Finmeccanica (EUR 15.72) 1 - Overweight

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1 September 28, 2005 Finmeccanica (EUR 15.72) 1 - Overweight EQUITY RESEARCH ITALY European Aerospace & Defense Initiation of Coverage A Company on the Move 0 - PLEASE SEE END OF DOCUMENT FOR IMPORTANT DISCLOSURES - m l 7 Investment Conclusion! Anticipate volatility as Finmeccanica continues major acquisitions and divestitures and simultaneous change from Italian GAAP to IFRS. We believe Finmeccanica is moving in right direction to pure play aerospace defense company. Initiate coverage with 1-Overweight rating. Summary! Massive restructuring of portfolio has led to 35% increase in share price over past 12 months vs. DJ STOXX change of +22%.! Expect 5-7 significant additional transactions including sale of assets worth 1.8 billion and acquisition of assets worth 700 million.! End result is large Italian pure play aero-defense company with attractive growth opportunities. Company Rating Target (EUR) New: 1 - Overweight New: Old: 0 - Not Rated Old: -- Sector View: 1 - Positive FY Dec 2004A 2005E 2006E 2007E Currency EUR Actual Old New Old New Old New Revenue (m) PTP (m) EPS *EV/CE *EV/Sales *EV/OR *P/E Stock Overview * Calendarised data Market Data Financial Summary Market Cap (m) 6460 Five Yr. EPS CAGR (%) 14% Shares Outstanding (m) Return on Equity FY03 (%) 14% Float (%) 66% Current BVPS - Net Div Yield (%) 1.7% Net Debt (m current) 539 Convertible Yes ADR Ratio - 26/9/05x S O N D J F M A M J J A S O N D J F M A M J J A S FINMECCANICA I:FNC/WIEXUKL(R.H.SCALE) Source: DATASTREAM Reuters SIFI.MI Bloomberg FNC MI ADR - Performance 1M 3M 12M Absolute % Rel. Market % Rel. Sector % Week Range Summary and Conclusions The New Finmeccanica: Finmeccanica is being reborn as a new and important pure-play European aerospace and defense company. This New Finmeccanica, as we define and model it, is a high-tech and broadly diversified pure aerospace and defense company competing in aircraft and aeronautics design and manufacture, aerostructures, defense electronics, communications and information technology. Like BAE and Rolls Royce, but unlike EADS and Thales, it has access to the US markets, and has a major presence on big US programs such as the Joint Strike Fighter, the US101 Presidential helicopter, and the C27J. It has industrial plants in Philadelphia and a new facility in South Carolina. It also is a major participant in the Airbus A380 and the Boeing 787, and Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) ON PAGE 27 AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 28 1

2 potentially the new Airbus A350 program. We estimate New Finmeccanica will have almost EUR 11bn of pure aerospace & defense sales in 2006E, EBIT of EUR 750m, and net income of more than EUR 400m. By 2009, we estimate that sales could be one-third larger than 2005, EBITA nearly two-thirds higher, and EPS growth still faster. By this time next year, we forecast the shares of New Finmeccanica could potentially be valued at EUR 7bn, or 10% more than today s value, and should continue to grow. In our view, the non-italian ownership of New Finmeccanica shares could quadruple relative to current ownership. New Finmeccanica is not yet a reality, but it is already well conceived and underway. We see several aspects of the transformation of Finmeccanica which have been driven from the top, where CEO Pier Francesco Guarguaglini has set the overall strategy and CFO Alessandro Pansa has been charged with the financial implementation. The changes to the financial structure have been particularly significant, and have been accomplished with no degradation to the balance sheet. We would also highlight the renewed commitment to businesses that are better run, better focused and more profitable. Our experience is that whenever managements are focused intensely on improving the operational aspects of the business, both the company and the share price do well. There are two main challenges for investors seeking to understand Finmeccanica. First, with so many M&A events recently completed, and with so many planned additions and deletions to the Finmeccanica portfolio, it is very hard to say with confidence which businesses the market is actually valuing. For the next several reporting periods, it is likely that the businesses included in the results will be different from the businesses included in the prior period results and different again from the periods to follow. Second, Finmeccanica s change from Italian GAAP to IFRS, its higher tax rate, and its substantial loans and advances from the Italian state all make comparisons of Finmeccanica s financial results with other defense companies very difficult and confusing. When changes in the business base and in the financial accounting occur simultaneously, the analysis is more than doubly hard. Our experience is that investors will struggle with these issues, and that the management team will need to go out of its way to increase both the quality and quantity of its financial disclosures and guidance. We know from long experience that a good CEO and CFO team can contribute billions to the market value of a company s shares, both through good execution and through good communication; we expect the Finmeccanica team to be good at both. The transformation into New Finmeccanica includes: the acquisition of the GKN s 50% share of Agusta-Westland (closed November 2004), the first stage of the EuroSystems deal with BAE in Avionics (closed in April 2005), the creation of two satellite joint ventures with Alcatel (already approved and closed 1 July 2005), the sale of the remaining 60m shares of the company s ST Microelectronics holding, and lastly, and most importantly in our view, the divestiture of its non-core transport and energy businesses. As a first step in this last goal, the company announced the planned listing of its Ansaldo Signal train electronics and signal businesses. At its June AGM, Finmeccanica approved a 1 for 20 reverse stock split, resulting in a lower share count and mid-teens stock price. The New Finmeccanica has growth objectives through program wins and acquisitions. The company has expressed a high interest in acquiring or venturing with parts of Thales as well as the BAE Atlas marine electronics division, which is being divested. The Italian government has also stated its intention potentially to reduce its shareholding and involvement with management. In our view, each of these actions has been and continues to be a step in the direction of focusing the company and increasing shareholder value. The New Finmeccanica is about 58% defense electronics and systems, about 22% helicopters, and about 20% aeronautics. As Italy s only large aerospace/defense company, New Finmeccanica not surprisingly has an Italian character and substantial business and political support at home, but it is also broadly represented either as a partner or subcontractor in the major pan- European joint projects and ventures including Eurocopter, Eurofighter, MBDA (the European missile company), and Airbus. New Finmeccanica also has an open door to the US, both as a result of its excellent products, diverse group of companies and Italy s excellent relationship with the US. One of the core strengths of Finmeccanica is that it has solid and established business relationships far beyond the Italian borders. The combined defense electronics, systems and space companies (which we estimate represent ~EUR 5.7bn sales in 2005E) are fast-growing and second only to Thales in its electronics, space and communications capabilities and sales. With the addition of the 2

3 former BAE avionics assets in the UK, New Finmeccanica will provide most of the Eurofighter electronics/avionics, heads up displays for the US F-16, and a large number of air traffic control and communications products. The helicopter company (which we estimate represents ~EUR 2.4bn sales in 2005E) has manufacturing facilities in Italy, the UK and the US. Its US101 was recently selected for the US Presidential helicopter, and is a leading contender for the Air Force search and rescue helicopter program known as the PRV (Personnel Recovery Vehicle). A 32% stake in Eurocopter s NH-90 program rounds out the helicopter business. The aeronautics company (which we estimate represents ~EUR 2.2bn annual sales in 2005E) is made up of Alenia, which produces parts for Boeing and Airbus, including the new A380 and the new 787 Dreamliner, as well as Aermacchi, which manufactures military training aircraft, and provides structures for the US Joint Strike Fighter and the Eurofighter. On The Right Path, But Not Without Investor Issues to Overcome: Although we are encouraged to see the dramatic transformation to the New Finmeccanica, and excited to see the creation a new large aerospace company, in the short-term the company and its shares face some tough challenges. These challenges can be summarized as (1) uncertainty over what businesses are really in and what business are out of the portfolio given the expected high levels of M&A and (2) uncertainty over how to interpret the financial statements and how to value these assets. Both tasks are further complicated by changes in the accounting methods and treatments: " The divestiture plans for the non-core businesses (Transportation and Energy) have begun, with the announcement that the company will list its Ansaldo Signal assets as a first step in a complete divestiture of this business. The proceeds of the listing and the value to shareholders will be determined by the marketplace but, in our opinion, the Signal listing taken alone will likely be dilutive to EPS. We do not know how fast the company will be able to sell the other less-attractive, non-core assets. The process of cleaning these businesses up for a potential sale to others is likely, in our view, to result in provisions, restructuring, and charges to the P&L. We estimate that the divestiture of non-core businesses is likely dilutive in the nearterm, but the more focused business model should warrant a higher valuation. We believe New Finmeccanica will likely become a more attractive investment as a pure-play in aerospace/defense. The announcement of the disposal of Ansaldo Signal was well-received by the market, with the shares outperforming by 13% relative to the market: however, we expect some potential volatility in the shares during the remaining divestiture processes. Offsetting the divestitures and their potential dilution are the planned and announced acquisitions such as Datamat, the purchase of the BAE share of the EuroSystems JV, and the potential acquisition or merger with Thales. " Transformation from Italian GAAP to IFRS will likely lead to some confusion and difficulties in comparing past and present performance. The current Italian GAAP financials provides limited insight to a number of metrics and the company s adoption of IFRS and its treatment of development spending and government advances and loans is sufficiently different from other European and US companies that confusion about the meaning of EBIT, EPS, and cash flow is predictable. These issues are compounded by the various moving pieces in the company s ownership and taken together, we do not believe it is possible to construct comparable financials for the recent past and potential future with a high degree of accuracy; however, this will likely change with the adoption of IFRS. In our view, it will take 6-18 months for a clear consensus on Finmeccanica shares to emerge. " The company has divested a significant part of its stake in STMicroelectronics, but it still retains 60mm shares, worth ~EUR 800m (based on closing price of EUR 13.60, 23 September 2005), or about 12% of the current Finmeccanica market cap. " This is a transitional year for key business segments: the fully-owned AgustaWestland, the newly-formed Defense Electronics JV with BAE Systems, as well as the JVs with Alcatel and Space. There could well be upfront costs to achieve long-term cost savings and synergies, and getting the newly acquired businesses to operate on a new higher level could take time. 3

4 " Mr. Guarguaglini has commented to the press and investors that Finmeccanica and the Italian government are in favor of a defense electronics tie-up with Thales. In our opinion, the structure and pricing for the potential deal is not well understood by investors, and most believe it is not highly likely (nevertheless, the complex and prolonged political decision process in France only adds uncertainty to all the companies involved, including Finmeccanica). " Like Thales and EADS, Finmeccanica has a high state ownership of 32%. Although the company enjoys the advantage of government projects and refundable launch aid, outside shareholders are always concerned about the overrepresentation of the state s interest, and want assurances that the company is being run for profit and the benefits of public shareholders. Share Price: Short-term Hard Call, But Solid Long-term Potential: Although Finmeccanica shares have traded up more than 35% since last September, we believe they remain an attractive long-term investment. The vast bulk of the increase in share price is related to the disposition of its STMicro shares, but the awakening of the market to the coming of New Finmeccanica is also responsible for the share price moves. Given the recent strong stock performance and the remaining uncertainties around the above mentioned issues, we would not be surprised to see some downward pressure on the shares of Finmeccanica. Finmeccanica is trading at 15.7x our forecast 2006 EPS estimate of At our price target of 16.50, Finmeccanica would be trading at 14.2x our forecast EPS. Assuming all of the non-core assets are divested and all announced acquisitions are consummated, we estimate the New Finmeccanica is currently trading at 16.1x our 2006 EPS estimate of 0.98 and an EV/EBITDA multiple of 6.3x, with a dividend yield of just under 2%. Our price target means New Finmeccanica would trade at 14.6x P/E on our 2007 EPS estimate of 1.13 and an EV/EBITDA of 5.8x assuming our EBITDA estimate of nearly 1.2bn. We have not included over 3bn of potentially refundable advances and loans from the Italian government in our calculation of EV. If we were to include these long-term liabilities, the aforementioned EV to EBITDA multiples would rise by 2.7x EBITDA turns, and one would have to be willing to accept an 8.6x EV to EBITDA multiple to be comfortable with our price target. At our price target both current Finmeccanica and New Finmeccanica would be trading at a 5% free cash flow yield, despite very large investments in new commercial and military aircraft programs. Figure 1 illustrated our reconciliation from current Finmeccanica to the New Finmeccanica, adjusting for all the expected transactions, and Figure 2 showed the valuation metrics for our target price of on 2007 estimates for both the current Finmeccanica and the New Finmeccanica, which we have defined in the following section. Figure 1: From Current Finmeccanica to New Finmeccanica Market Net Enterprise ( million) Value Debt Value Current Finmeccanica YE , ,153 Purchase of 25% of BAE Avionics JV 385 Purchase of Datamat in Listing Signal ( 607) Divesting Other Non-Core ( 396) Free Cash Flow In Excess of Dividends ( 304) New Finmeccanica YE ,617 ( 113) 6,504 Note: Current Finmeccanica Year End 2005 Net Debt include the 60 million shares of STMicro, value at ~ 800m. Source: Lehman Brothers estimates and company reports Figure 2: Target Price Valuation Metrics Target Price of Current New Target Price Valuation on 2007 Finmeccanica Finmeccanica EV/EBITA 7.6x 8.0x EV/EBITDA 5.5x 5.8x PE 14.2x 14.6x Free Cash Flow Yield 5.6% 5.2% Source: Lehman Brothers estimates and company reports 4

5 Defining The New Finmeccanica In addition to modeling Finmeccanica under its current business structure, we believe the company should be analyzed and valued based on the probable end results of the transformation process, a company we call the New Finmeccanica, and which we envision to be 100% Aerospace and Defense. As soon as the new company is visible, we believe Investors will also look past the near-term reshuffling of the businesses, and toward 2007 and even to 2008 and beyond for the new and focused Finmeccanica. We have modeled the New Finmeccanica under the following assumptions: " Model Pro Forma for 100% Agusta Westland transactions. " Model Pro Forma for the BAE Finmeccanica EuroSystems and Alcatel transactions. " Assumed sales of all 153m shares of STMicro, of which 93m was used to fund the AgustaWestland acquisition and 60m shares used to fund BAE Avionics transaction. We have also assumed a subsequent capital gain of ~ 427m on the sale of 60m shares of STM. " Assumed the acquisition of Datamat at a cost of 270m. " Assumed the IPO of Ansaldo Signal and subsequent sale of all of the shares for a reduction in net debt of ~ 600m. " Assumed the divestiture of the balance of the non-core businesses with a further reduction in net debt of 400m. We illustrate our New Finmeccanica financials and the implication of our model assumptions in Figures 3 through 7. The new organizational structure for the New Finmeccanica is also presented in Figure 8. 5

6 Figure 3: New Finmeccanica Valuation and Key Metrics New Finmeccanica Milan: SIFI.MI Rating: 1-Overweight Adjusted Price: (Sep-27-05) 2003PF 2004PF 2005PF 2006E 2007E 2008E Financial Statistics (Lehman Brothers Estimates) Value of Production 8,783 9,432 9,928 11,144 11,558 12,395 VOP Growth 7.4% 5.3% 12.3% 3.7% 7.2% EBIT ,023 EBIT Margin 5.7% 5.8% 6.6% 6.7% 7.4% 8.3% EBITA ,023 EBITA Margin 6.9% 7.0% 6.7% 6.7% 7.4% 8.3% EBITDA ,002 1,065 1,189 1,379 EBITDA Margin 9.4% 10.1% 10.1% 9.6% 10.3% 11.1% Net Financial Charges Incl F/X 90 (19) (65) (47) (31) (12) Cash and Cash Equivalents 2,494 2,495 1,883 1,950 2,194 2,622 Debt 2,323 2,503 2,081 2,081 2,081 2,081 Net Debt (171) (113) (541) Launch Aid 1,900 2,550 2,750 2,950 3,150 3,250 Net Debt Include Launch Aid 1,729 2,559 2,948 3,081 3,037 2,709 Cash Flow from Operations Capex Free Cash Flow Weighted Average Diluted Shares Weighted Average Diluted Shares Net Income pre-goodwill and exceptionals Dividends Per Common Share Dividend Yield 1.3% 1.3% 1.7% 1.7% 1.8% 1.9% EPS- pre goodwill and exceptionals EPS Growth 3.0% 27.4% 14.4% 15.9% 26.5% Valuations at Current Stock Price $15.74 $15.74 Market Value 6,638 6,639 6,640 6,641 6,641 6,641 Enterprise Value 6,467 6,647 6,838 6,772 6,528 6,100 Same Year Ratios on Current Stock Price Enterprise Value to Sales 0.74 x 0.70 x 0.69 x 0.61 x 0.56 x 0.49 x Enterprise Value to EBIT 12.9 x 12.3 x 10.5 x 9.0 x 7.6 x 6.0 x Enterprise Value to EBITA 10.7 x 10.0 x 10.4 x 9.0 x 7.6 x 6.0 x Enterprise Value to EBITDA 7.8 x 7.0 x 6.8 x 6.4 x 5.5 x 4.4 x Free Cash Flow/Market Value 4.4% 3.7% 2.9% 2.7% 5.5% 8.4% Free Cash Flow/Net Income 106.8% 87.1% 52.9% 44.3% 76.5% 91.9% Price to EPS 24.2 x 23.5 x 18.4 x 16.1 x 13.9 x 11.0 x Dividend Yield 1.3% 1.3% 1.7% 1.7% 1.8% 1.9% Valuations at Target Stock Price $16.50 $16.50 Estimated Return including Dividend Yield 6% 8% 10% 12% Market Value 6,958 6,959 6,961 6,961 6,961 6,961 Enterprise Value 6,787 6,968 7,159 7,093 6,848 6,420 Same Year Ratios on Target Stock Price Enterprise Value to Sales 0.77 x 0.74 x 0.72 x 0.64 x 0.59 x 0.52 x Enterprise Value to EBIT 13.5 x 12.8 x 11.0 x 9.5 x 8.0 x 6.3 x Enterprise Value to EBITA 11.2 x 10.5 x 10.8 x 9.5 x 8.0 x 6.3 x Enterprise Value to EBITDA 8.2 x 7.3 x 7.1 x 6.7 x 5.8 x 4.7 x Free Cash Flow/Market Value 4.2% 3.5% 2.7% 2.6% 5.2% 8.0% Free Cash Flow/Net Income 106.8% 87.1% 52.9% 44.3% 76.5% 91.9% Price to EPS 25.3 x 24.6 x 19.3 x 16.9 x 14.6 x 11.5 x Dividend Yield 1.2% 1.3% 1.6% 1.7% 1.7% 1.8% * are IAS; are IFRS Source: Lehman Brothers estimates and company reports 6

7 Figure 4: The New Finmeccanica Transactions Completed Transactions Completed Purchase of 50% AgustaWestland Status Change to Sales ( mm) Change to EBIT/A Interest Effect Change to PBT Change to Operating Cash Flow (Increase)/De crease in Net Debt Change to EPS Completed Nov , (56) (1,588) Comments Finmeccanica acquired GKN's shares of the joint venture bringing ownership to 100% on AgustaWestland Sell 93 million shares of STM Pro Forma dissolution of AMS joint venture with BAE, and acquire various businesses from BAE and form the New Avionics JV. Complete rearrangement of space ventures with Alcatel including majority ownership of satellite manufacturing to Alcatel and majority of services to Finmeccanica Completed Nov , Final Agreement closed April (25) (715) Final Agreement signed Jan Closed July (4) (4) (2) (100) 0.00 Total +1, (34) (961) *in millions of euros, except per share data Source: Lehman Brothers estimates and company report To finance the 1.6 billion acquisition cost, 93 shares of STM were sold raising 1.4 billion BAE and Finmeccanica have come to agreement on the break up of the assets of AMS and for a sale of various assets to Finmeccanica. The transaction was closed in April Two new JVs: Alcatel Alenia Space, Alcatel will hold 67%, combine Alcatel Space and Alenia Spazio's activities. Telespazio, Finmeccanica will hold 67%, combine Telespazio with Alcatel Space Services and Operations activities. Figure 5: The New Finmeccanica Transactions Expected Transactions Expected, Adjustment to New Finmeccanica Actual Status Change to Sales ( mm) Change to EBIT/A Interest Effect Change to PBT Change to Operating Cash Flow (Increase)/De crease in Net Debt Change to EPS Comments Purchase of the remaining 25% of Avionics JV from BAE Expected in (13) 14 8 (385) Finmeccanica has the call option to buy and BAE has a put option to sell the remaining 25% of the Avionics JV. Sell the remaining 60 million shares of STMicro Not complete Listing of Ansaldo Signal Partial Listing Expected End of 2005 (607) (70) +21 (49) (29) +607 (0.07) Finmeccanica has sold down its shares of STM and we expect it to divest the remaining shares for cash. In valuing the "new Finmeccanica", we assume Finmeccanica sold all 60 million shares in We assume a full listing of Ansaldo Signal in Assume total EV of 607 mm, with zero net debt. Divest the remaining Non-Core Finmeccanica (Remaining Transportation segment and Energy segment). Not complete (1,749) (42) +14 (28) (17) Total (1,867) (85) 50 (35) (20) 1,442 (0.05) *in millions of euros, except per share data Source: Lehman Brothers estimates and company report These assets are non-core and a planned to be divested. We assume either a contemplated sale of these assets to Fincantieri or to another party. Assume total EV of 400 mm, with 350 mm of net debt. 7

8 Figure 6: The New Finmeccanica Transactions Completed Deal Action Consideration Segment Date Aermacchi Acquisition Purchased 67% stake, to bring effective control to 94% ( 160) Aeronautics 7/1/2003 Fiat Avio Acquisition Purchased 30% stake, 70% to Carlyle Group ( 143) Aeronautics 7/1/2003 AgustaWestland Acquisition Purchased GKN's 50% stake to bring effective control to 100% ( 1,500) Helicopters 11/30/2004 STMicroelectronics Share Disposal Sold 93 million shares; retain 59 million shares 1, /1/2004 Telespazio SpA Acquisition Assumed 127 million in debt ( 240) Space 8/2/2002 Alcatel/Alenia New JV Formed 2 separate JVs with Alcatel; services and manufacture ( 100) Space 7/1/2005 Marconi Mobile Holdings Acquisition Assumed 43 million in debt ( 614) Defence Electronics 8/2/2002 BAE AMS Acquisition AMS dissolved; form avionics JV with 75% control for FIN, 25% BAE ( 515) Defence Electronics 4/30/2005 Total Acquisitions ( 1,830) Source: Lehman Brothers estimates and company report Figure 7: The New Finmeccanica Transactions Expected Current Structure Problem Proposed Solution Timeframe Energy & Transport Cons. Subs Low Margin Non-Core #1 Inject into JV with Fincantieri and retain 30% stake #2 Sell assets to competitor, private equity, or venture capital STMicroelectronics Holding Non-Core Holding Sell shares, though subject to restrictions Q Datamat Announced - Complete acquisition by purchasing remaining outstanding shares YE 2005 Ansaldo Signal Cons. Sub Non-Core Holding List 50%-70% on exchange Q New BAE JV JV JV Structure Purchase BAE's remaining 25% share of JV Q State Holding of Shares Investor Perception Government has no stated intention on reducing 32% stake -- Source: Lehman Brothers estimates and company reports 8

9 Figure 8: New Finmeccanica Organization Chart New Finmeccanica* 11.1B Sales Core Aerospace & Defense 100% of Total Aeronautics 2,225mm Sales Aeronautics 20% of Total 1,318mm Sales 167mm EBIT 15% of Total 20% of Total AgustaWestland 2,450mm Sales 22% of Total 260mm EBIT 31% of Total Space 921mm Sales 8% of Total 37mm EBIT 4% of Total Defence Electronics 4,614mm Sales 40% of Total 317mm EBIT 35% of Total Defence Systems 1,086mm Sales 10% of Total 78mm EBIT 10% of Total Alenia Aeronautica 100% Owned Satellite Services JV 67% Owned SELEX Comm 100% Owned SELEX Integrati 100% Owned MBDA 25% Owned Aermacchi 100% Owned Satellite Manufacturing JV 33% Owned SELEX Sensor & Airborne 100% Owned IT (incl Datamat) 100% Owned Oto Melara 100% Owned Officine Aeronavali 100% Owned Laben 100% Owned WASS 100% Owned Quadrics 100% Owned Space Software 100% Owned *Based on Lehman Brothers 2006 estimates Source: Lehman Brothers estimate and company reports 9

10 Valuation and Investment Issues The New Finmeccanica is a major step in the rationalization and consolidation of the European aerospace and defense industry. Phase I established national champions and some international joint ventures, while Phase II begins the necessary specialization and strengthening of assets owned in one country but domiciled in another, a process that is likely to be bilateral and complementary. The New Finmeccanica is the result of the same kind of vision, creativity, and flexibility that created the first mega defense company in the U.S. in Lockheed Martin and in Europe in EADS, the first real cross-border European aerospace-defense company. Finding a way forward in the rationalization and consolidation of the European defense industrial base has been slow, arduous, political and often confusing for investors. The New Finmeccanica, we believe, will be simple to understand, easy to like and profitable to own. Our investment thesis is that the shares of Finmeccanica will be valued on the New Finmeccanica and not the old Finmeccanica, as soon as the new company comes into better view. Stocks are forward-looking instruments, and we expect that Finmeccanica shares will reflect the new company as early as possible, and certainly well before the New Finmeccanica financials and results are completely clear of the vestiges of the old Finmeccanica. There are clear risks in trying to value Finmeccanica on the company it is likely to be, especially without a full set of financials for the new company. We think the excitement about the New Finmeccanica will be tempered by the continued (though diminished) importance of the STM shares, high Italian taxes, the fact that the New Finmeccanica is not yet a reality (by both accounting treatment and by certain operational issues), and uncertainties within the various businesses. The Finmeccanica share price is already up over 35% since last September, and the value of the underlying Finmeccanica businesses has more than doubled. The earnings of the company are nearly certain to be confusing as the various transactions that take the old Finmeccanica to the New Finmeccanica take place. That confusion will be compounded by accounting changes that come with the shift from Italian GAAP to IAS and IFRS accounting which are to be implemented in Moreover, some of the New Finmeccanica business units are in transition, such as the civil aerostructures programs which are still going down as the Boeing 717, 757, and 767 programs come to end while the A380 and 787 programs are just ramping up. Additionally, while the euro is less of an issue for Finmeccanica than other European companies, all aerospace companies have a significant amount of work valued in dollars. Despite these headwinds, the path of Finmeccanica is becoming clearer and we believe the creation of a New Finmeccanica should be complete within the next year or two. We have a high degree of confidence in the Finmeccanica leadership team and trust that the share price will reflect the progress of the company along its path of transformation, as well as its focus on cost control and more growth. 10

11 Figure 9: Five Year Price Volume Graph Price Volume mm's Jan-00 Sep-00 M ay-01 Feb-02 Oct-02 Jun-03 Feb-04 Nov-04 Jul-05 - Volume Price Source: Bloomberg Figure 10: Five Year Relative Price Performance versus DJ Stoxx Weekly 30% 20% Cumulative 60% 40% 10% 0% 20% 0% -10% -20% -20% -40% -30% Jan-00 Aug-00 M ar-01 Sep-01 Apr-02 Nov-02 Jun-03 Jan-04 Aug-04 Mar-05-60% Weekly Cumulative Source: Bloomberg Figure 11: One Year Relative Price Performance versus DJ Stoxx Weekly 12% Cumulative 30% 8% 4% 20% 10% 0% 0% -4% -8% -10% -20% -12% Sep-04 Nov-04 Jan-05 M ar-05 A pr-05 Jun-05 A ug-05-30% Weekly Cumulative Source: Bloomberg 11

12 STMicro Shares Finmeccanica s market capitalization has been dominated by the company s 153m shares of STMicroelectronics which it owned until recently. Those STM shares valued at the market price of STM were worth as much as 10.5bn in 2000, 75% of the value of the Finmeccanica shares. Two things have been happening: the value of the STMicro shares has fallen by about 80% and Finmeccanica has reduced its shares by about 60%. In November 2004, the company sold 93m shares of STM and used 1.4bn of proceeds to acquire the 50% of Agusta-Westland owned by GKN. At today s price of STMicro, the remaining 60m STM shares are worth just over 800m or 12% of Finmeccanica s market capitalization. Figure 12: Total Finmeccanica Declined, New Finmeccanica Rose Market Value 14,000 14,000 12,000 12,000 10,000 10,000 8,000 8,000 6,000 6,000 4,000 4,000 2,000 2, May-00 Dec-00 Jul-01 Feb-02 Sep-02 Apr-03 Nov-03 Jun-04 Jan-05 Aug-05 Finmeccanica Market Cap ex STM Holding Finmeccanica Market Cap Source: Lehman Brothers estimates, Bloomberg In July 2003, Finmeccanica issued a 500m bond which is convertible into approximately 20m shares of STM at a price of 25 per share. At today s ~ STM share price, the conversion feature is very far out of the money and it is likely that the bond will need to be repaid with cash. However, management has indicated that it is likely to sell these shares, and the company has entered into hedges that will not require it to hold the actual STM shares. Therefore, the total ~60m shares with a value of more than 800m are unencumbered and could be sold and used for additional acquisitions. In our valuation of Finmeccanica, we have assumed that all of the remaining 60m STMicro shares are sold for a total of ~EUR 830m, and have included that value in cash and marketable securities. Clear of the depressant effect of the STM holdings on the Finmeccanica shares, and with the New Finmeccanica starting to take shape, the value of Finmeccanica s shares has risen to 6.4bn, over 35% since September In that same timeframe, the underlying value of the Finmeccanica businesses, excluding the STMicro shares, has more than doubled to 5.6bn. We believe the markets have been watching and are already reacting. 12

13 High Italian Tax Rate Finmeccanica expects to pay Italian taxes amounting to approximately 40-45% of the 2005 pre-tax income. This compares with tax rates that range from just over 26-40% for other companies in our coverage. The company pays taxes in two categories: IRAP (Italian local tax on production activities) and IRES (Italian corporate income tax). The IRAP is paid based on the net value produced in the given regional authority's territory, and has been running at a ~ 80-90mm per year for the past several years regardless of profitability. The IRAP taxes have been the main cause of Finmeccanica s higher and unstable effective tax rate. The Italian corporate income tax rate has been declining in recent years and is expected to be 30-33% for We expect the effective tax rate for Finmeccanica to continue to decline over the next several years, largely due to higher foreign production content, which usually has lower tax rate and does not incur IRAP. The European Commission has deemed the IRAP tax illegal, and therefore, it may be eliminated or replaced by some other legal tax. This may lead to a reduced tax rate for Finmeccanica, however, the timing and probability of this are unknown. Although we expect declining tax rates for Finmeccanica in the short run, the relatively high tax rates still cause valuation distortions when comparing Finmeccanica with other defense companies using Enterprise Value. We often see investors and analysts setting normative EV to EBITDA or EV to EBIT/A multiples in order to establish a sum-of-the-parts valuation or price target. When comparing high tax rate Finmeccanica to other lower tax-paying aero/defense companies in other countries, setting a normative EV to EBITA ratio is the same as saying Finmeccanica should have a much higher P/E as shown in our illustrative data in Figure 13. An 8.0x EBITDA multiple for a low-tax company equates to a 14x P/E while the same 8.0x EBITDA multiple implies a 21x P/E for the higher-tax-paying company. This difference is widened if there is little or no debt as the interest rate tax shield is very high as shown in the Figure 14, and the more than 23x P/E that goes with an 8.0 EBITDA multiple and 50% tax rate. Figure 13: High Italian Taxes Require Care with EBITDA Valuations Lower Tax Rate Higher Tax Rate Company A Company B Company C Company D Sales 1,000 1,000 1,000 1,000 EBITDA Depreciation EBIT/A Interest Expense (10) (10) (10) (10) PBT Tax Rate 25% 35% 40% 50% Tax (19) (26) (30) (38) Net Income Valuation Matrix Normative EV to EBIT/DA 8.0x 8.0x 8.0x 8.0x Implied EV 1,000 1,000 1,000 1,000 Net Debt Implied Equity Value Implied P/E 14.2x 16.4x 17.8x 21.3x Source: Lehman Brothers estimates 13

14 Figure 14: Lower Debt Makes Things Worse Lower Tax Rate Higher Tax Rate Company A Company B Company C Company D Sales 1,000 1,000 1,000 1,000 EBITDA Depreciation EBIT/A Interest Expense (1) (1) (1) (1) PBT Tax Rate 25% 35% 40% 50% Tax (21) (29) (34) (42) Net Income Valuation Matrix Normative EV to EBIT/DA 8.0x 8.0x 8.0x 8.0x Implied EV 1,000 1,000 1,000 1,000 Net Debt Implied Equity Value Implied P/E 15.5x 17.9x 19.4x 23.3x Source: Lehman Brothers estimates If we start the other way around, and say we have a view on the correct P/E, then as shown in Figure 15, this implies very different EBITDA multiples depending on the tax rate. The capital structure can alter this relationship in a high tax paying company. This is because the tax shield in the high tax paying regime is much higher, so that a higher debt structure dampens the differences while no debt makes things worse. In our high tax and low debt structure, relatively normal P/Es lead to what appear to be very low EV to EBITDA ratios. Figure 15: High Tax Rates and Low Debt Lead To Low EV to EBITDA Lower Tax Rate Higher Tax Rate Company A Company B Company C Company D Sales 1,000 1,000 1,000 1,000 EBITDA Depreciation EBIT/A Interest Expense (1) (1) (1) (1) PBT Tax Rate 25% 35% 40% 50% Tax (21) (29) (34) (42) Net Income Valuation Matrix Implied EV to EBIT/DA 8.2x 7.2x 6.6x 5.6x Implied EV 1, Net Debt Implied Equity Value 1, Normative P/E 16.0x 16.0x 16.0x 16.0x Source: Lehman Brothers estimates The New Finmeccanica we have modeled has very little debt (as we have assumed the sale of the balance of the STM shares and the divestiture of the non-core assets along with the debt). As a result, New Finmeccanica has little debt and relatively high tax rates, so our target 17x P/E only translates into a low EV to EBITDA multiple of 6.4x, compared with the industry average of ~7-8x. We know that New Finmeccanica will probably make more acquisitions, will likely need the cash for the BAE put/call options, and has heavy capex for its Alenia-Vought JV for the 787 Dreamliner. The company could also buy part of the Italian state s holdings. These possible cash outlays might cause the net debt level to increase in the future, but as its effective tax rate migrates from a much higher bracket to a normal level of 35-40%, we expect Finmeccanica shares to trade more in line with its comps. 14

15 Italian Government Support for R&D As of year-end 2004, Finmeccanica recorded 2.6bn of refundable loans, advanced by the Italian ministry of industry pursuant to Italian Law 808/85. We think the question of what these advances really are and under what, if any, circumstances they will in fact be repaid is key to understanding Finmeccanica s EBIT, net income, cash flow and enterprise value, and any use of these metrics in estimating the value of Finmeccanica shares. It seems likely that significant R&D spending will continue to be funded by the 808/85 advances and repayable loans. Total operating cash flows from 2001 through 2004, totaled 1.9 billion. The company carries the government payments first as advances, then when the work is done as work in progress, and the amounts are then liquidated on delivery. Some investors have suggested that the development dollars should be expensed, and the 808/85 amount treated as debt. This is the treatment we see at EADS/Airbus for its refundable launch aid for new products. It is clear that Finmeccanica, at least, views the situation quite differently. It sees the advances as payment for the R&D to be collected later. In military programs if the government in fact has agreed that the R&D will be recouped from production the advances may in fact never be repaid, in which case expensing the funds as R&D and then treating the 808/85 money as debt is a gross distortion of the actual situation. The disclosures made by the company about exactly what programs are being funded, how all the money from the Italian government is used, and exactly what is happening in the financial accounts are limited. The balance of funds recorded and forecast to be recorded as 808/85 liabilities is shown in Figure 16. These accounts reflect the net balances that result from undisclosed inflows from the government and offset by undisclosed outflows for repayments. After being roughly flat at approximately 800m for several years before 2001, the net balance has now risen steadily over the past three years, and 758m of the cash flows over the period have come from increases in government advances. Figure 16: Finmeccanica Government Advances/Launch Aid ,500 3,250 3,300 3,150 2,950 3,000 2,750 2,550 2,500 3,500 3,000 2,500 2,000 1,900 2,000 1,500 1, ,150 1,500 1, A 2002A 2003A 2004A 2005E 2006E 2007E 2008E 2009E Launch Aid (Eur Millions) 0 Source: Lehman Brothers Estimates and company Reports We can see some of what is happening at Finmeccanica regarding the law 808/85 advances from the filings of an investigation filed against Italy by the EU staff. The EU investigation revealed that the Italian government had laws in place which contemplated state aid in the amount of 3.2bn over the period of 1999 through The projects investigated by the EU for which Finmeccanica received assistance include the spending for the MD-11, the MD-95 (now the defunct 717), DO-328, the A109, and the EH101. It is not clear how much if any of the repayable loans were in fact repaid because these projects had poor acceptance in the market and thus their financial characteristics were also weak. As a result, given the fact that the payments for the repayable loans is tied to the production, and the production was much lower than probably anticipated, advances under 808/85 for these commercial 15

16 aircraft programs seem unlikely to be repaid further. At least part of the rise in the 2003 accounts was due to the acquisition of Aermacchi, which received support for the DO328. Based on company guidance, we expect the inflow from repayable government loans to be 200m each year for the next several years, largely due to new programs such as the Boeing 787, the Airbus 380, and potentially the A350, all of which require upfront capital investment. It would appear that the more recent projects are significantly more economically viable and thus a greater chance of actually being a real repayable obligation and a real liability. From a practical point of view and taken in the aggregate, many of these liabilities are unlikely ever to be repaid, and the portion that will be repaid is so far into the future that payments ought to be significantly discounted. It is clear that the management of the company views these liabilities to be distant, certain to be recovered from production, and as a practical matter of small consequence to the analysis of their equity value. While we cannot be sure, we think it is usually inappropriate to treat the launch aid spending as R&D and the launch aid as debt, unless we are very sure that these are real liabilities. We suspect it would be wiser for investors to believe the Italian government is helping Finmeccanica and therefore to question whether we as investors should treat this government assistance as a very large discount to the valuation. The treatment of Finmeccanica s large launch aid can lead to very different calculations of both enterprise value and EBIT/A. Below is an illustrative example of two companies, Company A, which expenses government supported R&D and treats Launch Aid as debt and Company B, which capitalizes the R&D and does not treat it as debt. The example shows us that by fully expensing its R&D, Company A s EBITA margin is much lower than Company B s, and furthermore, Company A is much more expensive on an EV/EBITA multiple. Figure 17: Illustrative Example of Impact of Accounting Treatment of Launch Aid Company A Company B % of R&D Expensed 100% 0% % of R&D Capitalized 0% 100% Total Revenue 11,000 11,000 Launch Aid Balance BOP 2,900 2,900 Launch Aid Received Launch Aid Balance EOP 3,100 3,100 R&D Expensed R&D Capitalized EBITA EBITA Margin 5.2% 7.0% Valuation Equity Value 4,000 4,000 1 Net Debt 4,100 1,000 Enterprise Value 8,100 5,000 EV/EBITA 14.2x 6.5x 1 Includes 3,100 million of launch aid for Company A Source: Lehman Brothers Estimates and company Reports 16

17 How Does Finmeccanica Compare With Other Defense Groups? We expect that New Finmeccanica can post sales in the 11bn range or more in Figure 18 shows how the company compares with its European peers on total sales. Figure 19 shows how the company rates against its closest defense peers in Europe and in the U.S. on various valuation metrics. Finmeccanica and Thales both have ~60% sales from defense businesses, while other companies such as BAE, EADS, Smiths Group and Rolls Royce generate more than 50% of their revenues from civil operations. On a relative valuation basis, Finmeccanica is trading at similar P/E level to its global peers, while at a discount on EV/EBITDA and EV/Revenue basis. The higher Italian tax rate explains part of the trading differential. Finmeccanica also has a much lower free cash flow yield, particularly compared with an average 7-8% yield offered by its peers. A major reason for this low free cash flow yield is not that the cash flow from operations is low, but rather because the company is investing in capital spending programs at a rate 3-4x the usual level, primarily in support of the Boeing 787 program. Figure 18: European Aero and Defense Company 2005 Sales millions 40,000 34,318 36,000 32,000 28,000 40,000 36,000 32,000 28,000 24,000 20,000 20,434 75% 24,000 20,000 16,000 12,000 8,000 4,000-50% 10,252 11,711 8,894 40% 37% 4,133 50% 77% 25% 63% 60% 23% 23% 77% BAE* EADS Thales Finmeccanica Rolls Royce Smiths Group 16,000 12,000 8,000 4,000 - Defense as % of Total Revenue Civil as % of Total Revenue *BAE based on consensus estimates Source: Lehman Brothers estimates and company reports Figure 19: Relative Valuation Versus Defense Peers P/E 1 EV/Revenue EV/EBITDA FCF/Mkt Cap. Rating CY06E CY07E CY06E CY07E CY06E CY07E CY06E CY07E General Dynamics 2-Equal Weight 14.7 x 12.7 x 1.08 x 0.97 x 8.6 x 7.4 x 6.9% 6.8% L-3 Communications 2 Rating Suspended 16.8 x 14.9 x 1.19 x 1.02 x 8.8 x 7.6 x 6.9% 7.1% Lockheed Martin 2-Equal Weight 14.6 x 13.2 x 0.72 x 0.67 x 6.7 x 6.1 x 8.2% 8.3% Northrop Grumman 2-Equal Weight 12.8 x 11.4 x 0.68 x 0.63 x 6.5 x 6.1 x 9.6% 8.2% Raytheon 2-Equal Weight 15.3 x 13.0 x 0.85 x 0.75 x 7.3 x 6.6 x 8.9% 9.8% US Average 14.8 x 13.0 x 0.9 x 0.8 x 7.6 x 6.7 x 8.1% 8.0% BAE SYSTEMS 2,3 Rating Suspended 12.3 x 10.7 x 0.75 x 0.7 x 7.5 x 6.4 x 7.2% 8.2% EADS 1-Overweight 15.0 x 12.0 x 0.76 x 0.6 x 5.5 x 4.1 x 10.3% 14.0% Smiths Group 1-Overweight 13.3 x 11.6 x 1.64 x 1.5 x 9.0 x 8.3 x 5.6% 6.2% Global Average 14.6 x 12.7 x 1.0 x 0.9 x 7.5 x 6.6 x 8.1% 8.6% Finmeccanica 1-Overweight 16.3 x 13.9 x 0.63 x 0.6 x 6.6 x 5.5 x 2.7% 5.5% discount to US peer group -10% -6% 30% 30% 13% 19% discount to Global peer group -11% -9% 36% 36% 12% 17% 1 US P/Es are GAAP P/Es. BAE P/E excludes goodwill and exceptionals. 2 Based on consensus estimates 3 Including pensions in EV Source: Lehman Brothers estimates and company reports 17

18 New Finmeccanica: Good Business, Good Public Policy The metamorphosis of old Finmeccanica into New Finmeccanica is a complete makeover, and it makes progress on many of the issues which have confronted policymakers in creating both a strong national aerospace/defense champion and a well run and financially successful company. Like most of its European partners, Italy understandably has a desire for a strong, technically advanced aerospace/defense capability as a part of its industrial base. These goals satisfy both national defense and national security policy objectives, and retain the industrial and employment benefits that come from Italian defense spending, and from Italy s participation in pan- European co-operative defense and space programs, and international civil aircraft programs. The challenge for Italian policymakers has been to avoid being marginalized by larger and more ambitious defense activities in France, the UK and Germany, while at the same time running an efficient defense industrial base. It has been clear to us that the European aerospace and defense industry needs consolidation and specialization of its collectively large and diverse defense industrial assets. The problem has been that each country had its own tank plants, shipyards and airplane companies. There was also the question of how to consolidate and eliminate redundant and excess capabilities without simply having the larger and more defense-oriented countries take over at the expense of the smaller countries, while at the same time privatizing the industrial and scientific assets. The solutions have focused on the creation of joint programs such as Eurofighter to reduce duplication of programs, joint ventures such as MBDA, mergers to reduce overcapacity and destructive competition, and the creation of companies like EADS. Another important step has been specialization of the assets and management control in individual countries. In return for giving up (say) missile production to Country 1, Country 2 might get a major role in helicopters, or a less important role in aircraft might lead to a major role in avionics. Progress has been slow and far from perfect, but the major European joint companies are now emerging. However, it is not sufficient to focus simply on European markets. The next and more lucrative step for European aerospace/defense companies is to acquire or maintain access to the world s largest aerospace defense market, the United States. With executive leadership and vision by the Finmeccanica management team and noteworthy support from Italian political leaders, the New Finmeccanica has solved these problems in a fashion that we think is broader-based than any other defense company in Europe. Finmeccanica and Italy have: " High participation in joint programs for military equipment purchased by governments including Eurofighter, NH-90, and ATR in Europe. In the US, Italy participates in the Joint Strike Fighter program, the 767 Tanker, the C27J transport and the US101 presidential helicopter. " Regular participation in government-provided launch aid for civil programs permitted under the EU agreements. This comes in the form of refundable government loans under Italian Law 808/85. " High participation in industrial joint ventures by Finmeccanica including MBDA, Vought Alenia, L-3, Alcatel Alenia, Agusta- Bell and ATR " A high degree of specialization in helicopters, so that New Finmeccanica is an international provider of helicopters in the UK and Italy as well as a joint venture partner in the provision of helicopters in France and Germany through its participation in the NH90 and in the U.S. through the Agusta-Bell joint venture " A high degree of specialization in avionics as Finmeccanica is the major provider of electronics for the four-nation Eurofighter, although not a final assembly location 18