Investors Could Clean Up With Covanta

Global adoption of environmental sustainability initiatives is one of the major growth drivers for

Covanta emerged from bankruptcy protection in 2004 with the help of billionaire investor Sam Zell, who remains the company’s chairman of the board and largest shareholder with a nearly 10% stake.

Primarily through acquisitions, the company’s operating footprint grew to encompass 41 WtE facilities in North America, and it recently brought on line its first European facility in Dublin. WtE facilities have been especially popular in densely populated parts of the United States where land commands a premium, such as the East Coast, or in states like Florida where high water tables can interfere with proper landfill management. Covanta’s operating footprint mirrors this dispersion, with nearly half of its facilities on the East Coast and six in Florida.

WtE Facilities Have a Hidden Environmental Benefit Historically, WtE development has been fraught with controversy; as such, we believe that Covanta's prospects remain misunderstood by the market, which creates an opportunity for environmental-social-governance investors to own a leader in WtE at a fair price. Sustainalytics, a leading provider of research on ESG factors (and 40% owned by Morningstar), scores Covanta particularly high in its Environment category. While environmental activists continue to malign trash incinerators on outdated notions of air quality concerns, modern WtE facilities are carefully constructed to reduce harmful emissions, making the method a surprisingly eco-friendly way of dealing with the ever-increasing trash piles generated by a growing population.

Supporting Sustainalytics’ claim of Covanta’s environmental leadership is research published by the U.S. Environmental Protection Agency that compares the amount of greenhouse gases emitted by 1 ton of trash that is either landfilled or incinerated. The agency concluded that while 1 ton of incinerated trash still produces a considerable amount of carbon dioxide, particularly from the combustion of plastics, displacing that same ton from a landfill avoids ongoing methane production. Depending on the nature of the material, decomposing trash in a landfill can produce methane for years, whereas that same ton takes a matter of hours to burn in a WtE facility. Recently published studies by the Intergovernmental Panel on Climate Change describe methane as a powerful greenhouse gas that traps heat in the atmosphere at a level that is 28-34 times greater than carbon dioxide over a 100-year timeframe (or up to 84 times more potent over a 20-year timeframe).

Large landfill operators like Waste Management WM and Republic Services RSG have led the charge on methane gas control, and the EPA estimates that up to 38% of U.S. landfills employ gas-to-energy technology; however, it takes a lot of decomposing trash in a landfill to produce only a little energy, making landfill gas-to-energy projects far less efficient than WtE. In a 2008 report, P. Ozge Kaplan, Joseph Decarolis, and Susan Thorneloe estimate that 1 ton of waste produces 470-930 kilowatt-hours of electricity when combusted in a modern WtE plant, whereas collecting methane from the same ton for use in a landfill gas-to-energy system produces only 41-84 kWh, about one order of magnitude less (for reference, the Energy Information Administration estimates that it takes almost 900 kWh to power an average-size residential home for a month). Moreover, the EPA estimates 28% of U.S.-based landfills lack any methane collection at all, while 34% burn off the methane with a flare (another form of combustion).

The EPA assigns additional environmental benefits to waste incineration. Electricity produced by WtE displaces electricity generated by fossil fuels such as coal and natural gas, with the latter carrying greater potential for methane leaks over the lifecycle of the power plant. In addition, many WtE facilities recover ferrous and nonferrous metal from the ash that remains after combustion. Recycling recovered aluminum, for example, displaces virgin materials, which also lends a greenhouse gas reduction benefit, albeit very small.

Despite Environmental Benefits, WtE Adoption Lags in the U.S. Covanta's value proposition has always been clear: WtE offers an environmentally superior method of waste management. Yet Covanta hasn't managed to expand its operating footprint in the U.S. in any meaningful way since 2009, when it acquired Veolia's North American assets. Covanta owns or operates 41 of the 71 WtE facilities in the U.S., with the capacity to process about 20 million tons of waste per year. Private-equity backed Wheelabrator (formerly owned by Waste Management) is the only other competitor that comes close, with 16 WtE facilities that can handle up to 7.5 million tons per year. Together, the two companies process over 80% of the 33 million tons incinerated in the U.S. annually. However, this volume pales in comparison with the amount of waste that is landfilled or recycled in the United States.

The EPA’s latest published figures suggest that of 258 million tons of garbage produced in the U.S. in 2014, only 13% was incinerated, whereas 35% was sent for recycling and over 50% was landfilled. WtE hasn’t gained share against conventional disposal since the 1990s, even though the EPA has promoted energy recovery as superior to landfilling as part of the agency’s official waste management hierarchy as early as 1988. Nevertheless, with waste regulations devised and enforced at the state level, the EPA’s recommendations are simply suggestions, not mandates. This, combined with the high capital costs needed to construct a WtE facility, an abundance of cheap land available for landfill use in the U.S., and lingering environmental concerns, has been enough to keep new WtE capacity in the U.S. at bay. For example, until Babcock & Wilcox brought its Palm Beach, Florida, facility on line in 2015, there hadn’t been a new WtE plant built in the U.S. since 1995.

Markets Outside U.S. Far More Favorable for WtE Growth Although Covanta originally bet that the significant gap between WtE utilization in the U.S. and other global markets would shrink over time, a preference for landfill-based disposal persists in the U.S. for two main reasons. First, the U.S. lacks any meaningful national policy support that would either encourage WtE development or discourage landfill-based disposal. Second, an abundance of land helps to keep disposal costs low, which continues to make landfilling an economically attractive choice in many parts of the country.

In contrast, islands with scarce amounts of land, such as Japan, Singapore, Taiwan, and Ireland/United Kingdom, favor WtE as a method of sustainable waste management rather than allocating finite amounts of land to the relatively unproductive purpose of burying garbage. Furthermore, governments in other parts of the world have established stricter policies with an eye toward effecting behavior change. For example, the European Landfill Directive, established in 1999, required member states to reduce the amount of biodegradable waste sent to landfills to 35% by 2016, with each country having the flexibility to decide how best to achieve the directive.

Germany has demonstrated success in eliminating landfill-based disposal with a 2005 mandate that required municipal solid waste to either be recycled, sent to a mechanical-biological treatment plant for anaerobic digestion/composting, or combusted in a WtE plant. Eighteen other European nations chose to implement a landfill tax with the intent that increasing the cost of disposal would be the most effective incentive for diverting garbage away from landfills toward more sustainable means of waste management. In many cases, the landfill tax represents a significant percentage of the entire cost per landfilled ton, which can serve as a powerful incentive to seek out more economical and environmentally friendly methods of waste management. Since the European Economic Area published its landfill tax report in 2013, the U.K. has been especially aggressive at raising landfill taxes. The current landfill tax per ton is approximately GBP 86, or about EUR 98. This partially explains why the U.K. has been a hotbed of activity lately for WtE development. The World Energy Council believes that WtE will continue to increase in popularity, which will drive the global WtE market to double between 2018 and 2025. As such, we believe Covanta’s future growth will depend on demonstrating successful expansion in markets outside the U.S.

Covanta Has Struggled to Communicate Its Growth Story Covanta's captive position in the structurally constrained U.S. market kept growth elusive. As such, the company was left quite vulnerable when its legacy contracts began to come up for renewal in 2009. Nearly all of Covanta's plants were built in the late 1980s or early 1990s. As these contracts came due, rates for waste management and power purchase agreements were marked to market after nearly 20 years of unadulterated terms, usually incorporating price escalators of some kind. Although Covanta successfully retained the majority of its original customer base during this contract transition period, renegotiated pricing terms mostly resulted in downward pressure on revenue and earnings growth.

With greenfield expansion in the U.S. unlikely and additional acquisition activity uncertain, Covanta turned to creative ways to combat the contract transition headwinds. The installation of specialized processing equipment boosted the quality and increased the resale value of Covanta’s recovered metals. In addition, Covanta increasingly sought to fill any excess capacity in its fleet with higher-priced “profiled waste,” usually by directly contracting with corporations, like Subaru and Costco, interested in meeting specific “zero waste to landfill” sustainability goals; however, these efforts weren’t enough to really move the needle in recent years. Covanta’s profiled waste business currently represents about 1 million tons and approximately $100 million of revenue at high contribution EBITDA margins of around 50%, but the small revenue base relative to Covanta’s $1.7 billion in overall sales means that outsize year-over-year growth in this business wasn’t nearly enough to completely offset contract transition headwinds.

Adding insult to injury, in 2013, Covanta lost a bid to a consortium led by European competitor Suez Environnement for the construction of a new WtE facility for Merseyside County in England after pursuing the project for the better part of a decade. This left only the fledgling Dublin project in Covanta’s international pipeline, making the market skeptical that Covanta would ever demonstrate meaningful growth beyond the constraints of its existing operating footprint in North America.

Finally, Covanta’s capital structure continued to concern investors. The company added about EUR 375 million in nonrecourse project debt plus convertible preferred shares to finance the Dublin project. Construction of Dublin coincided with a period in which energy and metal prices weakened considerably, which ultimately caused Covanta’s all-in leverage ratio to balloon since the end of 2014. This shows the inherent riskiness in leveraged financing years before the asset can contribute any meaningful cash flow. For example, Dublin came on line in the third quarter of 2017 after about three years of construction.

In addition, Covanta’s adjusted EBITDA at the end of 2016 covered interest expense a meager 3 times, and its expensive $1.00 per share dividend gobbled up over 75% of its 2016 adjusted free cash flow. We’ll further note that Covanta only subtracts maintenance capital expenditures from operating cash flow to arrive at its adjusted free cash flow figure. When fully deducting growth capital expenditures from operating cash flow as well, free cash flow has been negative for the past two years, a situation that is clearly unsustainable. Covanta insisted that once Dublin came on line and began producing reliable cash flow, these metrics would all improve. Nevertheless, in the meantime, Covanta’s ability to pursue additional growth opportunities in more favorable international markets was constrained.

We See a New Era of Growth The December 2017 announcement of a new joint venture with the Macquarie-backed Green Investment Group could serve as an inflection point for Covanta, making the risk/reward in the shares a lot more attractive for investors seeking ESG exposure. GIG will pay Covanta approximately $160 million for a 50% stake in Covanta's new state-of-the-art facility in Dublin, which became operational in the third quarter of 2017. The transaction becomes the foundation for a joint venture between Covanta and GIG, which plan to pursue six development projects in the U.K. In our view, the partnership removes the two elements of risk that we believe have weighed on Covanta's shares for quite some time. Macquarie's access to capital, significant experience in the U.K., and expertise in managing infrastructure development pipelines will immediately provide Covanta with some balance sheet relief while cementing a pathway forward for expansion in an island nation with a steep landfill tax--two factors that support WtE capacity development.

Covanta was already in advanced planning stages for three projects--Rookery, Newhurst, and Protos--that which represent approximately 1.2 million metric tons of new WtE processing capacity in the U.K. With Veolia secured as the waste supplier, Rookery could begin construction as early as the first half of 2018. U.K.-based hauler Biffa is Covanta’s waste supplier for Newhurst and Protos, which could move into the construction phase over the next 24 months. GIG also brings three smaller projects to the partnership, with a combined processing capacity of approximately 800 thousand metric tons.

With the partnership expected to close in early 2018, Covanta anticipates an immediate reduction in its all-in leverage ratio by about 1 turn versus third-quarter 2017 levels of 7.2. This will result from GIG’s $160 million cash contribution for its equity stake in Dublin plus the reclassification of Dublin’s newly refinanced EUR 450 million of project-based debt into assets held for sale, which will then be moved off balance sheet as part of the new joint venture. Covanta loses half of Dublin’s cash flow contribution to the joint venture in 2018, which will temper year-over-year growth in Covanta’s EBITDA and free cash flow. However, this shouldn’t concern investors, as going forward the company believes it will benefit from an additional $40 million-$50 million of annual free cash flow from its four most advanced U.K. projects (Rookery, Newhurst, Protos, and 1 GIG project), with no additional capital required. With contract transition issues in the rearview mirror and an expanded project pipeline, Covanta should finally be able to demonstrate sustainable growth in cash flow, which will result in lower leverage ratios and a healthier dividend payout ratio. We project that by 2021, Covanta’s all-in net debt/EBITDA leverage ratio could fall to 4.4 times, in line with the company’s 10-year average, and its dividend to free cash flow (operating cash flow less all capital expenditures) ratio could improve to around 60%.

Is Covanta Finally Digging a Moat? This is an important turning point in Covanta's story, as working with a strong development partner allows Covanta to significantly decrease its capital intensity while focusing on deriving value from its difficult-to-match operational expertise. To date, we've struggled to award Covanta an economic moat as decades' worth of meager returns on invested capital offset what would otherwise make for a strong qualitative moat argument. Over 80% of Covanta's waste revenue is contracted. This suggests that Covanta's customers, particularly those that commissioned the WtE facility, often face high switching costs when considering alternative means of waste disposal, whether such expenses come from transportation or landfill taxes. Covanta also possesses valuable intangible assets in the form of regulatory permits. In addition, siting WtE facilities near the center of municipal waste generation, versus trucking waste many miles away, has a clear cost advantage from a transportation perspective.

Nevertheless, contract transitions and erratic energy and metals pricing muted Covanta’s ability to reliably derive returns on an invested capital base that was originally inflated by acquisition activity. In addition, the oft-long timeline required for development projects meant that invested capital grew in support of projects that were still years away from generating cash flow. With the development burden shared by GIG in this new arrangement, Covanta’s capital intensity should decrease materially.

If the partnership manages to execute the project pipeline without any major setbacks, we expect this will lead to marked improvement in Covanta’s returns on invested capital, which could trigger a moat upgrade. Awarding a narrow moat would add nearly $5 per share to our $19 fair value estimate for Covanta, as we’d assume that the length of the company’s competitive advantage period would double from 5 years to 10 years, allowing the company to generate economic profit for a longer period than our no-moat base-case scenario suggests. While the new joint venture has yet to prove its mettle, we believe this partnership has derisked Covanta’s growth, and we encourage ESG investors to have a look at this leader in WtE.