Covanta’s Dividend Boost Now Faces a Test

Covanta Holding, through its subsidiaries, is the largest owner and operator of Energy from Waste (EfW) facilities in the U.S. The company accepts waste from its customers, mostly municipalities, and burns it to produce electricity. It also recovers iron and non-ferrous scrap metal in the process.

The U.S. currently generates 275 million tons of waste per year. About 11% of that is processed by EfW facilities. Covanta accounts for about two-thirds of the EfW total.

Growth opportunities in the U.S. are limited. Most EfW facilities are located in densely populated areas, such as the Northeast, where the less costly option of landfills is limited. The EPA has deemed EfW to be superior environmentally to landfills (in part because methane from landfills has 8 or more times the greenhouse gas effect); but EfW has been held back by the high cost of building new plants and local NIMBY opposition. Still, EfW is growing outside the U.S., especially in China, which has increased its EfW capacity from two to 14 million tons since 2000 and plans to increase the percentage of waste processed by EfW plants from 1% in 2005 to 30% by 2030.

In recent years, Covanta has pulled out all stops for growth. It has entered into service a C$264 million, 140,000 metric ton-per-year EfW facility near Toronto. In 2013, it acquired a 1,050 ton-per-day EfW facility in Camden, NJ for $49 million. That same year, it entered into a contract with New York City to transport and dispose of an estimated 800,000 tons per year of waste from marine transfer stations in Queens and Manhattan beginning in 2015. (Estimated costs for equipment and facility upgrades on this contract are $150 million.) It also acquired two strategically located waste transfer stations in New Jersey.

In 2014, Covanta began construction on a €500 million, 600,000 metric tons per year, 58 MW facility in Dublin, Ireland, scheduled to begin commercial operations in late 2017. It also accepted a contract to operate a 3,150 ton-per-day EfW facility in Pinellas County, FL.

Covanta recently opened a metals processing facility in Fairless Hills, PA to reduce operating and marketing costs for metal retrieved from its EfW facilities in NY, NJ and PA. In 2015, it acquired four environmental services businesses for $69 million.

Also in 2015, the company agreed to divest most of its investment in China. It anticipates the receipt of $100 million later this year from the sale of 90% of its equity investment.

To provide some certainty to shareholders during this transition period (and also presumably to keep pressure on management to perform), Covanta’s Board of Directors instituted a $0.30 annual dividend in 2011 and raised it steadily to $1.00 by 2014.

Covanta’s growth strategy is ambitious, but sensible since its new projects align reasonably well with its core competencies. (On the surface, the NYC contract may seem like a departure; but the company receives a fixed return on its $150 million investment, plus a fee for every container of waste that it takes from the city.  From the transfer stations, Covanta transports the containers by barge to Staten Island and loads the containers onto trains which transport them to one of its EfW facilities in upstate New York.)

Covanta was tossed a curveball, however, when prices for electricity and metals began to drop in 2014, just as it was ramping up its development projects. Consequently, the company’s earnings have fallen well short of the $1.00 annual dividend for the past three years.

Although it has been able been able to generate sufficient free cash flow (defined as cash flow from operating activities minus maintenance capital expenditures) to cover the dividend, it remains to be seen whether it will be able to generate sufficient earnings (and cash flow) to pay the dividend in the long run.

With the recent spurt in project development, Covanta’s leverage is high—debt is now 83% of total capitalization—and will likely get higher in the quarters ahead. However, that high leverage is mitigated somewhat by its use of non-recourse project financing, which totaled $350 million or 13% of total debt outstanding as of June 30.

The company has identified two instances of material weakness in its controls, one for its calculation of state income taxes and another for its accounting for construction costs on its recently completed facility in Canada. Both have not yet been resolved.

Some investors are betting against the stock. Barron’s shows a short interest of 11.6 million shares (equal to nearly 9% of the total outstanding and about 10 times average daily trading volume)  Short interest has increased by about one million shares over the past 30 days..

Covanta should have the ability to sustain the dividend for at least another year or so, barring a significant change in business conditions. It had $409 million of liquidity (i.e. domestic cash and availability under its revolving credit facility) at the end of June. The annual dividend requirement is currently $133 million.

According to my projections, Covanta will report a loss of $0.13 per share in 2016. Earnings should improve as more new projects come on line. I project EPS of $0.32 in 2017, which is well above consensus but still below the dividend.  My 2017 projection clearly looks aggressive; but if achieved, it would keep CVA on the path to dividend sustainability.

Unless the company announces new projects, its total capital expenditures should begin to decline. Newly completed projects should help to boost earnings – Dublin should bring in $35-$40 million of EBITDA annually when it is fully up and running – but it is unlikely that the company will be able to sustain a $1.00 annual dividend indefinitely without a rebound in electric power and scrap metal prices. (Any benefit from higher power prices would be achieved over time, however, due to hedging and contract commitments.)

I view Covanta’s common stock as attractive, but it has been struggling to hold its price level over the past four weeks. Besides the common, Covanta also has three series of senior unsecured notes outstanding, rated Ba3 by Moody’s and B by S&P. I favor the 6 3/8% Notes due October 2022; which have traded up modestly in recent weeks to 104.  That represents a yield 4.6% and a 320 basis point spread over the comparable maturity Treasury note.  At that level, I view the 6 3/8s as fairly priced.

September 19, 2016

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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