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Morningstar | Suez Faces a Challenging Political Backdrop in Catalonia

Suez's historical business is water distribution in France, where the group has long benefited from long-term contracts with municipalities offering comfortable margins.Since 2010, however, the group has been hit by massive contract renewals, which have significantly affected margins. The situation is now stabilizing in France since most of the contract renegotiations are over. However, the political backdrop for the water business in Spain is deteriorating, with mounting risk of a tariff cut in 2020. The other core historical business of the group is waste treatment in Europe. The business' high fixed costs and high sensitivity to industrial production have hurt it since the economic downturn in Europe. Despite significant efforts to reduce the cost base, the waste-treatment EBITDA margin slid from 16% in 2008 to 11.4% in 2018 as overcapacity weighed on prices. We forecast EBITDA margin to partially recover thanks to cost-cutting, stabilizing to around 14% in 2023. To offset declining profitability in Europe, the group has expanded internationally, notably in China, the Middle East, and Australia. We think that activity in those areas will see continued high growth due to urbanisation, economic growth, and demographics. However, we anticipate limited margin expansion, given the absence of a moat. The acquisition of GE Water increased the weight of international activities and bridged the gap with Veolia in the industrial water segment. However, we see limited value creation from this acquisition, given the high price paid. Financial discipline in this capital-intensive business is key. Until 2016, Suez earned returns on invested capital above peer Veolia. Since 2016, Veolia's ROIC has topped Suez's, reflecting Veolia's better capital allocation. In addition, Suez's acquisition of GE Water in 2017 has significantly diluted ROICs. The dividend has been flat since 2008, and management tends to allocate capital to acquisition. Barring any other sizeable acquisition, we forecast that the dividend will grow again as of 2021, by 4% per year though 2023, implying a 2018-23 CAGR of 2%, well below Veolia's 7%.