OREANDA-NEWS. September 21, 2015. Fitch Ratings has affirmed Veolia Environnement's (Veolia) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The rating of its undated deeply subordinated reset rate notes has been affirmed at 'BB+'. The Outlook on the IDR is Stable.

The ratings reflect Veolia's cost-reduction programme and prospect of stronger water earnings from 2016. While we expect the company to announce fresh cost cutting as part of its strategic update for 2016-18, visibility is currently limited. Veolia continues to buy back bonds, improving fixed charge cover to an expected average of 2.7x over the rating horizon.

These positives are offset by a potential increase in risk as the business model moves away from both Europe and municipal customers, with political and currency risk in emerging markets, and continued delay in the sale of Transdev (TRG). Free cash flow (FCF) pre-movements in working capital and disposals was negative EUR114m in 1H15 vs EUR121m in 1H14 and the decision to pay dividends in cash only means that we expect Veolia to remain slightly FCF negative. We expect funds from operations (FFO) adjusted net leverage to fall slightly to 4.9x by 2018 from 5.0x in 2015.

KEY RATING DRIVERS
Cost Reduction Vital
Veolia must cut costs to remain competitive or risk losing contracts or lower profitability at contract renewal or even lose access to new contracts altogether. The company achieved gross savings of EUR110m in 1H15, almost entirely responsible for EBITDA growth of EUR147m. However, in a slow growth macro environment, it seems unlikely that Veolia can retain the full benefit of cost cutting. Cumulative cost savings since 2012 are currently EUR692m, close to Veolia's original target of EUR750m. Therefore we believe that Veolia is likely to announce fresh cost cutting for 2016-18 at the investor day in December 2015, but at present we have limited visibility on the process, which is reflected in our projections. If Veolia can achieve cuts of 1% opex a year, this would imply annual cost savings of around EUR200m or 8% of EBITDA.

Waste Volumes Recovering
Although there are signs of a recovery in waste volumes, this has not been the case with pricing. Underlying revenues seem weaker than last year and although Veolia no longer breaks out earnings by division, its peers, including Suez, saw a fall in waste EBITDA margins in 1H15. We have lowered our waste EBITDA projections for Veolia. The main areas of weakness appear to be in Germany and pricing, both electricity and raw materials prices, specifically scrap metal as evidence grows of a slowdown in China, affecting sorting and recycling. We believe a solid performance in water partly offsets weakness in waste.

For Veolia, the process of contractual erosion is virtually complete, implying some recovery in water next year. At the group level, currency affects the 2015 financials, with a weak euro adding EUR64m to group EBITDA and EUR492m to debt in 1H15.

Transdev Disposal
Veolia is still looking to exit the transport business and could ultimately recover around EUR825m from TRG in equity and shareholder loans. This would be the last of the asset sales and with TRG's financial performance finally improving, it would be material. However, the transfer of Societe Nationale Maritime Corse Mediterranee (SNCM) to Transdev (TRG) was a precondition for the sale of Veolia's 50% of Transdev to Caisse Des Depots et Consignations (CDC). SNCM has gone into receivership, with a likely long lead time before Veolia can renew negotiations with shareholder CDC with a view to reducing its holding in TRG. SNCM is also faced with substantial contingent liabilities, which may further slow the process. In view of the uncertainty, Fitch continues to deconsolidate TRG from projections and has made no allowance for the sale.

Change in Dividend Policy
Veolia changed its dividend policy in 2014, ending the scrip option and paying the entire dividend for 2014 in cash. It has committed to maintaining the 2015 dividend payable in 2016. FCF in 1H15 was negative EUR114m pre-disposals and movements in working capital. Although the latter should reverse by year end, it is barely changed from the 1H14 figure of negative EUR121m. This is despite cyclical recovery, cost cutting and some help from currency. The company has said that deleveraging has finished and that it intends to invest all FCF post dividends in organic growth.

Shift in Business Model
Following last year's sale of Dalkia France and full consolidation of Dalkia International, the business mix has shifted away from Europe (57% of 1H15 revenues vs 78% 1H13) and towards energy services (18% of 1H15 revenues vs 17% 1H13). A lower margin and more capital intensive business, energy services have arguably higher business risk compared with the highly cash generative water, or waste business. At the same time, growth from new contracts has shifted away from municipal business towards industrial, which generally outsource financing with a higher counterparty risk. The focus on high growth, less developed markets may increase political and currency risk, particularly in emerging markets. The shift in business model, both by activity and by geographical market, if confirmed by the upcoming strategy update, entails a shift in risk, suggesting that there may be a case for tightening rating guidelines after the strategic update.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Veolia include:
- Slightly more conservative than guidance of CAGR in revenues of 3% and EBITDA of 5% through 2018. This reflects lower price indexation in water contracts and soft pricing in waste, notably in raw materials and scrap metal, as Chinese GDP growth continues to slow. The 2014 figure is distorted by currency (+4.2% in 1H15 revenues).
- With limited visibility on cost cutting at this stage, our EBITDA estimates are comparable with company guidance, but well below equity consensus, especially in the latter years of the rating horizon. Based on proforma 2014 EBITDA of EUR2,308m, Veolia is effectively guiding to 2018 EBITDA of EUR2,805m against our forecast of around EUR2,750m.
- No sale of TRG or repayment of the EUR405m intercompany loan and EUR418m equity.
- Dividends paid in cash, based on an estimated unchanged EUR0.70 per share in 2015, followed by EUR0.80 per share in 2017 and EUR0.93 in 2018, in line with equity consensus. This is a key difference versus the previous rating case, which assumed 50% cash/ 50% scrip.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Additional cost cutting, operational outperformance and sale of TRG.
- FFO net adjusted leverage falling below 4.7x, improvement in FFO fixed charge cover ratio towards 3.0x and positive FCF, on a sustained basis.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Operational underperformance and/ or a more aggressive debt funded acquisition strategy.
- FFO net adjusted leverage above 5.5x, a fall in FFO fixed charge cover ratio towards 2.0x and negative FCF, on a sustained basis.

LIQUIDITY
As at 30 June 2015, Veolia had group net liquidity of EUR2.6bn. This includes cash and cash equivalents of EUR918m at Veolia Environnement S.A. and EUR815m at group subsidiaries of which we view around EUR175m as restricted. The gross liquidity position of EUR5.8m includes undrawn committed bank facilities of EUR4.1bn. Fitch believes Veolia has adequate liquidity to meet debt maturities and operating requirements until the end of 2017. FCF at 1H15 was negative EUR114m pre-disposals and movement in working capital, with the latter expected to reverse by year end.