Thales. DCNS blows a 100m hole in Thales s waterline in line excluding DCNS, but little momentum

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1 Thales DCNS blows a 100m hole in Thales s waterline DCNS charges Aerospace & defence Thales announced on 23 January that it will consolidate a 100m share of a likely 300m 2014 net loss from DCNS, the French warship builder in which it holds a 35% stake. The nature of DCNS's problems, especially in submarines, means we have an especially low degree of confidence that this charge will be the last for DCNS. More generally, this announcement highlights the ongoing value destruction of the DCNS investment for Thales' shareholders, made consistently worse by the minority shareholding, and hence worrying lack of management visibility or control. We see a key challenge for new chairman Henri Proglio and CEO Patrice Caine as reversing this, and the damage it has caused. Year end Revenue ( m) EBIT* ( m) 12/12 14, /13 12,698 1, /14e 12, /15e 13,005 1, /16e 13,515 1, Note: *EBIT includes Thales share of DCNS EPS ( ) DPS ( ) 2014 in line excluding DCNS, but little momentum P/E (x) Yield (%) Thales has confirmed that, excluding the DCNS charges, results will be in line with what is, in our view, pretty anaemic guidance: "stable order intake and sales, and 5-7% growth in EBIT". This guidance has not changed through 2014; we think the company needs to show clear evidence of acceleration in 2015 to sustain the current share price; there was no sign of this in the 2014 nine-month orders and sales. DCNS may be a canary in French defence coal mine Thales has some attractive and strategically valuable businesses, most notably avionics for Airbus, air traffic management and rail signalling. However, we think investors should be concerned about the read-across from the DCNS announcement to Thales's broader defence activities in France, with ongoing "stealth" cuts to both R&D and production volumes becoming an increasing issue. Valuation: What discount for French government control? Thales s shares have recovered strongly from the October 2014 lows of c 37, reacting positively to the appointments of Henri Proglio and Patrice Caine to replace Jean-Bernard Levy. If the company can deliver the promised improvements in margins, the shares could trade at or below 80% EV:Sales from 2015e, and 7.0x EBITDA, falling to 6.5x in 2016e. however, we are cautious about the prospect for additional re-rating: the departure of Mr Levy (to EDF) highlighted the deep influence of the French government (holding 36% directly, 66% total in conjunction with Dassault); Thales has little ability to turn around DCNS given the government s 65% holding in that company. 29 January 2015 Price 47.9 Market cap 9,820m Net cash ( m) at end 2014e 958 Shares in issue 205.0m Free float 34% Ticker Primary exchange Share price performance HO Paris % 1m 3m 12m Abs Rel (local) (2.2) 10.8 (10.9) 52-week high/low Business description Thales is a defence and commercial electronics and systems company. Key product areas include radar, electronic warfare systems, electro-optics, missile and naval systems, commercial avionics, especially for Airbus, air traffic management, satellites, railway signalling and ticketing systems. Next event FY14 results 26 February 2015 Analysts Sash Tusa +44 (0) Jeremy Silewicz +44 (0) institutional@edisongroup.com

2 DCNS: 300m total charges for 2014 A 100m hole in Thales s waterline DCNS is the French warship builder, with 65% held by the French state and 35% by Thales. Products range from corvettes and patrol vessels, through increasingly complex frigates to assault ships (including the Mistrals being built for Russia, whose delivery is currently suspended) and nuclear and conventional submarines. On 23 January 2015 DCNS announced a c 300m net loss for 2014 (Thales s share is c 100m), reflecting: further losses associated with diversification into alternative energy projects, including wave energy and small nuclear reactors. This is not completely unexpected, following losses in 2013 and H114; and "increased costs to complete" for naval programmes, especially the Barracuda nuclear attack submarines (SSNs) for the French Navy. Barracuda submarine programme: More charges likely We see the Barracuda comments and charges as far more worrying than those related to the failed diversification efforts. The Barracuda programme (for up to six submarines) has been stretched out and deliveries look to extend from later this decade to the end of the following one. Given BAE Systems' well publicised problems (and c 700m of charges) with the comparable Astute submarine programme for the UK, we think the current c 100m of charges that DCNS seems to have taken is likely to be only a starting point. We would highlight worrying parallels with Astute, including an extended and increasingly weakly funded development phase (leading to skills fade), followed by a drawn-out production schedule. We note there is clear evidence, both from BAE and other submarine builders, that manufacturing such complex machines efficiently and with a minimum of programme management risk necessitates a "drumbeat" (the steady period between manufacturing each boat) of no more than two years. With an extended gap between design of the previous class of ballistic missile boats (SSBNs) and Barracuda, and an increasingly extended drumbeat, it is possible that DCNS is replicating almost all of BAE's experiences with Astute. Thales 29 January

3 Exhibit 1: BAE Systems demonstrated the dangers of an extended gap between submarine programmes, with major charges for the Astute programme in 2002 Source: Edison Investment Research Exhibit 2: The gap between the last of DCNS s Triomphant launches and the first Barracuda submarine is already approaching that between the Vanguard and Astute classes in the UK; we think it likely that the Barracuda drumbeat could slip towards that of the Astute as a cost-saving measure for the French government. Source: Edison Investment Research Thales 29 January

4 Thales has few easy options to reduce the risks of DCNS We do not believe turning DCNS around will be easy. Nor do we think this could be facilitated by Thales increasing its shareholding, and hence management control (rather, this would be more likely to just extend a big favour to the French government at the expense of institutional shareholders). We note that, were DCNS to scale back its civil diversification efforts to limit additional costs and losses, it would likely just uncover significant additional overheads that would, in the first instance, have to be covered by the core naval activities. More broadly, many (most?) of DCNS's problems appear ultimately to derive from the weak French defence budget, and hence uneconomic build rates and dockyard loading. With spending increases looking inconceivable to us in the short term, we believe the ripple effect could yet impact on Thales's land and air activities too. Forecasts and valuation We have cut our forecasts for 2014 by 9-16% to reflect Thales s 100m net share of DCNS loss. Ahead of FY14 results on 26 February we leave our 2015 and 2016 operating forecasts unchanged, but trim our EPS estimates to reflect a higher end-2014 share count. We note that dividend cover would fall to 2.2x in 2014e, but recover to 2.5x in e: we think Thales will want to give some indication of its confidence in the underlying operating businesses, as well as highlight the non-cash nature of DCNS s contributions, as an associate. Exhibit 3: Thales forecast changes EBIT ( m) Net income group share ( m) EPS ( ) Old New % chg. Old New % chg. Old New % chg. 2014e 1, (9) (15) (16) 2015e 1,130 1,130 N/A N/A (2) 2016e 1,235 1,235 N/A N/A (2) Source: Edison Investment Research forecasts Wanted: More orders, especially large ones The key risk that we see for 2015e is that, if Q414 order intake was not both materially stronger and higher quality than at the nine-month stage, the company will only be able to issue very subdued financial guidance. Thales's announcement of 2014 nine-month order intake and sales was hardly the strongest set of numbers for outgoing chairman & CEO Jean-Bernard Levy. Order intake was strong in both Aerospace (+28% organic 9m/9m) and from emerging markets (+10%), but this continued to be all but outweighed by declining orders in Transport (-11%) and Defence & Security, by far Thales's largest division (-13%). Thales's record over the tenures of both Levy and his predecessor Luc Vigneron has been for a book to bill which, excluding very occasional 1bn+ orders that the company refers to as jumbo, has been exactly 1.0x. So all the gains of the civil aerospace upcycle to date have been traded away by a continued shrinking of the core European defence activities. We note that the 1.5bn Project Marshall contract win that Thales announced on 31 October 2014 not only extends over 22 years, but will also be shared with Thales s partner NATS (the UK s National Air Traffic Services). Thus, although qualifying by headline size as a jumbo order, the effective impact on Thales s annual revenues is only around 43m, 0.34% of 2013 sales. Real jumbos move the needle of sales and earnings Thales typically refers to jumbo orders not just by reference to their size, but also an implication that, over the period of their delivery (typically 3-5 years for a large defence export programme such as the ongoing 1bn+ Indian Mirage upgrade programme) they will move the needle in Thales 29 January

5 terms of both revenues and earnings. We think that, were Thales to win a very significant portfolio of long-term government and defence service and support contracts, it might trend towards a higher rating. However, a single contract, even like Project Marshall (to upgrade and support the UK military air traffic control system) simply cannot deliver such an uplift. We think it increasingly likely that there could be a mismatch between investor expectations for (based on apparently strong order intake in Q414) and a weak underlying (ex-jumbos) book to bill, and hence revenue outlook. Exhibit 4: Q3 was another poor quarter for book to bill: there is an increasing risk that, absent a blowout Q4, Thales s 2015 revenues may be little better than flat Source: Thales quarterly data, Edison Investment Research Exhibit 5: Thales earnings record, forecasts and valuation m e 2015e 2016e Share price ( ) 47.9 Shares in issue (m) 205 Market cap ( m) 9,820 Group revenues ( ) 14,158 12,698 12,735 13,005 13,515 EBIT (m) 927 1, ,130 1,235 EBIT margin (including DCNS) 6.5% 8.0% 7.7% 8.7% 9.1% Net income group share EPS group share ( ) DPS Shareholders' funds 3,477 3,847 4,148 4,566 5,036 Depreciation & amortisation Reported net cash 930 1, ,037 1,089 Adjusted net (debt) incl. pension deficit (954) (781) (909) (831) (784) Adjusted net debt:equity 27% 20% 22% 18% 16% EV 10,773 10,600 10,729 10,650 10,603 P/E (x) Dividend yield (%) EV/Sales 76% 83% 84% 82% 78% EV/EBITDA Source: Thales historical data, Edison Investment Research forecasts Thales 29 January

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