Profit growth potential well understood, but underappreciated FCF growth. Upgrade to BUY.
* Defensive profit growth + underappreciated FCF growth + BS optionality
While the sales growth and margin accretion story are well-understood, we believe the
market underestimates the FCF generation potential going forward. We are 10% above
FCF 2016-2018e, and 15% above thereafter. We upgrade Thales to BUY (PT €92/share)
as we see: 1) attractive 11% EBIT CAGR profit growth 2016e-2018e; 2) defensive
profile with 65% of profits exposed to defence in the first year of a turning cycle; 3)
doubling of underlying FCF from 2015-2020e; 4) balance sheet optionality could
further unlock value. Thales trades attractively on 11.5x '17e EV/EBIT vs. average
European Industrial stocks trading on 14.5x, with higher growth and safer end markets.
* 10% above underlying FCF consensus 2016-2018e, 15% above thereafter
On the back of our detailed analysis of cash flow and prepayments we forecast
underlying FCF to double from €0.7bn to €1.4bn by 2020e. After a 55% cash
conversion (FCF/EBIT) over the last 5 years, we estimate an average cash conversion of
67% over 2016-2021e vs. consensus 56% and management guidance >60%. We
expect the improvement to come from: 1) lower capex investments (start 2018e) post a
period of elevated investments, 2) no more cash outflows related to past provision, 3)
resilience in terms of prepayments vs. market expectations – we model €400m decline
in prepayments over next 3 years, while consensus implies higher declines.
* Balance sheet optionality: M&A bolt-ons and higher dividend pay-out
Recent non-core asset disposals + further FCF improvement are incremental to an
already unlevered BS (-1.5x net cash/EBITDA ex pens). While share buybacks are difficult
to implement due to Thales' shareholder structure, we expect: 1) DPS pay-out ratio to
increase from 35% to 45% - dividend yield increasing from 1.9% to 3.3% (UBSe '19e
DPS 15% above cons); 2) any further bolt-on acquisitions could be earnings/value
accretive. A potential increase in DCNS stake could be perceived negatively by the
market, but we do not expect a decision before the French elections (May 2017e).
* Valuation: trades on 11.6x '17e EV/EBITA, 17.2x P/E, 6% underlying FCF yield
We upgrade our PT to €92/share (prior €75) to reflect: 1) higher mid-term profit growth
on the back of Indian Rafale order and FX transactional benefits starting 2018, 2)
higher cash conversion, 3) rolling forward our valuation. Our PT is based on a DCF
using cash conversion 89%, 5 year profit growth of 7.4% and a WACC of 9%,
implying a FV multiple of 14.3x EV/EBITA.