Digging for Pay Dirt in European Markets: Veolia Environnement

By Daniel Ferry - July 11, 2012 | Tickers: AWK, WTR, RSG, VE, WM | 0 Comments

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For the past few years, Europe has been embroiled in a financial crisis that never seems to end, always teetering on the brink of collapse without quite falling over. The reluctance of politicians to move decisively to settle the issue in one way or another has introduced so much uncertainty that capital has fled Europe in droves.

While this is certainly a reasonable response when faced with the potential collapse of an entire market, I believe that for the diligent investor, the mass exodus from European stocks has left some diamonds in the rough. Large companies with strong competitive advantages providing essential services will make money no matter what happens politically, and some of these giants have seen their share prices drop deep into value investing territory. Today I'm looking at a major infrastructure provider that derives over half of revenue from Europe, selling at an attractive discount.

Economic turmoil notwithstanding, Europeans will continue to require and pay for water, waste disposal, and energy, and French-headquartered Veolia Environnement (NYSE: VE) is one of the largest operators of these critical infrastructure services across Europe and the world. Veolia's shares have been punished relentlessly since the onset of the recession, falling from a high of over $90/share in 2007 to around $10 today.

Heavily reliant on government contracts, shrinking municipal budgets in its European core markets have hurt Veolia's pricing power. Worse, Veolia overextended itself at exactly the wrong moment, taking on steep debt just before the recession in order to expand operations in emerging markets. Though the company isn't in serious danger from its debt obligations, management has moved to create a little breathing room by reducing the dividend and seeking to raise about €5 billion through the sale of assets.

With poor market conditions and the perception that these sales are somewhat forced on Veolia, these assets were expected to fetch relatively undervalued prices. Last week, however, the company announced the sale of its regulated UK water utilities for £1.24 billion (nearly $2 billion), several months sooner and for about 10% more than analysts were expecting.

These sales are part of a comprehensive turnaround effort aimed at focusing the company on its competitive advantages, reducing debt, and expanding more strategically. Veolia will exit about half of the 70 countries it currently operates in, including the US solid waste business, where it believes significant capital expenditures would be required to achieve competitive economies of scale. It will also attempt to shed its transportation segment in order to concentrate on water treatment and distribution, waste management, and energy efficiency. Acting within these core competencies, the company intends to position itself as a financially attractive alternative for cash-strapped municipalities in developed markets who currently shoulder the expense of operating this infrastructure. With mature operations offering predictable free cash flow, Veolia hopes to expand its operations in the faster-growing markets of Eastern Europe and China as opportunities arise and its debt load shrinks.

The company is also seeking to simplify, streamline, and standardize its operations, with the hope of cutting overhead costs and eliminating redundancies. The move is meant to boost the firm's margins and return on equity, which has sank from the mid-teens before its spate of debt-fueled acquisitions to 2.3% today. While currently Veolia's profitability metrics significantly lag its largest peers in the water and waste industries, I believe its valuation has been beaten down sufficiently to more than reflect that:

Waste Management and Republic Services are the two largest American solid waste companies. Despite being asset-heavy companies, they earn drastically higher returns on equity than Veolia thanks to the scale and vertical integration of collection operations and landfills the companies enjoy in their home markets. To give a sense of the the sort of asset base Veolia was competing against in the American solid waste business, Waste Management has over 300 landfills, Republic nearly 200 — Veolia has 29. Rather than splash out capital to rival its competitors' scale and integration, I think Veolia is right to simply exit the market and concentrate on its higher-margin operations in its own developed markets.

American Water Works and Aqua America are notable for their impressive net margins, 12% and 21%, respectively, to Veolia's 0.6%. This is indicative of companies operating in mature turnkey markets, and indeed both companies largely limit their growth plans to convenient tuck-in acquisitions serving adjacent developed markets. The two water utilities also have much smaller debt obligations and interest payments than Veolia, with each having a leverage ratio of about 3.3 to Veolia's 7.1. As Veolia pares back its global ambitions to core markets and only its most promising developing opportunities, and unloads non-core asset to shed debt, it should start to see margin expansion.

Above all, these four large utilities have higher multiples than Veolia because they are all American, unexposed to the huge uncertainty over Europe's economic future. Relatedly, their business models are intact, and they do not face Veolia's daunting task of executing the turnaround of a massive company with global operations. 

Any restructuring attempt is inherently risky, and Veolia's failure to execute in the past doesn't inspire confidence. However, under the leadership of new CEO Antoine Frérot, who took the reins from empire-building Henri Proglio in 2009, the company has gained new focus and strategic vision. Veolia has a great opportunity to leverage its status as a world leader in sustainability and environmental solutions to capture new markets, and to boost profitability through a sharper concentration on operational efficiency.

For a business that is valued at only two-thirds of its book assets, there is limited downside to opening a position in Veolia at today's prices. While Frérot has given himself until the end of 2013 to execute a turnaround, a successful implementation should result in valuation multiple expansion to industry averages; suggesting a 50% upside or more. Patient investors can tide themselves over with a dividend yield of nearly 7% while awaiting the turnaround's completion.

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