Industrials

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

French aircraft engine maker Safran is said to be mulling a takeover of troubled peer Zodiac Aerospace. A union of two French aerospace suppliers has some attractions but it also risks making Zodiac's ingrained troubles Safran's own. 

Zodiac supplies aircraft seats and toilets. That's doesn't sound terribly sexy but in theory it should be a good business to be in right now. The seat industry is highly consolidated, aircraft sales are booming and airlines want increasingly elaborate business class accommodation.

Unfortunately, Zodiac is making a real pig's ear of its golden opportunity. It took on too many orders, leading to delays and cost overruns that have exasperated customers. The company has cut earnings guidance eight times in six months.

Chief executive Olivier Zarrouati, who has kept his job despite the "seats crisis," dropped hints last month that the company might be open to a bid. This week he insisted Zodiac isn't for sale.

Various families together control around 40 percent of the voting rights at Zodiac, yet own only about a quarter of the share capital. Presumably they aren't keen.

Still, were Safran to table a sufficiently attractive offer, it's reasonable to assume Zodiac have to look at it -- the company's long suffering institutional investors would surely insist.

Misaligned Stars
Zodiac's shares have tumbled because of seat delays and cost overruns
Source: Bloomberg

Therein lies the danger for Safran. Zodiac's owners would argue the current share price doesn't fairly value its potential -- the stock has tumbled more than 40 percent since its peak in March 2015.

Its investors were once accustomed to operating margins of around 13-14 percent but that return fell to just 6.4 percent in fiscal 2014/2015 and in the first half of the new fiscal year the operating margin narrowed further to 3.2 percent.

In contrast, Safran's operating margins have tended to be somewhere in between those two poles. Last year it achieved 11 percent, according to Bloomberg data.

Normally an acquirer's P/E needs be higher than the target's to ensure the combination is accretive to earnings per share. So it's concerning Zodiac's shares trade on 22 times forward earnings whereas Safran is on almost 16 times.

The big question, of course, is how quickly Zodiac's profitability can return to "normal."

Zarrouati insists Zodiac's manufacturing problems will be solved in about 18 months so some analysts think the combination will quickly enhance Safran's earnings power. But Safran shareholders can't be sure of that because Zodiac's track record of forecasting earnings is so poor.

Falling profits have also left Zodiac's balance sheet rather strained, which makes it a less attractive target.

Net debt is likely to increase to about 1.3 billion euros ($1.5 billion) in the fiscal year that ends in August, or about 2.9 times Ebitda, according to Bloomberg estimates.  

Safran faces its own challenges to ensure a smooth transition for a new aircraft engine called the LEAP, which it builds in a JV with General Electric. Arguably it doesn't need another big distraction right now.

To be sure it wouldn't have any troubles financing a deal in either cash or shares. It has about 1.8 billion euros in cash and equivalents and will receive another $710 million from the sale of its Morpho Detection unit to Smiths Group, announced this week.

Safran's net-debt to Ebitda ratio is a modest 0.4 times,  according to Bloomberg data, while its 25.8 billion-euro market capitalization is more than four times higher than Zodiac's.

The French state holds a 15 percent stake in Safran and would doubtless give its blessing to create a domestic aerospace champion. Safran's other shareholders should be more cautious.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Bryant in Frankfurt at cbryant32@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net