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Value Idea Contest: Veolia, Risky and Not Very Cheap

April 02, 2013 | About:
Chandan Dubey

Chandan Dubey

99 followers
I started this as a value idea contest pick. But by the time I finished doing all the research and writing it down, it ended up as something I would not buy.



1 History


Veolia Environnement (VE) is French multinational company which is active in four main areas: water supply/management, waste management and energy and transportation. All these businesses traditionally come under essential public services and are managed by the state.

The current company traces its roots to Compagnie Générale des Eaux (CGE) which was created to supply water to Lyon by a decree of Napoleon III in 1853. For nearly a century the company continued supplying water to Lyon and later also to Paris City. This changed in 1976 after the appointment of Guy Dejouany as the CEO of CGE. The socialist party came to power in 1981 and the winds of nationalization swept the industries of France. The Minister of Industry tried to buy shares through Saint-Gobain in an attempt to influence CGE. This hostile attempt was rendered unsuccessful when the president of France intervened in favor of CGE. Soon afterwards Dejouany put the company on a path of diversification; diversifying to transport (Connex and Onyx), energy (Dalkia), and Communication (pay tv Canal+). The expansion was accelerated when the new CEO Jean-Marie Messier took over in 1996. CGE took advantage of the deregulation in the French telecommunication market by creating SFR, which culminated in the 2000 demerger of CGE into Vivendi Universal and Vivendi Environment.

In 2003, Vivendi Environment changed its name to Veolia Environment. The chairman of the board since 2000, Henri Proglio was appointed the CEO of Veolia Environment in 2003. In 2005, the brand Veolia was created with a new logo and was active in the following businesses: water, environmental services, energy and transportation.

At the end of 2003, the company had a very large net debt load of €15.4 billion. Henri Proglio’s first order of business was clearly to reduce the debt. With €24 billion in revenue and €1.4 billion in operating income, it wasn’t an easy task. At the end of 2004 the company had €3.2 billion in equity and the net debt stood at €13 billion. Even after a clear mission of reducing debt, Henri was not successful and the debt reduction continued to elude him, standing at €13.9 billion at the end of 2005.

It is instructive to see that such a huge debt load was not without consequences. Pulling up the annual report of 2005 we observe that the company had revenues of €25.2 billion, OCF of €3.6 billion and a net income of €627.4 million. The interest expense was quite substantial and stood at €713.4 million. The company was paying nearly as much interest as its income.

Regardless, Henri went into a buying spree. He bought Cleanaway Holdings (a UK waste management company) at €859 million citing “significant revenue and cost synergies providing value creative growth” and then SuperShuttle, a carpooling service for airports spanning 23 airports in 17 U.S. cities; pushing Veolia’s net debt from €13.9 billion (2005) to €14.7 billion (2006). Interestingly, the press release of the 2006 annual report does not talk about reducing debt as a priority, as opposed to similar releases in 2004 to 2005.

The pace of acquisition really picked up in 2007 and 2008. Proglio spent around €4 billion in 2007 and 2008, pushing the company into 77 countries. It acquired SULO Group, a German waste management company (€1.5 billion), TMT, another waste management company (€338 million), and Thermal North America, a heating/cooling service provider ($788 million); among others.

All this buying took toll on the balance sheet. Proglio then went ahead with a €2.6 billion capital increase. He then bought People Travel Group, a airport ground transport service from Sweden, a few unregulated businesses from Thames Water and Bartin recycling group, a French recovery and recycler of ferrous and non-ferrous metals.

At the end of 2008 the cost of debt rose to €924.7 million (cf. net income €405 million) and the net financial debt rose to €16.5 billion. The balance sheet shows the retained earnings at -€4.56 billion, and equity of €9.5 billion with €6.7 billion in goodwill. Nearly five years of gross mismanagement had come to its head, and it became increasingly clear that the balance sheet cannot take any more mauling.

There was a marked shift in the tone of the financial statement for the year 2008. The report talks about “asset disposals” worth at least €3 billion during 2009 to 2011, in order to “generate internal resources for growth” (read less acquisitions).

Probably the mismanagement would have continued but for the appointment of Proglio to the CEO of EDF, the French utility company which is the largest in the world. Proglio remained the chairman of the Board and Antoine Frérot took the reigns of the almost-destroyed company.

In the beginning, the new CEO continued following a similar strategy. He acquired two new companies in 2010, NWR Energy for €97 million and a portfolio of non-regulated water activities from Group United Utilities for €193 million.

To preserve cash the company offered to pay its high dividend as shares and nearly 64% of the shareholder took it. A useful byproduct was an increase the equity of Veolia. Nevertheless, at the end of 2010 the company still had a relatively high net debt of €15.2 billion.

With time it was increasingly clear that the strategy of acquiring businesses is not creating as much synergies as the management had hoped for. The annual report of 2011, amid the collapsing share price, clearly shows a shift in the strategy. The company started selling assets and paying debt. In 2011 alone they were able to reduce debt by €3.4 billion.

Not surprisingly Proglio, who was still on the board of directors, was not happy with his protege destroying the assets he had accumulated so carefully. There were reports in the French media that Proglio had tried to oust Frerot. The struggle ended with the departure of Proglio from the board of directors in late 2012, after a media scandal targeting the fact that Proglio had kept executive positions (and his salary) both at EDF and at Veolia.

Antoine Frerot now only needs to worry about the company and not his job. He has a clear target of getting out of the transportation business and concentrating on water, waste and energy. He wants to cut debt to a range of €6 billion to €7 billion and scale back Veolia’s global operations.

2 Business

The company operates in three main segments: water services, waste management and energy services. The water services contribute 40% of the revenue while the waste and the energy segments are of the same size.

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Historically, water has been the best business with respect to margins, and the energy segment has been the worst. The margins have also deteriorated sharply and have been on a downward trend since 2007.

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Meanwhile, the net income has also been unstable

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But the free cash flow has always been positive and the company has managed to generate an average of $1.3 million free cash flow per year in the last 10 years. The interest expense has also remained stable around $1000 million. If the company is able to reduce the debt as it claims then there will be a significant decrease in interest expense and a commensurate increase in the net income and free cash flow.

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The mystery of positive free cash flow amid collapsing profitability and high interest expense becomes clearer after a closer inspection of the cash flow statement. Veolia, because of its large acquisitive nature, has very high depreciation and amortization expense of nearly €2 billion a year. If there is no capex, then the free cash flow gets a boost of €2 billion a year — a substantial sum! As the net income is after depreciation and amortization, it means that the company is still profitable. The lower net margin (since 2008) can be explained by a higher cost of acquisition which Veolia is paying now.

3 Capital Structure

Vivendi sold its stake in Veolia, piece by piece. Currently, the largest shareholder of Veolia is Caisse de Depots et Consignations, holding 11.6% of the stock. Caisse is a government organization from France which is in control of the parliament.

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4 Finance

The balance sheet of Veolia, even after two years of targeted debt reduction, is not great. The company has €11.3 billion in net debt.

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Following is the debt timeline of Veolia. Most of the debt is due in the next few years and Veolia needs to roll it back. It is not generating enough cash to repay them, and the survival will crucially depend on its ability to raise money from the capital markets.

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5 Management


The CEO of Veolia Antoine Frerot has now got the idea of focusing on a few business segments which were most profitable to the company. At the same time he also is going to cut back the number of countries Veolia is active in. By the end of 2013 he hopes to cut the number of countries from 77 in 2009 to 40.

Reading the financial presentation from 2006 and comparing it to 2013, I had a very strange feeling. In 2006, Henri was selling the idea of buying quality assets which will give Veolia synergies and grow its revenue. There was no talk about debt reduction or cost saving. He was selling the idea of growth.

Antoine on the other hand is selling the idea of focus and improvement of the balance sheet. He talks at length about asset divestment programs and he has kept adding new assets to sell. Now he is selling Veolia’s entire business in 33 of the 77 countries. He does not dwell on growth, or synergy.

Both Henri and Antoine seem to be selling something to the shareholders — instead of telling us how they are going to run a profitable business. Given that waste management as well as water supply are regulated industries, offer low margins and have a high capital expenditure; it is imperative for the management to keep their eye on running the business.

6 Dividend

Veolia has been a good dividend paying stock — except when it cut it in 2011 after keeping it the same in 2010. The dividend is now also offered as a scrip dividend, and they have not changed it during 2011 to 2012.

The dividend yield of the company is quite high (€0.7) at nearly 7% at current price of $12 a share. The payout ratio has been quite conservative, but I would not bet on the dividend growing or even remaining stable — unless it forces everyone to take the scrip dividend.

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7 Risks

The risks are numerous. Inability to raise money and roll over the debt (see Section of Finance) is one of the major ones. The company operates in a regulated industry. Any addition to the regulations or change in government policy can lead to permanent impairment to profitability. High interest rate risk is also one of the major ones. Given that the interest cover is around 1.5 the company is barely making its interest payments. An increase in the rates will leave the company unable to serve its covenants. It might need to raise capital to fulfil this requirement.

On top of that a lack in safety standards can lead to litigation. The operations of the company are imperative to health and safety of civilians in the countries in which it operates. Any serious mistakes will have major consequences in terms of compensation, loss in business and goodwill.

8 Valuation

Too difficult. I would not buy this company. Many things need to go right for the company to survive. It will probably need to roll over nearly €3 billion of debt in the next two years and failing that, raise more capital through equity offering. Given that the OCF is quite high at nearly €3 billion, it is possible that if the income does not collapse, it will be able to pay off some of the debt. But at this point, the downside and the upside are both quite high.

The EV of the company is €5 billion; market cap plus €12 billion of net debt is- around €17 billion. Even if it maintains its 10-year average free cash flow, the multiple is still high at 15 times free cash flow. I am sure that one can find better deals with less risk.

Additional disclosure: I do not own any shares. The data and information are taken from the following sources: Veolia's website and annual reports, Wikipedia, GuruFocus and Morningstar.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.5/5 (6 votes)

Comments

Ungoat
Ungoat - 1 year ago
Wow!

I don't know much about VE, but your post is great.

Honestly, I think you deserve to win this contest.

What you present is very true to my experience of value investing. Here's how I think about it:

A) You have an open mind. You went in thinking this stock might be a good investment for you, and changed your mind based on the data.

B) You have written one of the few articles that is related to what I spend 99% of my investing search on, which is rejecting stocks.

C) For me, a negative result is actually much more useful and educational. I'd rather read about risk factors and why not to invest in something, than why I should invest. Most articles are of the 'Gosh, look how cheap this is' variety. But I don't need 3 pages to convince me when something is cheap. Its obvious when something is cheap and I should be able to work it out on the back of a napkin. The risk is in buying something that looks cheap when it actually isn't. I think our training would be better served by more 'look, its actually not cheap' articles and less of the 'gosh, look how cheap it is' articles.

Well done!
cdubey
Cdubey - 1 year ago
Thank you for the kind words. Sadly reporting suffers from survivorship bias. We under report on the negatives. I was considering if I should post this or not. But finally I decided to do so.
RIPDOG44
RIPDOG44 premium member - 1 year ago
One of the best articles I've read on not only this site but many other investment sites.
bartjs
Bartjs - 11 months ago
great article

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