The Imperial Might of the Empire has this to say on the matter of Italy.
What amazed me first time playing as italy is what an incrediably powerful force the Italians controlled during WW2. First thing I do, as I micromanage rather than let the AI handle things, is completely overhaul the Italian OOB. I reoganise it along 3 brigade infantry divisions, starting adding art brigades to them, get rid of heaps of HQ's, and completely reassign leaders. The Italian army then becomes a lean mean machine. Then I kick ass, take out France singlehandedly, take out the Balkans and wage unwarranted wars of annilhation upon hapless and innocent peoples around the world, as befits the GLORY of the HOLY CORUGIAN EMPIRE!
!!!6!!!
Given the damage the Italian army (and navy) can then do I find it astonishing that they could have performed so badly, historically, in the Balkans and North Africa.
I would suggest that you carry out a similiar reorganisation of the Italian forces at the beginning of your game, and only then let the AI take over.
Incidentally, I was under the impression that Italian forces suffered from poor morale during the war. Some historical commentators have attributed this (and appalling leadership) as reasons for their defeat. However, I have recently read some articles that say that the fighting moral of the averge Italian soldier was not nearly so bad as some writters have made it out to be. Perhaps there was a wide variation in moral across different Italain units.