When last I wrote about European utility company Veolia (NYSE:VE) for Investopedia (back in March of 2012), I was cautious about the near-term prospects on the stock given the Street's likelihood of buying into (or rather, not buying into) the company's asset disposal and cost-cutting plans. The stock then proceeded to lose about one-third of its value over the next nine months, as worries about both management's ability to execute and the health of Western Europe's economy weighed on shares.
As this was happening, though, the company actually started making progress, and the shares have been moving up strongly since mid-summer as the Street has finally started buying the turnaround story. From where Veolia sits today, I see both opportunity and risk – I happen to side with the bulls who believe management will succeed in its cost-cutting targets, but I also have my worries about the extent to which the company may have to surrender these benefits to customers in order to maintain the business. All told, I see only modest upside to the shares right now, but the dividend isn't bad and I think the company can contain most of the risks it faces.
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Water And Waste Management Will Drive The Future
As the company has moved along with its asset disposal plans, it is clear that Veolia's water and waste management operations will remain central to the company's future. Veolia's water operations serve more than 120 million people (making it the largest water utility in the world), while its waste management operations are the second-largest in the world and the largest in Europe.
That's all well and good, but the key to Veolia is in driving better results. Veolia's water tariffs are about 9% below the global average, and Veolia meaningfully lags both Severn Trent (Nasdaq:STRNY) and Suez Environment (Nasdaq:SZEVY) when it comes to profitability. Margins are improving, but Veolia is going to have to work out how to reduce costs further in markets were labor reductions are not easy, as well as argue for better tariffs despite the ongoing economic pressures in Western Europe.
Veolia is better off with its waste management business, though here too the company trails rivals like Suez and global comps like America's Waste Management (NYSE:WM). Some of this can be tied to the European economy, as waste management operations are economically sensitive – as seen in the drop in Veolia's capacity utilization from about 70% in 2007 to a more recent level of 45%.
In addition to waiting for the economy to improve (leading to better utilization and margins), Veolia is looking to reposition its waste management business. In an effort to reduce both pricing pressure and pressure from recycling in the municipal business, Veolia is looking to boost the industrial contribution of this business from about 35% to 50%. It's a bold target, it could not only improve Veolia's pricing power in Europe, but give the company more of a “ride along” benefit in its customers overseas operations.
More To Do, With Risks In Place
Veolia still has work to do when it comes to restructuring and finalizing the disposal of businesses in the transportation and energy services spaces. But that's not the only execution risk remaining – as a company, Veolia has been relatively lackadaisical about costs and value-generating mergers and acquisitions. The threat, then, is that an improving European economy may embolden management to once again pursue growth and undo much of the progress already made so far.
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But that said, management should be appreciated for the progress they are making. Revenue was down 3% for the first half of this year, with EBTIDA down almost 8% and below consensus, but adjusted operating income was about 6% better than expected and recurring net income was about 22% above expectations. At the same time, volumes in the waste business are improving (or at least getting less-worse).
The Bottom Line
The bullish case for Veolia is pretty simple. First, the company has done better with its asset disposals and cost reductions than the Street was willing to believe or project, and management believes it isn't done yet. Second, this is a company highly levered to Western Europe's economy (about three-quarters of revenue comes from Western Europe), where it seems that economic conditions may have at last bottomed and started to improve.
As a dividend stock, I like Veolia a great deal more than I did a year and a half ago – I have confidence that restructurings, cost reductions, and tariff improvement efforts will, at a minimum, secure the dividend. In addition, there's that European recovery kicker that I think will become more interesting to shareholders as 2013 finishes out.
Still, Veolia isn't a raging buy. The dividend yield of over 6% is nice, but the company still has a lot of work to do to get its performance on par with other European utilities. Even if you assign a close-to-peer average of 6.5x to the company's expected EBITDA, it only suggests about 5% appreciation from here. It's worth noting, though, that there's a lot of controversy on this name, with sell-side price targets ranging from $9 to over $17. Uncertainty like that can often mean opportunity, and investors who are bullish on Europe may want to consider Veolia as a dividend-paying self-improvement story with significant leverage to any economic upside coming in Europe.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.