We initiate coverage of the Environmental Services sector with a BUY rating for Veolia Environnement (fair value €15, upside potential 34%) and a NEUTRAL rating for Suez Environnement (fair value €13, upside potential 23%).
- Solid long-term growth factors: We are bullish on sector fundamentals, whose long-term growth drivers should include demography (population growth and urbanisation), incentive-based regulation (heightened standards), improved management of water resources (supply/demand imbalance) and greater penetration by private players.
- Water contract renegotiations: The downward pressure on prices and margins for certain water contracts in France has revived investor fears. Around 5-10% of water revenue is renegotiated each year and we estimate the negative impact to EBITDA at around 1%. While the renegotiation pace is set to slow going forward, we think this risk is now fully understood by the market and discounted by the consensus.
- Exposure to economic cycles: The waste business is very highly correlated to fluctuations in GDP and industrial production. Weaker growth would reduce treated volumes and recycled materials prices. While our base scenario assumes 2012 growth of 0.5% in the Eurozone and 1% in the United States (BG forecasts), flat growth would result in a downward revision of 4-6% to our 2012 EBIT estimates.
- Preference for Veolia: We applaud Veolia’s refocus (€3bn in asset disposals, cost control, exit from 40 countries), which should boost performance and profitability and improve transparency. The risk/reward profile seems less attractive for Suez Environnement, with the economic slow-down now making 2012-13 targets look ambitious.