Berenberg European AerospaceDefence Sector Report Jun 17 2014 330pgs (Initiations)

BERENBERG EQUITY RESEARCH BERENBERG EQUITY RESEARCH
Aerospace & Defence

Flying through the
turbulence

Andrew Gollan
Analyst
+44 20 3207 7891
andrew.gollan@berenberg.com

Chris Armstrong
Specialist Sales
+44 20 3207 7809
chris.armstrong@berenberg.com

16 June 2014

Aerospace & Defence

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Aerospace & Defence

Table of contents

Flying through the turbulence 1
Sector overview 2
Aerospace and defence 10 charts to bring us up to speed 6
Stock summary five key picks 8
Stock summary the rest 11
UK and European aerospace and defence valuation table 14
US aerospace and defence valuation table 15
Share price performance 16
Valuation charts 18
Civil aerospace OE 20
Commercial jets delivery profile 25
Civil aerospace aftermarket 26
Defence market outlook 28
Global trends 28
US defence a stabilising situation 29
Appendix 1: Financial performance growth and margins 33
Appendix 2: Financial performance returns, cash, balance sheet 34
Appendix 3: EPS forecast trends by company 35
Appendix 4: Upcoming events 37
Companies

Airbus Group 38
BAE Systems 65
Cobham 89
GKN 112
Meggitt 142
MTU Aero Engines 169
QinetiQ 196
Aerospace & Defence

Rheinmetall 219
Rolls-Royce 244
Safran 269
Ultra Electronics 296
Contacts: Investment Banking 321
Disclosures in respect of section 34b of the German Securities
Trading Act (Wertpapierhandelsgesetz WpHG) 322

Aerospace & Defence

1
Flying through the turbulence

We initiate coverage on nine companies in the pan-European
aerospace and defence sector. We also include analysis of two further
companies in this report following a change of analyst.
Sector stance: We have six Buy and five Hold recommendations (no
Sells) with a preference for civil-aerospace-exposed stocks. Over the
last 12 months, civil and defence valuations have converged as
defence headwinds have moderated and civil profit momentum have
faltered. We look to the civil names to at least deliver against growth
expectations as the industry continues to increase production and as
aftermarket activity recovers. If they do, then current valuations look
attractive. There are risks, not least programme execution (and macro-
related, as discussed below), hence stock selection is key.
Stock picks: Our large and mid-cap stocks with the most upside are
respectively Safran (Buy, PT 62.5, upside 25%) and Rheinmetall
(Buy, PT 62.5, upside 22%). We are also Buyers of Airbus PT 60.5),
Rolls-Royce (PT 1,216p), Meggitt (PT 600p) and GKN (PT 440p).
Preferred large cap: Safran (PT 62.5) the optimal play on the
dual trends of the commercial aftermarket and original equipment
cycles. Safrans engine fleet has a relative structural advantage over its
peers that will drive continuous growth in high-margin spares.
Preferred mid-cap: Rheinmetall (PT 62.5) with the potential to
deliver a strong recovery in profits with both divisions back in growth
mode. Valuation metrics are low suggesting only modest upside is
priced in.
Defence headwinds moderating: The US finally has an executable
budget and top-line declines are moderating. Companies naturally
remain cautious but most expect to return to organic growth by 2015.
Commercial aerospace is all about execution: The fundamental
outlook for both the original equipment (OE) and aftermarket
remains positive but we caution that the industry is embarking on a
ramp-up of activity on an unprecedented number of new aircraft and
engine programmes, bringing with it execution risk and margin dilution.
Growth: Excluding earnings recovery at Airbus and Rheinmetall,
weak underlying sector EPS growth in 2014 (average: -2.4%) is due to
FX impacts and certain one-off charges. Thereafter, we anticipate an
improving earnings profile (three-year CAGR: 4.0%).
Performance: The sector is down by 5% ytd (or by 1% unweighted),
an 11% and 7% underperformance of the SXXP and the FTSE All-
Share respectively. We believe this has been driven by sector rotation
(after a strong 2013) and company-specific downgrades/de-ratings.
Best and worst performers: Cobham +18%, Rolls-Royce -19%.
Sector valuations have converged: The defence stocks re-rated over
the past year and now trade on multiples only slightly below the civil
aerospace average, except for the defence prime contractors (BAE
and Rheinmetall) that continue to trade at their historical 20-30%
discount. Based on our FY15 forecasts, the sector average P/E is
13.3x (ranging from Rolls-Royce on 15.4x to Rheinmetall on 9.9x),
and adjusted EV/EBITDA is 8.1x (ranging from Cobham on 10.0x
since the Aeroflex acquisition, and Airbus and Rolls-Royce on 7.5x).
Macro risks: As we go to print, the evolving geopolitical situation in
Iraq and other recent developments such as the Emirates order
cancellation are disproportionately affecting sentiment. Clearly, sector
valuations could be at risk if the macro situation deteriorates.

Airbus Group NV (Initiation)
Buy
Current Price
EUR 52.21
Price Target
EUR 60.50
11/06/2014 Paris Close

BAE Systems plc (Initiation)
Hold
Current Price
GBp 426
Price Target
GBp 445
11/06/2014 London Close

Cobham plc (Initiation)
Hold
Current Price
GBp 324
Price Target
GBp 325

GKN plc (Initiation)
Buy
Current Price
GBp 385
Price Target
GBp 440

Meggitt plc (Initiation)
Buy
Current Price
GBp 524
Price Target
GBp 600

MTU Aero Engines Holding AG
Hold
Current Price
EUR 68.33
Price Target
EUR 71.80 (64.40)
11/06/2014 XETRA Close

QinetiQ plc (Initiation)
Hold
Current Price
GBp 210
Price Target
GBp 225

Rheinmetall AG
Buy (Hold)
Current Price
EUR 51.22
Price Target
EUR 62.50 (42.00)

Rolls-Royce Holdings plc (Initiation)
Buy
Current Price
GBp 1,017
Price Target
GBp 1,216

Safran SA (Initiation)
Buy
Current Price
EUR 49.79
Price Target
EUR 62.50

Ultra Electronics Holdings plc
(Initiation)
Hold
Current Price
GBp 1,878
Price Target
GBp 1,970

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809

Aerospace & Defence

2
Sector overview
Initiating coverage on the European aerospace and defence sector
We initiate coverage on nine companies in the European aerospace and defence
sector. We also include analysis of two further companies in this report, MTU
Aero Engines and Rheinmetall, following a change of analyst coverage. Our key
picks are Safran, Rheinmetall, Rolls-Royce, Airbus and Meggitt. We also have
a Buy recommendation on GKN.
Recommendation table

Source: Berenberg estimates
Sector stance stock selection is key
Given the diversity of the companies under coverage, we make our
recommendations on an individual stock selection basis. However, if we assess our
initiations based purely on the number of Buy recommendations our sector stance
is positive with a slight bias towards civil aerospace facing companies. The civil
growth story is well understood, but central to our Buy calls is an assumption that
companies (and the industry) will execute profitably on various new aircraft and
engine programmes entering production. Defence stocks have universally re-rated
over the past 12 months, linked mainly to the improving US budget environment.
We have no Sell recommendations because we believe both earnings and valuation
risk is low given the relatively supportive macro environments.
We summarise our key picks below.
Safran, price target 62.5 the optimal play on the dual trends of the
commercial aerospace aftermarket recovery and the aircraft production
cycle: Safrans engine fleet profile has a relative structural advantage compared
to its peers that will drive continuous growth in high-margin spares. Temporary
shortfalls compared to Q1 expectations masked strong underlying momentum
that will become apparent in H2 and beyond.
Rheinmetall, price target 62.5 on a strong recovery path: Both divisions
are in growth mode with high revenue visibility in the Defence segment from
large multi-year international orders, while the Automotive segment is
benefiting from favourable end-market demand. Assuming management
Company Curr. Rating
Price
Target
Current
Price
Upside /
(Downside)
P/E (CY15)
EPS CAGR
(3yr)
Airbus Group EUR Buy 60.5 52.2 15.9% 15.0 29.8%
BAE Systems GBp Hold 445.0 425.8 4.5% 10.5 0.5%
Cobham GBp Hold 325.0 323.9 0.3% 14.6 3.0%
GKN GBp Buy 440.0 384.9 14.3% 12.6 5.9%
Meggitt GBp Buy 600.0 524.0 14.5% 13.4 4.3%
MTU Aero Engines EUR Hold 71.8 68.3 5.1% 15.2 0.8%
QinetiQ GBp Hold 225.0 210.0 7.1% 13.8 1.0%
Rheinmetall EUR Buy 62.5 51.2 22.0% 9.9 33.4%
Rolls-Royce GBp Buy 1216.0 1017.0 19.6% 15.4 6.3%
Safran EUR Buy 62.5 49.8 25.5% 15.0 9.5%
Ultra Electronics GBp Hold 1970.0 1878.0 4.9% 13.9 3.3%
Aerospace & Defence

3
continues to deliver against its mid-term Two-Pillar strategy, Rheinmetall
ranks as the highest EPS growth and lowest P/E stock in our coverage.
Rolls-Royce, price target 1,216p out of favour following two profit
warnings and the Emirates order cancellation: The shares are down by 19%
ytd compared to 11% consensus earnings downgrades. We see no structural
issues to detract from the long-term growth and margin expansion story, and
we expect investor confidence to steadily rebuild through the year. A crucial
investor briefing event is to be held on 19 June.
Airbus, price target 60.5 strong earnings growth driven by margin
expansion as legacy headwinds fade and programme risks diminish: The
market has over-reacted to the Emirates order cancellation; the shares have
underperformed the SXXP by 12% ytd. There is potential for progressively
positive newsflow through H2, such as A350 XWB certification and first
customer delivery (in Q3 and Q4 respectively), and order announcements at the
Farnborough Air Show (week commencing 14 July).
Meggitt, price target 600p well positioned in attractive end-markets
(civil aerospace and energy) translating to sustained earnings growth in
the mid- to high single-digit range: 48% of sales are derived from high-
margin aftermarket activity, which is a key differentiator. Investor interest is
starting to return after the November 2013 profit warning, which was caused
largely by one-off events. We see scope for valuation multiples to expand if
positive aftermarket trends continue.
A few sector observations
The (really) big picture
Civil aerospace: We estimate the commercial jet liner market will increase by
almost 50% by 2020 to c$130bn, equivalent to a revenue CAGR of 5.7%,
driven by planned production increases by Boeing and Airbus in both their
narrow-body programmes and a continued ramp-up in new wide-body
programmes such as the 787 and the A350 XWB. The launch and ramp-up of a
multitude of new aircraft and aero engine programmes increases risk. Execution
is key. We examine the outlook for the commercial aerospace sector in detail on
pages 20 to 27.
Defence: Global defence spending is flat-lining with higher growth regions
such as Asia and the Middle East offset by declines in the budgets of
Western/developed nations. The outlook for the defence industry is much
improved, however, now that the US budget environment has stabilised
(representing c34% of the global market). Headwinds are moderating in this,
the most important defence market for the industry, and for the first time in
several years the manufacturers are looking tentatively towards organic growth
scenarios. We examine the outlook for the defence sector in detail on pages 28
to 32.
Aerospace & Defence

4
Commercial jet market ($m) Total US DoD spending ($bn)

Source: Airframers/Airline Monitor/Berenberg estimates Source: US DoD, Berenberg estimates
Performance: A&D Index has underperformed in 2014
Despite the recent rally, a combination of rotation and negative forecast revisions
has seen the sector underperform the broader UK and European indices in the ytd
(the FTSE All-share by 7% and Stoxx600 by 11%). Within this is a wide range of
individual share price performances with Cobham and Rheinmetall leading our
coverage list, up by 18% and 14% respectively ytd, while Rolls-Royce is the
notable underperforming outlier, down by 19% with Airbus and MTU Aero
Engines the next relative underperformers, down by 7% and 5% respectively. We
examine sector and stock performance in more detail on pages 16 and 17.
Growth forecast momentum stalled towards the end of 2013
Positive sector earnings momentum that had for many years been driven by civil
aerospace strength started to slow through the second half of 2013 and turned
negative in early 2014 (as evidenced by downgrades to consensus earnings in the
ytd for nine out of the 11 companies we cover, by an average of 6%). Adverse
currency effects have been a key factor, with the majority of the companies
exposed to the US dollar and the effects of the strengthening of the euro and
sterling. Sterling-denominated companies have fared slightly worse in this respect
(we factor in our 2014 forecasts an average adverse EBIT effect of c3.5% for the
UK stocks we cover). In addition, a number of companies have reduced guidance
unexpectedly for a variety of company-specific reasons. Overall, underlying sector
earnings growth in 2014 is weak we forecast an average underlying EPS decline
of -2.2%, split civil aerospace 0.7% and defence -5.7% (excluding the distorting
effects of Airbus and Rheinmetall). Thereafter, we anticipate an improving earnings
with an average forecast EPS CAGR of 4.0% to 2017 for the sector, split 5.4% civil
and 2.0% defence, on the same basis.
Valuation the sector P/E has expanded by one turn over the past year
On a 12-month forward earnings basis, the sector average P/E has increased by
one turn over the past year to 14.4x, a 9% premium to the 20-year average of
13.2x. Both the defence and civil aerospace subsectors have contributed; for our
coverage universe the defence multiple has expanded by 2.2 turns to 11.3x while
the civil aero multiple has increased by 0.7 turns to 14.8x. The re-rating of defence
stocks was driven initially by receding concerns around the sequestration cuts and
then by improved US Budget visibility. We note an average share price increase of
40,000
80,000
120,000
160,000
Narrow-body Wide-body Regional jets
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CAGR
-4.3%
Aerospace & Defence

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18% for our defence stocks over the last year. Expansion of the civil aero P/E is
the combined effect of an average 4% increase in share prices and modest earnings
cuts over the same period. As a result of these re-ratings, the valuation differential
between the civil aerospace and defence subsectors has narrowed to just 1.6 turns
with civil stocks trading on an average P/E multiple of 14.4x with defence stocks
on 12.8x (based on our FY15 forecasts). We examine sector and stock performance
in more detail on pages 18 and 19.

Aerospace & Defence

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Aerospace and defence 10 charts to bring us up to speed
Sector performance 12-month A&D Index
versus FTSE All-Share and DJSTOXX600
Sector earnings momentum turned negative in
2014; FX is partly to blame

Source: Datastream Source: Bloomberg

Changes to company FY14 EPS forecasts since
January 2014; Average downgrade: 5.6%
Sector valuation 12-month forward P/E; sector
has re-rated over one year driven largely by
defence

Source: Datastream Source: Datastream

Company P/Es (average) CY14 15.2x, CY15
13.7x; multiples have converged
P/E versus EPS growth (three-year CAGR)

Source: Berenberg estimates Source: Berenberg estimates
90
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EPS Growth (14-16)
Aerospace & Defence

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Organic sales growth (three-year CAGR) Company end-market exposures

Source: Berenberg estimates Source: Berenberg estimates / Company data

Commercial aircraft deliveries: good growth but
new programme* execution is key
US defence procurement and RDT&E budgets
($bn): through the worst?

Source: Berenberg estimates/company data
* New programmes include A320NEO, A350, 737MAX, 787
Source: US DoD

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Procurement RDT&E
Aerospace & Defence

8
Stock summary five key picks
Safran: LEAP of faith (Buy, PT 62.5 25% upside)
Safran is our top large-cap pick in the European aerospace and defence sector. We
believe Safran is the optimal play on dual trends of the commercial
aerospace aftermarket recovery and the original equipment (OE) production
cycle. Safrans very large and relatively young engine fleet profile has a relative
structural advantage compared to its peers that will drive continuous strong growth
in high-margin spares parts. This will more than offset dilution from the launch
and ramp-up in production of the new CFM LEAP engine (for the B737MAX and
A320 aircraft).
Sentiment for the stock waned through the early part of 2014 as a long run of
positive earnings momentum stalled (mainly currency-related) followed by
lacklustre Q1 results (organic growth: 3.5%) due to unforeseen delays in helicopter
and defence programmes. We believe this masked strong underlying performances
in the Propulsion (services), Aircraft Equipment and Security divisions.
Management has assured the market that the effects of delays are temporary and
confirmed full-year guidance.
Safran shares are down by 1.4% ytd, which is a slight underperformance relative to
the stocks we cover. Business momentum is strong in the key civil aviation
businesses and we expect Safran will at least deliver to expectations. With the
shares trading on EV/EBITDA (FY15) of just 7.6x, we believe valuation risk is to
the upside.
Rheinmetall: building confidence; up to Buy (Buy, PT 62.5 upside
22%)
After a few years of poor financial performance and declining earnings,
Rheinmetall is on a strong growth recovery path with both divisions, Defence and
Automotive, experiencing top-line growth on a restructured cost base. The outlook
for Defence has been much improved by a number of large-scale, multi-year
international orders swelling the order book to a record 6.7bn and providing a
high level of sales cover compared to history. Growth in the Automotive division
is being driven by rising global auto production, including a strengthening presence
in China through its joint ventures and rising demand for its emission systems
products.
From the depressed level in 2013, the rate of profit growth over the next couple of
years is difficult to predict given a number of near-term risks such as the strong
second-half skew to the Defence divisions business that partly depends on
securing orders in the shorter cycle munitions businesses. Even if the company
delivers to our forecasts, which are pitched at the lower end of the 2015 margin
guidance range of 7-9% in Defence and 8% in Automotive (we forecast 6.7% and
7.7% respectively), then this stock is too cheap on just 8.8x P/E (FY15E).
Rolls-Royce: engine splutter: just needs a bit more choke (Buy, PT
1,216p upside 20%)
Investor confidence has been shaken by an uncharacteristic brace of warnings on
profit due to a sharper-than-expected reduction in defence aerospace activity and a
Aerospace & Defence

9
one-off charge in the Marine division. In effect, this translates to a lost year of
growth in 2014, the first time in over a decade that operating profits have declined
yoy. In reaction, the stock has significantly underperformed ytd, down by 19%
against an average decline of the sector of 1%. In our view, there are no structural
issues to de-rail the long-term growth story, backed by a c70bn orderbook and
the planned ramp-up in civil engine (Trent XWB) production. The high profile
Emirates cancellation of its 70 aircraft A350 XWB order last week is clearly a
disappointment but does not affect the programme, which still has a seven-year
backlog.
The key debate is around margin progression in particular, the net impact of
dilution from the A350 XWB launch and declining high-margin services revenues
on legacy programmes, offset by growth in the revenues derived from long-term
service agreements (LTSAs) and the benefits of restructuring and efficiency
initiatives. Our view is that the maturing LTSA model will prevail driving a return
to continuing profits growth from 2015.
We acknowledge the possibility of further share price volatility in the short term
with an investor briefing on 19 June when agenda items include an update on
strategy and long-term contract accounting. Long-term contract accounting will be
extremely important for investors understanding of the LTSA value proposition.
Provided management can communicate this effectively, it should allay concerns
about the quality and pace of the growth story and drive the rating higher, we
believe. Failure to do so will delay the sentiment recovery. Regardless, in 12
months time, we believe the market will be feeling more confident about the
Rolls-Royce story as the A350 XWB and LTSA effects become clearer and are
better understood.
Separately, investor appetite for large-scale M&A appears muted after the approach
to Wrtsil (market cap: 8bn) was rejected earlier this year. This threat of a
potential re-bid is weighing on the stock. Again, the 19 June investor briefing will
be key, given that the company has said it will address the subject of capital
allocation at the event.
Airbus: stand and deliver (Buy, PT 60.5 upside 16%)
Major programme risk continues to reduce as legacy issues fade (the A380 is
progressing towards achieving the 2015 breakeven objective and production of the
A400M is steadily ramping up) and new programmes mature (the A350 XWB is
nearing entry into service and the A320NEO development programme is
advancing). This together with operational improvements across the group is
resulting in steady margin expansion and improving profits quality, despite growing
losses related to launch of the A350 XWB.
As ever, Airbus faces a multitude of business challenges including the production
ramp-up of the A350 XWB, the launch of the A320NEO and the navigation of a
complex, multi-year restructuring of the Defence and Space business. We believe
that these risks are being well managed and the markets confidence will build as
further milestones are passed, which in turn could drive upgrades to consensus
forecasts. Flight certification of the A350 XWB is expected in Q3, with first
customer delivery (to Qatar Airways) to follow in Q4. Other significant news
before the year is out could include a decision on whether to re-engine the A330
and/or the A380 which, if pursued, would commit more development dollars, not
a major concern for us because R&D spend is trending down and it would extend
Aerospace & Defence

10
the life of existing platforms, deferring the need for more expensive all-new
aircraft developments.
Emirates cancellation of its order for 70 A350 XWB aircraft, while large, has
little bearing on the financial performance of the group in the near term or
the success of the overall programme (there is still c7 years of A350 XWB backlog
to execute). However, it raises the broader question of whether the aircraft order
cycle is softening and hence the risk of further cancellations. In the context of the
groups c5,500 aircraft backlog, we are not concerned but we recognise
sentiment towards Airbus (and the sector generally) will be adversely
affected by this development. Airbus continues to talk of a healthy order
environment and has confirmed it still expects to achieve a book-to-bill greater
than 1x in 2014. We expect positive order activity during the Farnborough Air
Show (14 July).
Year-to-date, Airbus shares have underperformed the European peer group by 6%
and Boeing by 8%, and in our view look good value if the company delivers
continued profit growth at the current trajectory.
Meggitt: under-rated (Buy, PT 600p upside 15%)
Meggitt is nearing the peak of an intensive product investment cycle and we
believe it is fundamentally well positioned in attractive end-markets (civil
aerospace and energy) to deliver long-term growth. High-margin aftersales
activity is a key differentiator to peer aerospace suppliers, accounting for almost
half of group sales and providing resilience in the military aerospace business.
The shares have rallied in recent weeks, indicating investors confidence is
returning following the November 2013 profit warning and the FX-led
downgrades in March 2014. Continued recovery of high-margin civil aftermarket
activity (27% of sales) is key to sustaining this confidence, particularly through the
interims which are expected to indicate a greater-than-normal H2 bias to financial
performance. Assuming it does, and management is able to confirm full-year
guidance, we see scope for valuation multiples to expand further (the shares
currently trade at an 10% FY15 P/E discount to civil aerospace peers on our
forecasts). Over the longer term, we expect Meggitt to deliver sustained earnings
growth (we forecast an EPS CAGR of 7% to 2017), which should continue to
drive the shares.
Aerospace & Defence

11
Stock summary the rest
BAE Systems: stabilising outlook (Hold, PT 445p upside 5%)
BAE has suffered a protracted downgrade cycle primarily due to weakness in its
budget-constrained US businesses which has translated into stagnant earnings since
2009. Improving budget visibility in the US, finalisation of Saudi contract terms
and agreement on the UK naval programme point to a more stable outlook, both
in the near and longer term. However, BAE is still the lowest earnings growth
company in our coverage, despite a 1bn share buyback (we forecast a three-
year EPS CAGR of 0.5%) and with few major contract opportunities in prospect
and budget constraints likely to endure, we see limited upside to this scenario.
Higher-growth commercial activities represent 5% of the group, too small to do
more than offset defence headwind.
The key investment attraction for us is the rock solid dividend, yielding
4.8% and providing strong support to already depressed valuation multiples. The
main risk to our neutral stance is multiple expansion. We are just not sure of a
meaningful catalyst in the short term.
Cobham: Aeroflex is a good deal but shares are fairly valued (Hold,
PT 325p upside/downside 0%)
The stock has significantly outperformed since the US defence budget agreement
in December and the market further welcomed the announcement in May of
Cobhams largest-ever acquisition, Aeroflex, for 870m. We agree that Aeroflex
appears to be an excellent strategic and technological fit, and in raw earnings
terms we estimate the transaction is c8% earnings-accretive in 2015 on an
underlying basis. Integration costs are high, however, at c130m over 3-4 years for
an annualised benefit of c50m.
Management has been consistent in longer-term guidance of delivering organic
growth in 2015 (for the first time since 2008) and the outlook is enhanced by
Aeroflexs greater mix of sales in commercial sectors. As a result, Cobham has
been the best-performing share in the sector ytd, up by 19% versus the
sector (which is itself up by 1%) and valuation metrics are relatively full (a
c14% premium to the sector on a 2015 P/E basis). Now the war chest has been
spent, there is a lack of near-term catalysts and we see little upside to the equity
story, hence our neutral stance.
GKN: driving through the headwinds (Buy, PT 440p upside 14%)
The fundamentals of the business are positive with the groups two core end-
markets, global automotive and aerospace, representing c85% of sales, growing
concurrently. This, we believe, will translate to managements stated ambition of
sustaining revenue growth ahead of end-markets over the mid- to long term (we
forecasts a sales CAGR of 4.5% and an EBIT CAGR of 7.2% to 2017). In the
short term, we recognise that performance and earnings growth will be
tempered by a combination of currency headwinds, the phasing of
aerospace programmes (a slow ramp-up in commercial and wind-down of
profitable military activity) and higher tax, which we believe will translate to a
muted H1 result and flat earnings for the year.
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12
Uncertainty about potential large-scale M&A may also affect sentiment,
with discussions ongoing (we believe) with Spirit Aerosystems to acquire its
underperforming Wing Systems (WS) business. WS would be highly
complementary to GKNs existing Airbus wing structures business, significantly
increasing the groups exposure to Boeing and other airframers. Management has a
good M&A track record and hence we are confident it will not overpay if a
transaction progresses. We believe the market is price-neutral on a potential deal
and hence we think it should be viewed as upside should it progress. In summary,
while we see potential for some share price volatility over the shorter term, the
fundamental outlook for GKN is positive. The rating is not particularly demanding
and we expect the shares price to steadily advance as the growth trend resumes.
MTU Aero Engines: in for the long haul (Hold, PT 71.8 upside 5%)
MTU generates c80% of its revenues in the commercial aerospace sector and the
group is well positioned for significant top-line growth in all areas: new engines
driven by the ramp-up in geared turbofan production (GTF); increasing
aftermarket from the V2500 engine fleet; and market share opportunities in the
engine maintenance business (MRO).
However, the rapid transition to GTF production over the next three to four
years is ambitious, industrially challenging and dilutive to margin due to
losses on new engine sales. We believe mix headwinds from the GTF will largely
neutralise the positive impacts of volume growth and continuous strong
momentum in the high margin V2500 spare parts business, as the expanding fleet
of engines mature. The ramp-up of activity on the GTF will also lead to cash
challenges over the next few years which, although well understood by the market,
will combine with low profits growth to constrain the valuation in the near term.
We think MTU remains a great long-term growth story once GTF
production matures and the V2500 aftermarket story develops further, and we
are comfortable that investors with long-term horizons will enjoy positive long-
term returns. However, following the recent rally in the share price, MTUs
valuation metrics have converged with Safran and Rolls-Royce and hence
we see limited upside in the near term on both an absolute and relative basis.
QinetiQ: looking ahead again (Hold, PT 225p upside 7%)
The valuation achieved on disposal of the US Services business (up to 130m) was
below market expectations but it concludes a flawed strategy of the previous
management and removes a drag on profit. QinetiQ has commenced returning
excess cash through a 150m buyback (equivalent to 12% of the current market
cap) and we suggest there is scope to extend this indefinitely at c50m pa based on
continued strong cash generation. After years of top-line decline, it is encouraging
that the groups core EMEA Services division has stabilised and returned to low
organic growth with the emergence of new opportunities, for example in
international markets. However, the main value hook for investors is the
momentum building in the Global Products (GP) division. While the strategy
to broaden the GP product range has been slow, recent strategically important
developments indicate significant potential for the OptaSense acoustic
sensing technology. It is still too early to quantify the opportunity and we
monitor developments closely but given the shares relatively high valuation, it
implies to us that investors are already pricing in an element of positive
Aerospace & Defence

13
expectation. The shares have bounced by 8% since the results in May and trade on
a CY15 P/E of 13.8x, a 15% premium to the sector.
Ultra Electronics: cautious optimism (Hold, PT 1,970p 5% upside)
Ultra is a high-quality, technology-rich electronics company with a broad range of
specialist capabilities in the defence, security, transport and energy sectors. Set
against the groups high standards and long-term record of growth, the business
has weathered a difficult three years in slowing defence markets which in 2014 is
likely to culminate in another year of flat earnings with low organic and M&A-
driven growth offset by currency effects. However, we are cautiously optimistic
that Ultra can return to sustained EPS growth driven by large contract
opportunities, growing non-defence activities and further potential upside from
acquisitions. Indeed, M&A activity has already picked up, with over 100m of
transactions announced ytd. In addition, Ultra has recently announced a number of
sizable new contracts supporting our view that the company can deliver steady
earnings growth over the next few years. The shares oversold following the March
prelims but have since rallied on the back of the contract newsflow and
acquisitions. In summary, notwithstanding the potential for some volatility through
the interim results (due to a strong weighting to H2), we view Ultra as a high-
quality, low-risk investment proposition, but now with insufficient valuation upside
on a 12-month view to Buy.

Aerospace & Defence

14
UK and European aerospace and defence valuation table
UK aerospace and defence

European aerospace and defence

Source: Berenberg/* Based on Datastream consensus estimates

Curr. Mkt cap 1M 3M 1Y YTD 2014E 2015E 2014E 2015E 2014E 2015E 2014E 2015E 2014E 2015E
BAE GBP 13,462 5% 5% 8% -2% 1.2 1.2 8.8 8.5 10.9 10.5 4.8% 5.0% 0.3% 5.9%
Chemring* GBP 431 3% -22% -16% -1% 1.5 1.5 9.0 8.9 14.9 13.5 2.4% 2.7% 8.2% 4.6%
Cobham GBP 3,688 7% 6% 24% 18% 2.6 2.2 12.5 10.1 16.3 14.6 3.2% 3.6% 3.9% 6.2%
GKN GBP 6,314 2% 0% 26% 3% 1.1 1.0 8.6 7.8 13.6 12.6 2.2% 2.3% 3.2% 6.0%
Meggitt GBP 4,221 9% 12% 1% -1% 3.0 2.9 10.2 9.3 14.5 13.4 2.6% 2.8% 3.9% 5.2%
QinetiQ GBP 1,381 0% -7% 14% -3% 1.1 1.4 8.5 9.2 14.3 14.8 2.0% 2.2% 7.7% 2.1%
Rolls-Royce GBP 19,184 2% -2% -13% -19% 1.3 1.3 7.9 7.4 16.4 15.4 2.1% 2.2% 3.2% 3.9%
Senior* GBP 1,215 2% -4% 14% -5% 1.4 1.4 8.3 7.9 13.4 12.7 2.1% 2.2% 6.3% 6.9%
Ultra Electronics GBP 1,311 8% 1% 12% -3% 1.9 1.8 11.0 9.7 15.0 13.9 2.3% 2.5% 5.1% 6.5%
Average 4% -1% 8% -1% 1.7 1.6 9.4 8.8 14.4 13.5 2.6% 2.8% 4.7% 5.2%
Defence average 5% -3% 9% 2% 1.7 1.6 10.0 9.3 14.3 13.5 3.0% 3.2% 5.1% 5.0%
Civil average (ex GKN) 4% 2% 1% -8% 1.9 1.8 8.8 8.2 14.7 13.8 2.2% 2.4% 4.5% 5.3%
FCF Yield Performance EV/Sales EV/EBITDA P/E Dividend Yield
Airbus Group EUR 40,926 7% 4% 23% -6% 0.8 0.8 8.3 7.5 18.2 15.0 1.7% 2.1% -0.4% 0.4%
Finmeccanica* EUR 3,749 7% -6% 64% 18% 0.6 0.6 5.0 4.8 9.4 8.4 2.4% 2.5% 13.7% NA
MTU Aero engines EUR 3,511 0% 7% -12% -5% 1.2 1.2 8.4 8.4 15.3 15.2 2.0% 2.1% 0.5% 0.7%
Rheinmetall EUR 2,020 2% -7% 30% 14% 0.6 0.6 7.3 5.5 16.2 9.9 1.9% 3.4% -3.6% 3.1%
Safran EUR 20,764 5% 3% 25% -1% 1.6 1.4 8.5 7.6 16.9 15.0 2.4% 2.7% 3.3% 5.5%
Thales* EUR 9,479 2% -2% 22% -2% 0.7 0.7 5.7 5.8 12.3 11.3 2.9% 3.2% 7.0% 7.5%
Zodiac Aerospace* EUR 7,636 4% 11% 29% 3% 1.7 1.6 10.0 9.3 16.4 15.0 1.5% 2.4% 4.6% NA
Average 4% 1% 26% 3% 1.0 1.0 7.6 7.0 15.0 12.8 2.1% 2.6% 3.6% 3.5%
Defence average 4% -5% 39% 10% 0.6 0.6 6.0 5.4 12.6 9.9 2.4% 3.0% 5.7% 5.3%
Civil average 4% 5% 12% -4% 1.2 1.1 8.4 7.8 16.8 15.1 2.1% 2.3% 1.1% 2.2%
Performance EV/Sales EV/EBITDA P/E Dividend Yield FCF Yield
Aerospace & Defence

15
US aerospace and defence valuation table
US Aerospace & Defence

Source: Berenberg/* Based on Datastream consensus estimates

Boeing* USD 97,789 2% 7% 32% -2% 1.1 1.0 9.3 9.1 16.1 14.6 2.3% 2.6% 8.0% 9.9%
General Dynamics* USD 41,099 6% 10% 53% 25% 1.3 1.3 8.9 8.6 15.4 14.2 2.2% 2.3% 6.4% 6.8%
Lockheed Martin* USD 52,529 0% 0% 55% 11% 1.3 1.2 8.4 7.9 14.4 13.0 3.5% 4.2% 8.1% 8.4%
Northrop Grumman* USD 26,176 1% 0% 47% 7% 1.2 1.2 7.6 7.3 12.5 11.2 2.3% 2.6% 8.6% 9.5%
Prime contractors average 2% 4% 47% 10% 1.2 1.2 8.6 8.2 14.6 13.2 2.6% 2.9% 7.8% 8.6%
Alliant Technology* USD 4,398 -8% 4% 74% 13% 1.0 1.0 6.3 6.1 10.9 10.3 1.0% 1.1% 7.2% 7.1%
B/E Aerospace* USD 9,842 -6% 9% 47% 7% 2.5 2.2 11.2 10.1 17.9 15.4 NA NA 4.3% 5.3%
Esterline* USD 3,654 4% 6% 56% 12% 1.8 1.7 9.4 8.4 17.7 15.3 NA NA 8.7% NA
L-3 Communications* USD 10,850 10% 9% 46% 18% 1.1 1.1 8.7 8.4 14.1 12.6 2.0% 2.0% 9.3% 10.8%
Precision Castparts* USD 38,872 5% 4% 22% 0% 3.4 3.1 10.3 9.4 17.1 15.3 0.0% 0.0% 5.4% 6.1%
Raytheon* USD 30,184 -1% -3% 45% 6% 1.5 1.5 8.0 7.1 12.7 10.6 2.7% 2.7% 8.1% 9.7%
Rockwell Collins* USD 10,790 1% -1% 23% 8% 2.6 2.5 11.2 10.2 15.8 14.2 1.6% 1.8% 5.6% 6.9%
Spirit AeroSystems* USD 4,316 0% 19% 53% -2% 0.9 0.9 7.1 6.9 11.3 10.7 NA NA 1.6% 3.1%
Textron* USD 11,219 4% 2% 51% 9% 0.9 0.9 8.5 7.7 15.2 12.5 0.2% 0.3% 5.4% 6.9%
Transdigm* USD 10,333 8% 9% 32% 21% 5.7 5.2 12.6 11.5 22.5 19.5 NA NA 4.7% 5.4%
Triumph Group* USD 3,658 8% 10% -12% -8% 1.3 1.3 6.7 6.3 10.9 10.0 0.2% 0.3% 8.9% 8.1%
Systems providers average 2% 6% 40% 8% 2.0 1.9 9.1 8.4 15.1 13.3 0.8% 1.2% 6.3% 7.0%
Embraer* USD 15,461 10% 3% 10% 11% 0.0 0.0 0.0 0.0 37.6 36.3 NA NA NA NA
Bombardier* USD 5,529 -7% 4% -20% -17% 0.4 0.4 5.4 5.4 8.3 9.6 2.5% 2.4% -1.1% 2.4%
CACI* USD 1,676 -1% -8% 11% -3% 0.8 0.8 8.3 8.5 12.3 12.3 NA NA 12.5% 12.1%
CAE* USD 3,875 2% -3% 39% 9% 1.9 1.9 8.0 7.6 16.2 14.8 1.4% 1.5% 5.8% 6.3%
SAIC* USD 2,137 19% 21% 0% 35% 0.0 0.0 0.0 0.0 13.9 12.4 2.5% NA 9.0% 9.9%
Services average 6% 3% 17% 14% 0.9 0.9 5.5 5.4 14.2 13.2 2.0% 1.5% 6.5% 7.7%
Defence average 2% 4% 54% 13% 1.3 1.3 8.2 7.7 14.0 12.5 2.3% 2.5% 8.0% 8.7%
Defence primes average 2% 4% 52% 14% 1.3 1.2 8.3 7.9 14.1 12.8 2.7% 3.0% 7.7% 8.2%
Civil Average 2% 7% 23% 1% 1.2 1.1 7.4 7.0 16.6 15.4 1.4% 1.5% 4.7% 6.1%
FCF Yield Performance EV/Sales EV/EBITDA P/E Dividend Yield
Aerospace & Defence

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Share price performance
Sector performance
Long-term context: Sector outperformance through 2012 and 2013 was driven
by strong business momentum in the commercial aerospace companies and
latterly by a re-rating of defence stocks as budget and sequestration-related
concerns eased. A breakdown of performance by sub-sector (second chart
below) illustrates the clear outperformance of civil aero stocks recovering from
the downturn in 2009. Over the same period, defence has gone virtually
nowhere, with defence spending pressures weighing heavily on financial and
share price performance.
Five-year Euro A&D Index, DJ Stoxx 600, FTSE
All-Share
Five-year civil aerospace and defence index

Source: Datastream, Berenberg A&D Index Source: Datastream, Berenberg A&D Index
Recent sector performance: Over the last year, the aerospace and defence
sector has performed in line with the DJ Stoxx 600 while outperforming the
FTSE All-Share by c9%. However, this reflects two distinct halves to the year
on a ytd basis, the A&D Index has underperformed the DJ Stoxx 600 by 11%
and the FTSE All-Share by 7%, with sentiment affected by negative earnings
momentum due to several unexpected warnings and adverse currency effects.
By sub-sector, our civil aero index is down by 8% ytd (heavily affected by Rolls-
Royce), while defence is up by 2%.
One-year Euro A&D Index, DJ Stoxx 600, FTSE
All-Share
Two-year civil aerospace and defence index

Source: Datastream, Berenberg A&D Index Source: Datastream, Berenberg A&D Index
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Aerospace & Defence

17
Stocks performance
Two years: Individual share price performances have been mixed over the last
two years, driven by company-specific events. In the civil aero grouping, the
clear winners have been Airbus, Safran and GKN, which have broadly
delivered to market expectations, while Meggitt, MTU Aero Engines and
Rolls-Royce have each disappointed and seen more significant downgrades to
consensus forecasts. In our defence grouping, BAE, Rheinmetall, Cobham
and QinetiQ have gained 40-50% over the same period while Ultra
Electronics is the notable underperformer (+13%) as its historical premium
rating eroded.
Two-year share price performance (civil aero) Two-year share price performance (defence)

Recent performance: On a one-year basis, only two stocks have seen negative
share price returns, Rolls-Royce and MTU Aero Engines. Rheinmetall has
been the star performer as it recovered from a very depressed level. Over the
more recent term, Cobham is the best performer ytd, marked up by 18% as the
market welcomed the strategically important and accretive acquisition of
Aeroflex. Rolls-Royce, the significant outlier, is down by 19% ytd.
Stock performance (one-year) Stock performance (ytd)

Source: Datastream, Berenberg A&D Index
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Aerospace & Defence

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Valuation charts
Sector valuation trading at a premium to long-term average P/E
Sector valuation long-term context: Based on an unweighted average of the
companies we cover, the sector is trading on a 12-month forward P/E of 14.4x,
which is a 9% premium to the 20-year average of 13.2x. By sub-sector, civil
aerospace and defence multiples broadly tracked each other until the 2008/9
global financial crisis, following which the civil sector rating recovered as
previously mentioned while defence multiples remained depressed for several
years reflecting slowing defence markets. Civil and defence ratings have
converged over the last year or so as fears on future defence cuts have receded.
European aerospace and defence 12-month
forward P/E (20-year)
European civil aero and defence 12-month
forward P/E (20-year)

Source: Datastream Berenberg created indices (mkt weighted) comprising
Airbus, BAE Systems, Cobham, GKN, Meggitt, QinetiQ, Rheinmetall,
Rolls-Royce, Safran, Ultra, Zodiac Aerospace)
Source: Datastream Berenberg created indices (mkt weighted) comprising
Airbus, BAE Systems, Cobham, GKN, Meggitt, QinetiQ, Rheinmetall,
Rolls-Royce, Safran, Ultra, Zodiac Aerospace)
Valuation metrics by stock: Here we rank the stocks we cover on a variety of
valuation measures. The most notable feature for us is how P/E multiples have
converged. The spread shown in the first chart is the narrowest we have seen
for many years.
P/E rankings (2015) EV/EBITDA rankings (2015)


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Dividend yield rankings (2015) FCF yield rankings (2015)


EV/Sales versus margin scatter (next year to
report)
P/E (prospective) versus forecast EPS growth
(three-year CAGR)


0%
1%
2%
3%
4%
5%
6%
0%
1%
2%
3%
4%
5%
6%
7%
AIR
BAES
COB
GKN
MGGT
MTXGn
QQ
RHMG
RR
SAF
ULE
0.0
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1.5
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3.0
3.5
0% 10% 20% 30%
E
V
/
S
a
l
e
s
Operating margin
AIR
BAES
COB
GKN
MGGT
MTXGn
QQ
RHMG
RR
SAF
ULE
8
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20
0% 10% 20% 30% 40% 50%
P
/
E

(
F
Y
1
4
)
EPS Growth (14-16)
Aerospace & Defence

20
Civil aerospace OE
The commercial aerospace sector is in the middle of an extended production up-
cycle, with the order backlog in the large commercial jet sector, which accounts for
over 85% of the civil aircraft market by value, covering an average eight years
production. A combination of structural factors is driving demand for new aircraft
pointing to sustained high production.
Replacement demand: The aging global fleet of first and second generation
airliners is increasingly being retired. According to Ascend, the replacement rate
has averaged 48% of aircraft deliveries during the past five years. Over time, we
expect this to increase both in absolute (unit) terms and as a proportion
because, by definition, the trend will increase in line with the historical fleet
profile.
Fuel efficiency: Aviation fuel represents 40-50% of airline operating cost
compared to 15-25% a decade ago when the oil price was 80% below where it is
today. Thus, the economic pressure to replace inefficient fleets remains a
significant demand driver and we suggest it will continue to do so at even a
materially lower oil price. We note the recent tensions relating to the situation in
Iraq has driven the price of oil up by another 6%. The same applies to other
environmental factors such as emissions and noise regulations driving the need
for new aircraft.
Economic growth: Commercial Aerospace is ultimately driven by economic
growth and can be surmised as a GDP plus sector, growing by 1.5-2.0%
above global GDP over the long term. While there are always short-term cycle
and regional variations, powerful structural trends such as emerging market
growth and low-cost travel have transformed the demand picture over the past
10-20 years. We note non-US and non-European markets account for over 50%
of the total backlog (higher excluding leasing companies) compared to 22% in
2000.
Backlog growth
The commercial large jet backlog has grown by a factor of four since 2004 to
almost 10,700 aircraft (11,500 including regional jets), representing around 55% of
the in-service fleet and dwarfs the previous cycle peak of 3,900 in 2000. Over this
period, more than 18,000 new aircraft orders have been placed (approximately
equivalent in number to the entire global fleet in 2004) despite spanning a severe
global financial crisis and aviation downturn,.
Aerospace & Defence

21
Large commercial jet backlog evolution; annual deliveries are covered more
than eight times

Source: Berenberg estimates, company data
Intense order activity has led to reduced cyclicality in production
After nine years of very high order intake, we consider it inevitable that the pace
will slow. This presents a risk to sentiment (and therefore valuations) because
slowing orders has historically been an important indicator that the production
cycle is peaking. In recent months, we detect rising investor concerns in this
respect, exacerbated by Emirates Airlines cancellation of a large order for A350
XWB aircraft. In our view, the Emirates event is specific to the operator and does
not represent a turning point in the cycle and overall, and given the long delivery
horizon, we believe the risk of a material change to the production outlook is
minimal. Indeed, recent commentary from Airbus and Boeing suggests otherwise,
with Airbus confirming its previous expectation of achieving a book-to-bill greater
than 1x (net of the Emirates cancellation) in 2014. Nevertheless, we recognise
sentiment could still be adversely affected if order activity declines sharply.
Book-to-bill (annual) Book-to-bill (three-month rolling)

Source: Berenberg estimates, company data Source: Berenberg estimates, company data
Since 2005, the combined Boeing and Airbus monthly book-to-bill ratio has
averaged 1.9x annually and 2.1x on a rolling three-month basis, marking the very
substantial order book expansion previously highlighted. In this strong demand
environment, both manufacturers have adopted a cautiously steady approach to
0.0
2.0
4.0
6.0
8.0
10.0
12.0
0
2,000
4,000
6,000
8,000
10,000
12,000
1
9
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9
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3
Backlog Deliveries Backlog to delivery (rhs)
0.0
1.0
2.0
3.0
4.0
0
1000
2000
3000
4000
2
0
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Orders Deliveries Bk-to-bill
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4
8 yrs of significant backlog expansion
Aerospace & Defence

22
production increases. By way of illustration, annual aircraft deliveries have more
than doubled from the trough in 2003 at a CAGR of 8%, which compares to
previous cycles when the average trough-to-peak increase of c50% over three to
four years, implied a CAGR of c12%. The result is lower volatility in the
production cycle as evidenced by the fact there were no production cuts through
the 2008/9 downturn, despite a sharp drop in air travel and a temporary period of
depressed order activity.
According to Ascend, 60% of the backlog is scheduled for delivery within four
years, compared to a profile of 90% within five years in previous cycles. Another
mitigating factor is the broad geographical spread of the backlog (see chart)
although we do not discount the view that some regions or airlines that may have
over ordered. For example, Lion Air (Indonesia) has 541 aircraft on order
compared to fleet of 100 in-service, and AirAsia (Malaysia), which has 277 aircraft
on order compared to an in-service fleet of 165. It seems highly possible that some
of these orders will be cancelled or deferred, although in our view the aircraft
OEMs will be able to accommodate even sizable changes should cancellations
occur, given the healthy market for new aircraft and the long lead-times for
narrow-body aircraft.
Backlog by region Aircraft delivery profile

Source: Ascend/*includes leasing companies
New programme it is all about execution
The last decade has also seen the launch of an unprecedented number of new
aircraft which are various stages of development or early production, including:
Airbus: the A380, the A400M, the A350-XWB (-800/-900/-1000), the
A320NEO family;
Boeing: the 787 (-8/-9/-10), the 747 (-8/-8F), the 737MAX (-7/-8/-9), 777X;
Others: the Bombardier CSeries (the -100/-300), the Comac C919, the
Mitsubishi MRJ, the Sukhoi Superjet 100, the Gulfstream G650, the
Embraer E-2 Jets, among others.
In addition, the market is waiting decisions from Airbus regarding a potential re-
engine strategy for the A330 and/or the A380 aircraft as part of wholesale
upgrades to improve fuel efficiency and extend the life of the platforms. The
outcome (on both decisions) is likely to be highly relevant to Rolls-Royce which
has competing engines on both of the existing aircraft, and also to a lesser extent to
Safran and MTU Aero Engines which have programme shares on the main
Asia
Pacific
Europe
North
America*
Middle
East
RoW
Unknow
n
500
1000
1500
2000
Narrow-body Wide-body RJs
Aerospace & Defence

23
competing engines from GE and Engine Alliance, the 50:50 joint venture between
GE and Pratt and Whitney.
We show our forecast deliveries by aircraft type in the table on page 25 but the
chart below illustrates clearly the seismic programme shifts facing the industry over
the next five years. The focus for the aircraft and engine OEMs is therefore new
programme execution in a high volume environment.
The volume of new aircraft programmes is set to rise substantially over the
next five years

We consider the status of key new programmes as follows.
A320NEO and 737MAX Big volumes but risk is relatively low
The majority of volume change in the industry will be in the narrow-body sector
with the introduction of the re-engined Airbus A320 and Boeing 737 families of
aircraft in 2015 and 2016 respectively. While neither of these aircraft have reached
first flight stage, we assess development risk as relatively low given the high degree
of commonality with the existing platforms (80%+). Both Airbus and Boeing claim
their respective development programmes are on track and have recently expressed
confidence in keeping to schedule, with Airbus expecting first flight of the
A320NEO by the end of 2014 while Boeing expects to fly the 737MAX about a
year later. Notwithstanding this, risk is elevated by the very rapid transition from
mature and profitable programmes to a new product set. Companies we cover that
are most exposed to the new narrow-body programmes are Airbus (A320NEO
airframe), MTU Aero Engines (with an 18% share of the GTF engine, a choice
on the A320NEO), Safran (with a 50% share of the CFM-LEAP engine offered
exclusively on the 737MAX and as a choice on the A320NEO), GKN (A320NEO
wings/structures and engine systems on the GTF engine).
Boeing 787 risks fading
After many years of problems and delays Boeing hit its 10 aircraft per month
production plan at the end of 2013. There are ongoing cost issues for Boeing to
work through, but overall programme risks are fading as production matures into
full rate. Companies we cover that are most exposed to the 787 are Rolls-Royce
(Trent 1000 as a choice of engine), MTU Aero Engines (with a 6.5% share on
GEs GEnx engine).

200
400
600
800
1,000
1,200
1,400
1,600
1,800
Series aircraft New narrow-body New wide-body
Aerospace & Defence

24
A350 XWB the next big all-new programme; ramp-up from 2016
Flight testing of the first variant of the A350-XWB (extra wide-body), the A350-
900, is nearing completion, with Airbus confident of achieving aircraft certification
in Q3 before first customer delivery to Qatar Airways in Q4. Early rate production
commences in 2015 with a sharp increase planned thereafter. Two more variants,
the smaller A350-800 and the larger A350-1000, are in early development but there
is speculation that: 1) Airbus may not proceed with the -800, especially if the A330
is re-engined, on which a decision is expected by the year-end, 2) a stretched -1000
variant may be a future option to compete more effectively with Boeings new
777X. Companies that we cover that are most exposed to the A350 XWB
programme are Airbus (airframe), Rolls-Royce (Trent XWB engines currently
sole source) and GKN (wing structures and engine systems on the Trent 1000).
B777X A long way out
Production of the recently launched successor to Boeings 777 aircraft is set to
begin in 2017 with first delivery targeted for late 2019/early 2020. The 777X will
compete at a seating capacity level at, and just above the A350-1000. Development
of the 777X is at an early stage and suppliers are still being selected. Both Safran
and MTU Aero Engines are bidding for a share on GEs GE9X engine which has
been selected as the sole power plant for the 777X with decisions likely to be
announced before the end of the year.
CSeries A troubled upstart
Bombardiers CSeries is a new family of narrow-body aircraft designed to compete
at the smaller end of the Boeing 737 and Airbus A320 ranges. The programme,
which is in the late stages of testing and early production, has been beset by
problems and entry-in-to-service of the smaller 110-seat variant (C100) has again
been delayed to the second half of 2015. The CSeries is the first aircraft to be
powered by Pratt & Whitneys PurePower GTF engine (the PW1500G), on which
MTU Aero Engines has a 17% share. In late May, Bombardier reported an engine
incident during ground testing which caused significant damaged and the flight
testing programme remains temporarily halted. Recent comments from Pratt &
Whitney suggest the problem can be fixed rapidly and flight testing is expected to
resume in the next few weeks. It therefore appears this latest issue does not
represent a fundamental or structural problem that could de-rail the GTF or whole
CSeries programme. In volume terms, the A320NEO is a far more important
programme for the GTF engine where deliveries are expected to commence in late
2015 and ramp up aggressively thereafter.

Aerospace & Defence

25
Commercial jets delivery profile
We estimate average annual growth in large jet deliveries of 4.5% pa over the next
five years, based predominantly on Boeings and Airbuss production plans and
underpinned by their collective backlog of more than $1trn. The market, in US
dollar terms, will grow faster we estimate at a CAGR of c9% due to the
increasing mix of higher value wide-body aircraft as outlined above.
Large commercial jet deliveries

Source: Company data/Berenberg estimates

Regional jet deliveries

Source: Berenberg estimates, company data, Airline Monitor
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 2020E
Boeing
717 20 12 12 13 5
737 215 170 199 209 291 324 284 367 366 365 411 434 468 492 504 384 96 48 24
737MAX 120 420 492 528
747 27 19 15 13 14 16 14 8
747-8 9 31 24 18 18 12 12 12 12 6
757 29 14 11 2
767 35 24 9 10 12 12 10 13 12 20 26 21 36 36 36 36 36 36 36
777 47 39 36 40 65 83 61 88 74 73 83 98 96 108 108 108 108 108 108
787 3 46 65 96 120 132 132 132 132 132
BBJ 10 6 3 4 11 6 6 5 10 7 4 6
Boeing 383 284 285 291 398 441 375 481 462 477 601 648 714 774 792 792 804 828 834
Airbus
A320 236 233 233 289 339 367 386 402 401 421 455 493 487 487 360 209 116 35 12
A320NEO 133 313 418 499 545
A300/310 9 8 12 9 9 6
A330 42 31 47 56 62 68 72 76 87 87 101 108 104 93 87 81 70 58 46
A340 16 33 5 4 2 2 3
A340-5/600 23 20 22 9 5 10 4 2
A350 6 17 35 58 104 116 128
A380 1 12 10 18 26 30 25 30 30 30 30 30 30 30
Airbus 303 305 320 378 434 453 478 498 510 534 588 626 627 627 644 691 737 737 760
Bombardier C-Series 6 12 24 30 30 30
Comac C919 6 36 42 48
Other 6 12 30 66 72 78
TOTAL 686 589 605 669 832 894 853 979 972 1,011 1,189 1,274 1,341 1,407 1,448 1,513 1,607 1,637 1,672
Source: Berenberg Bank, Company Reports
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 2020E
Embraer
ERJ 135 73 133 46 12 7 6 7 6 2 1
ERJ 145 60 43 45 64 33 19 11 21 41 30 24 24 24 24 24 24
ERJ 175 12 43 78 92 82 75 92 85 48 60 60 60 60 60 60 60
E-2 175 6
E-2 190/195 6 48 60
TOTAL 87 134 120 98 130 162 122 100 105 106 90 90 84 84 84 90 132 150
Bombardier
CRJ 200 140 152 100 36 1
CRJ 700/900/1000 51 62 20 74 63 62 56 60 41 33 14 26 36 36 36 36 36 30 24
TOTAL 191 214 120 110 64 62 56 60 41 33 14 26 36 36 36 36 36 30 24
Other
MRJ 70/90 20 40 40 30
ARJ21 700/900 20 40 40 40 30 30
SSJ 75/95 5 8 24 40 40 50 50 40 40 40
TOTAL 5 8 24 40 60 90 110 120 110 100
TOTAL 191 301 254 230 162 192 218 182 141 143 128 140 166 180 210 230 246 272 274
Aerospace & Defence

26
Civil aerospace aftermarket
Attractive sector
Given the very long lifecycle of aircraft, we view the civil aftermarket as an
attractive sector, typically characterised by high margins, strong pricing and high
barriers to entry and long-term structural growth (driven by growing and aging
fleets). The civil aero aftermarket, incorporating spare parts, maintenance, overhaul
and repair (MRO) is inherently more cyclical than aircraft production because
demand is closely linked to growth in air traffic and fleet utilisation trends.
Industry aftermarket growth was below trend growth through 2013
Over the past two years, industry aftermarket growth rates have dipped below
long-term trends (which are typically around 1.5% to 2.0% points above global
GDP), despite airlines improved financial health and steady growth in passenger
demand. This is partly due to careful fleet management and cash conservation by
the airlines, for example in response to slowing air traffic growth and economic
concerns about the eurozone through the second half on 2012. As a result,
passenger growth and airline capacity decelerated through 2012 into 2013 which in
turn led to a slowdown in aftermarket, exacerbated by airlines deferring and/or
reducing maintenance content and working down parts inventory.
Passenger growth (RPKs) and airline capacity growth (ASKs)

Source: IATA
Macro backdrop is supportive of a return to growth
Aviation industry trends are improving with airline profitability increasing and
global passenger growth sustaining above the long-term trend of around 4.5%.
International Air Transport Association (IATA) traffic data shows sequentially
improving half-yearly growth in passenger demand, measured in revenue passenger
kilometres (RPKs) as follows: H113: +4.5%; H213: +5.9%; 2014 ytd: 6.0%. Airline
capacity trends, measured in available seat kilometres (ASKs), which are a good
proxy for the aftermarket, have followed: H113: +3.7%, H213: +5.9%; 2014 ytd:
5.8%. IATA predicts further above trend growth in ASKs for the full year of 5.4%
(versus 5.2% in 2013 and 3.9% in 2012).

(25%)
(15%)
(5%)
5%
15%
25%
35%
45%
A
p
r
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p
r
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4
ASKs (Capacity) RPK (passenger growth)
9/11
attacks
Gulf War II
and SARS
Global
financial
crisis
Ash
cloud
Eurozone
concerns
Aerospace & Defence

27
Mixed recovery across the companies but overall 2014 continuing to trend
positively
In the chart below, we track companies aftermarket growth as an aggregate of
quarterly growth on whatever basis they report: eg spares, aftermarket, services
sales or orders. In our sample, we include inputs from Safran, Rolls-Royce,
Meggitt, MTU Aero Engines, United Technologies (Aerospace Systems and
Pratt & Whitney), Honeywell (Aerospace), and GE Aviation). Recovery by
company has been mixed with, for example, Safran delivering consistently strong
growth in aftermarket sales through 2013 (average of +19%) compared to the
average of the majority of companies seeing modest growth or declines.
Quarterly civil aftermarket growth trends good momentum into 2014

2014 aftermarket guidance in our stock coverage varies from low/mid-single-digit
to low- to mid-teens and general qualitative statements such as good progress,
the range due to company-specific issues and programme exposures. This implies
to us overall industry growth of just above mid-single-digit in 2014. Apart from
Rolls-Royce, which does not disclose financial details in their mid-period (IMS)
updates, all the other companies in our aftermarket grouping reported Q1 growth
in line with their full-year guidance given at the start of the year (see table below).
2014 aftermarket growth update (for companies under coverage)

Source: Berenberg estimates, company data. *Berenberg estimate

-20%
-10%
0%
10%
20%
30%
40%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2010 2011 2012 2013 2014
Sector ave. Ave. rev Ave. orders
Company FY14 guidance * Q1 result Comment / metric
Meggitt Mid-single digit "a continuation of improvement" (4%*) Civil aftermarket growth
MTU Aero Engines Mid-single digit high-single digit Spare parts growth
Rolls-Royce n/a n/a FY14 guidance - "good profit progress" in Civil
Safran Low-to-mid teens 12.40% Civil spares aftermarket growth
Aerospace & Defence

28
Defence market outlook
Global trends
World military spending in 2013 declined for the third year running, primarily a
reflection of further yoy reductions in the largest market, the US, more than
offsetting growth in many of the lower spending developing regions. Total defence
spending was c1.65trn, down by 3% yoy, with the US down by 11% yoy, partly
due to reduced spending on the Afghanistan conflict (funded through the Overseas
Contingency Operations OCO budget). While many developing nations and
higher growth regions such as Asia and the Middle East are modernising their
militaries and increasing expenditure on defence, most Western budgets remain
constrained by governments continuing fiscal pressures. Overall, we conclude that
the outlook for global defence spending is relatively benign; IHS Janes predicts flat
to slightly increased levels in 2014 being the net effect of moderating yoy
reductions in the US and further growth regions such as Asia and the Middle East
expenditure.
Major defence spenders (2013) Global defence spending trends ($bn)

Source: SIPRI Source: SIPRI
37%
11%
5%
37%
USA China Russia Saudi UK India ROW
0
500
1000
1500
2000
1
9
8
8
1
9
9
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9
8
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2
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2
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8
2
0
1
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2
0
1
2
ROW US
Aerospace & Defence

29
US defence a stabilising situation
By far the largest defence budget globally at around 37%, US budget trends will
continue to have a disproportionate impact on the overall defence market. The US
is the most important defence market for many of the companies in our coverage
universe.
US Defence spending long-term trends (2013
constant $m)
US Defence spending recent period and current
forecasts ($bn)

Source: US DoD ComptrollerFY14 Green Book
US budget down by 16% since 2010
Total US defence outlays peaked in 2010 at $690m, comprising $528bn Base
budget and $162bn OCO (supplemental funding for the Afghanistan and Iraq
conflicts). Spending has since declined by 16% to $578bn in FY13 with the base
budget down 6% (CAGR: -2%) to $496bn and the OCO down 46% (CAGR:
-19%) to $82bn as conflict expenditure winds down.
After three years of budget cuts and political posturing regarding the government
federal deficit situation causing disruption to the defence procurement process, the
Ryan-Murray Congressional Bipartisan Budget Act (BBA) was passed in December
2013, which effectively set two years of budgets (although the FY15 budget still
needs to be authorised) and removed the immediate threat of more further
sequestration cuts. This gives the defence industry some welcome visibility that it
has been lacking for several years. It is worth reminding ourselves of how we
arrived to this point and where the process has got to with respect to future
budgets.
2011-2013 BCA: The Budget Control Act (BCA) was passed in August 2011,
addressing federal budget and government deficit pressures. The BCA imposes
caps on discretionary government funding relative to the Congressional Budget
Office (CBO) 2010 baseline. For the defence budget, this equated to $492bn
lower spending over 10 years, around c$50bn/year. Failure by the political
parties to agree on early year reductions (and the federal debt ceiling issue)
triggered automatic across-the-board sequester cuts in March 2013 which
totalled $37bn in-year reductions (the full year would have been $55bn).
Overall, the Base budget fell by $34bn (6.6%) in FY13, although the budgets for
procurement and RDT&E (research, development, test and evaluation), the
budget lines most relevant to defence manufacturers, contracted slightly less, by
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
F
Y
4
8
F
Y
5
3
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8
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8
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8
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Y
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3
0
200
400
600
800
F
Y

0
0
F
Y

0
1
F
Y

0
2
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Y

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Y

0
4
F
Y

0
5
F
Y

0
6
F
Y

0
7
F
Y

0
8
F
Y

0
9
F
Y

1
0
F
Y

1
1
F
Y

1
2
F
Y

1
3
F
Y

1
4
F
Y

1
5
F
Y

1
6
F
Y

1
7
F
Y

1
8
F
Y

1
9
Base (FYDP) OCO
BCA cap FY15 budget plan
Aerospace & Defence

30
4.1% to 155bn. Through this period there was significant uncertainty around
the exact nature of cuts and risks to future funding lines, which was exacerbated
by late annual budget agreements (forcing prolonged periods of budgeting
under multi- part-year Continuing Resolutions) and resulted in a dislocated
procurement environment. As a result, order and contract approval delays have
been commonplace.
December 2013 January 2014: The BBA was passed in December 2013.
This is a two-year budget agreement which avoids a further government shut
down and replaces sequester spending cuts with savings from future-year cuts.
In January, the Omnibus Appropriations Bill was passed containing the FY14
Defense Appropriations Bill and outline of the FY15 request.
May 2015: In the route to finalising the FY15 Defense budget, the Senate
Armed Services Committee passed its version of the 2015 National Defense
Authorisation Act (NDAA) on 22 May at levels consistent with spending caps
for FY15 set out in the BBA; namely authorisations of $496bn (flat yoy) for the
Base budget including $91bn for procurement (-2.1% yoy) and $64bn for
RDT&E (+1.2% yoy)
OCO: The OCO is separate from Base defence spending and indeed exempt
from BCA spending caps. OCO spending peaked in 2008 at $187bn falling to
$82bn in 2013. The FY14 budget actually increased 3.9% yoy to $85bn but
reduces by 6.8% in FY15 to $79bn. As troop drawdown continues, we expect
annual OCO spending will decline for foreseeable future. We expect a reduction
to a much lower number when troop drawdown is complete, and when
remaining in-country commitments are defined.
Longer-term budget outlook is flat although sequestration risks remain
In summary, the BBA and subsequent defence appropriation bills have afforded a
level of visibility for the industry not seen for several years. We conclude that the
worst of the cuts to the Base budget has occurred (as shown in the chart above).
Even with future Base spending in line with BCA caps, and taking into account
future reductions in OCO budgets, total top line spending is likely to remain flat at
around $600bn for much of the rest of the decade. Indeed at the procurement and
RDT&E level the expectation is for modest rises (see chat below). This profile
incorporates the very substantial reductions to expected long-term spending which
have totalled almost $600bn to date against the expected level in 2010
(incorporating BCA reductions of $492bn over 10 years), $32bn of sequestration
cuts in 2013 and $76bn total reductions in the FY14 and FY15 budgets compared
with the US presidents original budget request. Or to it put another way, the
reductions absorbed so far are against a growth plan of many years ago. In
absolute terms, the dollar amount is set to rise (albeit modestly).

Aerospace & Defence

31
Procurement and RDT&E budget profile ($bn)

Source: Berenberg estimates; US DoD
2016 and beyond risks remain
We caution on 2016 and beyond as there is potential for further damaging
sequestor cuts if not repealed before by Congress. With a presidential budget
inbetween, it is difficult to predict whether the US political elite will be able to
address effectively the original problem of the government deficit and ongoing
federal budget issues which could again trigger sequestration cuts, presenting a risk
to the manufacturers. The US DoDs recently issued a report entitled Estimated
Impacts of Sequestration-Level Funding FY 2015, which reviewed where new
sequestration cuts may fall.
Top 25 US procurement programmes
For reference, we show here the top 25 US procurement programmes by value for
FY15, highlighting key priorities in a budget-constrained environment. It is
encouraging to see increased funding for a number of programmes that will be
important (primarily) to UK defence companies. Notable key future platforms
seeing stable or growing funding include the F-35 JSF aircraft (BAE Systems,
Cobham, Ultra) and the KC-46 Tanker aircraft (Cobham) programmes. The
other major increases for programmes relevant to our stocks reflect yoy recovery
after lower spending on 2014 partly due to the negative impacts of sequestration.
The DDG-51 Destroyer (Rolls-Royce, Ultra), the V-22 Tiltrotor aircraft (Rolls-
Royce, Cobham) and the C-130J transporter aircraft (Rolls-Royce, Ultra) are
examples.
0
20
40
60
80
100
120
140
160
180
200
F
Y

0
3
F
Y

0
4
F
Y

0
5
F
Y

0
6
F
Y

0
7
F
Y

0
8
F
Y

0
9
F
Y

1
0
F
Y

1
1
F
Y

1
2
F
Y

1
3
F
Y

1
4
F
Y

1
5
F
Y

1
6
F
Y

1
7
F
Y

1
8
F
Y

1
9
Procurement RDT&E
Aerospace & Defence

32
Top 25 US procurement programmes ($m)

Source: DoD

Programme Title
Organisatio
n Budget Activity
FY
2014
Qty
(units)
FY 2014
Budget
($m)
FY
2015
Qty
(units)
FY 2015
Budget
($m)
Delta
($m)
%
Change
Virginia Class Submarine NAVY Other Warships 2 5,409,326 2 5,288,668 -120,658 -2%
F-35 AF Tactical Forces 19 3,183,002 26 3,892,579 709,577 22%
DDG-51 NAVY Other Warships 1 1,729,604 2 2,969,354 1,239,750 72%
Virginia Class Submarine NAVY Other Warships 0 2,354,612 0 2,330,325 -24,287 -1%
P-8A Poseidon NAVY Combat Aircraft 16 3,347,044 8 2,166,487 -1,180,557 -35%
KC-46A Tanker AF Tactical Airlift - - 7 1,582,685 1,582,685 -
V-22 (Medium Lift) NAVY Combat Aircraft 19 1,435,731 19 1,546,359 110,628 8%
Littoral Combat Ship NAVY Other Warships 4 1,793,014 3 1,427,049 -365,965 -20%
JSF STOVL NAVY Combat Aircraft 6 1,274,559 6 1,303,605 29,046 2%
Carrier Replacement Program NAVY Other Warships 0 917,553 0 1,300,000 382,447 42%
UH-60 Blackhawk M Model (MYP) ARMY Rotary 70 1,218,916 79 1,237,001 18,085 1%
Spares and Repair Parts NAVY Aircraft Spares and Repair Parts 0 965,238 0 1,229,651 264,413 27%
Trident II Mods NAVY Modification of Missiles 0 1,130,865 0 1,190,455 59,590 5%
MH-60R (MYP) NAVY Combat Aircraft 19 704,329 29 1,131,712 427,383 61%
E-2D Adv Hawkeye NAVY Combat Aircraft 5 1,083,588 4 945,370 -138,218 -13%
CH-47 Helicopter ARMY Rotary 28 868,791 32 892,504 23,713 3%
H-1 Upgrades (UH-1Y/AH-1Z) NAVY Combat Aircraft 21 668,945 26 838,757 169,812 25%
Win-T - Ground Forces Tactical Network ARMY Comm - Joint Communications 1,725 769,477 1,280 763,087 -6,390 -1%
Evolved Expendable Launch Veh (Infrast.) AF Space Programs 0 559,413 0 750,143 190,730 34%
Joint Strike Fighter CV NAVY Combat Aircraft 4 1,059,114 2 689,668 -369,446 -35%
F-18 Series NAVY Modification of Aircraft 0 725,912 0 679,177 -46,735 -6%
Evolved Expendable Launch Veh(Space) AF Space Programs 5 807,991 3 630,903 -177,088 -22%
Chem Demilitarization - RDT&E ARMY RDT&E 0 633,911 0 595,913 -37,998 -6%
C-130J AF Other Airlift 6 477,517 7 580,396 102,879 22%
AH-64 Apache Block IIIA Reman ARMY Rotary 42 722,311 25 494,009 -228,302 -32%
Aerospace & Defence

33
Appendix 1: Financial performance growth and
margins
Forecast sales CAGR (three-year) Organic sales growth (next reported).


Forecast EBIT CAGR (three-year) Forecast EPS (adj) CAGR (three-year)


Forecast DPS CAGR (three-year) Operating margin (next reported)

-15%
-10%
-5%
0%
5%
10%
-6%
-3%
0%
3%
6%
Organic Ave Civil Ave defence
-10%
-5%
0%
5%
10%
15%
20%
25%
0%
5%
10%
15%
20%
25%
30%
35%
0%
5%
10%
15%
20%
25%
30%
73%
0%
5%
10%
15%
20%
25%
Aerospace & Defence

34
Appendix 2: Financial performance returns, cash,
balance sheet
RoCE (FY14E)
RoIC (FY14E)


Operating cash conversion Free cash conversion


Gearing (%) (next reported) Net debt/EBITDA (next reported)

0%
5%
10%
15%
20%
25%
0%
5%
10%
15%
20%
0%
50%
100%
150%
200%
Next reported Ave last 5yrs
-50%
0%
50%
100%
2014 Ave last 5yrs
0%
10%
20%
30%
40%
50%
Net cash
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Net cash
Aerospace & Defence

35
Appendix 3: EPS forecast trends by company
Airbus EPS forecast trends BAE EPS forecast trends


Cobham EPS forecast trends GKN EPS forecast trends


Meggitt EPS forecast trends MTU EPS forecast trends


0
1
2
3
4
5
2012 2013 2014 2015 2016
35
40
45
50
55
60
2012 2013 2014 2015 2016
15
18
21
24
27
30
2012 2013 2014 2015 2016
10
20
30
40
2012 2013 2014 2015 2016
EPS recovery
post autos
downturn
FX
cuts
20
30
40
50
2012 2013 2014 2015 2016
3
4
5
6
7
8
2012 2013 2014 2015 2016
Aerospace & Defence

36
QinetiQ EPS forecast trends Rheinmetall EPS forecast trends


Rolls-Royce EPS forecast trends Safran EPS forecast trends


Ultra EPS forecast trends

Source: Datastream

10
13
16
19
22
25
2012 2013 2014 2015 2016
Two yrs of 'beats' on
Global Products contracts
0
2
4
6
8
2012 2013 2014 2015 2016
20
40
60
80
100
2012 2013 2014 2015 2016
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2012 2013 2014 2015 2016
90
100
110
120
130
140
150
2012 2013 2014 2015 2016
Aerospace & Defence

37
Appendix 4: Upcoming events
Upcoming events

Source: Bloomberg
Date Company Event
19-Jun Rolls-Royce Investor Briefing
22-Jul QinetiQ Annual General Meeting
24-Jul MTU Q2 2014 Earnings Release
29-Jul GKN S1 2014 Earnings Release
30-Jul Airbus S1 2014 Earnings Release
31-Jul Rolls-Royce S1 2014 Earnings Release
31-Jul Safran S1 2014 Earnings Release
31-Jul BAE Systems S1 2014 Earnings Release
04-Aug Ultra Electronics S1 2014 Earnings Release
05-Aug Meggitt S1 2014 Earnings Release
07-Aug Cobham S1 2014 Earnings Release
08-Aug Rheinmetall Q2 2014 Earnings Release
23-Oct MTU Q3 2014 Earnings Release
23-Oct Safran Q3 2014 Sales and Revenue Release
07-Nov Rheinmetall Q3 2014 Earnings Release
14-Nov Airbus Q3 2014 Earnings Release
21-Nov QinetiQ S1 2015 Earnings Release
25-Nov MTU Investor and Analyst Day
Airbus Group NV
Aerospace & Defence
38

Stand and deliver

We initiate coverage on Airbus Group with a Buy rating and a 60.5
price target, implying 16% upside. Airbus is a pure-play on the
commercial aviation production cycle (two-thirds of sales) which we
believe will remain a strong market despite the recent cancellation of a
70 aircraft A350 XWB order by Emirates. The Airbus division backlog
remains at more than 600bn, underpinning growth for many years.
Operational risks such as the ramp-up of the A350 XWB and
A320NEO programmes and restructuring of the Defence and Space
(D&S) business are being well managed and we expect the benefits of
volume, operational improvements and fading legacy programme risks
will translate to sustained strong earnings growth. Forecast risk is to
the upside, we believe, and hence we view the sell-off as an
opportunity to buy.

Recent news mixed: Q1 results reassured investors both on near-
term issues (A350 XWB programme risks and cash pressures) and
longer-term concerns regarding the health of the order book. The
Emirates news last week cast further doubt on the strength of the
cycle, but both Airbus and Boeing have reported continuing strength
in the new aircraft market. Airbus has since re-iterated it expects to
grow the order book yoy in 2014.

Execution challenges are significant but being well managed:
Management appears confident of meeting A350 and A320NEO key
milestones, while the D&S restructuring is on track. Cash headwinds
are well understood. Longer-term, we anticipate a strong cash profile.

Valuation/shares: The sell-off leaves the shares down 7% ytd, a 6%
underperformance to the sector, and trading on relatively attractive
valuation multiples a 2015 P/E of 15.0x and an EV/EBITDA of
7.5x (on a pre one-time-items basis). There are a number of important
catalysts for the stock, including the Farnborough Air Show (week
commencing 14 July), when we expect a pick-up in order activity;
certification and first customer delivery of the A350 XWB (Q3 and
Q4 respectively); and the first flight of the A320NEO (Q4). Expect a
decision on the A330 re-engine strategy before the end of the year.

Buy (Initiation)
Current price
EUR 52.21
Price target
EUR 60.50
Market cap EUR 41,911 m
Reuters AIR.PA
Bloomberg AIR FP
Share data

Shares outstanding (m) 778
Enterprise value (EUR m) 45,583
Daily trading volume 2,178,920
Performance data

High 52 weeks (EUR) 57
Low 52 weeks (EUR) 40
Relative performance to SXXP CAC 40
1 month 2.9 % 4.1 %
3 months -3.1 % -1.6 %
12 months -1.9 % 1.4 %
Key data

Price/book value 3.3
Net gearing -167.9%
CAGR sales 2013-2016 3.7%
CAGR EPS 2013-2016 29.8%

Business activities:
Airbus is a leading commercial aircraft
manufacturer, with a product line that
ranges from 100 to 500 seat planes. Airbus
Defence and Space is Europe's number
one defence and space company, ranking
second for space and in the top 10 for
defence globally. Airbus Helicopters is
the world's number one in civil and
number two in defence.

Non-institutional shareholders:
Sogepa (French state): 12%; GZBV
(German investment arm): 10.7%; SEPI
(Spanish state): 4.1%
16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., EURm 2012 2013 2014E 2015E 2016E
Sales 58,443 57,567 58,249 59,998 64,220
EBITDA (adj) 4,197 4,624 5,490 6,155 7,098
EBIT (adj) 2,144 2,656 3,490 4,064 4,916
Net income (adj) 1,240 1,502 2,177 2,604 3,233
Net income 1,197 1,460 2,121 2,554 3,183
Net debt / (net cash) -11,724 -8,454 -7,867 -7,308 -7,940
EPS 1.46 1.84 2.73 3.28 4.08
EPS (adj) 1.51 1.90 2.80 3.35 4.14
FCFPS 0.87 -1.15 -0.21 0.22 1.94
CPS 0.22 -4.13 -1.29 -0.72 0.81
DPS 0.60 0.75 0.94 1.13 1.41
EBITDA margin (adj) 7.2% 8.0% 9.4% 10.3% 11.1%
EBIT margin (adj) 5.1% 6.2% 6.3% 7.1% 7.7%
Dividend yield 2.0% 1.4% 1.7% 2.1% 2.6%
ROCE 7.0% 10.0% 12.5% 13.7% 14.6%
EV/sales 0.4 0.8 0.8 0.8 0.7
EV/EBITDA 5.8 9.9 8.3 7.5 6.4
EV/EBIT 11.4 17.3 13.1 11.4 9.3
P/E 19.5 28.4 19.3 16.1 13.0
P/E (adj) 13.4 19.2 18.2 15.0 13.0
Source: Company data, Berenberg
Airbus Group NV
Aerospace & Defence
39

Airbus Group investment thesis in pictures
Airbus Commercial will generate over two-thirds
of group EBIT (clean) by 2016
Revenue growth underpinned by 690bn order
book; the quality of profits is improving as legacy
programme issues fade

Source: Berenberg estimates Source: Berenberg estimates/Airbus

EBIT bridge (m): revenue and operating
efficiencies partly offset by A350 support costs
and dilution impacts
FCF (m): FCF depressed for two more years due
to investment in new programme ramp-up,
strongly cash-generative thereafter

Source: Berenberg estimates/company data Source: Berenberg estimates

Management is confident A320NEO transition
risks are manageable; production guidance
increased to 46 aircraft from 2016
Airbus 12-month forward P/E of 15.2x is a 10%
premium to the average since flotation; earnings
are catching up

Source: Berenberg estimates/Airline Monitor Source: Datastream

67%
11%
22%
Airbus Helicopter Defence & Space
-2%
0%
2%
4%
6%
8%
10%
0
20,000
40,000
60,000
80,000
100,000
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
Sales RoS pre one-time RoS 'clean'
2,213
267
300
(500)
100
2,381
610
350
(600)
0
2,741
0
1,000
2,000
3,000
4,000
-3%
0%
3%
6%
9%
12%
-1,000
0
1,000
2,000
3,000
2011 2012 2013 2014 2015 2016 2017
FCF FCF yield
0
100
200
300
400
500
600
A320 family CEO NEO
0
5
10
15
20
25
30
Airbus Average Since Floatation
ave 13.7x
Airbus Group NV
Aerospace & Defence
40

Airbus Group investment thesis
Whats new: We initiate coverage on Airbus with a Buy rating and a 60.5 price
target, implying 14% upside.
Two-minute summary: Airbus is a pure-play on the commercial aircraft
production cycle with a c660bn order book providing a clear path to growth, not
least from an almost nine-year backlog in its core commercial aircraft business. In
light of such unprecedented demand, slowing order activity is inevitable, raising the
question of a softening order cycle. Emirates cancellation of an order for 70 A350
XWB aircraft has served to heighten concerns. We do not believe this event
indicates a general slowdown. On the contrary, Airbus has said the new aircraft
market remains active and has again confirmed its guidance for order book growth
in 2014. In the light of this and the existing 5,500 aircraft backlog (c8.8 years
production), we do not believe the Emirates development signals a change in the
outlook for production. In our view, the most important driver of valuation over
the next 12-24 months is the companys ability to execute on several challenging
programmes and deliver promised margin expansion. We are gaining confidence
that new programme risks are being well managed: A350 XWB certification and
first customer delivery milestones are edging closer (Q3 and Q4 respectively), the
first flight of the A320NEO aircraft (new engine option) is expected this year, and
industrial preparations for transition from the A320CEO (current engine option)
appear to be on track.
Also key to margin expansion is progress on the Defence and Space (D&S)
restructuring which management recently said will accelerate in H214. These are
complex business challenges, and there are many other pockets of risk across the
portfolio, but in our view they are more than countered by strong underlying
business momentum and fading legacy programme risks. Following the Emirates-
induced sell-off, the shares are down by 7% ytd, the second-worst-performing
stock in our coverage. If the company continues to deliver a consistent message of
steady progress on key programmes, we see upside risk to both to forecasts and the
valuation.
Key investment point one: multi-year improving margins; double-digit
upside at upper target range
Airbus is the second highest earnings growth company in our coverage with a four-
year clean EPS CAGR of 30%. A number factors are driving multi-year margin
progression, including strong momentum in Airbus Commercial, an improving
programme risk profile and cost reduction and operating improvements across the
group. At the Q1 results, management confirmed the 2015 target margin of 7-8%
despite growing A350 XWB losses. Our forecasts (and consensuss, we believe) are
pitched conservatively given significant business challenges relating to the ramp-up
of the A350 XWB, the development and ramp-up of the A320NEO and a complex
restructuring of the D&S business. Nevertheless, we sense a growing confidence
that these risks can be managed. Delivery to the upper end of the target range
implies 15% upside to our estimates.
Key investment point two: do not get hung up on the book-to-bill the
backlog profile is robust
Given the scale of the backlog (8.8 years), lower aircraft order activity is unlikely to
indicate future production cuts as it has done in historical cycles, although it could
weigh on investor sentiment if orders slow significantly and/or order cancellations
Airbus Group NV
Aerospace & Defence
41

and deferral rates pick up. The Emirates cancellation has served to heighten
concerns in the market. Airbuss book-to-bill ratio has averaged 1.9x over the past
10 years, building a record backlog of 5,500 aircraft, more than 3.5x the previous
peak in 2000. From this point, is reasonable to expect order rates to slow, we
believe, although we were encouraged to hear management refer to a continuing
healthy level of sales campaigns at the time of the Q1s and again following the
Emirates announcement. By aircraft type, the A330 poses a modest risk in the
short term given that the backlog of 260 aircraft gives only 2.5 years cover. A lack
of orders or a decision not to pursue a re-engine option (called the A330NEO)
would necessitate a production ramp-down of the current type over the next few
years. A decision on whether to re-engine is expected by the end of the year. In
summary, we believe the risk of a material reduction in aircraft production over the
next three to five years is very low, in spite of the level of order activity.
Key investment point three: cash headwinds for two more years
Current weak cash performance is a result of heavy investments ahead of growth
and planned ramp-ups in the A350 and A320NEO programmes. Historically,
Airbus has been highly cash-generative, averaging 63% free cash conversion over
the five years to 2012. However, we expect low free cash flows to persist through
2015 due to continuing investment commitments, leading to a trough net cash
position of c7bn, followed by a strengthening of cash performance thereafter.
Investment point four: D&S restructuring is complex management has
committed to an 8% RoS
At a cost of 232m a major restructuring of the groups underperforming D&S
businesses is underway, incorporating the merger of Astrium (space), Cassidian
(defence) and Airbus Military (aircraft). The objective is to improve operational
performance and leverage group synergies in the face of continuing difficult
markets, but the company has not quantified mid-/longer-term benefit objectives
other than re-iterating a previous target operating margin of 8% in 2015. We err on
the side of caution given the poor financial track record of these businesses,
implying c2% upside to our group EBIT forecast if the target is achieved.
Share price performance and valuation
Airbus shares are down by 7% ytd, slightly below consensus EPS downgrades of
9% (FY14) and equivalent to a 6% underperformance relative to the sector. This
followed an 85% appreciation in 2013 driven by both positive business momentum
and a strong re-rating as sentiment recovered after the BAE merger proposal
collapsed and significant structural, operational, shareholder and governance
changes were implemented. Through 2013, the 12-month forward P/E increased
by 4.9 turns (43%) implying upgrades accounted for around half of the share gains.
The shares now trade on a 15.0x FY15 P/E (on a pre-one-time items basis), a 13%
premium to the long-run average of 13.7x.
Airbus Group NV
Aerospace & Defence
42

Share price versus market and sector Airbus P/E since flotation (12-month forward)

Source: Datastream
Note re-based to Airbus share price
Source: Datastream
Forecast momentum
Year-to-date consensus FY14 EPS has decreased by 9% compared to negative 6%
for European aerospace and defence peers. We believe the revisions were partly
technical in nature, due to a re-aligning of consensus estimates after management
commenced use of a new definition of a profit based on an all-in margin (ie after
one-time items), which was discussed at the Airbus Global Investor Forum (GIF)
in December 2013. This, we believe, is a cleaner definition of profit but
importantly, it has also given the market a better understanding of the profit impact
of launch costs and dilution from the A350 programme. We believe that consensus
estimates rightly now factor A350 launch impacts into underlying EPS. The second
chart below highlights a modest return to positive EPS momentum following a
reassuring Q1 update.
Long-term forecast EPS changes () Short-term EPS revisions and share price ()

Recent results and outlook recap (Q114 result)
Q114: Results were slightly ahead of consensus at the operating and cash
flow level. Group revenue increased by 5.0% yoy while EBIT before one-
off items declined by 4.7% to 700m (versus consensus at 680m) mainly
reflecting R&D phasing (up by 17% to 727m) and mix, as expected. R&D
also affected FCF which was negative 2.0bn, a little below company-
gathered consensus, which we take as a positive given investors lingering
concerns on high cash demands from programme development and ramp-
up preparations.
20
30
40
50
60
AIR DJStoxx600 Pan Euro A&D
0
5
10
15
20
25
30
Airbus Average Since Floatation
ave 13.7x
0
1
2
3
4
5
2012 2013 2014 2015 2016
2.8
3.0
3.2
3.4
3.6
3.8
35
40
45
50
55
60
Share Price 12 mth fwd EPS
Airbus Group NV
Aerospace & Defence
43

In the detail: 1) Management confirmed the plan for 30 A380 deliveries in
2014 and that the 2015 breakeven objective is on track. Also, it confirmed
that the A350 is progressing towards full certification in Q3, and that the
first flight of the A320NEO will be achieved by the year-end. 2) The
strong profit recovery in Helicopters (margin: +300bp to 4.9%) was driven
by volume and recovery of Super Puma activity. 3) D&S revenue growth
of 3% was driven by project execution in Space with profits held yoy
despite adverse R&D phasing. The D&S restructuring programme is
progressing with full implementation from H214. 4) Hedging activity
slowed due to unfavourable rates. 2.2bn of new contracts were added
versus 6.0bn matured. The hedge portfolio totals $72.1bn at average rate
of $1 = 1.34 with 2014 fully covered at 1.35 and 2015 substantially
covered (we estimate 75% cover) at the same rate.
Key take-away for us profit quality is improving: Q114 was the first
quarter in over four years without one-off charges affecting EBIT, other
than a small (non-controllable) 19m currency mismatch credit on pre-
delivery payments. In other words, the reported P&L was not burdened by
unexpected programme charges or large non-recurring costs such as
restructuring and hence clean EBIT has converged with Airbuss
definition of EBIT before one-offs.
2014 outlook confirmed: Guidance was confirmed as stable revenues yoy
based on a similar level of Airbus deliveries as in 2013 (2013: 216 aircraft),
with a moderate return on sales growth on an EBIT before one-off
basis. We factor +10bp yoy to 6.3% in our forecast.

Airbus Group NV
Aerospace & Defence
44

Investment risks and concerns

Programme delay/cost overruns (especially A350): Over the past few years,
Airbus has taken charges totalling 558m against delays and higher costs on the
A350-XWB development programme. The flight testing programme appears to
be progressing well and management appears relatively confident about entry-
into-service (EIS) risks. However, an aggressive ramp-up will follow EIS and
there are two further variants still to bring to market, the A350-1000 in 2017
and the A350-800 in 2016 (but more likely in 2020). Any further cost overruns
will negatively affect the shares.

Book-to-bill ratio falls de-rating on cycle slowdown: After eight years of
very high order intake, we consider it inevitable that the pace will slow, leading
to fears in the market that the cycle has peaked. The Emirates order cancellation
raises further questions about the strength of the cycle and the robustness of
the order book. Airbus has said the market for new aircraft remains active and
management has confirmed it expects another year of orders at least equal to
deliveries (ie a book-to-bill of at least 1.0x) in 2014. Anything less may further
spook the market. We explore this in more detail on pages 16 and 17, and aside
from modest risk in the A330 programme which has a thinning backlog, we are
comfortable that Airbuss overall production outlook is secure and that
cancellation risk is limited. Nevertheless, sentiment could deteriorate if the
book-to-bill ratio falls significantly, or indeed the cycle is merely perceived to be
slowing, resulting in a lower rating (as it would for all commercial aerospace
stocks).

A320NEO transition: The A320NEO enters service in late 2015 which will
signal the start of a rapid ramp-up in production while at the same time activity
on the A320CEO (the current engine option), will begin winding down. A high
level of commonality between the two aircraft (c85%) mitigates development
risk but elements of new manufacturing processes, supply chain changes and
the mere fact that the NEO is a less mature aircraft raises operational risks
through the transition.

Cash flow weakness: Airbus is in a heavy investment phase (R&D, capex and
working capital) ahead of planned new product launches and further increases
in production in prospect, as well as a build-up of A380 inventory currently
affecting cash. We interpret guidance of persisting cash pressures as two years
of almost flat FCF, translating to net cash outflows approaching 1bn pa post-
dividends over the next two years. However, we are confident that Airbus will
become highly cash-generative from 2016.

Programme losses could increase or stay higher for longer (A380/A350):
Airbus is continuing to reduce fixed and recurring costs on the poorly
performing A380 programme and management confirmed in the Q1 results that
it expects to achieve break even by the end of 2015. Since its first flight in 2006,
the A380 has been a painful programme for Airbus. Missing this target will
disappoint the market. Also on A350, implicit in the guidance is 1.5bn-1.9bn
of losses on early-stage production after consumption of loss-making contract
(LMC) provisions. The launch costs associated with new programmes are now
better understood by the market and as a result, we believe the market is
increasingly assessing Airbuss underlying profitability on the basis of profits
after launch costs. Unexpected cost escalation above this amount will negatively
affect the shares.
Airbus Group NV
Aerospace & Defence
45

D&S restructuring execution risk: The business is undertaking a complex
restructuring programme over three to four years and apart from the
communication of broad mid-term margin targets, we currently have little
information to assess the mid- and longer-term benefits (we discuss this in more
detail on page 21). Full implementation of the programme starts in the H214. In
our view, the defence and space end-markets are unlikely to materially improve
soon, so slow progress on self-help could disappoint.

Currency exposure: Airbuss c$6bn pa net dollar exposure is well hedged by a
72bn hedgebook with an average rate of $1:1.34. However, if current spot
rates were to persist, and based on sensitivity if 1c equates to c100m, we
estimate 40m-100m pa of P&L headwind from 2016.

Airbus Group NV
Aerospace & Defence
46

Valuation
60.5 price target
Valuation summary table ()


We set our price target at 60.5 based on a blended average of DCF and sum-
of-the-parts (EV/sales and EV/EBITDA) analysis.

Our 60.5 price target equates to 15% upside to the current share price and
drives our Buy recommendation.

The implied price target P/E on a pre-one-time basis is 20.3x (FY14), falling to
16.8x (FY15) and 14.6x (FY16), and compares to Airbuss long-run 12-month
forward P/E of 13.7x (ie a c35% premium). This is justified, in our view, given
the significant business, governance and shareholder changes achieved over the
last 18 months, and the unprecedented backlog of commercial aircraft
supporting high rates of production through the rest of the next decade.
Sum-of-the-parts
We use peer average multiples for both FY14 and FY15 in our sum-of-the-parts
calculation. We apply EV/sales discounts of 20%, 33% and 40% to Airbus
Commercial, Helicopters and D&S respectively to reflect below-average margins.
Sum-of-the-parts table (FY14), m Sum-of-the-parts table (FY15), m


FY14 FY15 Assumptions
EV/Sales 57 57 Ave multiple 0.81x/0.8x
EV/Ebitda 55 61 Ave multiple 8.5x/8.2x
DCF 67 67 8.2% WACC / 2% TG
Average 60 61 Ave 60.54
EV/Ebitda Multiple EV/Sales Multiple Ave value
Airbus 30,657 8.9 31,467 0.79 31,062
Helicopter 5,148 8.3 7,208 1.10 6,178
Defence & Space 10,587 7.6 9,988 0.75 10,287
Other 116 7.0 -1,215 0.90 -550
Total 46,507 8.5 47,448 0.81 46,977
Net cash/(debt) 7,867
Pension (IAS19) -5,785
Other EV adjs -5,514
Equity value 43,546
Shares o/s (m) 778
Price per share 56.0
Airbus 33,285 8.7 32,035 0.78 32,660
Helicopter 5,659 8.0 7,155 1.04 6,407
Defence & Space 11,222 7.2 9,730 0.73 10,476
Other 339 7.0 -1,190 0.85 -425
Total 50,505 8.2 47,730 0.80 49,117
Other EV adjs -5,514
Equity value 45,686
Shares o/s (m) 778
Airbus Group NV
Aerospace & Defence
47

P/E versus Boeing
Airbus and Boeing12-month forward P/E since
Airbus Group (formerly EADS) flotation
Airbus P/E relative to Boeing

Source: Datastream
DCF
The table below summarises our DCF model which generates a valuation of 67.
Airbuss WACC calculation is distorted by the 6bn of net cash and further
complicated by other potential debt adjustments such as the 26bn of customer
advances and 5.7bn of refundable government advances. For simplicity, we apply
a 8.5% WACC which is 70bp higher than the cost of equity and slightly ahead of
the average of our peer group. In terms of sensitivity, a 100bp increase in WACC at
the current levels would change the valuation by +/- 9%.
DCF summary table (m)


DCF sensitivity WACC and margin DCF sensitivity WACC and terminal growth


0.0
5.0
10.0
15.0
20.0
25.0
30.0
J
u
l
-
0
0
J
u
l
-
0
1
J
u
l
-
0
2
J
u
l
-
0
3
J
u
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-
0
4
J
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6
J
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7
J
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8
J
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0
9
J
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1
0
J
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3
Airbus Boeing
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
J
u
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-
0
0
J
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1
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6
J
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7
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J
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J
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-
1
3
Risk Free rate 4.0% PV of disc flows (10yrs) 19,899
Equity risk premium 4.5% PV of terminal flows 34,464
Beta (x) 0.83 Net (debt) / cash 8,454
WACC 8.2% Pension & adj -10,736
Terminal growth 2.0% Total equity value 52,081
Terminal EBIT margin 10.1% NOSH (m) 778
Share value () 67
67 8.1% 9.1% 10.1% 11.1% 12.1%
7.2% 82 82 83 83 84
7.7% 74 74 75 75 75
8.2% 67 67 67 68 68
8.7% 61 61 61 62 62
9.2% 55 56 56 57 57
EBIT margin
W
A
C
C
67 0.0% 1.0% 2.0% 3.0% 4.0%
7.2% 65 73 82 97 121
7.7% 60 66 74 85 103
8.2% 55 60 67 76 89
8.7% 51 56 61 68 79
9.2% 48 51 56 62 70
Terminal growth
W
A
C
C
Airbus Group NV
Aerospace & Defence
48

Key investment point one: multi-year improving
margins; double-digit upside at upper target range

A number of factors are combining to drive multi-year margin
progression, in particular strong momentum in Airbus Commercial and
programme risk reduction, as well as cost reduction and operating
improvement across the group.

On this basis, Airbus is the second-highest earnings growth company in
our coverage. We forecast a four-year clean EPS CAGR of 30%. The
quality of profits is improving as legacy issues fade.

At the Q1 results, management confirmed the 2015 target margin of 7-8%
despite growing A350 losses. Our (and consensus) estimates are pitched
at the lower end of guidance reflecting the still significant business
challenges ahead, including A350 ramp-up, production transition to the
A320NEO and the restructuring of the D&S division.

However, we sense a growing confidence that risks can be managed.
Delivery to the upper end of the target range implies 15% upside to our
estimates.
Group EBIT (m)and margin (%) profile

Source: Berenberg estimates/Airbus
Profit forecasts and upside potential
We assume 400m of A350 cost overruns: After years of adjusting for one-off
items, including large programme charges, we believe the market is now assessing
group profitability (and hence valuation) on the basis of managements newly
defined all-in margin, ie after one-off charges and after absorbing A350 launch
losses. Our all-in forecasts include an assumption of 400m additional cost
escalation on A350, incurred evenly in 2014 and 2015. This has not been guided by
management but is merely an attempt to reflect risks relating to the launch and
industrial ramp-up of production of the A350.
Target margin implies up to 15% upside to our forecast: On this basis, we
estimate clean group margins, including dilution of costs associated with the A350
launch, of 6.7% in 2015 (or 7.0% excluding our assumed additional 400m cost
overruns on A350), which is at the lower end of managements 7-8% target. An
0%
2%
4%
6%
8%
10%
0
1,000
2,000
3,000
4,000
5,000
6,000
2012 2013 2014E 2015 2016 2017
Airbus Helicopter D&S
'Clean' EBIT margin Margin pre one-off
Airbus Group NV
Aerospace & Defence
49

outturn in the mid- to upper-end of the target range implies 4% to 15% upside to
our group EBIT forecast.
Management has also outlined a margin target before A350 losses of 10% by 2015
(ie before the expected costs associated with industrial ramp-up preparation, non-
series production cost and learning curve and pricing dilution effects). This is the
first time we have been able to scale the impact on the business of launching a
major new aircraft programme. The margin differential of pre- and post-A350
launch effects implies net losses of 1.5bn to 1.9bn pa by 2015. If nothing else,
we can infer from this that the mature series programmes, the A320 and A330, are
highly profitable.
Profit quality improving: Airbuss profit performance has been blighted for many
years by poorly performing legacy programmes (eg A380, A400M), and also by
one-off items that are non-recurring in nature but unfortunately seem to appear
every year. Since 2010, broad-based one-off charges have totalled almost 2bn and
have included 558m of A350 cost overruns, 336m of costs to solve the A380
wing-rib problem, 545m of D&S restructuring provisions and 335m Helicopter
programme losses. Given the level of restructuring and provisioning already
charged, management is confident that no further material one-off charges will be
incurred over the coming period (other than FX-related pre-delivery payment
(PDP) USD mismatch adjustments that are not in the groups control and can be
positive or negative). However, as previously mentioned we factor an additional
400m provision for unplanned cost escalation on A350.
Airbus divisional margin recovery
Airbus Commercial EBIT margin profile

Source: Berenberg estimate, Airbus
Note: Pre 2012, the data includes Airbus military aircraft division
Accounting for 61% of our 2014 group EBIT forecast, Airbus Commercial is key
to the group margin recovery story. Operating returns are still depressed by legacy
programme issues but the impacts are fading. The positive margin trajectory is
being driven by the following.

Volume: Production increases in all programmes. 2014 represents a pause in
aircraft volume growth but we see a modest rise in 2015 driven by initial
deliveries of A350, followed by another step-up in 2016 and 2017 as A320
production moves to rate 46 (per month), up 9.5% from the current rate 42.
-1%
1%
3%
5%
7%
9%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Operating margin Operating margin (pre one-time)
Airbus Group NV
Aerospace & Defence
50

Mix and price: Both are currently positive and contributing to profit drop-
through. Mix, price and volume effects are more difficult to predict as the new
A350 programmes ramp up and the A320 rapidly transitions to the NEO, but
we attempt to model launch impacts as described previously. Although Airbus
has not specifically stated as such, we also model modestly deteriorating pricing
on A320CEO through the ramp-down and transition to the A320NEO.

A350 continuing support (CS) costs relates to manufacturing support costs
not allocated to specific production aircraft (non-series costs). In the EBIT
bridge below, we have broken out A350 CS cost estimates given their
materiality to underlying profit in early-stage production. We estimate
incremental total CS cost of c300m in 2013, rising to c500m in 2014 and
600m in 2015.

Risk retirement on legacy/problem programmes, in particular the A400M and
A380, where the production costs are continuing to decline rapidly.
Management remains optimistic that the A380 programme will reach break-
even profitability by 2015, removing a very significant profit drag on the P&L
we estimate c300m in 2014.
EBIT (before one-off) bridge (m)


FX hedging will become a headwind if current rates persist: On the
negative side, FX tailwinds driven by favourable hedging rates will turn to
modest P&L headwinds (less than 100m) from 2016 based on current
hedgebook cover and the spot rates as shown in the charts below.

2,213
267
300
(500)
100
2,381
610
350
(600)
0
2,741
0
1,000
2,000
3,000
4,000
Airbus Group NV
Aerospace & Defence
51

Hedgebook cover (bn) Estimated FX headwind/tailwind (m)

Source: Berenberg estimates, Company data

0%
20%
40%
60%
80%
100%
120%
0
5
10
15
20
25
30
2013 2014 2015 2016 2017 2018
Hedgebook Exposure Cover
1.32
1.34
1.36
1.38
1.40
-80
-60
-40
-20
0
2014F 2015F 2016F 2017F 2018F
head-/tailwind F'cast hedge rate (rhs)
Airbus Group NV
Aerospace & Defence
52

Investment point two: look beyond the book-to-bill

In our view, lower aircraft order activity should not be a key area of
concern because it will not materially effect production. However, it
could weigh on investor sentiment because historically volume
reductions have followed a decline in the book-to-bill ratio.

Airbuss book-to-bill ratio has averaged 1.9x over the past 10 years,
building a backlog of around 5,500 aircraft. This is more than 3.5x the
previous peak in 2000 and equivalent to 8.8 years of current production.

Despite the Emirates order cancellation, Airbuss backlog profile is
robust and we view the 50%+ order exposure to non-European, non-US
airline customers as a structural advantage over the longer term given
superior growth potential in these regions. We do not believe the
Emirates decision to cancel 70 A350 XWBs represents a genuine
decision to give up capacity. The new aircraft market remains buoyant.

By aircraft type, the A330 poses a modest risk in the short term given that
the backlog of 260 aircraft implies only 2.5 years cover. A lack of orders
would probably necessitate a production ramp-down of the type over the
next few years. A decision whether to pursue a re-engine strategy
(A330NEO) is expected by the end of the year.

In summary, we believe risk to production rates over the next three to
five years is low.
Do not get hung up on slowing orders
With growth slowing in emerging market economies and Airbus reporting 164
cancellations ytd (including 70 A350 XWBs by Emirates last week), investors have
voiced concerns about the robustness of Airbuss backlog and the prospect of
lower order activity signalling the end of the cycle. This perception of risk is
significant because of the historical relationship between the book-to-bill ratio in
units (ie the ratio of aircraft ordered to aircraft delivered) and share price
performance. We consider this further in our industry report but for reference, in
each of the four previous production cycles in the modern jet era (to 2004), a
sustained book-to-bill of less than one has been followed one to two years later by
a cut to production.
Industry order cycle (aircraft pa) Industry delivery cycle (aircraft pa)

Source: Berenberg estimates, Airbus, Boeing Source: Berenberg estimates, Airbus, Boeing

0
500
1,000
1,500
2,000
2,500
3,000
0
500
1,000
1,500
2,000
2,500
3,000
Extended Delivery Cycle
Airbus Group NV
Aerospace & Defence
53

A key difference of the current cycle is the extended duration of positive order
activity; 10 years (albeit with a pause during the financial crisis) compared to four to
six in previous cycles. This in turn has resulted in the extended delivery cycle we
are experiencing today; so far 15 years compared to four to seven in previous
cycles. Demand for new aircraft is being driven by multiple structural factors such
as replacement, emerging market growth and fuel efficiency/emissions
requirements.
Airbuss book-to-bill ratio is reflected in the backlog evolution compared
to annual deliveries

Reduced cyclicality in production
One of the more interesting observations of the current cycle is that production
rates were held/increased through the 2008/2009 downturn despite a softening of
the order cycle. For the first time, the relationship of the book-to-bill ratio to
future production did not hold, primarily because of strong underlying demand and
the unprecedented scale of manufacturers backlogs. Areas of customer weakness
(deferrals and cancellations) were compensated by demand flexibility elsewhere in
the backlog with, for example, airlines bringing forward delivery of fleet
replacement orders. In summary, there is much reduced cyclicality in production.
Airbus has significant visibility from the backlog of 5,521, which is c3.5x larger
than the previous peak in 2000.
Airbus quarterly book-to-bill ratio Airbus backlog profile by region

Source: Berenberg estimates, company data Source: Airbus
0
1
2
3
4
5
6
2
0
0
0
2
0
0
1
2
0
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2
2
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3
2
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0
4
2
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2
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6
2
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9
2
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1
0
2
0
1
1
2
0
1
2
2
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1
3
2
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1
4
8 yrs of significant backlog expansion
0
2
4
6
8
10
0
1000
2000
3000
4000
5000
6000
2
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9
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1
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2
0
1
1
2
0
1
2
2
0
1
3
Backlog Deliveries Yrs cover (rhs)
0.0
1.0
2.0
3.0
4.0
5.0
Q1
10
Q2
10
Q3
10
Q4
10
Q1
11
Q2
11
Q3
11
Q4
11
Q1
12
Q2
12
Q3
12
Q4
12
Q1
13
Q2
13
Q3
13
Q4
13
Q1
14
13%
19%
33%
8%
7%
1%
18%
Nth Am Europe A. Pac M. East
Lat Am Africa Lessors
Airbus Group NV
Aerospace & Defence
54

Emirates A350 XWB cancellation a setback, but we do not believe it
indicates an inflection point in the cycle
Emirates is a major global airline and hence its decision to cancel such a large order
with Airbus (c2.5% of the division backlog) is a major setback. In terms of the
cycle, we do not believe this represents a decision by Emirates to give up capacity
based on, for example, a less favourable view of the long-term demand
environment. Hence, we do not subscribe to the view the cancellation marks a
cycle turning point and view this as a far more complex Emirates-specific fleet
decision, the outcome of which will become apparent some unspecified time in the
future. Airbus has since reported that the new aircraft market remains buoyant and
confirmed its expectation for new orders in 2014 to exceed deliveries (ie another
year of backlog growth).
The A330 is at modest risk of a production cut
A330 order activity has slowed over the last 18 months and with annual production
at just over 100 aircraft, the backlog reduced to 260 aircraft at the end of Q1.
Without new orders we suggest a rate cut will occur probably within the next year.
The A330 is a mature and therefore profitable programme, we estimate
contributing around 11.5bn of revenue (c19% of group). In our forecasts, we
assume a slow fade in A330 production from 2015.
Airbus is considering whether to pursue a re-engine strategy as a potential strategy
to extend the life of the A330 platform. A decision will ultimately hinge on the
availability of engine options, but if pursued, it will trigger an increase in R&D,
albeit much less than for development of an all-new aircraft, we suggest c20% less
or around c2bn total investment. Management has said it expects to reach a
decision on A330NEO by the end of 2014.

Airbus Group NV
Aerospace & Defence
55

Investment point three: cash headwinds for two more
years

Current weak cash performance is a result of heavy investments ahead of
growth and planned ramp-ups in the A350 and A320NEO programmes.

Historically, Airbus has been highly cash-generative, averaging 63% free
cash conversion over the five years to 2012.

However, we anticipate low free cash flows to persist through to 2015, to
a trough net cash position of c7bn, and to strengthen thereafter.
Cash profile to improve from 2016
At the end of 2013, management guided to a lower cash profile over the next few
year due to higher working capital and investments in growth. We estimate the
group will be broadly free-cash-neutral in 2014 and 2015 with increasing stock
build ahead of the A350 production ramp-up and lower military prepayments,
partly offset by reducing R&D and capex. After dividends, we estimate net cash
outflows will total around 1bn pa in both years. Thereafter, we anticipate a
strongly improving cash flow profile and forecast 9.3bn net cash by 2017.
FCF profile (m): free cash neutral for two more
years then followed by marked improvement
Investment profile (m): capex and R&D
stabilising but WC requirements increasing

Dividend growth to continue strongly
Airbus has a clearly defined dividend policy, distributing 30-40% of reported EBIT.
Shareholders can therefore expect strong dividend growth in line with our forecasts
(a 21% CAGR to 2017), irrespective of the weak free cash profile outlined above,
given the groups strong balance sheet ie 9bn net cash as at December 2013.

-3%
0%
3%
6%
9%
12%
-1,000
0
1,000
2,000
3,000
FCF FCF yield
-10,000
-8,000
-6,000
-4,000
-2,000
0
2,000
4,000
Capex R&D WC
Airbus Group NV
Aerospace & Defence
56

Dividend profile ( per share) 21% CAGR to 2017

Source: Berenberg estimates, Airbus Group

0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2010 2011 2012 2013 2014E 2015E 2016E 2017E
Airbus Group NV
Aerospace & Defence
57

Investment point four: Airbus D&S restructuring a
commitment to 8% RoS

A major restructuring of the groups underperforming D&S businesses is
underway, incorporating the merger of Astrium (space), Cassidian
(defence) and Airbus Military (aircraft).

It is still the early stages of a complicated plan, the benefits of which
have not been quantified other than a commitment to a previous margin
objective of 8% by 2015 and steady progress to 10% thereafter. This will
be achieved through operational efficiencies, reduced loss-making
activities and business improvement.

We err on the side of caution and factor a slower improvement in
profitability than the 8% 2015 target margin suggests. If achieved, the
target implies c2% upside to our group 2015 EBIT forecast.
D&S businesses have consistently underperformed
In 2013, combined ADS revenues and underlying EBIT were 14.4bn (25% of
group) and 942m (26% of group and a 6.5% margin) respectively. The individual
businesses have consistently underperformed with average margins over the past
three years as follows:
o Airbus Military 4.0% weighed by the A400;
o Cassidian 6.2% weighed by loss-making contracts and restructuring
charges;
o Astrium 5.6% due to weak services activity and increased competition.
Since 2010, we estimate restructuring charges in the ADS segment accounted for
440m out of a total 565m of one-off charges, including 292m for the current
programme.
ADS financial profile (m)

D&S target margin implies 2.5% upside
A provision of 242m was taken in 2013 for restructuring the groups D&S
businesses. Financial details are limited but the proposed restructuring is significant
0%
2%
4%
6%
8%
10%
0
4,000
8,000
12,000
16,000
20,000
2012 2013 2014 2015 2016 2017
Revenue Margin margin pre one-off
Airbus Group NV
Aerospace & Defence
58

incorporating a gross c12% reduction in headcount (c5,300 employees) and major
site consolidations across the businesses. Apart from this, management has not yet
quantified mid- or long-term benefits other than re-iterating a previous
commitment to achieving an 8% EBIT margin by 2015 with steady progress to
10% thereafter. Operational improvement initiatives are being targeted in areas
such as optimising engineering, manufacturing, supply chain, sales and industrial
footprint. Given the divisions consistent poor financial track record and our view
that soft end-market conditions will persist, we (and we believe consensus) factor a
margin lower than the aspiration, at least until we see tangible evidence of progress
on the plan and there is better visibility on the top-line outlook. The 8% margin
target in 2015 implies c70m of EBIT upside to our forecast based on a margin of
7.5%, equivalent to 1.7% at the group level.
The new D&S business lines
D&S business lines

ADS is structured into four business lines.
Military Aircraft (estimate: 41% of D&S sales) transport, mission and
combat aircraft
The near- and mid-term outlook is relatively positive with good visibility on a
number of in-production programmes including: 1) MRTT A330 tanker aircraft
multiple international orders in the backlog; 2) A400M production ramp-up is
underway although legacy provisions mean that in profit terms it will not
meaningfully contribute to returns); 3) Eurofighter steady and profitable
production is secure based on domestic, Saudi and Omani orders. Our concern
longer-term is the lack of international orders required to extend Eurofighter
production to beyond 2018. If a Saudi follow-on order for 48-72 aircraft fails to
materialise, then we suspect restructuring and wind-down actions will need to be
taken from 2016/17.
Space Systems (estimate: 29% of D&S sales) satellites, launchers,
missiles
Airbus Space Systems is the number two space company in the world with leading
positions in commercial space launchers and satellites (number one in
Europe/number two globally). This continues to be a highly competitive area but
41%
29%
20%
10%
Military Aircraft Space Systems CIS Electronics
Airbus Group NV
Aerospace & Defence
59

integration of the launch and satellite activities is expected to achieve improved
efficiencies and cost reduction. A pick-up in orders in 2013 gives some comfort
about the nearer-term outlook.
Communications, Intelligence & Security (CIS) (estimate: 20% of
D&S sales)
Airbus has a strong position in satellite communications, borders security systems
and public mobile radios. The objective of the restructuring is to combine
communication and services activities to offer higher value-add solutions including
long-term service contracts. Frankly, we have little feel for the prospects and
longer-term outlook for these business, although we note loss-making security
contracts that have adversely affected financial performance should wind down
over the next 12-18 months, removing a drag on profits. Management has hinted
that business disposals are possible in CIS as part of portfolio optimisation.
Electronic (estimate: 10% of D&S sales)
This includes C4 defence (command, control, communications and computers)
with defence electronics capabilities that are described by management as
enablers to the other sub-sectors.

Airbus Group NV
Aerospace & Defence
60

Divisional forecasts and EPS

Airbus segment revenues, profit and margin profile (m)


2012 2013 2014e 2015e 2016e 2017e
Revenue
Airbus 39,273 39,494 39,806 41,229 44,943 50,169
Helicopter 6,264 6,297 6,543 6,870 7,057 7,191
Defence & Space 13,520 13,121 13,250 13,300 13,450 13,200
HQ Consolidated -614 -1,345 -1,350 -1,400 -1,230 -1,230
Group 58,443 57,567 58,249 59,998 64,220 69,330
Revenue growth
Airbus 18.6% 0.6% 0.8% 3.6% 9.0% 11.6%
Helicopter 15.7% 0.5% 3.9% 5.0% 2.7% 1.9%
Defence & Space n/a -3.0% 1.0% 0.4% 1.1% -1.9%
Group 19.0% -1.5% 1.2% 3.0% 7.0% 8.0%
EBITA
Airbus 1,564 2,213 2,381 2,741 3,267 3,739
Helicopter 409 397 393 467 550 611
Defence & Space 825 911 888 1,024 1,063 1,056
OB and eliminations 166 48 11 32 36 39
EBITA (pre one-offs) 2,964 3,569 3,671 4,264 4,916 5,445
EBITA (reported) 2,144 2,656 3,490 4,064 4,916 5,445
Margin (%)
Airbus 3.0% 5.6% 6.0% 6.6% 7.3% 7.5%
Helicopter 6.5% 6.3% 6.0% 6.8% 7.8% 8.5%
Defence & Space 6.1% 6.9% 6.7% 7.7% 7.9% 8.0%
Margin (pre one-off) 5.1% 6.2% 6.3% 7.1% 7.7% 7.9%
Margin (reported) 3.7% 4.6% 6.0% 6.8% 7.7% 7.9%
EPS (EUR)
EPS basic 1.46 1.84 2.73 3.28 4.08 4.58
EPS reported 1.51 1.90 2.80 3.35 4.14 4.64
EPS pre one-time items 2.20 2.81 2.97 3.59 4.13 4.62
Airbus Group NV
Aerospace & Defence
61
Financials

Profit and loss account
Year-end December (EUR m) 2012 2013 2014E 2015E 2016E

Sales 58,443 57,567 58,249 59,998 64,220

Cost of sales -50,545 -49,240 -49,369 -50,561 -53,549
Gross profit 7,898 8,327 8,880 9,437 10,671
Sales and marketing -3,098 -3,176 -3,214 -3,310 -3,543
General and administration 0 0 0 0 0
Research and development -3,142 -3,160 -2,854 -2,760 -2,954
Other operating income 184 236 239 246 263
Operating costs 0 0 0 0 0
Investment income 0 29 29 30 32
Share of JV's and associates 247 346 350 361 386
EBIT 2,089 2,602 3,430 4,004 4,856

EBITDA (pre one-time items) 5,017 5,537 5,671 6,355 7,098
Depreciation -1,621 -1,600 -2,000 -2,091 -2,182
Amortisation of intangible assets -432 -368 0 0 0
EBIT (adj) 2,144 2,656 3,490 4,064 4,916
Unusual or infrequent items -875 -967 -241 -260 -60
Amortisation of goodwill - - - - -
EBIT 2,089 2,602 3,430 4,004 4,856

Interest income 237 168 160 160 160
Interest expenses -522 -497 -530 -500 -490
Other financial result -168 -301 -130 -150 -150
Net financial result -453 -630 -500 -490 -480
EBT 1,636 1,972 2,930 3,514 4,376
EBT (adj) 1,691 2,026 2,990 3,574 4,436

Income tax expense -438 -502 -816 -965 -1,198
Other taxes -253 -326 -26 -18 -18
Group tax (underlying) -691 -828 -807 -965 -1,198
Tax rate 27% 25% 28% 27% 27%
Tax rate (normalised) 28% 27% 27% 27% 27%
Profit after tax 1,198 1,470 2,115 2,549 3,178
Profit after tax (adj) 1,241 1,512 2,183 2,609 3,238
Minority interest 1 10 -6 -5 -5

Net income 1,197 1,460 2,121 2,554 3,183
Net income (adj) 1,240 1,502 2,177 2,604 3,233

Average number of shares (m) 819 792 778 778 780
Average number of shares (FD) (m) 820 793 778 779 781

EPS (reported) (p) 1.5 1.8 2.7 3.3 4.1
EPS (adjusted) (p) 1.5 1.9 2.8 3.3 4.1

Source: Company data, Berenberg estimates

Airbus Group NV
Aerospace & Defence
62
Balance sheet

Intangible assets 13,422 12,500 12,524 12,524 12,524
Property, plant and equipment 15,196 15,654 16,031 16,240 16,458
Financial assets 13,637 13,639 14,284 14,595 14,931
Fixed Assets 42,255 41,793 42,839 43,359 43,913

Inventories 23,216 24,023 26,323 28,723 30,473
Accounts receivable 6,790 6,628 6,628 6,628 6,628
Accounts receivable and other assets 6,567 6,896 6,896 6,896 6,896
Cash and cash equivalents 8,756 7,201 6,614 6,055 6,687
Deferred taxes 4,518 3,733 3,733 3,733 3,733
Current assets 49,847 48,481 50,194 52,035 54,417
TOTAL ASSETS 92,102 90,274 93,033 95,394 98,329

Shareholders' equity 10,409 10,864 12,517 14,340 16,642
Minority interest 25 42 36 31 26
Long-term debt 3,506 3,804 3,804 3,804 3,804
Pensions provisions 6,158 5,935 5,785 5,785 5,785
Government refundable advances 5,754 5,754 5,754 5,754 5,754
Customer advances 9,881 10,054 10,054 10,054 10,054
Other provisions and accrued liabilities 6,228 6,016 6,016 6,016 6,016
Non-current liabilities 31,527 31,563 31,413 31,413 31,413

Bank loans and other borrowings 1,841 1,826 1,826 1,826 1,826
Accounts payable 9,917 9,668 9,668 9,668 9,668
Customer advance payments 25,333 26,169 26,169 26,169 26,169
Other liabilities 11,557 8,688 9,535 10,078 10,716
Deferred taxes 1,504 1,454 1,454 1,454 1,454
Current liabilities 50,152 47,805 48,652 49,195 49,833

TOTAL LIABILITIES 92,113 90,274 92,618 94,979 97,914


Airbus Group NV
Aerospace & Defence
63
Cash flow statement
EUR m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 4,197 4,624 5,490 6,155 7,098

Other costs affecting income / expenses 575 567 -210 -421 -446
(Increase)/decrease in working capital -76 -2,164 -2,300 -2,400 -1,750
Cash flow from operating activities 4,696 3,027 2,980 3,334 4,902
Interest paid -690 -630 -530 -500 -490
Cash tax -376 -471 -449 -572 -710
Net cash from operating activities 3,630 1,926 2,002 2,262 3,702

Dividend from equity accounted investments 46 52 50 50 50
Interest received 237 0 160 160 160
Capex -3,270 -2,949 -2,400 -2,300 -2,400
Intangibles expenditure - - - - -
Income from asset disposals 73 60 23 0 0
Payments for acquisitions -201 -16 -24 0 0
Financial investments -96 -135 -345 0 0
Cash flow from investing activities -3,211 -2,988 -2,536 -2,090 -2,190

Free cash flow (memo) 716 -911 -165 172 1,512

Dividends paid -379 -469 -594 -731 -881
Net proceeds from shares issued 139 -1,744 127 0 0
Others -595 5 392 0 0
Effects of exchange rate changes on cash 459 0 23 0 0

Net cash flow 43 -3,270 -587 -559 631

Reported net debt 11,724 8,454 7,867 7,308 7,940


Airbus Group NV
Aerospace & Defence
64
Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 0.4x 0.8x 0.8x 0.8x 0.7x
EV/EBITDA (adj) 4.9x 8.3x 8.0x 7.3x 6.4x
EV/EBIT (adj) 11.4x 17.3x 13.1x 11.4x 9.3x
P/E (adj) 19.5x 28.4x 19.3x 16.1x 13.0x
P/FCFPS 33.8x -46.9x -253.5x 243.6x 27.8x
Free cash flow yield 3.0% -2.1% -0.4% 0.4% 3.6%
Dividend yield 2.0% 1.4% 1.7% 2.1% 2.6%

Growth rates
Sales 19% -1% 1% 3% 7%
Sales organic 17% -1% 1% 3% 7%
EBIT (adj) 65% 20% 3% 16% 15%
EPS (adj) 58% 28% 5% 21% 15%
EPS 15% 26% 48% 20% 24%
DPS 33% 25% 25% 20% 24%

Financial ratios
Dividend payout ratio 41% 35% 34% 34% 34%
Operating cash conversion 180% 73% 62% 60% 79%
FCF conversion 19% -47% -8% 7% 39%
Net interest cover 4.7 4.2 9.4 12.0 14.9
Net gearing 909% -345% -168% -103% -91%
Net debt/EBITDA -2.8 -1.8 -1.4 -1.2 -1.1
ROCE 7% 10% 12% 14% 15%
ROIC 2% 2% 3% 4% 4%
WACC -56% 21% 13% 11% 11%
FCF ROCE 7% -8% -1% 1% 9%
Working capital/sales 24% 27% 31% 34% 34%
Net R and D/sales (inc. capatalised costs) 5.4% 5.5% 4.9% 4.6% 4.6%
Gross R and D (inc. customer funded) 5.9% 5.8% 5.0% 4.5% 4.5%
Intangibles investment/sales 0.8% 0.6% 0.5% 0.3% 0.3%

Key financials

Income Statement (GBP m)
Sales 58,443 57,567 58,249 59,998 64,220
EBIT margin (adj) (%) 5.1% 6.2% 6.3% 7.1% 7.7%
EBIT (adj) 2,144 2,656 3,490 4,064 4,916
EPS (adj) (p) 1.5 1.9 2.8 3.3 4.1
DPS (p) 0.6 0.8 0.9 1.1 1.4

Cash Flow Statement (GBP m)
Free cash flow 716 -911 -165 172 1,512
Acquisitions and disposals - - - - -
Net cash flow 43 -3,270 -587 -559 631

Balance sheet (GBP m)
Other fixed assets 42,255 41,793 42,839 43,359 43,913
Total working capital 20,089 20,983 23,283 25,683 27,433
Gross debt 5,347 5,630 5,630 5,630 5,630
Pensions and similar obligations 6,158 5,935 5,785 5,785 5,785

BAE Systems plc
Aerospace & Defence
65

Stabilising outlook

We initiate coverage on BAE Systems with a Hold recommendation
and a 445p price target. The stock remains good value on a relative
basis with yield and buyback support. Downside risk to earnings is
abating with improved US budget visibility, but low growth and the
lack of near-term catalysts balances the risk/reward in our view.

Five-year downgrade cycle coming to an end: BAE has suffered a
protracted downgrade cycle primarily due to weakness in its budget-
constrained US businesses. This has translated into stagnant EPS
growth since 2009. Improving budget visibility in the US, finalisation
of Saudi contract terms and agreement on the UK naval programme
point to a more stable outlook, both in the near and longer term.

Growth opportunities are limited: BAE ranks as the lowest earnings
growth company in our coverage, despite a 1bn share buyback
(three-year CAGR: 0.5%). With few major contract opportunities in
prospect and budget constraints likely to endure, we see limited upside
to this scenario. Higher-growth commercial activities represent 5% of
the group, too small to do more than offset defence headwinds.

Cash returner: BAE is cash-generative, pays a progressive dividend
(currently yielding 4.8%) and by 2015 will have repurchased 2bn of
stock since 2010. Longer-term, we anticipate additional buybacks of
between 200m and 500m pa depending on programme phasing.

Q1 update/2014 forecasts: The Q1 update confirmed expectations
for the current year. Consensus forecasts are broadly unchanged.

Valuation/view: The shares have regained the majority of losses after
the February warning (down 2.1% ytd, slightly underperforming the
sector). BAE valuation metrics screen favourably; a 10.5x FY15 P/E
is a 24% discount to European peers and a c18% discount to the US
defence majors. The EV/EBITDA discount is lower (c1%) due to
BAEs large pension deficit. On balance, we think BAEs relatively
muted growth outlook is more than priced in when considering the
low risk profile and yield support, although we do not see sufficient
upside to rate a Buy. We would be very happy to hold for yield.

Hold (Initiation)
Current price
GBp 426
Price target
GBp 445
Market cap GBP 13,267 m
Reuters BAES.L
Bloomberg BA/ LN
Share data

Shares outstanding (m) 3,083
Enterprise value (GBP m) 18,447
Performance data

High 52 weeks (GBp) 468
Low 52 weeks (GBp) 376
Relative performance to SXXP FTSE 100
1 month 1.9 % 4.1 %
3 months -1.1 % 2.4 %
12 months -14.0 % 0.3 %
Key data

Net gearing 34.1%
CAGR sales 2013-2016 -1.6%
CAGR EPS 2013-2016 0.5%

BAE Systems develops, delivers and
supports advanced defence and
aerospace systems. The group is a
primary contractor for military aircraft,
surface ships, submarines, radar, avionics
and guided weapon systems.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 17,834 18,180 17,259 17,183 17,337
EBITDA (adj) 2,252 2,246 2,108 2,120 2,159
EBIT (adj) 1,895 1,925 1,768 1,790 1,819
Net income (adj) 1,268 1,359 1,238 1,254 1,280
Net income 1,068 174 892 910 936
Net debt / (net cash) -387 699 1,707 1,953 1,731
EPS 32.9 5.4 28.6 29.8 31.1
EPS (adj) 38.5 41.8 39.5 41.0 42.4
FCFPS 61.7 -5.6 1.4 25.1 29.7
CPS 40.9 -31.5 -32.3 -8.1 7.4
DPS 19.5 20.1 20.6 21.4 21.8
EBIT margin (adj) 10.6% 10.6% 10.2% 10.4% 10.5%
Dividend yield 5.8% 4.7% 4.8% 5.0% 5.1%
ROCE 24.7% 23.0% 18.7% 18.3% 18.3%
EV/sales 0.9 1.1 1.2 1.2 1.1
EV/EBITDA 6.8 8.1 8.8 8.5 8.1
EV/EBIT 8.1 9.4 10.4 10.1 9.7
P/E 10.2 80.6 15.1 14.4 13.9
P/E (adj) 8.8 10.4 10.9 10.5 10.2

BAE Systems plc
Aerospace & Defence
66
BAE Systems investment thesis in pictures
The most global defence prime contractor; key
exposure to Middle East insulates downturn
Poor organic growth profile due to downturn in
core US and UK defence markets

Source: Berenberg estimates Source: Berenberg estimates, Company data

Margins maintained despite revenue declines;
growth prospects remain elusive
A cash returner; 2bn buyback over six years

Source: Berenberg estimates, Company data Source: Berenberg estimates, Company data

A protracted downgrade cycle; line convergence
highlights low-growth outlook
Reduced fears on budget impact have driven re-
rating to two turns above the five-year average
P/E


UK
21%
Europe
14%
M.East
14%
N. Am
42%
Asia Pac
8%
RoW
1%
-15%
-10%
-5%
0%
5%
10%
15%
20%
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
-2%
0%
2%
4%
6%
8%
10%
12%
0
5,000
10,000
15,000
20,000
25,000
1
9
9
0
1
9
9
3
1
9
9
6
1
9
9
9
2
0
0
2
2
0
0
5
2
0
0
8
2
0
1
1
2
0
1
4
E
2
0
1
7
E
Sales Margin (rhs)
-500
0
500
1,000
1,500
2,000
Dividend Buybacks
Potential buyback Free cash flow
35
40
45
50
55
60
2012 2013 2014 2015 2016
4
6
8
10
12
J
u
n
-
0
9
D
e
c
-
0
9
J
u
n
-
1
0
D
e
c
-
1
0
J
u
n
-
1
1
D
e
c
-
1
1
J
u
n
-
1
2
D
e
c
-
1
2
J
u
n
-
1
3
D
e
c
-
1
3
J
u
n
-
1
4
BAE 12MFD P/E 5Y ave
re-rating
BAE Systems plc
Aerospace & Defence
67
BAE Systems investment thesis
We initiate on BAE Systems with a Hold rating and a price target of 445p. Despite
the re-rating through 2013, the shares relative valuation remains depressed
reflecting a protracted downgrade cycle, largely due to weakness in the groups core
US defence businesses. We believe downside risks are abating with improved
visibility from recent US budget deals and moderating future spending cuts. Near-
term growth opportunities remain limited, however. BAE is financially strong and
we view the principle investment attraction currently as income from dividends.
The dividend is secure and yields a sector-topping 4.8% while the 1bn share
repurchase programme is ongoing. This provides support to a valuation that
screens relatively well despite the recent rally. However, we struggle to identify
near-term catalysts to re-rate the shares further and view the stock as a market
performer.

Risk reduction: 2014 performance continues to be hampered by budget
pressures, although the rate of yoy reduction in US defence spending is
approaching the trough (probably 2015), we believe, even within Budget
Control Act 2011 (BCA) spending caps. In the nearer term, improving budget
visibility from the Bipartisan Budget Act is a clear positive for BAE (36% sales
exposure), and with a stable outlook in the groups UK/major programme
activity and positive momentum in Saudi activities, we believe downside risks to
earnings are abating.

Weak growth outlook, however: Earnings per share have stagnated around
the 40p level since 2009, despite c1.5bn of share buybacks (rising to 2bn by
2015). In forecast terms, BAE ranks lowest in earnings growth terms within our
group of covered companies; we see limited opportunities/upside scenarios for
this to change at any time soon.

Programmes stable: BAEs major equipment programmes are stable. The lack
of success in recent Eurofighter export campaigns, notably in the UAE and
India, is disappointing and raises questions about the long-term sustainability of
the programme beyond the existing European, Saudi and Omani contracts
(2017/18). We are relatively sanguine given the potential for a Saudi follow-on
order, continuing sustainment and upgrade activities on the aircraft type and
phasing of the F-35/Jump Strike Fighter (JSF) ramp-up in the latter part of the
decade. On the maritime programmes side, the agreement signed in 2013 with
the UK government on the UKs long-term Naval Programme eases risk
beyond the CVF (aircraft carrier) programme that completes in 2016, although
we still consider this business to be in long-term decline. The outlook for
submarines is positive, with the Astute submarine programme maturing and
workload building on the nuclear Successor programme through the next
decade.

High cash returns: BAE remains an attractive income play with a secure
dividend yielding 4.8% and a 1bn share buyback programme underway. The
combined payout to shareholders in 2013 was 836m, rising to over 1bn in
2014 with higher share repurchases planned. Dividend growth has slowed in
line with earnings but BAE is cash-generative and there is plenty of scope to
flex the payout to less than 2x cover, which we forecast. We also see potential
to extend the share buyback by 200m-500m per annum, depending on major
BAE Systems plc
Aerospace & Defence
68
programme phasing. In the absence of growth opportunities and low relative
valuations, we believe this represents a sensible allocation of capital.

Attractive valuation relative to European and US peers: Initial 2014
guidance given February was an effective c5% cut to consensus earnings
forecasts, prompting a sharp sell-off of the shares. The share price has since
recovered the majority of ground lost and ytd is down 2.1%, underperforming
our aerospace and defence peer group by 1.5%. The stock screens relatively
attractively on a P/E basis at 10.5x (2015), a c3% discount to the long-run
average but a 23% discount to the sector average of 13.7x and defence peer
average of 12.8x (c18%). It is also interesting to note that the P/E discount to
US defence primes (Lockheed Martin, Northrop Grumman and General
Dynamics) has widened over the last 12 months to between 6% and 25%.
Despite BAEs higher relative exposure to the weaker land sector, we note a
30% discount represents the upper range of valuation discount to the US peers
in recent times. The stock screens less favourably on an EV/EBITDA basis
however, after incorporating BAEs pension deficit as debt. At 8.5x, BAE trades
at a 4% premium to the sector FY15 EV/EBITDA of 8.2x.
Share price versus market and sector (re-based) BAE long-term P/E (12-month forward)

Source: Datastream
Note: re-based to BAE Systems share price
Source: Datastream
Forecast momentum
BAE has experience a protracted cycle of EPS downgrades due primarily to
sustained weakness in the groups US defence facing businesses. In particular,
BAEs US land systems activities have suffered materially from reduced spending
in both the core budget and the war-fighting Overseas Contingency Operations
(OCO) budget as the Afghanistan conflict winds down. The latest cut to consensus
estimates was again primarily due to lowered expectations in the US Land Systems
business as well as poorly performing contracts in US military support-related
activities. Including FX impacts, Datastream consensus for 2014 EPS has
decreased ytd by 6.5%, slightly more that the average sector revision of 5.6%.
250
350
450
550
BAE FTSE A-S Pan Euro A&D
0
5
10
15
20
BAE 20Y ave 10Y ave
ave 10.4x
ave 11.8x
BAE Systems plc
Aerospace & Defence
69
Long-term forecast EPS changes (p): protracted
downgrade cycle due to US defence weakness
Short-term EPS changes and price (p): latest
revisions reflect FX effects, the Salam pricing
agreement and further US headwinds

Recent results, outlook and guidance

FY13 results 4% profit miss and FY guidance lowered: Sales, EBITA and
EPS grew by 2%, 3% and 9% yoy respectively, around 4% below Bloomberg
consensus, albeit a consensus confused by the effects of Saudi contract price
negotiations. Growth was a combination of volume reductions in the US
businesses, more than offset by the resumption of Saudi Typhoon aircraft
deliveries and trading (catch-up) of price escalation on the Saudi Salam
programme. EBITA was 4% below consensus, of which we estimate c2.5% was
a genuine miss relating to underperforming contracts in the US Support
Solutions business. EPS was in line due to a lower tax rate. FY14 guidance was
for an underlying decline in EPS of 5-10% at constant currency.

Q114 (May 2014 IMS) Trading for the four months to 6 May was reported as
consistent with expectations outlined in February, albeit accompanied by a
health warning about currency headwinds (in common with many companies in
the sector). Full-year guidance as outlined above was maintained. An update on
the 1bn/three-year share repurchase said the group had bought back 104m
shares to date for 430m, with 217m acquired in 2014.

2014 forecasts: We forecast EBITA of 1.58bn for 2014, a 9% decline yoy,
reflecting non-recurrence of the Saudi Salam contract catch-up effects and
cautious growth assumptions for the US businesses. Our underlying EPS
forecast of 39.5p is a 6.5% decline yoy, although if the pre-2012 price escalation
effects are stripped out of the 2013 result (around 4p of earnings), we estimate
underlying business performance will have contributed c4% of growth (see
chart below).
35
40
45
50
55
60
2012 2013 2014 2015 2016
38
39
40
41
42
43
350
375
400
425
450
475
BAE Systems plc
Aerospace & Defence
70
2014 EPS reconciliation (p)


2015 and beyond: We forecast another flat revenue year but a slight
improvement in margins as US businesses stabilise. Including the effects of the
share buyback (that will complete in the year), we forecast 2015 EPS growth of
3.9% to 41.0p. At this stage, we anticipate a similar pattern of low/modest
earnings growth in the outer years.

41.8
(4.0)
37.8
0.3
0.7
(1.0) 1.7
39.5
30
32
34
36
38
40
42
44
BAE Systems plc
Aerospace & Defence
71

Pension deficit: BAEs IAS 19 accounting deficit is 4.5bn (3.5bn pre-tax),
comprising 26bn gross liabilities and 21bn gross assets. The annual service
cost is 250m with a total cash cost of 650m including c400m of deficit
reduction payments. The latest triennial review is underway and is expected to
complete in H2. The actuarial deficit (not disclosed) is likely to have increased,
we believe, but management is confident that deficit reduction payments will
not be required to increase. We can expect an update at the half-year results or
at the Q3 IMS.

Commercial growth insufficient to make a difference: Given that
commercial activities (non-defence/non-government) account for less than 5%
of sales, even strong growth can only modestly affect group performance.
Indeed we estimate strong gains in commercial activities (aerospace and cyber),
which we factor into our forecasts, could easily be wiped out by small negative
moves in the remaining business.

US defence headwinds to persist: We estimate direct sales exposure to US
Department of Defense (DoD) budgets is c36%. The two-year budget
agreement reduces near-term uncertainty, but beyond 2015 we suspect
downward pressure will persist as BCA spending caps come into play and the
prospect of sequestration looms again. However, we understand that BAE, in
common with most other defence companies we cover, is assuming little more
than a flat overall budget scenario over the mid- to long term, in line with a
realistic outcome tied to the BCA.

Contract execution: BAEs programme execution has been strong in recent
years, with risk retirement on major equipment programmes such as the Type-
45 Destroyer and Eurofighter Typhoon contributing significantly to group
profits. However, profitability in 2013 was adversely affected by a $47m charge
against the US Radford munitions supply contract due to lower-than-expected
activity, and also a $30m charge against cost overruns on commercial shipbuild
activity. While these individual issues have been addressed, it serves to highlight
that contract execution risks remain a feature of BAEs business.

Dividend growth slowing: BAEs progressive dividend policy is based around
2x cover and hence payout is naturally tied to earnings, where growth is
slowing. However, given BAEs typically strong balance sheet and cash
generation profile, in times of volatile earnings the company has flexed the
cover ratio in a range of 1.8x (2005) to 2.6x (2008). In 2013, the dividend was
raised by just 3%, equivalent to 2.1x cover. We forecast flat EPS in 2014
implying that cover must fall to around 1.92x to ensure an element of
progression. In summary, we are confident of BAEs ability to fund future
growth in dividends but we suggest it will be at a historically low rate limited, in
line with earnings.
BAE Systems plc
Aerospace & Defence
72

Impairments an ugly feature: An 865m non-cash impairment charge in
2013 was taken against goodwill in the US Land & Armaments (Armor
Holdings) and Intelligence & Security businesses (electronic systems) due to a
weaker long-term view of US defence spending. This follows a 856m write-
down of goodwill in 2010, also against the Land Systems business, Armour
Holdings (592m), and impairment against the US-based Products businesses
(264m). The NBV of goodwill in the balance sheet is 9.4bn (2012: 10.4bn;
2011: 10.7bn). On the positive side, return-on-investment-based calculations
look optically better.

Export contracts: International sales successes would be unlikely to affect
near-term forecasts materially but it would boost sentiment towards the stock
and build confidence in the longer-term outlook. We speculate that the next
tranche of Hawk trainer aircraft for India could be announced in the current
year. While the most material prospect, both financially (in the mid- to longer
term) and for sentiment, is a potential Eurofighter Typhoon follow-on order
from Saudi for 48-72 aircraft, worth c10bn including weapons systems. Our
best guess is that no announcement will be made before the end of the current
year.
BAE Systems plc
Aerospace & Defence
73
Valuation
445p price target
Valuation summary table


We set our price target at 445p based on a blended average of DCF and sum-

Our 445p price target equates to 4% upside to the current price and drives our
neutral recommendation.

The implied target P/E is 11.3x (FY14) falling to 10.9x (FY15) and 10.5x
(FY16), broadly in line with the 10-year average of 10.7x but below the 20-year
average of 11.8x (12-month forward P/E).

The P/E discount to US defence primes has widened over the last 12 months
to between 6% and 25%. In our view, this reflects BAEs higher exposure to
the land sector and negative earnings momentum. 30% represents the upper
range of valuation discount in recent times.
BAE 12-month forward P/E BAE P/E discount to US defence majors has
increased to c30%, the upper end of valuation
differential over the last 10 years

Source: Datastream

DCF 460 460 7.8% WACC / 1% TG
Average 447 445 Ave 445p
0
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BAE 12MFD P/E 20Y ave
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BAE Systems plc
Aerospace & Defence
74
Sum-of-the-parts
calculation.
Sum-of-the-parts table (FY14) m Sum-of-the-parts table (FY15) m


DCF summary table




EV/Ebitda Multiple EV/sales Multiple Ave value
Electronic Systems 2,964 8.0 2,863 1.23 2,914
Cyber & Intelligence 1,222 9.2 1,197 1.01 1,210
Platforms & Services (US) 2,074 8.0 2,771 0.85 2,423
Platforms & Services (UK) 7,770 8.5 8,081 1.19 7,925
Platforms & Services (Int'l) 4,370 8.5 4,560 1.13 4,465
HQ & other -447 5.0 291 1.00 -78
Total 17,953 8.5 19,763 1.10 18,858
Net cash/(debt) -1,707
Equity value 13,706
Shares o/s (m) 3,132
Price per share 438
Electronic Systems 2,670 7.6 2,722 1.20 2,696
Cyber & Intelligence 1,251 9.3 1,182 1.00 1,217
Platforms & Services (US) 2,078 7.7 2,639 0.85 2,358
Platforms & Services (UK) 7,535 8.1 8,086 1.17 7,811
Platforms & Services (Int'l) 4,247 8.1 4,570 1.12 4,408
HQ & other -400 4.5 276 1.00 -62
Total 17,382 8.2 19,475 1.09 18,429
Equity value 13,300
Price per share 425
DCF Model m
Beta (x) 0.95 Net (debt) / cash -699
WACC 7.8% Pension -3,665
Terminal EBIT margin 10.4% NOSH (m) 3,166
Share value (p) 465
465 9.0% 10.0% 11.0% 12.0% 13.0%
7.0% 546 549 552 555 559
7.5% 492 495 499 502 505
8.0% 446 450 453 456 459
8.5% 407 410 413 416 419
9.0% 372 375 378 381 384
EBIT margin
W
A
C
C
465 0.0% 1.0% 2.0% 3.0% 4.0%
7.0% 492 551 633 757 963
7.5% 448 497 563 659 809
8.0% 411 451 505 581 694
8.5% 377 411 456 516 604
9.0% 348 377 414 463 532
Terminal growth
W
A
C
C
BAE Systems plc
Aerospace & Defence
75
Key investment point one: low growth, limited catalysts
BAEs growth profile is the weakest of our coverage list with organic declines in
four of the past five years. 2014 guidance is for a further 5-10% decline following
the Saudi Salam contract negotiations boost in 2013, with flat-to-modest top-line
growth thereafter. We see limited opportunities for outperformance against this
expectation. In the longer term, however, major programmes, international sales
and stabilisation of the groups US activities point to a solid revenue profile.
Apart from modest growth in 2013, sales have
declined organically yoy since 2010 (%)
Despite significant revenue (m) headwinds,
BAE has been responsive in terms of self-help,
resulting in a70bp increase in RoS (%, rhs)

Self-help measures have sustained profitability
BAE has responded to weak demand conditions in its US businesses with rapid
cost reduction and efficiency measures. As a result, group EBIT margins have been
sustained around the 10% level since 2010, impressive given the scale of revenue
headwinds. To illustrate, three of BAEs four identifiable US segments, Electronic
Systems, Information Systems and Land & Armaments have seen substantial
revenue declines since 2010 of 17%, 19% and 62% (or 75% including 2014
estimates) respectively, totalling a GBP equivalent decline of around 4.3bn (or
c5bn including 2014). Cost reduction actions in the relevant businesses have
protected US segment margins to some extent, although it is strong execution and
programme maturity in the UK activities that have offset overall declines. We
forecast a 2014 EBIT margin of 10.3%, slightly down from 2013 but 50bp ahead of
2010.
Sales stagnate but near-term expectations are underpinned by a
robust order book
We forecast a 6% decline in 2014 revenues, broadly in line with managements re-
based guidance delivered in February. Near-term revenue expectations are
underpinned by a 43.1bn order book (2012: 42.4bn) with high opening order
cover positions for each segment: Electronic Systems c75%; US Platforms &
Services (Land & Armaments and Support Solutions) more than 80%; UK
Platforms & Services almost 90%; and International more than 80%. Over half
of the group backlog (c23bn) is represented by 15 major programmes including:
CVF carriers, Astute submarines, Typhoon Tranche 2 (236 aircraft) and 3A (88
aircraft), Oman Typhoon (12 aircraft), Saudi Typhoon (72 aircraft plus support),
-15%
-10%
-5%
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5%
10%
15%
20%
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E
5%
7%
9%
11%
13%
15%
0
5,000
10,000
15,000
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25,000
2
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7
E
Elect. Sys Cyber/Intel P&S (US)
P&S (UK) P&S (Int'l) Margin (rhs)
BAE Systems plc
Aerospace & Defence
76
UK Tornado Support (ATTAC), two landing helicopter dock ships (Australia),
CV90 infantry carriers (247 new and upgraded vehicles for Norway), Paladin (19
howitzers and 18 vehicles for the US Army) and UK general munitions supply.
Order book evolution (bn)

Source: BAE Systems
International sales offsetting softness in traditional markets but still
small in a group context
Despite a focus on growing commercial activities, we estimate only 5% of sales
(c900m) can be categorised as strictly non-defence and/or non-government:
1. c150m information assurance, cyber security and managed security
services for financial, corporate and communications customers this
relates to the UK Detica business, now called Applied Intelligence;
2. c550m commercial aircraft electronics (engine controls, cockpit controls,
head-up displays, power management systems) and vehicle hybrid drive
systems (the HybriDrive bus drive system);
3. c200m commercial ship support and build.
We see strong growth potential for BAEs commercial cyber security applications
(the Detica order book increased by 60% in 2013) as well as good growth in the
aircraft electronics business, driven by aircraft OEM production. Despite this, the
financial impact is small in the context of a group with 17bn-18bn sales and
1.8bn EBITA pa. By way of an example, if we assume relatively aggressive four-
year sales CAGRs of 30% in commercial cyber and 15% in commercial aerospace,
we calculate incremental revenues and profits of around 550m and 60m-65m
respectively, all else being equal. We estimate this could be neutralised by a mere
3% sales reduction in the remaining defence/security activities.
0
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2006 2007 2008 2009 2010 2011 2012 2013
Elect. Sys Cyber/Intel P&S (US) P&S (UK) P&S (Int'l) Group
BAE Systems plc
Aerospace & Defence
77
36% of sales to US defence; investment accounts to remain under
pressure but this is not unexpected
The two-year US DoD budget deal gives improved visibility on the groups US
defence sales and a reprieve on sequestration risks, clearly a positive for BAE given
its c36% direct sales exposure. However, we expect downward pressure on defence
spending for the foreseeable future, not least because spending caps implied by the
BCA are not factored into longer-term budget estimates.
1. BCA cuts not being met, although BAE is planning for them: Beyond
the current two-year plan, current DoD forecasts imply 8% growth in the
base budget in 2016, in effect ignoring the BCA caps. We simply do not see
this as a realistic outcome and our current assumption is for little-to-no
growth in overall spending (in real terms) from 2016. In particular, the
DoD investment accounts (equipment procurement and research,
development, testing and evaluation RDT&E), the areas of the budget
most relevant to BAE, are likely to experience further downward pressure.
We believe that BAEs base planning assumptions are prudent in this
respect, with management expecting no more than the BCA capped levels
of spending and a return to a pressured environment of recurring
continuing resolutions (CR). Recently published estimates of base spending
at BCA/sequestration levels indicates that 2014 and 2015 will be trough
years followed by low growth thereafter (see chart below).
2. Sequestration has not gone away: Also, without further progress on
deficit reduction, sequester cuts will, by law, re-commence from FY16. We
fear again for US politicians ability to reach agreement, particularly given
the presidential elections due in 2016. A pattern of political brinkmanship
culminating in inactivity is again a real possibility we believe. While we
capture in the charts below what the overall spending profile could look like
at BCA/post-sequestration levels, experience of sequestration in 2013
showed that adverse effects can be greater through, for example, disruption
in the equipment procurement process, regardless of where actual cuts are
targeted.
US DoD budget profile (total includes OCO)
compared to BCA ($bn)
US DoD investment accounts at BCA levels
pressured near-term but show a return to low
growth from 2016 ($bn)

Source: Berenberg estimates, DoD

450
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Procurement RDT&E
BAE Systems plc
Aerospace & Defence
78
Major programmes underpin near-, mid- and long-term term revenues
BAE is fundamentally a defence prime contractor deriving revenue from the
development, manufacture, support and sustainment of major military platforms.
The groups portfolio, particularly in air systems and maritime, underpin activity,
gives a high level of sales visibility.
1. Eurofighter a lack of Eurofighter exports is a modest concern but
production is secure to at least 2017, and probably beyond: Eurofighter
is the groups largest programme, generating sales of 2bn pa (including
Saudi and support activities), equivalent to c11% of group sales. We
estimate that around 400 aircraft have been delivered out of a total of 571
contracted (472 European partner nations/99 exports).
Eurofighter customer order profile

Source: Eurofighter
Failure to secure recent export opportunities, notably large requirements
from India (126 aircraft), which selected Dassaults Rafale, and UAE (60
aircraft), which reportedly is also favouring Rafale, although no down-
selection has been made, is a major disappointment for the Eurofighter
programme and raises the spectre of the current production schedule
running out in 2017/18. Certainly this is registering as a concern for
investors, but we are relatively sanguine at this stage. Firstly, we are
reasonably confident the long-speculated 48-72 aircraft Saudi follow-on
order will progress, particularly now that Salam contract price terms have
been agreed. This would sustain production through to the early 2020s and,
as prime contractor, we suggest that BAE will generate similar revenues and
profits to the current European partners shared programme at lower rates
of production. In addition, the existing, growing and aging fleet will require
support and periodic major upgrades over time. We understand that other
mid-term Eurofighter prospects, none of which are in BAEs longer-term
plan, include:

Bahrain 12 aircraft potentially acquired as part of and incremental to a
Saudi follow-on order;

Malaysia 18 aircraft, seemingly a longer-term prospect;

Qatar 24 aircraft.
We conclude that the outlook for Eurofighter is stable through our
investment horizon with only modest risk of restructuring in the years
beyond when partner nations activity slows down.
UK Germany Italy Spain
Partner
nations Austria Saudi Oman Exports TOTAL
Workshare 37% 30% 19% 14%
Tranche 1 53 33 28 19 133 15 15 148
Tranche 2 67 79 48 33 227 24 24 251
Tranche 3A 40 31 21 20 112 48 12 60 172
Tranche 3B
Country total 160 143 97 72 472 15 72 12 99 571
Shortfall to original contract 72 37 24 15 148 49
Original requirement 232 180 121 87 620 620
BAE Systems plc
Aerospace & Defence
79
Eurofighter Typhoon aircraft deliveries; the value
of direct export orders is higher than for partner
nations activity
F-35 is a high-priority programme already
delayed; BCA-funded levels actually increase
from 2017

Source: Berenberg estimates, BAE Systems Source: DoD FY14 Presidents Budget Submission
2. F-35/JSF increasing in importance: The US F-35/JSF programme will
become increasingly material to BAE as production ramps up through the
second half of the decade. BAE has a 15% share or c16-18% in value terms
including equipment. The programme is circa six years behind schedule but
is a priority for the US DoD to replace aging USAF fleets and hence budget
related risks referred to above are low in our view. Current revenues from
F-35 are c450m pa (c300m airframe/150m electronics) which we
estimate will rise to around 1.2bn by 2020 based on the current
production schedule. This dovetails conveniently with reducing activity on
the Eurofighter which we attempt to illustrate in revenue terms in the chart
below.
Eurofighter/F-35 revenue profile (m)

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European programme Exports (firm)
Exports (prospect)
Transition
from T1 to T2 Saudi
follow-on?
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Pre BCA (FY14 plan) BBA/BCA
0.0
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1.0
1.5
2.0
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3.0
3.5
2013 2014 2015 2016 2017 2018 2019 2020
Typhoon F-35 (at BCA levels) Total revenue
BAE Systems plc
Aerospace & Defence
80
3. Maritime stable for foreseeable future: We estimate that c2.1bn in
annual revenues are derived from UK maritime activity, broadly split 50%
naval surface ships, 30% submarines and 20% combat systems and
sustainment.

Surface ships: The 2013 agreement with the UK government on naval
surface ships is important because it substantially bridges what was a
looming workload gap between the end of the CVF carrier programme
and the Type-26 ship programme, with an order for three offshore
patrol vessels (OPVs). Current surface ship revenues are c1bn, which
we estimate will decline to around 800m over the next few years due to
programme phasing. In addition, OPV margins are likely to be below
CVF margins, which we estimate, with the revenue decline outlined
above, translates to a c60m profit headwind, equivalent to 3.5-4.0% of
current group profits. This is not insignificant, but certainly better than
the no-work/close-down/start-up-again option that was looming before
this agreement was reached.

Submarines: The core Astute programme is running at a steady beat
and in terms of maturity is shifting from the first three-boat, heavily
provisioned legacy contract to the independently priced boats four, five
and six ie Astute should become increasingly profitable through the
remainder of the decade. In addition, initial development activity on the
Successor nuclear deterrent programme is continuing, again with activity
set to rise significantly through the end of the decade. We understand a
main gate contract decision is not likely before 2016.
In summary, BAEs maritime activities should be stable through our forecast
horizon and grow in the longer term.
BAE Systems plc
Aerospace & Defence
81
Key investment point two: shareholder returns
BAE is cash-generative and management has for many years placed a priority on
shareholder returns. This continues with a progressive dividend policy and an
ongoing 1bn share buyback programme (including 2014 forecasts, we estimate an
average payout to shareholders over the next five years of 940m pa, of which
about two-thirds is dividend). We assess the BAE dividend as very secure (with a
sector-leading yield of 4.8%), but growth has stalled due to lack of earnings
progression which perhaps limits the relative attraction of BAE as an income stock.
The current three-year share repurchase programme is almost halfway through. We
suggest that a continuation of at least c200m/year (1.6%) could comfortably be
funded by excess free cash.

Cash-generative model; low FCF currently relates to contract timing: A
high proportion of BAEs revenues are tied to long-term equipment
programmes for government customers. Year-on-year group cash flows can be
highly volatile due to large customer advances (and utilisations thereof) but over
time the business model is cash-generative. By way of illustration, since 2006
the group has generated an average of just less than 1bn pa free cash flow,
equivalent to an average FCF conversion of 53%. Export contracts are in a
utilisation phase (of advances) which explains low FCF currently and below-
average cash generation over the next few years. In particular, Saudi and Omani
advances are being consumed, which will reduce FCF to an average of c650m
pa and FCF to around 35%. The chart below highlights the volatility in annual
FCFs.
Free cash flow profile is volatile yoy and depends on large programme
phasing (m)

Source: Berenberg estimates, BAE Systems
-30%
0%
30%
60%
90%
120%
150%
-500
0
500
1,000
1,500
2,000
2,500
Free cash flow Free cash conversion
BAE Systems plc
Aerospace & Defence
82

Progressive dividend policy (40-50% payout): The dividend policy is
described by management as progressive, and given the strong cash generation
profile, BAE has paid out an average of 45% of underlying earnings over the
past decade, over which time the dividend has more than doubled in absolute
terms to 625m, or 19.7p per share. Progression has slowed over the past three
years, however, in line with earnings, and we forecast just a 3.0% CAGR (three-
year), the lowest in our European aerospace and defence coverage list.
Nevertheless, BAEs dividend still ranks as the highest yielding stock at 4.8% on
our FY14E forecast (sector average: 2.5%).
Dividend growth slowed due to stalling earnings progression (p)


Share buyback to stimulate EPS could do more: Management has
undertaken three share buyback programmes over the last four years totalling
2bn: 500m in each of 2010 and 2011 and a 1bn, three-year repurchase
commencing in 2013, which the company is approximately halfway through.
We view this as a sensible allocation of capital given the profile of declining
organic growth, a strong balance sheet and historically low valuation of the
shares. We estimate that, to date, these schemes have cumulatively been c15%
enhancing to the EPS profile anticipated before they commenced. Completion
of the current buyback scheme will increase this to c18% by 2015, although
from today, the yoy impact/benefit is 2-3% and fully factored into our (and
consensus) estimates. Due to large often unpredictable programme flows,
forecasting BAEs cash flow on an annual basis is a hazardous exercise.
However, on our current estimates, which factor the lower free cash profile
outlined above, once the current buyback is completed in 2015, we estimate the
group will have c200m excess cash flow after dividends, and hence we suggest
BAE should continue to buy back shares at least at this rate. Over time, we
suspect a 500m buyback should be sustainable. The chart below summarises
cash returns to shareholders including potential addition buybacks.

0%
3%
6%
9%
12%
15%
0
5
10
15
20
25
2006 2007 2008 2009 2010 2011 2012 2013 2014E2015E2016E2017E
DPS DPS growth
BAE Systems plc
Aerospace & Defence
83
Share buybacks


-500
0
500
1,000
1,500
2,000
2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E
Dividend Buybacks Potential buyback Free cash flow
BAE Systems plc
Aerospace & Defence
84
Divisional forecasts
Divisional table (m)


Revenue 2010 2011 2012 2013 2014e 2015e 2016e
Electronic Systems 2,969 2,645 2,507 2,466 2,325 2,275 2,248
Cyber & Intelligence 1,201 1,399 1,402 1,243 1,181 1,182 1,203
Platforms & Services (US) 7,671 5,305 4,539 4,196 3,246 3,120 3,093
Platforms & Services (UK) 6,529 6,258 5,646 6,890 6,817 6,885 7,022
Platforms & Services (Int'l) 4,325 3,794 4,071 4,063 4,049 4,096 4,144
HQ 209 233 267 306 291 276 276
Intra group (629) (480) (598) (984) (650) (650) (650)
Group total 22,275 19,154 17,834 18,180 17,259 17,183 17,337
Revenue growth
Electronic Systems 2.4% -10.9% -5.2% -1.6% -5.7% -2.2% -1.2%
Cyber & Intelligence -7.8% 16.5% 0.2% -11.3% -5.0% 0.0% 1.8%
Platforms & Services (US) -8.8% -30.8% -14.4% -7.6% -22.6% -3.9% -0.9%
Platforms & Services (UK) 6.1% -4.2% -9.8% 22.0% -1.1% 1.0% 2.0%
Platforms & Services (Int'l) 18.2% -12.3% 7.3% -0.2% -0.4% 1.2% 1.2%
Group total 1.3% -14.0% -6.9% 1.9% -5.1% -0.4% 0.9%
EBITA (adj)
Electronic Systems 455 386 356 346 312 296 281
Cyber & Intelligence 108 136 124 115 111 114 115
Platforms & Services (US) 728 478 394 265 216 228 234
Platforms & Services (UK) 522 658 689 879 770 785 808
Platforms & Services (Int'l) 449 449 417 429 433 442 456
HQ (83) (82) (85) (109) (75) (75) (75)
Group total 2,179 2,025 1,895 1,925 1,768 1,790 1,819
EBITA margin (adj)
Electronic Systems 15.3% 14.6% 14.2% 14.0% 13.4% 13.0% 12.5%
Cyber & Intelligence 9.0% 9.7% 8.8% 9.3% 9.4% 9.6% 9.6%
Platforms & Services (US) 9.5% 9.0% 8.7% 6.3% 6.7% 7.3% 7.6%
Platforms & Services (UK) 8.0% 10.5% 12.2% 12.8% 11.3% 11.4% 11.5%
Platforms & Services (Int'l) 10.4% 11.8% 10.2% 10.6% 10.7% 10.8% 11.0%
Group total 9.8% 10.6% 10.6% 10.6% 10.2% 10.4% 10.5%
BAE Systems plc
Aerospace & Defence
85
Financials

Year-end December (GBP m) 2012 2013 2014E 2015E 2016E

Sales 17,834 18,180 17,259 17,183 17,337

Share of sales of equity accounted investments -1,214 -1,316 -1,997 -1,997 -1,997
Total operating expenses -15,353 -16,297 -15,750 -16,000 -16,150
Other operating income 280 128 1,966 2,313 2,339
Operating profit 1,547 695 1,478 1,500 1,529
Share of results of equity accounted investments 93 111 90 90 90
EBIT 1,640 806 1,568 1,590 1,619

EBITDA (adj) 2,252 2,246 2,108 2,120 2,159
Depreciation -357 -321 -340 -330 -340
EBIT (adj) 1,895 1,925 1,768 1,790 1,819
Unusual or infrequent items 57 -43 -40 -40 -40
Amortisation of goodwill -226 -189 -160 -160 -160
Impairment charges -86 -887 0 0 0
EBIT 1,640 806 1,568 1,590 1,619

EBT 1,369 422 1,203 1,235 1,279
EBT (adj) 1,684 1,745 1,583 1,615 1,659

Income tax expense -295 -246 -306 -320 -337
Other taxes -115 -138 -34 -35 -36
Group tax (underlying) -410 -384 -340 -355 -373
Tax rate 22% 58% 25% 26% 26%
Profit after tax 1,074 176 897 915 941
Minority interest -11 -8 -5 -5 -5

Net income 1,068 174 892 910 936
Net income (adj) 1,268 1,359 1,238 1,254 1,280

Average number of shares (m) 3,244 3,224 3,124 3,048 3,015
Average number of shares (FD) (m) 3,258 3,238 3,132 3,056 3,023

EPS (reported) (p) 32.9 5.4 28.6 29.8 31.1
EPS (adjusted) (p) 38.5 41.8 39.5 41.0 42.4


BAE Systems plc
Aerospace & Defence
86

Balance sheet

Financial assets 708 940 820 700 580
Fixed assets 13,921 12,611 12,241 11,926 11,606

Inventories 655 680 1,580 1,680 1,730
Accounts receivable and other assets 75 229 229 229 229
Deferred taxes 1,375 901 901 901 901
Current assets 6,978 6,169 7,069 7,169 7,219

TOTAL ASSETS 22,274 19,681 20,211 19,996 19,726

Long-term debt 2,967 2,524 3,532 3,778 3,556
Other provisions 449 403 403 403 403
Pensions provisions 4,607 3,665 3,445 3,175 2,855

Bank loans and other borrowings 21 402 402 402 402
Other liabilities 407 472 272 172 172
Deferred taxes 422 497 553 518 482

TOTAL LIABILITIES - - - - -


BAE Systems plc
Aerospace & Defence
87

Cash flow statement
GBP m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 2,252 2,246 2,108 2,120 2,159

Other costs affecting income / expenses -1,178 -404 -560 -510 -460
(Increase)/decrease in working capital 1,384 -1,637 -900 -100 -50
Cash flow from operating activities 2,458 205 648 1,510 1,649
Interest paid -170 -177 -185 -175 -160
Cash tax -115 -138 -250 -355 -373
Net cash from operating activities 2,173 -110 213 979 1,115

Dividend from equity accounted investments 94 95 80 80 80
Capex -359 -236 -230 -275 -280
Intangibles expenditure -43 -33 -20 -20 -20
Payments for acquisitions -5 -1 0 0 0
Financial investments -6 -5 0 0 0
Cash flow from investing activities -80 -43 -170 -215 -220

Free cash flow (memo) 2,081 -158 43 764 895

Dividends paid -620 -638 -636 -646 -658
Net proceeds from shares issued -16 -212 -400 -350 0
Others 277 -42 -15 -15 -15
Effects of exchange rate changes on cash 92 -41 0 0 0

Net cash flow 1,826 -1,086 -1,008 -246 223

Reported net debt 387 -699 -1,707 -1,953 -1,731


BAE Systems plc
Aerospace & Defence
88

Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 0.9x 1.1x 1.2x 1.2x 1.1x
EV/EBIT (adj) 8.1x 9.4x 10.4x 10.1x 9.7x
P/E (adj) 10.2x 80.6x 15.1x 14.4x 13.9x
P/FCFPS 5.5x -77.9x 312.8x 17.2x 14.5x
Free cash flow yield 18.2% -1.3% 0.3% 5.9% 6.9%
Dividend yield 5.8% 4.7% 4.8% 5.0% 5.1%

Growth rates
Sales -7% 2% -5% 0% 1%
Sales organic -5% 2% -5% 0% 1%
EBIT (adj) -6% 2% -8% 1% 2%
EPS (adj) -15% 9% -5% 4% 3%
EPS -11% -84% 429% 5% 4%
DPS 4% 3% 3% 4% 2%

Financial ratios
Operating cash conversion 115% -6% 12% 55% 61%
FCF conversion 106% -9% 2% 43% 49%
Net gearing -11% 17% 34% 38% 33%
Net debt/EBITDA -0.2 0.3 0.8 0.9 0.8
ROCE 25% 23% 19% 18% 18%
ROIC 7% 7% 7% 7% 7%
WACC 11% 8% 7% 7% 7%
FCF ROCE 35% -3% 1% 10% 12%
Working capital/sales -25% -18% -14% -14% -13%
Net research and development/sales (inc. capatalised costs) 0.8% 0.9% 0.0% 0.0% 0.0%
Gross research and development (inc. customer funded) 6.3% 6.1% 0.0% 0.0% 0.0%
Intangibles investment/sales - - - - -

Key financials

Sales 17,834 18,180 17,259 17,183 17,337
EBIT margin (adj) (%) 10.6% 10.6% 10.2% 10.4% 10.5%
EBIT (adj) 1,895 1,925 1,768 1,790 1,819
EPS (adj) (p) 38.5 41.8 39.5 41.0 42.4
DPS (p) 19.5 20.1 20.6 21.4 21.8

Net cash from operating activities 2,173 -110 213 979 1,115
Free cash flow 2,081 -158 43 764 895
Acquisitions and disposals 211 125 0 0 0
Net cash flow 1,826 -1,086 -1,008 -246 223

Total working capital -4,539 -3,356 -2,456 -2,356 -2,306
Gross debt 2,988 2,926 3,934 4,180 3,958
Pensions and similar obligations 4,607 3,665 3,445 3,175 2,855

Cobham plc
Small/Mid-Cap: Aerospace & Defence
89

Aeroflex is a good deal but shares are fairly valued

We initiate coverage on Cobham with a Hold recommendation and a
price target of 325p. The stock has significantly outperformed since
the US defence budget agreement in December and the market has
further welcomed the 870m acquisition of Aeroflex as a positive
strategic deal. Cobham is the best-performing share in the sector ytd
(up by 19% versus the sector, which is broadly flat). Cobham is set to
deliver organic growth in 2015 for the first time since 2008, and the
outlook is enhanced by Aeroflexs greater mix of sales in commercial
sectors. However, now the war chest has been spent, there is a lack of
near-term catalysts, and given the shares relatively full valuation, we
see little upside to the equity story on a 12-month view, hence our
neutral stance.

The M&A story has played out: At 870m, Aeroflex is a large deal
for Cobham but our initial assessment is positive in terms of price
paid and strategic fit. We estimate 8% EPS accretion on an underlying
basis and leverage increasing to c2.6x on completion (expected by
end-Q3), which suggests to us that large-scale M&A is off the agenda
for at least 18 months. Cobham will embark on a four-year 130m
integration plan, essentially an extension of the ongoing 190m
Excellence in Delivery (EiD) programme.

Organic growth will return in 2015, driven by higher growth
commercial sectors and a stabilisation in US defence-related activities.
Growth will be enhanced by the Aeroflex sales mix, which increases
the proportion of group sales to commercial markets to over 40%.

Dividend growth: Cobham has consistently rewarded investors with
double-digit dividend growth. Management has committed to growth
of 10% in 2014 and to a continuation of its progressive payout policy.

Valuation and performance: Cobham has outperformed the sector
by 19% ytd and the stock now trades at a 7% premium (2015 PE) to
the European aerospace and defence peer average. On this basis, we
feel upside potential relating to the Aeroflex acquisition is priced in,
and with limited other catalysts, we view the valuation as fair.

Hold (Initiation)
Current price
GBp 324
Price target
GBp 325
Reuters COB.L
Bloomberg COB LN
Share data

Performance data

1 month 3.4 % 4.5 %
3 months 1.4 % 9.4 %
12 months -1.0 % 4.5 %
Key data

Net gearing 48.7%
CAGR sales 2013-2016 8.4%
CAGR EPS 2013-2016 3.0%

Cobham designs and manufactures a
wide range of equipment, specialised
systems and components for the
aerospace, defence, energy and
electronics industries. Capabilities
include air refuelling equipment, life
support, communication systems and
bomb disposal robots. Cobham also
operates a range of aviation services for
the civil, military and government
sectors.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 1,749 1,790 1,849 2,200 2,281
EBITDA (adj) 392 386 387 479 500
EBIT (adj) 332 318 321 384 400
Net income (adj) 244 233 225 257 271
Net income 172 114 93 126 153
Net debt / (net cash) 641 441 413 413 374
EPS 16.0 10.7 8.4 11.1 13.5
EPS (adj) 22.5 21.6 20.1 22.4 23.6
FCFPS 21.0 13.9 12.9 20.3 21.2
CPS -13.4 -8.9 -61.0 8.6 8.7
DPS 8.8 9.7 10.6 11.7 12.9
EBIT margin (adj) 19.0% 17.8% 17.3% 17.5% 17.5%
Dividend yield 4.0% 3.2% 3.2% 3.6% 3.9%
ROCE 18.7% 16.8% 11.1% 13.7% 14.9%
EV/sales 1.6 2.1 2.6 2.2 2.1
EV/EBITDA 7.2 9.7 12.5 10.1 9.5
EV/EBIT 8.5 11.8 15.1 12.5 11.8
P/E 13.8 28.0 39.1 29.4 24.2
P/E (adj) 9.8 13.9 16.3 14.6 13.9

Cobham plc
90
Cobham investment thesis in pictures
Sales split by sector (m): improving mix of
higher growth commercial sales (41% of pro-
forma sales including Aeroflex)
Organic growth (%) has been flat-to-negative
since 2010 due to defence exposures; the outlook
is improving

Source: Berenberg estimates Source: Berenberg estimates, company data

EiD gains and Aeroflex synergies as a
percentage of EBIT (yoy and cumulative)
FCF (m): Cobham is strongly cash-generative
(10-year average cash conversion of 63%)


DPS and EPS profile (p); strong dividend record Re-rated through 2012 to above long-term
average P/E as defence sector concerns eased

Source: Berenberg estimates, Cobham Source: Datastream

0
500
1,000
1,500
2,000
2,500
2013 2014E 2015E 2016E
Commercial Defence/Govt
-10%
0%
10%
20%
30%
40%
50%
2
0
0
6
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7
2
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1
4
E
2
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6
E
2
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7
E
Organic Reported
0%
10%
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F
2
0
1
6
F
2
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1
7
F
2
0
1
8
F
as % of last yr EBIT as % of EBIT pre EiD
0%
20%
40%
60%
80%
100%
0
50
100
150
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4
E
2
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2
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E
FCF FCF conversion
0
1
2
3
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5
6
0
5
10
15
20
25
30
1
9
9
8
2
0
0
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2
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2
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2
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1
6
E
DPS EPS Cover (rhs)
5
10
15
20
25
COB 20Y Average 10Y Average
ave 14.0x
ave 12.6x
Cobham plc
91
Cobham investment thesis
Whats new? We initiate coverage on Cobham with a Hold rating and a 325p price
Two-minute summary: Our initial assessment of the strategic rationale for
acquiring Aeroflex, a US specialist microelectronics and testing business, is positive.
Aeroflex is highly complementary from both a technology and customer
perspective and further broadens the groups exposure to higher growth
commercial sectors to over 40% of sales. In completing this 870m acquisition,
Cobhams largest-ever, the M&A war chest has been spent, implying to us that
further upside for investors is limited to the potential for sales synergies from the
enlarged group. We think this is eminently possible, but with completion of the
deal not expected until Q314, it will take time to digest and drive the revenue
opportunity, in our view. Cobham is the best-performing share in the sector on a
ytd basis (+19%), despite c3% consensus FY14 EPS downgrades, resulting in a
premium 12-month forward P/E rating of 15.4x, which compares to the sector
average of 13.7x. This relatively full valuation and lack of near-term catalysts
compels us to take a neutral stance on the share.
Key investment point one: low organic growth and margin squeeze but the
outlook is improving
Cobham has not delivered positive organic growth since 2008. 2014 will be another
year of declines, although headwinds are easing in the core US defence sector and
with the addition of Aeroflex, higher growth commercial activities will represent
over 40% sales. Management is confident of a return to mid-single-digit organic
growth in 2015, now enhanced by the Aeroflex sales mix. We forecast slightly
lower organic growth of 3.3% rising to 4.0% in 2016. At the profit level, benefits
from the six-year EiD improvement programme continue to sustain margins and
we applaud progress made to-date, which in financial terms translates to 76m
annualised benefits and which is expected to rise to 105m pa by 2015. Integration,
reorganisation and improvement of Aeroflex will kick-start another c130m of
multi-year, EiD-esque investment, taking the total spend of these programmes to
over 300m for an annual benefit of 155m. This has been required to improve
competitiveness, sustain margins in a continually pressured defence environment
and ultimately to drive future growth opportunities. In summary, it is encouraging
to see organic growth returning, enhanced by the Aeroflex acquisition, and despite
the cost of EiD, Cobham is a fundamentally improved business, better organised
and positioned for when cyclical pressures ease.
Key investment point two: the M&A card has been played:
Acquisitions are a key element of the growth strategy as evidenced by the 870m
Aeroflex deal, Cobhams largest-ever, and which takes total expenditure over the
last 15 years to almost 3bn on over 50 acquisitions. Aeroflex is a provider of
specialist electronic technologies in the communications and wireless sector, and
appears to us to be an excellent strategic fit, both from a technology and customer
perspective. Integration costs are high, however, as previously mentioned, but on
an underlying basis, we estimate the transaction is 8% earnings-accretive in 2015
and increases pro-forma balance sheet leverage to 2.6x, which should fall to c2.2x
by the end of 2015. On this basis, we conclude that large-scale M&A will be off the
agenda for at least 18 months, limiting upside (or indeed downside) to deal
execution, integration and potential sales synergies.
Cobham plc
92
Key investment point three: high dividend growth:
Cobham has an impressive historical dividend profile, delivering a 13% CAGR
over the past two decades, with management committing to a further 10% increase
in 2014, even after completion of the Aeroflex deal. We anticipate a continuation
of double-digit growth through our forecast horizon, backed by strong cash
generation. On this basis, the shares yield a healthy 3.2% on our forecasts.
Share price and valuation limited upside
Over the past two years, Cobham shares have performed broadly in line with the
FTSE All-Share but have significantly underperformed European aerospace and
defence peers, primarily due to Cobhams lower relative growth and civil aerospace
exposure. However, this masks a catch-up and strong outperformance of both the
market and the sector ytd with Cobhams shares gaining 19%, comfortably the best
performing stock in the sector. This is despite Datastream consensus EPS
downgrades of 3.3% ytd. As a result, the stock has significantly re-rated to a 12-
month forward P/E of 15.4x, a 10% and 22% premium to the 20-year and 10-year
average respectively and a 12% premium to the sector currently. On this basis, we
view the valuation as relatively full.
Share price versus market and sector (re-based) Cobham 20-year 12-month forward P/E

Forecast momentum
Declining organic revenues since 2010 have translated to a profile of low-to-
modestly-negative earnings growth. Acquisitions, EiD benefits, lower tax and lower
interest benefits were not enough to fully offset organic declines and the dilution
effects of exiting non-core activities. Forecast momentum has just recently turned
positive, however, mainly due to the accretive impact of the Aeroflex acquisition
but also, we suspect, as confidence builds in the CEOs expectation of a return to
organic growth in 2015.

150
200
250
300
350
400
450
Cobham FTSE A-S Pan Euro A&D
5
10
15
20
25
COB 20Y Average 10Y Average
ave 14.0x
ave 12.6x
Cobham plc
93
Long-term forecast EPS changes (p); poor EPS
growth for five years
Short-term EPS changes and price (p)


Q1 2014 trading in line, full-year guidance unchanged: A brief trading
update in April confirmed that Q1 trading was in line with expectations, with
currency translational headwinds affecting the groups revenue and earnings (we
estimate a 6% yoy impact on Q1 PBT). In the quarter, Cobham completed
divestment of its last remaining non-core business, a process that has been
ongoing since 2010. The full-year outlook was confirmed, with the group
continuing to plan for organic revenue to decline by low to mid-single digits,
broadly as we have forecast and where consensus estimates have settled.

FY13 4% profit miss, full-year guidance tempered but long-term
guidance maintained: Revenue increased by 2% yoy (-4% organically),
broadly in line with expectations. Profit was c4% below consensus expectations
however (margin: -130bp yoy), with portfolio mix, R&D and investment effects
greater than expected. Cash performance was good with 85% conversion, ahead
of guidance of 80%. The dividend was increased by 10%, in line with the stated
policy. Broad revenue guidance was maintained with an organic decline of low
to mid-single digits in 2014 and a return to mid-single-digit growth in 2015.
However, implied guidance for EPS was lowered, we estimate by c5%, partly
due to FX effects.

2014 forecasts: Including three months contribution from Aeroflex, we
forecast sales of 1.85bn reflecting a 5% organic decline in the underlying old
Cobham businesses which is towards the lower end of guidance, we believe.
We anticipate a slight contraction in underlying margin with organic revenue,
portfolio mix and currency effects partly offset by 24m of EiD benefits.
Aeroflex accretion is largely offset by dilution from the share placing resulting
in our forecast EPS (adjusted) of 20.1p, 6% below 2013.

2015 and beyond return to mid-single-digit organic? Over the last 18
months, CEO Bob Murphy has consistently relayed his expectation that the
company will return to mid-single-digit organic growth in 2015. At the macro
level, this appears plausible, given that US defence budget headwinds should
alleviate as top-line reductions slow yoy, while organic growth in the groups
commercial activities continues to be strong (which of course is enhanced by
the Aeroflex sales mix). However, until visibility improves, we adopt a slightly
more cautious stance compared to guidance, forecasting 3.3% organic revenue
growth in 2015 rising to 4.0% in 2016.
15
18
21
24
27
30
2012 2013 2014 2015 2016
18
19
20
21
22
23
225
245
265
285
305
325
Cobham plc
94

High restructuring charges: The EiD operational improvement programme
has been running for three and a half years, with 156m associated costs
incurred to date and another 35m still to go (over 18 months), reported as
exceptional charges. Through integration of the Aeroflex acquisition, the
programme is soon to be materially extended; the company has guided to a
further c130m investment in restructuring over the next four years or so,
taking the total investment including EiD to over 300m. We applaud the scale
of cost reductions and the fundamental improvements in the groups operating
structures achieved so far, all of which are reported in underlying performance,
while costs are treated as exceptional. Treatment of multi-year charges as one-
off in nature can be argued as reasonable in our view given that EiD and now
Aeroflex are such large and defined programmes, although historically we note
that Cobham has frequently incurred restructuring charges that are reported
below the line.

M&A/integration risk: Now that Cobham is in the process of acquiring
Aeroflex for 870m, we consider that meaningful M&A will be off the agenda
for at least 18 months. We have faith in Cobhams rigorous M&A assessment
processes in terms of targeting strategic, value-creative deals but, as previously
indicated, the integration of a business the size of Aeroflex will be complex and
time-consuming. In short, integration risk is inherently higher on this,
Cobhams latest deal.

US defence headwinds to persist: Including Aeroflex, we estimate direct sales
exposure to US defence and security spending will be around 34% (37%
previously). The two-year US Department of Defenses (DoD) budget
agreement reduces near-term uncertainty, but beyond 2015 we suspect
downward pressure will persist as spending caps of the Budget Control Act of
2011 (BCA) come into play and the prospect of sequestration looms again.
However, we understand that Cobham, in common with most other defence
companies that operate in the US market, is planning conservatively and to a
base-case scenario that assumes BCA spending caps are the most likely
outcome.

Programme risk: Delays to new military equipment programmes could affect
growth projection if delayed further. In particular, we look to increasing activity
on the US KC-46 tanker and F-35 fighter aircraft programmes to phase with
reductions in Cobhams existing high shipset programmes such as the F/A18,
the F16 and the C130J. Risk is mitigated by the US DoD classification of these
new programmes as high priority, backed up with defined funding lines.

FX: Transaction currency risk is mostly hedged c18 months forward for costs
or revenues that are not in the underlying functional currency. Average hedge
rates are modestly positive over the next few years. The companys sensitivity to
currency translation risk, principally the US dollar and Australian dollar, is that a
10c move (c6%) equates to a c10m impact on PBT (c3%). We assume that
spot rates will remain at the same level for the rest of the year and hence factor
a 12m, or 4%, profit headwind into our forecasts. Net debt sensitivity is 30m
per 10c move, which we also factor into our estimates.
Cobham plc
95
Valuation
325p price target


of-the parts (EV/sales and EV/EBITDA) analysis.

A 325p price target equates to 0% upside to the current price and drives our
neutral recommendation.

(FY16), about 10% above the long-term average 12-month forward P/E of
14.0x.

The shares trade on a 14% premium to our European defence peer group,
although the valuation is broadly in line with Ultra Electronics, a close defence
systems and electronics supplier.
Sum-of-the-parts
We use peer average EV/EBITDA and EV/sales multiples which we apply to our
end-market analysis of Cobhams sales and EBIT after the Aeroflex acquisition (a
full year). We also incorporate a debt estimate after the acquisition into our model.
This generates a valuation of 291p, which is 10% below the current price.
Sum-of-the-parts table (FY15), m


FY15 Assumptions
EV/Sales 303 2.03x
EV/Ebitda 279 9.1x
DCF 394 7.1% WACC / 1.5% TG
Average (p) 325
Defence/Govt 1,478 8.8 1,684 1.8 1,581
Commercial 2,901 9.3 2,958 2.2 2,929
Total 4,379 9.1 4,642 2.0 4,510
Pension (IAS19) -95
Equity value 3,296
Price per share 291
Cobham plc
96
DCF
DCF summary table

Cobham is a strongly cash-generative business with a long history of cash returns
to shareholders. We therefore include a DCF analysis in our valuation analysis as a
reasonable approximation to a dividend discount model and incorporate financial
effects of the Aeroflex acquisition.


DCF Model m
Beta (x) 0.98 Net (debt) / cash -1,119
WACC 7.1% Pension -87
Share value (p) 394
394 17.0% 17.5% 18.0% 18.5% 19.0%
6.1% 475 487 500 512 524
6.6% 419 429 440 450 461
7.1% 373 382 391 400 409
7.6% 334 342 350 358 366
8.1% 301 308 316 323 330
EBIT margin
W
A
C
C
394 0.5% 1.0% 1.5% 2.0% 2.5%
6.1% 426 459 498 548 611
6.6% 382 408 439 477 524
7.1% 344 365 390 420 456
7.6% 312 329 349 373 402
8.1% 284 298 315 334 357
Terminal growth
W
A
C
C
Cobham plc
97
Key investment point one: low organic growth and
margin squeeze but the outlook is improving

No organic growth since 2008. There will be an inflection point in 2014
(less negative) followed by a return to positive growth in 2015.

The Aeroflex business will increase sales exposure to higher growth
commercial markets to more than 40%.

Margin upside is limited due to continuing defence pressures but should
at least be sustainable given increasing operational benefits from the EiD
transformation programme and a higher mix of commercial sales.
Recent poor record for growth
Cobham has not delivered meaningful organic growth since 2008, due mainly to
the groups historical c70% sales exposure to slowing defence and security markets,
predominantly to US and European customers. At the same time, margins have
come under pressure despite significant operational improvements derived from
the EiD improvement programme, with lower volumes and increased competition
in the groups shorter-cycle defence activities both contributory factors, in addition
to acquisition mix.
No organic revenue growth for five years;
Cobham is confident this will rectify in 2015 (%)
Group operating profile (%); defence budget
pressures have affected margins

Source: Cobham Source: Company, Berenberg estimates
Defence headwinds easing and business mix improved with Aeroflex
acquisition
2014 represents the growth inflection point, with the company guiding to a return
to mid-single digit organic growth in 2015. The principal driver is continued
positive trends in the groups traditional commercial activities (such as aerospace
and marine) and moderating defence headwinds. Contributing to this will be the
newly acquired Aeroflex business (the transaction is expected to complete by the
end of Q3), which has a 70% sales exposure in non-defence markets split as
follows: Commercial Communications (36%), Commercial Space (13%), Medical
and Energy (13%) and Commercial Aviation (8%).
-5%
0%
5%
10%
15%
20%
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
9/11
downturn
Profit
warning
A380
Financial
crisis
Defence
downturn
Cobham plc
98
US defence budget ($bn) Pro-forma group sales mix after the acquisition
of Aeroflex (2015)

Source: Berenberg estimates, US DoD *** FYDP Future Years Defense
Plan, BCA Budget Control Act 2011 spending caps
Incorporating the Aeroflex acquisition, we forecast that sales to commercial end-
markets will increase to around 42% by 2015, of which we estimate the main end-
market exposures are civil aerospace 10% (5% commercial jets), aviation services
8%, marine 6%, other industrial and commercial markets 3% and 6% respectively
(eg medical, wind energy). Broadly, over the next few years, we model mid-single-
digit organic growth across the group commercial markets and a modest decline-to-
flat revenues in the groups defence and security businesses to reflect their
exposure predominantly to US and UK/European defence customers where yoy
budget headwinds are moderating. In aggregate, we forecast organic growth of
3.3% in 2015, with the assumption it will rise to 4% in 2016.
EiD a major self-help programme extended to 2018 by Aeroflex
Group operating margin (%); operational
improvement and mix (M&A) should drive a
modest expansion
EiD gains and Aeroflex synergies as a percentage
of EBIT (yoy and cumulative)

Cobhams margin profile has been complicated by certain one-off factors such as
large contract milestones (eg FSTA) and portfolio mix changes, both disposals and
acquisitions. However, we conclude that the underlying trend over the past three
years has been negative, not least because group margins have contracted by 60bp
since 2010 despite realising 76m of EiD benefits, equivalent to 400bp of margin.
The scope of the original 131m/three-year EiD programme was extended and
accelerated in 2013 with total costs now expected to reach 191m by 2015,
450
500
550
600
650
700
F
Y

0
9
F
Y

1
0
F
Y

1
1
F
Y

1
2
F
Y

1
3
F
Y

1
4
F
Y

1
5
F
Y

1
6
F
Y

1
7
F
Y

1
8
F
Y

1
9
Total Base (FYDP) BCA cap
42%
58%
Commercial Defence/Govt
14%
15%
16%
17%
18%
19%
20%
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
0%
10%
20%
30%
40%
50%
60%
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
F
2
0
1
5
F
2
0
1
6
F
2
0
1
7
F
2
0
1
8
F
as % of last yr EBIT as % of EBIT pre EiD
Cobham plc
99
generating annualised savings of 105m. Peak annual investment in EiD was 56m
in 2013, driven by accelerated site rationalisations (27 completed to date), but the
rate of expenditure is expected to decline rapidly as the programme draws to an
end, halving in the current year to 28m but generating further incremental savings
of 24m.
Cumulative investment in EiD and Aeroflex
integration (taken as exceptional charges) (m)
Cumulative benefits from EiD and Aeroflex
synergies(m)

Cobham will commence another major integration and improvement programme
following completion of the acquisition of Aeroflex (Q314), which is expected to
cost a further c130m over four years for an annualised benefit of c50m. We
deem the investment in Aeroflex synergies to be an extension of EiD because
much of the planned investment is based on EiD practices and principles, for
example site optimisation, operational efficiencies and supply chain rationalisation.
We understand that the lower payback rate on the Aeroflex plan 0.38 for every
1.00 invested versus EiD at 0.55 is largely due to early lease-break penalties
which Cobham has said could total around $50m. The new programme dovetails
neatly with the EiD programme as activity winds down over the next two years
freeing up staff that are experienced in structural business change, integrations and
improvement initiatives. The EiD and Aeroflex integrations are very significant; by
2018, we calculate that the group will have spent over 300m (over eight years) for
an annualised benefit of 165m with margins largely unchanged. In terms of
underlying return on sales, we surmise that Cobham is running hard to stand still.
0
50
100
150
200
250
300
350
EID 1 costs EID 2 costs Aeroflex cost
0
50
100
150
200
250
300
350
EID 1 benefits EID 2 benefits Aeroflex benefits
Cobham plc
100
Key investment point two: through the acquisition of
Aeroflex, Cobham has played the inorganic growth card

Cobham is highly acquisitive, with the largest of them all, Aeroflex for
870m, recently announced and expected to complete by the end of
Q314.

We estimate pro-forma net debt/EBITDA of 2.8x (with a full year of
Aeroflex) as at December 2014 falling to around 2.2x by the end of 2016,
suggesting there is limited scope for further M&A in the near term.

Aeroflex is an excellent strategic fit, strengthening Cobhams technology
offering in the broader connectivity space (wireless and electronic
communications and testing). From a financial perspective, it is 7-9%
earnings accretive, but this excludes an expensive multi-year integration
programme as outlined above.

We conclude that the Cobham investment case, based on potential
M&A-driven upside, has largely played out. Market forecasts now
incorporate the financial impacts of Aeroflex, and given that we think it is
too early to accurately assess deal execution and integration risks, we
choose to take a neutral stance on the shares.
Acquisition spend (m): in 15 years, Cobham has
spent almost 3bn on over 50 acquisitions, the
largest of which, Aeroflex, is underway
FCF (m): Cobham consistently delivers cash
conversion at the upper end of the peer group

Cobham is highly acquisitive, funded by strong cash generation
We estimate that Cobham has made over 50 acquisitions over the past 15 years at a
total cost of almost 3bn, with individual transactions ranging from small
technology in-fills to large strategic deals such as REMEC ($257m), Lansdale
Sensors ($240m), M/A-COM ($425m) and SPARTA ($372m), and most recently
Aeroflex ($1.47bn). In the main, acquisitions have been fully funded by strong cash
generation; we estimate that Cobham has delivered an average of 63% free cash
flow conversion over the past 10 years.
Overall, we believe the acquisition strategy has been successful, as highlighted by
the groups long-term record of return on investment (RoI) exceeding the cost of
capital. Indeed, Cobham has consistently ranked towards the upper end of our peer
group return on capital measures, averaging 17.5% ROCE over the past 10 years.
0
200
400
600
800
1000
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
Axell
Wireless,
FBH
Thrane
&
Thrane
M/A
Comm,
Sparta,
Lansdale
Telerob,
Tivec Avant,
Corp Ten
Aeroflex
0%
20%
40%
60%
80%
100%
0
50
100
150
200
250
300
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
FCF FCF conversion
Cobham plc
101
Given the number and diversity of companies acquired, it is hard to assess
individual transactions, although inevitably some have not worked out as
anticipated. For example, SPARTA was sold just three years after acquisition and in
2013 Cobham wrote off 63m of goodwill from the US Tactical Communications
business due to slower defence activity in the US.
Aeroflex a mega deal for Cobham
On 20 May 2014, Cobham announced the proposed acquisition of Aeroflex
Holding Corp for $10.50 per share, equivalent to an enterprise value of $1.46bn
(869m at current exchange rates), comprising equity of c$920m (548m) and net
debt of $540m (321m). Aeroflex, Cobhams largest-ever acquisition, is a leading
provider of specialist electronic technologies and testing capabilities in the
communications sector, specifically radio frequency (RF), microwave integrated
circuits components and systems used in high performance environments and
wireless communications. End-markets include commercial space (13%),
commercial avionics (8%), commercial communications (36%), medical and energy
(13%) and defence and government (30%). Aeroflex appears to be highly
complementary to Cobham from a technology, capability and customer
perspective, and further broadens the groups exposure to higher growth
commercial business to 41% of sales.
Aeroflex sales split by end-market (year to FY13) Aeroflex sales split by division (year to FY13)

Source: Company data
Here we list some of the main details of the proposed deal.

Deal financials: The all-cash consideration of $1.46bn equates to a 2014
adjusted EBITDA multiple of 10.5x (based on Bloomberg consensus), a
reasonable valuation, we believe, given Aeroflexs niche technology capabilities
and its strong fit with Cobham. At c400m, Aeroflex will represent around 17%
of the enlarged group with similar levels of operating profitability (c17%
margin). Transaction fees, including a new $1.3bn/4.5-5% debt facility will total
around 35m, or 4% of the EV.

Equity placing of 180m/net debt to EBITDA increases to c2.6x: The
acquisition is being partially funded by a 5.6% equity share placing (60m shares)
which was competed on 20 May and raised gross proceeds of 180m. Assuming
the deal is completed by the end of Q314, we estimate the net effect will be to
increase balance sheet leverage to 2.9x, or 2.6x on a pro-forma basis, falling to
2.2x by the end of 2015. (Cobham has guided to 2.5x falling to 2.1x in 2015.)
While the share placing means Cobham has retained an element of financial
Space,
13%
Avionics,
8%
Medical
&
Energy,
13%
Defence
& Govt,
30%
Communications,
36%
Test
Solutions
43%
Microelectronics
Solutions
57%
Cobham plc
102
flexibility (should, for example, the opportunity arise to acquire small
technology in-fill deals), we conclude that meaningful M&A is off the agenda
for a while in our view, probably for a year or more until balance sheet
leverage trends towards 2x. This will at least afford management the time to
focus on driving value from the Aeroflex integration.

128m integration costs for 50m pa synergies: Cobham expects to achieve
annualised run-rate cost synergies of $85m/50m for a total investment of
$215m/128m as outlined previously. Areas of synergy have been highlighted
by the company as ~10% corporate overhead, ~50% site optimisation, ~15%
operational efficiencies and ~25% supply chain. The costs and synergies are
expected to be progressively incurred/realised over the next four years.

Forecast changes: While we did not have published estimates prior to the
announcement of the acquisition, our model confirms managements guidance
that the transaction is earnings neutral in 2014 and is significantly accretive
thereafter; we estimate c8% EPS accretion in 2015.
Cobham plc
103
Key investment point three: high dividend growth

Cobham has a long history of strong dividend growth, averaging 13% pa
over the past 20 years.

Even after funding the Aeroflex acquisition, management has committed
to a continuation of the progressive policy with 10% anticipated for 2014.
DPS (p): impressive dividend record;
commitment to 10% growth pa
DPS and EPS profile (p): cover has been falling
due to low EPS growth, although the situation is
stabilising now earnings are strengthening

Source: Cobham, Berenberg estimates Source: Cobham, Berenberg estimates
Committed to double-digit EPS growth
Despite weak earnings progression in recent years, management has committed to
10% dividend growth policy for the foreseeable future, backed by a strongly cash-
generative business. Indeed, managements confidence in the groups ability to
fund higher payouts was highlighted in 2011, when the dividend was increased by
35% yoy, despite slowing US military end-markets and negative organic sales
growth. At 10% growth pa, the shares offer a relatively attractive (and secure)
dividend yield of 3.3%, rising steadily to 4.4% by 2017.

0%
6%
12%
18%
24%
30%
36%
0
3
6
9
12
15
18
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
E
2
0
1
6
E
DPS Growth
0
1
2
3
4
5
6
0
5
10
15
20
25
30
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
E
2
0
1
6
E
DPS EPS Cover (rhs)
Cobham plc
104

Source: Berenberg estimates, Cobham
Revenue (GBPm) 2010 2011 2012 2013 2014 2015 2016
Communications & Connectivity 561 507 585 653 685 834 867
US Defence Electronics 500 469 460 411 429 602 613
Mission Systems 321 372 373 358 338 358 384
Aviation Services 274 308 327 365 398 412 423
HO & eliminations -26 -22 -32 -18 -6 -6 -6
'Core' Businesses Revenue 1,629 1,634 1,712 1,769 1,845 2,200 2,281
Non-core businesses 274 220 37 21 4 0 0
Group Revenue 1,903 1,854 1,749 1,790 1,849 2,200 2,281
Revenue Growth
Communications & Connectivity -4.4% -9.6% 15.4% 11.6% 4.9% 21.8% 4.0%
US Defence Electronics 3.3% -6.2% -1.9% -10.7% 4.3% 40.4% 1.8%
Mission Systems 10.5% 15.9% 0.2% -4.0% -5.4% 5.8% 7.3%
Aviation Services 18.4% 12.7% 6.0% 11.8% 9.1% 3.5% 2.5%
HO & eliminations 52.9% -15.4% 45.5% -43.8% -66.7% 0.0% 0.0%
'Core' Businesses Revenue 3.4% 0.3% 4.8% 3.3% 4.3% 19.3% 3.7%
Group total 1.2% -2.6% -5.7% 2.4% 3.3% 19.0% 3.7%
EBITA (adjusted)
Communications & Connectivity 122 119 128 124 126 158 166
US Defence Electronics 75 83 66 55 62 89 91
Mission Systems 62 84 81 74 65 69 74
Aviation Services 34 42 38 48 52 54 55
HO & eliminations 22 15 14 14 14 14 14
'Core' Businesses Revenue 315 343 327 315 320 384 400
Non-core businesses 33 23 5 3 1 0 0
Group total 348 365 332 318 321 384 400
Reported Margin
Communications & Connectivity 21.7% 23.5% 21.9% 19.0% 18.4% 19.0% 19.1%
US Defence Electronics 15.0% 17.7% 14.3% 13.4% 14.5% 14.8% 14.9%
Mission Systems 19.3% 22.6% 21.8% 20.7% 19.3% 19.3% 19.2%
Aviation Services 12.4% 13.5% 11.6% 13.1% 13.1% 13.0% 13.0%
'Core' Businesses Revenue 19.3% 21.0% 19.1% 17.8% 17.4% 17.5% 17.5%
Non-core businesses 12.1% 10.2% 13.4% 12.0% n/a n/a n/a
Group total 18.3% 19.7% 19.0% 17.8% 17.3% 17.5% 17.5%
Cobham plc
105
Appendix 1: Divisional snapshot
Communications & Connectivity (38% of sales, 41% of EBITA)
The Communications & Connectivity division, previously called Cobham
Aerospace & Security (CAS), is the largest segment by revenue and profits, and
specialises in aircraft and in-building communication equipment, law enforcement
and national security solutions, and satellite communication equipment for sea,
land and air applications. Capabilities include antenna, satellite communications
(SATCOM) and surveillance equipment. The Communications & Connectivity
division will also include the Test Solutions business from the Aeroflex acquisition,
which generates annual sales of around 165m from the testing of wireless
infrastructure and handsets, and aircraft avionics and radio mobile masts.
Communication & Connectivity sales profile (m)

US Defence Electronics (23% of sales, 21% of EBITA)
US Defence Electronics sales profile(m)


10%
13%
16%
19%
22%
25%
0
200
400
600
800
1,000
2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E
Communications & Connectivity Margin (rhs)
7%
9%
11%
13%
15%
17%
19%
21%
0
100
200
300
400
500
600
700
2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E
US Defence Electronics Margin (rhs)
Cobham plc
106
The US Defence Electronics division, previously called Cobham Defence Systems
(CDS), provides technology for network centric and intelligence operations, and
digital battlefield communications systems. This includes high-end defence
electronic components and sub-systems and sensor systems for large defence
equipment programmes, for example guidance and missile programmes, and sensor
systems and tactical communication systems. The US Defence Electronics division
will also incorporate the Microelectronics Solutions business acquired as part of the
Aeroflex acquisition, which generates around 220m pa of sales from its
microelectronics and semiconductors, microwave and radio frequency, and motion
controls products.
Mission Systems (18% of sales, 21% of EBITA)
Cobham Mission Systems (CMS) provides safety and survival systems for extreme
environments, air-to-air refuelling systems and mission systems for fast jets,
transport aircraft and helicopters, and remote-controlled bomb disposal robots.
CMS revenue (m) and margin profile CMS revenue by end-market (2013: 358m)

Source: Company data, Berenberg estimates Source: Company data

Cobham Aviation Services (22% of sales, 17% of EBIT)
The Cobham Aviation Services (CAVS) division delivers outsourced aviation
services to military and civil customers through military training, special mission
flight operations, and outsourced commercial aviation and aircraft engineering.
CAVS revenue (m) and margin profile CAVS revenue by end-market (2013: 365m)

Source: Company data, Berenberg estimates Source: Company data
16%
18%
20%
22%
24%
0
100
200
300
400
Mission Systems Margin (rhs)
US
Def/Sec
52%
Non-US
Def/Sec
40%
Com/GA
6%
Maritime
/Other
2%
10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
0
100
200
300
400
500
Aviation Services Margin (rhs)
Non-US
Def/Sec
47%
Com/GA
53%
Cobham plc
107
Appendix 2: Major programme exposures
Shipset values

Plane Ship Set Value $k Plane Ship Set Value $k
Military/Fast Jet Trainer Rotary
F16 500-900 EH101 380-600
F/A 18 E/F/G 1,000-2,500 EC175 80-170
F35 1,100 Apache 500
Eurofighter Typhoon 1,400 CH47 (Chinook) 90
Hawk 500 CH 53K 350
Rafale 170 S 61 500
PC-7 160 MH60/UH60 220-500
T50 100-150 V22 1,100
Gripen 190-500 Commercial
Medium/Large Military A320 60
A400M 3,250 A350 130
Sentry E-2D 250 A380 250
Poseiden P8 850 B737 50-110
C130/KC130 3000-3500 B777 50
UAV/Missiles B787 105-150
Predator/Reaper 350-700 C919 35
AMRAAM 50-150 G650 30
AARGM 120 Mitsubishi Regional Jet 50
PAC3/Patriot 130 Naval
Standard Missile 90-125 EDG 1000 1,200-1,400
Global Hawk 1700-2000 Aegis DPYIDV 2,200-3,200
Cobham plc
108
Financials


Sales 1,749 1,790 1,849 2,200 2,281

Cost of sales -1,173 -1,221 -1,261 -1,501 -1,556
Gross profit 575 569 588 699 725
Selling and distribution -81 -85 -87 -104 -108
General and administration -264 -328 -345 -376 -365
Share of profit after tax of JV's and associates 7 3 3 3 3
EBIT 238 159 159 222 255

EBITDA (adj) 392 386 387 479 500
Depreciation -60 -68 -66 -95 -100
EBIT (adj) 332 318 321 384 400
EBIT 238 159 159 222 255

EBT 204 127 116 160 194
EBT (adj) 303 291 282 326 343

Other taxes -27 -45 -34 -35 -32
Tax rate 16% 10% 20% 21% 21%
Profit after tax 172 115 93 126 153
Profit after tax (adj) 244 233 225 257 271
Net income from continuing operations 172 115 93 126 153
Income from discontinued operations (net of tax) 0 0 0 0 0
Net Income 172 115 93 126 153
Minority interest -0.1 -0.2 -0.1 -0.1 -0.1

Net income 172 114 93 126 153
Net income (adj) 244 233 225 257 271


EPS (reported) (p) 16.0 10.7 8.4 11.1 13.5
EPS (adjusted) (p) 22.5 21.6 20.1 22.4 23.6


Cobham plc
109
Balance sheet

Property, plant and equipment 305 351 355 345 330
Fixed assets 1,484 1,559 2,329 2,214 2,089

Inventories 306 316 296 296 306
Accounts receivable 281 318 318 318 318
Other current assets 26 16 16 16 16
Cash and cash equivalents 264 201 201 201 201
Deferred taxes 10 10 10 10 10
Current assets 888 860 840 840 850

TOTAL ASSETS 2,372 2,419 3,169 3,054 2,939

Long-term debt 317 310 310 310 310
Pensions provisions and similar obligations 73 87 91 95 99
Other provisions and accrued liabilities 60 54 54 54 54
Non-current liabilities 451 451 455 459 463

Bank loans and other borrowings 307 345 1,009 912 813
Accounts payable 350 370 370 370 370
Current liabilities 867 924 1,554 1,426 1,299



Cobham plc
110
Cash flow statement
GBPm 2012 2013 2014E 2015E 2016E

EBITDA (adj) 392 386 387 479 500

Other costs affecting income / expenses -60 -82 -93 -37 -35
(Increase)/decrease in working capital 30 -27 20 0 -10
Cash flow from operating activities 362 277 314 442 455
Net Interest -29 -29 -38 -58 -56
Cash tax -45 -38 -58 -65 -69
Net cash from operating activities 288 211 217 319 329

Capex -48 -58 -70 -85 -85
Payments for acquisitions -286 -129 -890 -10 -5
Dividend received from joint ventures 8 4 0 0 0
Financial investments 19 -22 0 0 0

Free cash flow (memo) 226 149 142 229 239

Dividends paid -93 -97 -107 -122 -136
Net proceeds from shares issued -19 -2 180 0 0
Others 0 0 0 0 0

Net cash flow -127 -93 -664 97 98

Reported net debt -361 -454 -1,119 -1,021 -923


Cobham plc
111
Ratios
Ratios 2012 2013 2014E 2015E 2016E
Valuation
EV/sales 1.6x 2.1x 2.6x 2.2x 2.1x
EV/EBIT (adj) 8.5x 11.8x 15.1x 12.5x 11.8x
P/E (adj) 13.8x 28.0x 39.1x 29.4x 24.2x
P/E 13.8x 28.0x 39.1x 29.4x 24.2x
P/FCFPS 10.5x 21.5x 25.5x 16.2x 15.5x
Free cash flow yield 9.5% 4.6% 3.9% 6.2% 6.5%
Dividend yield 4.0% 3.2% 3.2% 3.6% 3.9%

Growth rates
Sales -6% 2% 3% 19% 4%
Sales organic -1% -4% -3% 3% 4%
EBIT (adj) -9% -4% 1% 20% 4%
EPS (adj) 3% -4% -6% 11% 5%
EPS -5% -33% -22% 33% 21%
DPS 10% 10% 10% 10% 10%

Financial ratios
FCF conversion 53% 29% 23% 37% 39%
Net gearing 25% 30% 49% 46% 44%
Net debt/EBITDA 0.9 1.2 2.9 2.1 1.8
ROCE 19% 17% 11% 14% 15%
ROIC 13% 12% 12% 14% 14%
WACC 7.4% 7.4% 6.6% 7.1% 7.1%
FCF ROCE 16% 10% 6% 10% 11%
Inventory turnover (sales/inventory) 5.7 5.7 6.2 7.4 7.5
Self-funded R and D/sales 4.4% 5.0% 5.1% 5.0% 5.0%
Total R and D 8.9% 10.4% 11.2% 11.0% 11.0%
Capex/sales 2.8% 3.2% 3.8% 3.9% 3.7%

Key financials

Sales 1,749 1,790 1,849 2,200 2,281
EBIT margin (adj) (%) 19.0% 17.8% 17.3% 17.5% 17.5%
EBIT (adj) 332 318 321 384 400
EPS (adj) (p) 22.5 21.6 20.1 22.4 23.6
DPS (p) 8.8 9.7 10.6 11.7 12.9

Free cash flow 226 149 142 229 239
Acquisitions and disposals -242 -128 -890 -10 -5
Net cash flow -127 -93 -664 97 98

Other fixed assets 382 397 392 382 367
Total working capital 238 263 243 243 253
Gross debt 624 654 1,319 1,221 1,123
Pensions and similar obligations 73 87 91 95 99
GKN plc
Aerospace & Defence
112

Driving through the headwinds

GKN is a global engineering firm with leading positions in the
automotive, aerospace and industrial sectors. We initiate coverage with
a Buy rating and a price target of 440p. We are not suggesting
investors need to buy in early given the potential for muted half year
results on 24 July (mainly due to currency effects), and the c3%
relative share price outperformance against our peer group ytd.
However, we are positive about the fundamentals of the business,
which is benefiting positive cyclical and structural trends in the global
automotive and aerospace markets. Valuation multiples are
undemanding in our view, and we believe the shares will resume their
positive trajectory as the mid- and longer-term growth outlook is
steadily priced in.

Q1 strong underlying performance: Organic sales growth of 7%
in Q1 was offset by 6% currency effects. By division, Aerospace
(+5%), Driveline (+14%) and Powder Metallurgy (+8%) were
tempered by a 9% decline in Land Systems. Full-year guidance was
confirmed.

Above-market growth: We are confident that GKN will deliver top-
line growth ahead of its chosen markets driven by structural factors: in
Automotive, by favourable product and market exposures including
all-wheel drive, emerging markets, higher margin design sales, mega
platforms, electric-drive and the premium car sector; and in
Aerospace, which has lagged due to programme delays and lower
military sales, we estimate incremental sales from new programmes
could reach c$600m by 2018.

M&A potential should be viewed as upside: We assume talks on
the potential acquisition of Spirit Aerosystems Wing Systems (WS)
business are continuing with price negotiations likely to be centred on
its loss-making contracts. While we believe WS would be highly
complementary, we are confident management will only pursue a deal
that creates value.

Valuation: The share re-rating reflects increased Aerospace exposure
following the Volvo acquisition in 2012 (37% of EBIT). The stock
trades on an FY14 P/E of 13.6x falling to 12.6x, an 18% premium to
the long-run average.

Buy (Initiation)
Current price
GBp 385
Price target
GBp 440
Reuters GKN.L
Bloomberg GKN LN
Share data

Performance data

Relative performance to SXXP SXNP
1 month -0.5 % 1.2 %
3 months -6.0 % -2.7 %
12 months 5.0 % 10.8 %
Key data

Net gearing 25.0%
CAGR sales 2013-2016 3.8%
CAGR EPS 2013-2016 5.9%

GKN is a global engineering company
producing components for automotive,
aerospace and a variety of industrial
sectors. The company specialises in
driveline systems and power and torque
management systems, in addition to
being a tier one supplier of engine and
airframe structures and components to
the civil and military aerospace industry.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 6,904 7,594 7,621 8,002 8,486
EBITDA (adj) 784 928 962 1,025 1,099
EBIT (adj) 553 661 689 746 814
Net income (adj) 417 469 468 508 553
Net income 465 395 337 379 424
Net debt / (net cash) 871 732 665 432 121
EPS 29.3 24.2 20.6 23.1 25.8
EPS (adj) 26.0 28.3 28.5 31.0 33.6
FCFPS 7.4 22.3 12.5 23.3 28.8
CPS -20.9 9.2 4.1 14.2 18.9
DPS 7.2 7.9 8.4 9.1 9.9
EBIT margin (adj) 8.0% 8.7% 9.0% 9.3% 9.6%
Dividend yield 3.1% 2.0% 2.2% 2.3% 2.5%
ROCE 16.8% 21.4% 20.2% 21.4% 23.3%
EV/sales 0.8 1.1 1.1 1.0 0.9
EV/EBITDA 7.0 9.0 8.6 7.8 7.0
EV/EBIT 9.9 12.7 12.0 10.8 9.5
P/E 7.8 16.1 18.9 16.9 15.1
P/E (adj) 8.8 13.7 13.6 12.6 11.6
GKN plc
Aerospace & Defence
113
GKN investment thesis in pictures
Global manufacturer and technology group with
leading supplier positions with major aerospace
and autos OEMs
Revenue profile by division (m): growth has
stalled in 2014 partly due to currency but should
resume in 2015

Source: GKN Source: Berenberg estimates; GKN

Growing proportion of higher quality aerospace
EBIT (m)
New aircraft programmes to deliver substantial
incremental revenues ($m)

Source: Berenberg estimates, GKN Source: Berenberg estimates

Steady margin expansion: volume and
restructuring benefits tempered by investment in
capacity and new products
Shares have re-rated following the Volvo Aero
acquisition but valuation is not stretched

Source: Berenberg estimates, GKN Source: Datastream

VW
Airbus
Ford
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GKN plc
Aerospace & Defence
114
GKN investment thesis
Whats new? We initiate coverage on GKN with a Buy rating and a 12-month
price target of 440p.
Two-minute summary: The fundamentals of the business are positive, with the
groups two core end-markets, global automotive and aerospace, representing
c85% of sales, growing concurrently. This we believe will translate to
managements stated ambition of sustaining revenue growth ahead of end-markets
over the mid- to long term (we forecast a sales CAGR of 4.3% to 2017). However,
in the near term, performance and earnings growth will be tempered by a
combination of currency headwinds, phasing in Aerospace (with a slow ramp-up of
new commercial programmes and wind-down of profitable military programmes)
and higher tax, which we believe will translate to muted H1 results and flat earnings
for the year. We see potential for some share price volatility as a consequence, but
over time we expect the shares to advance as the growth trend resumes.
Key investment point one: sustainable growth above market rates
85% of sales are in the aerospace and automotive markets, both of which are in
cyclical upswings. GKN is positioned to benefit from multiple structural factors
that we believe will sustain top-line growth ahead of the market, which is a stated
management target. In automotive, this includes an increasing mix of higher
growth all-wheel drive (AWD) systems, product positions on a growing number of
high volume global platforms (defined by the industry as mega more than 1m
vehicles and large 500k to 1m vehicles pa) and exposure to developing
markets (eg China 10%). In Aerospace, where revenue development has lagged
due to commercial programme delays and lower military aircraft volumes, we
estimate four new programmes, the Boeing 787, the Airbus A350 XWB, the
F-35/JSF and the A400M aircraft, will generate over $600m of incremental
revenues by 2018.
Key investment point two: M&A upside
M&A has been a key element of the GKN growth strategy in recent years,
transforming the Aerospace portfolio through the Airbus Filton and Volvo Aero
acquisitions and deepening the groups penetration in higher growth Automotive
sectors such as AWD and geared systems through the acquisition of Getrag.
Management declared an interest in Spirit Aerosystems WS business when it was
effectively put up for sale last year and with no information to the contrary we
assume a potential acquisition remains a prospect. We believe WS would be an
excellent strategic fit, effectively replicating with Boeing GKN Aerospaces
position as the exclusive provider of primary wing structures to Airbus. We assume
the key negotiation point is around legacy loss-making contracts within the WS
business which makes it difficult to call the outcome or assess the financial
implications of a possible deal.
For the purposes of illustration, we suggest a 1bn valuation if WS was generating
industry margins of around 10%. The prospect of potential large-scale M&A and
heightened valuation uncertainties particular to WS could constrain GKNs share
price upside in the near term. However, management has a good track record and a
disciplined approach to capital allocation, and we are confident that it will not
pursue an acquisition unless it creates value for shareholders. We therefore see
limited downside risk, regardless of the outcome, and do not see uncertainty as a
reason to shy away from the stock.
GKN plc
Aerospace & Defence
115
Share price performance valuation
The GKN share has been a strong relative performer over the past few years,
driven by a combination of a continuation of a strong earnings recovery following
the autos-led collapse in the financial downturn and a re-rating underpinned by
earnings consistency and a growing proportion of sales into the higher rated
aerospace market. GKN shares are up by 3% ytd, the third-highest in our coverage
(a 1.5% outperformance of the SXNP Index) and currently trades on a 12-month
forward P/E of 12.8x, which is a 20% premium to the 10-year average of 10.7x.
Similarly on a 12-month forward EV/EBITDA basis, GKN trades on a 26%
premium to its long-run average.
Share price versus market and sector (re-based) GKN 12-month forward P/E (20-year)

Forecasts momentum has stalled
Strong earnings momentum in the years following the global autos downturn was
driven by volume recovery on a significantly restructured cost base. Over the past
two years, however, forecast momentum has been broadly neutral, with the latest
revisions (in 2014) being negative and mainly reflecting adverse currency effects.
Consensus EPS forecasts ytd are down by 7.4%, of which we estimate c5% relates
to FX adjustment with the rest due to a combination of a higher tax rate (22%
versus 20% in 2013) and modestly slower growth.
Long-term forecast EPS changes (p): growth
continuing but upwards momentum has stalled,
mainly due to FX
Short term EPS revisions and share price (p):
shares have caught up with forecast expectation

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GKN FTSE A-S Pan Euro A&D
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FX-driven
revisions
GKN plc
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116
Recent results and outlook

FY13 results: 2013 results were slightly ahead of consensus sales and profit
estimates. Initial guidance for 2014 was qualitative in nature, with management
indicating another year of progress which on a reported basis will be
tempered by expected currency effects.

Q114 results reassuring update, full-year guidance unchanged: A strong
underlying performance in Q1 was virtually neutralised by adverse currency
effects. An organic sales increase of 7% was offset by a 6% FX headwind.
Trading profit grew by 19%, helped by the absence of 23m of restructuring in
2013, resulting in a 130bp increase in margin to 8.7%. At the division level,
strong organic performances in the automotive segments (Driveline: +14%;
Powder Metallurgy: +8%) and Aerospace (+5% with commercial aerospace
up strongly offset by flat military) were partly offset by a 9% organic decline in
Land Systems due to weakness in agricultural equipment and the effect yoy of
contract completions. Underlying margins improved in Driveline (+30bp to
8.0%), Powder Metallurgy (+80bp to 11.0%) and Aerospace (+40bp to 10.3%),
offset by lower margins in Land Systems (-200bp to 7.4%). Full-year guidance
was confirmed (again not quantified) as an expectation of modest organic
growth throughout the rest of the year.

2014 forecasts: We forecast a relatively flat year overall, with revenue growing
only 0.4% to 7.6bn with organic growth offset by a c4% adverse FX effect.
We factor a 33bp improvement in group operating margin to 9.0%, resulting in
4.8% growth in trading profit to 689m, again with organic growth and lower
restructuring effects partially offset by FX. After incorporating a higher tax rate
of 22% (versus 20% in 2013), we forecast flat earnings of 28.6p.

2015 and beyond: In the absence of currency headwinds, we expect growth to
accelerate from 2015 driven by automotive and aerospace volumes. We forecast
sales growth of 5-6% in 2015 and 2016, with respective EBIT growth of 8%
and 9%. We anticipate similar growth in earnings as the impact of lower finance
charges are offset by a progressively higher tax rate.
Berenberg forecasts versus consensus

Source: Berenberg estimates, Bloomberg
Ber. Cons diff (%) Ber. Cons diff (%) Ber. Cons diff (%)
Sales (m) 7,621 7,369 3.4% 8,002 7,748 3.3% 8,486 8,161 4.0%
EBIT adj (m) 689 666 3.4% 746 741 0.7% 814 790 3.1%
EPS adj (p) 28.5 28.4 0.5% 31.0 31.5 -1.7% 33.6 33.6 0.1%
DPS (p) 8.4 8.6 -2.4% 9.1 9.4 -3.1% 9.9 10.1 -2.1%
2015 2016 2014
GKN plc
Aerospace & Defence
117

M&A upside/downside: GKN is an acquisitive company, as evidenced by the
more than 1.4bn spent on transactions over the past decade, of which 1.1bn
was in the last five years. We explore further in this note the potential
acquisition of Spirit Aerosystems WS business, which has been looming for the
best part of a year since Spirits decision to exit was announced. We believe WS
is an excellent strategic fit with GKNs existing wing structures business but it
would also represent a significant transaction we suggest at least high triple-
digit millions to 1bn in the context of the groups current net debt of
c700m, gearing of c35% and leverage of 0.7x. Management has a good record
of successfully executing large deals including the Airbus wings, Getrag
(Driveline) and Volvo Aero (Engine components) acquisitions, so we are
confident valuation downside risks relating to M&A is relatively low.

Aerospace growth continues to lag: While growth in the commercial aircraft
sector has surged in recent years, organic growth in the Aerospace division has
lagged delivering a four-year CAGR of just 1.8%. This is due to a
combination of delayed commercial aircraft programmes (the 787 and the
A350) and lower military aircraft volumes (the C-17, the F-18 and the F-15).
The pace of production ramp-up on the A350 represents the greatest risk to
near-term growth expectations, in our view, as volumes are set to increase
sharply up from a low base. The A350 delay risks are mitigated by programme
maturity and recent programme status updates communicated by Airbus. On
the military side, we expect continued volume declines on mature aircraft
programmes, although this will partly be offset by the steady ramp-up in
production of new, well-funded core programmes such as the A400M, the
F-35/JSF and the CH53-K helicopter.

Land Systems strategy is less clear: The Land Systems division continues to
underperform, having reported an organic decline in sales of 9% in Q114 which
followed a 6% decline in the year ended 2013 and a 1% decline in 2012. This
can be largely explained by end-market cyclicality, initially in the mining and
construction sectors, and more recently in the agricultural equipment market.
Notwithstanding market volatility, the long-term strategic direction of Land
Systems is not clear to us. Only modest progress has been made against
strategic objectives communicated at the time the division was created in 2010,
which included to globalise and increase the proportion sales outside of Europe
and to grow revenues both organically and by acquisition to 1.5bn within five
years. We forecast sales of 860m in 2014.

Cyclicality/valuation risk: GKN is one of the more cyclical companies in our
coverage, due to its exposure to automotive and industrial end-markets. This
has translated historically to share price volatility, with share price performance
particularly correlated to the global automotive sector (c80% share price
correlation over 30 years). However, the relationship is lessening as exposure to
the less cyclical and higher rated aerospace sector has increased. Nevertheless, a
slowdown in global auto production remains a central risk to the shares, initially
to a de-rating rating and ultimately to forecasts revisions.
GKN plc
Aerospace & Defence
118
Valuation
440p price target
Due to the conglomerate nature of the group with diverse end-market exposures, a
peer relative sum-of-the-parts valuation approach is appropriate, we believe. We
also blend a DCF fair value to capture the long-term growth profile.
Valuation summary table (p)


of-the-parts analysis (EV/sales and EV/EBITDA).

Buy recommendation.

The implied target P/E of 15.4x (FY14) falling to 14.2x (FY15) and 13.1x
(FY16) compares to a long-term average of 10.7x on a 12-month forward
earnings basis. We believe this is justified given the material changes in business
composition towards higher-quality aerospace activities (representing 37% of
group EBIT), structural improvements in the operating activities of Driveline
and Powder Metallurgy and the fact that the groups two core end-markets are
growing concurrently and experiencing a prolonged upturn.
Sum-of-the-parts
calculation.

DCF 462 462 8.4% WACC / 2% TG
GKNs 12-month forward P/E (10-year) GKNs P/E relative to FTSE All-Share (10-year)

Source: Datastream
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GKN plc
Aerospace & Defence
119

DCF valuation
We calculate a DCF fair value of 462p, within which we assume a terminal margin
of 10% and terminal growth rate of 2.0%. We also incorporate the 1.3bn IAS 19
accounting pension deficit as a debt/liability. Sensitivities to our key assumption
are shown in the two tables below.
DCF summary table




Driveline 2,929 7.5 2,912 0.83 2,920
Powder Metallurgy 1,230 8.5 1,026 1.07 1,128
Aerospace 3,320 9.2 3,107 1.39 3,213
Land Systems 715 7.4 958 1.11 836
Other businesses 36 6.8 90 1.30 63
Corporate -106 6.5 0 NA -53
Total 8,123 8.3 8,093 1.06 8,108
Net cash/(debt) -665
Pension (IAS19) -626
Equity value 6,817
Price per share (p) 416
Driveline 2,922 6.9 3,196 0.86 3,059
Powder Metallurgy 1,217 7.9 1,069 1.05 1,143
Aerospace 3,354 8.8 3,132 1.34 3,243
Land Systems 716 7.0 795 0.90 756
Other businesses 21 6.0 44 1.30 32
Corporate -98 5.5 0 NA -49
Total 8,132 7.8 8,235 1.03 8,184
Equity value 7,136
DCF Model m
WACC 8.4% Pension -1,271
Share value (p) 462
462 9.0% 9.5% 10.0% 10.5% 11.0%
7.0% 597 599 600 602 603
7.5% 529 530 531 533 534
8.0% 471 473 474 475 477
8.5% 423 424 426 427 428
9.0% 382 383 385 386 387
EBIT margin
W
A
C
C
462 0.5% 1.5% 2.5% 3.5% 4.5%
7.0% 484 553 653 809 1090
7.5% 437 493 572 690 886
8.0% 397 443 506 597 740
8.5% 361 400 451 523 631
9.0% 330 363 405 463 546
Terminal growth
W
A
C
C
GKN plc
Aerospace & Defence
120
Key investment point one: sustainable above-market
growth

GKN has delivered strong underlying growth (a 6.3% sales CAGR) since
the downturn. We believe growth can be sustained driven by the groups
more than 80% sales exposure to automotive and aerospace end-markets,
which are benefiting both cyclical and structural growth trends. We
forecast an organic sales CAGR of 4.3% to 2017.

Structural growth drivers underpin above-market growth potential in
automotive: 1) The rise of the mega/large platform (globally common
platforms), which account for over 70% of Driveline sales; 2) exposure to
higher-growth sectors, eg all-wheel drive (AWD), electric drive and
European premium cars; 3) exposure to higher-growth markets, eg
China, which now accounts for 10% sales.

Structural growth drivers underpin above-market growth potential in
aerospace: 1) the super cycle a record industry backlog supports
rising commercial aircraft production through to the end of the decade;
2) new programme exposures including the 787, the A350 (including the
TrentXWB), the A320NEO (including the GTF), the F-35/JSF and the
A400M.
Automotive and aerospace upcycles are in sync
Management has repeatedly targeted individual segments to grow ahead of their
core markets, which for GKN principally means automotive and aerospace,
representing c85% of group sales and c87% of EBIT. Above-market growth has
largely been achieved in automotive in recent years but the Aerospace division has
lagged, due primarily to lower military volumes and delays to new commercial
programmes, in particular the Boeing 787 and the Airbus A350. However, overall,
the group has generated consistent growth since the downturn, and with
automotive and aerospace production upcycles now in sync and new aerospace
programmes on a path to maturity (meaning lower risk), we expect GKN to deliver
its above average growth objective through our forecast horizon.
Group revenue (m) and EPS growth Organic revenue growth by segment: Driveline
and Automotive are consistently growing above
market rates; aerospace is set to pick up

Source: Berenberg estimates, GKN Source: Berenberg estimates, GKN
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2011 2012 2013 2014E 2015E 2016E 2017E
Driveline Powder Met Aerospace Land Sys
GKN plc
Aerospace & Defence
121
Why we think GKN can grow ahead of the automotive market
GKN has around 55% sales exposure to the global automotive sector, mainly
through the Driveline (100% of sales) and Powder Metallurgy (80% of sales)
divisions. Global light commercial vehicle (LCV) production has been growing
steadily since the financial-crises-driven collapse in 2009 and is forecast by IHS to
achieve compound growth of 3.5% pa to 2017. There is a clear split between
developing and developed markets, with 5.9% and 1.3% CAGRs respectively, but
GKNs businesses are broadly spread geographically (eg Driveline sales split:
Europe 37%, the US 36% and the RoW 27%, of which China is 10%). Hence we
view the global LCV production estimates as a good base from which to derive our
forecasts.
Global passenger car and LCV production Correlation of Driveline sales growth to global
automotive production

Source: Berenberg estimates, IHS data Source: Berenberg estimates, IHS data
Vehicle segment and platform trends are positive for GKN Driveline

AWD growth: Following the acquisition of Getrag in 2011, AWD systems
account for almost one-third of Driveline sales. Demand is increasing, with the
technology becoming more affordable and migrating to a greater number of
smaller vehicles, including small SUVs and crossover. IHS forecasts a 7.2%
CAGR to 2018 in this sector.

Exposure to mega platforms: Over 70% of Driveline revenues are derived
from mega platforms (more than one million vehicles pa) and large platforms
(500k to one million units pa). IHS estimates that these platforms account for
52% of the global market currently and forecasts a steady increase to 58% by
2018, driven by the OEM trend towards common global platforms. In other
words, mega and large platforms will represent c75m vehicles by 2018, up by
25% from the c60m vehicle currently.

Exposure to higher growth markets: China is now the largest and highest
growth LCV market globally and accounts for about 10% of Driveline sales.
The production outlook for China is for continued strong growth, with IHS
forecasting a 7% CAGR to 2018. Driveline should exceed this due to strong
OEM and platform positions (eg with SAIC and Geely) and greater value
content through the recently expanded SDS China JV (to include AWD and
eDrive products).
0
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1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Auto production Driveline organic sales
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Why we think GKN can grow ahead of the aerospace market
Following the acquisitions of Filton (Airbus wings) in 2009 and Volvo Aero
(engine components) in 2012, the Aerospace division accounts for c30% of group
sales and 37% of EBIT. By sector, the sales split in 2013 was 50% engine structures
and components (eg rotatives, nacelles, pylons, exhausts), 45% Aerostructures (eg
wing spars, trailing edges, fuselages) and 5% Special Products (eg transparencies,
anti-icing systems). The market outlook is positive with steady, long-term growth in
aircraft production underpinned by a record backlog and a growing installed base
of serviceable engines we estimate c450m of engine structures sales are
aftermarket related.
Aerospace sales split by sector (2013) Commercial aircraft production profile

Source: GKN Source: Berenberg estimates, Company data
Aerospace is well exposed to new high-growth programme

76% of division sales are to the commercial aircraft sector supplying products
to all the major aircraft and engine OEMs. GKN Aerospace will benefit from
industry volume increases across all aircraft categories but in particular from
new programmes ramping up. The first chart below shows our estimate of
GKNs top 12 aerospace programmes and highlights the growing importance of
the wide-body sector as volumes on the Boeing 787 and Airbus A350
accelerate. These two programmes, as well as the F-35/JSF and A400M military
aircraft will be key drivers of growth through to the end of the decade,
generating some $600m of incremental revenues by 2020.
Value of top 12 aerospace programmes ($m) Revenue profile of new programme ramp-up
($m)

Source: Berenberg estimates/Boeing/Airbus

45%
50%
5%
Aerostructures Engine structures
Special products
500
1000
1500
2000
Narrow-body Wide-body RJs
0
500
1,000
1,500
2,000
2,500
3,000
3,500
Narrowbody Widebody Military
CAGR 4.3%
0
200
400
600
800
1,000
1,200
A350 B787 F-35 JSF A400M
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Commercial aerospace growth will be tempered by lower military aircraft
volumes Military sales have declined by over 100m since 2009 (a -4% CAGR)
as activity on mature programmes such as the C-17 and F/A-18 slowed. We
expect further reductions over the coming years and assume in our model a -4%
sales CAGR to 2017 (to around 500m), weighted to 2014 and 2015. Downside
risk is mitigated by increasing A400M and the F-35/JSF volumes, both well-
funded programmes where production is set to rise as previously mentioned.
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Investment point two: M&A upside

Management has built a good track record of creating shareholder value
through large-scale M&A (Filton/Airbus wings, Getrag/Driveline and
Volvo Aero/engine systems).

GKN has publically stated an interest in the WS division of Spirit
Aerosystems (SPR US, not rated) which was put up for sale last year. WS
would be an excellent strategic fit for the groups existing wing structures
business.

At c$1.5bn of sales, WS would represent a large transaction. Valuation
uncertainties centre on its recent poor financial performance, which is
due to legacy contract structures. We have faith that GKN management
will only pursue a deal that is value-creative for shareholders.

If WS were achieving more normal margins of c10%, we suggest a
1bn valuation would be realistic. This could comfortably be financed
from existing debt resources (taking leverage to c1.5x). On this basis, we
estimate c5% earnings accretion.
Spirit WS what is it?
Spirit WS is a division of Spirit Aerosystems, the aerospace structures business that
was spun out of Boeing in 2005. WS specialises in the development and
manufacture of aircraft wing structures and components such as flight control
surfaces. Unsurprisingly, Boeing is Spirits largest customer by sales (85% of group
revenues), although WS also has built positions with several other aircraft OEMs,
most notably Gulfstream and Airbus.
WS would be a very complementary fit for GKN, in our view. It is the Boeing
equivalent and direct peer to GKNs existing wings business that was acquired
from Airbus in 2009 and which designs and manufactures primary wing structures
for all Airbus aircraft. WS would significantly increase exposure to Boeing
Commercial Airplanes (BCA), which currently represents just 3% of sales,
compared to c24% for Airbus. WS annual sales are around $1.5bn/900m, larger
than GKNs existing wing activities at around 700m.
Poor financial record
WS revenues have been steadily rising in line with Boeing production over the past
five years. Profit performance has been woeful, however, mainly due to poor
contract execution and, most significantly, the impact of certain loss-making
contract structures, most notably on the Gulfstream G280 and G650 programmes.
We estimate that WS programme losses on fixed price contracts have totalled
$747m over the past two years. Q114 saw an improvement in profitably to its
highest level in five years (12% margin and $50m of EBIT), due in part to
favourable cumulative catch-up adjustments on mature programmes. Margin
performance in years prior has been highly volatile with performance ranging from
heavily loss-making in 2012 and 2013 (more than $400m), to a peak annual margin
of 9.5% in 2010.
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Spirit Aerosystems revenue profile ($m) Spirit Aerosystems quarterly profit profile ($m)

Source: Company data Source: Company data
Insufficient information to determine a fair price
While it is clear to us that the Spirit WS business would be a highly complementary
fit for GKN, increasing exposure to Boeing and other manufacturers, it is most
certainly not clear on what financial terms an agreement might be made. There is
insufficient information to reasonably derive and assess potential valuation
scenarios, for example, whether legacy contract structures can be renegotiated.
However, for the purpose of illustration, if WS were to return to what we consider
to be more normal margins of around 10% (broadly in line with GKNs Airbus
wings business, we believe), then we suggest at least a 1.0x sales multiple would be
appropriate, implying a valuation of around 1bn. This could be comfortably
financed by GKNs existing financial resources leaving balance sheet leverage at
around 1.4x/1.5x EBITDA and assuming an interest rate of 5%, we estimate
such a transaction would be c5% EPS-enhancing.
Regardless of the lack of information, we remind investors that management has a
good record of financial discipline regarding large-scale M&A and hence it is our
firm view that a deal will only be pursued if there is a clear value proposition for
shareholders. We therefore conclude that the balance of risk around a potential
Spirit acquisition should be regarded as to the upside.

0
400
800
1,200
1,600
2009 2010 2011 2012 2013
-100
-80
-60
-40
-20
0
20
40
60
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1
2009 2010 2011 2012 2013 2014
-$405m
-$402m
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Divisional forecasts (m)

Divisional financial table (m)

Source: Berenberg estimates, GKN

Group revenues by segment (2013: 7.6bn) Group EBIT by division (2013: 661m)

Source: Berenberg estimates, GKN
Revenue (GBPm) 2011 2012 2013 2014 2015 2016 2017
Driveline 2,795 3,236 3,416 3,501 3,729 3,946 4,147
Powder Metallurgy 845 874 932 960 1,022 1,087 1,148
Aerospace 1,481 1,775 2,243 2,230 2,338 2,511 2,732
Land Systems 885 933 899 860 878 908 942
Other Businesses 106 86 104 69 34 34 34
Total 6,112 6,904 7,594 7,621 8,002 8,486 9,003
Revenue growth
Driveline 14.9% 15.8% 5.6% 2.5% 6.5% 5.8% 5.1%
Powder Metallurgy 11.3% 3.4% 6.6% 3.0% 6.5% 6.3% 5.6%
Aerospace 2.1% 19.9% 26.4% -0.6% 4.9% 7.4% 8.8%
Land Systems 26.6% 5.4% -3.6% -4.3% 2.1% 3.4% 3.8%
Other Businesses 21.8% -18.9% 20.9% -33.7% -50.7% 0.0% 0.0%
Group 12.6% 13.0% 10.0% 0.4% 5.0% 6.0% 6.1%
EBITA (adjusted)
Driveline 195 235 246 280 307 332 356
Powder Metallurgy 53 87 94 104 112 122 130
Aerospace 166 170 266 258 278 309 341
Land Systems 67 88 75 70 74 80 83
Other Businesses 3 -4 5 4 3 3 3
Corporate -16 -23 -25 -27 -28 -30 -32
Total 468 553 661 689 746 814 881
EBITA margin (adjusted)
Driveline 7.0% 7.3% 7.2% 8.0% 8.2% 8.4% 8.6%
Powder Metallurgy 6.3% 10.0% 10.1% 10.8% 11.0% 11.2% 11.3%
Aerospace 11.2% 9.6% 11.9% 11.6% 11.9% 12.3% 12.5%
Land Systems 7.6% 9.4% 8.3% 8.1% 8.5% 8.8% 8.8%
Other Businesses 2.8% -4.7% 4.8% 5.4% 7.4% 7.4% 7.4%
Group 7.7% 8.0% 8.7% 9.0% 9.3% 9.6% 9.8%
45%
12%
30%
12%
1%
36%
13%
39%
11%
1%
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Appendix 1 Divisional analysis
Driveline
(46% of group FY14 sales/39% of EBIT)
Driveline is the largest division in the group by revenue (c3.5bn), specialising in
the manufacture of components and systems that deliver and manage power to
automotive vehicles wheels. Selling predominately to the passenger and light
commercial vehicle market, Driveline is a global leader in the manufacture of
constant velocity joint systems (CVJs), with a c40% market share and has a strong
position in driveline systems and components for the AWD segment. Driveline
products are supplied to all the major automotive OEMs, and as a result the
division has a broad and global manufacturing footprint. Drivelines top 10
customers (with percentage of sales in brackets) are VW Group (15%), Renault
Nissan (11%), GM, Ford and Fiat (10%), Toyota (6%), Mitsubishi and JLR-TATA
(5%), BMW (4%) and Volvo (Geely) (4%).
Driveline sales by region of origin (2013) Driveline sales by product type (2013)

Source: Company data Source: GKN
Excluding OEM in-house manufacturers, management estimates Drivelines
product market rankings as follows.
Driveline products market position excluding OEMs

Source: GKN

Americas
36%
Europe
37%
RoW
27%
CVJ
systems
63%
AWD
systems
37%
Rank CVJ Sideshafts Propshafts AWD/PTUs AWS Couplings Performance Diffs. Electric Axle
1 GKN GKN GKN JTEKT GKN GKN
2 NTN Dana Magna BorgWarner Eaton Magna
3 Nexteer IFA Rotorian Dymos GKN American Axle American Axle
4 Hyundai WIA American Axle Hyundai WIA Honda Dana BorgWarner
5 Wanxiang/Neapco JTEKT American Axle Manga/WAI JV JTEKT Linamar
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Key points and business features

Driveline revenue growth is highly correlated to cyclical trends in global
auto production: Since the 2008/9 downturn, we estimate Driveline organic
sales growth has exceeded global automotive production by an average of
2.7ppt pa, and in every year apart from 2009 when the severe industry
contraction distorted the activity of many companies in the global supply chain.
We therefore consider Driveline as an auto plus sector, ie capable of
consistently growing ahead of the market, a view which is aligned to
managements assessment of the divisions longer-term growth potential.
Global passenger car and LCV production
Global auto production growth versus Driveline
organic sales growth

Source: IHS IHS / GKN / Berenberg estimates
Drivelines exposure to higher growth and more resilient sectors, coupled with
recent programme wins, supports a profile of sustained market outperformance.
These include the following.
1. Emerging markets: China currently represents 10% of division sales and with
IHS forecasting a four-year production CAGR of 7.3%, it is one of Drivelines
highest-growth regions. GKN recently extended its SDS JV in China to include
AWD and eDrive products, where demand is growing ahead of the overall
market (we discuss this further below). In addition, Brazil/South America (6%
of sales) and India (3% of sales) are important emerging markets for Driveline,
with both regions forecast by IHS to recover after recent weakness, with 3.6%
and 9.3% CAGRs respectively to 2017. In addition, GKN has highlighted a
number of investments to expand CVJ capacity, primarily in emerging markets
including Mexico, Poland and Thailand.
2. North America: During the downturn, Driveline won market share with a
number of OEMs (eg Ford), which has driven an increase in regional sales to
30% from 20% in 2010.
3. AWD Systems: Sales in the higher growth AWD segment have risen to
around 40% of the divisions, following the acquisition of Getrag in 2011 (23%
previously). Demand is being driven by the increasing popularity of SUVs,
lower cost systems and improved fuel economy and emissions, all of which is
seeing the migration of AWD technology to smaller cars. In addition to the
substantial opportunities in China mentioned above, AWD investments are
underway in Sweden, Italy and the US.
4. Premium car (European OEMs such as VW, Audi, Jaguar Land Rover
and BMW): Premium car sales both in Europe and in international markets
0
20
40
60
80
100
120
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
China India Other
CAGR 4.3%
-30%
-15%
0%
15%
30%
Auto production Driveline organic sales
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proved to be less cyclical through the broader downturn and exhibited solid
growth both domestically and in international markets in recent years. This has
been enhanced by additional sales and value content in the AWD sector as a
result of the Getrag acquisition in 2011.
5. Japan remains a headwind: Representing c12% of sales (c400m), Japan is a
major market for Driveline. IHS forecasts a further 9-10% decline in
production in 2014.

Driveline margins are finally starting to creep up. Driveline operating
margins have persistently failed to reach the 8-10% target range set by
management over three years ago, averaging 6.1% over the last decade (or 6.9%
excluding the 2009 industry collapse). CVJ and sideshafts is a relatively mature,
mass-produced technology, which limits margin potential in our view, not least
due to OEM pricing pressures, to around the mid-single-digit level. However,
we are gaining confidence that the business is capable of delivering above 8%
through-cycle returns for several reasons.
1. Selective bidding: In recent years, management has stuck to the mantra that it
is being more selective and disciplined in bidding CVJ and driveline
programmes. Due to the several-year lag from winning a programme to it
contributing to financial performance, we are only now starting to see signs of
a structurally improving margin. In this respect, it is significant that, for the
first time in 2013, Driveline experienced a net flat pricing environment
(typically, we would expect the business to absorb a net price down impact
from the OEMs of at least a low-single-digit pa).
2. Favourable sales mix of higher value AWD systems: Management has said
that Drivelines AWD content can be worth double rear-wheel-drive systems
or 9-10x standard front-wheel-drive (front sideshaft) systems.
3. Restructuring benefits: Profits quality is improving. Historically, multiple
restructurings have tended to be presented below the line. However, Nigel
Steins approach since becoming CEO two years ago has been to absorb
charges in the operating result. In 2013, Driveline delivered a margin of 7.2%
after 16m of restructuring charges, the majority of which related to cost
reduction. The operating margin would have been some 50bp higher at 7.7%,
excluding restructuring. No further charges are anticipated in the current year.
Driveline margins finally moving into target range

Source: GKN/Berenberg estimates
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Target margin range
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Financial profile

We model 5% organic CAGR to 2017, 1.8ppt ahead of estimated growth in
global auto production, driven by favourable regional exposures and growing
demand for AWD systems.

As previously mentioned, we assume steady margin expansion into the lower
end of the target range (8.6% by 2017), which translates to an EBIT CAGR of
9.7% to 2016. In terms of sensitivity, a 50bp improvement in margin equates to
around 20m of EBIT swing. By way of example, based on our 2015 revenue
forecast, a 9% margin (the mid-point of the Driveline target margin range)
would increase the division result by 10.7% and group EBIT by 4.3%.
Driveline revenue and margin profile (m)


-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
-200
0
200
400
600
800
1,000
1,200
Powder Metallurgy Margin (rhs)
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Powder Metallurgy
Powder Metallurgy (PM) is an advanced process technology that describes the
method of producing metallic components and structures through the process of
sintering; heating powdered metal in a furnace and compressing under pressure in a
mould until the particles adhere to each other. Compared to standard forging or
machining components, powder metallurgy benefits include the ability to produce
complex, smaller and lighter parts.
GKN is unique in the PM sector by being vertically integrated. It produces the
powdered metal through its Heoganas business (not to be confused with
competitor Hoganas) and also manufactures components at its Sintering
operations.
PM sales by product type (2012) PM sales by origin (2013)

Source: GKN Source: GKN

Strong market share: GKN is the global number one sinter metals
components manufacturer, which accounts for more than 80% of segment
sales. In powder production, Heoganas is the global number two supplier (it is
number one in the US).

Diverse customer base: The principle end-market for PM components is
Automotive, representing c80% of segment sales, with various industrial sectors
accounting for the balance. The largest customer by sales currently is Ford (9%
of sinter metals), followed by GM (6%), ZF Friedrichshafen (5%) and
FiatChrysler (4%).

Structural growth: PMs market share is steadily increasing, driven by demand
for lighter, more complex parts and systems in the pursuit of fuel efficiency and
lower emissions. Examples include high performance gears and differentials.
Over the last five years, PM value content per vehicle has risen from around
35 to 50 per vehicle (c7.5% pa).

Margin expansion through Design for PM: GKN has been steadily
increasing the level of design input on customers component requirements,
which commands a higher margin compared to the traditional build-to-print
model. We estimate that Design for PM (Powder Metallurgy) accounts for
around a third of segment sales (c300m), up from 20% in 2010.
Sinter
(autos)
73%
Hoeganas
(powder)
17%
Sinter industrial
10%
Americas
55%
Asia-
Pacific
8%
Europe
37%
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Growth in excess of the market: Positive industry demand trends, as
evidenced by the greater vehicle content and increasing proportion of higher
value design activities, are set to continue, we believe.
Financial profile

We model organic growth of 2.0% ahead of current IHS global automotive
forecasts to reflect increasing penetration of PM components in auto
production.

After absorbing 5m of restructuring in 2013, we forecast a step-up in margin
of 90bp to 11.0% in 2014, followed by modest expansion yoy thereafter,
reflecting a greater mix of Design for PM sales and volume benefits.
PM revenue and margin profile (m)


-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
-200
0
200
400
600
800
1,000
1,200
Powder Metallurgy Margin (rhs)
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Aerospace
GKN Aerospace is a tier one supplier of engine and airframe components,
structures, assemblies, transparencies and engineering services to the global
aviation industry. Annual revenues are c2.2bn split by sector: Aerostructures 52%
(c1.8bn), Engine Structures 43% (c960m) and Special Products 5% (c125m).
Commercial aerospace is the largest end-market, representing 73% of sales, with
military programmes accounting for 27%.
GKN Aerospace sales by sector (2013) Aerospace sales by market (2014E)

Source: GKN Source: Berenberg estimates
Products

Aerostructures (wing and fuselage) comprise primary wing structures (rear spar
and trailing edge), flap skins, winglets, fuselage sections and floor grids.

Engine structures comprise Nacelle and Pylon products such as engine
exhaust and intakes, and engine systems and services.

Special products include transparencies (aircraft windows and canopies) and
protection systems (anti-icing systems and fuel tanks).
GKN Aerospace revenue by segment (2013E) GKN Aerospace customer sales (2013E)


Engine
structure
s50%
Special
products
5%
Aerostructures
45%
Commercial
76%
Military
24%
40%
5%
21%
12%
10%
7% 5%
Civil Airliners Regional & BJ's Fast Jets
Rotorcraft Transports Aftermarket
Airbus UTC
GE Boeing
RR Safran
Honeywell MTU
Spirit Lockheed
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Strong market position: Two transformational acquisitions, the Airbus wings
facility (Filton) in 2009 for 136m and Volvo Aero in 2012 for 633m, have
secured GKNs position as a leading provider of metallic and composite aero
structures and complex parts for engines to all the major aerospace OEMs.
Filton brought with it life-of-programme positions on all Airbus aircraft
(primary wing structures) and as a consequence Airbus is the largest customer
by sales at around 20% (c450m). Other key customers include United
Technologies (Pratt & Whitney) 14%, GE Aero Engines 13%, Rolls-Royce and
Snecma (Safran) (both 5%). The business is under-exposed to Boeing
Commercial Airplanes (direct sales: c3% of segment) due to the companys
modest position on Boeings key series programmes, the 737 and 777. A
continued ramp-up in production of the 787, where GKN has a 3m shipset
value, should see sales to Boeing Commercial increase to around 4% of total
over the next few years. We estimate an acquisition of Spirit Aerosystems wings
business, a major supplier to Boeing, would substantially increase this to around
10% of sales in total (or c 800m).
GKN Aerospace revenue profile of top 12
programmes ($m)
Revenue profile of key new programmes ($m)

Source: Berenberg estimates/Boeing/Airbus Source: Berenberg estimates

New programmes to drive growth: Breaking down the Aerospace revenue
profile further, the key driver of growth is new programmes. By 2018, we
estimate annual sales of c$400m on the 787 (from less than $200m in 2013),
c$270m on the A350 (negligible), c$170m on the F-35/JSF (c$70m) and c$80m
on the A400M (negligible). To put it another way, we estimate that over $600m
of incremental revenues will be generated by these four new programmes by
2018. Sales derived from military platforms (currently c500m) will remain
under pressure due to budget constraints in the US. However, longer-term, we
expect military revenues to stabilise as the impact of declining mature
programmes (the F/A-18, the C130J) is offset by increasing activity on new
aircraft (the F-35 JSF, the A400M, the CH53-K).
Financial profile

In the light of strong volume growth in commercial aircraft production in
recent years, the organic sales CAGR of just 1.8% since 2010 has been a little
disappointing. This has largely been due to a combination of new programme
delays (eg the 787, the A350) and lower volumes of key military aircraft (eg the
C-17).
0
1,000
2,000
3,000
4,000
2013 2014 2015 2016 2017 2018 2019 2020
Narrowbody Widebody Military
CAGR 4.3%
0
200
400
600
800
1,000
1,200
2013 2014 2015 2016 2017 2018 2019 2020
A350 B787 F-35 JSF A400M
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We forecast only a modest pick-up in organic growth in 2014 and 2015 (+3.4%
and +4.9% respectively) as early A350 ship sets contribute, followed by an
acceleration in 2016 and beyond as Airbus moves to higher rate production.

We assume margins will be flat to modestly down in 2014 followed by steady,
multi-year expansion benefiting programme maturity and volumes.
Aerospace revenue and margin profile (m)


0.0%
3.0%
6.0%
9.0%
12.0%
15.0%
0
600
1,200
1,800
2,400
3,000
Aerospace Margin (rhs)
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Land Systems
Land Systems manufactures and services powertrain products and systems
primarily for the agricultural, construction, mining and industrial machinery
markets. It is the smallest division by revenue (c 850m), split into three
capability/product areas: Power Management, Structures and Aftermarket &
Services.
Land Systems sales split by activity (2013) Land Systems end-market exposure (2013)


Power Management: The transfer of power from the engine to the drive
system. GKN has leading market positions in agricultural Power Take Off
(PTO) shafts and high-speed primary drive shafts for construction equipment.

Structures: Examples include off-highway wheels (global leader) and
attachment systems for agricultural and specialist mining, construction and
utility vehicles; also in the automotive sub-frames and lightweight structures
used in the space sector.

Aftermarket & Services: The group has an established global distribution and
services structure.
Land Systems sales by geography (2013) Land Systems sales by customer (H113)


Power
Mgt, 41%
Structures,
36%
Powertrain Sys &
Services 23%
Const'n &
Mining
13%
Industrial
23%
Automotives
19%
Agriculture
45%
Americas
21%
RoW
3%
Europe
76%
9%
7%
5%
4%
4%
3%
2%
2%
1%
1%
62%
John Deere
Case N. Holl
Tata
Caterpillar
Claas
Agco
Ford
JCB
VW Group
Daimler
Other
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Revenue declining: Organic growth stalled in 2012 (+1% yoy) followed by a
6% decline in 2013 and a further 9% deterioration in Q114 due to softening
demand, initially for mining and construction and wind energy and more
recently in the agricultural equipment sector, and the impacts of two completed
automotive chassis contracts reducing revenues by c25m in 2013 and 20m in
2014.

Key drivers technology and expansion in to adjacent markets: Similar to
Driveline, market demand is being influenced by structural factors such as the
demand for more fuel efficient and lower emission power management systems.
Recent Land Systems product developments include: 1) continuously variable
drive systems for off-highway and industrial drivetrains, requiring complex
transmission and gear box capabilities; 2) electrical and hybrid drive AWD axles
and electric drive systems for secondary equipment on agricultural vehicles.
Management previously identified new or adjacent markets to target future
growth such as military vehicles, rail and wind power. However, we believe
opportunities are limited in the near term given our view that 1) the military
land vehicles sector is in long-term decline, especially in the US, and 2) the wind
power market will remain weak, we believe, due to persisting government fiscal
pressures.
Financial profile

We forecast a further 2.5% decline in the top line in 2014 followed by a modest
pick-up in 2015, based on our assumption of a slowdown in the agricultural
equipment market and reduced automotive sales due to contract completion (a
c20m impact yoy), partly offset by a recovery in industrial.

We model margins falling by a further 30bp in 2014 to 8.0%, reflecting lower
volumes and the loss of higher-margin contract completions, partly offset by
the impact of non-recurring restructuring in the previous year.
Land Systems revenue and margin profile


-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
-200
0
200
400
600
800
1,000
1,200
Land Systems Margin (rhs)
GKN plc
Aerospace & Defence
138
Financials

Year-end December (GBPm) 2012 2013 2014E 2015E 2016E

Sales 6,904 7,594 7,621 8,002 8,486

EBITDA (adj) 784 928 962 1,025 1,099
Depreciation -214 -235 -240 -245 -250
Amortisation of intangible assets -17 -32 -33 -34 -35
EBIT (adj) 553 661 689 746 814
JV profit -49 -64 -67 -72 -76
Operating profit 504 597 621 674 739
Unusual or infrequent items 131 38 0 0 0
Restructuring and impairment 26 0 0 0 0
EBIT 624 560 527 580 645
Share of profit after tax of JVs and associates 38 52 54 57 61

EBT 568 484 453 518 590
EBT (adj) 493 578 605 670 742

Other taxes 7 28 -21 -22 -24
Tax rate 15% 18% 28% 29% 31%
Profit after tax 488 407 341 383 428
Net income from continuing operations 488 407 341 383 428
Profit attributable to Pension Partnership 20 8 0 0 0

Net income 465 395 337 379 424
Net income (adj) 417 469 468 508 553


EPS (p) 29.3 24.2 20.6 23.1 25.8
EPS (adj) (p) 26.0 28.3 28.5 31.0 33.6


GKN plc
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139
Balance sheet
Year-end December (GBPm) 2012 2013 2014E 2015E 2016E

Fixed Assets 3,749 3,704 3,729 3,671 3,621

Inventories 885 931 1,081 1,201 1,301
Deferred taxes 302 225 225 225 225
Current assets 2,521 2,535 2,685 2,805 2,905

TOTAL ASSETS 6,270 6,239 6,414 6,476 6,526

Long-term debt 937 889 889 889 889
Pensions provisions 978 1,271 1,251 1,231 1,211

Bank loans and other borrowings 115 27 -40 -273 -584
Deferred taxes 204 178 178 178 178



GKN plc
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140
Cash flow statement
GBPm 2012 2013 2014E 2015E 2016E

EBITDA (adj) 784 928 962 1,025 1,099

(Increase)/decrease in working capital -104 -47 -150 -120 -100
Interest paid -71 -71 -73 -65 -60
Cash tax -62 -52 -60 -60 -55

Capex -278 -274 -350 -280 -290
Decrease / (increase) in loans granted 7 1 0 0 0
Proceeds from sales of subsidiaries 3 5 0 0 0


Dividends paid -101 -121 -137 -149 -162
Minority dividend -2 -3 0 0 0
Net proceeds from shares issued 134 3 0 0 0
Distribution from Pension Partnership to UK scheme -30 -10 0 0 0
Others 11 -2 0 0 0
Effects of exchange rate changes on cash -12 -10 0 0 0

Net cash flow -333 139 67 233 311

Reported net debt -871 -732 -665 -432 -121

GKN plc
Aerospace & Defence

141

Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 0.8x 1.1x 1.1x 1.0x 0.9x
EV/EBIT (adj) 9.9x 12.7x 12.0x 10.8x 9.5x
P/E (adj) 8.8x 13.7x 13.6x 12.6x 11.6x
P/E 7.8x 16.1x 18.9x 16.9x 15.1x
P/FCFPS 31.1x 17.5x 31.2x 16.7x 13.5x
Dividend yield 3.1% 2.0% 2.2% 2.3% 2.5%

Growth rates
Sales 13% 10% 0% 5% 6%
Sales organic 6% 3% 4% 6% 6%
EBIT (adj) 67% -10% -6% 10% 11%
EPS (adj) 16% 9% 1% 9% 9%
EPS 63% -17% -15% 12% 12%
DPS 20% 10% 6% 9% 9%

Financial ratios
FCF conversion 23% 61% 33% 57% 64%
Net gearing 31% 29% 25% 16% 5%
Net debt/EBITDA 1.1 0.8 0.7 0.4 0.1
ROCE 17% 21% 20% 21% 23%
ROIC 11% 12% 12% 12% 12%
WACC 8% 8% 8% 9% 10%
FCF ROCE 4% 14% 8% 14% 18%
Net research and development/sales (inc. capitalised costs) 3.3% 4.3% 4.0% 3.7% 3.8%

Key financials

Sales 6,904 7,594 7,621 8,002 8,486
EBIT margin (adj) (%) 8.0% 8.7% 9.0% 9.3% 9.6%
EBIT (adj) 553 661 689 746 814
EPS (adj) (p) 26.0 28.3 28.5 31.0 33.6
DPS (p) 7.2 7.9 8.4 9.1 9.9

Free cash flow 110 363 204 382 474
Acquisitions and disposals -445 -69 0 0 0
Net cash flow -333 139 67 233 311

Gross debt 1,052 916 849 616 305
Pensions and similar obligations 978 1,271 1,251 1,231 1,211

Meggitt plc
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Under-rated

We initiate coverage on Meggitt with a Buy rating and a 600p price
target, implying 15% upside. The shares recently recovered some of
the ground lost following the November 2013 profit warning and the
FX-led downgrades in March 2014, but remain good value in our
view. Meggitt is fundamentally well positioned to deliver long-term
growth in attractive civil aerospace and energy end-markets (c60% of
sales), with high-margin aftermarket activity (44% of sales) a key
differentiator to peer aerospace suppliers. Year-to-date, the shares are
down by 1%, which is a 2% relative underperformance to the FTSE
All-Share.

Aftermarket recovering: Quarterly trends are continuing to improve
and we expect Meggitt to deliver sequential improvements through the
rest of the year. This will be important in achieving full-year guidance
and ultimately restoring investor confidence after two years of slow
growth in aftermarket sales.

Nearing peak investment: Meggitt is emerging from an intensive
aerospace bid cycle and as a result is approaching peak investment in
product development for a number of new aircraft and engine
programmes. The associated financial and cash burdens will steadily
diminish as revenues grow and aftersales activity follows.

Forecasts: We forecast a modest decline in EPS in 2014, primarily
due to currency but also business disposal effects offsetting mid-
single-digit organic revenue growth. The groups financial performance
will be weighted to the second half for the same reasons, as well as a
high comparable growth rate in Energy and completion of military
contracts in 2013 (estimated EBIT split: 55% versus 52% historically).

Valuation/view: Meggitt shares have slightly underperformed the
sector ytd and trade at a 10% P/E discount to the European civil
aerospace peers (on 13.4x in FY15). There is clearly less valuation
upside following the recent bounce (+8% in one week), and tactically,
we acknowledge that an optically weak H1 performance (slight sales
decline) could present a risk to sentiment in the near term (interim
results are due on 5 August). However, we still see scope for the
shares to achieve a higher rating through H2 as investors confidence
builds in the full-year result and an improving growth trajectory from
2015.

Buy (Initiation)
Current price
GBp 524
Price target
GBp 600
Reuters MGGT.L
Bloomberg MGGT LN
Share data

Performance data

1 month 6.8 % 9.1 %
3 months 9.3 % 12.8 %
12 months -23.0 % -8.7 %
Key data

Net gearing 18.7%
CAGR sales 2012-2015 1.8%
CAGR EPS 2012-2015 2.6%

Meggitt is a global engineering group
specialising in extreme environment
components and sub-systems for civil
aerospace, military and energy markets.
The company manufactures control
valves, aircraft braking systems, heat
exchangers, environment control systems,
composite structures, sensing systems,
aircraft fire protection and defence
systems, including aerial target systems
and fire training.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 1,605.8 1,637.3 1,620.4 1,697.7 1,791.4
EBITDA (adj) 466.2 482.9 485.0 524.8 561.5
EBIT (adj) 392.1 397.2 398.0 424.8 455.5
Net income (adj) 285.5 296.9 294.1 317.7 344.4
Net income 235.5 232.3 212.7 240.2 266.9
Net debt / (net cash) 642.5 564.6 506.5 404.9 283.3
EPS 30.1 29.4 26.6 29.9 33.1
EPS (adj) 36.0 37.5 36.5 39.4 42.6
FCFPS 22.7 13.8 20.2 27.3 30.9
CPS 14.7 8.0 7.2 12.6 15.0
DPS 11.8 12.8 13.6 14.7 15.9
EBIT margin (adj) 24.4% 24.3% 24.6% 25.0% 25.4%
Dividend yield 3.1% 2.4% 2.6% 2.8% 3.0%
ROCE 11.9% 12.0% 11.6% 12.2% 12.9%
EV/sales 2.4 3.0 3.0 2.9 2.7
EV/EBITDA 8.3 10.7 10.2 9.3 8.5
EV/EBIT 12.2 16.4 15.4 13.9 12.5
P/E 12.7 17.9 19.9 17.7 16.0
P/E (adj) 10.6 14.1 14.5 13.4 12.4
Meggitt plc
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143
Meggitt investment thesis in pictures
2014E revenue splits (1.62bn); Civil Aero and
Energy growing, military declining
Underperformer following November 2013
warning and FX-related earnings downgrades in
February

Source: Berenberg estimates Source: Datastream

But positive mid-/long-term revenue growth;
company targeting 6-7% organic (m)
High-margin aftermarket finally showing signs
of recovery, supported by improving industry
trends

Source: Berenberg estimates, Meggitt Source: Berenberg estimates, company data

Peak product development cycle moving into
harvest
Improving in cash generation profile

Source: Berenberg estimates, Meggitt Source: Berenberg estimates, company data

18%
27%
22%
16%
11%
6%
Civil OE
Civil AM
Military OE
Military AM
Energy
Other
36
37
38
39
40
41
42
425
450
475
500
525
550
575
0
500
1,000
1,500
2,000
Braking Sys Control Sys Poly/Comp
Sensing Sys Equip. Grp
-10%
0%
10%
20%
30%
40%
Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1
2010 2011 2012 2013 2013
Biz jet
recovery
De-stocking /
maintenance
deferrals
0%
2%
4%
6%
8%
0
40
80
120
160
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Co funded Capitalised % of sales
0%
10%
20%
30%
40%
50%
60%
70%
0
50
100
150
200
250
300
350
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
FCF FCF conversion
Meggitt plc
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Meggitt investment thesis
Whats new: We initiate coverage on Meggitt with a Buy rating and a 600p price
Two-minute summary: Following a period of underperformance triggered by the
November 2013 profit warning, investors interest in Meggitt appears to be
returning. The shares have rallied by 8% in recent days apparently on no news,
although on a ytd basis remain 1.0% under water, which is in line with the sector
and a 2% underperformance the FTSE All-Share. For a long-term growth story,
organic growth of 1% in 2013 was a disappointment against year-earlier
expectations of mid-single-digit growth, but in our view, the issues that adversely
affected the group in the second half were largely one-off in nature and not
indicative of a structural increase in business risk. The long-term outlook for
Meggitt is positive, we believe, given the groups attractive end-market exposures
(civil aerospace and energy) and its aftermarket-based business model. Nearer-term,
the civil aftermarket is recovering and we expect sequential improvement as the
year progresses. On a 12-month forward P/E basis, the shares trade at 13.5x, a
c6% discount to civil aerospace peers. With investor confidence returning, we
suggest that mere delivery of 2014 expectations will be sufficient to drive the rating
higher.
Key investment point one: aftermarket trends are improving: 44% of group
sales are derived from aftermarket activities, of which 27% relates to the high-
margin civil aerospace sector. Meggitt supplies many of its spare parts and
aftermarket services on a sole-source or principle supplier basis, which ensures an
annuity-like revenue stream over the life of the aircraft. Continued recovery of the
civil aftermarket is key to the company delivering near-term growth expectations
and will be an important factor in improving investor sentiment towards the stock.
The macro backdrop is positive with global air traffic and aircraft utilisations
trending positively for over a year, indicating that demand for equipment spares
and repairs will continue to rise over the coming quarters. Meggitts aftermarket
activities have lagged the market recovery due to customer specific destocking and
airlines/operators deferring discretionary spending, and while it is too early to
factor into forecasts, we suggest an element of catch-up or volume upside is
possible, albeit not likely before 2015, in our view.
Key investment point two: the product investment cycle is peaking: Meggitt
is a long-cycle business with, in many cases, product development, production,
support and service activities spanning several decades. The company has emerged
successfully from an intensive aerospace bid cycle, having won significant new
business on number of new aerospace programmes which is driving heavy
investment in new product development. In addition, Meggitt is continuing to
invest in expansion of its energy business and also in the groups continuous
improvement programme the Meggitt Production System (MPS). We contend
that Meggitt is nearing the peak of the product investment cycle in relative terms
and that related financial and cash burdens will diminish as revenues grow and
aftersales activity follows.
Confidence in mid-term organic growth target (6-7%)
Meggitts end-market exposures are favourable and despite the 2013 setback and
currency affected 2014, management continues to re-iterate its mid-term organic
growth target of 6-7%. Over half of sales (Civil Aerospace 45%; and Energy
Meggitt plc
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145
11%) are set to grow strongly for the foreseeable future. Concerns about defence
exposures (38%) are overdone in our view given Meggitts platform exposures and
the resilience of the military aftermarket. Outside of the engine manufacturers,
Meggitt is unique among European aerospace and defence suppliers for its high
proportion of aftermarket sales (44% of group), with spares, replacement and
maintenance activity generating high-margin revenues for decades after original
equipment delivery. It is therefore a long-cycle business, and after an intense period
of product investment, we believe long-term growth potential is firming up.
Despite the recent rally, Meggitt shares have materially underperformed the sector
since mid-2013, exacerbated by the profit warning contained in the November
interim management statement (IMS) update. From an all-time high of 572.5p
before the warning, the shares have fallen by 8%. On a ytd basis, Meggitt is broadly
flat, which is a 2% relative underperformance to the FTSE All-Share. As a result,
the stock is trading on a 12-month forward P/E of 13.5x, above the long-run
average of 11.9x.
Share price versus market and sector (re-based) 20-year P/E

Source: Datastream
Note: re-based to Meggitt share price

Forecast momentum
Similar to many aerospace peers, Meggitt experienced a steady upgrade cycle after
the financial crisis as the civil aftermarket and industrial end-markets recovered
from cyclical lows. The positive forecast momentum ended in 2012, however,
mainly due to a slowdown in the civil aftermarket. Over the past year, consensus
EPS forecasts have been cut by 5.7% in part due to the one-off issues that caused
the profit warning in November 2013 and also due to adverse currency effects.
Year-to-date consensus downgrades of 5.6% are about the median for the sector,
and in Meggitts case is mainly due to FX effects.

300
400
500
600
700
800
Meggitt FTSE A-S Pan Euro A&D
4
8
12
16
20
Meggitt Average
ave 11.9x
Meggitt plc
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146
Long-term forecast EPS changes (p) EPS revisions and share price (rhs) (p)

Recent results and outlook recap

2014 IMS (four months to 6 May 2014): Trading was reported as broadly in
line with expectations. Further organic growth in civil aerospace OE (we
estimate growth of c7% yoy) and a continuation of an improving trend in the
civil aerospace aftermarket (we estimate c4% yoy growth) were offset by a
decline in military sales (due to contract completions) and flat revenues in
energy.

2014 outlook confirmed H2-weighted: Management confirmed its previous
expectation of mid-single-digit organic revenue growth and a further
improvement in net cash with performance significantly weighted towards the
second half, mainly due to contract phasing and completions. We forecast an
EBIT split of 45:55 in 2014 compared to a more typical (organic) profile of
48:52.

2014 forecasts slightly down yoy due to currency and scope:
Incorporating the effects of the strengthening of sterling against the US dollar,
the euro and the Swiss franc and disposed businesses, we estimate broadly flat
revenue and underlying EBIT in 2014. We incorporate a 4.3% adverse currency
impact and a 1.7% net reduction in yoy sales from disposed businesses to arrive
at a forecast sales of 1,620m (down by 1.1% yoy), while at the profit level we
forecast flat adjusted EBIT at 398m, again with organic growth offset by
currency and scope effects.
2014 revenue bridge (m)

20
30
40
50
2012 2013 2014 2015 2016
36
37
38
39
40
41
42
425
450
475
500
525
550
575
1,000
1,200
1,400
1,600
1,800
2013 sales Organic
growth
FX Scope 2014E sales
Meggitt plc
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147

Aftermarket recovery continues to lag: Meggitts civil aero aftermarket (27%
of sales) has lagged the industry average with customer destocking and
bankruptcy having disproportionate impacts. Management expects mid-single-
digit growth in aftermarket sales in 2014, but with momentum steadily building,
recovery will be skewed to the second half. The IMS indicated a continuation of
the improving trend in 2013, which we took to mean was around 4% yoy in Q1
following 2% and 3% in the previous two quarters. Given the importance of
civil aftermarket to the Meggitt investment case, any hint of missing the full-
year target would adversely affect sentiment, we believe.

Defence exposure (38% of sales): The majority of Meggitts defence sales are
to the US (61%) and Europe (23%), where downward pressure on budgets will
persist. Over the past three years, Meggitt has seen minimal correlation to US
Department of Defense (DoD) budget trends, with military revenues growing
organically by 5.0% in 2011, 4.2% in 2012 and -2.7% in 2013, compared to total
US DoD budget growth of 0%, -4.9% and -9.8% respectively. Meggitts military
business is broadly spread, with a large and resilient aftermarket component
(41%). Nevertheless, orders can be lumpy in nature, and visibility on spares
orders can be very low, for example. 2014 guidance is for a modest underlying
contraction: after taking account of the completion of two retrofit contracts
during 2013, we interpret this contraction as -4% yoy.

Relatively poor cash generation recently: Despite being a high-margin
business, Meggitt currently screens poorly against peers on a cash generation
basis. 2013 FCF conversion was 28% with a FCF RoE at 5.3%. This is largely
due to the current level of high investment and product development
expenditure ahead of new programme driven growth, a common theme among
many of Meggitts civil aerospace peers. On our forecasts, Meggitts cash
metrics will start to improve progressively from the current year (2014 operating
cash conversion and FCF conversion of 89% and 40% respectively).

Capitalisation: Rightly or wrongly, Meggitts capitalisation policy for R&D and
programme participation costs (product give-aways) is a millstone for the
rating and will continue to constrain valuation upside, we believe. We review the
subject in more detail later in this note, but for the record, we are sanguine
given Meggitts aftermarket business model which generates sustained high
margins predominantly on a sole-source/primary supplier basis over the life of
the platform. Nevertheless, we expect the capitalisation debate to remain at the
fore, not least through 2014 as product investments near the peak.

Currency risk: The groups primary currency exposure is to the US dollar,
given the almost two-thirds of sales that are generated from US businesses, but
there is also exposure to the Swiss franc, to a lesser extent. In terms of
sensitivities, a 10c move in the sterling: dollar rate affects PBT by c16m/c4%
and hence we factor a similar headwind in our 2014 forecasts which are struck
at $1.68 (versus $1.57). This this is partly offset by favourable transaction-
related effects of c4m based on average hedged rate of $1.53.

Low return on capital compared to peers: Meggitt screens as the lowest
ROCE company in our peer group (2014 ROCE: 12% versus an average of
16%). This is in part due to the high level of goodwill carried on the balance
Meggitt plc
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148
sheet (c1.5bn) from a number of large acquisitions and other intangibles such
as capitalised development costs and programme participation costs (PPCs)
(c0.5bn). We highlight two reasons that exacerbate Meggitts optically low
position: 1) several companies in our peer group with above-average ROCE
have written down material goodwill balances in recent years (eg BAE c2bn;
GKN c200m); 2) Meggitts capitalised R&D and PPCs should be assessed in
the context of a long-cycle aftermarket model, where returns on investment are
generated over a much longer timeframe than a pure equipment supply model.
In short, Meggitt is yet to enjoy higher returns from through-life support and
spare parts replacement on large part of its installed base of equipment.
Meggitt plc
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149
Valuation
600p price target

We set our price target at 600p based on a blended average of DCF and
sum-of-the-parts (EV/sales and EV/EBITDA) analysis.
Our 600p price target equates to 15% upside to the current price and
drives our Buy recommendation.
(FY16) compares to Meggitts long-run 12-month forward P/E of 11.9x
(ie c20% premium). We view this as justified given the long-term growth
outlook including the high-growth potential in energy and the steady
recovery in civil aftermarket activities, which deserves a premium multiple.
We highlight in the chart below that Meggitt has historically steadily re-
rated through the civil aerospace production upcycles. Our main
observation of the current cycle, which is proving to be the longest in
history, is that the shares have re-rated much more modestly.
Meggitt P/E shares have not re-rated as sharply in the current aerospace
upcycle so far

Source: Berenberg estimates, Datastream
EV/Sales 496 536 Ave mult 2.91x/2.9x
EV/Ebitda 565 585 Ave mult 10.8x/10.1x
DCF 708 708 7.7%WACC/2.5% TG
0
5
10
15
20
25
Meggitt 20Y Average
ave 11.9x
Meggitt plc
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150

Sum-of-the-parts
calculation.
Sum-of-the-parts table (FY14) Sum-of-the-parts table (FY15)

Source: Berenberg estimates/Datasteam Source: Berenberg estimates/Datasteam
We have adjusted peer average EV/sales multiples to reflect Meggitts high-margin
aftermarket activities. Similarly, we have applied a 10-25% premium to peer
EV/EBITDA multiples given the groups 48% of sales derived from annuity-like
spares activities.
DCF
The table below summarises our DCF model which generates a valuation of 708p
for Meggitt. Core assumptions include a 2.5% terminal growth against the groups
mid-term organic growth target of 6-7%. We chose to take a cautious stance given
recent shortfalls. Similarly, we factor a flat margin (26.0%) despite managements
previous comments that annual improvement of c20bp is possible over the longer
term as operational efficiencies are realised from the MPS internal improvement
initiative and aftermarket mix changes impacts.
DCF summary table

Given that momentum in the aftermarket business is driven by a growing and
maturing installed base, we believe our terminal growth assumption of 2.5% is
pitched cautiously, indicating long-term upside to the valuation. In terms of
sensitivity, a 100bp change in growth translates to c15% valuation. Also, we
highlight WACC sensitivity below it is interesting that even a 150bp increase in
discount rate still derives a valuation above the current share price, all else being
equal.

Civil OE 712 10.8 404 1.5 558
Civil Aftermarket 2,230 11.7 2,452 6.2 2,341
Military 1,056 10.3 829 2.0 942
Energy & Other 1,279 9.8 1,035 1.9 1,157
Total 5,277 10.8 4,719 2.9 4,998
Equity value 4,270
Shares o/s (m) 805
Civil OE 699 10.1 401 1.4 550
Civil Aftermarket 2,341 11.0 2,661 6.2 2,501
Military 932 9.6 750 1.9 841
Energy & Other 1,345 9.2 1,116 1.9 1,231
Total 5,317 10.1 4,928 2.9 5,123
Equity value 4,512
Shares o/s (m) 805
DCF Model m
Share value (p) 708
Meggitt plc
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151



708 24.0% 25.0% 26.0% 27.0% 28.0%
6.7% 846 877 907 938 969
7.2% 741 768 794 820 847
7.7% 657 680 703 725 748
8.2% 588 608 628 648 668
8.7% 530 548 565 583 600
EBIT margin
W
A
C
C
708 0.5% 1.5% 2.5% 3.5% 4.5%
6.7% 668 765 907 1139 1580
7.2% 605 683 794 965 1263
7.7% 551 614 703 833 1045
8.2% 504 556 628 729 886
8.7% 463 507 565 646 765
Terminal growth
W
A
C
C
Meggitt plc
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152

Key investment point one: aftermarket trends improving

44% of group sales are derived from aftermarket activities, of which 27%
relates to the high-margin civil aerospace sector.

Meggitt supplies many of its spare parts and aftermarket services on a
sole-source or principle supplier basis ensuring an annuity-like revenue
stream over the life of the aircraft.

Meggitts civil aftermarket has lagged the industry recovery over the last
year but the quarterly trend is improving.

Industry indicators remain positive and with an ending of customer-
specific de-stocking headwinds we expect Meggitt to deliver sequential
improvements through the rest of the year. This will be an important
factor in improving investor sentiment towards the stock.
Aftermarket play
At the group level, Meggitt derives 44% of its sales from aftermarket activities,
supplying spare parts, repairs, overhaul and maintenance of its equipment on over
60,000 aircraft worldwide. Within this, 27ppt relates to the high-margin civil
aerospace aftermarket; as a result, Meggitt generates the highest operating margin
of the companies we cover (five-year historical average: 24.9%). Despite
encouraging macro trends, Meggitts civil aftermarket revenues have disappointed
over the last 18 months (eg an organic decline of 1% in 2013), partially due to a
prolonged period of customer-specific de-stocking and also the effects of
disciplined maintenance scheduling by airlines/operators.
Robust sector recovery
The industry aftermarket recovery commenced in early 2013 and momentum has
carried through to 2014, with the latest IATA capacity data, a good proxy for
determining demand for spares and repairs for large and regional aircraft trends,
suggesting a robust upswing. IATA capacity data, defined as available seat
kilometres (ASKs), saw an acceleration in the second half of 2013 (up by 5.9%
yoy), which has continued through the first half of 2014, up by 5.8% ytd.

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Airline passenger growth has trended above the long-term average of 4.5%
in recent years, largely matched buy new capacity aircraft

Source: Berenberg estimates, IATA

Meggitts civil aftermarket has lagged its peers, with the company reporting flat
organic growth in 2013 following a 1% decline in 2012. On a sequential basis,
the quarterly trend turned positive in Q213 (+1% yoy) and has trended
positively since, albeit at a low level (Q313: +2%; Q413: +3%; Q114 estimate:
+4%). Comparator growth rates will ease through the second half of 2014, so in
our view, even a measured rebound of spares and repairs demand would
suggest that Meggitt will comfortably deliver against guidance of mid-single-
digit growth in the civil aftermarket in 2014, which will be an important driver
of sentiment towards the stock.
Aftermarket trends improving globally (quarterly
aftermarket sales growth)
Momentum is slowly building in Meggitts
aftermarket (quarterly growth yoy)

Note: quarterly aftermarket sales growth. GE and Pratt & Whitney spares
orders

The age profile of Meggitts installed base is not a concern: Meggitt has
often been questioned about the age of the aircraft fleet, and about whether
equipment is too old. In particular, concerns have circulated about the risk of
losing high-margin aftermarket sales as older aircraft are retired early to make
way for new aircraft which need less servicing. In recent years, strong growth in
civil aircraft OE sales has materially shifted the age profile of Meggitts
aftermarket revenues, with aircraft that are less than 10 years old now
(15%)
(10%)
(5%)
0%
5%
10%
15%
J
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4
ASK (capacity) growth RPK (passenger growth)
Global
financial
crisis
Ash
cloud
Eurozone
concerns
Recovery
-20%
0%
20%
40%
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
2010 2011 2012 2013 2014
MGGT HON
UTAS GE/PW spares
-10%
0%
10%
20%
30%
40%
Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1
2010 2011 2012 2013 2014
Biz jet
recovery
De-stocking /
maintenance
deferrals
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generating 50% of aftermarket revenues compared to 36% in 2008, directly
after the K&F wheels and brakes business was acquired.
Civil aftermarket revenues by fleet age (2008) Civil aftermarket revenues by fleet age (2013)

Source: Meggitt Source: Meggitt

General observations we make from this include the following.
4. The change in mix relating to early retirement of older aircraft and strong
growth in new aircraft has not materially affected Meggitts aftermarket
revenues or profits sufficiently to alter the long-term trajectory, otherwise
margin impacts would have been negative and/or more pronounced. By
way of illustration, revenues from the Meggitt Aircraft Braking Systems
(MABS) segment, which have a very high aftermarket content, have grown
modestly since 2009 (c1% pa) while EBIT margins are 50bp higher at
37.0%. We attribute this smoothing (of the impact of fleet changes) to the
very large installed base of aircraft on which Meggitt has equipment.
5. With a younger average fleet age than five years ago, we suggest Meggitt is
even better positioned to generate substantial aftermarket revenues as the
fleet matures. Put simply, the portfolio is broad enough to absorb these
shifts in fleet mix and a younger average age implies there are greater long-
term aftersales to come.
6. The absolute level of revenue generated from aftermarket continues to
increase steadily, driven by the growing installed base of serviceable
equipment. Management expects organic growth of 8-9% pa over the mid-
term.
Civil aerospace aftermarket sales profile (m) Civil aerospace aftermarket sales by sector (2013
estimate: 385m)

0-10yrs,
36%
10-20yrs,
48%
>20yrs,
16%
0-10yrs,
50%
10-20yrs,
33%
>20yrs,
17%
0
100
200
300
400
500
600
2012 2013 2014E 2015E 2016E 2017E
50%
29%
21%
Large jet
Regional jet
Biz jet
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Key investment point two: product investment cycle peak

Meggitt is a long-cycle business offering, in many cases, product
development, production, support and service activities spanning several
decades.

The group is in the midst of a heavy investment phase, partly due to high
win rates on an unprecedented number of new aerospace programmes
and also due to a rapid expansion of its energy business.

We contend that Meggitt is nearing the peak of the product investment
cycle in relative terms and that related financial and cash burdens will
diminish as revenues grow and aftersales activity follows.
Contract wins driving R&D
A steep increase in R&D spend in 2012 reflects multiple aerospace projects moving
to final development. In 2013, total R&D spend was 135m (of which 24m was
customer-funded)/8.2% of sales, the highest ever level, reflecting several years of
strong win rates on new programmes, including:

aircraft wheels and brakes eg the Bombardier C-Series, the Global Express
7000/8000, the Dassault Falcon 5X;

aero engine sensing eg the thermal control package and sole-source fire
protection on the Pratt & Whitney PurePower1000G GTF engine and
condition monitoring for the TrentXWB;

helicopter fuel systems eg the Sikorsky S92.
Self-funded R&D of 110m equates to 6.7% of sales which compares to an
average of 5.4% pa over the four years to 2011. We anticipate self-funded
engineering investment will continue to rise to a peak of 7% of sales in 2015 and
then fall (relatively) as sales grow.
R&D profile (ex-customer-funded) (m)

Source: Berenberg estimates, Meggitt
0%
1%
2%
3%
4%
5%
6%
7%
8%
0
20
40
60
80
100
120
140
160
2008 2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E
Co funded R&D charged Capitalised Gross R&D as % of sales
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Other new product investment should also decline from 2016
Meggitt supplies some equipment free of charge (wheels and brakes), but as the
sole source life-of-programme manufacturer, it generates high returns over the
long service life of the aircraft. The value of give-aways, which are capitalised as
PPCs is growing due to higher OE volumes on new business jets (eg the
Gulfstream G280/550/650, the Bombardier CRJ900/1000) and regional aircraft
programmes (eg the Embraer 175/195). In 2013, PPCs totalled 36.1m (2012:
35.7m) and we forecast this to rise to 40m in 2014 and to 45m in 2015, with
the yoy increase moderating thereafter. In addition to R&D and PPCs, Meggitt is
investing substantially in manufacturing facilities and production systems ahead of
expected volume growth. Capital expenditure increased by over one-third in the
two years to 2013 (to 71m) and the company has guided c70m-80m in 2014 and
2015). Thereafter we anticipate modest decline.
Pulling it all together (capex, PPCs and R&D), we anticipate peak total investments
relative to sales of 14% in 2015, equivalent to around 240m, more than double
the level of expenditure in 2010.
Total capital and product investments (m)

Impact of capitalisation (PPCs and R&D) c15% in 2013
It is not uncommon for civil aerospace companies to capitalise an element of
development and other costs where they are directly related to defined programmes
and/or there is an identifiable aftermarket stream over the life of the product, the
best example being the aero engine manufacturers and associated through-life
supply of spare parts. We have already discussed Meggitts equipment supply
aftermarket model, where a high proportion of parts/systems are supplied on a
sole-source basis. The majority of aircraft wheels and brakes programmes are
supplied on this basis with the OE supplied free of charge and replacement parts
supplied exclusively over the life of the asset. Meggitt capitalises these give-away
costs and OEM costs to secure participation on the programme (PPCs) and
amortises them over a period of up to 15 years (capitalised R&D is amortised over
up to 10 years).
The policy of capitalising intangibles and the markets perception of so-called
profits quality is the subject of continuing debate and, rightly or wrongly,
represents a constraint on the valuation. Conceptually, we are comfortable with the
0%
3%
6%
9%
12%
15%
18%
0
50
100
150
200
250
300
2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E
R&D (total) PPC Capex as % of sales
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policy given that it is akin to the razorblade model whereby the equipment is given
away but replacement parts are sourced exclusively from the manufacturer. As a
result, Meggitt retains strong pricing power and an annuity-like aftermarket revenue
stream over the life of the asset, sometimes for several decades. For the record, in
2013, Meggitt capitalised 106m of intangibles (R&D: 70m; PCCs: 36m), or
61m net of amortisation. Without capitalisation, operating profit would have been
15% lower.
Capitalised R&D and PPCs on the balance sheet
have been rising steadily (m)
Net capitalised R&D and PPCs as a percentage
of EBITA (after amortisation)

0
200
400
600
800
R&D PPCs
0%
2%
4%
6%
8%
10%
12%
14%
R&D PPCs
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Other investment considerations
Profit warning is not indicative of underlying issues
Meggitt does not give profit guidance, but the trading update in November 2013
was an effective warning that prompted a c7% cut to consensus EPS estimates.
The warning was due to a number of largely supply-chain-related issues (re-capped
below) and which we believe were mainly non-recurring in nature. A further
downwards adjustment to reflect FX transaction effects was a further knock to
sentiment, albeit due to uncontrollable factors. Any profit warning is a
disappointment but our main conclusion is that there do not appear to be any long-
term operational issues to suggest that risks within the business are structurally
higher. The issues that led to the warning were as follows.
4. Raw material supply (1): This related to an incorrect raw material
supplied by a third-party in 2012. Meggitt is liable to replace the equipment
over a number of years at the customers convenience, for which the
company booked a one-off 20m provision. Management does not expect
this issue to repeat.
5. Raw material supply (2): This related to an unexpected shortage of a raw
material called Tourmaline that is used in sensing equipment. We
understand that it has now been designed out of most new products but
that there have been some delays recertifying the products. The company
says it has substantially rectified this issue but that the costs of transition
and other impacts will create a small headwind in the 2014 profit bridge.
6. Contract award delay/project milestone slippage: This related to the
Heatric (heat exchanger) energy business where an expected contract award
was delayed until after the year-end (and subsequently received in May
2014). In addition, the energy business suffered from a one-month slip in a
project milestone (which is now progressing), delaying revenue recognition
under contract accounting. We estimate these two issues had an adverse
impact on profit of around 5m, which was absorbed above the line.
7. Site consolidations: Meggitt encountered production difficulties and
certification delays in the consolidation of two large sensing systems
businesses. We understand buffer stocks and delayed Federal Aviation
Administration (FAA) product certification have now cleared.

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Segment revenues, profit and margin profile (m)


Revenue (GBPm) 2010 2011 2012 2013 2014 2015 2016 2017
Aircraft Braking Systems 310 321 311 330 327 348 370 389
Control Systems 183 202 215 206 205 215 223 231
Polymers & Composites 156 171 187 181 176 178 178 178
Sensing Systems 208 234 240 240 245 263 284 301
Equipment Group 305 528 652 680 669 695 736 773
Group total 1,162 1,455 1,606 1,637 1,620 1,698 1,791 1,872
Revenue growth
Aircraft Braking Systems -2.9% 3.5% -2.9% 6.2% -1.2% 6.6% 6.2% 5.2%
Control Systems 0.5% 10.3% 6.6% -4.3% -0.4% 4.9% 3.9% 3.7%
Polymers & Composites 5.5% 9.7% 9.3% -3.3% -2.8% 1.2% 0.0% 0.1%
Sensing Systems 8.2% 12.2% 2.7% 0.1% 1.8% 7.3% 8.3% 5.8%
Equipment Group -1.4% 73.1% 23.5% 4.2% -1.7% 3.9% 6.0% 5.0%
Group total 1.0% 25.2% 10.3% 2.0% -1.0% 4.8% 5.5% 4.5%
EBITA (adj)
Aircraft Braking Systems 121 120 117 122 121 130 140 148
Control Systems 45 48 50 50 51 55 58 61
Polymers & Composites 28 32 34 30 32 33 33 33
Sensing Systems 40 43 36 34 36 41 47 51
Equipment Group 70 117 155 160 158 166 177 186
Group total 304 360 392 397 398 425 455 479
EBITA margin (adj)
Aircraft Braking Systems 39.0% 37.4% 37.6% 37.0% 37.0% 37.5% 38.0% 38.0%
Control Systems 24.5% 23.8% 23.2% 24.5% 25.0% 25.5% 26.2% 26.5%
Polymers & Composites 18.2% 18.5% 18.1% 16.7% 18.2% 18.5% 18.5% 18.5%
Sensing Systems 19.0% 18.5% 15.1% 14.3% 14.8% 15.5% 16.5% 16.8%
Equipment Group 23.1% 22.1% 23.8% 23.5% 23.6% 23.9% 24.0% 24.1%
Group total 26.1% 24.7% 24.4% 24.3% 24.6% 25.0% 25.4% 25.6%
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Appendix 1: Divisional overview
Meggitt is a global engineering group specialising in extreme environment
components and sub-systems for civil aerospace (45% of group revenue), military
(38%), energy (11%) and other (7%) markets. It is split up into five divisions:
Aircraft Braking Systems, Control Systems, Polymers & Composites, Sensing
Systems and Equipment Group. Approximately 45% of group sales are generated
from aftermarket activities. The matrix shows below highlights each division by
end-market and activity.
Meggitt market matrix (by division)

Source: Meggitt
Meggitt Aircraft Braking Systems (MABS) 20% of sales
MABS represents 20% of sales, generating 86% of its revenue from the aftermarket
and 14% from OE sales. It is the global number one supplier of wheels, brakes and
brake control systems business jets, regional jets and military aircraft, as well as
supplying to the commercial jet and general aviation markets. Characterised by a
high proportion of spares and services sales, it is the highest margin segment (the
average margin over the past five years is 37.5%). In the large majority of cases,
MABS is the sole source supplier to its aircraft programmes, providing parts and
equipment over the life of the platform.
MABS revenue and EBIT margin profile MABS revenue by market

Source: Berenberg estimates, Berenberg estimates, company data
Civil
Original equipment
Aftermarket
Military
Original equipment
Aftermarket
Energy
Other
>10% of Group revenue 3-10% of Group revenue 1-3% of Group revenue
Meggitt Aircraft
Braking Systems
Meggitt Control
Systems
Meggitt Polymers
& Composites
Meggitt Sensing
Systems
Meggitt
Equipment
Group
32%
34%
36%
38%
40%
0
100
200
300
400
Aircraft Braking Systems Margin (rhs)
8%
65%
28%
Civil OE
Civil Aftermarket
Military
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Capabilities: Wheels, brakes and brake control systems; brakes; heatsinks;
landing gear and brakes control; monitoring.

Selected programmes: 1) Civil the Embraer 190, the Bombardier C-Series
and the Global 7000 and 8000, the Falcon 7X Bombardier CRJ700, CRJ100
CRJ 200; 2) defence the Eurofighter, the JSF, the B1B, the G150, the A340,
the Falcon 7X, the Gripen, the V-22; 3) helicopters multiple platforms (Bell,
Boeing, Sikorsky and AgustaWestland).
Meggitt Control Systems (MCS) 13% of sales
MCS represents 13% of group revenue and generated 53% of its revenue from OE
and 47% from the aftermarket. This division designs and manufactures products
which manage the flow of liquids and gases around gas turbines in both aerospace
and industrial applications, and controls the temperature of oil, fuel and air in
aircraft. Its valve business also supplies industrial and airport ground fuelling
products.
MCS revenue and EBIT margin profile MCS revenue by market

Source: Berenberg estimates, Company data Source: Berenberg estimates

Capabilities: Heat management; control valves and sub-systems; electro-
mechanical controls; environmental control; fuel handling.

Selected programmes
o Aerospace valves: 1) Engines (the GE90; the V2500; the PW300, the
500, the 600; the Rolls-Royce Trent, the AE1107, the BR725; the
CFM56; the PW GTF, the SAM146); 2) airframes (the V22; the
Boeing 737/747/777, the C17, the F15, the F/A18; the Dassault
Falcon 7X; the Embraer MLJ; the Gulfstream G450, the 550, the 650;
the CJ130, the F16. 3) air-turbine starters (the P&W308, the R-R
BR725).
o Industrial gas turbines valves and control systems: 1) OEMs (GE,
Rolls-Royce, IHI, Siemens, Kawasaki); 2) aftermarket: Alliance
Pipeline, Trans-Canada Turbines, VBR, Wood Group, Petrobras,
MTU, Statoil.
o Heat exchangers: Commercial and military engines (the CFM56, the
Trent 900, the Trent 700, the GP7200, the PW2000, the F135 (the F-
35/JSF)).
22%
24%
26%
28%
30%
0
50
100
150
200
250
Control Systems Margin (rhs)
31%
24%
32%
7%
6%
Civil OE
Civil Aftermarket
Military
Energy
Other
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Meggitt Polymers & Composites (MPC) 11% of sales
MPC represents 11% of group revenue with military sales representing 60% of the
total. Products include flexible bladder fuel tanks, ice protection products and
composite assemblies for fixed wing and rotary aircraft and seals packages for civil
and military platforms. The company groups these market segments because of
their dependence on similar materials technology and manufacturing processes.
MPC revenue and EBIT margin profile MPC revenue by market

Source: Berenberg estimates, company data Source: Berenberg estimates

Capabilities: Flexible, ballistically-resistant and crashworthy fuel tanks; wet
wing fuel storage; high performance seals; specialist technical polymers; smart
electro-thermal ice protection systems; complex composite structures

Selected programmes: 1) Ice protection Sikorsky (fuel tanks, electro-thermal
ice protection equipment, secondary composite structures and interiors for a
range of military helicopters); 2) polymer seals B777 cargo door, A380 and
B787 trailing edges; multiple seals programmes with aircraft OEMs and major
Tier 1 and 2 suppliers; 3) fuel containment polyethane fuel bladders on every
US business jet, fighter, bomber, tanker, and transport; wet wing sealant on the
KC-10, the E-8C JSTARS, the Sikorsky S-76 and the UH-60, the C-130, the
KC-135, the P-3.
Meggitt Sensing Systems (MSS) 15% of sales
MSS represents 15% of group revenue and generated 80% of its revenue from OE
and 20% from aftermarket. It designs and manufactures critical, extreme
environment sensors to measure a variety of parameters such as vibration,
temperature, pressure, fluid level and flow in an aircraft and ground-based turbines.
Sensors are combined into broader electronics packages, which provide condition
data to engine operators and maintenance providers. MSS has migrated these
products into other markets requiring similar capabilities, such as test and
measurement, automotive crash test and medical pacemakers. It has also teamed
with MABS, to win a number of new commercial tyre pressure monitoring system
contracts. This is an example of the companys strategy is to apply their engine
condition-monitoring capability to the structural parts of aircraft.

14%
16%
18%
20%
22%
0
50
100
150
200
Polymers & Composites Margin (rhs)
25%
15%
60 %
Civil OE
Civil Aftermarket
Military
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MSS revenue and EBIT margin profile MSS revenue by market

Source: Berenberg estimates, company data Source: Berenberg estimates

Capabilities: Extreme environment sensing; condition-monitoring for air- and
land-based machinery.

Selected programmes: 1) LEAP Engine sensors for its LEAP-1A, 1B and
1C engines (the 737MAX, the A320NEO and the Comac C919); 2) engine
health monitoring fitted on over 90% of worlds commercial aircraft; 3) fluid
gauging on large turbofans, including the V2500, the CFM56, and the Trent
900 and 1000; 4) extreme environment sensing power plant vibration,
pressure, shaft displacement, velocity, ice build-up monitoring.
Meggitt Equipment Group (MEG) 41% of sales
MEG is the largest segment, representing 41% of Group revenue and generating
approximately 70% of its revenue from OE and 30% from the aftermarket. It
comprises a technologically diverse range of businesses (including PacSci), each of
which has different capabilities and a particular focus, ranging from fire protection
systems to electronics and electro-mechanical components and sub-systems.
MEG revenue and EBIT margin profile MEG revenue by market (2013E)

Source: Berenberg estimates, Company data Source: Berenberg Estimates

Capabilities: Aircraft fire protection and control systems; avionics; combat
systems (ammunition-handling, military electronics cooling, countermeasure
launch, recovery systems); live-fire and simulation training; heat transfer
equipment for off-shore oil and gas; automotive and industrial control
electronics.
12%
14%
16%
18%
20%
0
100
200
300
400
Sensing Systems Margin (rhs)
25%
14%
19%
42%
Civil OE
Civil Aftermarket
Military
Energy & Other
20%
22%
24%
26%
28%
0
200
400
600
800
Equipment Group Margin (rhs)
24%
23%
20%
15%
18%
Safety
Power
Defence
Energy
Other
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Selected programmes: 1) Fire protection and control overheat detectors
fitted on more than 90% of western commercial aircraft. Fire protection on all
Airbus aircraft, the 737NG and on all Dassaults business and military aircraft.
Fire protection and control products to multiple OEMS and tier 1
manufacturers; 2) power management converters on all Airbuss aircraft, a
high proportion of Boeing aircraft, and also every US fighter, interceptor and
bomber; 3) ammunition handling the AH-64 Apache, the AC-130U, the UH-
60 Blackhawk, the M-1128 Stryker 105 mm Mobile Gun System; 4) avionics
flight displays and threat warning indicators on a number of fast jet, cargo
aircraft and helicopters.
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Financials


Sales 1,606 1,637 1,620 1,698 1,791

Cost of sales -929 -981 -964 -1,010 -1,066
Gross profit 677 656 656 688 726
Operating costs -355 -356 -338 -338 -345
EBIT 321 300 318 350 380

EBITDA (adj) 466 483 485 525 561
Depreciation -32 -32 -37 -45 -48
EBIT (adj) 392 397 398 425 455
Unusual or infrequent items 10 -23 -5 0 0
EBIT 321 300 318 350 380

EBT 281 269 278 313 347
EBT (adj) 366 378 377 407 441

Other taxes -35 -44 -18 -17 -17
Tax rate 16% 14% 24% 23% 23%
Profit after tax 236 232 213 240 267

Net income 236 232 213 240 267
Net income (adj) 286 297 294 318 344


EPS (reported) (p) 30.1 29.4 26.6 29.9 33.1
EPS (adjusted) (p) 36.0 37.5 36.5 39.4 42.6


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Balance sheet

Fixed Assets 3,079 3,016 3,045 3,061 3,058

Inventories 291 299 329 349 379
Derivative financial instruments 5 11 11 11 11
Current assets 806 767 797 817 847

TOTAL ASSETS 3,885 3,784 3,843 3,879 3,906

Long-term debt 612 666 666 666 666
Pensions provisions 300 238 222 206 190

Bank loans and other borrowings 127 7 -51 -153 -274
Deferred taxes 290 219 219 219 219
Current liabilities 877 644 598 517 409



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Cash flow statement
GBP m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 466 483 485 525 561

Interest paid -28 -20 -21 -18 -14
Cash tax -35 -44 -53 -53 -66

Capex -36 -52 -72 -71 -65
Financial investments - - - - -


Dividends paid -72 -76 -107 -119 -129
Others -5 12 0 0 0

Net cash flow 130 25 58 102 122



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Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 2.4x 3.0x 3.0x 2.9x 2.7x
EV/EBIT (adj) 10.0x 12.4x 12.3x 11.5x 10.4x
P/E (adj) 12.7x 17.9x 19.9x 17.7x 16.0x
P/FCFPS 16.8x 38.1x 26.3x 19.4x 17.1x
Dividend yield 3.1% 2.4% 2.6% 2.8% 3.0%

Growth rates
Sales 10% 2% -1% 5% 6%
EBIT (adj) 9% 1% 0% 7% 7%
EPS (adj) 14% 3% -2% 8% 8%
EPS 25% -2% -9% 13% 11%
DPS 12% 8% 7% 8% 8%

Financial ratios
FCF conversion 53% 31% 42% 53% 56%
Net gearing 25% 21% 19% 15% 10%
Net debt/EBITDA 1.4 1.2 1.0 0.8 0.5
ROCE 12% 12% 11% 12% 13%
ROIC 4% 4% 4% 4% 4%
WACC 8% 8% 8% 8% 8%
FCF ROCE 7% 4% 6% 8% 9%

Key financials

Sales 1,606 1,637 1,620 1,698 1,791
EBIT margin (adj) (%) 24.4% 24.3% 24.6% 25.0% 25.4%
EBIT (adj) 392 397 398 425 455
EPS (adj) (p) 36.0 37.5 36.5 39.4 42.6
DPS (p) 11.8 12.8 13.6 14.7 15.9

Free cash flow 180 109 162 220 250
Net cash flow 130 25 58 102 122

Gross debt 739 673 615 513 392

169

In for the long haul

Following a transfer of analyst coverage, we restate our Hold
recommendation on MTU Aero Engines (MTU) with a raised price
target of 71.8 (from 64.40). MTUs long-term business prospects are
positive but near-term earnings and cash headwinds will constrain the
valuation, in our view.

MTU is embarking on a major transition phase: MTU generates
c80% of its revenues in the commercial aerospace sector and the
group is well positioned for significant growth in all areas: new
engines driven by the ramp-up in geared turbofan production (GTF);
increasing aftermarket from the V2500 engine fleet; and market share
opportunities in the engine maintenance business (MRO). However,
the rapid transition to GTF production is ambitious, industrially
challenging and dilutive to margin.

Forecast changes: We assume mix headwinds will largely neutralise
top-line growth effects over the next two-to-three years and we reduce
our margin assumptions accordingly, particularly in 2016 when GTF
production steps up. As a result we cut our FY14, FY15 and FY16
adjusted EPS by 1.5%, 4.6% and 9.2% respectively. Our three-year
EPS CAGR is 0.8%.

Structural growth in high-margin engine servicing: Strongly
developing aftermarket sales (spare parts) from the large and maturing
fleet of V2500 engines provides a solid underpin to MTUs future
business performance. Over the long term, V2500 will be a key driver
of group profitability.

Share price/valuation: MTU shares are down by 5% ytd, a c5%
underperformance relative to the sector. Despite this, the P/E
multiple has expanded due to an 8% cut to consensus EPS and as a
result the stock trades on an FY15 P/E of 15.2x, in line with Safran
and Rolls-Royce. We therefore view the valuation as less compelling
relative to peers given MTUs lower growth profile and lack of near-
term catalyst. Next news: interim results on 24 July.

Hold
Current price
EUR 68.33
Price target
EUR 71.80
Reuters MTXGn.DE
Bloomberg MTX GY

Changes made in this note
Rating Hold (no change)
Price target EUR 71.80 (64.40)

Chg
2014E 2015E 2016E

old % old % old %
Sales 3,706 0.5 3,997 -1.1 4,225 -2.5
EBIT
(adj)
373 0.2 387 -2.7 415 -7.0
EPS
(adj)
4.56 -1.5% 4.73 -4.6% 5.10 -9.2%

Share data

Daily trading volume 143,562
Performance data

Relative performance to SXXP SXNP
1 month -1.7 % -0.1 %
3 months 1.2 % 4.4 %
12 months -35.5 % -29.6 %
Key data

Net gearing 25.5%
CAGR sales 2013-2016 4.9%
CAGR EPS 2013-2016 0.8%

MTU is a manufacturer in the civil and
military aero engine industry and
provider of maintenance, repair and
overhaul services. The company designs,
manufactures and provides components
and spares for a wide range of engines
across all thrust and power categories.
Key engine positions include the V2500,
PW2000, EJ200 and GTF engines. It also
provides maintenance, repair and
overhaul services.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., EURm 2012 2013 2014E 2015E 2016E
Sales 3,379 3,574 3,723 3,951 4,121
EBITDA (adj) 579 537 544 556 576
EBIT (adj) 375 373 374 376 386
Net income (adj) 234 230 229 231 239
Net income 175 169 197 200 207
Net debt / (net cash) -391 -407 -461 -509 -510
EPS 3.4 3.3 3.9 3.9 4.0
EPS (adj) 4.6 4.5 4.5 4.5 4.6
FCFPS -2.7 0.5 0.4 0.5 1.5
CPS -3.7 -1.1 -1.1 -0.9 0.0
DPS 1.4 1.4 1.4 1.4 1.5
EBIT margin (adj) 11.1% 10.4% 10.0% 9.5% 9.4%
Dividend yield 2.0% 2.0% 2.0% 2.1% 2.2%
ROCE 17.0% 15.4% 14.0% 12.8% 12.3%
EV/sales 1.3 1.3 1.2 1.2 1.1
EV/EBITDA 7.7 8.3 8.4 8.4 8.1
EV/EBIT 11.9 12.0 12.2 12.4 12.1
P/E 20.0 20.6 17.7 17.6 17.0
P/E (adj) 14.9 15.2 15.3 15.2 14.8
170
MTU Aero Engines investment thesis in pictures
MTU is a commercial and military aero engine
company; over 80% of its sales are in the
commercial aerospace sector
Engine deliveries weighted by MTUs
programme share indicates significant volume
growth ahead driven by GTF

Source: Berenberg estimates Source: Berenberg estimates, Airline Monitor

Engine deliveries: the production ramp-up and
transition from V2500 to new GTF presents
execution risk; margin dilution is inevitable
...compensated by demand for spare parts from
the growing and maturing installed base of
engines, especially the V2500 (units)

Source: Berenberg estimates, Airline Monitor Source: Berenberg estimates, Airline Monitor

Aftermarket growth (%): recent trends are
supportive of a continued recovery in spares
demand (12-month rolling aftermarket growth)
MTUs P/E rating has converged with Safran
and Rolls-Royce

Source: Berenberg estimates, company data Source: Datastream

37%
16%
12%
35%
CommOE
Comm Spares
Military
MRO
-5%
0%
5%
10%
15%
20%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2011 2012 2013 2014
MTU spare parts Sector ave.
11
12
13
14
15
16
17
18
MTU Safran Rolls-Royce
171
MTU Aero Engines investments thesis
Whats new: Following a transfer of analyst coverage, we are re-stating our neutral
stance on MTU Aero Engines. We are cutting our EPS estimates by 2-9% due to
the dilution effect of accelerating production of new engines but we raise our 12-
month price target to 71.80, reflecting sector valuations and our positive view of
the groups long-term business prospects.
Two-minute summary: MTU is a victim of its own success. Earnings progression
over the next two to three years will be muted by the dilutive effects of increasing
engine production, and particularly due to the rapid transition from the established
V2500 engine (for the Airbus A320) to production of the geared turbo fan (GTF)
family of engines currently in development for five new aircraft programmes (the
Airbus A320NEO, the Bombardier CSeries, the Mitsubishi MRJ, the Irkut MS-21
and Embraer E-Jets E2). Over the past 12 months, earnings momentum has been
negative as the business challenges of transition have become clearer, although we
feel comfortable now that downside risk is limited based on our lowered estimates.
The shares have recently recovered their rating lost through the H213 downgrade
period, and on a relative valuation basis look less attractive at 15.2x P/E (FY15E)
versus the civil aero peer average of 14.4x. In summary, we are positive about
MTUs long-term prospects but a lack of catalysts and constrained growth near-
term and the shares relatively full valuation compel us to maintain our neutral
rating.
Key investment point one: positioned for growth in civil aero engine
but at the cost of margin
MTU is strongly positioned for a significant ramp-up in new engine deliveries but it
will be margin-dilutive due to higher losses on launch programmes. The mix
headwind will be substantial, particularly through 2016 and 2017 when GTF
production steps up this will be sufficient, we believe, to largely offset the
positive effects of both strongly developing aftermarket revenue and growth in the
MRO aircraft maintenance businesses. At the group level, we forecast that the 5%
sales CAGR to 2017 translates to just 2% EBIT CAGR, the second-lowest in our
civil aero peer group.
Key investment point two: momentum is building in the high-margin
spare parts activity
The V2500 is the groups most important aftermarket engine and with only half the
fleet having gone through their first major overhaul, we expect high-margin spares
revenue to grow continuously through to a peak in the middle of the next decade.
V2500 spares will therefore be a key driver and underpin of group profits for many
years (by 2020, we estimate it could account for 50-60% of group profits), while in
the nearer term, growth will offset reducing aftermarket on older engines (PW2000
and CF6) and the OE mix headwinds referred to above.
Key investment point three: potential to outgrow the commercial
MRO market but competition is increasing
As the third-largest engine maintenance operator globally, with experience of
servicing all major engine types, MTUs MRO business is well placed to compete in
the growth commercial MRO market. The company already has strong market
shares in engine maintenance and overhaul (eg V2500 c30%; CF6 and GE90
172
c10% each; and CFM56 8-10%), but competitive pressures are increasing as the
engine OEM service model shifts towards exclusive long-term service agreements
(LTSAs). MTU plans to further penetrate OEM LTSAs through cooperation
agreements (it is one of the few MROs with sufficient scale and capability to do so)
and also to grow the number of its own long-term agreements direct with airlines
or through partnerships. Nevertheless, despite a steady growth MRO environment
driven by the expanding/maturing global fleet, we expect the engine MRO sector
to remain highly competitive and hence to constrain segment margins.
MTU underperformed both the sector and the market through 2013 and early
2014, due to disappointment on the slow recovery in aftermarket activity and
lowered profit and cash guidance. The shares have recovered and indeed seen P/E
multiple expansion as consensus estimates have edged down further in 2014 (c8%).
The shares now trade on a 12-month forward P/E of 15.2x, a 27% premium to the
long-run average and in line with Safran and Rolls-Royce.
Share price versus market and sector (re-based,
two-year)
12-month forward P/E since flotation (average
12.0x)

Source: Datastream
Note re-based to MTU share price
Source: Datastream
Forecast momentum
Consensus forecast growth expectations have fallen sharply over the past year as
the headwinds associated with engine production growth and transition have
become better understood.
45
55
65
75
85
95
105
115
MTU DJ Stoxx 600 Pan Euro A&D
3
5
7
9
11
13
15
17
MTU Average
ave 12.0x
173
Long-term forecast EPS changes ();
convergence of forecast EPS highlights the
groups low-growth profile
Short-term EPS revisions and share price (); the
shares have recovered since the 2013 results
despite a further downgrade

Forecast changes
We have reduced our estimates to reflect a more cautious view on growth potential
in both the OEM and MRO segments. In addition, we have reduced our margin
expectation for the MRO business due to increasing competitive pressures from
the engine OEMs. At the earnings level, we trim our FY14 forecast by 1.5% with
increasing cuts to FY15 (4.6%) and FY16 (9.2%) respectively. We also assume the
dividend pay-out will remain broadly unchanged at c30% of adjusted net income
resulting in a respective 5%, 9% and 4% cut to our previous DPS expectations.
Changes to Berenberg estimates (m)


3
4
5
6
7
8
2012 2013 2014 2015 2016
4
4.5
5
5.5
60
65
70
75
80
FY14 Old FY15 Old FY16 Old FY14 New FY15 New FY16 New FY14 chg FY15 chg FY16 chg
OEM 2,451 2,627 2,728 2,471 2,590 2,674 0.8% -1.4% -2.0%
MRO 1,287 1,402 1,529 1,284 1,392 1,479 -0.2% -0.7% -3.3%
Revenue 3,706 3,997 4,225 3,723 3,951 4,121 0.5% -1.1% -2.5%
OEM 257 257 271 262 255 259 2.0% -0.8% -4.5%
MRO 116 129 144 112 121 127 -3.5% -6.1% -11.5%
EBIT (adj) 372 386 414 374 376 386 0.4% -2.4% -6.8%
OEM 10.5% 9.8% 9.9% 10.6% 9.8% 9.7% 0.1% 0.1% -0.2%
MRO 9.0% 9.2% 9.4% 8.7% 8.7% 8.6% -0.3% -0.5% -0.8%
Margin 10.0% 9.7% 9.8% 10.0% 9.5% 9.4% 0.0% -0.1% -0.4%
EPS (adj) () 4.56 4.73 5.10 4.49 4.51 4.63 -1.5% -4.6% -9.2%
DPS (adj) () 1.48 1.55 1.56 1.40 1.41 1.49 -4.8% -9.1% -4.2%
174
Berenberg versus consensus
We remain 2-5% ahead of 2014 consensus estimates (EBIT and EPS) although by
2016 we are 5-6% below, reflecting our cautious stance on the growth/margin
trajectory in both the OEM and MRO segments.
Berenberg forecasts versus consensus we are now 5% below 2016
consensus estimates

Sales (m) 3,720 3,778 -1.5% 3,895 4,043 -3.7% 4,009 4,305 -6.9%
EBIT adj (m) 376 358 5.1% 382 377 1.5% 389 413 -5.9%
EPS adj (p) 4.5 4.4 2.9% 4.6 4.6 -0.9% 4.7 4.9 -5.0%
DPS (p) 1.4 1.5 -3.5% 1.43 1.59 -9.7% 1.50 1.84 -18.3%
2016 2015 2014
175

Low profit growth and cash generation to persist: Volume benefits from
rising engine production and spare parts sales will be largely offset by a rapid
mix change to loss-making new engines. We forecast operating profit and
earnings CAGR of c2% over the next three years. Cash generation will also be
constrained by capital requirements through the ramp-up, including working
capital. We forecast FCF conversion at the lower end of our peer group (30-
40%) throughout our forecast horizon resulting in flat net cash generation after
dividends.

Lower spare parts demand: If the development of spare parts demand falls
below expectations due to reduced global flying or early fleet retirements for
example (eg Boeing 757s, PW2000), group margins could be adversely affected.
We believe consensus forecasts incorporate an overall assumption of sustained
mid- to high single-digit growth in MTUs commercial spares activity.

Programmes delays CSeries is behind schedule but NEO is on track:
Delays and cost escalation on new programmes, either internally or through the
supply chain, would adversely effect profitability and also sentiment. MTUs
main exposure is through its programme shares on the Pratt & Whitney GTF
family of engines currently in development for five new aircraft types: the
Airbus A320NEO, the Bombardier CSeries, the Mitsubishi MRJ, the Irkut MS-
21 and Embraer E2 jets. The GTF engine for the CSeries regional jet is certified
but the aircrafts entry-into-service (EIS) is already 18 months behind schedule
and a recent testing failure raises the possibility of further delays. Of more
importance to MTU over the longer term (due to the very high volumes) is the
A320NEO aircraft programme, which Airbus reports is on track for first flight
and customer delivery before the end of the year which would be positive for
sentiment.

Execution risk associated with GTF ramp-up: The rapid industrial ramp-up
of GTF volumes presents significant challenges for the group, both technical
and industrial. We examine this in more detail further on in the report (page
179) but we summarise here our concerns in terms of the inherent risks
associated with the rapid transition from production of a well-established
programme (the V2500 engine) to the new and more complex GTF engine,
while at the same time maintaining (and even increasing) overall volumes. We
acknowledge that MTUs industrial ramp-up preparations are advancing well,
including investment in new facilities, logistics and capacity expansion.
Nevertheless, execution risk remains a concern for us.

MRO competition increasing: Competition is increasing in the global MRO
sector as the engine OEMs increasingly look to secure a greater proportion of
services work on their own engines, for example, through LTSAs. We think
MTU is well placed to grow its overall share in the MRO market through its
existing programme positions and licence agreements, but we believe margins
will remain under pressure for the foreseeable future.

Military pressures longer-term: Military OEM revenues are relatively stable
underpinned by the EJ200 engine (Eurofighter) and TP400 engine (A400M)
programmes. We see potential downside to out outer-year forecasts if
Eurofighter production is further rescheduled (stretched) due to a lack of
international orders. Conversely, any new export orders would be positively
176
received not only extending production but also potentially enhancing cash flow
through programme advances.

MTU has low FX hedging cover compared to the peers: MTUs principle
currency risk is transactional, relating to excess US dollar sales over costs,
currently around $1bn pa. The company actively hedges exposure through a
rolling step hedge policy over the following 12 quarters, although there is some
scope to vary timing depending on spot rates. We estimate MTU has c$1.5bn of
cover (1.5 years) at an average dollar/euro rate of $1.29 with c70% of 2014 and
50% of 2015 net exposures covered. A one cent change in hedge rate equates to
c5m at the EBIT level, and based on a blended rate of hedge cover and spot
rate, we estimate MTU will face a 4m/1.2% EBIT headwind in 2014 with no
significant effects in 2015 but a 14m/3.6% headwind in 2016. We reflect this
in our forecasts.

177
Valuation
Valuation summary ()

We set our price target at 71.80 based on a blended average of DCF and
Our 71.80 price target equates to 5% upside to the current price and
drives our Hold recommendation.
The valuation disparity between our DCF valuation of 78 per share and
multiples-based valuations (average 68 per share) reflects a positive
longer-term outlook against nearer-term challenges that are currently
restricting profit and cash growth.
The implied target price P/E is 16x (FY14), 16x (FY15) and 15.6x (FY16)
compares to MTUs long-run 12-month forward P/E of 12.0x (ie c30%
premium). This is justified by the unprecedented visibility in the
commercial aerospace activities including a strengthening over time of the
core V2500 engine spare parts business.
P/E multiples for the pan-European aero engine peers have converged in
recent months. MTU shares have narrowed the discount that built through
2013 with P/E expansion for MTU while Safran and Rolls-Royce de-rated
as the market digested lower growth expectations. All three engine
manufacturers now trade at comparable valuation multiples.
MTU 12-month forward P/E since flotation European aero engine P/E comparison (12-
month forward); multiples have converged


DCF 78 78 7.2% WACC / 2% TG
3
5
7
9
11
13
15
17
MTU Average
ave 12.0x
11
12
13
14
15
16
17
18
MTU Safran Rolls-Royce
178
Sum-of-the-parts
calculation. We apply a 15% EV/EBITDA discount to MTUs OEM segment to
reflect the higher average margin and growth of our peer group.

DCF upside if growth outlook improves
The table below summarises our DCF model which generates a valuation of 78
The profits growth and cash generation outlook for the group is relatively low
through our forecast horizon due to high investment followed by an aggressive
ramp-up in production of lower margin new engines. We therefore take a cautious
approach to our assumptions with just a 2% terminal growth rate. MTUs valuation
is highly sensitive to this assumption and if/when cash generative growth resumes
it could point to material valuation upside. In the sensitivity table below, we show
that a 100bp higher growth assumption would increase our DCF valuation by over
20% (all else being equal).
DCF summary table




OEM 3,435 6.9 3,126 1.26 3,280
MRO 1,297 5.9 1,434 1.12 1,366
Total 4,732 6.6 4,560 1.21 4,646
Equity value 3,542
Shares o/s (m) 51
OEM 3,421 6.5 3,111 1.20 3,266
MRO 1,286 5.4 1,451 1.04 1,368
Total 4,707 6.2 4,562 1.15 4,635
Equity value 3,462
Shares o/s (m) 51
DCF Model m
Share value () 78
78 7.5% 8.5% 9.5% 10.5% 11.5%
6.2% 83 93 102 112 122
6.7% 72 80 88 97 105
7.2% 63 70 77 85 92
7.7% 56 62 62 62 62
8.2% 62 62 61 61 61
EBIT margin
W
A
C
C
78 0.0% 1.0% 2.0% 3.0% 4.0%
6.2% 73 85 102 130 184
6.7% 65 75 88 109 145
7.2% 59 67 77 93 119
7.7% 53 60 68 81 100
8.2% 48 54 61 70 85
Terminal growth
W
A
C
C
179
Key investment point one: positioned for growth in civil
aero engine but at the cost of margin
With a relatively muted earnings progression over the next two years, MTU is a
victim of its own success. The group is strongly positioned for a significant ramp-
up in new engine deliveries but this will be margin-dilutive due to the higher losses
on launch programmes. The mix headwind will be substantial, particularly through
2016 and 2017, when GTF activity steps up. This will be sufficient, we believe, to
almost entirely offset the positive effects of both strongly developing aftermarket
revenues and top-line growth expected in the MRO aircraft maintenance
businesses. At the group level, our forecast for a 5.3% sales CAGR to 2017
translates to just a 2% EBIT CAGR, one of the lowest in our peer group.
Sales (m) and margin (%): steady top-line
growth but margin continues to trend down
Group EBIT profile (m)

The new engine story volume, volume, volume (that is the problem)
The commercial OEM business is well positioned for the long term. Increased
participation in new engine programmes, particularly the GTF for the A320NEO
and CSeries aircraft and GEnx for the B787 engines, will drive sustained revenue
growth into the next decade, we believe. We outline MTUs major programme
shares in Appendix 2, while in the chart below we demonstrate their relative
importance by weighting engine deliveries by MTUs share. The V2500 that powers
the current A320CEO family (the current engine option) is MTUs most important
series programme: we estimate it accounts for almost 500m pa of sales, or 14% of
the group. In line with Airbus A320CEO production plans, we expect V2500
volumes to peak at over 500 engines in 2015 and then decline sharply to zero by
2020. At the same time, production of the various GTF programmes are scheduled
to ramp-up aggressively, initially for the Bombardier CSeries and then more
meaningfully for the A320NEO.
GTF launch engines and early-stage production units will incur greater losses than
V2500 and other more mature programmes a function of non-recurring launch
costs, discounting and cost yet to be learned-out of the manufacturing process.
MTU does not disclose series engine sales or margins but we estimate for every
100bp increment in the loss-margin assumed on new engine sales,
segment EBIT reduces by c15m, equivalent to a 4% of group operating
profit.
0%
3%
6%
9%
12%
15%
0
1,000
2,000
3,000
4,000
5,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Sales Margin (rhs)
0
100
200
300
400
500
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
180
Engine deliveries (units) Series engines weighted by MTU work share

Source: Berenberg estimate, Airline Monitors
Transition risks an unprecedented challenge
The main issue for the company over the period 2014-2019 is managing a rapid
shift in product mix while growing overall volumes. This brings with it multiple
operational, technical and financial challenges. GTF is a new platform, more
technically challenging and on which MTU is manufacturing a greater number of
complex modules and components than on the V2500, for example high-pressure
compressors and blisks (bladed rotors).
Engine deliveries (units) V2500 and GTF engine delivery profile

Source: Berenberg estimates, Airline Monitor
MTUs preparations to support the industrial ramp-up appear to be advancing well
while technical milestones on the various GTF programmes are being met.
Investments in capacity and new manufacturing capabilities are underway
including, in Germany, a new blisk shop, engine assembly and logistics facilities,
and in Poland, an extension of the MTU-Polska facility for blade manufacture, final
assembly and engineering.
0
50
100
150
200
250
V2500 PW2000 CF6 PW4000 GP7000 GEnx GTF
0
100
200
300
400
500
600
700
800
900
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
0
1
6
2
0
1
8
2
0
2
0
V2500 GTF Total narrow-body
181
Key investment point two: momentum is building in the
high margin spare parts activity
MTUs aftermarket trends have been volatile due to accelerated retirement of older
aircraft and deferred customer activity combining to offset strong development of
spare parts sales for the V2500 fleet. The spares outlook for older engines has
stabilised while spares demand for V2500 should grow continuously as the fleet
matures. The V2500 engine already accounts for almost 50% of MTUs
commercial aftermarket sales, and with only half the fleet having gone through
their first major overhaul, it will become the key underpin and driver of group
profitability over the long term.
Continuous growth in the V2500 aftermarket
The V2500 engine, a choice of powerplant on the Airbus A320 family of aircraft, is
manufactured by the IAE (International Aero Engines) consortium led by Pratt &
Whitney, in which MTU recently increased its stake in IAE to 16% (from 11%)
after Rolls-Royces exit in 2011. The V2500 fleet has grown strongly in recent years
(at a 10-year CAGR of 10% to around 5,500 engines), and as a result has a
relatively young average age of around six years. MTU has said that only about half
of the engines have gone through their first major overhaul (a high-value spares
event), with more than 70% yet to have their second shop visit. The fleet will
continue to grow and mature over the coming years, driving strong momentum in
spares sales that will continue through to the middle of the 2020s.
Installed fleet of engines (units) programmes of
importance
Spare parts sales profile derived from MTUs
programme shares (units of engines)

Source: Airline Monitor, Berenberg estimates
Peak installed base in 2018, peak aftermarket in 2024: V2500 production is
scheduled to grow to a record level of over 500 engines pa for the next two years
and then fade to zero by 2020, in line with Airbuss A320CEO production plans.
On this basis, we estimate the installed fleet on V2500s will peak in 2018/19 at just
under 7,000 engines, with peak aftermarket sales following in 2024. We illustrate
this in the second chart above which shows MTUs most important installed engine
fleets weighted by the companys programme share and applying a six-year lag, to
represent the approximate time to first engine overhaul.
V2500 could represent 60% of EBITA by 2020: We estimate V2500 spares
account for c250m pa of sales, around 45% of MTUs total commercial engine
aftermarket or 7% of group sales. After accounting for loss margins on new engine
0
2000
4000
6000
8000
10000
12000
1
9
7
1
1
9
7
5
1
9
7
9
1
9
8
3
1
9
8
7
1
9
9
1
1
9
9
5
1
9
9
9
2
0
0
3
2
0
0
7
2
0
1
1
2
0
1
5
2
0
1
9
V2500 CF6 PW2000 PW1000G GEnx
0
500
1000
1500
2000
1
9
7
7
1
9
8
1
1
9
8
5
1
9
8
9
1
9
9
3
1
9
9
7
2
0
0
1
2
0
0
5
2
0
0
9
2
0
1
3
2
0
1
7
2
0
2
1
2
0
2
5
V2500 CF6 PW2000 PW1000G GEnx
182
sales, we derive a V2500 EBIT of c140m, or c40% of group profit. Based on an
assumption of a double-digit (12%) CAGR in V2500 spares to 2020, driven by the
maturing fleet, we estimate spares sales could rise to over 500m or approximately
10% of total group, and close to 300m of EBITA (more than 60% of group).
V2500 spares will therefore be an increasingly dominant driver of future group
profits.
Other important aftermarket engines
MTUs next most important aftermarket-generating engines sale are the CF6 (CF6-
80C, powering Boeings 747 and 767 wide-body aircraft, and the CF6-80E
powering Airbuss A330 aircraft), and Pratt & Whitneys PW2000, on the Boeing
757 and the C-17 military transporter aircraft. We estimate these two legacy
programmes account for 18% and 13% of spares sales respectively.

CF6-80C/E (18%, stable): MTU has around a 6% share of GEs CF6
widebody engine which we estimate generates c18% of total spares sales. The
-80C variant, which is a choice of engine on the 747 and 767 aircraft, accounts
for over 80% of the CF6 fleet relevant to MTU and we expect modest yoy
declines in spares over the next five years reflecting a broadly flat fleet profile in
recent years (new engines net of retirements), further expected retirements and
modest growth in the 767 fleet. Spares revenues derived from the -80E variant
should continue to grow steadily driven by A330 fleet maturity. Bringing all this
together, we expect total CF6 spare parts sales to remain stable, with perhaps
modest declines towards the end of the decade.

PW2000 (13%, declining): MTU is an alliance partner on the PW2000 engine
with a 21% share. We estimate revenue exposure is c55% related to the Boeing
757 fleet (c750 engines with an average age 18 years) and c45% to the c1,000
engines on Boeings C-17 transporter fleet. Aftermarket sales have been volatile
due to the combination of early retirement of commercial aircraft and reduced
parts-buying by the US military due to sequestration, resulting in a c30% decline
in PW2000 spares sales in 2013. The outlook for military spares appears stable,
albeit at a lower level, following the hiatus last year, while we expect commercial
revenues to decline steadily to 2020 as 757 retirements have an impact. We
believe MTU has been cautious in this respect, including taking account of fleet
retirement plans of the two largest operators of the aircraft type, Delta (116
aircraft) and United Continental (131 aircraft). Based on these factors and
assuming a c6-8% pa fade rate over the next few years, we estimate the PW2000
will represent less than 10% of spare parts sales by 2020.

GP7000 (3%, growing): MTU has a 22.5% share in the Engine Alliance
venture between GE and Pratt & Whitney, which designs and produces the
GP7000 family of engines for the Airbus A380. The GP7000 fleet is small and
young (the A380 only entered service in 2008), with few engines having gone
through their first overhaul. Hence spares revenues are currently very modest in
a group context (we estimate c3%), although from this low base we expect
strong growth and for the engine to be contributing around 9% of total spares
by 2020.

GEnx (immaterial, growing): The B787 only entered commercial service in
2011 and hence spares revenues are yet to flow from GEs GEnx engine, on
which MTU has a 6.5% programme share. We estimate the engine will still only
account for c2% of spares sales by 2020 but will continue to grow in
importance thereafter.
183
Positive near-term macro trends supports outlook for spares demand
Against managements initial guidance of 15% growth in 2013, commercial spare
parts growth of 5% was disappointing and was the key driver of forecast
downgrades and ultimately share price underperformance through the second half
of the year. A significant factor driving the lower-than-expected outturn was
softness in PW2000 spares (referred to above). Guidance for 2014 is for a further
5% growth in commercial aftermarket comprising the three main major
programmes: V2500 mid-20s growth and roughly flat expectations for PW2000
and CF6. The 2014 Q1 result was slightly ahead of full-year guidance at c7% driven
by strong V2500 sales in the high-20s, although management said it expects the
rate to revert to guidance over the coming quarters.
Air traffic (RPK) and airline capacity growth
trends remain at or above the long-term trend
(c4.5%)
MTU spare parts growth lagged the sector in
2013 but recovered to 7% yoy in Q1, slightly
ahead of guidance for mid-single digits

Source: Berenberg estimates, IATA

Air traffic growth: While quarterly results can be misleading as to the long-
term trend, the underlying macro backdrop supports a steady growth outlook
for aftermarket-related activities. Global passenger growth measured as revenue
per passenger kilometre (RPK) is trending above the long-term average of 4.5-
5% (5.8% in 2013 with IATA forecasting a further 5.2% in 2014). In addition,
airline load factors are at a historically high 79%, indicating the in-service global
fleet of aircraft is being well-utilised. An additional factor driving current spares
demand is the recovery of maintenance that was deferred by airlines through
the downturn.
0%
2%
4%
6%
8%
10%
F
e
b
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1
2
A
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r
-
1
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-
1
3
D
e
c
-
1
3
F
e
b
-
1
4
A
p
r
-
1
4
RPK (passenger) ASK (capacity)
ASK (6m rolling)
-5%
0%
5%
10%
15%
20%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2011 2012 2013 2014
MTU spare parts Sector ave.
184
Key investment point three: potential to outgrow the
commercial MRO market but competition is increasing
MTUs aircraft engine maintenance business is the third-largest MRO service
provider with a market share of 8%. Overall, the MRO environment is healthy,
driven by the expanding global aircraft fleet, and MTU is well positioned on engine
programmes that should drive segment growth consistently above the market.
However, competition is intensifying, particularly from the engine manufacturers,
which are keen to capture a greater proportion of aftermarket from their own
engines, for example through LTSAs) MTU is responding through its own long-
term and/or exclusive service agreements with airlines and through partnerships
(eg MTU Zhuhai) and with greater cooperation with the engine OEMs. We
anticipate the MRO segment will deliver sustained good growth through our
forecast horizon but that operating margins will remain under pressure (see chart).
MRO segment revenue (m) and margin (%)


Favourable programme exposure to capture MRO work: Given the
companys scale and experience on most of the major aero engine programmes,
MTU is well positioned to compete for maintenance work in the independent
market, we believe. MTU said it has the following market share in the MRO
market: V2500 c30%; CF6 and GE90 c10% each; and CFM56 8-10%
(MTU is one of only three MRO operators licensed to service the very large
fleet of CFM56 engines).

Long-term contracts and partnerships: Around 25% of MRO revenues are
based on long-term contracts either direct with airlines or through joint
ventures for example, the MTU Zhuhai venture, where the group has further
invested in capacity expansion of the venture with China Southern to compete
for exclusive maintenance of contracts with airlines regionally.

Model shifting to OEM cooperation: The engine OEM service model is
increasingly shifting to LTSAs based on engine utilisation or power-by-the-
hour. MTU expects to maintain market share by increasing the number of
OEM cooperation agreements for example on certain parts for the GP7000
(low-pressure turbine), GEnx (turbine centre frame) and work share on the
GTF (yet to be determined).
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0
400
800
1,200
1,600
2,000
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue Margin (rhs)
Deconsolidation
of Zhuhai
185
MTU MRO revenue splits by market access


186

Source: Berenberg estimates, MTU Aero Engines
Revenue (GBPm) 2010 2011 2012 2013 2014E 2015E 2016E 2017E
Commercial OEM 1,178 1,401 1,603 1,891 2,021 2,162 2,267 2,414
Military OEM 486 446 503 501 451 428 407 399
OEM 1,664 1,847 2,106 2,392 2,471 2,590 2,674 2,813
MRO 1,074 1,117 1,306 1,214 1,284 1,392 1,479 1,612
Other Entities/ Holding Company 10 7 24 0 0 0 0 0
Consolidation/reconciliation -40 -39 -58 -32 -32 -32 -32 -32
Group total 2,707 2,932 3,379 3,574 3,723 3,951 4,121 4,393
Reported revenue growth
Commercial OEM 11.8% 19.0% 14.4% 18.0% 6.8% 7.0% 4.8% 6.5%
Military OEM -8.7% -8.3% 13.0% -0.5% -10.0% -5.0% -5.0% -2.0%
OEM 4.9% 11.0% 14.1% 13.6% 3.3% 4.8% 3.2% 5.2%
MRO 1.6% 4.0% 16.9% -7.0% 5.8% 8.5% 6.2% 9.0%
Group total 3.7% 8.3% 15.2% 5.8% 4.2% 6.1% 4.3% 6.6%
EBITA (adjusted)
OEM 231 239 264 264 262 255 259 264
MRO 78 94 114 109 112 121 127 137
Other Entities/ Holding Company -1 -2 -3 0 0 0 0 0
Consolidation/reconciliation 3 -1 0 1 1 1 1 1
Group total 311 330 375 373 374 376 386 401
EBITA margin (adjusted)
OEM 13.9% 12.9% 12.5% 11.0% 10.6% 9.8% 9.7% 9.4%
MRO 7.3% 8.4% 8.7% 8.9% 8.7% 8.7% 8.6% 8.5%
Group total 11.5% 11.2% 11.1% 10.4% 10.0% 9.5% 9.4% 9.1%
187
Appendix 1: Group outline
Revenue profile by activity (2014 segment sales EUR3.7bn)

OEM

The division: OEM is the largest division, accounting for 64% of 2013
revenue (of which 81% is commercial and 19% is military) and 68% of adjusted
EBIT. The division is responsible for designing, developing and manufacturing
commercial and military aircraft engines. It also produces spares parts for these
engines.

Capability/technology: The company is a major provider of sub-systems and
components for aero engines specialising in low-pressure turbines and high-
pressure compressors. MTU exploits this technological knowledge through
commercial collaborations with major engine manufacturers globally with a
typical programme share of 10-20%.
Divisional revenue and margin OEM revenue splits (2014)

Source: MTU Company data, Berenberg estimates Source: MTU Company data, Berenberg estimates

35%
18%
12%
35%
Comm OE
CommSpares
Military
MRO
4%
6%
8%
10%
12%
14%
16%
18%
0
500
1,000
1,500
2,000
2,500
3,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
OEM Margin (rhs)
Comm
OE
57%
Comm
Spares
24%
Military
19%
188
Commercial OEM (c82% of OEM sales and 53% of group)
In commercial OEM, components and modules supplied for new engines (series
sales) is a marginally loss-making activity, we believe with the spare parts
aftermarket accounting for the majority of profit.

New engine sales (c1.25bn): We summarise in the table below the key
engine programmes on which MTU has a material work share. In revenue
terms, the largest contributor by far is the V2500 engine (Airbus A320), with
the GEnx (Boeing 747/787) and GP7000 (A380) increasingly important
programmes. Together, we estimate that sales to these platforms account for
around two-thirds of series engine sales, or 23% of group.

Spare parts sales (c560m): Three engines account for around two-thirds of
total aftermarket sales: the V2500 (A320), the PW2000 (B757 and C-17), and
the CF6 (B747 and B767). We estimate spare parts account for around 30% of
segment revenues, or c16% of group.
Commercial engine programmes partners and end markets


Engine Program % share Alliance Partners End-market Aircraft
V2500 16%
Pratt & Whitney;
JAEC
A320
GP7000/7200 23%
GE; Pratt &
Whitney; Safran;
Techspace Aero
A380
JT8D-200 13%
Pratt & Whitney;
Mitsubishi; GKN
Boeing MD-80
PW1000G family 15-18%
Pratt & Whitney;
JAEC; GKN
A320NEO; Irkut MS-
21; Bombardier C-
Series; MRJ; Embraer
E-jets
PW2000 21%
Pratt & Whitney;
Avio; GKN
B757
PW4000 13% Pratt & Whitney B777
PW6000 18%
Pratt & Whitney;
Mitsubishi
A318
PW300/500/800 1525% Pratt & Whitney
Cessna Bravo &
Sovereign; Falcon
7X; Learjet 60; Do
328
CF6
A300/310/320/330;
B747/767; Boeing
DC10-30/MD-11
GEnx 7%
GE; Safran; Avio;
IHI
B747; B787
No share in programme but supplier
since 1972
189
Some more detail on key programmes
V2500 (MTU share 16%): The V2500 is the flagship engine program of MTU.
It is manufactured under an engine programme called International Aero Engines
(IAE), a consortium of Pratt & Whitney (a 61% share), MTU (a 16% share) and
Japanese Aero Engines Corporation (a 23% share) and has been in commercial
service since 1989. MTU primarily provides the low-pressure turbine, the turbine
centre frame, and various components of the high-pressure turbines.
There are currently around 5,500 V2500-powered aircraft in service globally with
around 1,700 ordered and still to be manufactured. The V2500 is used on narrow-
bodied commercial aircraft and is one of the two engine options for the A320
aircraft. It powers A319/320/321, Airbus Corporate Jets (ACJ), the Boeing MD-90
and the Embraer KC-390.
GP7000/7200 (MTU share 22.5%): MTU has a 22.5% share in the Engine
Alliance venture between GE and Pratt & Whitney, which designs and produces
the GP7000 family of engines, which is a choice of power plant on the A380
aircraft.
GEnx (MTU share 6.5%): GEnx is GEs next-generation engine programme,
which is designed to power medium-capacity long-range aircraft, and entered into
service in 2011. MTU designs, manufactures and assembles the turbine centre
frame. GEnx is an exclusive program to power the Boeing 747-8 aircraft and is one
of the options for the Boeing 787.
PW1000G family (MTU share 15-18%): The PW1000G is a family of new
generation GTF engines for commercial narrow-body and large regional aircraft. It
is expected to enter service in 2015. MTU will primarily provide the engines high
speed, three-stage low-pressure turbine and half of the eight-stage high-pressure
compressor systems. The engine has been selected by various aircraft
manufacturers Airbus for A320neo (PW1000G), United Aircraft for Irkut MS-21
(PW1400G), Bombardier for its CSeries aircraft (PW1500G), Mitsubishi for its
MRJ regional jets (PW1200G) and Embraer for its second-generation E-Jets
(PW1000G).
MTU has varied share in the engine family an 18% market share in PW1100G, an
18% share in PW1400G, a 17% share in PW1500G, a 15% share in PW1200G, a
15% share in PW1700G and a 17% share in PW1900G.
Military
MTU has been an integral supplier to the German armed forces, supporting nearly
all their aircraft and helicopters. Its engines are also used by other armed forces,
including the US Air Force. Legacy programmes include the RB199 engine for the
Tornado aircraft, while the two major programmes currently in production are the
EJ200 for the Eurofighter and the TP400 for the A400M.
Military OEM has slightly better margins than in commercial OEM; however, this
is not a growth part of the business. Management guidance is for revenues to
decline by c10% in 2014.
190
Military engine programmes partners and end-markets

MRO
The MRO division accounts for 37% of the groups 2013 revenue and 32% of its
adjusted EBIT. The group maintains a network of independent shops that
specialise in maintenance, repair and operations of commercial aircraft engines. It
provides the maintenance services, component repair and engine leasing services.

MTU manages a portfolio of maintenance contracts either one-time assistance or
long-term contracts. These long-term contracts mainly average 5-10 years, but
some extend to 15 years. As a result, revenue visibility is high. MTU has nearly 150
customers, of which the top 10% contribute c40% of the total divisional revenue.
Engine Program % share Alliance Partners End-market Aircraft
F117 21%
Pratt & Whitney;
GE; GKN
Boeing C-17
F110 2%
GE; GKN;
Techspace; Avio
F-15; F-16
F404/F414 4%
GE; GKN; Alstom;
Sauter Bachmann;
Mangellan
Super Hornet; F-18;
JAS 39 Gripen; T-50
Golden Eagle
EJ200
33% dev, 30%
prod
Rolls-Royce; Avio;
ITP
Eurofighter Typhoon
RB199 40% Rolls-Royce; Avio Tornado
Larzac 04 25% Rolls-Royce; Safran Alpha Jet
TP400-D6 28%
Safran; Rolls-Royce;
ITP
A400M
GE38 18% GE Sikorsky CH-53K
T64 30% GE
Sikorsky CH-53G,
GS, GA
MTR390-2C 40%
Rolls-Royce;
Turbomeca
Eurocoptor Tiger
MTR390-E 31%
Rolls-Royce;
Turbomeca; ITP
Eurocoptor Tiger
MRO revenue and margin MRO backlog and backlog coverage

Source: MTU Company data, Berenberg estimates Source: MTU Company data
4%
5%
6%
7%
8%
9%
0
500
1000
1500
2000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
MRO Margin (rhs)
0x
1x
2x
3x
4x
5x
6x
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
Backlog (ord bk + contracts) Ord bk cov
191
The MRO landscape is a fragmented and competitive one, with c3040
independent service providers. A number of airlines, aircraft manufacturers and
some alliance partners also provide maintenance services. MTU is able to maintain
its market-leading position due to its long-term relationships with its clients and
due to its OEM business (in general MROs share remains at least equal to the
engine program share that the OEM has). This reflects the changing commercial
aftermarket, where MRO services are increasingly being offered together with
engine sales contracts, giving an opportunity for MTU to further cement long-term
customer ties.
MTUs guidance for 2014 is for MRO growth in the high single-digit range,
predominantly due to rising demand for maintenance of the GE90 and V2500
engines.

192
Financials


Sales 3,379 3,574 3,723 3,951 4,121

Cost of sales -2,823 -3,192 -3,168 -3,361 -3,501
Gross profit 555 383 555 590 620
Operating costs -254 -232 -400 -443 -470
EBIT 301 316 327 330 340

EBITDA (adj) 579 537 544 556 576
Unusual or infrequent items -25 0 -22 -22 -22
EBITDA 554 537 522 535 555
Depreciation -87 -92 -95 -100 -105
EBIT 301 316 327 330 340
EBIT (adj) 375 373 374 376 386

EBT 273 262 293 296 307
EBT (adj) 347 341 340 343 353

Other taxes -15 19 -15 -15 -15
Tax rate 33% 33% 33% 33% 33%
Profit after tax 175 169 197 200 207

Net income 175 169 197 200 207
Net income (adj) 234 230 229 231 239


EPS (reported) (p) 3.4 3.3 3.9 3.9 4.0
EPS (adjusted) (p) 4.6 4.5 4.5 4.5 4.6



193
Balance sheet

Fixed Assets 2,440 2,563 2,585 2,595 2,591

Inventories 809 772 822 882 942
Current assets 1,826 1,896 2,024 2,191 2,385
TOTAL ASSETS 4,267 4,459 4,609 4,786 4,976

Long-term debt 539 600 600 600 600

Bank and other borrowings 80 86 86 86 86
Deferred taxes 207 204 204 204 204




194
Cash flow statement
EUR m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 579 537 544 556 576

Cash flow from operations before changes in w/c 335 284 297 315 337
Increase/decrease in inventory 15 37 -50 -60 -60
Change in operating receivables and payables -121 -72 -112 -105 -110
Increase/decrease in other working capital positions 21 -152 -16 -16 9
Interest paid -2 -5 -5 -5 -5
Cash tax 11 0 10 10 11

Capex -99 -86 -114 -110 -105
Payments for acquisitions 51 25 0 0 0

Free cash flow (memo) -135 26 18 25 76

Dividends paid -61 -69 -72 -72 -77
Others -194 47 0 0 0

Net cash flow -185 -57 -54 -48 -1




195
Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 1.3x 1.3x 1.2x 1.2x 1.1x
EV/EBIT (adj) 11.9x 12.0x 12.2x 12.4x 12.1x
P/E (adj) 14.9x 15.2x 15.3x 15.2x 14.8x
P/E 20.0x 20.6x 17.7x 17.6x 17.0x
P/FCFPS -25.9x 134.6x 195.0x 143.5x 46.4x
Free cash flow yield -3.9% 0.7% 0.5% 0.7% 2.2%
Dividend yield 2.0% 2.0% 2.0% 2.1% 2.2%

Growth rates
Sales 15% 6% 4% 6% 4%
EBIT (adj) 14% -1% 0% 1% 3%
EPS (adj) 14% -2% -1% 0% 3%
EPS 6% -3% 16% 1% 3%
DPS 13% 0% 4% 0% 6%

Financial ratios
FCF conversion 35% 29% 26% 28% 41%
Net gearing 26% 25% 26% 26% 24%
Net debt/EBITDA 0.7 0.8 0.8 0.9 0.9
ROCE 17% 15% 14% 13% 12%
ROIC 6% 6% 6% 6% 6%
WACC 8% 7% 7% 7% 7%
FCF ROCE -9% 2% 1% 1% 4%
Net R and D/sales 3.3% 2.6% 2.5% 2.4% 2.4%
Gross R and D/sales 4.8% 4.0% 3.7% 3.6% 3.5%

Key financials

Sales 3,379 3,574 3,723 3,951 4,121
EBIT margin (adj) 11.1% 10.4% 10.0% 9.5% 9.4%
EBIT (adj) 375 373 374 376 386
EPS (adj) (p) 4.6 4.5 4.5 4.5 4.6
DPS (p) 1.4 1.4 1.4 1.4 1.5

Free cash flow -135 26 18 25 76
Acquisitions and disposals 4 -23 0 0 0
Net cash flow -185 -57 -54 -48 -1

Gross debt 619 686 686 686 686
QinetiQ plc
196

Looking ahead again

QinetiQ is a UK-listed defence company providing technology-based
services and solutions (c80%) and products (c20%) to military,
government and some commercial customers. We initiate coverage
with a Hold recommendation and a 225p price target. The core
EMEA Services division has stabilised and returned to low organic
growth while positive momentum is building in the Global Products
division where recent strategically important developments indicate
significant potential for the OptaSense acoustic sensing technology.
It is too early to quantify the opportunity, but the shares relatively
high valuation implies to us that investors are already pricing in an
element of positive expectation. The shares have bounced by 7% since
the results in May and trade on a CY15 P/E of 14x, an 8% premium
to the sector.

US Services exit: The valuation (up to 130m with earn-out) was
below market expectations of more than 150m. Nevertheless,
disposal concludes a flawed legacy strategy, removes a drag on profits
and frees management to focus on the Organic Plus growth strategy.

150m buyback could be extended: QinetiQ is highly cash-
generative. We estimate net cash of c150m when the 12% share
buyback is completed in about a year. Large-scale M&A is not on the
agenda, we believe, and hence we suggest there is scope to extend the
buyback indefinitely at c50m pa (4%).

OptaSense is a classic disrupter technology: OptaSense sales
in 2014 were just c25m (3% of group), but we think that the market
opportunity could be large. Recent strategically important enabling
agreements, development contracts and customer trials point to
significant potential in the oil and gas (down-hole/fracking), rail
sensing and infrastructure (pipeline monitoring) markets. Although
impossible to forecast, we factor 80m of sales in 2017 (7% of group).

Valuation: The shares de-rated through the US Services disposal
process but the recent bounce leaves the stock trading on a CY15 P/E
of 14x. We see only modest valuation upside in the near term unless
OptaSense newsflow progresses more favourably than we anticipate.

Hold (Initiation)
Current price
GBp 210
Price target
GBp 225
Reuters QQ.L
Bloomberg QQ/ LN
Share data

Performance data

1 month -2.8 % -1.7 %
3 months -12.7 % -4.7 %
12 months -10.4 % -4.8 %
Key data

Net gearing -26.8%
CAGR sales 2013-2016 -18.7%
CAGR EPS 2013-2016 -1.5%

QinetiQ is a science and technology
research company formed from the UK
governments defence research and
development organisation. Its core
business is testing and evaluation services
for the MoD, funded predominantly
through the research budget. The rest of
the business is called Global Products,
which seeks to commercialise the
technologies developed in the core EMEA
services business, as well as a non-core
US military services business.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.03., GBP m 2012 2013 2014 2015E 2016E
Sales 1,470 1,328 1,191 843 787
EBITDA (adj) 201 205 155 131 132
EBIT (adj) 160 169 133 108 108
Net income (adj) 82 123 104 90 91
Net income 246 -133 -13 48 81
Net debt / (net cash) -122 74 171 144 190
EPS 37.9 -20.5 -1.9 7.7 13.7
EPS (adj) 12.5 18.9 16.0 14.4 15.5
FCFPS 25.3 31.2 17.3 4.5 13.3
CPS 22.9 28.3 13.0 -4.2 7.7
DPS 2.9 3.8 4.6 4.8 5.0
EBIT margin (adj) 10.9% 12.7% 11.1% 12.7% 13.7%
Dividend yield 1.8% 1.8% 2.0% 2.2% 2.3%
ROCE 14.6% 17.4% 18.1% 16.3% 16.2%
EV/sales 0.8 1.0 1.1 1.4 1.4
EV/EBITDA 5.9 6.5 8.5 9.2 8.2
EV/EBIT 7.5 7.9 10.0 11.2 10.0
P/E 4.2 -10.2 -116.8 27.8 15.5
P/E (adj) 12.8 11.1 14.3 14.8 13.8

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QinetiQ investment thesis in pictures
Group sales (m) and margin profile: re-sized
and restructured, QinetiQ now has a solid and
more profitable core business
Pro-forma sales split by division ex-US Services
(2016)

Source: QinetiQ, Berenberg estimates Source: Berenberg estimates

Net (debt)/cash (m): strengthening the balance
sheet c700m net cash delta in five years after
95m in dividends
Sales growth (%): emerging opportunities in both
EMEA and Global Products to drive sustainable
growth

Source: QinetiQ, Berenberg estimates Source: Berenberg estimates

Management has committed to a progressive
dividend policy (p)
P/E since flotation valuation looks relatively
full on a long-run basis but the quality of the
business is materially higher

Source: QinetiQ, Berenberg estimates Source: Datastream

0.0%
5.0%
10.0%
15.0%
20.0%
0
500
1,000
1,500
2,000
2
0
0
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2
0
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2
0
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E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
EMEA Services US Services
Global Products Total
Margin
81%
19%
EMEA Services
Global Products
-233
-301
-380
-538
-457
-261
-122
74
171
144
190
252
320
-600
-400
-200
0
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400
2
0
0
6
2
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5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
Net (debt) / cash Working capital
-30.0%
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
2
0
0
6
2
0
0
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2
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E
2
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2
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E
2
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E
Revenue growth Organic growth
0.0
1.0
2.0
3.0
4.0
5.0
6.0
2
0
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7
2
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E
2
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E
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E
2
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E
5
10
15
20
QinetiQ Average
ave 11.8x
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QinetiQ investment thesis
Whats new: We initiate coverage on QinetiQ with a Hold rating and a 225p price
Two-minute summary: QinetiQ is a UK-listed defence company providing
technology-based services and solutions to military, government and some
commercial customers. Under the stewardship of CEO Leo Quinn, the business
has been transformed over the past four years from its institutional government
heritage to a focused business in a position of financial strength. While QinetiQ is
not a high-growth story, we are encouraged to see the core EMEA Services
division stabilising and returning to low organic growth. In the Global Products
division, a number of new products and technologies are emerging that should, in
time, deliver managements strategy to diversify the portfolio of products that is
currently too small and overly reliant on shrinking defence budgets. In the case of
OptaSense, the divisions acoustic sensing technology, significant market
opportunities are emerging in the oil and gas services and rail infrastructure
markets, and we expect more positive contract developments over the next 12
months.
The shares underperformed through the US Services disposal process, albeit from
all-time highs, reflecting a valuation below expectations. The recent bounce
following the FY13 results in May leaves the shares down by 3% ytd, which is a
2.5% underperformance compared to the sector. The shares now trade on a
CY2015 P/E of 14x, a c8% premium to the sector, which indicates to us that the
market is pricing an element of upside from further OptaSense progress.
Key investment point one: longer-term upside from new products,
particularly OptaSense
Revenues in the Global Products division are still volatile due to the small portfolio
of products that are overly reliant on defence markets and conflict-driven demand.
Broadening the range to include more commercial-market-facing, revenue-
sustaining products is a key focus for management. The award of a number of
development and enabling contracts for OptaSense indicate it is a genuinely
disruptive technology with significant potential in the oil and gas and infrastructure
sectors. Predicting the timing and scale of commercialisation success is an
inherently difficult exercise but we are increasingly convinced that OptaSense
will become an important driver of shareholder value over the coming years.
Key investment point two: more cash returns in prospect
QinetiQ is a highly cash-generative business we estimate average cash conversion
after capex since flotation in 2006 of 120%. After an impressive 700m balance
sheet cash improvement over the past five years, the company reported net cash of
170m in March 2014. A 150m (c12%) share buyback programme announced at
the same time as the disposal of the US Services business has just commenced and
is expected to complete within a year. Incorporating this and ongoing cash
generation, we estimate group net cash of close to 150m by March 2015 and for it
to continue to rise thereafter. We do not think large-scale M&A is on the agenda,
so we suggest QinetiQ could sustain a additional payout of c50m pa, either by
way of share repurchase or special dividend.

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Following a strong relative performance in H213 and reaching an all-time high in
January of 236p, QinetiQ shares underperformed after the announcement in April
of the US Services disposal where the price achieved was below market
expectations. The share recovered partly over the last few months and ytd are
down by 3% compared to the average of our aerospace and defence coverage list
which is broadly flat. The 12-month forward P/E of 14.5x based on consensus
estimates is a 23% premium to the average 11.8x since flotation.
Share price versus market and sector 12-month forward P/E since flotation

Source: Datastream
Note: re-based to QinetiQ share price
Source: Datastream

Forecast momentum
Four years ago, growth expectations were substantially pared back, reflecting
slowing defence markets and the effects of reduced conflict-related spending.
However, financial performance in 2012 and 2013 significantly exceeded the
expectations that were set at the beginning of each year due to high-margin, short-
notice military product orders in the Global Products division. There have been no
major changes to consensus estimates through the 2014 results, with dilution
effects from the disposal of US Services largely offset by the share buyback
programme.
Long-term EPS changes (p): current growth
expectations are modest
Short term EPS and share price changes (p):
recent cuts to EPS reflects net dilution effect of
the US Services disposal and share buyback


150
200
250
300
QQ FTSE A-S Pan Euro A&D
5
10
15
20
QinetiQ Average
ave 11.8x
10
13
16
19
22
25
2012 2013 2014 2015 2016
Two yrs of 'beats' on
Global Products contracts
14.0
14.2
14.4
14.6
14.8
15.0
150
170
190
210
230
250
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200
Results recap (to March 2014): sales were slightly light but EBIT was 6% ahead of
consensus estimates.

Revenue declined by 10.5% yoy to 1,191m, down as expected compared to
2013, due to a strong contract-led Global Products comparator, and also the
anticipated effects of weakness in the US federal contracting environment and
troop drawdown from Afghanistan.

EBIT declined by 21.4% yoy to 132.7m (consensus: 125m) leading to a PBT
of 119.4m (consensus: 112m) and EPS of 16.0p (consensus: 14.7p), which
was helped by a lower tax rate (12.9% versus 19.2%).

Strong cash: Net cash amounted to 170m (74m in 2013) and compared to
consensus of around 140m with another year of strong cash generation (cash
conversion: 103%).

DPS: The dividend increased by 21% to 4.6p.

Outlook: Initial guidance for 2015 was vague and not quantified, as has become
the custom for the QinetiQ management in recent years: The board is
maintaining expectation for the overall group performance. Within this
guidance, management has said it expects EMEA Services to remain steady,
while Global Products will continue to be challenged by lower demand for
conflict-related products. We interpret from this that underlying consensus
estimates, adjusted for the US Services disposal and share buyback, were
broadly unchanged.
Disposal of US Services valuation was light but exit was the right
strategic move
On 22 April, QinetiQ announced the disposal of its US Services division for an
initial cash consideration of $165m (98m) plus a potential earn-out of up to $50m
(30m) depending on its performance to March 2015. While the valuation fell
short of market expectations of 150m-200m, we welcome the disposal as it
concludes the previous managements flawed strategy to aggressively expanding
into the US, and removes the groups exposure to the challenged US federal
services market. To put this into historical context, we estimate that the previous
management spent close to 800m on 14 US acquisitions between 2005 and 2010.
Since then, their collective revenues have fallen by c30% and overall margins have
halved to c4%. The individual businesses were proved, in an increasingly
competitive market, to be sub-scale and with headwinds unlikely to moderate any
time soon, we think disposal at the price achieved was appropriate for
shareholders, in our view. For the record, we model pro-forma group margins
post-exit from US services of 14% from c11% in 2014.

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Group revenue and margin profile (m)

Source: Berenberg estimates, QinetiQ

4.0%
8.0%
12.0%
16.0%
20.0%
0
500
1,000
1,500
2,000
EMEA Services US Services Global Products
Total Margin
US expansion
- 800m M&A
US defence
slow down
Stable core
businesses
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Slow progress transitioning the Global Products portfolio: It is three years
since the company introduced the strategy and investment framework intended
to diversify the groups portfolio of core products. Progress has been slow. We
estimate that just six products LAST Armor, TALON, PADS Q-Net,
SWATS (all-defence related products) accounted for over half the divisions
sales in 2014. OptaSense and Space Products are two areas showing
promising potential but predicting the timing and monetary value of successful
commercialisation is an inherently hazardous exercise. We believe the market is
starting to consider upside potential from new products as being core to the
investment case (as do we), so if progress is slower than hoped over the next 12
to 18 months, then valuation risk would shift to the downside.

Leo Quinn steps down: CEO Leo Quinn is the architect of the groups four-
year turnaround and can be credited with overseeing major structural change
internally and operationally, and ultimately creating significant shareholder
value. The historical civil service culture has been substantially transformed to a
more commercially focused business with a fundamentally more robust strategy
to realise value from the deep pool of intellectual property within the QinetiQ
portfolio. We are not aware that the company or Mr Quinn has made any public
reference to his intended tenure, but as the business moves into its next
strategic phase (following the disposal of US Services), we are cognisant of the
achievements so far and we speculate that there is a possibility that Mr Quinn
could move on within our investment horizon. If he were to step down, we
expect the shares to de-rate.

Defence budget pressures: Of the companies we follow, QinetiQ has the
highest proportion of sales to defence and security customers (c90%), although
direct exposure to the US is has fallen following the disposal of US Services. In
the UK, top-line budget pressures will persist, although this is mitigated in
QinetiQs case by the companys unique position to support transformation of
the UK Ministry of Defences (MoD) procurement and support organisation,
Defence Equipment & Support (DE&S), in order to reduce costs. The near-
term outlook in the US has improved with the recent two-year budget deal,
indicating a more gradual path to lower defence spending. However, we
anticipate continued downward pressure for the foreseeable future, particularly
in the Global Products division which is highly exposed to the US Department
of Defenses Overseas Contingency Operations budget (OCO), the
supplemental budget to fund the conflict in Afghanistan, which we expect to
decline as troop drawdown from Afghanistan continues over the next few years.

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Valuation
225p price target


of-the-parts (EV/sales and EV/EBITDA) analysis. We have used FY15
estimates and excluded the disposed US Services division.

Hold rating.

The shares currently trade on a 12-month forward P/E of 14.5x based on
Datastream consensus estimates, a 23% premium to the 11.8x average since
flotation. We believe this is justified by the improvement in business quality
over the past few years and the prospect of a return to a profile of steady
organic growth.

Based on our estimates, the implied target CY14 P/E is 15.2x falling to 14.8x
(CY15) and 13.8x (CY16).
12-month forward P/E relative to FTSE All-share 12-month forward EV/EBITDA (-5Y)

Source: Datastream
Sum-of-the-parts
There are few directly comparable companies to QinetiQ, so in our sum-of-the-
parts, we use peer average multiples adjusted for company-specific anomalies. For
EMEA Services, we use technical services and consultancy companies such as
SAIC, CACI, Mantech, CAE and Babcock. For Global Products, we use defence
technology companies such as Ultra Electronics, Cobham, Thales and L-3. On this
basis, we generate a sum-of-the-parts valuation that is a c5% discount to the
current share price.
FY15 Assumptions
EV/Sales 200 Ave multiple 1.38x
EV/Ebitda 204 Ave multiple 8.6x
DCF 271 7.9% WACC / 1.5% TG
Average 225 Ave 225p
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
QinetiQ P/E rel to FTSE A-S Average
ave 1.1
3
5
7
9
11
12m fwd EV/EBITDA Average
ave 6.4x
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Sum-of-the-parts valuation (m) DCF valuation summary

DCF
Our DCF valuation of 271p is 29% above the current price and is based on our
model excluding the US Services business and reflecting the share buyback. We
apply a terminal margin of 13.5%, slightly below the blended margin currently
achieved by EMEA Services and Global Products, on the assumption that potential
growth in higher-margin new products, International and non-military revenues
will be more than offset by continuing pressures in the core defence activities.
DCF Sensitivity WACC and margin DCF sensitivity WACC and terminal growth

EMEA Services 904 8.7 803 1.30 853
Global Products 190 8.2 266 1.69 228
Total 1,093 8.6 1,068 1.38 1,081
Net cash/(debt) 144
Pension (IAS19) -13
Equity value 1,212
Shares o/s (m) 600
DCF Model m
Risk Free rate 4.0% PV of disc flows (10yrs) 642
Equity risk premium 4.5% PV of terminal flows 831
Beta (x) 0.79 Net (debt) / cash 144
Share value (p) 271
271 12.5% 13.0% 13.5% 14.5% 15.5%
6.9% 253 317 317 317 317
7.4% 291 291 291 291 291
7.9% 269 269 269 269 269
8.4% 269 251 251 251 251
8.9% 235 235 235 235 235
W
A
C
C
EBIT margin
271 0.5% 1.0% 1.5% 2.0% 2.5%
6.9% 271 300 317 317 360
7.4% 267 278 291 306 325
7.9% 249 259 269 282 297
8.4% 234 242 251 261 273
8.9% 221 227 235 243 253
Terminal growth
W
A
C
C
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205
Key investment point one: longer-term upside from new
products, particularly OptaSense

Global Products revenues are volatile due to a product portfolio that is
too small and overly reliant on defence markets.

The transition to a broader range of commercial products is slowly
gathering pace driven by the Explore element of the groups Organic
Plus strategy. Predicting the timing and scale of successful
commercialisation is an inherently difficult exercise.

The OptaSense acoustic sensing technology represents the most
mature new product in terms of developing and scaling a business
model. We are increasingly convinced OptaSense has significant
market potential and in time will become an important driver of
shareholder value.
Global Products is an inherently lumpy business
The Global Products division (22% of 2014 continuing sales) comprises a relatively
small portfolio of mainly defence-related products eg robots, vehicle survivability
and defence electronics with sales that have been primarily driven by conflict-led
demand. Division revenues have fallen from a peak of 440m in 2011 to 175m in
2014 due to lower defence spending and the effects of the troop drawdown from
Afghanistan. The chart below highlights large revenue (and hence profit) variations
caused by a relatively few products. To reduce this volatility and produce more
sustainable revenues, managements strategic focus is on broadening the product
offering in principally non-conflict applications. Progress to date has been relatively
slow. We estimate that six core defence products LAST Armor, TALON,
PADS, Q-Net, SWATS accounted for over half the divisions sales in
2014. However, there are some promising high-potential businesses emerging
(which we discuss below) and while we do not expect them to drive a rapid shift in
product mix in the near term, we are increasingly confident of that one or more of
them will develop into an important driver of shareholder value.
Global Products revenue profile (m)

FY11 FY12 FY13 FY14
0
100
200
300
400
m
Q-Net
SWATS
TM
Robots
Armor
Other US Global Products
Other UK Global Products
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206
New products longer-term value opportunities

Test for Value: A number of new products within the division are categorised
in the Test for Value category, which are early-stage emerging technologies,
often from customer-funded developments being tested for commercial
viability and their potential to realise value. These include the following.
7. MEWS: This is a man pack electronic warfare (EW) system for searching,
intercepting and electronic attack. MEWS has already achieved initial sales
to two customers in Europe and has recently been specified by the US
Army as a platform to develop new a new EW system for the US military.
8. LineWatch Power Line Sensors: These are power distribution monitoring
systems for above-ground and underground power lines that can be used to
datalog live lines to detect power loss. The system is currently trialling
with two North American utility companies a process that the company
has suggested could lead to contract opportunities in the coming year.
9. Integrated Warrior System (IWS): This is a power and data management
system that integrates directly into the soldiers vest. QinetiQ is currently
bidding this product to an undisclosed customer, the outcome of which, we
speculate, will determine whether this product has a viable future and is
scalable.

Explore: Within the Explore category are a number of high-potential emergent
businesses where management is looking to materially scale the business model
to sales greater than 100m pa. These include standalone businesses such as
OptaSense (Distributed Acoustic Sensing DAS) and Space Products
(satellites, sub-systems and ground station services), and new products already
embedded in core businesses such as Robotic applique kits to remotely operate
Bobcat loaders (within Unmanned Systems). We estimate that the Explore
products within the division generated about 50m of revenues in 2014 but
have the potential to grow to significantly more. Of increasing interest to us is
OptaSense, which the company has discussed for several years, but a number
of important strategic developments in 2014 (eg trials, development contracts
and industry agreements) indicate growing momentum and more meaningful
revenues.
OptaSense is a classic disruptive technology the question for us is
timing and the business model
OptaSense, an acoustic sensor technology, is the most mature of the groups
new products in terms of developing commercial potential. It is a DAS solution
that converts standard fibre optic cable into an array of microphones capable of
monitoring assets and infrastructure over very large distances. It is an established
business that generated c25m of sales in 2014 including from existing commercial
uses in the infrastructure security sector for example, monitoring remote
pipelines for damage and security. Other opportunities for OptaSense are
emerging in areas such as rail sensing and oilfield services (seismic sensing) where,
for example, it is proving to be a much simpler and cheaper alternative to the
current geophone technology. In 2014, QinetiQ signed a number of development
contracts and enabling agreements that continue to prove that the technology is
genuinely superior to alternative or existing solutions.

Oilfield services: Following the ending of a three-year exclusivity agreement
with Shell, OptaSense has signed a number of enabling agreements to supply
QinetiQ plc
207
its products and services to both downstream oil and gas companies and oilfield
services companies (eg BP, ConocoPhilips, Baker Hughes and Chesapeake). In
addition, Shell extended and broadened its agreement to a three-year/10m
development contract to marinise the technology for subsea down-hole
applications that, according to management, opens up a significant market
opportunity (although not quantified). Acoustic sensing in the gas fracking
process and seismic profiling are other potential applications where initial
contracts have been awarded and could evolve into larger opportunities.

Rail sensing: Having recently delivered trials for Austrian Rail on its
infrastructure near Vienna, the company recently signed an 18-month/1.1m
development contract with Deutsche Bahn to validate OptaSense as a
technology to replace existing rail sensors. Again, this is relatively early stage but
potentially could represent a very large market opportunity.
Adoption of new technologies over entrenched industrial practices is an inherently
slow process. In each target market for OptaSense, management is focusing on
evolving the business model to optimise the value opportunity. For example, in oil
services, a vertical model is being pursued, with partnerships and licensing
arrangements with the major players deemed by management to be the best way to
access the market and rapidly increase market penetration through the existing
global distribution channels. At the other end of the commercialisation spectrum,
the model adopted for existing infrastructure security and pipeline monitoring
activities is direct equipment supply, mainly because contracts tend to be one-off
(by customer or project) in nature. In summary, we are growing in confidence that
OptaSense could, from a small base, become a material contributor to the group
within a matter of years. We factor sales rising from c25m in 2014 rising to
c80m by 2017.
Global Products sales profile (m) Global Products EBIT profile (m)

Source: Berenberg estimates, QinetiQ Source: Berenberg estimates, QinetiQ
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0
100
200
300
400
500
Global Products Margin (rhs)
0
10
20
30
40
50
60
70
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Key investment point two: more cash returns in prospect

Managements balance sheet achievements over the past five years have
been impressive: c700m of net debt/cash improvement after 95m of
dividend.

We estimate c150m of net cash even after the 150m/12% share
buyback is completed early next year, giving scope to extend the plan or
to return excess cash by other means.

We suggest that the company could comfortably sustain share
repurchases of 50m pa, c4% of the current market capitalisation.
Strong/inefficient balance sheet
Managements relentless focus on cash has transformed QinetiQs debt-laden
balance sheet in 2009 to a current net cash position of 170m, an inflow delta of
around 700m, which is after paying c95m of dividends. This is impressive, in
our view.
Net debt profile (m)

After incorporating the 150m share buyback and assuming 115m net proceeds
from the sale of US Services and ongoing cash generation, we estimate that group
net cash will be close to 150m by end-H115 (September). QinetiQ is a highly
cash-generative business we estimate average cash conversion after capex of
120% since flotation and by March 2016, we estimate the group will be
generating FCF of around 80m pa, equivalent to a FCF yield of c6%.
Management has hinted that an opportunistic acquisition would be considered if,
for example, it facilitated the commercialisation of a new product, but we do not
anticipate large-scale M&A in the mid-term. The next logical step, in our view, is to
distribute excess capital to shareholders. We believe QinetiQ could sustain a 50m
pa share buyback (currently 4% of equity), or annual special dividend, while
maintaining a progressive dividend as we profile in the chart below.
-233
-301
-380
-538
-457
-261
-122
74
171
144
190
252
320
-600
-400
-200
0
200
400
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E2016E2017E2018E
Net (debt) / cash Working capital
150m share
buy back
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Dividend profile (p): progressive dividend profile


0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
2007 2008 2009 2010 2011 2012 2013 2014 2015E2016E2017E2018E
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Divisional financials summary (m)

EMEA Services 652.7 610.1 594.6 607.0 619.1 637.7 650.5 663.5
Global Products 442.6 325.0 269.4 175.6 157.3 149.4 179.3 224.2
Continuing (pf) 1,095.3 935.1 864.0 782.6 776.5 787.2 829.8 887.6
Revenue growth
EMEA Services -5.9% -6.5% -2.5% 2.1% 2.0% 3.0% 2.0% 2.0%
Global Products 45.8% -26.6% -17.1% -34.8% -10.4% -5.0% 20.0% 25.0%
Group total 9.8% -14.6% -7.6% -9.4% -0.8% 1.4% 5.4% 7.0%
EBITA (adj)
EMEA Services 47.4 61.3 84.8 86.7 85.4 87.4 87.8 91.6
Global Products 52.1 66.2 60.2 27.0 18.9 20.2 26.0 33.6
Continuing (pf) 99.5 127.5 145.0 113.7 104.3 107.5 113.8 125.2
EBITA margin (adj)
EMEA Services 7.3% 10.0% 14.3% 14.3% 13.8% 13.7% 13.5% 13.8%
Global Products 11.8% 20.4% 22.3% 15.4% 12.0% 13.5% 14.5% 15.0%
Continuing (pf) 9.1% 13.6% 16.8% 14.5% 13.4% 13.7% 13.7% 14.1%
QinetiQ plc
211
Appendix 1: EMEA Services (78% of sales and EBIT pro-
forma)
QinetiQ is the UKs largest research and technology organisation, deeply
embedded in the MoD through the provision of technical services. Within the
EMEA Services business, QinetiQ also provides consulting, technical advice and
managed services to an increasing number of international customers. International
demand is a key driver of future growth; opportunities include procurement advice
to the Canadian government, testing and evaluation services for a Scandinavian
customer and strategic and procurement advice for a Middle Eastern customer. We
estimate that c9% of revenues can be categorised as international defence (ie
non-UK and non-US).
EMEA Services sales and margin profile (m)


Managed Services: We estimate that c480m of sales are from managed
services activities, predominantly providing testing and evaluation services for
the UK MoD under long-term contracts. Activities include the provision of
technical services in aerospace engineering, weapons and equipment testing and
evaluation, training and simulation, force/base protection, information and
intelligence, cyber security and procurement consultancy. By sub-sector,
revenues are split approximately: air 36%; weapons 36%; maritime 11%;
C4ISR (Command, Control, Communication, Computers, Intelligence,
Surveillance and Reconnaissance) 16%; and cyber 6%. Underpinning the
EMEA division is the 25-year Long-Term Partnering Agreement (LTPA),
through which QinetiQ manages a number of core MoD Test & Evaluation
(T&E) and Training Support capabilities in the UK. Other long-term contracts
include the 20-year Combined Aerial Target System (CATS).

Technical Services and Consulting: c150m of sales relates to the provision
of technical advice to mainly military customers including training and
simulation and C4ISR advice.

Financial performance: EMEA Services revenues have trended down since
flotation, largely due to the expected reductions in the UK MoDs research
budget. However, 2014 marks a stabilising of performance, with the division
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
540
560
580
600
620
640
660
680
700
720
2010 2011 2012 2013 2014 2015E 2016E 2017E
EMEA Services Margin (rhs)
QinetiQ plc
212
reporting organic growth (3%) for the first time in four years. Growth is being
partly driven by increasing demand for the groups technical and advisory
services in international markets. A number of opportunities are emerging, for
example the provision of ranges in Canada and technical services in the Middle
East. Despite overall revenue declines in recent years, operating margins have
increased significantly, up by almost 600bp since 2010, benefiting improved
operational performance and contract execution across the business.

Long-term outlook steady/low growth: EMEA Services provides the main
underpin of the groups core capabilities, and accounts for 90% of total
revenue. We believe the segment is capable of sustaining low single-digit growth
in the mid-term driven by opportunities in international markets and in the
training and simulation and cyber security sectors.
EMEA Services core businesses

Source: QinetiQ

QinetiQ plc
213
EMEA Services Explore businesses

Source: QinetiQ

QinetiQ plc
214
Appendix 2: A brief history
QinetiQ was formed from the UK MoDs defence research agency (DERA) in July
2001 and listed in February 2006. Its core business was (and largely still is) testing
and evaluation services for the MoD, funded predominantly through the research
budget. Post-flotation, the then management embarked on an aggressive
acquisition-led growth strategy, principally focused on expansion in the US,
spending c800m on 14 transactions between 2005 and 2010. Group revenues
doubled over this period to a peak of c1.7bn in 2011, growth that, together with
short-term demand spikes from conflict-related activity, masked a number of
increasing headwinds to underlying performance: initially erosion of the UK
research budget and then, more significantly, a slowdown in US defence spending.
QinetiQ revenue and margin profile since flotation (m)

The current CEO Leo Quinn, appointed in November 2009, inherited a 540m
debt pile (net debt/EBITDA c2.7x) and was forced almost immediately into
delivering two profit warnings in close succession as organic growth slowed and
balance sheet stress mounted. He embarked on a two-year self-help restructuring
programme focusing on cash generation and addressing both internal structural
issues (eg legacy employment contract structures) and external issues (managed
decline) and overall operational improvement.
Progress to date has been impressive, with just under 700m of net cash inflows
since 2009, a key driver being a c300m swing in working capital (to negative
NWC of 160m). In 2012, QinetiQ commenced implementation of the Organic
Plus strategy, which aims to deliver sustainable long-term growth based on a robust
framework for identifying and investing in technologies that can ultimately
contribute to core revenues in a meaningful way (deemed by management to be at
least 100m pa).

0.0%
3.0%
6.0%
9.0%
12.0%
15.0%
18.0%
0
300
600
900
1,200
1,500
1,800
Sales Margin (rhs)
QinetiQ plc
215
Financials

Year-end March (GBP m) 2012 2013 2014 2015E 2016E

Sales 1,469.6 1,327.8 1,191.4 843.5 787.2

Other income 5.2 5.8 7.0 7.0 7.0
Operating costs -1,051.7 -1,149.2 -1,018.8 -748.4 -662.6
Depreciation -32.5 -32.0 -22.6 -22.0 -23.0
Amortisation of intangible assets -29.3 -18.0 -12.0 -9.0 -9.0
Impairment 11.6 -253.5 -125.9 0.0 0.0
EBIT 372.9 -119.1 19.1 71.0 99.5

EBITDA (adj) 201.1 204.7 155.3 130.5 131.5
Depreciation -32.5 -32.0 -22.6 -22.0 -23.0
Amortisation of intangible assets -29.3 -18.0 -12.0 -9.0 -9.0
EBIT (adj) 159.6 168.7 132.7 107.5 107.5
Unusual or infrequent items 233.6 -273.8 -102.6 -28.5 0.0
Amortisation of goodwill -20.3 -14.0 -11.0 -8.0 -8.0
EBIT 372.9 -119.1 19.1 71.0 99.5

Interest income 2.2 1.7 1.9 1.9 0.0
Interest expenses -51.6 -18.3 -15.2 -5.5 0.0
Other financial result -7.2 -1.3 -1.7 -1.0 -1.0
Net financial result -56.6 -17.9 -15.0 -4.6 -1.0
EBT 316.3 -137.0 4.1 66.4 98.5
EBT (adj) 103.0 152.1 119.4 103.9 107.5

Income tax expense -70.0 3.8 -16.8 -18.3 -17.3
Other taxes -48.5 33.0 -1.4 -4.7 -1.2
Group tax (underlying) -21.5 -29.2 -15.4 -13.5 -16.1
Tax rate 22% 3% 410% 27% 18%
Profit after tax 246.3 -133.2 -12.7 48.2 81.2
Profit after tax (adj) 81.5 122.9 104.0 90.4 91.4
Minority interest 0.0 0.0 0.0 0.0 0.0

Net income 246.3 -133.2 -12.7 48.2 81.2
Net income (adj) 81.5 122.9 104.0 90.4 91.4

Average number of shares (m) 650.5 648.7 651.7 628.8 590.9
Average number of shares (FD) (m) 654.5 655.8 656.8 631.8 593.9

EPS (reported) (p) 37.9 -20.5 -1.9 7.7 13.7
EPS (adjusted) (p) 12.5 18.9 16.0 14.4 15.5


QinetiQ plc

216

Balance sheet
Year-end March (GBP m) 2012 2013 2014 2015E 2016E

Intangible assets 591 348 186 84 56
Fixed assets 850 594 421 328 305

Inventories 31 26 20 34 43
Current assets 579 587 616 630 639
TOTAL ASSETS 1,430 1,181 1,037 958 943

Shareholders' equity 599 438 378 279 308
Long-term debt 164 171 154 181 135


TOTAL LIABILITIES 1,430 1,181 1,037 958 943


QinetiQ plc

217

Cash flow statement
GBP m 2012 2013 2014 2015E 2016E

EBITDA (adj) 201 205 155 131 132

Other costs affecting income / expenses 13 -35 -4 -11 0
(Increase)/decrease in working capital 28 88 -8 -14 -9
Interest paid -39 -35 -11 -34 0
Cash tax -23 -2 2 -14 -16

Interest received - - - - -
Capex -22 -27 -24 -30 -28
Intangibles expenditure -1 -1 -3 0 0
Financial investments 11 0 0 92 19
Cash flow from investing activities -2 -15 -21 62 -9


Dividends paid -16 -20 -27 -27 -29
Net proceeds from shares issued -12 0 -1 -120 -24
Others -1 0 0 0 0
Effects of exchange rate changes on cash -11 11 11 0 0

Net cash flow 139 196 97 -26 46

Reported net debt -122 74 171 144 190


QinetiQ plc

218

Ratios
Ratios 2012 2013 2014 2015E 2016E

Valuation
EV/sales 0.8x 1.0x 1.1x 1.4x 1.4x
EV/EBIT (adj) 7.5x 7.9x 10.0x 11.2x 10.0x
P/E (adj) 4.2x -10.2x -116.8x 27.8x 15.5x
P/FCFPS 6.3x 6.6x 13.0x 47.1x 15.9x
Dividend yield 1.8% 1.8% 2.0% 2.2% 2.3%

Growth rates
Sales organic -11% -10% -8% 0% 2%
EBIT (adj) 10% 6% -21% -19% 0%
EPS (adj) -11% 50% -16% -10% 8%
EPS 4857% -154% -91% -493% 79%
DPS 81% 31% 21% 4% 4%

Financial ratios
FCF conversion 99% 115% 83% 26% 73%
Net gearing 14% -9% -27% -25% -34%
Net debt/EBITDA 0.6 -0.4 -1.1 -1.1 -1.4
ROCE 14.6% 17.4% 18.1% 16.3% 16.2%
ROIC 11.9% 14.4% 14.1% 12.4% 13.2%
WACC 14.9% 16.6% 20.1% 18.6% 20.4%
FCF ROCE 22.8% 55.5% 54.4% 20.9% 66.4%
Working capital/sales -3.8% -11.1% -13.0% -16.7% -16.8%
Capex / sales 1.5% 2.0% 2.0% 3.6% 3.6%

Key financials

Sales 1,470 1,328 1,191 843 787
EBIT margin (adj) (%) 10.9% 12.7% 11.1% 12.7% 13.7%
EBIT (adj) 160 169 133 108 108
EPS (adj) (p) 12.5 18.9 16.0 14.4 15.5
DPS (p) 2.9 3.8 4.6 4.8 5.0

Free cash flow 165 202 113 28 79
Net cash flow 139 196 97 -26 46

Total working capital -56 -147 -155 -141 -132
Gross debt 249 173 156 183 137


Rheinmetall AG
219

Building confidence; up to Buy

Following the Q1 update and a transfer of analyst coverage, we are
upgrading Rheinmetall to a Buy recommendation with a raised price
target of 62.5, indicating 22% upside. We are increasingly confident
that Rheinmetall can deliver a strong recovery in profits and hence
valuation metrics look attractive on a 2015 view.

Returning to sustained growth: Both the Defence and Automotive
divisions are experiencing top-line growth. Strong order intake from
international customers provides a solid underpin to Defence sales
over the next few years, while Automotive will continue to benefit
from growth in global auto production, in particular in the groups
Chinese businesses and JVs and in the Mechatronics division.

Improved earnings stability: In addition to volume effects,
operating performance will benefit from 106m of restructuring. We
factor incremental savings of c25m in 2014 and 40m-50m in 2015.

Short-term risks remain: Robust Q1 results, including confirmation
of 2014 guidance, reassured us that Rheinmetalls financial
performance has stabilised. We acknowledge short-term risks,
however, in particular the inherently back-end-loaded profile of
Defence sales, where our forecasts depend on securing short-order
items such as munitions. In addition, increasing execution risk relating
to the contract with Russia in the light of German trade restrictions.
Exposure is relatively low, though we estimate less than 3% of
EBIT in 2014.

Forecast changes: We lower our 2014 EPS by 8%, primarily
reflecting caution in the pace of margin recovery in Defence.
However, our 2015 EPS increases by 6.5% based on higher assumed
growth in Defence and Automotive.

Cheap valuation: Assuming full earnings recovery in 2015, the shares
look good value on a P/E of 9.9x, a c23% discount to the average of
European defence peers. Forecast risks are abating, we suggest
Rheinmetall presents an attractive investment proposition with both
valuation upside and growth potential.

Buy
Current price
EUR 51.22
Price target
EUR 62.50
Reuters RHMG.DE
Bloomberg RHM GY

Changes made in this note
Rating Buy (Hold)
Price target EUR 62.50 (42.00)

Chg
2014E 2015E 2016E

old % old % old %
Sales 4,869 0.0 4,959 3.7 - -
EBIT
(adj)
248 -19.2 328 -1.9 - -
EPS
(adj)
3.50 -7.9 4.95 6.5 - -

Share data

Performance data

High 52 weeks (EUR) 57.87
Low 52 weeks (EUR) 35.01
Relative performance to SXXP MDAX
1 month -2.6 % -2.5 %
3 months -11.8 % -7.9 %
12 months 9.7 % 13.5 %
Key data

Net gearing 15.6%
CAGR sales 2013-2016 5.8%
CAGR EPS 2013-2016 33.4%

Rheinmetall AG is an automotive, defence and
engineering group. The automotive division
produces pistons, engine blocks, components,
engine control systems and pump technology
aimed for the light vehicle and truck sectors. The
defence division designs and manufactures
armoured vehicles, military trucks, combat
systems and other military control systems.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Benjamin Glaeser
Analyst
+44 20 3207 7918
benjamin.glaeser@berenberg.com

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., EURm 2012 2013 2014E 2015E 2016E
Sales 4,704 4,613 4,868 5,144 5,465
EBITDA (adj) 462 425 440 564 631
EBIT (adj) 268 213 240 354 410
Net income (adj) 153 100 124 205 246
Net income 173 29 117 205 246
Net debt / (net cash) -98 -138 -226 -201 -175
EPS 4.5 0.8 3.0 5.3 6.2
EPS (adj) 4.0 2.6 3.2 5.3 6.2
FCFPS 3.5 0.3 -1.9 1.6 2.4
CPS 1.0 -1.1 -2.3 0.6 0.7
DPS 1.8 0.4 1.0 1.8 2.1
EBIT margin (adj) 5.7% 4.6% 4.9% 6.9% 7.5%
Dividend yield 4.9% 0.9% 1.9% 3.4% 4.0%
ROCE 14.0% 9.8% 10.3% 14.0% 15.0%
EV/sales 0.5 0.6 0.6 0.6 0.6
EV/EBITDA 4.9 8.4 7.3 5.5 5.0
EV/EBIT 8.1 24.4 13.6 8.8 7.6
P/E 8.0 58.7 17.2 9.9 8.4
P/E (adj) 9.0 17.1 16.2 9.9 8.4

Rheinmetall AG
220
Rheinmetall investment thesis in pictures
Revenue (m): top-line growth resuming and
margins recovering
EBIT (m): Defence recovery backed by orders
and operational performance across the group to
drive profits growth

Source: Rheinmetall, Berenberg estimates Source: Rheinmetall, Berenberg estimates

EPS (adjusted) (): the highest EPS CAGR in our
coverage at 28% (three years to 2017)
Revenue phasing of top six defence (m)

Source: Rheinmetall, Berenberg estimates Source: Berenberg estimates, company data

Estimated profit share from Chinese JVs (m) Long-term P/E (12-month forward)

Source: Berenberg estimates, company data Source: Datastream

0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
2
0
0
7
2
0
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9
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E
Defence Automotive Margin (rhs)
-100
0
100
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1
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E
Defence Automotive
0.0
1.0
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4.0
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6.0
7.0
8.0
0%
20%
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60%
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100%
0
200
400
600
800
1,000
% of Defence sales f'cast (rhs)
0
5
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Rheinmetall Average
ave 11.3x
Rheinmetall AG
221
Rheinmetall investment thesis
Whats new: Following a transfer of analyst coverage, we have updated our
forecasts to reflect recent results and company guidance and incorporate our latest
assumptions. We lower our 2014 EPS forecast by 8% but increase 2015 by 6.5%.
We raise the stock to a Buy recommendation (from Hold) with a price target of
62.5, implying 22% upside.
Two-minute summary: Rheinmetall delivered a robust Q1, further building
investors confidence that the group is returning to sustainable growth. We
acknowledge the inherent skew of Defence profits to the final quarter and that
risks relating to Russian contract exposure heighten both forecast and sentiment
risk in the short term, but given high levels of order cover and longer-term growth
prospects in both divisions, we believe investors should be looking towards 2015
and 2016 to value the shares. On this basis, the shares look very cheap on our
forecasts (c23% discount to European defence 2015 P/Es), and even better value
if managements 2015 targets are achieved, which imply c7% upside to our EPS
forecasts. Overall, we believe business risks are abating, especially in Defence given
improved order visibility. With volume growth and restructuring benefits boosting
the recovery in profits, Rheinmetall screens as the highest earnings growth
company in our coverage.
Key investment point one: defence risks are abating; orders are rising
After several years of poor financial performance, the outlook for the Defence
division is much improved with a record 6.2bn order book providing high order
cover over the next few years. We estimate the six largest contracts, predominantly
to international customers, will generate c600m of incremental revenue by 2017.
This excludes the recent Swedish order for 215 military logistics vehicles which
adds to the contracts under the existing Norway/Sweden long-term framework
agreement totalling c200m to date. Indications of intent under the framework
agreement are for up to 2,000 vehicles worth some 1bn through the period 2014-
2026. In summary, the Defence division has highly visible sales through a broad
spread of international orders, and hence revenue volatility will be considerably less
than historically. We view the main risk as project execution.
Key investment point two: robust growth outlook for Automotive
The Automotive division is well positioned to benefit from growth in global auto
production over the coming years. Two key drivers should support Automotive
growth ahead of the market: 1) exposure to China through the groups JVs and
wholly-owned foreign entities, we estimate Rheinmetalls total economic sales
exposure to China (ie based on the share of JV sales not normally consolidated) at
around 340m, or 13% of the Automotive division; 2) exposure to structural
growth segments, in particular through new products that reduce emissions and
improve fuel efficiency in the powertrain segment, such as higher value
Mechatronics engine control systems and pump products.
Following the disappointments of early 2013 when sentiment was adversely
affected by downgrades and hefty restructuring, the shares more than recovered
and enjoyed a period of relative outperformance into early 2014, driven by strong
order intake and consistent updates by management. Recent weakness, however,
Rheinmetall AG
222
has been fuelled partly by uncertainties about the Ukraine situation and the groups
exposure to Russia, although we suggest that the Q1 results and commentary went
some way to alleviating these fears. From the 3 March peak of 54.4, the shares
lost 18.5% in two months but recently recovered some lost ground driven mainly
by the market rally and also the order announcement for Swedish military vehicles.
The share price is now down 5% over three months but on a ytd basis, Rheinmetall
still ranks as the second-best-performing stock in our coverage, having gained 14%.
In terms of P/E valuation, the stock traded at very depressed ratings from mid-
2011 to mid-2013 due to declining defence activity and poor operational
performance. The main rating recovery occurred in the second half of 2013 as
defence orders built and managements improvement and growth strategy was
communicated and enacted. The 12-month forward P/E of 12x is slightly above
the 10-year average of 11.3x. However, on a 2015 earnings basis, the shares trade
on a P/E of just 9.9x, a 23% discount to European defence peers.
Share price versus market and sector (re-based) 12-month forward P/E (10 years)

Forecast momentum
Earnings forecast momentum stabilised through the second half of 2013 and with
growth now back on the agenda, 12-month forward EPS momentum has been
positive since September 2013 (see second chart below), driving the shares as
previously described.
Long-term forecast EPS changes (); growth
returning
12-month forward EPS (rhs) and share price ()

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Rheinmetall Average
ave 11.3x
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2012 2013 2014 2015 2016
3.0
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Rheinmetall AG
223
Forecast changes
We have updated our model assumptions to reflect recent guidance and our view
of the groups operational development potential. In summary, we cut our current
year earnings forecast by 8%, primarily reflecting caution in pace of margin
recovery Defence. Our FY15 EPS is upgraded by 6.5% based on assumed higher
growth in both divisions and higher margins in Automotive, partly offset by lower
margins in Defence. According to Bloomberg, we are 2-4% below consensus at the
EBIT and EPS level for the current year, in line for 2015 and c4% ahead in 2016
(as shown in the second table).
Changes to Berenberg estimates (m)



FY14 Old FY15 Old FY14 New FY15 New FY16 New FY14 chg FY15 chg
Defence 2,277 2,336 2,269 2,446 2,664 -0.3% 4.7%
Automotive 2,539 2,602 2,599 2,699 2,801 2.4% 3.7%
Revenue 4,816 4,939 4,868 5,144 5,465 1.1% 4.2%
Defence 117 165 84 165 202 -28.2% -0.2%
Automotive 168 199 176 209 228 4.7% 5.2%
Other/consol -20 -20 -20 -20 -20 0.0% 0.0%
EBIT (adj) 265 364 240 354 410 -9.4% -2.8%
Defence 5.1% 7.1% 3.7% 6.7% 7.6% -1.4% -0.3%
Automotive 6.6% 7.6% 6.8% 7.7% 8.2% 0.2% 0.1%
Margin 5.5% 7.4% 4.9% 6.9% 7.5% -0.6% -0.5%
EPS (adj) () 3.50 4.95 3.23 5.27 6.24 -7.8% 6.4%
DPS (adj) () 1.43 2.13 1.01 1.76 2.08 -29.0% -17.7%
Sales (m) 4,868 4,866 0.0% 5,144 5,170 -0.5% 5,465 5,432 0.6%
EBIT adj (m) 240 246 -2.4% 354 350 1.1% 410 394 4.2%
EPS adj (p) 3.23 3.35 -3.8% 5.27 5.34 -1.2% 6.24 6.03 3.6%
DPS (p) 1.01 1.11 -8.5% 1.76 1.78 -1.5% 2.08 2.06 1.0%
2014 2016 2015
Rheinmetall AG
224
Recent results highlights Q114 (May)
Order intake increased by 34% yoy driven by new defence contracts,
resulting in a record backlog of 6.7bn.
Revenues increased by 12% yoy (Defence: +14%; Automotive: +11%).
Adjusted EBIT improved by 15m, to just above break-even.
High free cash outflow of 472m was predominantly due to the build-up
of working capital ahead of new contract ramp-up.
The 2014 outlook was confirmed (sales: 4.8bn-4.9bn; EBIT: 230m-
250m).

Rheinmetall AG
225

Q1 performance leaves a lot to do, especially in Defence: Both the Defence
and Automotive divisions delivered strong top-line growth in Q1, albeit against
weak comparators, but the 15m yoy improvement in group profit (to break-
even) was modest in comparison. Notwithstanding the traditional second-half
weighting in defence, a strongly improving operating performance is required to
meet guidance, especially in the Defence segment where a Q1 operational loss
of 42m compares to full-year guidance of 85m-95m profit. We suggest risk is
mitigated by higher-than-normal order cover in the traditionally short-order
areas such as munitions, as well as the increasingly positive impact of
restructuring on operational performance through the second half.

Russian exposure: We comment on this in more detail in the Defence section,
highlighting potential execution risks if the German government fully restricts
defence trade and refuses to permit contract delivery. If the contract is cancelled
with no compensation (the worst case), we estimate a 2.6% profit exposure in
the current year which fades to a much lower level in 2015.

Contract export licences: The German government is reportedly planning on
taking a more restrictive stance on its approach to awarding defence export
licences, particularly in the case of countries that it considers to be oppressive.
Rheinmetalls current orders in the backlog are unaffected because licences are
already in place; however, a stricter licensing environment could disadvantage
the group in its ability to compete/bid for future export contracts.

High cash outflows: A 472m free cash outflow in H1 was materially below
consensus expectations, caused mainly by higher-than-expected investment in
working capital on large defence contracts. Rheinmetall does not give cash
guidance, although we estimate a substantial reversal through the second half of
the year, resulting in a full-year free cash outflow of c70m.

De-rating on profit miss: Given Rheinmetalls historical record of earnings
volatility, the valuation could be susceptible to a disproportionate de-rating if
the company fails to achieve guidance/expectations. In mitigation, we think the
valuation is far from fully pricing in forecast potential in the outer years which
should therefore limit downside risks in this respect.
Rheinmetall AG
226
Valuation


We set our price target at 62.5 based on a blended average of DCF and sum-

Our 62.5 price target equates to 22% upside to the current price and drives our
Buy recommendation.

2014 represents the first year of profit recovery and hence our EBITDA
multiple-based valuation is depressed at 45. We incorporate this into our
valuation methodology to reflect near-term risks, for example in the Defence
division, where forecast risk remains elevated due to uncertainties about short-
order-cycle activities and contract exposure to political risk in Russia.

The implied price target P/E is 19.5x (FY14) falling to 11.8x (FY15) and 10.1x
(FY16), reflecting our expectation of a strong earnings recovery by 2015. This
compares to Rheinmetalls long-run 12-month forward P/E of 11.3x, ie a slight
discount on a 2015 basis.

Rheinmetall shares have historically traded at a discount to defence peers
primarily, we believe, due to the groups reliance on domestic/European
customers in defence and also because of the groups lower rated automotive
and prime contracting defence activities. The shares currently trade at a 23%
P/E (2015) discount to our European defence peer group, which we believe to
be excessive, given improved order visibility, the higher proportion of
international contracts and the positive growth outlook for global automotive
production.
Sum-of-the-parts
calculation. We apply a 40% discount to Defence EV/sales multiples to reflect
Rheinmetalls lower margin prime contracting activities.

DCF 70 70 7.3% WACC / 1.5% TG
Defence 1,008 6.8 1,435 0.63 1,221
Automotive 1,836 5.9 2,174 0.84 2,005
Total 2,844 6.2 3,610 0.74 3,227
Pension -891
Equity value 2,110
Shares o/s (m) 38
Defence 1,704 6.6 1,541 0.63 1,622
Automotive 1,737 5.3 2,099 0.78 1,918
Total 3,441 5.9 3,639 0.71 3,540
Pension -891
Equity value 2,448
Shares o/s (m) 39
Rheinmetall AG
227
DCF summary table



DCF Model m
Share value () 70
70 6.0% 7.0% 8.0% 9.0% 10.0%
6.3% 91.2 91.2 91.2 91.2 91.2
6.8% 79.9 79.9 79.9 79.9 79.9
7.3% 70.5 70.5 70.5 70.5 70.5
7.8% 62.7 62.7 62.7 62.7 62.7
8.3% 56.0 56.0 56.0 56.0 56.0
EBIT margin
W
A
C
C
70 0.0% 1.0% 1.5% 2.5% 3.5%
6.5% 69.5 79.7 86.4 104.7 135.2
7.5% 56.1 63.0 67.2 78.4 95.2
8.0% 50.6 56.4 59.9 68.9 81.8
8.5% 45.9 50.7 53.6 60.9 71.1
9.0% 41.6 45.7 48.1 54.2 62.4
Terminal growth
W
A
C
C
Rheinmetall AG
228
Key investment point one: defence risks abating

After several years of poor financial performance, our confidence is
building in the outlook for Defence. We anticipate organic growth and
margin recovery throughout our forecast horizon.

Strong order momentum, including several large international contracts,
has increased the backlog to a record 6.2bn, providing higher-than-
normal sales order cover. With revenues secure, project execution has
become the key factor in determining the divisions long-term financial
performance.

In the near term, the timing of short-order activities such as munitions
remain hard to predict and other macro factors such as Russian contract
exposure and potential export licence restrictions could present a risk.
Improving operating performance
The defence division has performed poorly in recent years due to a number of
factors including phasing of major programmes, large order delays and execution
issues. A raft of very large orders secured through 2013 has markedly improved the
outlook for organic growth which, together with benefits from c70m of
restructuring over the past two years, will drive a significant improvement in cost
efficiency and therefore divisional profit performance, we believe.
Defence revenue (m): volume and restructuring
to driving margin recovery (rhs)
Volume and restructuring benefits will drive
improved EBIT in all divisions (m)

* EBIT after restructuring charges (20m in 2012 and 51m in 2013)
High order cover (6.2bn order book)
Several large international orders have swelled the Defence order book to a record
6.2bn as at Q1 2014, equivalent to about three years current divisional sales. Based
on expected programme phasing, we estimate order cover compared to our sales
forecasts as follows:

2014 85%;

2015 63%;

2016 45%;
0%
2%
4%
6%
8%
10%
12%
14%
0
500
1,000
1,500
2,000
2,500
3,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
Revenue Margin
-50
0
50
100
150
200
250
2011 2012 2013 2014 2015 2016 2017 2018
Combat Sys Electronic Soln Wheeled Veh
Rheinmetall AG
229

c2bn of orders deliverable in 2017 and beyond.
These are historically high cover levels and while there is an element of short-cycle
products in the groups portfolio, such as munitions (discussed below), our
confidence in the companys ability to deliver a more stable financial performance
in Defence is certainly improved.
Large contracts generating 600m incremental sales
Included in the backlog are four new orders secured in the last year:

Indonesia (216m) Leopard tanks, Marder tanks and ammunition services;

Qatar (475m) Leopard 2 components, self-propelled howitzers PzH 2000,
ammunition and services (deliverable 2015 to 2017);

Australia (1.1bn) military trucks (deliverable 2015-2020);

MENA country (320m) naval ammunition in various calibres (deliverable
mainly in 2016 and 2017);

Netherlands (550m) Boxer armoured vehicles.
In total, we estimate the top six defence programmes (of more than 100m) will
generate around 600m of incremental revenues by 2017 as shown in the second
chart below. Based on their phasing, these contracts alone provide rising sales
order cover of up to c35% by 2017. In addition to this, there is a further underpin
to Defence sales from the:
8. 1.1bn Puma vehicle series contract for Germany, currently generating c50m
of sales and rising to c200m pa by 2017;
9. The Norway/Sweden long-term framework agreement to supply up to 2,000
military logistics vehicles worth some 1bn by 2026. To date, c200m of
contracts have been placed (for 315 vehicles).
Order intake profile by region: future Defence
revenues will increasingly be derived from
international customers
Sales profile of the top six programmes (): we
estimate c600m of incremental sales by 2017

Russian contract risk we estimate 2.6% profits exposure in 2014
Included in our top six order analysis is the c130m training centre contract for
Russia awarded in 2011. With the construction phase (carried out in Germany)
28%
24%
17%
13%
30%
22%
11%
28%
14%
27%
32%
38%
28% 27%
40%
21%
0%
20%
40%
60%
80%
100%
2011 2012 2013 Q1 2014
Germany Rest of Europe
Asia/Middle East RoW
0%
20%
40%
60%
80%
100%
0
200
400
600
800
1,000
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
% of Defence sales f'cast (rhs)
Rheinmetall AG
230
substantially complete, we understand that the contract still has c60m of sales yet
to be recognised under stage-of-completion accounting, of which the company has
said c40m-45m is included within guidance for 2014. An export licence to Russia
was awarded at the time of contract award but the Germanys stance has hardened
due to the political situation in Ukraine and as far as we understand the delivery of
goods now has to be authorised by the German minister of trade. Rheinmetall has
said that it expects to clarify the status of the contract with the government over
the next few months. It is difficult to quantify the financial risks. We envisage as a
worst-case scenario that trade restrictions escalate and the German government
prevents delivery of the rest of the contract with no compensation. For the
purposes of illustration, we assume a 15% margin on remaining revenues (a 12%
overall margin, back-end-loaded for contract accounting), implying Rheinmetalls
total profit exposure of 9m on the remaining revenue, or c7m in 2014, if no
compensation is forthcoming, and no penalties are payable. This equates to c8%
risk to our current year Defence EBIT forecast, or 2.6% at the group level.
Outlook improving for underperforming munitions and wheeled
vehicles activity

Since being separately reported from 2012, the Wheeled Vehicles division has
been loss-making partly due to phasing of large contracts completions and also
new programme delays such as the Dutch Boxer and Australian truck
programmes. A delay in the award of the 1.1bn Australian truck contract in
particular has left a workload gap following completion of the long-running UK
military truck programme, and as a result, the Rheinmetall MAN Military
Vehicle JV (logistical vehicles) has been loss-making over the past two years.
We understand that overall the tactical vehicles business is now profitable with
activity underway on the Dutch contract and also a multi-year Algerian order,
while preparation for the ramp-up of the Australia contract is accelerating.

Weapons and ammunition activities sales declined by 14% yoy in 2013 to
580m (c27% of Defence) due to budget-constrained demand from key
customers, particularly in the US. In the 2014 outlook statement, management
guided down its previous expectations for a return to growth in 2014 to flat yoy,
due to a slower recovery in short-order demand for munitions. We believe
further risk to forecasts is mitigated by the high level of multi-year contracted
business and recurring activity, for example based on framework agreements.
The chart below highlights that future order intake gaps are at a relatively low
level, with sales cover of 75% for the remainder of the year and c55% cover in
both 2015 and in 2016.
Rheinmetall AG
231
Munitions revenue and order summary as at Q114 (m)

New JV formed to accelerate the internationalisation strategy
In January 2014, Rheinmetall formed a 50:50 joint venture with Ferrostaal, which
was created to accelerate the internationalisation efforts of the Defence division.
Ferrostaal is a provider of industrial services and solutions specialising in project
development, engineering and construction. The strategic rationale for Rheinmetall
is to meet the growing demand for local defence technology infrastructure,
increasingly required as part of defence equipment acquisition, by leveraging the
companys products and technology with Ferrostaals international profile and
project management expertise. The company expect gross JV sales of 200m-
300m, although we think it is too early at this stage to judge whether this is realistic
or indeed whether the venture will be successful.
0
100
200
300
400
500
600
700
800
2008 2009 2010 2011 2012 2013 2014 2015 2016
Sales Order backlog Recurring business Order intake gap
Rheinmetall AG
232
Key investment point two: robust growth and profit
outlook for Automotive

The Automotive division is benefiting growth global auto production
including exposure to high-growth emerging markets and structural
demand drivers such as emission legislation.

The groups Chinese businesses and JVs are growing rapidly, ahead of
markets rates. We estimate they could contribute almost 30m to
earnings by 2017.
Global auto production (vehicles m) Automotive sales by region (2013) excludes
Chinese JVs that, if proportionally consolidated,
would increase Asia sales from 9% to 17%

Source: IHS- April 2014 Source: Berenberg estimates, company data
Global auto production growth
The outlook for global auto production is positive with a CAGR of 3.5% to 2017,
according to IHS. There is a distinct split between mature and emerging markets,
with, for example, China and India expected by IHS to grow by 7% and 9%
respectively, and which together account for 31% of the market, compared to
IHSs Europe and US forecasts of 2.7% and 2.5% growth respectively.
Automotive revenue by division (m): we forecast
a 4% sales CAGR to 2017
Automotive EBIT by division (m): volume and
improved operational performance to translate
into 10% EBIT CAGR to 2017

0
20
40
60
80
100
120
China India Other
CAGR 3.5%
21%
44%
17%
1%
17%
Germany
Rest of Europe
Asia
RoW
Americas
-500
0
500
1,000
1,500
2,000
2,500
3,000
3,500
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
Hardparts Mechatronics Services Margin
-300
-200
-100
0
100
200
300
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
Hardparts Mechatronics Services
Rheinmetall AG
233
Auto growth is translating to growth in all divisions, especially
Mechatronics
We forecast a 4% sales CAGR and a 10% EBIT CAGR to 2017 in the Automotive
division, driven by volume and improving operational performance as the benefits
of 35m of restructuring flow through. Within this, we model Hardparts sales
growth slightly below the market (ex-JVs, as discussed below) due to the more
commoditised nature of the product, while for Mechatronics we anticipate above-
market growth rates driven by demand for higher-value new products that are
designed to meet new emissions regulations. An example is the exhaust gas
recirculation (EGR) products that Rheinmetall has developed and evolved to
incorporate cooling modules and increased capability in the light of EURO 5 and
EURO 6 legislation. As a result, Rheinmetall has said that it expects EGR content
value per vehicle to have increased by 2015 to four times the level of 2005.
China an engine of growth
In addition to three wholly-owned foreign entities (WOFEs) in China generating
c30m pa of revenues, Rheinmetall has a 50% interest in three Chinese joint
ventures, two in the Hardparts division and one recently established in the
Mechatronics division, specialising in electrical and mechanical pumps. The
WOFEs and JVs are growing rapidly, with a five-year sales CAGR to 2013 of 49%
and 26% respectively (at 100% for the JVs).
Regional auto production profile (units m) Chinese JVs: share of equity income (m)

Source: IHS Source: Berenberg estimates
Rheinmetall is growing ahead of the market due to the strong positioning of SAIC
Motor Corporation, its partner in the core Hardparts ventures and from established
business relationships with the German OEMs locally. We forecast a four-year
sales CAGR of 16% to 2017, and assuming a steady margin of 8% (which could be
higher when start-up costs relating to the pump venture fade), we calculate the
share of income from equity investments relating to the Chinese JVs will grow to
around 28m by 2017.

0
10
20
30
40
50
60
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
F
2
0
1
5
F
2
0
1
6
F
2
0
1
7
F
Europe China
0
5
10
15
20
25
30
35
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
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234
Divisional forecasts and forecast changes


Defence 2,007 2,141 2,335 2,155 2,269 2,446 2,664 2,823
Automotive 1,982 2,313 2,369 2,458 2,599 2,699 2,801 2,874
Group total 3,989 4,454 4,704 4,613 4,868 5,144 5,465 5,698
Revenue growth
Defence 5.7% 6.7% 9.1% -7.7% 5.3% 7.8% 8.9% 6.0%
Automotive 30.2% 16.7% 2.4% 3.8% 5.7% 3.8% 3.8% 2.6%
Group total 16.6% 11.7% 5.6% -1.9% 5.5% 5.7% 6.2% 4.3%
EBITA
Defence 249 212 145 60 84 165 202 225
Automotive 89 151 139 160 176 209 228 239
Other/consolidated -18 -20 -16 -7 -20 -20 -20 -20
Group total 338 363 284 220 260 374 430 465
Margin
Defence 12.4% 9.9% 6.2% 2.8% 3.7% 6.7% 7.6% 8.0%
Automotive 4.5% 6.5% 5.9% 6.5% 6.8% 7.7% 8.2% 8.3%
Group total 8.5% 8.1% 6.0% 4.8% 5.3% 7.3% 7.9% 8.2%
Rheinmetall AG
235
Appendix 1: Divisional snapshot
Defence (2014E sales: 2.25bn/46% of the group)
Rheinmetalls Defence division operates primarily in the military land sector, and
specialises in the manufacture and support of armoured vehicles, weapons, controls
and electronic systems, to domestic and European (c60% of sales) and
international customers (c40% of sales). Defence is split into three sub-divisions:
Combat Systems (43% of division/21% of group), Electronic Solutions (33% of
division/16% of group) and Wheeled Vehicles (24% of division/12% of group).
Defence divisional sales split (2014E 2.25bn) Defence sales and margin profile (m)

Combat Systems (43%)

Products: Armoured tracked vehicles (such as the Boxer, Puma Infantry
Fighting Vehicle, AMPV), NBC (nuclear, biological, chemical) protection
systems, turret systems and weapon stations, medium and large calibre weapons
and ammunition, propellants and powder.

Recent trends: The combat systems division has suffered as a result of budget
cuts in key customer nations which especially affected the munitions and
tracked vehicles businesses. This resulted in a 10% drop in revenue in 2013 to
1,027.
Electronic Solutions (32%)

Products: Air defence systems, command, control and reconnaissance systems,
soldier systems, fire control units, sensors, naval systems, land simulation, flight
simulation, maritime and process simulation.

Recent trends: Order intake was down significantly in 2013 to 615m (-35%
yoy). This was mainly as a result of the postponement of projects, particularly
air defence systems.
Wheeled Vehicles (25%)

Products: Logistical and tactical vehicles, customer service.

Recent trends: Sales in 2013 were down by 5% in 2013 to 539m as a result of
the finishing of the contract to supply military trucks to the British Army. The
43%
33%
24%
Combat Sys
Electronic Soln
Wheeled Veh
0%
2%
4%
6%
8%
10%
12%
14%
0
500
1,000
1,500
2,000
2,500
3,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
Revenue Margin
Rheinmetall AG
236
Wheeled Vehicles division posted the second-largest individual order in its
history with Australias Project Land 121 worth 1.1bn. This order was to
commission Rheinmetall MAN Military Vehicles to supply an extensive fleet of
2,500 protected and unprotected logistical trucks. Restructuring costs of 22m
were incurred in this division over the course of 2013, mainly to reduce capacity
in the truck plant in Vienna.
JV with Ferrostaal
In September 2013, Rheinmetall entered into a 50:50 JV with Ferrostaal to exploit
the international demand for local defence technology infrastructure, particularly in
Asia and the Middle East. Under the name Defence Solutions, the JV will offer
Rheinmetalls technology combined with Ferrostaals core expertise in project
management and contracting. They aim to take advantage of the trend away from
the traditional import of arms and towards the development of local infrastructure.
Automotive (2014E sales 2.6bn/54% of the group)
The Automotive division is a tier 1 manufacturer and supplier of components and
systems to automotive OEMs. It represents just over half of group sales and is split
into three sub-divisions: Hardparts (42% of division/23% of group), Mechatronics
(48% of division/26% of group) and Motor Services (10% of division/6% of
group). As a manufacturer of powertrain components and systems, the central area
of expertise is in the reduction of emissions, consumption and CO2, through
making weight savings and improving the performance of engines and drive
components.
Automotive sales by customer (2013) Automotive sales and margin profile (m)

Hardparts (42%) (previously KS Kolbenschmidt, KS Aluminium-
Technologie, KS Geitlager)

Products
10. Pistons petrol and diesel engine pistons and piston systems for cars
and commercial vehicles: these include all-steel, aluminium and ceramic
fibre reinforced pistons and the functional systems that they form a part of.
Manufacture takes place in Germany (with the headquarters in
Neckarsulm), France, the Czech Republic, the US, Mexico, Brazil, China
(JV with Shanghai Piston Works) and Japan. The core competitors include
Federal-Mogul and Mahle.
16%
14%
8%
6%
5% 5%
5%
4%
7%
13%
6%
11%
VW/Porshe/Audi
Ford
Renault/Nissan
PSA
GM
BMW
Fiat
Daimler
Others
Truck/Others
Ships/Power/MIR
Aftermarket
-15%
-10%
-5%
0%
5%
10%
0
1,000
2,000
3,000
4,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
2
0
1
8
E
Hardparts Mechatronics
Services Margin
Rheinmetall AG
237
11. Large bore pistons: The product range includes large bore pistons (150-
640mm) made of steel and aluminium supplied to virtually all
manufacturers of large four-stroke engines worldwide. Products include
monobloc aluminium pistons, spheroidal graphite monobloc and composite
pistons and spheroidal graphite iron and steel pistons. Manufacture takes
place in Germany and the US.
12. Aluminium engine blocks: Products include high- and low-pressure die-
cast cylinder engine blocks, including finished machining. Manufacture
takes place in Germany. The core competitors include Georg Fischer,
Honsel and Nemak.
13. Engine components/bearings: The current product range of over 3,000
marketable items, includes rod and crankshaft bearing shells, bushings and
thrust bushings, made of either solid metal or steel polymer composites.
Manufacture takes place in Germany, the US, Mexico, Brazil and India. Its
core competitors include Daido Metal, Federal-Mogul and Mahle.

Recent trends: Hardparts achieved constant currency growth of 3% (flat yoy)
in 2013. The group has been developing a number of new efficient and
emission-compliant piston products such as the STEELTEKS, LITEKS,
and NANOFRIKS.
Mechatronics (48%)

Products
14. Engine control systems: Products include actuators that control airflow,
emission control systems (secondary air systems to assist the catalytic
converter through temperature control and gas recirculation), and solenoid
valves (that operate to control the recirculation of gas emissions and to vary
turbine geometry in turbochargers) for both petrol and diesel engines.
These technologies focus on reducing gas emissions and increasing fuel
efficiency. Manufacture takes place in Germany, Spain, the Czech Republic,
the US, China and India. Its core competitors include BorgeWarner, Bosch
and Continental.
15. Pump technology: In this segment, Rheinmetall produces oil, vacuum,
water circulation and coolant pumps. Rheinmetall has had a market-leading
position with its electronically commutated water circulation pump (WCP),
since 1996. Manufacture takes place in Germany, Italy, France, Mexico,
Brazil and India. Core competitors include Bosch, Ixetic, Magna and SHW.

Recent trends: Mechatronics achieved constant currency growth of 9% (7%
yoy) in 2013 through a large number of product launches as well as through
increases in production in its high growth product groups. Management expects
the Mechatronics division to continue to benefit from the trend towards
downsizing engines, and making up performance through exhaust gas
turbochargers, through its dominant positions in the worldwide market for
electrical divert-air valves. This same trajectory has been positive for sales of
electrical water pumps and water circulation pumps, which are mainly used for
turbocharger cooling.

To ensure compliance with legal emission values in the commercial diesel
vehicle sector, exhaust gas recirculation (EGR) systems are increasingly
becoming necessary in addition to existing exhaust after-treatment systems.
Rheinmetall AG
238
Rheinmetall is positioned to benefit from this through its engine control
systems offering, including its SMART EGR (exhaust gas recirculation) check
valves. The estimated value-added of Rheinmetall Automotive per vehicle for
EGR doubled from 2005 to 2010, as a result of the move from EURO 4
regulation to EURO 5. The company estimates there will be a similar doubling
from 2012 to 2015 as a result of the move to EURO 6 from EURO 5.
Services (10%)

Products: Motor Service is the sales organisation for the worldwide aftermarket
activities of the Automotive division. It provides wholesalers, engine repairers
and independent workshops in 130 countries with the product ranges and
technical expertise of the Mechatronics and Hardparts sub-divisions.

Recent trends: Motor Service achieved constant currency growth of 3% (2%
yoy) in 2013. Over the longer term, the division has been a steady growth
business with a 7% sales CAGR over the past six years.
Rheinmetall AG
239
Appendix 2: Shareholder ownership profile (2013)
Shareholder profile Institutional ownership profile

Source: Company data Source: Company data

70%
17%
4%
3%
6%
Institutional Inv Stakeholders Treasury Stocks
Other Not Identified
40%
59%
1%
Europe
North America
RoW
Rheinmetall AG
240
Financials


Sales 4,704 4,613 4,868 5,144 5,465

Cost of sales -3,849 -3,881 -4,096 -4,328 -4,598
Gross profit 855 732 773 816 867
Operating costs -577 -651 -572 -495 -493
EBIT 278 81 200 321 374

EBITDA (adj) 462 425 440 564 631
Unusual or infrequent items 28 -101 -10 0 0
EBITDA 490 324 430 564 631
Depreciation and amortisation -194 -212 -200 -210 -221
EBIT 278 81 200 321 374
EBIT (adj) 268 213 240 354 410

Other financial result -3 -2 -1 0 0
EBT 250 63 182 311 371
EBT (adj) 222 164 192 311 371

Tax rate 20% 37% 28% 29% 29%

Net income 173 29 117 205 246
Net income (adj) 153 100 124 205 246

Average number of shares (m) - - - - -

EPS (p) 4.5 0.8 3.0 5.3 6.2
EPS (adj) (p) 4.0 2.6 3.2 5.3 6.2


Rheinmetall AG
241
Balance sheet

Fixed Assets 2,262 2,216 2,236 2,236 2,236

Inventories 796 909 959 979 999
Accounts receivable 1,032 984 1,014 1,034 1,064
Deferred taxes 150 155 155 155 155
Current assets 2,637 2,650 2,642 2,707 2,783
TOTAL ASSETS 4,899 4,866 4,878 4,943 5,019

Long-term debt -572 -523 -523 -523 -523
Pensions provisions and similar obligations -1,005 -988 -988 -988 -988
Other provisions and accrued liabilities -30 -31 -31 -31 -31
Non-current liabilities -1,607 -1,542 -1,542 -1,542 -1,542

Bank and other borrowings -27 -60 -60 -60 -60
Accounts payable -648 -721 -721 -721 -721
Other liabilities -1,054 -1,127 -1,034 -934 -832
Deferred taxes -98 -77 -77 -77 -77
Current liabilities -1,827 -1,985 -1,892 -1,792 -1,690

TOTAL LIABILITIES -1,969 -2,188 -1,989 -1,726 -1,446


Rheinmetall AG
242
Cash flow statement
EUR m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 462 425 440 564 631

Cash flow from operations before changes in w/c 415 260 347 465 529
Increase/decrease in inventory -9 -132 -50 -20 -20
Increase/decrease in accounts receivable 60 159 -30 -20 -30
Increase/decrease in accounts payable 0 0 0 0 0
(Increase)/decrease in working capital 51 27 -80 -40 -50
Interest paid -43 -47 -75 -70 -66
Cash tax -64 -45 -44 -81 -98

Capex -234 -191 -220 -210 -221

Free cash flow (memo) 132 10 -72 64 94

Dividends paid -69 -68 -15 -39 -68
Net proceeds from shares issued -26 5 0 0 0
Others -8 1 0 0 0
Effects of exchange rate changes on cash -5 0 0 0 0

Net cash flow 32 -40 -88 25 26



Rheinmetall AG
243

Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 0.5x 0.6x 0.6x 0.6x 0.6x
EV/EBIT (adj) 9.0x 12.8x 13.0x 8.8x 7.6x
P/E (adj) 9.0x 17.1x 16.2x 9.9x 8.4x
P/E 8.0x 58.7x 17.2x 9.9x 8.4x
P/FCFPS 10.5x 170.1x -27.8x 31.9x 21.9x
Free cash flow yield 9.5% 0.6% -3.6% 3.1% 4.6%
Dividend yield 4.9% 0.9% 1.9% 3.4% 4.0%

Growth rates
Sales 6% -2% 6% 6% 6%
Sales organic 6% -2% 6% 6% 6%
EBIT (adj) -22% -21% 13% 48% 16%
EPS (adj) -25% -35% 23% 63% 18%
EPS -18% -83% 298% 73% 18%
DPS 0% -78% 154% 73% 18%

Financial ratios
FCF conversion 49% 5% -30% 18% 23%
Net interest cover -14.9 -6.9 -8.1 -10.8 -11.4
Net gearing 7% 10% 16% 12% 10%
Net debt/EBITDA 0.2 0.3 0.5 0.4 0.3
ROCE 14% 10% 10% 14% 15%
ROIC 4% 3% 3% 5% 6%
WACC 10% 8% 7% 7% 7%
FCF ROCE 8% 1% -4% 4% 5%
Inventory turnover (sales/inventory) 591.0% 507.5% 507.6% 525.5% 547.0%
Capex / sales 5.0% 4.1% 4.5% 4.1% 4.0%

Key financials

Sales 4,704 4,613 4,868 5,144 5,465
EBIT margin (adj) (%) 5.7% 4.6% 4.9% 6.9% 7.5%
EBIT (adj) 268 213 240 354 410
EPS (adj) (p) 4.0 2.6 3.2 5.3 6.2
DPS (p) 1.8 0.4 1.0 1.8 2.1

Free cash flow 132 10 -72 64 94
Net cash flow 32 -40 -88 25 26

Total working capital 2,476 2,614 2,694 2,734 2,784
Gross debt -599 -583 -583 -583 -583
Pensions and similar obligations -1,005 -988 -988 -988 -988

Rolls-Royce Holdings plc
Aerospace & Defence
244

Engine splutter: just needs a bit more choke

Two profit warnings in quick succession and a large engine order
cancellation by Emirates has shaken market confidence in the hitherto
solid Rolls-Royce investment case. We believe the long-term reasons
for owning the shares ie significant growth potential and improving
cash profile absolutely hold and recent weakness is a buying
opportunity. The stock has lost its premium rating following a 19%
ytd share price decline compared to consensus EPS cuts of 10%, and
trades on an FY15 P/E of 15.0x and EV/EBITDA of 7.4x. Forecasts
have stabilised and we believe valuation risk is to the upside. We
initiate coverage with a Buy recommendation and a 1,216p price target.

Potential for further short-term volatility: The investor briefing on
19 June will be key to restoring investor confidence, with agenda items
to include an update on strategy, capital allocation and M&A, guidance
communication and long-term contract accounting. The latter is
extremely important for investors understanding of the Rolls-Royce
value proposition. Interim results on 31 July will also be key, given
that financial performance expectations will be heavily H2-weighted.

Maturing LTSA agreements a key driver of margin: An increasing
number of civil aero service agreements are reaching contract-end,
with associated risk retirement translating to increased profitability.
This we believe will be a key factor compensating increasing mix
headwinds resulting from the ramp-up in new engine deliveries and
from fading high-margin aftermarket activity on legacy engines. In
summary, we are confident that profit growth will return in 2015 and
continue through our forecast horizon.

Cash performance will improve but not before 2015: A heavy
investment phase ahead of growth will constrain the cash performance
near-term. We estimate peak R&D and capex outflows in 2014 with
higher Trent XWB related working capital in 2015 and 2016.

Valuation: Rolls-Royce is the worst-performing stock in our coverage
ytd, with the shares having fallen by 19% (versus the sector, which is
broadly flat). The P/E of 15.4x is in line with the average for
European civil aerospace companies, while the EV/EBITDA multiple
of 7.4x represents a c10% discount.

Buy (Initiation)
Current price
GBp 1,017
Price target
GBp 1,216
Reuters RR.L
Bloomberg RR/ LN
Share data

Performance data

High 52 weeks (GBp) 1,289
1 month -1.3 % 1.0 %
3 months -8.9 % -5.5 %
12 months -37.2 % -23.0 %
Key data

Net gearing -30.0%
CAGR sales 2013-2016 1.2%
CAGR EPS 2013-2016 6.3%

Rolls-Royce is a global provider of
integrated power systems and services to
the aerospace, marine, and industrial
power systems markets, specialising in
gas turbine and reciprocating engine
technologies. Just under half of group
revenue is derived from services and
support, including spare parts,
maintenance and repair activities.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 12,209 15,505 15,137 15,021 16,065
EBITDA (adj) 1,982 2,631 2,518 2,646 2,883
EBIT (adj) 1,495 1,831 1,778 1,841 2,043
Net income (adj) 1,103 1,224 1,237 1,323 1,479
Net income 2,321 1,367 1,283 1,323 1,479
Net debt / (net cash) 1,317 1,939 1,204 1,559 2,267
EPS 125.4 73.3 68.2 70.0 78.1
EPS (adj) 58.8 64.9 65.6 69.8 77.9
FCFPS 30.6 45.2 34.8 41.9 63.0
CPS 65.4 46.1 -41.6 18.7 37.2
DPS 19.5 22.0 22.6 23.3 26.0
EBIT margin (adj) 12.2% 11.8% 11.7% 12.3% 12.7%
Dividend yield 2.2% 1.7% 2.1% 2.2% 2.4%
ROCE 24.8% 27.2% 20.9% 20.7% 23.0%
EV/sales 1.3 1.5 1.3 1.3 1.2
EV/EBITDA 7.8 8.7 7.9 7.4 6.5
EV/EBIT 10.4 12.5 11.2 10.6 9.2
P/E 18.1 16.4 16.4 15.4 13.8
P/E (adj) 14.7 19.5 16.4 15.4 13.8
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245
Rolls-Royce investment thesis in pictures
Global power systems group specialising in gas
turbine and reciprocating engine technology
2014 revenue split
Revenue by division (m): flat profile in 2014 is a
blip

Source: Berenberg estimates Source: Berenberg estimates, Company

Civil EBIT margins are below peer average but
trending positively
Free cash flow (m): heavy product investment
to continue through 2014 but we expect cash
metrics to improve steadily thereafter

Source: Berenberg estimates, Company data Source: Berenberg estimates

Shares reacted strongly to downgrade guidance
stock still 17% below pre-warning price but just
starting to recover
P/E premium rating lost

44%
14%
12%
11%
19%
Civil Aero
Defence Aero
Marine
Energy/Nuc
Power Sys
0%
5%
10%
15%
20%
0
5,000
10,000
15,000
20,000
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Civil Defence Marine
Energy Power Sys Margin
0%
5%
10%
15%
20%
25%
RR Civil Aero Pratt & Whitney
GE Aviation Safran Aero Prop'n
0%
20%
40%
60%
80%
0
300
600
900
1,200
1,500
1,800
FCF FCF conversion FCF ROCE
67
69
71
73
75
900
1000
1100
1200
1300
February
warning
May
IMS
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
J
u
n
-
9
9
J
u
n
-
0
0
J
u
n
-
0
1
J
u
n
-
0
2
J
u
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3
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4
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5
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6
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7
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1
1
J
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-
1
2
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-
1
3
J
u
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-
1
4
RR P/E rel to FTSE A-S Average
ave 0.9x
Aerospace & Defence
246
Rolls-Royce investment thesis
Whats new: We initiate coverage on Rolls-Royce with a Buy rating and a 1,216p
price target, implying 19% upside.
Two-minute summary: Rolls-Royce has built a long record of growth, so two
warnings on profit guidance have dented investor confidence, recently exacerbated
by the loss of a large order for Trent XWB engines linked to Emirates decision to
cancel its order for 70 Airbus A350XWB aircraft. Rolls-Royce is the worst-
performing share in our coverage ytd, down by 19% compared to the sector which
is down by 0.5%, and is currently trading 17% below the pre-February profit
warning level. In our view, there are no systemic issues that fundamentally change
the long-term investment case for sustained growth and improving free cash flow,
and we are confident that profit growth will return in 2015. It is on these
assumptions that we base our recommendation. However, this comes with the
health warning that the shares could remain volatile in the near term. The following
two upcoming events will be key to re-establishing investor confidence.
10. Investor briefing (19 June): This will be a crucial in educating the market
about the profit power of the maturing long-term contract service model
which is key to margin expansion, and is central to our Buy case. Strategy and
capital allocation is also on the agenda, so managements M&A intentions
should become clearer, including the possibility of a resurrection of the
Wrtsil bid.
11. Interim results (31 July): FY14 guidance is for financial performance to be
heavily 2H-weighted (two-thirds versus c54% historically), with significant cash
outflows also expected in H1. We believe this can be explained by the phasing
of programmes and restructuring and by the 30m one-off charge in Marine.
Any weighting outturn better than guidance will be well received, we believe.
In summary, 2014 represents a lost year of growth for Rolls-Royce but the
fundamental investment case holds, in our view. Provided management can
communicate effectively over the next few months, we believe sentiment will at
least partly recover and drive the rating higher. Valuation metrics are currently not
reflecting this, we believe, with the shares now trading at an historically low mid-
single-digit P/E premium to the sector, and a c10% EV/EBITDA discount to
European civil aero peers.
A word on Emirates
As the sole engine provider on A350 XWB aircraft, Rolls-Royces loss of a c2.6bn
order linked to Emirates decision last week to cancel its purchase of 70 Airbus
A350 XWB aircraft is clearly a disappointment, not only due to its size (equivalent
to around 3.5% of the group order book and 4.0% of the Civil Aerospace division
backlog) but also because it represents a lost opportunity for Rolls-Royce to
significantly deepen its relationship with one of the most important global
operators of wide-body aircraft, Rolls-Royces stronghold market.
As we explain in our accompanying sector overview, we do not believe this event
indicates a general slowdown or inflection point in the civil order and production
cycle. We understand market concerns that it appears that Emirates has judged it
will not need as much capacity as it thought it did when it made the A350 XWB
order as launch customer in 2007 (for delivery from 2019!). However, firstly, we
note that Airbus is reporting a continuing healthy market for new aircraft and has
Aerospace & Defence
247
said it is confident of selling more A350 XWBs. Its management again confirmed
guidance for growth in the order book in 2014. Secondly, the Airbus backlog
stands at c5,500 aircraft (including 742 A350 XWBs). We simply cannot envisage
material production cuts within our investment horizon. Lastly, market
commentary suggests this is more about Emirates longer-term fleet decisions being
built around just the A380 and Boeings 777X aircraft, the planned successor to the
existing 777 (and Emirates preferred twin-engine wide-body aircraft), which was
launched in 2013. In short, we suspect cancellation does not necessarily mean that
Emirates is reducing its future capacity requirements and that Boeing will probably
turn out to be the beneficiary of Airbuss loss. Emirates has not confirmed this.
Growth has stalled but we are confident it will return in 2015
The lack of growth in 2014 and the development of nearer-term mix headwinds
have focused the market debate on whether Rolls-Royce can return to profit
growth next year. We believe it can. In 2015, we expect that the combination of
relatively low mix headwinds relating to the Trent XWB engine, higher volumes
and efficiencies on the Trent 1000 engine, increasingly profitable long-term service
contracts (LTSAs) and restructuring benefits will more than offset the effects of
the declining non-contracted time and materials (T&M) aftermarket and a muted
outlook in the Defence and Marine divisions. Longer-term, we highlight two
factors that are key to determining future growth in profit.
1. Increasing profitability of LTSAs: Maturing LTSAs will be a powerful driver
of profitability as contract risk is retired, we believe, which in turn will translate
to a structural increase in group margins.
2. Declining T&M aftermarket: Concerns in the market are overstated in our
view, given the substantial declines that have already been absorbed. By 2015,
we estimate the core RB211 engine will represent only 10% of Civil Aerospace
services sales. Future expected declines will have a diminishing impact on the
group.
Accounting vagaries the net effect of capitalisation policies is
diminishing
In our view, the recent adoption of the Financial Reporting Councils (FRC)
recommendations relating to recognition of third-party fees on new engine projects
more appropriately matches engine development costs with revenues over the
programme life-cycle, and at the same time removes an historical bugbear for some
commentators on the stock. Capitalisation of losses on new engines that are linked
to LTSAs (known as recoverable engine costs RECs) will remain a contentious
issue given that Rolls-Royce is the only European aero engine company to adopt
this policy. However, in a group P&L context, capitalisation policies are becoming
less material with the net P&L impact of capitalised R&D, RECs and engine
certification costs now reducing to a low-single digit percentage due to programme
phasing and higher amortisation.
Cash performance will improve but not before 2015
In common with many civil aerospace suppliers, Rolls-Royces cash performance is
currently affected by heavy development expenditure and capital investments ahead
of planned growth. We estimate that peak R&D and capex outflows in 2014 with
cash demands relative to the group falling steadily through 2016/17. In free cash
flow terms we expect a muted performance through 2015, and picking up
thereafter.
Aerospace & Defence
248
Risk of large-scale M&A will continue to weigh on sentiment
The Wrtsil (WRT1V FH, not rated) shares are still trading 19% higher than
before the acquisition talks began, indicating that the market believes that the
Rolls-Royce bid is not dead. The industrial logic of an acquisition appears to be
sound, we believe, propelling Rolls-Royce to a dominant position in reciprocating
engines for the marine and industrial sectors. However, investors appetite for such
a large transaction (EV is c8.5bn) is muted, with concerns centring on dilution of
the Civil Aerospace divisions growth story and potential distraction to
management. We suggest valuation multiples relating to a potential re-bid would be
relatively full (c2.0x EV/sales and c18.0x EV/EBIT) with earnings accretion
depending on the size and discount of any equity financing and/or share offer. We
believe an all-cash deal is an unlikely scenario and that a share offer would
represent a more appropriate deal structure. We look to management to provide an
up-to-date presentation on strategy, capital allocation and M&A at the 19 June
investor briefing. At least until then, we expect the risk of large-scale M&A to
continue to weigh on the valuation.
Up until early 2014, Rolls-Royce enjoyed strong relative outperformance since the
2009 downturn backed by consistent earnings growth. The share price reached an
all-time high of 1,289p in January 2014. This came to an abrupt end in February
when the company issued guidance that was c8% below consensus estimates at the
time, principally due to pared expectations in the Defence Aerospace and Marine
divisions. A further unexpected 30m charge in the Marine business disclosed in
the May IMS, and the somewhat confusing rhetoric accompanying the Energy
divisions asset disposal announcement in the same month, has done little to
restore investor confidence and the shares have remained range-bound, trading
between 1,000-1,100p, (currently towards the lower end following the Emirates
cancellation news). Year-to-date, Rolls-Royce is the worst-performing share in our
coverage, down by 19% compared to an average decline in the stocks we cover of
0.5%. As a result, the shares are trading on consensus 12-month forward P/E of
14.6x against a peak of 16.6x and a long-term average of 12.5x.
Share price versus market and sector (re-based to
Rolls-Royce)
10-year P/E (12-month forward)

Forecast momentum
Datastream consensus forecasts have fallen sharply since the guidance change in
February, exacerbated by adverse currency effects and the one-off charge in
600
800
1000
1200
1400
1600
RR FTSE A-S Pan Euro A&D
4
6
8
10
12
14
16
18
20
Rolls-Royce Average
ave 12.5x
Aerospace & Defence
249
Marine. Year-to-date, FY14 EPS estimates are 8% lower while 2016 forecasts have
been cut by 16% reflecting, we believe, the markets more cautious view on the
potential for growth acceleration in the Civil Aerospace business.
Long-term forecast EPS changes (p) Lower-than-expected guidance prompted a de-
rating of the stock


FY13 results (February) in line, cash ahead but full-year guidance 8%
below consensus expectations: Sales grew by 6% organically and margin
improved by 40bp excluding the dilution effect of Tognum. Underlying PBT
increased by 11% organically with EPS up 10% yoy, in line with estimates.
781m of FCF converted to a net cash inflow of 359m (312m ex-Tognum),
ahead of break-even guidance. The dividend increased by 13% and the order
book grew organically by 16% yoy to 72bn. Initial FY14 guidance was for flat
revenue, profits and cash flow, well below consensus estimates at the time,
reflecting lowered expectations in the Defence Aerospace (15-20% decline yoy
due to contract-completions) and Marine (lower yoy due to softness in
offshore) divisions. Consensus EPS forecasts duly came down by an average of
8%.

May IMS underlying in line, but FX headwinds and an unexpected
30m charge in Marine led to further downgrades: A layer of confusion
was introduced to guidance with the statement in May that there was no change
to expectations at the underlying level but excluding an unexpected one-off
30m charge in Marine to rectify a product issue. No further explanation on
this issue was forthcoming from the company. In addition, the company made
specific reference to an estimated 40m headwind on profit due to adverse
currency headwinds, implying that consensus estimates did not reflect the full
impact. Lastly, the guidance re-iterated that the profit and cash performance will
be significantly weighted to the second-half (two-thirds), reflecting a number of
phasing factors such as restructuring charges in Marine and Defence.

2014 forecasts: We forecast 2014 revenues of 15.1bn, a 1% organic decline,
and underlying operating profit of 1.78bn (margin: 11.7%) flat organically
and broadly in line with current guidance.

2015 and beyond: We anticipate a return to organic growth in 2015 (5% yoy)
driven largely by Civil Aerospace and with a further acceleration thereafter. We
also expect margins to improve progressively due to restructuring benefits and
20
40
60
80
100
2012 2013 2014 2015 2016
67
69
71
73
75
900
1000
1100
1200
1300
February
warning
May
IMS
Aerospace & Defence
250
operational efficiencies and higher contract profitability more than offsetting
mix headwinds. Our forecasts assume that group EBIT margins will increase by
60bp in FY15 and by a further 40bp in FY16. Note that our FY15 and FY16
forecasts reflect the full-year effect of the energy businesses disposal
equivalent to about a 3.5% dilution at the EPS level, implying that our
underlying estimates are c1.5% below consensus.

Aerospace & Defence
251

There is a risk that the strategy update on 19 June will fail to quell
concerns: As already mentioned, investor sentiment remains fragile, and so in
our view an unconvincing message at the investor Briefing in June represents
the most significant risk to valuation in the short term. Recent communications
announcing changes to guidance have not helped to improve investors
perceptions towards the company. This even applied to the disposal of the
energy assets to Siemens announced in May, an event that should have been
positive for sentiment, yet prompted more questions than answers.

M&A risk: We consider later in this report managements aborted approach to
Wrtsil (market cap: c8bn) earlier this year. A transaction of this scale was not
anticipated by the market and appears not to be attractive to investors.
Management has not subsequently ruled out large-cap M&A, fuelling
speculation that a bid could be resurrected. However, we suggest the probability
of a potential re-bid is lower following the 2bn buyout of the Tognum JV
stake from Daimler in April.

There is a risk that operating improvements will be slow to materialise:
Slower delivery of cost and cash improvements against expectations could
pressure forecasts and further erode confidence. Implicit in our (and the
markets) forecast is an assumption that margins will progressively benefit cost
reduction and efficiency improvement initiatives, particularly in the Civil
Aerospace division. Despite a two-year focus on this, progress appears, at least
outwardly, to have been limited. Steady operational improvement is an
important element in our assumption that adverse mix impacts of higher new
engine sales can be offset.

The shares are vulnerable to a de-rating: Despite the shares recent
underperformance, investors confidence remains fragile and hence the stock
could be vulnerable to valuation downside if financial performance falls short of
guidance. The current P/E valuation of 14.6x (12-month forward) is more than
a 15% premium to the long-term average (albeit is in line with civil aero peers),
leaving scope for further share price volatility if, for example, the company
lowers guidance again.

Programme delays: The key development programmes relate to the Trent
XWB for variants of the Airbus A350 aircraft (the -800 and the -1000). Major
milestones are being met on both the engine and aircraft developments, and in
Rolls-Royces case, engine maturity is reported by the company as being more
advanced at this stage than any other previous development programme.
Overall, we are relatively sanguine about programme risk in that we do not
consider it to be elevated compared to history.
Aerospace & Defence
252
Valuation
1,216p price target

We set our price target at 1,216p based on a blended average of DCF and
1,216p equates to a 19% upside to the current price and drives our Buy
recommendation.
Valuation disparity between our DCF valuation (1,380p per share) and
multiples-based valuations (average 1,134p per share) reflects the
aftermarket value embedded in the fleet that will generate long-term
growth in profits and cash flows.
The implied target price P/E is 18.8x (FY14), falling to 17.7x (FY15) and
15.9x (FY16), and compares to the long-run average 12-month forward
P/E of 12.6x (i.e. c40% premium). We believe this is justified by the
groups significant potential over the next decade, driven by a growing
installed base of serviceable engines under long-term (and increasingly
profitable) contracts.
P/E multiples for the pan-European aero engine peers have converged in
recent months. Rolls-Royce and Safran shares have lost their premium
rating since the beginning of the year as the market adjusted to lower
growth expectations. All three European engine manufacturers now trade
at comparable valuation multiples.
European aero engine P/E comparison relative
(12-month forward)
Rolls-Royce P/E relative to the FTSE All-Share;
the premium rating enjoyed over the past four
years has gone

Source: Datastream
EV/Sales 1,178 1,090 Ave multiple 1.4x/1.3x
EV/Ebitda 1,134 1,139 Ave multiple 9.4x/9x
DCF 1,380 1,380 8.1% WACC / 2% TG
Average 1,231 1,203 Ave 1216p
10
12
14
16
18
J
u
n
-
1
2
A
u
g
-
1
2
O
c
t
-
1
2
D
e
c
-
1
2
F
e
b
-
1
3
A
p
r
-
1
3
J
u
n
-
1
3
A
u
g
-
1
3
O
c
t
-
1
3
D
e
c
-
1
3
F
e
b
-
1
4
A
p
r
-
1
4
Rolls-Royce MTU Safran
0.6
0.8
1.0
1.2
1.4
1.6
J
u
n
-
0
4
J
u
n
-
0
5
J
u
n
-
0
6
J
u
n
-
0
7
J
u
n
-
0
8
J
u
n
-
0
9
J
u
n
-
1
0
J
u
n
-
1
1
J
u
n
-
1
2
J
u
n
-
1
3
J
u
n
-
1
4
R-R P/E rel to FTSE A-S Average
ave 1.1
Aerospace & Defence
253
Sun-of-the-parts
calculation. We apply a 5-20% premium to the civil and defence aerospace
multiples to reflect Rolls-Royces high proportion of aftermarket service revenues
(55%) and long-term sole-source contracts. We arrive at an average sum-of-the-
parts valuation of 1,134p, which is 8% above the current share price.

Source: Berenberg estimates, Datastream Source: Berenberg estimates, Datastream
DCF
DCF summary




EV/EBITDA Multiple EV/sales Multiple Ave value
Civil Aerospace 11,441 10.6 12,016 1.8 11,728
Defence Aerospace 4,091 10.0 2,795 1.3 3,443
Marine 2,388 9.6 2,404 1.3 2,396
Energy & Nuclear 805 7.8 1,611 1.0 1,208
Power Systems 3,348 8.8 3,433 1.2 3,391
Other -467 7.0 -147 1.0 -307
Total EV 21,606 9.7 22,113 1.4 21,859
Equity value 22,270
Price per share (p) 1,180
EV/EBITDA Multiple EV/sales Multiple Ave value
Civil Aerospace 12,120 10.0 11,511 1.6 11,511
Defence Aerospace 3,863 9.6 2,784 1.3 2,784
Marine 2,429 9.1 2,411 1.3 2,411
Energy & Nuclear 212 7.2 762 0.9 762
Power Systems 3,310 8.2 3,297 1.1 3,297
Other -495 7.5 -132 0.9 -132
Total EV 21,440 9.3 20,632 1.4 20,632
Equity value 21,398
DCF Model m
Beta (x) 0.80 Net (debt) / cash 1,204
Share value (p) 1,380
1336 11.5% 12.5% 13.5% 14.5% 15.5%
7.1% 1,587 1,608 1,629 1,650 1,671
7.6% 1,438 1,458 1,478 1,499 1,519
8.1% 1,313 1,333 1,353 1,372 1,392
8.6% 1,208 1,227 1,246 1,266 1,285
9.1% 1,118 1,137 1,156 1,174 1,193
EBIT margin
W
A
C
C
1336 1.0% 2.0% 3.0% 4.0% 5.0%
7.0% 1,466 1,653 1,933 2,400 3,333
8.0% 1,244 1,366 1,537 1,794 2,221
8.5% 1,156 1,257 1,394 1,592 1,904
9.0% 1,079 1,163 1,275 1,432 1,667
9.5% 1,012 1,083 1,175 1,301 1,483
Terminal growth
W
A
C
C
Aerospace & Defence
254
Key investment point one: growth has stalled but we are
confident it will return in 2015

Investor confidence has been seriously dented by two profit warnings
and the prospect of no growth in 2014. The market is questioning
whether Rolls-Royce can return to sustained profit growth (and margin
expansion) in the face of significant business and mix headwinds.

We concur with managements view that 2014 represents a break in the
long-term trend and that organic revenue growth will return from 2015,
driven predominantly by Civil Aerospace.

The key positive drivers are a combination of relatively low mix
headwinds (Trent XWB volumes will be low initially while BR725
volumes grow), volume and learning curve effects on the Trent 1000,
increasing profitability on maturing LTSAs, and restructuring and
operating efficiencies.

At the group level, we expect these factors to more than offset the adverse
effects of the declining T&M aftermarket, dilution from increasing Trent
XWB volumes and a muted outlook in the Defence and Marine
segments.
Steady top-line growth is not in question
We forecast a modest decline in revenue and profits in 2014 (-2%/-3%
respectively), broadly in line with guidance for flat organic growth and adverse
currency effects.
Group order book evolution (m); 71bn of
which Civil Aerospace is 60bn
Group revenue (m) and margin (%)profile

Source: Berenberg estimates, company data Source: Berenberg estimates, Rolls-Royce

New engine sales Trent XWB supports OE revenue growth: We adopt a
relatively cautious view on growth acceleration in our mid-term forecasts, with
just a 4.0% underlying sales CAGR to 2017 (adjusting for the Energy disposal),
again with Civil Aerospace being the main contributor. In particular,
incremental revenues from a near doubling of Trent engine production over the
next four years, mainly Trent-XWBs for the Airbus A350, will be the key driver
of an acceleration in sales growth from 2016.
Europe Asia/Middle East North America ROW
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013**
0
10
20
30
40
50
60
70
80
bn
0%
5%
10%
15%
20%
0
5,000
10,000
15,000
20,000
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Civil Defence Marine
Energy Power Sys Margin
Aerospace & Defence
255

Services: LTSA growth will more than offset declining T&M revenues:
Civil Aerospace services sales should also exhibit steady growth, driven by long-
term contract revenues (accounting for c80% of civil aftermarket), growing
broadly in line with the size and utilisation of the fleet, more than offsetting the
revenue headwind from declining T&M sales as older engines are retired, eg the
RB211 (we consider the profit impact of this below). We forecast Civil
Aerospace services will grow by c8% pa through our forecast horizon.
Trent production to drive group sales growth;
acceleration from 2015 driven by XWB ramp-up
Civil Aerospace services revenue profile (m);
LTSA revenues offset by declining T&M

Source: Berenberg estimates, Rolls-Royce Source: Berenberg estimates, Rolls-Royce
Profits growth and margins
CEO John Rishton has for several years communicated his focus on narrowing the
margin gap between the Civil Aerospace business and that of the aero engine peers.
The first chart below shows that the trajectory is in the right direction. The debate
in the near term is whether Rolls-Royce can achieve further improvements in the
face of potentially significant mix headwinds from:

rising OE volumes dilution effects of rising engine production, particularly
Trent XWB (A350) and to a lesser extent the Trent 1000 (B787);

falling T&M revenues high-margin spare parts revenues supplied on a T&M
basis are in decline, particularly on the RB211 engine due to retirement of
aircraft, deferred maintenance and a weaker pricing environment.
Civil Aerospace margins peer group (%) RB211 fleet decline profile (engines)

Source: Berenberg estimates, Rolls-Royce Source: Berenberg estimates, Airline Monitor
0
100
200
300
400
500
600
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
F
2
0
1
8
F
Trent 500 Trent 700 Trent 800
Trent 900 Trent 1000 Trent XWB
13% 5-yr CAGR
0
1,000
2,000
3,000
4,000
5,000
6,000
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
F
2
0
1
5
F
2
0
1
6
F
2
0
1
7
F
2
0
1
8
F
5-yr CAGR
8.0%
0%
5%
10%
15%
20%
25%
RR Civil Aero Pratt & Whitney
GE Aviation Safran Aero Prop'n
0
500
1000
1500
2000
2500
1
9
7
6
1
9
8
0
1
9
8
4
1
9
8
8
1
9
9
2
1
9
9
6
2
0
0
0
2
0
0
4
2
0
0
8
2
0
1
2
2
0
1
6
2
0
2
0
2
0
2
4
2
0
2
8
2
0
3
2
747 757 767
Aerospace & Defence
256
T&M incremental headwinds are diminishing
Rolls-Royce has said that less than 20% of 2013 Civil Aerospace services revenues
were derived from T&M activity (c650m), of which we estimate around two-
thirds (c450m or 12% of Civil Aerospace services revenue) is derived from the
RB211 engine which powers variants of the Boeing 747, 757 and 767 aircraft.
Rolls-Royce reported a c20% decline in RB211 aftermarket activity in 2013 largely
offsetting positive growth in LTSA revenues. The company has guided to a further
reduction of 20% in 2014 which again will broadly neutralise the effect of expected
growth in LTSA revenues, which is all in guidance.
As indicated in the RB211 chart above, the rate of revenue decline in 2013 and
2014 is higher than overall fleet retirements. We assume this disconnect is a result
of airlines fleet utilisation decisions (delaying overhauls), weaker spares pricing
dynamics and the switching use of 757 aircraft to lower frequency freight activities.
While we do not have hard numbers to work with (we rarely do with Rolls-Royce),
if our estimates above represent a reasonable view as to the scale of the RB211
business, then we can deduce from guidance that the associated spares revenues
will have fallen some 35% in two years, close to 200m. We suggest this translates
to a substantial loss of profits, of around 100m, which is equivalent to a 13% of
2012 group EBIT.
The main conclusion from this rather simplistic analysis is that by the end of 2014,
Rolls-Royce will have already absorbed a significant reduction in revenues (c350m
over two years) and therefore profits relating to the RB211 fleet. In short, future
expected declines will have a diminishing impact on the group both in absolute
terms and mix headwinds.
Civil margin expansion will be driven by maturing LTSAs and cost
improvement, although timing remains hard to predict
We believe the maturing fleet of engines under LTSAs will become increasingly
profitable, especially the Trent 700, driven by retirement of cost contingencies as
long-term contract risk milestones are passed. In our view, maturing LTSA
contracts will be the most important factor driving profitability in Civil Aerospace
(and hence the group) through the end of the decade and beyond. We are hopeful
this will become clearer when the company discusses TotalCare accounting at the
investor briefing on 19 June.
Installed thrust profile of wide-body fleet;
maturity of LTSAs (especially the Trent 700) will
have an increasingly positive impact on margins
We forecasts a 140bp improvement in Civil
Aerospace margins and a similar uplift in group
operating margins between 2014 and 2017

Source: Berenberg estimates, Rolls-Royce Source: Berenberg estimates, Rolls-Royce
0
100,000
200,000
300,000
400,000
2005 2007 2009 2011 2013 2015 2017
RB211-524 RB211-535 T500 T700
T800 T900 T1000 T-XWB
0%
5%
10%
15%
Group margin Civil Aerospace margin
Aerospace & Defence
257
Fleet installed thrust (installed base multiplied by engine thrust) serves as a proxy
for service revenues on engines supported under LTSAs. The first chart above
illustrates why we are confident that aftermarket revenues will continue to grow
we estimate the installed thrust of Rolls-Royces wide-body fleet will increase by
around c8% pa over the next five years, a combination of 13% growth pa in the
Trent installed thrust offset by c7% pa declines in the RB211 as engines are retired.
Trent 700 to drive a structural increase in the Civil Aerospace margin
An important observation is the increasing scale and maturity of the Trent 700 fleet
which powers the A330 aircraft. We estimate the average age of the Trent 700 fleet
is six years, just under half the duration of a typical LTSA (12-15 years), and as this,
plus the smaller but equally ageing Trent 800 (B777) fleet matures, we expect
retiring cost contingencies to increase contract profitability. Back-end-loaded
profitability is typical for any long-term contracting model that is priced correctly
with risks that are increasingly retired into maturity. Our conclusion from analysing
the Rolls-Royce fleet is that Civil Aerospace services margins will structurally
increase over the coming years driven by Trent-related LTSA activity more than
offsetting the (steadily diminishing) impact of lower T&M sales. This is turn will be
a significant factor driving group margins over the long term, we believe.

Aerospace & Defence
258
Key investment point two: accounting vagaries further
FRC-driven changes unlikely

In our view, adoption of the FRC recommendations better reflects the
long-term economic reality of engine development and programme
lifecycle by aligning the accounting treatment of self-funded and
customer-funded R&D. This puts to bed an accounting issue that has
been long debated by the financial community.

The risk of further accounting changes is negligible now that the
company has confirmed there are no ongoing enquiries with the FRC.

Capitalised intangibles, particularly recoverable engine costs (losses on
new engine sales), will remain a contentious issue. However, we estimate
that the net P&L impact has reduced to a low single-digit percentage of
profits due to programme-phasing and increasing amortisation.
Rolls-Royce has long been criticised for adopting various accounting policies with
the resultant mismatch of profits and cash. While we do not propose a forensic
examination of accounting policies in this note we consider the recent changes
recommended by the FRC and also, more broadly, the impacts of the capitalisation
policies. Whether or not we agree with them, we think it is likely some of the
financial community will continue to harbour concerns about Rolls-Royces
capitalisation policies and argue they reduce the quality of profits.
FRC change to accounting for partner entry fees is a red herring
In the past, fees paid by third-party manufacturers for a share of development
programmes, described as risk- and revenue-sharing partnership (RRSP) income,
was recognised as profit (and cash) in the year of receipt. No attempt was made to
capitalise and match against future payments to the risk sharing partner once the
engine moved into commercial production.
In the FY13 results, Rolls-Royce revealed that an FRC review required the
company to change its accounting policy to bring RRSP treatment into line with
that of R&D (where there is capitalisation). We agree with the FRCs
recommendation, which has been partially adopted by Rolls-Royce, to defer entry
fee receipts in proportion to R&D costs capitalised on new programme
developments and recognise it against the amortisation of these costs in the
production phase. The impact of the accounting change on pre-tax profits was a
restatement of +25m in 2012 and -39m in 2013 (or 1.6% and 2.1% respectively
of underlying profit).
In our view, the RRSP issue carried more weight historically when development
activity was higher and hence third party entry fees were greater, both in absolute
terms and relative to the size of the group. Once the TrentXWB engine
programme enters into service in Q414, we expect entry fee receipts to return to a
low level of several tens of millions of pounds (from 110m in 2013) followed by
modest fluctuations in line with the development phasing of the remaining
TrentXWB variants. In short, we conclude the P&L impact of entry fees
accounting is becoming less material.
Following further discussions with the FRC regarding accounting for TotalCare
contracts (essentially the capitalisation of losses on the sale of new engines linked
Aerospace & Defence
259
to LTSAs), Rolls-Royce commented in its recent IMS that no further adjustments
or restatements are required and that there are no other on-going enquiries with the
FRC. We note that Rolls-Royce is the only aero engine manufacturer to currently
adopting a policy of capitalising engine losses, which results in a pull-forward of
accounting profit on contracts where the LTSA is linked to the engine sale. We
consider this in more detail below.
Capitalised intangibles standard accounting treatment apart from
engine losses
In addition to more familiar intangible assets such as purchased goodwill and
software, Rolls-Royces accounting policies around the capitalisation of R&D,
engine certification costs and recoverable engine costs (RECs) have fuelled endless
debate about the overstatement of profits. As at December 2013, these items were
carried in the balance sheet with a net book value of 2bn (of which c500m
relates to Tognum), or around one-third of net assets. In P&L terms, we calculate
that the net impact of capitalisation has fluctuated over the past few years from
-3% to +25% of underlying profit, depending largely on the phasing of new
programme developments.

R&D: Where certain criteria are satisfied such as technical feasibility and
commercial viability, costs incurred towards the final stages of engine
development are capitalised and amortised up to a maximum of 15 years.
Capitalisation of R&D is not uncommon among aero engine peers and other
aftermarket companies where high development costs are incurred for long-
cycle products and revenues are reasonably certain (both OE and spares parts).

Certification costs: This relates to payments made to aircraft manufacturers to
participate in new engine programmes, as well as the costs incurred in meeting
regulatory certification requirements. Cost are capitalised if they are deemed to
be recoverable out of future sales and are amortised over a maximum of 15
years. Again, capitalisation of these participation costs is not uncommon in
the sector; Safran considers them as acquired intangibles and amortises over up
to 20 years while Meggitts policy is to capitalise programme participation costs
(PPCs) where it has principle supplier status and amortises them over a
maximum of 15 years.

Recoverable engine costs (RECs): As previously stated, the losses incurred
on engines supplied below cost are expected to be recovered from future
aftermarket sales. Capitalised RECs are amortised over the expected period of
utilisation by the original customer, typically the duration of the LTSA. Rolls-
Royce is the only engine manufacturer in our coverage to capitalise engine
losses.
Aerospace & Defence
260
Net capitalised intangibles impact on the P&L(m); positive P&L impact
is diminishing as development programmes come to an end, implying that
profits quality is improving

Source: Berenberg estimates, Rolls-Royce
The chart above demonstrates the P&L impact of Rolls-Royces capitalisation
policies (including those adopted from Tognum). We believe the net effects of
capitalised R&D and certification costs will reduce over the next few years when
the TrentXWB engine enters service. Conversely, RECs will increase as volumes
pick up. We calculate that the combined net P&L effect (of capitalising versus not
capitalising) becomes broadly neutral over the mid-/longer term. In the current
year, it represents a modest headwind to profit growth, although this is included in
managements financial guidance.
-10%
0%
10%
20%
30%
-100
0
100
200
300
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Engine certification costs Development
REC's % of adj EBIT
Trent 1000
Trent XWB
Trent 900
Aerospace & Defence
261
Key investment point three: cash performance will
improve but not before 2015

In common with many civil aerospace suppliers, Rolls-Royces cash
performance is currently affected by heavy development expenditure and
capital investments ahead of planned growth.

We estimate peak R&D and capex outflows in 2014 with cash demands
relative to the group falling steadily through 2016/17. As a result, we
expect a muted cash performance through 2015 with free cash flows
picking up thereafter.
Improved cash performance is a major focus of CEO John Rishton, but the group
is in a heavy cash investment phase so underlying progress has been hard to
observe. We were encouraged that inventory turnover picked up markedly in 2013
(3.4x versus 3.0x), but unfortunately a c300m beat on net cash generation versus
consensus went largely unnoticed due to the profit warning drawing more
attention. R&D spending is currently around peak levels, predominantly on the
TrentXWB, while investment in operational readiness (eg facility expansion and
modernisation) and working capital continues ahead of the planned increase in
production. In the chart below, we estimate cash outflows on self-funded R&D,
intangibles, capital expenditure and working capital which will collectively peak in
2014 at around 2.0bn (compared to our underlying EBIT forecast of 1.8bn).
Cash investments (m)

Source: Berenberg estimates, Rolls-Royce Company reports
-2,400
-2,000
-1,600
-1,200
-800
-400
0
400
-2,400
-2,000
-1,600
-1,200
-800
-400
0
400
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Capex Intangibles Other R&D WC Net outflows
Aerospace & Defence
262
R&D profile (m)

From 2015, we forecast a steady improvement in cash performance based on an
easing of investment commitments and an assumption that managements focus on
cash and operational efficiencies, particularly in Civil Aerospace which to date has
lagged, will deliver positive results. Within our forecast, we assume only a modest
improvement in inventory turns given that we believe it will be difficult to achieve
a materially better performance during the aggressive volume increases associated
with the ramp-in TrentXWB deliveries. Longer-term, we expect the Rolls-Royce
cash profile to become increasingly positive.
Free cash profile (m) and free cash returns


0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
0
200
400
600
800
1000
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
R&D (co funded) as % of sales P&L charge (inc capit'n impacts)
0%
10%
20%
30%
40%
50%
60%
70%
80%
0
300
600
900
1,200
1,500
1,800
2010 2011 2012 2013 2014 2015 2016 2017
FCF FCF conversion FCF ROCE
Aerospace & Defence
263
Investment point four: risk of large-scale M&A will
continue to weigh on sentiment

The market is pricing a high probability that Rolls-Royces aborted
approach to Wrtsil earlier this year will be resurrected. Wrtsils
shares are c20% higher than the pre-talks level.

The industrial logic of the acquisition is sound: Rolls-Royce would
become dominant in marine and industrial reciprocating engines.
However, investors appetite for a deal of this scale is muted (EV
c8.5bn). It dilutes the civil growth story and could distract management.

We suggest valuation multiples would be full; we estimate 2.0x EV/sales
and 18.0x EV/EBIT. Earnings accretion (or dilution) would depend on
the size and discount of any equity financing and/or share offer.

Maintaining an investment grade rating remains a high priority for
management, which suggests to us that a multi-billion pound, all cash
deal is an unlikely scenario and that a (combined) share offer would
represent a more probable deal structure.

In summary, we think there are too many variables to assess accurately
the potential financial impact of a deal of this magnitude. Managements
M&A intentions should become clearer at the investor briefing on 19
June, when the topic of capital allocation is on the agenda. Until then,
the risk of large-scale M&A will continue to constrain valuation upside,
we believe.
For the record why is Wrtsil of interest?
Wrtsil is a market leader in medium-speed diesel engines (52% market share) in
the marine and industrial sectors. By segment, revenues are split Ship Power 29%,
Power Plants 31% and Services 40%. This would complement Rolls-Royces strong
position in high-speed engines (Tognum) and the groups sub-scale position in
low-/medium-speed engines (Bergen). In terms of relative scale, Wrtsils Marine
business is larger than Rolls-Royces at c2.5bn of sales versus 1.8bn (assuming
Wrtsils services activities are broadly evenly split by sector). A combination
would create a c4.5bn Marine business accounting for c24% of the enlarged
Rolls-Royce group compared to 12% currently (ex-Submarines).
Aerospace & Defence
264

Civil Aerospace 4,919 5,572 6,437 6,655 6,758 7,347 8,175 8,950
Defence Aerospace 2,123 2,235 2,417 2,591 2,124 2,126 2,166 2,192
Marine 2,591 2,271 1,829 2,037 1,855 1,892 1,963 2,036
Energy & Nuclear 1,233 1,083 1,382 1,538 1,639 808 845 880
Power Systems 0 331 287 2,831 2,908 2,995 3,063 3,134
Intra-segment sales 0 -215 -143 -147 -147 -147 -147 -147
Group total 10,866 11,277 12,209 15,505 15,137 15,021 16,065 17,045
EBITA (adjusted)
Civil Aerospace 392 499 743 844 892 992 1128 1271
Defence Aerospace 309 376 395 438 338 329 336 340
Marine 332 287 235 233 204 218 236 255
Energy & Nuclear 27 16 78 74 85 24 50 60
Power Systems 0 80 109 294 314 332 346 357
Intra-segment sales -50 -52 -54 -54 -55 -54 -53 -52
Group total 1,010 1,206 1,495 1,831 1,778 1,841 2,043 2,230
EBITA margin
(adjusted)
Civil Aerospace 8.0% 9.0% 11.5% 12.7% 13.2% 13.5% 13.8% 14.2%
Defence Aerospace 14.6% 16.8% 16.3% 16.9% 15.9% 15.5% 15.5% 15.5%
Marine 12.8% 12.6% 12.8% 11.4% 11.0% 11.5% 12.0% 12.5%
Energy & Nuclear 2.2% 1.5% 5.6% 4.8% 5.2% 3.0% 5.9% 6.8%
Power Systems N/A N/A 38.0% 10.4% 10.8% 11.1% 11.3% 11.4%
Intra-segment sales N/A 24.2% 37.8% 36.7% 37.4% 36.7% 36.1% 35.4%
Group total 9.3% 10.7% 12.2% 11.8% 11.7% 12.3% 12.7% 13.1%
Reported revenue
growth
Civil Aerospace 9.8% 13.3% 15.5% 3.4% 1.5% 8.7% 11.3% 9.5%
Defence Aerospace 5.6% 5.3% 8.1% 7.2% -18.0% 0.1% 1.9% 1.2%
Marine 0.1% -12.4% -19.5% 11.4% -8.9% 2.0% 3.7% 3.7%
Energy & Nuclear 19.9% -12.2% 27.6% 11.3% 6.6% -50.7% 4.6% 4.1%
Power Systems N/A N/A -13.3% 886.4% 2.7% 3.0% 2.3% 2.3%
Intra-segment sales N/A N/A -33.5% 2.8% 0.0% 0.0% 0.0% 0.0%
Group total 7.5% 3.8% 8.3% 27.0% -2.4% -0.8% 7.0% 6.1%
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Financials


Sales 12,209 15,505 15,137 15,021 16,065

Adj for FX on transaction date -48 8 8 8 8
Cost of sales -9,432 -12,197 -11,965 -11,873 -12,698
Gross profit 2,729 3,316 3,180 3,156 3,375
Research and development -531 -683 -756 -761 -787
Disposal restructuring 699 335 200 199 243
EBIT 2,077 1,870 1,778 1,841 2,043

EBITDA (adj) 1,982 2,631 2,518 2,646 2,883
Depreciation -256 -372 -390 -420 -440
EBIT (adj) 1,495 1,831 1,778 1,841 2,043
Unusual or infrequent items 582 39 0 0 0
EBIT 2,077 1,870 1,778 1,841 2,043

Interest income -51 -58 -68 -95 -92
Interest expenses 10 15 16 25 26
Other financial result 730 -68 -30 -30 -30
Net financial result 689 -111 -82 -100 -96
EBT 2,766 1,759 1,696 1,741 1,947
EBT (adj) 1,434 1,759 1,696 1,741 1,947

Other taxes 114 -54 0 0 0
Tax rate 16% 22% 24% 24% 24%
Profit after tax 2,335 1,379 1,289 1,323 1,479
Minority interest -14 -101 -52 0 0

Net income 2,321 1,367 1,283 1,323 1,479
Net income (adj) 1,103 1,224 1,237 1,323 1,479


EPS (reported) (p) 125.4 73.3 68.2 70.0 78.1
EPS (adjusted) (p) 58.8 64.9 65.6 69.8 77.9


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Balance sheet

Fixed assets 7,863 9,681 10,978 10,858 10,698

Inventories 2,726 3,319 3,419 3,819 3,969
Other current assets 163 417 417 417 417
Deferred taxes 342 316 316 316 316
Current assets 9,935 13,134 13,234 13,634 13,784
TOTAL ASSETS 17,798 22,815 24,212 24,492 24,482

Long-term debt 1,234 2,164 2,899 2,544 1,836

Other liabilities 658 2,528 2,528 2,528 2,528
Deferred taxes 584 892 892 892 892



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267

Cash flow statement
GBP m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 1,982 2,631 2,518 2,646 2,883

Interest paid -41 -43 -82 -100 -96
Cash tax -219 -238 -407 -418 -467

Capex -435 -669 -702 -410 -415
Payments for acquisitions -20 -37 -2,000 0 0
Financial investments 1,084 442 985 0 0
Cash flow from investing activities 424 -740 -2,137 -785 -790

Free cash flow (memo) 574 852 657 794 1,197

Dividends paid -318 -417 -427 -439 -489
Net proceeds from shares issued -94 29 0 0 0
Others -76 -204 0 0 0
Effects of exchange rate changes on cash -54 -43 50 0 0

Net cash flow 1,096 622 -735 355 708

Reported net debt 1,317 1,939 1,204 1,559 2,267


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Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 1.3x 1.5x 1.3x 1.3x 1.2x
EV/EBIT (adj) 10.4x 12.5x 11.2x 10.6x 9.2x
P/E (adj) 18.1x 16.4x 16.4x 15.4x 13.8x
P/FCFPS 28.5x 28.3x 30.9x 25.7x 17.1x
Dividend yield 2.2% 1.7% 2.1% 2.2% 2.4%

Growth rates
Sales 8% 27% -2% -1% 7%
Sales organic 8% 6% -1% 5% 7%
EBIT (adj) 24% 22% -3% 4% 11%
EPS (adj) 23% 10% 1% 7% 11%
EPS 173% -42% -7% 3% 11%
DPS 11% 13% 3% 3% 11%

Financial ratios
FCF conversion 38% 47% 42% 49% 63%
Net gearing -4% -22% -30% -17% -21%
Net debt/EBITDA -0.7 -0.7 -0.5 -0.6 -0.8
ROCE 25% 27% 21% 21% 23%
ROIC 8% 7% 6% 6% 7%
WACC 9% 9% 8% 8% 8%
FCF ROCE 11% 15% 9% 11% 16%
Net R and D/sales (inc. capatalised costs) 4.3% 4.4% 5.0% 5.1% 4.9%
Gross R and D 4.7% 4.8% 5.2% 4.9% 4.9%

Key financials

Sales 12,209 15,505 15,137 15,021 16,065
EBIT margin (adj) (%) 12.2% 11.8% 11.7% 12.3% 12.7%
EBIT (adj) 1,495 1,831 1,778 1,841 2,043
EPS (adj) (p) 58.8 64.9 65.6 69.8 77.9
DPS (p) 19.5 22.0 22.6 23.3 26.0

Free cash flow 574 852 657 794 1,197
Acquisitions and disposals 1,089 237 -1,015 0 0
Net cash flow 1,096 622 -735 355 708

Total working capital 444 1,366 1,466 1,866 2,016
Gross debt 1,383 2,371 3,106 2,751 2,043

Safran SA
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A LEAP of faith

Safran is our top large-cap pick in the European aerospace and
defence sector. We initiate with a Buy recommendation and a 62.5
price target, indicating 26% upside. We view Safran as the optimal
play on the dual trends of commercial aerospace aftermarket and
original equipment (OE) production cycle.

Structural growth advantage: We believe Safran has a relative
structural advantage in its installed fleet and engine portfolio, and will
therefore benefit more than its civil aviation peers in both the ongoing
recovery in spares demand and in the OE production cycle. We
forecast a 7% sales CAGR and a 11% EPS CAGR to 2017.

Wall of spares: Strong growth in high-margin spares will be driven by
the large and maturing installed base of second generation CFM56
engines (Boeing 737/Airbus A320) and the GE90 engine (Boeing 777)
requiring overhaul. About 60% of the second generation CFM56 fleet
have not had their first major overhaul, indicating that substantial
value is embedded in the fleet.

Margin dilution fears overstated: Rapid transition of production to
lower-margin CFM LEAP engines for the new Airbus and Boeing
narrow-body aircraft may not be as dilutive as the market fears.
Structural improvement in Aircraft Equipment will also contribute to
group margin progression.

Strengthening cash: New product investment will peak in 2014 and
we expect FCF of 1bn+ pa from 2015 and the business to be net
cash positive by 2017. The dividend is tied to EPS, so shareholders
can expect high growth.

Q1 disappointed: Sales growth was just 3% but the negative factors
relating to helicopter and defence contract delays will reverse in the
coming months. Full-year guidance was unchanged.

De-rated on lack of momentum: The shares have underperformed
ytd (-7% relative to the SXXP) but still trade at a 9% P/E premium to
peer multiples. However, we think upgrade momentum will return
over the coming year and further drive the valuation.

Buy (Initiation)
Current price
EUR 49.79
Price target
EUR 62.50
Reuters SAF.PA
Bloomberg SAF FP
Share data

Performance data

Relative performance to SXXP CAC 40
1 month 1.2 % 2.4 %
3 months -2.2 % -0.7 %
12 months 0.3 % 3.6 %
Key data

Net gearing 14.4%
CAGR sales 2013-2016 6.8%
CAGR EPS 2013-2016 9.5%

Safran is a global aerospace, defence and
security group. It designs, manufactures
and services aircraft engines for the
commercial and military aircraft and
business jet sectors. It also supplies
mechanical and electrical systems for
both military and civil aircraft, including
landing gear, wheels and brakes, engines
structures and power systems. Safran is a
leader in biometric and detection security
systems, and in defence specialises in
navigation, optronics and avionics
systems.

Non-institutional shareholders:
French state: 22.4%
Employees: 14.7%
16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., EURm 2012 2013 2014E 2015E 2016E
Sales 13,560 14,363 15,314 16,231 17,480
EBITDA (adj) 2,165 2,542 2,803 3,078 3,353
EBIT (adj) 1,444 1,780 1,993 2,238 2,483
Net income (adj) 979 1,193 1,251 1,413 1,576
Net income 1,282 1,389 883 1,079 1,269
Net debt / (net cash) 932 1,220 1,217 622 -140
EPS 3.1 3.3 2.1 2.6 3.0
EPS (adj) 2.4 2.9 3.0 3.4 3.8
FCFPS 1.4 1.7 1.7 2.8 3.3
CPS 0.2 -0.5 0.0 1.4 1.8
DPS 1.0 1.1 1.2 1.4 1.5
EBIT margin (adj) 10.6% 12.4% 13.0% 13.8% 14.2%
Dividend yield 2.9% 2.2% 2.4% 2.7% 3.0%
ROCE 12.6% 12.5% 13.6% 14.5% 15.1%
EV/sales 1.2 1.7 1.6 1.4 1.3
EV/EBITDA 7.3 9.3 8.5 7.6 6.7
EV/EBIT 11.0 13.3 12.0 10.4 9.1
P/E 10.6 15.1 23.9 19.6 16.7
P/E (adj) 13.8 17.7 16.9 15.0 13.5
Safran SA
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270
Safran investment thesis in pictures
Revenue profile by market (m): sustained top-
line growth driven by commercial aerospace OE
and aftermarket
2017 EBIT split: we estimate higher margin Civil
Aerospace activities will account for over 70% of
group EBIT by 2017

Source: Berenberg estimates, Safran Source: Berenberg estimates

Strong growth in CFM56 spares revenue to mid-
2020s: maturity of the second-generation fleet will
drive strong profits momentum
Rapid transition from CFM56 to LEAP; risks are
manageable and margin dilution fears overstated

Source: Safran Source: Berenberg estimates, Airline Monitor

Break in forecast EPS momentum dented
enthusiasm but recent upgrade appears to
indicate confidence is re-turning ()
Trading at a 15.6x, a 12% premium to the average
10-year P/E rating


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Safran Average
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Safran investment thesis
Whats new: Safran is our top large-cap pick in the European Aerospace and
Defence sector. We initiate coverage with a Buy recommendation and a 62.5 price
target, indicating 26% upside.
Two-minute summary: We view Safran as the optimal way for investors to play
dual positive trends in the commercial aerospace aftermarket and original
equipment (OE) sectors, which together account for c70% of group profit.
Investor sentiment towards the shares faltered in early 2014 as earnings momentum
slowed (consensus EPS up 2.6% ytd). We look beyond this to the fundamental
strength of the aero engine and aircraft equipment businesses and, in particular, the
groups relative structural advantage of its maturing engine aftermarket model. We
believe Safran is capable of delivering sustained and sector-leading earnings growth
(an 11% EPS CAGR to 2017).
Key investment point one: Safran is the most attractive civil
aftermarket play in our coverage universe
Safran is in the sweet spot of the aftermarket cycle, benefiting from an acceleration
in the number of overhauls of its installed base of c26,000 CFM56 engines,
particularly second generation engines which account for over 60% of the fleet.
This will be a powerful driver of group profit growth, reflecting value embedded in
the fleet and payback for decades of investment.

Structural growth in high-margin engine servicing: The CFM56 powers
almost 80% of the worlds narrow-body commercial aircraft fleet, principally
Boeing 737s and Airbus A320s. The number of second generation CFM56
engines approaching their first major overhaul is accelerating, driving demand
for high-margin spares. This, we believe, will far outweigh the effect of reducing
volumes from an ageing and declining fleet of first generation CFM56 engines.
To illustrate, in Q1, Safran reported commercial aftermarket sales growth of
12% reflecting a 30% increase in second generation activity, comfortably
offsetting a 40% decline in first generation spares activity. Momentum in the
fleet is strong and we anticipate a near 50% increase in CFM56 spare parts
revenue by 2020, with growth continuing at a similar rate to at least the middle
of the next decade. In the context of the group, we estimate CFM56 represents
c40-45% of Safrans civil aftermarket sales (c1.7bn) and c40% of group EBIT
(c0.8bn). Safrans second most important engine programme, the GE90, which
powers the B777, is also increasingly contributing to spares momentum as the
fleet grows and matures.

Air traffic growth supporting near-term demand for overhauls: Air traffic
growth and aircraft utilisation trends are positive with global passenger growth
predicted by IATA to increase by 5.2% in 2013 (5.8% in 2012), above the long-
term rate of c4.5%. Coupled with airlines increasing profitability, the macro
backdrop is positive for recovery in spares demand following the cyclical slow
down in 2011/12. All civil aero aftermarket peers (GE, Pratt & Whitney,
Honeywell, Rolls-Royce and Meggitt) have reported further positive growth
trends ytd. Safran has guided civil aftermarket to increase by low to mid-teens in
2014 (Q1 was +12%).
Key investment point two: positive civil OE outlook programme risk
is lower than perception
Safrans dominance in the narrow-body aircraft sector through the CFM 50:50 joint
venture with GE will continue for the foreseeable future with the introduction of
the LEAP engine in 2016, which is sole source on Boeings new 737MAX and
Safran SA
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272
Comacs C919 aircraft, as well as an engine choice on Airbus A320NEO. Nearer-
term, continued strong demand for existing narrow-body aircraft (737NG and
A320CEO) ensures extended production of the mature and profitable CFM56
engine which in turn will smooth transition to the LEAP.

Smooth transition is key: A record CFM backlog of 11,300 engines,
comprising 43% CFM56 and 57% LEAP, secures a profile of rising production
through the rest of the decade, in line with the aircraft manufacturers. Phasing
from CFM56 to LEAP production will be rapid but risk is mitigated by
elements of commonality in the technology and the supply chain, and Safrans
experience of bringing new engines into production.

Dilution/mix concerns are overstated: Through the transition, early-stage
losses on the LEAP will dilute margin, although we think this is manageable
given 1) the extending production outlook for CFM56 (which is profitable), 2) a
fast learning curve (reducing costs) due to development maturity and the rapid
production ramp-up, and 3) the significantly positive impact of momentum in
the existing spares business referred above.
Key investment point three: profit upside and return to strong cash
generation
Alongside revenue and profit growth, capital investment and R&D commitments
should begin to moderate from 2014 and as a result we expect group cash
generation to improve steadily through our forecast horizon. We forecast a 7%
sales CAGR and an 11% recurring EBIT CAGR to 2017 (margin: 14.6%) and that
the group will generate FCF in excess of 1bn pa from 2015. Management has
previously stated an operating margin target of 15% by 2015, implying 9% upside
to our estimates.

130bp margin upside: Management initially outlined a margin target of
heading towards the mid-teens by 2015 over two years ago, which we believe
remains the target. Group operating margin was 12.4% in 2013 and we forecast
it will increase to 13.7% in 2015. Achieving target on our revenue estimates
implies 8% upside to operating profit.

Strengthening cash generation after high investment: Investment
expenditure has been high in recent years largely related to development and
capex on LEAP and development of the Silvercrest engine for large cabin
business jets. This should moderate from 2015 and we estimate FCF well in
excess of 1bn pa in the outer years of our forecasts and for the group to be in
a net cash position by 2016.

Safran SA
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273
Share price () versus market and sector (re-
based)
10-year P/E

Source: Datastream
Note: re-based to Safran starting share price

Safran shares performed strongly through 2012 and 2013 (+122%), initially driven
by a cyclical re-rating of commercial aero stocks and then by upgrade momentum
as the groups commercial aerospace activities strengthened. However, the shares
underperformed following the 2013 full-year results in February when lower-than-
expected growth guidance dampened enthusiasm as the sector overall suffered an
element of rotation. Sentiment was further adversely affected by a relatively weak
first quarter revenue result (3.5% organic growth), but the shares have since more
than recovered leaving the price down 1.4% ytd, slightly underperforming the
sector and a 7% relative underperformance to the DJStoxx 600. This represents an
8% fall from the peak level just before the 2013 results and leaves the stock trading
on less demanding prospective P/E of 16.9x falling to 15x, which is a c10%
premium to the long-term average (12-month forward P/E).
Forecast momentum
Long-term forecast EPS changes () Short-term EPS revisions and share price ()


FY 2013 results in line, full-year guidance below expectations: Sales grew
by 8% organically to 14.7bn with adjusted EBITA up 24% to 1.8bn, broadly
in line with consensus estimates. Sales growth was driven by the commercial-
aerospace-facing segments, Aerospace Propulsion and Aircraft Equipment, in
particular by double-digit growth in the aftermarket and services activities, more
than offsetting weakness in Security (-3%) and Defence (-2%) divisions. Full-
year guidance of mid-single-digit revenue growth and recurring operating
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Safran DJStoxx600 Pan Euro A&D
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Safran Average
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Safran SA
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income in the low-double-digit range fell slightly short of market forecasts
which we believe incorporated an expectation of another upgrade.

Q1 2014 Revenue shy but full-year guidance confirmed: Q1 organic sales
growth of 3.5% fell short of expectations, although management confirmed the
full-year outlook as unchanged. Civil aftermarket sales grew by 12% yoy (in US
dollars) and Security showed an encouraging organic improvement of 5% yoy.
However, Aerospace Propulsion delivered lower-than-expected sales growth
overall (+2.1%) due to helicopter engine production delays (customer-driven)
and slower services activity (US weather-driven). Defence also declined more
than expected (-12%) due to delayed deliveries relating to the supply chain and
certain customer acceptance issues (both now resolved). Despite an optically
weak Q1 performance and higher FX headwinds, management reiterated the
full-year guidance of mid-single-digit growth in sales and low-double-digit
growth in operating income.

2014 forecasts: We forecast 2014 sales of 15.3bn, up 5.3% organically, and
recurring adjusted EBITA of 2.0bn (margin 13.0%), up 10.5% organically,
both broadly in line with management guidance. This factors a recovery of sales
that were weak in Q1.

2015 and beyond: We anticipate multi-year mid-single-digit sales growth and
steady margin expansion throughout or forecast horizon driven by momentum
in the Aerospace Propulsion and Aircraft Equipment businesses and to a lesser
extent, growth and operational improvement in the Security segment. We
forecast 11.0% CAGR in EPS to 2017.
Berenberg versus consensus

Sales (m) 15,314 15,535 -1.4% 16,231 16,429 -1.2% 17,480 17,364 0.7%
EBIT adj (m) 1,993 2,055 -3.0% 2,238 2,316 -3.4% 2,483 2,482 0.0%
EPS adj (p) 3.0 3.0 0.6% 3.4 3.4 -0.6% 3.8 3.7 0.4%
DPS (p) 1.2 1.2 0.2% 1.35 1.35 0.1% 1.51 1.45 4.1%
2014 2016 2015
Safran SA
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Valuation the shares are susceptible to de-rating if growth is slower
than expected: Following a period of steady earnings upgrades, recent
momentum has stalled against expectations causing the stock to de-rate (the
shares are down 1.4% ytd while consensus EPS revisions are up 2.6%). We
think positive forecast momentum will return, possibly in H2 or early 2015 but
if it does not, or other negative risk factors outlined below have an adverse
impact, the shares may lose their current premium rating.

Programme risk/delays: New developments programmes represent a
substantial business risk for all aircraft and engine OEMs through, for example,
technological issues leading to delays and cost escalation, either in-house
directly or through the supply chain. Safrans main exposure is through the
LEAP engine for the 737MAX, A320NEO and C-919 narrow-body aircraft and
the Silvercrest engine for the Cessna Citation and Dassault Falcon 5X large
cabin business jets. Management recently stated that both programmes remain
firmly on track. An indication of programme maturity is the guidance that R&D
will to start fall after 2014. It is also worth noting that Boeing and Airbus
remain publically confident that the MAX and NEO programmes will launch
on time, to the extent that both manufacturers are already planning to raise
production through the ramp-up phase.

Capitalised R&D: The practice of capitalising R&D is common in aerospace
and defence companies where large, self-funded development commitments are
attached to defined programmes with future identifiable sales. Capitalisation
weighs on investor sentiment based on an argument of lower profits quality (we
estimate the net impact on Safrans P&L in 2013 was +c35%). We are relatively
sanguine given, for example, the groups near 100% capture of available CFM56
spare parts revenues and the lagged payback dynamic that is now turning
increasingly positive for the group. In addition, capitalisation levels are set to fall
as the LEAP and Silvercrest development programmes move in to early
production.

FX: Currency risk is minimal over the near term given the groups high level of
hedging cover. The principle risk is transactional relating to the excess US dollar
sales over costs, currently c$6bn pa. Safrans $18bn hedge book has an average
dollar/euro rate of $1.25 fully covering 2014 exposures and with diminishing
(but still high) cover to 2017 around the average hedge rate, including knock-
out option strategies. The achieved rate was $1.28 in 2013 and falls by about 1c
a year to 2016, giving a c40m pa tailwind to EBIT over the next three years
(equivalent to 2% of our 2014 EBIT forecast). On this basis, Safran has the
most advantageous hedge book profile of the companies we cover.

Use of capital: Safran has been highly acquisitive over the past five years
spending over 3bn, initially on a build-out strategy in the Security sector
(detection/ID) and latterly to expand capabilities in aircraft equipment (power
management/electrical systems). Management has indicated that large
acquisitions are not currently a focus, which we view as a positive given the
prohibitively high valuations of aerospace assets currently, and given our view
that the groups defence niches largely have critical mass. We forecast
improving cash generation and a net cash position by 2016 so we suggest the
debate around capital allocation and/or potential cash distribution will intensify
over the next 18 months or so.

French government disposal of shareholding: The French government
retains a 22% holding after disposing of 8% of its stake in 2013. This may be
considered an overhang but we believe institutional interest would be strong
should the French state decide to divest more of its stake (assuming it is around
the current price).
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Valuation
62.5 price target
Valuation summary table ()

We set our price target at 62.5 based on a blended average of DCF and
62.5 equates to 26% upside to the current price and places Safran as our
most preferred large cap stock.
Valuation disparity between a DCF valuation (76 per share) and
multiples-based valuations (average 55.5 per share) is a reflection of the
spare parts value embedded in the fleet that will generate steady growth in
profits and cash flows.
The implied price target P/E is 20.8x (FY14) falling to 18.4x (FY15) and
16.4x (FY16) compares to Safrans long-run 12-month forward P/E of
13.7x (i.e. c40% premium). This is justified by the unprecedented visibility
in the core engine business, a strengthening aftermarket model and
structural improvements in the Aerospace Equipment segment.
Sum-of-the-parts
calculation.

Source: Berenberg estimates/Datastream Source: Berenberg estimates/Datastream

DCF 76 76 7.5% WACC / 2% TG
Aerospace Propulsion 18,160 9.9 15,452 1.87 16,806
Aircraft Equipment 4,687 9.9 5,854 1.35 5,271
Defence 869 8.1 1,455 1.20 1,162
Security 1,211 7.9 1,717 1.13 1,464
Total 24,927 10.5 24,478 1.60 24,702
Equity value 22,664
Shares o/s (m) 418
Price per share () 54
Aerospace Propulsion 18,924 9.4 15,929 1.81 17,427
Aircraft Equipment 5,193 9.2 7,449 1.61 6,321
Defence 863 7.8 1,386 1.16 1,125
Security 1,330 7.7 1,737 1.10 1,533
Total 26,310 9.9 26,501 1.63 26,406
Equity value 24,961
Shares o/s (m) 418
Price per share () 60
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DCF
The table below summarise our DCF model which generates a valuation of 76.
DCF summary table

Given that momentum in the aftermarket business is driven by a growing and
maturing installed base, we believe our terminal growth assumption of 2% is
pitched cautiously. In terms of sensitivity, a 100bp change in growth translates to
c11% valuation. We also highlight sensitivity WACC below it is interesting that
even a 150bp increase in the discount rate still derives a valuation above the current
share price, all else being equal.

Aero engine relative P/E
Aero engine P/Es (12-month forward); Safran has underperformed its peers
ytd and valuations have converged

Source: Datastream
DCF Model m
Share value () 75.8
76 12.0% 13.0% 14.0% 15.0% 16.0%
6.5% 90.6 91.8 93.0 94.1 95.3
7.5% 72.5 73.6 74.7 75.8 76.9
8.0% 65.8 66.9 67.9 69.0 70.1
8.5% 60.1 61.2 62.2 63.2 64.3
9.0% 55.3 56.3 57.3 58.3 59.3
EBIT margin
W
A
C
C
76 0.0% 1.0% 2.0% 3.0% 4.0%
6.5% 73.2 81.8 94.1 113.5 148.5
7.5% 62.3 68.0 75.8 87.1 104.9
8.0% 57.9 62.6 69.0 77.9 91.3
8.5% 54.0 58.0 63.2 70.4 80.7
9.0% 50.5 53.9 58.3 64.1 72.3
Terminal growth
W
A
C
C
11
12
13
14
15
16
17
18
Safran MTU Rolls-Royce
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Key investment point one: Safran is the most attractive
civil aftermarket play in our universe
Safran is in the sweet spot of the aftermarket cycle benefiting an acceleration in the
number of overhauls of its installed base of c25,000 CFM56 engines. This will be a
powerful driver of profits growth reflecting value embedded in the fleet and
payback for decades of investment.
CFM56 fleet maturity to drive high-margin
spares sales to above 2bn
CFM spares parts revenue to accelerate from 2015

Source: Berenberg estimates, Safran Source: Safran

Large and maturing fleet: Through the 50:50 CFM joint venture with GE,
Snecma, Safrans aero engine business is strongly positioned in the narrow-body
commercial airline sector through the worlds best-selling engine, the CFM56. It
powers c80% of the global narrow-body fleet as the exclusive engine on
Boeings 737NG and as a competing engine on the Airbus A320 family of
aircraft (with a 56% share). The CFM fleet of c25,000 engines is approximately
five times greater than the competing engine in the narrow-body engine sector,
Pratt & Whitney/MTUs V2500 with an installed fleet of c5,000 engines, and
almost ten times greater than Rolls-Royces wide-body fleet of c2,800 Trent
engines.

Overhauls represent a high value event: Major engine overhauls represent
the value event in the Safrans engine service model, when high-margin spares
are used to replace life-limited and worn parts. Typically, the first major
overhaul of a commercial aircraft engine is seven to nine years from new, with a
second overhaul four to six years later. We estimate average revenue per
CFM56 shop visit is c$2m.

CFM56 and GE90 engines driving structural growth spares revenues: The
CFM56 fleet generates around two-thirds of Safrans total spares revenues. We
anticipate sustained strong momentum in this activity driven by the increasing
number of second generation CFM56s (which account for c16,000 engines or
two-thirds of the fleet), entering their first shop visit. We estimate that over
10,000 of these second generation engines are yet to have their first workshop
visit, highlighting the very significant spares value embedded in the fleet.
Furthermore an insignificant number (we estimate less than 10%) have had
their second major overhaul. In addition to CFM56, the fleet of GE90 engines,
which powers the Boeing 777 and on which Safran has a 23% share, is
becoming an increasingly important contributor to spares sales. The GE90
installed base is c1,500 engines with an average age of about seven years and we
estimate it accounts for 12-15% of Safrans total commercial spares revenues.
Safran also derives fees from maintenance, repair and overhaul activities.
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279
Around one-third of all CFM56 shop visits are carried out in GE/Snecma
shops while the majority of the rest are performed by third-party MROs with a
CFM Services agreement where GE and Snecma provide substantially all new
spare parts. Therefore, Safran (and GE) captures a very high proportion of the
available CFM56 spares market, a high 90%, we believe.

Air traffic growth and deferred overhauls recovering: The macro backdrop
air traffic growth and aircraft utilisation is positive. Global passenger growth
as measured by revenue per passenger kilometres (RPK) is trending above the
long-term average of 4.5-5% (5.8% in 2013 with IATA forecasting a further
5.2% in 2014). In addition, airline load factors are at an historically high 79%,
indicating the in-service global fleet of aircraft is being well-utilised. An
additional factor driving current spares demand is the recovery of maintenance
that was deferred by airlines through the downturn, which disproportionally
affected aftermarket activity for Safran through 2009 and again in 2011/12.
Essentially the aftermarket is recoupling to airline activity. The chart below
shows improving momentum in global aftermarket activity, together with
Safrans aftermarket growth and GEs quarterly spares order activity, both
heavily influenced by the CFM56 fleet. In Q1, Safran reported 12% yoy growth
in commercial aftermarket in line with previous full-year guidance of low-to-
mid teens in 2014, while GEs commercial spares orders increased 10% yoy
(with sales up 17%).
Aftermarket growth is trending positively but yoy variations can distort
quarterly results


Impact of declining fleets of older engines is diminishing: The fleet of
older first generation CFM56s is becoming less material in the context of the
overall aftermarket story. We estimate the first generation fleet currently
accounts for about 40% of the CFM installed base but generates c25% of total
spares sales. Each of these are falling yoy as aircraft are retired, sometimes early
as airlines seek to avoid expensive end-of-life overhauls and/or to take
advantage of cannibalising parts. Safran assumes a prudent rate of retirements
for forecasts purposes, we believe, having recently said that first generation
spare parts could fade to an insignificant level within 4-5 years.
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2011 2012 2013 2014
Safran GE spares orders Sector average
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Key investment point two: the civil OE outlook is
positive programme risk is lower than perceived
Safrans dominance in the narrow-body aircraft sector through the CFM joint
venture will continue for the foreseeable future with the introduction of the new
LEAP engine in 2016. Nearer-term, continued strong demand for existing narrow-
body aircraft (B737 and A320) powered by the CFM56 engine ensures extended
production and a smoothing of the transition to the LEAP.

Dominant in the narrow-body sector: The strength of the commercial
aircraft production cycle is underpinned by an unprecedented industry backlog
that is set to drive yoy record output in the narrow-body sector to beyond the
end of the decade. Safran supplies engines and equipment and systems on a
broad range of aircraft but again the groups key exposure is through the
CFM56 engine. The total CFM backlog (CFM56 and LEAP engines) of c11,300
engines is equivalent to 7.3 years of 2013 production.
CFM engine backlog evolution. LEAP has
overtaken the CFM56 (units - engines)
Engine production profile. Continued moderate
growth as CFM56 transitions to the LEAP (units
- engines)

Source: Berenberg estimates, Safran Source: Berenberg estimates, Safran

Record production and rising: CFM delivered a record 1,502 CFM56 engines
in 2013, representing a 20% increase from 2010, and as at March 2014, the
CFM backlog stood at c11,270 engines (4,919 CFM56/6,351 LEAP). Q1
volumes grew by 3% yoy and we anticipate only moderate volume growth until
Airbus and Boeing raise narrow-body production rates again in 2016/17 (by
10% and 12% respectively).

Smooth transition from the CFM56 to the LEAP is key: From 2016,
production of the CFM56 will be phased out with the introduction of its
successor LEAP, which is powering the next generation/iterations of narrow-
body aircraft.
16. Airbus A320NEO: The LEAP-1A is an engine choice for Airbus re-
engined A320 which has a planned entry into service (EIS) of 2015. It is
competing against Pratt & Whitneys PurePower geared turbo fan (GTF)
engine on the aircraft type, with a c50% share of competed orders
currently.
17. B737MAX: The LEAP-1B is the exclusive power plant on Boeings new re-
engined narrow-body aircraft with a planned EIS of 2016/17.
0
2,000
4,000
6,000
8,000
10,000
12,000
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
CFM56 LEAP
0
500
1000
1500
2000
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
0
1
6
2
0
1
8
2
0
2
0
CFM56 LEAP
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18. Comac C-919: The LEAP-1C is the exclusive power plant on Chinas new
entrant in the narrow-body aircraft market, the Comac C-919, with a
planned EIS of 2017, although this programme has been slipping.

Strong demand for Boeing and Airbuss new aircraft offerings has generated a
large backlog of LEAP engines of over 6,300 engines that now exceeds that of
the CFM56, itself a record level. Both airframe manufacturers are planning a
rapid production transition from the current 737NG and A320CEO platforms
to the new 737MAX and A320NEO, with a projected timeframe for complete
cross-over of 2015-2020. This is a very short time period in the context of long-
cycle aircraft and engine programmes and provides significant industrial and
technical challenges across the global supply chain, in particular for the engine
manufacturers carrying much greater technical risk. For Safran, this means
negotiating a production switch from the mature CFM56 to LEAP engines
while maintaining, or even slightly increasing, overall production rates.
Narrow-body aircraft production profile (units): a rapid transition from old
to new platforms

Source: Berenberg estimates. Airline Monitor
We consider risks and mitigations as follows.

New programme risk is relatively modest: Given the cutting-edge nature of
aero engine technologies, development risk (meaning delays and cost escalation)
is inherent in new programmes. The LEAP programme, and indeed the 737
MAX and A320NEO aircraft programmes, appear to be on track with both
manufacturers meeting key milestones and consistently re-iterating their
confidence in achieving their respective EIS dates. Development risk currently
associated with the narrow-body sector is mitigated by certain elements of
commonality with the predecessor programmes, particularly the airframe. The
LEAP engine has the same architecture as CFM56 and, for example, uses a
scaled-up version of the low pressure turbine (LPT) used on the GEnx engine
(B787). However, there are new technology differences such as the use
composite fan blades in high volume. In summary, while we accept there are
inevitable technology risks associated with the development of the LEAP, we
believe they are being well managed by Safran (and GE).

Industrial complexity relatively low: The CFM56 is a mature programme
being produced at high rates by a well-oiled supply chain. The inherent risks of
transition to the LEAP centre on the supply chain and the ability to cope with a
rapid ramp-up. We are reasonably comfortable about this. Firstly, Safran is well
advanced in terms of upgrading and expanding its own internal production
0
100
200
300
400
500
600
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
2
0
1
9
2
0
2
0
A320ceo A320neo 737NG 737MAX
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capacity. For example, two new fan blade facilities are coming onstream in 2014
and 2015 with projects completed or underway in a number of other areas such
as assembly (France, the US) and rotating parts (China, Mexico, France, the
US). Secondly, for bought-in components, management has demonstrated a
high level of focus on supply chain readiness. Lastly, CFM is experienced in
managing high-volume programmes and with elements of overlap with the
existing CFM56 supply chain, risk is mitigated.

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Key investment point three: profit upside and return to
strong cash generation
Safrans growth is underpinned by strong momentum in the commercial aero
engine and equipment businesses. Capital investment and R&D levels will
moderate and hence we expect group cash generation to materially improve in the
outer years of our forecast horizon We forecast 7% sales and 12% EBIT CAGR to
2017 (margin 14.6%). We note management has previously stated a margin target
of 15% by 2015, implying 9% upside to our operating profit estimates.

Margin target/aspiration implies upside: We anticipate steady margin
expansion driven by multi-year growth in commercial aerospace activities, in
particular an increasing mix of high-margin spares and services activities.
Management first communicated a 2015 target margin of mid-teens (which we
interpret as 15%) in 2011 and we believe it remains the aspiration. We forecast a
margin of 13.7% in 2015, 130bp below target, reflecting the many difficult-to-
quantify factors already mentioned, including mix headwinds (new engine
losses) and the effects of declining spares on retiring fleets, and positive impacts
such as margin progression in the previously underperforming Aircraft
Equipment, Security and Defence divisions. Management still appears confident
and, by way of illustration, a 15% margin on our current revenue forecast
implies 9% upside to recurring EBIT.
2015 15% target margin is not fully reflected in
consensus (or our) forecasts implies 11% upside
to operating profit
Safrans operating margin now tracking
industrial partner GE; industry returns are
improving as investment phase comes to an end

Why we think strong profit momentum can continue despite margin
headwinds

OE mix: The dilution effects from mix changes as LEAP production ramps up
while the mature (and profitable) CFM56 programme ramps down is difficult to
quantify. As for all new programmes, early-stage costs (on the LEAP) will be
higher than the standard costs for the CFM56. We categorise this as normal
learning curve costs and suggest a headwind in the 100s of millions (euros)
range costs will be absorbed by the Propulsion division between 2016 and 2020
(note that Safran does not capitalise engine losses). Firstly, we view this as
relatively modest in the context of annual group EBIT of 2.5bn+ by 2016.
Secondly, given the level of LEAP maturity reported by management and GE,
and other commonality factors outlined above, the company is confident that it
will move through the learning curve quickly and hence for less cost than for
historical programmes. Another factor that will mitigate mix headwinds is the
5%
10%
15%
20%
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Group margin Target
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
Safran Prop'n R-R Civil
MTU OEM P&W
GE Av
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extended period of (profitable) CFM56 production, a function of strong
demand for B737NGs, which will smooth mix dilution effects.

Falling R&D but lower capitalisation creates a profit headwind: Safran is
approaching the end of several years of heavy investment on new engine
developments, principally the LEAP and the Silvercrest, over which time gross
capitalised costs have risen significantly to 700m in 2013 (versus 180m in
2010). Total company funded R&D is starting to decline with the level of
capitalisation reducing markedly over the next few years as the Silvercrest and
then the LEAP move into early production.
Safran R&D profile (m)


We forecast that capitalised R&D will fall to around 400m by 2016, creating a
substantial profit headwind, exacerbated by increasing amortisation charges. By
way of illustration, we estimate the profit impact of capitalisation (net of
amortisation) in 2013 was 618m (c35%), reducing to 270m (c12%) by 2017
based on the engine programme schedule as we see it today. This is equivalent
to a total c340m EBIT delta over four years (see chart below). Again, the main
mitigation for the margin impacts of capitalised R&D relates to positive
momentum in the civil CFM56 aftermarket. The R&D profile may change in
the outer years depending on Safrans potential participation share on GEs
GE9X engine being developed for Boeings 777X aircraft, the re-engined
replacement for the 777, which is planned to enter service in 2019. Supplier
negotiations for work share agreements are underway and Safran appears
confident it will secure a share in the range of current programmes (8% on the
GEnx and 24% on the GE90). Success would lead to further investment
commitments (and capitalisation) but we would not expect significant increases
in overall R&D as we see it today. An announcement could be expected in
H214.

228
182 179
282
504
694 690
480
400
300
480
508
406
495
543
541
585
730
745
750
492
410
563
492
491
522
575
500
475
450
0%
2%
4%
6%
8%
10%
12%
14%
0
500
1,000
1,500
2,000
2008 2009 2010 2011 2012 2013 2014F 2015F 2016F 2017F
Capitalised R&D Expensed R&D
Customer Funded R&D Total R&D as % of sales
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Capitalised development costs (m)

Source: Berenberg estimates, Safran

Structurally improving margins in Aircraft Equipment (+200bp by 2016):
Services account for only 30% of Aircraft Equipment sales, the result of an
historical lack of focus on the aftermarket opportunity, for example in areas
such as engine nacelles and thrust reversers, and also a function of the
companys relatively young installed base of landing gear, aircraft wheels and
brakes (737NG/A320/777/787) and nacelles (A330/A380). The services
profile is improving slowly, although overall mix will not change materially over
the next few years due to strong growth in OE sales linked to new aircraft
programmes. In addition, the historical operating performance of Aircraft
Equipment has also been affected by legacy programme issues, now past (eg
A380 development). Aircraft Equipment RoS has increased by 280bp since
2010 to 9.2% and we model continued profit expansion to around 11% by
2016. This equates to c28m of profit improvement at 2013 margins, or 1.5%
of group underlying EBITA. Clearly a positive but relatively modest at the
group level.

Moving to long-term service contracts: With the introduction of the LEAP
engine, Safrans aftermarket model will undergo a slow shift from time and
materials (T&M) to long-term service agreements. The majority of LEAP
engines will be serviced on an engine flight hour (EFH) contract basis, similar
to Rolls-Royces TotalCare or power-by-the-hour model which has a
smoothing effect on profits due to the progressive long-term contract
accounting for revenues and costs. It also has the benefit of bringing forward
cash flows as steady customer payments are made over the life of the contract.
The key point is that LEAP engines will contribute immediately to Safrans
financial performance as the fleet builds, rather than waiting up to nine years for
the first major overhaul. We understand that 70-80% of the c6,000 LEAP
engines on order have been sold with EFH service agreements with an average
duration of 8-15 years.

Declining spares stream on aging first generation CFM56 fleet: We have
already touched on this and believe management has taken a prudent view on
the rate of first generation spares fade. In short, the first generation CFM56 is
becoming less significant to the group.

Cash profile improving: Group cash generation should significantly improve
from 2015 as profit growth and lower investment (capex and R&D) feeds
through. We anticipate c1bn FCF by 2015 and rising thereafter, even after
accounting for increased working capital as LEAP production ramps up.
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
100
200
300
400
500
600
700
800
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Capitalised R&D Net 'benefit' to EBIT
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Free cash flow to exceed 1bn by 2015 and continuing to rise (m)


0%
20%
40%
60%
80%
100%
120%
0
300
600
900
1,200
1,500
1,800
2009 2010 2011 2012 2013 2014 2015 2016 2017
FCF (EUR m) FCF conversion (RHS)
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Segment revenues, profit and margin profile (m)

Source: Berenberg estimates, Safran

Revenue (EUR m) 2010 2011 2012 2013 2014e 2015e 2016e 2017e
Aerospace Propulsion 5,604 6,110 7,005 7,589 8,243 8,820 9,614 10,383
Aircraft Equipment 2,834 3,097 3,691 4,091 4,336 4,640 5,058 5,412
Defence 1,240 1,264 1,315 1,197 1,215 1,191 1,173 1,173
Security 1,041 1,249 1,546 1,482 1,519 1,580 1,635 1,684
Other 41 16 3 4 0 0 0 0
Group total 10,760 11,736 13,560 14,363 15,314 16,231 17,480 18,652
Revenue growth
Aerospace Propulsion -1.2% 9.0% 14.6% 8.3% 8.6% 7.0% 9.0% 8.0%
Aircraft Equipment 2.4% 9.3% 19.2% 10.8% 6.0% 7.0% 9.0% 7.0%
Defence 16.9% 1.9% 4.0% -9.0% 1.5% -2.0% -1.5% 0.0%
Security 15.2% 20.0% 23.8% -4.1% 2.5% 4.0% 3.5% 3.0%
Group total 3.0% 9.1% 15.5% 5.9% 6.6% 6.0% 7.7% 6.7%
EBITA (adj)
Aerospace Propulsion 663 909 1,076 1,358 1,533 1,685 1,846 2,014
Aircraft Equipment 127 202 286 376 399 473 546 595
Defence 55 58 79 84 90 93 94 94
Security 128 139 145 120 129 145 155 168
Other -95 -119 -142 -158 -158 -158 -158 -158
Group total 878 1,189 1,444 1,780 1,993 2,238 2,483 2,714
Margin (adj)
Aerospace Propulsion 11.8% 14.9% 15.4% 17.9% 18.6% 19.1% 19.2% 19.4%
Aircraft Equipment 4.5% 6.5% 7.7% 9.2% 9.2% 10.2% 10.8% 11.0%
Defence 4.4% 4.6% 6.0% 7.0% 7.4% 7.8% 8.0% 8.0%
Security 12.3% 11.1% 9.4% 8.1% 8.5% 9.2% 9.5% 10.0%
Group total 8.2% 10.1% 10.6% 12.4% 13.0% 13.8% 14.2% 14.6%
Safran SA
Aerospace & Defence
288
Appendix 1: Group outline
Revenue by division (2013 sales 14.4bn)

Source: Safran company reports
Safran designs, manufactures and services aircraft engines for the commercial and
military aircraft and business jet sectors. It also supplies mechanical and electrical
systems for both military and civil aircraft, including landing gear, wheels and
brakes, engines structures and power systems. Its Defence division activities are
focused on avionics electro-optic systems while in Security the group has strong
positions in biometric identification and detection systems. Civil aerospace
accounts for around 60% of sales (c70% of EBIT) with Defence, Space and
Security making up the balance. We estimate that approximately 35% of group
revenues are derived from the civil aerospace aftermarket and service activities
(spare parts and maintenance and repair).
Aerospace Propulsion revenue splits (2013) Aircraft Equipment revenue splits (2013)

Source: Safran Source: Safran
Aerospace Propulsion (53% of sales/76% of EBIT): This is Safrans
largest division, specialising in aircraft engines and propulsion systems for
civil and military applications. The groups 50:50 JV with GE, called CFM,
manufactures the flagship CFM56 turbofan that powers the Boeing 737
and Airbus A320 with an installed base of almost 26,000 engines. CFM
accounts for around 50% of total Propulsion revenues split c40:60
OE:Services. Other important programmes include the GE90 (Boeing
777), on which Safran has a 23% share and which generates 15-20% of
Propulsion sales, and the GP7000 (A380). The group also provides engines
for a large number of civil and military helicopter programmes to all the
Aerospace
Propulsion
54%
Aircraft
Equipment
28%
Defence
8%
Security
10%
Civil
Aviation
64%
Missiles
& Space
11%
Military
Aviation
10%
Helicopters
15%
Engine
Systems
26%
Electrical
Systems
21%
Landing
Systems
51%
Other
2%
Safran SA
Aerospace & Defence
289
major OEMs (Sikorsky, Airbus Helicopters, Boeing, Bell, Agusta
Westland, HAL, Denel).
Aerospace Equipment (28% of sales/21% of EBIT): The Landing
Systems sub-division includes landing gear for civil and military aircraft
and helicopters (eg the A350, the B787, the A400M, the Rafale, the
Eurofighter, the Airbus Helicopters) and wheels and brakes for civil and
military aircraft and helicopters (eg the B787, the A380, the B737, the
A350, the A400M and the Tiger helicopter). Engine Equipment includes
nacelles and thrust reversers for commercial, regional and business jets and
power transmission and power electronic aircraft systems.
Defence revenue splits (2013) Security revenue splits (2013)

Source: Safran Source: Safran

Security (10% of sales/7% of EBIT): Safran is a leader in biometric
identification systems, accounting for c50% of segment sales (eg ID documents,
fingerprint biometrics and processing systems), detection systems (c20% of
segment sales) for explosives and dangerous substances, and access control
systems (smart cards, bank cards and secure access to business networks
account for c20% of the segment).

Defence (9% of sales/7% of EBIT): Optronics (night vision, periscopes,
drone systems) is the largest activity at around 50% of total, with the Avionics
(eg inertial navigation systems) sub-division accounting for the majority of the
rest.

Avionics
43%
Elec. &
Safety
Software
9%
Optronics
48%
Detection
16%
e-documents
22%
Identification
62%
Safran SA
Aerospace & Defence
290
Appendix 2: Equity holders (free float increased to 63%)
Equity holding (December 2011) Equity holding (December 2013)

Source: Safran company reports Source: Safran company reports
The French government reduced its stake in Safran from 30% to 22% through two
equity placings in 2013 (3.1% placed in March 2013 at 34.5, a 2.8% discount,
followed by a 4.7% stake in November 2013 at 46.3, a 3.6% discount). The free
float has increased commensurately to 63%. The French government has not
indicated any intention to sell down its position further but this has to be
considered a possibility given the broader fiscal position. We do not view this
potential overhang as a significant risk in part because equity markets are
generally cognisant of the fundamental attractions of the business and the most
recent sell-downs around these levels were significantly oversubscribed.

51.9%
1.9%
30.2%
16.0%
Public Treasury Shares
French State Employees
62.8%
0.1%
22.4%
14.7%
Public Treasury Shares
French State Employees
Safran SA
Aerospace & Defence
291
Appendix 3: Engine service agreement structures

T&M: Revenues are earned at the time of the actual shop visit based on
material, parts and labour costs. Income, expenses and cash coincide. Around
one-third of the fleet is serviced in this way.

Material Service Agreements: Guaranteed commercial conditions of parts
supply to airline or MRO providers (accounting for about 60% of total CFM
shop visits). Income, expenses and cash coincide.

Rate per flight hour (RPFH): These are long-term contracts generating
revenues on a fixed sum per flight hour, based on the estimated cost to perform
engine maintenance with performance/availability guarantees incorporated.
Revenue is booked and cash received progressively, resulting in a decoupling
from cash out. Around 20% of the CFM56 fleet is serviced under RPFH
agreements. This will shift rapidly with the introduction of the LEAP engine,
the majority of which are pre-sold with long-term RPFH contracts.
Safran SA
Aerospace & Defence
292
Financials


Sales 13,560 14,363 15,314 16,231 17,480

Other operating income 990 974 1,175 1,198 1,125
Operating costs -13,508 -14,543 -15,059 -15,627 -16,345
EBIT 1,243 1,287 1,719 2,066 2,504

EBITDA (adj) 2,165 2,542 2,803 3,078 3,353
Depreciation 340 363 380 400 410
Amortisation of intangible assets 381 399 430 440 460
EBIT (adj) 1,444 1,780 1,993 2,238 2,483
EBIT 1,243 1,287 1,719 2,066 2,504

EBT 1,739 1,926 1,610 1,881 2,146
EBT (adj) 1,259 1,623 1,900 2,145 2,390

Other taxes -179 110 0 0 0
Tax rate 25% 33% 44% 41% 40%
Profit after tax 1,306 1,418 902 1,102 1,295

Net income 1,282 1,389 883 1,079 1,269
Net income (adj) 979 1,193 1,251 1,413 1,576


EPS (reported) (p) 3.1 3.3 2.1 2.6 3.0
EPS (adjusted) (p) 2.4 2.9 3.0 3.4 3.8


Safran SA
Aerospace & Defence

293

Balance sheet

Financial assets 880 1,265 1,277 1,289 1,301
Fixed Assets 10,434 11,747 12,228 12,203 12,064

Inventories 4,131 3,998 3,998 4,048 4,173
Accounts receivable and other assets 761 1,062 1,049 1,036 1,023
Deferred taxes 421 377 377 377 377
Current assets 12,531 11,951 11,941 12,573 13,447
TOTAL ASSETS 22,965 23,698 24,169 24,776 25,511

Long-term debt 2,209 1,326 1,326 1,326 1,326

Bank and other borrowings 916 1,441 1,441 1,441 1,441
Other liabilities 1,303 1,438 1,484 1,530 1,576
Deferred taxes 156 205 205 205 205



Safran SA
Aerospace & Defence

294

Cash flow statement
EUR m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 2,165 2,542 2,803 3,078 3,353

Other costs affecting income / expenses 29 -7 6 11 14
Cash flow from operations before changes in w/c 2,194 2,535 2,810 3,089 3,368
Increase/decrease in inventory -388 45 0 -50 -125
Change in operating receivables and payables 228 178 0 0 0
Increase/decrease in other working capital positions 75 -68 0 0 0
(Increase)/decrease in working capital -85 155 0 -50 -125
Interest paid -54 -42 -35 -35 -35
Cash tax -433 -639 -709 -779 -851

Dividend from equity accounted investments -5 117 -6 -11 -14
Capex -427 -492 -451 -400 -400
Payments for acquisitions -279 -380 -200 0 0
Financial investments 0 -35 0 0 0
Cash flow from investing activities -1,337 -1,725 -1,562 -1,066 -964

Free cash flow (memo) 564 699 704 1,159 1,393

Dividends paid -300 -481 -500 -565 -630
Others -38 -74 0 0 0

Net cash flow 65 -288 3 594 762

Reported net debt -932 -1,220 -1,217 -622 140


Safran SA
Aerospace & Defence

295

Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 1.2x 1.7x 1.6x 1.4x 1.3x
EV/EBIT (adj) 11.0x 13.3x 12.0x 10.4x 9.1x
P/E 10.6x 15.1x 23.9x 19.6x 16.7x
P/E (adj) 13.8x 17.7x 16.9x 15.0x 13.5x
P/FCFPS 24.0x 30.1x 30.1x 18.3x 15.2x
Dividend yield 2.9% 2.2% 2.4% 2.7% 3.0%

Growth rates
Sales 16% 6% 7% 6% 8%
EBIT (adj) 21% 23% 12% 12% 11%
EPS (adj) 48% 22% 5% 13% 11%
EPS 161% 8% -37% 22% 17%
DPS 55% 17% 7% 13% 11%

Financial ratios
FCF conversion 39% 39% 35% 52% 56%
Net gearing 13% 15% 14% 7% -2%
Net debt/EBITDA 0.4 0.5 0.4 0.2 0.0
ROCE 13% 13% 14% 14% 15%
ROIC 12% 12% 13% 14% 16%
WACC 7% 7% 7% 7% 7%
FCF ROCE 9% 10% 10% 15% 17%
Net R and D/sales (inc. capitalised costs) 4.0% 3.8% 3.8% 4.5% 4.3%
Gross R and D (inc. customer funded) 8.1% 9.0% 8.7% 7.5% 6.4%

Key financials

Sales 13,560 14,363 15,314 16,231 17,480
EBIT margin (adj) (%) 10.6% 12.4% 13.0% 13.8% 14.2%
EBIT (adj) 1,444 1,780 1,993 2,238 2,483
EPS (adj) (p) 2.4 2.9 3.0 3.4 3.8
DPS (p) 1.0 1.1 1.2 1.4 1.5

Free cash flow 564 699 704 1,159 1,393
Acquisitions and disposals -279 -380 -200 0 0
Net cash flow 65 -288 3 594 762

Gross debt 3,125 2,767 2,767 2,767 2,767
296

Cautious optimism

Set against Ultra Electronics Holdings (Ultra) high standards and
long-term record of growth, the business has weathered a difficult
three years in slowing defence markets. 2014 is likely to be another
year of flat earnings with low organic and M&A driven growth offset
by currency effects. However, looking further ahead we are cautiously
optimistic that Ultra can deliver sustained EPS growth driven by large
contract opportunities, growing non-defence activities and further
potential upside from acquisitions. Nearer-term, we are mindful of the
strong H2 bias to the 2014 financial performance and, given the
recent rally, we think the shares are approaching fair value on a 12-
month view. We initiate with a Hold rating and a 1,970p price target.

Well positioned for the longer term: We estimate c1.8bn of
revenue potential over the next five years from a number of large
contract opportunities. In addition, long-term strategic trends such as
the US military forces Pivot to Asia-Pacific and investment in cyber
security and defence electronics play to Ultras strengths.

Upside from M&A: Ultra is highly acquisitive and activity in 2014
has accelerated with over 100m deployed ytd. We estimate Ultra
could comfortably spend a further 100m firepower on a c5%
earnings-accretive deal and remain below 1.5x leverage.

Valuation/view: Following the recent rally, the shares are trading on
an FY14 P/E of 15x, a modest premium to the long-term average, but
a 10% premium to the UK defence sector. We believe forecast risk is
relatively low but Ultra must, as a minimum, deliver the low level of
growth it has guided to continue building investors confidence that
the group is starting to grow again. We set our price target at 1,970p,
based on an average of sum-of-the-parts and DCF analysis, indicating
5% upside, hence our neutral stance.

Next news: Interim results on 4 August.

Hold (Initiation)
Current price
GBp 1,878
Price target
GBp 1,970
Reuters ULE.L
Bloomberg ULE LN
Share data

Performance data

High 52 weeks (GBp) 1,981
Low 52 weeks (GBp) 1,609
1 month 5.4 % 6.5 %
3 months -3.9 % 4.1 %
12 months -10.3 % -4.7 %
Key data

Net gearing 23.5%
CAGR sales 2012-2015 6.4%
CAGR EPS 2012-2015 3.5%

Ultra Electronics is a business made up of
180+ specialist capabilities with defence,
security and aerospace applications
worldwide. The company focuses on
sensing, control, communication and
display systems with an emphasis on
integrated IT solutions.

16 June 2014
Andrew Gollan
Analyst
+44 20 3207 7891

Chris Armstrong
Specialist Sales
+44 20 3207 7809
Y/E 31.12., GBP m 2012 2013 2014E 2015E 2016E
Sales 760.8 745.2 787.1 842.8 868.1
EBITDA (adj) 135.9 136.0 137.7 152.9 158.9
EBIT (adj) 121.8 121.7 122.0 135.7 140.2
Net income (adj) 86.9 88.5 88.4 96.0 99.3
Net income 61.0 38.2 56.8 57.0 59.8
Net debt / (net cash) 43.0 42.2 108.4 68.1 7.6
EPS 88.1 54.8 81.3 81.1 84.6
EPS (adj) 125.2 126.7 125.9 135.8 139.6
FCFPS 83.0 63.0 96.7 122.0 131.6
CPS 1.0 2.9 -97.2 57.1 85.1
DPS 40.0 42.2 43.4 46.8 48.1
EBIT margin (adj) 16.0% 16.3% 15.5% 16.1% 16.1%
Dividend yield 2.4% 2.2% 2.3% 2.5% 2.5%
ROCE 25.5% 25.4% 20.1% 22.8% 25.1%
EV/sales 1.7 1.9 1.9 1.8 1.6
EV/EBITDA 9.4 8.7 11.0 9.7 8.9
EV/EBIT 10.5 11.9 12.4 10.9 10.1
P/E 13.2 14.9 14.9 13.8 13.5
P/E (adj) 13.3 14.9 15.0 13.9 13.5

297
Ultra Electronics investment thesis in pictures
Sales by sector (2013 revenue 745m): over 180
niche technology capabilities in defence,
security, transport and energy sectors
Sales end-market: non-US/non-European
defence revenues are small but growing


Organic growth (%) affected by defence
slowdown (particularly in military radios)
EPS and DPS profile (p): earnings growth
returning


FCF and acquisition costs (m): average 77% of
annual FCF is invested in bolt-on/bolt-in
acquisitions
P/E relative: premium rating lost over the last
three years reflecting low-growth

23%
57%
20%
Security & Cyber
Defence
Transport & Energy
33%
8% 44%
15%
UK
Mainland Europe
North America
RoW
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
Organic Reported
0
25
50
75
100
125
150
175
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
E
2
0
1
5
E
2
0
1
6
E
2
0
1
7
E
EPS DPS
0%
40%
80%
120%
160%
0
40
80
120
160
FCF M&A M&A as % of FCF (rhs)
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
ULE P/E rel to FTSE A-S Average
ave 1.3

298
Ultra Electronics investment thesis
High-quality small/mid-cap defence electronics company
Ultra is a specialist electronics business with a broad range of capabilities in the
defence, security, transport and energy sectors. Within defence, Ultras businesses
are well exposed to governments priority areas of military spending such as cyber
and security (23%), and anti-submarine warfare (20%), which should mitigate
against enduring budgetary pressures. A diversified and specialised portfolio
equates to a relatively low earnings risk profile compared to European defence
peers.
Return to organic growth in 2014 but neutralised out by FX
In recent years, Ultra has not lived up to its historical status as a growth company
due to headwinds in defence, in particular in the US market, where disruption in
the procurement process has exacerbated the situation. A return to organic growth
in 2014 is therefore directionally significant for Ultra (albeit it is modest growth
we estimate 1%), with underlying gains in non-defence activities (43% of sales)
offset by a c3% FX headwind. At the EPS level, we anticipate another broadly flat
year (the fourth consecutive flat year). For 2015, we factor organic growth of 3%
which, together with the impact of acquisitions (discussed below), we estimate
translates to EPS growth of 8%.
Acquisition growth
M&A is a central to Ultras growth strategy, with over 75% of free cash flow
invested in acquisitions over the last 10 years. After a relatively quiet 2012 and
2013, Ultra has stepped up M&A activity in 2014 spending c$175m/c110m ytd
on three transactions: 3 Phoenix Inc (3PI, $70m plus up to $17m), Forensic
Technology ($94m plus up to $6m), ICE Corp ($8.6m). With Ultra, there is always
the possibility of further bolt-on acquisitions, but following these latest transactions
it is probably reasonable to expect the prospect of larger sized deals is diminished
in the short term. However, Ultra is highly cash-generative and balance sheet
leverage remains low we forecast December 2014 net debt/EBITDA of 0.7x
falling to 0.4x in 2015. Our M&A model suggests the group could deploy a further
100m, on an Ultra-style acquisition (ie similar margin and valuation multiple
profile) and remain comfortably under 1.5x leveraged, for c4% earnings accretion.
Increasing number of large contract opportunities
As the group has grown, so has the scale of potential contract opportunities.
Management has identified a number of large multi-year contract opportunities that
could bring substantial revenues over the mid-/longer term. We estimate blue-sky
annual revenues of 1.85bn, albeit not all incremental.
Over a two-year period, the Ultra share price has significantly underperformed the
sector, reflecting lower organic growth expectations. 2014 has been especially
volatile, with a c15% sell-off from the early January high of 1,970p to 1,670p,
driven by a combination of sector rotation and increasing currency headwinds. The
shares have since recovered to c1,900p buoyed by a series of enhancing
acquisitions and positive contract announcements. The shares currently trade on a
12-month forward P/E of 14.3x according to Datastream consensus, a 3%
discount to the long-term average of 14.7x.

299
Share price versus market and sector (re-based) 10-year P/E (12-month forward)

Source: Datastream
Note: re-based to Ultra Electronics share price
Source: Datastream
Forecast momentum just starting to become positive
After a long period of organic and acquisition-driven growth, earnings momentum
turned negative in mid-2012 as the defence market slowed. This was followed by a
more significant downgrade to consensus forecasts in early 2013 as the extent of
the slowdown in the groups tactical radio business became apparent. Forecast cuts
at the beginning of 2014 relate mainly to adverse currency effects. Overall, we
estimate consensus 2014 EPS estimates have been revised down by c10% since
December 2012, although it is encouraging that the latest revisions for 2015 and
2016 are positive, reflecting the impact of accretive acquisitions.
Long-term forecast EPS changes (p) Short-term EPS revisions and share price (p)

Recent results and outlook
IMS trading update for the four months to 29 April: Ultra reported
unchanged market conditions from those noted in early March and confirmed
previous qualitative guidance for the full year that the group will achieve progress
in 2014 currency being the caveat, which at current rates will have an adverse
impact on EBIT of 3.6m (c3% yoy), which we factor in our forecasts. The
statement also reiterated that the financial performance will be second-half-
weighted based on US order expectations and currency effects. We model a H1:H2
EBIT split of 45:55, compared to 48:52 historically.

1400
1800
2200
2600
3000
3400
ULE FTSE A-S Pan Euro A&D
8
10
12
14
16
18
20
Ultra Electronics Average
ave 14.7x
90
100
110
120
130
140
150
2012 2013 2014 2015 2016
127
129
131
133
1500
1600
1700
1800
1900
2000

300

Anaemic growth persists: Any shortfall or deferral of organic growth against
expectations will damage investors confidence that the group will return to a
sustained growth profile. This could have a long-term impact on the groups
relative valuation which has historically traded at premium multiples. Continued
downwards pressure on defence spending, particularly in the US, represents the
greatest risk in this respect.

Contract execution risk: Ultra is bidding for and delivering an increasing
number of large and complex contracts. Poor execution and/or programme
management could materially affect group financial performance.

Acquisition risk: We estimate Ultras acquisition growth model funded by
organically generated cash has, on average, delivered mid-single-digit revenue
growth annually. The scale of acquisitions will need to increase (number/size)
to have the same impact on the enlarged group. Ultra has a good track record of
M&A integration and value creation but the 44m write-down of goodwill on
Prologic in 2013 serves as a reminder of the risks inherent in a portfolio build-
out strategy.


301
Valuation
1,970p price target


We set our price target at 1,970p based on a blended average of DCF and sum-

A price target of 1,970p equates to 5% upside to the current price and drives
our neutral rating.

Ultra has historically traded at a 10-30% P/E premium to the average of UK
defence peers but this has eroded in recent years to c8% as relative organic
growth rates have normalised.

The implied target P/E is 15.6x (FY 2014) falling to 14.5x (FY 2015) compares
to Ultras long-run 12-month forward P/E of 14.7x.
12-month forward P/E 12-month forward P/E relative to FTSE All-Share

Source: Datastream
Sum-of-the-parts
We base our sum-of-the-parts on an end-market analysis and apply peer average
multiples for both FY14 and FY15. For the cyber and security and defence
businesses, we apply a 15% premium to peer average multiples in line with
historical trading levels.
EV/Sales 1,756 1,872 Ave multiple 1.6x/1.5x
EV/Ebitda 1,773 1,929 Ave multiple 10.5x/9.8x
DCF 2,240 2,240 7.5% WACC / 1.5% TG
Average 1,923 2,014 1,968p
8
10
12
14
16
18
20
Ultra Electronics Average
ave 14.7x
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
ULE P/E rel to FTSE A-S Average
ave 1.3

302

DCF
Our DCF model valuation of 2,240p is 19% above the current price. We adopt
relatively prudent assumptions to reflect our long-term cautious assessment of
western defence markets where Ultra is heavily exposed. For example, we use a
1.5% terminal growth rate, well below the companys historical average, and a
terminal margin of 15.8%, 50bp below 2013. A 1ppt increase in the terminal
growth rate adds c13% to the DCF while a 100bp variation in margin would have
an impact of around 4%.
DCF summary table



EV/Ebitda Multiple EV/Sales Multiple Average
Security & Cyber 311 10.2 284 1.6 298
Defence 834 10.3 815 1.8 824
Transport & Energy 291 10.8 325 2.1 308
Total 1,437 10.4 1,424 1.80 1,430
Pension (IAS19) -83
Equity value 1,239
Shares o/s (m) 70
EV/Ebitda Multiple EV/Sales Multiple Average
Security & Cyber 356 10.4 310 1.6 333
Defence 850 9.9 832 1.8 841
Transport & Energy 296 10.1 320 2.0 308
Total 1,503 10.0 1,462 1.78 1,482
Net cash/(debt) -68
Pension (IAS19) -80
Equity value 1,334
Shares o/s (m) 70
DCF Model m
Risk Free rate 4.0% PV of disc flows (10yrs) 743
Share value (p) 2240
2240 13.8% 14.8% 15.8% 16.8% 17.8%
6.6% 2266 2381 2497 2613 2729
7.1% 2048 2149 2250 2351 2451
7.6% 1866 1955 2043 2132 2221
8.1% 1712 1790 1868 1947 2025
8.6% 1579 1649 1719 1788 1858
EBIT margin
W
A
C
C
2240 0.5% 1.0% 1.5% 2.5% 3.5%
6.6% 2208 2339 2497 2928 3637
7.1% 2017 2124 2250 2584 3105
7.6% 1853 1941 2043 2308 2702
8.1% 1711 1784 1868 2082 2388
8.6% 1587 1649 1719 1893 2136
Terminal growth
W
A
C
C

303
Key investment point one: organic growth returning
Weak defence markets and persistent disruption in US procurement processes has
resulted in depressed growth for three years, with Ultra registering an organic sales
CAGR 2011-2014E of 1.2% compared with the 8.2% pa for the previous five
years. We sense that management is cautiously more optimistic about a return to
organic growth in 2014 given 1) the businesses most affected are already at multi-
year lows, 2) non-defence activities are continuing to grow (now 43% of group),
and 3) the list of contract opportunities is increasing in number and scale.
Challenges remain however, and it is too early to expect a sharp rebound in growth
trajectory, in our view. Notwithstanding this, the expected improvement in 2014 is
directionally significant given the companys recent history and will go some way to
restoring investors confidence that Ultra really is a growth company.

1% organic in 2014 is a relative outperformance: Until 2011, Ultra had a
record of delivering consistent earnings growth since its flotation in 1996
(CAGR: 17%), driven both organically and by acquisition. However, weakness
in its core US and UK defence and security markets translated into mid-single
digit declines in organic sales in 2012/13, or flat earnings after M&A impacts
and FX tailwinds. For 2014, Ultra entered the year with order cover levels
consistent with previous years (57%) and a number of larger opportunities that
could evolve over the next 6-12 months (discussed below). In addition, the FY
2015 US defence budget request and postponement of sequestration risks
reduces near-term uncertainty. With low but solid growth anticipated in the
groups non-defence sectors (43% of sales), management has indicated that low
single-digit organic growth is achievable in 2014, which would be a relative
outperformance compared to the UK defence peer average of around 5%.
Organic sales growth (%) Adjusted EPS growth (%)

Source: Berenberg estimates, Ultra Electronics

R&D investment maintained/increased: New technology and product
development is key to Ultras longer-term growth prospects and the company
has continued a programme of investment throughout the period of defence
market weakness. Company-funded R&D in 2013 was 5.8% of sales, in line
with the six-year average of 6.1% (see chart below).
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304
R&D investment (m)


Capitalisation of R&D depends largely on programme/contract phasing. The
step-up in 2013 (6.3m versus 0.6m in 2012) relates to a number of contracted
products entering late-stage development such as next-generation MMR radios
(interestingly, the military radios business has been Ultras weakest business
over the past two years, yet new product investment has increased) and Remote
Crypto Monitoring Systems (RCM). Total R&D on the balance sheet is modest
at 9.0m in December 2013, although there is potential for this to rise in the
mid-term with greater upfront development requirements on civil aerospace
programmes such as fuel tank inerting (Comac) and electronic door controls
(Airbus A350).

While it is positive to see Ultras continued investment in product development,
we suggest customer-funded R&D could come under pressure as governments
rein in project spend and look to contractors for greater competiveness. As a
proxy, the US Department of Defense (DoD) RDT&E (research, development,
test and evaluation) budget has fallen by 22% since 2011, but for Ultra,
government-funded R&D has so far held up around the 90m level (2011:
86m; 2012: 98m; 2013: 87m). If customer-funded R&D trends lower, then
it is likely all manufacturers will be required to support a greater element of
spend internally.

Cost reduction and efficiencies to help the bottom line: In addition to
organic growth, recent cost reduction initiatives should benefit earnings. Over
400 redundancies in 2013, predominantly in the tactical radios and Prologic
secure communications businesses, will deliver an annualised benefit of 20m
(10m incremental in 2014). Other overhead reductions and efficiencies from
several site consolidations should also be supportive of profits.
0%
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2007 2008 2009 2010 2011 2012 2013 2014E
Co funded Capitalised Co funded/sales (rhs)

305
Key investment point two: further M&A upside
M&A is a key pillar of Ultras growth strategy. Historically, the company has
reinvested around 75% of FCF in acquisitions targeting complementary products,
technologies or market positions. Over the long run, we estimate that M&A has
contributed an average of 6% earnings accretion annually. 2014 has seen a pick-up
in activity with three acquisitions totalling more than 100m. We estimate the
group could comfortably fund another 100m deal which could be c3% accretive
according to our model. We do not factor potential acquisition effects into our
forecasts.

Enhancing acquisitions funded out of organically generated cash: Ultra
has a well-established M&A strategy with 50 bolt-on/bolt-in acquisitions since
flotation in 1996. On average, we calculate the company has invested 77% of
annual FCF in acquisitions over the past nine years, equivalent to 51m pa. We
estimate these have generated incremental earnings growth of c6% pa
(calculated as the difference between organic and M&A growth each year).

Good track record; Prologic a blot: Ultras track record of integration and
value creation is relatively good. Despite the high number of acquisitions Ultra
has the highest ROCE in the sector at 28%, although Prologic, acquired in 2008
for $60m, is one of the few examples of an acquisition not entirely delivering
against the original business case in 2013, there was a 44m goodwill write-
down against Prologic and its bolt-in businesses Zu Industries and Scytale
(acquired for $48m and $7m respectively). In February 2014, Ultra acquired US
sonar business 3Pi for $70m initially with up to $17m deferred, a classic Ultra
deal highly complementary to the groups existing anti-submarine warfare
(ASW) businesses, bringing with it new capabilities and increasing market access
(to the US Navy). We estimate the 3Pi is 2% enhancing to 2015 earnings. In
addition, Ultra recently completed a CAD $94m (plus up to a further $6m)
acquisition of Forensic Technology WAI Inc, a specialist ballistics identification
and forensic analysis company, and a $8.6m acquisition of ICE Corp, a
specialist provider of aerospace electrical power management systems such as
control electronics, ice protection controllers and engine control interfaces.
Cash deployment on M&A (m)

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2006 2007 2008 2009 2010 2011 2012 2013 2014E
FCF M&A M&A as % of FCF (rhs)

306

100m of M&A firepower available: Taking into account the 102m of
acquisitions so far this year, we model that a further c100m could comfortably
be financed from internal funding and facilities. Based on a price-to-sales of
1.8x and generating an RoS in line with the group (c16%), we estimate around
3% EPS upside with balance sheet leverage retained at 1.4x. The tables below
highlight sensitivities of cost to target price/sales and net debt/EBITDA. We
assume the target company will have mid-teen margins, interest is charged at
5% and tax at 33%.
EPS enhancement potential from M&A Net debt/EBITDA sensitivity to M&A


3% 25 50 100 125 150
1.4 1.1% 2.2% 4.4% 5.5% 6.6%
1.6 0.9% 1.7% 3.4% 4.3% 5.1%
1.8 0.7% 1.3% 2.7% 3.3% 4.0%
2.0 0.5% 1.0% 2.0% 2.5% 3.1%
2.2 0.4% 0.8% 1.5% 1.9% 2.3%
Acq'n spend (m)
P
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s
a
l
e
s
135% 25 50 100 125 150
1.4 0.9 1.0 1.3 1.5 1.6
1.6 0.9 1.0 1.3 1.5 1.6
1.8 0.9 1.1 1.4 1.5 1.6
2.0 0.9 1.1 1.4 1.5 1.7
2.2 0.9 1.1 1.4 1.5 1.7
Acq'n spend (m)
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307
Key investment point three: larger contract opportunities
emerging could be catalysts for the stock
Due the nature of Ultras broad range of niche technologies and business units,
individual orders and contracts have tended to be relatively small, thus diversifying
risk and avoiding volatility and lumpiness inherent in defence contracting. This is
changing. Opportunities highlighted by the company recently are much greater
than usual, a function, we believe, of the groups scale and growing list of
capabilities that have evolved both organically and through acquisition. In addition,
there is an underlying shift by the customer, particularly the US DoD and UK
Ministry of Defence (MoD), to contract over a longer term (notwithstanding
shortened contracting time horizons currently due to dysfunctional processes in US
defence procurement). Ultra has a strong track record of converting opportunities
identified to contract awards. The bid list is as large as we have seen it over the last
decade and success in any number over the next 12-18 months will underpin long-
term revenue development, potentially giving upside to current expectations.
Larger revenue opportunities


Positioned for larger revenue opportunities (1.8bn of revenue over five
years): Historically, Ultra has only had one contract that totalled more than 5%
of revenues, the 200m three-year (extended to five-years) Omani airport IT
contract, won in 2011. The scale of opportunities is increasing as shown in the
table above. Collectively, we estimate a blue-sky scenario (100% win rate) would
translate to revenues of c1.8bn over five years. Some of these are not strictly
incremental, however. For example, the five-year IDIQ (indefinite
delivery/indefinite quantity) contract to supply sonobuoys worth $600m to the
US Navy. Ultra, through ERAPSCO, its JV with Sparton Corp, historically has
Contract Indicated Date Length Amount
Security & Cyber potential of 500m over 5+ years
UK Government cyber Bid review 5 yrs 300m
US Government cyber Mar14 5 yrs 80m
Global lawful intercept & cyber security operations centre Agreement 10 yrs $200m
Industrial SCADA cyber protection signed 5 yrs $50m
Defence potential of 890m over 5 years
IDIQ sonobuoy In negotiation 5 yrs $600m
Asia-Pacific torpedo defence Trials 2014 5 yrs 100m
Asia-Pacific high capacity radios Trials 2014 5 yrs $120m
US multi-mission radio Trials 2014 5 yrs 350m
Energy potential of 250m over 5+ years
Asia-Pacific nuclear sensors Won 5 yrs 20m
US Naval energy management Won 5 yrs $180m
US signalling and secondary power source In trials 5 yrs $60m
UK/US nuclear power plants life extension & new builds - 10 yrs 85m
Transport potential of 220m over 5+ years
Asia-Pacific fuel tank inerting for Comac Contract 5 yrs 25m
Middle East airport infrastructure new build & upgrades for study 10 yrs $200m
Global landing gear control units - 5 yrs 75m

308
supplied the majority of US Navy sonobuoys (expendables). However, the
contract award has secured high-level revenues in its largest market for five
years. We understand that very few of these opportunities are in Ultras five-
year plan (undisclosed). Positive progress over the coming year or so will
increase investors confidence in Ultras ability to return to a steady growth
trajectory.

Near-term contract opportunities and order visibility give comfort: Ultra
also has the usual slew of near-term contract opportunities in which
management has a high degree of confidence will convert to contract (see table
below). We estimate that these, together with a 781m order book, spares and
repairs, annual orders and IDIQs (multi-year call-off contracts), combine to
give c90% order cover against consensus 2014 revenue estimates, much higher
than the firm order cover of 57% would suggest. We outline these elements in
more detail in the table below. In addition to these, Ultra recently announced
$40m of ASW contracts, a $19m award by the US Navy for acoustic
countermeasures and three contracts totalling $21m won by the newly acquired
3PI business for Torpedo Warning Systems, ASW towed arrays and radar
command and control software.
Near-term contract opportunities

19. Firm orders: The order book declined by 14% yoy to 781m (2012:
905m), in part due to adverse foreign exchange shifts and the trading of a
number of contracts, such as the Oman airport IT contract and the End
Cryptographic Unit (ECU) replacement programme contract. As we have
mentioned, it is also a reflection of changes in order profile placement with
more orders being placed on an annual basis and, in the US, the DoD
moving towards the use of multi-year IDIQs as their preferred medium-
term contracting vehicles. This is highlighted by the geographical
divergence in opening order cover with just 37% in North America (2013:
48%) compared to the group at 57%.
20. Spares and repairs: The company estimates that repeat spares and repairs
cover another 10% of consensus revenue while IDIQs cover c4%.
Contract Timeframe Total Amount
Aircraft & Vehicle Systems
Fuel tank inerting for regional aircraft 2014 12m p.a.
EGDO Airbus 2014 65m
Boeing 737 PSC 2014 10m initial
XAC LGCU et al 2014+ 10m initial
Information & Power Systems
Future airport opportunities in Oman 2013+ 50m
UK EDF sensors 2014+ 30m
UK submarine power & control 2014+ 35m
Cryptographic key configuration 2014 10m
Tactical & Sonar Systems
US Navy secure energy management 2013 $15m p.a.
Fatahillah MLM ship 2 2014+ 20m
International sonobuoys 2014 $10m p.a.
WIN-T increment 1 extension 2014+ $40m

309
21. Annual orders: A number of important programmes are placed on an
annual basis which the company estimates covers more than 20% of 2014
consensus revenue. Examples are cargo handling systems and noise
cancellation systems for the A400M, airborne targeting pods for the
Eurofighter Typhoon, and ice protection for F-35 JSF engine intake and
B787 wings.

310

Aircraft & Vehicle Systems 174.1 166.1 147.0 155.5 157.6 161.5 166.4 169.7
Information & Power Systems 224.0 257.0 315.8 305.0 301.9 312.5 321.9 331.5
Tactical & Sonar Systems 311.9 308.7 298.0 284.7 327.6 368.8 379.8 391.2
Group total 710.0 731.7 760.8 745.2 787.1 842.8 868.1 892.5
Revenue growth
Aircraft & Vehicle Systems -3% -5% -11% 6% 1% 2% 3% 2%
Information & Power Systems 16% 15% 23% -3% -1% 3% 3% 3%
Tactical & Sonar Systems 12% -1% -3% -4% 15% 13% 3% 3%
Group total 9% 3% 4% -2% 6% 7% 3% 3%
Margin
Aircraft & Vehicle Systems 13.5% 18.8% 20.8% 20.8% 20.5% 21.0% 21.0% 21.2%
Information & Power Systems 12.3% 11.9% 14.2% 13.5% 13.2% 13.8% 13.7% 13.6%
Tactical & Sonar Systems 19.0% 19.6% 15.5% 16.9% 15.2% 15.9% 16.1% 16.3%
Group total 15.5% 16.7% 16.0% 16.3% 15.5% 16.1% 16.1% 16.2%
EBIT (adj)
Aircraft & Vehicle Systems 23.4 31.1 30.6 32.4 32.3 33.9 34.9 36.0
Information & Power Systems 27.5 30.5 44.9 41.2 39.9 43.1 44.1 45.1
Tactical & Sonar Systems 59.4 60.5 46.3 48.1 49.8 58.6 61.2 63.8
Group total 110.3 122.1 121.8 121.7 122.0 135.7 140.2 144.8
EBIT Growth (adjusted)
Aircraft & Vehicle Systems 3.5% 33.0% -1.6% 5.7% -0.3% 5.0% 3.0% 3.0%
Information & Power Systems 16.5% 10.8% 47.1% -8.2% -3.3% 8.2% 2.3% 2.2%
Tactical & Sonar Systems 16.3% 1.8% -23.4% 3.9% 3.5% 17.8% 4.3% 4.3%
Group total 13.4% 10.7% -0.2% -0.1% 0.2% 11.3% 3.3% 3.3%

311
Appendix: divisional overview
Ultra is a business made up of 180+ specialist capabilities across eight core
capability areas in three divisions: Aircraft & Vehicle Systems, Information &
Power Systems, and Tactical & Sonar Systems.
The business is characterised by a large number of independent niches across a
broad array of defence, aerospace and other transport programmes. These niches
have been built up both organically and through a significant number of small
acquisitions.
Aircraft & Vehicle Systems (AVS)
AVS represents 21% of group revenue and 27% of group EBIT. The division
designs and manufactures electromechanical and advanced technology products for
applications in civil and military aircraft, sea systems and land vehicles.
Revenue and positive mix has been driven by the long-term contracts in ice
protection and by the contract to provide cargo handling systems for the A400M.
These factors offset the 2013 headwind of an under-recovery of overheads in the
fuel cell business, which was driven by delayed UAV orders.
AVS revenue and margin profile AVS revenue by market

Capabilities

Aircraft systems
o Airframe ice protection systems used on 787 wing, exclusive life-
time contract with Pratt & Whitney on ice protection for F-35 JSF
engine intake and lift.
o Active noise and vibration control fitted on the Bombardier Q-
series, the Challenger and the Raytheon King Air aircraft; used to
cancel noise in the cargo bay and loadmaster zone of the A400M.
o Airframe system electronics landing gear control systems for civil
and military aircraft for Boeing and Airbus; custom translating wire on
the 747 and 787; cargo handling systems for the A400M.
o Temperature sensors military and civilian aircraft applications.
o Aircraft system test equipment integrity validation, safety calibration,
and calibration of fixed and rotary wing aircraft fuel, databus and
electronic filtering systems.
12%
14%
16%
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22%
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Aircraft & Vehicle Systems Margin (rhs)
13%
52%
35%
Security & Cyber
Defence
Transport & Energy

312
o Cockpit equipment switches, indicators, warning panels, lighting,
and pilot controls for the Eurofighter, Hawk, Lynx and the EH101.
o Airframe fatigue monitoring continuous monitoring of structural
integrity to detect anomalies.
o Airborne compressors a controllable energy source for pneumatic
ejection of aircraft munitions supplied to the F-35 JSF and to Boeings
Small Diameter Bomb.
o Pneumatic equipment and systems cooling infrared detectors, missile
seekers, and weapons carriage and release systems.

Card systems Magicard colour printers used for portrait ID and access
control applications in high security locations.

Vehicle systems
o Armoured vehicle systems human machine interface equipment to
control remote weapons stations used on the Stryker, Bradley,
Abrams, EFV, Protector RWS, LRAS, ITAS and ITSS platforms; also
provides power management systems, databus nodes and local
situational awareness systems.
o Pneumatic equipment and systems high-pressure pneumatic
products for land vehicles.
o Consultancy and systems solutions a partner in a UAE-based, Gulf-
centric consultancy and systems provider.
Information & Power Systems (IPS)
IPS represents 41% of group revenue and 34% of group EBIT. This division
supplies command and control systems for predominantly military applications,
security solutions, such as crisis management, and sensors and control systems for
civil and military nuclear reactors.
Revenue in this division was affected over the past few years by delays in the
federal procurement process, pushing back expected orders for the firm. The
reduction in software service contracts in the US affected Prologics business in
particular. This was offset by the Indonesian Fatahillah corvette upgrade and
strong demand for power management equipment for submarine programmes in
both the US and the UK.
IPS revenue and margin profile IPS revenue by market


9%
11%
13%
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17%
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Information & Power Systems Margin (rhs)
17%
54%
29%
Security & Cyber
Defence
Transport & Energy

313
Capabilities

Information systems
o Integrated crisis management solutions crisis planning and
management software for 30 police forces, UK and international
special forces, local authorities, prisons, ports and airports.
o Nuclear reactor control and instrumentation systems control and
instrumentation equipment used in the propulsion system of the Royal
Navys nuclear submarines.
o Nuclear qualified temperature sensors, pressure transmitters and fibre
optic networking systems.
o Airport and airline management and information systems check-in;
aircraft weight and balance systems; baggage management and
reconciliation.

Power Systems
o Power systems electrical power converters and control products and
low voltage sub-systems for naval vessels and applications.
o Signature management and control for ships and submarines
modelling, measurement and control of ships magnetic and electric
signatures so that a vessels profile can be minimised.
o Gas turbine electric start and regeneration systems used by the US
Navy and the Royal Navy.
o Transit system power equipment direct current systems used in
trains, trams.
o Nuclear reactor electric power drives moves the central rods to
regulate the output of a nuclear reactor.
Tactical & Sonar Systems (TSS)
TSS represents 38% of group revenue and 39% of group EBIT. The division
provides high capacity tactical radios, tactical surveillance and visualisation systems,
and anti-submarine warfare equipment such as sonar processors, anti-torpedo
defence and sonobuoys.
The division is affected by US budget cuts and contract delays and the continued
effect of lower tactical radio sales (2,000 sold in 2010, but only 52 in 2013); partially
offset by good sales in the US for anti-submarine warfare as part of the US
Militarys long-term strategic shift towards Asia-Pacific (Pivot to Asia-Pacific),
strong performance on a UK crypto programme, and further sales of surveillance
systems in both the UK and US.

314
TSS revenue and margin profile TSS revenue by market

Capabilities

Tactical systems
o Data link systems links naval, land, and airborne users to their home
base; including communications links that can penetrate buildings,
caves and bunkers, and that are resilient to conventional electronic
warfare counter-measures.
o Cryptographic systems.
o Command, control and information systems and battlespace
visualisation ability to represent data visually and track personnel.
o Airborne targeting pods equipping the UKs Eurofighter Typhoon
and Tornado aircraft with reconnaissance and air-to-ground targeting
capabilities.
o Electronic warfare equipment ability to monitor and analyse
communications and radar signals at all frequencies, and deploy
counter-measures.
o Nuclear incident management systems.

Sonar systems
o Airborne acoustic detection and sonobuoys.
o Torpedo defence and acoustic warfare systems that detect and locate
incoming torpedoes and provide the means to decoy or jam their
homing mechanism, through acoustic counter-measures; used by the
Royal Navy.
o Mine disposal systems supplier to the Royal Navy.
o Long range acoustic hailing and mass notification devices use for
bird clearance, active noise cancellations and avalanche initiation.
o Structural integrity monitoring for gas storage tanks and pipelines.

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17%
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Tactical & Sonar Systems Margin (rhs)
38%
60%
2%
Security & Cyber
Defence
Transport & Energy

315
Markets overview
Revenue by geography Revenue by market

US defence
The near-term outlook has improved, with the two-year Ryan-Murray Budget
Act leading to an enacted FY 2014 budget and executable FY 2015 budget request,
deferring the risk of further sequestration cuts until 2016. Services are still facing
cuts (the US Bipartisan Budget Act has moderated cuts to the defence investment
budget to 8% in FY 2014 and 2% in FY 2015), and as a result they are having to
prioritise programmes, with fewer new contracts being awarded and more upgrades
being undertaken instead. Management sees the move towards upgrades as a
positive trend for Ultra.
The result of this prioritising means that the US Armys Ground Combat Vehicle
programme is essentially dead (80% of the budget cut), while the major naval and
aircraft programmes have obtained the necessary funding (the US Navy was
awarded $950m more than budget). Ultra expects intelligence, surveillance and
reconnaissance capabilities to be prioritised. Programmes of note for Ultra that
continue to be funded include the Virginia class submarine, the Littoral combat
ship, and the F-35 JSF. This prioritisation of naval and aircraft programmes reflect
the Pivot to Asia-Pacific strategy. Ultras biggest military exposure is naval (66% of
total defence revenue), while its smallest exposure is to land-based programmes
(10%), with the remainder being made up of air programmes (24%).
Non-US defence
In Europe, the procurement process has been dislocated. In the UK, the defence
equipment budget has been re-set around a defined core programme. Further cuts
are likely at the next Comprehensive Spending Review, but there are signs that the
equipment acquisition budget will remain stable for the short-term. However, on-
going reorganisation of the MODs procurement process does generate the risk of
additional delays and programme uncertainty.
Outside of the US and European markets, there is a general uptrend in defence.
Ultra is well-positioned in the Middle East and Turkey, eg as the leading supplier of
sonar systems to the Turkish navy. The company is looking at the emerging
opportunities in Brazil and India. The latter is investing heavily in its blue water
naval capability, with a build programme of five or six ships a year for the next 10
years. There are also opportunities in India in other areas, such as high-capacity
radios. There are short-term defence cuts in Australia as part of government deficit
reduction, but there remain long-term programme opportunities for the firm. The
33%
8% 44%
15%
UK
Mainland Europe
North America
RoW
23%
57%
20%
Security & Cyber
Defence
Transport & Energy

316
government has committed to return defence spending back to 2% of GDP within
a decade.
Transport
Ultra is positioned to take advantage of secular trends in civil aviation, through
long-term positions in OEM, spares and overhaul that will last 20-25 years.
Infrastructure spending in passenger transport systems in both the developed and
developing world is strong. Ultra should benefit from these opportunities, with the
groups role as master systems integrator for the Muscat and Salalah airports in
Oman establishing its capabilities in the airport infrastructure market, although this
contract has been delayed, resulting in revenue deferred until 2016.
Rail infrastructure spending is another growth area, driven by Crossrail and the
possibility of HS2 in the UK as well as a strong export market. Ultra is positioned
to take advantage through its established specialist trackside power capability. As a
result, the 40m revenue derived from transport will double in five years, even if
no new orders are secured.
Energy
In the US, the government has approved four new-build Westinghouse reactors,
which will all use Ultras specialist sensors. The group has continuing involvement
in Chinas civil nuclear reactor build programme. Elsewhere, there is an emphasis
on nuclear plant life extension programmes, which management claims is positive
for the groups safety systems and sensors capabilities.
Security and cyber
Security budgets are growing in the face of terrorism, organised crime, drug
trafficking and other cyber threats. However, the legal intercept market has been
affected by the Snowden Affair; as a result, Ultra is repositioning itself towards
anti-narcotics, especially in Latin America.
There is also a worldwide concern about the security of energy, particularly from
cyber attack. Energy firms have recently been refused insurance cover against cyber
attacks because their defences are too weak. Ultra claims to have ready-made
technology that resolves these problems.


317
Financials


Sales 761 745 787 843 868

Cost of sales -535 -524 -571 -613 -630
Gross profit 226 221 217 230 238
Distribution expenses -1 -2 -2 -2 -2
Administrative expenses -141 -126 -133 -143 -147
Other operating expenses -2 -38 4 4 4
EBIT 88 57 87 91 94

EBITDA (adj) 136 136 138 153 159
Depreciation -11 -11 -12 -13 -14
EBIT (adj) 122 122 122 136 140
Unusual or infrequent items -1 9 0 0 0
EBIT 88 57 87 91 94

Other financial result 1 0 -5 -5 -5
EBT 80 49 77 78 82
EBT (adj) 117 117 117 128 133

Other taxes 11 17 8 11 12
Tax rate 23% 23% 26% 26% 27%

Net income 61 38 57 57 60
Net income (adj) 87 88 88 96 99


EPS (reported) (p) 88.1 54.8 81.3 81.1 84.6
EPS (adjusted) (p) 125.2 126.7 125.9 135.8 139.6



318
Balance sheet

Fixed Assets 505 458 539 513 472

Inventories 52 58 73 83 91
Derivative financial instruments 2 3 3 3 3
Current assets 288 337 352 362 370

TOTAL ASSETS 793 795 890 875 841

Shareholders' equity 314 320 352 380 409
Long-term debt 46 73 73 73 73

Bank loans and other borrowings 28 0 66 26 -35

TOTAL LIABILITIES 793 797 893 878 844



319
Cash flow statement
GBP m 2012 2013 2014E 2015E 2016E

EBITDA (adj) 136 136 138 153 159

Interest paid -5 -4 -5 -8 -7
Cash tax -26 -26 -20 -20 -22

Capex -20 -14 -15 -15 -15
Payments for acquisitions -35 -22 -107 -14 0
Financial investments 1 3 2 2 2


Dividends paid -27 -28 -30 -33 -34
Others 0 1 0 0 0

Net cash flow 3 1 -66 40 60




320
Ratios
Ratios 2012 2013 2014E 2015E 2016E

Valuation
EV/sales 1.6x 1.7x 1.8x 1.8x 1.7x
EV/EBIT (adj) 9.4x 10.5x 11.3x 11.3x 10.4x
P/E (adj) 11.8x 13.2x 14.1x 14.1x 13.4x
P/FCFPS 10.1x 20.1x 28.4x 18.7x 15.7x
Dividend yield 2.6% 2.4% 2.4% 2.4% 2.6%

Growth rates
Sales 3% 4% -2% 3% 4%
Sales organic 3% -4% -4% 1% 3%
EBIT (adj) 11% 0% 0% 1% 6%
EPS (adj) 11% 0% 1% 0% 5%
EPS -1% -8% -38% 59% 7%
DPS 11% 4% 6% 3% 5%

Financial ratios
FCF conversion 104% 70% 87% 78% 85%
Net gearing 14% 12% 12% 14% 4%
Net debt/EBITDA 0.3 0.3 0.3 0.4 0.1
ROCE 27% 26% 25% 23% 24%
ROIC 23% 20% 20% 19% 19%
WACC 8% 9% 9% 7% 7%
FCF ROCE 30% 16% 12% 16% 20%
Working capital/sales -3% -1% 3% 5% 6%

Key financials

Sales 732 761 745 770 804
EBIT margin (adj) (%) 16.7% 16.0% 16.3% 16.0% 16.2%
EBIT (adj) 122 122 122 123 130
EPS (adj) (p) 125.1 125.2 126.7 126.3 133.0
DPS (p) 38.5 40.0 42.2 43.6 45.8

Free cash flow 101 57 44 67 80
Acquisitions and disposals -142 -35 -22 -52 -10
Net cash flow -64 3 1 -14 40

Gross debt 87 74 73 87 47

Aerospace & Defence
321
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Please note that the use of this research report is subject to the conditions and restrictions set forth in the
General investment-related disclosures and the Legal disclaimer at the end of this document.
For analyst certification and remarks regarding foreign investors and country-specific disclosures, please
refer to the respective paragraph at the end of this document.
Disclosures in respect of section 34b of the German Securities Trading Act
(Wertpapierhandelsgesetz WpHG)
Company Disclosures

Airbus Group NV 5
BAE Systems plc no disclosures
Cobham plc no disclosures
GKN plc no disclosures
Meggitt plc no disclosures
MTU Aero Engines Holding AG no disclosures
QinetiQ plc no disclosures
Rheinmetall AG 3
Rolls-Royce Holdings plc no disclosures
Safran SA 5
Ultra Electronics Holdings plc no disclosures

(1) Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank) and/or its affiliate(s) was Lead
Manager or Co-Lead Manager over the previous 12 months of a public offering of this company.
(2) The Bank acts as Designated Sponsor for this company.
(3) Over the previous 12 months, the Bank and/or its affiliate(s) has effected an agreement with this company
for investment banking services or received compensation or a promise to pay from this company for
investment banking services.
(4) The Bank and/or its affiliate(s) holds 5% or more of the share capital of this company.
(5) The Bank holds a trading position in shares of this company.

Historical price target and rating changes for Airbus Group NV in the last 12 months (full coverage)

Date Price target - EUR Rating Initiation of coverage
16 June 14 60.50 Buy 16 June 14

Historical price target and rating changes for BAE Systems plc in the last 12 months (full coverage)

Date Price target - GBp Rating Initiation of coverage
16 June 14 445.00 Hold 16 June 14

Historical price target and rating changes for Cobham plc in the last 12 months (full coverage)

16 June 14 325.00 Hold 16 June 14

Historical price target and rating changes for GKN plc in the last 12 months (full coverage)

16 June 14 440.00 Buy 16 June 14

Historical price target and rating changes for Meggitt plc in the last 12 months (full coverage)

16 June 14 600.00 Buy 16 June 14

Aerospace & Defence
323
Historical price target and rating changes for MTU Aero Engines Holding AG in the last 12 months (full
coverage)

29 July 13 72.00 Hold 30 July 07
27 September 13 69.00 Hold
17 October 13 76.70 Hold
24 October 13 74.50 Hold
06 December 13 68.70 Hold
07 March 14 64.40 Hold
16 June 14 71.80 Hold

Historical price target and rating changes for QinetiQ plc in the last 12 months (full coverage)

16 June 14 225.00 Hold 16 June 14

Historical price target and rating changes for Rheinmetall AG in the last 12 months (full coverage)

17 October 13 42.00 Hold 10 April 03
16 June 14 62.50 Buy

Historical price target and rating changes for Rolls-Royce Holdings plc in the last 12 months (full
coverage)

16 June 14 1216.00 Buy 16 June 14

Historical price target and rating changes for Safran SA in the last 12 months (full coverage)

16 June 14 62.50 Buy 16 June 14

Historical price target and rating changes for Ultra Electronics Holdings plc in the last 12 months (full
coverage)

16 June 14 1970.00 Hold 16 June 14

Berenberg Equity Research ratings distribution and in proportion to investment banking services,
as of 01 June 14

Buy 42.47 % 62.07 %
Sell 15.66 % 3.45 %
Hold 41.88 % 34.48 %

Valuation basis/rating key
The recommendations for companies analysed by Berenbergs Equity Research department are made on an
absolute basis for which the following three-step rating key is applicable:
Buy: Sustainable upside potential of more than 15% to the current share price within 12 months;
Sell: Sustainable downside potential of more than 15% to the current share price within 12 months;
Hold: Upside/downside potential regarding the current share price limited; no immediate catalyst visible.
NB: During periods of high market, sector, or stock volatility, or in special situations, the recommendation system
criteria may be breached temporarily.

Aerospace & Defence
324

Competent supervisory authority
Bundesanstalt fr Finanzdienstleistungsaufsicht -BaFin- (Federal Financial Supervisory Authority),
Graurheindorfer Strae 108, 53117 Bonn and Marie-Curie-Str. 24-28, 60439 Frankfurt am Main, Germany.
General investment-related disclosures
Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank) has made every effort to carefully research
all information contained in this financial analysis. The information on which the financial analysis is based has been
obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the
relevant specialised press as well as the company which is the subject of this financial analysis.
Only that part of the research note is made available to the issuer (who is the subject of this analysis) which is
necessary to properly reconcile with the facts. Should this result in considerable changes a reference is made in the
research note.
Opinions expressed in this financial analysis are our current opinions as of the issuing date indicated on this
document. The companies analysed by the Bank are divided into two groups: those under full coverage (regular
updates provided); and those under screening coverage (updates provided as and when required at irregular
intervals).
The functional job title of the person/s responsible for the recommendations contained in this report is Equity
Research Analyst unless otherwise stated on the cover.
The following internet link provides further remarks on our financial analyses:
http://www.berenberg.de/research.html?&L=1&no_cache=1
Legal disclaimer
This document has been prepared by Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank). This
document does not claim completeness regarding all the information on the stocks, stock markets or developments
referred to in it.
On no account should the document be regarded as a substitute for the recipient procuring information for
himself/herself or exercising his/her own judgements.
The document has been produced for information purposes for institutional clients or market professionals.
Private customers, into whose possession this document comes, should discuss possible investment decisions with
their customer service officer as differing views and opinions may exist with regard to the stocks referred to in this
document.
This document is not a solicitation or an offer to buy or sell the mentioned stock.
The document may include certain descriptions, statements, estimates, and conclusions underlining potential market
and company development. These reflect assumptions, which may turn out to be incorrect. The Bank and/or its
employees accept no liability whatsoever for any direct or consequential loss or damages of any kind arising out of the
use of this document or any part of its content.
The Bank and/or its employees may hold, buy or sell positions in any securities mentioned in this document,
derivatives thereon or related financial products. The Bank and/or its employees may underwrite issues for any
securities mentioned in this document, derivatives thereon or related financial products or seek to perform capital
market or underwriting services.
Analyst certification
I, Andrew Gollan, hereby certify that all of the views expressed in this report accurately reflect my personal views
about any and all of the subject securities or issuers discussed herein.
In addition, I hereby certify that no part of my compensation was, is, or will be, directly or indirectly related to the
specific recommendations or views expressed in this research report, nor is it tied to any specific investment
banking transaction performed by the Bank or its affiliates.
Aerospace & Defence
325
Remarks regarding foreign investors
The preparation of this document is subject to regulation by German law. The distribution of this document in other
jurisdictions may be restricted by law, and persons into whose possession this document comes should inform
themselves about, and observe, any such restrictions.
United Kingdom
This document is meant exclusively for institutional investors and market professionals, but not for private customers.
It is not for distribution to or the use of private investors or private customers.
United States of America
This document has been prepared exclusively by the Bank. Although Berenberg Capital Markets LLC, an affiliate of
the Bank and registered US broker-dealer, distributes this document to certain customers, Berenberg Capital Markets
LLC does not provide input into its contents, nor does this document constitute research of Berenberg Capital
Markets LLC. In addition, this document is meant exclusively for institutional investors and market professionals, but
not for private customers. It is not for distribution to or the use of private investors or private customers.
This document is classified as objective for the purposes of FINRA rules. Please contact Berenberg Capital Markets
LLC (+1 617.292.8200), if you require additional information.
Third-party research disclosures
Company Disclosures

Airbus Group NV no disclosures
BAE Systems plc no disclosures
Cobham plc no disclosures
GKN plc no disclosures
Meggitt plc no disclosures
MTU Aero Engines Holding AG no disclosures
QinetiQ plc no disclosures
Rheinmetall AG no disclosures
Rolls-Royce Holdings plc no disclosures
Safran SA no disclosures
Ultra Electronics Holdings plc no disclosures

(1) Berenberg Capital Markets LLC owned 1% or more of the outstanding shares of any class of the subject
company by the end of the prior month.*
(2) Over the previous 12 months, Berenberg Capital Markets LLC has managed or co-managed any public
offering for the subject company.*
(3) Berenberg Capital Markets LLC is making a market in the subject securities at the time of the report.
(4) Berenberg Capital Markets LLC received compensation for investment banking services in the past 12 months,
or expects to receive such compensation in the next 3 months.*
(5) There is another potential conflict of interest of the analyst or Berenberg Capital Markets LLC, of which the
analyst knows or has reason to know at the time of publication of this research report.
* For disclosures regarding affiliates of Berenberg Capital Markets LLC please refer to the Disclosures in respect of
section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz WpHG) section above.
Copyright
The Bank reserves all the rights in this document. No part of the document or its content may be rewritten, copied,
photocopied or duplicated in any form by any means or redistributed without the Banks prior written consent.
May 2013 Joh. Berenberg, Gossler & Co. KG

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