Time to Drop This Star-Crossed Zodiac Deal

(Bloomberg Gadfly) -- Zodiac Aerospace may be getting cold feet about being bought by Safran SA. Shareholders in the bidder can only hope the mooted tie-up is about to fail.

Safran reached a preliminary agreement in January to buy poorly-performing Zodiac for 9.7 billion euros ($10.6 billion) including debt. This looked like an attempt to become a bigger shop for plane-makers by adding aircraft interiors to Safran's top-class propulsion business.

After nine profit warnings, Zodiac was happy to be acquired by a stronger parent. Weeks later, it issued a tenth alert. That confirmed suspicions that Safran was taking on a Herculean turnaround.

The two sides have been haggling over a new price ever since. Zodiac is ready to walk away if it's too low, according to French website BFM, and may replace CEO Olivier Zarrouati. The stock fell about 6 percent.

To make a deal stack up, hefty compromises would be needed. For starters, the price cut needs to be substantial to allow a transaction to cover its cost of capital, estimated at 9 percent, in 2020 -- as Safran initially anticipated it would.

Forecasting Zodiac's performance three years out is a guessing game. TCI, the hedge fund fighting the deal, envisages 500 million euros of operating profit at best in the near term. Deutsche Bank analysts estimate 759 million euros in 2020. Suppose Zodiac achieves 600 million euros and Safran extracts its promised 200 million euros of synergies, while the tax rate is about 30 percent. In that case, a deal at 6.3 billion euros including debt would make the required return.

That would imply an offer of about 18 euros a share, a 40 percent price cut. This still bakes in optimism around Zodiac's recovery and integration. 

For Zodiac shareholders, that should remain tempting: it would be a punchy 17 times expected 2018 earnings. The snag is that a group of core investors would lose certain tax advantages because they would get only a small stake in the enlarged group. They'd need a pact with other Zodiac owners to keep the fiscal perk. The French state, Safran's top shareholder, is willing to participate for the sake of the deal. But more allies would be needed.

Safran could help by shrinking itself relative to Zodiac going into any transaction. A mega-buyback of 20 percent of its market capitalization would leave net debt below 2 times Ebitda. Still, Safran couldn't do that in a hurry and the leverage might constrain R&D.

So an awful lot of budging is required to get a deal done. No wonder people seem to be digging in. It's hard to see Zodiac's first-half numbers, out on Friday, changing much. If Zodiac ends up having to do its own turnaround, starting by strengthening its balance sheet and management, and allowing its shares to find their level in the market, many will rejoice.

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

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

To contact the author of this story: Chris Hughes in London at chughes89@bloomberg.net.

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