Description
SUMMARY
CVA is an energy-from-waste (EfW) company making money collecting waste and generating electricity. CVA processes 20M tons of solid waste annually, equivalent to 7% of post-recycled municipal solid waste (MSW) in the US, operates 45 EfW facilities, predominantly in the US, and produces 10M MWh of baseload electricity annually. This is an attractive and misunderstood business, with barriers to entry and 75% of cash flows secured by long-term contracts with built in price escalators. CVA is a hybrid waste management business, with a “landfill that never runs out,” and an energy company, with a “negative cost of fuel.”
Even though 2/3 of CVA’s business is waste management, the shares trade more in line with merchant power generators, such as Calpine (CPN), than waste management companies, such as Waste Management (WM), and the shares have declined 35% from its peak in 2014 due to weak electricity/natural gas pricing.
Heading into 2017, CVA shares could be poised for material appreciation as comps in the energy business ease, capital intensity declines, cash flows grow, and leverage declines.
On an organic basis, including already announced projects, CVA could earn $485-530M in EBITDA by 2018. CVA will not be a meaningful cash tax payer until after 2020 converting around 40% of EBITDA to FCF. At a 15x multiple, on $1.50-1.65/share FCF, shares could be trading at $22-24 in 1.5 years for a 22-30% IRR.
While low natural gas/electricity prices have been a headwind in 2014/2015 any sustainable recovery could be a source of material upside. A 10% rise in natural gas price is around $7.5M in EBITDA or $0.02/share in FCF.
The 6% dividend yield appears to be covered by the 75% of the business that comprises irreplaceable infrastructure assets with highly contracted cash flows, limiting downside. CVA is operated by a shareholder-friendly management team with an ex-Air Products executive as CEO who is focused on Six Sigma /LEAN initiatives and Chairman Sam Zell, who owns around 10% of shares.
There are several catalysts that could drive a re-rating in the stock: Sustainable recovery in electricity/natural gas prices; stability/recovery in metals prices; inflection in cash flows and de-leverage late 2017/2018 which could make shares more investable.
BUSINESS REVIEW
CVA makes money when it collects waste and when it produces electricity from waste, generally under long-term contracts.
CVA processes 20M tons of solid waste annually, which is equivalent to 7% of post-recycled municipal solid waste in the US, operates 45 EfW facilities predominantly in the US, and produces 10M MWh of baseload electricity annually.
CVA’s investor presentation available at the link below and the Annual Report provides an excellent overview of the industry so I will not rehash.
http://investors.covanta.com/presentations.aspx?iid=103347
Business notes:
· Waste
o Over 2/3rd of revenue from waste with 85% under long-term contracts with inflation escalators. CVA is paid either on a “tip fee” basis, which is around 55% and where CVA retains 100% of economics, or under “service fee” contracts where the revenue is shared.
o The waste business is undergoing a positive mix shift where the uncontracted portion or spot tonnage business is being replaced by higher margin (50% vs 25% corporate average) “special” or “profile” waste.
· Energy
o Around 25% of the business is energy-related of which around 75% is contracted or hedged. Spot/merchant business is primarily PJM, NEPOOL and NYISO in the Northeastern US.
o CVA’s spot exposure has been steadily increasing which has exposed the company to low electricity and natural gas prices. While this mix shift has admittedly hurt the quality and stability of the business, it enables CVA to benefit from any sustainable rebound in electricity/natural gas prices with incremental sales at high incremental margins.
· Metals business
o Around 5% of CVA is the metals business where CVA extracts and recycles ferrous and non-ferrous metals selling at spot prices. Depressed metal prices, thanks to dumping by China, have been a headwind to this business.
VALUATION
Starting with 2016 EBITDA of $390-430M, projects such as the announced Dublin project and ongoing LEAN/Six Sigma initiatives by the ex-Air Products CEO add $85-90M EBITDA by 2018. CPI-linked pricing, positive mix shift to special/profile waste (2x margins), offset by negative mix shift to merchant/spot contracts in energy add around $10M EBITDA for an all-in EBITDA of $485-530M.
With around $130M interest payments, $10-15M cash taxes (CVA will not be a material cash tax payer until after 2020), and $110M maintenance capex, every dollar of EBITDA translates into around $0.40 of FCF before any growth capex. Therefore, 2018 FCF could be $1.50-1.65/share.
At a 15x multiple, CVA shares could trade at $22.50-24.50 in 1.5 years. The implied EV/EBITDA multiple is around 10x, and 2018 net debt of around $2.5B.
The 6% dividend yield which should be covered by the 75% of the business that comprises irreplaceable infrastructure assets with highly contracted cash flows, limits downside.
I’m not incorporating any upside from M&A and growth projects even though management likely pursues them. If management is able to close on acquisitions at 7x EBITDA multiples (management’s hurdle rate) they would be accretive to my numbers.
The more interesting potential upside is from any sustainable rise in energy prices. Just as CVA, was hurt on the way down by low energy prices, any sustainable rally could present material upside with very high incremental margins. Each 10% rise in natural gas price translates into $7.5M in EBITDA.
Risks
· For a highly levered equity, small changes in EBITDA expectations drive big changes in equity leading to significant volatility. CVA has around $2.4B of net debt; $1.2B of debt at the holding company level and $1.1B at Covanta Energy LLC with no material maturities until after 2020.
· The capital intensive nature of projects creates all kinds of project risk from downtime and delays. Please size the position appropriately.
· Declines in natural gas prices or metals pricing will hurt the business and the stock.
· Contract losses
· Rising interest rates will hurt utilities. To be clear, CVA hasn’t traded with utilities or participated in the utilities rally (XLU +10%, CVA -18%) over the last year so it may not be an issue for them.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.
Catalyst
· Sustained recovery in electricity/natural gas prices
· Sustained recovery in metals prices
· Inflection in cash flows and de-leverage in 2017/2018 could drive a re-rating in the shares. While leverage is high at 5.4x it will trend lower as Dublin begins to contribute cash flows in 2017.