Fitch Affirms Veolia at 'BBB', Outlook Stable
The affirmation reflects Veolia's EUR600m cost reduction programme for 2016-18 supporting higher estimated cash flows, which we estimate will take average funds from operations (FFO) adjusted net leverage to strong levels for the rating, further supported by the sale of Transdev.
This is despite tighter guidelines to reflect a shift in business mix away from municipal business and Europe towards industrial business and emerging markets. With capex and dividends set to increase, we expect underlying free cash flow (FCF) to remain negative. FCF pre-working capital movements, disposals and acquisitions was a negative EUR244m in 1H16 versus a negative EUR324m in 1H15. We expect fixed charge coverage to be adequate for the rating in the short-term.
KEY RATING DRIVERS
Cost Reduction Supports Earnings Visibility
With revenue growth slowing and turning negative in 1H16, cost cutting is becoming more important for Veolia. Its new cost-cutting programme of EUR600m through 2018 raises earnings visibility and supports higher estimates of cash flows than previously. The company delivered EUR121m in 1H16 against an annual target of EUR200m, driving an increase in EBITDA despite a challenging environment.
Veolia has recently taken additional steps to control costs in French water. In view of continued competitive price pressures, Fitch believes that the EUR600m figure is a minimum and would expect the company to look at similar additional cost-cutting measures in future.
Shift in Business Model
Veolia's business model has shifted over the last five years away from municipal towards industrial business and at the same time away from Europe towards emerging markets. Municipal business accounts for 55% of revenues against 70% five years ago, industrial for 45% of revenues against 30% five years ago, while Europe accounts for 57% of revenues against 64%.
A focus on high-growth emerging markets may increase political and currency risk, lowering the visibility of cash flows, while lower profitability in France makes it less likely that Veolia can utilise its tax losses. We have tightened our rating guidelines to reflect these changes.
Higher Capex Needed for Growth
Although it has had several major contract wins recently, the macro environment remains highly challenging and Veolia achieving its target of 2-3% average revenue growth and 5% EBITDA growth through 2018 is contingent on increasing capex from current levels. The company is guiding to EUR1.6bn-1.7bn of capex for 2016-18 against EUR1.3bn-1.4bn for 2015-16 and Veolia saw an increase in capex in 2Q16 for the first time in several years.
Capital discipline has improved, with a preference for a capex-lite model for some development projects. However, these are equity-accounted, implying a slight change to the composition of cash flow in future.
Sale of Transdev
After years of delay, Veolia has reached an agreement with Caisse Des Depots for the sale of Transdev, recovering EUR895m in shareholder loans and equity by 2018. The proceeds are included in our rating case, a key change from previously. Veolia will likely use the proceeds to pay down debt and fund capex.
The waste industry is currently facing a wave of consolidation. Although it has not ruled out large acquisitions completely, Veolia's strategy is not based on M&A and we believe that further asset disposals would be made as part of an asset arbitrage strategy to protect the balance sheet. It has slated further potential asset sales for a total of around EUR180m.
Underlying Cashflow Still Negative
Veolia intends to keep debt levels stable in the EUR8bn-EUR9bn range. Estimated average FFO adjusted net leverage of 4.4x over the rating horizon of four years, supported by additional cost-cutting and the sale of Transdev, are positive for the credit profile.
However, despite estimates of higher EBITDA, increases in capex and dividends imply continued sustained negative FCF. With relatively high-cost debt, we would not expect FFO fixed charge cover to meet our threshold figure of 3.0x for a potential upgrade before 2018.
Fitch's key assumptions within the rating case for Veolia include:
-Lower revenues than previously, reflecting negative currency impact, reduced construction activity as a result of Veolia downsizing this business and lower electricity prices. Our estimate of 2018 revenue of EUR24.5bn is also based on static waste revenues as a result of global economic weakness.
-Higher EBITDA margins and estimates across all three businesses, based on the new EUR600m 2016-18 cost cutting programme.
-Capex and dividends in line with company's guidance.
-Sale of Transdev stakes for EUR220m in 2016 & EUR330m in 2018.
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Additional cost cutting beyond the scope of the current EUR600m 2016-18 programme.
-Expected FFO adjusted net leverage below 4.5x, improvement in FFO fixed charge cover towards 3.0x and positive FCF, on a sustained basis.
-Business mix trending towards more predictable cash flows.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Operational underperformance or a more aggressive debt-funded acquisition strategy.
-Expected FFO adjusted net leverage above 5.0x, a fall in FFO fixed charge cover towards 2.0x and negative FCF, on a sustained basis.
-Business mix with significantly higher exposure to counterparty risk.
As at 30 June 2016, Veolia had group net liquidity of EUR2.5bn. This included cash and cash equivalents of EUR787m at group subsidiaries, of which we view around EUR200m as restricted. Veolia's gross liquidity position of EUR7.6bn includes undrawn committed bank facilities of EUR4bn.
Fitch believes Veolia has adequate liquidity to meet operating requirements and debt maturities until end-2017. FCF at 1H16 was negative EUR244m pre-disposals, acquisitions and movements in working capital, with the latter expected to reverse by year end.