Italian Market: Top Picks for 2016

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See page 67 for full disclosures and analyst certification

With a number of reforms already approved or in discussion, a more self-sustainable economic recovery in place and privatisation moving forward, we believe that Italy is progressing fairly well along our anticipated ‘New Normality’ route. Italy’s equity risk premium declined by almost 200bps in 2015 to 6.8%, also thanks to an unusual mix of simultaneous tailwinds (FX, oil prices, QE). Looking ahead to 2016, we believe that the equity premium might further decline to its long-term average at 6.0% (or a +13% market upside in 2016, all else being equal) driven by political stabilisation, the domestic economic recovery gaining steam and improved visibility on 2016-17 earnings.

 2016 market view and valuation. The Italian equity risk premium is currently lower than the other main euro area benchmarks. However, the premium is still rather distant (+250bps) from its pre-crisis level of 4.3% and 80bps above its 15Y average (at around 6.0%). Based on a 2016 market P/E (16.0x), valuations are broadly in line with the 15Y P/E average (15.8x), while on 2017 earnings, valuations are at an 11% discount. Looking ahead at 2016, we believe that conditions are in place for a further step down in Italian ERP, namely to hit its long-term average at 6.0% by YE16, as Italy progresses along its ‘route to normalisation’. Drivers should be ongoing political stabilisation (as reforms are being finalised), the economic recovery gaining steam (GDP seen at +1.2% in 2016E, from +0.7% in 2015E) and improved visibility on 2016-17 earnings forecasts. Risks are, in our view, government delays to implementing reforms in Italy, a reigniting of the euro area sovereign crisis, a more pronounced economic slowdown (mainly, China and emerging economies) and a fresh rise in geopolitical risks.

 Macroeconomic assumptions. While 2015 marked the reversal of the economic cycle in Italy (we expect GDP growth to close at +0.7%), after three and a half years of recession, 2016 could be the year in which growth “normalises”, returning to levels broadly in line with potential (we see 2016E GDP at +1.2%), with investments expected to take over from consumption as the main recovery driver. We expect the euro area to grow by 1.7% in 2016, accelerating from 1.5% in 2015. Above-trend growth is still being fuelled by a mix of positive external shocks (low oil prices, weak exchange rate, and accommodative economic policies).

 Investment themes: Sector Consolidation and Dividend Yields. We have identified two investment themes, which we believe are consistent with our reference scenario: Sector Consolidation and Dividend Yields. The former should be driven by a combination of macroeconomic (subdued growth and easier monetary conditions) and institutional factors (regulatory changes and declining country risk). The latter should reflect the current environment of historically low interest rates and the search for yield among investors.

 Top picks for 2016. Below, we show our 2016 Top Picks selection, with an eye also on consolidation trends and dividend yields.

Top Picks - 2016

Company Name Target Price _(EUR/share) Rating Sector Price (EUR/share) Mkt Cap (EUR M)

Atlantia 28.00 ADD Motorways 23.69 19,562.8

Autogrill 11.60 BUY Travel&Leisure 8.52 2,166.2

Banca Popolare di Milano 1.06 BUY Banks 0.84 3,697.9

EI Towers 63.37 ADD Media Services 56.05 1,580.6

Fiat Chrysler Automobiles 15.67 ADD Automobiles&Components 11.85 17,858.0

Finmeccanica 16.00 BUY Aerospace & Defence 12.47 7,209.1

Hera 2.70 ADD Multi-Utilities 2.43 3,619.6

Poste Italiane 8.10 ADD Logistics & Financial Services 6.75 8,815.5

Prysmian 22.50 ADD Capital Goods 19.15 4,095.3

Safilo Group 13.24 BUY Branded Goods 9.96 622.5

Salini Impregilo 5.40 BUY Construction 3.68 1,811.2

Unipol 5.65 BUY Insurance 4.48 3,211.4

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Source: Intesa Sanpaolo Research estimates

Equity Strategy Report

17 December 2015 Italian Market 2016 Equity Strategy Intesa Sanpaolo Research Department Giampaolo Trasi Product Co-ordinator +39 02 8794 9803 Equity Research Team Corporate Brokerage Research Team

Italian Market: Top Picks for 2016

Half-Way to ‘Normality’ and On Route to the Next Half

Index price performance, -1Y

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Equity Strategy Report 17 December 2015

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Intesa Sanpaolo Research Department

A Last Glance at 2015 Market Performance

In the first eleven months of 2015, the global stock market performances have been mixed overall, reflecting concerns about economic growth in Asia, weakness in commodity prices, uncertainties about US monetary policy, and a return of sovereign risk in the euro area.

International equity markets started 2015 on a positive note as the sharp EUR depreciation vs. USD favoured euro area equity markets, and in particular export-oriented sectors to the USD area. The start of the ECB quantitative easing in March was welcomed by equity markets, while it further weakened the euro currency. The simultaneous sharp drop in oil prices was positive news for consumers’ disposable income and, in a medium-term view, for industrial margins, particularly in energy-intensive sectors. The economic recovery gained ground in the euro zone, also sustained by the ECB’s accommodative monetary policy, and by a credit cycle recovery in the euro zone.

After hitting yearly highs in April, euro area equity markets lost momentum and then declined, as a result of a new heightening of the Greek sovereign debt crisis; moreover, political risk moved back to centre stage, as anti-EU political forces advanced in several European countries.

The stalemate in negotiations between Greece and European institutions triggered a more marked correction in equity indices since end-June, together with a temporary rise in bond yields, a spread widening in peripheral countries, and a general rise in investors’ risk aversion.

During the summer months, equity markets declined sharply, due first to rising concerns about growth in China and emerging economies, and to the prolonged weakness in commodity prices; thereafter, due to uncertainties about the timing of the FED rates hike and lastly, the strong impact on the automotive sector from the VW diesel-gate scandal.

In the final months of 2015, equity markets mainly moved sideways, awaiting clearer signals on growth trends in the euro area and in the Far East, and monetary policy decisions from the FED and the ECB. A new rise in geopolitical risk constrained equity markets in the euro zone in late 2015. On the other hand, expectations for the ECB EAPP extension (subsequently approved in early-December), supported equity markets in the euro area, in sight of more monetary stimulus, together with renewed euro weakness. The 3Q15 reporting season pointed to an ongoing demand recovery and consolidation in industrial margins, particularly for export-led international groups, thus providing support.

World equity markets – 2015 index performances

% Last index price YTD -3M -6M

FTSE MIB 21015.3 10.5 -3.4 -9.3

FTSE Italia All Share 22752.0 13.0 -2.7 -7.9

FTSE Italia STAR 25145.7 34.8 4.2 0.8

Euro Stoxx 337.1 5.5 1.1 -8.1 CAC 40 4549.6 6.5 0.1 -8.5 DAX 30 10340.1 5.5 2.1 -8.8 IBEX 35 9630.7 -6.3 -1.1 -13.7 FTSE 100 5952.8 -9.3 -2.7 -13.1 S&P 500 2012.4 -2.3 2.6 -4.6 Nikkei 225 19230.5 10.2 5.3 -5.6

Note: Priced at close on 11 December 2015; Source: Thomson Reuters

Giampaolo Trasi Head of Equity & Credit Research

+39 02 8794 9803 giampaolo.trasi@intesasanpaolo.com

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2016 Market Valuation and Earnings Outlook

In 2015 not only has the equity risk premium gap between Italy and the main euro area benchmarks (Germany, France, Spain and the Euro Stoxx) fully closed, but the Italian ERP is currently lower than most other euro area main equity markets. Despite the drop to 6.8% in 2015, the Italian ERP gap vs. its pre-crisis level remains substantial (250bps). Based on a 2016 market P/E (16.0x), valuations are in line with the 15Y P/E average (15.8x); on 2017 earnings, valuations are at an 11% discount. While not a clear-cut bargain, we expect Italian equities to further incorporate a positive ‘change in paradigm’, as long as the country moves ahead on its route to normalisation. Accordingly, we expect ERP to decline towards its long-term average (15Y) at 6.0%.

Italian equities vs. historic averages

At end-November 2015, the Italian market 2016 P/E stood at 16.0x, broadly in line with the 15Y average (15.8x). Based on a 2017 market P/E (14.1x), valuations are at an 11% discount to the 15Y average (on TF/IBES consensus data). Note that, in the course of 2015, the average monthly P/E has been 17.6x, or at a 12% premium to the long-term average.

Italian equity market – An historic comparison Historic

x P/E average 2016 2017

Italian Equity market 16.0 14.1

Premium/(Discount) to 15Y avg.(%) 15.8 1 -11

Premium/(Discount) to 10Y avg. (%) 13.3 20 6

Source: Intesa Sanpaolo Research elaboration on IBES consensus data (as of end-November 2015) Italian equities vs. Euro Stoxx

In terms of P/E, Italy trades at an 8% premium to the Euro Stoxx on 2016 figures (16.0x vs. 14.7x) and a 7% premium on 2017 (14.1x vs.13.2x). The Italian ERP is currently lower than the Euro Stoxx (6.8% vs. 7.0%, respectively): compared with end-2014 (Italian ERP: +100bps vs. Euro Stoxx at Dec-14; it was +180bps at end-2013), the gap has not only closed, but Italy is currently perceived as slightly less risky than the average euro zone equity markets. Based on the current EPS growth estimates, the Italian PEG looks more appealing than the Euro Stoxx (1.2x vs. 1.6x) in relative terms.

Italian equity market vs. Euro Stoxx – A comparative valuation

Equity Risk P/E EPS growth (%)

x Premium (%) 2016 2017 2015/14 2016/15 2017/16 PEG (1)

Italian Equity market 6.8 16.0 14.1 30.6 18.1 13.5 1.20

Euro Stoxx 7.0 14.7 13.2 12.3 8.5 11.5 1.60

(1) PEG calculation is based on current 2015 P/E and 2Y forward EPS growth; Source: Intesa Sanpaolo Research elaboration on IBES consensus data (as of end-November 2015) We note that Italy’s 2015 earnings growth (+30.6%) is distorted by the MPS effect (i.e. the bank

reported a huge loss in 2014, and is expected to recover profitability in 2015), and by the swing in Eni’s 2015 earnings forecasts. These effects, however, should become less significant moving forward to 2016 and 2017 earnings forecasts (see the Earnings Outlook section for details).

We also highlight that the current 2Y FWD EPS CAGR for Italy (namely, 2016 and 2017) is +15.8% vs. +10.0% for the Euro Stoxx, and we are now more confident about the delivery of 2016 and 2017 earnings growth for Italian companies. In fact, the domestic economic recovery, which began on the back of exogenous factors (low oil price, EUR depreciation, effects of QE), is now increasingly driven by domestic demand and seems capable of self-sustainment, in our view.

Valuation at a discount on 2017 P/E

More attractive on a PEG basis vis-à-vis Euro Stoxx

Improved earnings visibility on 2016-17

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Italian equities vs. Rest of the World

We compared the Italian equity market valuation with some international benchmark indices in order to assess the relative attractiveness of Italian equities; we used the FTSE MIB index benchmark for the purpose of this analysis. In particular, we focused on 2016 and 2017 P/E, on 2016-17 EPS growth and on the current Equity Risk Premium levels.

According to our elaborations, the Italian benchmark FTSE MIB is trading in line with average group P/E both on 2016 (15.3x vs. 15.0x average) and 2017 (13.2x vs. 13.4x average) earnings, when compared to the other international benchmarks.

However, when taking into account 2016-17 EPS CAGR, on a PEG basis, the FTSE MIB looks decidedly more attractively priced than all the other benchmarks in our analysis, together with Spain, backed by a sound EPS growth (+20.0% EPS CAGR in 2016-17, the highest among peers group), with a PEG at 0.95x.

In terms of implied Equity Risk Premium, the FTSE MIB stands at 7.2% slightly higher than the Euro Stoxx (7.0%), broadly in line with Germany (7.3%); both Anglo-Saxon markets (UK and US) are showing an ERP at 5.5%, well below the euro area indexes.

Country-risk and bank-risk in Italy

The tight correlation between the Italian banks index and the inverse of the BTP-Bund spread observed in recent years has broken in 2H15. ECB policy actions in 2015 had the effect of defocusing investors from the sovereign debt crisis, returning the ‘economy’ to centre stage, in our view. True that, during the summer months, the Greek crisis prompted a renewed rise in risk aversion and a return of the correlation between Italian banks and the BTP-Bund spread. However, this proved to be a temporary effect: later in 2015, the BTP-Bund spread declined again, while the trend in Italian banking stocks was broadly de-correlated, mainly driven by banks’ fundamentals rather than by Italy’s country risk.

Italy’s FTSE MIB: in line on P/E…

… but much cheaper on PEG…

...and in line on ERP

Equity market valuation and Equity Risk Premium by country

Country Index _{P/E (x)}2015 _{P/E (x)}2016 _{P/E (x)}2017 2016-17 EPS _{CAGR (%)} PEG _(x)(1) _{Premium (%)}Equity Risk

Italy FTSE MIB 18.9 15.3 13.2 20.0 0.95 7.2

France CAC 40 15.8 14.7 13.2 9.2 1.71 6.8

Germany DAX 30 13.9 13.4 12.1 7.0 1.98 7.3

Spain IBEX 35 16.8 14.6 12.9 14.2 1.18 7.5

Euro area Euro Stoxx 16.0 14.7 13.2 10.0 1.60 7.0

UK FTSE 100 15.8 15.1 13.3 9.0 1.75 5.5

Switzerland Swiss Market 17.3 16.5 15.0 7.6 2.28 7.3

US S&P 500 17.8 16.5 14.7 10.0 1.78 5.5

Japan TOPIX 15.3 14.1 13.1 8.2 1.87 7.4

(1) PEG calculation is based on current 2015 P/E and 2Y forward EPS growth; Source: Intesa Sanpaolo Research elaboration and IBES consensus estimates (as of end-November 2015)

No longer a major issue in 2H15

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Italian banks and Italian sovereign risk (2011-15)

Source: Intesa Sanpaolo Research elaboration on TR data

Equity Risk Premium analysis in Italy

Sharply down in 2015, beyond our expectations

At end-November 2015, the equity risk premium for the Italian market stood at 6.8%, well below the ERP level at end 2014 (8.7% at December 2014), and below our expected year-end 2015 target (at December 2014, we had forecast a level of 7.7%, then revised to 7.0% at June 2015).

The equity premium in Italy declined sharply in 2015, backed by an unusually favourable mix of tailwinds such as: a) the EUR weakness vs. the USD (potentially benefiting export-oriented sectors towards the USD area); b) the sudden decline in oil prices, with a potential impact on disposable income and industrial margins; c) the QE start, in an already accommodative monetary environment, prompting a credit cycle recovery, and supporting economic recovery expectations in Italy and the euro zone; and d) the drop in 10Y Italian BTP yields and in the BTP-Bund spread.

Italy has closed the ERP gap with euro area benchmarks

The following two charts show: on the left, the trend in the Equity Risk Premium for a number of international equity benchmarks since the beginning of the financial crisis; on the right, the gap between the current ERP and the pre-crisis ERP level (in terms of bps) for the same equity

0.25 0.45 0.65 0.85 1.05 1.25 1.45 1.65 1.85 2.05 2.25 Ju n-1 1 Se p-1 1 De c-1 1 M ar-1 2 Ju n-1 2 Se p-1 2 De c-1 2 M ar-1 3 Ju n-1 3 Se p-1 3 De c-13 M ar-1 4 Jun -14 Se p-1 4 De c-1 4 M ar-1 5 Ju n-1 5 Se p-1 5

1/(BTP-BUND) Italian Banks

Equity Risk Premium dropped in 2015 in Italy

1991-2015 Equity Risk Premium – Italian equity market

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benchmarks. For the purpose of this analysis, we set the beginning of the credit crisis at June 2007, when the ERP started its long upwards trend in all the main equity markets.

Equity Risk Premium - Italy vs. Rest of the World (Nov 2015) ERP gap to pre-crisis levels - Italy vs. Intl equity benchmarks

Source: Intesa Sanpaolo Research elaboration on TR/IBES data Source: Intesa Sanpaolo Research elaboration on TR/IBES data In 2015 not only has the equity premium gap between Italy and the main euro area benchmarks

(Germany, France, Spain and the Euro Stoxx) fully closed but the Italian ERP is currently, together with France, lower than the other euro area benchmarks. Spain is at present the “laggard” among euro area benchmarks in terms of equity premium, at 7.5%.

The polarisation between euro area indices and the Anglo-Saxon markets (UK FTSE 100 and US S&P 500) remains evident in relative terms, with both Anglo-Saxon markets trending at a 5.5% ERP, also reflecting a more advanced stage of their economic cycle.

Italian ERP remains very distant from its pre-crisis levels: compared to the 4.3% ERP level recorded at June 2007, the ERP gap for Italy at November 2015 is 250bps. Germany and the Euro Stoxx are showing a 230-240bps gap.

In market terms, it would take a 70% rise in the Italian equity index to drive the Italian Equity risk premium back to its pre-crisis level of 4.3%, all else being equal: namely, the FTSE MIB would need to shoot up to around 36000, a level last seen in January 2008; not a likely event for 2016, and for the foreseeable future, we believe.

A brief recap on our valuation metrics

While not a clear-cut bargain, we believe that Italian equities may offer upside in a 2016 view, under certain valuation metrics. We recap below our valuation approach.

 P/E vs. historic averages: based on a 2016 market P/E (16.0x), valuations are in line with the 15Y average (15.8x). Calculated on a 2017 market P/E (14.1x), valuations are at an 11% discount to the 15Y average;

 P/E vs. EPS growth: the current 2Y FWD EPS CAGR for Italy (namely, 2016 and 2017) is two-digit (+15.8%), but we are now more confident about the delivery of 2016 and 2017 earnings growth for Italian companies. The Italian PEG, currently at 1.20x, is among the lowest among euro area benchmarks, reflecting higher earnings visibility, in our view;

 Italy vs. Euro Stoxx: in terms of P/E, Italy trades at an 8% premium to the Euro Stoxx on 2016 figures (16.0x vs. 14.7x) and a 7% premium on 2017 (14.1x vs.13.2x). Italy sells at a discount on a PEG basis (1.20x vs. 1.60x), reflecting a more sustained EPS growth in Italy going forward;  Equity Risk Premium: Italian ERP is currently slightly lower than most euro area benchmarks.

It remains, however, rather distant (+250bps) from its pre-crisis level of 4.3%, and 80bps above its 15Y ERP average (c. 6.0%).

Italian ERP now lower than most euro area benchmarks

Still a large ERP gap for Italy vs. pre-crisis levels

Historical P/E: cheap on a 2017 view

PEG: relatively attractive, on improved earnings visibility

Italy vs. Euro Stoxx: more expensive on P/E, cheaper on PEG

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Earnings Outlook in Italy

Recent 3Q15 reporting season: a quick recap

The 3Q15 reporting season in Italy ended in mid-November. Based on our 3Q15 forecasts, we calculated that, out of the 75 companies in our preview sample, we had 31% results above expectations, 57% in line, and 12% of results below our forecasts. Overall, we judge the 3Q15 reporting season as in line with expectations.

Moreover, we tracked 29 companies’ announcements on FY guidance: a vast majority (20 companies, or 69%) confirmed FY guidance; if we add the 5 companies (17%) which lifted their guidance, we have 86% companies pointing to a stable or improving earnings trend outlook which we view as a positive signal also for 2016 expected earnings dynamics.

FX continued to play in favour of USD-exposed industrials and consumer-related companies (USD appreciated by almost 20% vs. EUR yoy in 3Q15). The economic recovery in EU is slowly moving ahead, thus supporting final consumer demand. Financials were mixed, with pressure on NII and fee income, balanced by lower LLP, with generally improving capital bases.

In 4Q15, the FX effect should remain a tailwind, but its benefit should gradually fade, due to a less favourable yoy base effect, while domestic demand, although subdued both in Italy and in the euro area, should still provide support.

For a more detailed sector and company analysis, refer to our report “Italian Market: 3Q15 Results” of 17 November 2015.

Preview coverage – 3Q15 results vs. our estimates 2015 quarterly results vs. our estimates

Source: Intesa Sanpaolo Research estimates Source: Intesa Sanpaolo Research estimates 2016 earnings outlook in Italy

Looking ahead to YE16, current IBES consensus earnings for Italy point to a double-digit earnings growth (+18.1%), while the current 2Y FWD EPS CAGR for Italy (namely 2016 and 2017) is +15.8% (vs. +10.0% for the Euro Stoxx).

From a top-down angle, Italian earnings forecasts might present a slightly higher downside risk than the Euro Stoxx, due to the slightly weaker Italian economic environment vs. the average euro area (Italy GDP growth 2016E: +1.2% vs. +1.7% for Euro area 2016E, according to our macroeconomic forecasts).

From a bottom-up fundamental angle, however, we are more confident than 12 months ago about the delivery of 2016 and 2017 earnings growth for Italian companies, as the domestic economic recovery (which began on the back of exogenous factors, such as the low oil price, EUR depreciation, effects of QE, supportive fiscal policy), is now being increasingly driven by domestic demand and seems capable of self-sustainment.

3Q15 reporting season at a glance

More confident about the delivery of 2016 and 2017 earnings for Italian companies

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On top of that, other drivers such as operating leverage (gained through efficiency actions during the crisis period), and the gradual effects of economic stimulus measures implemented in Italy in recent years are also supportive in this respect.

Also in 2015, earnings dynamics in the Italian banking sector have materially impacted earnings forecast statistics for Italy, somewhat distorting EPS growth rates for the whole market, all else being equal. Earnings growth forecasts for 2015 in Italy, in particular, have been highly influenced by: a) the MPS effect (i.e. the bank should recover profitability in 2015E, after having reported a huge loss in 2014, based on our and IBES consensus forecasts); and 2) Eni’s adj. earnings trend (expected to sharply decline in 2015E vs. 2014, based on our and IBES consensus forecasts)

Moving forward to 2016 and 2017 earnings forecasts, these factors should lose relevance, and Italy’s overall earnings growth trend should no longer be the result of a specific sector trend. This is the key outcome from our simulation below, which quantifies the effect of the earnings dynamics in the Italian banking sector vis-à-vis the rest of Italian equities.

First, we calculated the weighting of banks’ forecast earnings on total market earnings in the 2016-17 forecast period, with the support of available IBES consensus data. We then recalculated Italian earnings growth ex-banks in 2016-17 and, lastly, based on the same set of data, we recalculated the market P/E ex-banks for 2016 and 2017.

Based on our elaborations, 2016 EPS growth for the Italian market, excluding banks, would be +18.2% vs. +8.5% for the Euro Stoxx. In 2017, EPS growth ex-banks would be +12.0% vs. +11.5% for Euro Stoxx.

Note that the difference between earnings growth with and without banks, both in 2016 and in 2017, is relatively small. We believe that this is signalling a higher quality in expected earnings forecasts: the expected growth rates seem to be more broadly-based and homogeneous among financials and industrials, rather than depending on earnings swings in single sectors and stocks.

In valuation terms, Italy’s P/E ex-banks would remain at a slight premium to the Euro Stoxx in 2016, while the gap would almost close going forward to 2017 earnings.

The results are shown in the table below. Note that they represent an approximation, as the two IBES sample aggregates used in our simulation (Italian banks and Italian equities) are not fully homogeneous or comparable.

Italian Equity Market – EPS growth estimates with/without banks

% EPS growth P/E (x) PEG (1)

2016/15 2017/16 2016 2017 (x)

Italian Equity Market 18.1 13.5 16.0 14.1 1.20

Italian Banks 17.6 19.9 18.9 15.8

Italian Equity Market ex-Banks 18.2 12.0 15.2 13.5

Euro Stoxx 8.5 11.5 14.7 13.2 1.60

NM: not meaningful; (1) PEG calculation is based on current 2015 P/E and 2Y forward EPS growth. Source: Intesa Sanpaolo Research elaboration on IBES consensus data (as of end-November 2015)

Quantifying the effect of banks’ earnings on total market earnings

Italy 2016 EPS growth above the Euro Stoxx, net of banks

A more balanced earnings growth trend among sectors

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Normalisation in Italy and Country Drivers

We monitored the status of our 2014-16 ‘New Normality Paradigm’ for Italy. With a number of structural/institutional reforms achieved, or in the process of being discussed/approved in Parliament, some major privatisations deals finalised (such as Poste Italiane) and a few market reforms in place (i.e. Popolari banks), a successful EXPO 2015 behind us and an extraordinary Jubilee just starting, we believe that Italy is progressing well along its “normalisation” route. Looking at 2016, we believe that conditions are in place for further steps forward on this route, possibly prompting a decline in the Italian equity premium towards its 15Y average (2000-14) at around 6.0% by year-end 2016.

A short recap

We first presented our ‘New Normality’ paradigm for Italy at the end of 2013, envisaging a three-year (at least) 2014-16 period of “normalisation” for Italy, an evolutionary process involving politics, economics and financial markets. We expected this period to be characterised by subdued economic growth (both in Italy and the euro area), low interest rates and an accommodative ECB monetary policy, and relative financial stability.

We focused on four country-specific factors:

1.Political stabilisation, as a result of a broad-based structural reform process, also including an electoral system assuring country governability and a faster and more efficient legislative system;

2.Privatisation, conducive to investors’ broader market participation and a diminishing public presence in the economy, and to a gradual decline in risk aversion in the Italian equity market; 3.Corporate governance and market reforms, aimed at improving a historically rather opaque

corporate governance in Italy and the resulting conflicts of interest;

4. Special events (such as EXPO Milan 2015 and the 2015-16 Jubilee) which, if successfully finalised, could potentially have a positive influence on investors’ perception of Italy’s country risk.

Two years down the road, we monitor the status of our New Normality paradigm: in other words, we re-assess Italy’s country risk, so as to better understand the potential developments in the Italian Equity Risk Premium in 2016.

The next page offers a quick recap of the main goals achieved in 2015 and the key events or challenges we anticipate for 2016.

New Normality in Italy: time for a second yearly check-up

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The Four Normality Drivers - What’s been done in 2015? The Four Normality Drivers - What’s next in 2016?  Political stabilisation

Renzi has decidedly pushed through his reform agenda, marking important steps in 2015, following the approval of the labour market reform (Jobs Act), at end-2014; The new electoral law (so-called, Italicum) was approved in May 2015;

On Constitutional reforms, the new Senate will end perfect bicameralism in Italy. The rebalancing of local autonomies should reduce overlaps with central government (the Senate has approved the reform; a vote at the Lower House is scheduled on 11 January 2016); On structural reforms, Education, Justice, PA, plus measures on competitiveness and taxation, among others, have either been approved, or are awaiting implementation decrees, or are advancing in Parliament.

 Privatisation

With the Poste Italiane IPO, the government has broadly achieved its privatisation goals for 2015 (0.4% GDP), in addition to asset divestments already finalised in 2014 (see the tables below).

 Governance and market reforms

We believe that the approval of the Popolari Banks reform has probably been the main goal achieved in 2015, in terms of governance reforms in Italy, following changes in takeover regulation introduced in 2014.

 Special situations: EXPO Milan

EXPO Milano 2015 took place from 1 May till 31 October 2015. It hosted over 21M visitors (over 6M from abroad). EXPO was a successful event, not only for its economic impact, but also in terms of a “re-launch” of Italy’s image abroad: in our view, it contributed to reduce the perceived country risk.

 Political stabilisation

A referendum on the Constitutional reforms should take place in 2H16 (likely in October); we expect it to confirm the Parliamentary resolutions;

We expect Renzi to finalise the PA (implementing decrees) and Justice (criminal proceeding, among others) reforms, while a reduction in taxation on corporate and individuals has been postponed to 2017 and 2018, respectively, also due to ongoing budget constraints; In Spring 2016, local elections in main Italian cities (Rome, Milan, Naples, Turin and Bologna, among others) will be a key political test for the government;

All in all, we see a relatively low risk of government crisis, or early elections, in 2016 (the end of the current legislature is 1Q18).

 Privatisation

In 2016, the privatisation pipeline might include, among others, assets like the Italian Railways and ENAV (air control systems), on top of possible disposals of some minority stakes in listed companies. The government has committed to raising around 0.5% GDP from privatisation in both 2016 and 2017.

 Governance and market reforms

In 2016, we anticipate that the Popolari banks reform should lead to a wave of consolidation in the banking sector, possibly leading to the creation of third and fourth Italian “champions”, able to compete in a more competitive environment.

 Special situations: The Jubilee of Mercy

The extraordinary Jubilee of Mercy officially opened on 8 December, and will last until November 2016. According to independent sources (Censis), around 33M visitors are expected in Rome during the period (about 70% from abroad); the impact in terms of public works for Italy should, however, be relatively limited.

Source: Intesa Sanpaolo Research estimates and elaboration

In the next section, we focus on one of our selected country drivers, the Italian Privatisation plan, briefly summarising the state of the art and the prospects for 2016.

Italian Privatisation plan: an update

In 2015, the Italian Treasury moved ahead with its previously-announced privatisation plan. In February, a 5.74% stake in Enel was placed on the market through an ABB, bringing MEF’s stake in Enel down to 25.5%, cashing in around EUR 2.2Bn.

More importantly, in 4Q15 the Italian Treasury finalised the IPO of Poste Italiane, by selling a 35.3% stake to retail and institutional investors and cashing in around EUR 3.1Bn.

Italian privatisation plan so far: a recap

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After an approximate EUR 3.6Bn cashed in 2014, the Italian Treasury booked EUR 5.3Bn in 2015 from the two above-mentioned placements (see below in the report for the actual calculation of the total privatisation cash-in in 2015), and remains committed to a comprehensive privatisation plan in the coming years.

Italian privatisation plan (2014)

Company Industry Selling

shareholder

Stake disposed %

Buyer Cash-in (EUR Bn) CDP Reti Holding co.

(energy transp. networks)

CDP 40.9 State Grid China/ Cassa Forense/ Foundations

2.41

Fincantieri Ship building CDP-Fintecna 27.5 IPO 0.36

Rai Way Media broadcasting and transmission

Rai 34.9 IPO 0.28

TAG Gas transportation CDP (CDP Gas) 89.2 SNAM 0.51

Source: Intesa Sanpaolo Research elaborations; companies’ websites; press sources (Il Sole 24 Ore; MF)

A recent update of the government’s medium-term economic agenda (DEF) pointed to a targeted value of asset privatisations at 0.4% of GDP in 2015, 0.5% in 2016 and 2017, and 0.3% in 2018. This could amount to around EUR 30Bn in the 2015-18 period, which is slightly dilutive vs. the target of 0.7% of GDP per year, included in the previous three-year plan.

Note that for the purpose of calculating the targeted value of privatisation to GDP (0.4% GDP in 2015, equal to around EUR 6.5Bn), the Italian Treasury also included two additional deals in 2015 (i.e. the related cash-in is strictly destined to reduce public debt, although they are not, strictly speaking, asset disposals): a) the reimbursement of Monti bonds from MPS (EUR 1.1Bn); and b) the extraordinary dividend from ENAV (EUR 0.2Bn), thus meeting the target for 2015 (source: MEF).

Italian privatisation plan (2015)

Company Industry Selling

shareholder

Stake disposed %

Buyer Cash-in (EUR Bn) ENEL Utilities – Power Generation) Italian Treasury 5.7 ABB 2.2 Poste Italiane Logistics & Financial Services Italian Treasury 35.3 IPO 3.1 Source: Intesa Sanpaolo Research elaborations; companies’ websites; press sources (Il Sole 24 Ore; MF)

In the table below, we recap some potential privatisation deals currently in the Italian Treasury pipeline for 2016, based on recent government announcements and bearing in mind the originally announced privatisation plan. The Italian Treasury Minister Padoan, in particular, has recently referred to ENAV and the Italian Railways as the main privatisation goals for 2016. On top, we include in the table below some selected minority stakes owned by the Treasury (STM and Eni) for which a possible divestment has been discussed in the past; also, plans for a valorisation of Grandi Stazioni Retail (55% owned by Ferrovie dello Stato) are ongoing.

What lies ahead in 2016?

Italian privatisation plan – Pipeline 2016

Company Industry Selling Shareholder Stake to be disposed %

ENAV Air traffic control services Italian Treasury 49

Ferrovie dello Stato Railways Italian Treasury c. 40

Other possible divestments

STMicroelectronics Semiconductors Italian Treasury 14

Eni Oil & Gas Italian Treasury 4.3

Grandi Stazioni Retail Retail activities of14 main Italian railways stations

Ferrovie dello Stato (55%) EuroStazioni (45%)

100 NA: not available; Source: MEF, Intesa Sanpaolo Research elaboration, press sources (Il Sole 24 Ore; MF)

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Intesa Sanpaolo Research Department

13

How the ‘New Normality’ may support Italian equity valuations

The path towards a ‘new normality’ standard in Italy could have a positive influence on investors’ risk aversion, contributing to reduce Italian country risk in the medium-long term. Starting from an equity risk premium of 8.7% in December 2013, we believe that the full and smooth unfolding of this ‘normalisation’ scenario could drive Italy’s ERP back to its 15Y average (2000-14), at around 6.0%.

With a number of structural reforms achieved, or in the process of being approved in Parliament, a more self-sustainable economic recovery in place (though admittedly weaker than the euro zone average), some major privatisations deals finalised (such as Poste Italiane), a successful EXPO 2015 behind us and an extraordinary Jubilee just getting underway, we believe Italy is progressing well along our 2014-16 ‘New Normality’ route.

The equity premium for Italy has indeed reflected such developments, moving sharply downwards from 8.7% at end-2013 to the current 6.8%, certainly helped by an unusual mix of simultaneous tailwinds in 2015 (FX, oil prices, QE). The benchmark FTSE MIB moved up by around 11% since end-2013.

Looking ahead at 2016, we believe that conditions are in place for a further step down in the Italian ERP, to hit its long-term average (2000-14) at approximately 6.0% by year-end 2016, namely -80bps in equity premium. This as a result of political stabilisation (as reforms are being finalised), the economic recovery gaining steam (GDP seen at +1.2% in 2016, from +0.7%), and improved visibility on 2016-17 earnings forecasts.

In the table below, we show our ‘New Normality’ country-specific drivers as discussed above, with an assessment of their probability, and the expected impact on the equity risk premium (ERP) in 2016.

Country-specific drivers: probability and expected impact on ERP in 2016

Driver Probability Impact on ERP in 2016

Reforms and Political stabilisation Medium/High Medium

Privatisation Plan proceeding Medium/High Medium/low

Consolidation among Popolari banks High Medium/Low

Extraordinary Jubilee Open 8 Dec 2015 Low

Source: Intesa Sanpaolo Research elaborations

Aligning Italy’s risk premium to 15Y average (2000-14)

The Equity Risk Premium in Italy currently stands 80bps above its 15Y average 2000-14 (approx. 6.0%, based on our ERP model). In 2000-14, the Italian ERP ranged from its historical low (1.7% at February 2000, at the height of the Internet bubble) to its historical high (12.0% at June 2012, only a few weeks ahead of Draghi’s “whatever it takes” game-changing statement).

The average of such a long and highly-diversified period (c. 6.0%) can be regarded, in our view, as a medium-term target for the ERP level in Italy, as long as the economic, financial and political environment moves towards ‘normalisation’.

As such, we simulate below the implicit upside for Italian equities, assuming Italy’s ERP returns to its long-term average of around 6.0%, all else being equal.

New Normality and equity risk premium in Italy

Scope for a further decline in equity premium…

...in a 2016 horizon

Italian ERP back to its 15Y average

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We would obtain a 2016 P/E of 18.0x (or a 14% premium to its 15Y average P/E of 15.6x), and a 2017 P/E of 15.9x (in line with its 15Y average). The PEG would appear to be neutral at 1.35x. The implied market upside from current levels would be approximately 13%.

Italy country risk – Italian Equity Market back to its 2000-14 ERP average

% Equity Risk Implied Index P/E (x) PEG (x)

Premium performance 2016 2017

Current – Italian Equity Market 6.8 16.0 14.1 1.20

Back to 2000-14 average (6.0%) -80bps

Italy “ERP-normalised” 6.0 +13 18.0 15.9 1.35

Source: Intesa Sanpaolo Research elaboration on IBES

2000-15 Equity Risk Premium and 15Y average – Italian equity market

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Investment Conclusions

In 2015 not only has the equity premium gap between Italy and the main euro area benchmarks (Germany, France, Spain and the Euro Stoxx) fully closed, the Italian ERP is also currently lower than most other euro area main equity markets. Despite the drop to 6.8% in 2015, the Italian ERP gap vs. its pre-crisis level remains among the largest of the main international equity benchmarks (+250bps).

With a number of structural reforms achieved, or in the process of being approved in Parliament, a more self-sustainable economic recovery in place, albeit admittedly weaker than the euro zone average, some major privatisations deals finalised (such as Poste Italiane), a completed successful EXPO 2015 and an extraordinary Jubilee now underway, we believe Italy is progressing well along our 2014-16 ‘New Normality’ route.

Looking ahead at 2016, we believe that conditions are in place for a further step downwards in Italian ERP, to return to its long-term average (2000-14) at around 6.0% by year-end 2016 (namely, -80bps in equity premium), as a result of political stabilisation (as reforms are finalised), the economic recovery gains steam (GDP is seen at +1.2% in 2016, from +0.7%), and improved visibility on 2016-17 earnings forecasts.

As such, we set our base-case equity premium at 6.0% at end-2016E, or 80bps below the current ERP level, implying a 13% equity market upside (from the current FTSE MIB level at 21,100) and a 2016 P/E at 18.0x and 2017 P/E at 15.9x, all else being equal. Note that the time horizon for our forecast is end-2016E: we see this upside gradually materialising over the course of next year.

Italian Equity Market in 2016E – Expected ERP range and index performance

% Equity Risk

Premium Implied index performance 2016 P/E (x) 2017 P/E (x)

Current valuation levels end-2015 6.8 - 16.0 14.1

ERP target – Our base case 6.0 +13 18.0 15.9

ERP worst case 7.2 -7

Source: Intesa Sanpaolo Research elaboration and IBES consensus estimates

Risks are, in our view, government delays to implementing reforms in Italy, a reigniting of the euro area sovereign crisis, a more pronounced economic slowdown in global demand (in particular, China and emerging markets) and a fresh increase in geopolitical risks. We note that, during the summer months, the Italian equity market went through a mix of the above factors (namely, concerns about China and emerging markets, the Greek political crisis, and a perceived loss of momentum in Italian government action). The equity premium showed resilience, hanging around the 7% mark; if we add 40bps to the current ERP level (up to 7.2%), the implied downside would be around -7%.

No longer the ‘laggard’ in the euro zone

Progress on our ‘New Normality’ route

Conditions are in place for a further decline in equity premium in 2016

Our base case: a 13% upside in a 12-month horizon..

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Two Investment Themes: Sector Consolidation and Dividend Yields

Looking at Italian equities in 2016 from a bottom-up angle, we have identified two investment themes, which we think are consistent with our above-described reference scenario: Sector Consolidation and Dividend Yields. The former should be driven by a combination of macroeconomic (such as subdued growth and easier monetary conditions) and institutional factors (such as regulatory changes and declining country risk). The latter should reflect the current ongoing environment of historically low interest rates and the consequent search for yield among investors.

Consolidation Games

We believe that a key investment theme for the Italian equity market in 2016 could be sector consolidation and M&A. In the course of 2015, in fact, we have already witnessed a number of major cross-border M&A deals in the Italian equity market (Pirelli-ChemChina; Hitachi–Ansaldo STS/Breda; Dufry-WDF, Heidelberger-Italcementi, Yoox-Net a Porter, Mitsubishi-DeLclima, to name a few).

On the other hand, we believe that there are a number of drivers still pushing in the direction of sector consolidation in 2016. Some drivers depend on the broader international context, others are, in our opinion, country-specific to Italy. We briefly list below some of them:

 Easier credit conditions. Following the ECB’s EAPP in March 2015 (extended up to, at least, March 2017 at the December ECB meeting), monetary conditions are likely to stay very accommodative in the euro area in the medium term. Credit availability and ample market liquidity in an historically low interest rates environment would make it easier to finance extraordinary M&A deals;

 Size and cost efficiency. In general terms, the search for efficiency and market size were among the key drivers behind some of the recently-finalised M&A deals in Italy. In an increasingly competitive environment, the need to cut the cost base is a priority in several sectors, more so as the economic landscape remains shallow in the euro area and in Italy;  Regulatory changes in Italy. Some recent decisions/economic policies of the Italian

government have had the effect of creating conditions for sector consolidation, with the aim of introducing more efficiency in certain industries. The reform of Popolari Banks is an obvious example as are moves in certain regulated sectors (for instance, the government is pushing to reduce the number of local utilities while in the airports sector, the government is aiming at creating a more integrated system with fewer sector players);

 Political stability and a declining risk premium. Last, but not least, the ongoing normalisation process in Italy, widely discussed above, also has the beneficial effect of enhancing attractiveness for long-term investments in Italy. Higher political stability (at least by Italy’s past standards) and an ongoing reform process should diminish the perceived country risk. The investment horizon should become more visible in the medium term, thus promoting a gradual decline in the equity premium for investors.

In the table below, we highlight a few possible consolidation stories in the Italian equity market, indicating the main drivers, and the sectors and stocks potentially involved in them. The table is not intended as a recommended list, rather it should be regarded as special situations to be monitored, in sight of prospective governance and control developments, going forward in 2016 and beyond.

Consolidation: already underway in 2015…

..but likely to continue in 2016, too

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Italy - Consolidation Games in 2016

Company Consolidation Driver Comments Anima Holding (ADD) Consolidation in the

asset management sector, also related to the M&A scenario for Popolari banks

Anima recently presented a non-binding offer (EUR 700-800M, in cash and shares, plus an earn-out) for Arca SGR, owned by several Popolari banks, with AuM close to EUR 30Bn (almost 45% of Anima’s current AuM). The offer values Arca at a 2014 P/E of 27-31x and 2.4-2.7% P/AuM (based on October’s Assogestioni data). According to the press (Il Sole 24 Ore, MF and Il Messaggero), Arca’s shareholders also received other offers and could evaluate a potential IPO process as an alternative. In our view, the final outcome is still uncertain, also depending on the Popolari risiko which, however, could open up additional M&A opportunities for Anima, having BPM and CreVal as shareholders.

Azimut Holding (ADD) Consolidation in the asset management sector, also related to the M&A scenario for Popolari banks

While continuing its strategy of foreign expansion, Azimut remains interested in a potential large-sized acquisition in Italy (either a network of financial advisors or an asset management company owned by a bank). Mr Giuliani, the group's CEO, recently said that Azimut could be ready to pay around 12x the earnings of a potential targeted company, also considering the possibility of becoming a shareholder of a cooperative bank, should the deal be value accretive and envisage a distribution agreement of at least 10 years.

Banca Generali (HOLD) Consolidation in the asset gatherers sector (mainly private banks)

Mr Motta, the CEO of Banca Generali, recently confirmed that the group is evaluating potential external growth opportunities, given its good capital position (Common Equity Tier 1 of 13.4% at end-September and an excess capital of EUR 187M, up to EUR 201.4M on a fully-loaded basis). He added that Banca Generali’s main interest is for small private banks in Italy. Santander’s Italian private banking activities (EUR 2.7Bn AuM), recently acquired by UBS Italy, were on the group’s radar.

Fiat Chrysler

Automobiles (ADD) Reduction of capital requirements and development costs

Since 1Q15, FCA’s CEO has reiterated his view that an aggregation between players would generate value creation within the sector, thanks to the achievement of strong synergies on the development costs side. In this context, on a number of occasions, the manager has highlighted GM as FCA’s most suitable partner for a potential aggregation.

Finmeccanica (BUY) Implementing the ‘One Company’ strategy

We believe that 2016 will be the year in which the company will truly begin to benefit from its new organisational structure, which has led to the creation of a “One Company” model. Consistent with this strategy, along with the steady delivery of efficiency improvements, we think that Finmeccanica is committed to strengthening only those activities where it can effectively stand out, while better valorising its non-core assets through the disposal or switch of assets with other players.

Prysmian (ADD) Bolt-on acquisitions As confirmed by the group, we believe that in 2016 Prysmian might finalise bolt-on acquisitions for a size up to EUR 1Bn in order to strengthen its positioning in higher-value segments or key strategic markets. We view bolt-on acquisitions as preferable to a transformational one in terms of capital return and financial sustainability as the group does not plan to seek financing from the market.

Safilo Group (BUY) A stable European distribution

Different to the statements by the common shareholder Hal Holding, we do would not fully rule out a merger between Safilo and the Dutch listed distribution chain Granvision Combining the retail and production activities would result in a new entity with a solid 70% retail controlled business to better compete in the licensing arena (about EUR 800M managed by Safilo and approx. EUR 2,400M by Luxottica) and to improve the product penetration, maybe with a dedicated good quality new “Granvision” private label produced in Safilo’s Italian plants, characterised by lowering volumes. Capex to improve the stores image would be one of the first issues to address, in our view. Telecom Italia

(NO RATING) Wind-3 pending merger, EU TLC consolidation, Brazilian consolidation

Telecom Italia should benefit from the Wind-3 merger, if approved (EU clearance expected in 2H16), in terms of stabilisation of the mobile customer base and a potential ARPU increase. Moreover, with Vivendi often stating that TI is key to pursue the ambition of a Southern Europe media/TLC platform (a still unclear strategy in our view), Vivendi’s recent entry in TI’s Board enhanced TI’s “prey” profile in a forthcoming European telecom sector consolidation. It remains to be assessed if Xavier Niel (long optional position) could play a role going forward.We also recall the long-rumoured TI-Orange press scenario, officially denied by TI-Orange itself and unlikely in our view, given the limited cross-country synergies. Lastly, we highlight the potential impact from a Brazilian consolidation, with Oi-TIM Brazil being a potential scenario following the LetterOne proposal and pending regulation, political and financial variables.

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Italy - Consolidation Games in 2016

Sector Consolidation Driver Comments Airports Structural changes driven by

regulation

After decades of inertia, the Italian airport sector is undergoing rapid and structural changes driven by more favourable regulation, which: 1) ensure adequate returns on capital; and 2) require increased efficiency, as envisaged by the Piano Nazionale Aeroporti. As a result, on the one hand significant capex plans are being executed by major airports (well exceeding EUR 4Bn in the next 5 years) while, on the other, a consolidation process is beginning to take off (Venice and Verona, Pisa and Florence), which we expect to continue (Milano and Bergamo), potentially involving both listed and non-listed companies.

Banks Popolari Banks Reform One year on from the approval of the Popolari banks reform and before the deadline for the transformation into joint-stock companies (December 2016), we believe that the Italian Popolari banks will start the consolidation process in 2016. We expect the process to lead to the creation of the third and fourth national champions with the aim of improving their competitive positioning and cost efficiency in an environment that we expect to remain characterised by profitability under pressure due to low interest rates

.

Insurance New regulation (Solvency II) When presenting its 2014-17 Business Plan and its EUR 500M rights issue (concluded in 4Q14), Cattolica highlighted its interest in M&A transactions. Management, however, recently confirmed that the group is on standby as regards its potential external growth strategy. The new regulatory framework on capital (Solvency II), with its application in January 2016, could also favour M&A in the sector across Europe. Mr. Cimbri, Unipol’s CEO, has said in the past that the group could evaluate potential external growth opportunities abroad. The latter’s new business plan should be presented in Spring 2016.

Motorways Rationalisation of motorway concessions

and operators

Pending the EU approval of the network development plan, the Italian government reiterated that it is willing to rationalise the high number of motorway concessions and operators, so as to increase efficiencies and free up resources to update the domestic network. In our view, an aggregation should focus around the main players, with Atlantia and SIAS controlling 44% and 20% of the Italian toll-roads, respectively.

Towers INWIT change of control,

Possible spin-off of Wind-3 combined towers, Small M&A

The ongoing tender offer on Telecom Italia’s stake in INWIT is the key consolidation driver, in our view, with Cellnex/F2i representing the most likely bidders. The bidding price remains the key issue to assess. Moreover, if successful, the Wind-3 merger could also be an opportunity should the combined entity decide to dispose its tower network (around 8,000-9,000 sites in our view). We also flag small M&A deals (telecom and radio) indicated to be on the 2016 radar by EI Towers’ management on top of those already announced in 2015. As for broadcasting towers, we think that a merger between EI Towers and Rai Way remains the most accretive option, although we acknowledge that it may not be on the government’s agenda in 2016. Utilities M&A among local utilities Given the high number of domestic local operators in the multi-utility sector, the government

(led by Mr Renzi) has tried to stimulate mergers by reducing the number of public controlled companies, envisaging incentives for existing entities (also through the recent PA reform, Madia law). While only partially effective so far, we believe that an acceleration in this trend is on the cards: i) implementing decrees related to the PA reform, also introducing penalties for a failure to consolidate; ii) the final start of the gas tenders; iii) the potential assignment of regulatory power in the waste segment to the AEEGSI; iv) the updated regulatory framework in water, driving towards a single operator for each minimum territorial area. In a scenario of a pick-up in in M&A deals, we view domestic local listed multi-utilities (Hera, Acea, A2A and Iren) as the main beneficiaries, each one in its reference area.

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Intesa Sanpaolo Research Department

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The hunt for dividend yields

In the current environment of historically low interest rates in the euro area, and in the light of our expectations of this lasting into 2016 and possibly beyond, we believe that investors should continue to rank dividend yields rather high in their stock selection criteria.

Italy - 2013-2015 Dividend yield vs. 10Y BTP yield

Source: Intesa Sanpaolo Research elaboration on Factset

As such, we have revised our large-caps equity coverage to identify those stocks presenting higher 2015E dividend yields (to be distributed in Spring 2016) and 2016E (to be distributed in Spring 2017), taking duly into account visibility on dividends, i.e. potential earnings risks.

In the following table, we show a selection of large Italian stocks under our coverage (belonging to FTSE MIB, plus other selected names), based on our expected dividend yields 2015-2016E.

Selected Italian Large Caps - 2015-16E dividend yields

Company Name Dividend Yield _{2015E (%)} Dividend Yield _{2016E (%)} Price (EUR/share) Mkt Cap (EUR M) Rating

UnipolSai 6.8 7.2 2.21 6,150.5 HOLD

Azimut Holding 6.5 6.7 21.65 3,101 ADD

Eni 6.0 8.3 13.24 47,770 HOLD

Cattolica Assicurazioni 5.4 5.8 6.95 1,189 ADD

Snam 5.4 5.4 4.66 15,774 HOLD

Poste Italiane 4.7 4.8 6.75 8,816 ADD

Unipol 4.7 5.6 4.48 3,211 BUY

Generali 4.6 5.2 16.44 25,595 BUY

Mediolanum 4.5 4.5 7.15 5,269 ADD

Terna 4.4 4.4 4.54 9,125 HOLD

Enel 4.3 3.9 3.75 35,300 BUY

Banco Popolare 4.0 3.9 11.62 4,208 BUY

Atlantia 3.9 4.7 23.69 19,563 ADD

Tenaris 3.8 3.9 10.60 12,514 HOLD

Hera 3.7 3.7 2.43 3,620 ADD

Banca Popolare di Milano 3.5 3.5 0.84 3,698.0 BUY

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Italy: Towards a Normalisation of Growth

In Italy, as expected a year ago, 2015 marked the reversal of the cycle. After three and a half years of recession, economic activity has perked back up starting in the first quarter of the year, driven by the tailwinds generated by the shocks in financial markets (interest rates, exchange rate, oil prices), as well as by the effects of the ECB’s Quantitative Easing.

However, the recovery has lost steam in the course of 2015, as the rebound in investments at the beginning of the year (in the means of transport and construction sectors) proved short-lived, and the summer brought signs of a significant slowdown in foreign trade; accelerating consumer spending only offset these adverse trends in part.

As a result, the pace of GDP growth, faster than expected at the beginning of the year (0.4% qoq in 1Q and 0.3% qoq in 2Q) slowed to 0.2% qoq, falling short of expectations in the summer quarter. Therefore, average annual growth in 2015 should level-off at 0.7%,

above the rate estimated one year ago (0.4%), but one tenth lower than our latest forecast (0.8%, in any case at the most cautious end of consensus estimates). However, annual GDP unadjusted by workdays (three more than last year), which is an important variable in drawing up public finance reports, should reach the 0.8% target.

As elsewhere in Europe, at the moment the economic recovery is being driven by consumption, as shocks on domestic demand coming from energy and interest rates seem to be proving more effective ex post (than ex ante based on the econometric models), and stronger than the effect on exports of the exchange rate, also considering that this latter effect was balanced by a downturn in global demand (in particular from emerging countries). Consumption was also supported by the effects on disposable income of the Irpef bonus, which came fully into force starting in 3Q14 (and which according to the Bank of Italy1_{was 90% spent), as well as by} the recovery in employment, which began last year and strengthened in 2015 (also spurred on by government incentives, according to the Bank of Italy surveys2_{). Low interest rates (and the} improvement of credit conditions) also seem to have played a role, as indicated by the robust growth (by around 7% yoy) of durable goods’ consumption.

As has regularly been the case in the past few years, once again the indications provided by sentiment surveys tended to overestimate the pace of growth. Based on Istat data, in November consumer confidence hit a long-term high (for the past 20 years at least) and business sentiment surged to its highest level in eight years; however, increased optimism among economic operators was reflected only in part by the spending of consumers and, especially, corporates. In all likeliness, the depth of the crisis experienced over the past few years has depressed the expectations of economic operators to such an extent that even a marginal improvement is perceived as being very significant; another explanation may lie in the polarisation of the economic situation of households and businesses (markedly negative queues in retail), as well as in the effects of business bankruptcies on the survey sample. This suggests caution in drawing overly optimistic indications on the growth trend from the evolution of survey data.

Going forward, after a 0.7% growth in 2015, we confirm our latest forecast for an acceleration to 1.2% in 2016. The estimate is compatible with a quarterly GDP growth still in the 0.3% qoq area throughout 2016, in line with the average level recorded in 2015 (in other words, economic activity is not seen to accelerate significantly).

After having grown (0.9%) more than GDP in 2015, consumption should accelerate to 1.2% in 2016. The rebound in the real disposable income of households recorded in 2015 (the first after a string of seven years on the decline) is expected to strengthen in the course of next year (to 1.5% from 0.9%, based on our estimates). The recovery in purchasing power is mostly driven by higher employment: we forecast a 0.8% increase in employment numbers in 2016, in line with 2015 (based on our estimates, the unemployment rate could approach 11% in average 2016 terms).

1_{“Annual Report on 2014”}

2_{See “Hirings: the effects of the labour market measures as reflected in the administrative data”, Economic} Bulletin 4/2015.

Paolo Mameli - Economist

+39 02 8796 2128 paolo.mameli@intesasanpaolo.com

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In 2016, investments could take over from consumption as the main driver of the recovery. After growing modestly in 2015 (0.6%), investments should accelerate to 1.6% in 2016. While investments in means of transport picked up already this year (+35% based on our estimates, albeit due to an anomalous surge at the beginning of the year), the important development in 2016 should be the recovery of investments in machinery and equipment, which are expected on the increase by 2.8% in 2016, after the surprise -0.8% slide (for the fifth consecutive year, the seventh out of the past eight) seen in 2015. Businesses should resume investing thanks to persistently ultra-accommodative financial conditions, and to the fact that final demand has already reversed (this should at least ease the caution of enterprises in taking capex investment decisions). The expansionary measures contained in the 2016 Budget, and in particular the possibility of a maxi-amortisation (of 140%) on new investments implemented between 15 October 2015 and 31 December 2016, will also help.

The construction sector must be discussed separately. The contraction of the industry (for the ninth year in a row) in 2015 (-1%, based on our estimates) came as no surprise. The industry was the hardest hit by the crisis, and is the last in exiting the recession, indeed at a very sluggish pace. Only in the past few months, the signals of a recovery in transactions on the existing homes market, the recovery in the affordability ratio, the demand for mortgages by home purchasers, and the sharp rebound in builders’ confidence, have become compatible with a reversal in the industry. However, in 2016 we expect little more than a stabilisation (+0.3%), ahead of a stronger recovery over the following years.

Public spending rebounded surprisingly (+0.3%) in 2015 (after four negative years on the run), but is expected to dip back down in the course of 2016 (-0.1%) as a result of the cuts provided for by the latest Stability Laws. In 2016 as well, public spending will definitively not be among the main drivers of the economic cycle.

Foreign trade could make a negative contribution to growth in 2016 as well. We expect trade flows in both directions to slow, although in 2016 imports are estimated to grow more than exports (3.9% vs. 3.2%), as it was the case in 2015. The slowdown in exports (from 3.9% in 2015) is explained by the smaller additional impact of the exchange rate shock. Sales to the United States and to other European countries (United Kingdom, Spain, some Eastern European countries) should continue to prove rewarding, as opposed to a negative contribution from the emerging markets (Russia, China, Latin America, OPEC countries); however, based on forward-looking indicators, demand from emerging countries may also have bottomed out late in the summer of 2015, and signs of a recovery could start to come in the course of 2016.

 In 2016, as in 2015, we expect economic policies to positively impact the cycle, albeit not decisively (a few tenths of a point):

 The Quantitative Easing programme implemented by the ECB in 2015 was effective in

unblocking the monetary policy transmission mechanism, as the sharp drop in government bond yields translated into an easing of credit conditions and into a significant decline in the interest rates applied by banks to businesses and households (currently both more favourable in Italy on average than in the rest of the euro area); in this sense, the extension to beyond September 2016 of the asset purchase programme, announced by the ECB on 3 December (together with the further deposit rate cut) may have a further positive impact on growth, which however will not be decisive, as the decision failed to aid a further drop in interest rates or a depreciation of the euro’s exchange rate (both of which, in fact, moved in the opposite direction); on the whole, we believe that the Quantitative Easing programme may have an impact (through the changes triggered on the interest rate and exchange rate trends) of around 0.7% on Italian GDP growth in the 2015-2016 biennium (of which 0.1-0.4% in 2016);

 In 2016, fiscal policy, as was also the case in 2014-15, will be slightly accommodative, thanks to the measures included in the Stability Law (change in the cyclically-adjusted primary balance: at least -0.4% next year, in line with this year); the 2016 budget is expansionary, but only if compared to a scenario under current legislation which priced in the triggering of safeguard clauses, with “automatic” hikes in indirect taxes; in general, we estimate a “theoretical” impact of fiscal policy on GDP growth in 2016 of one to two tenths.

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returning to levels broadly in line with potential (although it will take years to close the output gap which has opened up since 2007). Inflation, on the other hand, is still not expected to “normalise”: after two year

Italian Market: Top Picks for 2016

Top Picks - 2016

Equity Strategy Report

Index price performance, -1Y

Contents

A Last Glance at 2015 Market Performance 3

Top Picks and Sector Strategy at a Glance 27

Oil&Gas Sector: Negative 36

Intesa Sanpaolo Research Department

A Last Glance at 2015 Market Performance

World equity markets – 2015 index performances

2016 Market Valuation and Earnings Outlook

Italian equity market vs. Euro Stoxx – A comparative valuation

Valuation at a discount on 2017 P/E

Country-risk and bank-risk in Italy

Equity market valuation and Equity Risk Premium by country

Equity Risk Premium analysis in Italy

Equity Risk Premium dropped in 2015 in Italy

Equity Risk Premium - Italy vs. Rest of the World (Nov 2015) ERP gap to pre-crisis levels - Italy vs. Intl equity benchmarks

A brief recap on our valuation metrics

Italian ERP now lower than most euro area benchmarks

Recent 3Q15 reporting season: a quick recap

Preview coverage – 3Q15 results vs. our estimates 2015 quarterly results vs. our estimates

3Q15 reporting season at a glance

Italian Equity Market – EPS growth estimates with/without banks

Quantifying the effect of banks’ earnings on total market earnings

Normalisation in Italy and Country Drivers

New Normality in Italy: time for a second yearly check-up

Italian Privatisation plan: an update

Italian privatisation plan (2014)

Italian privatisation plan (2015)

What lies ahead in 2016?

Intesa Sanpaolo Research Department

Country-specific drivers: probability and expected impact on ERP in 2016

Aligning Italy’s risk premium to 15Y average (2000-14)

Scope for a further decline in equity premium…

2000-15 Equity Risk Premium and 15Y average – Italian equity market

Investment Conclusions

Italian Equity Market in 2016E – Expected ERP range and index performance

No longer the ‘laggard’ in the euro zone

Two Investment Themes: Sector Consolidation and Dividend Yields

Consolidation: already underway in 2015…

Italy - Consolidation Games in 2016

Intesa Sanpaolo Research Department

Selected Italian Large Caps - 2015-16E dividend yields

Italy: Towards a Normalisation of Growth

Paolo Mameli - Economist