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Covanta coverage reinstated +6
15:28 18-Feb-16
Only July 8th of 2015 I removed Covanta from my pick list due to exposure to commodities prices. Since then CVA has fallen over 40%. After examining yesterday's earnings report and the macro situation, I'm reinstating my coverage of the company and giving it a dedicated section on the website. The reasons for the decline in stock price are pretty much centered on the commodity risk I cited, plus some delays in the opening of the company's plant in Durham. The latter issue seems resolved and I continue to think that fuel prices are in the process of bottoming, though metal prices are another matter.
Current Situation and Timing
I will address each of the commodities issues in separate sections, but my main reason for giving Covanta dedicated coverage is the sustainability of the dividend, which is approaching 8% yield, though it will remain frozen at 25 cents this year. I view the dividend as sustainable because about two thirds of revenue comes from waste processing, and 85% of that is guaranteed by long-term government contracts. Consequently, though the hybrid EPS results in a current fair value range of just $1.40-2.10, free cash flow of over $2.00 tells a different story. The latter interpretation is supported by the fact that Covanta has mostly fixed-rate debt, and no maturities until at least 2020. Current development projects are already fully financed and management confirmed no need to raise capital for the foreseeable future in yesterday's report.
That management, including a new CEO, has done an excellent job in cost cutting and forecasting the current environment, which shows up in energy hedges as well as the company meeting forecasts even in what could be regarded as an unfavorably perfect storm. Efficiency measures have already shown good results and more progress is expected over the coming year. I think Covanta is another case, like BGC, where excellent management really shines and my confidence is further boosted by multiple open market insider buys at the end of last year:
| Transaction Date |
Insider |
Title |
Shares Purchased |
Price Range |
Shares Owned |
|---|---|---|---|---|---|
| 2015-Dec-14 | Holsten, Joseph M |
Director | 80,780 | 14.49 – 14.49 | 128,318 |
| 2015-Dec-14
|
Holsten, Joseph M |
Director | 35,000 | 14.43 – 14.43 | 82,538 |
| 2015-Dec-8 | Jones, Stephen J |
CEO |
20,000 | 14.80 – 14.80 | 130,444 |
| 2015-Dec-8 | De Castro, Michael J |
Officer |
10,000 | 15.00 – 15.00 | 25,677 |
Thus, although the current environment for Covanta is challenging, I think the company can easily weather it, and that the market has not yet priced in a change in environment. Recent results have been depressed not only by the Durham project, but contract transitions in the main business, which are abating going forward. There are signs that the smart money is already recognizing this, as the shorted float seems to have hit a peak a month ago but would still need to be reduced by more than half to return to normal levels. For the short term, a more normalized 6% dividend yield would imply a price of $16.67, which I think is appropriate given the difficult environment. The dividend could even continue increasing after this year, which would justify further upside, but that would depend largely upon macro conditions.
Long-Term Factors:
- Metals: metal recovery represents the smallest portion of Covanta's income, at less than 10%, and the one most under pressure. In the past, management had forecast the impact of this segment based on the HMS #1 index, but this was an oversimplification. HMS mostly measures steel and iron prices. Non-ferrous (mostly aluminum) stable at $600/ton. For HMS, at prices under $200 per ton, many of the metals processors that served as middle-men are below break-even and have dropped out of the equation. In response, Covanta has opened the Fairless Hills facility, which processes the metals and can sell directly to international buyers. Even in the current environment where, HMS prices have been cut in half, this facility is seeing a 20% ROI despite having been operational for just 4 months. As a result, Covanta may look to open more such facilities. Furthermore, management's 2016 estimates for this segment are based on HMS prices of $120-150, which are well below the current index value of $157. This looks to me like another example of excellent adaptability from management and something that will eventually turn out to be an example of what doesn't kill you makes you stronger.
- International Expansion: Covanta's new facility in Dublin, Ireland is more than halfway completed and already has over 60% of its capacity contracted. Covanta's award-winning, proprietary CLEERGas process was also a hit in China, where the government bought out Covanta's share in a pilot project for over $110M in July. The reduced exposure to that country was well timed, but the the technology is sorely needed as it reduces mass and volume by 75% and 90% respectively. Covanta's implementation is uniquely efficient in that it uses only 20 to 25% of the air typically needed and, critically, does not require waste preprocessing. These claims have been independently verified in a study from Columbia University on the first commercial scale in implementation in Tulsa, OK. Now that Covanta has begun international projects, there should be great interest in Australia, Europe and other more environmentally conscious jurisdictions, especially in light of the new international climate accord.
- Energy: Covanta will get about a third of its revenue by generating energy from the trash it collects in environmentally-friendly ways. Not only does this drastically reduce landfill requirements, it also cuts overall greenhouse gas emissions more than any other power source. Over 75% of the company's energy revenue was contracted or hedged in 2015, and that percentage will increase in 2016, allowing the Covanta to continue to grow its revenue from this segment, even in the current environment. As the U.S. eventually catches up to Europe and other countries in environmental management, I expect this to grow into a replacement for coal, especially in the PJM region that is Covanta's historical home base. Outside that region, there are signs that attitudes are already changing. Furthermore, the fly ash from these operations has many uses and is finding new ones, which can improve both sustainability and profitability. Should fuel prices rise again, CLEERGas even has potential to be a better alternative to hydrocarbon drilling or even the budding electric economy that I've written about.