Alstom: Potential For A Positive Surprise (OTCMKTS:ALSMY)

Investment thesis

Alstom SA (OTCPK:ALSMY), a rolling stock producer with global reach, looks like an interesting buy opportunity with a non-linear return profile – specifically before the earnings call on the 10th of May. I think, there is a high chance that the potentially dilutive capital raise will not go through which shall catapult the stock price. If not, with the dilution more than priced in, the stock still has strong long-term fundamentals.

In my opinion, the market has overreacted to the temporary negative working cap fluctuations revealed in October/November 2023 and a new equity issue is not that certain. Assuming normalization of working capital requirements once issues on Amtrak and Aventra contracts are sorted out and given the recently announced sale of the North American signaling business for EUR 600m, there should be enough breathing room in the balance sheet not to go further with an equity raise.

Please note that it is a relatively risky, event-driven opportunity. Although I believe Alstom has good long-term prospects supported by a secular trend of making transport more environmentally friendly, in the short term there might be high volatility driven by announcements on the next steps of the balance sheet improvement program.

In the article below, I first analyze a short-term view of the drivers of the stock and then zoom out to look at a long-term perspective and valuation.

Short-term view

Looking at Alstom’s stock chart it is very easy to see the date when they issued a profit warning for 1H23/24 – 4th of October 2023, which caused close to 40% drawdown on the next day. It is not often that you see such a reaction to a release confirming sales and profitability guidance, but the problem here was a negative EUR 1.15bn movement on FCF caused by a working capital swing. The reasons for this were twofold: (1) a production ramp-up thanks to increasing sales, (2) a delay in payments on the Aventra contract, and (3) lower down payments on new contracts.

What certainly didn’t help is a mixed track record of the company after it acquired Bombardier Transportation in January 2021. With poor profitability on legacy contracts and slowish integration, the stock has already lost 60% (in EUR, 52% in USD ADR) from Jan-21 to Sep-23 – pre-profit warning, while EUROSTOXX 50 grew by single-digit and EUROSTOXX 600 by mid-teens in that period.

Quickly after the profit warning, Alstom released information that its investment grade rating had been confirmed by Moody’s, but it came at a cost. Alstom committed to maintaining the investment grade rating and announced balance sheet improvement initiatives assuming EUR 2bn inorganic measures including:

• Asset disposal program (EUR 0.5 = 1.0bn);
• Equity-like issuance;
• Capital increase;

Potential capital raise is what in my opinion was the main negative trigger to the stock price. Let’s first take a look at what caused the problems – working capital, and then how it is being cured.

Working capital deep dive

Looking at a net working capital in a company that sells in long contracts and recognizes them in line with IFRS15 is always an interesting journey (those who have gone through it can skip the next paragraph).

In the case of companies like Alstom, except for standard NWC positions (inventories, trade receivables, and trade payables), there are also so-called contract assets and contract liabilities. In short, they are the results of discrepancies between (1) a cost incurrence profile of a contract and (2) a customer payments schedule. Revenue and costs on each contract are recognized in line with the percentage of completion method based on a cost profile, while payments are commercially agreed upon with the customer at signing and are usually subject to some milestones. Each contract is always on one side – either a customer has already paid more than a percentage of completion indicates (then there is a liability, called sometimes “unrecognized revenue”), or the company incurred more costs than covered by the client so far (then there is an asset – “soft” or unbilled receivables).

What happened in Alstom’s case in 1H2023/24 was an increase in asset-side working capital:

1. Inventories days increased from 79 to 90 days – a result of raw material purchases for production ramp-up following recent good growth in sales.
2. Contract assets increased from 97 to 114 – a result of delays in Aventra (UK regional trains) and Amtrak contracts.
3. Trade receivables also increased, but it was mostly balanced by a trade payables increase.

The problem with the Aventra program is not only a negative impact on NWC of ~EUR 500m (my estimation – 10% out of the total EUR 5bn selling price), but also a negative gross margin (impact in 1H2023/24 of 80 bps on aEBIT – EUR 70m in that period only). It is a part of the negative Bombardier legacy – low/negative margin contracts, that shall fade away over the next couple of months. The contract is completed in already 97% (and paid in 89%). Alstom assumes it will be finalized in 1H2024/25. Amtrak is an Alstom product that is not getting US homologation as fast as it should, but it is smaller (EUR 1.5bn selling price) and 75% paid.

Looking back at a longer period, it draws attention that it is the second time Alstom surprised negatively by the NWC movement. The first time was in 1H2021/22 – also resulting from production ramp-up, but maybe also a solid review of Bombardier’s legacy contracts. After that NWC stabilized at a new level nominally (and improved if counted in days, as sales increased).

Balance sheet improvement drivers

As a countermeasure to a balance sheet gap that put investment grade rating at risk, Alstom declared an action plan composed of 2 main pillars – EUR 2.0bn of inorganic measures to improve the balance sheet and a cost-cutting program.

Focusing on the balance sheet improvement program, Alstom declared its intention to (1) sell assets between EUR0.5 and 1bn, (2) raise structured equity and (3) raise capital. In my opinion, that plan may have been prepared and announced under pressure from the rating agency and actually Alstom does not need EUR 2.0bn and the risk of solution (3) is minimal.

Firstly, the NWC gap in 1H2023/24 amounted to less than EUR 1bn, and it should not increase further as the key reasons are transitory (inventories ramp-up) or one-offs (the Aventra contract).

Secondly, already EUR 630m has been raised through the sale of the North American signaling business. Although Alstom has not provided information on the profitability of that business, the buyer – Knorr-Bremse did it in their press release on the transaction. Revenue of EUR 300m with a 16% EBIT margin implies an EV/EBIT multiple of 13.1x, compared to ~9x for Alstom.

Thirdly, given the interesting asset base, system projects, and some long-term servicing contracts it is quite attainable to organize some JV equity-like funding on the part of Alstom’s businesses. It would be costlier than debt, but non-dilutive for common equity holders.

Fourthly, management clearly stated that if they were to be sure that an equity raise would be needed, they would just do it, instead of waiting and keeping shareholders uncertain. This comment gave the impression that they believe that the situation will solve itself (which I tend to believe as well) and just wanted to buy time with the rating agency.

Fifthly, even if there will be an equity issue of EUR 0.5-1bn if done at the current market price (and some small discount) it will have a much smaller impact than EUR 3bn market cap loss in October 2023.

Long-term horizon

Alstom – brief intro

Alstom is a pure-play rail sector producer encompassing 4 business lines.

Rolling stock and components (RSC) (53% revenue in 2022/23) – production of trains is a main pillar of the company. It is the largest segment and an enabler of other businesses. In the long term, it is expected to grow in line with a general rail market (~3% annually) with high single-digit profitability.

Services (23% of revenue in 2022/23) – servicing and overhauls of existing fleet is a segment growing mostly on the back of RSC with 40% of orders won through bundled production and services contracts. However, it is also winning new business, as many rolling stock owners prefer to use external services for maintenance, and producers have here a clear know-how advantage. The targets for the services segment are 10%+ growth with mid-teens profitability.

Signaling (15% of revenue in 2022/23) – railway signaling systems that Alstom installs are a very important component of the reliability and safety of the infrastructure and are also crucial in improving line capacity. While general signaling market growth is estimated at 4%, Alstom shall achieve higher rates given its strong position in Europe, where the ERMTS system needs to be implemented in Germany and Italy.

Systems(10% of revenue in 2022/23) – very large and long systemic projects (i.a. Riyadh metro) with high single-digit profitability.

Source for market growth rates: The company cites the UNIFE market study.

Market Opportunity

In my opinion, Alstom as a leading rolling stock producer will benefit from good rail sector prospects. Rail, both intra- and intercity is the most efficient and environmentally friendly way of transporting goods and people in-land. Fast and reliable rail public transport (metro, city trains, tramways) is the most obvious solution to pollution and traffic jams in large metropolitan areas.

In mid-distance in-land freight rail transport emits 24g of GHG per tonne-km, while road trucks emit 137g as estimated in a report prepared for European Environmental Agency. Given the strong ESG push from the European Union (and not only there), investments in rail can get preferential treatment and governmental support, which ultimately goes to Alstom’s top line. Given that Europe accounts for 62% of Alstom’s revenue it might be an important driver of sales growth.

Valuation

If my thesis is right and there will not be an equity issuance, as well as Alstom will be able to deliver its mid-term targets of 5% CAGR on sales and 8-10% aEBIT margin, prospects for Alstom’s stock are very good.

On the one hand, margin improvement once legacy contracts’ issues are sorted out may actually happen and significantly drive profitability. Assuming that the current EV/ aEBIT multiple of 9.15x is right that would imply 100% upside potential over the next two years.

On the other hand, very recently market applied a higher multiple to Alstom’s stock – over 12x. To some extent, it included expectations on margin improvements, but even a 12x multiple is much less than the current Industrials median of 17.6x (based on SA’s valuation table).

Risks

First of all, if there is an equity increase (which I believe will not), strong and unpredictable short-term stock price moves may happen.

It is also worth mentioning that with businesses with long-term construction-like contracts that report using IFRS15, it is impossible to verify assumptions on contract cost curves and determine whether contract assets and liabilities estimations are correct. These positions can be easily “managed” so it requires some degree of faith in the management’s transparency.

Also, while legacy contracts slowly expire and Alstom seems to control profitability on its contract relatively well, it cannot be excluded that some issues with large contracts may happen in the future.

Conclusions

To summarize, I think Alstom is a short-term buy, as the market overreacted and there is a chance that the fresh equity issue will not be needed. Reasons for the working capital gap look transitory or one-off and should not cause further liquidity deterioration.

In the long term, Alstom also looks attractive given supporting secular trends and a potential margin improvement.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.