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Covanta coverage reinstated +6

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:

Price Range
2015-Dec-14 Holsten, Joseph M
Director 80,780 14.49 – 14.49 128,318
Holsten, Joseph M
Director 35,000 14.43 – 14.43 82,538
2015-Dec-8 Jones, Stephen J
20,000 14.80 – 14.80 130,444
2015-Dec-8 De Castro, Michael J
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:
Like almost everything I cover, my primary interest in Covanta is for its technology.  Even though the current environment is challenging, I think CVA is already a bargain, and one that puts time, and the broad human situation on the side of current investors.  I plan to cover more undervalued, high-quality, dividend-paying stocks in the future for investors who want moderate risk and gain more income.  BGCP remains my top pick in this category and overall.