Description

Business Description

Alstom is a global industrial company based in France that offers a full range of products and services for the rail industry, specifically the transit (i.e., passenger) segment. On September 26, 2017, Alstom and Siemens agreed to combine their rail businesses in a merger of equals, uniting the two dominant European players into the second largest global rail company behind Chinese powerhouse CRRC. Combined Alstom entity will be 2x, 4x, and 8x as large as the #3, #4, and #5 players, respectively (Bombardier, Hitachi, and Stadler).  

Thesis

Alstom’s transformational merger with Siemens creates an opportunity to buy an above average quality business with significant cost synergy opportunities at a very attractive valuation. We’d direct readers to an earlier VIC pitch from November 2017 for additional detail about the transaction. Despite the transformational aspect of the deal and its many financial attractions, Alstom has been missing from most investors’ radar screens.

Deal Rationale

• Consolidates what is effectively the “big 4” (Alstom, Siemens, Bombardier, and CRRC) into a “big 3”
  • Positions the combined entity to better address Chinese competition (meaning CRRC)
  • Leaves Bombardier (which was originally rumored to be a potential Siemens merger partner), already weakened thanks to its overleveraged balance sheet, as a distant #3
  • The newly formed European champion could emerge as the “Airbus of rail”
• Significant cost synergy opportunity
  • Management has identified €470m in synergies (run-rate four years post-close) split roughly equally across procurement, SG&A, and R&D/other, which would be ~40% accretive to pro forma adjusted EBIT
    • Our research calls were largely confirmatory with experts suggesting a high likelihood of full synergy achievement and the potential for further upside. We believe there’s a good chance management is ultimately able to capture well above its synergy target.
• For context, €470m is only ~3% of total pro forma expenses
  • Rolling stock represents ~42% of pro forma revenues. ~60% of the cost of rolling stock is components from suppliers (vs. labor and assembly).  Assuming rolling stock generates below corporate average gross margins (10%) and 60% of COGS is components implies almost >€4bn of supplier spend. If Alstom can get a 5% reduction (highly feasible in the context of doubling purchasing power), that alone is almost €200m of savings
  • Alstom standalone Research, Selling, and Administrative expenses are €175m, €187m, and €352m, respectively. We don’t have the same level of detail for Siemens Mobility, but even if Siemens operating expenses are 50% as large as Alstom’s suggests €1bn in combined R&D, S&M, and G&A across the combined entity that they can go after
• Beyond the four year timeframe outlined for achievement of the €470m, there should be significant synergies from streamlining R&D as each of Siemens and Alstom have competing platforms in each product category, i.e., reduce duplication of two high speed platforms, two commuter rail platforms, etc.
• Alstom and Siemens received cooperation with the French and German unions as part of signing the Business Combination Agreement on 3/23/2018

Areas of Inefficiency

• Off-the-run situation with lack of pure-play publicly-traded comps at scale
• Long time period between signing and closing (deal signed September 2017, likely Q4 2018 or Q1 2019 close)
• Alstom has only recently been a transportation-focused company
  • The company historically generated the vast majority of revenues and profits from its Power and Grid segments, which were sold to GE in 2015
• The Siemens Mobility segment is a small part of the company (only 10% of revenue) and thus not an area of focus for investors
• Complex project accounting and limited detailed pro forma disclosure
• Sparse European sell-side coverage

Alstom/Siemens Merger Overview

• Siemens merges its Mobility and Rail Traction Drive business into Alstom, in exchange for shares that give them 50% ownership of the pro forma entity. Siemens also receives warrants to purchase an additional 2 percentage points of Alstom shares exercisable four years after closing
• Alstom shareholders retain ~50% ownership in the pro forma entity and will receive two special dividends of €4/share each at deal close (expected year-end 2018—see below for transaction structure and indicative timeline)
  • A “control premium” of €4.00 per share (~€900m in total) will be paid to Alstom shareholders only at closing; this is effectively funded by Siemens
  • Alstom expects to pay another €4.00 special dividend (~€900m in total) to Alstom shareholders only using proceeds that are expected to be received from General Electric upon exercise of put options held by Alstom related to their earlier divestment of its energy businesses to GE (~€2.5bn in total proceeds, puttable in September 2018)
• Targeted net cash at closing (after payment of special dividends) of €0.5 to €1.0bn
  • Very strong pro forma balance given net cash position upon closing
• While Siemens in theory could end up owning >50% and has 1 more board seat than Alstom, Alstom appears to be the “surviving entity”
  • The Alstom CEO will lead NewCo, the primary headquarters will remain in Paris (though they will maintain German footprint for foreseeable future), and Siemens Alstom will be listed on Euronext Paris

Transaction Structure and Indicative Timetable

Industry Dynamics

The ~$170bn global rail market is split 50/50 between OEM equipment and after-sales activities and is relatively fragmented with the three legacy global players (Siemens, Bombardier, and Alstom) together claiming ~13% market share, roughly equal to that of CRRC, the dominant Chinese competitor. Excluding China, however, where the Western players are effectively closed out of the market, Siemens and Alstom together have 21% OE market share compared to CRRC at ~4%. The market is probably more concentrated than these figures would suggest. Excluding China and maintenance / aftermarket work done by governments / customers themselves that is hard to isolate and is rarely in play, pro forma Siemens-Alstom has much more significant market share. Importantly, it has even more dominant market share in the higher margin signaling and services businesses (vs. rolling stock, which is more commoditized and lower margin).  

The global rail transit market is characterized by modest through-the-cycle growth driven by a few macro trends: urbanization, congestion, environmental concerns, and infrastructure expansion / maintenance. Government spending on public transportation, which is based on passenger activity and the level of public funding, is the primary driver of industry demand. According to industry body UNIFE, the global transit rail market is expected to grow at a 3.2% CAGR until 2021, while Europe, Alstom’s largest market, is expected to grow at 3.0% over the same time period. Growth by segment should be relatively balanced across rolling stock, signaling, services, and infrastructure.   

Key Risks

The primary investment controversy is the risk that CRRC poses to Siemens-Alstom outside of China. CRRC was formed via the merger of two Chinese state-owned companies, CSR and CNR, in 2015 and has a virtual monopoly in China. The large wave of spending on Chinese rail infrastructure has peaked and CRRC is looking to expand its presence in other emerging markets as well as developed markets like the US and Europe. Simply put, the fear is that the Chinese are cost advantaged relative to the European incumbents, can finance projects on terms that the incumbents are unwilling to match, and / or are willing to run their non-China business at relatively low margins for some period of time in order to establish a foothold.  

We believe a few factors mitigate the CRRC risk: (1) CRRC has a more limited product offering, particularly in signaling, (2) high regulatory barriers to entry, especially in Western Europe, and (3) overstated cost structure / aggressive contract bidding fears. Alstom benefits from years of advanced R&D and technology investments, which provide competitive insulation for more complicated projects. In addition, local, national, and multi-national governmental organizations are often reluctant to grant contract wins to Chinese companies for passenger infrastructure-related contracts. While CRRC has won some pieces of business in the U.S., our research suggests that pricing was not anomalous relative to other similar contracts. Finally, many countries impose localization rules, e.g., the U.S. Buy America Act, which requires manufacturers to build a high proportion of total costs in the local area, which reduces CRRC’s advantage from manufacturing in China and shipping abroad. A pickup in domestic Chinese demand, which has been weak over the past few years, could also curb CRRC’s ability to utilize its manufacturing capacity for overseas expansion. Overall, we view the CRRC risk as exaggerated, especially on Alstom’s medium-term profitability, which is largely based on a very strong backlog.  It’s worth noting that both Alstom and Siemens have record backlogs at the moment, despite a purportedly more competitive environment brought on by CRRC in recent years.

We believe there’s limited regulatory risk for the deal closing. The deal appears to have the support of both the French and Germany governments. The French government owns ~20% of Alstom and Emmanuel Macron has voiced his support for the transaction already. Alstom and Siemens are also likely using the CRRC threat as a means of pushing through what might otherwise have been a challenging deal to get done (both with regulatory bodies but also labor unions).

Valuation

• Roughly €3.00 of 2020 pro forma EPS
  • Assumes 5% revenue growth, which is in-line with each of Alstom and Siemens’s individual targets and appears reasonable relative to industry growth expectations
    • Alstom has generated exceptionally strong organic backlog growth of ~10% over the past 5 years, which provides extremely high revenue visibility over the next 3-5 years
    • In addition, the order pipeline appears promising. According to Morgan Stanley on 03/26/18, “We had a helpful meeting with the Alstom IR team in London earlier this week, and see the tender pipeline as moving closer toward the ~€10bn annual run rate seen in the past few years as opposed to the previous underlying rate of ~€6-7bn.”
    • Given high backlog visibility in near-term revenues, we believe management should be very capable of delivering on their 5% organic growth target through 2020
  • Margins expand ~60bps to 8.7% EBIT margin (ex. synergies) in 2020.  This is driven by a combination of mix (~20-30bps), normal course efficiencies, and some operating leverage
  • €235m synergies achieved (half of €470m target)
• Alstom current trades at €38 per share.  With a 14x P/E, which we think is conservative, and €3 of earnings power, the stock is worth €42, to which we add €8 per share in special dividends (received upon transaction close), ~€4.50 for present value of remaining synergies capitalized at 14x multiple, and ~€2-3 per share in expected net cash at year-end 2019, we arrive at a price target of €57 (up ~50% from current levels)
• In a highly punitive bear case scenario in which the deal doesn’t close, we assume a 10% cut to standalone Alstom consensus EPS and 12x P/E multiple plus proceeds from GE options, which yields ~28% downside
• Overall, we think Alstom has the potential to generate a very strong return over the next couple years with a highly attractive risk/reward

Disclaimers:

We and our affiliates are long ALO FP. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

• Deal close (targeting end of 2018)
• Greater pro forma disclosure
• Progress on synergy targets after deal close