Deals

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

Many things could end up haunting French aircraft engine-maker Safran SA over its 9.7 billion euro ($10.3 billion) agreement to acquire cabin equipment maker Zodiac Aerospace SA. But remarks made by Safran CEO Philippe Petitcolin when the deal was announced stand out:

"We believe, based on what we have seen, what we have discussed with them that, yes, they are at the bottom of their performance”

On Tuesday evening, Zodiac issued another profit warning -- the tenth in little more than two years, according to Bloomberg's Andrea Rothman -- after yet another aircraft seat production snarl-up, this time at a Welsh plant. The company lowered 2017 operating profit guidance by about one quarter. To nobody's surprise, the shares tumbled 14 percent.

Losing Pressure
Safran's offer for Zodiac helped stem a long share price slide
Source: Bloomberg

In the wake of pressure from British activist investor TCI Fund Management Ltd., which opposes the deal, investor debate about Safran-Zodiac has centered on the complex structure of the cash and shares merger. The terms appear to grant Zodiac's family shareholders preferential treatment and tie the hands of other investors. For more on that read Gadfly’s Chris Hughes here and here

Though important, it's no longer the biggest problem. In fact, the situation is quite simple: this is a bad deal for Safran because buying Zodiac exposes the company to unacceptable risks. At the very least, Safran must adjust the terms of its offer. Petitcolin should also think about canceling it. TCI will seek the removal of his chairman Ross McInnes if he doesn't.

The latest warning shows Petitcolin was wrong about Zodiac’s operating woes. It’s not entirely his fault: due diligence was restricted to Zodiac's publicly available information. But what else doesn't he know?

It's possible Zodiac will one day get a grip on its production troubles and its profitability may recover. But Safran can’t be certain when that will be, or what will be left of the cabin business when it does. Who would be comfortable placing a seat order with Zodiac right now? Zodiac’s long-term prospects in cabin equipment (60 percent of revenues) are diminished. Remarkably, Zodiac CEO Olivier Zarrouati stands to become deputy chief executive of a combined Safran-Zodiac. Talk about rewards for failure.

Constant Disappointment
Analysts have had to repeatedly lower their profit expectations for Zodiac
Source: Bloomberg

Safran's argument that the deal will cover its cost of capital in three years is open to considerable doubt. That was based on forecasts of 750 million euros of operating profit at Zodiac in 2020, treble the amount it's likely to generate this year. But Safran can no longer pretend to have confidence in Zodiac's projections. Its warning wipes out as much as 80 million euros in expected profit this year, equal to 40 percent of the yearly synergies the deal is expected to generate.  

Safran says it didn’t know about Zodiac’s latest difficulties before announcing its bid in January and is reviewing its offer after Tuesday night's shocker. Yet it reaffirmed its belief that it can transform Zodiac. Doubtless, there’ll be political pressure for Safran to stay the course. Zodiac is an important Airbus supplier and the French state owns 14 percent of Safran (and 22 per cent of voting rights). French president Francois Hollande supports a deal.  

Yet institutions own most of Safran's shares and they need to make their voices heard. Safran should prime the ejector seat.

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

  1. Though to be fair those synergies are recurring whereas profits should rebound.

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

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net