Description

Covanta Holding Corporation (NYSE: CVA)     Current Price: $17│12 m Price Target: $8

May 16, 2016                                                                                     SI Ratio: 8.8% │ SI % Float: 10.7%│ GC Borrow

If you are looking for an energy company that generates energy that is dirtier than coal, has higher leverage than Chesapeake, and generates lower EBITDA than Peabody Energy, let me introduce you to Covanta.    

Company Overview

Covanta is a Waste to Energy company. CVA incinerates trash to generate power. As a byproduct, it additionally recovers and sells recycled metal.

Built in the 1980’s and 1990’s, incinerators were a form of renewable energy. However, environmentalists point to the fact that incineration releases more carbon dioxide than coal and particularly a huge amount of furans and dioxins[1].

CVA is highly levered and depends on energy prices to be profitable.  

Investment Thesis

CVA is hedged for 2016, but the hedges will start to roll off by 2017. As the hedges roll off, Covanta will not generate sufficient cash flow to operate the business. As an example, market energy prices collapsed to $24.21 for PJM East, where CVA does most of its market business. The contracted and hedged price is approx. $60.

Covanta’s EBIT breakeven cost is higher than the PJM market price where CVA sells most of its energy.

Not only is the equity worthless at negative EBIT, but debtholders are likely to suffer large losses.

Because of cash interest expense and Capex being larger than D&A, CVA will run out of liquidity options by the end of next year.

Energy Markets

I introduced these section in the write-up for those not familiar with the energy markets. It’s pretty basic, for more information and in-depth details please visit https://learn.pjm.com/electricity-basics/market-for-electricity/gas.aspx

To a simple level, the PJM East pricing market, where CVA sells most of its energy “at market prices”, is dominated by two factors: Gas prices and System Load. System load is the amount of energy required by consumers. The higher the demand, the higher the energy price. System load will be affected by seasonality.

For Q1’16, PJM pricing was $24.21, largely due to $2 natural gas price. For Q1’15, the average price was $62.83

For reference, I am modeling at market energy prices of $30, $35, and $38 for 2016, 2017, and 2018, respectively.

To reiterate, as CVA’s hedges roll off, Covanta will sell more of its energy below its cost to generate energy. The company is burning cash paying its interest expense and high Capex, which is higher than its non-cash expenses.

How Did This Happen?

Four reasons

1.- The real driver of the business is energy prices, and Covanta sought increasing exposure to energy markets. In fact, looking at their old investor presentations you will notice that they mention it as the number one driver of the business!!

2.- Covanta changed its “pitch” in 2011, after natural gas briefly collapsed to $2.  It took out the “Primary Drivers of the Business” page and introduced one mentioning that “Covanta gets paid every step of the way”

This is very misleading. The company depends on waste in order to produce energy. Waste is not CVA’s profit center. Waste is a loss-leader necessary to generate a profit with energy. Because 85% of the waste revenue is contracted and the fact that the tipping fees for WTE is much higher than landfill, there is no way to make waste revenue a profit center. CVA introduced this slide and it mislead analysts.

And here is why it is deceiving: mathematically, Energy has represented about 30% of the company’s revenues and thus waste seems to be the largest contributor. However, the way the business works is that CVA agrees with the municipalities to charge a “tipping fee” and CVA retains the profits from the energy. In other words, the prices are set such that CVA’s breakeven Spark Spread is  ~$40 MWh.

Covanta even changed its logo in 2014, but not its business. Most sell side analysts use waste management businesses as comps. This is incorrect.

3.- CVA’s use of FCF includes change in WC and subtracts only maintenance Capex. However, most of the waste facilities were built in 1980s and 1990s, and we should expect a high level of maintenance. I am skeptical of CVA’s ability to parse through its Capex and tell me what growth is or not. The fact is that CVA is a capital intensive business.

4.- Adjusted EBITDA has recurring annual add-backs. Adjusting for these items increases real leverage to about ~8x

Why does CVA report FCF and Adjusted EBITDA this way? And why didn’t they hedge?

§  Management annual cash incentives are based on (67%) Adjusted EBITDA and (33%) on CVA’s FCF

§  Management stock compensation is based on Total Stock Return performance (3-YR cycles). A possible explanation of why they didn’t hedge was that the volatility of the energy markets would actually help management earn more because of how their bonus was structured

By having a volatile stock performance, management could earn more than twice the amount of RSUs!

“

Is WTE Green?

No. The New York Department of Conservation found that the state’s incinerators emit up to 14 times more mercury as coal-fired power plants per unit of energy.

Denmark—the poster child of Europe’s incinerator industry— recently discovered that its incinerators were releasing double the quantity of carbon dioxide than originally estimated, and had probably been doing so for years, causing Denmark to miss its Kyoto Protocol GHG reduction targets.[2] Due to the low calorific value of waste, incinerators are only able to make small amounts of energy while destroying large amounts of reusable materials.

Incinerators are the most expensive method to generate energy and to handle waste, while also creating significant economic burdens for host cities. According to the U.S. Energy Information Administration Annual Energy Outlook 2010, the projected capital cost of new waste incinerator facilities is $8,232 per kilowatt hour. That is twice the cost of coal-fired power and 60 percent more than nuclear energy. Waste incinerator operations and maintenance costs are ten times greater than coal and four times greater than nuclear.[3] Billions of taxpayer dollars are spent subsidizing the construction and operations of incinerators. In 2011, Harrisburg, PA became the largest U.S. city to declare bankruptcy, and the financial blame rests squarely on the shoulders of its staggering debt payments for upgrades at the city’s incinerator.[4] Detroit taxpayers have spent over $1.2 billion dollars in debt service payments from constructing and upgrading the world’s largest waste incinerator.[5]  

Other Keys To Investment Thesis

§  California passed legislation SB 350 in October of 2015, outlining that waste to energy will not be considered renewable energy. State governments will favor wind and solar versus incineration. Other renewable energy has become much cheaper and is 100% clean energy. WTE is a terrible deal for municipalities

§  Air Products recently announced it would exit the waste to energy sector and off-load its two gasification WTE plants in England. Air Products mentioned that the technology was not what they had expected to be and were disappointed in the outcome. Air Products will take a pretax charge of ~$1B

§  Auditors cite “material weakness” in Covanta’s internal controls

§  Covanta’s plants are between 21 and 35 years old

§  Previous CEO left the firm in March 2015 after natural gas prices fell by 50% compared to the previous year

§  Covanta previously filed for bankruptcy in 2002. It cited CA energy crisis and 9/11 as its prime reasons

§  Waste Management has better and cheaper landfill solutions for municipalities

Business Summary

CVA processes 20 million tons of solid waste annually, representing 5% of the solid waste generation in the U.S. They operate 46 WTE facilities in North America and 11 additional energy generation facilities including wood biomass and hydroelectric. In total, these assets produce approximately 10 million megawatt hours (MWh).

19 of the facilities operate on what is called a tipping fee. A tipping fee is a charge levied on the quantity of waste processing facility. It is generally levied to offset the cost of maintaining and operating the site.

On a service fee basis, CVA charges a fixed fee for the waste, and CVA shares the energy and metals revenue with the client.

Industry Summary

Waste to Energy is a part of overall MSW (municipal solid waste) generation. Since 2000, MSW has leveled off, and in a per Capita basis it is actually declining even when Real PCE continues to go up as the public has become conscious about packaging.

§  There are three possible alternatives to get rid of waste: 1) landfill, 2) recycle, and 3) combustion

§  The trend since 1990 has been to recycle more and send less to landfill and incineration

There are 113 waste incinerators in the U.S. and 86 of these are used to generate electricity. Only a couple of incinerators have been built in the U.S. after 1997, due to public opposition, identified health risks, high costs and the increase of practices such as recycling and composting. In recent years, the incinerator industry has tried to expand their sector by marketing their facilities as “Waste to Energy” (WTE), using what some environmentalists say are “misleading claims”.  Incineration waste per capita has fallen ~20% since 2000.

Valuation

Valuation is perhaps the toughest part of this particular memo. I’ve had arguments with hedge fund PMs about the “right EV/EBITDA” multiple. However, there isn’t a real comp on Waste to Energy business. Some sell-side analysts look at waste management business.

Here is the point: CVA is running out of cash. Its adjusted EBITDA is as garbage as the waste they incinerate, and what makes it worse is the high level of maintenance Capex required to run the business. If energy prices stay as low as they are and follow the current forward curve, I believe Covanta will file for bankruptcy — with a negative FCF and negative EBIT, there is little hope for the equity.

However, the equity value is effectively an option on energy prices with a strike price of $50/MWh, an almost 100% increase from current prices.  I believe that the best form to value the business is to replicate the trade, which I can find for less than $5.00 on the option markets.

From a practical perspective, CVA shareholders are in the name because of its large $1.00 per share dividend. Total liquidity in Q1’16 was $520M. I expect CVA to have less than $100M of liquidity by 2017, and as the hedges roll off, their cash flow shortfall will only get worse. CVA should cut the dividend to buy themselves more time to increase the chances of a rise in energy prices. When this happens, I believe the stock price will trade to $8, as it will be clear the CVA is not the FCF play that the sell-side and long-only tout. I expect this to happen in the next 12 months.

Risks to the Investment Thesis

§  Increase in natural gas prices

§  CVA’s contracts are with governments and they are involved in the economics, as described earlier. They may be inclined to help CVA if they run into liquidity problems

§  Even though CVA is levered 5.7x using their adjusted EBITDA and I expect it to increase, CVA may be capable to raise debt and buy themselves time

Catalyst

Potential dividend cut in the next 6-12 months. Investors figuring out that company is burning cash, and that the future looks dire with low energy prices and little hedge in place.