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A return to profit

Suez's has finally turned the corner after a terrible period. But a cloud still hangs over the French industrial and services group in the form of a dispute with a minority shareholder over its complex structure, writes Nick Watson

The improvement in Suez's business is evident from its financial results. The conglomerate, which provides electricity, natural gas, water and waste-management services in more than 130 countries, made a capital gain of Euro753m ($1.0bn) from the sale of an interest in a French broadcaster, M6, which helped boost its net profit to Euro1.8bn. This was a sharp turnaround from 2003, when the firm made a net loss of Euro2.2bn, because of massive write-downs to various assets.

The return to profitability was underpinned by the company taking a knife to costs and debt as part of what it calls its Optimax plan. Costs fell by Euro0.917bn in 2004, surpassing the Euro0.9bn target, while debt fell by almost 25%, to Euro11.5bn.

The big generators of cash for Suez were the international energy business as well as the energy-services division, which generated, respectively, 26% and 16% of cash flow last year. Disposals of assets, such as its 30% stake in Chilean utility Iam, helped it cut net group debt by Euro3bn, although gearing remains high at 91%. "The financial discipline installed by the management two years ago is clearly bearing fruit," says John Honore, an analyst at the brokerage, SG Cowen.

This more disciplined approach looks set to continue. The Optimax plan for 2005 and 2006 envisages further cost reductions of Euro0.55bn, half of which will be achieved by the end of December. And the firm is still looking to rid itself of other non-core, under-performing assets, such as Aguas Argentinas, its water and waste-management business, in Santa Fe, Argentina. Selling Aguas to local Latinaguas would be a relief to Suez, which has battled unsuccessfully with the authorities for three years to increase the prices it charges in Santa Fe and Buenos Aires.

Yet some of the group's other medium-term objectives have already been achieved. For example, the group's return-on-capital-employed was 11.9% as of the end of 2004, up from 8.5% in 2003 and above the 11% target set for 2006.

The group's structure is also now much simpler. Suez, which at one stage had 13 listed subsidiaries, is now organised into four operational divisions in two lines of business – energy and environment.

Suez also plans a "selective, but sustained investment programme" of Euro10.5bn, of which Euro7bn will be spent in the 2004 to 2006 period. Some will be spent on liquefied natural gas (LNG) ventures. Suez, which is involved in the entire process, from liquefaction and shipping to marketing and distribution, oversees LNG supply from various countries and owns and operates import facilities on both sides of the Atlantic.

In February, Suez subsidiary Tractebel LNG Trading signed a 20-year deal with Yemen LNG to buy 2.5m tonnes a year from its planned plant, which its developers hope will be operational by 2009. Tractebel has an option to take a 7.5% stake in the project.

Yet for some shareholders, Suez's restructuring efforts do not go far enough. In the week before the group's results were announced, on 10 March, New York investment firm Knight Vinke Asset Management, which last year led calls for reforms at Royal Dutch Shell, demanded a more ambitious restructuring programme, which it claims will unlock substantial value to shareholders.

Suez's Knight-mare

"We do not have an issue with the quality of the business [Suez], but with its capital structure, which is very inefficient," argues Eric Knight, managing director of Knight Vinke, which is being backed by the giant US pension fund, Calpers, which owns stakes worth Euro130m in Suez and its Electrabel subsidiary. This 50.1% stake in Electrabel, the dominant power utility in Belgium, is the focal point of much of Knight Vinke's ire.

The shareholder says that of the world's 100 largest publicly traded utilities, Electrabel is the only one that operates with net cash on its balance sheet. If a company chooses to use 100% equity to finance itself rather than using debt, as Electrabel does, the rate of return on equity will systematically be lower than that allowed by regulators.

Knight says the reason Suez allows this situation to persist is because the group benefits from being able to borrow Electrabel's surplus cash. However, this, he claims, is harming the interests of Electrabel shareholders, because instead of the company receiving a 15% return on its cash, it obtains only a few percent in interest by lending to the parent group. Persuading Electrabel to leverage its balance sheet would help Suez, he argues, because the group would be forced to clean up its own balance sheet and divest non-core assets.

Knight Vinke also argues that unravelling the firm's complex corporate structure reveals a funding gap between what the group pays to service its debt and the money it receives in interest from its cash and securities. Because the average cost of Suez's debt (4.8% in 2004) is significantly higher than the interest and dividend income it receives from its cash and equity holdings (around 2.0-2.5%), there is a funding gap of about Euro1bn a year, he claims. "The Optimax plan is a key plank of the company's strategy to cut costs, but no matter how far it goes with the plan it can't eliminate that funding gap."

The solution, argues the fund, is for Suez to decide what are core and non-core businesses and sell off the latter to pay down debt. With Electrabel, Knight Vinke says Suez should consolidate 100% of it, spin it off or even have Electrabel buy out Suez. "Either way we're not fussed," say Knight.

Although Suez refuses to comment on the complaints, there are signs that it is responding to the criticisms – in the past two months it has sold off a further Euro2bn of non-core assets, including its remaining 25% stake in the UK's Northumbrian Water Group.

SG Cowen notes that Albert Frère, the leading shareholder of Suez, with 7.1% of the capital, told the Libre Belgique newspaper that the acquisition of a 100% in Electrabel had not been a possibility in the past because Suez did not have the resources, but that now the issue could be considered.

"To judge by these remarks, it is just a matter of time before Suez consolidates 100% of Electrabel," claims SG Cowen's Honore. "The management has not gone this far down the road in simplifying the group's structures only to stop now."

SG Cowen says an offer is unlikely to happen before 2007, because the cost of the transaction could be a hefty Euro11.5bn and a two-year timeframe would give the management teams of the firms a chance to sort out the details over how to merge the two businesses into a single listed entity.

Although Eric Knight claims his fund is a mainstream value investor with an investment timeframe of, perhaps, three years, opinion is divided over whether he is prepared to wait that long.

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