France-based global utility Veolia Environnement (VE) has given investors a pretty wild ride. The company's excessive ambition for growth stoked a lot of bullish sentiment early in the decade, but the combination of Europe's deep recession and sloppy execution lead to disappointing margins, cash flows, and investors.
Veolia management started taking turnaround efforts seriously in 2013, pushing ahead with cost cuts, asset sales, and a restructuring of the company's operating priorities. The company still has a lot to do if its going to produce margins on par with its close peer Suez Environnement (OTCPK:SZEVY), let alone American comps like American States Water (NYSE:AWR) or Waste Management (NYSE:WM), but the better than 100% trough-to-peak move tells me that a lot of investors buy the self-improvement story and/or want to be positioned in basic services as Europe's economy turns around.
One Of The Largest In The World
Veolia certainly does not lack for scale. This company generates more than 40% of its revenue from Veolia Water, a water utility active in over 40 countries and serving more than 100 million people. Veolia generates more than a third of its revenue in France and no other country even comes close in terms of revenue contributions.
For all of that scale, it does not appear to generate particularly compelling margin synergies. Veolia has long lagged Suez in terms of adjusted EBITDA margins (the gap was about three points recently), and Veolia's mid-teens EBITDA margins don't come anywhere close to the margins produced by American water utilities like American States at almost 34% or American Water Works (NYSE:AWK) at over 46%.
The waste management business (Veolia Environmental Services) is similar on both fronts. This is the second-largest waste management operation in the world, serving about 47 million people, and the largest in Europe. Generating close to a third of the company's revenue, this business generates substantial revenue from France, the UK, and Germany (close to 70%). Here too, though, the profitability is not so impressive - lagging multinational peer Suez by around a point and a half (EBITDA margins) and American companies like Waste Management by a more substantial degree.
Veolia also has its majority interest in Dalkia, a business that designs, builds, maintains, and operates a range of building, industrial, and facility services like heating, cooling, and lighting.
Cost Cutting Is Key
Veolia's lack of cost/operating efficiency is a central issue. Some readers may scoff and suggest "it's a French company, what do you expect?", but that doesn't really explain the gap with Suez, nor other European utility companies. I believe the issue is more structural - Veolia prized growth for growth's sake and, in my opinion, bid on projects and business with almost no concern for long-term profitability or returns on capital.
Unwinding and improving those decisions and businesses is going to take time. Management has been delivering on cost cuts. Over 100 million euros of cost savings materialized in 2013 on top of 60 million in 2012, and management believes a total of 750 million in cuts (relative to a starting point at the 2011 Investor Day) is attainable through 2015. That may only be around 3% of the company's revenue base, but it's quite significant next to EBITDA of around 1,800M euros. These cuts are largely coming from areas like purchasing/sourcing, shared operating and IT costs, and overall efficiency.
Getting Creative Helps...
Management also seems to realize that there is only so much it can do within the scope of its municipal utility businesses. To augment those opportunities (and offset the risks that cost cuts may be given back in the form of lower rates), management is getting more creative in targeting new business opportunities.
Veolia wants to increase its exposure to industrial customers, where it can provide a range of services from water supply and recycling to waste management and material recovery/recycling. The company recently announced a nearly 1 billion euro deal with Novartis covering 15 facilities across Europe, and management has referenced other opportunities like providing comprehensive services to food and beverage companies, as well as enhanced pollution treatment/prevention (particularly for resource companies), decommissioning, and enhanced oil recovery and water management in the energy sector.
… But Boardroom Spats Do Not
There is certainly some skepticism on the Street as to whether Veolia's plans go far enough and whether they will hit the goals laid out by management. Apparently this skepticism extends to the boardroom and ownership group. The Dassault family (which owns about 6% of Veolia and is the second-largest owner) apparently wasn't happy and was rumored to be agitating for a new CEO. That followed rumors a little further back that the former CEO of Veolia (and current CEO of EDF, Henri Proglio) wanted Frerot out as he unwound a lot of Proglio's unprofitable overseas expansion.
Given that the current CEO Antoine Frerot was recently reappointed for another four-year stint, perhaps this issue is settled for the time being. Should the recent run of clean quarters stop, and/or should the upward rise in the stock come to an end, that could start up all over again and create more uncertainty for shareholders.
The Bottom Line
While improving the company's long-term growth prospects is a frequent topic of management conversation, I'm not looking for Veolia to grow revenue much beyond a low-to-mid single-digit rate (around 4%). If the company can hit its cost-cutting goals and get FCF margins back into the 3% range, the company can once again fund its dividend payments, delever, and merit a fair value close to $20. Given that an industry-average EBITDA multiple of 7x on 2014 EBITDA estimates only produces a target of $15.50, though, it is clear that a lot of Veolia's value lies in improvements further down the road.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.