I am maintaining my buy recommendation on shares of Veolia Environment (VE) and increasing the price target to $25 from $19 (2013 target) on stronger European fundamentals, strength in the company's core assets and continued cost cutting measures. My two primary concerns remain intact however, with a potential tax increase on French companies, and a decrease in the dividend payout ratio which current yields 5.3%.
Veolia Environment S.A. is the world's largest waste and utility management company. Based in Paris France the company provides environmental services through three divisions, water, waste, and energy management. Water Management include services for municipal and industrial clients which designs and builds technology solutions for sanitation and saving water; Waste Management provides its customers, industries and communities solutions for covering the collection, sanitation, waste recycling, among others; Energy Management sector provides energy and climate conditioning services, power equipment installations and industrial maintenance.
Current Market Overview:
Over the past five years Veolia's management has been selling assets in order to return the company to financial stability. In 2011 it began divesting its transportation assets, a smart move given the low margins, increased regulation, and falling demand. The company is the leader in water treatment services providing wastewater services and drinking water to over 171 million people. Veolia's energy services business segment is the leader in Europe providing 4.5 million apartments with hot water and over 23,000 educational, cultural, sport and leisure establishments with needed utilities. The waste management segment employs over 575,000 people who provide services to 47 million people at 686 facilities around the world. Veolia operates through several subsidiaries including, Veolia Water North America, Dalkia Investissement, VEETRA, VES North America Corporation, among others
Cash Flow Report (2013 Report):
Cash flow from operations remained steady, but at $2.05 billion for 2012, are the lowest in 5 years. Investing activity on the other hand has turned positive for the first time since 2007, due in part to a decrease in capital expenditures and the sale of three billion in non-performing assets. Cash flow from financing activity for the year came in at negative $2.27 billion. On closer inspection we can see that the company paid down $333.5 million in long-term debt and an additional $1.27 of current debt. As a result free cash flow from 2012 came in at negative $802.9 million, substantially worse than previous years, but as I mentioned above, there are multiple trends that show a turnaround in financial and investment activity should occur by 2015 and will translate to strong positive cash flow. Operating activity remains the wild card. It is contingent on the company's ability to increase revenue which, do to asset sales over the years, came in at $29 billion for 2012, up 3.02% from the previous year, and unchanged from 2010, but down 15% from 2009.
Balance Sheet Revitalization:
The balance sheet is the strongest in over seven years. While the company has sold assets over the past few years, they have raised cash and paid down debt with the proceeds (Total assets are up 11% since 2007 but down 17.7% since its high in 2007). Long-term debt should drop $1 billion to roughly $16.5 billion and will have an immediate effect on interest expenses, which has burdened the company's bottom line. Long-term debt is at the lowest levels since 2005 (Long-term debt as a percentage of capitalization stood at 50.6% in 2012, the lowest in over a decade). Furthermore the company has been able to raise a substantially amount of cash which it can use to cushion itself from future problems.
Last year Veolia purchased a 50% stake in Latin American waste management company Proactiva, its first major acquisition in 3 years, serving 42 million customers in 8 countries. The company also received a contract to provide services in the United Kingdom, a market it withdrew from in 2011. Veolia's mid-term strategy is to get 50% of revenue from fast growing markets. Though the company is still far from achieving this goal (VE received 40% of 2012 revenue from France and 35.8% from the rest of Europe), the strategy could lead to greater profits as most of the developing world lacks basic sanitary infrastructure for their growing needs. I would not be surprised if most of this growth comes through acquisitions (I will be concerned over how these deals will be funded Equity, debt or cash). With the overall European economy weak, investors remain skeptical about the company's ability to generate future revenue from these slow markets. Yet waste management and energy efficiency are two extremely important services and I don't expect governments, companies, and individuals to scale back on VE services.
Tax Increase Risk?
The corporate tax rate in France has remained steady at 33.33% for quite some time. Though the rate is one of the highest in the world, I would not rule out the possibility of an increase in the future. French President Holland sent tremors around the European financial markets when he tried to instill a 75% income tax on individual's making over 1 million Euros a year. The French Judiciary quickly voted against such an idea, but one has to wonder if such a far-reaching burden could be shifted onto corporations (Rumors are that Holland is toying with the idea of taxing large companies further). With a growing budget deficit and increasing citizen liabilities, the French government may indeed act. In May 2013 France officially slipped back into a recession and is likely to stay there until reforms to stimulate growth are adopted. Government cuts are bound to occur but are extremely difficult as government officials and various labor parties cannot seem to ever agree on anything, leading to more protests and riots that can at times shut down all economic activity in the country. While an increase in corporate rates will hurt the country's competitiveness, this may be the only option if both sides don't make concessions for the greater good.
One major concern for potential investors remains the extremely attractive dividend yield. At a current 5.3% the yield however is considerably higher compared against competitors and well above the S&P 500 average of 1.90% for the first half of 2014. In April the company paid out .96 cents per ADR, half of what it paid out in 2011 and well off its high of $2.45 set in 2007. Last year I raised concern over the dividend and while cash flow from financing and investing activity remain unpredictable at best, I do not expect management to announce any significant changes to its dividend policy in the near future. Cash flow from operating activity on the other hand has continued to decrease due to continued divestitures of non-core assets such as transportation.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.