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Covanta 4Q17 report ?5

13:29 23-Feb-18

I'll start my review of Covanta's call by following up with some more quantified detail on the dividend for 2018.  My guess is that the worst-case scenario would be a cut to the bottom of management's FCF projection for the year.  That would not align with management's statements about how they only consider the dividend over the long term, but it would allow for increased growth.  I think it's equally possible that management could raise the dividend by a penny, just to stop the questions, with negligible impact to growth.  The more likely, consistent, responsible, and shareholder-friendly paths would be to either put up with the questions and leave the dividend as is, or cut to the top of their range after evaluating the U.S. market and growth opportunities.  I've summarized the possibilities in the following table:

Likelihood	10%	30%	50%	10%
quarterly dividend in cents	13	19	25	26
most likely to happen	June	March	--	March
short-term price target at 6% yield	$8.67	$12.66	$16.67	$17.33

Again, no matter what happens this year, I expect the quarterly dividend on CVA to move to at least 37 cents per share, and the stock price to rise into the mid-twenties as we progress through the first half of the next decade.  However, discounting that projection by 10% per year leaves the long term price target right around where I have it now, and there are other, more complicated possibilities.

Hopefully the operational detail for Covanta will help explain how I'm arriving at these projections.  Here it is by segment:

Waste Processing:

• the company should see double digit waste volume growth this year, and improving fees.
• with the exception of the long expected exiting of the Hennepin facility, there are no meaningful waste contract transitions for two years, adding clarity for the short-term.
• for 2018, 3% same store price growth is projected, which handily outstrips nominal inflation.  However, contracts are indexed to local inflation measures, albeit with some lag.  There is every reason to believe that will take off over the longer term.
• Environmental Services grew 24%, 16% organically, and should continue growing.
• a permit for the first ash reuse processing plant is expected this year, with operation starting in 2019, and more sites to follow once full-scale results are proven.  This should result in at least a 70% volume reduction of disposed material.
  
• $10M in settlements from Fairfax, which became fully operational in December, is still due this year.
  
• statistical analysis is being used to improve operations.
  
• improved fire protection measures are being installed over the next few years.  At the plants that Covanta merely operates, the costs born by the owners.

Energy:

• 2018 is almost completely hedged or contracted; only 3.5% exposure remains.
• 2019 hedging has already begun but, consistent with my thoughts on the market, forward prices are not increasing in line with current ones.  However, there is less need as Covanta has no further energy contract transitions until the mid-2020s.
• management also made cryptic comments about new initiatives to improve energy sales
• waste energy is generally (and correctly) considered renewable energy in most areas, which offers great opportunities in conjunction with all the state initiatives I've highlighted in my AES and NRG Yield analysis.
  

Metals:

• HMS estimated at $235-285 per ton for 2018, though it has averaged $317M so far.
• this better than expected pricing has been something of a trend, and section 232 tariffs would likely improve pricing dramatically.
  
• 90% of non-ferrous metals were processed resulting in 74% price growth, that should improve by another 50% this year, and more as ash processing develops.
  

Financing/Other:

• GIG cash went straight to paying off debt, which results in improved credit metrics, and will reduce future project financing costs.
• Again, the GIG deal is only for the U.K. and could be replicated for other geographies, there have already been talks along these lines.
• Rookery project construction should start in the second quarter.
• 2018 projections do NOT include Rookery financing, Manhattan MTS startup, or ash processing.  The first might be a pleasant surprise, the latter two are projected to cost $60M ($35 and $25M respectively) this year.
• the new tax code is seen as net positive.  However, management notes that it is being marketed as simple territorial scheme and that is not the case!
  

When you put it altogether, 2018 will see a lot of development and operational costs, which is causing particularly tough YoY FCF comparisons, because the accounting on projects that were finishing up augmented that stat the past two years.  However, the improved operations, resulting in the reduced FCF guidance for 2018, but also a doubling from those levels ($140-200M) through 2019 and 2020.  As we move further into the next decade, management projects FCF to grow to at least $250M, which is where my dividend and price target come from, and that's without any of the newer projects that are being planned!  I continue to regard Covanta's management as best-in-class and, in contrast to what UDC is doing, they have added Free Cash Flow Before Working Capital to their reported metrics so we can more easily track operational progress.
 
Really, though, I think we're just at the beginning of Covanta's transformation.  Management has already acknowledged the possibility of exiting lower margin U.S. plants, if terms can not be renegotiated.  The latter is the more likely possibility, as Covanta's solutions are generally the cheapest overall, but as I alluded yesterday, predicting anything in the U.S. has become a precarious business.  Management's comments about the tax code could easily auger a structure whereby the more valuable international development becomes completely segmented from Covanta as we know it today.  That's a lot of uncertainty, but most of it is only for the next few months, and the prospects look better than ever beyond that.  I view the 9% drop so far as unjustified for patient long-term investors, in light of Covanta's improved opportunities.

The Covanta conference call has just concluded.  There were no real surprises, but lots of very good detail.  Most important, though, was commentary on the dividend.  In short, I can not completely rule out a change (and possible cut) to the dividend this quarter or next.  It looks like the market is already pricing in a cut, but I put it the way I did because management reiterated a commitment to the dividend and that it is a decision that is made decade by decade, not year by year.  However, they also said that given FCF guidance of $70-100M for 2018, which does not cover the dividend, they get constant questions on the topic, and the one way to stop those is to change it.  Note that my back of the envelope calculations indicate that the quarterly dividend should rise to at least 37 cents by the middle of the next decade.  Thus I am cautiously buying the dip.  I will have more operational notes out later, but I wanted to get this out as close to market open as possible.

On 02/22/2018 04:55 PM, Esekla wrote:

Covanta has released earnings for its fourth quarter:

• EPS of 9 cents misses by 12 cents
  
• on $495M in revenue, beats by $33M
  
• the 25 cent dividend is also confirmed, though dates are not specified
  
• 2018 EBITDA guidance of $425-455M implies ~8% YoY growth
  

Most figures are not comparable with analyst estimates due to the new revenue and expense split with GIG, and the market seems to recognize that. 

The conference call occurs tomorrow morning.  More after that.

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