We anticipate Leonardo’s credit metrics and FOCF will improve over 2022-2023 to levels commensurate with an investment-grade profile.
After a challenging 2020, when the pandemic weighed on Leonardo’s profitability and credit metrics, Leonardo’s credit metrics started to recover slowly, sustained by its defense and governmental business. In 2021, adjusted FFO to debt rose to 26.7% (after taking into account €101 million of non-recurring expenses in our adjusted EBITDA figure) from 18.7% the previous year due to significant free cash flow generation, restoring its rating leeway. For 2022-2023, under our revised base case, we expect further strengthening of Leonardo’s credit metrics due to S&P Global Ratings-adjusted FOCF and higher earnings due to increasing revenue and margins at its Defense Electronics & Security division (DES). We now forecast Leonardo’s FOCF at more than €450 million per year, owing to lower annual working capital outlays of €250 million-€350 million, down materially from €643 million in 2021. We believe the working capital improvement is mainly fueled by large orders moving to a more advance phase and by the majority of growth stemming from DES, which is typically less working-capital intensive. This will result in our FFO projection potentially improving sustainably beyond 35% over the coming 18-24 months.
Leonardo’s aerostructure business will continue to weigh on profitability, so we now estimate the group’s adjusted EBITDA at 10.0%-10.5% in 2022 before gradually improving in 2023-2025.
According to the company’s expectations, the aerostructure business will reach breakeven in 2025, implying that it will continue to drain cash for the next two to three years. Consequently, we now anticipate that over 2022-2023 this business will depress margins by 150 basis points (bps) to 200 bps. Although the group can rely on increased volumes due to faster recovery of demand from ATR (Aerei da Trasporto Regionale) and Airbus (narrow body aircraft A321 and A220), we still anticipate a difficult operating environment and subdued demand for Boeing’s 787 Dreamliner. We also expect the defense programs–Eurofighter and JSF–will contribute positively to margins and cash generation.
Some tailwinds from governments’ enlarged defense budgets could incrementally help Leonardo’s aerostructures and defense business in the medium term.
For time being, we anticipate that Leonardo’s top line will strengthen in 2022 by 4%-6% to €14.5 billion-€15 billion from €14.1 billion in 2021. Leonardo continues to benefit from its resilient defense and governmental business, which as of the end of 2021 represented about 88% of its revenue. Although we do not anticipate meaningful sales improvements over 2022-2023 as defense budgets increase, we would expect a moderate rise in new orders over the next few years. In 2021, Leonardo’s order intake reached €14.3 billion up by 4% against the same period the previous year. We note that about 50% of the orders represent Leonardo’s DES division, which we expect will fuel the group’s growth over the coming two to three years. Leonardo’s order backlog remains strong at €35.5 billion, unchanged from the same period a year ago.
Financial policies could support deleveraging in light of an expected material increase in FOCF.
We understand that Leonardo’s management is strongly committed to improving the quality of its cash generation, while limiting the use of off-balance-sheet working capital arrangements, aiming to strengthen its capital structure. Although Leonardo’s leverage isn’t tied to any specific key metric, its management is fully committed to achieving and maintaining an investment-grade credit profile. We also note that the company has no declared dividend policy. In 2021, the group didn’t distribute dividends, as a result of lower earnings due to the effects of the COVID-19 pandemic. However, over 2017-2020 shareholder remuneration reached €81 million per year. In our view, this amount does not represent a generous dividend pay-out compared with Leonardo’s earnings. Nevertheless, it was material compared with the company’s S&P Global Ratings-adjusted FOCF, which averaged about €115 million annually over those years. In our base case, we expect Leonardo to retain dividends of €80 million-€90 million per year over 2022-2024 in line with historical levels, which is well below anticipated FOCF improvements.
Governance factors will be important for an investment-grade standing.
We believe Leonardo’s governance structure and oversight are in line with local Italian governance standards. The board comprises 12 members (75% independent), with a separate CEO and chair. The Italian Ministry for the Economy and Finance, via its 30.2% stake in Leonardo, has right to present a list of candidates that usually receives the most votes and, therefore, de facto appoints a CEO every three years. The company’s code of conduct comprises several policies to hedge the comparatively high risks of fraud, corruption, and whistleblowing, which the aerospace, defense, and security sector typically faces. These policies apply to all directors, employees, suppliers, and agents. However, in the past years, Leonardo has faced several allegations related to bribery and corruption. At the same time, we recognize that the company has been discharged from the most prominent cases, for example, the one in India. The CEO is currently on trial connected to his previous role at Monte Dei Paschi di Siena for alleged false accounting and market manipulation. We understand Leonardo continues to act in line with best market practices and did not have major cash outflows related to bribery, fraud, or litigation cases in the recent past. Continuing this track record, demonstrating strong risk management practices, and continued transparent reporting in line with investment-grade peers in the sector will also be important considerations for the rating.
The positive outlook reflects the possibility of an upgrade over the next 18-24 months.
We will raise the ratings if Leonardo’s:
•S&P Global Ratings-adjusted EBITDA margins improve beyond 12% by the end of 2023 and approach 13% thereafter;
•Adjusted FFO to debt is sustainably above 35%; and
•Adjusted FOCF to debt is sustainably above 15%.
An upgrade would also hinge on management’s commitment and ability to maintain a very strong balance sheet, sound liquidity buffers under any market circumstances, and a positive track record of running the business with no material governance controversies. This would result, for example, from continued tight and transparent working capital management, and sound treasury management, with a significant amount of cash and committed credit lines.
We would revise the outlook to stable if FFO to debt were to stabilize at about 30% or if FOCF to debt fails to increase sustainably above 15%. This could materialize if the company’s margins or working capital requirements improve less than we currently forecast in our base case. Profit margins stabilizing at 12% or lower in the long term, due to contract dilution or unexpected one-off costs, could also lead us to revise the outlook to stable.
Environmental, Social, And Governance
ESG credit indicators: E-2, S-3, G-2
Social factors are a moderately negative consideration in our credit rating analysis of Leonardo, primarily due to the pandemic’s impact on Leonardo’s aeronautics business, which will continue to affect its profitability for the coming two to three years, albeit moderately improving. We regard the pandemic as a social factor that has affected Leonardo’s operating performance and credit metrics. The pandemic caused a significant decline in air travel and lower demand for passenger airplanes, and we do not expect these to recover to pre-pandemic levels until at least 2023. We regard governance and environmental risks as neutral considerations in our credit rating analysis of Leonardo.