Covanta: An Overlooked ESG Play

Summary

• Covanta is the world's largest waste-to-energy company.
• Compared to dumping in a landfill, the waste-to-energy process removes approximately 1 ton of CO2-equivalent from the atmosphere for each ton of waste processed.
• Currently, 50% of waste in the U.S. ends up in a landfill.
• CVA's discounted cash flow valuation shows a fair value of $31.52/share at an 8.6% free cash flow growth rate over 15 years.

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To achieve the broadly held goal of getting to net zero carbon emissions by 2050, we need to evaluate every greenhouse gas-emitting industry for ways in which to reduce its environmental footprint. One such industry that hasn't garnered a lot of attention is waste management. Landfills, which are the destination of 50% of municipal waste in the US, are estimated by the EPA to contribute 15% of the methane emitted in the US each year, a CO2-equivalent to the emissions from 21M passenger cars. A superior and already scalable alternative to landfills are waste-to-energy (WtE) plants, which are estimated to reduce greenhouse gas emissions by 1 ton of CO2-equivalent for each ton of waste processed at the facilities. As the world leader in the WtE industry, I believe Covanta (NYSE:CVA) deserves a place in your portfolio.

Business Overview

So how do Covanta WtE facilities work? Instead of waste being piled into landfills, it's brought to Covanta plants where it's combusted and the resulting hot steam is converted into energy to be fed into the electric grid. Furthermore, heavy metals left over in the resulting ash are recycled and sold back into the market. The gases resulting from the waste combustion are collected, cleaned, and filtered until 99.9% of what comes out of the stack is comprised of normal components of air, including water vapor, nitrogen, oxygen and carbon dioxide.

Covanta plant in Palm Beach, Florida; source.

While the facilities do still emit greenhouse gas in the form of carbon dioxide, as mentioned above, overall greenhouse gases are reduced by up to 1 ton for each ton of waste processed at their facilities compared to landfills. This is due to a combination of preventing the methane emitted from landfills (a much more potent greenhouse gas than CO2), decreasing the amount of fossil fuels needing to be burned to power the grid, and recycling metals that otherwise would have ended up in a landfill. Covanta WtE plants are less impactful than landfills on surrounding environments, meaning they can be stationed closer to population centers. This reduces the emissions generated from long transport of waste to landfills located far from where the waste originated. Each Covanta facility falls well below local environmental regulations for air pollution, and Covanta has been consistently reducing the concentration of each pollutant emitted in their plants over time.

Beyond greenhouse gases, concern over environmental contamination from landfills is growing. Toxic chemicals and microplastics leaking from the landfills can contaminate water supplies and disrupt nearby ecosystems. In addition, waste in landfills takes a very long time to decompose, meaning we need to constantly find new land in which to make them. As we generate more and more waste every year, compounded with waste accumulation over time, it's clear we need better solutions.

One additional benefit of WtE plants is they're able to produce electricity at any time of day, as opposed to wind and solar, which can only produce power intermittently. As more EVs come onto the road and more wind and solar plants are commissioned, the strain on our battery supply increases, limiting the ability of wind and solar to meet our energy demands. Sourcing a higher percentage of energy from WtE plants can help make the grid both more renewable and more resilient, while decreasing our reliance on batteries.

WtE is an already well-established technology that's widely recognized across countries and states as superior to landfills for the environment, so I expect governments to begin pushing for more of these plants. With Covanta being the leader in this space, opportunities could abound.

Industry Outlook

The waste management industry overall was $2.1 trillion in 2019 and growing every year, so Covanta only needs to gain a small fraction of market share to grow well past their current ~$1.9B revenue run rate. Covanta operates primarily in the US, Canada, and Europe, with Europe showing the most interest in expanding WtE capacity to date.

Covanta already has a portfolio of 4 projects in the UK that are scheduled to begin operation over the next 4 years that are expected to generate $50-60M in free cash flow per year. Management also expressed optimism during the Q4 '20 earnings call that the favorable regulatory climate will pave the way for more deals in the UK and Ireland in the future. The EU has a binding target of <10% of their waste being sent to landfills by 2035

With the Biden administration's priority of investing in renewable energy infrastructure, it's reasonable to assume a renewed focus on diverting waste away from landfills in the US will be part of that agenda. Because of the clear environmental advantages outlined above for WtE plants over landfills, I think there is a good chance expanding our WtE capacity will be an area of focus. There are currently 75 WtE plants operating in the US compared to 552 in Europe, so clearly there is a lot of room for growth if it becomes part of our environmental agenda.

China is also projected to greatly increase their WtE capacity over the coming years. Covanta does have one plant they began construction in 2020, so they may be able to gain a foothold in the Chinese market as well. To be conservative, I'm assuming no further growth in China, but the optionality of expanding in China or other markets provides a nice margin of safety to growth assumptions in the US and Europe.

The biggest risk to the WtE industry's growth, and consequently Covanta, is a lack of regulatory support, without which new facilities won't be build. While WtE's superiority over landfills is apparent, the ideal solution to our waste problem is to produce less in the first place. As a result, investments may instead be directed at increasing our recycling capabilities, composting, and shifting toward reusable materials. We'll likely never reach a point where we recycle 100% of what consume, however, and whatever residual waste is unable to be recycled should be processed in WtE facilities rather than dumped in a landfill.

Financials/Valuation

Given that they serve a public utility, Covanta's operations are highly resilient. This resiliency was demonstrated by them reporting 2020 EBITDA within their pre-pandemic guidance range despite decreased waste supply from their typical customer base. There tends to be some top line fluctuation due to their exposure to both energy prices and commodity prices for heavy metals, but this is short term noise that doesn't have any impact on their prospects for growth and long-term outlook.

In my valuation model, I start with projecting the waste-to-energy processing capacity through 2035 in the US and EU, Covanta's chief target markets. Given the superiority of waste-to-energy over landfills outlined above, I'm assuming the US follows a similar trend to the EU in decreasing the share of waste we send to landfills. While the EU is mandating <10% of waste ending up in landfills by 2035, I'm assuming a less aggressive target of 20% for the US over the same time frame. This is still a fairly dramatic 30% decrease from the current 50% of our waste going to landfills. I assume half the share diverted from landfills will go to recycling and composting, while the other half will go to WtE plants. Of this half going to WtE, I assume 33% will go to Covanta, a conservative take rate given their current 75% market share in the US. Under these assumptions, I project Covanta's annual free cash flow (FCF) generation in the US will increase by ~$130M by 2035.

Clearer projections are available for the EU. A peer-reviewed calculation estimates there will be 141M metric tons of residual waste after amounts recycled and sent to landfills in 2035. The EU currently has capacity for 91M metric tons in WtE plants and 10M metric tons in other incinerators. Given this data, I assumed WtE capacity in 2035 will have increased by 40M metric tons (141 - 91 - 10). Overall, assuming a 20% take rate on new deals in the EU, this yields $50M FCF contribution from their existing pipeline and $48M of incremental FCF from increased capacity through 2025.

The additional FCF contributions of $98M in Europe, $130M in the US, and $7M from their Zhao project currently under construction in China yields a projected FCF CAGR of ~8.6% through 2035 in my base case. Discounting these cash flows back to present value gets us to a base case fair value per share of $31.52 today, an ~120% premium over the price at this writing of $14.05. As an added bonus, we get to enjoy a nice 2.25% dividend yield while we wait for growth to kick in. A summary of the key assumptions and present values for base, bear, and bull cases can be seen below. Assumption cells are highlighted blue in the model for anyone looking to play around with the numbers themselves.

Source: Author's Valuation model.

Conclusion

Covanta is the world leader in constructing and operating waste-to-energy facilities, an industry which could experience secular growth as countries around the world search for more sustainable alternatives to sending waste into landfills. At an implied free cash flow growth rate of 8.6%, Covanta's intrinsic value implies a return in excess of 100% from current levels. Little to no growth is baked into the current stock price, so any momentum gained in the waste-to-energy industry over the coming years should accrue to Covanta shareholders.

Analyst’s Disclosure: I am/we are long CVA. 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.