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Covanta 2Q17 results +5

10:02 29-Jul-17

I think a clarification on the note below is in order.  I spent a lot of time towards the end discussing the dividend because I think the stock price will be tied to that for (at least) months to come.  I probably should have clarified that I see almost zero chance of a change in dividend in the near-term, and that's supported by Q&A with the CEO:

I don't expect at all that our dividend will be impacted

Saying that management refused to rule out a dividend cut was probably poorly stated on my part.  It would have been better to say that it's a tight time, and management acknowledges the balancing act it has had to do between reducing leverage and maintaining the dividend, but has no plans for a cut.

The conference call has just concluded.  Here are my notes in descending order of importance:

Energy: Hedging (in the low thirties) and contracts leave less than a third of 2018 energy production left to market pricing.  In a way, that's a shame given how current energy prices have been progressing, but it documents what absolute nonsense Seeking Alpha Editors have been selecting for Pro publication.

Balance Sheet: Similarly, debt levels are about 3.5x equity, which should represent a peak.  Management affirmed its commitment to lower that leverage by year end.  However, the ratio has been as high as 6x, and an analyst offered the opinion that even 7x would be acceptable.  Refinancing debt to lower interest rates just a few months ago was 10x oversubscribed.  I think management is doing the right thing in cutting debt in the face of rising rates and limited visibility, but no matter how you look at it negative sentiment surrounding the sustainability of debt levels seems completely unfounded.

Waste Processing: MSW (municipal solid waste) contract pricing was up 4%, and spot prices have also increased.  The Fairfax facility downtime was a drag on operational results and that is now expected to continue into the fourth quarter.  $10M of $17M in insurance proceeds in Q2 were for Fairfax, and that should be representative of the recovery for each quarter of downtime.  However, reimbursement will naturally lag each quarter and extend into early 2018.  Fairfax should have improved operations next year, though, and I find it impressive that 2017 EBIDTA guidance was maintained despite this.  I further note that Puerto Rico continued to pay its utility contracts even in bankruptcy, and Covanta is generally the cheapest service supplier available.  That combined with facility insurance makes waste processing is one the most secure business models available. 

Metals: Iron prices were somewhat challenging and the outlook is still uncertain.  HMS pricing was $263/ton for the quarter and projected at $225-250 for the year.  Non-ferrous has been good though, and the business is transitioning to centralized processing.  In particular, copper sales are changing, with long sales cycle but great profits, particularly to Europe.  I continue to see metals recycling as a long-term growth driver along with innovation in ash reuse.

Growth: Covanta closed a small pharmaceutical disposal acquisition but declined to provide detail.  I'm fairly certain that's because this is an ongoing growth initiative where management is interested in buying sites with "DEA reverse distribution center" licenses.  This is a very high margin business that is tied to the opioid problems in many states.  Management also stated that the Biffa projects will be structured with that company as the primary waste supplier, with substantial local knowledge which should mitigate NIMBY issues of the sort we've seen in Dublin, and Covanta as the operator.  Relative equity percentages are TBD and the development will follow the Rookery project (where Covanta is a majority owner) with Veolia, one of the world's largest environmental services companies ($12.6b market cap).  For context, Rookery is expected to become operational in late 2020.  More info on the Biffa projects should be available early next year but there was an interesting question about the timing of the investment and its effect on the dividend.  Management refused to completely rule out a dividend cut, which is troubling.  However, the timing of any development investment is generally flexible and given the balance sheet discussion above, I continue to believe the dividend will be maintained.  If it were to be cut, I think it would only be in order to take advantage of an overwhelmingly good long-term opportunity.  Managements sometimes passively talk a stock price down in advance of being bought.  I think that these development agreements show that the best way to look at Covanta is as a waste management technology provider.  That is something that is going to garner progressively greater interest over time.

In conclusion, this was a good quarterly report despite seasonality and challenges in Fairfax and Dublin.  The near-term valuation for CVA is likely to be tied to the dividend, which continues to put my fair value estimate at $16.67 until we have hard evidence of a change in policy either way.  The next dividend iteration will almost certainly be maintained at 25 cents and should be announced sometime in late September.  That should generate further stock price increases beyond this morning's 5% jump, but there is room for continued volatility going into next year.  I intend to continue taking advantage of any ignorance that the market offers.

On 07/27/2017 04:35 PM, Esekla wrote:

Covanta has reported financial results for its second quarter:

• a loss of 22 cents per share misses by 7 cents
• on revenue of $424M, which beats by $8M

The company also affirms 2017 guidance (Adjusted EBITDA of $400-440M, FCF of $100-150M) and that Dublin remains on track.  The Fairfax facility is expected to resume waste processing in the fourth quarter and insurance should mitigate downtime expenses.  Perhaps most importantly, management confirms two new projects in the U.K. through a Joint Development Agreement with Biffa.  Arrangements like this should allow Covanta to continue expanding while simultaneously reducing debt and risk.  The conference call is tomorrow morning, and I am likely to report again after that.

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