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Covanta holding Corp Inc. (NYSE:CVA)

Q3 2009 Earnings Call

October 22, 2009 8:30 am ET

Executives

Marisa Jacobs – Vice President, Investor Relations & Corporate Communications

Tony Orlando – President & Chief Executive Officer

Mark Pytosh – Executive Vice President and Chief Financial Officer

Analysts

Paul Clegg – Jefferies & Company

JinMing Liu – Ardour Capital Investments

[Tom Noack]

[Hamzah Mazari]

Dan Mannes – Avondale Partners

Michael Hoffman - Wunderlich Securities

Michael Horowitz – Robert W. Baird

[Greg Oril] - Barclays Capital

Patrick McGlinchey – Sidoti & Company

Operator

Welcome to the Covanta Holding Corporation Third Quarter 2009 Financial Results conference call and webcast. This call is being taped and replay will be available to listen to until midnight eastern time on Thursday, October 29, 2009. The playback number is 888-286-8010 for callers in the United States.

Again that is 888-286-8010 for callers in the United States and 617-801-6888 from outside of the country. Again that number is 617-801-6888 if calling from outside of the country. The replay pass code is 64332101. Again the replay pass code is 64332101. The webcast will also be archived on www.covantaholding.com. Again that is www.covantaholding.com and can be replayed or downloaded as an MP3 file.

At this time for opening remarks and introductions, I'd like to turn the call over to Marisa Jacobs, Vice President of Investor Relations and Corporate Communications.

Marisa Jacobs

Welcome to Covanta Holding Corporation's Third Quarter 2009 conference call. Joining me on the call today will be our President and CEO, Tony Orlando, and our Executive Vice President and CFO, Mark Pytosh. We'll provide an operational and business update, review our financial results, and then take your questions.

The following discussion may contain forward-looking statements and our actual results may differ materially from those expectations. Information concerning factors that could cause such differences can be found in the company's reports and registration statement filed with Securities and Exchange Commission. The content of this conference call contains time sensitive information. It is only accurate as of the date of this live broadcast October 22, 2009. We do not assume any obligation to update our forward-looking information unless required by law. Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of Covanta is prohibited.

The information presented includes non-GAAP financial measures. Reconciliation to the most directly comparable GAAP measures and management's reason for presenting such information is set forth in the press release that was issued last night. As these measures are not calculated in accordance with GAAP, they should not be considered in isolation from our financial statements that are prepared in accordance with GAAP. It should also be noted that our computation of adjusted EBITDA may differ from similarly titled computations used by other companies.

I will now turn the call over to our President and CEO, Tony Orlando.

Tony Orlando

Thanks everyone for joining us this morning. This was a solid quarter. Our team continued working effectively to offset a significant portion of the economic headwind, and we made positive progress on numerous growth initiatives highlighted by a speedy completion of the majority of the Veolia acquisition.

As a result of this acquisition, we are now operating a sixth additional energy from waste facilities along with one additional transfer station. The integration work is progressing nicely and we expect to complete the transaction by closing on the Dade operating contract near the end of they year.

We are reaffirming our guidance on all key metrics. I'm pleased to note that taking into affect our solid third quarter and anticipated contribution from these new facilities, we now expect to finish the year near the midpoint of the guidance ranges. Mark will review the quarterly financial results in detail and he'll help you understand the numbers by sorting through the noise that relates to several contract transitions.

I'll give you an overview and offer some color on the market conditions. Let me start by noting that our quarterly operating cash flow of $111 million was slightly better than our third quarter last year. Organizationally, we are driven by cash so I'm really quite pleased with this performance and I'm confident we'll finish the year with strong free cash flow.

Turning to adjusted EBITDA, we were down $15 million from last year, that's less than 10%. There were two big drivers both in the existing domestic business, an $8 million revenue reduction due to lower recycled metal prices and another $8 million revenue reduction due to lower energy price and production.

You will not that I did not mention waste as a big driver, that's a positive . Our existing business tip fee revenue was down about $4 million, but more than half of that related to internalizing waste disposal from our new transfer stations in Philadelphia. And this revenue decline is directly offset with lower cost.

Waste disposal tip fees across the system are down only slightly, which caused less than a $2 million decline in revenue. Normally, of course, we'd like to see our tip fees escalate a few million dollars, but considering the difficult economy we're pleased with how well the waste side of the business is holding up. So again, the two big drivers were metal and electricity.

Our recycled metal revenue is down compared to last year. However, we have seen a nice uptick from the second quarter. In fact, we're up about 50%. Pricing during the third quarter was pretty close to historic averages, and remember scrap metal prices were extremely low at the end of last year. So we anticipate metal revenues to show a year-over-year improvement in the fourth quarter.

If prices hold steady, our metal revenue will finish the year about $24 million down from 2008, and that's pretty close to the middle of the $15 million to $30 million range we estimated at the beginning of the year.

Let me turn to energy markets. I'm going to get into more detail than normal because this is important for us and I know it's a topic of interest to our shareholders. As you probably know, market conditions were fairly challenging in the third quarter and prices dropped considerably. Around Labor Day, natural gas prices hit a seven-year low and PGM electricity prices sank well below $40 per megawatt hour.

Fortunately, we've seen a nice recovery since then. On a full-year basis, we are now forecasting our market energy prices to be about $45 per megawatt hour. In spite of the market dip, that is slightly higher than the forecast I gave you on our last earnings call because of some steps that we've taken at our Hempstead facility.

Looking forward to 2010, if low energy prices persists it is obviously not good for us, but it is not nearly as bad as you might expect. We have a number of contractual, regulatory, and operational tools at our disposal to mitigate the downside. For example, our contract at the Niagara facility allows us to opt into fixed price rate every six months.

Previously we were better off selling at market prices, but now we've opted to sell our output at a fixed price through July. Next spring we'll decide if we want to move back to the market or continue selling at fixed price.

At our Hempstead Long Island facility where our long-term fixed price tower contract coincidentally expires today, we have an alternative to the current low market prices, and for now we've chosen to exercise that alternative by selling our electrical output at avoided cost. The avoided cost is a rate established periodically by the Long Island Power Authority Board, and it is used by LIPA both for purchasing power from companies like Covanta and also to establish billing rates for LIPA customers.

The current avoided cost rate is lower than our old contract rate, but is preferable to spot market prices. It was approved by LIPA's Board this past May, so it's reasonably current and we believe it's likely to remain at or close to the same rate for some time. If we're right, this reduces our market exposure and mitigates the revenue decline related to the expiration of the Hempstead contract.

We're also taking steps at our biomass facilities to mitigate downside. Unlike energy from waste facilities where we are paid for our fuel, the biomass facilities have to pay for wood waste and, therefore, if the spread between wood prices and electricity prices is too small, we will not operate 24/7 at full load. We call this operating in a dispatch mode in response to the bark spread, which means we curtail output when the bark spread is tight and increase output when the bark spread is wide.

We have been operating two of our California facilities in the dispatch mode and we plan to do the same at our main biomass facilities. This significantly reduces our downside exposure going forward while preserving the upside. I think of this as managed market exposure.

Furthermore, regarding our two California biomass facilities that we're currently operating at dispatch mode, we are now negotiating a long-term fixed price arrangement at attractive prices. Both parties want to do this. The buyer in California wants reliable renewable generation and we gain predictability while improving our current economics. Hopefully we'll agree to a deal before the end of the year, which subject to regulatory approval, would lockup a little over 100,000 megawatt hours.

So what does all of this mean for 2010 energy price exposure? I've previously noted that we have about 2.5 million megawatt hours of exposure next year and that includes the Hempstead, Niagara facilities as well as the biomass facilities that I just described. Provided the Hempstead avoided cost rate stays at the same level as we anticipate, our market downside exposure will be cut in half, yet we retain most of the upside if the market rebounds.

With this framework, let we reset the outlook for next year. As you may recall, we previously estimated a $25 million to $30 million decline in our 2010 domestic energy portfolio with most of that related to the Hempstead and union contract rolling off.

Using the current forwards curve and the strategies I just described, we're holding the line on that $25 million to $30 million decline. If actual prices come in below the forwards curve, we'll feel it on the fully exposed energy which is now about 1.2 million megawatt hours.

However, if prices come in higher, we'll get a proportionately greater uptick because we would increase the output at our main biomass facilities and opt back into the market at other facilities. For an equal price move, our upside is about 50% greater than the downside. And given how low the market is today, I believe the long-term potential for significant price increase is far greater than the potential for a significant decline.

It's also worth noting that we don't have another period of major power contract roll off for several years. So we have the benefit of the stability through 2013 with the potential upside of additional exposure to long-term energy prices. Overall, I really like our position.

We own significant, climate friendly energy capacity that generates power 24/7 and is located in the densely populated areas where renewable energy will be most highly valued. Over the coming years, I see limited downside and meaningful upside.

Let's turn now to the Veolia acquisition. I'm proud of our team for moving so quickly to close the majority of this transaction. We're very happy to welcome nearly 300 new employees to the Covanta family. After only a few weeks of working with them, it's clear this is a group of very talented people and we're even more excited now about the synergies we can create.

Mark will discuss the financial impact of this transaction, but I want to note that the integration process is well underway and progressing as planned. We are now operating the Americas business with one new region, six in total, and the facilities have been allocated among the regions to enhance our operating efficiencies.

Furthermore, we are excited to be working with our new clients and partners to create value. To that end, just a couple of days ago we signed a definitive agreement to acquire the minority owner 40% stake in the Montgomery County, Pennsylvania facility for $24 million. We anticipate this transaction will be completed by the end of the year, after which Covanta will own 100%.

We currently operate this facility under a service fee arrangement dedicated to Montgomery County and that contract runs through 2014. It's an excellent facility in a great location so we're excited to take over sole ownership and we look forward to continuing to serve this new client.

Turning to our growth pipeline, we have a lot going on in addition to the Veolia transaction. Let me just give you some updates. In Europe we're making good process. Starting construction of the Dublin project is our top priority. And we took a big step closer to that goal a few weeks ago when the Commission for Energy Regulation granted the project authorization to construct.

We are now awaiting the last approval and working with our client on final details regarding some minor changes and project enhancement. I am confident this will be a marquee project for the City of Dublin and for Covanta.

We also received good news in the U.K. where we were selected as the winning bidder for the long-term waste disposal contract for Buckinghamshire County. This is the culmination of a two-year bid process where Covanta was chosen from the original group of 12 companies that expressed interest and seven that submitted proposals. This success is a real credit to the experience and hardworking team we've built in the U.K. and they've only just begun.

We are now working with our Bucks client to finalize the contract with a goal of signing in the spring. This contract would then become effective after we complete a new EFW facility we are pursuing in nearby Bedfordshire Country. So there's still much work to be done. Our goal is to have planning permission for this new facility to support start construction start in 2011. And the Bucks bid is the first of many where we hope to be successful.

We are currently engaged in approximately 10 other bids. Communities will be selecting the winning bids during the next six months to two years and I'm confident we'll win our fair share. In addition, we're making progress with planning permission on two merchant projects Covanta is developing. Without question the U.K. continues to be a very exciting market for us.

In the Americas I'll start with the expansion that we are just now completing in Hillsborough County, Florida. This is a 600-ton-per-day expansion that cost over $100 million and is owned and funded by the client community. We completed the expansion project acceptance test a few weeks ago, and just two days ago we received word from our client that we have satisfied all conditions to declare the new unit in commercial operation.

I'm very pleased with the performance of our team. I'm particularly pleased with the new low-NOx technology we installed. This technology really sets Covanta a part as a leader in the industry and we continue to invest in R&D to drive the industry forward.

We continue to make progress on other expansion opportunities, including the H-Power facility in Hawaii. We're working to support our client community on this publicly owned facility. Construction will start promptly upon receipt of the requisite permits. And like Dublin, we expect this to occur very soon.

We're also making progress on several greenfield project opportunities. One such opportunity is a small publicly owned energy-from-waste facility in the Durham-York area outside of Toronto. Last spring we were selected as a preferred bidder on this project. And we are now working to agree on contract terms with our client, so we can proceed with permitting and other work necessary to support the target construction start in 2011.

In China, we now have two projects under contract and moving forward, Chengdu and Taixing and we're continuing our measured pursuit of long-term growth in this market. I've said many times before these development projects are challenging and time consuming but the effort will be well worth it. During the last couple of years, our team has worked effectively to build a meaningful pipeline of development opportunities.

These efforts have brought Covanta to the cusp of a new era. We see at least a five-year period during which we will have continuous construction activity on the order of $0.5 billion per year. And this investment will typically be levered with project debt enabling us to generate attractive equity returns.

Given the nature of developing complex projects, there will likely be a few delays and setbacks along the way, but I am confident our team will successfully push forward to satisfy our client's needs and create meaningful shareholder value.

Turning to the legislative process in Washington, D.C., we also have some positive developments to discuss. Last quarter I reported on the potential benefits of the Waxman-Markey bill that passed the House in June. Now, the action on energy policy has moved to the Senate. Shortly after the summer recess, Senators Kerry and Boxer reported out of committee a climate bill and it also recognizes the benefit energy-from-waste plays in mitigating global warming.

Furthermore, just two weeks ago the White House issued an executive order titled "Federal Leadership in the Environmental Energy and Economical Performance," which defines energy generated from municipal solid waste as renewable. We think it is quite meaningful that the White House and both houses of Congress have all recently weighed in by defining energy from waste as renewable. But the policy debate is far from over and it is hard to predict when we might see a bill passed into law.

With health care still taking center stage, we don't expect definitive action until next year, although there is some speculation that renewable energy policy may be taken up this year separately from climate change. We'll just have to wait and see how this plays out.

The upcoming Copenhagen summit might shed some light on the U.S. process and we're eager to see what global policies might be established to promote energy from waste. At one of the conferences leading up to the main event in Copenhagen, Covanta will be making a presentation about the climate benefits that could be achieved through the adoption of a comprehensive waste management policy supporting more recycling, more energy from waste and less land filling.

The benefits would be very meaningful, one gigaton of CO2 reduction. That's the equivalent of doubling the fuel economy of the entire fleet of 250 million U.S. cars. We hope policymakers will agree this is low-hanging fruit in the battle against climate change.

On that note, I will turn it over to Mark to discuss the financial results.

Mark Pytosh

I would like to start by discussing the detail of our 2009 third quarter segment results with those of last year's comparable quarter. In the domestic business, total revenue for Q3 declined by $9 million. Revenues from our existing business declined by $32 million and our new businesses contributed $23 million primarily from Veolia, the Philadelphia transfer station, the main biomass plants in Tulsa.

Domestic waste and service revenues declined in Q3 declined by $5 million to a total of $232 million. There are several moving pieces in there many of which relate to contractual transitions. So let me walk you through this in more detail than usual.

The overall $5 million decline comes from netting a $22 million decline in the existing waste and service business against $17 million of new business. The new business is driven by the Veolia contribution of $12 million and the rest relates to the other acquisitions made in the past 12 months.

Of the $22 million decline in waste and service revenue for the existing business approximately $12 million relates to contract transitions, which I will discuss further in a moment. Of the remaining decline the primary driver was the $8 million drop in metals pricing. For metals this is the last quarter of difficult comparisons with 2008 and it appears that pricing is continuing to recover from lows seen earlier this year.

Now let me explain how the contract transitions impacted revenues. When service fee contracts transition into tip fee structures there is a decline in waste and service revenue associated with the repayment of the related project debt. However, this is all set by our receipt of a higher percent of the energy revenues going forward.

The Indianapolis and Kent facilities went through this transition over the past 12 months impacting the comparability of our year-over-year waste and service revenues. Debt service revenue declined by $5 million in the quarter. The other contract related change in the quarter relates to the Detroit facility where we purchased a minority ownership position.

As a result we now pick up our income or loss through the equity income line, not in our operating results, causing reductions in reported revenues and expenses compared to prior quarters. In addition to the debt service revenue reduction in the quarter, the contract transitions resulted in lower waste and service revenue of approximately $7 million.

Domestic electricity and steam revenues were essentially flat but there were a few moving parts. The existing business electricity revenues fell $5 million from 2008. This is a net number driven by a lower electricity pricing production resulting in a combined drop in the existing business of $8 million. This decline was partially offset by $3 million of net revenues resulting from contract transitions at our Indy, Kent, and Detroit facilities.

The $5 million in new business came from the main biomass and Tulsa plants. Domestic plant operating expenses increased by $11 million. In the existing business they actually declined by $9 million. The key drivers were lower unscheduled downtime, reduced hydrocarbon costs, contract transitions at the Detroit facility and lower disposal costs offset by increases from normal cost escalation and additional costs related to the contract transitions in our Indianapolis and Kent facilities.

New business accounted for $20 million of the increase of domestic plant operating expenses due to the addition of the Veolia plant, the Philadelphia transfer station, Tulsa, and wood costs at the main biomass plants. [Wrecks] we recorded in the quarter for the main biomass plant, which we treat as a contract expenses on our income statement, partially reduced the new business expense.

During the quarter the new businesses were a slight contributor to adjusted EBITDA driven by a positive contribution of a few million from the Veolia plant, largely offset by small losses in the main and the Tulsa plants. And to summarize the quarter in the domestic business, the key drivers were the lower metal revenues of $8 million and the lower electricity revenues of $8 million while the rest of the business remained essentially flat.

Now turning to the international business. Total international revenues declined by $22 million due to lower electricity pricing at our two Indian facilities driven by our lower fuel costs, which is a [pasture] of costs in the contract. International plant operating expenses decreased by $23 million primarily due to the lower fuel costs.

And at the consolidated Covanta Holding level, general and administrative expenses for the company increased nearly $6 million to $29 million up from $23 million in 2008, due entirely to the recognition of $6 million of transaction expenses and costs for the acquisition of the Veolia assets. Excluding those costs, G&A would have been flat year-over-year with the increase in the international G&A offset by a reduction in the domestic G&A. Total debt service decreased by $1 million to $26 million in the third quarter of 2009 and was flat excluding the non-cash convertible debt expense.

Lower interest rates on our floating rate deck compared to 2008 and lower principle balances were offset by the inclusion of the convertible note issued in May. Rates remained at low levels during the quarter as compared to 2008 and we continue to borrow at under 2% on our term loan. Reported diluted earnings per share were $0.26 in the third quarter 2009, but excluding the transaction expenses related to the Veolia acquisition diluted earnings per share would have been $0.28 compared to $0.30 in 2008.

The non-cash convertible debt related expense was about $3.5 million or $0.02 per share in the quarter. Depreciation was $48 million in the quarter down from $52 million in the third quarter of 2008 due to certain assets reaching the end of their depreciation cycle.

Our cash taxes net of refunds are expected to be approximately $10 million in 2009. We had unrestricted cash of approximately $373 million at September 30. Total corporate debt, including the convertible debentures, was approximately $1.5 billion. We paid down net debt of $14 million during the quarter, most of which was project debt.

A billion of project debt remained outstanding at the end of the quarter as we recently added more project debt from the Veolia acquisition. Total net debt was $1.9 billion. This amount is net of unrestricted cash and restricted funds set aside explicitly for project debt principle repayment in the amount of $190 million.

In late August we completed the acquisition of six of the seven plants from Veolia and paid $245 million in cash. We're expecting to close the acquisition of the Dade operating contract near the end of the fourth quarter, but still expect to have greater than $250 million in cash on the balance sheet after the purchase. With an undrawn $300 million revolver we will have ample liquidity to fund our investment in Dublin and the other growth initiatives in the near-term.

Now turning to operating cash flow where we had continued strong performance. Total adjusted EBITDA declined $15 million from the third quarter of 2008 for the reasons that we've noted before. Cash flow from operating activities before acquisition costs for the third quarter was $111 million up from $109 million in 2008.

During the third quarter, we had less outflow in the operating restricted funds and received an $11 million tax refund, which resulted in greater cash generation in the quarter. The company's investments of cash in the third quarter were $251 million, which included maintenance capital of $9 million, the net $234 million we paid for the Veolia plant in August and approximately $8 million of other investments described in Exhibit 4 of the press release.

Our maintenance CapEx spending for the year is still expected to be approximately $60 million not withstanding the addition of the Veolia facilities. As Tony noted earlier, our 2009 guidance remains unchanged. We now expect to be close to the midpoint of our guidance on all three metrics.

Our core business has been performing well despite the headwinds and we will generate significantly free cash flow in 2009. We're staying focused on growing the business and continue to look for new opportunities created by the difficult conditions.

With that we look forward to answering your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Paul Clegg - Jefferies.

Paul Clegg - Jefferies & Company

Just wanted to understand the impact of the Veolia acquisition on your full-year guidance versus what you talked about last time. You were talking about the lower end of the range last time and now you're talking about the midpoint. How much does Veolia figure into that?

Mark Pytosh

Just to give you some perspective, the initial six plants are about 2/3 of the EBITDA of the total and we're going to have them for 1.5 quarters.

Paul Clegg - Jefferies & Company

So if we look at what you said before, previously you talked about adding about $60 million in 2010 EBITDA. Can you sort of extrapolate that backwards then?

Mark Pytosh

Yes.

Paul Clegg - Jefferies & Company

Okay, so it should be around a similar amount? Actually on the same topic of the $60 million in 2010 EBITDA it seems like you closed the acquisition somewhat earlier than what you originally expected. Do you see the potential to benefit from kind of additional synergy in 2010 given that you have several months of 2009 to start that integration process?

Tony Orlando

That potential is there. This is Tony, and certainly I think importantly now that we've had the opportunity for the last six weeks or so to be operating these facilities, we're really quite pleased with the people. And as I mentioned, we've already integrated the regions so that the teams are working well together. We've gotten a great head start, I think, on the synergy.

So of course we're going to work hard to create as many efficiencies as we can out of that transaction, and also by doing things like the item that I mentioned where we acquired the 40% share of the facility in Montgomery County, Pennsylvania. So we're certainly glad to get it done early. We're getting a good jump on it and we're going to do everything we can to maximize the value, both for our shareholders and for the client communities.

Paul Clegg - Jefferies & Company

Just to make sure I understood the answer to the first part of my question. If we sort of take the 1.5 quarters of $60 million that would be the contribution to overall EBITDA, so when we look at you kind of talking moving from the low end of EBITDA guidance to the midpoint, it sounds like most of that really is coming from Veolia.

Tony Orlando

Well, we're not going to have the 60. What I said was we bought 2/3 of the EBITDA because we don't own the Dade contract, so it's only 2/3 $40 million.

Paul Clegg - Jefferies & Company

You talked last quarter about boiler availability and I think you had reached sort of 90.9% almost 91% in the first half. Any update on that and the boiler availability in the third quarter? How has that program been tracking to improve availability?

Mark Pytosh

We continue to have real good progress there. We actually finished this quarter at 91.4% so we're up about 0.5% from the end of the second quarter. Having said that, that's fairly typical because we don't do as much maintenance activity during the third quarter.

Our unscheduled maintenance continues to track actually very closely to the benefit that we saw last quarter, so we're real happy with that. We did have a little bit more scheduled maintenance activity in the third quarter this year than we had in the third quarter last year, so that did tend to kind of mask a little bit of the unscheduled savings.

But overall we're really pleased with that program. I think our team is doing a great job operating the facilities and we're running at 91.5% is a tremendous feat. So we're going to continue to strive to maintain that and find ways to enhance reliability.

Operator

Your next question comes from JinMing Liu - Ardour Capital.

JinMing Liu – Ardour Capital Investments

A question related to the Veolia facilities. What is the current condition of those facilities? My question there is whether we should expect higher downtime and maintenance costs for the fourth quarter and the first quarter 2010?

Tony Orlando

Our balance at the facilities are in good working order. We do think that bringing to bear – one of the things that Covanta has that is really fairly unique. Being as big as we are in this industry, we have a lot of expertise in all kinds of different maintenance fields. Everything from specializing how to maintain refuse cranes to maintenance of boilers.

So we do think that over the course of time we're going to drive the availability of those facilities up a little bit, but we're talking about 1% or 2% kind of thing. I mean they were run consistent with industry standards and we're look to just raise the game a little bit.

JinMing Liu – Ardour Capital Investments

Talking about being big, currently Covanta operates more than I think close to half of the total numbers of waste disposal facilities in the country, whether that poses some challenges for you to acquire additional facilities down the road.

Tony Orlando

The marketplace in the U.S. in terms of the number of Energy-from-waste facilities, there are roughly 89 facilities around the country, a total of just about 30 million tons of capacity. After we complete the Veolia transaction we'll be at about 20 million tons of capacity. So that's a pretty big portion of the Energy-from-waste industry.

However, of course, that's a very small portion of the overall waste disposal industry because this country still relies predominantly on landfills. So from a waste disposal perspective, which is really where the market lies from a market participant perspective, we're still a relatively small percent somewhere in the, I don't know, 5% to 10% range.

JinMing Liu – Ardour Capital Investments

My last question is really to your fixed price energy agreement. So you made some adjustment there. Can you disclose to us a marriage what would be the price for your fixed price contracts for next year?

Tony Orlando

Next year, and we've talked about this previously, in 2009 rough numbers we're about $80 per megawatt contracted. Next year we're going to be about $70 per megawatt contracted. And the decline in that contracted power sales is really primarily related to the two contracts I mentioned, Hempstead and Union.

So we're going to be about $70 contracted next year. And as we look at the market, next year we see a slight uptick based on the forward curves from where we are this year. Again as I mentioned earlier, our market based pricing this year we expect to finish around $45 per megawatt hour.

Operator

Your next question comes from [Tom Noack].

[Tom Noack]

Could you just give us an update on sort of what you're seeing from municipalities in terms of their health and also have you received any requests for contract renegotiations or seen any material weakness there. You talked about Harrisburg last time so maybe an update on that and anything else, any other new developments on that part.

Tony Orlando

I think clearly the economy is presenting challenges for everybody and local municipalities are no exception. Having said that, all of our municipal clients, including Harrisburg, are current right now. I think the benefit that we have is both the combination of the long-term relationship that we have with our client communities, as well as the fact that we're providing essential services.

What we've seen clearly is some challenges that the municipalities have. We're going to work with them to do what we can to help them just as we always do in our long-term relationships. But it just hasn't been an issue yet and we really don't expect it to be.

The one big challenge I think that's kind of been in the news a lot lately is Harrisburg. As I did mention, they are current with all of their payables to us at this point. But they are facing some terribly serious challenges there and we're going to keep a close eye on that and do what we can to both service our client and to protect our interest.

[Tom Noack]

Any material requests for contract renegotiations?

Tony Orlando

No, not really. I think we had not seen that at all.

[Tom Noack]

Just on sort of a big picture topic, you talked about the environmental benefit of Energy-from-waste and specifically on the benefit of greenhouse gas emissions, I'm wondering if you could maybe provide some numbers around that appreciating that if you just take a landfill that's emitting methane, methane is 20 times more potent then carbon dioxide as a greenhouse gas.

But presumably by combusting the same waste you're generating on a volume base is far more carbon dioxide than if you just let it set there. So can you kind of help us out on kind of a lifecycle basis versus burning versus not burning. What the actual true greenhouse gas emissions were?

Tony Orlando

Sure, the lifecycle basis, and this is using an EPA model not our model, and plugging in the average U.S. electricity production, so it's a combination of natural gas and coal, and plugging in the average gas recovery rates at landfills, you get a one ton of CO2 equivalent reduction for every one ton of waste that we process, and that's on a lifecycle basis.

And its primarily you're getting three benefits. You're getting the offset of fossil fuel. You're getting the methane benefit at the landfill. And also because we're recycling metal, it's a pretty significant amount actually. We're recycling 400,000 tons of metal per year which they need to mind that virgin metal and so that also contributes to the lifecycle benefit.

Operator

Your next question comes from [Hamzah Mazari].

[Hamzah Mazari]

If you could just talk about valuations of assets in your pipeline right now, how competitive is bidding, what the multiples look like, as well as you spoke of spending $500 million levered with project that on a consistent basis. We know this business is lumpy but how should think about the ramp up of your acquisition pipeline? Looking forward a couple of years is there one year where we going to get all these projects online and we'll see a big bump up to your bottom line. How should we think about that?

Mark Pytosh

First of all, just to talk about the pipeline, we continue to be actively looking for opportunities both here in the states as well as Europe and China and valuations have been a lot better in the last few months as evidenced by Veolia.

And I don't think there's been any significant change in valuation, although with the financing markets getting better by the week, obviously, that will probably start to raise the level of competition for assets looking out into 2010. But we're still very active and we're looking for businesses that fit well in to our core.

On the project pipeline, Tony talked about roughly $500 million a year. It will be a little lumpier than that. It would be nice to be able to predict it with certainty, but on a $500 million capital investment the parent company would be investing around $150 million in equity and the rest would generally be project debt.

And what's going to happen is that there's going to be a lot of construction activity for the next two to three years and then we will enjoy the benefit of the cash flow really starting in 2012 or 13. You'll start to see a significant, just from the development pipeline, a ramp up in the contribution from all this construction activity.

So we'll be investing starting shortly. We actually invested a little bit in Dublin this quarter and that'll be a big investment in 2010, and as Tony talked about some of those other projects 2010 and beyond we'll be investing a significant amount in the core business.

[Hamzah Mazari]

Just one last question, what's your internalization rate right now? We know you bought a couple of transfer stations, what's your target there and on your waste volumes how much of that is contracted out right now?

Tony Orlando

This is Tony. We've got about 1 million tons of capacity now at our transfer stations, actually slightly over 1 million tons of capacity in our transfer stations. And virtually all of that waste is delivered to our facilities, very high percentages, probably over 90%. So we have about 85% of our waste is under contract.

If you recall earlier in the year I talked about 80% to 85%, because of the Veolia acquisition we've actually increased the waste that we have under contract because they're fully contracted up at those facilities. So we're now about 85% contracted so we've got about 2.5 to 3 million tons of waste that's kind of on the market out of almost 20 million tons that we handle, and then of that 2.5 tons we've got 1 million of it covered at the transfer stations.

Operator

Your next question comes from Dan Mannes - Avondale.

Dan Mannes – Avondale Partners

I am going to belabor a point that I think gets asked every quarter and I guess I'm a little confused. It seems like the way you're talking about the power position for 2010 has evolved a little bit. The 25 million to 30 million headwind is one, obviously, you guys have talked about for a while, but previously when you talked about it my understanding is that primarily related to just the step-down of primarily the Hempstead contracts and now you're sort of saying that's your entire power position.

And I guess I could use some clarification there because I would have assumed the piece of your power position that's already open, the 1.5 million megawatt hours that you're earning 45 on this year, should get a potentially material uptick going into next given the contango in the forward curve. So could you maybe take a step back and walk us through I guess the power open position for next year and what that 25 million to 30 million of headwind actually applies to?

Tony Orlando

Yes, again, as we've said we're talking about the entire portfolio. Maybe just to kind of recap some of these discussions we've had previously, we've talked about 25 million related to the Hempstead and Union contracts rolling off. We've talked midpoint through the year, I think it was the last quarter, that that's probably closer to 30. So we've kind of just said let's try not to confuse the issue by focusing on one contract let's just look at the entire portfolio and what's the year-over-year change?

So we put a little range on it, 25 to 30. We will get a little bit of a benefit based on the forward curve as you described the contango and for those who are not familiar with that term it basically means the forward prices are higher than the current prices, and they're higher by maybe 10%.

I mean we're looking at market prices next year that are right about $50 per megawatt hour on a full-year basis versus the rate this year that's at 45. So you're talking maybe a 10% uptick on those contracts where we do have an open position next year. When you roll it all together so that might be another $5 million uptick so that kind of gives us a range 25 to 30.

Dan Mannes – Avondale Partners

Okay. So this has been an evolution that 25 or 30 does refer to your entire power position not just Hempstead and Union, just to clarify again so I'm 100% clear here. And to the extent the forward curve continues to firm, that should eat into that to some degree?

Tony Orlando

Yes, that's the entire portfolio and, like I say, as we look at the forward curve we're seeing about a $50 average market price next year.

Mark Pytosh

And then the metric that Tony used, Dan, just to be clear is we will get on the million of market energy megawatts, we will get 1.5 times the benefit. So if we went up $10 a megawatt that would be $18 million.

Dan Mannes – Avondale Partners

So when you talk about a $50 power curve for next year, are you referring specifically to [PGM] because I'm looking at, I guess the power curves I'm looking at the 2010 contango is a lot steeper than that. Are you talking about a curve from today or from a couple of weeks ago?

Mark Pytosh

It's a pretty current curve. We try not to update it everyday but what we're looking at is where we specifically have our fully exposed power. Some of that is PJM, some of that's in New York ISO some of that's in California, some of that's New England ISO.

So we're looking at kind of our blended rate across the entire portfolio and that's what we're seeing right around $50. And I've seen some people quoting numbers in some reports of 70 or 80. Those are looking at peak prices during the summer months. We're looking at full year average prices around the clock 24 hours a day because that's how we produce.

Dan Mannes – Avondale Partners

Lastly just touching on the development and following up on a prior question. You guys probably have what's called three in the U.K. one in Ireland one in the U.S. and one in Canada that seem – these are merchants plants that are fairly far developed. I mean assuming a reasonable hit rate, are we looking at a scenario where we could have ground breaking on one or two of these a year for a couple of years?

And just talking about sort of the phase in, I mean there's a potentially you could have let's call it one to two of these coming on a year for let's call it a 2012 to 2015 or for a two to three year stretch. I mean these are going to be some pretty big construction projects but also some pretty material benefits to your bottom line.

Tony Orlando

Absolutely, and that's really what we're looking at is one to two a year and the key, getting Dublin started this year, we've got as you mentioned some projects here in the U.S., we've got Canada, we've got the projects in the UK, 2010 one maybe two and then 2011 maybe two, maybe 2012 it might be a couple of projects.

And so what you'll see is roughly 30 to 36 months after the start of construction, call it three years to make it simpler, you'll start to see the economic benefit of each one of those and each one of those projects is meaningful.

Operator

Your next question comes from Michael Hoffman - Wunderlich Securities

Michael Hoffman - Wunderlich Securities

Very quickly just on the recycled metals, were volumes a little bit better in the third quarter than you might have thought, the change year-over-year in the pricing was still pretty steep, so.

Mark Pytosh

The volumes were up a little bit but that's not the driver. One of the things to keep in mind or to bear in mind with respect to our recycled metal, it does tend to be kind of a lower quality metal than your traditional scrap metal that maybe is recycled from auto yards or whatnot.

And therefore we get a little more volatility in our price both when it's moving up and when it's moving down then maybe the indices would indicate. So our volatility tends to be a little greater and when the market starts picking up we get that benefit quicker and when it goes down we feel the pain quicker.

Michael Hoffman - Wunderlich Securities

And then overseas electricity tends to have this peak in the third quarter, should we look at the fourth quarter sort of relevant change kind of holding together? Are there any things that we ought to be thinking about relative to the overseas electricity revenues?

Mark Pytosh

Well, the biggest driver to the Indian plants is the price of oil. It's been a little firmer here recently, so there may very well be a little bit of an uptick in revenue and expense in the fourth quarter. That's the biggest driver. We've been on a dispatch base as been running at a higher level consistently for the last two years, and that doesn't look like that's going to change.

So really the one variable that we'll move around quarter-to-quarter will be the price of oil, which is our feedstock. So it feels like it's going to be a little stronger in the fourth, but it's not a meaningful change like we saw last year's third to fourth. You can't use that as a pattern because oil dropped significantly from three to four.

Tony Orlando

And I would also just point out that as that revenue moves up and down our cost moves up down, so it's really not an economic driver one way or the other. I mean it could be some timing. We saw some timing issues last year in the fourth quarter, but there's really not a big economic driver as that international revenue moves up and down.

Michael Hoffman - Wunderlich Securities

Fair enough, but you did have a material improvement in profitability year-over-year in the business, too. So we should hold onto that margin going into the fourth even if you get sort of one-for-one step-up?

Mark Pytosh

The fourth and international, as we said last quarter, will be significantly better than last year's fourth quarter.

Michael Hoffman - Wunderlich Securities

Okay, and the I hate belabor this electricity thing, but obviously everybody is trying to figure out how to get their hands around it. If you look at third quarter where the numbers are in revenues, they're in all likelihood all things being equal, there'd be a slight dip in the fourth quarter, slight dip in the first, and then it probably gets pretty flat sequentially on same store comparison?

Tony Orlando

The question was, what can we expect for energy prices going forward?

Mark Pytosh

He was talking about our revenues.

Tony Orlando

Yes, our revenue. I think the fourth quarter is likely to see a little bit of a decline and I think that's really primarily related to the Hempstead contract that rolls off, as we said the contract ends today coincidentally, so we're going to see a dip from that and that's going to be the biggest impact in the fourth quarter.

Typically, we do get a little seasonal uptick in the summer because prices are generally higher in the summer and we get a little higher capacity payment. So seasonally, we're normally going to see a little higher energy revenue in the summer, a little lower in the winter, kind of the shoulder months, the fall and the spring. But the big driver on that revenue, really, is going to be what happens to market prices.

Michael Hoffman - Wunderlich Securities

Right, I get that. But all things being equal, the way to think about the model is you get a dip in 4Q, little dip in first Q, and then a little seasonal lift. But the worst of that dip actually happens pretty soon and then it's just a rollover effect, all things being equal.

Mark Pytosh

Yes, I think I understand your question now. When you get to the second quarter next year, it's really quarter-to-quarter going to be moving based on what the market price is.

Michael Hoffman - Wunderlich Securities

That's what I was trying – you said that better than I asked it.

Tony Orlando

Let me just go through this one more time. You get the Hempstead contract today, so you're going to get a dip in the fourth quarter for the Hempstead contract. The Union contract rolls on December 31 so you'll see a dip to that. And then that's kind of the number that we're talking about that $25 million to $30 million will get spread out through the course of the year.

Michael Hoffman - Wunderlich Securities

Then offsetting that you did acquire some electricity, so that $30 million netting that in there or then I have to add back what you acquired?

Mark Pytosh

Yes, you're going to end up with probably at the end of the day close to a wash from the downtick in the existing portfolio and the addition of the new. The good thing is, at least for the few quarters next year you'll be able to see what's coming from the new and where the existing is declining. So you'll know kind of what the two numbers are isolated from one another.

Michael Hoffman - Wunderlich Securities

So all things being equal, current prices stay where they are and the portfolio as it is, total revenues in '09 electricity compared to 2010 are down a little bit, not as much as the $25 million or $30 million because of the offset of the acquisition.

Mark Pytosh

Yes. It will be roughly flat.

Michael Hoffman - Wunderlich Securities

Okay, that's what I thought. The Dublin, you said you spent a little money in this quarter. When you said this quarter, did you mean the third quarter or actually the fourth quarter because that's where we are?

Mark Pytosh

Well the third quarter, if you look in the exhibit in press release for CapEx we've spent about $6 million because we're doing a bunch of work to get started there, so we $6 million in the quarter.

Michael Hoffman - Wunderlich Securities

I mean, originally there was big thought that you were going to spend a lot of money this year and obviously the permitting delays, what should we model for cash flow for Dublin in the fourth quarter?

Mark Pytosh

I don't think it's going to be a big number for the fourth. It'll be several million, but it won't be a big number. In the first quarter is when the number is going to start to grow substantially.

Michael Hoffman - Wunderlich Securities

Okay, so the next part of that, the $500 million we really should think about as 2010, not anything really happening at the tail of this year. Then Veolia, can you help us a little? If I heard right, $12 million in revenues $2 million in EBITDA was the contribution as it was closed. What would it have been if it was pro forma for the whole quarter?

Mark Pytosh

First of all, I don't really know because we only had it had ourselves for half, but the numbers that – I can't remember who asked the question, but we said that the first six are about 2/3 of the EBITDA, so $40 million.

Michael Hoffman - Wunderlich Securities

Is it 2/3 of the revenues too, so it's at 30% margins?

Mark Pytosh

Well, we didn't give the revenue numbers for that, but it's probably accurate, in that zip code.

Michael Hoffman - Wunderlich Securities

Then what's the impact of getting 100% of Montgomery on the other third? I mean that other $20 million, basically, is Montgomery County, right?

Mark Pytosh

Well the only thing that will affect us we won't have any minority interest going out below the operating income number.

Tony Orlando

The other third is the Dade operating contract that we haven't yet closed. So when we talk about $50 million for the Veolia deal that did not include the pickup of purchasing the 40% minority stake at the Montgomery facility. That's a new transaction with a different party, and that transaction does not have a big EBITDA impact. We're happy to own 100% and it's a good cash-driven deal. It just shows up as an equity pickup because we already had majority control of that facility.

Michael Hoffman - Wunderlich Securities

Okay, so the offset is a minority interest.

Tony Orlando

Yes.

Operator

Your next question comes from Michael Horowitz – Robert W. Baird

Michael Horowitz - Robert W. Baird

I'm going to look at this a different way. We've talked enough about the downside. I want to understand. You've mentioned a few of your facilities that are operating in dispatch mode, and clearly you have a few facilities that aren't contributing to EBITDA given the environment. If I look at trying to normalize the performance of your portfolio, let's say when you are able to have all of your assets contributing. How should I look at that ex-Veolia?

Tony Orlando

We're trying to kind of give some general rules because each one of the facilities, obviously, will respond a little bit different to economic conditions and it's just not possible to get that precise. So what we try to do is provide some general rule. We said, look, if we have on the downside it's roughly 1.2 million megawatt hours for every dollar the price drops. It's $1.2 million.

On the upside, it's going to be roughly 50% greater than that because the ability to kind of opt back in the market to increase output at the biomass facilities and other operational things that we can deploy. So the upside, if the market moves, is going be substantially higher. So if you have a $10 to $15 movement in the power prices, we'll get that full $30 million back.

Michael Horowitz - Robert W. Baird

Then something else that was in the news recently since we've already asked every other question on this call. Some news around the Union facility and around the community there looking to sell it, if I recall that facility also has a [Martin Boiler] operating at it, which gives you some advantages there. Can you comment on any of the things we read in the local papers there?

Tony Orlando

Let me kind of just set the stage there a little bit. We currently have a long-term lease at that facility that runs through 2023 and Covanta also has at its option to extend that lease five years to 2028. So today we own the economic benefit through 2028. The community is considering might they be able to monetize the value after 2028 in some way shape or form by selling the value after 2028 and, of course, we'll consider buying that value but that's an awful long time from now 2028.

So I think this is probably to some extent one of the more creative thoughts that one of the communities have to try to deal with some of the pressures that they're under with respect to the current economy. But, again, we already own the facility's economic value for nearly two decades and we'll work with the community to see if we can create some additional value that we'd both be happy with.

Operator

Your next question comes from [Greg Oril] - Barclays Capital.

[Greg Oril] - Barclays Capital

The $45 a megawatt hour that you quoted for this year's pricing, that includes the benefit of the avoided cost usage for Hempstead or that's Hempstead rated market?

Tony Orlando

That includes our current using the avoided cost rated Hempstead for these last couple of months.

[Greg Oril] - Barclays Capital

How long are you locked into that? How does that work in terms of opting in and out?

Tony Orlando

We have the ability to opt in or out with a reasonable degree of frequency and I think we're going to try to maintain some stead predictability both for ourselves and for the utility there, but we do have the ability to opt in and out there. And then it really comes down to what the community, not the community but the utility the Long Island Power Authority. They are the ones that set that avoided cost rate and they can do that periodically.

[Greg Oril] - Barclays Capital

Does it make sense now to kind of use 9 million as a decent quarterly run rate on the scrap metal or do you see additional improvements there?

Tony Orlando,

Again, I think that one's going to be purely based on what happens with the scrap metal market. I would tell you, though, that at the 9 million number that's very close to the 10-hyear historic average for metal prices. So assuming the next 10 years is consistent with the last, I guess that's probably a pretty good average run rate.

But we also know we'll see a lot of volatility in that pricing and, again, particularly for us we're going to see more volatility than you see in the scrap market indices just because of the nature of the material that we're selling.

Operator

Your next question comes from Patrick McGlinchey – Sidoti & Company

Patrick McGlinchey – Sidoti & Company

Just a follow-up on the recovered metals, can you just give a breakdown of revenue domestic versus international in the quarter and what pricing looks like in your major markets there?

Mark Pytosh

On the metal side, virtually I think all of the metal comes domestically so there's no international component there and the market has been steady. It rose during the third quarter from the July 1 to September 30 and I think the outlook for the fourth quarter what we've seen so far looks like a pretty steady kind of performance in the fourth versus the third. I have a hard time looking beyond the next couple of months in that market given how volatile it's been, but the fourth quarter looks like it's going to be pretty comparable to the third.

Tony Orlando

So far in October we're running pretty close to where we were on average for the third quarter.

Patrick McGlinchey – Sidoti & Company

Have you in the past sold some scrap metal internationally?

Mark Pytosh

Well, we sell virtually all of our scrap internationally to either Turkey or China. So virtually all our scrap goes offshore, which has generally been a better market than the U.S.

Tony Orlando

But it's all domestic revenue because it's all scrap metal that comes out of the domestic plants it's just that it's getting sold – we'll sell it to kind of the highest bidder but of late really for the last several years, as Mark said, it's mostly going to China and Eastern Europe.

Operator

There are no more questions.

Tony Orlando

Well, thanks everybody. Again, I think we had a good solid quarter, we're pleased. We still have a lot more work to do. We're focused on finishing the year strong here and getting some of the deals in our pipeline across the finish line and look forward to talking to you at the year end.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a great day.

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Source: Covanta Holding Corp. Q3 2009 Earnings Call Transcript
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