Summary: DHC is an extremely attractive short with overstated EBITDA, decreasing future cash flows and an undeserved run in share price:
• Overstated EBITDA. Investors have taken an overly aggressive view when calculating both current and future EBITDA:
-They incorrectly believe that DHC will continue to receive approximately $61mm per year from municipalities for debt paydown. This $61mm is included in the per ton tipping fee that DHC receives when a municipality provides a Covanta waste to energy (“WTE”) facility with garbage. (Covanta is the subsidiary of DHC that owns and operates WTE plants.) Conversations with DHC’s CEO and IR have confirmed that when long term service agreements are renegotiated after the debt has been paid down, DHC is unlikely to receive comparable tipping fees. As a result, some or all of this $61mm in EBITDA will go away.
-They have attributed as much as $60mm of EBITDA to CIPH, the international operations of Covanta, but CIPH’s future performance is questionable and the cash flow it generates must be used to meet debt obligations related to its project debt for the foreseeable future. Further, management told investors that CPIH had “zero value” in October 2004. Ascribing any material value to such an asset appears aggressive.
• Decreasing free cash flow. DHC’s future free cash flow will be reduced by increased capex and cash tax obligations. First, capex spikes every five to seven years when plants require extensive maintenance. This spike will occur soon. Second, although DHC possesses approximately $516mm of NOLs (as of 12/31/04), its Covanta plants are almost completely depreciated on a tax basis as a result of accelerated depreciation. When the NOL expires, the company will not record depreciation expense for tax purposes relating to these assets, resulting in effective tax rates in excess of 40%, reducing free cash flow.
• Undeserved increase in share price. DHC’s January 2005 acquisition of American Ref-Fuel Corporation (“ARC”) resulted in DHC’s shares doubling to approximately $16 in two weeks time, creating $565mm of equity value. This increase can largely be attributed to investors’ unfounded belief that management could increase Covanta’s plants profitability to a level commensurate with those of ARC and the attention that the acquisition shed on the DHC story as a whole. We believe that DHC paid a full price for ARC. As a result, we question the logic behind the recent price appreciation.
DHC has appeared on VIC in recent history (as a long on 2/17/04), so in the interest of not repeating information provided before, this write-up will attempt to pick up where the previous posting left off. As the previous posting explained, DHC is a story involving multiple acquisitions, bankruptcies, and a constantly evolving capital structure shaped by three well known investors who have been involved with the company for several years and currently hold approximately 40% of the equity: Sam Zell’s SZ Investments, Marty Whitman’s Third Avenue Trust and DE Shaw.
DHC completed its acquisition of Covanta on March 10, 2004. In 2004, Covanta accounted for more than 95% of DHC’s $715mm of revenue. (NAICC, an insurance subsidiary, generated $23mm.) Covanta operates 25 WTE plants that were constructed in the mid 1980s through the mid 1990s. The company owns 16 of these plants and manages the remaining 9 under service contracts. Covanta also has interests in other domestic and international energy producing assets. (CIPH revenues were $140mm in 2004.)
Covanta’s WTE plants have two sources of revenue: tipping fees and energy sales. Tipping fees refer to the rates that Covanta charges for accepting garbage. Twenty year service agreements between Covanta and the local community provide a formula for determining the tipping fee, the minimum amount of garbage the town must deliver to the plant per year and the percentage of the energy revenues generated by the plant that Covanta would retain (typically 10%). Note that the construction of almost all Covanta plants was financed with municipal bonds issued by the local community. The tipping fee paid by the municipality encompasses several pass through costs including the interest and principal payments that correspond to the debt issued to finance the plant. As a result of this structure, the debt service paid to Covanta is included in its revenues and EBITDA. For managed plants, Covanta receives a service fee for operating the WTE plant. In most instances, Covanta takes advantage of additional capacity by soliciting garbage from outside waste providers as well.
In January 2005, DHC acquired WTE operator ARC for $740mm in cash and the assumption of $1.5bn of debt (both recourse and non-recourse project debt) from CSFB’s Alternative Capital Division and AIG Highstar Capital. The market response was deafening, with DHC’s shares almost doubling from around $8 at the time of the acquisition to approximately $16 two weeks later. To finance a portion of the transaction, DHC will conduct a $400mm rights offering that gives all DHC shareholders the option to purchase 0.9 shares of DHC stock for $6.00 per share. Assuming full participation, the transaction will result in the issuance of 68mm shares and bring DHC’s share count to 144mm. DHC also plans to refinance much of its non-project debt.
ARC owns five WTE plants and manages one. Interestingly, its plants are materially more profitable than those of ARC resulting in EBITDA margins of approximately 56% versus 34% for Covanta. This profitability gap can be explained by several factors. First, its plants are dramatically larger. ARC’s plants process 75% more waste per day and produce almost 100% more energy per year. Second, ARC’s plants are all located in the northeast where a combination of dense populations and restrictive waste laws has resulted in higher tipping fees. Finally, service contracts are another key factor. Four of ARC’s facilities’ service contracts are structured so that ARC receives 100% of the energy revenues. Only a few Covanta plants deviate from the 10% structure described above. As a result, energy sales account for 40% of ARC’s revenues and 33% of Covanta’s revenues.
Why is this a great short?
DHC’s service contracts begin to expire in 2007. Many investors have indicated to us that they believe DHC will likely negotiate new, more favorable contracts upon expiration because current contracts include below market tipping fees. Conversations with DHC’s President and CEO Tony Orlando and IR suggest a very different scenario. Instead of an opportunity for greater profitability, the contract expirations will likely move tipping fees in one direction: down.
Upon expiration, the municipalities have the option to renew their current service agreements for five years or renegotiate. Management has told us that, on average, current tipping fees are at market rates. Remember that each plant, however, has its own service contract. Depending upon the initial terms and waste disposal developments in the area since the original contract was signed, different municipalities are paying a range of tipping fees that may be below, at or above market rates. Upon expiration of a given contract, the municipality will renew the contract if its tipping fees are below market rates. If a given contract is above market, however, the municipality will not renew and instead renegotiate a new contract at the lower market price. Rates will fall, not rise, relative to the market as the initial service agreements expire.
Tipping fees will fall further when the project debt is repaid in conjunction with the expiration of the original service agreements. Recall that the formula used to calculate service fees includes interest and principal for project debt that then flows into DHC’s top line and down to EBITDA. Many investors believe that when the project debt is paid down, DHC will pocket the difference. The only analyst who covers the company is very bullish on the stock and cites this issue as one of the investment’s key merits. He explains the bull thesis on this matter by using an apartment analogy: when the debt used to finance a building is paid down, tenants do not demand lower rent. In the case of Covanta, however, the “renter” guaranteed the debt used to finance the “building” – not exactly the typical landlord/tenant relationship. Instead, DHC management has explained that the $61mm for project debt that DHC received in 2004 will contractually go away as the project debt is repaid beginning in 2007. (Note that the $61mm is conservative because it represents the period in 2004 that DHC owned Covanta, from March 10 to December 31. A full year figure is not available.)
The $60mm of EBITDA attributed to CIPH is another area of concern. Several factors have made us skeptical of these assets’ worth:
• At the annual meeting in 2004, Sam Zell (who was the chairman of the board) explained that DHC had assessed CIPH to be worth nothing when evaluating the purchase of Covanta.
• Within the last year, DHC has attempted to sell these assets, but chose not to do so. Bulls could argue that this decision reflects newfound value in the assets, while bears will point to Zell’s comments and hypothesize that DHC did not receive real interest in the assets from prospective buyers.
• At best, DHC will have to wait for years before it can make use of the cash flow generated by CIPH because of the covenants associated with these assets’ project debt. These covenants mandate that all cash flow must be used to pay down the project debt before it can be used by Covanta or DHC for other purposes.
Undeserved increase in share price
On January 31, 2005, the day before DHC’s acquisition of ARC, its shares closed at $8.17. In approximately two weeks time, its price almost doubled and has remained close to this level since that time. This increase created $565mm of undeserved equity value.
We believe that DHC paid a full price for ARC. To begin, both parties involved were sophisticated investors. DHC had Covanta’s management team for industry expertise and a board that included representatives from SZ Investments, Third Avenue and DE Shaw. The sellers were two private equity funds. We are somewhat leery of the 8.3x EBITDA multiple DHC paid (its shares were trading at 6.4x) and do not view this price to be a bargain. Importantly, the sale took place at a time of historically high fuel prices. Note that energy sales account for 40% of ARC’s revenue and unlike Covanta, the majority of these sales occur at market prices.
Given these considerations, we would not have expected DHC’s stock price to change materially when the transaction was announced. If management can achieve the $20mm of synergies they predict, this difference would provide a fraction of the price appreciation occurred. Further, given the sophistication of both sides, we assume they split the synergies and 50% of the benefit would have been factored into the price. (Assuming a 10% free cash flow yield, a 40% tax rate and 144mm shares, synergies would account for approximately $0.42 per share.)
Instead, we attribute the stock’s rise to investors who became aware of the DHC story when DHC announced the acquisition. Many of these investors then made two faulty assumptions: (1) EBITDA would increase when Covanta’s service agreements expired and (2) Covanta’s plants could operate at levels of profitability comparable to those of ARC. As we have indicated, conversations with management suggest otherwise. Instead, we believe that Covanta’s EBITDA will decrease, not increase, in future years as service agreements come up for renewal and that discrepancies in size, location and service agreements explain the vast majority of the profitability gap between Covanta and ARC.
Decreased free cash flow
DHC’s future free cash flow will be reduced by increased capex and cash taxes. Management has explained to us that Covanta’s plants require increased capital expenditures every five to seven years. As result, Covanta’s capex will spike dramatically from its 2004 level of $12mm in a few years and will do so again every five to seven years thereafter.
DHC’s free cash flow will also be reduced by approximately $25mm per year when its NOLs expire as a result of its use of accelerated depreciation. As mentioned above, the company has NOLs of $516mm. Our analysis suggests that these NOLs will be used up by 2011. After the NOLs are extinguished, Covanta’s effective tax rate will be in excess of 40%.
Covanta’s plants are almost completely depreciated as a result of the accelerated depreciation for tax purposes that DHC has employed. Consequently, Covanta no longer benefits from the tax shield provided by depreciation expense. When the NOLs are extinguished, DHC’s free cash flow will be reduced by $25mm. We calculated this number by applying a 40% tax rate to Covanta’s $65mm of GAAP D&A expense. The resulting $25mm tax shield that would have been created if tax and GAAP depreciation were identical vanishes and reduces cash flow by $25mm.
We believe that DHC should trade for $4.38 per share, 60% less than its current price of $10.91. (We have adjusted these prices for the rights offering. Using the pre-offering share count of 73.2mm shares, our price target would be $8.62 versus the current price of $15.01.) We arrive at this number in the following manner:
$511.8mm of pro forma EBITDA
6.0x EBITDA multiple
Equals: $3,070.8mm of enterprise value
Less: 2,637.9mm net debt
Equals: $432.9mm of equity value
Assuming 144mm shares outstanding, we calculate a per share value of $3.01 before accounting for $0.96 per share of the NOL and $0.42 per share of synergies. Including the PV of the NOL and the synergies, we arrive at a share price of $4.38.
The key assumptions of our model are as follows:
• No growth. Legislation has made building WTE plants uneconomical. As a result, building ground to a halt during the mid-1990s. While some facilities have expanded, new WTE plants appear unlikely. We have used the 2004 pro forma financials provided in DHC’s April 5, 2005 8K as the basis for our valuation and have not built any top line growth into our model. Note that in the projections found in Covanta’s bankruptcy filings, the company forecast revenues growing at a 1% CAGR from 2003-2007.
• We used a 6.0x multiple to reflect the business’s lack of growth and our uncertainty regarding the quality of the $511.8mm of EBITDA. Currently, the stock is trading at 8.2x.
• We estimated the per share present value of DHC’s NOL by assuming a constant cash tax basis of $75.9mm. We also reduced the NOL by any unused portion that expired in a given year until the NOL was exhausted 2011. We then calculated the tax shield using a 40% tax rate and discounting these future values at a 10% discount rate. This yielded a present value of $138.5mm or $0.96 per share at 144mm shares.
We are currently short DHC.