Description

Investment Summary 

I think risk/reward on Covanta is very good into 2021. Business is a moated, waste-to-energy producer that should see long-term pricing growth of 3-5% with minimal volume growth, is recession resilient and has a high value UK JV that the market is giving no value for. To put some numbers to this: Covanta trades at 9.8x my 2021 US-only EBITDA and 8.7x if I deduct what I think their UK EfW assets could be worth. This compares very favorably to landfill companies (WCN, RSG, WM) that likewise grow 3-5% per year and trade at 12-16x EBITDA. Sam Zell just replaced the CVA CEO with a shrewd former PE guy and launched a strategic review that was announced 3Q’20. While details on the strategic review were light, Zell noted 1) they weren’t getting any value in the public markets for their UK JV (he also lamented that the last EfW sale in the UK traded hands for 18x EBITDA rel to CVA core-business at 10x) and 2) that 20% of their assets generated 80% of the EBITDA and that they would be looking at addressing that via either asset sales or cost cuts.

In 2021, I think it is very plausible to see CVA ex-UK business trade at 10.25x my 2022 EBITDA (core business value of $15/share; note every turn of EBITDA is worth $3.3/share or 25% upside) plus $4/share of value for their UK JV for a total value of $19.5/share. This would be ~45% upside to stock. For context, CVA core business trades at a ~6% 2020 FCF yield, volumes shouldn’t go down much in recessions and should see LT growth of ~5% plus you have UK assets where the last comp traded for 18x EBITDA (vs CVA trading at 10x). 

Business Overview: Covanta takes municipal solid waste (MSW) from large urban centers (mostly in the Northeast) and incinerates the waste to generate power (energy from waste or “EfW”) that it sells in the wholesale power market. 

US Domestic Energy from Waste Facilities: Energy to Waste is a medium quality business with recession-resilient characteristics. While volume trends should be flattish given EfW facilities are already highly concentrated in markets where they are economic, long-term trends in EfW pricing are very favorable given landfill dynamics discussed below. CVA should see 0-1% volume growth and 3-5% pricing growth indefinitely. 

• EfW Concentration: Covanta controls market. Covanta makes up ~50% of the energy from waste market. Its other large competitor is Wheelabtrator, a private company that was sold by Waste Management (“WM”) in 2014. 

• EfW Near-term Volume Growth: Stagnant historical growth but potential for ~1-2% growth in coming years as MSW going to recycling stagnates.  MSW is a ~1-2% per year grower (follows population trends) (Exhibit A). However, MSW that is provided to the EfW market has been stagnant over the last decade. Recycling has taken significant share of waste processing in the 2000s (Exhibit B). However, in 2017, the Chinese (our largest purchaser of recycled paper) put have significant restrictions on the import of OCC (“old corrugated cardboard”). This sent the price of OCC to decade lows and will keep recycling largely “out of the money.” (Exhibit C) 

• EfW Long-term Volume Growth: EfW is unlikely to meaningfully grow volumes longer-term given high cost, localized nature of product. EfW facilities cost a lot more to operate than a landfill ($30/t cost for EfW vs $45/t for landfill). However, they are more “green” given the high toxicity of CH4 emissions from landfills (Exhibit D). Thus, you only really see EfW facilities in places that either have strict land permitting requirements (thus landfills are very far from waste and have high transportation costs relative to nearby EfW facilities) or have favorable legislation that support “green” EfW facilities. Thus, Covanta is focused on the Northeast and has not built new facilities over the last several years despite their current facilities running at >90% utilization (Exhibit E/F). 

• Pricing: Pricing, not volumes, is the big story for EfW. I expect 3-5% long-term pricing for Covanta. Landfill pricing (which EfW competes with) secularly grows MSD per year (Exhibit G). This has been driven by 1) significant consolidation in landfill space (some estimate big 3 landfill players control >60% of the market) and 2) mom and pop landfills have been shrinking from rising NIMBY/Section D regulatory costs (Exhibit H). This has been reflected in strong EFW tip fee growth in recent years (Exhibit I)

• Knocks on the US EfW Business? 

• 1) Assets are super old (20-30 years). The fear is this is the “US steel” of the waste space. There was some evidence to support this assertion in 2019. Maintenance costs for 2020 were guided to be $430-$450mm, up $30-$50mm after being flat for the prior4 years. Management also said these costs were a “reset” higher but also guided to longer-term cost growth of 3%. My view is these assets aren’t falling apart but modeling 3% growth in maintenance expenses from 2021 is a fair way to view this business

• 2) “How can you put a multiple on this fake business??” Unlike solar and other “green” energy forms, EfW will never be cheaper than landfills. These businesses exist because there is a dearth of acceptable landfill space in places like NYC and some green energy policies. Thus, volume growth will be anemic. This criticism is totally fair and in part why I believe CVA is creating the UK JV below.

UK JV: UK is a more secularly growing market for EfW given exorbitant taxes the UK puts on landfills. 

• What is the UK JV: Covanta has a 50-50 JV with GIG that owns 1 currently operational EFW facility and is developing 4 (2 should open in 2022, 1 in 2023, 1 in 2024).

• UK Market is very good for EFW: Unlike the US market, the UK market has imposed a highly punitive tax on landfills (over $80/ton). This has driven the UK landfill market from 65% share of MSW in 2005 to 15% today (Exhibit J)

• What is the JV worth to CVA? Wheellabrator agreed to sell 4 of its UK plants (2 wholly owned) for a rumored 16-18x EBITDA. This was clearly a big motivator for the Sam Zell to initiate a strategic review process. Assuming CVA can sell their assets at 17x EBITDA, that would be worth ~$3.5/share or ~27% of current market value of company (Exhibit K)

Energy Business: For the first time in a very long time, energy prices will not be a significant headwind for Covanta. CVA has no major power contract expirations through 2024 and currently hedged power prices are close to spot power prices. Longer term there are still significant questions re: their longer-dated out of the money contracts.

• Why was the power business core to legacy CVA short pitch: Covanta entered into power contracts that were 20-30 years long with utilities in the 1980s (ie before shale gas prices drove down the price of electricity). Those contracts began to expire around 2016. The argument from bears was that CVA was not a waste company but an O&G company. CVA’s waste assets had high fixed costs and power prices would collapse at near 100% incremental margins. 

• Power Contracts: Power contracts are sold in the northeast (analysts look to PJM pricing). As noted in the summary, CVA has no power contracts that expire until after 2024. However, about 1/3 of their current power sales come from legacy contracts set at $66/MWh when spot market prices are closer to $25/MWH. Resetting those contracts to spot pricing will be a LT ~$80mm headwind to EBITDA (18% of 2019 consolidated EBITDA).

• Northeast Electricity Market: Market is highly complex. A lot of new generation supply is entering the market over the next few years; there are capacity auctions that distort cost curves and add further complexity; and there are questions around nuclear power subsidization. Add to that that the largest driver of electricity prices is the price of natural gas, you have a very tough market to model! Thus, to be conservative and account for all the complexity, I model LT electricity prices at $23/MWh compared to the forward market at $27/MWh and assume CVA receives ~13% lower capacity revenue than they have in any of the prior 5 years. That being said, gas prices tend to drive the ship on power prices (Exhibit L) and I have some vague sense of confidence those prices are trough-ish. 

Valuation: Valuation is definitely enticing for CVA. Core CVA business (ex-UK) trades at 9.8x and 8.7x if you remove the value of the CVA UK JV from the enterprise value. This compares to landfill businesses that current trade at 12-16x EBITDA (Exhibit M). I definitely could see this business trading to 11-12x based on recent trends (every turn is worth ~25% upside to the stock). WCN/RSG/WM all grow revenue ~3%-4% organically in benign macro. CVA grows 1-5% organically too (prbly going to be on higher end going forward) but these electricity contract pricing declines have concealed it. Moreover, in 2020, CVA is seeing flat volumes YoY given resiliency of its portfolio (LT service contracts that are volume independent and residential focused garbage that has seen its volumes swell in covid) while other peer companies are seeing volumes down MSD (Exhibit N). 

Exhibit A

Exhibit B

Exhibit C

Exhibit D

Exhibit E  

Exhibit F 

Exhibit G 

Exhibit H 

Exhibit I 

Exhibit J 

Exhibit K 

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Exhibit L 

Exhibit M

Exhibit N 

Catalyst

Completion of strategic review