TMCnet News
COVANTA HOLDING CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The terms "we," "our," "ours," "us," "Covanta" and "Company" refer to Covanta Holding Corporation and its subsidiaries; the term "Covanta Energy" refers to our subsidiary Covanta Energy Corporation and its subsidiaries. The following discussion addresses our financial condition as of September 30, 2014 and our results of operations for the three and nine months ended September 30, 2014, compared with the same periods last year. It should be read in conjunction with our Audited Consolidated Financial Statements and Notes thereto for the year ended December 31, 2013 and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Form 10-K for the year ended December 31, 2013 ("Form 10-K"), to which the reader is directed for additional information. The preparation of interim financial statements necessarily relies heavily on estimates. Due to the use of estimates and certain other factors, such as the seasonal nature of our waste and energy services business, as well as competitive and other market conditions, we do not believe that interim results of operations are indicative of full year results of operations. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts and classification of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. OVERVIEW Covanta is one of the world's largest owners and operators of infrastructure for the conversion of waste to energy (known as "energy-from-waste" or "EfW"), and also owns and operates related waste transport and disposal and other renewable energy production businesses. Energy-from-waste serves two key markets as both a sustainable waste management solution that is environmentally superior to landfilling and as a source of clean energy that reduces overall greenhouse gas emissions. Energy-from-waste is also considered renewable under the laws of many states and under federal law. Our facilities are critical infrastructure assets that allow our customers, which are principally municipal entities, to provide an essential public service. In addition to our core EfW business, we offer a variety of sustainable service offerings in response to customer demand, which are sometimes offered through joint ventures or with third parties. We can help clients adopt a holistic "Reduce, Reuse, Recycle, Recover" waste management strategy from end to end. We offer tailored recycling and recovery solutions, providing alternatives to landfills to enhance our customers' reputation and reduce their risk. For a discussion of our facilities, the energy-from-waste process and the environmental benefits of energy-from-waste, see Item. 1. Business in our Form 10-K. Our EfW facilities earn revenue from both the disposal of waste and the generation of electricity and/or steam, generally under contracts, as well as from the sale of metal recovered during the EfW process. We process approximately 20 million tons of solid waste annually, representing approximately 5% of the solid waste generation in the United States. We operate and/or have ownership positions in 45 EfW facilities which are primarily located in North America, and 11 additional energy generation facilities, including other renewable energy production facilities in North America (wood biomass and hydroelectric) and 18 transfer stations. In total, these assets produce approximately 10 million megawatt hours ("MWh") of baseload electricity annually. We also operate a waste management infrastructure that is complementary to our core EfW business. We own or hold equity interests in energy-from-waste facilities in China and Italy. We also have investments in subsidiaries engaged in insurance operations in California, primarily in property and casualty insurance, whose remaining business was transitioned into run-off in 2012, and collectively account for less than 1% of our consolidated revenue. During the third quarter of 2014, we entered into an agreement to sell our insurance business, subject to regulatory approval. Strategy Our mission is to provide sustainable waste and energy solutions, which we intend to pursue through the following key strategies: • Preserve and grow the value of our existing portfolio. We intend to maximize the long-term value of our existing portfolio of facilities by continuously improving safety, health and environmental performance, working to provide superior customer service, continuing to operate at our historic production levels, maintaining our facilities in optimal condition, extending waste and service contracts and conducting our business more efficiently. We intend to achieve organic growth through expanding our customer base and service offerings, adding waste, service or energy contracts, seeking incremental revenue opportunities by investing in and enhancing the capabilities of our existing assets, and deploying new or improved technologies, systems, processes and controls targeted at increasing revenue or reducing costs. • Expand through acquisitions and/or development in selected attractive markets. We seek to grow our portfolio primarily through acquisitions and the development of new facilities or businesses where we believe that market and regulatory conditions will enable us to utilize our skills and invest our capital at attractive risk-adjusted rates of return. We are currently focusing on opportunities in the United States, Canada, Ireland, and China. We believe that our approach to these opportunities is highly-disciplined, both with regard to our required rates of return and the manner in which potential acquired businesses or new projects will be structured and financed. 34 -------------------------------------------------------------------------------- Table of Contents • Develop and commercialize new technology. We believe that our efforts to protect and expand our business will be enhanced by the development of additional technologies in such fields as recycling, alternative waste treatment processes, gasification, combustion controls, emission controls and residue recovery, reuse or disposal. We have advanced our research and development efforts in some of these areas relevant to our EfW business, and have patents and patents pending for major advances in controlling nitrogen oxide ("NOx") emissions. • Advocate for public policy favorable to EfW and other sustainable waste solutions. We seek to educate policymakers and regulators about the environmental and economic benefits of energy-from-waste and advocate for policies and regulations that appropriately reflect these benefits. Our business is highly regulated, and as such we believe that it is critically important for us, as an industry leader, to play an active role in the debates surrounding potential policy developments that could impact our business. • Allocate capital efficiently for long-term shareholder value. We plan to allocate capital to maximize shareholder value by: investing in our existing businesses to maintain and enhance assets; investing in strategic acquisitions or development projects, when available; and by returning capital to our shareholders. • Maintain a focus on sustainability. Our corporate culture is focused on themes of sustainability in all of its forms in support of our mission. We seek to achieve continuous improvement in environmental performance, beyond mere compliance with legally required standards. EXECUTION ON STRATEGY Consistent with our strategy, we have executed on the following during the first nine months of 2014: Capital Access and Allocation During the first nine months of 2014, we: • increased our quarterly cash dividend by 39% to $1.00 per share on an annualized basis beginning in the third quarter of 2014; • executed agreements for project financing in September 2014 totaling €375 million to fund a majority of the construction costs of the Dublin Waste-to-Energy Facility (see discussion below under Asset Management); • borrowed $47 million under an equipment financing capital lease arrangement in August 2014 to purchase barges, rail cars, containers and intermodal equipment related to our contract with New York City; • issued $400 million of 5.875% senior notes due March 2024 to fund the repayment of $460 million of 3.25% Cash Convertible Notes which matured on June 1, 2014; and • amended our Credit Facilities to: • extend the termination date of our Revolving Credit Facility by two years from March 28, 2017 to March 21, 2019; • increase the aggregate amount of the Revolving Credit Facility by $100 million to $1.0 billion; and • lower the pricing on our Term Loan due 2019 by 0.25% from the prior rate. Asset Management, Development and Acquisitions Fairfax Energy-from-Waste Facility In April 2014, we entered into a waste disposal agreement with our client at the Fairfax EfW facility, extending our relationship under a tip fee arrangement effective at the end of the current service agreement in February 2016. The initial term of the new agreement will end in 2021, with two additional five year renewal periods upon mutual agreement of the parties. Beginning in 2016, the client will provide approximately 60% of the facility's waste capacity under the new agreement. York Energy-from-waste facility In May 2014, we extended the service agreement for the York EfW facility from 2015 to 2020 on substantially the same terms as the existing agreement. Niagara Energy-from-Waste facility At our Niagara EfW facility, we installed a new natural gas package boiler to augment the steam generation from our EfW boilers, as well as a steam line connection to new customers. The improvements, which began in 2012, were essentially completed by the second quarter of 2014 and the boiler became fully operational during the third quarter of 2014. Capital expenditures related to these improvements were approximately $4 million for the nine months ended September 30, 2014 and $13 million for the twelve months ended December 31, 2013. 35 -------------------------------------------------------------------------------- Table of Contents Indianapolis Energy-from-Waste Facility and Advanced Recycling Center In August 2014, we extended our existing waste disposal agreement with the City of Indianapolis from 2018 to 2028, under which it will continue to supply approximately 35% of the facility's waste capacity. The agreement also contemplates the construction and operation of an Advanced Recycling Center ("ARC") adjacent to our Indianapolis EfW facility, which will recover recyclables from mixed municipal solid waste using state-of-the-art sorting technology. Once necessary permits are received, we expect to invest approximately $45 million to build the ARC facility. Dublin Energy-from-Waste Facility In September 2014, we entered into an agreement with the Dublin City Council ("Dublin") to build, own and operate a new 600,000 tonne per-year, 58 megawatt facility in Dublin, Ireland (the "Dublin Waste-to-Energy Facility"). The project will source residential, commercial and industrial waste from Dublin and the surrounding areas and will sell electricity into the local electricity grid, with over 50% of the facility's generation expected to qualify for preferential pricing under Ireland's renewable feed-in tariff. We have commenced construction of the facility, which will take approximately three years to complete, with operational commencement expected in late 2017. We will operate the facility under a 45-year public-private-partnership, after which ownership of the facility will transfer to Dublin. Our total investment in the project is expected to be approximately €500 million, funded by a combination of third party non-recourse project financing (€375 million) and project equity (approximately €125 million). For additional information related to funding for this project, see Item 1. Financial Statements - Note 7. Consolidated Debt - Dublin Project Financing. Garco Industrial TSDF Acquisition In September 2014, we acquired Garco, Inc., a treatment, storage and disposal facility ("TSDF") located in Asheboro, North Carolina, specializing in the treatment, management, transportation and disposal of non-hazardous industrial waste and field/facility remediation projects. This acquisition is not material to our condensed consolidated financial statements and therefore, disclosures of pro forma financial information have not been presented. Durham-York EfW Facility We are constructing a municipally-owned 140,000 tonne-per-year EfW facility to be built in Clarington, Ontario, located in Durham Region, Canada. The project is expected to begin operations in early 2015, after which we will operate the facility under a 20 year contract. Organic Growth Investments During the nine months ended September 30, 2014, we invested approximately $29 million in various organic growth investments, primarily for the Niagara natural gas package boiler ($4 million), Essex particulate emissions control system ($12 million) and various metals recovery systems ($7 million). Nine Months Ended Growth Investments (in millions): September 30, 2014 Organic growth investments $ 29 New York City contract (intermodal equipment purchases and enhancements to existing facilities) 45 Total Organic Growth Investments and New York City contract $ 74 Cost Savings Initiatives In June 2014, we announced that we are implementing several initiatives to improve process efficiency and reduce ongoing expenses across our business. We are targeting cost savings that we expect to benefit Adjusted EBITDA by approximately $30 million in 2015. It is expected that the initiatives will not materially impact Adjusted EBITDA in 2014, as the costs of implementation will generally be expected to be offset by initial savings. The initiatives can be categorized under two broad themes: 1. Reducing costs of goods and services. This will be driven by: • New strategic procurement practices to further leverage our scale and purchasing power; and • A multi-year effort to increase labor efficiency during maintenance outages. This is planned to be accomplished with a combination of best practices, enhanced planning and modest capital investments. 2. Reducing staff during the second half of 2014 by improving process efficiency and implementing best practices including: • Upgrading and leveraging existing information technology systems to streamline processes; and • Centralization and reorganization of certain overhead functions, including accounting, finance, and procurement. 36-------------------------------------------------------------------------------- Table of Contents Business Outlook In 2014 and beyond, we expect that our financial results will be affected by several factors, including: market price movements, contract transitions, organic growth and acquisitions, and our ability to manage facility production and operating costs. Based upon current assumptions for market prices upon contract expirations, future contract transitions in the aggregate are expected to adversely impact our financial results; however, we expect that these impacts will be more than offset by the combined benefits of our organic growth initiatives, such as metals recovery systems and increased special waste revenue, cost efficiencies expected under our recently announced cost savings initiatives and our new contracts such as New York City and Dublin. Factors Affecting Business Conditions and Financial Results Economic - Changes in the economy affect the demand for goods and services generally, which affects overall volumes of waste requiring management and the pricing at which we can attract waste to fill available capacity. We receive the majority of our revenue under short- and long-term contracts, which limits our exposure to price volatility, but with adjustments intended to reflect changes in our costs. Where our revenue is received under other arrangements and depending upon the revenue source, we have varying amounts of exposure to price volatility. The largest component of our revenue is waste revenue, which has generally been subject to less price volatility than our revenue derived from the sale of energy and metals. Waste markets tend to be affected, both with respect to volume and price, by local and regional economic activity, as well as state and local waste management policies. Furthermore, global demand and pricing of certain commodities, such as the scrap metals we recycle from our EfW facilities, can be materially affected by economic activity. In recent years, metal markets have been less volatile. At the same time, United States natural gas market prices influence electricity and steam pricing in regions where we operate, and thus affect our revenue for the portion of the energy we sell that is not under fixed-price contracts. Energy markets tend to be affected by regional supply and demand, as well as national economic activity and regulations. At certain of our biomass facilities, lower energy prices combined with higher fuel prices have caused us to economically dispatch operations where continued operations are not currently profitable. We will continue to consider this practice. Seasonal - Our quarterly operating income within the same fiscal year typically differs substantially due to seasonal factors, primarily as a result of the timing of scheduled plant maintenance. We conduct scheduled maintenance periodically each year, which requires that individual boiler and/or turbine units temporarily cease operations. During these scheduled maintenance periods, we incur material repair and maintenance expenses and receive less revenue until the boiler and/or turbine units resume operations. This scheduled maintenance usually occurs during periods of off-peak electric demand and/or lower waste volumes, which are our first, second and fourth fiscal quarters. The scheduled maintenance period in the first half of the year (primarily first quarter and early second quarter) is typically the most extensive, while the third quarter scheduled maintenance period is the least extensive. Given these factors, we normally experience our lowest operating income from our projects during the first half of each year. Our operating income may also be affected by seasonal weather extremes during summers and winters. Increased demand for electricity and natural gas during unusually hot or cold periods may affect certain operating expenses and may trigger material price increases for a portion of the electricity and steam we sell. Performance - Our EfW facilities have historically demonstrated consistent reliability; in 2013 our average boiler availability was 92%. We have historically performed our operating obligations without experiencing material unexpected service interruptions or incurring material increases in costs. Across our fleet of facilities, we operate and maintain a large number of combustion units, turbine generators, and air and water-cooled condensers, among other systems. On an ongoing basis, we assess the effectiveness of our preventative maintenance programs, and implement adjustments to those programs in order to improve facility safety, reliability and performance. These assessments are tailored to each facility's particular technologies, age, historical performance and other factors. As our facilities age, we expect that the scope of work required to maintain our portfolio of facilities will increase in order to replace or extend the useful life of facility components and to ensure that historical levels of safe, reliable performance continue. For additional information about such risks and damages that we may owe for unexcused operating performance failures, see Item 1A. Risk Factors included in our Form 10-K. In monitoring and assessing the ongoing operating and financial performance of our businesses, we focus on certain key factors: tons of waste processed, electricity and steam sold, and boiler availability. Our ability to meet or exceed historical levels of performance at projects, and our general financial performance, is affected by the following: • seasonal or long-term changes in market prices for waste, energy, or ferrous and non-ferrous metals for projects where we sell into those markets; • our ability to operate at historic performance levels as our facilities age, and the extent to which our annual maintenance expenditures increase over time; 37-------------------------------------------------------------------------------- Table of Contents • our ability to avoid increases in operating and maintenance costs and unscheduled or extended outages while ensuring that adequate facility maintenance is conducted so that historic levels of operating performance can be sustained; • seasonal or geographic changes in the price and availability of wood waste as fuel for our biomass facilities; • seasonal, geographic and other variations in the heat content of waste processed, and thereby the amount of waste that can be processed by an EfW facility; • contract counterparties' ability to fulfill their obligations, including the ability of our various municipal customers to supply waste in contractually committed amounts, and the availability of alternate or additional sources of waste if excess processing capacity exists at our facilities; • our ability to extend or replace existing waste and energy contracts, and the extent to which prevailing market conditions result in decreased or increased pricing or adjustment of other terms under such contracts; • the success or lack of success in implementing our organic growth programs which are focused on growing our waste revenue, increasing our metal revenue, managing our assets and improving efficiency to reduce cost; • the extent and success of our construction activity and the timing of payments we receive for such activity; and • the availability and adequacy of insurance to cover losses from business interruption in the event of casualty or other insured events. General financial performance at our international projects is also affected by the financial condition and creditworthiness of our international customers and partners, fluctuations in the value of the domestic currency against the value of the U.S. dollar, and political risks inherent to the international business. Business Segment We have one reportable segment, North America, which is comprised of waste and energy services operations located primarily in the United States and Canada. Our EfW projects generate revenue from three main sources: (1) fees charged for operating projects or processing waste received, (2) the sale of electricity and/or steam, and (3) the sale of ferrous and non-ferrous metals that are recovered from the waste stream as part of the EfW process. We may also generate additional revenue from the construction or expansion of a facility when a municipal client owns the facility. Our customers for waste services or facility operations are principally municipal entities, though we also market disposal capacity at certain facilities to commercial and sustainable waste solutions customers. Our facilities sell energy primarily to utilities at contracted rates or, in situations where a contract is not in place, at prevailing market rates in regional markets (primarily PJM, NEPOOL and NYISO in the Northeastern United States). We also operate, and in some cases have ownership interests in, transfer stations and landfills (primarily used for ash disposal rather than municipal solid waste) that are ancillary and complementary to our EfW projects and generate additional revenue from disposal fees or operating fees. We currently operate EfW projects in 16 states and one Canadian province, and are constructing an EfW project in a second Canadian province. In September 2014, we entered into an agreement to build, own and operate a new energy-from-waste facility in Dublin, Ireland. Most of our EfW projects were developed and structured contractually as part of competitive procurement processes conducted by municipal entities. As a result, many of these projects have common features. However, each contractual agreement is different, reflecting the specific needs and concerns of a client community, applicable regulatory requirements and/or other factors. 38 -------------------------------------------------------------------------------- Table of Contents The following summarizes the typical contractual and economic characteristics of the three project structures in the North America segment: Service Fee Service Fee Tip Fee (Owned) (Operated) Number of facilities: 18 7 16 Client(s): Host community and municipal Host community, with Dedicated to host and commercial waste limited merchant community customers capacity in some cases exclusively Waste or Per ton "tipping fee" Fixed fee, with performance incentives and service inflation escalation revenue: Energy Covanta retains 100% Share with client revenue: (Covanta retains approximately 20% on average) Metals Covanta retains 100% Share with client revenue: (Covanta typically retains approximately 50%) Operating Covanta responsible for all Pass through certain costs to municipal costs: operating costs client (e.g. ash disposal) Project debt Covanta project subsidiary Paid by client Client responsible service: responsible explicitly as part of for debt service service fee After service N/A Covanta owns the Client owns the contract facility; clients have facility; extend expiration: certain rights set with Covanta or forth in contracts; tender for new facility converts to contract Tip Fee or remains Service Fee with new terms For a discussion of the common features to these agreements, as well as important distinctions among them, see Item. 1. Business in our Form 10-K. Our waste service and energy contracts expire at various times between 2014 and 2038. The extent to which any such expiration will affect us will depend upon a variety of factors, including whether we own the project and/or the real estate to which a contract relates, market conditions then prevailing, and whether the municipal client exercises options it may have to extend the contract term. As our contracts expire, we become subject to greater market risk in maintaining and enhancing our revenues. As service agreements at municipally-owned facilities expire, we intend to seek to enter into renewal or replacement contracts to operate such facilities. As our waste service agreements at facilities we own or lease expire, we intend to seek replacement or additional contracts, and because project debt on these facilities will be paid off at such time, we expect to be able to offer rates that will attract sufficient quantities of waste while providing acceptable revenues to us. At facilities we own, the expiration of existing energy contracts will require us to sell our output either into the local electricity grid at prevailing rates or pursuant to new contracts. We generated 82% of our waste and service revenues in the North America segment in 2013 under contracts at set rates, while 18% was generated at prevailing market prices. Over time, we will seek to renew, extend or sign new waste and service contracts in order to maintain a significant majority of our waste and service revenue (and EfW fuel supply) under multi-year contracts. We will pursue opportunities to enter into fixed contracts for energy generation as well; however, we expect that the percentage of our energy revenue sold under contract will decline as existing arrangements expire, thereby increasing our exposure to energy market prices over time. To date, we have been successful in extending a majority of our existing contracts to operate energy-from-waste facilities owned by municipal clients where market conditions and other factors make it attractive for both us and our municipal clients to do so. See the Execution on Strategy discussion above and Item 8. Financial Statements And Supplementary Data - Note 3. Acquisitions and Asset Management in our Form 10-K for additional information. The extent to which additional extensions will be attractive to us and to our municipal clients who own their projects will depend upon the market and other factors noted above. We expect that multi-year contracts for waste supply at facilities we own or lease will continue to be available on acceptable terms in the marketplace, at least for a substantial portion of facility capacity, as municipalities continue to value long-term committed and sustainable waste disposal capacity. We also expect that an increasing portion of system capacity will be contracted on a shorter-term basis, and so we will have more frequent exposure to waste market risk. In contrast, as a result of structural and regulatory changes in the energy markets over time, we expect that multi-year contracts for energy sales will generally be less available than in the past, thereby increasing our exposure to energy market prices upon expiration. As our existing contracts have expired and our exposure to market energy prices has increased we have begun entering into hedging arrangements in order to mitigate our exposure to near-term (one to three years) revenue fluctuations in energy markets, and we expect to continue to do so in the future. Our efforts in this regard will involve only mitigation of price volatility for the energy we produce, and will not involve speculative energy trading. 39 -------------------------------------------------------------------------------- Table of Contents Our 2014 projected mix of contracted and market-exposed energy generation is as follows: Projected Energy Megawatt Hours (MWh) At Full Year 2014E Market and Contracted by Facility Type (a) As of October 1, 2014 EfW At Market 0.9 Contracted & Hedged 4.7 Total EfW 5.6 Biomass (b) At Market 0.4 Contracted 0.3 Total Biomass 0.7 Total 6.3 (a) Covanta share only (b) Additional 0.3 million MWh of Biomass energy is economically dispatched, but available to run In conjunction with our EfW business, we also own and/or operate 18 transfer stations and four ash landfills in the northeast United States, which we utilize to supplement and more efficiently manage the waste supply and ash disposal requirements at our EfW operations. With respect to our sustainable service offered in addition to our EfW services, we expect to enter into a range of short- and longer-term contractual arrangements, depending upon the service sought by customers. RESULTS OF OPERATIONS The following general discussions should be read in conjunction with the condensed consolidated financial statements, the notes to the condensed consolidated financial statements and other financial information appearing and referred to elsewhere in this report. Additional detail relating to changes in operating revenues and operating expenses and the quantification of specific factors affecting or causing such changes is provided in the segment discussion below. During the fourth quarter of 2013, assets related to our development activities in the United Kingdom met the criteria for classification as Discontinued Operations and as such all prior periods have been reclassified to conform to this presentation. See Item 8. Financial Statements And Supplementary Data - Note 4. Dispositions and Discontinued Operations in our Form 10-K for additional information. The comparability of the information provided below with respect to our revenues, expenses and certain other items for the periods presented was affected by several factors. As outlined above under Overview - Execution on Strategy and in Item 8. Financial Statements And Supplementary Data - Note 3. Acquisitions and Asset Management in our Form 10-K, our business development initiatives, contract transitions, and acquisitions resulted in various transactions which are reflected in comparative revenues and expenses. These factors must be taken into account in developing meaningful comparisons between the periods compared below. The Results of Operations discussion below compares our revenues, expenses and certain other items during each of the years presented for continuing operations. The following terms used within the Results of Operations discussion are defined as follows: "Same store": reflects the performance at each facility on a comparable period-over-period basis, excluding the impacts of transitions and transactions. "Transitions": includes the impact of the expiration of: (a) long-term major waste and service contracts, most typically representing the transition to a new contract structure, and (b) long-term energy contracts. "Transactions": includes the impacts of acquisitions, divestures, and the addition or loss of operating contracts. 40 -------------------------------------------------------------------------------- Table of Contents |