Country Research Italy. It s not about Interest Rates. Italy would probably be as the weakest major Eurozone economy...

Transcription

1 See page 158 for Analyst Certification and Important Disclosures Industry Report EQUITY RESEARCH: EUROPE Country Research Italy 8 April 25 Roberto Casoni roberto.casoni@citigroup.com London Alessandro Falcioni alessandro.falcioni@citigroup.com Milan Mauro Baragiola mauro.baragiola@citigroup.com Milan Carmen Nuzzo carmen.nuzzo@citigroup.com London Gurvinder Brar gurvinder.brar@citigroup.com London Giulia Raffo* giulia.raffo@citigroup.com London Riccardo Rovere riccardo.rovere@citigroup.com Milan With Special Thanks to Pierluigi Amoruso * US investors please contact one of the other analysts If you wish to receive our Italian Team Research via , or be removed from our list, please contact: Simona Donati Product Co-ordinator (39-2) simona.donati@citigroup.com Made in Italy and all Smith Barney publications are available on the GEO (Global Equities Online) website. If you are not already registered as a GEO user and would like to access the service, please contact us and we will arrange a personal login. Made in Italy It s not about Interest Rates Italy would probably be as the weakest major Eurozone economy......but political reason could push the government towards a generous 26 budget: media and construction stocks to benefit A vista on the Italian insurance sector Italian banks would benefit from higher interest rates but also from foreign offers Real Estate Funds as a new investment class Quant analysis sees Amplifon, Brembo and Marzotto in the top ranking Our top picks among the small and mid caps are Amplifon, Marzotto, Campari, Pirelli Real Estate and Astaldi Value stocks with good potential in the long term are Interpump and Indesit Our top picks among the big caps are ENEL, Autostrade and Mediaset Smith Barney is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Europe

2 Made in Italy 8 April 25 Table of Contents Interest Rates Up Or Not Up: That Is Not The Question... 3 Italian Insurance Panorama... 7 Italian Banks Under Attack Italian Small- and Mid-Cap Panorama: A Quantitative Approach Real Estate Funds: The Italian Scenario Italian Mutual Funds February Data Collection Italian Macro Scenario Snapshots 41 Non-Rated Snapshots 137 2

3 Made in Italy 8 April 25 Interest Rates Up Or Not Up: That Is Not The Question Positive economic surprises are less likely in Italy We would focus on defensive characteristics......low gearing or debt at fixed rates Italian banks under foreign challenge ENEL offers the attraction of a solid dividend yield Interest Rates up or not up: that is not the Question Recent sell-off in some bond proxies triggered by higher inter rates and fears of further increase has provided a good entry level for a few Italian stocks (Enel, Autostrade). For others we believe a further re-rating is very company-specific and that any stronger economic activity will be only beneficial (Amplifon, Mediaset, Marzotto, Campari, Pirelli Real Estate, Astaldi). It is fair to point out that positive economic surprises are less likely in Italy given the lower than EU average growth rate. An expansionary fiscal policy might be adopted towards year-end with an overly generous 26 budget for obvious political reasons due to forthcoming election in spring 26. The two sectors that should continue to benefit from a potential confirmation of Berlusconi as Prime Minister are media and construction. Generally speaking, we believe the above stocks have enough defensive characteristics (either high div yield or sustainable good FCF yields or both) to fare well in a subdued economy (having mostly discounted sensitivity to interest rates in terms of DCF valuation) as well as benefit from economic recovery in that top line growth is higher than GDP. Also, most of these companies have either low gearing or debt at fixed rates. The sector that stands to benefit most from perceived higher interest rates is banking. Valuations in this sector have been pushed higher by the unprecedented opportunity offered by foreign 'invaders', namely ABN AMRO and BBVA, to be successful with their respective bids on Antonveneta and BNL. Further upside here is linked to ability of Bank of Italy to morally persuade a counter bidder among sceptical Italian big banks. Valuations currently seem to discount the achievement of synergies that have not even been achieved by national champions in the past. BNL appears more in play than Antonveneta (given the former s smaller size and paper-only offer), but we are in dangerous territory where only cognoscenti dare to play. As you know, we are much better in picking stocks on a bottom-up approach than top-down. ENEL offers the attraction of a solid dividend yield (4.7% in 25 and 5.1% in 26) with the likelihood of a further increase triggered by the forthcoming sale of WIND. This being the case, ENEL would have the opportunity to re-leverage the balance sheet by 3.7 billion and investors would get a.5 div (6.7% dividend yield) for the next five years as the extra.61 additional dividend is unlikely to be paid out as a one-off jumbo. On the operations, ENEL should be able to cut costs further by 3mn due a combination of better fuel mix and further redundancies and rationalisation. The announcement of the placement of a further 2% is not going to be a cap for the stock, as the market has been eager to buy higher stakes in the recent past, and we anticipate strong retail appetite. We have a 8.1 target price driven by SOP valuation at which point ENEL would still trade at 4% discount vs peers on EV/EBITDA. 3

4 Made in Italy 8 April 25 We believe the strong visibility (and low risk) of Autostrade s underlying business should underpin valuations Amplifon combines aggressive acquisition strategy with visible organic growth Astaldi as the best pick in the fast growing construction sector in Italy Campari is the sixthlargest spirits producer by volume worldwide Marzotto announced spin-off would make investors to focus on the luxury division of the company Autostrade has de-rated on the back of market expectations of a rise in interest rates. In a recent report, we challenged current market valuations by building into our valuation model (DCF-based) the forward interest rate curve (of a 1-year bond), which incorporates the market expectations of a rise in rates (3-4bps within 1 year, still arriving at our new price target of 28.2, up from 2.34). We believe the strong visibility (and low risk) of Autostrade s underlying business should underpin valuations, even with the possibility of delayed approval of work on new construction projects. We would further add that the adoption of new accounting principles later this year could significantly favour dividend payment (potentially doubling the current forecast 2.1% yield). Amplifon is, in our opinion, a perfect holding for long-term investors. The company is implementing a new and more aggressive acquisition strategy that, combined with the visible organic growth typical of the hearing aid industry, should lead to around 1. billion sales by (vs 49 million in 24). Strong free cash flow generation and current financial resources can support the strategy. Margins are also set to improve, thanks to strong purchasing power. According to the plan, EBITDA should more than double in three to four years, hence the theoretical fair value. The possibility of merging with Impregilo and giving birth to the largest Italian construction/general contractor player has evaporated. Nevertheless, we still believe that Astaldi is the best pick within this fast-growing sector in Italy (Berlusconi promised to invest 125 billion on infrastructures and he is somehow delivering) with a strong ability to finance projects. The current business plan estimates a doubling of 24 net profit by 26. The concessionary activities put in place will begin to have an impact only from 27 and should produce a further acceleration in bottom-line growth. Campari is the sixth-largest spirits producer by volume worldwide. At first glance investors might be tempted to value Campari using a straight peer comparison. However, in our view this methodology doesn t allow financial investors to fully price in all of Campari s features. We believe that the Italian group has a different risk profile from the heavyweights competing in the sector. It normally targets smaller, strong, local brands and has proven it can make a very good use of the cash it produces. About 17% of sales are transformed into free cash flow every year and is re-invested in order to reach a sales and Ebitda CAGR of 15% (average of the past five years) despite the fact that the market organically grows no more than 5%. Marzotto has announced the spin-off of the textile division, and from July 25 there will be two separate stocks listed: Marzotto Textile and Valentino Fashion Group. The textile operations are left with 12m debt, offset by financial assets and properties with an estimated market value of 14m. The JV with Verzoletto increases the chances that this company will not only continue to be a good cash generator ( 15m in 4) but can also improve its EBIT to around 5% (from 1% pro forma in 4) by We have valued the Textile business at a market cap of 175m, or 2.42 per share. As a consequence Valentino FG implicit market price is 13.7 per share, which would put it at around 11.8x PE6 compared to a sector average of 18x. Trading at Valentino FG is sound: Valentino is expected to more than double sales by 7-8 to E3m, and EBIT margin is expected by the company's management to exceed 15% by 26 (from 1% in 24). Hugo Boss is expecting top line to grow 7-9% in 25 with improving margins. 4

5 Made in Italy 8 April 25 Pirelli Real Estate remains a good play in the fast-growing property service market Benetton under competitors pressure Fastweb s ARPU to be driven down by competition Indesit could benefit from the consolidation of the European market Interpump could gain attention thanks to new acquisitions Pirelli Real Estate remains a good play in the fast-growing property service market. The stock combines a clear market leadership (3% market share), favourable change in the regulatory environment (launch of real estate funds and opportunistic funds), strong management team with international expertise, potential opportunities in segments such as NPLs backed by properties, dividend yield exceeding 4% to be distributed in May 25 and a business plan that targets a 2% EBIT CAGR between 24 and 26. Currently, we concerned about two stocks: Benetton and Fastweb: Benetton is suffering from increasing competitions in the markets, where historically the brand has been strong, and from a re-organisation that, contrary to the management expectations, does not have the full support from the franchisees network. The stock has suffered over the past two months after the decision of implementing a price cut strategy. We believe that per share discounts most of the negatives arising from the news. What is still to be understood is whether this is going to be the last time or not. Certainly the product is not considered hot and some of the franchisees have started left the group. Fastweb s recent rights issue was based on financing a new and accelerated (compared to the previous one) investment plan. On one hand we believe that the company s business model is just terrific, on the other we do not believe that the assumptions at the basis of the plan are correct. We believe that competitions will drive Fastweb s ARPU down. For this reason we remain sceptical on the stock. Some cheap stocks might remain cheap There are few stocks in Italy that are currently trading at low multiples (absolute) and that, despite this, struggle in recovering the lost ground. Indesit is probably the best known of those. Since September 24 the stock has suffered the impact of raw material price increase and fierce competitors coming from East. Mainly, the company has suffered from macro negatives as it continues to steal market share from the other two EU giants, Elettrolux and Whirlpool. In addition, we believed that a current (difficult) market conditions would have accelerated the consolidation process, as a result of the big pressure on the smaller players margins. Instead, in talking with the company, it looks like the situation is not evolving and that 25 targets still rely on a 3% price increase that the market might not easily absorb. Interpump might be a different story. The company (market leader worldwide in its segment pumps and power take-off) missed a trigger and the recent acquisition of Hammelmann Group might be the catalyst. Hammelmann is the world s leading manufacturer of very high pressure plunger pumps. We deem the acquisition a positive step for the Interpump group industrially, given the possible synergies with the industrial division of the group. Interpump has in the past heavily relied on acquisition growth and has a strong track record both in paying down acquisitions and integrating them well and generating strong synergies with the rest of their business. This time, the price paid is a little bit higher than usual (9x 24 EBIT) but the impact will be positive anyway. Before this acquisition (announced the 6th of April), Interpump traded at 9x P/E 25: this is a cheap stock that might not remain cheap. 5

6 Made in Italy 8 April 25 The document includes also a section prepared by our Quantitative Analysis team and focused on the Italian Mid/Small Caps (below 5. billion market capitalisation). The result of the analysis highlights Amplifon and Brembo as the best-ranked two stocks under our coverage. Marzotto, Campari and GranitiFiandre are included in the second decile. Within the companies that will be presenting at the New York conference on the 13th of April and on which we have produced a non rated snapshot, the best rankings, according to our Quantitative team, are reached by Zignago (wine and glass), Buzzi- Unicem (cement), Recordati (pharmaceutical), Aedes (real estate) and Sogefi (auto component). If we limit the ranking of attractiveness based only on value and growth criteria, the analysis highlights Sogefi, Buzzi, AEDES, Socotherm (coating for oil pipes) and Sorin (med tech). 6

7 Made in Italy 8 April 25 Italian Insurance Panorama 1 We are initiating coverage on the Italian insurance sector with an underweight stance relative to the rest of Europe Five consecutive years of outperformance have left the Italians at a premium relative to their European peers Reasonable growth prospects in life and savings appear to be largely discounted in current share prices, particularly given the margin risk In addition, we see little scope for a fall in the cost of capital, given the low starting point Our preferred name is Generali from a combination of margin resilience, better near-term earnings momentum, larger scope for return on capital improvements and stronger positioning on pension reform Initiating on Italian insurance lacking relative value We are initiating coverage of the Italian insurance sector, with an underweight stance relative to the rest of the European insurance sector. Whilst we are bullish on the European sector as a whole, believing growth and/or a potential fall in the cost of capital is not fully discounted at current share prices we see less attractive opportunities within the Italian subsector. On the one hand the scope for a fall in cost of capital is considerably less (implied betas are near or below 1); on the other hand, realistic life and savings growth (particularly given higher margin risk) is discounted in current share prices in our view. Key risks to a relative underweight stance on the Italian insurance subsector include: (1) these stocks (apart from Mediolanum) have defensive characteristics, that could be attractive in the event of weaker-than-expected equity markets; (2) there could be more upside from balance sheet restructuring (additional leverage, increased repatriation) than we have given credit for; (3) we are relatively cautious on the medium-term outlook for life margins, they could prove to be more resilient; (4) we are still reluctant to ascribe significant uplifts from the transfer of TFR flows into pension products given uncertainty on the final framework and the likely significant role of group pension schemes, with lower margins and participation of non-insurers; this could prove to be too conservative if transfers to individual personal pensions (PIPS) are higher than expected. Our initiation recommendations and target share prices are summarised below: Italian stocks are listed in order of preferences. 1 This is an excerpt from Italian Insurance Basta Pasta, Smith Barney, 9 March 25. 7

8 Made in Italy 8 April 25 Figure 1. Italian Insurers Recommendation, Target Price and Potential Upside/Downside Recommendation Current Price ( ) Target Price ( ) Expected Total Return Expected Share Price Return Expected Div Yield Generali Hold/Medium Risk % 1.9% 1.6% RAS Hold/Low Risk* % 1.6% 5.% Alleanza Hold/Medium Risk * 6.3% 2.9% 3.5% Mediolanum Sell/High Risk % 2.4% 2.2% Italian Average 3.2% Sector Buys Average Upside 9% Share prices as at 2 March 25. *Please note that since the original report was published the RAS rating has been changed to 2M (5 April) and Alleanza target price has been reduced to 1.4 (24 March). Source: Smith Barney estimates. Looking at the investment case The Italian insurance sector offers some attractions as an equity story: Top-line life sales growth should continue to be reasonable: (1) the promotion of a wider range of products by revitalised agency/financial advisor networks; (2) linked to this further scope for switching out of mutual funds into insurance products; (3) potentially some additional benefit from completion of pension reform (or at the very least use of this issue as a marketing tool in general). Non-life top-line growth should also be solid pricing pressure is not particularly evident yet, and non-motor lines are still relatively underpenetrated versus the rest of Europe. Dividend prospects for a stock like RAS (committed to lowering the level of excess capital) are resilient; there may be more upside in this area in the case of Generali and Alleanza (although we are sceptical). In any case some investors may see the strong capital and cash flow position of the Italians as an attraction in more volatile market conditions. However, we also highlight a number of other issues Unattractive relative performance and valuation The Italians outperformed the wider insurance sector by some 12% in 24, having performed well in relative terms for several years (apart from during the 23 post early March bounce). 8

9 Made in Italy 8 April 25 Figure 2. Italian Insurers Performance Relative to European Peers Mar- Aug- Mar-1 Aug-1 Feb-2 Aug-2 Feb-3 Aug-3 Feb-4 Aug-4 Feb-5 Sources: Datastream and Smith Barney. Italian Insurers Relative to Europeans Figure 3. Italian Insurers Relative to European Equity Markets, European Insurers and Italian Banks Sources: Smith Barney and Datastream. vs DJStoxx vs European insurers vs Italian Banks The valuation stands at an average P/EV of 1.7x (or 1.6x P/EV excluding Mediolanum), for an average estimated normalised ROEV of 12% or (11% excluding Mediolanum). This compares to the sector average P/EV of 1.4x, for average returns of 12%. Some premium may be justified by solid long-term growth prospects and/or a lower cost of capital. However, we would highlight risks such as interest rate or new business margin related are arguably higher than other parts of Europe. 9

10 Made in Italy 8 April 25 Figure 4. Italian Insurers Valuation are Towards the Top-End of the Sector P/EV 4E versus Normalised RoEV 22% 2% Line of Fair Value Beta 1.35, LTG 2.9% Mediolanum 18% 16% 14% 12% 1% Converium Britannic Skandia RSA Alleanza Generali Swiss Re Swiss Life Munich Baloise Mapfre RAS AGF Storebrand Aegon FP Average Aviva L&G Allianz AXA IPM Prudential ING Fortis Zurich 8% 5.% 7.% 9.% 11.% 13.% 15.% 17.% Source: Smith Barney estimates. Relative to earnings headline, earnings multiples are not useful (given accounting differences, not least as a result of an absence of use of acquisition cost deferral). Embedded value operating earnings multiples are more useful the Italians trade at an average 13x 25E EV earnings, for 24-6 estimated CAGR of 9%, compared with the sector at 1x 25E EV earnings and a 24-6 estimated CAGR of 8%. Figure 5. Estimated P/E on 25E EV Operating Earnings versus 24-6E CAGR in EV Operating Earnings P/E 5E (on EV Earnings) 4-6 CAGR in EV Earnings Generali % RAS % Alleanza % Mediolanum % Italian Average % Sector Average 1. 8.% Source: Smith Barney estimates. Relative to fundamental valuations we have run base case, bear case and more optimistic scenarios (summarised below). Key sensitivities stressed for include: (1) new business margins; (2) combined ratio; (3) potential upside from pension reform. We note an average 3% upside to base case valuations, 11% downside to bear and 1% upside to more bullish valuations. Figure 6. Potential Upside/Downside to Target Price, Bear Case and Best Case Fair Value (Euros) Base Case Upside/ Downside Bear Case Upside/ Downside Best Case Upside/ Downside Generali % % % RAS % % % Alleanza % % % Mediolanum % % % Average 3.2% 1.8% 9.7% Source: Smith Barney estimates. 1

11 Made in Italy 8 April 25 Examining implied life new business profit multiples is problematic given the noise from valuations of the other businesses and debate over the appropriate discount to apply to the face value of life in-force/embedded values. However, we see this approach as increasing in importance with advent of European embedded value (given less debate about the in-force), and a renewed focus on growth. Deducting estimated fair values for each business, then the life EV (with an appropriate discount applied) we see the average implied multiple of 25E new business profits for the Italian stocks is at around 14x on average. This compares with a sector average (excluding the Italians) of around 1x. In our view the implied multiple of the Italians looks relatively full top-line growth prospects are solid, but there are margin risks. Figure 7. Estimated Implied New Business Multiples the Italian Names are at the Rich End of the Sector (Local Currency in Millions Except per Share Data) Aegon Allianz Aviva AXA Fortis ING Legal & General Prudential Generali RAS Mediolanum Alleanza Share Price Shares in Issue 1, ,262 1,914 1,298 2,175 6,513 2,36 1, Market Capitalisation 16,62 35,544 15,21 39,72 27,743 51,59 7,62 11,889 32,219 11,888 4,7 8,82 Add Non-Equity Capital 7,632 11,3 4,978 7,216 4,35 13,295 1,121 2,65 7,335 Gives Enterprise Value 24,234 46,844 2,179 46,936 32,93 64,84 8,741 14,494 39,554 11,888 4,7 8,82 Deduct Fair Value of: Non-Life 1,786 2,683 7,825 1,162 3,19 3, ,87 3,98 Banking 9,221 2,875 24, Asset management 8, ,32 1,444 3, ,575 3,926 1, Other ,552 5, Undeployed Capital 1,85 2,9 8 1, , Adjust for Pension Deficit 1, , Adjust for Central Costs 523 9,423 1,63 2,34 1, Leaves Implied Value of the Life Business 22,966 15,41 14,49 32,268 7,777 28,21 8,618 12,66 25,156 6,16 2,981 7,817 Life EV (Ranging from face value to 1% discount) 18,876 13,119 1,141 23,328 8,236 19,673 5,88 6,965 13,14 3,91 1,334 4,46 Life New Business Profit ' Implied Life Multiplier Source: Smith Barney estimates. Margin risk has been a worry for some time, but now there are potential catalysts for a greater focus on the issue Reported new business margins are materially higher in this region than elsewhere in the world (including some of the very high margin Asian markets). We see some margin risk to these margins going forward. This is clearly not a new issue; we are aware analysts have been focused on this risk for some time. In actual fact, despite this concern margins have proved resilient in recent years (even increased in some cases). Various explanations can be given for the higher margins including: (1) use of life companies domiciled in the low tax regime of Ireland; (2) use of more aggressive EV assumptions (in respect of risk margin and capital allocation); and (3) charging structures (relatively generous up-front loadings, greater occurrence of unit linked double charging structures). We see heightened margin risk in the context of pension reform, which may involve competition from cheaper group pension products (see below). Whilst this may focus specifically on the PIP product there is clearly a risk of contamination to other product areas. In any case there appears to be heightened regulatory interest in issues associated with charging. For example last year the Bank of Italy recommending changing performance fee charging structures for mutual funds. 11

12 Made in Italy 8 April 25 In addition, ISVAP (the insurance regulator) has issued indications that increased transparency of life charging structures (for example including annual reduction in yield) will be required. A research study undertaken by Centre for Research on Pensions and Welfare Policies (CERP) analyzed and compared the costs associated to both open pension funds and PIPs. The main outcome of the analysis is the existence of a wide discrepancy between the two product propositions: Open funds appear to have fairly low costs, in line with other European countries and not too far from closed funds charges. PIPs, instead, are characterised by significantly higher level of charges. Figure 8. Estimated Costs for Personal Pension Plans Based on Constant Real Contributions of 1, Final Pension Wealth Charge Ratio Equivalent Loading Annual IRR Reduction In Yield Equivalent Annual Charge Open funds average 21, % 8.22% 3.45% 1.55% 1.7% Worst 21, % 12.49% 2.9% 2.1% 1.67% Best 22, % 4.71% 3.89% 1.11%.6% PIP average 2, % 16.64% 2.32% 2.68% 2.29% Worst 18, % 23.81% 1.27% 3.73% 3.46% Best 21, % 9.49% 3.3% 1.7% 1.25% Source: CERP. Pension reform not necessarily a straightforward upside On the subject of pension reform itself we would caution that potential upside for insurers is not necessarily that straightforward: (1) much has yet to be finalised in respect of the finer details (rules of transfer, portability, taxation rules for the invested assets, rules governing the management of assets, rules governing charging levels); (2) uncertainty on the extent to which employees will choose to transfer their severance pay into pension products (given potential pressure from trades unions/employees to leave within the TFR); (3) uncertainty on the extent to which pension flows go into group open/closed schemes instead of personal (PIPS) these group schemes will have significantly lower margins and will also be managed by non-insurers (asset managers/banks). Low interest rate risk cannot be ignored Whilst our in-house view is that long-term interest rates are set to rise in Europe they are still likely to remain in a range lower than recent history (particularly pre-euro entry). In Italy a significant part of the in-force business (see below for Generali) is subject to guarantees (averaging 3%-3.5%), in many cases liabilities are longer than invested assets. Much work has been done to minimise mismatches and reinvestment risk and new business has been redesigned (guarantees apply to maturity value not annual return). The effective embedded option cost of the new design new business is significantly lower, although in-force risks from low interest rates are still an issue. In looking at embedded value disclosure, a downward shift in interest rate assumptions by 1% would lower life EVs on Generali, Alleanza and RAS by an average 4% (net of a shift in risk discount rate). This is higher than a European average of around 2% (excluding the Swiss names). 12

13 Made in Italy 8 April 25 It could be argued that, given the use of an aggressive risk margin (around 2bp lower than the European average) it may be generous to shift risk discount rate and investment return assumptions in tandem, rather any change of assumptions involving lower interest rates should shift assumed investment returns by more than risk discount rates. Figure 9. Generali Italian Life Technical Reserves Split by Type of Guarantee Specific Asset Provision 5% Nil 6% At Maturity 21% Annual Roll-up 68% Source: Company reports. Figure 1. Estimated Impact of a 1bp Drop in Investment Yield on Italian Insurers EV Impact on Life EV Impact on Total EV Impact on Life EV (RDR unchanged) Impact on Total EV (RDR unchanged) RAS 1.4% 4.8% 15.2% 7.1% Generali 5.2% 3.2% 11.9% 7.6% Alleanza 6.7% 5.% 12.6% 9.4% Sources: Company reports and Smith Barney estimates. It is harder to see restructuring upside relative to recent history Restructuring efforts by the Italian insurers have been a significant contributor to improved returns and valuations in recent years at least in the case of RAS (under Greco s leadership) and Generali (with improved performance measurement initiatives). The outcome of these restructuring efforts is impressive, but we feel the market has rewarded this. Going forward, getting earnings or valuation upside from operational initiatives will be considerably more challenging: In the case of RAS product innovation is now the key driver of growth, but may bring with additional margin risk. At Generali, further upside requires more attention on the group s capital structure and work on improving returns from a collection of miscellaneous lowreturn investments, both of which are hard to execute. At Alleanza, a new CEO may bring some new momentum to the group, but we see problems such as the drag from excess capital or the run-off of a large old book as more protracted. 13

14 Made in Italy 8 April 25 Italian insurance sector in the context of the wider European sector Ultimately we need to think about the Italian insurers in the context of our wider views on the European insurance sector as a whole. We are positive on the sector as a whole because: We see long-term growth as not being fully discounted in share prices. We see scope for a reduction in the sector s cost of capital, assisted by developments such as the advent of European embedded value (which more appropriately deals with risk). How do the Italians fit in with this broader sector view? In respect of growth, we see good long-term top-line growth in the Italian market, but greater margin risk than elsewhere in Europe. In respect of the cost of capital the Italian insurers already have a significantly lower beta than the rest of the sector, the scope for a cost of capital reduction appears less (see chart below). The exception is Mediolanum a significantly more equity geared play. Figure 11. Two-Year Adjusted Beta versus DJ Stoxx Generali RAS Alleanza Swiss Re Aviva Mediolanum Average ZFS AXA Prudential Allianz ING Munich Re Aegon Source: Bloomberg. European embedded value and the Italians European embedded value involves: Explicit allowance for guarantees and options; Expanded sensitivity analysis; and Fuller assessment of the appropriate level of capital to hold for the business. 14

15 Made in Italy 8 April 25 We see the adoption of European embedded value as a potential positive for the sector to the extent that it increases confidence in embedded value as a valuation reference. We hope that increased confidence in in-force value will move investment debates on to considerations of appropriate multiples for new business rather than the correct discount to apply to embedded value. We foresee less upside in respect of this for the Italians than the rest of the sector (not least as implied new business multiples are higher). In our view the existing calculation base of the Italians is relatively aggressive in the risk margin and capital allocation being used (see table below). Generali has given broad indications on European embedded value in respect of its Italian business, suggesting that the impact is relatively minor given their belief that the existing risk margin already reflects much of the potential cost of options and guarantees (so once guarantee costs are deducted there is a compensating effect of a lower risk discount rate). We would expect the treatment adopted by Generali to be that adopted by the other Italians in effect the actual reported impact of EEV will be minimal. However, we would point out there is less scope for use of a lower discount rate with the Italians compared with the rest of the sector, given the relatively aggressive starting point. In addition, it could be argued investors may be less willing to give credit for enhanced EV given the likelihood that lower than average risk margins will continue to be used. Figure 12. Italian Insurers EV Assumptions Appear Aggressive Relative to European Peers EV ASSUMPTIONS Solvency Risk Discount Rate Risk Free-Rate Risk Premium RDR-Equity Return RAS EU min 6.85% 4.14% 2.71%.% Alleanza EU min 7.25% 4.5% 2.75%.% Generali EU min 7.32% 4.63% 2.7%.14% Mediolanum EU min 7.25% 4.5% 2.75%.25% Average 7.17% 4.44% 2.73%.1% AXA Economic Capital 7.6% 4.48% 2.58%.7% Allianz Economic Capital 8.2% 4.3% 3.9%.55% Aegon 165% EU min 8.% 5.1% 3.%.% Fortis 173% EU min 7% 4% 3%.% ING 1.5x EU min 7.8% 4.68% 3.12%.3% ZFS Economic Capital 7.8% 4.5% 3.3%.3% Aviva EU min 7.82% 4.66% 3.16%.63% Prudential EU min 7.4% 4.8% 2.6%.1% Legal & General EU min 7.2% 4.7% 2.5%.1% Skandia EU min 7.5% 4.54% 2.52%.1% Swiss Life EU min 7.5% 3.5% 4.% 2.% Total average 7.46% 4.49% 2.97%.12% Sources: Company reports and Smith Barney estimates. Our stock views We have taken into consideration several factors in ranking the Italian insurance stocks: Margin resilience: (1) product dependence; (2) distribution channel mix (bancassurance margins are lower as a result of commission sharing arrangements and arguably more resilient); (3) dependence on Irish tax regime (not likely to change short term but more vulnerable longer term); (4) support from foreign operations (where margins are lower); and (5) vulnerability to regulatory interference/direct competition from group pension schemes. Non-life outlook: (1) further scope for improvement in liability lines; and (2) exposure to potential growth in non-motor lines. 15

16 Made in Italy 8 April 25 Flexibility and efficiency of the capital base (1) approach to excess capital; (2) willingness to liberate excess capital; (3) impact of excess capital on flexibility of overall returns. Taking these issues into account, we initiate coverage of the Italian insurers with the following ranking: 1 Generali is our preferred name given: (1) margin resilience with scope for improved efficiency at INA and in the foreign operations; (2) non-life profitability has some room left for improved profitability (at Assistalia); and (3) the group is the best positioned to benefit from any upside from pension reform given relationships with corporates, and existing role in managing group pension schemes. Offsetting factors that limit our recommendation to Hold include: (1) our average fair value is around 28, leaving insufficient upside, the current price/ev of 1.4x looks full relative to normalised returns of around 1.5%; and (2) the long-term return is limited by the group s capital structure (excess capital), we don t see this changing in the near term. 2 RAS enjoys the rare attraction of a solid growth profile supported by the repatriation of excess capital. Key strengths include: (1) good support from generous dividends; (2) solid outlook in non-life; (3) well positioned towards pension reform, albeit more dependent on personal pension versus group schemes; and (4) top class management. However, five years of outperformance and a highly visible management team have left little unexplored in our view. Our target price of 18 is very close to the current share price and the current P/EV of 1.8x appears full for an across-the-cycle return of c12%. In addition, we envisage relatively high vulnerability towards the level of product loadings across agencies and FAs, with the latter being also sensitive to the assumed tax rate (dependence on the Irish tax regime). 3 Alleanza key strengths are related to its: (1) leadership position in the Italian life market; (2) widespread distribution force, which leverages off a strong bancassurance platform and a large agency network; and (3) a good position to benefit from pension reform, albeit more dependant on personal pension versus group schemes. However, the good rally in the second half of 24 has left the share very close to their fair value, trading at 1.5x EV for a normalised RoEV of c.1% and at 15x 5E EV earnings. Our target price of 1.7 per share is very close to current share price 2, thus leaving a limited potential upside. In addition, we see the long-term return potential limited by the presence of excess capital, absence of leverage and by a relatively mature in-force book. 4 Mediolanum will face an increasingly challenging competitive market in our view as: (1) current life new business margins do not look sustainable, in particular in relation to the flagship products, unit-linked pension plans, which account for 7% of group s new business value; (2) forthcoming pension reform is likely to put pressure on current loadings and structure of pension plan products; (3) the sales network, a vital driver of growth or an asset gatherer, has shrunk in a context where main competitors were scaling up their networks; and (4) as the group s CEO moves towards retirement age succession risk increasingly threatens. 2 Please note that the Alleanza target price was reduced to 1.4 on 24 March, after publication of the original initiation report. 16

17 Made in Italy 8 April 25 Finally, we note that as goodwill accounts for over 5% of Mediolanum s market cap, the stock looks vulnerable to new sales and margin trends. Our valuation methodologies point to a range of fair values between 5.3 per share and 5.7 per share, from which we derive our price target of 5.4. What makes Italian stocks different from other European insurers? The Italian insurers under our coverage share a number of characteristics that distinguish them from other European insurers: EV new business margins are high in the domestic market at least for agency and financial advisors business (bancassurance margins are lower as a result of commission sharing arrangements). We believe that high margins reflect a number of issues: 1) more aggressive EV assumptions; 2) relatively generous product loadings (often up-front); 3) a significant assistance from double-charging in unitlinked products (management fees plus asset management and performance fees); 4) use of Irish tax regime; and 5) in some cases long duration assumptions. Figure E New Business Margins Across the Sector Italian Names Enjoy the Highest Margins Group New Business Margin 24e Principal Areas of Operation AGF 6.3% France AXA 15.9% France/US/Japan/UK Aegon 5.6% US/Netherlands ING 12.7% US/Netherlands/SEAsia Fortis 19.5% Benelux Aviva 13.5% UK/Pan-Euro Bancassurance Prudential 25.% UK/US/Asia Legal & General 3.% UK Zurich 11.4% UK/Switzerland/Germany Average Europe Ex Italy 15.5% Generali 17.1% Italy,France,Germany RAS 32.2% Italy, agents & bancassurance Alleanza 34.3% Italy, agents & bancassurance Mediolanum 5.8% Italy, personal pensions Average Italian Insurers 33.6% Average Italian Insurers, ex Mediolanum 27.9% Italian Domestic Agent/FA Business Only Generali 25.5% RAS 52.2% Alleanza 48.5% Mediolanum 5.8% Average 44.3% Italian Domestic Agent/FA Business as a % of Group APE Generali 3% RAS 41% Alleanza 54% Mediolanum 1% Sources: Company data and Smith Barney estimates. 17

18 Made in Italy 8 April 25 Capital and balance sheet structures are relatively inefficient compared with the rest of the sector, thus holding back overall returns. The Italian insurers are the best capitalised in Europe, a factor that has given them considerable resilience in periods of market volatility. The cash flow profile is also strong, particularly given the fact that new business strain is offset by high up-front loadings. Leverage is relatively low or non-existing; in particular, the use of qualifying hybrid instruments versus sector peers is highly limited. Several initiatives have been taken to address this issue: 1) RAS is committed to reducing the excess capital through large dividends (which is also helping its parent Allianz); and 2) Generali has focused on returns on allocated capital there are some plans to exploit excess capital through additional equity leverage for example; 3) both Generali and Alleanza have spun-off their real estate assets in a joint venture company, Generali Properties, which may facilitate easier liberalisation of excess capital in due course. However, we would point out that: 1) RAS s ability to assist returns with leverage is limited by restriction on debt raising from its parent company s existing leverage; 2) we are unsure of the willingness of Generali and Alleanza management to pursue more radical capital restructuring; and 3) it is possible that excess capital is retained as a buffer to cover interest rate risk/ mismatch issues in traditional life book. There has been more product innovation than other parts of continental Europe, albeit unit linked are still less developed than the US and UK The Italian savers have shown considerable risk aversion in recent years, as witnessed by equity fund outflows and the collapse of unit-linked sales (about 4% of 2 levels on our estimates). Sales of traditional regular and single premium business have performed particularly well, given the appeal of guaranteed returns. However, other products have been developed: 1) index-linked structured products (with a derivative offering downside protection and the participation on the upside of an equity index); 2) some guaranteed unit-linked products (albeit limited); 3) multimanager mutual funds/fund of funds/hedge fund backed products, in particular taking advantage of a more flexible regulatory environment in Ireland (where life subsidiaries have been domiciled). The product innovation has assisted recent sales momentum (particularly at RAS), albeit we see some margin/regulatory risk (the transparency of unit-linked product charging is under investigation). Figure 14. Estimated Level of Unit-Linked Sales 24 versus 2 and Overall Contribution 24e Unit Linked Sales as a % of 2 24e Unit Linked Sales as a % of Total Germany 112% 2% Italy 4% 4% Netherlands 65% 49% Spain 2% 4% France 56% 2% Continental Europe Average 59% 27% UK 131% 6% US 95% 6% US & UK Average 113% 6% Source: Smith Barney estimates. 18

19 Made in Italy 8 April 25 Italian Banks Under Attack 3 A foreign challenge for the Italian banking system BBVA and ABN AMRO are challenging the Italian banking system. The situation remains extremely fluid and is likely to affect the Italian banks sector as a whole. Different stocks could be viewed from different angles and the same stock could be viewed as a European target or a domestic consolidator. The only foreseeable outcome in the short-term is share price volatility. With regards to the BNL and Antonveneta bids, despite the difficulties in forecasting the myriad possible outcomes, if we had to choose which of the two bids was more likely to succeed we would pick ABN over BBVA. Italian banks could be viewed from different angles After the tender offers launched for BNL and Antonveneta, the Italian banks sector could be viewed from different angles. First, the Italian banks market cap might lead the market to consider the whole sector as a possible cross-border target. In particular, Italian banks that have foreign shareholders might be considered takeover targets. These would include Banca Intesa, Sanpaolo IMI and Capitalia (not covered). Second, the market might decide that domestic consolidation is more necessary now than before. On the back of this, Unicredito and possibly Banca Intesa could be considered domestic consolidators. We attach greater odds to regulators authorising the offers It is impossible to forecast the opinion of the regulators about the two tender offers launched. On the one hand, we would not see any reason why the protective attitude of the regulators would have changed in the past few days. On the other hand, the fact the European Commission is keeping a close eye on the development of the situation would make it more difficult for domestic regulators to simply reject the bids. We do not see many candidates ready to counter-bid If we assume the domestic regulators authorise the offers, a natural way to preserve the national interest would be a counter-bid from a domestic player. We do not consider this likely for the following reasons. First, we do not see many candidates interested (we would exclude Unicredito, Banca Intesa and Sanpaolo and we do think that Monte Paschi could eventually do something just with share issuance). Second, a domestic player (BPVN) has already taken a step back from the BNL saga 4. 3 Please refer to Italian Banks Dealing with Uncertainty, Smith Barney, 31 March Reuters Popolare Verona denies media reports it might counterbid for Banca Nazionale del Lavoro. 11:41, 21 March

20 Made in Italy 8 April 25 Actions taken by an aggregation of different entities look more effective in the BNL situation Counter-bids from white knights would not be the only possible response to preserve the national interest. Actions could be taken by an aggregation of different entities. This is what happened in early 23, when there was speculation that Generali might have possibly been an interest of French financier Vincent Bollore and Groupama SA, which started to build stakes in Mediobanca (which controlled 13% of Generali) 5. At that time, Italian financial institutions started buying Generali shares to defend the national interest. Something similar happening today cannot be ruled out for both BNL and Antonveneta, but given the different shareholders structures we would consider this to be more effective for BNL than for Antonveneta. BBVA and ABN AMRO could make their offers more attractive Our preliminary calculations would indicate that both BBVA and ABN AMRO could make their offers more compelling, if necessary. This would be an easier exercise for BBVA (excess capital of around 2 billion pre-transaction) than for ABN, but the (more attractive) all-cash offer to Antonveneta shareholders and language used by ABN AMRO management suggest it is highly committed to winning any eventual bidding war for Antonveneta. 5 Bloomberg UniCredito, allies are aiming for 2% of Generali, Ansa says 13:34, 5 March 25 (New York). 2

21 Made in Italy 8 April 25 Italian Small- and Mid-Cap Panorama: A Quantitative Approach Quant analysis on 13 Italian mid/small caps Research and ranking based on six factors Reply has the best results in our sample Small software and services companies in the first decile Construction stocks still in good shape Ranking stock on six factors value growth quality financial leverage earnings momentum and price momentum Methodology Our sample is set up with Italian stocks with a market cap between 5 million and 5 billion: we considered stocks from the Mibtel index and from the Numtel index. We excluded from our sample stocks with no estimates for the factors we take into consideration. We use six factors to identify attractive or unattractive stocks. The first is the composite valuation measure, which is an equally weighted combination of 12- month forward price-to-earnings, cash flow-to-price, dividend yield and EBITDA to enterprise value (EV). Second, we rank stocks on a growth measure. This is a combination of earnings growth (year on year), percentage EPS growth (five years) and price-earnings to growth (PEG). The third factor that we take into consideration is a quality factor, derived from return on equity (ROE) and EBIT margin. We also include a risk factor in our analysis. This factor is linked to total debt to equity, short-term debt to equity and long-term equity ratios. The fifth factor is earnings momentum, where we take into consideration one-month changes in EPS, three-month changes in EPS and earnings revisions (12-months forward). Finally, our analysis also includes a price momentum rank, influenced by one-month price percentage changes, three-month price percentage changes and year-to-date price percentage changes. Combining these six factors, we arrive at a combined average and a combined rank, which allows us to divide the sample into ten deciles of 13 stocks each, where 1 represents the most attractive decile. 21

22 Made in Italy 8 April 25 Reply ranks the highest Small software and services companies in the first decile Construction stocks still in good shape Amplifon in the spotlight Poor profitability and financial problems for last decile stocks Stocks scores Overall ranking Following our approach, we consider Reply as the best stock of our sample. The company is very well positioned in terms of growth ranking (.9) and earning momentum ranking (.95). On the other hand, Reply does not have an outstanding value ranking (.28): this is related to the low dividend yield of around 1%. In the first decile we find three software and services companies: Reply (first overall), Datamat (fifth overall) and Engineering Ingegneria Informatica (eighth overall). All these three stocks offer a good risk ranking combined with a comfortable growth ranking. Moreover, Reply and Datamat appear to be also hot stocks with a high price momentum ranking (.79 and.93, respectively). It is worth noticing that three construction stocks are still among the first sixteen stocks: Italcementi (seventh overall), Buzzi Unicem (fifteenth overall) and Cementir (sixteenth overall). These stocks combine a very high quality ranking with a positive earnings momentum ranking. Amplifon offers a very good combination of growth ranking (.79), earning momentum ranking (.89) and price momentum ranking (.94). In mid-march the new CEO delivered a clear message of growth for the next four to five years: 1) organic growth (in excess of 6%-7% per annum versus a 9% organic growth in 24); 2) growth by acquisitions, with a priority in the US market as well as Germany and the UK. All these factors have maintained the focus on the stock, bringing it into the first decile. In the last decile, we find companies such as Tiscali and Alitalia, with low risk rankings (.24 for Tiscali and.32 for Alitalia) and very poor quality momentum rankings (. and.3 respectively). Impregilo is also in the last decile: the company was saved at the end of last month by a consortium led by Gemina and Autostrade. 22