Income-seeking investors sometimes find the best opportunities from market corrections and bear markets. Good businesses can be temporarily affected by economic slowdowns such as the one caused by the COVID-19 pandemic in 2020.
As share prices of these businesses fall, dividend yields can move into the 5% to 10% range, or even beyond. That's the case with Covanta (NYSE:CVA), the world's largest waste-to-energy provider. With its business segments recovering, Covanta's 7.25% yield might seem enticing, but investors need to be wary of its debt.
Helping the planet
Covanta may not be a well-known name, but it's been in the waste business since the 1980s. The company incinerates waste that can't be recycled, and turns it into energy used as electricity for homes and business, and steam for industrial use. Covanta also has an environmental solutions segment that helps businesses safely handle waste and meet sustainability goals.
The waste-to-energy business reduces 21 million tons of greenhouse gas emissions annually as the incinerated waste is kept from producing methane in landfills. It also generates enough electricity to continuously power 1 million homes, and recycles 550,000 tons of metal per year from its waste streams.
Though the company had minimal disruptions in its own operating facilities from the pandemic, the business was negatively affected in several other ways. Activity in its environmental services business dropped, energy production was lower along with the decreased operations of its customer base, and pricing was down along with that of energy and commodities. Covanta also entered 2020 with four growth projects in the U.K. under construction or in advanced development. Construction on its Scottish plant was suspended due to the pandemic, but has since resumed.
The company has reacted to the events with cost savings measures, including a reduction in its dividend by about two-thirds, lowered compensation, and a $400 million senior notes offering to replace higher-cost debt.
Investors cheered its recently reported third-quarter earnings results, as the company returned to profitability after reporting losses in the prior two quarters. But even with the recent uptick in the stock, shares remain down almost 40% since the start of 2020. That may be because even with the business recovering, investors are right to question if the reduced dividend is sustainable.
Mountain of debt
Covanta ended 2019 with almost $2.4 billion in long-term debt, and $63 million in cash and cash equivalents. Though it reported $140 million in 2019 free cash flow, the company estimated prior to the pandemic that that would be lower in 2020. As of Sept. 30, 2020, its net debt is up to more than $2.5 billion.
Though it has generated $84 million in free cash flow for 2020 through the third quarter, the dividend reduction and cost saving initiatives are estimated to account for about $90 million in fiscal year 2020. Third-quarter free cash flow was just $3 million.
Need for change
The company's board of directors recognized the need for a change. It announced a new strategic review of Covanta's operations and capital structure, along with a new president and CEO, with its third-quarter earnings announcement.
Chairman of the board Sam Zell said in the company's third-quarter conference call: "Everything will be on the table for review, including our asset and operations, growth priorities and capital structure."
Newly appointed CEO Mike Ranger discussed capital allocation priorities in the call. When questioned about future capital spending and the dividend, he responded rhetorically: "Are we allocating capital to keep plants running that are producing profitability that warrants that capital investment?"
Ranger didn't mention the dividend in his reply. Undertaking a strategic review likely will result in either asset sales, or adjustments to rid the company of inefficient operations. The executive change and review of capital allocation is a signal of changes to come. Until the balance sheet is also addressed, investors should be wary of investing to reach for the high dividend yield.