Description

Situation Overview

madler934 did a good job describing Enviva in 2016 so this write-up will echo his description of the business. Enviva is an attractive investment now because the company is coming off a historically bad year and has recently completed the first in a series of dropdowns and expansions that will meaningfully increase earnings. At an 8% yield on the 2021P dividend of $3.04, the stock is worth $38 (+17%) for a total 2-year return of 33%, with continued growth in the dividend driving longer-term upside.

Enviva Partners is the world’s largest producer of wood pellets used as a renewable substitute fuel for coal in power plants. The company’s cost advantages and reliable production capacity have helped it secure long-term contracts with European and Japanese utilities on terms that limit commodity exposure and provide visibility into long-term earnings growth. With good dividend coverage, an 8.1% dividend yield and potential to grow distributable cash flow more than 60% between 2019 and 2021, Enviva trades at an unwarranted discount to commodity sensitive MLPs and is inexpensive on an absolute basis.

Note: consensus estimates can vary widely due to differing assumptions around future M&A. The projections in this write-up reflect organic capex opportunities at North/Southampton and the recent Hamlet/Wilmington transaction.

Business Description

The use of wood pellets for utility-scale energy production became viable in the last decade as European countries and Japan implemented tax and subsidy schemes to support decarbonization and the use of renewable energy sources. Converting coal-burning plants to pellet-burning plants is an economically attractive option for utilities that need to reduce coal emissions while meeting baseload electricity demand. Repurposing coal-fired plants also preserves jobs in the utility sector and parts of the coal supply chain, moderating job loss, a common social and political objection to decarbonization.

Demand for utility-scale wood pellets in the UK and Europe has grown under a system of renewable obligation credits (“ROCs”) and feed-in tariffs that provide direct subsidies to utilities for using wood pellets in converted coal-burning plants. Today, Europe burns 11.5m tons of wood pellets annually and bioenergy provides around 7% of the UK’s total primary energy supply. Under the ROC system, a converted coal-fired plant may earn €50/MWh for energy production plus €50/MWh from a ROC subsidy while the wood pellets cost €75/MWh, netting a €25/MWh profit. The same energy produced by coal would earn no profit (the cost of production plus taxes is about €50 MWh) and the costs of wind and solar are above €100 MWh and require much larger subsidies. Similar subsidies in Japan have spurred global demand for a reliable, low cost, high volume source of utility-grade pellets. Enviva Partners was formed in 2010 and has grown with support from its sponsor, Riverstone Partners, to meet the unique demands of this rapidly growing market.

Enviva Partners is the world’s largest supplier of utility-grade wood pellets. The company’s six production facilities and vertically integrated network of port terminals and storage facilities make it the only wood pellet producer capable of meeting the decades-long supply requirements of its large utility customers. The company’s success securing long-term supply agreements can be attributed to its scale, reliability and structural costs advantages.

Enviva’s production plants were intentionally built near large forestry sites in the Southeastern U.S.  to establish two enduring competitive advantages: (1) a reliable, abundant raw material source and (2) lower production costs. Enviva’s raw material suppliers are within 75 miles of its production facilities, lowering shipping costs to Enviva’s plants and the cost per ton of finished pellets. Additionally, Enviva receives discounted pricing as the largest buyer of low-value wood materials from timber harvesting, further lowering its production costs. Finally, Enviva’s owned infrastructure assets—four terminals and storage facilities—lower its storage and shipping costs while increasing the reliability of its output (the cost per pellet will decline further as the business scales). These costs and operating advantages make Enviva an attractive long-term partner for utilities in need of consistent fuel supply.

The company’s current annual capacity of 3.5m metric tons is fully contracted and is expected to grow to 5m with additional investments through 2021. In discussions with former employees, it is clear Enviva cannot add capacity fast enough to meet growing demand and by 2022, the company and its sponsor will have 6m tons of annual contracted demand, representing 80%+ volume growth.

Investment Thesis

Predictable, visible growth runway: Enviva’s contracts are structured to generate highly predictable and consistent revenue and cash flow. Nearly all of Enviva’s contracts are long-term (10-15 year), dollar-denominated, “take-or-pay” agreements that obligate the customer to take a fixed quantity of product at a stated price, with pass-through clauses for commodities and inflation. Most of the counterparties are large, mission-critical utilities earning healthy profits from the subsidized use of wood pellets, further strengthening the predictability of earnings.

In 2019, the company will sell significantly more tons than in 2018 as orders deferred due to hurricane disruption in 2018 are realized. The following year, in 2020, contracted demand grows 17.5% (3.2m to 3.8m) and continues ramping up through 2022 as the first large Japanese contracts come online. This ramp in volume excludes potential demand from new markets including Germany, South Korea and other European and Asian countries. The growth outlook for the business is compelling.

Pipeline of accretive dropdowns: In addition to the organic growth outlined above, Enviva will grow through a series of accretive dropdown transactions from its sponsor, the Riverstone Funds. Over the last few years, Enviva has completed four drop-downs at attractive valuations (6x-7.5x EBITDA) that significantly increased production capacity and added 3m MTPY of terminal capacity. The sponsor has a pipeline of three more drop-downs through 2024 and an organic expansion opportunity that could collectively double EBITDA over the next few years. With deals transacted at 7.5x and funded with a mix of debt and equity, the most recent dropdown and plant expansion will drive dividend growth from $2.54 in 2018 to $3.04 in 2021 (assuming 1.2x dividend coverage). While some of the added dropdown capacity is redundant with the organic growth discussed above, a portion will be incremental and accretive

On April 2, 2019, Enviva closed a dropdown of a production plant in Hamlet, North Carolina and raised money to fund a terminal payment and the expansion of capacity at its Northampton and Southampton plants. The transaction was funded by issuing 3.4m common units to the sponsor (~$100m at $29.21 p.s.) and issuing 3.5m shares in an offering to existing investors (we believe a few of the top shareholders, including ValueAct, took down the entire offering). The company also raised 2019 dividend guidance from $2.61 to $2.65 and established 2020 distribution guidance of $2.87-$2.97 per share. Most importantly, the company sees a path to $210m-$240m of EBITDA in 2021 with an additional $200m of debt-financed investments, which should drive the dividend above $3 per share.

Riverstone owns over 45% of the Enviva Partners, LP common units so its interests as the sponsor (the GP) are aligned with shareholders’ interests.

Favorable regulatory backdrop: The current regulatory regime is favorable for Enviva and future regulatory changes should sustain demand after the current UK subsidy system expires in 2026. Going forward, the EU and the UK have adopted carbon tax systems that will gradually increase the cost of coal production while increasing the value of renewable energy. The carbon tax system will provide a larger per MWh subsidy for wood pellet use than the existing subsidy scheme, without direct government involvement (carbon emitting producers will buy carbon credits from carbon neutral producers). Many European countries are committed to the complete phase-out of coal over the next 10-15 years and the regulatory mechanisms forcing the transition will support wood pellet usage. Some arrangements with the UK government extend beyond 2026, including subsidies supporting MGT Teesside which recently finalized a 1m MTPY contract with Enviva that runs through 2034.

Asia is beginning to adopt wood pellet usage and Enviva foresees the Japanese market being as large as the UK market with additional growth opportunities in South Korea and China. The long-term regulatory framework and growing global phase-out of coal will support wood pellet and biomass use for many years to come.

Many environmentalists prefer wind and solar over wood-burning renewables, but wind/solar are incapable of meeting baseload electricity demand and are not “dispatchable” (power output cannot be adjusted according to demand). Other than nuclear, which many environmentalists also oppose, there is no suitable renewable substitute other than biomass for the baseload power generated by coal. Also, by buying unused trees and residuals that are byproducts of forestry activity and requiring all of its suppliers to plant a commensurate number of trees for each tree Enviva buys, the company encourages forestation by large timber farms. The whole trees Enviva uses are harvested as part of broader forestry activity and have no other purpose. The company pays ~$25/ton for hollow, short and damaged trees while good trees sell for over $100/ton so the economics for farmers favor selling healthy, large whole trees. The company takes meaningful measures to ensure forestation offsets its wood consumption.

Valuation

EVA trades at an 8.1% dividend yield and 9.0x 2020P EBITDA. Distributable cash flow more than covers the dividend and, given the long-term, take-or-pay nature of Enviva’s contracts, with strong counterparties and low FX exposure, the yield is discounted relative to commodity-exposed MLPs trading below an 8% yield.  With contractual visibility into 10%+ volume growth in 2019 and 80% contracted growth through 2022, Enviva’s distribution could grow from $2.65 to $3.04 by YE 2021 and $3.20 by 2022 which, holding today’s yield constant, would imply a price of $37-$39 (+15-21%) before factoring in the dividend. It is likely investors will come to appreciate Enviva’s unique competitive advantages, visible earnings outlook and discounted yield and the stock will rerate to the 7.5%-8.0% yield range and a $40+ price (30%+ upside).

Any positive developments with new customers and German regulations will drive additional upside.

Risks

Renewals after 2026: Many of Enviva’s contracts expire in the 2026-2027 timeframe as the initial UK subsidies come up for renewal. Carbon tax credits should make wood pellet-use economically viable, but changes to existing regulations could cause volatility in Enviva’s pricing and volume at that time. A recent contract win with MGT-Teesside for 1m tons through 2034 suggests initial subsidies may persist beyond the current phase.

Commodity and foreign exchange exposure: A small portion of Enviva’s costs fluctuate with oil prices (trucking wood supply to production plants and finished pellets to port terminals) and 7% of Enviva’s payments are GBP and CAD based. The overall margin impact of oil prices is muted, and the company has forward currency hedges to protect its near-term downside in the event of a large FX move (note: a 20% decline in the GBP would drive a 2% decline in revenue, before counting the benefit of offsetting hedges). Finally, EVA’s main counterparty in the UK, Drax, owns a wood pellet plant in the U.S. that could be part of an arrangement to provide pricing accommodation in the event of a severe currency move (we think this is unlikely, but the point is there are potential commercial arrangements to make EVA whole in the event of large FX shifts). EVA’s counterparties need to meet coal decommissioning requirements by 2025 so there is regulatory impetus to maintain the existing relationship.

Reliance on expansion through dropdowns: The company will pursue dropdown acquisitions to meet long-term contractual obligations by the mid-2020s. There is no guarantee the transactions will be done at favorable valuations and the company will rely on credit markets to complete the acquisitions. We believe ValueAct’s presence as a top shareholder will encourage prudent transaction activity.

Operational risk: Wood pellet production can be dangerous and Enviva’s facilities are frequently in the path of hurricanes that can temporarily stop production. The production process involves grinding wood into a dry, highly flammable pulp in a hot production facility with heavy machinery, so fires and explosions cause occasional shutdowns (Enviva had to close a facility in 2018 following a fire, negatively impacting 2018 results). In our conversations with a former plant manager of Enviva’s largest production plant in Cottondale, FL, we were assured the company has high safety standards and operates with best in class safety and quality control procedures that minimize the incidence and impact of plant closures. The company has business interruption insurance to cover any shortfalls from weather and accident-related production issues.

Environmental litigation: Dealing with environmental naysayers is a part of life for Enviva. To most environmentalists and regulators, wood-pelletization is viewed as a crucial intermediate step towards decommissioning coal-powered plants and preserving jobs, an important social externality of decarbonization. However, burning wood pellets does generate carbon emissions and has a much larger carbon footprint than wind/solar renewables so opposition persists. A group of individuals and NGOs has filed a lawsuit in the EU in which the plaintiffs contend the inclusion of forest biomass in the EU’s RED II directive violates their rights and freedoms and is, therefore, impermissible under EU law (RED II requires nations to achieve 32% renewable energy consumption by 2030, more here: http://tinyurl.com/yxtk5tdh). There is no guarantee the lawsuit won’t be successful, but the probability of success is low. RED II, the UK subsidies and the renewables framework supporting wood pellet use were established and vigorously debated repeatedly for over a decade and are unlikely to change overnight. Furthermore, there is ample support for wood pellet use from NGOs and research institutions that should encourage sustained and additional wood pellet adoption in future regulations.

Model Overview

Catalyst

- Earnings growth driven by recent Hamlet dropdown.

- German and Japanese contract signings.