exception of shale oil and iron ore, the supply capacity across many cyclical industries has been reduced over the past few years, and firms are very cautious about making new investments. As a result the threat of big industrial capacity reductions on the developed world economies is small. Consider that US new housing construction is still running at just 1mln units per year. That level is below the trough levels seen in past recessions in the 1970s, 1980s and 1990s. There simply aren’t enough excesses in the developed world economies to precipitate a major recession.

With this playbook in mind the current sell-off in stocks presents an opportunity to increase risk exposures. Crucially though, if rising PE ratios cannot be relied upon to provide investment returns and economic growth is constrained by capex-shy firms, then, outperforming investments require profit growth that is independent of economic growth. Concretely, outperforming investments require profit growth from margin expansion.
Pirelli is a business will clear and achievable margin expansion targets. Management is accountable and has made the targets public: http://pid2013.iwebcasting.it/assets/files/booklet.pdf.

Pirelli aims for an operating margin in excess of 15% by 2017, up from 13% in 2013. An operating margin in excess of 15% translates into a net profit margin, after interest payments and tax, of around 8.5%. Even if revenues don’t growth at all – an 8.5% net margin on EUR 6.1bn of sales – Pirelli will deliver net profit of over EUR 500mln by 2017. Pirelli’s market cap today is EUR 5bn. If Pirelli maintains its PE rating at 16x then without any aid from rising market PE ratios or rising economic growth, Pirelli can reach a market cap of EUR 8bn, 50% higher than today.

Pirelli’s transformation from a hodgepodge industrial holding company into a lean premium-focussed tyre company began in the mid 2000s. Equity investments in other businesses (including Italian banks, airlines, and media) topped out at EUR 5.5bn in 2005, funded with nearly EUR 3bn in debt. By 2010 these investments had been mostly eliminated and debt brought down to around EUR 1bn. The clean balance sheet set the stage for the first industrial plan (2011 – 2013). During that period Pirelli invested aggressively into areas where it has competitive strengths.

Specifically, Pirelli used its EUR 400-500mln of annual operating cash flow to almost double capex investment, from around EUR 250mln per year to over EUR 400mln, in order to transition production capacity away from mid-range tyres, where it is subscale versus Continental and Michelin, towards prestige tyres, where it enjoys around 50% market share. It invested in its industrial/agricultural business in Latin America, where it has a dominant share. It also invested in Russia, which has a big premium winter tyre market.

This focussed investment enabled Pirelli to grow its premium tyre volume share from around 25% of total company volumes to nearly 40% from 2011 to 2013, and in so doing, increasing company revenue from EUR 4.8bn in 2010 to EUR 6.1bn in 2013, despite the overall standard tyre volumes being flat. The improvement in sales mix pushed operating margins from 9% up to 13%.

Premium tyres enjoy high margins (20% higher contribution margins than standard tyres) because in the replacement market customers show high fidelity to the original tyre manufacturer. This is because, in addition to the customer’s desire for performance, in many cases premium tyres are designed in tandem with a particular car model, and thus are directly recommended and approved by the car manufacturer during replacement.

Moving forward Pirelli’s second industrial plan (2013 – 2017) involves a continuation of the current strategy. With production capacity investments in place Pirelli expects premium tyre sales growth (7%) to continue to outpace standard growth (2.5%), as premium tyre penetration grows in emerging markets (currently 11% versus 32% in mature markets). Under this scenario Pirelli’s premium volume share will increase from 38% of total company volumes up to 44%, the resulting mix improvement coupled with cost efficiencies from a more streamlined premium product portfolio will push margins higher still, from 13% to 15%.

Expectations for growth embedded in Pirelli’s plan are conservative. For example, the industrial market – for truck and tractor tyres – is forecast to grow volumes at just 2% per year. Similarly, the consumer tyre business is forecast to grow volumes at 5%, of which the premium segment is expected to grow at 10%, implying a continuing stagnant standard range market. Strong economic growth is not necessary for Pirelli to expand margins.

Moreover, as capex intensity declines free cash flow will converge with net income, de-gearing the balance sheet from EUR 1.4bn of net debt to around EUR 500mln, and allowing cash returns to shareholders to rise from EUR 160mln in 2013 to over EUR 250mln. The improving cash remuneration will make it hard for the stock market to ignore the improving operating business.

Pirelli aims for an operating margin in excess of 15% by 2017, up from 13% in 2013. An operating margin in excess of 15% translates into a net profit margin, after interest payments and tax, of around 8.5%. Even if revenues don’t growth at all – an 8.5% net margin on EUR 6.1bn of sales – Pirelli will deliver net profit of over EUR 500mln by 2017. Pirelli’s market cap today is EUR 5bn. If Pirelli maintains its PE rating at 16x then without any aid from rising market PE ratios or rising economic growth, Pirelli can reach a market cap of EUR 8bn, 50% higher than today.