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Is Covanta's Juicy Dividend Safe?

Barbara Noverini, CFA

Barbara Noverini: Investors seeking a juicy dividend yield should be aware that waste-to-energy operator Covanta's highly levered balance sheet and recently muted free cash flow challenged the sustainability of the company's generous $1 per share dividend. That said, we believe that a recently announced joint venture between Covanta and the Macquarie-backed Green Investment Group provides support for the dividend, while illuminating a growth pathway for Covanta in attractive international markets.

As of the third quarter, Covanta's all-in leverage ratio was over 7 times EBITDA, significantly higher than historical levels, as the company financed the build of a new waste-to-energy plant in Dublin, Ireland. Plus, in recent years, contract transitions and low metals and energy pricing led to lower free cash flow, which stressed Covanta's dividend to free cash flow payout ratio.

Going forward, Covanta's new joint venture with Green Investment Group will split ownership of the state-of-the-art Dublin facility, while together the entity will pursue up to six new development projects in the United Kingdom, a region with widespread support for incineration as part of a sustainable waste management plan. Contributing Dublin to the joint venture will immediately help Covanta delever by about one turn, and through the end of the decade, it is likely that cash flow from four advanced-stage projects will begin to meaningfully build.

Investors should be aware that this new joint venture has yet to prove its mettle, and the development of new incineration facilities is no easy feat; however, we believe this partnership has de-risked Covanta's growth story and should strengthen the sustainability of the company's dividend.