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Covanta: Green Day Hopes Turn Into Boulevard Of Broken Dreams (NYSE:CVA)

Investors have had the benefit of a fantastic rally off the 2020 lows. Many stocks have hit new highs and the capital gains have been stellar. Bargain hunters tend to focus on what has been left behind though. This allows them to examine the laggards and see if there is still value to be had. We look at one such company today that has not got anywhere near its old highs.

Covanta Holding Corporation

Covanta (NYSE:CVA) provides the following services:

  • Sustainable waste management.
  • Clean renewable energy solutions.
  • Comprehensive recycling solutions to address complex environmental challenges.

Covanta’s operations are underpinned by its modern “energy from waste” facilities. These safely convert 20 million tons of waste from municipalities and businesses into clean, renewable electricity. This electricity powers over 1 million homes and recycles over half a million tons of metal.

On recycled paper, Covanta appears to be the best stock for today, where a disdain towards carbon-emitting energy sources is prevalent. But things have not worked out exactly like that. The stock is down 21.75% over the last 5 years and was down almost 55% as recently as a month back.

Data by YCharts

Even investors who are looking at total returns over the past decade, have not seen much green.

ChartData by YCharts

Financials

Covanta has struggled to get its EBITDA off the floor. The trailing 12-month number is significantly below what it was just 2 years back and a bit lower than what it was almost a decade back.

ChartData by YCharts

EBITDA can be misleading at times and adjusted EBITDA can provide a better picture. In Covanta’s case, adjusted EBITDA was significantly higher for both the full year 2019 ($428 million) and trailing 12 months ($446 million, slide 15).

Source: Covanta Q4-2019 press release

Covanta will likely hit the $430-$445 million mark for 2020. These are our estimates as the company has not given specific guidance. There lies the issue though. Even taking those higher numbers, Covanta’s debt to adjusted EBITDA is currently in the 6.0X range.

Source: Covanta Q3-2020 presentation

That is a ridiculous amount of leverage and the credit agencies have not been too thrilled either (emphasis ours).

S&P Global Ratings lowered Covanta Holding Corp.’s issuer credit rating and senior unsecured debt to B+ from BB-, after its recent financial performance fell short of expectations.

Covanta’s deeply subordinated debt was also downgraded to B- from B. The ratings outlook is stable.

“We measured Covanta’s year-end 2019 adjusted debt to EBITDA at 6.5x and expect leverage to remain at or slightly above this level through 2021,” the rating agency said in a March 27 report. “The company is facing a number of market headwinds that weigh on profitability in the near term, namely depressed power and metals commodity prices.”

According to Ratings, Covanta’s plant operating expense may also temporarily increase due to its integration of recently acquired facilities to its operations base. The company is also completing its U.K. expansion plans, which include three projects under construction and one in advanced development.

Source: S&P Global

Despite that level of leverage, Covanta’s free cash flow generating abilities have been on the low side. Covanta has been producing free cash flow in the range of $100-$140 million annually. We want to add here that Covanta’s free cash flow calculation is done by subtracting out maintenance capex from operating cash flow.

Source: Covanta Q4-2019 press release

Actual capex has been far higher than that.

ChartData by YCharts

Of course, the rest can be counted as “growth” capex, but the growth has not come. To Covanta’s credit, the company has been able to keep net debt relatively steady via its dividend cut and sale of select assets over the last few years.

Source: Covanta Q4-2019 press release

Current valuation

Despite the stock not having delivered returns, it is still trading at close to 10X EV to EBITDA. The adjusted EBITDA has been stagnant and free cash flow has not grown over the years. The $42.25 million in annual dividends though should be well covered but that gives investors a sub 3% yield. Even assuming Covanta can sustainably deliver a $140 million free cash flow, the free cash flow yield is sub 10%. Overall these numbers combined with rather high leverage, keep us away.

Why Not Go Short?

The current sharp run-up in the stock alongside weak fundamentals might have gotten a few bears excited. We don’t wanted to be counted among them. There are two key reasons for that. The first is that ultra depressed power prices may mark a big reversal in 2021 and Covanta will likely surprise to the upside. We don’t want to get in front of that. The second reason is that Covanta is a “green energy stock.” ESG-themed products are getting a whirlwind of fund flows.

A Guide to ESG Investing and How Much Money is at Stake - Katusa Research

Source: Katusa Research

If those funds ever find a reason to invest in Covanta alongside improving fundamentals in 2021, your shorts positions will feel excruciating pain.

Conclusion

Covanta does not meet our valuation thresholds and the debt load is just too large. The free cash flow yield covers the dividends but deleveraging will take time. An investment in Covanta has been a boulevard of broken dreams over the last 10 years. While the long side does not interest us, we are going to strongly recommend that bears also reconsider their case. GDP will be strong in 2021 and improving power prices will help Covanta. If ever an ESG fund manager gets tired of holding Tesla, Inc. (TSLA) at 20 times 2050 year earnings and decides to send some money this way, bears will not be too thrilled. We give this a neutral rating. Investors looking for “green stocks” should consider this one instead, especially if they dislike high leverage ratios.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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