Alstom (OTCPK:ALSMY) (OTCPK:AOMFF) recently announced the signing of a definitive purchase agreement for Bombardier Transport (BT) at an updated €7.15 billion enterprise value – a €300 million reduction from the previous announcement. The expected closing has been moved forward to Q1 ’21 (relative to H1 ’21 previously). While the lower valuation is a slight positive, I believe that the revised terms remain unfavorable to Alstom, considering the risks associated with BT’s project execution and the challenging path toward margin recovery at BT. Pending evidence of free cash flow improvement and the resolution of project issues at BT, I remain on the sidelines.

A Closer Look at the Updated Terms

To recap, a definitive purchase agreement has now been officially signed between Bombardier (OTCQX:BDRBF), Alstom, and Caisse de depot (CDPQ) that will see Alstom purchase BT (currently owned by CDPQ) for a lowered $8.4 billion enterprise value (€7.15 billion). Excluding further downward adjustments linked to the net cash protection mechanism, the implied price range for the acquisition is in the €5.5 billion to €5.9 billion range (down from the prior €5.8 billion to €6.2 billion).

Source: BT Acquisition Presentation Slides

While the moderate price cut is positive, it was already widely anticipated by the market after BT reported c. €380 million in unexpected project charges for its FQ2 results. And considering Alstom has explicitly stated it will take FQ2 results of BT into account when negotiating a final, definitive merger agreement, the extent of the reduction (€300 million EV vs. the €380 million charge) was perhaps even a little disappointing. Encouragingly, the closing window was narrowed to Q1 ’21, although the financing structure remains the same as communicated previously, including the €2 billion rights issue and the planned reserved capital increases of CDPQ and Bombardier at €2.6 billion and €0.5bn, respectively.

Breaking Down the Targeted Synergies

Alstom also confirmed its targeted synergies of €400 million (c. 6% of the BT revenue base) to be achieved in year 4 to year 5 despite remedies offered to the EU and to restore BT margins towards standard levels in the medium term. While the target seems optimistic in context, it remains lower than the synergy targets on comparable deals in the EU. For instance, the 10% cost synergies targeted by Siemens (OTCPK:SIEGY) for its Invensys (OTC:IVNSF) acquisition, along with the c. 6% target in the failed Siemens-Alstom merger.

Of the synergy target, procurement is guided to account for one-third of the total, with the remaining set to come from product-related savings, R&D, and industrial synergies. The outsized contribution from procurement makes sense, as c. 60% of Alstom’s production costs are on components sourced from third-parties. Meanwhile, industrial synergies are relatively small by comparison, as management does not aim to reduce its footprint post-acquisition.

Source: BT Acquisition Presentation Slides

BT’s Key Project Risk is a Concern

In recent years, BT has been suffering from worrying delays and cost overruns across its projects. Risks remain as two major projects (Deutsche Bahn IC2 2010 and SBB Dosto) have yet to be finalized, and therefore, there is still a probability that we could see cost overruns on these projects. On the other hand, for all the other major projects that have now been delivered, there is still a risk that BT also incurs additional costs here, as issues can arise in the months following the final delivery – for instance, 2019 saw c. €500 million in legacy project cost overruns.

A Complex Turnaround Process

It is also worth noting that while Bombardier’s rail business brings additional scale, with c. $8.3 billion in revenues as of the last fiscal year (about in line with Alstom), its EBIT margin profile is far lower at c. 1% on an adjusted basis (including project charges). This compares to Alstom’s c. 8% margins.

To make things worse, Bombardier’s performance has shown signs of deterioration, and in FQ2 alone, the group reported a significant drop in revenues, alongside a project charge of c. €380 million, driving widening losses. Similarly, the average margin of the backlog is now likely much lower, which does not bode well for Alstom’s planned turnaround.

While the long-term strategic rationale may make sense, the financial outcome may not as it will likely take several years to restore Bombardier’s project execution and margins towards the targeted 6-8% range. As such, I think investors will need to exercise some skepticism with regard to management guidance for a double-digit EPS accretive outcome by year 2.

Source: BT Acquisition Presentation Slides

A Pricey Deal Filled with Uncertainties

Assuming the current EV of €7.15bn for the BT acquisition, the implied EV/EBIT multiple comes to c. 11-12x relative to historical average adjusted EBIT levels, and c. 7x adjusted for targeted synergies. That seems reasonable, but should the disappointing EBIT results since 2019 persist, forward-looking EV/EBIT multiples could move much higher into the high-teens/low-20% unadjusted for synergies.

Therefore, I view the revised terms as unfavorable to Alstom considering the future risks associated with the deal, especially with project charges continuing to pile up in FQ2. Furthermore, the pandemic has increased uncertainties around the rail traffic outlook, which could materially affect deal economics, considering BT is currently loss-making. The next steps will be the extraordinary general meeting for shareholders to approve the transaction, followed by the rights issue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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