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Edited Transcript of PPAMF earnings conference call or presentation 29-Oct-19 5:30pm GMT

Nine Months 2019 Pirelli & C SpA Earnings Call

Milan Oct 31, 2019 (Thomson StreetEvents) -- Edited Transcript of Pirelli & C SpA earnings conference call or presentation Tuesday, October 29, 2019 at 5:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andrea Livio Donato Casaluci

Pirelli & C. S.p.A. - General Manager of Operations

* Marco Tronchetti Provera

Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO

* Maurizio Sala

Pirelli & C. S.p.A. - Executive VP and Chief Planning & Controlling Officer

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Conference Call Participants

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* Ashik Kurian

Exane BNP Paribas, Research Division - Analyst

* Gabriel M. Adler

Citigroup Inc, Research Division - Senior Associate

* Gaetan Toulemonde

Deutsche Bank AG, Research Division - Research Analyst

* Henning Cosman

HSBC, Research Division - Analyst

* Kai Alexander Mueller

BofA Merrill Lynch, Research Division - Associate and Analyst

* Martino De Ambroggi

Equita SIM S.p.A., Research Division - Analyst

* Monica Bosio

Banca IMI SpA, Research Division - Research Analyst

* Sascha Sebastian Gommel

Jefferies LLC, Research Division - Equity Analyst

* Thomas Besson

Kepler Cheuvreux, Research Division - Head of Automobile Sector

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Presentation

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Operator [1]

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Welcome to Pirelli's Conference Call with Mr. Marco Tronchetti Provera, the Executive Vice Chairman and CEO of Pirelli, will present Pirelli's 9 months financial results as of September 30, 2019. (Operator Instructions) Moreover, a live webcast of the event and the presentation slides are available in the Investor Relations section of the Pirelli's website.

I would now like to introduce Mr. Marco Tronchetti Provera. Please go ahead.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [2]

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Thank you, and good evening, ladies and gentlemen. Welcome to our 9 months conference call. We are witnessing a harsher market and competitive environment. Two key dynamics are in play; lower Original Equipment prices, both in terms of volumes and prices; effective replacement prices, especially in standard and high value product with lower technological contents as competitions claim most to keep plant running.

We countered these downturn by reinforcing our position in the High Value market, progressing our program to lessen the exposure to standard by reducing volumes and stocks and continuing the implementation of our restructuring plan launch in the first half.

Through these actions, we were able to limit the impact of the external headwinds on profitability, while protecting our cash flow.

We are preparing a new 3-year plan in view of a difficult market and competitive scenario in 2020, first half 2021. We are front-loading a major cost and breakeven point reduction. This is a company-wide effort involving all sections and regions. The new business plan will be presented in the first quarter 2020.

Let's start by looking at how the market environment has changed compared to the scenario we described in August. The global car production outlook for the full year 2019 is weaker than expected, almost minus 6% versus a minus 7% according to our July estimates, mainly in Europe, Asia Pacific and North America in both Synergic and Premium segment. The overall weakness impacted the Original Equipment tire market with a full year decline now expected to reach 8% minus on standard and around minus 1 on 18 inches and above. The 18 inches and above replacement volume trend is confirmed to be in line with a double-digit growth.

In this scenario, pressure on car tire pricing has now eased, especially in Europe during the third quarter. In the Original Equipment, a downturn in demand pushed major carmakers to ask for price revision. And in the Replacement, the largest tire makers redirected their production originally planned for the OEMs to the aftermarket, creating pressure on prices.

The Tier 1 price increase in the fourth quarter in Europe will have to be faced by still weak demand. In this environment, we reacted to the following actions: in the High Value, we strengthened our leadership by seizing new profitable opportunities in the Original Equipment channel, diversifying our portfolio and increasing our presence outside Europe. And by leveraging on pull-through in the Replacement channel and protecting the value of our -- value on specialties.

In the Standard, we are proceeding with lowering the exposure to the less profitable products, accelerating the reduction of inventories, reduced 22% year-to-date at 9 months or 16% in first half, and continued implementation of the restructuring planning. In cost cutting, we are accelerating towards company-wide structural program aimed at lowering the breakeven point from 2020 onwards.

Let us now briefly review Pirelli's key performance in the first 9 months of 2019.

The top line trend was marked by an increase in High Value segment, now accounting for more than 67% of our total revenues and the ongoing reduction in the Standard segment. In a very tough market environment, we were able to limit the impact of external headwinds on our profitability through our internal levers, such as price/mix, efficiency and further efforts in our cost cutting program.

The profitability trend is also affected by unabsorbed fixed cost following the decline in production to reduce Standard inventories. The net income reached 10% weight on sales in the first 9 months of 2019. Remind you that a positive one-off is included in both 2018 Patent Box and 2019 Brazilian fiscal credit.

Finally, we close the 9 months with a net financial position of EUR 4 billion or EUR 4.5 billion including the IFRS 16 impact, discounting the usual seasonality of the working capital and the dividend payments in this current quarter of the year. Return of net debt improved in the third quarter with positive cash flow generation of EUR [12 million] versus a cash absorption of EUR 113 million in third quarter 2018, benefiting from the above-mentioned reduction inventories.

Looking now to the 2019 outlook update. Based on the 9 months results and on the trend we envisaged for the fourth quarter of the year, we are updating our full year guidance. Revenues are expected to be at least EUR 5.3 billion, the growth of around 2.5%., assuming as largely lower reduction of Standard volumes, a price/mix improvement in low range of the previous guidance, reflecting the challenging price scenario and a different mix and more contained reduction of Standard and a better ForEx. Mr. Casaluci will comment on that later.

High Value rate is confirmed at 67% of our revenues and 85% of the adjusted EBIT before start-up costs.

As for profitability, we now forecast an adjusted EBIT margin higher than 17%, up to 17.5%. By result of this, as the previous guidance is due to the external headwinds, the progression of Standard inventories reduction and inclusion of some of the short-term cost-cutting actions planned for 2019 to a wider and more structural plan aimed at reducing the breakeven point from 2020.

The net cash flow generation before dividends is now expected between EUR 330 million and EUR 350 million versus the previous guidance of EUR 350 million, EUR 380 million. Mr. Sala will comment on that later.

Let's now look to the medium-term scenario. Scenario we envisaged for the short-term in 2020 is very challenging. Current forecasts are pointing to a weakening economic environment, likely to worsen due to a more troubling global trade outlook.

In the United States, growth is slowing down, affected by trade wars and decreasing manufacturing confidence. In Europe, the manufacturing sector continues to slide, and trade war fee has continued to weight on business confidence.

In China, GDP growth is gradually slowing as a result of deleveraging trade tensions and weaker global growth. The greatest risk for this area is a full-blown trade war with the United States.

Looking to the markets, we confirm our positioning as the only consumer tire specialist and focused on the High Value that continues to grow faster than the rest of the market backed by over car parc that keeps growing at a positive pace.

Premium and prestige parc, we proceed it's expansion on average plus 5% between 2019 and 2022. Synergy car parc will also grow at 3% average growth rate. Within this segment, there is an upper layer of premiumization cars that is growing fast and demanding High Value tires. Over 18 inches and above tire demand considering both Original Equipment and Replacement will exceed 300 million tires in 2022, slowing down from double-digit to high single-digit and (inaudible) concentrated in 3 High Value regions more than 95% of the market.

In a worsening car production outlook on the medium term Original Equipment, demand is expected to slow down with many outer and past players anticipating no recovery in the next 3 years. In that list, the 18 inches and above will continue to grow, while Standard demand will be negative.

Electrification and SUVs will keep pushing from large rim sizes and high-technology tires enhancing technological barriers. Replacement demand will capitalize of the circulating premium and prestige parc. We do continue to believe that High Value is a more resilient segment in an economic downturn and defendable through our barriers to entry with technologies; material processes for design; application innovation like Run Flat, Noise Canceling, electric vehicles; brand awareness and consideration; customer loyalty rates, both OEMs and users.

Strategic focus is confirmed, but a worsening scenario calls for a strengthening of the competitiveness of our business model. The new plant's goals are greater cash generation and maintaining leadership and sustainability. The enforcement of the business model will be based on 4 pillars; consolidation of technology, innovation and leadership, bringing to the market innovative products and future mobility solutions, increasing at the same time product's environmental efficiency; significant production in the cost base and the breakeven point already beginning from 2020; selective approach to High Value growth; containment of investments, in particular, those aimed at increasing production capacity.

Considering that the external scenario is becoming more challenging compared with expectations of recent months, we are strengthening significantly the plan to reduce breakeven already in 2020. Therefore, the presentation of the industrial plan will take place in the first quarter 2020.

And now, I leave the floor to Mr. Casaluci. Please.

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [3]

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Thank you, Mr. Tronchetti, and good evening, ladies and gentlemen. The first 9 months of 2019 closed with of a EUR 4 billion revenues, growing organically by 2.3% or plus 2.8%, including the fixed impact. The growth was much more pronounced in the third quarter, 4.1% organically or 6.7% in total. High Value volumes increased by 6% in the period with a strong improvement in the third quarter, 10.2% compared with 3.4% in second quarter and 4.5% in first quarter.

In the third quarter, we increased our global market share in car 18 inches and above by almost 1 percentage point, recording a positive 12.7% volume growth, 5 percentage point higher than the market. This trend was sustained in both channels. In Replacement by the pull-through effect and the success of Specialties in 18 inches up. And in the Original Equipment channel, we benefited in Europe from new vehicle launches fitting High Value tires, compliant with the new CO2 emission rules, and from new contracts in North America and Asia Pacific.

Trend remains weak in Standard, reduction of 12.2% in the first 9 months, 8.8% negative in the third quarter discounting the global slowdown of the car 17 inches and below market, and Pirelli's decision to cut less profitable products.

Price/mix improved by 5.4% in the first 9 months. The trend in the third quarter was consistent with our full year guidance and discounts. The higher sales in the Original Equipment channel, tuning the channel mix negative, a positive product mix in line with the first half trend and pressure on prices, less pronounced in the High Value, thanks to our high exposure to Specialties.

A couple of words on pricing. In the Original Equipment, the weak car demand is pushing major carmakers to adopt exceptional cost measures. This is affecting some of the current contracts. Looking forward, we are working to limit the impact by being more selective in serving OEMs, focusing more on Original Equipment and Replacement, integrated profitability and expanding our partnership to include new Premium and electric vehicle clients.

In the Replacement channel, we are experiencing pricing pressure on Standard and on 18 inches and above, not specialties, mainly in Europe, which is becoming a more competitive segment. Pirelli announced the price increase effective from early October in Europe about 2% to 3% in summer and winter and its successful implementation will rely on market trend dynamics. ForEx trend was positive, 0.5% in the 9 months, 2.6% in the third quarter after some U.S. dollar appreciation and some lower volatility of emerging markets currencies.

Moving to profitability. Pirelli closed the first 9 months with an adjusted EBIT of EUR 685 million, a 17% margin. Internal levers, price/mix, efficiency and cost-cutting actions contributed to limit the impacts of the external scenario, exchange rate, volatility -- sorry, exchange rate volatility, increase in the cost of production factors, weakness in market demand and pressure on prices.

In more detail, price/mix of certain raw material headwind and the volume reduction. Industrial efficiencies generated saving for 1.4% of sales, which compensated the rising inflation costs. Cost-cutting actions contributed to limit the increasing D&A and the other expenses and the unabsorbed fixed cost of Standard, stable start-up cost and ForEx. In particular, the third quarter was mainly impacted by the lower contribution from price mix with a drop-through of 45% mirroring the dynamics already explained, the above-mentioned actions on inventories, resulting in EUR 10 million cost impact, higher costs related to sponsorship logistic and other operative costs, EUR 10 million from cost-cutting.

Let's now have a look at the performance by region. EMEA closed the first 9 months with organic sales of 2% negative, impacted by the strong decline of Standard, 12.3% negative, which now accounts for about 35% of total car volumes, about 40% in the first 9 months of 2018. In High Value, we recorded a 2.3% organic growth improving versus the 0.6% in the first half, thanks to the rebound of the Original Equipment sales and the stable sound performance of Replacement. Overall, profitability was in the mid-teens range for the region, lower than the first 9 months of 2018 due to weak volume strain in Standard, followed by lower production, increasing inflation in Romania due to the local currency devaluation and the above-mentioned pressure on pricing. Winter inventories are at a normal level. The success of the winter season is -- will also depend on favorable weather conditions.

In North America, we recorded an organic growth of 5.7% driven by High Value sales and improved market share. In the Replacement through the success of our specialties in the 18 inches and above and our original [indiscernible] All Season products. In the Original Equipment channel with the expansion of our customer base, we started delivering High Value products with high technological contents to premiumization models of U.S. and [regional] Synergic OEMs and opportunity to strengthen our feet in pull-through market. Profitability is confirmed in the 20s range, improving versus 2018 as a result of the higher weight of the High Value sales, cost efficiencies and progressive strengthening of the U.S. dollar.

In Asia Pacific, trends are improving with an organic growth of 5.2% versus of a 4.2% in the first half of the year. In the High Value, we consolidated our leadership with a solid performance in both the car and motor business. New OEMs contracts are reaching the delivery phase, both with Asian and German premium manufacturers. Profitability confirmed in the 20s range, stable year-on-year.

Russia and Nordics grew organically by 5.4%. The focus on the most profitable segments and the market recovery impacted favorably on the region 9 months result with an organic growth of 34% in High Value revenues compared to a 3% decline of Standard organic sales. Profitability confirmed in the mid-teens range, slightly lower than the same period of 2018 on the back of higher unabsorbed fixed cost in standard, local production increasingly devoted to Europe was reduced in the third quarter in order to optimize Europe's inventories level.

Finally, South America. The results are reflecting the implementation of the new go-to-market in the region. The pruning of the less profitable rim size in the Standard segment, combined with our repositioning of the profitable Standard products. This is leading to a double-digit decline in volumes, balanced by an even higher price mix increase. Strong acceleration on the High Value still a smaller segment with the market but with promising growth opportunities, stronger distribution strategy more focused on profitable trade channels.

Profitability, high single-digit, has improved in the first 9 months of 2019. Cost-cutting measures limited the unabsorbed fixed cost in local plants where production was lowered in order to optimize the inventories level.

Let's finally move to the operational drivers of our guidance. We foresee a High Value growth of at least 7.5% in volumes, outperforming the market in both channels and with an improving trend in the last quarter of the year supported. In the Original Equipment by the contribution of (inaudible) locations and new supply Contracts in North America and Asia Pacific. In the Replacement by the pull-through effect.

For Standard, we forecast a double-digit decline, minus 11%, an improvement versus the previous indication, mainly in South America. The combined trend of High Value and Standard will bring volumes down 2%. Price/mix improvement is now expected at the lower end of the previous guidance, 4.5% positives versus previous guidance from 4.5% to 5%, factoring the challenging pricing environment in the Standard business and in the nonspecialties High Value and a different product in channel mix. ForEx almost stable. Hence, the top line is expected to be at least EUR 5.3 billion.

High Value weight over sales is confirmed at 67%, in line with the previous indication. Adjusted EBIT margin is expected to be in the range of higher than 17%, up to 17.5%. The delta versus the midpoint of the previous guidance is mainly explained by higher input cost for EUR 10 million due to increasing cost inflation in Romania, U.K., Turkey and Argentina. A lower contribution from cost-cutting from EUR 70 million to EUR 50 million since some of the planned actions are now replaced by medium-term cost-reduction initiatives, EUR 20 million of unabsorbed fixed cost on Standard due to a lower production. We confirm the following drop-through: 40% on volumes, around 55% on price/mix and 15% on ForEx.

I now leave the floor to Mr. Sala.

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Maurizio Sala, Pirelli & C. S.p.A. - Executive VP and Chief Planning & Controlling Officer [4]

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Thank you, Mr. Casaluci, and good evening, ladies and gentlemen. Net income in the first 9 months of 2019 was EUR 386 million or 9.6%, in line with the previous year. We remind you that both 9 months 2018 and 9 months 2019 include a positive one-off impact, Patent Box in 2018 and Brazilian tax credit in 2019 with a net impact of around EUR 100 million.

Tax rate in the first 9 months of 2019 is equal to 26%, in line with full year target. Excluding all the one-offs and nonrecurring items, net income adjusted amounted to EUR 380 million versus EUR 404 million in the same period of 2018, where the difference is mainly related to the Argentina hyperinflation impact.

We ended the first 9 months with the net financial position of EUR 4 billion, EUR 4.5 billion including the IFRS 16 impact discounting the usual seasonality of the working capital and the dividend payments in the second quarter of the year.

Net cash flow before dividends improved year-over-year by EUR 349 million, minus EUR 612 million in 9 months 2019 versus minus EUR 961 million in 9 months 2018.

This result is attributable to a better operating cash flow, minus EUR 252 million versus minus EUR 634 million in 9 months 2018, which saw lower CapEx year-over-year consistent with the full year guidance, a limited cash absorption for working capital minus EUR 963 million versus minus EUR 1.245 billion at the end of September 2018 benefiting from the already announced recovery actions on Standard inventories.

More specifically, inventories in the 9 months saw a reduction in volumes of 9%, minus 4% in June, with minus 22% of Standard volume decline, minus 16% in first half and the plus 1.5% of High Value products, plus 5% in first half. Following the actions taken, we already reached an inventory level in line with the end of year target of a 20.5%, 21% weight on revenues compared with 21.7% at the end of 2018.

Despite the usual seasonality of the business, the quarter saw a positive net cash flow of plus EUR 12 million versus a negative cash absorption of minus EUR 131 million in third quarter 2018, driven by the recovery actions on inventories and the lower year-over-year CapEx.

For the full year 2019, we expect to generate a solid net cash flow before extraordinary operations and dividends between EUR 330 million and EUR 350 million. This result will be achieved through a tight control on the working capital and lower investments, EUR 380 million versus 2018 EUR 463 million.

The new guidance is only slightly below the one of August between EUR 350 million and EUR 380 million, thanks to additional recovery actions of raw material and control of the distribution stocks pursuing the low end of inventory over sales guidance 20.5%. Lower dividends to minorities and lower cash-out for access that partially offset the reduction of EBIT adjusted. In line with the usual seasonality of the business, in the last quarter of the year, we expect a positive reversal of working capital and other by around EUR 900 million, EUR 857 million in the first quarter -- in the fourth quarter of 2018 deriving from the receipt of trade receivables in conjunction with the winter sellout, further reduction of inventories and increase of trade payables also due to the usual weight of investments in the last quarter of the year.

Pirelli's gross debt amounted to EUR 5.6 billion at the end of September 2019 with an average life of 2.4 years, as approximately 70% of it is now due beyond 2021. We remind that we have the right to stand at the unchanged economic conditions, the maturity of 2 of our committed bank lines to 2022 and 2024, respectively. Our cost of debt on an annual basis related to the last 12 months stands at 2.99% from 2.95% in December 2018.

And now, I leave the floor back to Mr. Tronchetti.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [5]

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Thank you, Mr. Sala. And now we can open the Q&A session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from Kai Mueller of Bank of America Merrill Lynch.

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Kai Alexander Mueller, BofA Merrill Lynch, Research Division - Associate and Analyst [2]

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First up, basically, just trying to understand, you are, obviously, seeing better volumes in the third quarter and also now targeting us or guiding us towards the upper end of your prior range, at the same time take down some of your margin expectations. When you think about your business and you run it, how do you think going into the end of this year then also into next year, how you prioritize volumes versus prices?

And then the second question is really on the cost cuts you mentioned. You said, obviously, some are not coming through this year. You are planning to do them more structural into next year. Can you outline a little a bit what those structural changes are in order to take the breakeven down -- breakeven point down further?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [3]

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I'll start from the second question and then I leave the floor to Mr. Casaluci for the first question. So as you see, we postponed the plan in order to enhance the 2020 breakeven reduction. The actions we are implementing both on costs of headcount, costs related to purchasing, but the largest part comes from a different approach to the design to cost, designed to value of the products and the industrialization cost and the cost of production in our factories. So we are now working in a more integrated methodology between the cost design and the evolution of the production in our factories. And we see the largest part of our cost reduction will come from these area. It's very analytic job we are doing, which involves all functions -- technical functions and industrial functions together with the commercial side because altogether we are now working on a value-based evolution of our products, rated also to Replacement in the market with a continuous control on the value creation and pricing. So that is why we are postponing. To answer in a single and easy way, the largest part of this will come from the cost of the products and the cost of production of products. These are the major changes we are putting in place. Mr. Casaluci?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [4]

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Thank you, Mr. Tronchetti. As far as price/mix versus volume, clearly, the priority for us is and will remain to support the price/mix grow and as a consequence, the profitability. And also in the last quarter, our priorities to capitalize the price increase that we have announced. You see a better performance in terms of volume, mainly because of 2 reasons; because we are enlarging our customer base in the Original Equipment as we announced since the beginning of the year, mainly North America and in Asia Pacific; because we are -- we see that there are a lot of important synergy carmakers that are entering into the Premium segment with new interesting models and we want to stay with them in these development and we want to enlarge our coverage, mainly in Asia Pacific and North America, as I said before.

Second point, the reduction on Standard is lower than before, and you will see that we do not target any more a double-digit decrease on the Standard, simply because we have already cut and phased out all the second brands and the less profitable segment. And now we are following more the speed of the market instead of accelerating as what has happened in the last 2 years.

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Operator [5]

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Our next question is from Gabriel Adler of Citi.

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Gabriel M. Adler, Citigroup Inc, Research Division - Senior Associate [6]

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On price/mix in the High Value segment, it was quite weak, at about negative 2% in the third quarter, could you talk through the key drivers of the weakness here in price/mix in High Value? And would you agree that it's a sign of increased competition, particularly on 18 inch and above products?

And then my second question would be on the lowering of inventories through reducing production in the Standard segment. I just like to understand whether you think that this is a longer-term issue relating to tire oversupply in the market? And whether you expect Standard production to remain low in the 2020 in order to address this oversupply?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [7]

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So I'll start from the question on price/mix in the High Value. Price/mix in the High Value in the third quarter was slightly negative. This is mainly linked to 2 reasons: first, which is the most important, accounting for more than the half of the effect in the negative channel mix as I mentioned before because we grow in the Original Equipment, the High Value more than what happened in the Replacement in the third quarter. And the second, the discounting for 1/3 of the impact is the price pressure in the products 18 inches up, not protected by different technologies or what we call Specialties.

All in all, the price/mix that we recorded in the third quarter, 3.5% positive, is the best performance of the industry. So to answer to the first question, in the benchmark, we always perform more than the double than the best performer of the industry in the price/mix and these remain a target for us.

As far as the outlook on 2020, sorry, but I haven't understood the question, if it's related to volume or market or what?

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Gabriel M. Adler, Citigroup Inc, Research Division - Senior Associate [8]

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It's relating to reduction of -- reducing production in the Standard segments. Is that -- is this thought of -- to be thought of as one-off in the third quarter or is this the new normal?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [9]

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Yes. In the third quarter, you'll see a lower reduction in the Standard compared to the first half because we compare ourselves with a previous year, where we had an acceleration in the reduction of the Standard, which happened mainly in the third and fourth quarter, linked to the South American market [crisis] and also because we are accelerating the program of reduction of inventories in the Standard.

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Operator [10]

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The next question is from Martino Ambroggi of Equita.

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Martino De Ambroggi, Equita SIM S.p.A., Research Division - Analyst [11]

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The first question is on the price increases that you mentioned during the speech. Are they fully implemented? And if you could separate your comment by region and by segment, please?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [12]

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Yes. the price increases are already implemented effective from 1st of October in Europe and in United States up to 3%. The price increases are not flat but different product by products. And we have focused at the price list increase mainly on the product where we have a leadership in the Original Equipment that we are protected by different technologies and specialties, and in the lower end of the Standard where we want to continue our exit strategy from the segment.

If we move on the other regions, we have applied another price increase of 5% in Brazil following the local inflation and opportunities to improve the price/mix performance as you -- as I explained that is one of the main driver of the increased profitability in South America.

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Martino De Ambroggi, Equita SIM S.p.A., Research Division - Analyst [13]

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Okay. In any case, no problem to implement these price hikes. That's the major point. The second question is on the restructuring actions that you mentioned. If you look at you mentioned that major importance will be the design to cost and different industrialization. I don't know if I'm right, but this takes time and thus the benefits will be probably more evident in 2021 rather than in 2022 -- in 2020, sorry, or maybe I'm wrong on this and this seems to be the most important portion of the cost savings that you have in mind.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [14]

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I'll answer to the second part and then I'll leave the floor to Mr. Casaluci for the first part of your question. What you're saying here is true that these actions are effective later. What we are doing is a bit different because we are on one hand simplifying the so-called SKU, we call them IP codes. So we are reducing the number of items, which is an analytic process. Combining products that can have the same mix of raw materials to simplify things. We are combining this with actions in the factories to standardize some processes, thanks to the automation we have in our factories, and to simplify in a drastic way, the cost of production, increasing productivity in our factories. This is not a process we started in the last couple of months. We started last year this process. We accelerated the process in June, when we started watching to the market deterioration and to the need to implement action faster. These actions are now already in place in some factories and we see the possibility, more than the possibility, the certainty that these actions will be implemented, having effects in large part already in 2020.

It is not something we have done at the last minute. And these processes are helping a lot the modeling of products and also the simulators we are using. So we are facing a demand from the Original Equipment that is a cost-cutting -- is a drastic process of cost cutting on this side, asking for prices decrease already in 2019 that are affecting our accounts. And taking into account all of these, we made all the actions in order to reduce the cost of product. So the simplification is possible today, thanks to digital, thanks to simulators, thanks to the mathematic model. And in our plan, what we have is a continuous investment in technology that allow us to implement all these actions, reducing drastically investment on capacity because obviously, year-end, we have capacity available that -- as it was already announced in our IPO from 2020, the demand of capacity for us would have come down drastically. And we are moving investments to the technological side. And this is why we are ready to deliver already in 2020, a consistent result out of these actions. Mr. Casaluci?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [15]

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Thank you, Mr. Tronchetti. So as far as the -- our capability to increase the price, I have to divide. The products where we have the leadership in the Original Equipment that we are more protected, we are confident to apply successfully the price increase we announced. On the other High Value products and on the Standard is our priority and we will do our best to apply the full price increase. Clearly, in this segment, it will depend also from the price discipline of the market. The first signal on the month of October are positive. We are monitoring daily the impact.

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Martino De Ambroggi, Equita SIM S.p.A., Research Division - Analyst [16]

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Okay. If I may, very last on the drop-through for price/mix in Q3 was 49%, maybe you mentioned it during the presentation, but what should we expect for Q4?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [17]

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It's 55% on the full year basis, which is a bit higher than 40% in the last quarter as expectation.

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Operator [18]

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The next question is from Sascha Gommel from Jefferies.

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Sascha Sebastian Gommel, Jefferies LLC, Research Division - Equity Analyst [19]

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The first one would be, again, on price/mix. So we see a significant deterioration again in the fourth quarter implied by your guidance. I was wondering if you can share a few thoughts about price/mix in 2020, how you see that shaping up?

And then my second question would be on the cost line item, D&A and others. It seems that especially the other parts has been changing from the first half to the third quarter quite a bit, so I was wondering if you can give more details around the other part of that line, what changed then?

And then very finally, you upped your cost cutting from EUR 50 million to EUR 70 million with Q2 results and now you take it down back to EUR 50 million again. What is that EUR 20 million gap? What kind of are we taking out again?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [20]

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So before leaving the floor to Mr. Casaluci, I want to underline one thing on price/mix. The recent deterioration is visible and the implementation of tougher actions into our plan focus on 2020 because we see that to protect our profitability, we have to reduce the cost of our products. No way in this environment without a drastically cost reduction, the profitability we achieved and we want to increase cannot be protected. That's why we are acting in a deep way on our cost basis, mainly on products and, obviously, on product. Mr. Casaluci?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [21]

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Yes. I have to add that the deterioration of the price/mix is not so materially significant versus the guidance, while it is if we compare the third quarter versus the first half. In the first half, the price/mix performance was 6.4% positive and the third quarter is 3.5% positive. And this was more or less expected in our previous guidance. The delta versus the third quarter and the first half is linked to 2 effects: The first one, the discounting 2/3 of the impact is the negative channel mix. So higher weight on the Original Equipment. The second, the discounting 1/3 of the delta versus the first half is related to price pressure on the High Value segment without protection of the Original Equipment technologies and in the Standard.

Expectation for 2020. It's not yet time to disclose the price/mix because we're still working on it, but I do expect a stabilization on the channel mix effect. We are discounting a negative channel mix effect in the third, and we will also discount also negative one in the first quarter of 2019 because of the comparison versus last year. If you go back to the third and fourth quarter of 2018, you will see a particularly outstanding price/mix performance. So I do expect that these effects will be stabilized in 2020. I do expect a reduction on the impact of less Standard sales because we will move from a double-digit decrease into a high single-digit decrease on Standard. So we will have a less positive impact coming from the Standard reduction, while the growth on the High Value and the micro mix effect will be confirmed. So it will be closer to what we have seen in the first half of 2019 than in what we see in the second half.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [22]

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And Mr. Sala, can you please answer on depreciation?

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Maurizio Sala, Pirelli & C. S.p.A. - Executive VP and Chief Planning & Controlling Officer [23]

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Yes. For your concern on depreciation, the variation in the third quarter versus the previous quarters, 1/3 is related to the depreciation that in the region of the year has grown by EUR 30 million and the remaining part is coming from the fact that last year we increased the action on cost starting from second semester. So EUR 20 million in the third quarter and EUR 30 million in the last quarter. So practically the comparison base now for this point of view is comparing the third quarter versus third quarter of last year, in which the action already increased. There are no major differences from this point of view quarter-by-quarter.

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Operator [24]

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The next question is from Henning Cosman of HSBC.

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Henning Cosman, HSBC, Research Division - Analyst [25]

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Sorry, I need to come back to the price/mix again. Also looking at deterioration and the drop-through, is it possible at all to give us, as a one-off maybe, the proportion of price and the proportion of mix within that? I'm just assuming that the price has become more negative within it because the -- if we assume that the drop-through on price is 100% that it would explain the various drops. So that's my first question. And ultimately, to reconcile just why the trade mix is -- why the price is so weak because you're main competitor, the French competitor doesn't appear to have similar issues on the pricing in the Premium segment. So that's the first question.

Second question, I'm afraid I still don't fully understand why you moved the timing of the announcement of the comprehensive financial plan? I appreciate the extra granularity that you've given today, but I'm just wondering what's changed compared to 5 weeks ago when you announced the timing to be in December? Or for what reasons you think you might have better visibility in Q1 than what you would have in December? So if you could please just tell as one more time why you're moving it? And what's the benefit of doing it in Q1 rather than in December?

And then just finally, on the coverage of the fixed cost, if you could just explain, again, why there's now an under coverage of fixed costs even though you're seeing the reduction in Standard less negative than in the previous plan? Why is there now a bigger under coverage of fixed costs?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [26]

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I'll answer to the part of your question related to the postponement of the plan. Postponement of the plan is due to the effective deterioration of the market. We see this through the requests that are coming from the Original Equipment. We are now finalizing the contracts for next year related to prices. We saw that the pressure on prices in our Original Equipment is becoming more and more visible and combining this with the existing situation in the Standard business and in the lower part of the 18 inches and above made us confident that the only way to continue growth in profitability looking forward is to act deeper into our cost basis and to implement all these actions effective 2020. We wanted to have more time available to be really active from 1st -- January 1, 2020, and bringing backward some actions that we're expected to have results in '21, '22 because we see the toughest time coming sooner than expected. That is the situation. And the real pressure, obviously, today comes from the Original Equipment. We have to answer to this through technology and cost basis reduction to keep profitability already in 2020 at a level that is in line with the expectation of us and of the market. Mr. Casaluci?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [27]

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Yes. So as far as price/mix performance and the worsening of the drop-through, I sum up what I said before. The difference between the third quarter, 3.5% positive, and the first half, 6.4% positive on the price/mix, is 3 points. Out of these 3 points of worsening of the price/mix, 2 are linked to the channel mix, and again, it's something that we do expect also in the first quarter and then will be recovered when we will be back to the normal channel mix from beginning of 2020. And 1 point is the price environment.

If we compare the Pirelli price performance into the market based on the public information we have, we see that the performance on price of Pirelli is better than the average of the Tier 1 into the market. Having said that, we know we have opportunity to do better and better, and this is our main focus for the coming months and as I said before, we are confident we can improve.

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Maurizio Sala, Pirelli & C. S.p.A. - Executive VP and Chief Planning & Controlling Officer [28]

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For your concern on the undercover of fixed cost, you are right, considering the fact that in term of sales, the sales of Standard were reduced by 8.8% in the second quarter -- in the third quarter, while in the cumulative data were minus 12%, minus 13%. But this is what we have in terms of sales. What is important here is what happened in internal production, which in the third quarter were reduced the stocks. So by acting on the production volumes by reducing the stock versus the end of last year that at the end of first half, we were in term of volumes minus 4% and we reached minus 9% in the third quarter with minus 22% on Standard. So this was the action that we did in order to have a better control of the stocks and for the cash management and to reach targets of the cash.

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Henning Cosman, HSBC, Research Division - Analyst [29]

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Can I just follow up on the price? Would you say it's fair to say that price was already negative 1% year-over-year in the first half, so the 1 percentage point deterioration is order of magnitude minus 1 in the first half and minus 2 year-over-year in Q3? Is that roughly fair?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [30]

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No. No. It's not correct. It is too high. We don't disclose the difference between price and mix. We never do. But your estimation in terms of pure price negative impact is too high.

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Operator [31]

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Our next question is from Monica Bosio of Banca IMI.

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Monica Bosio, Banca IMI SpA, Research Division - Research Analyst [32]

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Most of my questions have been already answered, but just a follow-up on the drop-through of the price/mix. The slowdown of the Original Equipment has created available capacity, which has reversed into the aftermarket. But I've noticed, and correct me if I'm wrong, that there is still -- there is also some pricing pressure on new contracts for Original Equipment. So does this mean that the price pressure is going to intensify? And if yes, what kind of drop through do you expect in 2020? It will be 55% on the full year, maybe, could be -- it could go down in 2020 or am I wrong?

And the second question is on the separation rates of the plants. What is the separation rate of the plants for High Value tires? And what about that rate of separation for Standards? And do you still expect unabsorbed fixed cost in 2020 reasonably as you have reduced the stock? This kind of unabsorbed cost that should be one-off, am I right?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [33]

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So I'll answer to the first part of your question. Mr. Casaluci will answer to the second part. You are right, on Original Equipment, there is our price pressure that will go on in 2020 in -- even in a tougher way than what we saw in beginning of 2019. That's why, as I mentioned before, we see an opportunity coming from reduction of the breakeven in 2020 to continue our policy in the very high end serving our customers at a convenient price, but with cost that allow us to be profitable in this segment. We, obviously, do not comment on drop-through on 2020 because it will be part of our plan in 2020. But you can imagine that the figures of 2020 will be affected in a very consistent way by the plan we will present. So any comment that I make today could anticipate something that we will deliver with the plan. Mr. Casaluci?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [34]

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Thank you, Mr. Tronchetti. Yes, we confirm higher pressure on price coming from new contracts, which is part of the environment we are facing in this period of time. Our reaction is, first, as Mr. Tronchetti mentioned, to work deeply on the cost of the product both in production and product specification. And second, to be more selective in approaching the new project, always evaluating the interest of new projects, looking at the integrated profitability between the Original Equipment sales and the expected future Replacement sales. This is also one of the reasons why we are enlarging our customer base, entering a new Premium segment of new customers.

Moving to the saturation. Our saturation on the High Value capacity is higher than 95%, while our saturation on the Standard capacity today is close to 75%, which means roughly 7 -- sorry, EUR 6 million of nonsaturated capacity. This is due to the reduction of that demand and due to our target to reduce the stock as Mr. Sala was mentioning before. Our structuring plan already announced as a target to close this gap and to arrive to a full saturation of the capacity also on Standard. For the time being, we have in our numbers, the inefficiency of the fixed cost not absorbed by production.

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Monica Bosio, Banca IMI SpA, Research Division - Research Analyst [35]

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Okay, but not for other impact?

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Andrea Livio Donato Casaluci, Pirelli & C. S.p.A. - General Manager of Operations [36]

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No. Only Standard. The High Value is fully saturated capacity.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [37]

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On this topic to remind you that we announced the restructuring in Brazil and the change of scope of our factory in Italy that are part of this reduction of the breakeven point and upgrading of our mix. Obviously the economic effect of this will start coming in second half of 2020 and full effect will be in 2021.

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Operator [38]

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The next question is from Gaetan Toulemonde of Deutsche Bank.

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Gaetan Toulemonde, Deutsche Bank AG, Research Division - Research Analyst [39]

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I'm going to be extremely brief in my question. If I look at the raw material price today, am I right to assume that next year it could represent a tailwind by approximately EUR 50 million to EUR 70 million, 7-0, or I do my math absolutely, wrong?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [40]

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I have an easy answer, it's too early to say. Contracts we already have in our portfolio are making us in a position to begin next year in line and a bit better than last year. That's the situation we foresee for the beginning of next year for contracts that are effective January 1. But we are talking about a minor part of the raw material, so it's too early to give you an answer.

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Operator [41]

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The next question is from Thomas Besson of Kepler Cheuvreux.

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Thomas Besson, Kepler Cheuvreux, Research Division - Head of Automobile Sector [42]

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I'll try to be brief as well. Two questions please. The first one is could you please give us an idea of the indirect contribution you still get in 2019 from your industrial tire business through the technical assistance and the supply of semifinished products? The first one. And the second, when you -- when I look at your third quarter, it seems that price/mix has been better in Standard than in High Value, should we assume that in the third quarter, the profitability gap between the 2 segments actually declined and the profitability of High Value tire decline while Standard improved or is it incorrect?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [43]

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I'll answer to the second question. Can you please repeat the first question because we couldn't hear it well?

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Thomas Besson, Kepler Cheuvreux, Research Division - Head of Automobile Sector [44]

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Sure. So I'll repeat the first question. Could you please indicate what we should expect from the indirect contribution of your former industrial tire business to the group adjusted EBIT in 2019?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [45]

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We don't have businesses that are out of our -- we have royalties that's the only thing we have, that is in line with what we -- so there is nothing new in this area.

Related to the second question on profitability, I have to confirm that the profitability on Specialties tires continue to be in line with the profitability we had in the past. And the only effect we see in the last months of this year is the reduction in profitability of the Original Equipment, that is the point we see the only difference. But all in all, we don't see a reduction of integrated profitability and the action we are putting in place are focused to consolidate this business model.

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Operator [46]

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The next question is from Ashik Kurian of Exane BNP Paribas.

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Ashik Kurian, Exane BNP Paribas, Research Division - Analyst [47]

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I've just got 2. First one is on the destocking that you're doing on -- sorry, I'm hearing my echos. Can you hear me? Hello?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [48]

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Of course, could you please restart your question? We see if there is question off-line or what?

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Ashik Kurian, Exane BNP Paribas, Research Division - Analyst [49]

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Yes. So the first question is you've said you're destocking on the Standard tires, that should normally translate into some free cash flow support from destocking. I'm just wondering if that is factored into your new cash flow guidance because I would have expected some support to free cash flow from the destocking that you're doing on the Standard side. And also wondering whether you now are anticipating higher restructuring charges to offset some of the destocking benefit you are having.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [50]

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I'll answer to the second question and Mr. Casaluci will answer to the first part. The -- let's see, the cost related to restructuring, thanks to the balance sheet we have, will be such that not to affect the result, the net result that can be in line with last year. You know that we had the advantages related to the positive effect of the fiscal recognition of our rights in Brazil and the Patent Box. So this allow us to have year-end not -- negative effect compared to last year to our net result. And there will be, obviously, cost related to restructuring to pay the cost of next year. Mr. Casaluci? Mr. Sala, sorry?

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Maurizio Sala, Pirelli & C. S.p.A. - Executive VP and Chief Planning & Controlling Officer [51]

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For your concern, the Standard, the major action that we have in term of impact on the cash flow on the Standard is coming from the reduction of the inventories from this point of view that we target at the end of last year and we reached already in the third quarter. We want to keep also for the last quarter of the year. And then for sure, the Standard is contributing to the cash with the results generated by the activities on Standard. Also if it is with a lower profitability in any case is a business in which the investments are lower because the capacity is already there. So practically each activity that we are doing is without having any larger CapEx or any investment in CapEx. So in terms of profitability in any case is currently a good contribution to the full picture of the cash flow of the company.

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Ashik Kurian, Exane BNP Paribas, Research Division - Analyst [52]

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I know it's maybe a bit too early to comment on the 2020 plan, but you said it's based on improving the free cash flow. Can we assume that the current CapEx levels can be sustained? I mean is that part of you reducing the cost of producing tires? So would some of the free cash flow support for 2020 and beyond come from a lower than previously planned level of CapEx?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [53]

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We already, as I mentioned before, during the IPO process, we said that at the beginning and for the first 3 years, we would have had around 8% of investments going down to 7% and landing to about 6% on sales in 2020. So I think, that you have to keep in mind these figures, looking to the fact that the capacity installed doesn't need to be supported with more investments, sorry. The investment in the next 3 years will be lower than the investments we had the last 3 years. That is a way to answer to your question without answering to the planned figures.

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Operator [54]

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The next question is from (inaudible) of Allianz Global Investors.

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Unidentified Analyst, [55]

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Could you comment on the pricing pressure in the OE business? Is this structural issue because of new competition? Or is it rather a cyclical issue because of excess capacity?

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [56]

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It's the automotive industry that is facing major restructuring. It is visible, the problem of high investment in new technologies, reduction of growth in China and in Europe, strong reduction in co-country in Europe, that is Germany, all the needs of investments are putting pressure on the automotive industry and the automotive industry is putting pressure on our suppliers and we are putting pressure on our suppliers. So the world is changing and we have to accelerate the changes inside our company to continue successfully the performances we had. And so I think it is a structural change as it will be structural change in our cost basis we are going to implement and we are implementing now, accelerating the process in the last few months. And so we cannot talk about cycle. We talk about an industry that is facing different times compared to the past.

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Operator [57]

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Mr. Tronchetti Provera, there are no questions registered at this time, sir.

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Marco Tronchetti Provera, Pirelli & C. S.p.A. - Executive Deputy Chairman & CEO [58]

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So thank you to everybody. Thank you. This -- we conclude today's program. Thank you for your attention, and have a good day -- have a good evening.