Siemens AG (SIE GR) and Alstom SA (ALO FP) announced on September 26, 2017 an agreement to combine their rail businesses in a merger of equals (newco to be named “Siemens Alstom”), a deal bringing together former arch-rivals from Germany and France to create the second largest global rail company behind Chinese state-owned CRRC (1766 HK), formed in the summer of 2015 through the merger of China’s two largest train or “rolling stock” manufacturers, CSR Corp and China CNR Corp. Siemens Alstom’s combined $18 billion in sales still lags far behind CRRC’s $35 billion, but this may be a bit of an unfair comparison as 92% the latter’s revenue comes from its protected access to the huge Chinese market. In terms of the international market ex China, Siemens Alstom will be the clear global leader.

 

We believe that the merger will make it through the lengthy antitrust review process with minor remedies, largely because of the small (< 20%) share of the combined entity in the global rail supply market, as well as the significant competitiveness of a number of well-capitalized competitors in areas where there is more market concentration (companies such as Bombardier, Hitachi and Stadler).  We also believe that this merger is truly transformative, giving Alstom a broader geographic footprint, a better business mix weighted more heavily towards the higher margin signaling and services businesses, and a diversified 4 year backlog that will provide very strong visibility.  Furthermore, post deal the company will be in a net cash position of over € 500 million, which will provide the company will significant balance sheet optionality.  For all these reasons, we believe Alstom should trade at least at a peer multiple EV/EBITA (PF FY18E) of 11.0X, which equates to a pre-dividend share price of € 45 per share for 29% upside.

• Siemens will contribute its Mobility business to the newco as well as the rail traction drives business (which generates about €600 million in revenue). In exchange, Siemens will gain control of 50.67% of the newco as of the combination date. The company has the right to acquire 2 percentage points of additional shares (via warrants) four years after closing.

 

• If Alstom backs away from the transaction it will have to pay a break-up fee of €140 million.

 

• The French government has committed to refrain from exercising an option to acquire the 20 percent stake in Alstom that it borrowed from French construction firm Bouygues SA. Bouygues in turn has pledged to hold on to its shares until the transaction is approved by shareholders, or until July 2018 at the latest.

 

 

 

• On a regional basis, a combination between Siemens and Alstom will create a very strong player in many markets, so the limiting factor in this deal is without a doubt going to be the anti-trustreview. The European Commission may impose conditions like re-selling significant assets such as UK signaling assets or rolling stock production sites in Germany. But in reality, both management teams have good reason to be optimistic that anti-trust clearance can be achieved. The two suppliers have less than 20% of the global market share of the rail supply market, and where there are concentrated sub-segments, there are strong, well-capitalized competitors that could buy divested assets in any remedy situation.

 

• The regional train sector shows similar patterns, but competition is opening up and there are some strong players. Despite high market concentration in countries like Germany, Belgium and France, because there are such formidable competitors including Bombardier, Stadler and Hitachi, EC remedies will likely be limited.

 

• The market for railway signaling systems, which are designed to control the railway traffic and to guarantee the safe operation of trains on the railway network, is largely national, with high barriers to entry, although trends towards higher standardization may change this. The merger with Siemens and Alstom will create a formidable European player with at least a 40% market share in some countries, but with strong competitors like Thales, Bombardier and Hitachi, there are likely some logical remedies.

• Potential sources of cost synergies, other than reduction of personnel include

 

- Procurement savings: raw materials (especially steel and aluminium), as well as various components, are likely to be a significant proportion of costs within the rolling stock business. The number of suppliers in a large number of areas can be pruned, which should result in supply chain savings.

 

- Scale benefits in SG&A costs: the combined organization can achieve economies of scale in functional and operational areas. In particular, pre bid processes for large contracts need not be duplicated.

 

- Product development costs: Future product development costs for the combined entity (for example for next generation high speed rail development) are likely to be significantly reduced as the two companies pool their R&D resources.

 

America while Siemens is stronger in China, Europe and the United States.

 

 

Valuation:

Siemens Alstom pro forma for the merger trades at a FY18E EV/EBITA of 9.2X if you include just € 150 million of synergies (out of the € 470 million expected by year 4 post deal).  We think these synergies are quite attainable and the margin enhancement beyond FY18 is likely underestimated by the Street.  As such we think the stock should at a minimum trade at the MSCI Europe Capital Goods sector average of 11.0X.  With EBITA of € 1.52 billion, net cash offset by unfunded pension and other off balance sheet liabilities, and 452 million shares outstanding, this equates to a post-dividend fair value of € 37 per share and pre-dividend fair value of € 45 per share, for upside of about 29%.

 

Alstom (ALO FP) Valuation Pro Forma
Price per shareSi	34.91
Shares Outstanding, fully diluted (mm)	452
Equity market cap (€ mm)	15,779
Less special dividends (€ mm)	-1,800
Less net cash after exercise of GE puts (€ mm)	-700
Plus unfunded pension, other off B/S liabs	700
Enterprise Value (€ mm)	13,979
FY18E PF Revenue	16,700
FY18E PF EBITA pre-synergies	1,370
FY18E PF EBITA margin pre-synergies	8.2%
FY18E PF EBITA post-synergies (discounted)	1,520
FY18E PF EBITA margin pre-synergies	9.1%
EV/EBITA (FY18E pre-synergies)	10.2X
EV/EBITA (FY18E post-synergies)	9.2X